Economic Survey of Japan 2005: Getting the most out of public sector decentralisation


How can relations across levels of government be improved?

Revamping fiscal relations across levels of government, the topic of the special chapter in this Survey, is of paramount importance in supporting fiscal consolidation. Local government debt has ballooned from less than 15 per cent of GDP in the early 1990s to 40 per cent in FY 2003. While the negative aspects of decentralisation have thus materialised, the benefits have not yet been fully reaped. In particular, local government's ability to innovate and respond to the preferences of local citizens is constrained, the fragmented provision of publicly-funded services results in diseconomies of scale and the decentralised tax system is too complex. The "Trinity Reform" plans to reduce earmarked grants, reform equalisation grants and increase local taxes. However, for this reform to be fully effective, it must be accompanied by bolder initiatives in at least three areas: mechanisms to discipline local government fiscal behaviour and to improve the efficiency of intergovernmental grants and local taxes.

Mechanisms to secure fiscal discipline at the local government level need to be improved as they are too lenient and their coverage is inadequate. Such mechanisms were overridden by expansionary fiscal policies implemented during the past decade. The planned removal of the central government's approval system for local bond issues in FY 2006 calls for a strengthening of other instruments, notably fiscal rules and market instruments. To be effective, existing fiscal rules should be hardened, while support to local jurisdictions facing financial troubles should be reduced, so as to limit moral hazard problems. Financial markets should be allowed to play a more prominent role in disciplining local government behaviour through credit ratings in bond markets. This would require that the central government state clearly that it will not intervene as a lender of last resort to local governments and ensure that adequate information on local governments' outstanding and implicit liabilities is readily available.

Intergovernmental grants have been used extensively for macroeconomic stabilisation and income redistribution, often at the expense of allocative efficiency. The grant system should be reformed to promote local governments' ability and incentives to introduce managerial innovations so as to better respond to needs at lower cost. This would require basing the equalisation criteria on objective needs, rather than actual spending, and changing the conditionality of earmarked grants from input or procedural criteria to outcomes. In parallel, the use of earmarked grants should be reduced, relying as much as possible on independent cost-benefit analysis and examining whether alternative financing methods block grants or direct transfers to individuals would be more cost-effective. The grant system should also be amended to eliminate incentives to issue debt by removing local bond repayment costs from the formula used to calculate grant entitlements. This would also help to contain sub-national spending or at least encourage the development of the local tax base. In addition, the amount available for equalisation grants should no longer be set at a fixed share of annual national tax revenues in order to avoid a pro-cyclical trend in local government spending.

Making the cost of local public services more visible to local taxpayers can enhance fiscal discipline. This calls for increasing the effective tax autonomy of local governments while keeping the tax system as simple and neutral as possible. Although there are a number of local government taxes, revenues have been restricted by a proliferation of rebates and existing discretionary powers have been used in a limited and often distorted way. Rather than creating new local taxes, many of the existing rebates should be removed, while introducing market valuation of property for tax purposes. In addition, the deduction of local taxes from central government tax bases should be ended, while central government permission to issue local bonds should no longer be conditional on local authorities applying tax rates at, or above, the rates set by the central government. At the same time, reliance on taxes that are highly volatile or can be easily shifted to other jurisdictions or which may hamper the swift adjustment of the economy over the  economic cycle should be avoided.

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