Updated December 1997
| Food and Agriculture Organization of the United Nations | United Nations Capital Development Fund | International Fund for Agricultural Development | German Agency for Technical Cooperation | Swiss Agency for Development and Cooperation | World Bank |
Rome
16-18 December 1997
Technical Consultation on Decentralization
Documentation
THE PURPOSE of this paper is to review the issues in designing of inter-governmental fiscal relationship and international finance institution's allocations for rural development. The paper is structured in such a way to discuss the intergovernmental fiscal arrangements in Pakistan and India in sections 1 and 2 respectively. This is followed by a general discussion in section 3 on the consequences of using different instruments of fiscal transfer on the behaviour and incentive of various government levels. Section 4 defines the structure of local taxes and issues of fiscal sustainability for benefit taxes. Section 5 will discuss the different mechanism to ensure financial control without undermining local autonomy. Finally section 6 discuss the implications of sequencing of decentralization strategies.
Compared to the share of different tiers of government in resource mobilisation, the allocation of functional responsibilities appears to be somewhat more balanced. The federal government incurs 74 percent of total recurring expenditure followed by provincial governments with 23 percent and local governments with 4 percent. The share of these governments in development expenditures, on the other hand, is 65, 29 and 6 percent respectively.
The inter-governmental fiscal transfers, is a prominent feature of the public finance structure of Pakistan. These transfers either take the form of revenue-sharing or grants and loans. In Pakistan financial resource transfers take place at four stages. First, from the federal government to the provincial government, second, from provincial government to the local governments, third, from federal to local, and fourth, from local to local governments.
The following types of flows of funds can be distinguished:
Provincial shares in the divisible pool are historically based on two parameters, i.e., population and collection. From population criterion the province of Punjab gets the highest share (57.97 %) followed by Sindh (23.34%), NWFP (13.39%) and Baluchistan (5.30%). The significance of these revenue transfers to the provinces has increased rapidly over time. In 1972-73 revenue sharing transfers financed 37% of the recurring expenditure of the provinces which increased in 1984-85 to 51% and by 1994-95 to 65%. Furthermore, to finance the recurring account deficits of the provincial governments, the federal government gives ad hoc subventions/grants. Initially these subventions/grants were given only to the tow backward provinces, namely, Baluchistan, and NWFP. But now all the provinces receive these revenue deficit grants. In 1974-75, such grants were 6% of the total provincial recurring expenditure. This has increased to 21% in 1994-95.
Also the development expenditure of the provincial governments is by and large, financed by the Annual Development Program (ADP) of the federal government. 90% of the overall ADP is distributed between the provinces on the basis of population while the remaining 10% is given to the two backward provinces, NWFP and Baluchistan.
Funds under the ADP are given both as grants and loans to the provinces. However, bulk of the allocations (around 95%) are given in the form of loans bearing an annual interest rate of about 14%. Repayment of these development loans constitutes the only form of transfer of funds from the provincial to the federal governments.
It is also important to note that the deterioration in the state of provincial finances, as reflected by the growing dependence on deficit grants, implies that their ability to support operations of local governments has become more limited. Clearly, unless there is a major change in fiscal relations between the federal and provincial governments and/or the fiscal effort of the latter improves, it will be increasingly difficult for the flow of funds to reach the local level.
Revenue sharing between the provincial and the urban local government primarily consists of property tax and betterment tax. Bulk of the revenues from these taxes is transferred to the relevant local government 85% of property tax (net of collection costs) to given to the local government in Punjab, Sindh, and Baluchistan, while the share is higher at 95% in NWFP.
No revenue-sharing presently exists between the provincial and the rural local governments.
The second fundamental difference in the fiscal transfers is the lack of access of local governments to revenue-deficit grants unlike the provincial govt. Grants-in-aid received from the Provincial governments are specific in nature and generally used to finance recurring expenditure on education, health etc. Any recurring deficits have to be financed by the local government itself.
Finally, while transfers from the provincial to the federal government consist only of debt servicing of loans taken from federal government, local governments make an additional transfer to provincial governments in the form of revenue from surcharges on local taxes. Such surcharges have been levied in NWFP and Punjab. In NWFP, there is a surcharge (education cess) of 12% on octroi, proceeds from which are transferred to the provincial government in entirety. In Punjab, the district local councils transfer 20% of the proceeds from local rate to the provincial governments. This tendency of the provincial governments to ride on the back of the local government is a unique feature of the public finance structure of Pakistan.
It appears, therefore, that during the last fifteen years while on the one hand the provincial governments dependence on federal government has increased both on the recurring and development account, local governments (both urban and rural), on the other hand, have had to rely more on their resources to discharge their obligations.
The lack of increase in financial support from provincial governments is attributable to the deterioration that has taken place in their financial position over time. The fact that since the budget of 1989-90, the federal government has placed a ceiling on the total flow of funds to the provinces means that the provincial governments will now have to exercise more economy in their expenditure. It is unlikely that under these conditions higher grants or revenue shares will be given by the provincial governments to the local govt. unless there is simultaneously a reduction in expenditure liabilities or an expansion in the revenue-sharing arrangements with the federal govt.
In the rural areas, transfer of revenue are more elaborate. Revenue-sharing takes place between the district and union councils in the provinces of Punjab and Sindh. Taxes shares are however, not the same across provinces. In Punjab district councils give 20% of the income from local rate and cattle fairs to the union councils. In Sindh, 25% of the total collection from export tax (net of collection costs) is transferred from the district to the union councils. Therefore, there is a growing tendency for the councils to evolve revenue-sharing arrangements at the local level. If this contributes to a degree of fiscal equalisation then it will lead to some reduction in the extent of spatial inequality in access to services.
According to Article 160 of the 1973 Constitution, the President of Pakistan is expected to constitute a NFC every five years to make recommendations on the distribution between the federation and provinces of the net proceeds of divisible pool taxes (as specified by the President), the making of grants-in-aid, and exercise of borrowing powers by the provinces. Three NFCs were constituted in 1979, 1985, and 1996 but no consensus could be reached among the provinces on the distribution formula.
The NFC Award of 1991 expands the size of the divisible pool of taxes to include two additional taxes, excise duties on tobacco and tobacco manufacturers and sugar. These taxes are to be shared between the federation and the provinces on a 20:80 basis and distributed among the provinces on the basis of population. The award also transfers proceeds from development surcharge on natural gas, royalty on crude oil and net profits on hydel power generation to the province on collection basis. This large increase in the quantum of revenues to be distributed on the basis of collection makes the 1991 award unique in the history of inter-governmental fiscal relations in the country.
On top of this, special annual grants of Rs.700 million for five years to Sindh, one billion to Punjab, Rs.200 million to NWFP and Rs.100 million to Baluchistan for three years each has also been announced.
Table 1 gives the revenue sharing formulae from 1937 to National Finance
Commission Award 1991. Recently the government of Pakistan has announced
another award, NFC 1997. However, few provinces has registered their complaints
against the award, picture is still not very clear. Of course, the consequences
and impact of this award is yet to be seen, therefore, we have discussed
the consequences of NFC 1991 award on the following macro-variable.
| Tax Head | Niemyer Award 1937 | Raismon Award 1951 | NFC 1962 | NFC 1964 | NFC 1970 | NFC 1974 | NFC 1991 |
|---|---|---|---|---|---|---|---|
| Income tax | 50% | 50 | 50 | 65 | 80 | 80 | 80 |
| Sales tax | - | 50 | 50 | 65 | 80 | 80 | 80 |
| Central excise on tea, tobacco & betel nut | - | 50 | 60 | 65 | 80 | - | 80 |
| Export duty on jute & cotton | 62.5 | 62.5 | 100 | 65 | 80 | 80 | 80 |
| Royalty on excise duty on gas | On Collection Basis | ||||||
| Development surcharge on gas | -do- | ||||||
| Royalty on crude oil | -do- | ||||||
| Profit from hydro-electricity | -do- |
1.4.1 Regional imbalances
Though the NFC 1991 award has benefitted all the four provincial governments in Pakistan, the extent of benefit varies significantly across provinces. For example, the biggest province Punjab is among the major beneficiaries while a less developed, backward province - NWFP has gained the least. This anomaly is perhaps a consequence of the lack of innovation in the revenue sharing formula and the exclusion of important considerations like backwardness, urbanisation land area etc. This situation has been exacerbated by the special grant structure announced which reverses the earlier practice when special grants were given to the two smaller provinces largely in recognition of their relative backwardness. If this imbalance on the recurring side is to be removed and horizontal equity across provinces ensured in future, it is important that development transfer to the provinces through the ADP should be based on an improved formula which takes into account regional imbalances so that the improvement in provincial finances can be sustained overtime.
1.4.2 Decentralisation
The NFC Award 1991 represents can be seen as a big step forward in the process of decentralisation in Pakistan. However, for the process of decentralisation to be meaningful, along with the purse strings, regulatory controls will also have to be released by the federal government. As such, there is a strong case for winding up of federal ministries in areas like education, health, housing, agriculture, local government and rural development, etc., which essentially relate to provincial functions. Instead, inter-provincial coordination functions could largely be performed by the Planning Commission.
Simultaneously, all functions in the concurrent list of the Constitution which had been taken over by the federal government should be transferred back to the provinces. This includes university education, fertilizer subsidy, flood control SCARP projects, highways, etc. Not only will this strengthen the provincial governments but it will also relieve the federal budget of the burden of expenditure on these functions. Given the improved financial position of the former they should be in a position to take on all functions constitutionally allocated to them.
On top of all this, it can be argued, that the process of decentralisation and devolution of functions will be incomplete if simultaneously the relationship between the provincial and local governments is also not altered. Hitherto, the former have not only encroached on the functions of the latter but they have also preempted their fiscal powers. After 1991 the provinces are better off financially, they should be willing to establish a system of grants and revenue-sharing arrangements with local governments in taxes like motor vehicles tax, professions and callings tax, etc, and involve them increasingly in the provision of local service like primary education, curative health, law and order, etc. Strengthening of local governments is the last remaining step in the process of decentralisation. Without this, the goal of involving people in the management of their affairs will remain largely unfulfilled.
1.4.3 Fiscal effort
Despite the change in the pattern of inter-governmental fiscal relations brought about by the NFC, there iwas the danger that the provinces may slacken further their fiscal effort and increase their current expenditure more rapidly to absorb the short run surpluses that they will enjoy following the award. Given the macro resource constraints that the country faces it was important that the provinces also economise on resources and play a role in the mobilisation of additional resources.
The NFC Award has made reference to the recommendations of the Tax Reforms Committee regarding generation of higher revenues from provincial source. The Committee had demonstrated that provincial own revenues can be almost trebled in theee years by exploration of the revenue potential that currently exists in sources like the property tax, motor vehicle tax, irrigation charges, stamp duties, etc.
Even in the absence of discretionary changes in divisible pool taxes by the federal government, the overall surplus on the revenue account of the four provinces combined in 1991-92 was Rs.7 billion. If this amount was used in the development purposes the future tax capacity of the provinces would have been increased. But in all provinces , with different degree, the surplus was used for non-development purposes. For this reason after two years of NFC award provincial budgets again went in deficit. Also, an incentive mechanism may be instituted in the ADP allocations to the provinces whereby matching development grant are given to provinces equal to the additional revenues generated by them from their respective taxation proposals. This will ensure that the higher taxation is translated into higher level or better provision of services. The provinces will then find it politically more attractive to develop their own sources. However, this feature was absent from the said award.
In conclusion, it can be said that the NFC Award of 1991 represents a big step forward in the process of decentralisation in the country. It rationalises inter-governmental fiscal relations and not only improves the financial position of the provinces but also gives them considerably more autonomy. However, the full benefits could not be reaped, because the provinces were not motivated to mobilise their own resources and the process of decentralisation down to the level of the local governments was not achieved.
1.5.1 Expenditures
Analysis of the fiscal state of local government indicates that, by and large, local governments have a budgetary surplus. Also, in general, 60 to 70 percent of their total expenditure is devoted to the maintenance of existing services. Development authorities are, by and large, self financing bodies primarily involved in the development of infrastructure, particularly land. But water and sanitation agencies are generally facing overall budgetary deficits. Over 83 percent of the total recurring expenditure of the local governments is in the urban areas which account for about 30% of the total population. The relatively small share of rural areas testifies to the fact that levels of service provision are low compared to the urban areas. On the service side, major heads of recurring and development expenditure of the local councils are water supply, public health, roads and street lighting, education land curative health.
The average per capita recurring expenditure in local councils is Rs. 90. Per capita expenditure in the rural areas is generally lower than Rs.15 indicating a significant difference in the level of expenditure between the urban and rural areas of the country. On the development side, per capita expenditure by local councils is much lower, generally below Rs.50/-. It appears that though provision of physical infrastructure has higher priority in the urban areas, greater importance has been attached to social infrastructure in the rural areas.
Eleven different flows of funds have been identified from different levels of government for development of local services. Six emanate from the provincial ADP while three are from the federal ADP, Execution of most of these programmes lies with the local and provincial governments while maintenance responsibilities rest almost exclusively with the former.
1.5.2 Revenues
The overall municipal tax/GDP ratio for the urban and rural areas is 1.39 and 0.24% respectively. The low magnitude of the ratio in the rural areas implies that the rural areas are relatively undertaxed by local governments. Tax-to-income buoyancy of urban and rural municipal taxes is estimated to be 1.02 and 1.98 respectively implying that both urban and rural tax collections have exhibited a faster growth than income between the period 1979-80 and 1992-93. The high overall buoyancy of municipal taxes is a consequence of the relatively high fiscal effort of the local governments and the buoyant nature of the tax bases. In case of property tax the high level of buoyancy of octroi collection in Karachi and Quetta can be attributed to the presence of an ad valorem structure as opposed to specific rates generally in the country.The only slow-growing tax base is that for the tax on transfer of property, both in the urban and rural areas.
1.5.3 Sources of local revenues
Octroi tax is the single largest source of revenue for the urban local councils, accounting for about half of total receipts. Other important sources include the property tax and tax on transfer of immovable properties. Among the important rural taxes are export tax, tax on transfer of immovable property and local rate. Grant-in-aid and development grants are generally of miner importance both in the case of urban and rural local council.
1.5.4 Tax administration
A major proportion of the revenue collection responsibility of local councils
has been handed over to private contractors who generate 68% of revenues
in the urban and 50% in the rural areas. Overall cost of municipal tax collection
is 6% of revenues. It tends to be significantly higher for smaller cities/towns.
| Share % | |
|---|---|
| Punjab Local Provincial Federal TOTAL | 43 48 09 100 |
| Sindh Local Provincial Federal TOTAL | 54 39 07 100 |
| N.W.F.P Local Provincial Federal TOTAL | 40 52 08 100 |
| Baluchistan Local Provincial Federal TOTAL | 66 28 06 100 |
The inefficiencies in the context of the privatisation of collection for both export tax and octroi can be tackled by ensuring the competitiveness of the auctioning process of contractors.
Reluctance to extend rating areas, regressivity of the assessment formula and low frequency of assessment have been identified as major issues in the context of property tax administration. A case can also been made to handover collection responsibilities to the local councils in the larger cities.
1.5.5 Sharing of taxes of local origin
Taxes in which the nominal and effective burden falls within a local jurisdiction have been defined as taxes of local origin. According to this definition some of the important federal taxes which are of a local origin are personal income tax, wealth tax and gift taxes. Important provincial taxes of local origin are motor vehicle tax, professional, trade and callings tax, entertainment tax, part of stamp duty, and land revenue.
Estimates show that 50% of revenues from taxes of local origin accrue to the provincial government, 7% to the federal government while the remaining 43% remain with local governments. Contrary perhaps to expectations, the share of revenues from taxes of local origin taken away by higher levels of government is substantially higher in rural areas (73%) compared to the urban areas (52%).
Revenue sharing between provincial and local governments is very limited, and restricted to the property tax in urban areas and virtually no sharing in rural areas.
Wherever there is an overlap in fiscal powers, provincial governments have preempted the common taxes. This includes the tax on professions, trades and callings, the motor vehicle tax and the entertainment tax.
The deteriorating financial position of provincial governments has meant that these government have not only encroached on local fiscal powers overtime but also the flow of funds in real per capita terms to the local governments had tended to decrease.
Unlike the federal government, provincial governments have shown a tendency to ride on the back of a lower level of government. For example, the provincial government of NWFP levies surcharge (education cess) on octroi.
A large proportion of the revenues from taxes of local origin is, in fact, taken away by higher levels of governments, especially the provincial governments. Contrary to expectations, the share of resources transferred from the rural areas is greater.
In recent years, some revenue-sharing arrangements have been established among the local governments, especially in the rural areas. For example, district councils have started giving a share of the local rate or export tax to the UCs.
In conclusion we can say that the fiscal position of local councils are relatively satisfactory. This is a very viable institution and has all potentials to be very effective in the provision of many services which can be characterised as essential in any civilised society. For this purpose however, the federal and provincial governments have to change their attitude towards local government, more fiscal autonomy must be given to local government and more justifiable revenue sharing with lower government must be developed. To control any irregularity in the use of fiscal power, new arrangements must be framed.
| Finance Commission | Federal Income Tax | Federal Excise Duty | |
|---|---|---|---|
| I | 1952-58 to 1956-57 | 55 | 40 |
| II | 1957-58 to 1961-62 | 60 | 20 |
| III | 1962-63 to 1965-66 | 66.7 | 20 |
| IV | 1966-67 to 1968-69 | 75 | 20 |
| V | 1969-70 to 1973-74 | 80 | 20 |
| VI | 1974-75 to 1978-79 | 85 | 20 |
| VII | 1979-80 to 1983-84 | 85 | 40 |
| VIII | 1984-85 to 1988-89 | 85 | 45 |
| IX | 1989-90 to 1994-95 | 85 | 45 |
Regarding the criteria for sharing among states of net proceeds of federal income tax and excise duty, during the period 1952-53 to 1983-84 distribution of revenues from both taxes was predominantly based on total population size. The seventh and the eight awards, however, considerably reduced the importance of total population and the state's income became the major determinant of its' revenue share. The most important factor, called the distance factor, influencing distribution is the average difference in a state's per capita income from the highest per capita income. 50% of excise duty revenues were distributed on this basis during the period 1979-80 to 1988-89 while 45% of the income tax revenue are the average difference in a state's per capita income from the highest per capita income. 50% of excise duty revenues were distributed on this basis during the period 1979-80 to 1988-89 while 45% of the income tax revenue are being distributed on this basis since 1984-85. Another criterion reflecting the state's total income, introduced by the Eighth FC, is the IATP size. This is estimated by multiplying the three year average per capita income of the state by its total population.
The significance of the inclusion of state's tax collection in determining its revenue share has historically being recognised in India by all FCs. 10% to 20% of tax revenues continue to be distributed on this basis since 1952. The current award has also included backwardness in determining a state's revenue share.
In all, it appears that revenue sharing in India has been based on four broad criteria: (i) the general need of the region (population factor has been used as a proxy); (ii) existing financial capacity of the state; (iii) its contribution to the national exchequer in terms of tax collection; and (iv) its level of development (captured through backwardness and percentage of poor).
First reason in favour of allocation of means and responsibilities rest on the assumption that one government level is relatively efficient in collection of revenue or disbursement of expenditure. For example national government operate in relative open economic environments and may be efficient to undertakes major expenditures projects, but may be inefficient to undertaken small projects. Also national government, usually have reasonable infrastructure and efficient tax machinery to collect major taxes, but may be economically inefficient to collect smaller taxes. Sub-national level government on the contrary may not have necessary infrastructure and therefore, unable to collect larger taxes and may be very efficient to collect taxes of small and local base. Therefore, the allocation of means and responsibilities must be based on the efficiency criterion.
The second reason is based on the fact that subnational governments may lack the resources needed to finance basic levels of local public service that may be regarded as the minimum requirement for civilized existence.
The third reason in favour of allocation is based on the assumption that state and local voters may be unable to agree on the appropriate mix of benefits received and ability-to-pay elements in the taxes needed to finance the programs they desire.
The fourth reason of the allocation of governmental functions and means is that the services whose externalities does not confined to the boundaries of an individual state or services whose costs and benefits cannot be aligned area-wise within a state, should be allotted to the centre. On the other hand, services whose provision requires an accommodation of local peculiarities, needs and aspirations should be in the hands of the states.
The fifth reason that can also be advocated for the allocation among different governments is known as adequacy of revenues. By adequacy we meant not only a capacity of a level of government to produce a given initial amount of revenues but also its capacity to sustain it in such a manner as to permit the maintenance of a given volume and quality of governmental services.
The sixth reason is that there is a case of sharing of other taxes which are 'sub national' in character but has been preempted by higher levels of government.
Musgrave (1983) gives some additional criteria for the allocation.
First criterion for fiscal transfer is that the fiscal transfer from national government should not intervene in the decision making process of the sub-national governments. The sub-national government should be autonomous to introduce their own tax rates and cesses on central taxes irrespective what they receive in the form of divisible pool and grants.
The second important criteria for this transfer is that the revenue means of the sub-national government should be adequate to discharge their designated responsibilities. This implies that the allocated funds should vary directly with fiscal need factors and inversely with the taxable capacity of each subnational government.
The third criterion state that the fiscal transfer should be based on the constitutional arrangement to make sure certainty in the transfer. Even the grants must be based on the predetermined formulae. The fourth criterion `efficiency' argues that the grant from higher government should not distort the choices of resource allocation and the types of activity of lower government.
The fifth criterion `simplicity' argues that the transfer formulae should be simple and easy to comprehend by all concerned parties.The sixth criterion states that the proposed transfer plans should provide incentives for better fiscal management and discourage inefficient practices.
The seventh criterion states that in the case of specific grant there should
be a mechanism to ensure that these grants are properly utilized. These
cataria may be in conflict with each other and therefore a grantor may decide
his priorities while comparing policy alternatives.
3.3.1 Divisible pool
The first and foremost instrument of fiscal transfer from national to sub-national government is the constitutional requirement of distribution of government's revenue pool. There are two important issues arises in the discussion of divisible pool, first what taxes and non-taxes should constitute the divisible pool and second, how this pool should be distributed among all governments.
Regarding the first issue it can be argued that all taxes which fall within the fiscal power of two levels of government are included in the divisible pool and efficiency criteria should be used for the collection purposes. If one level government collects the revenues and then it is be transfer to the other government. This raises the problems of sincerity in the efforts and the accountability. For example in Pakistan both Excise duty and sales tax may be impose. Excise duty was not part of the divisible pool whereas sale tax was, since the revenue collection, equity and efficiency of both taxes are same, the federal government always used to prefer sales taxes to impose.
The second important problem arises in intergovernmental transfer is that If national government transfer revenues from divisible pool it will increase the permanent income of the subnational and that in turn will affect both the revenues and expenditures pattern. There are several possible scenario arises, first, increase in transfer through divisible pool might slacken the fiscal efforts of subnational governments. Second, increase transfer may also change the expenditure pattern and it is more likely to increase nondevelopment expenditures. In both cases the fiscal deficit of subnational government will persist and have the tendency to increase further. If the increased transfer is being used for development purposes then it will increase the tax potential of subnational governments in future and subsequently needs less grant.
Regarding the second issue of fiscal transfer, that is, how the tax pool should be distributed among the national and sub-national governments. Generally following formulae are used for the revenue sharing.
3.3.2 Grants
The second instrument of revenue transfer from national to sub-national governments comprises of grants. There are several types of grants through which resources shifts from federal to local government. Among them are block grant, matching grant, specific or categorical grant and deficit grant.
A non-matching block grant can be used for any purposes. But usually in most of the developing countries, it is being used to pay the salaries of the employees of the councils. Matching or non-matching specific grants are those which are provided by the federal government for specific purposes with or without raising the matching fund by the local government. Generally the purpose of the specific grant is productive and known as development grant and given for education and health purposes.
Matching specific grants may give an incentive to the local government to generate own resource to attract matching grant. However, the benefits of the matching grant are regressive in nature as the richer local councils have more access to matching grants. The matching grant especially the open-ended matching grants can increase the supply of public goods by the lower level government. This also tackle the problem of benefits externalities. This situation arises when one local government finance and provide a service but it benefits also the residents of the other local council which do not contribute in financing of the service.
Matching grants are more effective than the block grant. This happens because the block grant has only income effects but the matching grants have both income and substitution effects. For example if the higher government is providing matching grants for education, then the local government will provide more education because, first, due to income effects of grant this local council is richer now, and second due to the substitution effects now the education is cheaper commodity than other services.
It is believed that due to the matching requirements of conditional grants the sub-national governments often induce to neglect activities that do not receive Federal funds in favour of those that are Federally supported. In such a way it "distort" the budgets of state and local governments by inducing changes in the expenditure patterns. However, the matching grant may be frame in such a way that lower-level governments should respond to Federal grants, not by "distorting" at least their development expenditures.
The third type of grant is known as the deficit grant. This grant is provided by the national government to the sub national government, if their budget are in deficit. The purpose of this grants is to fill the deficit of the lower government, therefore, naturally it has the tendency to have adverse impact on the fiscal efforts of the sub-national government.
For the sake of discussion and with the courtesy of Shah (1993) we summarizes below the main principles to deal with the fiscal gaps of subnational government through different types of fiscal arrangement.
For any tax proposal to be sustainable, the built-in-elasticity/buoyancy is the most important characteristics. In this regard it is very important to know whether the growth in any tax can be attributed to an expanding tax base or whether it is primarily the consequence of improved fiscal efforts arising from improvement in tax administration, broadening of effective tax base and discretionary changes in tax rates. This will help the policy maker to make taxes buoyant and that can be sustained into the foreseeable future. This also requires an identification of the tax base of each major taxes and its actual and potential growth.
Buoyancy of a tax gives the responsiveness of its revenue yield to changes in income. It is defined as the percentage in total yield (or yield of individual taxes) associated with a given percentage change in GDP (or relevant component of GDP). The magnitude of the buoyancy coefficient which is the product of tax-to-base buoyancy and base-to-income buoyancy depends on the level of tax rates, the progressively of the rate structure, whether tax rates are specific or ad-valorem in character and the change in the tax base due to changes in income. High magnitude of the tax-to-base buoyancy coefficient are an index of fiscal effort. The fiscal effort can only be sustainable if the tax base is diversified, frequent escalation resorted to in tax rates, and scope for improvement in tax administration should be exploited to the full extent.
The provincial government should play regulatory role in the discharge of financial function by local councils. The approach must, however, be one of standardization and improvement of procedure and not of exercising control. Also in the case of smaller local council the role should be supportive rather than controlling in nature. This require following measures:
Even in the context of development programs, it will be difficult for councils to fully implement the large number of schemes. Therefore, joint provision by both provincial and local governments will continue to be the only viable strategy except that the latter's share could be increased somewhat. It can be argued that the financial arrangement that could be used to implement the decentralization program should consist of specification of shares (increasing over time) of the local councils in the provincial ADP allocations for sectors which are being decentralized.
Therefore, financing of the increased involvement of local councils should come through specific development grants from the provincial ADP. It can be suggested that the technical capability of the local government department be strengthened to provide the necessary extension services, especially to smaller urban and rural councils, and to expedite the process of technical sanctions. In addition, financial information systems and project monitoring and evaluation activities will have to be strengthened at the provincial level to ensure successful implementation of the decentralization program.
It is necessary also that the recurrent cost implications of the decentralization program be worked out to ensure its sustainability. This should meet by local councils through his resource mobilization strategy, If, however, this is not the case then additional recurring grants-in-aid from provincial government may be required.
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