metadata: authors: 0: author: Shah,Anwar M.
count: World
docna: 0: docna: Public services and expenditure need
            equalization : reflections on principles and worldwide
            comparative practices
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Adjustment and Lending,Health Care Services Industry,Disability,Public Sector Economics,Educational Sciences,Public Finance Decentralization and
            Poverty Reduction,Law and Justice Institutions
teratopic: Public Sector Development,Macroeconomics and Economic Growth,Urban Development,Finance and Financial Sector Development
abstracts: cdata!: This paper reviews the conceptual
            challenges as well as lessons from worldwide experiences in
            implementing public services and expenditure need
            compensation in fiscal equalization transfers with a view to
            developing guidance for practitioners. The paper concludes
            that while in theory a strong case for a comprehensive
            fiscal equalization can be made, in practice fiscal need
            equalization as part of a comprehensive equalization program
            introduces significant complexity. This works against the
            simplicity, transparency and general acceptability of the
            program. This does not imply that fiscal need equalization
            should be abandoned in the interest of simplicity and
            transparency. Instead simplicity, transparency and local
            autonomy are preserved by having fiscal need equalization
            through public service oriented (specific purpose block
            transfers) output based fiscal transfers that impose no
            spending requirements for any functions or objects of
            expenditures. Such transfers contrast with traditional
            earmarked transfers, which impose conditions on spending for
            specific purposes or objects of expenditure and subsequent
            verification/certification of such expenditures. Such
            output-based block transfers would further enhance citizen
            based accountability for results and thereby offer potential
            for enhancing public confidence and trust in government operations.
repnme: repnme: Public services and expenditure need
            equalization : reflections on principles and worldwide
            comparative practices
display_title: Public services and expenditure need
            equalization : reflections on principles and worldwide
            comparative practices
listing_relative_url: /research/2012/03/15954847/public-services-expenditure-need-equalization-reflections-principles-worldwide-comparative-practices
topicv3: Education m1327048 470,Fiscal Decentralization m1327382 829,Mortality m1504365 3661,Health m1504661 3480,Disability m1583873 4215
publishtoextweb_dt: 2012-03-01T00:00:00Z
historic_topic: Public Sector Development,Macroeconomics and Economic Growth,Urban Development,Finance and Financial Sector Development
no_of_pages: 37
author_keys: 0: author_key: 93058
model_extractions: WPS6006 Policy Research Working Paper 6006 Public Services and Expenditure Need Equalization Reflections on Principles and Worldwide Comparative Practices _Anwar Shah_ The World Bank East Asia and the Pacific Region Poverty Reduction and Economic Management Unit March 2012
Policy Research Working Paper 6006

# **Abstract**

This paper reviews the conceptual challenges as well as lessons from worldwide experiences in implementing public services and expenditure need compensation in fiscal equalization transfers with a view to developing guidance for practitioners.

The paper concludes that while in theory a strong case for a comprehensive fiscal equalization can be made, in practice fiscal need equalization as part of a comprehensive equalization program introduces significant complexity. This works against the simplicity, transparency and general acceptability of the program. This does not imply that fiscal need equalization should be abandoned in the interest of simplicity and transparency. Instead simplicity, transparency and local autonomy are preserved by having fiscal need equalization through public service oriented (specific purpose block transfers) output based fiscal transfers that impose no spending requirements for any functions or objects of expenditures. Such transfers contrast with traditional earmarked transfers, which impose conditions on spending for specific purposes or objects of expenditure and subsequent verification/certification of such expenditures. Such output-based block transfers would further enhance citizen based accountability for results and thereby offer potential for enhancing public confidence and trust in government operations.

This paper is a product of the Poverty Reduction and Economic Management Unit, East Asia and the Pacific Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank. org. The author may be contacted at shah.anwar@gmail.com.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Public Services and Expenditure Need Equalization: Reflections on Principles and Worldwide Comparative Practices**

_Anwar Shah, World Bank_ (shah.anwar@gmail.com) Key words: Fiscal need, expenditure need, equalization, intergovernmental fiscal transfers, financing subnational expenditures JEL codes: R51, H71, H75 Sector Boards: PS, HD, SD, URBAN
# **Public Services and Expenditure Need Equalization: Reflections on Principles and Worldwide Comparative Practices**

_Anwar Shah, World Bank_<sup>_1_</sup> (shah.anwar@gmail.com)

## **1. Introduction**

Fiscal equalization transfers are conceptually justified on fiscal efficiency and regional fiscal equity grounds. Political imperatives to have a shared sense of political and economic union, paves the way for instituting such transfers in most large especially federal countries. There is also a common consensus that conceptually such transfers should equalize to a specified standard both the fiscal capacities and fiscal needs. In practice, implementing such a comprehensive system of equalization transfers represents a difficult challenge especially the difficulties posed by the objective measurement of expenditure needs. This paper reviews the conceptual challenges as well as lessons from worldwide experiences in implementing public services and expenditure need compensation in fiscal equalization transfers with a view to developing guidance for practitioners.

This paper concludes that while in theory a strong case for a comprehensive fiscal equalization can be made, in practice fiscal need equalization as part of a comprehensive equalization program introduces significant complexity which works against the simplicity, transparency and general acceptability of the program. This does not imply that fiscal need equalization should be abandoned in the interest of simplicity and transparency. Instead simplicity, transparency and local autonomy are preserved by having fiscal need equalization through public service oriented (specific purpose block transfers) output based fiscal transfers that impose no spending requirements for any functions or objects of expenditures. Such transfers contrast with traditional earmarked transfers, which impose conditions on spending for specific purpose or object of expenditure and subsequent verification/certification of such expenditures. Such output-based block transfers would further enhance citizens‘ based accountability for results and thereby offering potential for enhancing public confidence and trust in government operations.

The rest of the paper is organized as follows. Section 2 presents conceptual justification of equalization transfers. Section 3 discusses practical considerations in designing fiscal need equalization transfers. Section 4 provides a brief survey of international practices in fiscal needs equalization. Section 5 discusses practical difficulties in equalizing expenditure

> 1  Paper  presented  at the International Conference on  ̳Service Standards and Financial Equalization in Decentralized Countries: International Evidence and Perspectives for Italy, July1, 2010, Bocconi University, Milan, Italy. This is a revised and expanded  version of an earlier paper that was presented at the 2007 Copenhagen Workshop on Measuring Local Government Expenditure Needs. The views expressed in this paper are those of the author alone and should not be attributed to the World Bank. Comments may please be addressed to:   shah.anwar@gmail.com

2
needs with special emphasis on the pioneering work done in Australia. Section 6 discusses output-based transfers as a simpler and better alternative to expenditure need equalization. A final section presents concluding remarks.

# **2. Bridging the Fiscal Divide through Fiscal Equalization Transfers – Conceptual Considerations**

Fiscal equalization transfers are advocated to deal with fiscal inefficiency and fiscal inequity concerns arising from decentralized decision making (Boadway, 2007). These transfers are also justified on political considerations. Large regional fiscal disparities can be politically divisive and may even contribute to the threats of secession (Shankar and Shah 2003). This threat is quite real: since 1975 about 40 new countries have been created by the break-up of existing political unions. Fiscal equalization transfers could potentially forestall such threats and create a sense of political participation, as demonstrated by the impact of such transfers on the separatist movement in Quebec, Canada.

Decentralized decision making results in differential net fiscal benefits (imputed benefits from public spending minus tax burden) for citizens depending on the fiscal capacities of their place of residence. This leads to both fiscal inequity and fiscal inefficiency in resource allocation. Fiscal inequity arises as citizens with identical incomes are treated differently depending on their place of residence. Fiscal inefficiency in resource allocation results from people in their relocation decisions comparing gross income (private income plus net public sector benefits minus cost of moving) at new locations; economic efficiency considerations warrant comparing private income minus moving costs only without any regard to public sector benefits. A nation that values horizontal equity (the equal treatment of all citizens nationwide) and fiscal efficiency needs to correct the fiscal inequity and inefficiency that naturally arise in a decentralized government. Grants from the central government to states and/or local governments can eliminate these differences in net fiscal benefits if the transfers depend on the tax capacity of each state relative to others and on the relative need for and cost of providing public services. The more decentralized the tax system is, the greater the need for equalizing transfers. Boadway (2007) notes that differential net fiscal benefits may also arise in regional/local policy choices in response to local preferences. Such differentials, however, should not be considered for equalization purposes.

The elimination of net fiscal benefits requires a comprehensive fiscal equalization program that equalizes fiscal capacity (the ability to raise revenues from own bases using national average tax rates) to a national average standard and provides compensation for differential expenditure needs and costs due to inherent cost disabilities rather than differences that reflect different policies. Some economists argue that if public sector tax burdens and service benefits are fully capitalized in property values, the case for fiscal equalization transfers is weaker, as residents in rich states pay more for private services and less for public services and vice versa in poorer states. According to this view, as argued by Oates (1982), fiscal equalization is a matter of political taste. This view gained currency at the federal level in the United States and explains why there is no federal fiscal equalization 3
program there. In contrast, local fiscal equalization drives most state assistance to local governments in the USA, especially school finance. Conceptually, full capitalization requires a small open area with costless mobility. Most federations and even states in large countries do not fulfill this condition. As a result, criticism of fiscal equalization using the capitalization argument may have only weak empirical support (Shah, 1988a).

# **3. Designing Fiscal Need Equalization Transfers: Alternate Approaches**

The case for fiscal equalization rests on eliminating different net fiscal benefits across states that give rise to fiscally induced migration. Such differential net fiscal benefits can arise as a result of decentralization of taxing authority and decentralized public expenditures. Differences in the demographic composition of the population across jurisdictions will result in differential needs for decentralized public services, such as education, health and social welfare. Differences in age distribution affect the need for schools, hospitals, and recreational facilities. Differences in the incidence of poverty and disease may affect the need for education, training, health, social services, and transfer payments. Jurisdictions with higher need factors would have greater need for revenues to provide comparable levels of public services at comparable levels of taxation. These need differentials are likely to cause substantial variations across jurisdictions in the level and mix of public goods provided, resulting in different net fiscal benefits A strong case for equalization can be established on grounds of efficiency and equity to compensate for need differentials that give rise to different net fiscal benefits.

The fiscal federalism literature treats differential costs as synonymous with differential needs, but some cost differences may arise from deliberate policy decisions by sub national governments rather than differences in need. Boadway (2004) argues that even for inherent cost disadvantages, such as differences between urban and rural areas, the equity advantage of more equal provision must be weighed against the efficiency costs. If it is more costly to deliver public services in rural areas than urban areas, it is inefficient for an equalization program to neutralize these cost differences. Even in unitary states, the level of public services in remote, rural, or mountainous areas is usually lower than in more densely populated urban areas. Under a decentralized fiscal system, a policy choice must be made about minimum standards, but there is no justification for providing the same level of services in remote and urban areas, as, for example, the Australian fiscal need equalization program does for its Northern Territories. Instead, as Boadway suggests, one could stratify locations in all regions by their costs and equalize across regions within comparable strata. Equalization grants should partially offset only inherent disabilities, disregarding cost differences that reflect deliberate policy decisions or differences in the efficiency with which resources are used.

In practice, expenditure need is more difficult to define and derive than fiscal capacity. The difficulties include defining an equalization standard; understanding differences in demographics, service areas, populations, local needs, and policies; and understanding strategic behavior of recipient states. Despite these formidable difficulties, numerous attempts have been made to measure expenditure need. The approaches can be broadly 4
classified into three main categories: (a) ad hoc determination of expenditure needs, (b) representative expenditure system using direct imputation methods, and (c) the theorybased representative expenditure system.

# **_(a) Ad hoc determination of expenditure needs_**

This approach uses simple measures of expenditure needs in general-purpose transfers. The factors used and their relative weights are arbitrarily determined. Germany uses population size and population density adjustments, China uses the number of public employees, and India uses measures of backwardness.

# **_(b) The representative expenditure system using direct imputation methods (RES-DIM) or the standardized cost approach (RES-SCA)_**

This approach seeks to create a parallel system on the expenditure side to the one given by the representative tax system on the revenue side. This is done by dividing sub national expenditures into various functions, determining total expenditures by each jurisdiction for each function, identifying relative need/cost factors, assigning relative weights using direct imputation methods or regression analysis, and allocating total expenditures of all jurisdictions on each function across jurisdictions on the basis of their relative costs and needs for each function (see Table 1 adapted from Barati and Szalai, 2000), for a compilation of need factors used in European countries and Table 2 for need factors used in grant financing of health care worldwide).

The advantage of this approach is that it obviates the need for the very elaborate calculations and assumptions needed to quantify the provision of services at some defined level. It does so by using the sum of actual total expenditures as the point of departure for measuring expenditure needs, reducing the problem to one of allocating total need among sub national governments on the basis of selected indicators of need, including proxies for need if desired. The disadvantage of this approach is that it does not necessarily exclude expenses incurred by any of the provinces that go beyond the concept of a ―reasonable level of public service.‖ However, the approach can be adjusted to exclude identifiable excesses from total expenditures (for example gold standards for some services or relatively unaffordable benefits provided by some rich states) in respect of which needs are to be allocated.

The following hypothetical example illustrates the treatment of welfare expenditures using a crude approach for establishing expenditure needs under a representative expenditure system. Assume that there are 10 states in Grantland, that the unit costs of welfare are equal in all states, and that needs for welfare vary based on the percentage of the working-age population that is unemployed, the percentage of the population that is not of working age, and the percentage of families with a single parent. The independent grants commission assigns a 40 percent weight to the percentage of the working-age population that is unemployed, a 35 percent weight to the percentage of the population that is not of working age, and a 25 percent weight to the percentage of families with a 5
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# **Table  2.  Need Factors Used for Grant Financing of Health Care in Selected Countries**

_Country name_ _Need Factors for Health Care Grants_ _(a) Need based top-up for health care in general grants_ Belgium Age, gender, unemployment, disability Finland (to local governments) Age, disability, remoteness, local tax base Germany Age, gender Netherlands Age, gender, urbanization, income base Switzerland Age, gender, region, income _(b) Need-based specific purpose transfers for core health services_ Denmark Age, children of single parents England Age, sex, mortality, unemployment, elderly living alone France Age Italy (two-thirds) Age, gender, mortality Northern Ireland Age, gender, mortality, low birth weight Norway (50 percent) Age, gender, mortality, elderly living alone Portugal (15 percent) Burden of illness: diabetes, hypertension, AIDS, tuberculosis Scotland Age, gender, mortality, rural costs Spain Cross-boundary flows Sweden Age, living alone, employment status, housing Wales Age, gender, mortality, rural costs _(c) Health transfers using composite indexes based upon principal component analysis_ Brazil Infant mortality, 1–64 mortality, 65+ mortality, mortality rate by infectious and parasitic diseases, mortality rate for neoplasia, mortality rate for cardiovascular conditions, adolescent mother percentage, illiteracy percentage, percentage of homes without sanitation, percentage of homes without running water, percentage of homes without garbage collection.

South Africa Percentage female; percentage children under 5; percentage living in rural area; percentage older than 25 without schooling; percentage unemployed; percentage living in traditional dwelling, shack or tent; percentage without piped water in house or on site; percentage without access to refuse disposal; percentage without access to phone; percentage without access to electricity; percentage living in household headed by a woman.

_Source_ : World Bank (2006).

7
total for the second factor, and 2.2 percent of the total for the third factor. State _A_ ‘s estimated need for a standard level of welfare expenditure would then equal: $5 billion x (0.048 x 0.40) + (0.03 x 0.35) + (0.022 x 0.25) = $176 million, or 3.2 percent of all state expenditures.

Shah (1994a) provides an application of the approach using provincial-local expenditure functions for Canada and uses quantitative analysis in selection and weighting of factors for various expenditure functions (see Table 3).

**Table 3 :  Weighting of factors for  provincial-local expenditure functions for Canada**

|Expenditure Category|Need/Cost Factors<br>Relative Weights|
|---|---|
|Transportation &|Snowfall (Annual - in centimeters) SNOW<br>0.1020|
|Communications|Highway Construction Price Index (HCPI)<br>0.6580|
||Paved roads and streets per square kilometer of area (RSPR)<br>0.0005|
||Non-cultivatable area as a proportion of total area (NCAR)<br>Total<br>0.2357<br>1.0000|
||Index = (0.10*ISNOW +0.66*IHCPI + 0.0005*IRSPR +<br>0.24*INCAR)*ISRP|
|Post-Secondary Education|Full time enrollment in grade 13+(000)(PSS)<br>0.048|
|(PSE)|Percentage of Population having a minority language as mother<br>tongue (ML)<br>0.19|
||Provincial Unemployment Rate (UR)<br>0.018|
||Education Price Index (EPI)<br>0.717|
||Help Wanted Index (HWI)<br>0.010|
||Foreign Post-Secondary Students (FPS)<br>0.017|
||Total<br>1.000|
||Index = (0.18*IPSS + .70*IML + .08*IUR + .04*IFPS)*IHWI*IEPI|
|Elementary and Secondary|Population under 18 (PO17)<br>0.014|
|Education (ESE)|Population Density (PD)<br>0.017|
||Education Price Index (EPI)<br>0.969|
||Total<br>1.000|
||Index = (.02*IPD + .98*IEPI)*IP017|
|Health (HE)|Alcoholism (Hospital separations for Alcohol related cases)<br>(ALCO)<br>0.123|
||Urban Population (PU)<br>0.877|
||Total<br>1.000|
||Index = (0.123*IALCO + 0.877*IPU)|
|Social Services (SS)|Single Parent Families (SPF)<br>1.00|
|Police Protection|Criminal Code Offenses (CCO)<br>0.39|
||Proportion of Population in Metropolitan (PMAR) Areas<br>0.61|
||Total<br>1.00|
||Index = (.39*ICCO + .61*IPMAR)|
|General Services (GS)|Private sector wages (Industrial composite) (AMW)<br>0.769|

8
|Percentage of population having a minority language as mother<br>tongue (ML)|0.001|
|---|---|
|Population Density (PD)|0.023|
|Population (POPF)|0.039|
|Snowfall (Annual - in centimeters) (SNOW)|0.168|
|Total|1.000|
|Index = (. 001*ML + 0.175*ISNOW + 0.80*IAMW + .024*IPD)*IPOPF||

Note: Calculations based on regression coefficients. The use of a variable prefixed by I means that a relative index of the variable is used. Source : Shah (1994a).

This approach is subjective and therefore potentially controversial. Recent experience in Australia vividly demonstrates the problems that arise if such an approach is followed in practice as discussed in the following section. Some subjectivity and imprecision can be alleviated by using quantitative analysis in choosing factors and weights as done in Denmark, Finland, Japan, Netherland and Norway and termed as the ―standardized cost‖ approach. However, these refinements add multiple layers of complexity.

# **_(c) The theory-based representative expenditure system (RES-TB)_**

The theory based representative expenditure attempts to implement conceptually desirable view of expenditure needs equalization objectively i.e. localities to be compensated for inherent cost disabilities rather than differences that reflect different policies, preferences and differential fiscal capacities. This means that the influences of these latter factors must be isolated. By doing so, the representative expenditure system can be significantly improved. This is done by using a conceptual framework that embodies appropriately defined concept of fiscal need and properly specified expenditure functions that are estimated using objective quantitative analysis, as proposed by Shah (1996) for Canada. Under this refined approach, the so-called _the theory-based representative expenditure system_ , the equalization entitlement from expenditure category _i_ equals the per capita potential expenditure of jurisdiction _A_ for category _i_ based on own need factors if it had national average fiscal capacity _minus_ per capita potential expenditure of jurisdiction _A_ on expenditure category _i_ if it had national average need factors and national average fiscal capacity. The formula for equalization entitlement based on expenditure classification _i_ for state x could be stated as follows: where _EE_<sup>_i_</sup> _x_<sup>is the equalization entitlement for expenditure classification</sup><sup>_i_for state</sup><sup>_x_,</sup> _POPx_ is the population of state _x_ , _PCSE_<sup>_i_</sup> _x_<sup>is the per capita standardized expenditure by</sup> state _x_ on expenditure classification _i_ (or the estimated amount the state would have spent to meet actual needs if it had national average fiscal capacity), and _PCSE_<sup>_i_</sup> _na_<sup>is the</sup> national average per capita standardized expenditure for classification _i_ . This is the estimated expenditure for all states, based on national average values of fiscal capacity and need. The equalization entitlement for a particular expenditure classification could be positive, negative, or zero. The total of these entitlements in all expenditure categories is 9
considered for equalization. This approach in practice has not been used by any country as of this date in equalization grant application. This is understandable due to the complexity of this approach.

A comprehensive system of equalization determines the overall entitlement of a state by considering its separate entitlements from the representative tax system and the representative expenditure system. Only states with positive net entitlements are eligible for transfers of all or some fraction of the total amount, with the fraction determined by the central government based on the availability of funds.

This approach is even more difficult to implement than the less refined approach of the RES-DIM/SCA used in many OECD countries, but it has the advantage of objectivity and it enables the analyst to derive measures based on actual observed behavior rather than ad hoc value judgments. The relative weights assigned to various need factors and their impact on allocation of grant funds are determined by econometric analysis. Furthermore, this approach yields both the total pool and the allocation of fiscal need equalization grants among recipient units. This method requires specifying determinants for each service category, including relevant fiscal capacity and public service need variables. A properly specified regression equation yields quantitative estimates of the influence each factor has in determining spending levels of a category of public service. This information can be analyzed to determine what each local jurisdiction would actually have spent if it had national average fiscal capacity and but actual need factors. This then can be compared to the standard expenditure for each service based upon an evaluation of the same equation for determining what each local jurisdiction would have spent if it had the national average fiscal capacity and also national average need factors. The sum of differences of these two expressions for all expenditure categories would determine whether or not the local jurisdiction had more (if sum was positive) or less than the average needs (if sum was negative) (see Shah 1996 for a Canadian application of this approach).

# **4. The Practice of  Equalizing Expenditure Needs: A Review of Worldwide Experiences**

A number of countries use expenditure needs equalization in grant allocation. In this section, we review selective experiences to draw some general lessons. Countries are grouped by a stylized view of their approach to expenditure need determination.

# **_(a) Ad hoc approaches to determining expenditure needs_**

_Canada_ Federal fiscal equalization program is solely focused on fiscal capacity equalization to a specified standard. A recent Government of Canada Panel studied the desirability and feasibility of introducing expenditure need compensation in the equalization formula but concluded against its introduction to preserve transparency and objectivity of the system (see Canada, 2006). However, to compensate for expenditure needs, equal per capita 10
block federal transfers are made available to provinces to finance health and postsecondary education with conditions on minimum service standards and access and no condition on spending and no federal oversight on provincial spending on assisted services. Federal transfers to the three territories nevertheless take expenditure needs into account in a crude manner by simply adjusting base year expenditure per capita by the average growth in provincial spending.

<mark>The Canadian provinces use simple measures of expenditure need in their generalpurpose transfers to municipalities These include population size, population density, population growth factors, road length, number of dwelling units, location factors (such as northern location), urbanization factors (primary urban population and urban/rural class) and social assistance payments (see Shah 1994b). One of the more sophisticated of these approaches is taken by Saskatchewan, where the standard municipal expenditure of a class of municipalities is assumed to be a function of the total population of the class. Regression analysis is used to derive a graduated standard per capita expenditure table for municipal governments by population class. In general simpler approaches used by the Canadian provinces have proven to be manageable and less controversial. Service specific need variables are also considered in provincial specific purpose transfers to local governments (Shah, 1983, 1994).</mark>

# _Germany_

Germany uses an ad hoc approach in determining expenditure needs. Lander-local transfers in Germany use a number of expenditure need factors in allocating lander transfers to local governments. The most important factor is weighted local population size with weights that progressively increase with the population size of the jurisdiction. Landers of Hesse and Saarland also give higher weights to local jurisdiction with population size smaller than 5000 inhabitants. In addition to weighted population, a majority of landers use additional factors such as military forces, police officers, children, pupils/students, area, roads, and regional income (―regional centrality‖), growth rate, health resort and mining. Factor weights are arbitrarily determined (see Otter, 2008).

# _Italy_

Italy‘s 2001 Constitution identifies health and social protection as ―essential services‖ minimum levels of which must be provided at the regional level. This is interpreted to mean that there must equalization of expenditure needs to enable regional governments to meet minimum standards of such services. For the remaining regional and local services, constitution seems to imply that fiscal capacity equalization without an explicit consideration of expenditure needs would be fine. Subsequent national legislation has extended these essential services to a still undefined list of municipal and regional functions (see Brosio and Piperno, 2008, p.143). While this issue, remains to be clarified, currently VAT is allocated among regional governments based upon fiscal capacity and expenditure needs. For this purpose, expenditure needs are disaggregated by health and non-health needs. Health needs are primarily determined either by using population or population weighted by age groups for various health services such as outpatient services, 11
inpatient care, and public health promotion and prevention programs. For non-health needs, information on factors used is not available but in the past population or service area received primary consideration (see Brosio and Piperno, 2008 for details).

# _<mark>South Africa</mark>_

<mark>South Africa uses expenditure need factors in its equitable share transfers to the provinces (South Africa 2006). The equitable share formula applicable for 2006–08 focuses almost entirely on need factors, with only a 1 percent weight given to negative needs (per capita GDP). The formula uses the following shares:</mark>

- <mark>A basic share (14 percent weight) is derived from each province‘s share of the national population.</mark>

- <mark>An education share (51 percent) is based on the size of the school-age population (5–17) and the average number of learners (grades R–12) enrolled in public ordinary schools over the past three years.</mark>

- <mark>A health share (26 percent) is based on the proportion of the population with and without access to medical aid.</mark>

- <mark>An institutional component (5 percent) is divided equally among the provinces.</mark>

- <mark>A poverty component (3 percent) is based on incidence of poverty.</mark>

- <mark>An economic output component (1 percent) is based on data on GDP by region.</mark>

# _Switzerland_

Switzerland introduced cost equalization component financed solely by the Federal Government in the Federal Equalization Program introduced in 2008. It allocates about 18% of the total pool using the need/cost factors, the remaining 82% are distributed by the fiscal capacity component based upon factor incomes. The cost factors used are: population size, population density, area, population 80 plus years, large cities, foreign adult residents for more than 10 years, unemployed, and people requiring cantonal assistance.

# _United States of America_

USA has no formal federal-state and federal-local fiscal equalization program for reasons outlined earlier but state transfers to local governments take both fiscal capacity and expenditure need into consideration – the latter mainly in specific purpose block transfers such as school finance (see Box 1).

**____________________________________________________________________________________**

12
## **Box 1,  Financing Schools in the United States**

U.S. states have taken various approaches to school finance. The states of Hawaii, Idaho, and Washington fully finance primary and secondary education. In contrast, New Hampshire covers only 9 percent of school finance.

Delaware and North Carolina finance education through bloc grants that are indexed to population, GDP, and inflation growth rates. The grants are derived by calculating equal amounts per unit based on the number of students, teachers, classrooms, courses, classes, and other factors. The units can be standardized using various yardsticks, such as class size and teacher:pupil ratios. Various measures of students, including enrollment, average daily attendance, enrollment weighted by grades, types of programs, and number of students with special needs, are used.

Other states use equalization grants, including foundation grants, percentage equalization grants, and district power equalization grants.

_Foundation grants_ vary inversely with the fiscal capacity of a school board. The grant allocation is based on an application of the representative tax system approach to fiscal capacity equalization per student across school districts. The following formula is used: foundation grant = (maximum per student grant – own school district contribution per student based on mandated minimum tax rate applied to per student tax base)  enrollment Forty-two states have adopted variants of this approach, with 22 states specifying the minimum mandated tax rate. Various measures are used to determine enrollment, including the number of students on the rolls on a specified date, average daily attendance, and average attendance over a period. Most states (36) use a scheme that weights enrollment by grade, program, and student disabilities.

Rhode Island uses a _percentage equalization grant_ —a matching cum equalization grant for school spending based on the following formula: grant per student = [1– matching rate x (per capita tax capacity in the district/ state average district tax capacity per capita)]  district spending per capita _District power equalization grants_ , used in Indiana and Washington, include incentives for increased tax effort in an equalizing grant. The formula used is:

> grant = (per capita average fiscal capacity – per capita fiscal capacity of the district)  district tax rate

_Source_ : Vaillancourt (1998).

____________________________________________________________________________________

# **_(b) Representative expenditure system/ standardized cost approaches_**

# _Australia_

A sophisticated variant of this methodology is used by the Commonwealth Grants Commission (CGC) of Australia, which simply equalizes what all states on average actually spend. The CGC defines standard expenditure as the cost of supplying average performance levels for the existing mix of state-local programs. Relative expenditure needs are then determined empirically using direct imputation methods for 41 state-local expenditures. The use of expenditure need factors is extensive. Several hundred factors specific to 41 areas of expenditures in three broad categories are used: (a) scale factors; 13
(b) demographic factors – these include dispersion, urbanization, social composition and age structure; and (c) environmental factors including physical and economic factors (see Table 4).

**Table 4. Costs/Need Factors Used in the Australian Expenditure Need Calculations**

|**_Factors_**|**_Justification _**|
|---|---|
|**Indigenous influences**|Higher cost of services|
|**Socio-demographic**<br>**composition**|Effects of age, sex, cultural and linguistic diversity,<br>income and cross-border use of services|
|**Wage levels**|Wage differentials across states|
|**Other input costs**|Costs of office rent and electricity, interest costs,<br>isolation from major sources of supply, retirement<br>benefits|
|**Administrative scale of**<br>**service provision**|Effects of sub-optimal service area and population|
|**Urban influences**|Effects of urban complexity, urban traffic<br>management, urban transit capital and pricing<br>subsidies|
|**Population dispersion**|Net<br>effects<br>of<br>population<br>dispersion<br>and<br>geographical location on hospital costs and patient<br>transport|
|**Economic Environment**|Effects of structure and nature of state economies,<br>road use, availability of private medical services,<br>national capital region etc.|
|**Physical Environment**|Effects of climate, natural hazards, conservation<br>tasks, water availability, physical environment,<br>road and bridge length|
|**Expenses - other**|Miscellaneous factors, and interaction among<br>factors|

Source: Spasojevic, 2008 State-local transfers in Australia follow the CGC methodology and are faced with similar measurement issues although the degree of difficulty may be considerably less as local governments in Australia have extremely limited expenditure responsibilities i.e. mainly roads and rubbish.

# _Denmark_

Denmark uses a variant of the representative expenditure system approach where statistical analysis aids in identifying need factors that are further scrutinized for their incentive effects. Demographic factors (population by age groups with the highest weight for school age population and commuting time) with are assigned 70% of the weight whereas socio-economic factors receive 30% weight (see Table 5) ( Mau, 2008).

14
|Denmark|DE|Norway|Norway|Netherlands|BL|
|---|---|---|---|---|---|
|Expenditureneedscotena<br>|Weight<br>|Expenditure needs cotena|Week<br>|Expendieneedsofena|Weight<br>|
|Age<br><br>|Pat.||pet<br>||pet<br>|
||of|||||
|rt)|a2|<br>Agegroups||Dwellzs|i4|
|17-19|Ll|<br>15|33|||
|34|20|615|30.8|Ageenoup(0-19years|10|
|15-34|a4|1%|1|||
|35-38|19|7-79|i]|Localregionalfimetions|6|
|4|17|B08|a3|||
|65-74|43|80yearsormare|49|Highdensity|Q|
|75-84|5,6|||||
|&5years ormare<br>|a8|16-39 years divarced.<br>|a8<br>|Low mncome mdtviduals|5|
|Commingtime<br>|LA|16-39yearsunemployed<br>|1<br>|Socialcashbenedts|5|
|<br>2-50 yearsummemploved<br>= 37."<br>|54|<br>Commuting time<br>||)<br>|<br>Social support|5|
|2440 withoutvocationaltamme*<br>|i)|Traveldistance T<br>|1a<br>|Minorities|4|
|Renteddwellmz*<br>|1|Traveldistance1<br>|Ll<br>|Regional resional fictions|3|
|Peychiatric patiemts*<br>|Ls|Mantality<br>|a5<br>|Pupilssecondary education|3|
|Families mn certain types of devellmgs*<br>|45|Single67yearsormore<br>|a5<br>|Selected pirysical features.|17|
|(Children<br>ofpoorlyedacatedparents*|45|Inigo|O53|Populatoncharacteristics|7|
|||16yearsormorementallyhandicapped|a)|||
|Single<br>marethan65yearsold*|O7|||Taxcapacity|-20|
|<br>Low income mdtviduals*<br>|3.0|‘Lessthan 16 yearsmentallyhandicapped<br>|0-4<br>|<br>(Others|6|
||LS|||||
|||<br>Rumal districts|05|||
|Tnumigrants and descendants*|OF|||||
|Mamiberoflivingyearslost*|O7|||||
|Declme im populations mammber*|O7|||||
|Tak|100,0||10,0||1000|
# _Japan_

Japan uses a ―standard cost‖ approach per unit of service for 24 local service functions in determining the expenditure needs of local governments. Expenditure need for each service is determined by applying average cost to the service units in each local government multiplied by an adjustment coefficient. Unit costs are average unit cost for the nation as a whole and are obtained by dividing net costs (gross costs minus earmarked revenues) by the number of measurement units. These calculations are done by the Ministry of Internal Affairs and Telecommunications. The modification coefficient takes into account the size of the municipality with smaller municipalities having an adjustment factor greater than one. A few example of such calculation are reported below (see Mochida, 2008, p.177): Fire/ambulance service: Standard unit cost x population x adjustment factor Roads improvement: standard unit cost x road length (km) x adjustment factor Elementary school; standard unit cost x number of classes x adjustment factor Welfare for the elderly: standard unit cost x population 65 and older x adjustment factor

# _Netherlands_

Expenditure need allocation for the Municipal Fund is based upon the ―difference analysis‖ (Huigsloot, 2008, p.106). For this purpose 14 clusters of local services are analyzed for cost differences among municipalities due to exogenous factors. First municipal expenditures are corrected for any differences in definitions and recording of expenditures. Then statistical analysis is carried out to isolate contributions of exogenous and endogenous factors in contributing to cost differences. A deliberative political and policy review process is then used to decide on the choice of exogenous factors for formula allocation for each of the 14 service categories from among those identified by statistical analysis (see <mark>Table 5</mark> for the types of indicated selected and see Huigsloot, 2008 for further details).

# _Norway_

The General Purpose Grant Scheme in Norway incorporates expenditure need equalization consideration due to ―involuntary production costs‖ (costs attributable to exogenous factors) among municipalities and counties. Statistical analysis is carried out separately for counties and municipalities to identify objective exogenous factors (see <mark>Table 5</mark> for factors and weights) and municipalities and counties with below average expenditure needs contribute to the grant pool and above average expenditure needs receive from the pool (Lilleschulstad, 2008). Mostly demographic and travel time factors are used in expenditure needs determination.

16
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Source: Tingvall, 2008

# _United Kingdom_

General purpose transfers to local governments in the UK are distributed through the Local Government Finance Settlement comprising (a) revenue support grant; (b) redistributed business rates; and (c) Police Grant. The overall system is termed as the Formula Grant (FG). The FG is calculated as follows: FG= Relative Needs (RN) _minus_ Relative Resources (RR) _plus_ central per head allocation (CA) and _plus/minus_ stabilization (floor damping) adjustment (SA) RN is determined by classifying local expenditures into 6 major service groups: children‘s services, adults‘ personal social services, police, fire, highway maintenance, environmental, protective and cultural services. Population, social, economic and physical characteristics of each local authority are used as indicators of need. An attempt is made to keep these indicators to a manageable level. Fixed costs of all services are also taken into consideration. RR is calculated separately for four separate groups (upper tier services, lower tier services, fire authorities, police authorities) of authorities by examining a local authority‘s (LA) tax base per capita against minimum LA tax base per capita. CA is determined residually as the balance of central grant after compensating for needs. SA adjustment is made to ensure that all LAs receive a guaranteed minimum increase in grant over the previous year (see Ponsford, 2007 for further details).

Overall, the UK uses an objective method to assess fiscal capacities and somewhat subjective methods to assess expenditure needs.

# **5. Practical Difficulties in Implementing Expenditure Needs Equalization with Special Emphasis on the Australian Experience**

The previous section highlighted international practices in determining expenditure needs. We observed that these approaches over time have grown in their rigor and complexity in their attempts to achieve a better handle on differential expenditure needs attributable to exogenous factors. Is all this effort worthwhile? We draw upon a half a century of the Australian experience to reflect on this question as most of these approaches have replicated a variant of various models developed initially by the Commonwealth Grant Commission (CGC) for Australia. In view of the demonstration effect of the work by the CGC worldwide, it is useful to review the Australian approach to draw lessons from the Australian experience.

The overall approach in assessing expenditure needs used by the CGC is highly data and subjective judgment intensive. Continuous refinements over time to accommodate opposing points of view have led to super complexity and non-transparency. Further, the approach assumes that costs are independent of management paradigm and resource use is independent of incentives. As an example, expenditure need for government secondary 18
education is determined separately for government and non-government schools. A mixture of actual and notional enrollments is used with special weights for diplomatic families. Student populations from disadvantaged groups are given weights ranging from 1.1 to 1.7. Year 11 and 12 grades receive 20% upward adjustment in costs. Factors used in expenditure need determination include, administrative scale, administrative input costs, service delivery scale, urban influences, humanitarian refugees, cross border students, vandalism, dispersion, isolation, school input costs, wages, accommodation, electricity, rural students and isolation factors. Somewhat different factors and factor weights are used for government and non-government schools. If private schools have above average costs, additional grants are assessed although the state may or may not finance such education.

The Australian system seeks absolute comparability for all 41 state-local services rather than just merit goods (some would question whether this is worth pursuing). Australia‘s Commonwealth Grants Commission makes these calculations using broad judgments and sampling services. With the single exception of the Northern Territory, which has a large aboriginal population, there is little cross-state variations in the expenditure needs of the Australian states. A special grant for the Northern Territory would simplify the Australian program while achieving its equalization objectives.

Australia‘s approach raises several questions. Is equal access to all services in remote areas desirable at any cost? If a rich state decides to buy limousines for its officials, or make higher welfare payments to its aboriginal population, why should equalization payments to poorer states go up? Such an approach diverts states‘ energies to demonstrate that they ―need more to do less‖ or ―money does not buy much‖ as opposed to ―doing more with less.‖ as higher spending is rewarded and cost-saving in delivering improved services is discouraged by the equalization grant formula. Such a system rewards some bad behaviors, including excessive use of some services by specific groups, tax expenditures by states to attract capital and labor, and state assumption of contingent and non-contingent liabilities.

In addition to conceptual difficulties, the Australian program is plagued with measurement problems. The determinants of expenditure needs for various expenditure categories are arrived at based on broad judgments. Arbitrary procedures are used to derive factor weights and combine various factors into functional forms. State disabilities stemming from various factors are multiplied. For highly correlated factors, disabilities are artificially magnified through double counting and multiplication. Table 7 illustrates this point where for government secondary education, category disability is lower than a simple or weighted average of individual disability factors for rich states and vice versa for poor states. Under such a program, use of judgment on factors and weights is inevitable, but such judgments invite controversy and compromise the credibility of the whole program. The results are often disappointing. As the commission acknowledges:

> ―given the number of conceptual and empirical difficulties... and numerous judgments.. different relativities (and grant outcomes) could be just as valid as those presented [here]‖. (Commonwealth Grants Commission 2000, p.2)

19
# **Table 7.  An Example of Expenditure Need Determination in Australia: Secondary Education Expenditure Need Factors Government Secondary Education Factors -**

|**Disability Factors**|**NSW**|**Vic**|**Qld**|**WA**|**SA**|**Tas**|**ACT**|**NT**|
|---|---|---|---|---|---|---|---|---|
|Dispersion|0.9973|0.9921|1.0093|1.0106|0.9972|0.9952|0.9885|1.071|
|Grade Cost|1.0014|1.0028|0.9966|0.995|0.9992|0.9998|1.0016|0.9979|
|Input Costs|1.012|0.995|0.986|1.003|0.991|0.99|1.008|1.034|
|Relevant Population|0.9749|0.8874|1.0983|1.1639|0.9679|1.1422|0.975|1.2226|
|Administrative Scale|0.9946|0.9946|0.9946|1.0065|1.0105|1.0304|1.0463|1.1139|
|Service Delivery Scale|0.9922|0.9906|1.0031|1.0153|1.0166|1.038|0.9714|1.1141|
|Vandalism & Security|1.0023|1.0023|0.9973|0.9973|0.9973|0.9923|0.9923|0.9923|
|Cross-border|0.9965|1.0001|1.0001|1.0001|1.0001|1.0001|1.066|1.0001|
|**Category Disability**|**0.9692**|**0.8658**|**1.0815**|**1.1941**|**0.9772**|**1.1917**|**1.044**|**1.6605**|

Source: Commonwealth Grants Commission, Australia, 1995-96 Review The Australian experience highlights the practical difficulties associated with implementing fiscal need compensation as part of a comprehensive fiscal equalization approach (see Shah, 2004, 2008).

Denmark, Japan, Netherlands and Switzerland among others take great care in equalizing expenditure needs in central-local transfers. However, none of these countries have found a method of determination that escapes controversy and criticism. In fact, experience shows that more complex the approach the greater criticism it invites.

In conclusion, there neither is nor their ever will be a holy grail of expenditure need equalization. All practical methods by their nature are subjective and controversial. Sophisticated and complex methods have not shown to be superior to simpler determination of expenditure need equalization through specific purpose output-based fiscal equalization transfers as discussed in the following section. The opposition to such rough but simple and transparent justice partly comes from a lack of understanding of these newer types of transfers and equating them with traditional earmarked grants. These issues are discussed at length in the following section.

# **6. A Simpler Approach to Expenditure Need Equalization: Use of OutputBased Transfers for Merit Public Services**

Economic rationales for output-based grants (used interchangeably with performanceoriented transfers in this chapter) stem from the emphasis on contract-based management under the new public management framework and strengthening demand for good governance by lowering the transactions costs for citizens in obtaining public services under the new institutional economics approach. The new public management framework seeks to strengthen accountability for results by changing the management paradigm in the public sector from permanent appointments to contractual appointment and 20
continuation of employment subject to fulfillment of service delivery contracts. It seeks to create a competitive service delivery environment by making financing available on similar conditions to all providers – government and non-government.

The new institutional economics approach argues that dysfunctional governance in the public sector results from opportunistic behavior by public officials, as citizens are either not empowered to hold public officials accountable for their noncompliance with their mandates and/or for corrupt acts or face high transactions costs in doing so. In this framework, citizens are treated as the principals and public officials the agents. The principals have bounded rationality—they act rationally based on the incomplete information they have. Acquiring and processing information about public sector operations is costly. Agents (public officials) are better informed than principals. Their self-interest motivates them to withhold information from the public domain, as releasing such information helps principals hold them accountable. This asymmetry of information allows agents to indulge in opportunistic behavior which goes unchecked due to high transactions costs faced by the principals and a lack of or inadequacy of countervailing institutions to enforce accountable governance. Results-based accountability through output-based grants empowers citizens by increasing their information base and lowering their transactions costs in demanding action.

Output-based transfers link grant finance with service delivery performance. These transfers place conditions on the results to be achieved while providing full flexibility in the design of programs and associated spending levels to achieve those objectives. Such transfers help restore recipients‘ focus on the results-based chain (figure 1) and the alternate service delivery framework (competitive framework for public service delivery) to achieve those results. In order to achieve grant objectives, a public manager in the recipient government would examine the results-based chain to determine whether or not program activities are expected to yield the desired results. To do so, he or she needs to monitor program activities and inputs, including intermediate inputs (resources used to produce outputs), outputs (quantity and quality of public goods and services produced and access to such goods and services), outcomes (intermediate- to long-run consequences for consumers/taxpayers of public service provision or progress in achieving program objectives), impact (program goals or very long-term consequences of public service provision), and reach (people who benefit from or are hurt by a program). Such a managerial focus reinforces joint ownership and accountability of the principal and the agent in achieving shared goals by highlighting terms of mutual trust. Thus internal and external reporting shifts from the traditional focus on inputs to a focus on outputs, reach, and outcomes—in particular, outputs that lead to results. Flexibility in project definition and implementation is achieved by shifting emphasis from strict monitoring of inputs to monitoring performance results and their measurements. Tracking progress toward expected results is done through indicators, which are negotiated between the provider and the financing agency. This joint goal setting and reporting helps ensure client satisfaction on an ongoing basis while building partnership and ownership into projects (Shah 2005b).

21
**Figure 1.  Results Chain with an Application to Education Services**

|Program<br>Objectives|Inputs<br>|Intermediate<br>|Outputs|Outcomes|Impact|Reach|
|---|---|---|---|---|---|---|
|Improve<br>quantity,<br>quality,<br>and<br>access to<br>education<br>services|Educational<br>spending by<br>age, sex,<br>urban/rural;<br>spending by<br>grade level,<br>teachers,<br>staff,<br>facilities,<br>tools,<br>books,<br>regulations|Enrollments,<br>student-<br>teacher ratio,<br>class size|Achievement<br>scores,<br>graduation<br>rates, drop-<br>out rates|Literacy<br>rates,<br>supply of<br>skilled<br>professio<br>nals|Informed<br>citizenry,<br>civic<br>engagement,<br>enhanced<br>international<br>competitive<br>ness|Winners and<br>losers from<br>government<br>programs|

Source: Shah (2005b) Output-based grants must have conditions on outputs as opposed to outcomes, as outcomes are subject to influence by factors beyond the control of a public manager. Public managers should be held accountable only for factors under their control. Outcome-based conditions diffuse enforcement of accountability for results. Since the grant conditions are concerned with service delivery performance in terms of quality of output and access, the manager is free to choose the program and inputs to deliver results. To achieve those results, he or she faces positive incentives by grant conditions that encourage alternate service delivery mechanisms by contracting out, outsourcing, or simply encouraging competition among government and non-government providers. This can be done by establishing a level playing field through at par financing, by offering franchises through competitive bidding, or by providing rewards for performance through benchmarking or yardstick competition. Such an incentive environment is expected to yield a management paradigm that emphasizes results-based accountability to clients with the following common elements:

- Contracts or work program agreements based on pre-specified outputs and performance targets and budgetary allocations.

- Incentives for replacement of lifelong rotating employment with contractual appointments with task specialization.

- Local autonomy and managerial flexibility but accountability for results to own residents (citizens).

- Redefinition of public sector role as purchaser but not necessarily provider of public services.

- Adoption of the subsidiarity principle—that is, public sector decisions made at the level of government closest to the people, unless a convincing case can be made not to do so.

22
- Incentives for cost efficiency.

- Incentives for transparency and competitive service provision.

Under such an accountable governance framework, grant-financed budget allocations support contracts and work program agreements, which are based on pre-specified outputs and performance targets. The grant recipient‘s flexibility in input selection— including hiring and firing of personnel and implementation of programs—is fully respected, but there is strict accountability for achieving results. The incentive and accountability regime created by output-based transfers is expected to create responsive, responsible, and accountable governance without undermining local autonomy. In contrast, traditional conditional (earmarked) grants with input conditionality undermine local autonomy and budgetary flexibility while reinforcing a culture of opportunism and rent seeking where such culture exists (table 8). Even where such a culture of opportunism may not be a concern as in most OECD countries, citizen empowerment engendered through such transfers would be invaluable in strengthening citizen trust and confidence in their governments.

**<u>Table 8. Features of Traditional Earmarked and Output-Based Conditional Grants</u>**

|_Feature_|_Traditional Earmarked grant_|_Output-based grant_|
|---|---|---|
|Grant objectives|Spending levels|Quality and access to public<br>services|
|Grant design and administration|Complex|Simple and transparent|
|Eligibility|Recipient government<br>departments/agencies|Recipient government provides<br>funds to all government and non-<br>government providers|
|Conditions|Expenditures on authorized<br>functions and objects|Outputs -service delivery results|
|Allocation criteria|Program or project proposals<br>approvals with expenditure<br>details|Demographic data on service<br>population (potential clients)|
|Compliance verification|Higher level inspections and<br>audits|Client feedback and redress,<br>comparison of baseline and post-<br>grant data on quality and access|
|Penalties|Audit observations on financial<br>compliance|Public censure, competitive<br>pressures, voice and exit options<br>for clients|
|Managerial flexibility|Little or none. No tolerance for<br>risk and no accountability for<br>failure.|Rewards for risks but penalties<br>only for persistent failure.|
|Local government autonomy and<br>budgetary flexibility|Little|Absolute|
|Transparency|Little|Absolute|
|Focus|Internal|External, competition, innovation<br>and benchmarking|
|Accountability|Hierarchical to higher-level<br>government, controls on inputs<br>and process with little or no<br>concern for results|<br>Results-based, bottom-up, client-<br>driven; empowers citizens to<br>hold their governments to<br>account.|

_Source_ : Shah (2007).

23
Output-based grants create incentive regimes that promote a results-based accountability culture. In the following we provide a few hypothetical examples of such fiscal transfers.

# **_Output based operating transfers for setting national minimum standards for merit goods (education, health, social welfare and infrastructure)._**

(a) _Output based school grants to encourage competition and innovation in education_ . Output based grants create incentives regime to promote the results based accountability culture. Consider the case where the national government aims to improve access to education by the needy and poor as well as enhance quality of such education. A commonly practiced approach is to provide grants to government schools through conditional grants. These grants specify the type of expenditures eligible for grant financing, for example, books, computers, teachers‘ aides etc and also financial reporting and audit requirements. Such input conditionality undermines budgetary autonomy and flexibility without providing any assurance regarding the achievement of results. Such input conditionality, in practice, is difficult to enforce as there may be significant opportunities for fungibility of funds. Experience has also demonstrated that there is no one-one link between increase in public spending and improvement in service delivery performance. To bring about accountability for results, consider an alternate, output based design of such grants. Under the alternate approach, national government allocates funds to local authorities based upon school age population (see Box 2). The local authorities in turn pass these funds to both government and non-government providers based upon school enrollments. Conditions for receipt of these grant funds for nongovernment providers are that they must admit students on merit and provide tuition subsidy to students whose parents do not have sufficient means to afford such fees. Conditions for the continuation of funds for all providers will be to improve or at the minimum maintain baseline achievement scores on standardized tests, improve graduation rates and reduce dropout rates. Lack of compliance with these conditions will invite public censure and in the extreme case a threat of discontinuation of funds with perpetual non-compliance. In the meanwhile reputation risks associated with poor performance may lead to reduced enrollments and associated reduction in grant funds through parental choices. There are no conditions on the use of funds and schools have full autonomy in the use of grant funds and retain unused funds. Such grant financing would create an incentive environment for both government and non-government schools to compete and excel to retain students and establish reputation for quality education as in the final analysis it is the parental choice that would determine available grant financing to each school. Such an environment is particularly important for government schools where typically staff have life-long appointments and financing is assured regardless of school performance. Budgetary flexibility and retention of savings would encourage innovation to deliver quality education. Thus output based grants preserve autonomy, encourage competition and innovation while bringing strict accountability for results to residents. This accountability regime is self enforcing through consumer (parental choice in the current example) choice. Such a school financing regime is especially helpful for countries where several local jurisdictions are plagued with poor quality of teaching and 24
worse teacher absenteeism or lack of access to education in rural areas. The incentive regime provided by results based financing will create market mechanism to help overcome these deficiencies over time.

- (b) _Output based grants for local health financing_ . A similar example of such a grant in health care would allocate funds to local authorities based upon weighted population by age class with higher weights for senior citizens (65 years and over) and children (under 5 years). The distribution by local authorities to providers would be based upon patient use. Minimum standards of service and access to health care will be specified for the eligibility to receive such transfers.

- (c) _Output based grants for social welfare_ . Such grants would provide matching assistance to local authorities based upon the relevant service population e.g. elderly without care, single mothers, orphans etc.  Matching rate would vary with the fiscal capacity of the local jurisdiction with higher matching rate for richer jurisdictions.

- (d) _Output based transfers for road maintenance_ .  Such a grant would be based on classification of roads by types and traffic use  and  provide per kilometer grants differentiated by the type of road classification. Minimum standards of up-keep service for such roads will be specified and future grant releases will depend upon local authorities certifying those standards are being met and providing information on road conditions and use.

Table 9 notes a few useful applications of such transfers.

**Box 2.  Fiscal need compensation through output based transfers for school finance - An illustrative example** _Allocation basis to state/local governments:_ school age population – population aged 5-17,

_Distribution basis for service providers:_ Equal per pupil to both government and non-government schools. _Conditions:_ Universal access to primary and secondary education. Non-government school access to poor on merit. Improvement in achievement scores and graduation rates from baseline. No conditions on the use of funds.

_Penalties:_ Public censure, reduction of grant funds and risk of termination with persistent non-compliance. Grant funds automatically decrease if parents pull out their children from non-performing school.

_Incentives:_ Grant funds increase automatically as school attracts more students. Retention of savings for optional use from better management of resources.

_Impact implications:_ Encourages competition, innovation and accountability to citizens for improving quality and access. Automatic monitoring and enforcement provisions through parental choices 25
_Source_ : Shah (2007)

**<u>Table 9: Better Practices in  Simpler  and Transparent Equalization Grant Design</u>**

|**Grant objective**|**Grant design**|**Examples of better**<br>**practices**|**Examples of practices**<br>**to avoid**|
|---|---|---|---|
|**Fiscal capacity**<br>**equalization:**||||
|To enable provincial/Local<br>fiscal capacity to provide<br>comparable levels of public<br>services at comparable<br>burdens of taxation per<br>capita|General non matching<br>fiscal capacity equalization<br>transfers|Fiscal equalization with<br>explicit standard that<br>determines total pool as<br>well as allocation (Canada,<br>Denmark, and Germany)|General revenue sharing<br>with multiple factors (Brazil<br>and India); fiscal<br>equalization with a fixed<br>pool (Australia, China)|
|**Expenditure need**<br>**equalization:**||||
|To enable provincial/local<br>governments to meet<br>minimum or average<br>standards of merit public<br>services|Conditional nonmatching<br>output-based bloc<br>transfers with conditions<br>on standards of service<br>and access<br>Conditional capital grants<br>with matching rate that<br>varies inversely with local<br>fiscal capacity|Road maintenance and<br>primary education grants<br>(Indonesia before 2000,<br>Finland)<br>Education transfers<br>(Brazil, Canada, Chile,<br>Colombia) Health transfers<br>(Brazil, Canada, Finland)<br>Capital grant for school<br>construction (Indonesia<br>before 2000), highway<br>construction matching<br>grants to states and local<br>governments (United<br>States)|Comprehensive<br>expenditure need<br>equalization as in Australia<br>Conditional transfers with<br>conditions on spending<br>alone (most countries), pork<br>barrel transfers (USA e.g.<br>$200 million earmark in<br>2006 for a “bridge to<br>nowhere” in Alaska), ad hoc<br>grants<br>Capital grants with no<br>matching and no future<br>upkeep requirements|

) Source: Boadway and Shah (2009) 26
# **7. Recent International Initiatives toward Introducing Output-based (Performance-oriented) Grants to Sustain National Minimum Standards for Merit Goods and Achieve Expenditure Needs Equalization**<sup>**2**</sup>

Results based finance has recently been used to sustain national minimum standards for merit goods and achieve expenditure need equalization in a few countries. Most of these practices are in the fields of education and health only but in a limited number of cases such finance has been used in other public goods such as infrastructure. The following paragraphs highlight these examples.

# **(a) Results Based Financing of Education**

Several countries have launched innovative programs to create results based accountability in financing sub-national education programs. These are reviewed in the following paragraphs: _Australia: National Schools Specific Purpose Payments, 2009_ The National Education Agreement specifies the following objectives for this grant program: _ensuring that all children are engaged in and befitting from schooling, with a goal of lifting the Year 12 attainment rate to 90 percent by 2015_ ; and _ensuring children meet basic literacy and numeracy standards and continuing to improve overall literacy and numeracy achievements_ .

These are equal per capita payments for both government and non-government schooling to all States. Out of this the government schools component for each state is based upon each State‘s share of full time equivalent student enrollments in government schools. The growth factor for government school component is the product of the growth in average government schools recurrent costs and the growth in full time equivalent in government schools. The grant funds are required to be spent on schooling but States have full budget flexibility to allocate funds as they see fit to achieve mutually agreed objectives. The program has not set any benchmarks for performance but as part of an overall reporting and accountability framework, states must provide performance data to the Commonwealth and to the general public. The COAG Reform Council will collate data for all states and will publish such statistics and analytical reviews of performance for government and general public use (The Australian Treasury, 2009).

_United States: Race to the Top (RTTT) Competitive Grant Program, 2009_ This $4.35 billion program was launched by President Obama on July 24, 2009 to mark a new federal partnership in education reform with states, districts and unions to accelerate change and boost improvements. The program invites states to apply for financing by undertaking to implement four core interconnected reforms as follows:

> 2 This section is based upon Shah (2009).

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Raising standards: Agreeing to adopt internationally benchmarked K-12 standards Closing the data gap: Establish data bases to monitor advances in student achievement and identification of effective instructional practices Improving quality of teachers and principals especially in high poverty schools: Establish strategies for rewarding and retaining top-notch teachers and separation of nonperformers Turning around lower performing schools: Introduce major reforms to change school culture and replace staff and principals As a part of eligibility for financing, each state‘s record will be examined for its compatibility with providing a progressive environment for improving education standards and access. For example, states that limit alternative routes to certification for teachers and principals or cap the number of charter schools will be at a competitive disadvantage. States that explicitly prohibit linking data on achievement or student growth to principal and teacher evaluations will be ineligible for the grant until they change their laws (see Duncan, 2009).

# _United States No Child Left Behind (NCLB) Act of 2001_

The NCLB provides federal financing of elementary and secondary education (K-12 schooling) provided states agree to requirements for student testing, accountability and strive for improvements in achievement scores and equity in access to education by various income and ethnic groups. NCLB requires states to test students in reading and mathematics annually in grade 3-8 and once in grade 10-12 and in science once in grades 3-5, 6-8, and 10-12. Individual schools, school districts and states must publicly report test results in the aggregate and for specific student subgroups including low income students, students with disabilities, students with English as a second language and major racial and ethnic groups.

NCLB requires that states, school districts, and schools to ensure all students are proficient in grade-level math and reading by 2014. States define grade level performance. Schools must make ―adequate yearly progress‖ towards this goal, whereby proficiency rates increase in the year leading up to 2014. The rate of increase required is chosen by each state. In order for a school to make adequate yearly progress (AYP), it must meet its targets for student reading and math proficiency each year. Schools that fail to make adequate yearly progress for two consecutive years must draft a school improvement plan. A school failing to meet AYP for three consecutive years must initiate a performance improvement plan and also implement public school choice – students given option to move to other public schools. A fourth year failure requires restructuring and supplemental education services – school financed special instruction. If a school fails to make AYP in the fifth year, it must implement restructuring including changes in staff and management or converting into a charter school run by a private management company.

The NCLB Act also provides for special education finance incentive grant to (i) reward ―good school finance‖ states – those that spend more on public education and distribute 28
funds equitably; (ii) provide twice the amount of funds to high poverty school districts in ―bad school finance states‖ – those which spend relatively less on education and distribute funds inequitably to school districts (see Foundation for New America, 2009).

Local governments in the Province of Alberta, Canada, use a novel approach to determine the allocation of taxpayers‘ contribution to school finance. This is done by resident taxpayers through designation of their education component of the property tax bill to either public or parochial (religious, private) school boards. These declarations determine the total amounts of property tax finance available to public and provide providers. Schools receive grants on a per pupil basis and parents retain option to send their children to a school of their choosing regardless of their exercise of voting on school finance. Higher education financing assigns weights to enrollments by different programs with medical and engineering education receiving higher weights than humanities.

_Results Based Education Finance: Developing and Transition Country Examples_ Conditional non-matching output-based transfers to ensure national minimum standard in merit goods or for fiscal need compensation are rarely used in DTEs. Nevertheless, one finds a few shining examples of programs that marry equity with performance orientation in grant allocation.

Brazil has a noteworthy national minimum standards grant programs for primary education. Under the 14<sup>th</sup> amendment to the federal constitution, the state and municipal government must contribute 15 percent each of their two principal revenue sources (state value added tax and state share of the federal revenue sharing transfers for states, and services tax and the municipal share of the state revenue sharing transfers for municipalities) to FUNDEF - special fund for primary education. If the sum of the state and municipal required contributions, divided by the number of primary school students, is less than the national standard, the federal government makes up the difference. The total amount of the FUNDEF is then distributed among the state and its municipal providers is distributed on the basis of school enrollments (see Gordon and Vegas, 2004 for a review of the FUNDEF program).

Chile‘s (and the State of Michigan, USA) school grants finances vouchers for school age population giving parents a choice in sending their children to public or Catholic/private schools. An additional performance grant providing 25% additional grant as salary bonus for teachers in the best performing schools based upon a National System to Evaluate School Performance (SNED in Spanish, see Gonzalez, 2005). Central per capita transfers for education in Colombia and South Africa, and the capitation grant to Malaysian states come close to the concept of such a transfer.

The operating grant for schools (became defunct in 2000) in Indonesia used school age population (ages 7-12) as criteria for distribution of funds to district governments. This was supplemented by a matching capital grant (local government to provide land for school) to achieve minimum standards of access to primary schooling. These grants 29
enabled Indonesia to achieve a remarkable success both in improving literacy as well as minimum standards of access across the nation.

# **(b) Resulted Based Financing of Healthcare**

Canada and Brazil lead the way in results based intergovernmental finance in health as discussed below.

_Canada: Canadian Health Transfers Program (CHT)_ A good illustration of a simple yet effective design of such a grant system is the Canadian Health Transfers (CHT) program. Under this program, the federal government provides per capita transfers for health to the provinces with the rate of growth of these transfers tied to the rate of growth of the GDP. There are no conditions on spending but there are strong conditions on the access to health care. As part of the agreement to receive these transfers from the federal government, the provinces undertake to abide by several access related conditions and face penalties as specified below if there was a breach of any condition. The five conditions are: (1) Universality: To provide universal coverage; (2) Portability: Residents have the ability to move to another province and retain health coverage in the province of origin for a transition period. Residents and non-residents have equal access; (3) Public insurance but public/private provision: The province agrees to provide universal insurance to all but financing of public and private providers on equal footing – both get reimbursed from the public insurance system using the same schedule of payments negotiated by the provincial medical association; (4) Opting in and Opting out: All health providers have the option of opting out of the system and bill patients directly and not follow the prescribed fee schedule. The clients of these providers get reimbursed according to government prescribed schedule of payments by submitting claims; and (5) No extra billing: All providers opting in the system cannot bill patients directly especially for charges in excess of the prescribed schedule.

Penalties include (a) threat of discontinuation of the grant program if conditions (1) through (4) are breached and dollar for dollar reduction of grant funds for breach of condition (5).

The program has enabled Canadian provinces to ensure universal access to a high quality health care to all residents regardless of their income or place of residence.

_Brazil: Unified Heath System (SUS)_ Fiscal transfers in support of the Unified Health System – SUS that operationalizes the constitutional obligation of universal right to free health services - are administered under a federal program called annual budget ceilings –TGF. The TGF has two components.

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Equal per capita financing from for all municipalities is provided to cover basic health benefit. Funding for hospital admissions and high cost ambulatory care is subject to ceiling for each type of treatment. All registered health care providers – state, municipal, or private are eligible for grant financing through their municipal government (World Bank, 2001, Shah 1991).

# **Results Based Finance of Other Services**

Only a handful of examples available as noted below.

_Indonesia_ - The District/Town Road Improvement Grant used as allocation criteria, length of roads, condition, density (traffic use) and unit costs as criteria for distribution of funds. This grant program helped monitoring the health of the road network on a continuing basis and was successful in keeping roads in good working conditions in most jurisdictions (Shah, 1998).

_Chile_ - Grants to municipal governments for water and sewer access by the poor cover 2585% (means tested) of a household‘s water and sewer bill for up to 15 cubic meters a month with the client paying the rest (Gomez-Lobo, 2002).

_Argentina_ – Federal transfers to provinces for social insurance are based upon number of poor women and children enrolled in social insurance and performance on key output measures (Eichler, 2008).

# **8. Conclusions Regarding the Practice of Fiscal Need Equalization**

Fiscal capacity equalization is relatively straightforward to comprehend and is feasible (with some difficulty) to implement once a (political) decision is made on the standard of equalization. Fiscal need equalization is a complex and potentially controversial proposition, because by its very nature it requires making subjective judgments and using imprecise analytical methods. An analytical approach such as regression analysis using historical data is inadequate to handle this challenge when underlying structures are subject to change due to technology and other dynamic considerations. Great care is needed to specify the determinants of each service. An ideal fiscal need equalization system- theory based representative expenditure system as outlined earlier – is difficult to implement and therefore for good reasons has not been implemented anywhere in the world. Instead partial and ad hoc yet complex equalization is quite common place and appears politically popular yet controversial. Such methods tend to make the system opaque and in the long run invite citizens‘ distrust of government operations. When looked at closely, these complex methods seldom advance equity objectives.

This need not be the case. Fiscal need compensation can be more simply and objectively achieved on a service by service basis for major local merit services such as education, health, infrastructure etc. by the use of output-based national minimum standards grants as done in Canada and Finland for health and post-secondary education. Such grants can 31
use simple and objective service based indicators such as school age population for school finance, weighted population with greater weights for infants/children and senior citizens for health finance, etc. Continuity of finance can be assured by maintaining minimum standards of access and service quality. Such transfers will preserve local autonomy while enhancing simplicity, transparency and citizen based accountability for service delivery performance.

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