Transfer systems1 form an important element of subnational government financing because they can help ensure that different subnational governments are able to provide at least the minimum acceptable level of services. In general, transfers are used to reduce fiscal disparities at two levels a) between central government and subnational government (vertical fiscal gap), and b) between subnational governments (horizontal fiscal gap). Vertical fiscal gaps can be diminished by paying lump sum transfers to subnational governments. Horizontal fiscal gaps are usually tackled with equalisation systems, which are based on indicators and formulas that take into account differences between subnational governments in tax bases (tax base equalisation) and in service needs and special circumstances (expenditure equalisation).
A well-working transfer system ensures that subnational governments can provide comparable level of public services with comparable tax rates. Comparability is important mainly for two reasons: first, the central government can better monitor subnational governments using indicators on service availability and quality, and second, local residents can compare the local public services and tax rates of their own jurisdiction to situations in neighbouring jurisdictions.
To classify the different types of transfers, the OECD Fiscal Federalism Network developed a taxonomy of grants. The main separation is between earmarked (conditional) and non-earmarked (unconditional) grants. Subnational governments must use earmarked grants or the conditional grants for a specific purpose whereas they can spend non-earmarked or unconditional grants freely. Both main types of transfers are further divided into mandatory and discretionary transfers. Mandatory transfers are defined in law, whereas discretionary transfers do not have such clear basis. Discretionary grants are generally not recommended in wider use, as they may make the transfer system more complex and less transparent, making it more likely to suffer from lobbying and corruption practices. The discretionary grants can be divided into grants for capital expenditure and grants for current expenditure.
Earmarked grants may be further subdivided into matching and non-matching grants. Earmarked grants aim to incentivise municipalities to spend funds on specific projects. Such grants are typically used by central governments to internalise externalities, i.e., to ensure that the recipient municipality or region will also take into account the effects on other jurisdictions when making investment decisions. Matching grants (i.e. a certain percentage of subnational government expenditure in a specific service, say in education) can be useful especially when a new public service is launched. Using matching grants more widely and for a longer time is generally not advisable, because matching grants have been shown to have a tendency to boost spending growth, which can jeopardise the long-term sustainability of public finances (creating or aggravating issues related to higher public deficits, public debt, tax rates, etc.). Earmarked grants, especially matching grants, can be problematic for municipalities with low levels of own revenue, especially if the conditional grant is a matching grant, i.e., an own funding share of the recipient municipality is required. This is because for the municipalities with weak tax bases it can be hard to raise enough own revenue to cover the self-financing shares.
The non-earmarked (unconditional) grants can be divided into block grants and general purpose grants. Block grants and general purpose grants are typically defined using formulae, and they are usually recommended for funding subnational governments because they come with no strings attached and allow subnational governments a wider margin of manoeuvre to allocate the resources according to local needs and circumstances. Non-earmarked grants give more decision-making freedom for regions and municipalities to use the funds. There are three main types of such transfers: general per capita grants, revenue equalisation grants, and expenditure equalisation grants. A general per capita grant provides the same amount of revenue per capita to each municipality.
The problem with such general per capita grant is that it does not consider the (tax) revenue capacity or the expenditure needs of the municipality. Equalisation grants have been developed for that purpose. The revenue equalisation grants assist municipalities whose tax capacity is lower than some standard level, usually the average. Expenditure equalising grants aim to take into account the service needs (e.g., number of students, demographics, length of roads) and circumstantial factors (e.g., population, population density, remoteness) of expenditures to ensure that every municipality can provide at least a minimum acceptable level of service with a comparable tax rate. Vertical equalisation arrangements refer to transfers from the central to subnational governments, whereas horizontal equalisation arrangements constitute transfers from wealthier jurisdictions to poorer ones, a practice also known as the “Robin Hood principle”.
OECD countries have most often opted for vertical fiscal equalisation transfers alone (e.g., Australia, Canada, Japan) or for a combination of the horizontal and vertical approaches (e.g., Finland, Germany, Norway, Spain, Sweden and Switzerland).
