Over the years, many attempts have been undertaken to evaluate local revenue sources according to a set of key principles (Smoke, 2013). Such principles include:
• Revenue adequacy: covering subnational budgetary needs (based on the “finance follows function” principle).
• Revenue buoyancy: growing in proportion to the economy and expenditure needs.
• Stability: avoiding large fluctuations in revenue yields that would undermine the ability of subnational governments to provide services.
• Correspondence between payments and benefits (including limiting tax exporting).
• Distortionary Impact: minimizing distortions of economic decisions made by individuals and firms (e.g. resulting from differentiated base assessment and rates).
• Autonomy and Accountability: allowing subnational governments discretion to make independent decisions (creating a link between revenue generation and service delivery).
• Administrative feasibility: ensuring the scale and complexity of administration is consistent with capacity and affordable to the subnational government.
• Political feasibility: maximizing the likelihood of acceptance of a source through consistency with political reality, e.g. taxpayers see value for money, fair treatment, less visible/onerous (small payments over time versus large lump sums).
• Equity: ensuring fair treatment among equals (horizontal) and across different groups (equals) framed in terms of income but can use other points of reference.
There are no subnational governments in the world that can fully function without a certain level of intergovernmental support. In practice, finance often does not follow function, and central governments across the globe give local authorities more expenditure responsibilities than those can finance from their own revenue sources. Generally, greater capacity to generate their own revenues make subnational governments in developed countries less dependent on support from higher tiers of governments than those in developing countries. Consequently, resource flows from higher to lower tiers of governments average 70-72 per cent of local government funding in developing countries and 38-39 per cent in developed countries (Alam, 2014).
The traditional rationale for intergovernmental transfers is the objective for a welfare maximizing government to reallocate resources between richer and poorer jurisdictions in order to reduce both horizontal (same tiers of government) and vertical (different tiers of government) imbalances, and to correct for externalities. The actual drivers for intergovernmental transfers can vary, however. Public finance literature explores factors that are shaped by equity and efficiency considerations such as the
The impact of intergovernmental transfers on local revenue generation remains under debate. Some have argued that large unconditional intergovernmental grants lead to lump-sum tax reductions or lower the incentives for local governments to collect fees and taxes, thus ‘crowding out’ own source revenue mobilization. Others argue that most fiscal transfers are spent on the provision of public goods and services, increasing local economic development and tax compliance, and consequently, ‘crowd in’ local tax revenues. Studies that highlight the crowding out effect mostly focus on more developed countries with relatively well-developed fiscal systems and significant own source revenue generation (Kalb, 2010; Zhuravskaya, 2000).
However, such capacity is highly constrained in most LDCs. In cases where local capacity to generate own-source revenue is weak, intergovernmental transfers are a crucial lifeline and may further crowd in local revenue generation. For example, evidence suggests that in Tanzania, a 1 per cent increase in intergovernmental transfers leads to an extra 0.3-0.6 per cent increase in own source revenue generation for local government authorities (LGAs) (Masaki, 2015). Moreover, intergovernmental transfers are often the only regular source of local income for reasons of political interference in own source revenue generation. In many LDCs, local governments are frequently dependent on central government approval for taxes, fees and charges they wish to impose. In certain cases, local governments may wait for years or even decades to get such approvals (see Lesotho Case Study).
Smoke (2015) argues that intergovernmental transfers make sense as part of smart division of responsibilities between the central and local government based on their core advantages and competencies. In this connection, the author highlights that “central governments have inherent advantages in generating revenues and local and regional governments have inherent advantages in providing certain key services, invariably necessitating intergovernmental transfers.” At the same time, LRGs must be able to raise an adequate share of the resources to (i) reduce demands on central budgets, (ii) create a fiscal linkage between benefits of local services and the costs of providing them, and (iii) help repay loans on long-term capital investments (Smoke, 2015).