Report No. 15487-AR Argentina Provincial Finances Study...Both democratic politics and sound...

Report No. 15487-AR

ArgentinaProvincial Finances StudySelected Issues in Fiscal Federalism(In Two Volumes) Volume Il: Technical Annexes

July 12, 1996

Public Sector Management & Private Sector Development DivisionCountry Department ILatin America and the Caribbean Regional Office

,,.c,t of the World Bank "

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Currency EquivalentsCurrency Unit: Peso

US$1 = ARG$1

Fiscal YearJanuary 1 to December 31

ABBREVIATIONS AND ACRONYMS

ATN Aportes Tesoro Nacional, Transfers of National TreasuryCAS Country Assistance StrategyCFI Coparticipacion Federal de ImpuestosEFCB Emergency Financial Control BoardFEDEI National Electric Development FundFIEL Foundation for Latin Amercian Economic ResearchFONAVI National Housing FundGDP Gross Domestic ProductGO General Revenue BondIDB Interamerican Development BankMAC Municipal Assistance CorporationMCBA Municipalidad de Buenos AiresNBI Unsatisfied Basic NeedsPEM Public Expenditure Management

ARGENTINA PROVINCIAL FINANCES STUDY

Technical Appendixes'

Table of Contents

Annex 1: Restructuring Fiscal Federalism In Argentina

Introduction ................................................... 1Approach ................................................... 3

The Big Questions ................................................... 3Expenditure Assignment ................................................... 3Revenue Assignment ................................................... 4Vertical Imbalance ................................................... 4Equalization ................................................... 6Policy Objectives ................................................... 7

Provincial Taxation ................................................... 8Introduction ................................................... 8Criteria for a Good Provincial Tax .................................................. 11Automobile Taxes ................................................... 13Property Taxes .................................................. 16Gross Receipts Tax ................................................... 17Additional Revenue Possibilities .................................................. 18

Revenue-Sharing and Intergovernmental Transfers .................................................. 21Introduction .................................................. 21Intergovernmental Fiscal Transfers: Principles .................................................. 24The Present Transfer System ................................................... 30

Conclusion .................................................. 39References .................................................. 40

Boxes:

Box 1. Argentina: An "Emerging" Federation? ....................................... .............. 2Box 2. Accountability as the "Bottom Line" . .................................................... 5Box 3. Interpersonal Resdistribution and Intergovernmental Transfers .............. ..............7Box 4. Municipal Taxes And Fees .................................................... 10Box 5. What Is A "Provincial" Tax? .................................................... 12Box 6. The Choice Of Subnational Taxes .................................................... 13

The authors of the Appendixes were as follows: Annex 1, Restructuring Fiscal Federalism, Richard Bird;Annex 2, Walking Through Argentina Fiscal Federalism, based on Juan Sanguinetti's Report; Annex 3-Improving Financial Management Capacity, David Grossman; Annex 4 - Financial Capacity Assessmentand Simulation Model - Ben Darche.

Box 7. Limits To Property Taxation ............................................................ 15Box 8. A Provincial Vat? ............................................................ 19Box 9. Fiscal Capacity And Fiscal Effort ............................................................ 23Box 10. Matching (Conditional) Transfers ......................................... 26Box 11. Changes In Coparticipation Law, 1988-1995 ................................................... 29Box 12 Determining The "Primary Distribution" ........................................................ ;... 32Box 13. Capitation Grants For Education .......................................... 34Box 14. Determining The Secondary Distribution ......................................................... 35

Tables:

Table 1. Tax Collections, by Level of Government and Type of Tax, 1994 ...................... 9Table 2. Major Provincial Taxes, 1994 ................................................................. 11Table 3. The Structure of Provincial Revenues,1995 ........................................................ 21Table 4. Provinces: Selected ndicators ................................................................. 22Table 5. Transfers to Provinces, 1994 ................................................................. 31Table 6. Allocation of taxes that make the shared-revenues pool .............. ....................... 31

Annex 2:- Walking Through Fiscal Federalism In Argentina ....................................... 42

Annex 3: Strengthening The Institutional Framework ............................................... 46

Introduction .................................................................. 46

Assessing Financial Management .................................................................. 48Financial Management Systems .................................................................. 48

Budgeting .................................................................. 47Accounting .................................................................. 50Auditing .................................................................. 50Performance Measurement .................................................................. 52Integrating The Components .................................................................. 52

Other Significant Management Systems ................................................................ 53Relationship Between Responsibility And Resources ............................................... 53Willingness To Manage .................................................................. 54

Current Status Of Provincial Financial Management ............................. ...................... 54

Strengthening Provincial Fiscal Management ................................................................ 56Relevant Experience .................................................................. 56Standard Fiscal Control echanisms .................................................................. 60Fiscal Emergency Control echanisms .................................................................. 62

Increasing Access To Long Term Finance .................................................................. 64Relevant Experience .................................................................. 64

Applicability To Argentina ............................................................ 66

Recommended Actions .................................................................. 66

Annex 4: Comparative Creditworthiness Assessment of The Argentine Provinces.. 70

Introduction .................................................................. 70Creditworthiness Measures in the Context of the Argentine Provinces ....................... 70Creditworthiness Simulation Model Methodology and Results ................................... 72

Indicator trends .................................................................. 77M ethodology and Results ............................ ...................................... 78

Conclusions .................................................................. 83

Tables in the Text

Table 1: Printout Model to project Main Variables ...................................................... 73Table 2: Population and Economic Base Indicators and Score ..................................... 86Table 3: Financial Operations and Debt Indicators .................................................... 87Table 4: Debt Indicators' scores ........................................................ 88Table 5: Expenditure Flexibility and Financial Management Score ............................... 89Table 6: Creditworthiness Matrix ........................................................ 90Table 7: Simulation of Ranking Provinces ........................................................ 94

Annex 1: Restructuring Fiscal Federalism in Argentina 1

Restructuring Fiscal Federalism in Argentina

Introduction

1.1. Intergovernmental fiscal relations are under strain in Argentina. The system of "fiscalfederalism" patched together in the last days of the hyperinflationary 1 980s is unsuited to today'scircumstances. Over the last decade, Argentina has undergone fundamental restructuring. Therestoration of democracy and the curbing of the endemic inflation have made Argentina a verydifferent country than it was in the early 1980s. But the process of structural change is by nomeans finished. Both democratic politics and sound economic policy demand further majorchanges in the fiscal relations between levels of government. The present federal fiscal systemgrew up in an era of non-democratic government and was crystallized in its present form in themiddle of hyperinflation. It is no surprise that the fiscal institutions developed in such differentcircumstances do not serve the new Argentina well. Nor, in the absence of major changes, arethey likely to do so in the future.

1.2. An important symptom of the present mismatch of fiscal institutions and fiscal needs hasbeen the emergence of significant deficits in a number of provinces in recent years. Changes areneeded both to avoid the emergence of similar problems in the future and to ensure that the"downsized" and restructured state sector provides incentives not only for sound financialmanagement at all levels of government but also for the effective and efficient delivery of publicservices.

1.3. Fortunately, 1996 offers two important opportunities for change in this direction. First, incompletion of the Pacto Fiscal, provincial governments are committed to reform their tax systemsin several specific ways. Second, the Constitution mandates that a new "Coparticipation"(Revenue-Sharing) Law is to be introduced by the end of this year. In part for these reasons,Argentine government and researchers have done an enormous amount of work on thesesubjects, and agreement appears to have been reached on the need for major changes. As yet,however, there is by no means consensus as to the precise nature of the desired changes.

1.4. One reason for the lack of consensus is the complexity of the problems that must beresolved. Some are short-term e.g. the fiscal crisis in a number of provinces. Others are long terme.g. the need to ensure that decentralized services are provided efficiently. Some are notcontroversial e.g. the need to design and implement a more stable system of transfers. Others areinherently controversial e.g. the extent to which fiscal transfers should be regionally redistributive.

1.5. The complexity of the underlying political-economic situation and the fluid nature of themany proposals for changes in federal fiscal institutions make it difficult to be comprehensive orinnovative with respect to fiscal federalism in Argentina. Our approach is to stand back from the

2 Annex 1- Restructuring Fiscal Federalism

on-going discussion, raise some fundamental questions about intergovernmental finance and tosuggest some of the implications of alternative ways-of answering these questions.

Box 1. Argentina: An "Emerging" Federation

Although Argentina's constitution has long been fornally federal in nature, its political and fiscal institutions have for manyyears operated in a centralized fashion. Throughout the world, the range of institutional structures and relations withinnominally federal countries is as wide as it is within nominally unitary countries. Indeed, the difference between a tightfederation such as Malaysia or Germany and many unitary countries is probably less than that between such federations andlooser federations such as India and Canada, in which state governments have more power to act independently with respect toexpenditure and taxing patterns. The constitutional label matters less than the reality of how intergovernmental relations workin practice.

In the traditional world of fiscal federalism (or multi-level finance), as set out by Oates (1972) in principle everything -boundaries, assignments, the level and nature of transfers, etc. - is up for grabs. In "federal finance," however, jurisdictionalboundaries and the assigrnent of functions and finances are generally taken to be fixed at some earlier (constitutional) stageand not open to further amendment in normal circumstances. In the conventional approach to fiscalfederalism, as a rule thecentral government's policy preferences are clearly dominant (in practice, if not so clearly in theory) as exemplified by thedominance of conditional transfers. Infederalfinance, however, rather than simply assuming consensus on e.g. the degree offiscal and regulatory harmonization to be attained, or even the degree to which an internal common market should be sought,such matters are in some real sense determined jointly by both levels of government in some appropriate political(constitutional) forum. In addition, both levels of government may properly pursue their own distributive policies, again withno presumption of central dominance. In such a federal setting, intergovernmental transfers are generally both equalizing andunconditional, as, for example, Shah (1995) emphasizes.

The appropriate analytical framework in the fiscal federalism setting is thus clearly a principal-agent model in which theprincipal (the central government) may alter jurisdictional boundaries, local government revenue and expenditureresponsibilities, and intergovernmental fiscal arrangements in its attempt to overcome the farniliar agency problems ofinformation asymmetry and differing objectives between principal and agent. The appropriate analytical framework in thefederal finance setting, however, is more one of bargaining between principals (who are not necessarily equal) - what oneCanadian author (Simeon, 1972) has called, in a useful analogy to the world of international relations, "federal-provincialdiplomacy." In some countries - Canada, Switzerland - this may not be a bad description of federal-state relations (Bird, 1986).

It is critical to distinguish these two broad approaches in principle because the implications for policy design that followfrom them are very different, especially with respect to the design of intergovernmental transfers. Federal finance raisesdifferent problems than those considered in the traditional literature on fiscal federalism. For example, unlike the latter, afederal finance perspective must pay close attention to the institutional analysis of reality. Particularly careful attention must bepaid to the lessons of public choice analysis with respect to the importance of what has been called the fundamental"Wicksellian connection" (3reton, 1996) between taxing and spending in order to ensure both accountability and themaintenance of a legitimate system of governance in terms of public support of government. As emphasized earlier, the"federal finance" perspective suggests that the appropriate analytical framework is one of negotiation among equals - in thewords of Wheare's classical political treatment of federalism (1969, p.10) among federal and state governments that are"...each, within a sphere, co-ordinate and independent."

Argentina has by no means as yet gone this far, however, so the basic principal-agent approach has been followed in thisreport. However, over time the federal finance approach may become increasingly applicable. The present discussion onreforming the coparticipation system perhaps afford an illustration: both sides, center and provinces, must reach an agreementbefore any significant changes can be made inthe system..

1.6. Argentina appears to be what may be called an "emerging" federation (Box 1). Thedecisions to be made with respect to intergovernmental fiscal arrangements over the next few


years are likely to prove critical influences on the nature of the state in the long run. Such mattersshould not be decided by a few persons working in isolation under a tight deadline. They are thecore of nationhood and will inevitably take time and careful effort to work out and implement.The present report is intended as a first small contribution to this important task.

The Approach of this Report

The Big Questions

1.7. Four big questions must be answered with respect to intergovernmental finance in anycountry, whether formally "federal" or not:

(a) Who does what? - the question of expenditure assignment.(b) Who levies what taxes? - the question of revenue assignment.(c) How is the (virtually inevitable) imbalance between the revenues and expenditures

of subnational governments that results from the answers to the first two questionsto be resolved? - the question of vertical imbalance.

(d) To what extent should fiscal institutions attempt to adjust for the differences inneeds and capacities between different governmental units at the same level ofgovernment? - the question of horizontal imbalance, or equalization.

1.8. Ideally, these questions should be approached in the specific circumstances of eachcountry with the aim of achieving the relevant policy objectives - not only the normal publicfinance trio of efficiency (allocation), equity (distribution) and stabilization but also economicgrowth as well as such nebulous (but politically resonant) goals as "regional balance." In manyinstances, of course, there will be conflicts not only between these objectives but also betweenlocal and central perceptions of the weights to be attached to them.

1.9 Moreover, intergovernmental fiscal policies must be developed taking into account bothpolitical constraints (e.g. the strength of different regions and groups in political decisions) andeconomic constraints (e.g. the stage of development of financial markets) facing policy-makers.Finally, all policy changes proposed must start from the given set of initial conditions: everycountry has a history, and the current state of its fiscal institutions in large part reflects the resultsof the process of policy change over time.

Expenditure Assignment

1.10 The question of expenditure assignment, is not discussed extensively in the present report.How government functions should be divided among levels of government is a complex matter, towhich each country has its own unique solution. Basically, Argentina has assigned majorexpenditure responsibilities in the area of education (primary and secondary), health, justice


(police), and urban services to provincial and local governments. On the whole, this assignment isreasonable, in line with theory and international practice.

1.11 Other important questions could use further study - e.g. the division of functions betweenprovinces and municipalities, variations in the efficiency (or lack of it) with which importantservices such as education are provided, the degree of national interest in the efficient andeffective provision of services (education, some health) related to the level of "human capital"embedded in potentially migratory workers, and so on. Such matters must largely be left aside inthe present discussion, however.

Revenue Assignment

1.12. Who levies what taxes is one of the major issues in Argentina at present. This question isdiscussed at more length in the next section. A number of important issues of tax policy designand implementation must be considered in Argentina. The "correct" revenue assignment in amulti-level government structure, particularly in an "emerging" federation like Argentina (Box 1),is by no means clear in principle, and is certainly likely to prove highly controversial in practice.

1.13 The fundamental problems are two. First, the central government can inherently collectmost taxes more efficiently than can provincial governments. Second, the potential tax bases thatcan be reached by the latter vary widely from province to province. The first of these problemsgives rise to vertical imbalance; the second produces horizontal imbalance. To some extent theseproblems may be alleviated by e.g. using provincial surcharges on national taxes, as discussedbelow. Most of the desired (and desirable) aims of decentralized revenue policy can be achievedsolely by allowing variation of the rates of such surcharges, perhaps subject to a constraint onminimum rates to restrict competition for tax base. In addition, since "tax exporting" breaks thecritical link between provincial spending and residents' tax burden, care should also be taken toprevent provinces from exporting their tax burdens - e.g., limiting access to the taxation ofbusiness. '

Vertical Imbalance

1.14. No matter how revenues and expenditures are reassigned, a problem of vertical imbalancewill almost certainly remain, or so worldwide experience suggests. Even if the tax base of therichest province enabled it to balance "own" revenues and expenditures, imbalances would remainfor all the rest. Moreover, history suggests that the differential elasticity of expenditures andrevenues assigned to different government levels would soon lead to a re-emergence of a verticalimbalance problem even for the richest province. One way or another, structural "gaps" willemerge and have to be dealt with.

'Parenthetically, all of these questions - like those on expenditure assignment - should also be considered withrespect to the division of functions and finances between provincial and muncipal governments, although thisaspect cannot be further considered here.


1.15 Tfie most common alternative is to have centrally-collected revenues transferred toprovincial governments. Such transfers are of course the major source of provincial revenues inArgentina today, and this situation seems unlikely to change significantly for most provinces in thefuture. Together with a properly designed provincial (and municipal) tax base, a properly designedtransfer system is therefore a key element in the needed rethinking of Argentina's federal financesystem. Section 4 report discusses the major issues that need to be considered in this respect.

1.16 It may be useful to emphasize two key points here: First, all transfers (not just"coparticipation") must be taken into account when discussing vertical imbalance: a pesotransferred is a peso transferred, no matter what label is attached to it. Second, as many writerson fiscal federalism in Argentina have properly stressed, a critical aim in redesigning the transfersystem is to ensure that adequate incentives for "fiscal responsibility" are provided.Accountability is the public sector equivalent of the "bottom line" in the private sector (see Box2). Without adequate accountability public sector decision-makers are unlikely to make effectiveand efficient resource allocation decisions (to the extent that any political process can producesuch decisions).

Box 2. Accountability as the "Bottom Line"

If decentralization is to work, those charged with providing local infrastructure and services must be accountableboth to those who pay for them and to those who benefit from them. Unfortunately, enforcing accountability at the locallevel is not always easy. It requires clear incentives from above and the provision of adequate information to localconstituents as well as the opportunity for them to exercise some real influence or control over the service delivery system."Informal" organizations almost by definition must be structured like this or they cannot exist. But it can be a challenge

in the political and social circumstances of many developing countries to introduce a similar degree of responsiveness intoformal governmental organizations.

Accountability is the key to improved public sector performance, and information is the key to accountability.The systematic collection, analysis, and reporting of information that can be used to verify compliance with goals and toassist future decisions is thus a critical element in any decentralization program. Such information is essential both toinformed public participation through the political process and to the monitoring of local activity by central agenciesresponsible for supervising and (usually) partially financing such activity. Unless local "publics" are nmade aware of whatis done, how well it is done, how much it cost, and who paid for it, no local constituency for effective government can becreated. Unless central agencies monitor and evaluate local performance, there can be no assurance that functions ofnational importance are adequately performed once they have been decentralized.

An important accompaniment of any decentralization program is thus an improvement in national evaluationcapacity. Decentralization and evaluation (e.g. cost-benefit analysis) are not substitutes; they are complements. Anessential element of the "hard budget constraint" system needed to induce efficient local decisions is adequate centralenforcement capacity in the shape of credible infonnation-gathering and evaluation. The "carrot" of central financialsupport of local efforts must be accompanied by the "stick" of withdrawn support if performance is inadequate, which ofcourse requires both some standard of adequacy and some way of knowing whether performance is satisfactory.

6 Annex 1- Restructwrinf Fiscal Federalism

1.17 The critical point in this respect is accountability at the margin i.e. it is perfectly possible(in principle) for a provincial government to be 90% dependent of federal transfers and still befully accountable - to its citizens and/or the central government, depending on circumstances. Forthis reason, the best form of intergovernmental transfer is one the amount of which is fixed inadvance, i.e. will not be altered as a result of any (in-period) action by the recipient. Such atransfer by formula implies that at the margin, local actions to raise or lower local revenues orexpenditures will directly affect outcomes - which is what is needed to ensure politicalaccountability. 2

Equalization.

1.18 Horizontal imbalance, or equalization, is the most controversial, and least amenable toanalytical resolution, of the four "big questions" and it is discussed more extensively in section 4below. At this stage, it may suffice simply to make three comments.

(a) Interpersonal and interregional equalization are different matters, and there is nonecessary connection between the two (see Box 3). Indeed, it is a serious mistaketo attempt to achieve interpersonal distributional goals through interregionaltransfers: the result is likely to be both redistributional failure and an undulycomplex and ineffective transfer system.

(b) An equally important distinction must be drawn between equalization and regionaldevelopment (or "balance") policies: again, there is no necessary connectionbetween the two. In the present paper, to keep matters simple, it is assumed thattransfer policies have (and should have) no specifically "regional development"objectives.3

(c) Finally, as discussed later, a properly-designed (and simple) equalization formulacan and should provide all the incentives that are needed (or desirable) for"fiscal effort."4

2Two exceptions to this rule, discussed later, are when transfers are explicitly intended either to ensure theprovision of specific services at specific levels (i.e. the transfers are essentially payments to provinces acting asagents: see Box 14) or to induce provinces to provide more of certain services than they would otherwise do (seeBox 11).

3This is clearly an oversimplification: for more discussion, see Bird (1982, 1984)

4See also the discussion of fiscal effort in Box 10. Incidentally, an equalization formula can also, if desired,achieve the vertical balance goal discussed above. That is, rather than considering the questions of "primarydistribution" (federal-provincial) and "secondaxy distribution" (interprovincial) separately, they can be resolvedsimultaneously (as in e.g. Canada) if desired. This point is not pursued fiuther here, however.

Annex 1: Restructuring Fiscal Federalism in Argenhna 7

BOX 3. Interpersonal Redistribution and Intergovernmental Transfers

Some analysts assess intergovernmental transfers in part by how successfully they serve as proxies for directinterpersonal distnbutional measures (Porto and Sanguinetti, 1995). Although most transfers to provinces are unconditional inArgentina, the relationship of transfers and poverty is broadly positive, with poorer provinces receiving more support from thecentral government, though it is not the very poorest that gain most. The regional redistributive process seldom runssmoothly, however. For instance, the data in Porto and Sanguinetti (1993) indicate that per capita transfers to the poorestprovinces (Chaco, Formosa and Santiago del Estero), which have around 40% of their populations under the poverty line, areonly slightly higher than the average per capita transfer to all provinces. On the other hand, some wealthier provinces receivedalmost double the average per capita transfer.

In many countries, transfers, particularly those for investment purposes, are clearly influenced by politicaUy-relatedterritorial criteria. In Chile, for example, most regional investment is done by the central government (72%) and, as inArgentina, favors frontier regions in the south with low population density (Aisen and Magalanes). Nonetheless, the poorestregions of Chile (Maule and Biobio) received investment per capita close to the average alocated by the central government in1991 (using data from Espinoza and Marcel, 1993). Of course, mnany poor families live in rich regions. Over half the Chileanswith incomes below the poverty line live in the wealthiest regions of the country - the Metropolitan Region of Santiago,Valparaiso and Libertador (all in Central Chile). Tenitorially based transfers are inherently inefficient in reaching these poorfamilies.

In principle, the greater the weight that the central government places upon the equitable delivery of essential services tospecific groups of poor citizens, the less the weight that can be given to the autonomy of local governments to spend as they seefit. If a principal aim of central policy is to deliver "basic needs" to the poor, either the central government should do it itself,or it will have to develop an elaborate and detailed (and probably not very effective) monitoring system to ensure that localgovernments perform their role as agents of central policy efficiently and equitably. Decentralization, properly carried out,may have many virtues But doing exactly what the central government wants in terms of income redistribution is not likely tobe one of them.

International experience suggests that the main guideline for those who would decentralize successfully, while at thesame time focusing on poverty-alleviating policies, should be do not conmlicate ntergovenunentalfinance unnecessariy. Ifthe central government wants to deliver specific services to specific (poor) households, it should do so if it can without furthercomplicating intergovernmental finance. Many of the complications, and complaints, characterizing intergovernnental fiscalissues in most countries result from overloading the system with tasks for which it is ill-equipped, such as targeted povertyalleviation. Whenever feasible, direct tansfers to the poor are better than indirect transfers to localities - even poor localities -that are intended primarily to help poor households.

In short, if the provision of a nationwide basic unifonn level of health or educational services is an importantobjective of national policy, the national government should either provide such services itself or directly (e.g. through somevariant of vouchers) transfer the needed resources to the target population.

Policy Objectives

1.19. Finally, although the point is probably clear enough in what has already been said in thissection, it may be useful to emphasize that the discussion of provincial taxes and transfer design insections 3 and 4 simply assumes that the principal concerns of policy in this area are, essentially,


the usual public finance triad of equity, efficiency, and stabilization, subject to the usual publicchoice constraint of political feasibility in the special context of an emerging federal state.

1.20. Equity is considered here only in the limited sense of "equalization" as understood in theusual fiscal federalism literature. Stabilization is taken into account largely in discussing thestarting point for the simulation exercise described later (deciding the size of the distributablepool) and how this total might be adjusted over time. The main focus here is on efficiency - and,indeed, even equalization as understood here can be interpreted as an "efficiency" concept.5

1.21. "Efficiency" as used in the discussion of intergovernmental fiscal matters, however, is alabel that covers many, concepts - not simply allocative efficiency within the public sector, butalso the broader concept of the efficient division of resources between the public and privatesectors (political efficiency or accountability) and the narrower concept of administrativeefficiency, as well as the real "bottom line" as far as citizens are concerned - the effective deliveryof desired public services. The most critical issue in this respect, although not one that can bedeveloped at length here, is undoubtedly the broad concept of political efficiency i.e. who (in anideal world) determines what should be done - the local political community (and how isefficiency to be secured if resources come from "other people's money"?) or the centralgovernment (monitoring, conditionality, and other means of achieving so-called "incentivecompatibility)? This debate constitutes an important underlying theme in the following discussion.

Provincial Taxation

Introduction

1.22 In many ways the key to a sound decentralized fiscal structure lies in the revenue structureof subnational governments. If, as in Argentina, the provinces are responsible for the provision ofsuch important public sector activities as health and education, sound policy would suggest thatthey should be able to levy sufficient taxes to meet the demands for such services - provided, ofcourse, that those who make the demands are also those who have to pay the taxes. While theneeds of national governments and considerations of administrative efficiency and feasibilitygenerally mean that this aim of making each level of government fully responsible for financing itsown activities is unattainable, it is sometimes possible to approximate this goal at least for therichest subnational governments. The extreme variation in the economic bases and characteristicsof Argentina's provinces (see Table 4) means, however, that transfers are likely to remain thedominant source of revenue for many poorer provinces, no matter how amply taxing powers arebestowed on the provinces.

1.23 At present, most taxes in Argentina are collected by the central government (Table 1).The only tax field where provincial and local taxes dominate is with respect to taxes on assets -the real property tax and motor vehicle taxes. The abolition of the national assets tax in 1994

5For further discussion of this fianework, see Bird (1993); also Boadway and Flatters (1982).


means that this field has effectively become 100% subnational. The only other field wheresubnational taxes are important (apart from the social security taxes, which are not discussedhere) is with respect to domestic consumption taxes - the gross receipts tax and the stamp tax.

Table 1. Tax Collections, by Level of Government and Type of Tax, 1994Percent

Tax National Provincial Municipal Total

Income 100.00 0.00 0.00 9.36

Social Security 77.54 22.46 0.00 26.95

Property 14.26 64.61 21.13 6.00

Consumption 74.09 21.83 4.08 47.02

Trade 100.00 0.00 0.00 4.49

Other 74.45 15.80 9.75 6.18

Total 75.03 21.17 3.80 100.00

Source: Instituto de Economia y Finanzas, Universidad Nacional de Cordoba, based on data from Secretaria deProgamacion Economica y Secretaria de Asistencia de Reforma Economica Provincial

1.24. Municipal governments - excluding the Municipality of the City of Buenos Aires, which isincluded with the provincial level in Table 1 - are unimportant as taxers, and what taxes they docollect are almost entirely in the form of supplementary levies on provincial taxes on grossreceipts, real property, and automobiles (see Box 4). For this reason, although there areconsiderable variations between provinces in the role and importance of municipal governments,the discussion in this section focuses entirely on provincial taxes.

1.25. Unfortunately, the present provincial (and local) revenue structure in Argentina is, andseems likely to remain, inadequate for even the richest provinces to become essentially self-financing. Basically, the provinces have only three important taxes: on automobiles, on realproperty and on sales (see Box 5). By far the most important of these is the tax on gross receipts(Table 2), 60% of which is collected in the province and municipality of Buenos Aires, withanother 20% of the total being collected in the three other "big" provinces - Mendoza, Cordoba,and Santa Fe. The taxes on automobiles and property could certainly be strengthened in designand implementation, but even at their best these two sources of revenue will almost certainlyremain both relatively small and relatively inelastic. The only potentially important tax theprovinces possess is the gross receipts tax, which (together with the stamp tax) is currentlyundergoing major reform. This section, after a brief discussion of general criteria for subnationaltaxes, discusses in turn the automobile tax, the property tax, and the sales tax. The sectionconcludes with a brief review of other possible sources of provincial revenue.


Box 4: Municipal Taxes and Fees

Argentina is unusual in that, stnctly speaking, municipal governments are not allowed to levy any taxes at all. Insad,they are restricted to imposing "tasas" or fees for services. In practice, however, most of these "tasas" appear to resemblelocal taxes more than fees for specific services rendered. In 1994, 51% of municipal "own" revenue came from (in effect)surcharges on the provincial gross receipts taxes, 23% from taxes on real property, and 11% from taxes on automobiles,with the balance from a vanety of other minor sources. To put this another way, in 1994, although municipalities leviedless than 4% of all taxes, they accounted for 18% of total gross receipts taxes, 24% of real property taxes, and 25% ofautomobile taxes.

In some respects, the apparent idea underlying muncipal finance in Argentina makes a good deal of sense. Localgovernments can and should from an economic point of view be viewed as, in effect, "firms" delivering packages of localpublic services to residents. Like all firms they should ideally be financially self-sufficient in the sense that people shouldwant what they deliver enough to be willing to pay for it. From this perspective, the first rule of local finance should be:"Wherever possible, charge." For efficiency, charges should be levied on the direct recipients of benefits, whetherresidents, businesses, or "things" (real property). While user charges are likely to be viewed by local officials solely as apotential additional source of revenue, their main economic value is to promote economic efficiency by providing demandinformation to public sector suppliers and to ensure that what the local public sector supplies is valued at least at(marginal) cost by citizens. This efficiency objective is particularly important at the local government level since the maineconomic rationale for local government in the first place is to improve efficiency. Whenever possible, local publicservices should therefore be charged for - of course, at properly-set prices - rather than given away.

Although in most countries much less use is made of charging at the local level than seems desirable, and manyof the charges that are levied are poorly designed from an efficiency point of view, at least three types of local "charge"revenue exist almost everywhere: (1) service fees, (2) public prices, and (3) specific benefit charges.

"Service fees" include license fees (marriage, business, dog, vehicle) and various small charges levied by localgovernments essentially for performing specific services - registering this or providing a copy of that - for identifiableindividuals. Charging people for something they are reqwured by law to do may not always be sensible - for example, ifthe benefit of (say) registrating births or deaths is general and the cost is specific - but on the whole there is seldom muchharm, or much revenue, in thus recovering the cost of providing the service in question.

"Public prices" include the revenues received by local governmuents from the sale of private goods and services(other than the cost-reimbursement just described). In principle, prices of locally-provided services to identifiable privateindividuals -whether public utility charges or admission charges to recreation facilities - should be set at the competitiveprivate level, with no special tax or subsidy element included.

A final category of charge revenue is "specific benefit" taxes. They are (in theory) related in some way tospecific benefits supposedly received by specific taxpayers. Examples are: special assessments, land value incrementtaxes, improvement taxes, front footage levies, supplementary property taxes related to the provision of sewers orstreetlighting, development exactions and charges, delineation levies, and so on. Most such charges are imposed either onthe assessed value of real property, changes in that value, or on some characteristic of that property - its area, its frontage,its location. Such charges are common in Argenina e.g. in 23 municipalities in the Province of Buenos Aires within the"conurbation" of Buenos Aires, 4 charge for street lightng and cleaning on a frontage basis, 3 on the basis of a fixedcharge per residence, and 1 on a combination of the first two bases and 1 on a combination of frontage and fiscal value.On the other hand, the other 14 all charge on the basis of a surcharge on the provincial property tax base (Provincia deBuenos Aires, Noticias de Economia, marzo y abril 1995, pag.29).


Table 2. Argentina: Major Provincial Taxes, 1994

Tax Perent of Toal

Gross Receipts 56.2

Stamp 10.1

Property 17.4

Automobiles 9.9

Other 6.4

Total 100.0

Source: Ministerio del Interior, Secretaria de Asistencia para la RefornaEconomica Provincial, Estadisticas de Recaudacion y Coparticipacion.

Criteria for a Good Provincial Tax

1.26. Two basic principles of assigning revenues to subnational governments may be suggested.

* First, "own-source" revenues should ideally be sufficient to enable at least the richestsubnational governments to finance from their own resources all locally-providedservices primarily benefiting local residents.

o Second, to the extent possible, subnational revenues should be collected from localresidents only, preferably in relation to the perceived benefits they receive from localservices.

* More specifically, among the characteristics that may be sought in an "ideal"subnational tax are the following (Box 6):

* The tax base should be relatively immobile, to allow local authorities someleeway in varying rates without losing most of their tax base.

* The tax yield should be adequate to meet local needs and sufficiently buoyantover time (i.e., it should expand at least as fast as expenditures).

* The tax yield should be relatively stable and predictable over time.* The tax base should be visible, to ensure accountability.* The tax should be perceived to be reasonably fair by taxpayers.* The tax should be relatively easy to administer efficiently and effectively.

1.27 On the whole, is much to be said for allocating taxes on property to lower levels ofgovernment, as is done in Argentina. Similarly, a case can also be made for allocating either a"business" tax (like the present tax on gross receipts) or a sales tax (like the proposed retail salestax) to the provinces. On the other hand, an even stronger case can be made for allocating an


income tax (in the form of a surcharge) to the provinces. Moreover, both experience in othercountries and theoretical considerations suggest that there may be much to be said in favor ofgiving provinces power to levy a few excise taxes e.g. on alcohol, tobacco, and fuel in addition tothe existing tax on autos. These points are discussed briefly at the end of this section.

Box 5: What is a 'Provincial Tax?

The question posed in the title of this box may seem odd, but in fact it is by no means always clear who has, soto speak, "ownership" of a particular tax source. In principle, a "truly provincial" tax might perhaps be defined as one (i)assessed by provincial governments, (ii) at rates decided by provincial governments, (iii) collected by provincialgovernments, and (iv) with its proceeds accruing to provincial governments. In the real world, many taxes may possessonly one or two of these characteristics, and the "ownership" of the levy may be unclear.

In Argentina, for example, through the "coparticpation" system, many taxes accrue in part to the provinces, buttheir rates (and bases) are determined by the national government, which also assesses and collects the taxes. For mostpurposes, as is indeed commonly done in Argentina, such taxes might be considered to be really central government taxesaccompanied by transfers allocated to the provinces. This interpretation is plausible because (for the most part) there islittle connection between the amount transferred and the amount collected locally.

On the other hand, what looks to be a central tax and a related transfer program may be considered to be aprovincial tax from some perspectives. If, for example, the provincial government determines the tax base and rate andreceives all the revenues, then the only role the central government plays is as a collection agent: it may even bereimbursed for its work for instance, by being allowed to retain a small percentage of collections. Presumably, the centralgovernment has a comparative advantage in tax collection, and the provincial government has contracted for its servicesin this respect. In this case, there is no intergovernmental transfer.

Although constitutionally some interpret the present Argentine system of "revenue-sharing" along these lines -because in effect the provinces have delegated much of their revenue-raising power to the centre and are, so to speak,"compensated" through coparticipation - this interpretation is not economically meaningful because the revenues arebasically not distributed on a derivation basis and all the relevant tax rates and bases are entirely determined by thenational government For this reason, the only "provincial" taxes discussed in this report are those for which theprovinces have authority to set bases and (within limits) rates, as well as to collect the taxes and spend the proceeds,namely, the taxes on real property, automobiles, and gross receipts. In principle, however, as discussed briefly in thereport provinces rmight levy surcharges on national taxes, which would be collected by the national government and theproceeds remitted to the province which imposed the surcharge. Such surcharges would be "provincial" taxes in terms ofpolitical accountability even though the national government still determined the tax base and actually collected the tax.


Box 6: The Choice of Subnational Taxes

part from transfers, subnational government taxes around the world may be divided into five groups: property taxes,business taxes (of mnany sorts), sales taxes, excises, and income taxes. The matrix depicts some of the salientcharacteristics of these revenue sources in terms of a number of possible criteria. While this presentation is obviouslyimpressionistic, it reflects the experience of a wide variety of developing countries.

PropertyTax Income Tax Sales Tax Excises Business Tax

Mobility +

Adequacy + - + ?

Buoyancy + + + +

Stability + +

Exportability +/- +/- + + -

Visibility + + + + l

Fairness + + ? ? -

Acceptability - - ? +

Administration ? + ? + +

"Mobility" refers to the mobility of the tax base. "Adequacy", "buoyancy", and "stability" to characteristics of the taxrevenues. "Fairness" refers to the conventional notion of tax progressivity, and "administration" to the ease with whichsuch a tax can be administered at locally-determined rates. "Acceptability" is a guess as to the political popularity of thedifferent taxes and is clearly related to "visibility" on the one hand and the "exportability" of the tax to non-residents onthe other. The perspective taken in assigning the values in the table is that of the benefit model of local government A "+l" means that the tax is good, a "-" that it is bad, and a "?" that it is indeterminate. A "+/-" means that the tax is good to theextent it falls on residents and bad to the extent it falls on non-residents. The income tax is assumed to be easy toadminister locally as a surcharge on the national tax. The property tax is assumed to be costly to administer. The "excise"column assumes that both fuel and vehicle taxes (basically progressive) and taxes on alcohol and tobacco (regressive) areimposed.

Automotive Taxes

1.28. The taxation of motor vehicles may be justified for three distinct reasons, andcorrespondingly divided into three separate categories. First, such taxes may provide significantrevenue: in Argentina in 1994, for example, provincial and municipal automobile taxes accountedfor 1.6% and national taxes on fuels for 3.3% of all taxes, or approximately 5% in total.6 Second,such taxes may have significant distributive aspects given the presumably high income elasticity ofprivate motor vehicle ownership and usage. Third, since motor vehicles are of little use without

6In addition, an unknown share of collections from the VAT and gross receipts taxes are also of courseattributable to automobile sales.


roads, and roads are basically publicly-provided, there is an obvious strong benefit linkage (seeBox 4) between automobile taxation and expenditure on streets and highways.7

1.29 The most important tax from a revenue perspective is the fuel tax, which is also thesimplest and cheapest form of automotive taxation from an administrative perspective. Much asthe national government appreciates the revenue it receives from this source, there is no reasonwhy fuel taxes could not equally well be levied at the provincial level. Different provinces couldimpose different taxes, subject the constraint that they would not likely be able to differ muchfrom the rates imposed by their neighbors (e.g. in the Buenos Aires area), given the mobility ofthe tax base. Administratively, differential provincial fuel taxes could easily be imposed at therefinery or wholesale level, with the refiner or wholesaler acting a collection agent for theprovinces and remitting the taxes in accordance with fuel shipments. If an option is to increaseprovincial "own" revenues (at the expense of national revenues, but presumably with acorresponding drop in national transfers8 ), a fuel tax would be one of the easiest ways to do so.

1.30 Fuel taxes are related both to road usage and to such external effects of vehicles asaccidents, pollution and congestion, although not in any very precise way. To the extentautomotive taxation is intended to "price" either the utilization of publicly-provided services orexternalities, fuel taxes are at best a crude instrument. Toll roads on the one hand (like the newhighway to La Plata) - i.e. "privatization" as it were - and a redesigned set of annual automobile(and driver) license fees can serve this "benefit tax" function much better. Such fees might bebased on such features as e.g. age and engine size of vehicle (older and larger cars generallycontribute more to pollution), location of vehicle (cars in cities add more to pollution and tocongestion), driver records (20% of drivers are responsible for 80% of accidents), and especiallythe axle-weight of the vehicle (heavier vehicles do exponentially more damage to roads andrequire roads that are more costly to build).

1.31 Finally, to the extent that it is desired to achieve some redistributional goal throughautomotive taxation, this can best be done by a national excise tax at the time of initial sale. Thepresent Argentine system, in which every province levies an array of annual taxes that vary withthe year and mrodiel of the 'eh,ic)e; a:pare5v!; 'argely in the attempt to levy a "progressive" tax,makes little sernt.&. -is appo-.- is admiinistratively complex and costly; it is not related in anyconsistent way to any distributional objective; it unduly penalizes newer (and more efficient)vehicles; and it does not "price out" public services or externalities in any meaningful way.

1.32. Provincial taxation of automobiles is a good idea. More specific study of the appropriatedesign of the automobile tax system in Argentina seems warranted, but better-designed annuallicense charges could appropriately be set at the provincial level, perhaps within national"guideline" parameters. More res-evue, anG 6etl.er econom'c effec.ts. could be achieved through arevised system of auton;kot;ve ta7: _.r, a: .pro' incial r-venues c(;uk-A be stidl iurther boosted bygiving the provinces access to trie iuel tax (through surcharges). Apart from the benefit linkages

7For extensive discussion of this question, see Heggie (1995).

8At present, some fuel tax revenues are channeled into various funds related to provincial investment (seeFigure 1). This mnatter is not discussed further here, however.

Annex 1. Restructuring Fiscal Federalism in Argentina 15

already cited, automotive (and fuel) taxation appears to be the only provincial revenue sourcethat, in principle at least, should demonstrate more than unitary income-elasticity, thus matchingthis aspect of some of the key services (education, health) for which the provinces are responsible.

Box 7: Limits to Property Taxation

While it is common to note the low level of property taxes in countries such as Argentina and to argue that there is thusobviously much room for increased local "fiscal effort" in this respect. While there is truth in this afirmation, experienceeverywhere suggests that it is neither quick nor easy to obtain additional revenues from property taxes.

The property tax is the most widespread form of local taxation. Unfortunately, experience suggests that such taxes are noteasy to administer and that they are never politically popular owing to their visibility and to certain inherentadministrative difficulties. Even in the most sophisticated countries, local property taxes seldom yield enough to financelocal services. No developed country which depends significantly upon property taxes for local fiscal resources has a localgovemment sector that accounts for more than 10 percent of total public spending (Bird and Slack, 1991). Moreover,despite substantial efforts in some countries and considerable foreign assistance, these figures have not changed much overthe years (Dillinger, 1991). The property tax may be a useful source of local revenue, but it is unlikely to providesufficient resources to finance a significant expansion of local public services in any country. Indeed, many countries havebeen hard-pressed even to maintain the present low relative importance of property tax revenues in the face of varyingprice levels and political difficulties.

A number of conditions must be satisfied for local property taxes to play a more important role in financing local activities(Dillinger, 1991). The political costs of reliance on the property tax are so high that no government with access to"cheaper" sources of finance will willingly do so. Like access to intergovernmental transfers to cover local spending,access to taxes on business which can largely be exported must be curtailed to make property taxes more attractive and, toconfront local decision-makers with the true economic (and political) costs of their decisions.

Even if this essential structural pre-condition is met. a number of other policy reforns are needed to turn the property taxinto a responsive instrument of local fiscal policy. First, and importantly, local governments must be allowed to set theirown tax rates: with the Pacto Fiscal's limits, this is no longer the case in Argentina. Secondly, the tax base must bemaintained adequately, which is easier to say than it is to do in any country. Finally, a series of procedural reforms isoften needed to improve collection efficiency, valuation accuracy, and the coverage of the potential tax base (Kelly, 1994).

One reason for the widespread resistance to the property tax is because it is a very visible tax, for several reasons. First,unlike the income tax, the property tax is not deducted at source but generally has to be paid directly by taxpayers inperiodic lump sum payments. Taxpayers who pay taxes directly to govermment tend to be more aware of the size of theirtax bill than those whose take-home pay is reduced by weekly or monthly tax deductions. The need to make such periodiclarge payments may well add to the accountability and responsibility of governments, but it also greatly increases thesensitivity of taxpayers to even nominal increases in taxes.Secondlv, the inelasticity of the property tax has a similar effect. Since the base of this tax does not as a rule increaseautomatically over time, the periodic nominal increases in property tax bills needed to maintain real revenues when pricelevels rise require increased tax rates. In terms of political accountability, this need to confront the people with the cost ofgovernment represents a virtue of the property tax; however, the downside (from the government's point of view at least)is the heightened visibility of nominal tax increases and the accompanying political resistance.Thirdly, property taxes of course finance such services as education, roads, and garbage collection. The quantity andquality of these services (or their absence) is thus readily linked to the property tax. When potholes develop in their set,taxpayers are understandably quick to question the taxes that supposedly finance street repair. Once again, the very featurethat makes the property tax a good source of local government revenue in principle makes it especially vulnerable topolitical resistance in practice.


Property Taxes

1.33. Argentina is unusual in the extent to which the provinces, rather than the municipalities,collect taxes on real property. Although there appear to be considerable variations in the propertytax from province to province, on the whole it is probably fair to conclude that (1) undoubtedlymore revenue could be collected from this source in most provinces but that (2) it is almostcertainly unrealistic to look to property taxes either for a substantial increase in revenue or as asource for funding all or most of provincial expenditures on such services as education and health(Box 7).

1.34. A rather odd feature of the Pacto Fiscal (Decreto 1907/93) is that it imposes maximumproperty tax rates (1.2% on rural, 1.35% on suburban (and "subrural"), and 1.5% on urbanproperties) and further decrees that the tax base in no case can exceed 80% of the market value ofurban or suburban, or the value of the land alone for rural, properties.9 That is, the maximumrates that can be established by any province vary from 0.96% of market value for rural to 1.2%for urban properties. This feature is not justified because in principle there is no reason why anymaximum needs to be established at all with respect to residential properties - though there maybe a case for a maximum (to restrain tax exporting) as well as a minimum (to restrain tax basecompetition, if desired) with respect to industrial and commercial properties.

1.35 Regardless of the merits of this requirement, however, its existence implies that it wouldbe fair at the present time to assume that the effective property tax rates currently in force in mostof Argentina are below these limits. Casual examination of the systems in Santa Fe, Mendoza,and Buenos Aires provinces support this conclusion. In the city of Santa Fe, for example, arecent sample survey found that two-thirds of the lots shown as "vacant" in the tax recordsactually had buildings on them, while of the lots shown with buildings, 46% actually had morebuilt-up area (30% more) than recorded. In total, 56% of all properties were underrecorded inthe records, and the true area of improvements was at least 40% greater than recorded.. Anothersample in a nearby municipality (Santo Tome) similarly found 52% of properties underrecorded inone way or another.

1.36. Although there is no information that permits linking these physical facts to values, thesefigures suggest that it might not be unreasonable to expect at least a 30%-40% increase in the taxbase as a result of an improved and updated fiscal cadastre. An increase of around this magnitudeappears to be anticipated in Mendoza (where it was said that the tax base was already close to"market values."). Similarly, a 1994 amnesty in Buenos Aires Province reportedly led 400,000taxpayers (including 170,000 whose land was vacant according to the tax roll) to report 30million square meters of construction previously unknown to the authorities (Provincia de BuenosAires, Noticias de Economia, setiembre/octubre 1994, page. 7).

1.37 As this fragmentary evidence suggests, there is undoubtedly considerable room to improvecollections from provincial (and municipal) property taxes in Argentina. All the usual techniques

91n addition, the Pacto "recommends" that the municipal surtaxes on the property tax should not exceed 0.4%or 80% of the value, or 0.32%.


could be used for this purpose10: up-to-date mapping; better and more consistent application ofwell-established valuation techniques; improved flows of information from Property Registries,local building license authorities, public utilities, etc.; improved collection procedures - none ofthe offices visited seemed to have the knowledge one would expect of the distribution of pastliabilities; and of course improved enforcement against non-payers. All these measures would helpand, within reason, no doubt all should be used, albeit with more emphasis than seems evident inArgentina at the moment on improving the "sharp end" - collection and enforcement - rather thanthe technically more costly (and less immediately productive in terms of revenue) mapping andsurveying end.

Gross Receipts Tax

1.38 The major revenue sources of the provinces have traditionally been an antiquated grossreceipts tax levied at various rates on different activities and an even more antiquated stamp tax.The Pacto Fiscal requires the stamp tax to be abolished and the gross receipts tax changed to a"oretail" sales tax. Considerable steps have already been taken in this direction in most provincese.g. by exempting primary and some industrial activities as well as suppressing most of the stamptax. As of 1995, the tax on primary production had been eliminated completely in 6 provinces andreduced to rates of 1% or less in 20 of the 24 (including MCBA) provinces, while the tax onindustry had generally been lowered to 1.5%, compared to the general rates of 2.5% on wholesaletrade, and 3.5-3.5% on retail trade and services."1 After some delay, the move to a "retail" salestax is supposed to be completed throughout the country in 1996.

1.39. From the point of view of reducing the economic distortion of the tax system, this changeis obviously desirable. From the point of view of strengthening provincial revenues, however, theeffects of replacing the existing stamp and gross receipts tax are less clearly desirable. Thenational government has estimated that a 3.5% rate on retail sales would produce the samerevenue as the existing tax, but other estimates suggest that the required replacement rate on thefeasible tax base may be as high as 6-7% on average, with the Municipality of Buenos Aires andsome provinces (e.g. San Luis) requiring rates as high as 10%.12 Clearly, adding a provincialretail tax (or VAT, which in theory has essentially the same base) to an existing federal VAT ofover 20% is not something which is either obviously desirable or likely to be politically oradministratively feasible, to say the least. For this reason, there is concern over the possiblydeleterious effects on provincial finances of the tax changes mandated by the Pacto Fiscal.

10 '°For a useful recent review, see Keith (1995).

"1The gross receipts tax, even simplified to the point it was in 1995, is not a simple tax: laying out the rates andexemptions for the 24 provinces takes 20 pages of small type!

2 See e.g. "Sustitucion del impuesto sobre los ingresos brutos: uno propuesta para la transicion," trabajopresentado a las 27 Jornadas de Finanza Publicas, Universidad Nacional de Cordoba, September 1994; also"Propuesta para un sistenia tributario federal", Ministerio de Economia de la Provincia de Buenos Aires, LaPlata, 1994, p. 53.


1.40 On the whole, these fears are not warranted. Although some provinces may havedifficulty in collecting as much from the new tax as they did from the old, on the whole theprovinces as a whole should be able to achieve this goal. One reason for this is that the new tax,like the old, will largely be collected (via what is called "perception") at the pre-retail stage. Thatis, a manufacturer or wholesaler selling a product for 100 pesos to a retailer will actually charge,say, 103 pesos, with the additional 3 pesos being remitted to the government as a sort of"withholding" against the 6 pesos (or whatever) the retailer is in principle supposed to chargewhen he sells to a final consumer, at e.g. a 100% markup for an extax price of 200, or 206 tax-inclusive. The retailer will then owe the government 6 pesos less the 3 pesos already withheld fora net tax due of 3 pesos. And of course if, as is all too likely, the retail sale does not come to thenotice of the authorities, at least they have the 3 pesos. The mechanics of this system are similarto a value added tax, and like a VAT one of the reasons for adopting it is to avoid losing all therevenue by making the only taxable act the hardest to control, namely, the final sale.

1.41 Fiscal disaster thus seems unlikely as a result of this tax change. Nonetheless, three otherpoints should also be made about the on-going reforms in provincial sales taxes:

(a) First, precisely because the "new" tax is not going to be all that different from the"old", the effects of the tax substitution on economic efficiency seem unlikely tobe very large. Indeed, what gains there are have already largely been realized as aresult of the exemption of the primary sector.

(b) Second, although there has been considerable discussion in Argentina of thepossibility of going all the way to a provincial VAT, such a move does not reallyseem desirable, both because of the inherent technical problems of subnationalVATs (see Box 8) and because in practice, as with the "retail" tax, such a changewould likely amount, at the present level of provincial tax administration inArgentina, to more a change in name rather than in reality.

(c) Finally, to reveit to the revenue perspective, this change in sales taxation certainlydoes not constitute a significant additional source of provincial revenue. Even ifthe new tax - indeed any general provincial consumption tax - were to be assuccessfully implemented as possible, the best that may be expected is for itselasticity to be unity. This may be more than the other main provincial taxes, but itis still less than is likely to be required to maintain, let alone increase, provincial"self-sufficiency" in financing services such as health and education.

Additional Revenue Possibilities

1.42 In the long run, it is desirable in Argentina to expand the revenue base of the provinces inorder to permit at least the richer provinces to become largely "fiscally self-reliant." Perhaps theeasiest way to accomplish this goal quickly would be to permit the provinces to impose taxes onthe final consumption not just of motor vehicle fuel (as discussed in section 3.3.), but also of suchother traditional excise goods as alcoholic beverages and tobacco.13 Later, as and when

'3For some discussion of provincial excises, see the B.A. study cited in note 12 above.


Argentina develops a significant income tax at the national level, the provinces might be permittedto impose proportional surcharges (to be administered by the national government) on thenational tax base. Properly designed, both provincial excises and provincial income taxsurcharges are both administratively feasible and allocatively efficient sources of revenue forsubnational governments.,4 The case for increased provincial access to general consumption taxes,although frequently discussed in Argentina, is considerably less strong (Box 8).

1.43 As mentioned earlier, a critical aspect of any expansion of provincial taxes should be toensure that the capacity of provinces to "export" their fiscal burdens to others is kept strictlylimited, for example, restricting provincial taxation of corporation profits, of sales at origin (asopposed to destination), and perhaps of nonresidential property.15 A second consideration is toprevent inefficient "tax competition" by requiring that, where businesses are taxed, at least aminimum tax should be levied. Since competition should take care of any problem at the upperend, no maximum seems needed. In addition, special problems invariably arise with respect totaxing natural resources in all countries in which, as in Argentina, provinces "own" the resourcesthat fall within their territory, but even in this case there may be feasible solutions that can bereached by agreement rather than by imposition from above - provided that the whole set offederal-provincial fiscal relations (including regionally-diverse federal tax concessions) is treatedtogether rather than one by one. 16

Box 8: A Provincial VAT?

International experience shows that no one, anywhere, has managed to work out an acceptable system for taxingsales independently at two levels of govemnment. Germany has a single VAT levied at the national level, with the statesreceiving a share of the revenues according to an agreed formula. Switzerland and Australia tax sales only at the federallevel and the United States only at the state level. The European Community, of course, also taxes only at the country, notthe community, level. Only Brazil, India, Canada, and Argentina attempt to tax sales at both state and federal levels, andonly Brazil and the province of Quebec in Canada attempt to levy a form of VAT at both levels. In every country whichattempts to tax sales separately at two levels of government, citizens are suffering unnecessarily high costs of taxation.

There are at least five resolutions to the "two-tier" sales tax problem. First, all of the sales tax may end up as aprovincial VAT or retail sales tax. This is an unlikely outcome. The federal government cannot give up the revenuewithout compensatingly drastic changes on the expenditure side that will take years if not decades to work out. Moreover,both analysis and experience suggests that only a relatively low-rate retail sales tax can be successfully levied withreasonable success at the subnational level even in countries with good tax administrations like Canada. Certainly, theprospect of a provincial retail sales tax of 20% or more in Argentina seems as remote as the propect of a 20% provincial

'4See, for example, the discussion in McLure (1993).

'5Box 8 notes that there is a possible benefit argument for pernitting limited subnational taxation of production(i.e. exports) as well as consumption. Theoretically, this is correct: in practice, however, what local jurisdictionsusually want to do is - understandably - to load as much of their tax burden as possible on "outsiders", which hasnothing to do with any "benefits" local expenditures may confer on the taxed firms.

'6See e.g. the discussion in McLure, Wallich and Litvack, 1995.


VAT seems unworkable. Those who think the European Union compromise of a "deferred payment" destination-basisVAT solves the administrative problems of provincial VATs in a situation where there is also an upper-level VAT shouldexamine more closely the only actual experience with this system, in the Province of Quebec in Canada (Mintz, Wilson,and Gendron, 1995). Incidentally, in the Quebec case, the province administers both the federal and the provincial VATs:there is no instance in which, as some have proposed in Argentina, the two levels of VAT are administered independentlyexcept in Brazil, where, as is well-known, the state VATs are both on an origin basis and not well administered.'

Secondly, all of the sales tax may move to the federal level. This is probably the best solution in many ways. It iscertainly technically feasible, and would obviously have substantial cost advantages. Moreover, it could be compensatedby a corresponding transfer of personal income tax "room" to the provinces, although it would be by no means simple towork out the details of such a transfer, and substantial adjustments would almost certainly also be required in theequalization system. Of course, some problems could be avoided if, as is the case in Germany, all or some of the proceedsof the tax could be distributed to the provinces on some agreed basis, but in effect this would simply amount to anexpansion of the coparticipation system in exchange for giving up some provincial taxing power. It it is not obvious whyeither the federal or the provincial governments would be wiling to make such a switch

Thirdly, the sales tax could become a joint federal-provincial tax, administered by one or the other level ofgovernment on a commonly-determined base, but with each government determining its own tax rate. The only way twolevels of government can levy sales taxes at a reasonable cost is by agreeing on a common tax base and letting one level ofgovernment collect the tax for both. From the point of view of accountability, this solution is preferable to the Germanapproach just mentioned. However, it seems unlikely to be workable in Argentina both because of inherent difficulties in"provincializing" the VAT base and the probable impossibility of imposing retail sales taxes at high levels in Argentina.

Fourthly, Argentina could adopt the "Canadian solution" of true provincial retail sales taxes combined with afederal VAT. As the current pressure in Canada to move from this solution to some sort of two-level VAT suggests,however, this solution is not likely to prove stable for long, even if the provinces were in fact capable of administering realretail sales taxes (as opposed to relabelled pre-retail stage levies), which seems unlikely.

In any case, it is not clear that this path is any more desirable than the fifth alternative, which is simply to carryon with the present "cleaned-up" provincial gross receipts tax - the so-called "retail" sales tax.. Although the VAT may bethe best of all possible sales taxes in some general sense, as has often been claimed, in a federal state, in which both levelsof government tax sales, there may be more to be said for maintaining two distinct sales tax bases, even at the cost of someeconomic distortion.18 This "solution" is obviously both untidy and economically somewhat costly but such costs mayperhaps be viewed as part of the price paid for a federal system which presumably has offsetting virtues e.g. with respect tobetter satisfming local preferences. So long as the perceived political cost of developing a more coherent national sales taxsystem exceeds the benefits, economic and otherwise, of doing so, one is unlikely to emerge, no matter how often analystsmay deplore the current state of affairs.

"7A reform proposal currently being discussed in Brazil is to replace the present system by a combinedstate-federal VAT, with the revenue from the nationally-determined "state" rate going to the state ofdestination (i.e. where goods or services are consumed). Many details remain to worked out (see Silvaniand dos Santos, 1996), but this would of course not really be a "provincial" tax in the tenns defined in Box6 above.

"81n this connection, it should be mentioned that to the extent provincial taxes on business are intendedto be "benefit" taxes, they should be levied on an origin rather than destination basis (Oakland and Testa,1995). Moreover, since taxes should be neutral in how they affect different factors of production, thissuggests that there may be more of a case for a provincial VAT - as a tax on production, not consumption -than is often argued, although this point cannot be further discussed here.


Revenue-Sharing and Intergovernmental Transfers

Introduction

1.44 The key to improving the incentive structure of intergovernmental finances in Argentinaclearly lies in reforming transfers and in particular the most important transfer, that arising fromthe Coparticipation Law. This is true for two reasons: First, the present and probable fitureimportance of these transfers in provincial revenues (Table 3); and, second, because the greatdiversity of conditions in the 24 provinces (Table 4) means that most of them will inevitablyremain largely dependent on federal transfers, no matter what is done in the longer run withrespect to improving provincial revenue powers and collections (e.g. by supporting of technicalassistance to provincial tax administrations).

Table 3. The Structure of Provincial Revenues, 1995

Item Millions of Pesos Percent of Total

Current Income 24,092.3 90.8Provincial Jurisdiction 10,930.9 41.2Taxes 9,290.7 35.3Non-tax revenue 1,660.2 6.3

National Jurisdiction 13,141.4 49.6Coparticipation 10,421.6 39.3Royalties 574.9 2.2Education Fund 48.0 0.2Social Security 172.5 0.6Roads 280.0 1.1Infrastructure 139.8 0.5Other 1,504.6 5.7

Capital Income 367.4 1.4Transfers (Aportes) 2,061.0 7.8

Non-repayable 1,177.8 4.4Repayable 883.2 3.3

TOTAL 26,520.7 100.0

Source: Direccion Nacional de Coordinacion Fiscal con las Provincias

22 Annex 1- Restructuing Fiscal Federalism

Table 4. Provinces: Selected 1ndicators

Per Tax Per Capita Index OwnProvinces PopuL Urban Capita Capacit Own Dev. Revenues

000 1/ % % NBI GDP Index Rev Transf Copart 1991 as %total (Media=-100) Total

Rev.2 3 4 5 6 7 8 9 10 11 12

Capital Federal (munic) 2,988 8.6 100 8 243.3 -- 784 7 59 92Buenos Aires (prov) 13,334 38.6 95 17 85.0 118 310 28 248 121 44Catamiarca 288 0.8 70 28 38.9 41 94 137 1,150 78 SChaco 891 2.6 69 40 21.8 53 119 73 610 67 17Chubut 397 1.1 88 22 86.0 101 227 94 591 125 23Cordoba 2,915 8.4 86 15 45.6 100 335 40 344 135 51Corrientes 853 2.5 74 31 42.0 42 97 64 521 86 16Entre Rios 1,063 3.1 78 21 42.4 74 264 63 518 105 33Formosa 444 1.3 68 39 22.0 31 66 120 971 62 7Jujuy2/ 552 1.6 82 36 36.0 63 200 81 651 75 25LaPampa2/ 281 0.8 74 14 72.0 88 536 117 862 135 39La Rioja 2/ 246 0.7 76 27 43.0 41 89 201 1,081 88 SMendoza 1,501 4.3 78 18 67.0 109 299 44 343 117 4Misiones 2/ 878 2.5 63 34 25.0 42 107 63 476 71 1Neuquen 460 1.3 86 21 81.9 63 610 143 553 112 3RioNegro 557 1.6 80 23 51.3 82 235 86 561 118 2Salta 952 2.8 79 37 31.8 56 190 60 464 83 8San Juan2/ 551 1.6 80 20 36.2 68 142 80 674 107 1SanLuis 320 0.9 81 22 126.7 64 225 112 826 104 21Sant. del Estero 696 2.0 61 38 55.0 30 105 88 670 61 1SantaCruz 180 0.5 91 15 24.3 71 533 247 1,213 118 23SantaFe 2,934 8.5 87 18 95.7 131 300 42 353 132 5Tierra del Fuego 97 0.3 97 22 232.9 104 107 386 1,659 106 3Tucuman+A216 1,210 3.5 77 28 40.4 77 130 53 447 96 22Total 34,587 100.0 80 20 100.0 351 47 370 45

I/Projection for 1995 prepared by the Ministry of Interior, SAREP2/ Provincial GDP for these provinces has been estimated

1.45 The data in Table 4 are included both to demonstrate the diversity of the fiscal andeconomic conditions in the 24 provinces (including MCBA) and because some of these numbersare used later in this report to illustrate the effects of alternative transfer systems.


BOX 9. Fiscal Capacity and Fiscal Effort

As it has been recognized clearly in the Argentine literature (Piffano, 1995) some measure of fiscal capacity is anessential element in the design of an intergovernmental transfer that will provide appropriate incentives to local fiscaleffort and to the appropriate use and management of transfer funds by recipient govermnents. One such measure wasconstructed some years ago for 1980 (see Table 4), and Piffano (1995) has suggested how this index might be updated, butit appears no one has as yet actually done so.

In the absence of such a measure, a rough approximation may perhaps be attempted by using the geographicGDP data presented in Table 4. As Porto and Sanguinetti (1995) state - and is mentioned in the report - this index is notlikely to be closely correlated with any reasonable tax capacity index, so this approximation must be used with care. Thecorrelation ratio between per capita own-revenues and per capita provincial GDP for those provinces for which the datawere available was 0.86, which is high for this sort of (non time-series) data. Even so, if we interpret "fiscal effort" as thedeviation between "expected" taxes (as estimated in this case on the basis of GDP) and actual taxes, it is interesting to notethe extent of these deviations. With a very few exceptions (notably Neuquen), those provinces which appear to have aboveaverage "effort" by this measure are more or less the "rich" provinces - i.e. those with "development indexes" well abovethe national average (see Table 4). This result presumably reflects mainly the bias in using per capita GDP as a measureof tax base since calculations for earlier years suggest that a more appropriate tax base measure is more highly correlatedwith the development index (e.g. correlation coefficient of 0.82 for 1980) than with GDP (correlation coefficient of 0.54):see Porto and Sanguinetti, 1995. In other words, with a more appropriate measure of tax base, the picture shown in thegraph -which largely accords with the conventional view in Argentina of "fiscally lazy" poor provinces - might easily bereversed.

In any case, even if capacity could be measured in some better way'9 many problems would remain ininterpreting changes in "effort" measures in an intergovernmental context. For example, one cannot assume either thattax bases and tax rates are independent (as in the usual "effort" measure) or that it takes the same amount of "effort" for apoor locality to raise taxes by 1 percent as it does for a rich locality to do so (which is also implicitly assumed in the usualmeasures). Even if no adjustment is made for this proportionality bias, experience in a number of countries suggests thatintroducing an effort correction into fiscal transfers often simply gives more to poorer areas - that is, increases theredistributive effect of transfers - because in practice it often turns out that poorer areas, once their much smaller fiscalcapacity is taken into account, often levy relatively higher taxes than their richer neighbors in any case. While it is ofcourse not obvious that this conclusion can be carried over to Argentina - indeed, as just noted, the figure suggests thecontraiy - such considerations, combined with the fact (discussed in the text) that the suggested form of equalizationtransfer in any case embodies a strong implicit incentive for all transfer recipients to levy taxes at least at average levels,has led most analysts to conclude that it is neither necessary nor desirable to include explicit "effort" factors in transferformulas - even when such factors can be calculated in some reliable way. Even if this is true, it is important to take "fiscaleffort" into account in a more general sense. The reason is simply because require local citizensmust to pay in somemeaningful sense for what they get if those who make local expenditure decisions are to be held accountable (throughlocal political institutions) for their actions.

'9For a recent examnple of how to do this, see e.g. Jha (1995): similar calculations could likely be madefor Argentina.


Intergovernmental Fiscal Transfers: Principles

1.46. Transfers in many ways constitute the heart of subnational finance. In themselves,transfers are neither good nor bad: what matters are their effects on such policy outcomes asallocative efficiency, distributional equity, and macroeconomic stability. Intergovernmental fiscaltransfers play several distinct roles in all countries with decentralized governmental structures. Inthe first place, such transfers are used to "close the fiscal gap", that is, they generally constitutethe principal way in which such countries achieve "vertical fiscal balance", or ensure that therevenues and expenditures of each level of government are approximately equal. Second,transfers are used to achieve "horizontal fiscal balance" ("equalization") among localgovernments. Thirdly, transfers may be used to stimulate local fiscal effort, that is, to encouragelocalities to raise their own resources. Finally, transfers may be used to influence local spendingdecisions in accordance with national policy goals. Each of these points is discussed briefly,before turning to an analysis of Argentina's existing transfer system, with special reference tocoparticipation.

1.47 Closing the Fiscal Gap. As Table 3 shows, the major role of transfers in Argentina issimply to transfer money from where it is collected (the federal government) to where it is spent(the provinces). In principle, of course, such fiscal "gaps" may also be closed, and vertical fiscalbalance restored, by transferring revenue-raising power to local governments, by transferringresponsibility for expenditures to the central government, or by reducing local expenditures orraising local revenues. Invariably, however, there remains sufficient mismatch in the revenues andexpenditures assigned to different levels of government for an important "balancing" role to beassigned to intergovernmental fiscal transfers. From the point of view of providing incentives tosound financial management, what is critical that these transfers should not simply close whatever"gap" arises as a result of actual provincial fiscal actions. Rather, transfers (or at least the majortransfers such as coparticipation) should be basically invariant to current provincial actions, asdiscussed below.

1.48 Equalization. Equalization is a controversial policy objective in many countries, and thebasic economic case for such transfers must be understood clearly. On the one hand, such atransfer may be needed to enable "poorer" local governments -- "poorer" in terms of theircapacity to raise resources out of local taxes imposed on local residents (not in terms of how highthe private incomes of those residents or the output of the locality may be) -- to respondadequately to central transfers intended to generate the appropriate level of public goods (asdiscussed below). On the other hand, an equalization transfer may be needed to enablegovernments that are poor in the sense just defined to provide an adequate "minimum bundle" oflocal public services to citizens. The argument in this case, similar to the familiar basic needsargument, is broadly that e.g. all citizens of Argentina should be entitled to some basic level ofsuch services, regardless of where they happen to live. If this proposition is accepted, then thecase for some equalization transfers is strengthened (but see Box 3).

1.49 If horizontal fiscal balance (another name for equalization) is interpreted in the same gap-filling sense as vertical fiscal balance, an equalization transfer might seem to imply that sufficienttransfers are needed to equalize revenues (including transfers) and the actual expenditures of each


local government. Such "fiscal dentistry" makes no sense, however. Closing all gaps betweenactual outlays and actual own-source revenues for all local governments ignores differences inlocal preferences for public and private goods and thus vitiates the basic economic rationale forlocal government in the first place. Moreover, this approach to equalization ignores localdifferences in needs, in costs, and in own revenue-raising capacity. Finally, equalizing actualoutlays clearly discourages both local revenue-raising effort and local expenditure restraint, sinceunder this system those with the highest expenditures and the lowest taxes would get the largesttransfers.

1.50 For these reasons, in all countries with formal systems of equalization transfers, the aim iseither to equalize the capacity of local governments to provide a certain level of public services orthe actual performance of this level of service by local governments. The performance criterion,which adjusts the transfer received in accordance with the need for the aided service (and whichmay also allow for cost differentials) is in principle more attractive to central governments -- orthose concerned primarily with the provision of certain services such as education or socialassistance -- since the level of service to be funded is determined centrally and the transfer can bemade conditional on the provision of that level of service. Unfortunately, this approach maysuffer from the same disincentive effect on the revenue side as equalizing actual outlays, sinceunless adjustment is made for differential fiscal capacity that government which tries least againgets most.

1.51. In principle, then, any sound design for general fiscal transfers to provinces should pivoton some notion of revetue capacity. At one extreme, the aim might be to provide each localgovernment with sufficient funds (own-source revenues plus transfers) to deliver a (centrally)predetermined level of services. Because such capacity-based transfers are generally based onmeasures of potential revenue-raising capacity and not on actual revenues, no disincentive tofiscal effort is created by this approach. Differentials in the cost of providing services may or maynot be taken into account. Ensuring that the recipient governments will in fact use the funds theyreceive as the central government might wish requires that receipt is conditioned in some way onperformance (and compliance is monitored in some way).

1.52. Fiscal Effort. While the evidence on the effects of transfers on local fiscal effort is farfrom clear in any country, there is some empirical evidence that transfers may sometimes tend todiscourage such effort (defined as the extent to which measured fiscal capacity is utilized: see Box9). Nonetheless, it is generally not a good idea to include an explicit fiscal effort element in atransfer formula. Suppose, for example, that a transfer is made directly dependent on the relationof the effective tax rate in the recipient municipality to the average national effective tax rate.One problem with this proposal is that the measurement of fiscal effort is considerably morecomplex than usually seems to be realized (Box 9)-- even if, as suggested earlier, localgovernments are largely restricted to non-exportable taxes. If, for instance, tax bases are sensitiveto tax rates, then the usual measures overestimate capacity in low tax-rate areas (and henceunderestimate the effort needed to increase tax rates) because the base will decline if the rate isincreased.


1.53 More importantly, putting too much weight on fiscal effort in allocating grants undulypenalizes poorer areas, in which, by definition, a given percentage increase in effort (as usuallymeasured) is more difficult to achieve. The problem giving rise to the need for equalization in thefirst place is that the capacity (tax base) of poor areas is too low, not that their tax rates are toolow. Most fiscal effort measures inevitably reward the richer recipient governments, which findsuch tests easier to meet. Imposing such an additional penalty on poor regions in a transferprogram that almost invariably falls far short of fully equalizing fiscal capacity seems hard tojustify.

1.54 Matching Grants. A final component of many transfer systems is what is called a matching(conditional) grant, in which the central government pays only part of the cost of certainexpenditures carried out by local governments. At the extreme, where the central governmentpays all the cost of work carried out by a local government acting as its agent, what is reallyhappening is simply cost reimbursement. Several rationales for such transfers may bedistinguished, each with different implications for program design, as discussed in Box 10.Although some of the points mentioned in Box 10 could no doubt be explored further in thecontext of Argentina, in the present report this statement of general principles is the onlytreatment of matching grants.

BOX 10. Matching (Conditional) Transfers

Matching or conditional transfers in principle have important economic and fiscal advantages in terms of bothallocative efficiency (spillovers) and the efficient use of scarce central government resources to attain desired levels ofcertain services. In addition, while of course rendering provincial governments more susceptible to central influence andcontrol, matching grants have the important political advantage of introducing an element of local involvement,commitment, accountability, and responsibility for the aided activities (see Box 9). Such grants may be particularlyimportant with respect to capital investment projects (where they may substitute for, or supplement, subsidized loans).

The rationale for matching grants that has the strongest basis in the economic literature is that the benefits fromthe local activity in question may spill over to other jurisdictions, that is, provide benefits to localities other than thosewhich decide whether to undertake the activity. Since such external benefits will not be taken into account by anyparticular local government in deciding how to spend the funds at its disposal, in general too little such externality-intensive activity will be undertaken unless the local government receives a unit subsidy just equal to the value at themargin of the spillover benefits.

The correct matching rate (m), or the proportion of the total cost paid by the central government, should thus beset by the size of the spillovers. This rate may decline as the level of expenditure rises, if the externalities diminish. Itmay also vary across localities if there are reasons to expect greater externalities in some places than in others or if there isreason to expect a higher local price elasticity of demand for the service in question in some areas as opposed to others.Basically, however, a matching grant program designed to encourage the optimal provision of public services would beexpected to vary primarily with the nature of the activity, that is, the matching rate should depend upon the level ofassociated externalities.

Since no country has achieved full equalization of local fiscal capacities, however, a uniform matching leveloffering, in effect, the same "price" to different local governments would in practice discriminate against poor regions.Indeed, even if revenue bases were fully equalized, there might still be grounds in terms of need or cost differentials forincluding an equalization element in matching grant formulas. For example, per capita grants for roads in sparsely

Annex 1: Restructuring Fiscal Federalism in Argentin - _ _ 27

populated and mountainous regions should generally be larger because the per capita cost of achieving any particularstandard of road service will obviously be higher.

A quite different rationale for matching grants may arise from the e.xistence of a central government budgetconstraint. If the central government wishes to use its scarce budgetary resources to attain given standards of expenditureon certain services provided by local governments, it should pay only as much of the cost as is needed to induce each localgovernment to provide that level of service. With a grant of m percent of cost, the effective price to the locality is 1-m. Toensure maximum total (local plus central) expenditure on the service in question, given the total size of the centralgovernment contnrbution, the optimal way to allocate the given total amount among localities will be to vary it inversely tothe price elasticity of local demand for the service (assuming no cross-price elasticity effects).

Moreover, as a rule matching grants should probably also be inversely correlated to the income level of therecipient government. The purpose of such transfers is essentially to ensure that all local governments, regardless of theirfiscal capacity, can (or do) provide a similar level of certain specified public services to their residents. The basic idea issimply to set the price of the service (1-m) to each local government in such a way as to neutralize differences in capacityby varying the matching rate (m). The higher the income elasticity of demand for the service, the higher the matchingrate needed for low-income recipients (to offset the higher expenditures out of local resources on the aided service inhigher-income areas), and the higher the price elasticity, the lower the matching rate needed to achieve a given level oftotal expenditures. In practice, there may thus be a case for varying matching rates inversely with income levels evenwhen only the incentive effects (and not the distributional effects) of matching grants are considered.

Unfortunately, neither theory nor available empirical studies provide clear guidelines to determine the precisematching rate appropriate for particular expenditure programs, let alone how those rates should be varied in accordancewith the very different characteristics of different provincial governments (see Table 4). A possible approach might be tothink of the matching rate for each program as having two components. The basic matching rate for each service wouldreflect the degree of central government interest in the provision of that service - whether that interest is motivated byconcern over spillovers, the "merit good" nature of the activity, or simply the desire to implement some plan. This basicrate could then be altered inversely to some measure of local fiscal capacity (the relevant "income" measure in thiscontext). The matching rate faced by any particular province for aiv particular program would then be higher the greaterthe degree of central interest and the lowver the (expected) degree of local enthusiasm (price-elasticity) and ability (income-elasticity) to support that program. T'hough data limitations mean that such refinements are most unlikely to be relevantin Argentina for some years. these principles should nonetheless be kept in mind in developing an intergovernmentaltransfer system -or indeed asysteni of subsidized municipal credit, where exactly the same considerations are relevant.

One reason why matching grants are less commonly found than theory suggests is because, even when there areinterjurisdictional spillovers, they may largely be infraniarginal and of course the appropriate subsidy (matching) rate isthat which applies at the margin. Another reason is that in many instances redistributional concerns, not efficiencyconcerns, determine matching rates: poor localities get more assistance because they are poor, not because (as suggestedabove) a higher matching rate is required to induce them to produce the socially optimal amount of the service in question.Intergovernmental transfers may have a role to play in distributional policy, but it is important not to confuse their

distributional and allocative tasks (see Box 3). Matching grants should be used primarily for activities in which there is aclear and significant interjurisdictional externality at the marginal level of senrice provision. Where such externalitiesaffect only a few localities. a more efficient approach might be direct agreements or arrangements among the affectedlocal goverunents.

Perhaps the most basic problem with the matching approach is that it is quite demanding in terms ofinformation. Ideally, its application requires (1) a clear specification of the level of senrice to be provided - in one provinceof Canada, for example, there are 29 different types and levels of primway education service specified; (2) fairly accurateand up to date estimates of the costs of providing each level of service - as in Australia; (3) local governments which havea fair degree of tax autonomy -as in, for example, Sweden; (4) careful specification of "standard" tax rates, as for instancein Canada; (5) estimates of local fiscal capacity, as, again, in Canada; and (6) some idea of the probable effect of income


differentials on local responses to differential matching rates (i.e. the price of the aided service), as in some U.S. studies.As these examples suggest, not even any developed country does all these things, let alone any developing country.

Nonetheless, examples of matching grant systems may be found in such diverse countnes as Korea and Zambia.In both cases, local govemments receive a transfer which equals the difference between the estimated cost of providing a

specified level of local services and the expected revenues to be raised locally by applying a standard set of local tax rates.Similar systems, with varying degrees of refinement, have been proposed in many other countries (e.g. Hungary) and to alimited extent already exist for some services in others (e.g. Colombia).

1.55 Other Objectives. In addition to the economic arguments for transfers discussed above,there are of course also important political arguments for transfers:

(a) It may be necessary, for example, to transfer some resources to jurisdictions thatdo not, strictly speaking, need them in order to make it politically feasible totransfer needed amounts to other jurisdictions.

(b) It may also be essential to transfer resources simply in order to keep someeconomically non-viable local governments (e.g., small rural governments) alivefor political reasons -- to salvage regional pride, to provide jobs for localsupporters, or for some other reason.

In such cases, the main design problem is to minimize any collateral damage to the presumedeconomic objectives, both by achieving the political ends in as cost-effective a way as possible andby trying to ensure that the design of such transfers offsets the good features of other transfers aslittle as possible.

1.56. In summary, the main substantive aim of a well-designed transfer program is to "get theprices right" in the sense of facing local decision-makers with the full consequences of theiractions. The first step in getting the right incentives from intergovernmental transfers is, asargued earlier, to ensure to the extent possible that provincial (and local) own-source revenuesshould come from local taxpayers in a politically accountable way. In particular, the access ofprovinces to taxes that they can export to non-residents (except to the limited extent such taxesmay offset the provision of local public goods that lower production costs) should be restricted..

1.57 Given such a system, the next step is to recognize that in some sense local authorities mustbe made responsible to the central authorities or, more accurately, to taxpayers at large, whenthey are spending central funds. From this (principal-agent) perspective, there is thus in principlelittle role for completely unconditional transfers -- except to the extent that such "transfers" arenot really transfers at all but rather simply represent either central reimbursement for locally-executed central projects or central collection of local taxes (for example, because it would notbe cost-effective to set up separate local tax administrations) and the return of the revenues to theplace of collection.


BOX 11. Changes in Coparticipation Law, 1988-1995

Law No. Date Contents How it affected total Pool Who Benefited23.548 1988 Defines the shared taxes 1. Taxes: all but international

and distribution of pool 2. Sharing: 56.66% provinces 42.34% centralrevenues 3. Floor: 34% national taxes go to provinces

4: Sharing: Dev: 43.7%Interne 19.1%Underd. 27.3%Low Dens. 9.9%

Idem Idem Defines provincial taxes Gross income: Stamps, Real StateVehiclesInheritances and gifts

23903 April Changes distribution of 50% distributed as before The provinces1991 the assets tax 50% earmarked to education and culture (35% lose 35% of 50%

to the nation) (65% to the provinces) of 56.66% the__________ _______________________________________________ assets tax,

23966 August Changes distribution of 1. VAT - 11% goes to Social Security (90% Provinces lose91 VAT and Fuel tax and national: 10% prov. Cajas) 90% of 11% of

creates a new tax - 89% shared as usual 56.66% of VAT2. Fuel Tax - Nation 34%-29 (96) Provinces lose

Fonavi 42% - 42 34% of 56.66%Provinces 24 - 29% of Fuel tax

3. Creates Wealth tax - 90% earmarked for Brings 10% ofsocial security (national). 10% to provinces tax proceed to

provinces24049 Early Transfers educational Before sharing, a portion is taken out Unclear whether

1992 expenditures to transferredprovinces (about $1.6 revenue ismillion, or 8.5% of sufficient tonational taxes) finance education

24,073 April Income and-corporate 10% Conurbano (Buenos Aires) Provinces lose in1992 tax (impuesto sobre 4% Other provinces according to basic needs favor of social

ganancia 2% ATN fund securitv20% to the Social Security67% shares as usual

1992 August Pacto Fiscal 1. Nation retains 15% of shared tax pool Imprecise2. Nation retains $43.8 million a month torescue provincial governments in difficulties3. Nation assures a floor of $725 million amonth to the provinces.

Pacto 1993 Several Policy measures 1. Nation ensures a floor of $740 million aFiscal II August month to provinces

2. Retains $45.8 million month to helpprovinces (ATN)


1.58 Even when for constitutional or other reasons, some major transfers must be unconditionalas is likely to continue to be the case in Argentina, the central government - that is, taxpayers ingeneral - have a legitimate interest in what is done with transfers to provincial governments. Inparticular, it seems appropriate to assume that there is a legitimate national concern to ensure thatservices such as education and health are available throughout the country at least at minimumstandards. There is therefore a strong case for at least limited conditionality, for instance, byrequiring that some portion of transferred fimds should be spent on e.g. education or health. Forthis reason, it might be considered appropriate to consider converting at least part of the basiccoparticipation transfer to a "capitation" payment intended to ensure that all Argentineans, nomatter where they happen to live, have access to some basic package of e.g. education and healthservices. How such a system might work is sketched in Box 13, drawing on precedents fromColombia and South Africa, as well as a number of developed countries.

1.59 Compliance with any conditions that might be considered appropriate could be monitoredin part through requirements for uniform and timely local financial reporting and through periodicnational inspections and audits of lozal facilities. Although in the current situation it is probablypolitically inadvisable to alter the present unconditionality in any important way, at the very leastthe national government should make every reasonable effort to improve local financial reporting- for example, making the provision of such reports a condition for receiving grants - as well asattempting to improve its information base on what is going on with respect to the provision oflocal public services.

The Present Transfer System.

1.60. Overview. The system of intergovernmental transfers that now exists in Argentina is not asimple one. As shown in Table 5 (and Figure 1), there are a variety of different transfers,determined and distributed in different ways. The core of the present system of provincialtransfers in Argentina is what is called "coparticipation," or revenue-sharing. The basiccoparticipation transfer (Law 23,458) accounted for 66% of all federal transfers to provinces in1994, and if the "guaranty clause", "service transfers", and the new "profits tax" transfer areincluded as part of the basic revenue-sharing system, as they should be, this figure rises to 83%.Virtually all these transfers are funded by designated portions of specific national taxes (Table 6),and distributed among the provinces in accordance with a variety of rules.. The present systemwas established in essentially its present form in 1988, although it has subsequently been alteredmany times (see Box 11). Figure I and the related tables give an accurate, if somewhat simplified,picture of its complexity.

1.61 What this picture does not make clear, however, is that the present system isfundamentally flawed both in terms of how the "primary distribution" - the amount of revenuestransferred to the provinces - and the "secondary distribution" - the division of this "distributablepool" among the provinces - are determined. The "primary distribution" both distorts national taxpolicy and introduces undesirable instability into provincial finances. The "secondary distribution"in the 1988 law is completely arbitrary, and indefensible from any public policy perspective. Both


aspects of the law require change, and soon, if the problems of the last few years are not to re-emerge in varying guises in the years to come.

Table 5. Transfers to Provinces, 1994

Transfer As percent of total

Coparticipation (L. 23,548) 65.6Guaranty Clause 1.8Transfer of services (L. 24,049) 9.8Profits Tax (L.24,073) 6.0Education Fund 0.9Social Secuity 1.3Provincial Roads 2.2Infiastructure Works 1.1FEDEI 0.6Special Compensation Fund 4.0FONAVI 6.6

Total 100.0

Source: As for Table 2.

Table 6. Allocation of taxes that make the shared-revenues pool(in Percentage)

Central Government

Taxes Total Provinces Social TreasurySecurity

AssetsFederal 50.0 43.0 57.1 0.0Educational Fund 50.0 35.0 65.0 0.0

ProfitsFederal Sharing 64.0 43.0 57.1 0.0

Social Security 20.0 0.0 0.0 100.0Fund ATN 2.0 0.0 100.0 0.0Fondo Conurbano (Social Programs) 14.0 0.0 100.0 0.0

Value Added TaxFederal Share 89.0 43.0 57.1 0.0Social Security 11.0 . 0.0 10.0 90.0

Personnel AssetsSocial Security 90.0 0.0 0.0 100.0Provincial Cajas of Social Security 10.0 0.0 100.0 0

Fuel TaxesFonavi 42.0 0.0 100.0 0.0Provincial Govt. 24.0 0.0 100.0 0.0National Treasury 34.0 100.0 0 0.0

Remaining SharingFederal Govermment 100.0 43.0 57.1 0.0


1.62 Primary Distribution. The central issue with respect to the "primary distribution" ofrevenue-sharing relates to the proportion of national current revenues that is redistributed to theprovinces. The way this proportion is now determined is undesirable from the point of view ofboth national and provincial governments, quite apart from the question of how much isredistributed through this mechanism. The latter aspect is understandably that which is mostdiscussed in Argentina, but it is really the structural issue that is critical.

BOX 12. Determining the "Primary Distribution"

Basically, there are only three ways to determine how much money is to be distributed throughintergovernmental fiscal transfers: (1) as a fixed proportion of central government revenues; (2) on an ad hoc basis, i.e., inthe same way as any other budgetary expenditure; and (3) on a "formula-driven" basis, i.e., as a proportion of specificlocal expenditures to be reimbursed by the central government (see Box I1) or in relation to some general characteristicsof the recipient jurisdictions. Many variants of all three methods are found around the world.

Examples of transfer systems that determine transfers as a proportion of national current revenues ma) be foundin the Philippines, where 20 percent of national internal revenue collections are distributed among local govermments (onthe basis of population and land area), and in Colombia, where approximately 25 percent of (non-earmarked) nationalcurrent revenues are distributed to the departmental (intermediate-level) governments (in part in equal portions and inpart on the basis of population). Similar systems operate with respect to most major taxes in some developed countrie: e.g.Austria, where local governments receive about 12 percent of income and value added taxes; Japan, where localgovernments receive 32 percent of income and alcohol taxes. In both cases, the resulting total is distributed in accordancewith a formula taking into account such factors as population and community size. Large federal countries such as India,Brazil, and Nigeria also tend to use such systems.

Many other countries (e.g. most of the transitional countries of central and eastern Europe) have "tax sharing"systems that distribute a fixed share of certain national taxes -e.g. the income tax or the value added tax - among localgovernments. Although many of these systems of "sharing" particular central taxes attempt to allocate all or part of thetotal thus determined in accordance with the origin (or "derivation") of the tax revenues being shared, others (e.g. inGermany, Hungary, and Morocco) allocate the total set by the shared tax amount in accordance with a formula thatattempts to take into account both needs and capacity. On the whole, despite its popularity, sharing specific national taxesis less desirable than sharing all national taxes because it leads central governments over time to tend to increase morethose taxes which they do not have to share.

Canada's largest federal transfer to the provinces (the so-called EPF, or "established programs financing",transfer), was initially set in per capita terms to be equal in amount to certain (matching) transfers it replaced, and hassince been escalated as a function of a three-year moving average of nominal GDP growth. The Canadian federalgovernment has, over time, weakened the link to GDP grouth (the adjustment factor is now GDP growth less 3 percent)and imposed a "cap" on the absolute amount of transfers going to the richest provinces. Such measures may relievefederal finances. Another approach might be to have a "horizontal equalization" transfer, as in Germany and Denmark,under which, in effect, rich local governments directly transfer resources to poor localities without directly affectingcentral revenues. But only Chile among developing countries appears to have such a system (World Bank 1993).

1.63. Suppose, for example, as appears to be more or less agreed, that the amount to bedistributed in 1997 will be the same amount (in real terms) as in 1996. This amount at present isdetermined by a completely arbitrary division of national revenues into "coparticipable" and "nocoparticipable." The predictable result ofthis system in circumstances of fiscal crisis has been


repeated national government changes intended to reduce the so-called "masa coparticipable" e.g.by "pre-coparticipacion" (removing certain revenues from the total subject to revenue sharing)and similar maneuvers. A preferable approach might be simply to provide, for example, that the"shareable" amount be increased annually by, say, a moving average of the increase in GDP, or allcurrent national revenues, in the preceding 3 or 5 years (see Box 12).

1.64 Such a system would (1) provide the provinces with a stable flow of resources, and (2)permit the national government to establish its tax and budgetary policy without having tointroduce distortions in order to work around the revenue-sharing system. This is desirable bothto provide a degree of budgetary stability for both levels of government - to insulate the centralbudget to some extent from local problems and to provide a "hard" budget constraint for localgovernments - and to permit sufficient budgetary flexibility over time to accommodate thereasonable growth of local finances.

1.65 Secondary Distribution. Essentially the same approach, of "grandfathering" the presentprovince by province distribution at 1996 real levels is probably politically the best way to achieveany desired change in the secondary distribution. Any changes in interprovincial distribution willhave to be made at the margin. Since there is no apparent rationale for the current distribution(which essentially just crystallized the outcome of political negotiations in the inflationary 1980s),at least in principle there would seem to be ample opportunity for improvement in this regard.20

1.66. In the long run, the most important improvement would be to alter the terms of thediscussion from "who gets how much" to "why" this system exists and "what" it is supposed todo. From this perspective, perhaps the most important change that could be made would be to setup a better process for establishing and adjusting fiscal federal issues - e.g. perhaps a body like ofthe Comision Federal de Impuestos (though with a small and preferably full-time expert staff tosupport its work) - to consider and report periodically and publicly on such matters in the future.In the absence of such a forum, all that can be suggested here is a simple system that appears atfirst glance to serve the main objectives that have been discussed in the Argentine context, that

20 If, as seems desirable, the fiscal status of the provinces and the effects of altering central transfers is to beexamined more closely, considerably more work needs to be done to improve the data available and toexamine these (and other) propositions much more closely. Despite this caution, however, even this first,crude glance at readily available information suggests two interesting propositions, both of whichobviously need to be explored in more detail in later work:

(a) First, the NBI and "development" indexes are almost perfectly negatively correlated (0.94): and both areonly weakly related to the pattem of either all transfers or coparticipation alone. This suggests that thepresent transfer system is unlikely to redistribute income in accordance with any reasonable "needs"measure.

(b) Second, own revenues and GDP are, for those provinces for which the latter information is available,highly positively correlated (0.86). Unfortunately, GDP and the only "tax capacity" index available, that for 1980,are only weakly correlated (0.31), which means the later exercise (in Box 9) which uses GDP as a proxy forcapacity may be suspect. Further analysis of Argentine provincial finances urgently requires estimation of a morereliable and up-to-date index of tax capacity than could be undertaken for this report. Piffano (1995) has suggestedone way in which such an index could be constructed, but as yet no one appears to have undertaken this task.


should be feasible, and that may, after it is thoroughly aired (and no doubt altered in some ways),perhaps even prove to be acceptable.

1.67. The most important aspects of the proposed scheme are twofold. First, divide the "masacoparticipable" into two components. Second, distribute each component in accordance withdifferent, objective, factors. The objectives this scheme attempts to achieve are essentially two:(1) to ensure that all Argentineans, no matter where they happen to be born, have equal access toa "basic" package of health and education services, and (2) to provide incentives to all provincialgovernments to exploit their tax bases to at least national average levels. Ensuring "efficiency" inpublic service provision can best be achieved in a democratic state by making politiciansresponsible at the margin for spending their taxpayers' money properly: the proposed system doesthis.

1.68. The first component of the revised system would be an equal per "unit" (e.g. per student inthe case of education; population in the case of health), perhaps adjusted to the extent considerednecessary, where the information is reliable, by major cost differentials (see Box 13). While it isof course a political decision as to whether or not the use of this transfer is monitored by thecentral government, at the very least, as with all transfers, strict and prompt (and audited)financial reporting should be a condition of receiving this transfer.

Box 13: Capitation Grants for Education

Assume that the provision of a cerain basic level of primary and secondary education to all Argentinians is afundamental goal of the national government, but that, as is the case, this function is actually delivered by the provinces.How can transfers be used to help achieve this goal? The key is to establish a per capita transfer based solely on the cost ofproviding the desired standard of service to the relevant population. In a recent system along these lines proposed in SouthAfrica, for example, the approach taken was to establish a minimum amount per student that should be spent by eachprovince on education and to ensure that the required funding was mnade available through a national transfer. Theminimum standard was determined by estimating the average cost of teachers at the national (not provincial) averagesalary to allow all school-age children (excluding those in private schools) to attend school. A 35:1 ratio of pupils toteachers in secondary schools, and 40:1 in primary schools was assumed. The grant thus estirated was then increased by29% to allow for necessary costs other than teachers' salaries. Provinces would be free to spend more than this if thevwished to do so out of other resources, but they are expected to spend at least this amount. A somewhat sirnilar scheme iscurrently under consideration in Colombia (for a detailed analysis and simulation, see World Bank, 1996).

Broadly, the factors that need to be determined to design such a basic educational transfer system are thefollowing - unit cost of provision, number of units provided, rate of extension of coverage, adjustments to unit cost overtime, division of transfer between departmental and municipal levels of government, rate of transition, and the monitoringand enforcement of the system. The last of these factors is discussed in general in Box 3. The balance of the presentsection discusses briefly the other factors mentioned.

Adjustmntd of Unit Cost. How should the initially determined unit cost be adjusted over time? Presumably. at aminimum it should be held constant in real terms. But there seems no reason to provide for any systematic adjustmentprocedure other than indexation, assuming the expansion of coverage has already been taken into account, as discussedabove.

1.69 Once the amount needed to achieve the goal of the first component of the system isdeducted from the total to be distributed (the primary distribution or masa coparticipable), theresidual can then be distributed in accordance with some version of a standard equalization

Lao parrodei9no Eun ASIGNACION DE RECURSOS TRIBUTARIOS NACIONALESrmeh mari parcirdo199dodmprntm195onor percepdo ANALISIS FORMACION DE LA MASA COPARTICIPABLE - DISTRIBUCIONde copauciped6n federalde ipuestos, ronformne a '~ O19

Laley23.548ylamodfica- =6ndeimpuestoalas ga-nanea, aol Como tamb 6n ~~'~Sj los pactog fwales I y 11'ospacto&fa~ajestyl . .MENOS( -)hasta PROVINCIA BS. AS. 60% ENERGIA

30MiIlones p/ 95-'96 Hasta 65OMilones aruales, distrib. menwal, _* .-Fondo Emerg. Social inc. a su copartcipad6n. Destino especifico.

Conurbano10°% RosaroSanta Fe Compensadones 40%

| . _. .... . .. .. . . ~~~~~~~~~~~~~~~Regionales1 ~~~~~~~~~~~~Excedente an forma mensual propor- t|_

cdonada - Ver Anexo Ganancias

GANANCIAS -70% r -- D-EI,F ROVlNCIAS (1 * %O de 29%)

20% 4% SIN BS. AS. Obras Infraest. cEnerg. E16ct. -O- 8,7% O

INTERNOS ylu Obrs. P tb. 29%) 29% MY OTROS 2%A. T. N.

COPARTICIPADOS | Fdo. Desq. Fiscales - V % i 2%17)4% S64% e's' S45,8 Millones TVal (60 de 29T

t | | | l ~~~~~~~~~~~~~~desde 1993 r% - T

1 100% _ {11, N ' .' r} >'f-; C 5,05 4r O.NAV11O . 42% Blc0PAR0n%0A0'N 85% _ 1PART 6 MilIones LI * 89% _ mRUTA . :ETA mensuales en 1996. Ver anexo E!' | g 50% _~ * .J.ir-- 4s:f-t uL sb'+'' [ ' z 1 ~ 41}95%+ 65% Fondo

: ACTIVOS 5Educa5ivo

29%l l ( residu sl ) HFo~ndoespecial para 35% ~ 9

t I t ~~~~~~~~ e l e q u ilib o srio f scla l ft |IMPUESTFCOM. EXTERIOR

89% 90%IVA (18%) LIj1U D%- D. ESTADIST.

.. | ~~IVA (18% __%,10J _ 9%4BEE || SBEc

INISTERIOELINTERIORSECRETARMDASISTENCI PARA0 LA BIEfORMANECONOMICA PROVINCML AR IT I NTERNOS

MINIS TERIO DEL INTERIOR SECRETARIA DE ASISTENCLA PARA LA REFORMA ECONOMICA PROVINCIAL AREA POLITiCA YADMINISTRACION 7TRiBUTA'RIAI'


formula. To take a simple example, the residual amount could first be divided by population andan equal amount per capita allocated to every province: this, or some similar calculation,essentially measures needs. The amount thus calculated could then be reduced by an amountcalculated on the assumption that every province levies taxes on the tax base it has its disposal (itsfiscal capacity) at the estimated average national (effective) rate. In terms of the money eachprovince has to spend, the result of this system will be to (1) penalize any province that leviesbelow-average taxes on its tax base, and (2) to reward any province that demonstrates greater"fiscal effort". The major problem in implementing such a scheme is the lack of good informationon provincial tax bases, but some preliminary simulations have been carried out to illustrate theapproach (see Box 14). Of course, much more work along these lines would be needed todevelop an appropriate and workable formula for Argentina, assuming this general approach isaccepted.

Box 14: Determining the Secondary Distribution

Once the total to be distributed in transfers to provinces is determined, how should it be distributed? Mostexperts agree that a formula incorporating both local "needs" for expenditures and local "capacities" to finance suchexpenditures out of their own resources should be used for this purpose. Such a formula, if properly designed, has theadditional virtues of stimulating local governments to make at least an average level of "effort" to finance the expendituresthey carry out and ensuring that they remain accountable to local residents at the margin.

A number of countries use some variety of formula intended both to equalize public expenditures in localitieswith differing needs and capacities and to stimulate local fiscal efforts, although severe data problems often constrain theparameters employed in such formulas. India, for example, allocates some proportion of transfers in accordance with percapita income levels in the different states, but few other developing countries do so owing to data difficulties. Argentinaitself had some experience with a transfer formula along these lines with the 1973 coparticipation law, which distributed65% in accordance with population, 10% in accordance with the inverse of population density, and 25% in accordancewith an index of the "developmental gap", which in turn was based on measures of the quality of housing, the number ofvehicles per inhabitant, and the level of education.

Sometimes, cruder adjustments are made simply by reserving a larger share of the transfer for parts of thecountry considered to be especially poor or needy e.g. mountainous regions (as in Switzerland) or remote regions (in thesystems of municipal transfers of some Canadian provinces) or those with large concentrations of particularly poor groups(India). Perhaps the most common formula elements found in developing countries are population and land area, perhapswith some adjustment for some of the factors just mentioned (e.g. remoteness from central markets) or for the size of themunicipality (as some proposed systerms in Colombia).

Transfers intended to finance particular types of service e.g. road maintenance or education are often linked toparticular measures of need - or existing capacity - such as length of roads or number of students. At one extreme, thisapproach leads to the sort of "norms" found in Viet Nam and a number of other transitional countries (e.g. Hungary), andmay give rise to problems e.g. allocating funds on the basis of installed capacity, which may reflect past political decisions,rather than need. More careful determination of expenditure needs may have some role with respect to conditional grants- e.g. for basic education (see Box 13) - but it is not likely to prove too useful with respect to grants intended to financegeneral local expenditures. Experience in countries such as Australia and Canada suggests that a very high level ofreliable disaggregated data is required before the detailed "norm" approach makes sense. In the absence of such data,


sirpler approaches based on e.g. population and a simple "categorization" of localities (by size, by type, perhaps byregion) seem more likely as a rule to prove useful in measuring general expenditureneeds.

Despite the strong theoretical reasons for doing so (Box 9), relatively few countries appear to include explicitmeasures offiscal capacit in their formulas. Examples are India and Nigeria, where some measure of tax effort isincluded in the basic distnbutional formula to states, and Korea, which assumes that a standard tax rate is applied by citiesand lowers the transfer if the actual rate is lower. Colombia also has such an element in one of its transfer programs.Chile goes further and actually "taxes" richer localities to some extent by reducing their transfers and raising those grantedto poorer localities. Capacity measures of various sorts are more common in transfer formulas in developed countries. InSpain, for example, 25 percent of local transfers are allocated in accordance with local tax coUlections (and 70 percent onpopulation). Denmark and Sweden, like Canada and Australia, explicitly calculate local transfers on the assumption thatthe average "national" local tax rate is applied, thus creating an incentive to levy at least average taxes since thoselocalities that levy above average local taxes are not penalized while those that levy below average taxes are not rewarded.Of course, this approach makes sense only if local governments have the ability to vary local tax rates, as, within limits,they do in Argentina. The absence of much local autonomy with respect to local taxes combined with data difficultiesprobably explains the relatively few examples of transfer programs incorporating explicit capacity measures in developingcountries.

An Example

In the absence of adequate data on either capacity or needs, all that can be done here to illustrate the sort ofsystem that might be considered to replace the present totally arbitrary coparticipation "fonnula" in Argentina is to presenttwo illustrative simulations. As and when better data become available and the nature of the formula desired becomesclearer, many more such simulations may of course be carried out in order both to determine the resulting distnbutionand, equally important perhaps, to help improve understanding of the implications of including different elements in theformulas.

The first simulation is not really formula-based, but it involves a transparent quantitative calculation. It simplycalculates the current average total revenues per capita for Argentine provinces (inlcuding all transfers) and transfers theexact amount of resources necessary to bring below average provinces up to the average level. It is, in this sense, an"equalization" program, and by definition it maintains the total amount tranferred to provinces via revenue-sharing, i.e.,the current "primary" distribution.


Actual System

Populat Transf Per Capita (Pesos) Per Capita (av100) Total Equali7A |

Provinces % % Total Own Transfers Total Own Transfers Per StructResources Resours Resources Resoes Capita % ||

Capital Federal 8.6 1.4 856 784 73 113 248 16 (23) -0.4(munic)Buenos Aires (prov) 38.6 22.8 573 310 263 75 98 59 451 39.0Catamarca 0.8 2.2 1,279 94 1,185 168 30 266 667 1.2Chaco 2.6 3.9 790 119 670 104 38 150 641 3.7Chubut 1.1 2.6 1,239 227 1,012 163 72 227 534 1.4Cordoba 8.4 6.6 688 335 353 90 106 79 426 8.1Corrientes 2.5 3.3 696 97 599 92 31 134 664 3.7Entre Rios 3.1 4.2 861 264 597 113 84 134 497 3.4Formosa 1.3 3.0 1,125 66 1,058 148 21 238 695 2.0JLljuy 1.6 2.6 922 200 722 121 63 162 561 2.0La Pampa 0.8 2.0 1,651 536 1,115 217 170 250 225 0.4La Rioja 0.7 3.4 2,186 89 2,096 287 28 471 672 1.1Mendoza 4.3 4.0 715 299 416 94 95 94 462 4.5Misiones 2.5 3.1 652 107 544 86 34 122 654 3.7Neuqueni 1.3 4.0 1,935 610 1,325 254 193 297 151 0.5Rio Negro 1.6 2.7 996 235 761 131 74 171 526 1.9Salta 2.8 3.5 758 190 567 100 60 127 571 3.5San Juan 1.6- 3.0 959 142 817 126 45 183 619 2.2San Luis 0.9 2.2 1,355 225 1,130 178 71 254 536 1.1Sant. del Estero 2.0 3.5 867 105 762 114 33 171 656 3.0Santa Cruz 0.5 2.7 2,876 533 2,343 378 169 526 228 0.3Santa Fe 8.5 7.6 699 300 398 92 95 89 461 8.8Tierra del Fuego 0.3 0.4 2,556 107 2,449 336 34 550 654 0.4Tucuman 3.5 4.0 642 130 512 84 41 115 631 5.0Total 1995 100.0 100.0 761 316 445 100 100 100 445 100.0

Memo ItemAdvanced Prov. 68.4 42.4 648 371 277 85 118 62 390 59.9Intermediate 12.1 16.2 877 199 678 115 63 152 562 15.7Low Density 5.4 14.6 1,557 399 1,158 205 126 260 362 4.4Underdeveloped 14.0 27.4 905 112 793 119 36 178 648 20.0

The second simulation follows the basic guidelines outlined in the main text of this techniical annex It separatescoparticipation into two parts: a capitation grant for financing education and health and a rough "equalization" grantbased on a formula of traditional indicators. The division of the resources between the two is determined by the aggregate"need" of the provinces for financing education. Based on a per student education cost estimate of Arg$ 755, the totalnumber of students, and the 1994 total coparticipation levels, 39 percent of coparticipation would be consumed with theeducation capitation grant. Based on per-capita health cost ($122) and the provincial population, it was esfimated thatanother 31% would be consumed with health expenditures. The remaining 30 percent, in our hypothetical example, isbased on a simple formula with weighted traditional indicators: 40 percent on population, 40 percent on NBI, and 20percent on the inverse of GDP.


Per Capita Distribution of Transfers _

(%) Prov. Structure Scenario A Scenario BGDP I

Province Population NBI (avi100) Actual Total Capitation Equalizi Full EqualHealtb,Ed.

(a) (b) (c) (d) (e) (f) (g) (h)MCBA 8.6 8 243.3 1.3 6.4 7.5 4.2Buenos Aires 38.6 17 85.0 24.0 30.8 37.4 17.0 39.1Catamarca 0.8 28 38.9 2.5 1.7 0.9 3.2 1.2Cordoba 2.6 15 21.8 7.4 3.6 2.7 5.4 8.0Corrientes 1.1 31 86.0 3.4 1.6 1.2 2.4 3.6Chaco 8.4 40 45.6 4.2 7.3 8.3 5.2 3.8Chubut 2.5 22 42.0 1.9 3.1 2.7 4.0 1.2EntreRios 3.1 21 42.4 4.5 3.3 3.2 3.5 3.7Formosa 1.3 39 22.0 3.2 2.5 1.4 4.9 1.9Jujuy 1.6 36 36.0 2.7 2.6 1.9 4.1 1.9LaPampa 0.8 14 72.0 2.0 1.1 0.8 1.8 0.3LaRioja 0.7 27 43.0 3.0 1.5 0.8 3.0 1.0Mendoza 4.3 18 67.0 3.9 4.1 4.4 3.5 4.4Msiones 2.5 34 25.0 3.2 3.3 2.7 4.8 3.5

euquen 1.3 21 81.9 2.0 1.7 1.4 2.4 0.2RioNegro 1.6 23 51.3 2.6 2.1 1.7 2.9 1.8Salta 2.8 37 31.8 3.7 3.7 3.1 4.8 3.7San Juan 1.6 20 36.2 3.0 2.1 1.7 3.0 2.4San Luis 0.9 22 126.7 2.2 1.3 0.9 2.1 1.0SantaCruz 0.5 15 55.0 2.0 1.1 0.8 1.9 0.2SantaFe 8.5 18 24.3 7.8 7.6 8.4 6.1 8.9Santiago del Estero 2.0 38 95.7 3.8 2.7 2.2 3.8 3.1Tierradel Fuego 0.3 22 232.9 1.5 0.8 0.3 1.8 -

Tucuman 3.5 28 40.4 4.3 3.9 3.7 4.2 5.3RAverage 100.0 20 100.0 100.0 100.0 100.0 100.0 100.0Notes: Average National Education Cost = $755.3 per student -- Corresponding percentage of education cost

Transferable amount 39%; Health per-capita cost = $125.2 Percentage for health 30%1/ Pre-primary, Primary and Secondary Students

Source: Governnent of Argentina, SAR Education Decentralization Project, Mission estimates, Table 18 Stat. Appendix

As can be seen, both simulations imply major revisions in the allocation of transfers among provinces. The first

"equalization"' approach represents a more radical departure from the current system, while the second represents what

appear to be fairly minor changes in provincial shares, but which in terms of per capita revenues could be significant.

The point of this exercise is to illustrate in this very simple way how the various factors that should in principle

be taken into account in devising a rational system of intergovernmental transfers can readily - albeit very roughly in this

preliminary analysis - be presented and discussed in a consistent, simple quantitative framework. Much more work

obviously needs to be done along these lines, to develop better measures of both need and capacity, to devise more accurate

costing for capitation grants, to determine the relevant weights, and indeed to decide whether this general approach of

splitting the transfer into different components should be adopted. This first crude exercise is simply intended to illustrate

the kind of work that is needed, not to do this complex job. The precise answers that may emerge over time from the

extended technical and political discussion of such factors which has just begun in Argentina are, in a sense, less

important than ensuring that the consistent and coherent framework which is needed to make such discussion productive

is established, perhaps along the lines shown here.


Conclusion

1.70 In the short run, apart from an approved debt "work-out" system to deal with the currentdifficulties of a few provinces, the major immediate task that needs to be clarified with respect toArgentine intergovernmental finance is the primary distribution formula for coparticipation. Amore stable system is clearly needed. Such a system is technically easily achievable along the linessuggested earlier. The basic problems in changing the present system are entirely political.

1.71. Work needs to be done on developing and discussing alternative secondary distributionschemes: the key points are to make the system conducive to both sounder financial managementand to the achievement of important public policy objectives. In principle, as illustrated in thepresent report, this can be done. In practice, however, to change the present system will requirenot only considerably more technical work (e.g. in developing better measures of needs andcapacity) but also, equally important, a change in the nature of the political discussion from thepresent virtually exclusive focus on regional shares to emphasize more the objectives of thesystem and its success in achieving them.

1.72 In some ways, of course, the fundamental questions that arise with respect tointergovernmental finance are related more to provincial revenues than to federal transfers. Withrespect to provincial revenues in Argentina, there seems to be no urgent reason to revise (orreverse) the changes already in process. But what needs to be emphasized is that (1) thesechanges will not alter, and cannot alter, the basic parameters of the intergovernmental financeproblem in Argentina and (2) that to implement taxes effectively in the poorer provinces inparticular will undoubtedly require provision of significant technical support to their revenueadministrations. One aspect of provincial taxation that would appear to repay immediate attentionwould be to devise a more adequate and appropriate system of automotive taxation.

1.73 Consideration should be given to the possibility of redesigning the provincial revenuesystem to make at least the richer provinces more self-sufficient. The most feasible way toachieve this aim in the long run is likely through provincial surcharges on income tax, but thisnotion has been little discussed in Argentina and would require a more secure (and probably moresubstantial) federal income tax than now exists. A provincial VAT, which has been morediscussed, raises considerable technical problems. It may be useful to consider these problems inthe context of the similar problems currently being discussed in a number of other countries(Brazil, Canada, India) but it seems unlikely that provincial revenue needs can be met by addingto the already high consumption tax in Argentina. A more promising source of provincial revenuewould seem to be excise taxes on the consumption (not the production) of a few importantconsumer goods as fuel, liquor and tobacco.


References

Artana, D. et Al., 1995 "Argentina" in R.Lopez Murphy, ed. Fiscal Decentralization in LatinAmerica (IDB)

Bird, R. M. (1982) "Expenditure Policy and Regional Development" Revista di diritto finznziarioe scienza delle finanze.

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Bird, R. M. (1993) "Threading the Fiscal Labyrinth" Some Issues in Fiscal Decentralization,"National Tax Journal

Bird, R.M. and N.E. Slack (1991) "Financing Local Governments in OECD Countries,: inJ.Owens and G.Panella. eds. Local Government (North Holland)

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Breton, A. (1991) Urban Property Tax Reform (World Bank)

Dillinger, W. (1991) Urban Property Tax Reform (World Bank)

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Isham, J.D. Naryan and L.Protchett (1991) "Does Participation Improve Project Performance?"World Bank Policy Research WP 1357

Jha, R.M.S. Mohanty and S. Chatterjee (1995) Fiscal Ef,ficiency in the Indian Federation(Reserve Bank of India)

Keith, S.H. (1993) Property Tax in Anglophone Africa (World Bank Technical Paper No. 209)

Mc Lure, C.E. (1993) "The Brazilian Tax Assigrunent Problem: Ends, Means, and Constraints."in A reforma fiscal no Brasil" (Sao Paulo)

Oakland, W.H. and W.A. Testa (1995) "State and Local Government Taxation of Business,"NTA Forum


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Porto A. and P. Sanguinetti (1995) "Las transferencias intergubernamentales y la equidaddistributiva: El caso Argentino, "Seminario de Cartagena, Octubre, 1995

Porto, A. et al (1994) "Pr opuesta para un sistema tributario federal", La Plata

Sanchez, F and C Gutierrez (I 995) "Colombia" in R. Lopez Murphy, Ed., FiscalDecerltal,zaitiou in Latin America (IlDB)

Silvani, C. and P. dos Santos (1996) "Administrative Aspects of Brazil's consumption TaxReform" (IMF)

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Wheare, K.C. (1969) Federal Government (Oxford University Press).

42 Annex 2

Annex 2: WALKING THROUGH THE FEDERAL FISCAL SYSTEM IN ARGENTINA

1853-1890: Separation of tax powers:

2.1. Argentina traditionally is a very decentralized country. For most of its history, thecountry's provinces were ruled by a governor and had very few dependency links from thecenter. In 1853, the first National Constitution was promulgated. It clarified thedistribution of tax capacity among government levels.

* The national government had the exclusive power over external trade;• In agreement with provinces, it could levy indirect taxes. It could levy direct

taxes only in special cases and for limited time* Provinces were sovereign to levy all types of taxes for unlimited time.

2.2 In 1886, taxes on external trade accounted for 95% of all central revenues.Financial gaps at the central level were financed by external borrowing. The provincesfinanced their expenditures with locally raised taxes -- mainly real state and inheritancetaxes. Transfers from the central government were minimal -- 1.8% of central spending.Provincial spending was contained within their economic and financial capacity. Therewas thus a large variation in spending between provinces.

1890-1935: Coordination of Tax Sources

2.3. In 1890, the central government was unable to finance the country's debt servicewith additional foreign borrowing. External trade revenues had declined and the centralgovernment had to create alternative revenue sources. Indirect/excise taxes -- which hadbeen the exclusive power of the provinces -- were now levied by the nation on theproduction and consumption of tobacco, sugar, alcohol.

2.4 In 1929, the international economic crisis lead to a further decline in the collectionsof the external trade taxes. New domestic taxes were created -- the Gross Receipt Taxand the Profit Tax. The importance of external trade taxes fell drastically -- from 95% oftotal central taxes in 1865 to 59% in 1930. At the same time, the proportion of centraltransfers in financing provincial spending increased from 6.5% to 11.5%. The differencesamong provincial spending become less visible.

1934-95: Tax Revenue Sharing.

2.5. 1934 - Three Basic Laws: With falling external trade and reduced access toexternal financial markets, Argentina central government had no solution but improvingthe national tax system. In 1934 three tax laws were passed to improve tax revenues and

Annex 2: Walking Through the Argentine Fiscal Federal System 43

avoid double taxation. These laws form the basis of the centralized system that stillprevails in Argentina.

* The first law (12.139) establishes the unification of all excise taxes and acoparticipation system for those among the provinces that join the agreement.Each province would receive a share proportional to the tax revenue collectedbefore the tax law was passed. Since 1940, the distribution system movedaway from the fixed proportion and towards a system based on population.The law required that all similar taxes levied by the provinces would beeliminated.

* The second law, 12.143, levied a tax over the domestic sale of merchandise

* The third law, 12.147 established the allocation of the profit tax.

* The two last taxes would be shared as follows:

82.5% to the central government17.5 % to the provincial governments (and municipality of Buenos Aires)distributed as follows:

30% in proportion to population30% in proportion to provincial budgeted expenses30% according to their own revenues10% according to the sales taxes effectively collected the yearbefore

2.6. 1947-58: Law 12.956 Law 12956, 1947 introduces another sharing formula forthe revenues of the Profit tax, Transaction tax, Sales Tax and Extraordinary Revenues.The new formula allocates

79% to the central government21% to provinces and municipality of Buenos Aires, shared as follows:

9% by the collection of these taxes in each province27.14% function of the provincial tax revenues27.14% function of budgeted provincial spending27.14% based on population

9.58% inversely related to population

2.7. The provincial governments were obliged to share with the municipalities at least10% of the revenues they received from the center.

2.8. 1959-1966:. Law 14.788 established that the share of the nation would declinefrom 66% in 1959 to 58% in 1963. The provincial share would increase from 34% in1959 to 58% in 1963. The inter-province distribution would be as follows:

44 Annex 2

25% according to direct provincial taxes25% function of budgeted expenses25% function of population25% equally among all of them

2.9. 1973-1979- Law 20.221: Law 20.221 established the basis of the presentArgentina's coparticipation system:

* All national taxes -- except external trade, specific taxes, and 15% ofautomobile taxes -- would be distributed withiln a single system.

* The provinces will not raise taxes on basis already taxed by the centralgovernment with the exception of the property tax, profit taxes, gift tax. andautomobile tax.

* The Regional Development Fund (Fondo de Desarollo Regional) was createdto finance investment in public works of regional interest

* The primary distribution was defined as follows:

* 48.5% to the Central government (of this 1.2% to MCBA) and 0.8% toTerritorio Nacional de Tierra del Fuego

* 48.5% to the provinces* 3% to the Regional Development Fund

* The second distribution would be as follows:

* 65% as fnction of the populationl* 25% function of the development gap between the province and the

most developed area in the country* 10% to the provinces whose population density was less than the

provincial average and in proportion to the difference between thepopulation density of each province and the national average

2.10. The level of development of the province would be measured as the arithmeticaverage of the following indicators

* Housing quality, per last census* Education level of human resources* Cars per inhabitant

Annex 2: Walking Through the Argentine Fiscal Federal System 45

2.11. It was created the Commission Federal de Impuestos (with representative of thecentral government and of the provinces) with the following functions:

- Approve the sharing weights- Control the payment of the participation's- Control the execution of the duties provinces accepted as part of the deal

2.12. As a result:

- there was an increase of 25% in the resources transferred to the provinces- the distribution across provinces changed as well:

- The share of the advanced group increased 10%- the intermediate's increased 37%- the less developed group, 52%- the low density group - 46%

- the spending became more decentralized and the participation of nationalresources into provincial spending increased to 69%

Table Al: Share of Provinces in the Provincial Allocation (%)

Provinces Population Before Law After Law20.221 20.221

Advanced Development 66.8 57.5 50.7Intermediate 13.0 15.7 17.2Low Density 4.0 7.8 9.1Poor 14.3 18.9 23.1

2.13. Late 1980 Reform - Laws 22.293 and 22.294. Law 22.293 replaced the NationalPension System by the National Social Security Fund. In 1981, the VAT tax rate wasraised to 25%, to be lowered to 20% later in the year. In 1985 to 1987, no ley conveniowas agreed upon and the secondary distribution became discretionary. In 1988 the lawapproved fixed the secondary distribution at the level of the relative spending.

46 Strengthening the Institutional Framework

ANNEX 3STRENGTHENING THE INSTITUTIONAL FRAMEWORK

OF PROVINCIAL FINANCE

Introduction

1. During the nearly two centuries since Argentina became independent, itsprovinces have played a vital governmental role. This role has continued and increasein recent decades since the end of military rule and the country's return to democracy.Provinces are directly responsible for over half of total governmental expenditures inArgentina.

2. As mentioned in Chapter 2, Argentina provinces improved the management oftheir finances between 1990 to 1992, their current operating deficit having fallen from19.5 percent of total revenues to only 2.0 percent. In 1992, the collective deficitincreased sharply to 8.5 percent of total revenues and has continued at or above thatlevel to the present. The collective deficit masks great variations in outcome amongProvinces. Buenos Aires Province managed to keep its budget substantially in balancein the 1992-95 period, as did others of the more populous and economically activeProvinces such as the Federal Capital and Santa Fe. By contrast, a substantial numberof smaller Provinces, such as Rio Negro, Jujuy, San Juan, La Rioja and Tucuman(which together account for a quarter of the nation's population) are in very difficultfiscal and economic circumstances. Some of these Provinces are so deeply in deficit atthe present time that they have resorted to paying Provincial employees and suppliers inscrip issued by the Province's public sector banks.

3. The sharp turnaround in 1992 in what had been an improving pattern ofProvincial finance was due in substantial measure to the response in many Provinces toan apparently major improvement in national revenues in 1991 and 1992. Totalcoparticipation revenues available to the Provinces in this period rose from 10.3 billionpesos in 1990 to 13.5 billion pesos in 1991 and then to 20.4 billion pesos in 1992.These substantial increases, of 31 percent from 1990-91 and 51 percent from 1991-92,were significantly higher than had been the rate of growth in prior years or than therate experienced after 1992. In fact, the increase in 1991 and 1992 in the pool ofnational revenues from which coparticipaton revenues are drawn was sufficiently greatthat the Provinces accepted responsibility for the cost of a substantial part of what hadbeen Federally-financed education and health functions.

4. These functions were therefore "decentralized" to the Provinces, paid for by aspecial designation of about a billion pesos in coparticipation revenues that wasdistributed according to the cost of the services rather than in line with the customaryformula. In point of fact, the educational and health functions, while Federally-financed, were already physically located within the Provinces and their administrativeand policy operations appear to have been little affected by the change in financing.

Annex 3:Strengthening The Instutional Frameowrk 47

Argentina's decentralization appears to have been essentially a fiscal change, ratherthan representing a clear policy choice about the appropriate level of government atwhich various functions should be administered.

5. Provincial officials apparently took the sharp rises in their coparticipationrevenues in 1991 and 1992 as a signal of further good times to come. Provincialspending, largely on personnel and on payments to municipalities (mostly to supportthe cost of municipal personnel) rose rapidly. Total Provincial current expenditures,stable or declining from 1986 to 1990, rose from 11.9 billion pesos in 1990 to 14.0billion pesos in 1991 and 18.8 billion pesos in 1992. These increases were well abovethe estimated cost of the decentralized functions of education and health personnel (forwhich the special coparticipation distribution was designated). After 1992, the currentspending levels of the Provinces continued to rise, reaching an estimated 25.4 billionpesos in 1995. As a measure of what happened, it can be noted that in 1991, when anational revenue "boom" seemed to be under way, the total ratio of current spending ofthe Provinces to coparticipation receipts was only 2.02, well below the prior (1990)level of 2.48 times coparticipation receipts. The ratio fell further in 1992, to only 1.98times coparticipation receipts. As a result of the combination of increased Provincialspending and slowing national revenues, however, by 1995 this ratio returned to 2.44times copartipation receipts, or essentially to the level that prevailed before the"boom".

6. During the 1990-95 period, the Provinces as a group also increased receiptsfrom their own-source taxes and other revenues. In fact, during the 1992-95 periodwhen overall Provincial fiscal conditions were worsening, their own-source revenuesincreased by 24 percent, contrasting sharply with the less than 2 percent gain incoparticipation distributions during the same years.

7. Despite their revenue gains, the Provinces' financial position worsened from1992-95 because their expenditures grew even more rapidly. The expansion ofProvincial expenditures appears to have been largely due to such causes as increasedpersonnel costs and the growing cost of short term borrowing to cover annual deficits.Personnel costs rose both as wages rose (for example, the decentralized teachers andhealth workers were brought up to Provincial wage levels, at a cost of as much as 25percent more per year in salaries) and as the number of employees rose at bothProvincial and municipal levels. It is important to note that there were major variationsin Provincial response to the revenue "boom" of 1991 and 1992. Some Provinces(Buenos Aires and La Pampa are examples) kept their spending increases withinreasonable limits and, as a result, were expected to end 1995 with balanced budgets.Other Provinces are in a state of fiscal crisis and are pleading with the FederalGovernment for assistance.

8. Many Provinces in Argentina have are so hard-pressed for funds to meet theircurrent operating expenses that they are unable to invest in even the most essentialcapital improvements. As a result, basic infrastructure needs have gone unmet, to the


detriment of both the delivery of services to their citizens and their prospects foreconomic development. Even those Provinces which have been able to maintain areasonable degree of balance in their recurrent budgets have not been able to accesssources of long term financing except in a very limited number of cases (as, forexample, Buenos Aires Province, whose financial strength has won it an internationalcredit rating equal to the of the Federal government). In addition to reviwing the needfor stronger financial management, this paper examines possible means to expandaccess to long term financing for infrastructure investment by Provinces that candemonstrate their capacity to pay the debt service on such obligations.

A. ASSESSING PROVINCUIL FINANClAL MANAGEMENT

Financial Management Systems -- Basic Standards

9. Basic standards of financial management call for a sub-national government toensure that:

(i) it has reliable and integrated sub-systems in the core financial fields ofbudgeting, accounting, auditing and performance measurement.

(ii) the most important aspects of governance, including strategic planning andpersonnel management, are capable of providing essential support to the corefinancial management sub-systems.

(iii) the service responsibilities of the government and its resource mobilizationcapacity are consistent with one another; and

(iv) elected and appointed officials must demonstrate the will to utilize theirresources and systems in a responsible and fiscally sound manner.

The following paragraphs describe the essential elements of these financialmanagement sub-systems and related factors.

(i) Budgeting

10. Subnational governments should adopt budgets that distinguish clearly amongappropriations for recurrent and capital expenditures and that specify the revenues thatwill be used to support them.

Recurrent Budget Requirements. Sound practice calls for sub-nationalrecurrent budgets to:

(i) be formulated and adopted in advance of the fiscal year to which theyapply;


(ii) include multi-year projections of expenditure and revenue as well as datafor the coming year and comparisons with the past year;

(iii) conform to the accounting system's definitions of events and be closelylinked to the accounting system so that accounting reports can be used totrack budget operations;

(iv) identify planned expenditures in terms of both object and programmaticor responsibility categories;

(v) be administered through a system of periodic allotments of spendingauthority to operating entities; and

(vi) be sufficiently comprehensive and transparent so as to present ananalyst with a full view of the government's operations.

Capital Budget Requirements. Sound practice calls for capital budgets to:

(i) include a multi-year investment program for at least three years inadvance of the coming fiscal year;

(ii) be framed in terrns of defined projects, using "lump sum" appropriationsonly where many small projects are involved;

(iii) be based on appropriate analyses of the investment conditions andneeds of the jurisdiction;

(iv) be appropriating documents that define where resources are to comefrom, rather than merely " wish lists" of desired plans or projects;

(v) be linked to a project information system that tracks prior appropriationsand projects to provide a realistic basis for anticipating the need forfunds; and

(vi) be administered under a method of project cost and design control (withrespect to such factors as scope, design and final cost approval).

Revenue Budget Requirements. While the revenue component of the budgetcan be integrated into the expenditure budgets or be stand-alone documents,sound practice calls for it to:

(i) be based on realistic estimates of all anticipated revenues;(ii) include a cash flow component to anticipate the need for short termborrowing; and(iii) be closely linked to the reporting system for revenue collection.

A widespread problem faced by governments in the developing world isinadequate revenue collection under existing tax, fee and other financial systemsdue lack of enforcement, political interference and insufficient informationabout liabilities.

Other Requirements. In many governmental situations, there are "off budget"agencies for whom the local government nevertheless has some fiscalresponsibility. Public water and sewer systems or other parastatal organizations


are common examples of such situations. In these cases, the generalgovernment budget should reflect the existence and degree of commitment ofthe government to finance such entities.

(ii) Accounting

11. At least minimal accounting requirements should be set forth in national orprovincial law. In the US, the concept of Generally Accepted Accounting Principles(GAAP) has been applied to sub-national governments, partly through governmentaction (principally the US Government Accounting Office) and more recently byactions of a public-private organization called GASB (the Government AccountingStandards Board), modeled on a long-successful private body. Argentina has notadopted requirements for governmental accounting systems equal to the standards thatare commonly in use in the private business sector.

12. At the sub-national level, accounting sub-systems should meet the followingminimum standards:

* Use a consistent set of accounting categories, including a clearly definedchart of accounts for both revenues and expenditures.

* Utilize a consistent accrual rather than cash basis or, if they use a mixedcash/accrual basis, be certain to record expenditures on an accrual basis.

* Be supported by adequate internal control systems. Vital to sound internalcontrol systems are such matters as: (1) segregation within all sensitiveprocesses such as the handling of cash or cash-equivalent instruments; (2)identification of risks of various types and installation of systems or controls toguard against them; (3) maintenance of secure written and/or computerizedrecords of all financial transactions; and (4) assurance of adequate numbers ofproperly trained staff in all key fiscal positions.

* Ensure accurate and timely reporting of financial information, especiallyincluding spending against budgetary appropriations. With the advent ofcomputerized information systems, the standards for the speed and level ofdetail of financial reporting have advanced rapidly, although progress has beenslower in many developing countries, especially in the public sector.

(Mii)Auditing

13. Sound financial management requires careful monitoring and evaluation toproduce the "feedback" that enables managers to improve their operations. There arefive aspects of auditing that are relevant in this regard:


* Post-Audit. The requirement of a fiscal year-end financial audit iswidespread in developing and industrialized countries. In Argentina, theresponsibility for audit performance is lodged in a public audit agency (usuallyan agency of the legislative arm rather than the executive). In the US, andincreasingly in Western Europe, the principal responsibility for post-audit ofgovernment's financial results is now assigned to a private firm of accountants(in the US, usually CPA's). These firms are employed by the governmentbeing audited but are required to assert their professional independence from it.In the US, the private accounting firm's results and findings are then madepublicly available.

* Performance Auditing. In the most advanced environments (such as thoseof the Supreme Audit Agencies of the US, Great Britain and Australia and someof the sub-national governments in these countries) the audit process has beenextended from a purely fiscal emphasis to cover the management environment aswell. Thus, an audit by the UJS General Accounting Office or by an agencysuch as the Office of the New York State Comptroller will focus largely on theway in which the audited government entity carries out its functions and theprogrammatic results it achieves. Such performance audits may or may notaddress financial activities at all -- but they should always include a review ofthe internal control systems of the auditee.

- Internal Audit. It is considered good practice in government (as well asprivate industry) for there to be an internal audit function. While such internalunits cannot achieve the degree of independence sought by external public andprivate auditors, they can achieve some degree of independence by beingattached directly to the office of the chief executive of the government they areassigned to audit. Internal auditors may address financial functions but are evenmore likely to investigate managerial and performance issues. Their positioningwithin the government reduces the level of suspicion and even hostility that attimes characterizes the response of an auditee to an external auditor.

* Pre-Audit. Practices with regard to pre-audit vary widely. In the bettermanaged US sub-national governments, the tendency has been to eliminate pre-audit of expenditures by audit or budget agencies. Instead, the pre-auditfunction is made a responsibility of the operating unit making the expenditure.In developing world countries, where less reliance can generally be placed onstrong internal controls, the external pre-audit is still quite widespread. Thepre-audit function may examine every proposed expenditure prior to itsauthorization, or limits may be set below which pre-audit is not required. Pre-audit is often seen by the auditee as a time-consuming interference withmanagement responsibility.


* Audit Response. Audit findings and recommendations call for responses tocorrect weaknesses and improve government operations. Effective managersplace great importance to responding to audits.

(iv) Performance Measurement

14. In the most advanced sub-national governments, an additional type ofmanagement system is installed to measure and monitor the performance ofgovernmental operations. Performance measurement systems focus on indicators ofnon-financial inputs (such as manpower levels), outputs (such as number of truck-loadsof refuse collected) and outcomes (such as whether or not crime is reduced to anacceptable level by the local police force). Common features of performancemeasurement systems include:

* Management Plans. Typically, such a system is installed to support amanagement planning process involving the setting of targets for the level ofaccomplishment sought. In the US, many advanced municipalities now havesuch systems; in addition, GASB is experimenting with requiring theestablishment of such non-financial targets and measures as a necessarysupplement to financial reporting in conformity with GAAP. Managementplans can be prepared at the highest level of a government but should alsocontain components that apply directly to all significant subordinate managers.

D Productivity Analysis. Improving the quality of governmental performancecalls for constant attention to ways in which unnecessary operations can be cutand inefficient ones made more productive. Management analysts and engineersare essential to the success of such a process, as is support from higher levelmanagers.

* Citizen Feedback. The basic function of a sub-national government is todeliver services to the population and businesses it serves. Advancedgovernments have adopted the techniques used by progressive businesses, suchas using "report cards" from their citizens as a means of judging the quality ofpublic service delivery. In addition, statistical sampling of the population canask questions such as: How clean are the streets in your neighborhood? Is thepolice force responsive when you call them for help? Are the parks safe foryour children to play?

(v) Integrating The Components of Financial Management

15. To be fully effective, the four management sub-systems described above need todo more than simply to meet sound standards for what they cover. They also need tobe linked to one another in an integrated framework. Perhaps the single most criticallinkage is that between the budgeting system (government's principal policy instrument)

Annex 3:Strengtheninz The Instutional Frameowrk 53

and the accounting system which provides the underpinning of financial informationwithout which budgeting is little more than guesswork. Auditing provides both a checkon the validity of accounting reports and the adequacy of internal controls shouldconstitute essential feedback to sound budgeting. Performance measurement systemsplay something of the same reporting and feedback roles with respect to the real worldof service delivery.

Other Significant Management Systems

16. In addition to the four component sub-systems of financial management, thereare other govermnental activities of critical importance in achieving sound financialconditions. Two such activities are:

* Strategic Planning. To provide context and direction for government'sactivities, a strategic planning process is necessary. A sound process of thistype should include analysis of such matters as: (1) the social and economicpatterns and prospects of the jurisdiction; (2) intergovernmental relationshipswith both higher level and subordinate governments; (3) the physicalenvironment, including such features as land use, transportation andinfrastructure, and air and water quality; and (4) identification of the key goalsand objectives of the government's leadership.

* Personnel Management. Because governmental personnel account for morethan half of the operating expenditures of most state and local governments,fields such as recruitment, training, assignment, supervision and compensationare of critical importance.

Relationship Between Responsibility And Resources

17. Two of the most basic governmental powers that are typically spelled out innational and/or provincial law are the definitions of the service functions for whicheach level of government is responsible and how the revenues to support these servicesmay be obtained. These two matters are at the root of many of the most difficultfinancial difficulties involving sub-national jurisdictions. While there are manycomplex aspects to each, the thing that is most critical is whether the two are in areasonable relationship with one another. When service responsibilities are too great orare growing too fast to be supported by the resources available, fiscal pressure growsuntil something has to give -- either the jurisdiction fails to meet its service deliveryobligations or it fails to keep its budget in balance, or both. Assessing whether a sub-national government has the capacity to balance these two forces is not easy, but itsimportance to sound finance cannot be stressed too strongly. A term that has come intovogue in US municipal parlance to describe this issue involves whether or not a city hasachieved "structural balance" between revenues and expenditures.


Willingness To Manage

18. A less concrete factor -- but one that is crucially important to soundgovernmental finance -- is determining whether or not the elected and appointedleadership has the will to manage. Included in this concept is whether leadership isprepared to make the difficult and often unpopular choices with regard to employeewages, public service and investment levels and the imposition and collection of taxesand fees that are essential to achieving a balanced budget. Even in cases where anelected leader is prepared to take the heat for a necessary but unpopular step, specialinterests can oppose and obstruct the decision.

B. Current Status Of Provincial Financial Management

19. As for the current situation of the Provinces of Argentina and the observationsthe mission could collect indicate the following classification: (a) Satisfactory FinancialManagement: Buenos Aires; San Luis; La Pampa; Santa Cruz. (b) Fair to reasonablemanagement: Santa Fe, Mendoza, Corrientes; (c) Poor Financial Management:Formosa; Chaco; Salta; Tucuman; La Rioja; Rio Negro; San Juan; Jujuy

20. Among the shortcomings those with poor financial management, are the following:

* Budgets are adopted late and do not truly control public spending (asevidenced by major deficits, failure to pay valid wages and invoices, etc.).

* Accounting systems are slow and inaccurate, lack connection to valid internalcontrols, utilize a mixture of cash and accrual basis, etc.

* Audit systems fail to produce prompt and accurate year-end financial reports,and are purely financial, rather than managerial, in their scope.

* Performance measurement and productivity improvement systems are non-existent.

* There is little or no evidence of sound linkages among the various financialmanagement systems.

* There is little or no evidence of strategic planning.

* To the degree that many Provinces make capital investments, they are notpart of any comprehensive investment strategy.

* Personnel practices allow increases in wages and staffing without theavailability of resources to finance them.


* There is little or no evidence that service responsibilities and resourcemobilization capacity are in balance or are being brought into balance (despitethe fact that these Provinces tend to receive much higher than average per capitacoparticipation revenues).

* There is little or no indication of the will to manage effectively, as evidencedby resort to the use of scrip when revenues are exhausted, non-payment ofcontractor vouchers and the tendency to borrow without clear prospect ofrepayment capability.

21. In sharp contrast, some provinces, such as Buenos Aires, Santa Fe and Mendozahave good budgets. The Province of Buenos Aires has a budget which is competentlyand professionally organized; is capable of producing accounting information and auditreports sufficient to enable it to sell securities on the international markets (with acredit rating equal to that of the Federal Government); and has apparently strong willto manage effectively and within its means, as evidenced by its maintaining a nearlybalanced budget during difficult years and despite its receipt of the smallest amount ofcoparticipation revenues on a per capita basis. Santa Fe, a Province in the secondcategory that the mission also visited, appeared to lack financial management systemsof the degree of sophistication and capability of Buenos Aires. Nevertheless, it isclearly a competently managed government.

Institutional Strengths and Weaknesses

22. The Federal system in Argentina contains institutional strengths and weaknesses.The long history of Provincial independence -- marred though it has been by periodsduring which there was intervention and even suppression of local independence by theFederal government -- is itself a major source of institutional strength. It means thateven at times when some Provinces are in crisis, other Provinces can continue tooperate responsibly and effectively. However, the tradition of Provincial independencefrom Federal oversight and direction is also a matter that can allow fiscallyirresponsible behavior by individual Provinces to continue over relatively long periodsof time. It has also been linked with the electoral process in ways that have oftenresulted in special treatment to bail out heavily indebted Provinces, a pattern that hastended to encourage some Provincial officials to believe that they will not be requiredto face the consequences of their decisions.

23. Argentina benefits from an educational system that has produced a highlycompetent class of professionals in most aspects of financial management. In the bestinstances, the quality of trained personnel and of professional standards in budgeting,accounting, auditing and most other aspects of public management is world class. Thecountry has organizations such as ASAP ( the Asociation Argentina de PresupuestoPublico), which has over 300 individual members and 100 institutional affiliates and


which provides professional seminars and courses in public sector budgeting andaccounting, as well as a number of university-based professional training programs infinance and economics. The mission's visits to the governments of Buenos Aires andSanta Fe Provinces bear out this finding of high caliber financial management.However, reportedly this same high quality of financial management personnel andpractices is not found in all Provinces. In addition, and especially in those Provinceswhere fiscal problems are currently most critical, sound financial managementpractices appear to have often given way to other considerations.

C. Strengthening Provincial Fiscal Management

Relevant Experience Elsewhere

24. It is not very easy to find successful contemporary experience that is directlycomparable to the situation now faced by the Argentina provinces with respect to thesevere fiscal problems of a number of the country's Provinces. What especiallydistinguishes the Argentine situation is that the Provinces are sovereign entities, notcreatures of the central government. This situation is parallel to that of CanadianProvinces, American States or German Lander. But there are no very relevant cases offiscal crisis, accompanied by Federal intervention, in any of these countries.

25. In the United States, the most recent cases of default on securities by a stategovernment occurred over a hundred years ago. In Canada, what is now the Provinceof Newfoundland was at one time an independent nation. In the 1930's it sufferedeconomic problems of such severity that it asked to be readmitted as a British colony;subsequently, Newfoundland became a Canadian Province.

26. There is a body of experience elsewhere that may have relevance to Argentina,although it does not involve sovereign entities. This is the US experience with fiscalcrises at the municipal and county level, of which the case of New York City in themid-70's is perhaps the most widely known. The US experience differs from thesituation of Argentina in that municipalities and county governments are creatures ofstate governments, not sovereign entities. This is also the case with other, more recentUS. instances of fiscal crisis and bankruptcy at the sub-state level -- such as those ofthe City of Bridgeport, Connecticut, and Orange County, California.

27. City of Bridgeport: In the case of Bridgeport, a city of about 50,000population which is popularly believed to have been a recent instance of the use of US.municipal bankruptcy law, the city never did actually enter a condition of bankruptcyor receivership. The city was beleaguered by severe financial problems, caused in partby deteriorating economic conditions and in part by municipal mismanagement.Bridgeport had, in fact, long been subject to the control of a State of ConnecticutFinancial Review Board. In the late 1980's, the mayor of Bridgeport declared theintention to file for bankruptcy to obtain protection from the city's creditors andunions; however, he was overruled by State officials who the arranged for a State

Annex 3.Strengthening The Instutional Frameowrk 57

agency to issue bonds to relieve the city's inability to access the capital markets,ordered the city to balance its budget through increases in local taxes and providedadditional State financial aid.

28. Orange County is closer to a contemporary case of municipal bankruptcy (apetition to this effect was actually filed) but both the cause of the crisis and theeconomic situation of the county make it quite different form the situation of thetroubled Argentine Provinces. The county's difficulties arose not out of either generalmismanagement nor economic hardship. What happened was that the CountyTreasurer, using both County reserve funds and those of other entities such as schooldistricts within the county, engaged in speculation in the municipal security markets,employing risky techniques such as the sale and purchase of derivatives. As long asinterest rates fell, the "investment" was successful and the county made handsomereturns on its own money and those of the subordinate levels of government. Wheninterest rates rose, however, it became apparent that what was going on was speculationwith public funds. The County suffered losses in the billions of dollars.

29. Given the wealth of Orange County, and the taxing powers potentially availableto the county, even a large loss could have been handled without outside intervention orbankruptcy protection. However, County officials, supported by the voters, refused touse the economic assets and taxing powers available to them and filed for bankruptcyinstead. The Orange County situation is still on-going and it is not entirely clear how itwill finally be resolved (for example, the County is suing its investment advisers,claiming that they misled the Treasurer). The State of California has acted to makereserve resources available to the County to enable it to meet its obligations. Prior tothis incident, Orange County was believed to be a weli-managed local governmentwith an excellent credit rating. It seems likely that, as in other instances ofunwillingness (rather than inability) to pay, the county will suffer long-lasting daniageto its reputation and credit rating. Perhaps the single thing that Orange County can bestdemonstrate to Argentina's Provinces is the vital importance of the will to manage.

30. The case of New York City, whose fiscal crisis became public in 1975, andthose of other large American cities (such as Cleveland in the 1970's, Philadelphia inthe 1980's and Washington, D.C. in the 1990's) also differ in many particulars fromthose of Argentine Provinces. They do, however, share certain characteristics,including institutional features, that may have considerable relevance to the situation inArgentina. Put succinctly, the New York City fiscal crisis case developed as follows:For many years, going back at least into the early 1960's, the city had experienced astructural imbalance between the revenues available to it (from its own taxes and feesand from financial aid it obtained from the State of New York and the FederalGovernment) and the expenditures required to meet its broad array of serviceobligations (many of the most costly of which, including income maintenance andhealth care for the poor, were mandated on it by State law).


31. Each year, closing the gap between anticipated revenues and expenditures was adifficult challenge, fought out in the public arena as the city strove to obtain more aidand/or authorization to levy taxes from the State government. This annual drama wasgiven wide publicity by the concentrated presence of many organs of the media withinNew York. Each year, the "crisis" was eventually resolved, or declared to beresolved, by agreement between the city and the state. In fact, during the 60's andearly 70's the resolution of the crisis was often financed in the form of borrowing oneither a short or long term basis, not by bringing expenditures into balance withrevenues.

32. Two factors helped in making this postponement of the crisis possible. Onewas the poor state of the city's accounting system, which was on a cash basis, lackedany independent auditing and had other significant shortcomings. The other was thecontinuing willingness of the private municipal security markets to accept major cityborrowings, based on the investors' confidence in the guarantees in the StateConstitution that all municipal securities were backed by the "full faith and credit" ofthe nation's largest city whose property base could be taxed to any degree necessary topay interest and amortization on general obligation securities (virtually the only typethe city sold).

33. This long-continuing condition came to full crisis in mid-1975 when themunicipal security market -- itself undergoing severe stresses caused by high inflationand a national recession that hit New York especially hard -- refused to acceptadditional city notes or bonds. Unable to borrow to cover its large cash flow needs,the city was in a condition that threatened bankruptcy or at least some form ofreceivership. In point of fact, neither New York nor any of the other large US. citiesthat have experienced fiscal crises in recent decades has actually used the provisions ofbankruptcy law. In New York City's crisis, the city came close to defaulting on somenotes and appealed to a State court for a stay of payment; the court refused therequest, citing the fact that the notes were backed by the city's promise to pay, andordered it to do so. With assistance from the State, the city did so.

34. What may be relevant to the Provincial situation are the institutional steps takento address the crisis. These measures have become part of an almost standardrepertoire of corrective measures taken in US. urban fiscal crises; close parallels can befound in the subsequent approaches to the problems of Philadelphia and Washington, aswell as smaller municipalities such as Yonkers. Prominent among the correctivemeasures were:

a. An Emergency Financial Control Board was established by the Stategovernment, the body with sovereignty over the city. The EFCB wasauthorized to approve or disapprove the city's annual budget (by decidingwhether or not it was likely to be in balance) and to mandate steps necessary toensure balance, including disapproval of collective bargaining and othercontracts, reducing the level of municipal employment and changing other

Annex 3:Strengthening 7he Instutional Frameowrk S9

aspects of municipal finance. The EFCB did not itself have the authority tomake specific changes in the city's budget; this authority remained in the handsof the city's mayor and legislature. What EFCB could do was require the cityto take the actions necessary to achieve balance (with the threat of removal ofcity officials from office and other punitive steps to back up its orders). EFCBcould also require the city to strengthen its financial management systems.Among the important institutional strengthening measures ordered by the EFCBwas the institution of a new computer-based, integrated budgeting andaccounting system designed to produce accurate, timely and comprehensiveprogress reports on the city's finances. EFCB also directed the city to retain anindependent private accounting firm to produce reliable year end financialreports.

b. A special unit of the State Comptroller's Office was established to monitorthe city's financial operations and to report its technical conclusions on them tothe EFCB. The State Comptroller's Office also expanded its performanceauditing of city operations.

c. Another new State agency, the Municipal Assistance Corporation, wasestablished to help the city meet its cash flow needs and also to finance its mosturgent infrastructure investment requirements by borrowing on its behalf onboth a short and long term basis. MAC's legislative authorization gave it prioraccess to the stream of State assistance payments that were regularly made to thecity and also to substantial amounts of State-collected city sales and income taxrevenues as backing for the securities it sold on the private markets. MAC alsoissued long term bonds to finance the city's accumulated deficit. While MAC'sinitial borrowings for the city carried high interest rates, in subsequent years itscredit rating gained it access to lower rates; in fact, as rates fell in general insubsequent years, MAC was able to refinance its longer term bonds and producesubstantial savings.

d. New York State government also acted to revise the financing of several ofthe city's service responsibilities. For example, the State agreed to pay the thefull non-tuition cost of the senior colleges of the City University (instead of 50percent) and the full salary costs of the State judicial system in the city (up from50 percent). The State Health Department also assumed some previouslymunicipal health responsibilities. In this area of service restructuring, however,what was done was minor in comparison to what many observers felt shouldhave been accomplished. Virtually no change was made in either the financingor administration of the public assistance and health care programs that servedthe city's population. These costs were both substantial and unusual in that onlyNew York City, among all US. municipalities, was required to bear any part ofthem (elsewhere, they were state responsibilities). The burden of these welfareand medical costs has continued to be a major factor in the city's annualstruggles to balance its budget up to the present day.

60 Strengthening the Institutional Franework

e. The Federal Government also participated -- reluctantly -- in the resolutionof the city's problems. Its principal assistance was in the form of some shortterm lending at a time when the city's cash flow problems were most severe.The Federal Govermnent also put its weight behind the State pressure forreform of the city's financial management and information systems.

f. The Securities and Exchange Commission investigated the causes of thecity's crisis and, in cooperation with private security market institutions,considerably strengthened the requirements for disclosure of current financialand economic information at every sale of securities by MAC or, subsequently,by the city itself. The major credit rating companies (which had raised thecity's credit rating only a year or so before the fiscal crisis broke into the news)suspended their ratings after the crisis became public. About a decade after thecrisis, and after it had become clear that the quality of the city's financialinformation and performance had significantly improved, the major ratingcompanies restored the city's rating to a low investment grade.

g. A variety of other institutional steps were also taken, ranging from changesin State law to regulate more closely the purposes for which municipalitiescould borrow to the establishment of a range of non-governmental organizationsto monitor and discuss the city's problems.

35. By 1986, after three years of severe crisis conditions and more years of closemonitoring by the EFCB, MAC and the State Comptroller, New York City was able toachieve a balanced budget for three successive years, measured according to thestringent generally accepted accounting principles (GAAP) to which EFCB had boundit. The city's achievement was helped by the institutional strengthening steps that weretaken, but also was made feasible by other factors, principally among them the fact thatthe mid-80's saw an economic upswing that strongly affected the real property marketon which much of the city's taxing power was based. New York City was able toregain access to the private security markets on its own. Since that time, the city hascontinued to balance its budget each year. The FCB remains in place, but as amonitoring rather than a control agency, with the word "Emergency" dropped from itsname.

Standard Repertoire Of Fiscal Control Mechanisms

36. Since New York's fiscal crisis, actions similar to many of the changes madethere have been taken across the United States to upgrade the quality of financialmanagement so as to ensure that sub-national governments (both states andmunicipalities, etc.) maintain more effective control over their fiscal operations.

Annex 3.Strengthening 7he Instutional Frameowrk 61

Generally, these improved control mechanisms fall into two broad classes: First, thereare those designed for normal or "standard" circumstances to ensure that governmentoperations conform to sound financial management practices. Second, there is a rangeof actions that have been applied in emergency or "crisis" situations when the ordinarysteps fail to keep matters under control, whether for reasons of external events orinternal shortcomings of the government in question. The following paragraphsindicate approaches to fiscal control that have been used in both of these circumstances.

The Checklist Of Linked Systems

37. The set of standards used by the mission to assess Provincial financial managementconstitute a benchmark that can be used in designing improvements, especially in thoseProvinces that now have only fair to poor levels of such systems.

The Role of Market Mechanisms

38. There are significant private market mechanisms that impact on government fiscalcontrol. Most of these involve the issuance of debt (especially long term bonds).They include:

* Bond and Note Credit Ratings. In the industrialized world, the privatemunicipal securities markets rely on credit ratings issued by reputable firms(such as Standard & Poor's and Moody's) as a basis for assuring investors ofthe likelihood of repayment. In the developing world, such firms havegenerally rated national government credit and those of major parastatals buthave less frequently been involved with sub-national governments because of thegeneral absence of private market interest in such securities. In order to obtaina rating, a government must present comprehensive financial information to therating firm (as well as paying a fee). The firm then does its own analysis andsets the rating.

* Monitoring/Credit Watch. A more recent form of activity by the ratingfirms is monitoring of rated governments to make certain that their financialcondition is not worsening and, if it is, to warn the general public.

* Disclosure Requirements. It is typical that before securities can be sold onthe private market that the issuer disclose information on its fiscal operations,social and economic conditions, etc. The need to do so acts as an incentive forsecurity-issuing bodies to improve their fiscal systems and condition.

* Bond Counsel and Investment Advisers. Another important adjunct toentry into the private securities market is the need to use professional adviserswho can provide a stimulus for improvement of fiscal systems.


* Disclosure/Due Diligence Requirements. Disclosure requirementsmandated by the private sector can play a useful role in giving advance warningof emerging fiscal crises. As an example, each sale of a security by New YorkCity is now accompanied by issuance of a detailed and comprehensive report onthe city's finances and budget and those of any government entity with which ithas a close relationship.

Privatization of Governmental Functions

39. Privatization is increasingly looked to in both the developing and industrializedworld as a means to improve the efficiency of service delivery and reduce cost. Byshifting operations outside the scope of government it may reduce the fiscal burden onthe public sector. Privatization has its potential downsides, too: (1) if the moreprofitable of fee-generating services are privatized, government may be left with aneven more difficult task; and (2) effective privatization requires some maintenance ofgovernmental involvement (contract monitoring, service quality and equity screening,etc.) of a type unfamiliar to many local governments.

Fiscal Emergency Control Mechanisms

40. Improvements in the financial management practices of Argentina's Provincesalong the lines discussed in the preceding paragraphs would do much to reduce thelikelihood of future fiscal crises. However, such action is too late to prevent thecurrent crisis conditions. In these cases, the options available include the following:

* Imposition Of An External Control Organization. Where it has the basicpower, or where the affected jurisdiction agrees, a higher level government,concerned with the dire fiscal condition of a lower level government, canimpose a control organization. The control organization should have sufficientpower to mandate adoption of a balanced budget either by cutting expendituresor raising revenues, or both, as well as other necessary measures (such asrequiring the installation of dependable financial management and informationsystems). The New York State Emergency Financial Control Board for NewYork City, in its initial actions, ordered the city to cut its work force by one-fifth and pay no wage increases to employees for a period of several years. Thecontrol organization is still in place twenty years after the city's mid-70' s fiscalcrisis, although it now is more of a monitor than a direct control agency;however, its full array of powers will spring into action again if the city fails tobalance its budget at any time.

* Imposition of Penalties on Public Officials. Many countries have legalprovisions under which local officials can be fined or even imprisoned forimproper fiscal actions. In principle, harsh penalties should cause local officialsto be more cautious in their actions, but the political and judicial obstacles to


imposing severe penalties generally prevents them from being used enough to bean effective deterrent.

* Financial Aid and Borrowing Assistance. When a state or localgovernment no longer has credibility for borrowing on its own, it may beappropriate for higher level government to create a substitute entity to carry outsuch borrowing. This is a practice that must be used with considerable caution:the debt problems of many provincial governments in developing countries suchas Argentina and Brazil have probably been made more severe by indiscriminateuse of provincial banks and other institutions in this way. To be of value incorrecting a fiscal emergency, a substitute borrowing mechanism itself mustoperate under strict discipline and not simply as an agent of the troubledgovernment. A classic case of the responsible use of such a mechanism hasbeen that of the New York State Municipal Assistance Corporation (MAC) forNew York City.

* Basic Changes in Responsibilities and Resources. Depending on theparticular distribution of legal and Constitutional powers, higher levelgovernments may be able to take legislative or even executive action to relieve afiscally stressed local government of its service responsibilities, either assumingthem itself or re-assigning them to another jurisdiction or to a parastatalenterprise. For example, in the mid-1980's, the Prime Minister of Jamaicaordered that most of the major service functions of Kingston, the capital city, bere-assigned to national ministries and parastatal corporations. In extremecircumstances, a higher level government may have the power to entirelyabolish a lower level government that is unwilling or unable to resolve a fiscalcrisis or to merge it into another local government entity. In many countries,this would be considered too extreme a step (for example, in many LatinAmerican nations, even municipalities have constitutionally guaranteedautonomy and, in most of Latin America, states or provinces have fullConstitutional status). In other countries, however, such action would beconsidered as entirely feasible. For example, in Great Britain, municipal andcounty-level governments have often been restructured or even abolished byParliamentary action. In Canada, local governments that have become fiscallyinsolvent have been abolished and their responsibilities transferred to otherjurisdictions by action at the Provincial level.

* Bankruptcy is a fiscal emergency measure that is often discussed but thathas been relatively little used in recent decades. The US Federal Governmentand many US. states have adopted provisions of bankruptcy law that apply tomunicipalities, at least in principle. But neither in the US nor in other countriesare there examples of the use of bankruptcy provisions by sovereign entitiessuch as states or Provinces.


* Upgrading Management Systems. Whatever emergency actions are taken,it is essential that the opportunity be used to upgrade the budgeting, accountingand other financial management practices in the affected sub-nationalgovermments. Such action does not substitute for the above-listed steps, but isan essential supplement to them.

D. INCREASING ACCESS TO LONG TERM FINANCE FOR CAPITALINVESTMENT

41. In order to achieve their goals over the long run, it will be essential for theProvinces of Argentina to gain access to sources of long term finance for csapitalinvestment. If this access is to be obtained from the private credit markets, whetherinternal or external, most Provinces will have to go beyond minimally necessaryavoidance of financial crisis conditions to build a reputation for fiscal stability. Thefollowing paragraphs outline the US municipal experience in this regard as a guide towhat may be necessary.

Relevant US Experience

42. State and municipal governments in the United States depend heavily on theprivate market as a source for the long term financing of their physical capitalinvestments. This market is known generically in US parlance as the "municipalsecurities market" although it is also used by state governments and by a broad range ofparastatal entities (in US parlance, "special districts"). This section presents asummary description of the experience of US. states and local governments in using thetwo main types of long term financing available in the municipal security market:general obligation and revenue bonds.

43. General obligation bonds were the earliest form of municipal security to develop inthe US. Their name is derived from the fact that such bonds are backed by thecommitment of the entity which sells them to utilize all of its revenues and taxingpower to pay debt service sufficient to cover interest and amortization. Thiscommitment is usually expressed in the State Constitution as well as in the charter ofthe municipality, and is described as a pledge of the "full faith and credit" of themunicipality. Under US law, any seller of a general obligation bond (or GO bond, asthey are commonly known) can be directed by the courts of its state to pay debt service-- even if doing so requires forgoing payment of other expenses such as municipalwages or the imposition of additional taxes. Failure to pay can only be avoided by thefiling of municipal bankruptcy, and even then it is likely that the court will definepayment to bondholders as being among the highest priorities of the bankruptgovemnment. Because of the difficult experiences with municipal bankruptcy in pastdecades (such as during the Depression of the 1930's), it has become a quite rare eventin the US. And only a small fraction of the few municipal bankruptcies in recent yearshave involved defaults on GO bonds.

Annex 3.Strengthening The Instutional Frameowrk 65

44. In most US states, the sale of GO bonds is constrained by two principal factors:conditions set in State law and others set by the private market. State law setslimitations of the following types: (1) it limits the amount of GO debt that an entitycan have outstanding at any time; (2) it specifies the purposes for which funds can beborrowed (generally, only for land purchase, construction and the purchase of majorequipment, plus associated costs of design and supervision); (3) it defines the allowableterm or length of the borrowing for any given purpose; and (4) it specifies the sourceof revenues that must be used for payment of debt service (usually, the real propertytax). In many jurisdictions, sale of GO bonds also requires approval by both thelegislative body of the jurisdiction and by a vote of the citizens. It is this last-citedconstraint that has limited the use of GO bonds in many states and cities and has led tofar greater reliance on the use of revenue bonds.

45. Revenue bond issuance is also restricted by law, but because the payment of debtservice is backed by a designated stream of revenues, not the general resources of thejurisdiction, it usually does not require approval of the voters, nor is there generallyany statutory limit on the amount of revenue bonds that a jurisdiction can haveoutstanding (as long as it can persuade the market that it will have sufficient revenuesfor debt service). The potential availability of revenues is the greatest constraint on theuse of revenue bonds. Other common constraints include: (1) the purposes for whichsuch bond receipts can be used and (2) the length of term of the bonds.

46. In order to provide assurance to potential bond buyers of the likelihood that theywill be repaid promptly upon the maturing of a municipal security, a number of creditrating companies (of which Standard & Poor's and Moody's are the best known)examine the management and other features of any jurisdiction that plans to sell bonds.The higher the rating they assign (with the AAA rating of the Federal Government atthe top), the more secure the investment is expected to be and, all other things beingequal, the lower the interest rate likely to be charged.

47. To obtain a credit rating, a government jurisdiction normally both pays a fee to therating company and agrees to provide all requested information on its operations,finances, revenues, legal situation, economy, demography, etc. The rating companythen assigns its analysts to examine the data and to do independent research asnecessary to supplement or corroborate it. After this, the rating company advises theapplicant of its conclusions and, after offering an opportunity for appeal and submissionof additional information, determines the rating, and makes it public, together with anycomments the rating firm deems appropriate. In the US, the credit rating of a localgovernment is seen as a very important factor, often even more important than themodest differentials in interest rates associated with various ratings would seem towarrant.

48. In order to enhance their credit ratings, governments can take a number of steps.First among these is to enhance their reputation for managerial competence (especiallywith respect to their financial management) and their resource mobilization capacity, so


as to assure potential investors of both their ability to pay and their willingness to placepayment of debt service at the top of their priorities. There are also specific techniquesthat can be used to enhance a rating, such as: (1) purchase of bond insurance(essentially, a letter of credit from a private firm) ensuring that, if the governmentdefaults, the insurer will pay off the debt on its behalf; (2) by setting up reserve funds,administered by a reliable trustee, to assure the payment of at least several years of debtservice in the event of a default, thus allowing time for court action to enforcepayment; and (3) obtaining either an actual guarantee or at least a substantial indicationof support (in US parlance, a "moral obligation") from a higher level of government.Such enhancements are used more often with regard to revenue bonds than GO's, butin the case of a government whose record has been spotty, they can also help in the saleof GO bonds.

Applicability To Argentina

49. To a considerable degree, many elements of US practice, as described above,already exist in Argentina and are available to Provincial governments. This isdemonstrated by the fact that at least one Province, Buenos Aires, has obtained a creditrating sufficiently high to have enabled it to sell about $300 million worth of bonds inthe US and Europe. Also, it is clear -- from the practices of private firms in Argentina-- that all of the technical advisory services that a Province would need for the issuanceof long term securities are available within Argentina.

50. What is most lacking if more Provinces are to obtain access to long term financingfor capital investment appears to be the following:

* Few of the Provinces are comparable to Buenos Aires in either thesophistication or the competence of their professional leadership, the quality oftheir financial management systems or the state of balance in their finances overrecent years.

* The private investment market in Argentina has little confidence in theleadership and management of most Provinces with respect to such vital mattersas the capacity to deliver services and collect revenues. The market also doubtsthe depth of Provincial commitment to using all resources to assure therepayment of borrowed funds. This lack of confidence will be difficult toovercome, given the current troubled state of fmances in a number of Provincesand their willingness to resort to questionable practices such as the issuance ofscrip to pay suppliers and government employees. Few lenders would beprepared to tolerate such action.

E. Recommended Actions

51. There are three closely related sets of actions that are needed to address thefinancial problems of the Provinces. The first is to remedy the current position of

Annex 3:Strengthening 7he Instutional Frameowrk 67

indebtedness and financial crisis of many Provinces. The second requirement is tomake certain that the situation does not simply re-occur by significantly improving thefinancial management systems of these and other Provinces. The third step will beactions to attain access to kong term finance for capital investment. Some Provincesmay act on their own to address one or all of these needed steps. For example, BuenosAires Province is clearly already motivated and capable of strengthening its financialmanagement systems and has already attained market access for long term finance. Asanother example, the new leadership in other Provinces such as Neoquen is making apublic commitment to address their debts and upgrade their management.Unfortunately, past Argentine history does not suggest that confidence can be placed inthe leadership in all Provinces to make and maintain a commitment to bettermanagement. Reinforcement of this commitment will be essential if Federal assistancein a debt bail-out is to be more than a temporary solution.

52. What is needed is a two-part approach: in return for agreement to assumeresponsibility for currently unmanageable debts of the Provinces (by issuing its ownlong term debt to finance the assumption) the Federal Government needs to obtain abinding commitment to the reform and strengthening of Provincial financialmanagement. This paper presents a framework for defining the type of managementsystem that should be installed (see the checklist of financial management systems,above). Each Province that is willing to make a binding commitment to reform inreturn for Federal assumption of debt should agree to a specific schedule of steps toachieve this goal. The schedule should specify the minimum content of themanagement system to be created; establish a definite time table for putting it intooperation and should also provide for the technical assistance necessary forimplementation.

53. Provinces not currently so indebted that they are likely to agree to theconditionality approach outlined in the preceding paragraph should be offeredcomparable technical assistance. It may also be feasible to condition receipt of otherFederal financial assistance (other than coparticipation, which the Provinces view astheir right, not Federal aid) on agreement to a schedule for upgrading of financialmanagement systems.

54. Other measures to remedy financial emergency and to ensure the maintenanceof adequate financial management practices could include:

* In the case of recalcitrant Provinces, where no other means to ensureProvincial efforts to balance their budgets seem likely to prove effective, aFinancial Review Board, with a majority of Federal and private sector membersdesignated by the Federal Government, could be established. Such a Boardcould be given the authority to mandate reductions in staffing and/or wages andin other spending by the Province until the budget is balanced. The creation ofthe Board, and its operation for at least a decade, could be made a condition ofFederal assumption of Provincial debts and/or additional financial aid.


* The Auditor General should be given the authority (probably under an act ofthe Congress) to set budgeting and accounting standards for all governmentalentities in Argentina that receive more than minimal amounts of Federalfinancial assistance. Such standards could be modeled on the US GenerallyAccepted Accounting Principles (adapted to Argentine conditions) and shouldinclude a requirement that each Province obtain an independent audit of its year-end financial results.

* Provinces should be encouraged to move toward obtaining credit ratings thatwould enable them to access the private market for the sale of securities.

55. Steps that should be taken by any Province that wants to gain access to theprivate investment imarket are the following:

* Management. The quality of the core financial management systems of theProvince must be brought up to acceptable levels. An accompanying paper setsforth in some detail what is involved in this regard with respect to budgeting,accounting, auditing and performance measurement. Provinces probably don'tneed to meet every one of the demanding standards in the checklist, but formost Provinces a major upgrading of systems and of the skill levels of financialmanagement personnel will be required.

* Willingness To Manage. A more subjective challenge will be for Provincialleadership to demonstrate a lasting commitment to improve the quality ofservice delivery and management as well as showing their commitment to givetop priority to payment of debt service on any Provincial securities.Overcoming the skepticism of the market about Provincial leadership will be avery difficult task.

* Enhancing Credit Quality. In addition, most Provinces will have to utilizeone or more approaches to enhancing their credit quality. Possible actionstoward this end include: (1) establishing trustee systems that will receiveProvincial revenues in quantities sufficient for annual debt service; (2) settingreserve funds that will give creditors confidence of future revenue availability;and (3) obtaining external backing either from a bond insurance firm orgovernment entity that will guarantee repayment in the event of default by theProvince.

* Demonstrating Financial Capacity. In addition to the foregoing actions,Provinces that want to borrow on a long termn basis will have to be able todemonstrate that they have the financial capacity to repay their debt. A step thatwill have to be taken before there is a real possibility of convincing investors offinancial capacity will be coping with the present unpaid debts of many of the


financial capacity will be coping with the present unpaid debts of many of theProvinces

56. In some cases, it may be more feasible to meet the standards for issuance of arevenue bond if the Province establishes a separate public enterprise (such as a watercompany) that has a defined stream of revenues from service fees and that can assureinvestors of their access to such revenues through bond covenants and other legalinstruments. Where Provincial functions have been fully privatized (as in the case ofelectricity companies, for example), the approach to obtaining capital funds forinvestment can follow standard private sector practices.

57. In their revenue haring arrangements with the Federal Government, Provincesalready have one source of revenues that is available to use as backing for borrowing(although at present such revenues are mostly being used as security for short termloans). The major advantage in borrowing against coparticipation funds is that theProvince can ask the Federal Government to guarantee to pay the funds to bond buyersin the event that the Province fails to pay. In this sense, borrowing againstcoparticipation is roughly parallel to the issuance of GO bonds by a municipality in theUS. Such backing is as good as the Federal Government's commitment to withholddebt service -- but no better.

58. There are difficult obstacles to be overcome before Provinces can use their own-source revenues (such as the taxes on gross business receipts, real property and motorvehicles) as backing for long term debt. The principal difficulties will arise in trying toassure the purchasers of securities that such revenues will actually be available and willbe used to pay debt service -- even in the face of pressures to pay public employees andother priority concerns of Provincial leadership.

59. Because these own-source revenues are collected by the Provinces themselves,there is no real possibility of a guarantee of repayment by the Federal Government (asthere is with respect to coparticipation) nor is there a clear record of enforcement ofdebt obligations by Argentine courts. One possible approach to remedy this defectwould be for a Province to amend its Constitution to pledge its "full faith and credit"for such repayment. In addition, it is likely to be some time after such an amendmentbefore the nation's private investors are willing to place their confidence in it.

70 Annex 4

ANNEX 4

COMPARATIVE CREDITWORTHINESS ASSESSMENTOF THE ARGENTINE PROVINCES

1. This paper presents a methodology to evaluate provincial creditworthiness, including asimulation model that projects selected financial indicators over a five year period. Thesimulation model is used in conjunction with historical data to develop the analysis. This is adynamic approach toward credit analysis for the Argentine Provinces that attempts tointerpret the current provinciai fiscal crisis in light of possible debt workout and other fiscalsolutions. The model could be used as a tool by the government to test alternative debtrestructuring, revenue enhancement, and expenditure control assumptions to deal with thecurrent situation and develop appropriate policies that address the fiscal issues confronting theprovinces.

2. The first section of the paper briefly discusses the concept of creditworthiness in thecontext of the Argentine Provinces. The second section presents the methodology for theanalysis including the structure of the simulation model and the initial results. The finalsection presents the ranking of the provinces based on the creditworthiness indicators andconclusions.

A. Creditworthiness Measures in the Context of the Argentine Provinces

3. Creditworthiness is defined as the willingness and ability of the provinces to repaytheir debt obligations to public and private creditors. This is the typical definition used bycredit rating agencies in the U.S. to evaluate the credit quality of public agencies. The fourprimary criteria used by the rating agencies for assessing subnational debt (in this case theequivalent of states in the U.S.) are (a)Population and Economic Base, (b) FinancialOperations (including Expenditure Flexibility), (c) Debt Factors and (d) FinancialManagement. The basic definitions of the these criteria for the provincial creditworthiness arepresented below. The definitions are not comprehensive and do not represent a thoroughcredit evaluation. The intent is to incorporate key elements of a credit evaluation. Acomplete credit assessment of each province in Argentina would be a very significant effort,especially in gathering and validating information in the four primary criteria areas. Thepurpose of the current exercise is to incorporate the key credit criteria into a quantitativeapproach that ranks provinces according to their creditworthiness. The analysis will use asimulation model and other data to generate values for the four creditworthiness criteria.

4. An important aspect of this approach is a comparison of creditworthiness among theprovinces; i.e. an empirical method, rather than a "normative" method that comparesprovincial creditworthiness with an agreed upon standard.

Annex 4: Financial Capacity Assessment 71

5. Criteria: The definition of the four credit criteria is the following:

(a) Population and Economic Base - Population dynamics, i.e. its structure and growth,are the foundations of the economy and are important elements of any credit analysis.The economic base reflects the wealth of the province and the basis of its revenues; i.e.provincial assets and the benefits derived from those assets, usually in the form of taxes,fees and other government revenues.

In the case of the Argentine provinces, the major own source tax revenues collectedinclude property tax, a turnover tax (Ingressos Brutos), stamp tax, and auto tax, althoughtax reform is changing the type of taxes collected at the provincial level.' The majoreconomic factors that impact tax collections and also provide the basis for co-participation revenues are provincial economic growth, employment, and personalincome. Combined with the annual rate of population growth, these variables are used inthe simulation model to construct the Population and Economic Base Indicators.

(b) Financial Operations - Financial Operations analysis is the most important elementof creditworthiness in the Argentine context. Financial Operations are measured by threeother indicators (i) Operating Balance; (ii) primary surplus and (iii) ExpenditureFlexibility:

(i) Operating Balance is the major factor that determines whether theprovince can continue to provide public services, support its debt obligationsand invest in capital works. It is defined as current revenues less currentexpenditures, including debt service payments, and indicates the ability of theprovince to pay its bills. Debt service is included because it is an annualexpenditure that should be paid from current revenues, although borrowing isoften used for amortization and interest payments2 . If we assume that debtservice payments are made for capital works, then the Operating Balanceprovides a good indication of the ability of the province to provide publicservices, including infrastructure expenditures that are necessary for generaleconomic development.

(ii) Primary Surplus is equivalent to the Operating Balance except that debtservice payments are excluded, and capital works funded with current revenuesare included. This measure is another way of demonstrating the amount ofrevenues available for debt service. Because the Argentine provinces useborrowing to a large degree to fund current operations, the Operating Balanceindicator is used as a measure of Financial Operations in the creditworthinesssimulations. However, Primary Surplus/Debt Service is considered as a debtindicator in the simulations.

See Chapter [31 of this report for a discussion of provincial tax reform.2 Provincial borrowing for debt service payments is one of the root causes of the current crisis.

72 Annex 4

(iii) Expenditure Flexibility is the ability of a public agency to controlexpenditures in the event of a downturn in revenues. This is especially criticalin the Argentine context because of the volatility of revenue income and thelack of appropriate budgeting and financial planning by the provinces. Inaddition, the short-term nature of debt obligations puts further cash flowpressure on the provinces to pay creditors causing payment delays to vendorsand public employees. Recently, provinces have had to issue their own"script" as payment to vendors and employees because of a cash flowsqueeze. The cash flow squeeze was partially caused by the impact of the"Tequila" effect, but a decline in tax revenues and poor financial managementexacerbates the situation.

(c) Debt Indicators - An increasing debt service burden means that a province isspending fewer of its resources on services and investment which may have a negativeimpact on economic growth. It also gives the province less flexibility in itsexpenditures and ability to respond to negative changes in the fiscal environment(fewer revenues accompanied by inflexible spending). Debt indictors used in thesimulation model include debt burden and debt capacity indicators.Debt burden is often measured in relationship to the population base supporting thedebt with tax revenues. The measure used in the simulation model is Debt PerCapita, or the burden of debt facing the population. Debt capacity is indicated by thePrimary Surplus/Debt Service. Essentially, this measure shows the amount of fundsavailable to pay debt service after taking into account current expenses and capitalworks funded with current revenues. Primary Surplus combined with the OperatingBalance Indicator provides a good view of the provinces ability to maintain its currentoperations and ability to continue capital investments.

(d) Financial Management is the ability of the province to manage and controlbudgeting and cash flow. Important elements of financial management are the qualityand capabilities of the accounting and budgeting systems to provide information aboutthe province's fiscal status and to inform decision makers about the alternatives toaddress budget and cash flow problems before they balloon into intractable crises.

6. The simulation model uses a subjective financial management indicator derived fromour analysis -- see Annex 3.

B. Creditworthiness Simulation Model Methodology and Results

7. The "model" was developed to rank the provinces according to a "creditworthiness"indicator. The basis is a cash flow spreadsheet that combines historical and forecastedrevenue and expenditure data to develop the four creditworthiness indicators. The majorspreadsheet revenue and expenditure categories, assumptions, and method of calculatingOperating Balance, Primary Surplus, Primary Surplus/Debt Service, and Debt Per


Capita are illustrated in an example, below. The complete set of cash flows for the 24provinces is attached as Annex 1. The model uses historical revenue, expenditure and debtdata from the Secretaria de Asistencia para la Reforma Econornica Provincial for the period1991 through 1995 and Ministry of Interior estimates for 1996, converted to 1995 real pesos.It then forecasts 1977 through 2000 revenue, expenditure and debt variables, as more fillydiscussed below. The creditworthiness indicators were then derived from the results of thesimulations. Table 1 is the spreadsheet for Buenos Aires which serves as word base for all theprovinces.

Table 1 - Projecting Main Financial Variables - Example of Printout

Provincia de Buenos Aires In Real 1995 Pesos

1991 1992 1993 1994( 1995(** 1996 1997 1998 1999 2000

1 - RECURSOS CORRIENTES 4374 6488 6935 7508 7414 7506 7769 8079 8403 8739

DeJurisdicci6n Provincial 2288 3406 3745 4157 4138 4114 4258 4428 4605 4790

.Tributarios 2119 3048 3326 3700 3468 3705 3835 3988 4148 4313

. No tributarios 168 358 419 457 670 409 423 440 458 476

DeJurisdicci6n Nacional 2086 3083 3190 3351 3276 3392 3511 3651 3797 3949

-Coparticipaci6n No Afectada 1906 2591 2482 2483 2418 2408 2492 2592 2696 2803

-TransferenciasAfectadas 181 491 1333 1389 1463 1507 1560 1622 1687 1754

-Regalias 0 0 0 0 0 0 0 0 0 0

II -EROGACIONES CORRIENTES 4901 5830 6625 7303 7011 7111 7297 7525 7786 8169

Personal 2841 3219 3442 3651 3464 3555 3679 3827 3980 4139

RBs.yScios.NoPersonales 583 716 849 1033 1150 880 911 947 985 1025

. Intereses de la Deuda

Hasta 1995 28 179 151 153 150 237 197 140 97 54

Despues 1995 0 0 0 0 0 0 66 70 126 250

Transferencias 1449 1716 2184 2465 2415 2439 2443 2542 2599 2703

-aMunicipios,Docentes,Otras 1117 1397 1924 2233 2170 2146 2314 2407 2459 2557

-aEmpresasPcas. Pciales. 10 13 1 1 11 13 13 14 15 15

-aOrg. SeguridadSocial 321 305 259 231 91 112 116 121 125 130

11I - RECURSOS DE CAPITAL 13 27 121 96 36 38 39 40 42 43

IV - APORTES 170 113 235 261 110 129 133 137 141 145

VI - EROGACIONES DE CAPITAL 366 473 658 875 821 762 765 801 825 850

VII - TOTAL REC. Y APORTES 4557 6629 7290 7865 7560 7673 7941 8257 8585 8927

VIII-TOTALDEEROGACIONES 5267 6303 7283 8177 7832 7873 8062 8326 8611 9019

IX - NECESIDAD DE FTO. (VII-VIII) -710 326 7 -312

X. USO DEL CREDITO 0 0 0 0 -272 -200 -121 -70 -26 -92

XI. AMORTIZACION DE LA DEUDA 0 554 697 799 801 1027

Internacional

Bancos Privados/Bonos

Bilateral 18 18 18 18 18Multilateral (BIRF/BID) 9 9 9 9 9

Naclonal 4 4 4 4 4Entidades Privadas 5 5 5 5 5Entidades Publicas 336 447 462 347 347

Flotante 0 111 126 11 11

Deuda despues 1995 6 336 336 336 336 336

74 Annex 4

Table 1 - Projecting Main Financial Variables (cont.)

1991 1992 1993 1994( 1995(*) 1996 1997 1998 1999 2000

XII. - DEUDA, INTERESES 2525

Inteaclonal 8.00% 227 16.6 15.03 13.47 11.9 10.34

Bancos Privados/Bonos 10% 45 3.51 2.633 1.755 0.878 0

Bilateral 8% 78 5.928 5.616 5.304 4.992 4.68

Multilateral (BIRFIBID) 7% 104 7.163 6.786 6.409 6.032 5.655

Nacnonal 12% 2298 235 182 126 85 43

Entidades Privadas 107 amortized 100/oann. till 12% 322 38.64 25.36 10.27 8.988 7.7042007

Entidades Publicas 12% 1976 196.8 156.5 116.2 75.88 35.57

Flotante 15% 0 0 0 0 0 0

AVOTEs on nacional deuda

115 due in 98

107 due over 97-2007 period, assume smooth amort.

100 due in 97

Required Fbnancing 12% 1996 1997 1998 1999 2000 2001 total

1996 Debt 554

Principal 110.8 110.8 110.8 110.8 110.8 554

Interest 66 53 40 27 13 199

1997 Debt 697

Principal 139.4 139.4 139.4 139.4 557Interest 17 67 50 33 -33

1998 Debt 799

Principal 160 160 160 480

Interest 19 77 58 0

1999 Debt 801

Principal 160 160 320Interest 96 77 38

2000 Debt 1027Principal 205 205Interest 25 25

Total Interest 0 66 70 126 250 512Total Principal 0 111 250 410 570 1341

Debt Stock (after 1995) 554 1140 1689 2080 709

Debt Stock (prior 1995 debt) 2171 1706 1227 862 497

Debt Stock (flotante) 0 0 0 0 0

Total Debt Stock (before & after 1995) 2725 2846 2916 2942 1206

Debt Service(before and after 1995) 591 839 940 998 1238

Population 14 14 15 15 15

1992 GDP(in 1986 constant prices) 812


Table 1 - Projecting Main Financial Variables (cont.)

1991 1992 1993 1994 1995 1996 1997 1998 1999 200

INDICATOR TRENDS, Buenos Aires

Primary Surplus(deficit) -865 365 -197 -516 -268 -130 -30 -37 14 23

Operating Account Balance -527 659 309 206 403 41 -104 -176 -158 -366

Operating Account/Unrestr. Rev. -17% 14% 8% 5% 5% 1% -1% -2% -2% 4%

Debt StockfPopulation 191 197 199 198 80

Debt Service/Unrestr. Rev. 19% 18% 26% 26% 33%

Primary Surplus/Debt Service -0.22 -0.036 -0.039 0.014 0.018

REVENtUE TRENDS (annual % change)

Tnibutarios 44% 9% 11% -6% 7%

Coparticipacion No Afectada 36% -4% 0% -3% 0%

Jurisdiccion Provincial 23% 19% 22% 11% -23%

Jurisdiccion Provincial/Rec. Corr. 52% 52% 54% 55% 56%

EXPENDITURE TRENDS(annaul % change)

Personal 13% 7% 6% 5% 3%

Bs. y Scios. No Personales 23% 19% 22% 11% -23%

Trabajos Publicos 2% 48% 23% 4% 13%

I.Recursos Corrienle.s (Current Revenues)

9. Current revenues are derived of Provincial and non-Provincial sources. The provincialsources included in the model are the ingresos brutos, inmobiliario, automotores, sellos, andothers taxes. In some cases these taxes were changed in 1995 and may be eliminated incertain provinces in the near future. Due to the uncertainty regarding the replacement forthese provincial tax revenues, the model assumes that they will still be imposed until 2000 andcontinue to grow at the country-wide annual GDP rate between 1997 and 2000. Non-provincial current revenue sources include formula co-participation revenues, discretionaryfederal transfers and natural resource royalties (principally oil and gas). These revenues arealso assumed to grow at the GDP rate between 1977 and 2000.

II. Erogaciones Corrientes (Current Expenditures)

10. Current expenditures are broken down into personnel, goods and services, interest ondebt and transfers to municipalities (co-participation), provincial enterprises and socialsecurity. Personnel and goods and services are expected to grow at the GDP rate between1997-2000. Interest on debt is historical between 1991 and 1995 and forecasted for 1996

through 1997 based on the assumptions described below for Amortizacion de la Dueda andDueda, Intereses. Transfers to municipalities from 1996 through 2000 are based on the

76 Annex 4

proportion of municipal revenues received in 1995 applied to total 1996 revenues. This sameproportion was used to derive the 1997 through 2000 municipal transfer amounts. Transfersto provincial enterprises were based on the 1995 amount. If the transfer in 1995 was zero, themodel assumed that the 1997 through 2000 would be zero. Amounts greater than zero wereforecasted to grow at the annual GDP rate. The same principal applied for the social securitytransfers.

III. Recursos de Capital (Capital Resources)

11. Capital resources are derived from the sale of assets such as land, privatizations,provincial company shares; dividends from provincial companies and other non-debt sources.The values for 1991 through 1995 are historical, 1996 estimated, and the 1997 through 2000forecasted based on the annual GDP growth rate.

IV Aportes (Government Grants)

12. These are non-reimbursable and reimbursable government grants to the provinces andinclude transfers for housing, tax advances, discretionary transfers from the treasury (ATN)and other types of provincial support from the central government. The procedure fordeterring the grant amounts is the same as was described for Capital Resources.

VI. Erogaciones de Capital (Capital Expenditures)

13. This category includes public works and other capital expenditures. The 1996estimated values grow at the GDP rate between 1997 and 2000.

Items VII through X

14. These sections of the model determine the amount of additional financing required tofund current and capital expenditures including interest payments and debt service. This is aniterative process as the amortization and interest payments are a function of the existing andnew debt that is issued to maintain a positive cash balance. If there are insufficient fundsavailable to pay for current and capital expenditures, then the model issues additional debt.

XI. Amortizacion and Intereses de la Deuda (Debt Amortization)

15. Amortization is divided into two sections, debt issued prior to 1995 and new debtissued in 1996 and beyond. The debt is categorized into International, National and Floating.International debt consists of multilateral institutions (World Bank and BID), bilateral loansand private international banks. National debt consists of private and public creditors.Floating debt is the amount of debt due vendors, contractors and other provincial creditors,including "script" and other short-term borrowing instruments used by the provinces.

16. The amount of outstanding existing debt was provided by the Ministries of Interiorand Economy. The specific terms and conditions of both national and international debt was

Annex 4: Financial Capacitv Assessment 77

only available for Cordoba, Mendoza and Buenos Aires. The Ministry of Economia provideddata on debt maturity, interest rate, grace period and principal payments for multilateral debtfor most of the provinces, but there was almost no debt information on domestic borrowing.In this case the model assumed that the debt was divided evenly between public and privatecreditors, amortized over a five year period with equal annual principal installments beginningin 1996. The outstanding debt was paid by 2000. The interest rate assumption for bothpublic and private outstanding domestic debt was 12%.

17. The maturity and interest assumptions for outstanding domestic debt do not reflect theactual terms of this debt. The rationale for using a five year amortization with a 12% interestrate is to show what may be possible in a restructuring of this debt with assistance from theFederal government. The actual outstanding debt probably has a much shorter life (mostlikely less than three years), although this will vary depending on the type of security and thefiscal condition of the province as perceived by the creditor. If the amount of Deuda Flotantewas known, it was amortized over a five year period, with a 15% interest rate.

18. Regarding future debt, the Uso de Credito line item calculates the amount of new debtrequired to amortize the outstanding debt and support the difference between current andcapital revenues and expenditures. The amount of new debt is calculated each year. Theborrowing assumptions are similar to the assumptions used for the outstanding domestic debt;five year amortization with equal annual principal payments at 12% interest. Principalinstallments and interest payments begin the year after the debt is issued.

19. Once principal and interest payments are known for pre and post 1995 debt, the modelthen calculates total outstanding debt stock in each year and also the annual debt servicepayments. This information is then used to construct the debt indicators.

Indicator Trends

20 The last section of the model calculates the Financial Operations and Debt indicatorsused in the analysis:

Primary Surplus,Operating Account Balance,Debt Stock/Population,Primary Surplus/Debt Service andPersonnel Expenditure Trends.

21. The first two indicators are calculated for each year between 1991 through 2000. Theremaining indicators, except Personnel Expenditure Trends, are calculated annually for theyears 1996 through 2000. Personnel Expenditure Trends are a historical analysis of annualchanges in personnel expenses between 1991 and 1996.

22. Primary Surplus is defined as total current revenues less total expenditures(excluding interest payments) but includes expenditures on works funded with current

78 Annex 4

revenues. Operating Account Balance is the same as above, but includes interest andprincipal payments and exclude capital works funded with current revenues. If a provinceuses current revenues to fund investments and has little or no debt outstanding the PrimarySurplus will be lower than the Operating Account Balance. On the other hand, provincesthat have significant debt will have a lower Operating Account Balance than PrimarySurplus. How debt is amortized has a major impact on the Operating Account Balance,especially if it is necessary to borrow further for amortization payments. -This is the scenariothat unfolds for the heavily indebted provinces, especially if measured on a per capita basis,and places them in a relatively low creditworthy ranking, as is discussed in more detail in theresults and conclusions sections.

23. The debt indicators, Debt Stock Per Capita and Primary Surplus/Debt Service, arecalculated from 1996 through 2000, respectively. The forecasted debt assumes refinancing ofexisting debt and also a specific structure for future debt (required primarily to fundamortization). Alternatives to the refinancing and future debt described in XI, above, couldalso be developed and new scenarios run for debt with different amortization schedules andmaturities. The alternative debt scenarios could then be used to test the changes in therelative creditworthiness of the provinces.3

24. The final indicator used in the creditworthiness analysis is Personnel ExpenditureTrends, a proxy measure of expenditure flexibility. This indicator is defined as the averageannual change in Personnel Expenditures from 1991 through 1996. It is a historical measureto indicate a trend over time. Future Personnel Expenditures are assumed to grow at therate of GDP and are not included in the indicator.

Methodology and Results

25. The creditworthiness assessment ranks the provinces on a single total score comprisedof the Population and Economic Base, Financial Operations, Debt Indicators and FinancialManagement. The simulation model provides the base data for the Financial Operations(including Expenditure Flexibility) and Debt Indicators. Additional information was gatheredto develop scores for the Population and Economic Base and Financial ManagementIndicators.

26. A score is developed for each indicator for each province based on the number ofstandard deviations from the average value of the indicator. These scores are then weighteddepending on their contribution to creditworthiness and summed to derive a singlecreditworthiness score. Below is a discussion of the composition of each indicator, theirscores and results.

3The changes are relative because the creditworthiness assessment uses mean scores and standard deviationsfrom the mean of the four primary indicators to measure creditworthiness. See the Methodology Section for amore detailed discussion of relative creditworthiness.

Annex 4: Financial Capacit Assessment 79

27. Population and Economic Base - the components of the Population and EconomicBase Indicator are:* annual population growth rate between 1980 and 1991;* the average annual unemployment rate between 1991 and 1995* 1991 GDP Per Capita

28.6 Table 2 shows the values for each of the Population and Economic Base Indicatorsand the score, as measured by the number of standard deviations from the mean for eachprovince. The mean population growth for the provinces between 1980 and 1991 was about2.38% per year. Low density provinces, such as Tierra del Fuego, Neuquen, Chubut, andSanta Cruz had the highest growth rates reflecting their natural resource base developmentthat attracts migrants. The advanced provinces including the Municipality of Buenos Aires(MCBA), Buenos Aires, Cordoba and Santa Fe are among those with the lowest growth rates.The more advanced provinces-- Buenos Aires, Cordoba, Municipality of Buenos Aires andSanta Fe -- also experienced the highest growth in unemployment lead by Buenos Aires andCordoba. These provinces had unemployment rates at least 1% higher than the average rateof 1.22% per year between 1991 and 1995. The final measure of Economic Base, 1991 GDPPer Capita had a mean value of 1,969. MCBA, San Luis and Santa Cruz, representing theadvanced, intermediate and low density provinces, respectively, had the highest GDP percapita scores.

29. The Population and Economic Base total score places Tierra del Fuego in the firstposition followed by Santa Cruz, Chubut and MCBA. This ranking reflects their high growthrates and low density relative to GDP. They probably also represent the strongest localeconomic base to support public services, assuming that the low density provinces can attractenough investment to stimulate economic development. Interestingly, some of the moreadvanced provinces, such as Cordoba and Buenos Aires have a low score indicating slowpopulation growth, below average GDP Per Capita. This indicates a potentially stagnatingeconomy with potential negative consequences for future revenue generating capability. Bothof these provinces generate about 50% or more of their current revenues from their own taxbase. This tax base potential may be threatened if unemployment continues to grow.

30. Financial Operations - Table 3 illustrates the two components of the FinancialOperations Indicator, Average Operating Balance/Current Revenues and OperatingBalance/ Current Revenue in the Year 2000. As discussed above, the Operating Balanceis perhaps the most significant creditworthiness indicator because it determines the ability ofthe province to repay its debt, maintain public services and provide investment for futureeconomic growth.

31. The mean Operating Balance for the provinces over the ten year duration of theanalysis is positive in only three provinces, San Luis, Santa Fe and Mendoza, and MCBAshowing a positive figure. The mean Operating Balance in the year 2000 almost triples fromnegativel62.7 to negative 443.4 million pesos, showing a deteriorating fiscal position for allthe provinces expect the four that continue to show improved positive balances. The

80 Annex 4

deteriorating situation is principally caused by the need to amortize existing debt which forcesthe provinces to pay for this amortization with new loans, creating a downward OperatingBalance spiral. This places the provinces in a precarious position. They need to lengthen thematurities of their outstanding debt while keeping interest rates low enough so as not toabsorb more current revenues with debt service payments. This balance - between extendedmaturities and interest rates, will have to be carefully managed to give the provincialexpenditure control and revenue generation reforms time to form a strong foundation forfuture fiscal stability.

32. The total financial operations score, as shown in Table 3, ranks all of the advancedprovinces in the top six with the exception of Cordoba. Cordoba' s problem is related to itslarge outstanding debt which requires significant new loans to allow for amortization of alldebt within five years. Clearly this approach is not possible as demonstrated by the largenegative Operating Balance in the year 2000

33. Debt Indicators - Table 2 also illustrates the results of the two debt indicators,Average Debt Stock/Population and Primary Surplus/Debt Service. The mean DebtStock/Population between 1995 and 2000 is over $1,000 pesos per person per year, asubstantial amount if compared to the average of about $400 USD per capita for the 50 statesin the U.S. The values also show tremendous variability ranging from almost $5,000 percapita in La Rioja to $0 in San Luis.

34. The basic reason for the high Debt Per Capita among the provinces is the result of alarge existing debt burden in 1995 that in the model is then amortized over the next five yearsrequiring the issuance of new debt and additional borrowing for amortization. The situationstarts to stabilize for Buenos Aires by the year 2000, but Cordoba's debt burden spiralcontinues upward beyond the year 2000. Many of the Low Density and Underdevelopedprovinces have increasing debt burdens that reach levels over $1,000 pesos per capita. Thereason for this increase is the amortization of existing debt combined with deficits in total cashflow (operating account and investment). This indicates that these provinces have tosignificantly cut back on their operations, decrease investments, and refinance outstandingdebt, or use some combination of the three. Since many of these provinces show highpopulation growth rates it will most likely not be possible to reduce services. Reduction incapital investments will most likely slow economic growth. The balance between expenditurecontrol for operating costs and capital investment is important in these provinces and thedevelopment of multi-year operating and capital budgets to maintain this balance should be ahigh priority for the Low Density and Underdeveloped Provinces.

35. The Primary Surplus/Debt Service Ratio is negative in almost all the provincesexcept Buenos Aires Mendoza, San Luis, Tierra del Fuego and MCBA. MCBA and Mendozaachieve ratios greater than one which means they are in a good fiscal position to prepare aprudent borrowing program for capital investments to stimulate economic development. BothSan Luis and Tierra del Fuego will not have any outstanding debt by the year 2000 and arealso well positioned to invest cautiously. The negative ratios demonstrated by the otherprovinces reflect a negative primary surplus by the year 2000. It means that the provinces


have to reduce current expenditures and/or non-debt financed capital expenditures beforeconsidering any additional borrowing for investment. Most of their borrowing will benecessary to amortize outstanding debt.

36. The Debt Indicator provincial ranking, as shown on Table 5, combines the Debt PerCapita and Primary Surplus/Debt Service indicators equally. The four provinces with aPrimary Surplus/Debt Service ratio score the highest for this indicator. Also, theIntermediate Provinces seem to be clustered toward the higher scores reflecting a goodbalance between the amount of essential services for the population and capital investmentsthat require borrowing. In addition to low debt service the average and year 2000 debt stocksare sufficient below the provincial mean to support the high ranking for these provinces.Lower ranked provinces for this indicator come primarily from the Underdeveloped and LowDensity Provinces; La Rioja, Catamarca, Formosa, (Underdeveloped) and Santa Cruz andChubut (Low Density). These provinces do not have the economic growth and revenuegenerating capacity for operations and investment and have to rely on borrowing to covertheir requirements.

37. Expenditure Flexibility - This indicator is comprised of two components thatdemonstrate expenditure flexibility (or lack thereof); privatization of state owned enterprisesand personnel expenditure trends. Regarding privatization, the provinces own a significantnumber of enterprises including water and sewer systems, banks, transport companies, powerenterprises, hotels and casinos and a variety of other businesses that usually require subsidiesfrom the provincial treasury. To reduce these fiscal transfers, the provinces are in the processof privatizing their enterprises. The privatizations will reduce operating expenditures and givethe provinces greater flexibility in managing their budgets.

38. The method for developing the Privatization score was to assign two points to aprivatized bank and one point to a province if it has passed a law to sell its bank. Provincesreceive one point each for any other enterprise that is privatized. The Privatization score wasthen combined with the Personnel Expenditure score to derive the expenditure flexibilityrankings.

39. The average Privatization score was 2.17 with Formosa receiving the highest score -5. Almost every province has begun a privatization program and has sold at least oneenterprise (or passed a law for the sale of the provincial bank) except for Chubut, Cordobaand MCBA. Cordoba's poor ranking in Financial Operations and Debt Indicators shouldencourage it to proceed more quickly with state enterprise privatization, especially itsprovincial banks, to stem the flow of transfers from the provincial treasury to the enterprises.MCBA, having very high scores in these indicators is not as pressed to sell its enterprises, butit should continue to evaluate the impact these enterprises may have on treasury transfers inthe future.

40. Personnel Expenditures, which comprise between 55% to 75% of provincial currentexpenditures, is the major cost category that has a short and long term impact on the

82 Annex 4

Operating Balance. Governments have a tendency to expand the bureaucracy during times ofpositive Operating Balances, but have a difficult, if not impossible task of reducingemployment during revenue downturns. To reflect this situation the Personnel Expenditureindicator gave a higher score to those provinces that had lower personnel growth between1991 and 1995. The mean growth rate for all the provinces was determined and provinceswere scored on the number of deviations from the mean (the greater the number of standarddeviations, the lower the score).

41. The lowest personnel growth occurred in the northern Underdeveloped Provinces ofFormosa, Jujuy and Salta and the Intermediate Province of Salta and the highest growth inTierra del Fuego, Catamarca and MCBA. The remaining provinces clustered around the meangrowth rate of 7. 15% per year.

42. The Personnel Expenditure score was combined with the Privatization score toderive a total Expenditure Flexibility Score, as shown in Table 5. The combinedExpenditure Flexibility score shows the importance of privatizations and constrainedpersonnel expenditures. Formosa, ranked 15 for the Financial Operations Indicator and 21 forDebt Indicators, but received the highest score for Expenditure Flexibility. This offsets itstendency toward a negative operating balance and high per capita debt which is forecasted tocontinue to grow through the year 2000. It is essential for Formosa to continue withprivatization and expenditure control reforms so that investments and current expenditures donot require additional borrowing exacerbating its precarious fiscal position. Until Formosa isable to reduce its outstanding debt it should continue its privatization effort (if there isanything left to sell) and constrain personnel costs. Other high ranking provinces in theExpenditure Flexibility category, such as Neuquen, Corrientes and La Rioja should follow thesame policy as Formosa.

43. The low scoring provinces in the Expenditure Flexibility category include Tierra delFuego, Chubut, Cordoba, and MCBA. This is an interesting mixture of Advanced,Underdeveloped and Low Density Provinces. The two Advanced provinces have notprivatized any enterprises and have also increased personnel expenditures significantly aboveaverage. MCBA is able to offset this tendency with controls on other expenditures and agood revenue base. Cordoba, on the other hand, has not been able to control totalexpenditures resulting in a poor Operating Balance and deteriorating debt situation. TheLow Density Provinces of Tierra del Fuego and Chubut should also be concerned about thegrowth in personnel expenditures especially because of the high population growth rate andthe potential for increased demand for public services in the future.

44. Financial Management - The quality of a financial management system determinesthe ability of the province to plan for changes in the political, economic and financialenvironment and the capacity to respond to these changes in a timely fashion,. This isespecially important in the Argentine context as these environments are susceptible to rapidchange which can have severe impacts on a province's fiscal condition. The provincialadministration needs to have an information system capable of analyzing the impact of thesechanges on its financial performance. However, quantifying the quality of a financial


management system is difficult. Nevertheless this indicator was included in thecreditworthiness assessment because of its importance.

45. The Financial Management Indicator was developed after a cursory, subjectiveevaluation of the provinces' accounting, budgeting, auditing systems and debt managementundertaken during the Bank mission to Argentina in February, 19964. To create the FinancialManagement Score, the provinces' financial management systems were placed into threecategories; Satisfactory, Fair to Good and Poor, receiving a score of 3:2:1 points respectively.For those provinces that were not included in the mission assessment, a proxy score wasdeveloped based on their Personnel Expenditure score. This is an arbitrary assignment thatattempted to maintain a total Expenditure Flexibility score that was not distorted by missingdata. Table 5 shows the Financial Management Score which is broken down into threeclusters corresponding to the three evaluation categories.

C. Conclusions

46. Table 6 shows the combined indicator score for provincial creditworthiness. Thescores for each credit criteria were first weighted according to their impact on overallcreditworthiness and then combined into a single measure. The Financial Operations scorereceived a weighting of three, Debt Indicator two and the other indicators one. The rationalefor using these weightings is based on the discussion of credit criteria in section I.

47. The chart shows a clear clustering of higher quality provinces with the top three(MCBA, San Luis, Buenos Aires) having a point score ranging 12.51 to 72 points. Theseprovinces have positive Operating Balances, debt that is significantly amortized by the year2000 without resorting to heavy additional borrowing, good financial management, and astrong economic base.

48. A second cluster forms in provinces ranked 4 through 10 with scores from 6.12 to 4.5Two are Advanced Provinces (Santa Fe and Mendoza), two are Intermediate Provinces (EntreRios and Salta), and one is Low Density. The clustering of these provinces generally showstheir moderate Operating Balance deficits (except Tucuman), and better than average debtindicators (except Neuquen). This group is also generally characterized as scoring lower thanaverage on Population and Economic Base Indicators.

49. The third cluster of provinces has scores ranging from 4.5 60 -1.8 These provinceshave a mixture of credit issues, but they are all characterized by deteriorating OperatingBalances and high Debt Per Capita ratios, except Tierra del Fuego, which is a special casebecause of its location and unique population and economic circumstances. In addition toTierra del Fuego, this group includes Chubut, Santiago del Estero, Corrientes and Misiones.They are distributed in all provincial categories except the Advanced Provinces. An exampleof the precarious credit position of these provinces is Chubut. It is characterized by high debt

4 See David Grossman's paper "Argentina's Provinces: Strengthening the Institutional Framework ofProvincial Finance"

84 Annex 4

per capita, a growing operating account deficit, and poor expenditure control (noprivatizations and high growth in personnel expenditures). Theses negative credit qualities areoffset to some extent by Chubut's population growth and potential economic developmentprospects. But the latter is a long term potential that may help to improve the financialcondition of the province only if it is able to address its immediate fiscal problems. Actions toaddress expenditure controls are also necessary for Chubut, such as the privatization ofprovincial enterprises.

50. The last group of provinces are those that are in serious credit difficulty. Both largeand small, Advanced and Underdeveloped Provinces are contained in this group. Theyinclude Rio Negro, Chaco, San Juan, Santa Cruz, Cordoba and La Rioja. The most salientcharacteristic of this group are very poor Operating Balances and high debt per capita. Thesetwo credit issues will continue to face these provinces over the next few years as they struggleto control their debt while improving Operating Balances.

51. Another way of illustrating creditworthiness of the provinces is to rank them bypopulation group. Table 7 shows the total creditworthiness scores broken down by threepopulation groups; over 1,500,000; 500,000 to 1,500,000 and less than 500,000. There is nocorrelation between population size and credit quality, as all of the population groups haveboth high and low ranking provinces. Large or small, several provinces have problems of highdebt and poor operating balances. These provinces will need time to restructure theirfinancing and control expenditures to improve their fiscal condition. If the central governmentparticipates in the restructuring of outstanding debt, a key aspect of the debt workout will bethe control of future borrowing.

52. The policies the central government develops to control provincial borrowing in anattempt to limit moral hazard will depend on several factors, the most important of which isthe reform of the coparticpation law. Presently, coparticpation revenues are used by theprovinces to secure debt obligations. With the reform of the law, the central government hasthe opportunity to manage any debt secured by these revenues, although there is aconstitutional interpretation regarding the degree to which it may interfere in the collectionand distribution of coparticipation.

53. One goal of the coparticpation reform is to create a provincial financing system thatencourages the private markets to regulate borrowing by rewarding fiscally prudent provinceswith lower interest rates and punishing the profligate with little or no access to credit. Thechallenge is to find a control mechanism that allows the rouge provinces to workout theircurrent problems and become "creditworthy" providing them with access to future creditwhile limiting or abolishing the government's role as lender of last resort role for bailouts ifthis occasion should arise.

54. Specific regulations should be developed which clearly define how the centralgovernment will monitor and control the use of coparticpation revenues to secure debt. Itmay establish some type of provincial financing board with professional representation fromthe provinces and the central government. This board would establish the requirements for


allowing the provinces to secure debt with coparticpation. In addition to fiscal conditions forborrowing, such as maintaining minimum debt and financial operations ratios, it would alsorequire adequate accounting, budgeting and auditing systems and procedures to monitor theprovinces fiscal condition and would provide technical assistance to train provincial officials infinancial information management systems.

86 Annex 4

Table 2:Population and Economic Base Indicators and Score

Annual Unemploy. 1991Population SDs from Annual SDs from Per Capita SDs from Total Rank

PROVINCE Growth Mean Growth Mean GDP Mean Score80-91 80-91 (av=100)

BUENOS AIRES 1.41 -0.56 2.34 1.44 85.00 0.30 -1.70 21CATAMARCA 2.31 -0.04 0.78 -0.56 38.90 -0.48 0.04 9CORDOBA 1.32 -0.61 2.16 1.21 45.60 -0.37 -2.19 24CORRIENTES 1.76 -0.36 2.17 1.22 42.00 -0.43 -2.01 23CHACO 1.72 -0.38 1.49 0.35 21.80 -0.77 -1.50 19CHUBUT 2.94 0.33 0.45 -0.98 86.00 0.32 1.63 3ENTRERIOS 1.11 -0.74 1.32 0.13 42.40 -0.42 -1.29 16FORMOSA 2.86 0.28 -0.50 -2.20 22.00 -0.77 1.71 2JUJUY 2.13 -0.14 1.67 0.58 34.20 -0.56 -1.29 15LAPAMPA 2.12 -0.15 1.40 0.24 68.80 0.03 -0.36 13LA RIOJA 2.84 0.27 1 07 -0.19 40.70 -0.45 0.01 11MCBA 0 14 -1.30 1.78 0.72 243.30 2.99 0.97 6MENDOZA 1.59 -0.46 0.49 -0.93 41.50 -0.44 0.04 10MISIONES 2.81 0.25 0.21 -1.29 24.20 -0.73 0.81 7NEUQUEN 4.52 1.24 1.89 0.86 81.90 0.25 0.63 8RIO NEGRO 2.68 0.17 1.20 -0.02 51.30 -0.27 -0.07 12SALTA 2.57 0.11 2.35 1.45 31.80 -0.60 -1.94 22SAN JUAN 1.20 -0.68 1.28 0.08 36.20 -0.53 -1.29 17SAN LUIS 2.78 0.23 0.99 -0.29 126.70 1.01 1.53 5SANTA CRUZ 3.17 0.46 0.70 -0.66 95.70 0.48 1.60 4SANTA FE 1.21 -0.68 1.73 0.65 55.00 -0.21 -1.54 20SGO.ESTERO 1.16 -0.71 0.99 -0.29 24.30 -0.73 -1.15 14T.DEL FUEGO 9.21 3.96 -0.36 -2.02 232.90 2.81 8.80 1TUCUMAN 1.53 -0.49 1.59 0.48 40.40 -0.45 -1.43 18

0.00

Mean 2.38 1.22 67.19SD 1.72 0.78 58.91

Source: Encuesta Permanebte Hogar - INDEC, Mission Estimates


Table 3: Financial Operations Indicators' Score

Province Operational Balance Operational Balance% Revenues % Revenues

Average SDs from 2,000 SDs from Total RankingMean Mean Score

B.A. -0.02 0.60 -0.04 0.60 1.20 4Catamarca 0.77 1.16 1.34 1.35 2.50 1

Cordoba -0.90 -0.01 -0.55 0.32 0.31 11Corrientes -0.93 -0.04 -1.12 0.01 -0.03 15Chaco -1.12 -0.17 -1.58 -0.24 -0.41 17Chubut -1.19 -0.22 -1.73 -0.32 -0.54 18Entre Rios -0.28 0.42 -0.35 0.43 0.85 10Formosa -0.71 0.12 -0.92 0.11 0.24 12Jujuy -0.78 0.07 -1.12 0.01 0.08 13LaPampa -0.01 0.61 -0.15 0.53 1.14 7La Rioja -6.69 -4.08 -8.43 -3.98 -8.05 24MCBA 0.06 0.66 0.05 0.65 1.30 3Mendoza -0.10 0.54 -0.04 0.60 1.14 6Misiones -1.22 -0.24 -1.79 -0.36 -0.60 20Neuquen -0.19 0.48 -0.45 0.37 0.85 9Rio Negro -1.65 -0.54 -2.27 -0.62 -1.16 23Salta -0.12 0.53 -0.16 0.53 1.07 8San Juan -1.48 -0.42 -1.90 -0.42 -0.84 21San Luis 0.30 0.83 0.30 0.78 1.61 2Santa Cruz -1.45 -0.40 -2.33 -0.65 -1.05 22Santa Fe -0.03 0.59 -0.08 0.57 1.17 5S. del Estero -0.78 0.07 -1.18 -0.03 0.04 14T. del Fuego -1.26 -0.27 -1.08 0.03 -0.24 16Tucuman -1.31 -0.31 -1.63 -0.27 -0.58 19

Mean -0.88 -1.13SD 1.43 1.83

88 Annex 4

Table 4: Debt Indicators' Score

Province Per Capita Debt Per Capita Debt Primary Surplus/ Total Rankingdebt Service Score

Average SDs from 2,000 SDs from SDs fromMean Mean Mean

B.A. 173 0.77 80 0.83 0.02 0.20 1.80 3Catamarca 1978 -0.80 3185 -0.82 -0.56 0.19 -1.43 21Cordoba 1158 -0.09 1608 0.02 -0.13 0.20 0.13 14Corrientes 998 0.05 1335 0.16 -0.37 0.20 0.41 12Chaco 1375 -0.28 2128 -0.26 -0.46 0.20 -0.34 17Chubut 1444 -0.34 2542 -0.48 -0.71 0.19 -0.62 19Entre Rios 217 0.73 239 0.74 -0.51 0.20 1.67 7Formosa 1534 -0.42 2131 -0.26 -0.48 0.20 -0.48 18Jujuy 888 0.15 1435 0.11 -0.60 0.19 0.45 11LaPampa 476 0.51 869 0.41 -0.60 0.19 1.11 9LaRioja 4860 -3.32 7431 -3.06 -0.91 0.19 -6.19 24MCBA 102 0.83 12 0.86 0.05 0.20 1.90 2Mendoza 454 0.53 401 0.66 0.21 0.21 1.39 8Misiones 1154 -0.08 1750 -0.06 -0.75 0.19 0.05 15

Neuquen 781 0.24 1423 0.12 -0.79 0.19 0.55 10RioNegro 1614 -0.49 2561 -0.49 -0.58 0.19 -0.78 20Salta 166 0.78 221 0.75 -0.64 0.19 1.72 4San Juan 195 0.75 235 0.75 -0.72 0.19 1.69 5

SanLuis 0 0.92 0 0.87 0.00 0.00 1.79 1SantaCrniz 3321 -1.97 6097 -2.36 -0.90 0.19 -4.14 23SantaFe 186 0.76 289 0.72 -0.54 0.19 1.67 6S. delEstero 1195 -0.12 1916 -0.14 -0.65 0.19 -0.07 16T. del Fuego 40 0.89 12 0.86 -301.04 -4.50 -2.75 22Tucuman 1064 -0.01 1528 0.06 -0.36 0.20 0.25 13

Mean 1057.19 1643 -13.00|SD 1146.57 1889 64.07


Table 5: Expenditure Flexibility and Financial Management

Expenditure Flexibility Score Financial Management Score

Privt. (1) Score Per. Per. Exp Exp. Flex. Exp. Flex Fin. Fin. Fin.Mgmt. Mgmt.

Exp. (2) Score Score Rank Mgmt. Score Rank

B.A. 1.00 -0.81 4.00 0.87 0.05 12 3.00 1.72 1

Catamarca 4.00 1.28 14.00 -1.89 -0.61 15 2.00 0.39 5

Cordoba 0.00 -1.51 6.00 0.32 -1.19 21 2.00 0.39 5

Corrientes 4.00 1.28 6.20 0.26 1.54 3 2.00 0.39 5

Chaco 3.00 0.58 7.80 -0.18 0.40 9 1.00 -0.94 14

Chubut 0.00 -1.51 7.40 -0.07 -1.58 22 2.00 0.39 5

Entre Rios 3.00 0.58 7.40 -0.07 0.51 8 2.00 0.39 5

Formosa 5.00 1.98 -2.00 2.52 4.50 1 1.00 -0.94 14

Jujuy 1.00 -0.81 3.20 1.09 0.27 10 1.00 -0.94 14

La Pampa 1.00 -0.81 7.40 -0.07 -0.88 18 3.00 1.72 1

La Rioja 3.00 0.58 4.00 0.87 1.45 4 1.00 -0.94 14

MCBA 0.00 -1.51 10.40 -0.90 -2.41 23 3.00 1.72 1

Mendoza 2.00 -0.12 9.20 -0.56 -0.68 16 2.00 0.39 5

Misiones 2.00 -0.12 9.40 -0.62 -0.74 17 2.00 0.39 5

Neuquen 3.00 0.58 3.60 0.98 1.56 2 2.00 0.39 5

Rio Negro 1.00 -0.81 5.80 0.37 -0.44 14 1.00 -0.94 14

Salta 2.00 -0.12 3.00 1.14 1.03 5 1.00 -0.94 14

San Juan 1.00 -0.81 7.40 -0.07 -0.88 18 1.00 -0.94 14

San Luis 4.00 1.28 8.80 -0.45 0.82 7 3.00 1.72 1

Santa Cruz 2.00 -0.12 8.00 -0.23 -0.35 13 1.00 -0.94 14

Santa Fe 1.00 -0.81 7.60 -0.12 -0.94 20 2.00 0.39 5

S. del 4.00 1.28 8.40 -0.34 0.93 6 1.00 -0.94 14EsteroTucuman 3.00 0.58 8.80 -0.45 0.13 11 1.00 -0.94 14

T. del 2.00 -0.12 15.80 -2.38 -2.50 24 1.00 -0.94 14Fuego

Mean 2.17 7.15 1.71

SD 1.43 3.63 0.75

(1) Score based on one point for each state owned enterprise that has been privatized (Banks receive 2 pts.)and a law passed to privatize provincial banks; Source: "Situacion de las Proviincias Argentinas",Ministero del Interior, Diciembre, 1995.(2) Average annual increase in personnel expenditures, 1991-1995

90 Annex 4

Table 6: Creditworthiness Matrix - Scores and Ranking, 2000(Standard Deviations from the Mean)

Province Economic Financial Debt Expenditure Financial Total Ranking

Base Operations Indicators Flexibility Management Score

B.A. 1.20 1.80 -1.70 0.05 1.72 7.27 3Catamarca 2.50 -1.43 0.04 -0.61 0.39 4.48 11

Cordoba 0.31 0.13 -2.19 -1.19 0.39 -1.81 17

Corrientes -0.03 0.41 -2.01 1.54 0.39 0.65 12Chaco -0.41 -0.34 -1.50 0.40 -0.94 -3.)6 21Chubut -0.54 -0.62 1.63 -1.58 0.39 -2.43 19Entre Rios 0.85 1.67 -1.29 0.51 0.39 5.49 7Formosa 0.24 -0.48 1.71 4.50 -0.94 5.1W 8Jujuy 0.08 0.45 -1.29 0.27 -0.94 -0.X 13La Pampa 1.14 1.11 -0.36 -0.88 1.72 6.12 5La Rioja -8.05 -6.19 (.01 1.45 -0.94 -36.04 24MCBA 1.30 1.90 0.97 -2.41 1.72 8 OU 2

Mendoza 1.14 1.39 0.04 -0.68 0.39 5.95 6

Misiones -0.60 0.05 0.81 -0.74 0.39 -1 23 16

Neuquen 0.85 0.55 0.63 1.56 (.39 6.23 4

Rio Negro -1.16 -0.78 -0.07 -0.44 -0.94 -6.51" 22

Salta 1.07 1.72 -1.94 1.03 -0.94 4.78 9

San Juan -0.84 1.69 -1.29 -0.88 -0.94 -2.27 18San Luis 1.61 1.80 1.53 0.82 1.72 12. 51 1

Santa Cruz -1.05 -4.14 1.60 -0.35 -0.94 -11.12 23Santa Fe 1.17 1.67 -1.54 -0.94 0.39 4.76 10S. del Estero 0.04 -0.07 -1.15 0.93 -0.94 -1.17 15T. del Fuego -0.24 -2.75 8.80 -2.50 -0.94 -0.85 14Tucuman -0.58 0.25 -1.43 0.13 -0.94 -3.47 20


Table 7: Argentina Provinces - Simulation of Rankings

Province Economic Financial Debt Expenditure Financial TotalBase Operations Indicators Flexibility Management Score

San Luis 2 3 5 7 1 1MCBA 3 1 6 23 4 2BA. 4 2 21 12 2 3Neuquen 9 10 8 2 5 4La Pampa 7 9 13 1 8 3 5Mendoza 6 8 10 16 9 6Entre Rios 10 7 16 8 7Fonnosa 12 18 2 1 14 8Salta 8 4 22 5 16 9Santa Fe 5 6 20 20 11 10Catamarca 1 21 9 15 8 11Corrientes 15 12 23 3 6 12Jujuy 13 11 15 10 19 13T del Fuego 16 22 1 24 24 14S. del Estero 14 16 14 6 17 15Misiones 20 15 7 17 10 16Cordoba I1 14 24 21 12 17San Juan 21 5 17 19 23 18Chubut 18 19 3 22 13 19Tucuman 19 13 18 11 20 20Chaco 17 17 19 9 18 21Rio Negro 23 20 12 14 22 22Slanta Cruz 22 23 4 13 21 23La Rioja 24 24 11 4 15 24

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Report No. 15487-AR Argentina Provincial Finances Study...Both democratic politics and sound...

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