Policy Paper - UNDP in Sudan

Policy Paper

Fiscal Transfers: Towards a Pro‐poor System

Assessment of the existing Inter‐Governmental Fiscal Transfers System in Sudan 23 October 2013 COUNTRY OFFICE SUDAN

Author: Mekki M. El Shibly Principal, University of Medical Sciences and Technology UNDP Sudan Gama'a Avenue, House 7,Block 5 P.O.Box 913 Postal Code 11111 Khartoum – Sudan Phone: (+249) 187120000 Fax: (+249) 183783764 (+249) 183773128

Table of Contents Section

Page i iv V Vi vii viii 1 4 4 4 5 5 5 6 7 8 10 10 11 12 13 16 19

Table of Contents List of Tables List of Figures Acronyms and Abbreviations Acknowledgements Executive Summary 1. Introduction 2. Theoretical and Conceptual Framework 2.1 Definitional and Conceptual Issues 2.1.1 Definition and Rationale of Fiscal Decentralization 2.1.2 Definition and Scope of Poverty 2.2 The Theoretical Framework 2.2.1 First Generation Theory of Fiscal Federalism 2.2.3 Second Generation Theory of Fiscal Federalism 2.3 Theoretical Perspectives on Decentralization and Poverty Reduction 2.4 Relevance of Fiscal Decentralization Theories to Developing Countries 3. Fiscal Decentralization and Poverty Alleviation in Sudan 3.1 The Federal Fiscal System and Pro‐poor Policy 3.1.1 Revenue and Expenditure during the Period 1981‐2002 3.1.2 Revenue and Expenditure during the Period 2003‐2010 3.1.3 Revenue and Expenditure during the Period 2011‐2012 3.2 Legal and Institutional Background of Fiscal Decentralization: 3.3 Sudan Poverty Profile 4. Trends in Fiscal Transfers and Poverty Reduction 4.1 The Extent of Fiscal Decentralization in Sudan 4.2 Assessment of Federal and States Fiscal Capacity and Tax Effort 4.3 The Allocative Formula 4.4 The Incidence of Vertical and Horizontal Imbalances 4.4.1 Vertical Fiscal Imbalance 4.4.2 Horizontal Fiscal Imbalance 4.5 States Budgets and Fiscal Management 4.6 Fiscal Decentralization and Poverty Reduction 4.7 Addressing Inter‐State Spill‐Over Effects of Pro‐Poor Expenditures

23 23 24 27 30 30 33 34 37 40

5. Challenges and Constraints to Fiscal Decentralization 5.1 Inappropriate Sequencing of Federal Resource Availability and States' Spending Responsibilities 5.2 Inadequate Adherence to the Federal and States' Roles in the Provision of Pro‐Poor Social Services

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42 42 42

5.3 Lack of Complementary Policy Reforms in the Civil Service and Regulatory Frameworks 5.4 Inadequate Capacity Building to Enhance Transparency in Budget Processes 5.5 Lack of Sufficient Own and Transferred Federal Resources Hampered the Implementation of an Effective "Hard Budget Constraint" on the States 5.6 Failure of Federal Control of States' VAT Resources in Adhering to Equity Requirements 5.7 Failure of Intergovernmental Transfers to Offset Fiscal Vertical Imbalance 5.8 Failure of Intergovernmental Transfers to Moderate Fiscal Horizontal Imbalance 5.9 Rising Risk of States Incurring Debt Obligations Leading to Massive Federal Support in the Form of Extraordinary "Bailouts" 5.10 Weak Fiscal Institutions and Inadequate Social Service Delivery Failed to Reduce Inequality and Poverty 5.11 Paucity of Data Impeded Designing Effective Designing Intergovernmental Equalization Transfers Formula 5.12 Inadequate Transparency in the Federal Allocation of Resources Hampered Legitimacy, Violated Equitability and Weakened Budgetary Processes 5.13 Meagre Effort Focus Federal Transfers to the Poorest States to Enable More Targeted Development Spending and Reduce Inequality Across States 6. Overview of Experiences and Lessons from Selected Countries 6.1 Vertical Fiscal Imbalance 6.1.1 Unconditional Grants 6.1.2 Conditional and Equalization Grants 6.1.3 The Macroeconomic Consequences of State Borrowing 6.2 Horizontal Imbalance 6.3 Matching Grants 6.4 Poverty Alleviation 6.4.1 Pro‐Poor Health Services 6.4.2 Pro‐Poor Basic Education Services 6.4.3 Agricultural Services 6.4.4 Socio‐economic Infrastructure 6.5 The Political Dimension of Intergovernmental Transfers 7. Toward a Reformed Pro‐Poor Intergovernmental Transfers System in Sudan 7.1 Constitutional, Legal and Regulatory Implications 7.2 Institutional Reform 7.3 Addressing the Paucity of Data to Facilitate Designing Effective Designing Intergovernmental Equalization Transfers Formula 7.4 A Suggested Revised Pro‐Poor Allocative Formula 7.5 Addressing the Vertical and Horizontal Imbalances ii | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

43 43 43 44 44 44 45 45 45 46 46 47 48 49 49 50 50 52 53 54 55 56 56 56 59 59 60 62 62 64

7.5.1 Directing Intergovernmental Transfers to Offset Fiscal Vertical 64 Imbalance 7.5.2 Directing Intergovernmental Transfers to Offset Fiscal Horizontal 66 Imbalance 7.6 Capacity Building to Enhance Transparency in Budget Processes 66 7.7 Ensuring Complementary of Policy Reforms in the Civil Service and 67 Fiscal Regulatory Frameworks 7.8 Bridging the Governance Gap 67 7.9 Attraction, Management and Coordination of Donor Support 68 7.10 Synchronization of Federal Resource Availability and States' 70 Spending Responsibilities 7.11 Adherence to the Federal and States' Roles in the Provision of Pro‐ 70 Poor Social Services 7.12 Enhancement of Own and Transferred Federal Resources to 70 Stimulate the Implementation of an Effective "Hard Budget Constraint" on the States 7.13 Hedging against States Incurring Debt Obligations Leading to 71 Massive Federal Support in the Form of Extraordinary "Bailouts" 7.14 Ensure Transparency in the Federal Allocation of Resources Restore 71 Legitimacy, Preserve Equitability and Strengthen Budgetary Processes 7.15 Maximize Effort to Focus Federal Transfers on the Poorest States to 71 Enable More Targeted Development Spending and Alleviation of Inequality Across States 8. Recommendations 73 8.1 Summary of Conclusions 73 8.2 Recommendations 75 8.2.1 Constitutional, Legal and Regulatory Implications 75 8.2.2 Institutional Reform 76 8.2.3 Addressing the Paucity of Data to Facilitate Designing Effective 76 Designing Intergovernmental Equalization Transfers Formula 8.2.4 A Suggested Revised Pro‐Poor Allocative Formula 77 8.2.5 Addressing the Vertical and Horizontal Imbalances 78 8.2.5.1 Directing Intergovernmental Transfers to Offset Fiscal Vertical 78 Imbalance 8.2.5.2 Directing Intergovernmental Transfers to Offset Fiscal 78 Horizontal Imbalance 8.2.6 Bridging the Governance Gap 79 8.2.7 Attraction, Management and Coordination of Donor Support 80 8.2.8 Capacity Building to Enhance Transparency in Budget Processes 81 9. References 82

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List of Tables Table

Page

Table (3.1) Public Finances (Percentage of GDP) Table (3.2) Current Federal Transfers to States (2011‐2012) Table (3.3) Federal Transfers to States and Total Current Expenditure (2010‐2012)

14 14 15

Table (3.4) State Revenue Sources Table (3.5) Status of Poverty and Hunger MDG Goal Table (3.6) Poverty by Household Characteristics, Location and States Table (4.1) Sudan Tax Effort Compared with Some LDCs Table (4.2) Subsidies Indicators and Weights (1997‐2005) Table (4.3) Subsidies Indicators and Weights (2006‐2013) Table (4.4) The States Share from Federal Government Support Table (4.5) Development Allocations Indicators and Weights (2006‐ 2013) Table (4.6) States Own Revenue (2011‐2012) Table (4.7) State Allocation of Current Expenditures by Chapters (2011‐ 2012)

18 19 22 25 28 29 29 30

Table (6.1) The structure of Sub‐national Governments in Selected Countries

47

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36 39

List of Figures Figure

Page

Figure (3.1) Sudan Poverty Count by State (% of Population below the Poverty Line)

20

Figure (3.2) Poverty Headcount Rates by Education of Household Heads

20

Figure (3.3) Poverty Head Count by State: Percentage of the Population with Consumption below the Poverty Line

21

Figure (4.1) Central Government Execution of Selected Fiscal Indicators, 2010 Figure (4.2) Selected Fiscal Indicators by Government Level

23 24

Figure (4.3) Fiscal Decentralization and Vertical Fiscal Imbalance

32

Figure (4.4) Federal Transfers to States

32

Figure (4.5) Per Capita Federal Transfers by State

34

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Acronyms and Abbreviations AfDB BPT CBS CPA FFAMC FGTFF GDP GFS GFSM HCR HFI HIPC IBRD IMF INC IPSAS MDGs MoFNE MWSS NBHS NRF NSSF PAU PIT PRSC PRSP SDG SGTFF SSA UNDP VAT VFI

African Development Bank Business Profit Tax Central Bureau of Statistics Comprehensive Peace Agreement Fiscal and Financial Allocation and Monitoring Commission First Generation Theory of Fiscal Federalism Gross Domestic Product Government Finance Statistics Government Finance Statistics Manual High Council on Resources Horizontal Fiscal Imbalance Highly Indebted Poor Countries International Bank for Reconstruction and Development International Monetary Fund Interim National Constitution International Public Sector Accounting Standards Millennium Development Goals Ministry of Finance and National Economy Ministry of Welfare and Social Security National Baseline Household Survey National Revenue Fund National State Support Fund Poverty Action Unit Personal Income Tax Poverty Reduction Support Credit Poverty Reduction Strategy Paper Sudanese Pounds Second Generation Theory of Fiscal Federalism Sub Saharan Africa United Nations Development Program Value Added Tax Vertical Fiscal Imbalance

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Acknowledgements The study greatly benefited from the valuable assistance from the staff of the United Nations Development Program (UNDP), Khartoum. The author is particularly grateful to Mr. Getachew Adem Tahir, whose professionalism and organizational skills were instrumental in the completion of the research work. Special thanks are also extended to Mr Jorg Kuhnel and Dr Abdelatif Taha for their valuable contribution. The author of the study is grateful to the officials at the Ministry of Finance and National Economy (MoFNE) and the Financial Allocation and Monitoring Commission (FFAMC). Special thanks are accorded to Mrs. Amna Abbakar and Mr Mohamed Eisa for providing data on federal and states budgets. Great appreciation is also due to the participants in the Policy Round Table Discussion on “Inter‐governmental Fiscal Transfer System for Pro‐poor Growth and Poverty Reduction in Sudan: Global Lessons Learned”. Their constructive suggestions and comments are highly acknowledged. Thanks are also due to Mrs Wafaa M Osman for providing word processing assistance. Dr. Mekki Elshibly, 3 December 2013

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Executive Summary In common with the worldwide drive towards decentralization, the federal system of governance was adopted in Sudan in 1992 when three main levels of authorities were created: the federal government, the states and local communities. A three tiers federal system composed of federal, state and local authorities was put into operation. The current federal system in Sudan consists of 18 states and 199 local communities. The institutional body of the fiscal system in Sudan is specified in Chapter V of the Interim National Constitution (INC) to include: the National Revenue Fund (NRF) and the FFAMC. The present study aims at supporting future public policy decisions in Sudan in the area of decentralization, namely through galvanizing views, new ideas and perspectives on the existing fiscal transfer system, with a view to reforming it to become more pro‐poor and equitable.

Conclusions:

The research conducted arrived at the following seven key conclusions: 1. Poverty and income inequality remain high in all states 2. Government finances remain relatively centralized 3. The tax system in Sudan is fragmented, unevenly applied, and suffers from widespread exemptions 4. There is lack of any systematic relationship between the actual current transfers to states and poverty reduction 5. Expenditure decentralization has increased on the back of declining revenue decentralization 6. There is an absence of a fair and equitable system of fiscal equalization 7. There is a disparity between expenditure responsibilities and revenue allocations Poverty and income inequality remain high in all states

According to the 2010 Sudan Millennium Development Goals (MDGs) Progress Report, the incidence of poverty stood at 46.5 percent in 2009. The poverty gap ratio and the poverty severity index stood at 16.2 percent and 7.8 percent, respectively. The incidence of poverty ranges from a little over 25 percent of the population in the capital (Khartoum) to more than 66 percent of the population in Northern Darfur. About 44.8 percent of the population of Sudan are consuming below the food poverty line of 69 SDG per month. The food poverty index is higher in rural areas (55 percent) than urban areas (28 percent). The overall inequality measured by the Gini coefficient is estimated at 0.353, which is quite moderate compared to countries with similar levels of development in Sub‐Saharan Africa (SSA) and the Middle East. Although there is disparity in income viii | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

between rural and urban areas, there is no significant difference in the magnitude of the Gini coefficient for rural (0.331) and urban (0.329) areas. While the Gini coefficient is 0.31 in the Northern Region, it is 0.38 in Darfur and 0.36 in Kordofan, indicating that poverty reduction will be difficult in regions with high income inequality such as Darfur and Kordofan. As for the nutrition situation, Sudan is characterized by high levels of underweight and chronic malnutrition, as well as persistently elevated levels of acute malnutrition. Nationally, one third (32.2 percent) of children under the age of five years in Sudan are moderately or severely underweight. Pro‐poor Expenditure at federal and state level is very limited

Three periods of time can be distinguished in relation to pro‐poor spending trends: 1981‐2002, 2003‐2010 and 2011‐2012, with the later interval reflecting the developments after the secession of the southern part of the country and the termination of the oil decade. According to the evidence, the fiscal policy in Sudan during the period 1981‐ 2002 was far from being pro‐poor. During the period between 1999 and 2010, Sudan witnessed "the oil decade" which was characterized by the strongest growth trend in the country’s history. The period 2003‐2010 witnessed a drastic change in the composition of government expenditure, with the federal share in total expenditure dropping from 92 percent in 2000 to 64 percent in 2006, due to the implementation of the Comprehensive Peace Agreement (CPA) which emphasized the role of sub‐ national governments in the country's public finance. The relatively huge amounts of oil reserves accumulated were not translated into equivalent public investments in education, health and infrastructure. The year 2011 witnessed the secession of South Sudan, which resulted in the loss of 75 percent of Sudan’s oil reserves and the decline in revenues by more than 50 percent bringing the economy to the verge of recession. Despite the measures taken to boost tax yield, the high level of unrecorded transactions in the informal economy, estimated at 65 percent of GDP, decidedly diminished the impact of the fiscal adjustment policies. Pro‐poor spending on social services, including health and education, averaged only one percent during 2011‐2012. The thorough examination of the impact of fiscal federalism on poverty in Sudan requires the availability of consistent data including the decomposition of federal and states’ expenditure by functional classification. However, such classification is not consistently available for the entire period 1990‐2012, as the commencement of the 1990s witnessed the government's discontinuation of providing the functional classification of expenditure in the federal budget. Instead, it provided aggregate allocations of spending grouped in four chapters that obscure the conventional functional classification.

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During the period 1998‐2001, federal government in Sudan systematically followed a pattern of spending that is not beneficial to the poor. Spending wages and salaries claimed an average of 25 percent of government expenditure, whereas social services that directly benefited the poor received a very modest share (3.8 percent) of total spending. As for the period 2001‐2003, the federal government allocated an average of 6.3 percent of total expenditure for social services (education 4.4 percent, health 1.6 percent, and water 0.3 percent). On the other hand, defense and security activities accounted for an average of 23.8 percent of government spending during this period, while external and internal debt service accounted for nine percent and infrastructure expenditure averaged 9.9 percent. While per capita GDP in Sudan was an average of approximately $1,000 (25 percent higher than the SSA countries), Sudan’s health outcomes left it on par with countries near $400 per capita GDP. Pro‐poor spending in Sudan showed a relative increase during the period 2000‐2006. During the period 2000‐2004, pro‐poor spending averaged approximately $16 per capita (19.3 percent of total federal expenditures and 2.8 percent of GDP). This was followed by a marked rise in federal poverty‐reducing expenditure which increased to $68 per capita in 2006 (24.8 percent of total central expenditure and 5.5 percent of GDP). Although this represented an encouraging increase, it was still below budget plans (6.6 percent of GDP). It is worth noting the averages for Heavily‐Indebted Poor Countries (HIPCs) (seven percent of GDP), for neighboring Ethiopia (19 percent of GDP) and Uganda (11 percent of GDP). Government finances have remained relatively centralized

For measuring the extent of fiscal decentralization in Sudan, the International Monetary Fund (IMF) used the execution rate by the state governments of four general government fiscal indicators: total revenues, tax revenue, total expenditures and compensation of employees. Research shows that the decentralization of government finances is still very limited and the central government retains most of the execution power, ranging from 71 percent to 97 percent, on each of the four fiscal indicators. This continuation of this pattern during most of the years since the adoption of fiscal decentralization in Sudan in 1995 reveals that government finances have remained relatively centralized. Another feature of fiscal decentralization in Sudan is the outpacing of expenditure decentralization over revenue decentralization. This indicates the prevalence of vertical fiscal imbalance (VFI). This means that the devolution of revenues responsibilities falls short of the devolution of expenditure responsibilities. For instance, in 2010, the federal government collected about 97 percent of total taxes and 86 percent of total revenues. However, while the state governments accounted for a relatively high proportion of government employees – and all the associated costs of salaries and recurrent expenditures ‐ the central government accounted for only 71% percent and 74% percent, respectively. This indicates that

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the central government has maintained control on the revenue collection while assigning more expenditure responsibilities to state governments. Tax system in Sudan is fragmented, unevenly applied, and suffers from widespread exemptions

At about 6‐7 percent of GDP (which does the figure refer??), Sudan’s tax effort is low for its level of per capita GDP. Direct taxes amounted to only about 1.2 percent of GDP and comprise: Business Profit Tax (BPT), Personal Income Tax (PIT), tax on Sudanese residents abroad and various stamp duties. Indirect taxes (customs duties, VAT, and excise taxes) accounted for about 80 percent of total tax revenue, with taxes on international transactions dominating. There are indications that the tax system in Sudan is fragmented, unevenly applied and suffers from widespread exemptions and tax holidays that limit the effectiveness of the existing regime. It is estimated that current exemptions from VAT reduce the revenue take by about 1.2 percent of GDP. Significant tax is also forgone by the dominance of the activities in the informal economy which is estimated to be twice the size of the formal economy. This negative scenario was aggravated by the gains from the oil sector during the period 1999‐2010. In order to strengthen the process of non‐oil revenue collection, there is a need for a renewed effort toward reforming the tax administration and developing a comprehensive reform plan. Such a plan must include the development of an adequate information management system and the further development of human resources. Additional measures could include the reform of taxpayer compliance to avoid further evasion of taxes and the resulting need for a cumbersome administration. Lack of a systematic relationship between the actual current transfers to states and poverty reduction The federal transfers to states include the following categories: (i) Current earmark transfers that are allocated to wages, operations, and social subsidy and are determined by existing costs. (ii) Block transfers that are determined according to a formula based on weighting criteria including population size, minimum requirement for government responsibility, social development (health and education), and the states’ ability to collect own revenues. (iii) Development transfers which are determined on the basis of alternative indicators such as the states’ development needs and absorptive capacity. Article (16) of the Presidential Decree No (12) of 1995, stipulates the setting up of the National States Support Fund (NSSF) for states with the objective of transferring resources from the centre to the states on a fair and equitable basis. In allocating transfers to the states, the Fund identified nine indicators which were adopted with the aim of achieving a fair and equitable system of transfers. The xi | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

indicators include: financial performance, population size, human resources, natural resources, infrastructure, education, health, security and per capita income. In 2005, the FFAMC was formed as a specialized committee to revise the above indicators. The committee confirmed the identified indicators and recommended slight modifications in the weights attached to some of them. From a pro‐poor perspective, one would expect the formula‐based transfers to states to be strongly linked to poverty at the state level. However, available evidence reveals that there was no systematic relationship between the actual current transfers to states and poverty reduction. Rather, those transfers correlated more strongly with state population size than with the percentage of rural population where most of the poor are situated. Expenditure decentralization increased on the back of declining revenue decentralization: The VFI, measured as the gap between own spending and own revenues at the state level, is very high in Sudan. In 2010, only about 33 percent of states’ expenditures were mobilized from states’ own revenue sources. This contradicted international evidence which revealed that sub‐national governments in developing countries finance up to 70 percent of their spending from own sources. The VFI has increased overtime due to a progressive devolution of spending responsibility, coupled with increasingly‐centralized revenue functions. Between 2000 and 2010, the VFI increased from 25 percent to 70 percent, indicating that the mismatch of spending and revenue decentralization has increased. This trend reflects increased expenditure decentralization on the back of declining revenue decentralization. During the same period(2000‐2010), the share of state expenditure in general government expenditure rose from 19 to 26 percent, while the revenue share fell from 23 percent to 14 percent due to the limited capacity of states to collect own revenues, which in turn led to an increased states’ dependency on federal transfers. This unsatisfactory performance of states to mobilize own revenue is largely attributed to the lack of infrastructure and human capacity, and depressed economic activity due to security problems in some states. According to the states’ final account reports, the ratio of state own revenues to total revenues fell from 76.4 percent in 2000 to 38.9 percent in 2010. Another notable feature of the VFI is the large dispersion among states. Whereas VFI registered 34 percent in Khartoum and the Red Sea, this ratio reached 89 percent in Blue Nile. Absence of a fair and equitable system of fiscal equalization:

The modalities adopted in Sudan for the horizontal allocation of resources among the states reveal significant variation. Transfers per capita accrued to the top xii | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

recipient state were, on average, six times higher than the bottom recipient during the period 2000‐2010. The Blue Nile, the River Nile and the Northern States were the highest recipients of federal transfers on a per capita basis while North Kordofan, Red Sea and South Darfur figured at the lower end of the ranking. There is also evidence that the current mechanism for the allocation of national resources is not entirely transparent and leaves space for discretionary (political) allocations, undermining any notion that the system is a fair and equitable one. As a result, a number of states have expressed dissatisfaction about being under‐resourced on the grounds of their large population size and the spread of poverty. Mismatch between expenditure responsibilities and revenue allocations:

The analysis reveals that the states budgets portray a rising bias in favor of recurrent expenditure to the detriment of development expenditure. There is also an evident lack of transparency in the allocation of federal transfers, which render these revenues unpredictable and hence limit their capacity for forward planning. This causes a mismatch between expenditure responsibilities and revenue allocations, resulting in a widening of the gap between states' revenues and expenditures. The ultimate result is hampering budget execution, especially with regards to development expenditure which targets service delivery to the poor. As for the financial management, there is no evidence of transparent guidelines to monitor the roles and responsibilities of states and local governments. Furthermore, there are no transparent mechanisms from the states and local governments to show the destiny of the federal cash transfers. Evidence also reveals a lack of intergovernmental flow of functional information, which prevents prudent fiscal management. A comparison between federal and state government accounts shows significant negative discrepancies between the consolidated transfers reported by states and the expenditure in transfers to states reported by the federal government, the latter reflecting a markedly rising trend since 2005. These administrative limitations and a lack of essential human skills, aggravated by institutional drawbacks, have collectively acted as an impediment to the authorities' capacity to plan, execute and monitor state and local governments' budgets.

Key Messages & Recommendations: Towards a Reformed Pro‐Poor Intergovernmental Fiscal Transfers System To address the issues identified, actions in the following 8 areas are necessary. Constitutional, Legal and Regulatory Implications: (i) In view of the complexities embodied in the adoption of fiscal federalism in Sudan, the relationship between various stakeholders must be codified in the constitution, laws and regulations. More flexibility is needed to change xiii | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

the specificity of implementation instruments, while enshrining the political and philosophical principles in the constitution and the operating structures in the laws. (ii)

Given that macroeconomic stability ranks high in the policy agenda, intergovernmental fiscal relations should be a matter of regulation under the Minister of Finance and National Economy, to give the ministry maximum flexibility in public expenditure management.

(iii)

The allowance of sub‐national governments to borrow when they have the capacity to repay should be a regulatory and not a constitutional matter. It should be clearly codified that local government loans are internal obligations of local governments and not of higher levels of government.

(iv)

A participatory approach requires that the legal and regulatory system should provide full, timely and easily‐accessible public disclosure of resource allocation decisions—in budgets, procurement and expenditure programs. Citizens must have reliable, secure access to the means to enforce appropriate penalties for rules violations.

Institutional Reform:

(i)

The institutional reform of fiscal decentralization should be designed with adequate incentives for appropriate institutional behavior. It must also be implemented gradually to avoid antagonizing the powerful federal bureaucracies or stretch the limited capacities of sub‐national governments.

(ii)

The federal government should assist local governments in adhering to the legal and constitutional provisions that prevent abuse and corruption.

(iii)

Reform programs should be designed to help local governments meet a progression of well‐defined and objectively‐verifiable performance standards in revenue generation and pro‐poor service provision.

(iv)

Donor technical assistance programs are needed to devise individually‐ tailored reforms to provide flexibility to adapt to the differences across various local authorities. It is also important to accord the local governments the power to manage their own resources and be held accountable for performance by their citizens.

Addressing the Paucity of Data to Facilitate the Design of intergovernmental Equalization Transfers Formula:

(i)

The thorough examination of the impact of fiscal federalism on poverty in Sudan requires the availability of consistent data involving the decomposition of federal and states expenditure by functional classification.

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(ii)

There is a great need to strengthen comparable GFS (Government Finance Statistics) ‐consistent reporting on the revenue side at both federal and states levels. On the expenditure side, reporting by functional classification (across health, education, roads, etc.) and economic lines (wages, salaries, subsidies, etc.) are an essential prerequisite for any systematic analysis of the fiscal position of the states.

(iii)

A comprehensive and consistent database of government finance for documentation purposes could also improve fiscal reporting by making budget plans and execution publicly available. Transparent guidelines clarifying revenues and expenditure assignments between states and localities would enhance revenue collection, streamline expenditure assignments and set the basis for sound wage and salary policies.

Suggested Revised Pro‐Poor Allocative Formula:

In view of the limited success achieved in directing the intergovernmental transfers towards the poor segment of the population, it is recommended to adopt modified transfer scheme that focuses on the sectors that directly enhance the on‐ going poverty alleviation efforts. These sectors, which are within the national priorities, include: education, health, water, roads, and agriculture. It is also to be emphasized that the suggested revised transfer scheme should be phased out over a period of three years. This is intended to minimize the disruptive consequences of implementing a large sudden change in resource allocations to sub‐national jurisdictions, which could potentially result in inefficient allocation or even misappropriation of public resources by local governments. (i) (ii) (iii) (iv)

Using the revised formula for the allocation of 10 percent of the transferred resources in the first year, Using the revised formula for the allocation of 40 percent of the transferred resources in the second year, Using the revised formula for the allocation of 70 percent of the transferred resources in the third year, Using the revised formula for the allocation of 100 percent of the transferred resources from the fourth year onwards.

The factors to be used in proposed allocation formulae for each of the six sectors are outlined as follows: (i) Primary and Secondary Education: number of school‐aged children (100 %). (ii) Health Services: population (70 %), poverty count (based on regional poverty rates (10 %), vehicle route mileage (10 %) and infant mortality count (10 %)

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(iii) (iv) (v) (vi)

Rural Roads: kilometers of local earth roads (67 %), kilometers of local gravel or paved roads (33 %). Water Supply and Sanitation: population (70 %), land area (15 %) and poverty count based on regional poverty rates, (15 %). Agricultural Extension Services: number of agricultural producers (70 %) and land area (30 %). Administration Allocations: population (70 %), land area (15 %) and poverty count (based on regional poverty rates) (15 %).

Addressing Vertical and Horizontal Imbalances: Directing Intergovernmental Transfers to Offset Vertical Fiscal Imbalance: (i)

Transfer revenue‐raising power to local governments.

(ii)

Transfer responsibility for expenditures to the central government.

(iii)

Reduce local expenditures/raising local revenues.

(iv)

Give the states fair shares of the major national taxes collected in their jurisdictions, including VAT.

(v)

States should assist the federal government in revenue mobilization by providing information on local taxpayers, and thereby increasing the pool of tax revenues.

(vi)

Unconditional grants should be allocated annually with reference to the reassignment of tasks between the federal and states governments. The total amount of the grant is calculated on the basis of a formula that includes the unconditional grant of the previous year, corrected by the increase in the general price level, plus the net change in the budgeted costs of running newly‐introduced or discontinued services.

(vii)

With regard to conditional grants, the federal government should ensure that states allocate the funds transferred to finance certain pro‐poor services, such as primary education, primary health, water supply, agricultural extension and roads. Furthermore, these earmarked grants should target the ensuring of minimum nation‐wide standards for the provision of pro‐poor services. In this sense, the transfers are referred to as equalization grants addressing the horizontal imbalances between states with an effect in closing the vertical fiscal gap.

(viii)

Enhance the internal audit; improve the reporting systems and the compliance with established financial regulation in all sub‐national jurisdictions. This calls for implementing a sound capacity building program in financial management and monitoring the destiny of the grants transferred.

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Directing Intergovernmental Transfers to Offset Fiscal Horizontal Imbalance: (i)

Recognize that geographical areas usually differ with respect to resource capacity and needs and that the tax base per capita often differs substantially between urban municipalities and district councils. The needs for public services may differ because some areas, for example, have a higher percentage of school children and/or elderly people than others.

(ii)

Design fiscal institutions to cope with the complex reality of the variation between states and localities and avoid further aggravation imposed by the political imperatives of treating even the most unequal jurisdictions uniformly, and by historically‐rooted conflicts and rivalries between regions and population groups.

(iii)

Allocate equalization grants to channel funds from relatively wealthy jurisdictions to poorer ones, with the objective of realizing horizontal equity between states and within‐state equity.

(iv)

The redistribution among states alone will not bear fruit, unless it is accompanied by appropriate internal redistributive measures. This shifts the responsibility to states and local jurisdictions to engage in redistribution. It follows that the harmonization between national and sub‐national efforts is essential for success in targeting the poor segments of the population.

Bridging the Governance Gap: (i) Focus on fostering cooperation between the different levels of government to enhance service provision, ensure the democratic process is uninhibited, provide dedicated local revenues and promote a legislative and administrative culture of efficiency and responsiveness. (ii)

The democratic process needs to become a natural and consistent aspect of government at national, states and local levels. Local government posts need to become fully competitive and strong measures taken to ensure freedom and fairness.

(iii)

Localities should receive all locally‐generated and collected revenues that have been sanctioned by the federal government, including property tax and a portion of receipts from locally‐collected national income tax.

(iv)

Enactment and implementation of deterrent anti‐corruption laws as effective governance cannot be attained in a corrupt environment. Greater accountability and transparency will go a long way to creating a climate of honesty. The perceived climate of dishonesty can only negatively impact regional investment and economic growth.

(v)

Strengthen the judiciary to be capable of being impartial in resolving the disputes between national and sub‐national governments.

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(vi)

Decentralization laws should be further clarified through legislative action to clearly define sub‐national authority and the authority that rests with the central government. Local levels of government should be stopped from operating with unchecked autonomy to interpret laws as they see fit.

(vii)

Efforts to strengthen local governments should avoid the creation of parallel governance institutions which, in the longer term, may work to further weaken efficient traditional administration systems.

Attraction, Management and Coordination of Donor Support:

(i)

Take the necessary measures to enhance Sudan's illegibility for HIPC relief. The relief from donor countries and multinational agencies under the HIPC initiative was one of the main sources of donor support, which was a driving force behind the widely acknowledged success of the Ugandan experience with fiscal decentralization.

(ii)

Establish and invigorate a Poverty Action Unit (PAU) within FFAMC to coordinate the present donor resources earmarked for states suffering from conflict, with the objective of utilizing some of the technical and financial recourses to improve the intergovernmental transfer mechanisms to these states. These funds include: the Darfur Reconstruction and Development Fund; the Eastern Sudan Reconstruction and Development Fund; the West Kordofan Reconstruction and Development Fund; the Darfur Compensation Fund; and the Peace Building Project in South Kordofan and the Blue Nile.

(iii)

Channel donor support directly to pro‐poor sectors like primary and secondary education, health, rural feeder roads, agriculture extension, water and environmental sanitation, micro‐finance and adult literacy.

(iv)

Design the future donor support modalities in the field of decentralization, away from the typical program support to a sector budget support/and or general budget support with clear agreements on the milestones and targets to be achieved in the field of poverty.

(v)

Attract donor support to assist in invigorating revenue raising and mobilization capacity of states governments and localities to reverse the reliance on smaller, non efficient, low yielding taxes, especially on agriculture and smaller enterprises (taxes focusing on production instead of wealth and income). This can be assisted by donor support in the field of tax administration and tax evasion.

(vi)

Engage potential donor assistance in programs containing elements of capacity building, especially in relation to planning, budgeting and raising revenue, with special attention to poverty and gender sensitivity.

(vii)

Focus donor assistance on mainstreamed (on‐budget) support mechanisms rather than jurisdiction‐specific donor support (development grants). This requires new tools for dialogue between the federal government and the

xviii | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

donor community on issues like Poverty Reduction Support Credit (PRSC) and the Poverty Reduction Strategy Paper (PRSP) process at central government level, with more on fiscal decentralization issues like strategic and action planning. (viii)

Strike a balance between the need for federal government/donor control in the allocation of poverty oriented expenditure with the need to preserve sub‐national governments' autonomy. While sub‐national governments need to have enough fiscal control and discretionary powers to plan their activities in an efficient way, there is a strong desire to ensure that funds are utilized within poverty‐sensitive areas and that inequality across states and localities is minimized.

(ix)

Focus on appropriate incentives in the introduction of donor programs in local jurisdictions to improve financial management, tax collection and efficient utilization of donor funds.

(x)

Prepare a fiscal decentralization strategy in Sudan in coordination with the World Bank and other bilateral donor‐support. The objective of the strategy is to strengthen the process of decentralization in Sudan through increasing sub‐national governments’ autonomy, widening local participation in decision making and a streamlining of fiscal transfer modalities to local governments in order to increase the efficiency and effectiveness of local governments to achieve poverty alleviation objectives within an transparent and accountable framework.

Capacity Building to Enhance Transparency in Budget Processes: (i) Encourage significant investments in capacity building and improving performance fiscal management systems at the states level, in particular aiming at improving transparency of the budget process in all its phases. (ii)

Improve the potential of state and local governments to manage economic and social development. Capacity building refers to both human capital and technological development and demands support for training activities as well as technological endowments; for both of these, development partners can play a significant role. Selected areas of need include revenue estimation, overall budget process, collection procedures and development planning and execution.

xix | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

1‐

Introduction The turn of the twenty first century witnessed drastic changes in governance structures in developing countries. During the twentieth century governments were largely unitary and centrally‐managed, their activities were also significantly constrained by bureaucracy and red tape. The relationship with the rest of the world was limited due to the dominance of a doctrine of self‐reliance. By the beginning of the twentieth century, developing countries moved towards federal and con‐ federal forms of government. The role of the central government was gradually transformed from management to leadership in response to the requirements of globalization and the localization of power. Focus on inputs was replaced by a focus on results, as competition and accountability pushed governments to be more open and dynamic. Influenced by these developments, fiscal federalism started attracting more general attention, largely because of pressures for greater decentralization in many countries around the world. The term “fiscal decentralization” refers to an increase in taxing and/or spending responsibilities given to sub‐national jurisdictions. In many cases of fiscal decentralization, additional layers such as states, provinces, and regions are created. The recent tendency towards more fiscal decentralization originates from four different sources. First, deepening democratization has given more voice and weight to the preferences of specific groups or regions. Second, globalization is creating market areas that are no longer identical with national territories. Third, in the jargon of economists, decentralization may be similar to a “superior good,” which becomes more desirable when incomes increase. Fourth, as incomes and the flow of information increase, and as differences in income levels across regions within countries rise, the richer regions become more aware that, through the tax system and spending programs, some—or at times a lot of—income redistribution is taking place from the richer to the poorer regions. This realization leads to demands on the part of the richer regions to reduce the role of the national government and to increase that of sub‐national governments (Tanzi, 2001). In common with the worldwide drive towards decentralization, the federal system of governance was adopted in Sudan in 1992 when three main levels of authorities were created: the federal government, the states and local communities. The current federal system in Sudan consists of 18 states and 199 local communities. The system involves devolving more expenditure functions and revenue sources to the states. Accordingly, total revenue of the states witnessed substantial increases over the past two decades. Concurrently, states have increased their dependency on transfers to meet their responsibilities for the provision of basic social service delivery. Large increases in transfers to states have contributed to rapid growth in state spending and weakened incentives to raise state own revenue. International experience suggests that it is important to evaluate the impact of an intergovernmental transfer system in developing countries in terms of its

1 | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

incentive effects on sub‐national governments. These include the overall efficacy of sub‐national pro‐poor service delivery and accountability, sustainable fiscal policies, and own source revenue mobilization. The differences between the "centralist" poverty reduction agenda and "fiscal decentralization" reform continue to characterize today’s international practice. However, the notion of community‐ driven development –which embraces the view that poverty is local and that poverty alleviation requires involvement at the local level‐ is increasingly gaining followers among policy practitioners and in the development literature. Nevertheless, donor‐supported development activities and poverty reduction programs have traditionally been centrally driven and top‐down. Even when the recognition is made that community involvement and ownership is needed for sustainable economic development and poverty alleviation to take hold, many community‐driven development programs purposely circumvent local government authorities who are seen as inefficient, corrupt, and prone to elite dominance (Boex et al, 2006). Others focus on the limited capacity of local entities implementing development projects. However, the efficacy of decentralization in the provision of pro‐poor public goods has been questioned by those who believe that decentralization may lead to the “capture” of public resources by the elite and administrations at the local level. It is also feared that decentralization can also lead to fragmentation of society or exclusion of the poor in the presence of a local elite, and to corruption. Decentralization can also induce political tensions between regions if they have significantly different income levels and natural resource endowments. Taking account of economies of scale in the provision of public goods and services, and the need for coordinated fiscal policy, a centralized government is presumably better able to internalize externalities. In the context of Sudan, the improvement of pro‐poor public service delivery, and the assurance that services are delivered in an equitable manner, take on even greater urgency. Hence, this paper aims at providing an assessment of ongoing issues in Sudan and on the impact of intergovernmental transfers and various levels of fiscal decentralization on poverty alleviation. The overarching objective is to introduce proposals to policy makers at various levels of government and the international partners, which may assist in realizing the desired objectives. This includes the assignment of expenditure responsibilities, the assignment of revenue sources to sub‐national governments, intergovernmental fiscal transfers, and local government borrowing. At the same time, the paper intends to uncover how poorly‐ designed fiscal decentralization programs can be harmful to the objective of poverty alleviation. Based on the analysis of Sudan's past experience with fiscal decentralization, the paper attempts to provide specific recommendations on how the central government, sub‐national governments and donor support can interact to design fiscal decentralization reforms in a more pro‐poor manner and how poverty reduction strategies can embrace a proactive solid role for central and sub‐ national governments.


The paper is organized as follows: section two lays the theoretical and conceptual framework of the study and discusses the relevance of fiscal decentralization theories to developing countries. Section three analyses the state of fiscal decentralization and poverty alleviation in Sudan. This includes the salient features of the fiscal system, the legal and institutional background of fiscal decentralization, Sudan poverty profile and the functional classification of government current expenditure. Following this, section four examines the trends in fiscal transfers and poverty reduction, including: the extent of fiscal decentralization in Sudan, an assessment of federal and states fiscal capacity and tax effort, measuring of states fiscal need and fiscal capacity, intergovernmental transfers allocative formula, the incidence of vertical and horizontal imbalances, states budgets and fiscal management, fiscal decentralization and poverty reduction and addressing inter‐state spill‐over effects of pro‐poor expenditures. Section five analyses the challenges and constraints to fiscal decentralization in Sudan. These include a number of elements, among them: the inappropriate sequencing of federal resource availability and states' spending responsibilities; inadequate adherence to the federal and states' roles in the provision of pro‐poor social services; weak fiscal institutions and inadequate social service delivery which fail to reduce inequality and poverty;inadequate transparency in the federal allocation of resources hampering legitimacy; and meagre effort on the part of the federal government to focus federal transfers to the poorest states to enable more targeted development spending. Section six follows which highlights the lessons learned from selected countries with respect to: vertical fiscal imbalance, horizontal fiscal imbalance, matching grants and poverty reduction. Section seven is devoted to present proposals toward a reformed pro‐poor intergovernmental transfers system in Sudan. These proposals include: addressing paucity of regular flow of data, institutional fiscal reform, a suggested revised formula, coping with vertical and horizontal imbalances, capacity‐building, management and coordination of external support, making Zakat proceeds more pro‐poor, agricultural policies (Dutch disease), fiscal benefits from civil service reform, coordination between fiscal and financial measures and bridging the governance gap. Finally, section eight presents a summary of the conclusions and recommendations.


2‐

Theoretical and Conceptual Framework

2.1 Definitional and Conceptual Issues: 2.1.1 Definition and Rationale of Fiscal Decentralization: The economic literature points to three distinct dimensions of decentralization, namely political, administrative and fiscal dimensions. Each dimension has unique characteristics, objectives and conditions for success. While the political dimension refers to the transfer of authority from central to local authorities, the administrative component focuses on the transfer of functional responsibilities from central to local authorities and the fiscal dimension deals with the financial relationship between all levels of government. However, despite the usefulness of distinguishing between the different dimensions of decentralization, there is nonetheless considerable overlap between the three dimensions. (Boex et al 2006). Fiscal decentralization, widely regarded as the core component of decentralization, can be defined as ‘devolution of authority and responsibilities for public functions from the central government towards local governments with regards to spending and revenue collection’. Fiscal decentralization refers to the public finance dimension of intergovernmental relations. It is defined today as allowing lower levels of government to raise and/or spend an increasing share of the state budget (Fritzen 2006). Fiscal decentralization specifically addresses the reform of the system of expenditure functions and revenue source transfers from the central to sub‐national governments. Hence, it plays a pivotal role in any decentralization program. Accordingly, fiscal decentralization has been regarded as an appealing feature of economic reform programs based on the following considerations:  Decentralization of spending increases allocative efficiency since local governments have better local information and, hence, can affect non‐uniform provisions that better match the preferences of the local constituency and are more capable of reflecting the demand for local services than a remote central government. (Samuelson, 1954, Oates, 1972).  Decentralization of fiscal activity is expected to boost accountability and transparency in public good delivery that would help ensure its dynamic efficiency.  Taxpayers are expected to better cooperate with local governments that are accountable.  Decentralization is likely to improve the “competitiveness” of governments and enhance innovation—and hence allow governments to act to satisfy the desires of their citizens.




People are more willing to pay for services that respond to their priorities, especially if they have been involved in the decision‐ making process for their delivery.

Nevertheless, some economists like Tanzi (2000) advocate that while decentralization might be necessary from a political point of view, there are some possible adverse consequences of decentralization, such as increased corruption, excessive regulation, difficulties in introducing efficient tax reform and difficulties in maintaining macro stability. (Said et. al, 2003). 2.1.2 Definition and Scope of Poverty: Poverty reflects a condition of low income and failure to satisfy basic needs and manifests itself in the prevalence of risk, uncertainty about the future, vulnerability, powerlessness, lack of voice, representation and freedom. During the 1980s and 1990s, the concept of poverty gradually evolved from the notion of minimum level of subsistence to the notion of relative deprivation, which defines poverty as the failure to maintain the standards prevailing in a given society. More recent debates have added other elements to the poverty definition, including such intangibles as capabilities, dignity, autonomy, vulnerability, voice, empowerment and participation (Boex et al 2006). This broad definition of poverty had a direct bearing on the criteria for measuring it. Hence, the measurement of poverty has been widened to include, in addition to income, a broad set of non‐ income basic needs, such as primary education, basic health, and access to social services like clean water.

2.2 The Theoretical Framework: 2.2.1 First Generation Theory of Fiscal Federalism: The First Generation Theory of Fiscal Federalism (FGTFF) was introduced by the work of Samuelson (1954 and 1955), Musgrave (1959) and Arrow (1970). Their contribution focused the nature of public goods, the conceptualization of the roles of the private and public sectors and the active and positive role for the government sector, in terms of correcting various forms of market failure, establishing an equitable distribution of income, and stabilizing the economy at high levels of employment with stable prices, as set in the Keynesian theory (Oates, 2005). The main focus of FGTFF was on the failure of the market mechanism in providing public goods, which necessitated the intervention of the government to take the appropriate measures to handle the market failure. The first generation theorists investigating fiscal federalism tended to associate the process of fiscal decentralization with an enhancement in the overall degree of public sector responsiveness to a public demand and, ultimately, to an improvement in the economic efficiency of public economic activities, by better linking resource allocation with public preferences. Musgrave (1959) introduced three different branches or categories of public finance: economic stabilization, income distribution and resources allocation. In the specific public finance perspective on federalism,


the Musgravian branches of public finance proved useful in setting the constraints to fiscal decentralization, stabilization and distribution, and the potential benefits of fiscal decentralization, efficiency, (Duc Hong Vo, 2010). The main theoretical concern is whether fiscal decentralization influences economic stability. The first generation theorists postulate that fiscal federalism does achieve the macro‐stabilization objective. However, macro stabilization represents a constraint on the devolution of fiscal powers to sub national governments, (Oates, 1972). As for income distribution, fiscal decentralization does not seem to be systematically helpful in this respect, as economic interdependences between the economies of sub‐national jurisdictions act to reduce any diversity in the distribution of goods that would exist across lower level governments. As such, income redistribution has a greater chance of success if it is carried out by the central government (Oates, 1972). Hence, FGTFF produced a vision of fiscal federalism in which the central government took the lead in macroeconomic stabilization policy, introduced basic measures for income redistribution and provided efficient levels of output of national public goods. Paradoxically, an aggressive local government program, for example, to redistribute income from rich to poor establishes undesired incentives for out‐migration of the well‐to‐do and in‐migration of low‐ income households. The FGTFF regards the final branch of public economics, resources allocation, as the area in which fiscal decentralization can be most effective. The theory justified this with two main reasons. First, scarce resources should be more efficiently allocated under a decentralized fiscal system due to the better position of understanding how to maximize benefits from the use of resources in their localities. Second, the character of ‘impure’ or local public goods adds a local congestion dimension to service provision that national governments may not be well‐placed to manage, (Vo, 2010). 2.2.3 Second Generation Theory of Fiscal Federalism: It is to be stated at the outset that FGFF and SGFF approaches are complementary rather than competing. FGFF focuses on the optimal design of fiscal institutions in the context of welfare maximization without respect to the incentives of political officials. The main contribution of the Second Generation Theory of Fiscal Federation (SGTFF) is that it extends and adapts FGFF lessons to the context of incentives and self‐interested political officials. The turn of the twentieth century witnessed the emergence of the SGTFF, the basis of which originated outside the sphere of public finance literature, namely, the theory of the firm, the economics of information, the principal–agent problem and the theory of the contract (Oates 2005). The SGTFF has two main concerns. The first is the underlying political processes represented by the lack of commitment from government officials to


maximize the welfare of their constituencies. This consideration has obvious links to public choice theory – which was the main ‘non‐core’ stream of the FGTFF (Volume, 2010). The second concern of SGTFF is the issue of asymmetric information and political agents, as some particular participants have more knowledge of local preferences, tastes and cost structure compared to others. In dealing with this issue, the second generation theorists introduced the framework of industrial organization and microeconomic theory. As such, SGTFF focuses on the issue of balance between the degree of fiscal centralization and fiscal decentralization. In contrast with FGTFF, which acknowledges the general support of fiscal decentralization, SGTFF points to the dangers of going too far along this route. There are two main motives that characterize SGTFF, namely, incentives and information. The two motives are instrumental in the realization of economic efficiency. On one hand, incentives are helpful in discouraging outward migration of people and firms from a jurisdiction. On the other hand, knowledge of local preferences and tastes is crucial to achieving economic efficiency when local public goods and services are provided by sub national governments. In common with FGTFF, SGTFF's logic for the design of fiscal transfers focuses on lowering the tax burden. But it also emphasizes allocating sufficient taxes to sub‐national governments so that they have strong fiscal incentives to foster local economic growth (Weingast, 2006). The SGFF approach suggests that lower level governments are unable to foster local economic prosperity if they capture a significant increase in revenue along with that prosperity. Hence, SGFF advocates the redesign of transfer systems so as to allow significant horizontal equity while providing high marginal incentives. 2.3 Theoretical Perspectives on Decentralization and Poverty Reduction: The theoretical aspects of the relationship between decentralization and poverty reduction have recently received increasing attention in economic literature. Theories on this relationship are based on a number of different perspectives that can result from devolving political and administrative responsibility and fiscal resources to lower tiers of government. The four most common approaches are concerned with: proximity to the poor, information transfer, and transaction costs; voice and accountability; role of local capacity; and no relationship. What is clear from a review of these approaches is that the extent to which decentralization itself has an impact on poverty reduction outcomes is not a clear‐ cut or resolved issue, and there is definite disagreement as to the merit of undertaking fiscal decentralization in a context where a government prioritizes poverty reduction for political, economic or development reasons (Bjornestad, 2009). Oates (1999) argues that the proximity of policy makers to the target group reduces information and transaction costs in identifying the poor. Conning and Kevane (2002) advocate that sub‐national authorities are likely to have better


information on who the poor are. However, communities that have clear rules for determining who the poor are will tend to be more effective than outside agencies in targeting programs to the poor within a given community. Local participation through fiscal federalism has a direct impact on well‐being through selecting the beneficiaries of anti‐poverty programs, which improves targeting. This takes place through the improvement of the delivery of public services with the outcomes shaped by inequalities and uneven distribution of resources within the community (Mansuri and Rao 2004). Shah (1998), Wallis and Oates (1998) argue that local governments’ lack of human, financial and technical capacities reduces their scope for providing the appropriate pro‐poor level of public services through decentralization. Hence, the financing and administrative authority should remain in the hands of the human, financial and technical rich and central governments. Other economists argue that even if decentralization is effective in changing the relationship between local governments and their constituents, decentralization is in and of itself not a sufficient condition for poverty reduction. Rather factors such as central government commitment to poverty reduction, effectiveness of central government institutions and functions, gender sensitivity in public financial management, etc, will be more determinative in whether or not the outcomes of decentralization will be pro‐poor (Crook and Sverisson 1999). 2.4 Relevance of Fiscal Decentralization Theories to Developing Countries: Economic theories generally involve abstraction, simplification and generalization. This is even more so with respect to theorizing fiscal decentralization, especially in developing countries. Although context should never be ignored in public policy analysis, there are some relatively established practices and standard institutions that must be considered. Many economists advocate the case for centralizing the stabilization and distribution functions in developing countries, as the issues surrounding assignment of responsibility for both the expenditure and revenue dimensions of the allocation function in developing countries are considerably complex. A number of explicit and implicit assumptions underlying public finance theory in general and fiscal federalism in particular, may be violated in some developing countries. This violation takes the form of: the relevance of individual preferences as the principal basis for defining demand; the potential role of mobility in generating an efficient spatial pattern service provision; the applicability of conventional models of public choice; and the existence of an adequate legal basis for an effective intergovernmental system. To the extent that such mechanisms and assumptions are not valid, some of the standard policy prescriptions of the theory may have to be discarded or adapted (Smoke, 2001).


However, even if basic principles are essentially valid, typical conditions in developing countries can substantially affect the way they should be interpreted. Widespread poverty may make preferences more homogeneous across local jurisdictions, justifying greater centralization of some functions. This could be offset, however, by substantial spatial diversity in local environments and economic bases and/or by the existence of widely‐ dispersed and poorly‐linked settlements, both of which might suggest the need for greater decentralization. In addition, a wide diversity of socio‐political and institutional conditions can also influence the need and prospects for fiscal decentralization. Furthermore, the vast majority of developing countries are essentially unitary states in which local governments are the creation of the centre. Typical federal states are created by virtue of a voluntary union of decentralized units which agree to surrender certain powers to the central government. Most of the few developing countries with semi‐autonomous state governments are quasi‐federal in that the state structure was at least partially imposed from above. As a result, local governments are greatly influenced by the state bureaucracy with few true autonomous powers. In extreme cases, the central government may appoint the members of local government councils rather than permit their election by popular vote. In contrast, some local authorities are independent legal entities with significant autonomy. In developing countries, there is a wide range of differences between levels of governments. First, systems differ in the number of levels of government that exist and the relationships among them. Second, local authorities differ in their degree of political decentralization and grassroots legitimacy. Third, local authorities differ in their degree of autonomy in revenue‐raising and expenditure decision‐making. Fourth, local authority systems differ in the average degree of fiscal capacity relative to service responsibilities. Fifth, there are large differences across countries in the way fiscal data are classified, to them extent that even if data were available, it could be difficult to compare them.


3‐

Fiscal Decentralization and Poverty Alleviation in Sudan 3.1 The Federal Fiscal System and Pro‐poor Policy: The federal system of governance was adopted in Sudan in 1992 when three main levels of authorities were created: the federal government, the states, and local communities. The current federal system in Sudan consists of 18 states and 199 local communities. The division of responsibilities among the three tiers of government was enacted in the 1998 Constitution as follows:  The federal government's responsibilities include the traditional national level functions such as defense, foreign relations, monetary, fiscal and exchange rate policies. Over and above these, its responsibilities include: transport and communication, energy and mining; higher education, planning and education policy, monitoring education quality and providing transfers to the poorer states to finance schooling; education and posting of high‐level of medical personnel; water policy and large‐scale federally‐ owned irrigation projects.  The state governments' responsibilities include: providing secondary education and procurement and distribution of school textbooks to all pupils; health care at hospitals and dental care units; construction, operation and maintenance of small water schemes; and agricultural development.  The localities' responsibilities include: preschool and primary education, supply and management of primary health care and environmental sanitation (garbage collection and sewerage management). It is to be stated at the outset that an equitable and transparent fiscal system and budget allocation in Sudan are key to progress toward broad‐based growth, poverty reduction and the realization of its MDGs. This sheds light on the importance of pro‐poor spending which is defined as “spending that benefits the poor more than the non‐poor; spending that actually reaches the poor; and spending expected to have an impact on the welfare of the poor over time” (IBRD, 2007). As for Sudan, pro‐poor spending is considered by the Ministry of Finance and National Economy to include:  all federal recurrent expenditures except wages/salaries/ pensions for ministers and politicians, and all expenditure on goods and services, excluding defense;  all federal development expenditures, both locally and foreign financed; and  80 percent of current and block transfers to states, plus all regional development projects both locally and foreign financed. (IBRD, 2007).


3.1.1 Revenue and Expenditure during the Period 1981‐2002: The federal government budget witnessed various phases during the last three decades. In 1991, the budget deficit was 8.4 percent of GDP but drastically fell to 3.6 percent in 1992 and continued to be below two percent for most of the period 1993‐2002, UNDP (2006). Government revenue for the period 1980‐1991 averaged 11.6 percent cent of the GDP and dropped to 8.9 percent of the GDP for the period 1992‐2002. Government revenue amounted to an average of ten percent for the whole period 1980‐2002. By contrast, government expenditure as a ratio to GDP scored an average of 19.4 per cent for the period 1980‐1991 and dropped sharply to an average of 11 per cent of GDP during the period 1992‐2002. Government expenditure was thus slashed by almost half after 1992. The reason behind this positive development in expenditure was the strict implementation of the self‐imposed structural adjustment programs which were adopted as part of the national comprehensive strategy. However, the analysis of the functional nature of the reduction in government spending reveals that it was the poor who suffered most as the expenditure reduction was mainly in social services. As for the composition of revenue, during the period 1980 to 1991, tax revenue as a share of GDP averaged 8.2 percent, before dropping to an average of 5.8 percent during the period 1992‐2000. This reflected a wide divergence from the averages registered for developing countries (18 percent) and for developed countries (38 percent). Another feature of the tax structure from the standpoint of poverty alleviation is the dominance of indirect taxes throughout the period 1980‐ 2002, reaching 58 percent and 42 percent for the periods before and after 1992, respectively. As direct taxes bear appositive characteristic for achieving pro‐poor growth, there is urgency for the government to substitute direct taxes for indirect taxes. A closer look at the federal expenditure during the period 1978‐1988 reveals that debt service and military and defense spending topped expenditure items standing at 17.8 percent and 15.2 percent of GDP, respectively (UNDP, 2006). Expenditure on education and health were only 1.2 percent and 1.9 percent, respectively. This is yet another characteristic which distanced Sudan’s fiscal policy from being pro‐poor. Functional analysis of federal expenditure for subsequent years was made difficult as the government discontinued providing such data from the beginning of the 1990s. Instead, aggregate allocations of expenditure were grouped in four chapters. During the period 1992‐2002, Chapter I (mainly wages and salaries) accounted for 26.4 percent, Chapter II (mainly goods and services for government units) 52.4 percent, Chapter III (direct transfers to states) amounted to 10.3 percent, and Chapter IV (development expenditure) amounted to 10.9 percent. Significantly, Chapter III (direct transfers to states) accounted for the smallest share of


government spending, thus limiting their capacity to meet their escalating obligations for providing education, health, water and sanitation. 3.1.2 Revenue and Expenditure during the Period 2003‐2010: During the period 1999‐2010, Sudan witnessed "the oil decade" which was characterized by the strongest growth trend in the country’s history. It is estimated that about US$ 83 billion (SDG 252 billion in 2010 prices) worth of oil revenues were extracted during this period, resulting in a major change in the composition of government revenue and expenditure. In 2003 taxes accounted for 34 percent of total revenue with direct taxes constituting only 18 percent, while the share of other taxes (including indirect taxes, custom duties and VAT) reached 82 percent of total tax revenue. Oil revenue constituted 54 percent of the government total revenue which represented 86 percent of the total non tax revenue, whereas its contribution to total GDP stood at only ten percent, a clear reflection of the reliance on the oil sector. This resulted in the fragmentation of the tax system and the lack of fiscal sustainability, leading to increased reliance on inflationary domestic financing, a situation worsened by the wide tax spread exemptions and tax holidays. In 2010 (the year which witnessed the end of the oil decade) the share of taxes in government total revenue stood at 44 percent; oil revenue constituted 51 percent of the government total revenue. However, the period 2003‐2010 witnessed a drastic change in the composition of government expenditure, with the federal share in total expenditure dropping from 92 percent in 2000 to 64 percent in 2006. The reason for this major change was the implementation of the CPA which emphasized the role of sub‐ national governments in the country's public finance. Chapter I (wages and salaries) stood at 35 percent of government expenditure. Federal wages and salaries (Chapter One) enjoyed the major share of government expenditure, with general operation and maintenance ranking second, and the development budget having the lowest priority. Defense spending increased sharply in 2006 reaching 30 percent of all federal current expenditures i.e., 2.9 percent of GDP (IBRD, 2007). Aggregate spending on development projects rose from 1.3 percent of GDP in 2000 to four percent in 2004, before falling to 2.9 percent during the period 2005‐2006. Paradoxically, the relatively huge amounts of oil reserves accumulated were not converted into equivalent public investments in education, health and infrastructure. As such, the decade long oil boom witnessed the heavy reliance of the country on the oil sector and the failure to lay the foundation for a vibrant non‐ oil economy. The decade's neglect of the agricultural and industrial sectors was sufficient to diminish their capacity to offset the subsequent loss of oil revenue. This was further exacerbated by the misuse of oil funds on consumption and imports which resulted in negative national savings, averaging minus 7.4 percent of gross national income during the oil boom decade 2000‐2010.


3.1.3 Revenue and Expenditure during the Period 2011‐2012: The year 2011 witnessed the secession of South Sudan, which was accompanied by the fall of oil production by three quarters and the decline in revenues by more than 50 percent bringing the economy to the verge of recession. The deficit in the trade balance reached a record US$ 9 billion in 2011. The market exchange rate dropped first from 3 SDG/USD to around SDG 5 and then later to around 7.1 SDG/USD, after its slight appreciation following the official rate devaluation in June 2012. Inflation soared to more than 40 percent, triggered by rising transport and import costs of necessary goods, while the fiscal deficit reached approximately five percent of GDP. Confronted by this serious economic crisis, the government launched the Second Five‐Year Strategic Plan (2012‐16), which aims to diversify the economy away from oil to agriculture and other sectors, as well as the Three‐Year Program for Sustainability of Economic Stabilization 2012‐2014. Fiscal policy was the first resort to cater for the immediate negative impact of the secession of the south. A supplementary budget was introduced in the second half of 2011 to accommodate the 35.6 percent loss in total revenue without jeopardizing growth. The amended 2011 budget focused on cutting spending, increasing taxes and removing subsidies (AfDB, 2012). In order to contain the fiscal deficit, the government removed subsides from major fuel products and sugar, with an estimated saving of one percent of GDP in 2011. In an effort to boost tax yield, VAT exemptions were reviewed and the structure of import tariffs was reformed. The tax on telecommunications was raised to 30 percent in the second half of 2011 up from 20 percent and a 5‐10 percent development tax was imposed on selected consumer imports. Nevertheless, the high level of unrecorded transactions in the shadow economy, estimated at 65 percent of GDP, decidedly diminished the impact of the fiscal adjustment policies. Despite the fiscal reforms, expenditure reduction remained below the level needed to compensate for lost oil revenue, generating a fiscal deficit of five percent of GDP in 2011. The wage bill (Chapter One) amounted to 44 percent of government spending in 2011 and is expected to decline to 40 percent in 2012. The share of Federal transfers to state governments was 27 percent of total government revenue during the period 2011‐2012. Pro‐poor spending on social services, including health and education, averaged only one percent during the same period. Capital expenditure was a mere 8.2 percent of the 2011 budget, 50 percent less than originally budgeted. The share of capital expenditure in GDP fell from 2.6 percent in 2010 to 1.3 percent and 1.4 percent in 2011 and 2013, respectively.


Table (3.1) Public Finances (Percentage of GDP) 2003 2006 2007 2008 2009 2010 2011

Total revenue and grants Tax revenue Oil revenue Grants Total expenditure and net lending Current expenditure Capital expenditure Excluding interest Wages and salaries Interest Primary balance Overall balance

2012

2013

16

21.0

20.6

22.7

16.3

16.4

12.1

10.7

10.6

5.8 9.1 ‐ 15.3

7.4 11.2 ‐ 25.6

6.9 11.6 ‐ 26

6.6 14.9 ‐ 24.2

7.1 7.9 ‐ 21.2

6.5 8.5 ‐ 19.5

7.5 5.3 ‐ 16.4

5.2 2.6 ‐ 14.1

5.1 2.5 ‐ 14.9

12.7 11.1 4.1 1.6 2.3 0.7

21.1 20.0 5.8 1.2 ‐3.4 ‐4.6

21.1 20.2 6.8 1 ‐4.4 ‐5.4

20.9 3.4 20 5.1 0.9 ‐0.6 ‐1.5

18.2 2.9 17.2 5.6 1 ‐3.8 ‐4.8

16.8 2.6 15.9 4.9 0.9 ‐2.2 ‐3.1

14.8 1.8 13.3 5.1 1.5 ‐2.8 ‐4.3

11.5 1.3 9.6 4.9 1.9 ‐1.5 ‐3.4

11.8 1.4 9.7 5 2.1 ‐2.2 ‐4.3

Source: AfDB, (2012) and IMF 2012

As table 3.1 shows, total government revenue fell from 22.7 percent of GDP in 2008 to 12.1 percent in 2011 and to 10.7 percent in 2012, before it fell further to 10.6 percent in 2013. Oil revenue fell from 14.9 percent of GDP in 2007 to 5.3 percent, 2.6 percent and 2.5 percent during the same years. Current expenditure also witnessed drastic decline in the years following the secession of the South and the subsequent loss in oil revenue.

In 2010, current expenditure was 18.2 percent of GDP but it fell to 14.8 percent in 2011 and to 11.5 percent in 2012, while it was projected to increase slightly to 11.8 percent in 2013. A similar pattern was recorded for capital expenditure, which fell from 2.6 percent to 1.8 percent and then to 1.3 percent, before rising slightly to 1.4 percent during the same years.

Despite the fall in revenue after the secession of the south, wages and salaries witnessed steady performances during the period covered, ranging between 4.9 percent and 5.0 percent of GDP during the same years. The consequent effect of the fiscal developments was the deterioration in the fiscal deficit from 3.1 percent of GDP in 2010 to about 4.3 percent in 2012 and 2013. Table (3.2) Current Federal Transfers to States (2011‐2012) (SDG) Item Current Transfers Compensation for Agric. Taxes Broadcasting Children Free Medical Care President's Grant Total GDP % of GDP

2011

2012

2,806,348,680 330,000,000

2,793,600,000 330,000,000

19,869,998 28,000,000 503,934,000 3,688,152,678 186,689,900,000 1.96

19,869,998 27,996,667 755,901,000 3,927,367,665 243,412,800,000 1.61

Source: Ministry of Finance and National Economy


Item

2010

% from Total Exp.

Rate of Change %

2011

% from Total Exp.

Rate of Change %

2012

% from Total Exp.

Rate of Change %

As for transfers to states after the secession of the South, Table (3.2) shows that total federal current transfers to states dropped to 1.61 percent of GDP in 2012 from 1.96 of GDP in 2011. This decline is consistent with the overall drop in total government expenditure due to the loss of 75 percent of the oil revenue due to the secession of the South. According to the Annual Report of the Bank of Sudan 2012, total current transfers to states dropped by 48.5 percent in 2012, (Tabl3 3.3). Table (3.3) Federal Transfers to States and Total Current Expenditure (2010‐2012) (SDG million)

Transfers to States Total Current Expenditure

5,755.8

23.8

20.5

11,012.1

38.5

91.3

5,666.1

21.6

(48.5)

24,162.1

100

10.1

28,578.3

100

18.3

26,272.1

100

(8.1)

Source: Bank of Sudan Annual Reports.


3.2 Legal and Institutional Background of Fiscal Decentralization The declaration of the revenue‐sharing agreement between the federal and state governments in 1995 marked the start of the process of fiscal decentralization in Sudan. Proclamations were issuedincreasing the number of states from nine to 26. A three‐tier federal system composed of federal, state and local authorities was operated. The principles of wealth‐sharing between the federal government, the government of South Sudan and lower levels of government was enacted in the INC and CPA in 2005 to address regional disparities. The Constitution grants governments of Northern States the right to legislate for raising revenue collection through a variety of local taxes and charges for services provided by the state. The federal government is assigned the power to collect customs revenues, business profit taxes, personal income taxes, and VAT. In addition to tax revenues, the federal government accrues non‐tax revenues, mainly from oil. This vision of fiscal decentralization led to substantial increases of transfers from the federal to the state levels with the aim of effectively delivering public service and broader development outcomes. The INC, in article (185), states guiding principles for equitable sharing of resources and common wealth:  Resources and common wealth of the Sudan shall be shared equitably to enable each level of government to discharge its legal and constitutional responsibilities and duties to ensure that the quality of life, dignity and living conditions of citizens are promoted without discrimination on grounds of gender, race, religion, political affiliation, ethnicity, language or religion.  The sharing and allocation of the resources and common wealth of the Sudan shall be based on the premise that all parts of the country are entitled to development.  Revenue sharing shall reflect a commitment to devolution of powers and decentralization of decision‐making in regard to development, service delivery and governance.  No level of government shall withhold any allocation or financial transfers due to any other level of government. In case of dispute, any level of government, after attempting amicable solution, may initiate proceedings in the Constitutional Court. The institutional body of the fiscal system in Sudan is specified in Chapter V of the INC to include: The National Revenue Fund (NRF):  All revenues collected nationally for or by the national government shall be pooled in the NRF administered by the national treasury. The NRF shall embrace all accounts and sub‐funds, into which monies due to the government are collected, reported or deposited.




All the revenues and expenditure of the government shall be on budget operations and made public.

Fiscal and Financial Allocation and Monitoring Commission (FFAMC): A FFAMC shall be established to ensure transparency and fairness in regard to the allocation of nationally‐collected funds to the government and the states. It undertakes the following duties and responsibilities:  Monitor and ensure that equalization payments (grants) from the NRF are promptly transferred to respective levels of government.  Guarantee appropriate utilization and sharing of financial resources.  Ensure that resources allocated to conflict affected areas are transferred in accordance with agreed upon formulae. The structure, functions, duties and operations of FFAMC are specified in the Republican Decree No 31 in July 2007. The purpose of the equalization grants is to provide revenues to enable all states, especially the less prosperous ones, to provide reasonable levels of services and local development. In addition, the federal government undertakes national development in accordance with national development plans. More funds than those provided from the NRF are transferred to the states. These include grants from foreign sources and resources secured from borrowing from internal and external sources. It has been observed that the share of the states from the NRF has been growing over time in harmony with the growth of national revenues and GDP. At present it stands at 24 percent whereas the federal government has a share of 76 percent. It should be noted that states have their own funds from source prescribed by the INC (Hassan, 2013). The fiscal decentralization system assigned the states three sources of revenue namely (a) own revenues (taxes, fees, and user charges); (b) shared revenues (mainly consist of 43 percent of VAT collection, ten percent of public enterprise profits and two percent of petroleum revenue); and (c) federal transfers (from the budget through the NSSF are determined by agreed formula). Local government revenues comprise taxes on property, local transportation, local livestock production (40 percent of which is transferred to the state governments) and other local taxes or duties, as well as transfers from the state governments of some profits from public enterprises (IMF, 2012b). States’ budgets are prepared by the council of state ministers and approved by the State Assembly. The states enjoy the freedom to allocate their financial resources, except federal transfers through the NSSF, which are earmarked for specific capital or social development projects. States’ expenditures are broadly set in the constitution; with the main outlays going for primary health care, basic education and safe drinking water. The allocation, through the NSSF, of funds


among the different states is based on a set of criteria which are: financial performance; population density; availability of natural resources; human resources expertise; adequacy of available infrastructure; education level; availability of health services; security situation; and average per capita income. The High Council on Resources (HCR) allocates to the states their share of the VAT and public enterprise profits. The HCR designates the public enterprises or joint ventures whose profit is to be allocated to the states and determines each state’s share (Brixiova et al, 2003). Table (3.4) State Revenue Sources

Source: IBRD, 2007


3.3 Sudan Poverty Profile: In a recent study, the Central Bureau of Statistics (2009) examined the status of MDGs in Sudan and found that the incidence of poverty stood at 46.5 percent in 2009. The poverty gap ratio and the poverty severity index stood at 16.2 percent and 7.8 percent, respectively. The incidence of poverty ranges from a little over a quarter of the population in the capital (Khartoum) to more than two thirds of the population in Northern Darfur. About 44.8 percent of the population of Sudan are consuming below the food poverty line of 69 SDG per month. The food poverty index is higher in rural (55 percent) than urban areas (28 percent). The overall inequality measured by the Gini coefficient is estimated at 0.353 which is quite moderate compared to countries with a similar level of development in SSA and the Middle East. Though there is disparity in income between rural and urban areas, there is no significant difference in the magnitude of the Gini Coefficient for rural (0.331) and urban (0.329) areas. While the Gini coefficient is 0.31 in the Northern Region, it is 0.38 in Darfur and 0.36 in Kordofan, indicating poverty reduction will be difficult in regions with high income inequality such as Darfur and Kordofan. As for the nutrition situation, Sudan is characterized by high levels of underweight and chronic malnutrition, as well as persistently‐elevated levels of acute malnutrition. Nationally, one third (32.2 percent) of children under the age of five years in Sudan is moderately or severely underweight. Table (3.5) Status of Poverty and Hunger MDG Goal Indicators

Sudan

2015 Target

Estimated poverty incidence (% of total population)

46.5%

23%

Prevalence of child malnutrition (underweight for age; % under 5)

32.2%

16%

Proportion of population below minimum level of dietary energy consumption

28%

14%

Source: UNDP (2012) As a part of its poverty assessment in Sudan, the World Bank prepared a poverty profile for the country (IBRD 2011). It estimated that 46.5 percent of the population in Sudan is below the poverty line. Poverty rates are substantially lower in urban areas, where 26.5 percent are below the poverty line, compared to 57.6 percent of the rural population. Figure (3.1) shows the poverty headcount rate—the fraction of the population living below the poverty line—for each of the states. The poverty rate is highest in Northern Darfur and lowest in Khartoum. It has also been found that education levels are very low, and poverty rates correlate highly with education – 45 percent of household heads have no formal education. Poverty rates are highest for those living in households whose head has no education and are also


high for those whose heads have only some primary education. Figure (3.2) shows poverty headcount rates by education of household heads. Figure (3.1) Sudan’s Poverty Headcount by state (% of population below the poverty line)

Source: IBRD, 2013

Figure (3.2) Poverty Headcount Rates by Education of Household Heads

Source: World Bank analysis of NBHS 2009. Figure (3.3) Poverty Head Count by State:


Percentage of the Population with Consumption below the Poverty Line


Table (3.6) Poverty by Household Characteristics, Location and States

Source: IBRD, 2011


4‐

Trends in Fiscal Transfers and Poverty Reduction

4.1 The Extent of Fiscal Decentralization in Sudan: Fiscal decentralization is notoriously difficult to measure, especially in the absence of reliable consistent data, as in Sudan. However, most empirical studies consider the extent of fiscal decentralization as the local share of total government expenditures (Oates, 1985; Jin et al, 2005). This indicator measures the degree of local expenditure responsibility in the economy. Alternatively, the local share of total government revenue is also considered as an acceptable measure of the extent of fiscal decentralization. For measuring the extent of fiscal decentralization in Sudan, the IMF (2012) used the execution rate by the state governments of four general government fiscal indicators: (a) total revenues (b) tax revenue (c) total expenditures and (d) compensation of employees. Figure (4.1) shows that in 2010 the decentralization of government finances was still very limited and the central government retained most of the execution power, ranging from 71 to 97 percent, on each of the four fiscal indicators. The repetition of this pattern during most of the years since the adoption of fiscal decentralization in Sudan in 1995, reveals that the government remains relatively centralized. Figure (4.1) Central Government Execution of Selected Fiscal Indicators, 2010

Sources: MOF, States Final Accounts Reports, and IMF staff, 2012


The evolution of the fiscal aggregates during the period 2000‐2010 reveals that the ratios are relatively stable reflecting only minor change (Figure 4.3). Tax effort was the fiscal indicator with the lowest dispersion over time while expenditure and compensation of employees showed a visible, though minor increase in decentralization. Revenue, on the other hand, evolved toward a more centralized structure over the period 2000‐2010. Figure (4.2) Selected Fiscal Indicators by Government Level

Source: IMF, 2012 Another feature of fiscal decentralization in Sudan is the outpacing of expenditure decentralization over revenue decentralization, which indicates the prevalence of a VFI. This is an indication that the devolution of revenues responsibilities falls short of the devolution of expenditure responsibilities. The year 2010 typifies this characteristic as the federal government collected about 97 percent of total taxes and 86 percent of total revenues (Figure 4.3). However, the state governments accounted for a relatively high level of government employment, and all the associated salary and expenses costs. Here, the central government accounted for only 71 percent and 74 percent respectively. In other words, the central government has maintained control on the revenue collection while assigning more expenditure responsibilities to state governments (IMF, 2012b).

4.2 Assessment of Federal and States Fiscal Capacity and Tax Effort: The weakness of tax policy and administration in Sudan has been observed by El Shibly, 1990 and IBRD, 2007. At about 6‐7 percent of GDP, Sudan’s tax effort is low for its level of development (Table 4.1). Direct taxes amounted to only about 1.2 percent of GDP and comprise a Business Profit Tax (BPT), a Personal Income Tax


(PIT), a tax on Sudanese residents abroad and various stamp duties. Indirect taxes (customs duties, VAT and excise taxes) accounted for about 80 percent of total tax revenue, with taxes on international transactions dominating. There are indications that the tax system in Sudan is fragmented, unevenly applied and suffers from widespread exemptions and tax holidays that limit the effectiveness of the existing regime. This negative scenario was aggravated by the gains from the oil sector during the period 1999‐2010. Table (4.1) Sudan Tax Effort Compared with Some LDCs

2001

2002

2003

2004

2005

2006

Average 2001‐06

(in percent of GDP) Sudan

5.5

5.4

5.8

7.5

6.9

6.3

6.2

Algeria

9.3

10.6

10.0

9.5

8.5

8.2

9.4

Egypt 2/

13.4

13.4

13.3

13.8

14.1

15.9

14.0

Kenya 2/

16.5

15.9

16.6

17.0

18.0

16.6

16.8

Nigeria

17.2

14.2

15.0

16.6

16.8

16.1

16.0

Yemen

7.3

7.3

7.1

7.3

7.3

6.6

7.2

Unweighted average

12.7

12.3

12.4

12.8

12.9

12.7

12.7

Source: IBRD, 2007


This state of affairs calls for improved revenue collection and tax administration in Sudan. A number of significant reforms have been introduced in recent years, but Sudan’s non‐oil revenue base remains thin. Reform of both direct and indirect taxes remains to be vital towards achieving medium‐term fiscal sustainability as well as non‐inflationary domestic financing, especially in the aftermath of the end of the oil decade. There is a critical need for a comprehensive tax administration modernization strategy, which articulates a vision for tax administration in the long term. Faced with the precarious consequences of the diminishing oil revenues, the government adopted a number of economic measures in June 2012 aimed at restoring the eroding fiscal balance. At the fiscal level, the policy measures implemented included enhancing revenue through increasing the VAT from 15 to 17 percent, raising the development tax from ten to 13 percent, increasing the business profit tax on the banking sector from 15 to 30 percent. It also included increasing stamp duties on financial transactions and international flights, repealing the negative list used to limit imports and imposing instead import tariffs and enhancing revenue collection and lifting discretional tax exemptions. As for expenditure, the measures adopted included the phasing out of fuel subsidies and strengthening social safety nets, liberalizing the price of sugar and consolidating ministries at all levels of government. On the social spending front, the government raised the salary of civil servants and pensioners by 100 SDG per month (about 40 percent of the minimum wage), more than doubled spending on social benefits and lowered custom duties on main staples and exempted medicine. However, due to the complete negligence of the traditional productive sectors in the economy, namely agriculture and industry, the fiscal, monetary and exchange rate measures taken were slow to bear the anticipated results. The average growth of six to seven percent, which characterized the economy for the period 1999‐2010 dropped to only two percent in 2012. The targeted inflation rate of 17 percent in 2013 was missed and the rate reached as high as 45 percent. The Sudanese pound lost more grounds against the dollar as the dollar was equivalent to SDG 7.3 by mid‐2013 in view of the deterioration of the current account deficit to an average of 6.9 percent of GDP during the period 2012‐2013 (IMF, 2012a). Despite the government's attempts to reform the system of direct taxes (such as streamlining the customs tariff framework), some elements are distortionary, discretionary and inequitable. Corporate tax incentives exacerbate existing distortions and inequities, narrow the tax base and undermine the overall tax effort. A key example of this is the unequal tax holidays and import duty exemptions to investors under the Investment Encouragement Act (IBRD, 2007). In particular, reform of the direct tax structure could include the rationalization of BPT rates and coverage in conjunction with a larger effort to eliminate exemptions and tax holidays.


The realization of the desired results from the fiscal reform may not be achieved before addressing structural limitations of the tax system. Indirect taxes account for the lion’s share of total tax revenue in Sudan, with customs duties representing the single largest component—and VAT a close second. This vital tax regime in Sudan suffers from widespread exemptions and an inadequate level of the VAT threshold. While customs duties play a critical role and account for about 33 percent of tax revenue, the regime has an excessive number of exemptions. In particular, efforts should continue to reduce tariff dispersion and the top tariff rate. It is estimated that current exemptions from the VAT reduce the revenue take by about 1.2 percent of GDP. Significant tax is also forgone by the dominance of the activities in the shadow economy which is estimated to be twice the size of the formal economy. In order to strengthen the process of non‐oil revenue collection, there is a need for a renewed effort towards reforming the tax administration and developing a comprehensive reform plan. Such a plan must include the development of an adequate information management system and the further development of human resources. Additional measures could include the reform of taxpayer compliance to avoid further evasion of taxes and the resulting need for a cumbersome administration (IBRD, 2007).

4.3 The Allocative Formula: An effective allocative formula should satisfy the following criteria:  Revenue adequacy: the sub‐national authorities should have sufficient resources, with the transfers, to undertake the designated expenditure responsibilities.  Local tax effort and expenditure control: formulas should ensure sufficient tax efforts by local authorities and should not support fiscal deficits.  Equity: transfer should vary directly with local fiscal needs and inversely with local fiscal capacity.  Transparency: the formulas should be announced and each locality should be able to forecast its own total revenue (including transfers) in order to prepare its budget.  Stability: The formulas should be stable for at least five years to encourage long‐term planning by sub‐national governments (Ma 1997). In Sudan, the federal transfers to sub‐national governments (states) include the following:  Current earmark transfers, which are allocated to wages, operations, and social subsidy and are determined by existing costs.  Block transfers, which are determined according to a formula based on weighting criteria including population size, minimum requirement for government responsibility, social development (health and education), and the states’ ability to collect own revenues.




Development transfers, which are determined on the basis of alternative indicators such as the states’ development neediness and absorptive capacity. However, the experience of the past reveals that the difficulty in identifying and quantifying the underlying indicators for the allocation of the federal transfers implies a significant variation in the implementation of development projects across states. This has resulted in the dissatisfaction of many states with the transfer mechanisms and their repeated demands for reform. Since the adoption of the federal system in Sudan in 1995, and until the INC in 2005, no clear indicators have been identified in the sharing of financial resources between the federal and states governments. Article (16) of the Presidential Decree No (12) of 1995, stipulates the setting up of the NSSF for states with the objectives of transferring resources from the centre to the states on a fair and equitable basis. In allocating transfers to the states, the Fund identified nine indicators which were adopted with the aim of achieving a fair and equitable system of transfers. Table (4.2) depicts these indicators and the weights attached to each of them. Table (4.2) Subsidies Indicators and Weights (1997‐2005) Indicator Financial Performance Population Size Human Resources Natural Resources Infrastructure Education Health Security Per Capita Income Total

Weight (%) 20 10 10 10 10 10 10 10 10 100

Source: States Subsidies Fund report, June 2006. In 2005, a specialized committee was formed by the Financial Allocation and Monitoring Commission (FFAMC) to revise the above indicators. The committee confirmed the said indicators and recommended slight modifications in the weights attached to some as shown in Table (4.3)


Table (4.3) Subsidies Indicators and Weights (2006‐2013) Indicator Financial Performance Population Size Human Resources Natural Resources Infrastructure Education Health Security Per Capita Income Total

Weight (%) 10 10 10 15 10 10 10 15 10 100

Source: States Subsidies Fund report, June 2006. The application of the amended formula for the allocation of federal transfers to states resulted in distributing the funds as shown in Table (4.4). Table (4.4) The States Share from Federal Government Support State Khartoum Red Sea Kassala Gadarif Gazira White Nile Sinnar Blue Nile North Kordofan South Kordofan North Darfur South Darfur West Darfur Nile Northern Total

Share (%) 4.7 6.6 6.8 6.3 5.8 6.1 6.3 7.6 7.7 7.1 7.3 7.2 7.9 6.0 6.6 100

Source: National States Support Fund From a pro‐poor perspective, one would expect NSSF current transfers to states to be strongly linked to poverty at the state level. However, available evidence reveals that there was no systematic relationship between the actual NSSF current transfers to states and poverty reduction. Rather, those transfers correlated more strongly with the state population size than with the percentage of rural population where most of the poor are situated (UNDP, 2006). Significantly, the above indicators are only applicable in determining the horizontal distribution of the federal subsidies. Different indicators are operational when considering allocations for development. These indicators include the needs of the various states, their development constraints and absorptive capacities. Table


(4.5) shows the indicators used for federal allocations directed to the states for development purposes (Suliman, 2006). Table (4.5) Development Allocations Indicators and Weights (2006‐2013) Indicator Strategic importance of the development project Extent of the project’s positive impact on man and animal Effect of non‐implementation on outward migration and security Whether project is part of the overall development plan of the state Impact of the project on local community and Poverty reduction Project implementation costs and the technical and financial execution abilities of the state Priority given to the less developed states Total

Weight (%) 15 15 15 15 15 15 10 100

Source: National States Support Fund A closer look at the federal development transfers to the states reveal that they do not seem to target reducing disparities between states. There are indications that these development transfers have been allocated on an ad hoc basis. As for the VAT grant, which is a portion of the VAT collected that is returned to the state of origin, evidence shows that the three relatively wealthier states (Khartoum, Gezira and Red Sea) received approximately 78 percent of VAT transfers in 2002 and 2003. Gezira, Gadaref and Sinnar received about 38 percent of Agricultural Compensation grants in both 2002 and 2003. As such, there is little evidence that such grants have an impact on reducing fiscal disparities between states. For most of the funds allocated to the states by the NSSF (current transfers, VAT allocations, and agricultural compensation grants), data paucity hindered the determination of their impact on poverty alleviation. Based on simple correlation coefficients, it appears that most of these transfers were not redistributive and did not reduce fiscal disparities between states (UNDP, 2006).

4.4 The Incidence of Vertical and Horizontal Imbalances: 4.4.1 Vertical Fiscal Imbalance (VFI):

In allocating resources vertically Sudan follows a pragmatic approach. Past level of revenues and expenditures of the federal government and states are considered as proxies for the required expenditure. It has been commonly accepted that expenditures are sticky on their path downwards, unlike revenues which can be increased with relative ease to meet the increasing demands for revenues especially from the states. Vertical allocation of revenue is approved by the council of FFAMC, which is composed of representatives of the federal government and finance ministers from all the states. Past experience reveals that more resources are transferred by the federal government to the states than the approved allocations to


meet acute difficulties eg, unforeseen state budget deficits and accumulated budgetary arrears (Hassan, 2013). The calculation of (VFI) is done using the following formula: VFI = 1 ‐ [ (R s / R) / (E s / E)] Where: VFI = Vertical Fiscal Imbalance Rs = State Revenue R = Aggregate Domestic Revenue Es = State Expenditure E = Total Expenditure (Federal Plus States) A value of zero for VFI indicates that states are autonomous in their decision‐ making as their expenditure and revenue share in the aggregate are the same. On the other hand, a coefficient close to one indicates absolute federal control over the states, as states’ revenue share is extremely small in aggregate, relative to the expenditure share (Adem 2001). The vertical fiscal imbalance, measured as the gap between own spending and own revenues at the state level, is very high in Sudan. Only about one‐third of states’ expenditures were mobilized from states’ own revenue sources in 2010 (IMF, 2012b). This contradicts the international evidence which reveals that sub‐national governments in developing countries finance up to 70 percent of their spending from own sources. The vertical fiscal imbalance has increased overtime due to a progressive devolution of spending responsibility, coupled with increasingly centralized revenue functions. Between 2000 and 2010, the VFI increased from 25 percent to 70 percent indicating that the disparity between spending and revenue decentralization has increased (Figure 4.4). This trend reflects increased expenditure decentralization on the back of declining revenue decentralization. The share of state expenditure in general government expenditure has risen from 19 to 26 percent, the revenue share has fallen from 23 to 14 percent (Figure 4.5) due to the limited capacity of states to collect own revenues, leading to an increase in states’ dependency on federal transfers. This unsatisfactory performance of states to mobilize own revenue is largely attributed to the lack of infrastructure and human capacity, and depressed economic activity due to security problems in some states. According to the states’ final account reports, the ratio of states own revenues to total revenues fell from 76.4 percent in 2000 to 38.9 percent in 2010. Furthermore, transfers to states (capital and current), which accounted for 7.7 percent of total central government expenditure in 2000, rose to 19.5 percent of total government disbursement in 2010 (Figure 4.5). About 57 percent of this increase occurred in 2005, with the signature of the CPA and the introduction of the Interim National Constitution. This underscores the fact that since the deepening of fiscal


decentralization in Sudan in 2005, federal transfers have been the predominant financial resource available for the states. Figure (4.3) Fiscal Decentralization and Vertical Fiscal Imbalance

Source: IMF, 2012b Figure (4.4) Federal Transfers to States

Source: MOF, States final account reports, and IMF staff calculations


Another notable feature of the states’ composition of revenues is the great variation across sub‐national governments, resulting in significant differences in vertical imbalances. While the average vertical fiscal imbalance during the period 2000‐2010 was approximately 70 percent, a large dispersion among states was observed. Whereas vertical fiscal imbalance registered 34 percent in Khartoum and the Red Sea, this ratio reached 89 percent in Blue Nile. This heterogeneity is largely attributed to the dispersion of expenditure across states, the standard deviation of expenditure being 43 percent higher than the standard deviation of own revenues. This indicates that, while there are significant differences in the capacity of states to raise own revenue, the latter varying from nine SDG per capita in North Darfur to 142 in Khartoum, the variation of expenditure across states is mostly determined by the amount of central transfers (IMF, 2012). 4.4.2 Horizontal Fiscal Imbalance: The allocation of federal revenues among the 18 states in Sudan is done through an index constructed to reflect the proposed share of every state in the increase in the allocated revenues. This approach intends to avail a level of revenue that meets states commitments in an equitable, transparent and credible fashion. A weighted average scheme is used to construct the index where suitable weights and criteria are selected, bearing in mind data limitation. The diversity of data necessitates normalization and standardization prior to computation. All variables are converted to ratios to overcome the diversity of units of the selected absolute variables. The horizontal allocation of revenues includes:  Revenues to meet current expenditure.  Compensation in lieu of abolition of states agriculture taxes by the federal government.  Revenues for state development (Capital expenditure) in addition to the federal development expenditure that may benefit states directly or indirectly. The index of the current revenue allocation is determined on the basis of the following variables: population, agriculture, security, education, health, fiscal performance, average distance from desirable locations, non‐budgeted sources. It is to be noted that the present indices for the allocation of revenues to the states are about three years old. There seems to be a scope for new indices to be constructed in view of the creation of new states and the recent developments in the economy of the states. The allocations to the local governments should be given special care in the quota assigned to the states in view of their role in the provision of education, infrastructure and addressing the causes of local conflicts. However, the modalities adopted in Sudan for the horizontal allocation of resources among the states reveal significant variation. Transfers per capita accrued to the top


recipient state were on average six times higher than the bottom recipient during the period 2000‐2010 (Figure 4.6). The Blue Nile, the River Nile and the Northern States are the highest recipients of federal transfers on a per capita basis, while North Kordofan, Red Sea and South Darfur figure at the lower end of the ranking (IMF, 2012). There is also evidence that the current mechanism for the allocation of national resources is not entirely transparent and leaves space for discretionary (political) allocations. It is not clear whether the current allocations for VAT and agriculture compensation is made on an annual derivation basis, or based on historic collection and agriculture production level estimates. In practice, the current transfers are largely allocated to assist in covering the rising public sector and security costs, or defined by a formula. While the former may distort incentives, hamper investments and limit the flexibility of state balances, the latter is based on criteria that are difficult to reproduce under the constraint of data paucity. This has led to discouraging the identification and applicability of a fair and equitable system. Consequently, some states expressed dissatisfaction at being under‐resourced on the grounds of their large population size and the spread of poverty. Figure (4.5) Per Capita Federal Transfers by State

Sources: States Final Account Reports, and IMF staff calculations

4.5 States Budgets and Fiscal Management: There is a solid conviction that accountable and autonomous sub‐national governments with adequately transparent budgets and sound fiscal management are indispensable for the realization of successful fiscal decentralization. Nevertheless, the available evidence reveals that fiscal performance of state and local governments in Sudan is characterized by detrimental weaknesses. As it has been shown in Section


(4.5), states’ own revenue mobilization capacity is very low. This major drawback is attributable to the following:  Poor infrastructure.  Inadequate capacity building for staff.  Insecurity hazards, especially in Darfur, Blue Nile and South Kordofan.  Insufficient diversification of markets for agricultural exports.  Underdeveloped financial facilities at state and local levels.  Lack of incentives for the private sector.  Prevalence of political consideration in the allocation of resources. A closer examination of the states’ budgets portrays a rising bias in favour of recurrent expenditure to the detriment of development expenditure. There is also an evident lack of transparency in the allocation of federal transfers which render these revenues unpredictable and hence limit their capacity for forward planning. This causes a disparity between expenditure responsibilities and revenue allocations, resulting in a widening gap between states' revenues and expenditures. The ultimate result is the hampering of budget execution, especially with regards to development expenditure targeting service delivery to the poor. As for financial management, there is no evidence of transparent guidelines for monitoring the roles and responsibilities of states and local governments. Furthermore, there are no transparent mechanisms from the states and local governments to show the destiny of the federal cash transfers. Evidence also reveals the lack of intergovernmental flow of functional information, which acts as a detriment to prudent fiscal management. A comparison between federal and state government accounts shows significant negative discrepancies between the consolidated transfers reported by states and the expenditure in transfers to states reported by the federal government, the latter reflecting the significantly rising trend since 2005. These administrative limitations and the lack of essential human skills, aggravated by the institutional drawbacks, have collectively acted as an impediment to the authorities' capacity to plan, execute and monitor state and local governments' budgets. Table 4.6 shows that the states own revenue during the period 2011‐2012. The total actual revenue showed an increase of 44 percent from SDG 2888.39 million to SDG 4149.41 million. This is partially attributed to the creation of two more states (Central and East Darfur) in 2012. The actual revenue for Central Darfur and East Darfur in 2012 amounted to SDG 140.26 million (FFAMC).


Table (4.6) States Own Revenue (2011‐2012) 2011 Planned Actual

State Red Sea

Rate (%)

Planned

2012 Actual

Rate (%)

306.38

191.30

62.00

2 51.91

266.27

106.00

432.24 131.5

193.96 114.70

45.00 87.00

334.96 125.5

360.34 111.90

107.50 89.00

123.81 1497.14

57.26 1360.45

46.00 90.08

139.38 2029.00

93.59 1983.19

67.00 97.07

122.92 94.05

129.16 95.92

105.00 102.00

154.29 106.82

134.32 116.96

87.00 125.00

Northern W Darfur

210 87.55 83.43

150.41 66.45 42.15

72.00 76.00 51.00

229.00 99.1 44.55

185.86 74.97 10.63

81.00 75.06 23.00

Al gadarif Kasala Nile River

139.95 155.25 133.32

110.55 133.73 110.94

79.00 86.00 84.00

198.84 195.81 175.47

155.30 153.86 181.17

78.00 78.05 103.00

W Nile Blue Nile

126.50 60.80

97.51 33.90

77.00 55.80

121.3 64.24

138.00 42.79

114.00 66.06

3709 298.73

35.70 104.56

94.00 35.00

8025.99

4149.41

51.70

Gezira S Darfur S Kordufan Khartoum Sinnar N Darfur NKorduf

E Darfur C Darfur

Total

3704.84

2888.39

74.47

Source: FFAMC


4.6 Fiscal Decentralization and Poverty Reduction: As explained in Section Three, a variety of factors have led to the prevalence of poverty and poor social indicators. The combination of prolonged civil war, natural disasters and a heavy debt burden, have contributed to both rising poverty and a erosion in the level and quality of social service delivery in recent years in Sudan. There is also an evidence of clear regional dimension to poverty in Sudan. Most surveys underscored the observation that the poorest states are those that are periodically hit by droughts, namely the Darfur and Kordofan states and the Red Sea. The thorough examination of the impact of fiscal federalism on poverty in Sudan requires the availability of consistent data involving the deconstruction of federal and state expenditure by functional classification. However, such classification is not consistently available for the entire period 1990‐2012, as the commencement of the 1990s witnessed the government's discontinuation of providing the functional classification of expenditure in the federal budget. Instead, it provided aggregate allocations of spending grouped in four chapters that obscure the conventional functional classification as follows (UNDP, 2006): Chapter I: This aggregate expenditure category consists of wages and salaries for all federal employees and the central government contributions to the Pension Fund and central government contributions to the Social Security Fund. Allocations to this category indicate the extent of involvement of the federal government in the provision of jobs in the economy. Chapter II: This expenditure category consists of goods and services purchased for governmental units. In addition, it includes social subsidies that directly benefit the poor, which are mainly directed to subsidizing electricity, free medication in emergencies, free medicines for kidney dialysis and heart disease, and support to poor students in higher education. Also included here are centralized obligations, which include internal debt, external debt, travel abroad, subscription in international organization, custom duties for government units, pipeline fees, training, replacement of equipment and emergency reserves. Chapter III: This expenditure category consists of current and development transfers to states, as well as agriculture tax compensation for states through the Federal Rule Chamber (FRC). These transfers are called Central Grant‐in‐Aid to the States. At the time, the states prepare their budgets (including revenue and expenditure estimates), the federal government finances their deficits through these transfers. They are strictly unconditional transfers, and the states are not required by law to report details of their spending to the federal Ministry of Finance and National Economy. Chapter IV: This expenditure category consists of national development expenditure, transfers of development funds to states, capital contributions in government projects financed by foreign loans and financing of agriculture. Allocations in this chapter for development are directed to maintain and sustain the


functioning of existing projects. Contributions in capital in late 1990s became significant as the government started to undertake some serious investments in oil sector projects. UNDP, 2006 found that during the period 1998‐2001, federal government in Sudan has systematically followed a pattern of spending that is not beneficial to the poor. Spending wages and salaries claimed an average of 25 percent of government expenditure, whereas social services that directly benefit the poor received a very modest share (3.8 percent) of total spending during 1998‐2001. As for the period 2001‐2003, the federal government allocated an average of 6.3 percent of total expenditure for social services (education 4.4 percent, health 1.6 percent, and water 0.3 percent). Transfers to states accounted for an average of 8.8 percent of government spending during this period, and state administration accounted for an average of 5.4 percent. During the same period, defense and security activities accounted for an average of 23.8 percent of government spending, while external and internal debt service accounted for nine percent and infrastructure expenditure averaged 9.9 percent. Consequently, UNDP in 2006 concluded that there is an imperative for restructuring federal expenditure to make it both growth enhancing and poverty‐reducing. Furthermore, IBRD (2007) observed weak performance of human development relative to income per capita. While per capita GDP in Sudan was an average of around $1,000 (25 percent higher than the Sub‐Saharan African countries), Sudan’s health outcomes put it on a par with countries nearer $400 per capita GDP. Rapid economic growth is relatively recent, and there is an associated delay in programs and policies having an effect. At the same time, a concerted effort is needed to ensure this opportunity is used to put the country on a path towards significantly improved pro‐poor outcomes. As such, there is a great need for improved fiscal decentralization with federal, state and local governments fulfilling their pro‐poor social service delivery responsibilities Nevertheless, pro‐poor spending in Sudan has relatively increased during the period 2000‐ 2006. During the period 2000‐2004, pro‐poor spending averaged approximately $16 per capita (19.3 percent of total federal expenditures and 2.8 percent of GDP). This was followed by a remarkable rise in federal poverty‐reducing expenditure which increased to $68 per capita in 2006 (24.8 percent of total central expenditure and 5.5 percent of GDP). Although this represented an encouraging increase, but was still below budget plans (6.6 percent of GDP). It is worth noting the average for HIPC countries (seven percent of GDP), and for neighboring Ethiopia (19 percent of GDP) and Uganda (11 percent of GDP).


Table (4.7) State Allocation of Current Expenditures by Chapters (2011‐2012) (SDG) 2011

Item

2012

Planned

Actual

Planned

Actual

Chapter I

844,828,085

12,857,269,351

560,549,985

437,714,361

Chapter II

321,182,238

254,876,024

247,171,888

132,046,632

Chapter III

1,402,593,492

23,628,976,342

1,140,803,575

256,665,458

Total Expenditure

2,568,603,815

36,741,121,717

1,948,525,448

826,426,451

Source: Ministry of Finance Table (4.7) shows that expenditure of the states on Chapter I, which is primarily wages and salaries, increased from 35 percent of total expenditure in 2011 (SDG 12,857,269,351) to 53 percent of total expenditure in 2012 (SDG 437,714,361). This indicates that the period following the secession of the South witnessed a new direction of state expenditure towards more spending on wages and salaries at the expense of pro‐poor development expenditure. Notwithstanding this reported trend in federal and states pro‐poor spending, there are a number of important remarks to be made. 1.

There is no reliable consistent information from the sub‐national governments about the quality of efficiency in utilizing these pro‐poor federal funds for their intended purposes.

2.

The growth in pro‐poor spending has occurred in the context of rapidly expanding total expenditures that characterized the oil decade. There are no indications that this rise in federal pro‐poor expenditure involved reallocation in level terms from other spending categories as all categories experienced real growth.

3.

There are indications that the increase in pro‐poor federal transfers reinforces the overall trend in pro‐poor spending which is skewed toward the federal level, suggesting under‐funding of poverty‐reducing expenditure at the state and local levels, where basic pro‐poor services are financed and delivered.

4.

The available evidence reveals that most of the federal share of pro‐poor spending was development‐oriented, while state pro‐poor spending has increasingly been allocated to recurrent expenditure (approximately 66 percent in 2006 and 53 percent in 2012). The dominance of recurrent pro‐poor spending (mainly wages and salaries) over development spending at the state level raises concerns, since improving service delivery to the poor in the longer term requires investment in schools, clinics, roads and water. The


relative emphasis on recurrent spending leaves little room for items that have a direct impact on the quality of services such as investments in facilities, equipment and capacity development (IBRD, 2007). 5.

The functional database compiled by the World Bank reveals that agriculture and livestock was the largest item on average, despite notable annual fluctuations. Total expenditure on infrastructure (roads and bridges, energy and electricity and water) averaged approximately 25 percent of federal pro‐ poor spending. A similar average was also observed for social subsidies.

6.

As health, education and water are constitutionally the responsibility of sub‐ national governments, their shares remained modest and stable at eight percent, four percent and 0.3 percent of total federal pro‐poor expenditure.

7.

Case studies targeting the functional classification of states' expenditure revealed that due to the eroded infrastructure, state spending on pro‐poor facilities remained far below what is needed to meet the MDGs. State‐level allocations to pro‐poor activities were mostly for general public services, reflecting support for wages and salaries.

8.

The extremely low level of states' investment spending in the health and education sectors, with over 95 percent allocated to current expenditure, is an issue of great concern. The desired pro‐poor service delivery requires much higher investment in health and education infrastructure.

9.

Limited progress toward the improvement of social indicators was observed, rendering a strong case for refocusing expenditure to those states with higher poverty rates. Trends in education, health and access to safe water reveal that nearly two decades of decentralization have not led to a visible improvement in pro‐poor social service delivery in Sudan.

10.

The experience of decentralization in Sudan might affect poverty directly through regional targeting of transfers and indirectly through higher efficiency in local public service delivery and the related growth effect.

4.7 Addressing Inter‐State Spill‐Over Effects of Pro‐Poor Expenditures: By their nature, some pro‐poor states' expenditure results in spill‐over effects (externalities) on other states. These expenditures include water and air pollution control, inter‐state roads, higher education (graduates may leave for other states to work), hospitals may be used by neighboring states, etc. Hence, the spread of the benefits of certain pro‐poor projects beyond a state's jurisdiction may discourage such a state from investing in such projects. It follows that the federal government needs to provide incentives or financial resources to address the problems of under‐ provision of such essential pro‐poor projects. Under these circumstances, federal conditional grants are called for to address spill‐over effects. These federal subsidies can take the form of matching


open‐ended grants. For example, a grant might indicate that whenever a state government spends a dollar on education, the federal government will contribute a dollar (or fifty cents) as well. The open‐ended characteristic of the grant implies that the federal government's support will continue without limits. In some cases, federal governments may attach a ceiling by specifying some maximum amount that it will contribute. This mechanism is referred to as closed‐ ended matching grant. Most countries resort to this approach to matching grants for budgetary reasons. In some countries, the total sum of matching grants is limited by the federal government selection criteria. Spill‐over effects need to be recognized in the design of inter‐governmental transfers. The extent of cost compensation by federal governments should be consistent with the degree of the spill‐over. It is argued that a variable matching grant involving a lump sum may be an appropriate form of compensation to retain equity. This grant is considered more effective in inducing a change in the output level of local authorities. It is further argued that it is important to include spill‐over effects in the assessment of local spending needs in order to ensure inter‐ jurisdictional equity (G/Egziabher et al, 2009). It is to be emphasized that the design of an equitable mechanism to address spillover effects in the allocative formula requires data on a list of variables, such as the number of out‐of‐state beneficiaries, unit cost accounting and the type of pro‐poor services rendered. In Sudan, specific conditional grants, which constitute important transfers for addressing spillover effects, appeared to decline through 2005, then increased remarkably in the 2006 budget (from SDG 55 to 364 million). However, a series of non‐transparent special grants can be problematic, and individual specific grants should have a clear policy goal. Policy work is needed to identify the demand and appropriate design for a limited number of this type of transfer (IBRD, 2007).


5‐

Challenges and Constraints to Pro‐Poor Fiscal Decentralization In Sudan Fiscal decentralization has been on the policy agenda of Sudan since its independence in 1956. It was mainly driven by political pressures motivated by multiple ethnicities and wide regional disparities in incomes and resource endowments. Decentralization pressures reflected a desire for more participatory government and a greater voice for local constituents in the allocation of budgetary resources. As such, since 1995, efforts have been exerted in Sudan to design intergovernmental fiscal arrangements that can assist in realizing the desired political objectives. This, however, proved to be a formidable task as fiscal decentralization is one of the more complex areas of public finance, since it spans a number of policy and institution‐building issues, requiring careful coordination and sequencing. Further complications are exercised by the strong influence of historical, political, and social, as well as economic, forces that characterized the various regions of Sudan. Under such circumstances, the Sudanese experience with fiscal decentralization, which spanned nearly two decades, faced a number of challenges and constraints. The complexity inherent in the fiscal decentralization process in Sudan was further aggravated by its cross‐cutting impact, which arises from its far‐ reaching impact on a wide range of issues, including service delivery, poverty reduction and macroeconomic stability For policymakers, who often have little control over the political genesis or pace of fiscal decentralization, the challenge is to implement it in a way that ensures the stability, efficiency and equity of the economic system. In identifying the lessons learned and the challenges that face fiscal decentralization in Sudan, the following observations may be made:

5.1 Inappropriate Sequencing of Federal Resource Availability and States' Spending Responsibilities: The experience of fiscal decentralization in Sudan reveals lack of appropriate sequencing between availing the resources to the states and assigning them the spending responsibilities. It has been observed that spending mandates were handed down to the states without adequate provision of resources, leading to a significant deterioration in the quality of the decentralized pro‐poor public services.

5.2 Inadequate Adherence to the Federal and States' Roles in the Provision of Pro‐Poor Social Services: The experiences of Sudan in this area, as outlined in Chapter IV reveals the lack of adherence to the responsibilities of each level of government as specified in the constitution. States have continuously failed to comply with their obligation to provide the primary education and health services assigned to them.


5.3 Lack of Complementary Policy Reforms in the Civil Service and Regulatory Frameworks: The practice of fiscal decentralization in Sudan, which lasted for nearly two decades, has been characterized by a deteriorating level of pro‐poor social services in health, education, infrastructure and water. An important factor behind this unsatisfactory performance has been the inadequate scope for geographic or functional mobility of qualified civil servants. Similarly, the devolution of subsidized public services (e.g., utilities) to local governments has not led to a reduction of subsidies. On the contrary, the lack of regulatory framework (like price adjustment by local authorities) has resulted in the deterioration of such services.

5.4 Inadequate Capacity Building to Enhance Transparency in Budget Processes: A close examination of the states’ budgets portrays a rising bias in favor of recurrent expenditure to the detriment of development expenditure. There is also an evident lack of transparency in the allocation of federal transfers which render these revenues unpredictable, and hence limit their capacity for forward planning. This causes a disparity between expenditure responsibilities and revenue allocations, resulting in a widening of the gap between states' revenues and expenditures. The ultimate result is hampering budget execution, especially with regards to development expenditure targeting service delivery to the poor. The realization of the potential efficiency gains of fiscal decentralization in the provision of pro‐poor public goods and services in Sudan requires significant investments in capacity‐ building and improvement of performance fiscal management systems at the states level, in particular aiming at improving transparency of the budget process in all its phases.

5.5 Lack of Sufficient Own and Transferred Federal Resources Hampered the Implementation of an Effective "Hard Budget Constraint" on the States: The entire period of decentralization in Sudan witnessed a persistent and significant disparity of spending needs and resources of the states. Overt time, this led to an inadequate provision of satisfactory public services, and to fiscal indiscipline (typically resulting in inappropriate resort to borrowing, or accumulation of arrears). It should be conceded, however, that a great difficulty was encountered in assessing the spending needs of the states in the absence of reliable information on cost‐ effectiveness of spending programs at all levels of government.


5.6 Failure of Federal Control of States' VAT Resources in Adhering to Equity Requirements: It has been observed that the VAT grant, which is a portion of the VAT collected by the federal government that is returned to the state of origin, is not distributed fairly. The three relatively wealthier states (Khartoum, Gezira and Red Sea) received approximately 78 percent of VAT transfers. Under such circumstances, the federal control over a portion of states resources failed to promote accountability of the states to their constituents, which has negatively affected fiscal responsibility and tax compliance.

5.7 Failure of Intergovernmental Transfers to Offset Fiscal Vertical Imbalance: The vertical fiscal imbalance has increased overtime in Sudan due to a progressive devolution of spending responsibility coupled with increasingly centralized revenue functions. Between 2000 and 2010, the vertical fiscal imbalance increased from 25 to 70 percent indicating that the mismatch between spending and revenue decentralization has increased. This contradicts the international evidence which reveals that sub‐national governments in developing countries finance up to 70 percent of their spending from own sources. In Sudan, however, the share of state expenditure in general government expenditure has risen from 19 to 26 percent, while the revenue share has fallen from 23 to 14 percent due to the limited capacity of states to collect own revenues leading to an increased states’ dependency on federal transfers. The vertical fiscal imbalance phenomenon is likely to worsen in view of termination of the "oil decade" following the secession of the oil‐rich southern part of Sudan.

5.8 Failure of Intergovernmental Transfers to Moderate Fiscal Horizontal Imbalance: The modalities adopted in Sudan for the horizontal allocation of resources among the states reveal a significant variation. Transfers per capita accrued to the top recipient state were, on average, six times higher than the bottom recipient during the period 2000‐2010. The Blue Nile, the River Nile and the Northern States are the highest recipients of federal transfers on a per capita basis. On the other hand, North Kordofan, Red Sea and South Darfur figure at the lower end of the ranking. There is also evidence that the current mechanism for the allocation of national resources is not entirely transparent and leaves space for discretionary (political) allocations.


5.9 Rising Risk of States Incurring Debt Obligations Leading to Massive Federal Support in the Form of Extraordinary "Bailouts": Article 11C of the Interim National Constitution allows states to resort to borrowing to bridge the gap between their limited revenue sources and their escalating expenditures. This raises the concern that fiscal decentralization may weaken fiscal discipline to the extent that states may undertake commitments or incur debt obligations that subsequently result in massive federal support, in the form of extraordinary transfers, or "bailouts." Such bailouts could in turn cause national fiscal imbalances, excessive borrowing, and macroeconomic instability.

5.10 Weak Fiscal Institutions and Inadequate Social Service Delivery Failed to Reduce Inequality and Poverty: Despite efforts to regulate the institutional relationship between MOFNE, NSSF, FFAMC, states and local governments, the role of each is yet to be fully comprehended by all stakeholders. The frequent lack of transparency and accountability has often constrained the realization of the desired objectives. The observed weakness in fiscal institutions and inadequate social service delivery has so far been ineffective in reducing inequality and widespread poverty.

5.11 Paucity of Data Impeded Designing Effective Intergovernmental Equalization Transfers Formula: The determination of the extent and efficacy of fiscal federalism in Sudan is facing a daunting challenge in the form of data paucity. The absence of the necessary data on relevant local fiscal, demographic and socio‐economic variables hindered the quantification of local expenditure needs and fiscal capacity. This acted as a major predicament to the efforts aiming at designing formula‐based equalization grants in an efficient, equitable and transparent manner. Furthermore, the design of an equitable mechanism leading to address spillover effects in the allocative formula requires data on a list of variables, such as the number out‐of‐state beneficiaries, unit cost accounting and the type of pro‐poor services rendered. As such, data becomes an additional hurdle in the implementation of a sound system of fiscal decentralization in Sudan. It is to be emphasized that the thorough examination of the impact of fiscal federalism on poverty in Sudan requires the availability of consistent data involving the decomposition of federal and states expenditure by functional classification. However, such classification is not consistently available for the entire period 1990‐ 2012, as the commencement of the 1990s witnessed the government's discontinuation of providing the functional classification of expenditure in the federal budget.


Instead, it provided aggregate allocations of spending grouped in four chapters that obscure the conventional functional classification. Consequently, some states expressed dissatisfaction about being under‐resourced on the grounds of their large population size and the spread of poverty.

5.12 Inadequate Transparency in the Federal Allocation of Resources Hampered Legitimacy, Violated Equitability and Weakened Budgetary Processes: An effective allocative formula should satisfy the following criteria: revenue adequacy, local tax effort and expenditure control, equity, stability and transparency. Since the adoption of the federal system in Sudan in 1995, and until the Interim National Constitution (INC) in 2005, no clear indicators were identified in the sharing of the financial resources between the federal and states governments. Article (16) of the Presidential Decree No (12) of 1995, stipulates the setting up of the NSSF for states with the objectives of transferring resources from the centre to the states on a fair and equitable basis. In allocating transfers to the states, the Fund identified nine indicators which were adopted with the aim of achieving a fair and equitable system of transfers. From a pro‐poor perspective, one would expect NSSF current transfers to states to be strongly linked to poverty at the state level. However, available evidence reveals that there was no systematic relationship between the actual NSSF current transfers to states and poverty reduction. Rather, those transfers correlated more strongly with state population size than with the percentage to the rural population where most of the poor are situated.

5.13 Meager Effort Focus Federal Transfers to the Poorest States to Enable More Targeted Development Spending and Reduce Inequality Across States: There are observed indications that federal development transfers to the states have not targeted a reduction in disparities between states. Evidence shows that development transfers have been allocated on an ad hoc basis. As for the VAT grant, which is a portion of the VAT collected that is returned to the state of origin, the three relatively wealthier states (Khartoum, Gezira and Red Sea) received approximately 78 percent of VAT transfers in 2002 and 2003. Gezira, Gadaref and Sinnar received about 38 percent of Agricultural Compensation grants in both 2002 and 2003. As such, there is little evidence that such grants have an impact on reducing fiscal disparities between states. For most of the funds allocated to the states by the NSSF (current transfers, VAT allocations, and agricultural compensation grants) data paucity hindered the determination of their impact on poverty alleviation. Based on simple correlation coefficients, it appears that most of these transfers were not redistributive and did not reduce fiscal disparities between states (UNDP, 2006).


6‐

Overview of Experiences and Lessons From Selected Countries Comparative studies on fiscal decentralization in developing countries reveal that most countries have several tiers of government. In addition to the federal level, many countries have two sub‐national levels: provincial (state) and local governments (Table 6.1). Lower levels of government often undertake important fiscal functions, both on the revenue and the expenditure sides. In such federal systems various forms of fiscal arrangements between the federal and lower levels determine the way in which taxes are allocated and shared among the various levels of government, and how funds are transferred from one level to another (Fjeldstad, 2001). Thus, intergovernmental transfers, both vertical (between levels of government) and horizontal (within levels) are important for the development and operation of an efficient and effective public sector. Table (6.1) The structure of Sub‐national Governments in Selected Countries Country Sudan

Intermediate

Kenya

17 (states) 9 (regions) 2 (city Admn.) 66 (zones) 39 (country councils)

Malaysia

13 (states)

Mozambique South Africa Tanzania

10 (provinces) 9 (provinces) 21 (regions)

Uganda

45 (districts) 13 (municipalities)

Ethiopia

Local

44 (local councils) 185 (municipalities) 550 (woredas)

52 (municipal, town and urban councils) 143 (city, municipal and district councils) 33 (municipalities) 850 (local authorities) 92 (district councils) 18 ( municipal and district councils) 1 (city council) 950 (sub‐countries) 39 (municipal divisions) 51 (town councils)

Source: IBRD, (2000) It has been observed that the organization of intergovernmental fiscal systems varies from country to country. These variations are normally a reflection of historical and geographical characteristics of each country, the degree of heterogeneity of the population and the role the government plays in the economy. This diversity among countries resulted in a wide range of differences on the systems adopted for the resolution of inter‐governmental structures and functions. Notwithstanding the complications inflicted by this diversity on broad generalization, reference to the relevant experiences of other countries remains the only guidance available. Despite its limitations, the experience of other countries provides useful


lessons in assessing the potential strengths and weaknesses of intergovernmental fiscal systems in Sudan. This chapter addresses some of the key issues that are of general relevance with respect to intergovernmental transfers in Sudan. The objective is to derive some lessons that should be taken into consideration in reforming the system of federal transfers to the states. Four main issues represent the focus of concern with respect to intergovernmental functions and finances in the countries selected. The first issue addresses the vertical fiscal imbalance. The second addresses the horizontal fiscal imbalance. The third deals with the issue of matching grants. The fourth addresses the role played by fiscal transfers in poverty alleviation.

6.1 Vertical Fiscal Imbalance: Vertical fiscal gaps in developing countries may be bridged through the following ways: transferring revenue‐raising power to local governments; transferring responsibility for expenditures to the central government; or reducing local expenditures/raising local revenues. In the majority of developing countries, the disparity between revenues and expenditures of lower level governments is shouldered by the transfers from the central government. Experience with fiscal federalism in almost all developing countries reveals that central governments assign more expenditure functions to sub‐national governments than can be financed from the revenue sources allocated to those governments. These results in a mismatching of functions and finances – often referred to as ‘vertical imbalances’. The general outcome is that sub‐ national governments in developing countries are generally dependent upon transfers from higher levels of government. This imbalance provides the basic rationale for a system of transfers to assist in bridging the fiscal gap. A number of methods are used by these countries to close the fiscal imbalances of sub‐ national governments, the most commonly‐used methods are systems of revenue‐ sharing and grants. As for revenue sharing, it has been common practice that central governments in developing countries keep the major taxes, especially the corporate income tax, multistage taxes such as the VAT and taxes on foreign trade. In its effort to fill the vertical fiscal gap, the central government gives lower levels of government a share of the major national taxes collected in its jurisdiction. On their part, the sub‐national governments may assist in revenue mobilization by providing information on local taxpayers, and thereby increasing the pool of tax revenues. The sharing of tax revenues can be done either on a tax‐by‐tax basis or on the entire pool of central government tax revenues. Argentina, Brazil and Pakistan provide an example of the first kind. The common practice for the distribution of shared revenues among sub‐national governments is the adoption of derivation approach, whereby each jurisdiction gets the same share of the revenue collected in its area (Fjeldstad, 2001). The tax‐by‐tax sharing arrangement has been subject to two criticisms. First, it may give the central government an incentive to concentrate its collection and enforcement efforts on the taxes that are either not


shared or shared to a lesser degree (Ahmad, 1997). Second, it may encourage the central government to focus increases in rates on the shared taxes, which may result in distorting the tax system. Hence, revenue sharing based on the entire pool of government revenues may be preferable for developing countries. Furthermore, grants are also widely used by developing countries as another method to close the vertical imbalance. Three broad categories of grants are commonly used as follows:

6.1.1 Unconditional Grants: Ghana uses a system where at least five percent of total central government revenues are to be allocated to a ‘Common Fund’ for the disposal of sub‐national governments. In Uganda, unconditional grants are determined annually with reference to the reassignment of tasks between the national and sub‐national governments. The total amount is calculated on the basis of a formula that includes the unconditional grant of the previous year, corrected by the increase in the general price level, plus the net change in the budgeted costs of running newly devolved or subtracted services. Ethiopia uses a system that starts with estimates of total resources available from tax and non‐tax revenue and counterpart funds. The national government allocates the total pool between itself and the regional governments on the bases of a formula that has been subject to frequent changes since its introduction in 1995.

6.1.2 Conditional and Equalization Grants: The experience of developing countries reveals that the provision of conditional block grants from the centre to sub‐national governments has been a major factor in decentralization reforms. The conditionality attached to grants is imposed by the central government to ensure that sub‐national governments allocate the funds transferred to finance certain pro‐poor services, such as primary education, primary health, water supply, agricultural extension and roads. These grants are normally directed to finance recurrent costs only. Although the earmarking of the grants limits the decentralization process, it is largely justified on the basis of its positive distributional consequences in ensuring minimum nationwide standards for the provision of pro‐poor services. In this sense, the transfers are referred to as ‘equalization grants’ (used to address horizontal imbalances between sub‐national governments with the effect of closing the vertical fiscal gap). In order for the block grant system to operate efficiently, authorities should ensure the preservation of accountability, and predictability. The practice of fiscal decentralization in many developing countries has been characterized by the lack of accountability. These often relate to the absence of internal audit, poor reporting systems and noncompliance with established financial regulation. It has been observed that in


Tanzania some local authorities divert large shares of the grants disbursed for the education and health sectors to other uses. As for predictability, sub‐national governments in Tanzania often experience delays and irregularities in the receipt of grants. The lesson learned out of this experience is that capacity building in financial management and monitoring are essential for the success of central controls on the destiny of the grants transferred.

6.1.3 The Macroeconomic Consequences of State Borrowing: The practice of fiscal decentralization in developing countries shows that the devolution of revenues and spending responsibilities to sub‐national jurisdictions has often resulted in curtailing the capacity of the central government to carry out stabilization and macroeconomic adjustment through the budget. The situation is worsened when sub‐national governments face no hard budget constraints. Central governments' intervention for bailing‐out sub‐national governments when in financial difficulty often weakens the incentives for sub‐national governments to economize on costs, and can generate resource waste and rigidity within local authorities. This can trigger macroeconomic imbalances typically manifested by the resort of sub‐ national governments to borrowing to close the gap between revenues and expenditures. The reported lack of stability and transparency in the fiscal system in African countries prompted the resort to formula‐based revenue‐sharing and other transfer systems. However, many African countries, adopting the formula‐based transfer system, encountered a number of problems. These problems include: frequent changes in the allocation formula; use of variables reflecting discretionary policy choices made by the recipient sub‐national governments; little attention paid to equalization; and few incentives to increase own revenue generation by lower level governments (Brosio, 2000).

6.2 Horizontal Imbalance: Many developing countries experience fiscal horizontal imbalance arising from the variation in geographical areas with respect to resource capacity and needs. The tax base per capita in these countries often differs between urban municipalities and district councils. Nevertheless, the needs for public services may differ between jurisdictions, according to the age composition of its population. Several complications are encountered in the design of fiscal institutions to cope with the socio‐political repercussions of attempting to treat the most unequal jurisdictions uniformly. This is often exacerbated by historically rooted conflicts and rivalries between various jurisdictions and population groups. Under such circumstances, fiscal decentralization has to major concerns namely: the horizontal equity between states and within‐state equity. The handling of these problems is often left to equalisation grants to channel funds from relatively wealthy jurisdictions to poorer ones.


Such transfers are often based on an equalization formula that measures the ‘fiscal need’ and ‘fiscal capacity’ of each jurisdiction. The formula is intended to allocate higher transfers to the jurisdictions with the greatest fiscal need and the least fiscal capacity. Experience in many African countries reveals that formula‐based transfers may encourage sub‐ national authorities to understate their tax bases or relative wealth in order to maximize transfers from the central government. Although efforts have been exerted in developing countries to handle the problems of horizontal imbalance between states, differences among individuals within a local authority or province remain a major point of concern. The redistribution among regions alone will not bear fruit, unless it is accompanied by appropriate internal redistributive measures. This shifts the responsibility onto sub‐ national jurisdictions to engage in redistribution. It follows that the harmonization between national and sub‐national efforts is essential for the success in targeting the poor segments of the population. In general, the main responsibility for poverty alleviation and income distribution should remain at the central government level, partly to secure a national standard level of public goods and services. However, provinces and local authorities can play important roles through the delivery and management of social services. Nonetheless, the central government needs to retain a monitoring role to ensure that redistributive goals are satisfied (IBRD, 2000). The international experiences on transfer allocation criteria reveals that most countries are using indicators on population as a proxy for expenditure needs. Many countries are using various proxies for costs of the service provision, like the density of the population/land area and cost indexes. Other countries are using various poverty indices and measures for the backwardness of certain areas. A number of countries use performance‐related measures. For instance, Uganda uses performance measures applied in the allocation of development grants, Kenya uses performance on introduction of new financial management and accounting reforms, Tanzania uses administrative performance/pilot testing with certain districts, Ghana and Pakistan uses tax effort. More efforts are exerted in developing countries to introduce a link between the size of the central transfers and the administrative/financial performance of the local governments to encourage better administration and financial performance in sub‐national governments (Uganda, 2003). The data constraint, however, has prompted most developing countries to rely on limited criteria for the allocation on central government transfers (often 1‐4 criteria). In Malawi for instance, the first 30 percent of District Development Fund (DDF) is allocated to district councils based on the “equal shares” principle. This reflects the assumption that all districts – regardless of population size and other characteristics ‐ are assumed to have a certain fixed need for capital infrastructure. Allocation of the remaining 70 percent of the DDF is based on four equally weighted factors namely: population, land area, illiteracy, and infant mortality.


In South Africa, the 1996 constitution provides for the nationally collected revenue being vertically divided into the three layers of government, ie national, provincial and local government. The allocation of transfers is not formula‐based. It is largely based on political judgment driven from historical expenditure patterns, including fiscal capacity, expenditure efficiency, developmental needs, service backlogs and national priorities such as the fair distribution of critical services like water, housing and electricity.

6.3 Matching Grants: After devising the mechanism for distributing the central government transfers to the sub‐national governments through the allocative formula, fiscal decentralization determines whether the transfer should be made conditional on the provision of certain services at specified levels. The fungibility of money entails that even if the central transfers are allocated solely on need and capacity basis, there is no guarantee that the recipient governments will use the funds as desired by the central government unless receipt is closely monitored. Past experience has shown that a certain level of conditionality is indispensable, particularly when important national services such as education and health are provided by local governments. Although matching (or conditional) transfers reflect the dominance of the central government over the sub‐national governments, they enjoy the important political advantage of ensuring the local involvement, commitment, accountability, and responsibility for the aided activities. The experience of developing countries with matching grants reveals only limited success. This is attributed to the focus of many developing countries on re‐ distributional concerns, rather than efficiency concerns in determining the matching transfers. Accordingly, poor localities may get more assistance because of their poverty, not because a higher matching transfer induces them to produce the socially‐ optimal amount of the service in question. Another important problem with the matching approach in developing countries is its high demand for consistent data and regular flow of information, which are lacked in most countries. In Ethiopia, for instance, the experience with spill‐over effects is confined to Dire Dawa and Harrari regional state. Approximately 15 percent of expenditures on health and education were estimated to be spill‐over effects due to services provided to non‐residents in the adopted 2007 grant formula. The basis and the approach for such determination are not clear. In the design leading up to a formula to address spillover effects, data will be sought on a list of variables, such as the number of out‐of‐region/area beneficiary population, unit cost accounting and type of services rendered (G/Egziabher, 2009). In Zambia and Korea matching rates are differentiated according to characteristics of the recipient regions. The transfers received by sub‐national governments equal 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. Similarly, the fundamental problem with this transfer


mechanism is that it is highly information intensive. Many other developing countries allocate transfers using a formula intended both to equalize public expenditures in sub‐national jurisdictions with differing needs and capacities and to stimulate local fiscal efforts, although severe data paucity hampers the parameters employed in such formulas. Simpler approaches used in Morocco and Colombia through using proxies such as population and a simple ‘‘categorization’’ of localities (by size, by type, perhaps by region) have sometimes proved to be helpful guides to general expenditure needs. Even if information is abundant as in developed countries, it is still difficult to determine the precise matching rate appropriate for particular expenditure programs, let alone how those rates should be varied in accordance with the very different characteristics of different sub‐national governments. It follows that, despite the evident theoretical appeal of matching grants, the practical experience of many countries reveals that conditional transfers seem to have diminished the fiscal efficiency of sub‐national governments (Bird and Smart, 2002). Another important component of the central transfers to sub‐national governments is that directed towards financing local capital investment. The significance of these transfers stems from the government's desire to externalize the benefits from these investments and the fact that some of the projects financed may constitute essential ingredients of national development programs. Efforts to improve the transfers for financing capital investment in developing countries need to give active consideration to the following measures:  Sub‐national governments should have an articulated investment and maintenance plan.  The transfers to sub‐national governments should be allocated on objective basis away from political influences.  The selected investment projects should be subjected to cost‐benefit analysis.  The capacity of sub‐national governments should be enhanced to be capable of mobilizing financing, managing construction, and operating the project efficiently.  The central government should devise an efficient system of monitoring and evaluation for the activities financed.  Sub‐national governments should assist the central government in assessing their future financing needs.

6.4 Poverty Alleviation: One of the main arguments for fiscal decentralization is the role that can be played by sub‐national governments in delivering pro‐poor social services financed largely through fiscal transfers from the central governments. The design of such transfers in developing countries is based on two different mechanisms. The first one is the "federalist" approach which entails providing simple lump‐sum transfers, with no conditionality other than the usual requirements for financial auditing to ensure


that all regions have adequate resources to provide such pro‐poor services at acceptable minimum standards. This approach believes that it is neither necessary nor desirable for the central government to attempt to influence local expenditure patterns. The second mechanism is the "conditionality" approach which assumes that sub‐national governments are merely agents for the central government to execute national policies, such as in providing primary education and basic health services. Accordingly, the transfers are made conditional on the funds actually being spent on the achievement of a certain standard of pro‐poor social services. The strategies used for poverty alleviation vary from one developing country to another depending upon political, economic and administrative parameters (Bird and Rodriguez, 1999). Some countries emphasize improving the productivity of the poor through increasing their level of human capital and improving access to markets and resources. Others focus on social safety nets through delivering to the poorest members of society the minimal services and resources needed for human life. Both strategies rely on sub‐national governments to assist in delivering the pro‐poor services to targeted segment of the population.

6.4.1 Pro‐Poor Health Services: Decentralization has long been advocated as a desirable process to improve pro‐poor health systems, service quality and coverage through contributing to achieving greater equity, efficiency and quality in health spending, including improved efficient resource management and accountability (Boex et al, 2006). Fiscal decentralization for health service delivery has been favored in many developing countries as it permits a closer flow of information and interaction between health service providers and recipients. Evidence from developing countries reveals that successful health decentralization policies have led to the desired results, whereas poorly designed decentralization has serious consequences for health service delivery. Improvements in healthcare services should help fighting poverty due to the bi‐ directional relationship between economic growth and health status. Better health enhances income by improving productivity, while higher economic growth allows better human capital formation and better health outcomes (Gupta and Mitra, 2004). Empirical investigation on the impact of health decentralization on outcomes for the poor has not been conclusive. In some cases, the decentralization of health services rendered positive results, while in other cases there has been no significant impact on responsiveness to the poor and development orientation (Sekher, 2005). When health care services are devolved in the absence of corresponding intergovernmental transfers, local authorities will be required to charge user fees and mobilize substantial own local resources to improve local services. Consequently, decentralization of healthcare services can place a substantial fiscal burden on poor areas and communities, unless the central government provides equalizing resources through the transfer mechanism.


The district health care in Burkina Faso, and municipal health care programs in Brazil, are successful examples of how health decentralization has benefited the rural poor (IBRD, 2004). Other success stories are linked to hospital autonomy and privatization, which mostly relate to increased accountability, lower staff absenteeism, and better allocation of funds (Boex et al, 2006).

6.4.2 Pro‐Poor Basic Education Services: The improvement in the efficiency, effectiveness and equity in the provision of basic education stands as a main justification for basic education decentralization in developing countries. Decentralization enables a relationship of accountability between the users of public services and providers. The benefits of decentralized education contribute both directly and indirectly to sustainable economic development and poverty reduction. Education provides knowledge, skills, values and attitudes that increase productivity, employability and knowledge to improve quality of life. Empirical evidence reveals that the return to investment in education is higher for primary education, followed by secondary and higher education. In Sub‐Sahara African countries the return on investment in primary, secondary and higher education has been estimated at 24, 18 and 11 percent, respectively (IBRD, 2005). In practice, governments in developing countries are faced with the challenge of electing which government level to devolve responsibility and decision‐making authority for primary and secondary education. The actual provision or delivery of basic education is often characterized by decentralized provision, whereby sub‐national governments are responsible for assuring the actual provision of education. Empirical studies have generally shown that education decentralization in developing countries has contributed to improvements in access to education (El Salvador and Nicaragua); student learning (El Salvador and Nicaragua); student attendance (India); teacher attendance (El Salvador, India, and Nicaragua); and education quality including poor and rural poor areas in these countries (Boex et al, 2006). In particular, the case of Educo schools in El Salvador has become a world model on successful improvement in access to education, quality, and accountability, particularly to the poor, through the devolution of responsibilities to lower levels of government, including schools and the community. Another example of success is a community‐government partnership in Madhya Pradesh (India) named the Education Guarantee Scheme (EGS) which has successfully established 31,000 new schools and enrolled two million additional children, many from the poorest groups in society, while at the same time reportedly reducing the unit cost and improving the quality of the education provided in only few years (Boex et al, 2006).


6.4.3 Agricultural Services: The demographic structure of the majority of developing countries reveals a strong link between sound agricultural programs and poverty reduction, as the majority of people still live in rural areas. Thus, to the extent that agricultural extension and support programs are effective in increasing agricultural production, these programs directly increase the earning potential of poor rural households. Decentralization can improve the level of efficiency in local jurisdictions by assuring that the agricultural extension services that are provided respond to local needs. In that sense, decentralization enhances the utilization of local knowledge, local participation and ownership by using local resources. Furthermore, decentralization has the potential to enhance transparency and accountability in the delivery of agricultural services, allowing local governments and community groups to more closely monitor service providers in order to reduce shirking by extension workers and to ensure that extension services are timely delivered.

6.4.4 Socio‐economic Infrastructure: Experience in many developing countries shows the development of local socio‐economic infrastructure from the center has resulted in inefficient modes of service production. A decentralized development strategy typically assigns important responsibilities for the provision of economic infrastructure to the local government level, including the construction of local roads and transportation networks; water pumps, boreholes, piped‐water and sewerage and sanitation schemes; irrigation projects; and the construction of local markets. The low population density in rural areas has negatively influenced the access to public services. Hence, investment in roads and transport infrastructure can facilitate the equitable access in rural areas to basic education, health care services, as well as access to markets for local agriculture products. In addition to improving access to basic services, construction of rural roads also alleviates income poverty by increasing agricultural productivity and enabling the poor to find better‐paying work. At the same time, rapid urbanization in many developing countries has created high demand for urban infrastructure and basic services in urban areas. It has been estimated that in 2002 only 61 percent of the urban population in low‐income countries had access to public sanitation services (IBRD, 2005). Furthermore, decentralized maintenance of roads results in efficiency gains. It also leads to an improvement in the general accessibility to socio‐economic services and a reduction in maintenance costs. Therefore, decentralized management of public investment is a sine qua non of improving the living conditions of the rural poor.

6.5 The Political Dimension of Intergovernmental Transfers: Theories of fiscal federalism postulate that determining intergovernmental transfers on political considerations results in an inefficient allocation of resources


across geographic jurisdictions. Transfers allocated on a political basis can also instigate tensions between classes, and ethnic and religious groups, which are concentrated in distinct geographical areas. Nevertheless, empirical evidence consistently confirms that the practice of allocating government resources based on political relationships continues to be pervasive worldwide. Many developing countries have adopted formulas for determining intergovernmental transfers as a strategy to limit the role of political considerations in resource allocation. An investigation was undertaken in Ghana during the period 1994 to 2005 to determine whether the formula‐based system of resource allocation from the central government to sub‐national governments was influenced by political considerations. The evidence reveals that the mechanism does not eliminate politically‐ motivated targeting of the transfers. Per capita transfers were higher in districts where vote margins in the previous presidential election were lower, suggesting that swing districts were targeted. There is evidence that the transfer formula indicators and their weighting were chosen and amended to produce politically desired patterns (Banful A, 2011). A similar study for Senegal covering the period 1997‐2009 shows that equity concerns do not affect the allocation of intergovernmental transfers in Senegal, leading to the conclusion that the resources distribution system does not comply with the dictates of normative theory. Evidence also reveals that political considerations influence the horizontal allocation of transfers. Analysis also suggests that the distribution of central resources follows a pattern of tactical redistribution more than patronage, swing communes being targeted while partisan communes are not (Caldeira, 2012). There is a debate among researchers about how transfers are affected by the political characteristics of the recipient groups. According to one school of thought, transfers are targeted towards districts with relatively more ‘swing voters’. The main assumption is that voters are willing to compromise their political party preferences if presented with economic benefits from another party. Another group of researchers argue that voters respond more strongly to economic incentives provided by the political party they prefer. The prediction under this "core supporter” model is that politicians are risk‐averse and will target more resources to areas where they have concentrated political support to assure the best return in terms of votes. An additional perspective is that central governments in developing countries may find it necessary to transfer some resources to jurisdictions that do not really need them, in order to make it politically feasible to transfer needed resources to other jurisdictions. It may also be essential to transfer resources simply in order to keep some economically nonviable local governments alive for political reasons (Bird and Smart, 2002). The practical experience in many developing countries shows that landmark changes in intergovernmental fiscal arrangements often arise out of important political developments that create the need and opportunity for change without allowing the time to think about longer term repercussions. Examples of acting in


haste with respect to intergovernmental fiscal arrangements are Brazil’s post‐military constitution of 1988, South Africa’s post‐apartheid constitution, and, perhaps most dramatically, the situation in many central and eastern European countries following the dissolution of the Soviet Union. The lesson drawn from these experiences is to allow for an adequate transition, despite the practical problems encountered in the real‐world political situations.


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Toward a Reformed Pro‐Poor Intergovernmental Transfers System in Sudan The success of the fiscal decentralization process in Sudan largely depends on the existence of a sound financial structure at central and sub‐national levels. There are different types of intergovernmental transfers available to policy makers, but the proper choice is necessarily linked to the specific objectives that are being pursued (Martinez‐Vazquez and Sepulveda, 2011). There are several policy objectives behind intergovernmental transfers in Sudan, including the following:  reduction of vertical imbalances;  reduction of horizontal imbalances;  poverty alleviation through the provision of pro‐poor services;  development financing;  adjustment for positive and negative spill‐overs;  Enhancement of fiscal autonomy. In order to ensure the realization of each policy objective of the intergovernmental transfers, it is recommended to use a separate transfer program to pursue each single objective. This also facilitates the monitoring and evaluation of each transfer program. The formula‐based approach, which is used in Sudan, is one of the common approaches used in developing countries to the allocation of intergovernmental transfers among sub‐national governments. The justification for using the formulae‐ based distribution is to minimize the discretionary power of politicians and ensure transparency, fairness and certainty in the distribution of central grants.

7.1 Constitutional, Legal and Regulatory Implications:  

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In view of the complexities embodied in the adoption of fiscal federalism in Sudan, the relationship between various stakeholders must be codified in the constitution, laws, and regulations. The constitution should enshrine the broad principles on which fiscal decentralization is to operate, including the rights and responsibilities of all levels of government, the description and role of key institutions at central and local levels, and the basis on which detailed rules may be established or changed. Laws should define the specific parameters of the intergovernmental fiscal system and the institutional details of the local government structure, including key structures, procedures, accountabilities and remedies. Regulations associated with each law should interpret and detail the practices and measures by which the related law will operate. As macroeconomic stability ranks high in the policy agenda, intergovernmental fiscal relations should be a matter of regulation under the Minister of Finance and National Economy, to give that ministry maximum flexibility in public expenditure management.


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As fiscal federalism is a complex and dynamic system, more flexibility is needed to change the specificity of implementation instruments, while enshrining the political and philosophical principles in the constitution and the operating structures in the laws. The legal and regulatory system should recognize the significant differences in management capacities through a classification of sub‐national governments. Policies and strategies to address these differences must be coherently considered. The allowance of sub‐national governments to borrow when they have the capacity to repay should be a regulatory and not a constitutional matter. It should be clearly codified that local government loans are internal obligations of local governments and not of higher levels of government. A participatory approach requires that the legal and regulatory system should provide full, timely, and easily accessible public disclosure of resource allocation decisions—in budgets, procurement, and expenditure programs. Citizens must have reliable, secure access to the means to enforce appropriate penalties for violations of rules.

7.2 Institutional Reform: The institutional body of the fiscal system in Sudan is specified in Chapter V of the INC to include: The National Revenue Fund (NRF):  All revenues collected nationally for, or by the national government, shall be pooled in the NRF and administered by the national treasury. The NRF shall embrace all accounts and sub‐funds, into which monies due to the government are collected, reported or deposited.  All the revenues and expenditure of the government shall be on budget operations and made public. Fiscal and Financial Allocation and Monitoring Commission (FFAMC): A FFAMC should be established, to ensure transparency and fairness in regard to the allocation of nationally collected funds to the government and the states. It undertakes the following duties and responsibilities:  Monitor and ensure that equalization payments (grants) from NRF are promptly transferred to respective levels of government.  Guarantee appropriate utilization and sharing of financial resources.  Ensure that resources allocated to conflict affected areas are transferred in accordance with agreed upon formulae. It is to be emphasized that the structure and interrelationships of national and sub‐national institutions is instrumental in influencing local fiscal performance. Poor inter‐jurisdictional institutions, strict and inconsistent central control of sub‐national functions, inadequate legal empowerment of sub‐national governments, and redundancy or ambiguity in the assignment of responsibilities and revenues across


government entities have created spatial inequities and inefficiencies and undermined sub‐national capacities. The meager efforts to deal with such problems have often been unrealistically aggregative and hastily‐implemented. Under such conditions, the institutional reform of fiscal decentralization should be designed with adequate incentives for appropriate institutional behavior; and implemented gradually to avoid antagonizing the powerful federal bureaucracies or stretch the limited capacities of sub‐national governments (Smoke, 2003). The federal government should also assist local governments in adhering to the legal and constitutional provisions that prevent abuse and corruption. Reform programs should be designed to help local governments meet a progression of well‐defined and objectively‐verifiable performance standards in revenue generation and pro‐poor service provision. In the meantime, federal controls should gradually be relaxed. It is also recommended to seek donor technical assistance programs to devise individually‐tailored reforms to provided flexibility to adapt to the differences across various local authorities. It is also important to accord the local governments the power to manage their own resources and be held accountable for performance by their citizens through various institutions for asserting accountability, such as annual reports and audits and the local government legislature. Despite efforts to regulate the institutional relationship between MOFNE, NSSF, FFAMC, states and local governments, the role of each is yet to be fully comprehended by all stakeholders. The frequent lack of transparency and accountability has often constrained the realization of the desired objectives. The observed weakness in fiscal institutions and inadequate social service delivery has, so far, been ineffective in reducing inequality and widespread poverty. This calls for major reform as follows:  building capacity at the sub‐national level to meet administrative and institutional requirements  improving the transparency and predictability of federal transfers to the states  enhancing the capacity of fiscal institutions and budget credibility at the state level  upgrading project management and social delivery to advance poverty reduction  directing federal transfers toward the poorest states to reduce disparities across states  Enhancing the capacity of states to mobilize own revenues to reduce vertical imbalances and boost fiscal responsibility (IMF, 2012b).


7.3 Addressing the Paucity of Data to Facilitate Designing Effective Designing Intergovernmental Equalization Transfers Formula: The determination of the extent and efficacy of fiscal federalism in Sudan is facing a daunting challenge in the form of data paucity. The absence of the necessary data on relevant local fiscal, demographic, and socio‐economic variables hindered the quantification of local expenditure needs and fiscal capacity. This acted as a major predicament to the efforts aiming at designing a formula‐based equalization grants in an efficient, equitable and transparent manner. It is to be emphasized that the thorough examination of the impact of fiscal federalism on poverty in Sudan requires the availability of consistent data involving the decomposition of federal and states’ expenditure by functional classification. However, such classification is not consistently available for the entire period 1990‐ 2012, as the commencement of the 1990s witnessed the government's discontinuation of providing the functional classification of expenditure in the federal budget. Instead, it provided aggregate allocations of spending grouped in four chapters that obscure the conventional functional classification. Consequently, some states expressed dissatisfaction about being under‐resourced on the grounds of their large population size and the spread of poverty. Hence, in view of the crucial significance of addressing the data issue, there is a great need to strengthen comparable GFS‐consistent reporting on the revenue side at both federal and states levels. On the expenditure side, reporting by functional classification (across health, education, roads, etc) and economic lines (wages, salaries, subsidies, etc) are an essential prerequisite for any systematic analysis of the fiscal position of states. In turn, improved data on sect oral outcomes would highlight potential disparities and spillovers across states. At the same time, a few basic and credible indicators and parameters for the design of an equitable intergovernmental transfer formula would need to be updated periodically. Extending the GFSM 2001‐compatible economic classification to all the states would enhance the quality of accounting at the state level and make it consistent with central government accounts (IMF, 2012b). This results in the elaboration of the coverage of the fiscal accounts to the general government level, leading the internalizing of the capacity of states to create debt and offset the federal fiscal adjustment efforts through "bail‐outs". A comprehensive and consistent database of government finance for documentation purposes could also improve fiscal reporting by making budget plans and execution publicly available. Transparent guidelines clarifying revenues and expenditure assignments between states and localities would enhance revenue collection, streamline expenditure assignments and set the basis for sound wage and salary policies.

7.4 A Suggested Revised Pro‐Poor Allocative Formula: The revision of intergovernmental equalization transfer mechanisms in Sudan is a key element of local government finance reform. This is a particularly difficult task


in the absence of substantial data on relevant local fiscal, demographic, and socio‐ economic variables. The absence of the necessary data to adequately quantify local expenditure needs and fiscal capacity in order to allocate formula‐based equalization grants in an efficient, equitable and transparent manner forms an additional obstacle in the implementation of a sound system of intergovernmental fiscal transfers in Sudan. However, despite the paucity of the first‐best data, a formula‐based pro‐poor equalization transfer scheme is still preferable to a discretionary negotiated grant approach because of its superior role in the realization of transparency, predictability and accountability objectives. In view of the limited success achieved in directing the intergovernmental transfers towards the poor segment of the population, which was observed in Section Four, it is recommended to adopt a modified transfer scheme where the grants to each state are demand‐driven, based on a number of client‐focused financial norms. The recommended formula‐based pro‐poor system focuses on the sectors that directly enhance the on‐going poverty alleviation efforts. These sectors, which are within the national priorities, include: education, health, water, roads, and agriculture. In view of the importance of local administration in states' poverty reduction, an allocation scheme is also proposed for improving the administrative capacities of sub‐ national jurisdictions. A separate simple formula is suggested for each sect oral transfer scheme bearing in mind the fulfillment of the objectives of transparency and simplicity. This suggested scheme is similar to the one successfully implemented in Tanzania since 2004 (Tanzania, 2003 and 2010). It must also be emphasized that the suggested revised transfer scheme should be phased out over a period of three years. This is intended to minimize the disruptive consequences of implementing a large sudden change in resource allocations to sub‐ national jurisdictions, which could potentially result in inefficient allocation or even misappropriation of public resources by local governments.  Using the revised formula for the allocation of 10% of the transferred resources in the first year  Using the revised formula for the allocation of 40% of the transferred resources in the second year  Using the revised formula for the allocation of 70% of the transferred resources in the third year  Using the revised formula for the allocation of 100% of the transferred resources from the fourth year onwards. The factors in the proposed sectoral allocation formulae for each of the six sectors are shown as follows: Primary and Secondary Education:  Number of school‐aged children (100%). Health Services:  Population (70%).


 Poverty count (based on regional poverty rates (10%)  Vehicle route mileage (10%)  Infant mortality count (10%) Rural Roads:  Kilometers of local earth roads (67%)  Kilometers of local gravel or paved roads (33%) Water Supply and Sanitation:  Population (70 %)  Land area (15%)  Poverty count based on regional poverty rates, (15%) Agricultural Extension Services:  Number of agricultural producers (70%)  Land area (30%) Administration Allocations:  Population (70%).  Land area (15 %).  Poverty count (based on regional poverty rates) (15%).

7.5 Addressing the Vertical and Horizontal Imbalances: Although Sudan’s government was optimistic about the CPA signed on January, 2005 and the subsequent secession of South Sudan in July, 2011, the two major developments triggered a significant economic shock. The secession resulted in Sudan losing 75 percent of its oil production, 50 percent of its fiscal revenues, and about 66 percent of its international payment capacity. Adjusting to a shock of such magnitude proved to be beyond the government’s own capacities in the virtual absence of international support. The deterioration in the security situation in Kordofan, Darfur and the Blue Nile states aggravated the serious economic challenge facing the government. As a result of the secession of South Sudan and the loss in oil revenue, the fiscal vertical shock was estimated to be SDG 1‐2 billion in 2011. The amended 2011 budget witnessed a cut in federal transfers to states by 20 percent, with capital transfer reduced by 46 percent, while total expenditure was cut by seven percent. The extent of the vertical fiscal shock was felt more severely in the 13 states with heavier fiscal dependence on federal support – the percentage revenue losses were in the range of 13 percent (River Nile) to 17 percent (Blue Nile). States with stronger own revenue capacities (Khartoum and Red Sea) experienced much smaller percentage revenue losses ‐ eight and 10 percent of their revenues, respectively. The cut in federal transfer to states resulted in significant regressive effects, given the primary role of state governments as key basic service providers. The breakdown of national (including both federal and state level) health and education


expenditures reveals the importance of state governments in basic service delivery – 63 percent of national health expenditures and 83 percent of national education expenditures were financed by the state budget in 2009.

7.5.1 Directing Intergovernmental Transfers to Offset Fiscal Vertical Imbalance: The vertical fiscal imbalance has increased overtime in Sudan due to a progressive devolution of spending responsibility, coupled with increasingly‐ centralized revenue functions. Between 2000 and 2010, the vertical fiscal imbalance increased from 25 percent to 70 percent indicating an increase in the disparity between spending and revenue decentralization. This contradicts the experience of comparable developing countries, where sub‐national governments typically finance up to 70 percent of their spending from own sources. The share of state expenditure in general government expenditure has risen from 19 percent to 26 percent, while the revenue share has fallen from 23 percent to 14 percent during the same period. This is due to the limited capacity of states to collect own revenues and led to an increase in states’ dependency on federal transfers. The vertical fiscal imbalance phenomenon has worsened in view of termination of the "oil decade" after the separation of the oil‐rich southern part of Sudan in 2011. The vertical fiscal gap in Sudan may be bridged through the following ways:  transferring revenue‐raising power to local governments  transferring responsibility for expenditures to the central government  reducing local expenditures/raising local revenues  giving the states a fair share of the major national taxes collected in their jurisdictions, including VAT  states assisting the federal government in revenue mobilization by providing information on local taxpayers, and thereby increasing the pool of tax revenues  Determining unconditional grants annually with reference to the reassignment of tasks between the federal and state governments. The total amount of the grant is calculated on the basis of a formula that includes the unconditional grant of the previous year, corrected by the increase in the general price level, plus the net change in the budgeted costs of running newly introduced or discontinued services  Using conditional grants, the federal government should ensure that states allocate the funds transferred to finance certain pro‐poor services, such as primary education, primary health, water supply, agricultural extension and roads. Furthermore, these earmarked grants should target ensuring minimum nation‐wide standards for the provision of pro‐poor services. In this sense, the transfers are referred to as equalization grants addressing the horizontal imbalances between states with an effect in closing the vertical fiscal gap


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Enhancing the internal audit, improving the reporting systems and the compliance with established financial regulation in all sub‐national jurisdictions. This calls for implementing a sound capacity building program in financial management and monitoring the destiny of the grants transferred.

7.5.2 Directing Intergovernmental Transfers to Offset Fiscal Horizontal Imbalance: 

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Addressing the problem of ‘horizontal balance’ requires the recognition that geographical areas usually differ with respect to resource capacity and needs. The taxbase per capita often differs substantially between urban municipalities and district councils. The needs for public services may differ because some areas, for example, have a higher percentage of school children and/or elderly people than others. Designing fiscal institutions to cope with this complex reality is often problematic, and may be further aggravated by political imperatives of treating even the most unequal jurisdictions uniformly, and by historically‐ rooted conflicts and rivalries between regions and population groups. Fiscal decentralization has two major concerns namely: the horizontal equity between states and within‐state equity. The handling of these problems requires equalization grants to channel funds from relatively wealthy jurisdictions to poorer ones. Such transfers are often based on an equalization formula that measures the ‘fiscal need’ and ‘fiscal capacity’ of each jurisdiction. The formula is intended to allocate higher transfers to the jurisdictions with the greatest fiscal need and the least fiscal capacity. Although efforts have been exerted in Sudan to handle the problems of horizontal imbalance between states, differences among individuals within a local authority or province remain a major point of concern. The redistribution among states alone will not bear fruit, unless it is accompanied by appropriate internal redistributive measures. This shifts the responsibility to sub‐national jurisdictions to engage in redistribution. It follows that the harmonization between national and sub‐national efforts is essential for the success in targeting the poor segments of the population.

7.6 Capacity Building to Enhance Transparency in Budget Processes: A close examination of the states’ budgets portrays a rising bias in favor of recurrent expenditure to the detriment of development expenditure. There is also evident lack of transparency in the allocation of federal transfers which render these revenues unpredictable and hence limit their capacity for forward planning. This causes a disparity between expenditure responsibilities and revenue allocations, resulting in a widening of the gap between states' revenues and expenditures. The ultimate result is hampering budget execution, especially with regards to development expenditure targeting service delivery to the poor.


The realization of the potential efficiency gains of fiscal decentralization in the provision of pro‐poor public goods and services in Sudan requires significant investment in capacity‐building and improvement to performance fiscal management systems at the states level, in particular aiming at improving transparency of the budget process in all its phases. The pursuit of capacity building for decentralized governance requires a programmatic approach to improving the potential of state and local governments to manage economic and social development. Capacity building refers to both human capital and technological development and demands support for training activities as well as technological endowments; for both of these, development partners can play a significant role. Selected areas of need include revenue estimation, overall budget process, collection procedures, and development planning and execution (IMF, 2012).

7.7 Ensuring Complementary of Policy Reforms in the Civil Service and Fiscal Regulatory Frameworks: The practice of fiscal decentralization in Sudan, which lasted for nearly two decades, has been characterized by a deteriorating level of pro‐poor social services in health, education, infrastructure and water. An important factor behind this unsatisfactory performance has been the inadequate scope for geographic or functional mobility of qualified civil servants. Similarly, the devolution of subsidized public services (eg, utilities) to local governments has not led to a reduction of subsidies. On the contrary, the lack of regulatory framework (like price adjustment by local authorities) has resulted in the deterioration of such services.

7.8 Bridging the Governance Gap: It is widely accepted that good governance provides the basic mechanism for the realization of efficiency gains associated with fiscal decentralization. It is through the election of public officials and through other democratic institutions, such as referenda or polls that taxpayers reveal their preferences for goods and services and their willingness to pay for them. Democratic governance guarantees some degree of responsiveness and accountability of regional and local officials to taxpayers and voters. Decentralization promotes democracy and fiscal decentralization needs democratic governance to deliver the advantages associated with a more efficient provision of public services (Martinez‐Vazquez and McNab, 1997). Good governance is sine qua non for pro‐poor fiscal transfers. The attainment of pro‐poor fiscal decentralization in Sudan calls for essential measures in order to realize good governance. These measures include:  Focus on fostering cooperation between the different levels of government to enhance service provision, ensure the democratic process is uninhibited, provide dedicated local revenues, and promote a legislative and administrative culture of efficiency and responsiveness.


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Encourage resources‐rich states like Khartoum, Red Sea and Gezera to provide assistance to resources‐poor states and give them incentives to cooperate in the joint provision of pro‐poor services. The democratic process needs to become a natural and consistent aspect of government at both the national and sub‐national level. Local government posts need to become fully competitive and strong measures taken to prevent vote‐buying and intimidation. Localities should receive all locally‐generated and collected revenues that have been sanctioned by the federal government, including property tax and a portion of receipts from locally‐ collected national income tax. Enactment and implementation of deterrent anti‐corruption laws as effective governance cannot be attained in a corrupt environment. Greater accountability and transparency will go a long way towards creating a climate of honesty. The perceived climate of dishonesty can only negatively impact regional investment and economic growth. Strengthen the judiciary to be capable of being impartial in resolving the disputes between national and sub‐national governments. Decentralization laws should be further clarified through legislative action to clearly define sub‐national authority and the authority that rests with the central government. Local levels of government should be stopped from operating with unchecked autonomy to interpret laws as they see fit. They should also discontinue responding to central government information requests at their convenience. Efforts to strengthen local governments should avoid the creation of parallel governance institutions which, in the longer term, may work to further weaken the efficient traditional administration systems.

7.9 Attraction, Management and Coordination of Donor Support: In view of the difficulties encountered in realizing an efficient intergovernmental transfers system in Sudan, there is a strong case for attracting foreign transfers to assist in reforming the system. Successful fiscal decentralization proved illusive in the context of financial and political instability prevailing in Sudan, particularly in the aftermath of the secession of the South. Evidence from developing countries in similar conditions reveals successful fiscal federalism has been realized through long term bilateral and multilateral donor support. The attraction of donor support requires implementing a host of measures, particularly at the governance level.  One of the main sources of donor, which was a driving force behind the widely acknowledged success of Ugandan experience with fiscal decentralization, was the relief from donor countries and multinational agencies under the HIPC initiative. Hence there is a good case for taking the necessary measures to enhance Sudan's illegibility for HIPC relief.  Establish and invigorate a PAU within FFAMC to coordinate the present donor resources earmarked for states suffering from conflict, with the objective of utilizing some of the technical and financial recourses to improve the intergovernmental transfer mechanisms to these states. These funds include:


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the Darfur Reconstruction and Development Fund; the Eastern Sudan Reconstruction and Development Fund; the West Kordofan Reconstruction and Development Fund; the Darfur Compensation Fund; and the Peace Building Project in South Kordofan and the Blue Nile. Channel donor support directly to pro‐poor sectors like primary and secondary education, health, rural feeder roads, agriculture extension, water and environmental sanitation, micro‐ finance and adult literacy. Design the future donor support modalities in the field of decentralization, away from the typical program support to a sector budget support/and or general budget support with clear agreements on the milestones and targets to be achieved in the field of poverty. Attract donor support to assist in invigorating the system of local revenue raising and mobilization to reverse the reliance on smaller, non efficient, low yielding taxes, especially on agriculture and smaller enterprises (taxes focusing on production instead of wealth and income). This can be assisted by donor support in the field of tax administration and tax evasion. Engage potential donor assistance in programs containing elements of capacity‐building, especially in relation to planning, budgeting and raising revenue, with special attention to poverty and gender sensitivity. Focus donor assistance on mainstreamed (on‐budget) support mechanisms rather than jurisdiction‐specific donor support (development grants). This requires new tools for dialogue between the federal government and the donor community in issues like PRSC and the PRSP process at central government level, with more on fiscal decentralization issues like strategic and action planning. Strike a balance between the need for federal government/donor control and imposing poverty oriented expenditure with the need to preserve sub‐national governments' autonomy. While sub‐national governments need to have enough fiscal control and discretionary powers to plan their activities in an efficient way, there is a strong desire to ensure that funds are utilized within poverty‐sensitive areas and that inequality across states and localities are minimized. Focus on appropriate incentives in the introduction of donor programs in local jurisdictions to improve financial management, tax collection and efficient utilization of donor funds. Prepare a fiscal decentralization strategy in Sudan in coordination with the World Bank and other bilateral donor‐support. The objective of the strategy is to strengthen the process of decentralization in Sudan through increasing sub‐ national governments’ autonomy, widening local participation in decision‐ making and streamlining of fiscal transfer modalities to local governments in order to increase the efficiency and effectiveness of local governments to achieve poverty alleviation objectives within an transparent and accountable framework.


7.10 Synchronization of Federal Resource Availability and States' Spending Responsibilities: The experience of Sudan with fiscal decentralization reveals a lack of appropriate sequencing between availing the resources to the states and assigning them the spending responsibilities. It has been observed that spending mandates were handed to the states, without adequate provision of resources, leading to a significant deterioration in the quality of the decentralized pro‐poor public services. These federal resources should have been made available to sub‐national governments pari passu with the assignment of spending responsibilities (IMF, 2009). This implies that increased devolution of expenditure functions should be conditioned on the compliance of the states; and could proceed at different speeds as capacity varies between states. At the same time, the pace of decentralization should be, as much as possible, linked to the capacity of states to carry out effectively the functions assigned to them.

7.11 Adherence to the Federal and States' Roles in the Provision of Pro‐ Poor Social Services: The experiences of Sudan in this area, as outlined in Chapter IV reveals the lack of adherence to the responsibilities of each level of government, as specified in the constitution. States have continuously failed to comply with their obligation to provide the primary education and health services assigned to them. While inevitably pro‐poor spending responsibilities in education and health will overlap across federal and states levels of government, it is important to ensure adequate compliance and clarify the role of each level of government in the provision of the services, to avoid under‐provision, duplication, waste, and loss of accountability.

7.12 Enhancement of Own and Transferred Federal Resources to Stimulate the Implementation of an Effective "Hard Budget Constraint" on the States: The entire period of decentralization in Sudan witnessed a persistent significant mismatch of spending needs and resources of states. This has led over time to an inadequate provision of satisfactory public services, and to fiscal indiscipline (typically resulting in an inappropriate resort to borrowing, or accumulation of arrears). It should be conceded, however, that a great difficulty was encountered in assessing the spending needs of the states in the absence of reliable information on cost‐ effectiveness of spending programs at all levels of government. In order to facilitate the effective implementation of a “hard budget constraint” on states, they must be provided with an overall resource envelope that ex ante would allow them to carry out their assigned spending responsibilities at an average level of efficiency.


7.13 Hedging against States Incurring Debt Obligations Leading to Massive Federal Support in the Form of Extraordinary "Bailouts": Article 11C of the Interim National Constitution allows states to resort to borrowing to bridge the gap between their limited revenue sources and their escalating expenditures. There raises concern that fiscal decentralization may weaken fiscal discipline to the extent that states may undertake commitments or incur debt obligations that subsequently result in massive federal support, in the form of extraordinary transfers, or "bailouts." Such bailouts could, in turn, cause national fiscal imbalances, excessive borrowing, and macroeconomic instability. It is, therefore, recommended that the federal government maintains strict control over the fiscal behavior of states without undercutting the goals of fiscal decentralization, including autonomy. Furthermore, the federal government should be prepared to give strong incentives to prop up the finances of local governments when the pro‐poor services provided locally benefit the rest of society. However, if such an intervention is not performed with care, it may create disincentive effects on states in the provision of pro‐poor services using local resources that produce substantial spillover not non‐residents.

7.14 Ensure Transparency in the Federal Allocation of Resources Restore Legitimacy, Preserve Equitability and Strengthen Budgetary Processes: An effective allocative formula should satisfy the following criteria: revenue adequacy, local tax effort and expenditure control, equity, stability and transparency. Since the adoption of the federal system in Sudan in 1995 and until the INC in 2005, no clear indicators were identified in the sharing of the financial resources between the federal and states governments. Article 16 of the Presidential Decree No 12 of 1995, stipulates the setting up of the NSSF for states with the objectives of transferring resources from the centre to the states on a fair and equitable basis. In allocating transfers to the states, the Fund identified nine indicators which were adopted with the aim of achieving a fair and equitable system of transfers. From a pro‐poor perspective, one would expect NSSF current transfers to states to be strongly linked to poverty at the state level. However, available evidence reveals that there was no systematic relationship between the actual NSSF current transfers to states and poverty reduction. Rather, those transfers correlated more strongly with state population size than with the percentage of rural population where most of the poor are situated.

7.15 Maximize Effort to Focus Federal Transfers on the Poorest States to Enable More Targeted Development Spending and Alleviation of Inequality Across States: There are observed indications that federal development transfers to the states have not targeted reducing disparities between states. Evidence shows that development transfers have been allocated on an ad hoc basis. As such, there is little


evidence that such grants have an impact on reducing fiscal disparities between states. For most of the funds allocated to the states by the NSSF (current transfers, VAT allocations, and agricultural compensation grants) data paucity has hindered the determination of their impact on poverty alleviation. Based on simple correlation coefficients, it appears that most of these transfers were not redistributive and did not reduce fiscal disparities between states (UNDP, 2006). The refocusing of federal transfers to the poorest states would facilitate more targeted development spending and reduce inequality across states. Furthermore, associating federal transfers with poverty trends in states would improve the distribution of capital investment to those areas where the delivery of basic pro‐poor services is inadequate. At the same time the devolution of social spending would better respond to local necessities. This, in turn, would decrease horizontal inequality and enliven economic growth.


8‐

Summary of Conclusions and Recommendations

8.1 Summary of Conclusions

In common with the worldwide drive towards decentralization, the federal system of governance was adopted in Sudan in 1992 when three main levels of authorities were created: the federal government, the states, and local communities. The current federal system in Sudan consists of 18 states and 199 local communities. The present study aims at supporting public policy decisions in Sudan through galvanizing views, new ideas and perspectives on the existing fiscal transfer system, with a view to turning it more pro‐poor and equitable. The study began by laying the theoretical and conceptual framework for analyzing fiscal federalism and examined relevance of fiscal decentralization theories to developing countries, including Sudan. The analysis was done through dividing the period covered in the study into three intervals: 1981‐2002, 2003‐2010 and 2011‐2012, with the final interval reflecting the developments after the secession of the southern part of the country and the termination of the oil decade. It has been found that fiscal policy in Sudan during the period 1981‐2002 was far from being pro‐poor. During the period 1999‐2010, Sudan witnessed "the oil decade" which was characterized by the strongest growth trend in the country’s history. The period 2003‐2010 witnessed a drastic change in the composition of government expenditure, with the federal share in total expenditure dropping from 92 percent in 2000 to 64 percent in 2006 due to the implementation of the CPA which emphasized the role of sub‐national governments in the country's public finance. The relatively huge amounts of oil reserves accumulated were not converted into equivalent public investments in education, health and infrastructure. The year 2011 witnessed the secession of South Sudan, which was accompanied by the fall of oil production by three quarters and the decline in revenues by more than 50 percent bringing the economy to the verge of recession. A supplementary budget was introduced in the second half of 2011 to accommodate the 35.6 percent loss in total revenue without jeopardizing growth. The government removed subsides from major fuel products and sugar, with an estimated saving of one percent of GDP in 2011. Despite the measures taken to boost tax yield, the high level of unrecorded transactions in the shadow economy, estimated at 65 percent of GDP, decidedly diminished the impact of the fiscal adjustment policies. Pro‐poor spending on social services, including health and education, averaged only one percent during 2011‐2012. The vertical fiscal imbalance, measured as the gap between own spending and own revenues at the state level, is very high in Sudan. In 2010, only about one‐third of states’ expenditures were mobilized from states’ own revenue sources (IMF, 2012b). This is at odds with international evidence which reveals that sub‐national governments in developing countries finance up to 70 percent of spending from their own sources. The vertical fiscal imbalance has increased over time due to a


progressive devolution of spending responsibility coupled with increasingly centralized revenue functions. Between 2000 and 2010, the VFI increased from 25 percent to 70 percent, indicating that the mismatch of spending and revenue decentralization has increased. This trend reflects increased expenditure decentralization on the back of declining revenue decentralization. The share of state expenditure in general government expenditure has risen from 19 to 26 percent, while the revenue share has fallen from 23 to 14 percent, due to the limited capacity of states to collect their own revenues, resulting in an increased dependency by states on federal transfers. This unsatisfactory performance of states to mobilize their own revenue is largely attributed to the lack of infrastructure and human capacity, and depressed economic activity due to security problems in some states. According to the states’ final account reports, the ratio of own revenues to total revenues fell from 76.4 percent in 2000 to 38.9 percent in 2010. Another notable feature of the states’ composition of revenues is the great variation across sub‐national governments, resulting in significant differences in vertical imbalances. While the average vertical fiscal imbalance during the period 2000‐2010 was approximately 70 percent, a large dispersion among states was observed. Whereas vertical fiscal imbalance registered 34 percent, in Khartoum and the Red Sea; this ratio reached 89 percent in Blue Nile. This indicates that, while there are significant differences in the capacity of states to raise own revenue, the latter varying from nine SDG per capita in North Darfur to 142 in Khartoum, the variation of expenditure across states is mostly determined by the amount of central transfers. The modalities adopted in Sudan for the horizontal allocation of resources among the states reveal significant variation. Transfers per capita accrued to the top recipient state were, on average, six times higher than the bottom recipient during the period 2000‐2010. The Blue Nile, the River Nile and the Northern States are the highest recipients of federal transfers on a per capita basis, while North Kordofan, Red Sea and South Darfur can be found at the lower end of the ranking. There is also evidence that the current mechanism for the allocation of national resources is not entirely transparent and allows for discretionary (political) allocations, which undermines any claim to it being a fair and equitable system. As a result, some states have expressed dissatisfaction at finding themselves under‐resourced to meet the needs of their large population and the spread of poverty. The analysis of the trend in federal and states pro‐poor expenditure reveals that there is no reliable, consistent information from the sub‐national governments about the quality of efficiency in utilizing the pro‐poor federal funds for their intended purposes. The growth in pro‐poor spending has occurred in the context of rapidly‐ expanding total expenditures that characterized the oil decade. The evidence from 2011 and 2012 shows no indication that an overall rise in federal pro‐poor expenditure involved any reallocation from other spending categories, since all categories reflected real growth.


There are indications that the increase in pro‐poor federal transfers reinforces the overall trend in pro‐poor spending, which is skewed toward the federal level, suggesting an under‐funding of poverty‐reducing expenditure at the state and local levels, where basic pro‐poor services are financed and delivered. Furthermore, the available evidence reveals that most of the federal share of pro‐poor spending was development‐ oriented, while state pro‐poor spending has increasingly been allocated to recurrent expenditure (approximately 53 percent in 2012). The dominance of recurrent pro‐poor spending (mainly wages and salaries) over development spending at the state level raises concerns, since improving service delivery to the poor in the longer term requires investment in schools, clinics, roads and water. The relative emphasis on recurrent spending leaves little room for items that have a direct impact on the quality of services, such as investments in facilities, equipment and capacity development. Due to the eroded infrastructure, state spending on pro‐poor facilities has remained far below what is needed to meet the MDGs. State‐level allocations to pro‐poor activities were mostly for general public services, reflecting support for wages and salaries. The extremely low level of states' investment spending in the health and education sectors, with over 95 percent allocated to current expenditure, is an issue of great concern.

8.2 Recommendations In order to ensure the realization of each policy objective of the intergovernmental transfers, the introduction of a separate transfer program is recommended to pursue each single objective. This also facilitates the monitoring and evaluation of each transfer program. The formula‐based approach, which is used in Sudan, is one of the common approaches used in developing countries for the allocation of intergovernmental transfers among sub‐national governments. The justification for using the formulae‐based distribution is to minimize the discretionary power of politicians, and ensuring transparency, fairness and certainty in the distribution of central grants. 8.2.1 Constitutional, Legal and Regulatory Implications:  In view of the complexities embodied in the adoption of fiscal federalism in Sudan, the relationship between various stakeholders must be codified in the constitution, laws, and regulations.  As macroeconomic stability ranks high in the policy agenda, intergovernmental fiscal relations should be a matter of regulation under the Minister of Finance and National Economy, to give that ministry maximum flexibility in public expenditure management.  As fiscal federalism is a complex and dynamic system, more flexibility is needed to change the specificity of implementation instruments, while enshrining the political and philosophical principles in the constitution and the operating structures in the laws.  The legal and regulatory system should recognize the significant differences in management capacities through a classification of sub‐national governments.


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Policies and strategies to address these differences must be coherently considered. The allowance of sub‐national governments to borrow when they have the capacity to repay should be a regulatory, and not a constitutional matter. It should be clearly codified that local government loans are internal obligations of local governments and not of higher levels of government. A participatory approach requires that the legal and regulatory system should provide full, timely, and easily accessible public disclosure of resource allocation decisions—in budgets, procurement, and expenditure programs. Citizens must have reliable, secure access to the means to enforce appropriate penalties for violations of rules.

8.2.2 Institutional Reform: 

The institutional reform of fiscal decentralization should be designed with adequate incentives for appropriate institutional behavior; and implemented gradually to avoid antagonizing the powerful federal bureaucracies or stretch the limited capacities of sub‐national governments.  The federal government should also assist local governments in adhering to the legal and constitutional provisions that prevent abuse and corruption.  Reform programs should be designed to help local governments meet a progression of well‐defined and objectively verifiable performance standards in revenue generation and pro‐poor service provision.  Donor technical assistance programs are needed to devise individually tailored reforms to provided flexibility to adapt to the differences across various local authorities. It is also important to accord the local governments the power to manage their own resources and be held accountable for performance by their citizens through various institutions for asserting accountability such as annual report and audits and the local government legislature.  Capacity needs to be built at the sub‐national level to meet administrative and institutional requirements. 8.2.3 Addressing the Paucity of Data to Facilitate Designing Effective Designing Intergovernmental Equalization Transfers Formula:  The thorough examination of the impact of fiscal federalism on poverty in Sudan requires the availability of consistent data, involving the decomposition of federal and states expenditure by functional classification.  There is a great need to strengthen comparable GFS with consistent reporting on the revenue side at both federal and states levels. On the expenditure side, reporting by functional classification (across health, education, roads, etc) and economic lines (wages, salaries, subsidies, etc) are an essential prerequisite for any systematic analysis of the fiscal position of the states.  A comprehensive and consistent database of government finance for documentation purposes could also improve fiscal reporting by making budget plans and execution publicly available. Transparent guidelines clarifying revenues and expenditure assignments between states and localities would enhance revenue collection, streamline expenditure assignments and set the basis for sound wage and salary policies. 76 | Assessment of the Existing Inter‐Governmental Fiscal Transfers System in Sudan

8.2.4 A Suggested Revised Pro‐Poor Allocative Formula:  In view of the limited success achieved in directing the intergovernmental transfers towards the poor segment of the population, which was observed in Section Four, it is recommended to adopt a modified transfer scheme that focuses on the sectors directly enhances the on‐going poverty alleviation efforts. These sectors, which are within the national priorities, include: education, health, water, roads, and agriculture.  It is also to be emphasized that the suggested revised transfer scheme should be phased out over a period of three years. This is intended to minimize the disruptive consequences of implementing a large sudden change in resource allocations to sub‐national jurisdictions, which could potentially result in inefficient allocation or even misappropriation of public resources by local governments.  Using the revised formula for the allocation of ten percent of the transferred resources in the first year,  Using the revised formula for the allocation of 40 percent of the transferred resources in the second year,  Using the revised formula for the allocation of 70 percent of the transferred resources in the third year,  Using the revised formula for the allocation of 100 percent of the transferred resources from the fourth year onwards.  The factors in proposed sectoral allocation formulae for each of the six sectors are shown as follows: Primary and Secondary Education:  Number of school‐aged children (100%). Health Services:  Population (70%).  Poverty count (based on regional poverty rates (10%)  Vehicle route mileage (10%)  Infant mortality count (10%) Rural Roads:  Kilometers of local earth roads (67%).  Kilometers of local gravel or paved roads (33%). Water Supply and Sanitation:  Population (70%).  Land area (15%).  Poverty count based on regional poverty rates, (15 %). Agricultural Extension Services:  Number of agricultural producers (70 %).  Land area (30 %).


Administration Allocations:  Population (70 %).  Land area (15 %).  Poverty count (based on regional poverty rates) (15 %).

8.2.5 Addressing the Vertical and Horizontal Imbalances: 8.2.5.1 Directing Intergovernmental Transfers to Offset a Fiscal Vertical Imbalance: The vertical fiscal gap in Sudan may be bridged through the following ways:  transferring revenue‐raising power to local governments  transferring responsibility for expenditures to the central government  reducing local expenditures/raising local revenues  giving the states a fair share of the major national taxes collected in their jurisdictions, including VAT  states assisting the federal government in revenue mobilization by providing information on local taxpayers, and thereby increasing the pool of tax revenues  determining unconditional grants annually with reference to the reassignment of tasks between the federal and states governments. The total amount of the grant is calculated on the basis of a formula that includes the unconditional grant of the previous year, corrected by the increase in the general price level, plus the net change in the budgeted costs of running newly introduced or discontinued services.  conditional grants, federal government ensuring that states allocate the funds transferred to finance certain pro‐poor services, such as primary education, primary health, water supply, agricultural extension and roads. Furthermore, these earmarked grants should be adequately targeted , ensuring minimum nation‐wide standards for the provision of pro‐poor services. In this sense, the transfers are referred to as equalization grants addressing the horizontal imbalances between states with an effect in closing the vertical fiscal gap.  enhancing the internal audit, improving the reporting systems and the compliance with established financial regulation in all sub‐national jurisdictions. This calls for implementing a sound capacity building program in financial management and monitoring the destiny of the grants transferred. 8.2.5.2 Directing Intergovernmental Transfers to Offset Fiscal Horizontal Imbalance:  Addressing the problem of ‘horizontal balance’ requires the recognition that geographical areas usually differ with respect to resource capacity and needs. The tax base per capita often differs substantially between urban municipalities and district councils.  The needs for public services may differ because some areas, for example, might have a higher percentage of school children and/or elderly people than others.


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Designing fiscal institutions to cope with this complex reality is often problematic, and may be further aggravated by political imperatives of treating even the most unequal jurisdictions uniformly, and by historically rooted conflicts and rivalries between regions and population groups. Fiscal decentralization has two major concerns, namely: the horizontal equity between states and within‐state equity. The handling of these problems requires equalization grants to channel funds from relatively wealthy jurisdictions to poorer ones. Such transfers are often based on an equalization formula that measures the ‘fiscal need’ and ‘fiscal capacity’ of each jurisdiction. The formula is intended to allocate higher transfers to the jurisdictions with the greatest fiscal need and the least fiscal capacity. Although efforts have been exerted in Sudan to handle the problems of horizontal imbalance between states, differences among individuals within a local authority or province remain a major point of concern. The redistribution among states alone will not bear fruits, unless it is accompanied by appropriate internal redistributive measures. This shifts the responsibility to sub‐national jurisdictions to engage in redistribution. It follows that the harmonization between national and sub‐national efforts is essential for the success in targeting the poor segments of the population.

8.2.6 Bridging the Governance Gap:  Focus on fostering cooperation between the different levels of government to enhance service provision, ensure the democratic process is uninhibited, provide dedicated local revenues, and promote a legislative and administrative culture of efficiency and responsiveness.  The democratic process needs to become a natural and consistent aspect of government at both the national and sub‐national level. Local government posts need to become fully competitive and strong measures taken to ensure freedom and fairness.  Localities should receive all locally generated and collected revenues that have been sanctioned by the federal government including property tax and a portion of receipts from locally collected national income tax.  Enactment and implementation of deterrent anti‐corruption laws as effective governance cannot be attained in a corrupt environment. Greater accountability and transparency will go a long way to creating a climate of honesty. The perceived climate of dishonesty can only negatively impact regional investment and economic growth.  Strengthen the judiciary to be capable of being impartial in resolving the disputes between national and sub‐national governments.  Decentralization laws should be further clarified through legislative action to clearly define sub‐national authority and the authority that rests with the central government. Local levels of government should be stopped from operating with unchecked autonomy to interpret laws as they see fit. They should also discontinue responding to central government information requests at their convenience.


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Efforts to strengthen local governments should avoid the creation of parallel governance institutions which, in the longer term, may work to further weaken the efficient traditional administration systems.

8.2.7 Attraction, Management and Coordination of Donor Support:  In view of the difficulties encountered in realizing an efficient intergovernmental transfers system in Sudan, there is a strong case for attracting foreign transfers to assist in reforming the system.  There is a good case for taking the necessary measures to enhance Sudan's illegibility for HIPC relief. The relief from donor countries and multinational agencies under the HIPC initiative was one of the main sources of donor support, which was a driving force behind the widely acknowledged success of Ugandan experience with fiscal decentralization.  Establish and invigorate a PAU within FFAMC to coordinate the present donor resources earmarked for states suffering from conflict, with the objective of utilizing some of the technical and financial recourses to improve the intergovernmental transfer mechanisms to these states. These funds include: the Darfur Reconstruction and Development Fund; the Eastern Sudan Reconstruction and Development Fund; the West Kordofan Reconstruction and Development Fund; the Darfur Compensation Fund; and the Peace Building Project in South Kordofan and the Blue Nile.  Channel donor support directly to pro‐poor sectors like primary and secondary education, health, rural feeder roads, agriculture extension, water and environmental sanitation, micro‐finance and adult literacy.  Design the future donor support modalities in the field of decentralization, away from the typical program support to a sector budget support/and or general budget support with clear agreements on the milestones and targets to be achieved in the field of poverty.  Attract donor support to assist in invigorating the system of local revenue raising and mobilization to reverse the reliance on smaller, non efficient, low yielding taxes, especially on agriculture and smaller enterprises (taxes focusing on production instead of wealth and income). This can be assisted by donor support in the field of tax administration and tax evasion.  Engage potential donor assistance in programs containing elements of capacity building, especially in relation to planning, budgeting and raising revenue, with special attention to poverty and gender sensitivity.  Focus donor assistance on mainstreamed (on‐budget) support mechanisms rather than jurisdiction‐specific donor support (development grants). This requires new tools for dialogue between the federal government and the donor community in issues like PRSC and the PRSP process at central government level, with more on fiscal decentralization issues like strategic and action planning.  Strike a balance between the need for federal government/donor control and to impose poverty oriented expenditure and the need to preserve sub‐national governments' autonomy. While sub‐national governments need to have enough fiscal control and discretionary powers to plan their activities in an


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efficient way, there is a strong desire to ensure that funds are utilized within poverty‐sensitive areas to minimize inequality across states and localities. Focus on appropriate incentives in the introduction of donor programs in local jurisdictions to improve financial management, tax collection and efficient utilization of donor funds. Prepare a fiscal decentralization strategy in Sudan in coordination with the World Bank and other bilateral donor‐support. The objective of the strategy is to strengthen the process of decentralization in Sudan through increasing sub‐ national governments’ autonomy, widening local participation in decision making and streamlining of fiscal transfer modalities to local governments in order to increase the efficiency and effectiveness of local governments to achieve poverty alleviation objectives within a transparent and accountable framework.

8.2.8 Capacity Building to Enhance Transparency in Budget Processes:  The realization of the potential efficiency gains of fiscal decentralization in the provision of pro‐poor public goods and services in Sudan requires significant investments in capacity building and improvement of performance in fiscal management systems at the states level, in particular aiming at improving transparency of the budget process in all its phases.  The pursuit of capacity building for decentralized governance requires a programmatic approach to improving the potential of state and local governments to manage economic and social development. Capacity building refers to both human capital and technological development and demands support for training activities, as well as technological endowments; for both of these, development partners can play a significant role. Selected areas of need include revenue estimation, overall budget process, collection procedures, and development planning and execution.


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