Fiscal policy instruments and the political economy of designing programs to reach the poorest

Ehtisham Ahmad October 2007

The views in this paper are personal and do not necessarily represent those of the IMF.

The issues Information needed to identify the

poorest Generally those unable to participate in the

labor market Marginal groups without family support Often excluded from formal programs:

pensions or unemployment insurance Information available to localities, but

not easily to the center/donors

The issues (continued) Local officials: may not have the

appropriate incentives to implement “central programs” “Capture by elites” Absence of information on “outcomes”

In addition, overlapping responsibilities: typically allow the local governments

to “pass the buck” to the center

Policy instruments: taxation Trend to centralize broad based

taxes (VAT, CIT); e.g., China and Mexico

Need for some own-source revenues at margin for accountability

Poorer areas may lack resources to meet poverty spending

Policy instruments: transfers Equalization transfers used in many

advanced countries (Australia, China) But may not ensure that needs of the

poorest are met in all cases Scope for targeted interventions?

Central government operations Could be costly and administratively demanding

Central financing and local operations Likely model: but possibility of leakages Political economy considerations and policy design

The policy agenda: examples from Mexico and China Can one use insights from

developments in method to design programs to support the poorest? Use of competition—both across regions as

well as over time Importance of defining program objectives;

monitoring mechanisms/ Contracts—enforceability? Moves towards performance budgeting?

Sequencing of measures to move in this direction

Some experiences

Local provision: China Wu bao (five guarantees)—minimum basic

guarantee for those without family support (largely rural)

Reasonably well targeted Based on community identification and support Variance based on community/local government resources Together with anti-poverty program, covered 6 percent of

the rural population in early 1990s. Variance in level of local support increases after

market based reforms Increasing difficulties in getting local governments

to implement central programs Grain silos (federal programs, financed by center,

administered by local governments)

Central provision:Mexican insights Mexican Progresa/Opportunidades

regarded as successful central anti-poverty program

Together with Seguro Popular to top up health care for uninsured Direct Federal administration Coverage: 70 percent of rural population; 25

percent of total population Disincentives to participate in the formal sector

Replication of Communidades Red Solidaridad (El Salvador); Tekoporã

(Paraguay) Also direct central provision Attempts to involve local governments not

successful Kudos to center; what’s in it for local politicians? Clear example of “overlapping responsibilities”

What could be done by the center to better utilize local information and implementation? Cost effectiveness is important

Hybrid: central finance, local provision Di bao; largely urban program in China, since

1999 local selection of recipients Variable eligibility criteria Central funding—0 in rich areas, 100 percent in Tibet

Protects center from open ended program, but possible exclusion of the poorest

Possibility of tighter central determination of criteria, without risk of open-ended costs?

Minimize incentives for local governments to misrepresent needs and divert resources

Method Draws on “competition” models

Used horizontally in the external aid literature Failure of conditionality in foreign aid Svensson J.

(1999) and (2003) Multi-tiered nested decision-making (Ahmad et

al, 2002) Intertemporal developments (simple 3-period

model—Ahmad and Martinez, 2004) Specific/conditional transfers to local governments Appropriate feedback mechanisms or penalties Inherent in multi-year budgets where future funds

depend on intermediate performance targets.

Main result Competition between recipient units

and freedom of allocation over time (multi-year budgeting) reduce diversion of transfers towards local goals

Requires: Clear definition of “outcomes” that can be

monitored Rather than just tracking of funds Multi-year budgets

The model Each year the central government

distributes: a transfer,2T, to regions A and B

A and B can, and prefer to, divert a share, maximum of F, of the transfer to their own goals

Center cannot monitor easily the use of funds/extent of diversion But can tell if there are no “grain silos” being

built Number of wu bao individuals/families housed

PoliticalA and B

No regional, no intertemporal competition

Regionalcompetition

Regional and intertemporal competition

1. First year in office

Each receives T, can divert maximum fraction F of T

Each receivesT, can divert maximum fraction F of T

Each receivesT, can divert maximum fraction F of T

2. Last year in office

Same Depending on use by A and B, transfer can be allocated totally to A or B. Winner receives 2 T

Depending on use by A and B, transfer or 4T is allocated to winner, or moved to period 3. Winner receives 4T

3. First year in office

Same as in 1. Same as in 1. Transfer can be 0, or 4T

Results Maximum diversion of transfer, F.

Diversion Less than F, but not zero

Still less diversion, with possibility of zero diversion. T totally spent for CG objective.

Conclusion: Options Direct central provision of the programs

Possible, but could be costly and demanding on administrative resources

Local provision, with own-financing, leads to accountability, but Variability of resources—poor regions worse off

Central financing of earmarked transfers, with local administration Likelihood of diversion of resources, but....

...there is an alternative Introduction of competition plays a role in

effective transfer design, Even in the presence of overlapping competencies Horizontal competition (using foreign aid literature

seen insufficient to remove incentives to divert) Multi-period budgets with future funds dependent

on demonstrable outcomes the most effective instruments

Can credible contracts be designed? (i.e., will funds be cut-off for non-performance?)

Conclusions Contracts should specify “outcomes”,

introducing relative performance criteria Can be developed over time, in moves

towards performance budgeting Preconditions: better monitoring of both non-

financial and “costing” elements More flexibility in cases where clarifying

responsibilities may be a lengthy process (e.g., both Mexico and China)