chapter  6
46 Pages

6 Capital infrastructure and equity objectives in decentralized systems JORGE MARTíNEz - VázqUEz AND ANDREY TIMOFEEV

Introduction: issues and motivation Equity concerns about decentralization are particularly acute in the case of capital infrastructure services. This is because the share of subnational governments in total capital expenditures of a country is typically twice their share in total recurrent expenditures (Martínez-Vázquez and Timofeev, 2012). This is true for developing and developed countries. While on average the subnational share of capital expenditures is 60 percent, the share of subnational governments in recurrent expenditures is 30 percent (Figure 6.1). In addition to the potential disparities in the quantity and quality of public services offered to residents, to the extent that the availability of public infrastructure determines the attractiveness of a locality for doing business, unless properly addressed, fiscal disparities in the stock of infrastructure can feed back through different levels of private investments into economic disparities, creating a vicious circle for less endowed subnational jurisdictions. For that reason central governments might desire to implement even higher degrees of equalization for productive economic infrastructure than for social infrastructure.1 To the extent that the main objective of intergovernmental grants, and more in particular equalization transfers, is to ensure the “adequate” financing of decentralized functions, it is easy to argue convincingly that this adequacy should be assessed in terms of the entire expenditure needs, including capital infrastructure. Generally, in most decentralized systems the need to provide equal financing abilities, taking into account the different fiscal capacities of subnational units, to provide a standard basket of public services is not questioned. However, this broad consensus in the theory and practice of fiscal federalism has been focused on the recurrent expenditures needed to finance those public services. Nevertheless, it is pretty immediate that most of these services cannot be adequately provided without the existence of the complementary infrastructure inputs (e.g., recurrent expenditures for teacher salaries, textbooks, etc. need to be complemented by school buildings to deliver education services.). While the system of grants should balance available resources with the entirety of capital and non-capital costs in the provision of subnational services, it is a separate and unresolved question in the intergovernmental grants literature

whether capital financing needs should be arranged separately in an earmarked manner. On average, explicit capital grants account for only about one-third of net subnational investments and this share ranges from less than one-fifth in lower-middle counties to over a half in OECD countries (Figure 6.2). In particular, in the transitional countries capital grants have played a smaller role in the financing of local infrastructure than own current and capital revenues of local governments (the latter often from the sale of assets), and borrowing; in particular, borrowing has been more prevalent in Central Europe (Swianiewicz, 2004). Conceptually, there are potential efficiency losses associated with the different treatment of operating and capital cost needs of subnational governments; for example, it can lead to deferred maintenance. The practice of budget unity and integrity allows for establishing the optimal level of activities needed to maintain or replace public infrastructure assets according to their originally contemplated serviceability. In particular, proper maintenance can avoid the capital costs of replacement for the optimal period of time. On the other hand, under separation of capital budgets and funding, local managers might try to save on operating costs by not performing (or deferring) maintenance at the proper time without perceiving, or trying to shift to another level of government, the incurred capital costs of this strategy. Furthermore, depending on the practices of upperlevel governments, in some countries, proper maintenance of capital infrastructure may reduce the chances of receiving funds for capital rehabilitation, as the practice of allocation of grants may be based on the physical shape of assets.2