Revenue assignment

From a multi-day seminar for the Joint Finance Commission of the United Republic of Tanzania

1. United Republic of Tanzania Joint Finance Commission Revenue Assignment Presented by the Asian Institute for Technology William P. Kittredge, Ph.D. Visiting Scholar in Residence DOI: 10.13140/RG.2.1.2292.3126

2. Intergovernmental Fiscal Relations Definitions Intergovernmental fiscal relations is a term that refers generally to division of fiscal powers and responsibilities among levels of government. Fiscal decentralization refers to an intergovernmental system where the balance of power moves more toward the sub-national government sector than has been the case.

3. Intergovernmental Fiscal Relations Financial responsibility is a core component of decentralization. If local governments and private organizations are to carry out decentralized functions effectively, they must have an adequate level of revenues –either raised locally or transferred from the central government– as well as the authority to make decisions about expenditures.

4. Intergovernmental Fiscal Relations Fiscal decentralization can take many forms, including a) self-financing or cost recovery through user charges, b) co-financing or co-production arrangements through which the users participate in providing services and infrastructure through monetary or labour contributions; c) expansion of local revenues through property or sales taxes, or indirect charges; d) intergovernmental transfers that shift general revenues from taxes collected by the central government to local governments for general or specific uses; and e) authorization of municipal borrowing and the mobilization of either national or local government resources through loan guarantees.

5. Intergovernmental Fiscal Relations In many developing countries local governments or administrative units possess the legal authority to impose taxes, but the tax base is so weak and the dependence on central government subsidies so ingrained that no attempt is made to exercise that authority.

6. Revenue Assignment Governments rely on a wide variety of tax instruments available for their revenue needs, such as direct, indirect, general, specific, business and individual taxes. The question addressed here is which types of taxes are most suitable for use by each level of government.

7. Revenue Assignment Principles of Tax Assignment The assignment of taxes by jurisdiction depends partly on the mix of various taxes used in the country overall. In public finance theory, the issue of the ideal tax mix even in the unitary state has not been widely developed. Governments almost universally employ tax systems that apply different taxes apply to basically the same bases. For example, general sales taxes, payroll taxes, and income taxes have bases that overlap considerably.

8. Revenue Assignment Principles of Tax Assignment From the point of view of standard efficiency and equity, one should be able to make do with a single general tax base, yet no governments behave that way. The usual reason given for this is that administrative considerations play an important role. A mix of taxes keeps the rate on any tax low , thereby reducing the incentive to evade or avoid the tax. Furthermore, by using a mix of taxes, taxpayers who would otherwise be able to avoid taxation of one type are caught in the net of another, making the tax system fairer . The importance of the various taxes in the overall mix remains, however, a matter of judgement rather than something that can be deduced from the principles.

9. Revenue Assignment These same general considerations apply in the case of assigning taxes in a federal government system. Efficiency and equity arguments have to be tempered by administrative considerations, and the exact assignment depends upon informed judgement We can, however, outline the economic principles that come into play in deciding which taxes to assign to lower levels of government. Market Efficiency Effects Equity Administrative Feasibility Fiscal Need

10. Revenue Assignment M arket Efficiency Effects The market is said to be functioning efficiently if all resources ( labour , capital, goods, and services) are free to move from one region to another without impediments or distortions imposed by policy. All taxes and tax systems reduce market efficiency, in a technical sense. “ The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing” Jean Baptiste Colbert Minister of Finance under King Louis XIV of France circa 1650

11. Revenue Assignment M arket Efficiency Effects Decentralized tax systems can interfere with the efficiency of the economic union in two ways: Uncoordinated taxation produces excessive distortions in markets, especially those that exhibit mobility (e.g. capital and tradable goods). This situation can be ameliorated to the extent that governments recognize resource mobility.

12. Revenue Assignment M arket Efficiency Effects BUT, the recognition of mobility alone while necessary is not sufficient because they may choose to engage in socially wasteful beggar-my-neighbour policies to attract resources. If all jurisdictions engage in such policies, the end result will simply be inefficiently low taxes (or high subsidies) on mobile factors. This is a very important consideration in development policy because it can take place at the national, region (e.g. mkoa), and local (wilaya) levels. Mobile capital (businesses you want to locate in your jurisdiction ) will negotiate hard to maximize the wealth of their shareholders – government must do the same!

13. Revenue Assignment Equity The tax-transfer system in one of the main instruments for achieving redistributive equity . The argument for making equity a federal objective is simply that all persons ought to enter into society’s ‘social welfare function’ on an equal basis, and presumably the federal government is the only level that can ensure that residents in different regions are treated equitably. This may be tempered if states have different tastes for redistribution, or if centralized decision-making is not guided by normative criteria. To the extent that equity is viewed as being a federal policy objective, decentralized taxes can interfere with the achievement of those objectives. Equal opportunity should not be confused with equal outcomes.

14. Revenue Assignment Equity As before, uncoordinated tax policies may induce arbitrary differences in redistributive consequences. Given the mobility of labour and capital, the states may engage in perverse redistributive policies using both taxes and transfers to attract high-income persons and repel low-income ones. (e.g. Oconee County GA USA) Beggar-my-neighbour redistributive policies are likely to be offsetting with respect to resource allocation, but will result in less redistribution than in their absence. This is obviously likely to be more of a problem for those taxes & transfers that are redistributive in nature.

15. Revenue Assignment Administrative Feasibility The revenue raising decentralization may increase the burdens associated with collection and compliance, for the public and private sector. There are burdens associated with collecting any tax . Administrative burdens for the public sector reduce the net proceeds of the tax, regardless of the gross revenues. Taxpayer burdens decrease market efficiency.

16. Revenue Assignment Administrative Feasibility Further evasion and avoidance increase, especially for taxes where mobility is a factor. While not directly inversely proportional the effect is always present and can be pronounced. In either case, tax revenue forecasts that fail to consider this factor will tend to over-estimate revenues. If the tax base straddles more than one jurisdiction, rules for allocating tax revenues among jurisdictions need to be implemented. (e.g. Australian GST revenues) Absent allocation rules some tax bases may face either double taxation or not taxation at all. Auditing procedures may also be distorted for those tax bases which involve transactions across state boundaries.

17. Revenue Assignment Fiscal Need To ensure accountability, revenue means should be matched as closely as possible to revenue needs . Thus tax instruments intended to further specific policy objectives should be assigned to the level of government having the responsibility for such a service. Thus progressive redistributive taxes, stabilization instruments, and resource rent taxes would be suitable for assignment to the national government. While tolls on inter-municipal roads are suitably assigned to state (mkoa) governments.

18. Revenue Assignment Fiscal Need In countries with a federal level VAT, it may be too cumbersome to have sub-national sales taxes. In such circumstances, the fiscal need criterion would suggest allowing sub-national governments access to taxes that are traditionally regarded as more suitable for national administration, such as personal income taxes. Reconciling the Difference: Making Sub-national Governments Accountable, While Preserving Efficiency and Avoiding National Distortions.

19. Revenue Assignment The main problem with the tax assignment that emerges from the preceding prescriptions, in that that they may not provide sufficient revenues for lower-tier governments. In part for this reason, local and especially intermediate-level governments in many countries levy a variety of specific (excise) taxes on gambling, motor vehicles, and so on. However, such levies seldom produce sufficient revenue to finance a significant part of major expenditures such as education and health that are often assigned to sub-national governments.

20. Revenue Assignment Resolutions The first way is to supplement local revenues by intergovernmental fiscal transfers - without undesirably reducing local efforts to collect their own taxes. The second option is to permit sub-national governments to levy their own broad-based taxes - as long as they burden local beneficiaries only.

21. Revenue Assignment Resolutions In principle, a retail sales or personal income tax is possible. In practice, however, the only efficient, desirable broad-based sub-national tax that seems feasible is likely to be a flat-rate surtax (often called "piggybacking") on a national personal income tax. Retail sales taxes are seldom feasible in the circumstances of developing or transitional countries. Note: Australia has a Goods and Services Tax (GST) that is collected nationally and re-distributed to the states. It is a VAT-like tax that is imposed on services (e.g. lawyers and accountants) as well as goods.

22. Revenue Assignment Whether with respect to such a surtax, a local property tax, or local taxes in general, the critical elements required to ensure local accountability without efficiency costs are: restrict local governments as much as possible from exporting taxes permit them to set their own tax rates. For efficiency, it may be desirable to assess the base of a tax centrally and even to have it collected by the central government; but for accountability it is critical that the local authorities are responsible (perhaps within limits) for setting the tax rate.

23. Revenue Assignment Redefining Local Powers A special situation exists in a few transitional countries, including those of NIS, China and Vietnam, where local governments have traditionally had a larger role in administering national tax bases. In these transition economies the central government may not have full control over its tax bases due to local administration of these.

24. Revenue Assignment Redefining Local Powers For example, in China and Russia, revenues were collected at the local level (via a tax contracting system in China) and shared upwards. This created local level incentives to make better collection efforts for taxes fully retained at that level and less effort for taxes that were largely transferred upwards . Local governments in these countries preferred to receive transfers in kind or contributions from own enterprises rather than collect higher corporate taxes that had to be shared with higher levels. Revenue sharing on a tax by tax basis led to highly varied levels of efficiency in tax administration.

25. Revenue Assignment Further, in a country with conflict among levels of government, sub-national administration of national taxes is not advisable since the sub-national entity can refuse to submit national taxes if it becomes disgruntled (e.g., Tatarstan in Russia). China has recently strengthened its central tax administration to collect revenues from central and shared taxes. Problems are also caused by overlapping, uncoordinated administration, especially for sales and excise taxes. This administrative burden comprises much of the argument against internet sales taxes in the US.

26. Revenue Assignment Finding the Right Balance Decentralization has the potential to reduce accountability by breaking the links between the levels of taxation and expenditure. Major expenditure responsibilities are being transferred to local governments in an effort to improve service delivery, but there are few high-revenue taxes which can be assigned to local governments without creating national economic distortions.

27. Revenue Assignment Finding the Right Balance Efficiency in tax administration suggests that local governments should levy taxes on immobile factors (e.g. property taxes) Fiscal need criteria suggest that they should also levy cost recovery user charges such as frontage taxes (tax per linear front foot of property), tolls on local roads and poll taxes. These tax revenues are unlikely to be sufficient in many localities, and thus, intergovernmental transfers are required to mitigate this imbalance. While taxation increases can create constituent pressure for good local performance, some grant designs can create central government pressure for local performance.

28. Government Monopolies Why Have Government Monopolies? State-Run Liquor Stores State-Run Lotteries

29. Why Government Monopoly? 'Natural Monopoly' A declining long-run cost curve gives large firms a competitive advantage—and leads to monopoly. Unregulated private monopolies select inefficient levels of output. So governments either: Regulate private monopoly Set up a government monopoly Personally, I do not like the current usage of the term, as it implies a monopoly condition that is somehow pre-destined.

30. Why Government Monopoly? 'Natural Monopoly' If the government monopoly uses the private monopoly price it: Maximises its revenue Causes the same distortion as the private monopoly! Transforms monopoly profits into government revenue. Even at the monopoly price, a consumer surplus (CS) is generated, but there is a clear trade-off between CS and government revenue.

31. Why Government Monopoly? 'Natural Monopoly' If the government sets the efficient price it: Maximises consumer surplus in this market But it loses money And must raise revenue elsewhere, undoubtedly causing distortion (i.e. lost consumer surplus) in other markets. Put another way, government subsidizes the government monopoly with other revenues

32. Why Government Monopoly? Regulation Governments sometimes decide to monopolize a good or service on policy grounds. Hence they prohibit private production and provide the product themselves. This case involves the same trade-off between CS and government revenue. In practice, the agency problem minimises the impact of regulation of monopolies, or business in general

33. State Liquor Stores in the United States According to Fisher, 18 states have a state-run liquor monopoly, sometimes at the wholesale level, sometimes for both wholesale and retail. (Fisher, 2006) This reflects the prohibition tradition in some states—not a natural monopoly. It gives the state control over advertising and sales. It boosts tax exporting because a state can charge a high price to non-residents even if it cannot tax them.

34. State-Run Lotteries Irish Sweepstakes authorized 1930 and promoted worldwide, initially in expatriate Irish communities “ Numbers racket” place bet with local bookmaker The first U.S. state lottery was in New Hampshire in 1964. Now every state except Hawaii and Utah have some form of legal gambling. Lotteries raise a small share of state revenue (1.2% in 2009).

35. State-Run Lotteries Policy Issues Legalization (Should lottery gambling be allowed?) Government Provision (Should lotteries be a private or government monopoly?) Rate of Taxation (How much revenue should the state claim?) Earmarking (Should the revenue be earmarked for education?) Promotion (How should lotteries be designed and advertised?)

36. State-Run Lotteries Rate of Taxation Lotteries provide a classic example of the trade-off between CS and revenue: The analytical case for lotteries is based on the CS they generate, which is minimised by high implicit tax rates. The political case for lotteries is based on the money they raise, which is maximised by high implicit tax rate. In this case (as in many others!) politics wins, that is, the implicit tax rates are very high.

37. State-Run Lotteries Rate of Taxation Where: t= implicit tax rate R = state revenue P = prizes awarded C = administrative costs

38. State-Run Lotteries Rate of Taxation According to Fisher, the values of these variables for the U.S. as a whole (per $1.00 of sales) are: R = $0.329 P = $0.605 C = $0.066

39. State-Run Lotteries In 2010, implicit lottery tax rates range from 26.1% (Oregon) to 413.1% (West Virginia) and are all far higher than the rates for any other type of tax. These high rates of tax cause enormous distortion between lotteries and other types of commodities. But they also cut back on the social costs (externalities) of lotteries and export taxes to non-residents However, other research shows that the primary purchasers of lottery tickets are low-income, low-educational attainment individuals (Covert 2013)

40. Public Pricing User Fees: An Alternative to Taxation Key justifications: Some public monopolies are used as revenue sources (e.g. lotteries) The benefit principle justifies linking payments to the people who use a service. Fees are needed to ensure efficient usage of a public service.

41. Public Pricing User Fees: An Alternative to Taxation Focus on setting efficient public prices, i.e., prices to support an efficient allocation of resources. Public pricing often raises equity issues, as well. In some cases, high prices may discourage the use of a public facility, such as a zoo, by low-income groups. In other cases, high public prices may hit vulnerable groups hard. An example is the impact of a subway fare hike on “captive riders,” namely, low-income workers who cannot afford a car.

42. Public Pricing User Fees: An Alternative to Taxation To promote efficiency, a public price (P) should be set equal to marginal cost (MC). If P=MC, then consumers base their usage decisions on the true resource cost. As in a private market, decisions based on true resource costs leads to efficient outcomes.

43. Public Pricing User Fees: An Alternative to Taxation In some cases, the margin is not well defined and some judgement is required. Consider the case of public transit. One could say that the last rider is the margin, in which case MC is essentially equal to zero. One could say (more reasonably) that the last bus route is the margin, in which case MC could be set to the cost of the route divided by the average number of passengers.

44. Public Pricing User Fees: An Alternative to Taxation Special Cases Pricing rules need to be adjusted in the presence of: Externalities (as discussed earlier, also affect taxing rules). Variation in usage over time, which is usually referred to as the 'peak load' period.

45. Public Pricing User Fees: An Alternative to Taxation Pricing decisions can get very complicated. Consider transit fares: Raise fares to eliminate a deficit. Lower fares to protect captive riders. Raise fares at rush-hour to account for congestion on public transit. Lower fares at rush-hour to account for the positive externalities of transit (lower pollution and congestion on highways) and the unpriced externalities (pollution and congestion) from driving.

46. Public Pricing User Fees: An Alternative to Taxation The key lesson: One cannot achieve many objectives with one pricing tool! A policy maker needs as many policy tools as objectives: Raise fares to lower a deficit (and/or raise taxes for transit since the entire area benefits from the transit system). P rovide discount cards for low-income people to protect captive riders Use peak-load pricing to account for congestion on public transit. Raise parking fees or raise gas taxes or charge tolls or implement a rush-hour pricing scheme in some zones (as in London or Singapore ) to address pollution and congestion.

47. References Covert, B. (2013) How Lotteries Are Bad For Players, Winners, And States http://thinkprogress.org/economy/2013/05/20/2035751/lottery-powerball-poverty-state-budgets/?mobile=nc Accessed: May 20, 2013 at 12:00 pm Fisher, R. (2006). State and Local Public Finance (3rd ed.). South-Western College Pub. Kittredge, W.P., (2004) Local Government Fiscal Condition Analysis. University of Georgia Press. Musgrave, R.A. (1959) The Theory of Public Finance: A Study in Public Economy New York: McGraw Hill Smith, A (1776) An Inquiry Into the Nature And Causes of the Wealth of Nations. Chapter II of Book V