The Role of Economic versus Political Factors in the Incidence of Intergovernmental Transfers in Nigeria

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The main element of Nigeria's system of intergovernmental fiscal transfers - known as the "Federal Allocations" - is driven by a set of vertical and horizontal allocations formulae. The vertical sharing formula determines the share of national revenues that is passed on to state and local governments, and it typically receives the greatest political attention. However, the horizontal allocation formula is also of major importance, and determines the allocation of resources among Nigeria's 36 states. In this paper we use a unique data set on Federal Allocations to examine the distribution (or the "incidence") of transfers across the states. Our empirical analysis suggests that the current allocation formula fails to achieve its stated objectives of equalizing expenditure needs and stimulating fiscal effort. Instead, the current incidence of transfers does not channel more resources to states with greater expenditure needs, and does not stimulate fiscal effort. The formula in fact is pro-wealthy, and provides disproportionately greater transfers to less populous states.

JEL Classifications: H770, H790, O230

Keywords: Intergovernmental fiscal relations, horizontal and vertical allocation formulae, fiscal incidence

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The design and implementation of intergovernmental transfer systems are important considerations in the theory and practice of intergovernmental fiscal relations. Particularly in developing countries, intergovernmental transfers typically represent the single largest source of finance for state and local governments. This is certainly true for Nigeria, one of the most important economies in sub-Saharan Africa, where over 80 percent of Nigerian subnational government financial resources derive from intergovernmental transfers.

There are many sound economic justifications for intergovernmental transfers playing such an important role in subnational finance. Among others, transfers can be used to encourage or to stimulate specific "virtuous" subnational government activities (such as basic education and health care); to equalize the fiscal conditions of state and local jurisdictions; to finance activities that generate spillovers to nearby jurisdictions; and to increase the fiscal effort exerted by state and local government. From the perspective of state (or local) governments, the transfer system should provide subnational governments with a high degree of autonomy over their own finances, enable them to plan their budgets in a timely way with a minimum of uncertainty, and assure them of elastic revenue sources.

Unfortunately, no single grant mechanism can achieve all these goals, as different grant mechanisms each have advantages and disadvantages. Indeed, the ultimate design of a country's intergovernmental transfer system depends upon whose perspective is taken and upon the policy objectives that are deemed most important by the national government. In funding state and local governments, the Federal Republic of Nigeria has chosen to rely upon a formula-based, unconditional grant system that - on paper, at least - complies with many of the economic principles of a sound intergovernmental transfer mechanism (Bahl and Linn, 1992; Ahmad, 1997; Ma, 1997; Boex and Martinez-Vazquez, 2001).

However, even when a country relies on a formula-based allocation mechanism, the distribution of public resources is always a political issue. While the "vertical" dimension of grants (or the division of resources between the federal and the state governments) has tended to receive the bulk of the attention in Nigeria, the design of the "horizontal" allocation formula (or the way in which grant funds are allocated across the states) is perhaps of greater political importance. Both the choice of the allocation formula and the precise manner in which the formula-based allocations are computed appear to cause a rift between the federal government's stated policy objectives and the ultimate allocation of financial resources among state governments. …