Tax, decentralisation and intergovernmental relations

“A career in politics is no preparation for government”, said one of the characters in the 1970s British TV comedy series, Yes Minister. They had a point. After all, to newly elected politicians, government seems to be set up as a testing and complex route for taking (or stopping) decisions and implementing policy.

Another episode of the series aptly shows the one economist in the entire country who truly understands the system for financing local government, a situation closer to reality than top officials around the world might care to admit. Being effective in government depends on navigating a complex multi-layered edifice, with different hierarchies, committees, and reporting structures within departments and ministries, and between national and local authorities. The French even call it a mille-feuilles (a thousand layers), after one of their delicately assembled–and sometimes messy to handle–cream pastries. 

Explaining exactly how these intergovernmental relations actually work is particularly problematic where taxation and public spending is concerned. The recent shutdown of the “non-essential” US federal government activities demonstrates the arbitrary way in which responsibilities across government can be distributed. School budgets, for instance, may reflect a patchwork of different national and local government funding sources.

The inherent gearing of subnational funding creates issues around transparency and accountability for decisions. Take a situation where only 10% of a subnational government entities budget is provided by local taxation: a cut of nearly 1% in transfers from central government gets translated into a local tax increase of 20% if local budgets are maintained. It is no surprise, then, that the relationship between local and national government can become very acrimonious. New, unfunded, statutory mandates that require extra spending on things such as the provision of further social care, education and health care, or even simply a cut in national budget transfers to subnational government tiers, require an offsetting and relatively large rise in local taxes or unpopular cuts in those local services where statutory provision requirements are less binding. A blame game often ensues.

Policymakers across the OECD and beyond constantly grapple with this maze of intergovernmental relations in their daily lives. And many want to reform it, in some cases to decentralise powers to local authorities, in others to recoup more tax revenue from local authorities for national spending. But would such moves improve or worsen effectiveness, and how can that be measured?

The 2013 International Tax Dialogue (ITD) global conference, which takes place in December, aims to help provide answers. It asks how taxation in the context of intergovernmental relations can be used to contribute to shaping countries’ development and improve the lives of their citizens. Before the Industrial Revolution in the late 18th century, economic structures and services were often primarily local, and not always well resourced. National governments’ primary concerns were skewed towards security, and in particular how to pay for war. Indeed, income tax in its modern form was introduced by the British in 1798 to pay for the Napoleonic wars.

But the Industrial Revolution also brought the rise of new cities. Finance was needed to support growth, targeting the likes of education, power, transport, water, and sewage infrastructure, the legacy of which can still be seen today. However, the responsibility for raising revenue and the decision making for this growing range of public services shifted to national governments, with subnational governments acting as administrative vehicles where government money was increasingly spent rather than raised.

Nowadays, there is a shift towards greater decentralisation of spending responsibilities in many countries. In the UK, for instance, local government now accounts for over a quarter of total government spending, but raises less than 5% of total tax revenue.

Ensuring a link between the beneficiaries of decisions relating to expenditure and a broad willingness to pay the taxes needed to fund them, and holding politicians accountable for the outcomes, are vital for effective democratic government. Yet the disconnect between expenditures and taxation responsibilities has few obvious solutions. Professor Richard Bird summed up traditional economists’ views when he wrote that that the taxes over which control could be best be passed to subnational government are but “slim pickings”. True, some countries such as the Latin American countries shown in our graph have reduced the subnational mismatch between spending and their own tax revenues.

But for many developed countries Professor Bird’s observation remains true. Indeed, the share of local and regional level tax revenue now as a percentage of GDP is a small fraction of national revenues in most countries. The Czech Republic, for instance, raised only 1.2% of total revenues at sub-central level in 2011. A handful of countries demonstrate that the opposite is possible. In Finland for instance, nearly a quarter of total tax revenues are the responsibility of local authorities, and not central government.

In short, real policy choices, such as adding a larger local element to national income taxes, do exist, and these can give subnational government more control over their own revenues. These choices deserve greater scrutiny. And, as Finland shows, they can apply to large and small developed countries, and perhaps to developing countries too. Sub-Saharan African countries typically raise less than 1% of GDP in tax revenue from sub-central levels, for instance, yet they face similar choices. However, they face additional constraints in terms of technical capacity and institutional shortcomings.

Centralised governments are not set up to address the myriad different situations that occur at the local level. Calls for decentralisation are likely to become louder, boosted by the recent global financial crisis, and in part a reaction against the globalisation which many people blame for the crisis. People want government structures to be more responsive to local needs. Different communities in different locations face different problems. These differences may be hard to discern from the centre. Innovative solutions, such as the creation of citizens’ budget committees which rely on more local input from households, businesses, and civil society may provide a way forward.

Decentralisation is a balancing act that must take factors such as the degree of development and urbanisation into account. A new Industrial Revolution is now taking place in many developing countries as existing cities become mega-cities and new ones spring up. This is putting relations between city and national governments to the test, as countries struggle with governance, planning, and tax revenue-raising needs thrown up by recent mass urbanisation, and the need to deliver services to an expanding middle class. The imperative of ensuring greener growth adds another layer of complexity in terms of which levels of government should do what. How much freedom should subnational governments have to determine local pollution taxes?

There is also the question of how far decentralisation can go before encountering diminishing returns. In small towns and villages people may well acquire more tax-raising and decisionmaking power, but fragmentation and weaker economies of scale could ultimately blunt their action. India has more than five times as many local government entities as China, but is this structural difference a consequence or a cause of underlying local conditions affecting the delivery of public services? At what point do any benefits from very localised and probing political accountability come at too high a cost in terms of basic efficiency?

Clear divisions in terms of accountability at all levels are vital if the potential benefits of decentralisation are to be realised. Since constitutional powers are relatively fixed, as is the geographic size of countries-and these are the key factors identified in academic literature as determining the extent of fiscal decentralisation-it is through ideas about the merits of decentralisation that future policy direction will be shaped. The International Tax Dialogue conference will be an important opportunity for ministers and officials at all levels of government to discuss and understand these issues, and help them make better choices and improve their own policymaking.

The views expressed are those of the author and should not be interpreted as a statement of the policy positions of the ITD partner organisations.

The 5th ITD global conference on tax and intergovernmental relations will take place in Marrakech, Morocco, from 3 to 5 December 2013. For further information, please visit the ITD website at www.itdweb.org/Tax-Intergovernmental-Relations/Pages/Home.aspx


Reference

Bird, Richard M. (2010) “Subnational Taxation in Developing Countries, A Review of the Literature”, Policy Research Working Paper 5450,The World Bank, October.

Please visit: www.oecd.org/tax/

© OECD Observer No 296 Q3 2013





Economic data

E-Newsletter

Stay up-to-date with the latest news from the OECD by signing up for our e-newsletter :

Twitter feed

Suscribe now

<b>Subscribe now!</b>

To receive your exclusive print editions delivered to you directly


Online edition
Previous editions

Don't miss

  • Africa's cities at the forefront of progress: Africa is urbanising at a historically rapid pace coupled with an unprecedented demographic boom. By 2050, about 56% of Africans are expected to live in cities. This poses major policy challenges, but make no mistake: Africa’s cities and towns are engines of progress that, if harnessed correctly, can fuel the entire continent’s sustainable development.
  • “Nizip” refugee camp visit
    July 2016: OECD Secretary-General Angel Gurría visits the “Nizip” refugee camp, situated between Gaziantep and the Turkish-Syrian border, accompanied by Turkey’s Deputy Prime Minister Mehmet Şimşek. The camp accommodates a small number of the 2.75 million Syrians currently registered in Turkey, mostly outside the camps. In his tour of the camp, Mr Gurría visits a school, speaks with refugees and gives a short interview.
  • OECD Observer i-Sheet Series: OECD Observer i-Sheets are smart contents pages on major issues and events. Use them to find current or recent articles, video, books and working papers. To browse on paper and read on line, or simply download.
  • Queen Maxima of the Netherlands gives a speech next to Mexico's President Enrique Pena Nieto (not pictured) during the International Forum of Financial Inclusion at the National Palace in Mexico City, Mexico June 21, 2016.
  • How sustainable is the ocean as a source of economic development? The Ocean Economy in 2030 examines the risks and uncertainties surrounding the future development of ocean industries, the innovations required in science and technology to support their progress, their potential contribution to green growth and some of the implications for ocean management.
  • OECD Environment Director Simon Upton presented a talk at Imperial College London on 21 April 2016. With the world awash in surplus oil and prices languishing around US$40 per barrel, how can governments step up efforts to transform the world’s energy systems in line with the Paris Agreement?
  • Happy 10th birthday to Twitter. This 2008 OECD Observer interview with Henry Copeland said you’d do well.
  • The OECD Gender Initiative examines existing barriers to gender equality in education, employment, and entrepreneurship. The gender portal monitors the progress made by governments to promote gender equality in both OECD and non-OECD countries and provides good practices based on analytical tools and reliable data.
  • Once migrants reach Europe, countries face integration challenge: OECD's Thomas Liebig speaks to NPR's Audie Cornish.

  • Message from the International Space Station to COP21

  • COP21 Will Get Agreement With Teeth: OECD Secretary-General Angel Gurría on Bloomberg

  • The carbon clock is ticking: OECD’s Gurría on CNBC

  • If we want to reach zero net emissions by the end of the century, we must align our policies for a low-carbon economy, put a price on carbon everywhere, spend less subsidising fossil fuels and invest more in clean energy. OECD at #COP21 – OECD statement for #COP21
  • They are green and local --It’s a new generation of entrepreneurs in Kenya with big dreams of sustainable energy and the drive to see their innovative technologies throughout Africa. blogs.worldbank.org
  • Pole to Paris Project
  • In order to face global warming, Asia needs at least $40 billion per year, derived from both the public and private sector. Read how to bridge the climate financing gap on the Asian Bank of Development's website.
  • How can cities fight climate change?
    Discover projects in Denmark, Canada, Australia, Japan and Mexico.
  • Climate: What's changed, what hasn't, what we can do about it.
    Lecture by OECD Secretary-General Angel Gurría, hosted by the London School of Economics and Aviva Investors in association with ClimateWise, London, UK, 3 July 2015.

  • Climate change: “We should not disagree when scientists tell us we have a window of opportunity–10-15 years–to turn this thing around” argues Senator Bernie Sanders.

  • In the long-run, the EU benefits from migration, says OECD Head of International Migration Division Jean-Christophe Dumont.
  • Is technological progress slowing down? Is it speeding up? At the OECD, we believe the research from our Future of ‪Productivity‬ project helps to resolve this paradox.
  • Is inequality bad for growth? That redistribution boosts economies is not established by the evidence says FT economics editor Chris Giles. Read more on www.ft.com.
  • Catherine Mann, OECD Chief Economist, explains on Bloomberg why "too much bank lending can slow economic growth".
  • Interested in a career in Paris at the OECD? The OECD is a major international organisation, with a mission to build better policies for better lives. With our hub based in one of the world's global cities and offices across continents, find out more at www.oecd.org/careers .

Most Popular Articles

Poll

What issue are you most concerned about in 2016?

Unemployment
Euro crisis
International conflict
Global warming
Other

OECD Insights Blog

NOTE: All signed articles in the OECD Observer express the opinions of the authors
and do not necessarily represent the official views of OECD member countries.

All rights reserved. OECD 2016