The coronavirus (COVID-19) pandemic that has been wreaking havoc throughout Latin America and the Caribbean (LAC) since the first quarter of the year has had a major impact not just on people’s health but also on public finances in every country, both at national and at subnational level. According to the International Monetary Fund (IMF), the region’s real gross domestic product (GDP) is expected to decline by 8.1 percent in 2020 and to recover slightly in 2021.
Even before the arrival of the virus, LAC’s inter-governmental finances were facing all sorts of systemic problems, which the pandemic both exposed and intensified, hindering the ability of subnational governments (SNGs) to deliver quality goods and services to their citizens.
Strengthening the capacities of subnational governments is all the more relevant given the key role they have played in the fight against the pandemic. In line with the support the IDB has been providing lately to the region’s SNGs, the Bank’s Fiscal Management Division organized a webinar with our decentralization and subnational fiscal management expert network to discuss the challenges and opportunities for medium -and long- term reform that the pandemic is posing to intergovernmental finances in the region. This webinar is part of a series of virtual discussions that we have been conducting within our network. Last May, we held a series of virtual dialogs to discuss the subnational governments’ response to the crisis and the lessons learned to tackle the pandemic.
Our latest event was opened by IDB’s fiscal management specialist Andrés Muñoz and by New York University professor Paul Smoke, had interventions by participants from most of the network’s member countries, and final remarks by professor Richard Bird of the Rotman School of Management of the University of Toronto. Based on the presentations and knowledge shared by participating countries, we have produced a summary of the challenges discussed and the opportunities for reform, as well as some ideas on how to implement them.
Problems Exposed and Intensified by the Pandemic: Three Main Issues
There are three major problems with intergovernmental finances in the region that the coronavirus crisis is exacerbating:
Growing vertical imbalances. Before the pandemic struck, LAC’s SNGs were already showing a strong dependence on transfers, of about 5% of GDP on average, which is a larger share than that of other development regions. This strong dependence weakens SNGs’ accountability to citizens, causing fiscal laziness, lower quality of public expenditure, and fewer incentives for fiscal responsibility, among other problems. This year, the crisis is increasing regional SNGs expenditures and reducing their revenues, making these vertical fiscal imbalances (the difference between SNGs own revenues and their spending needs) to surge rapidly and dramatically. Further complicating matters, the resources that SNGs are receiving in the form of transfers are also being affected, jeopardizing not just fiscal sustainability but also the supply of subnational goods and services that are essential for the population.
Major regional disparities. There are major economic and fiscal disparities between SNGs in every country in the region. For example, during 2018 the average difference between those intermediate governments (provinces, states) in LAC with the highest and lowest per capita spending was fourfold – much bigger than in OECD countries. This creates huge disparities, regarding quality and access to public services, between regions within each country. In addition, the pandemic is also having asymmetrical regional impacts that will probably further amplify existing territorial disparities.
Fragile fiscal sustainability. Before the pandemic, both fiscal deficits and debt at subnational level were on the rise, although relatively low and in most cases still manageable. On average, SNGs in the region’s largest countries, which have more financial tools at their disposal, had a deficit of around 0.5% of GDP and debt of nearly 6% of GDP. However, this apparent sustainability conceals a procyclical fiscal behavior, often triggered by rigid fiscal frameworks and rules that lead to declines in subnational public investment and impair future economic growth prospects. The pandemic has further worsened this scenario, generating SNGs liquidity problems and weakening their debt servicing capabilities. It is also forcing both national and subnational governments to reallocate resources for the emergency, pulling them away from key infrastructure projects, which are being either halted and/or postponed.
In sum, the current pandemic is exacerbating these three traditional problems of our region’s intergovernmental finances.
What can be done in this situation? Possible themes for the future reforms’ agenda
In this scenario, it is probably imperative for regional countries to begin drawing action plans and reforms to their intergovernmental finances to better tackle the sector’s traditional problems. These efforts should hinge upon key principles, such as enhanced local autonomy, recognition of territorial asymmetries, a quest for a more balanced regional development, better intergovernmental coordination and cooperation, and interrelatedness among all pillars of fiscal decentralization systems. Priorities to be considered include:
1. Better management, review, and expansion of SNGs tax powers. The region’s SNGs need to have access to sufficient revenues, more collection efficiency, and an equitable revenue growth. Regarding sufficiency, the key is having more solid revenues that are diversified and less distortive. Concerning collection efficiency, aspects such as tax administrations integration and interoperability are crucial, as is the need to conduct a thorough review of each country’s tax administration models, bearing in mind the asymmetries between SNGs. Regarding equitable revenue growth, property tax and land value capture are instruments that have become particularly relevant due to their progressiveness and lower negative incidence on local economic growth.
Two countries that are taking action in this regard are Peru –which is promoting an integrated municipal tax collection system and updating its urban land registries– and Guatemala, which is making improvements to its Integrated Financial Management System for Local Governments in order to support municipal revenues.
2. Clearly define and coordinate expenditure responsibilities. The SNGs, working together with their central governments, need to do more with less, reducing expenditure inefficiencies.
One of the keys for this is more clarity in the responsibilities of each level of government. More clarity would help reduce expenditure overlaps and generate more transparency and incentives for better SNG accountability. In addition, coordination can play a key role in the post-pandemic era, for example promoting collaborative or demand-aggregation procurement, collaborating in capacity building, and making arrangements for the intergovernmental planning of public investments.
On this last topic, many countries in the region (Argentina, Chile, Colombia, and Honduras, to name but a few) are crafting different initiatives that aim to boost the consistency and linkability between national and regional planning, seeking to maximize the impact of each individual project.
3. Address territorial fiscal disparities. For current expenditure, it is key to stimulate equalizing transfers to bridge the gap between spending needs and fiscal capacity at the subnational level. This can help SNGs to provide public services that are comparable, in terms of quality and quantity throughout the territory, based on a similar fiscal effort. The same approach should apply to capital expenditure, designing capital transfers based on equity criteria to make compensations that are in line with the SNGs accumulated infrastructure stock, or implementing regional economic convergence transfers.
For example, in Chile a bill was introduced in Congress that, among other things, aims to restructure transfers to regional governments along territorial equality lines. And Peru is reforming its Regional Compensation Fund (FONCOR), both adding more funds and boosting its territorial distribution capacities.
4. Setting up stabilization mechanisms. For SNGs, predictability in the flow of transfers is essential to meet their public service and financial obligations.
There are a number of different ways to mitigate transfer volatility, from including countercyclical elements such as linking transfers to a fixed real economic growth rate –which is what Colombia did for many years– to the creation of stabilization funds. Mexico is a good example of the latter approach, with the establishment more than a decade ago of the Federative Entities Revenue Stabilization Fund (FEIEF). Later, when the pandemic struck, the central government changed the operating rules, implementing a new system to finance the fund that is expected to help maintain the stability of resources’ flow to the SNGs. In addition, Peru is designing a mechanism called Canon and Royalties Stabilization Fund (FOCAR) to help tackle the problem of high volatility of resources stemming from natural resources’ fiscal revenue.
How to Implement Reforms to Strengthen Subnational Finances in a Post-COVID-19 World?
To launch a reform of intergovernmental finances, the first –and probably the easiest– step is its technical design. However, it is also crucial to understand and incorporate political economy considerations, including their legislative debate. Here are some ideas that can help boost a reform’s chances of success:
Identify the problems and the tactical entry points. For the initial stages of a reform, it can be helpful to focus on changes that are easy to implement in the short term and that are likely to yield the most benefits and generate the least resistance from other stakeholders. In other words, first go for the low-hanging fruits. Short-term results tend to legitimize the reform in the eyes of the different groups involved (including public opinion), and help solidify the political will that is needed to thrust ahead with the reform. It is likewise vital to clearly identify the problems you want to solve, as well as their origin, to avoid wasting limited resources and discouraging stakeholders. For example, it is possible to invest large sums of money updating property registries without improving revenue collection, simply because citizens may decide not to pay property taxes if they feel that the public services they are receiving from the government are not good enough. In cases like this, it may be wiser to invest first in awareness campaigns to help people understand why it is important to pay taxes if they want services to improve.
Forge political and institutional agreements. In any reform, and in those dealing with fiscal decentralization, it is important to identify partners willing to spur its implementation. With this in mind, it is crucial to remain open-minded about having to negotiate at least some aspects of the proposal. These negotiations require establishing and empowering intergovernmental coordination mechanisms for policy design and implementation; embedding performance incentives in the reforms (be they legal, political, or financial) to spur implementation; and paying careful attention to SNGs asymmetries. In sum, it is essential to include in the reform some elements coming from the SNGs, as reform processes too often tend to focus on central government goals while disregarding SNG demands and objectives.
Build capacities in the right sequence. During reform implementation, it is critical that central governments provide monitoring and technical assistance to those SNGs requiring it. Whenever possible, once the pandemic is over, this assistance should be provided on site to build up trust and stronger links among the different levels of government. When designing the reforms, it is also important to link the assistance and capacity building to the specific functions that are being taken over by the SNGs. Lastly, it is also necessary to build capacity on governance issues, not just on technical matters.
At the IDB’s Fiscal Management Division, we know that meeting the short-term needs created by the coronavirus pandemic is a pressing issue for all nations in LAC. However, the post-pandemic phase is just around the corner, and those governments that are better prepared, with more advanced and concrete plans, will be navigating this next stage more comfortably.
 “Fiscal decentralization and coronavirus: challenges and opportunities in the post-pandemic world” webinar, held on Sept. 24, 2020 as part of the activities of the Decentralization and Subnational Fiscal Management Network of LAC.
 Estimated figure based on IDB’s Subnational Fiscal Information Platform.
 For more information on inequality in the region, go to: “IDB. (2020). The Inequality Crisis: Latin America and the Caribbean at the Crossroads.”
 There already is evidence in Brazil of the asymmetric regional fiscal impacts caused by the pandemic (MacDowell and Rossi, soon to be published).
 For more information, go to: “The hidden potential: Determinants and opportunities of the property tax in Latin America.”