2.1. Introduction

In June 2004, the Commission tabled its submission for the Division of Revenue for 2005. As part of the submission, the Commission made Recommendations on its review of the PES and LES formulae emphasising key issues with respect to the different components of the two formulae. The recommendations made in respect of the PES formula assumed that the structure of the formula would not be changed.

Following on previous Commission engagements with stakeholders, in particular, the Finance Committees of the national and provincial legislatures and, following on decisions of government (as detailed in Annexure E of the Division of Revenue Bill for 2004), National Treasury also embarked on a review of both the provincial and local equitable share formulae, and the broader provincial and local government fiscal framework. In conducting this review, National Treasury, through a task team of the Technical Committee on Finance consulted widely with the Commission and other key stakeholders including government departments and organised local government. This submission constitutes the FFCís comments on Governmentís response to the Commissionís recommendations contained in Annexure E to the 2005 Budget Review.

In preparing its comment on Governmentís response to its recommendations, the Commission would like to emphasise that its recommendations are part of the FFC on-going work on the IGFR system. This FFC work is informed by stakeholder responses to annual submissions and specific requests from the legislatures and the three spheres of government. In addition, the Commission conducts further research to underpin specific recommendations dealing with matters of principle at the request of Government. In the absence of formal protocols the Commission believes that its current approach is the most practical way for determining the nature and content of its submission within the terms and conditions set out in the Constitution and other legislation.

In developing formal protocols of understanding with government the Commission would like to highlight the need for a comprehensive response to its recommendations by all government departments, organised local government and legislative stakeholders. It may be also useful that the final response from Government indicates, even in broad terms, areas of engagement for the next budget and MTEF cycle. This would undoubtedly ensure that the Commissionís next annual submission is informed by the needs of all stakeholders.

2.2. The Provincial Equitable Share

In making its recommendations on the PES formula, the Commission conducted a detailed examination and evaluation of the individual components in order to establish how each component performed against the policy objectives. Among these objectives was the improvement of equity in access to basic services and the efficiency with which resources are utilised. The following section summarises the Commissionís recommendations on the equitable sharing of nationally raised revenue.

2.2.1 Provincial Revenue Raising Capacity

The Commissionís recommendations highlighted the need to augment provincial own revenues by encouraging provinces to take advantage of the provisions of the Provincial Tax Regulation Process Act (2001) that enable provinces to implement their tax powers as provided for in Section 228 of the Constitution. This recommendation arises from the fact that due to lack of substantive "own" revenue, it has been difficult for provinces to alter expenditure patterns according to their needs. While the allocation formula aims to respond to the expenditure obligations of provinces, the expenditure patterns do not seem to reflect expenditure need but rather tend to equalise per capita expenditures across provinces.

The Commission recognises that recourse to tax powers by provinces entails many legislative requirements and procedural stages. However, the Commission would appreciate a more direct response to the principles proposed in the FFC submission given that some provinces envisage introducing certain provincial taxes in the future.

2.2.2 The Economic Activity Component

A proposal related to provincial own revenue was the possible review of the use of the economic activity component as a proxy for tax capacity. The Commission accepts the argument that in areas where economic activity is high, public infrastructure tends to come under pressure and therefore provinces with higher economic activity should be compensated. However, the Commission also believes that the economic activity component may be effectively applied if it is more precisely defined and an empirically tested method used to determine its relative weight in the formula. In its response to the FFC proposal Government does not advance an empirical reason for reducing the weight of the economic activity component by one percent. This may be viewed as an indirect incentive for provinces to improve on their revenue raising capacity as highlighted in the FFC proposals.

However, the decision to alter the weight for economic activity was accompanied by the introduction of a 3% poverty component weight in the formula. While the Commission understands the need for the formula to be redistributive, the introduction of such a poverty weighting into the current formula is not supported by any explanation and/or empirically tested method on which this decision was made. The Commission believes that before redistributive components are introduced into the formula, it is important to analyse and evaluate the impact of such components on the roles, powers and functions of provinces and, against other requirements listed in Section 214(a-j) of the Constitution.

2.2.3 The Poverty Component and Targeting

The Commission would like Government to note that, in the coming year, it will review all the transfers in the system aimed at addressing poverty. This exercise will be carried out across the spheres of government in order to evaluate the performance and impact of poverty-targeted grants with respect to the beneficiaries and economic development. In the first instance, the Commission intends to make proposals on grant design options that may address unintended duplication and the inefficient use of fiscal resources by the different spheres of government. In the second instance, the Commission has decided to investigate the possible refinement of the IGFR allocation system that will balance government provision of constitutionally mandated basic services taking account of the criteria listed in Section 214 (2) (a-j) of the Constitution and other macroeconomic constraints. In particular, the Commission is concerned with the fiscal consequences of rising unemployment, socio-economic inequality and the resulting poverty. These factors will put increasing pressure on the demand for social security grants, given the obligations on Government provided in the Bill of Rights.

Another important aspect of the Commissionís submission related to how different beneficiary groups are treated in the PES formula. Demographic data heavily drives the formula. However, all individuals are treated the same in the formula regardless of socio-economic status. The Commissionís submission highlighted the issue of poverty impacting differently, for example on learners from different socio-economic categories. This observation, however, does not imply that poorer provinces need to be compensated by the formula but rather that provinces with a high number of poor people have a cost disability that needs to be taken into account in the allocation of resources. For example, instead of treating learners as having the same ability, capability and access to education in the education component of the formula, an approach may be adopted that categorises learners into poor-urban, poor rural, etc and different weightings assigned to the different categories. This means direct targeting of beneficiaries in the allocation formula.

While the Commission is cognisant of some of the political imperatives associated with the decision to introduce a poverty component in the formula, it also urges government, in the phasing in period, to undertake a rigorous investigation to determine the factors that drive the different components in the formula in order to avoid ad hoc changes and new components in the transfer system. In its submission the Commission indicated that the long-term structure of the formula should reflect the policy priorities and objectives of the government. Such an approach may require a different structure of the formula altogether.

2.2.4 The Services Components

With respect to specific social sector components of the formula, the response of the Government supports the Commission proposals and addresses most of the past concerns of the Commission in the new formula. While the education component still utilises the school-age population, it will end the double weighting of this against the actual enrolment. The education component will also incorporate ECD with the age cohort expanded to incorporate Grade R.

Government agrees with the Commission proposal for replacing the medical aid non-medical aid population with differential demographic group utilisation rates in the health care component of the PES formula. However, government also notes that the current data are not very credible and thus emphasises the need for the health sector to improve the collection of the data for future use in the formula. For the next period more recent data on the medical and non-medical aid population will be utilised. While the Commission accepts the concerns of Government with respect to data, it also emphasises in its proposals that the relevant departments need to be encouraged to prioritise the collection of credible data for use in the formula.

Government has not fully addressed the Commissionís proposal on the social development component of the formula. In acknowledging developments with respect to the shifting of social security grants to national government, the Commission is concerned about the possible neglect in the funding of welfare services in the provinces. The Commission urges government to expedite the process of defining the basket of welfare services that provinces need to provide in order to avoid compromising the delivery of these services. As part of its on-going research, the Commission noted the discrepancies prevalent in the delivery of welfare services in different provinces.

2.2.5 Removal of the Backlogs Component

A key proposal of the Commission was that the backlogs component of the PES formula should be folded into the basic component and a separate conditional grant for infrastructure backlogs be set up and allocated to provinces through the Commissionís capital expenditure model. The response from Government was to accept that the backlogs component had not really served the purpose for which it was designed. The component was duly removed from the formula.


2.3. Conditional Grants to Provinces

2.3.1 Capital Grants

The principle of a conditional grant for infrastructure backlogs was accepted by government, but it was indicated that the Commissionís model could not be implemented at the moment due to inadequate data. Instead, National Treasury put forward an alternative approach to allocating the infrastructure grant. Government believes that the Commissionís model does not deal with the issues that the current provincial infrastructure grant aims to address. The Commission however, would like to highlight that its proposed model refers to infrastructure backlogs in a generic sense and is not directly aimed at the existing provincial infrastructure grant.

While the Commission notes Governmentís comments, it also emphasises that its model, in its current form, uses aggregated capital expenditure data from National Treasury and aggregated provincial capital stock data from the South African Reserve Bank. To provide broad indications of horizontal infrastructure grant allocations to provinces from a policy determined pool of funds the model does not require any extra data than the expenditure data held by National Treasury and the backlogs data held by the SA Reserve Bank. If there is agreement that these data are credible, then the Commissionís grant scheme does present government with a very flexible tool for allocating conditional infrastructure grants to address provincial infrastructure backlogs and on going capital expenditure needs. Since the formula allocates a grant for backlogs in terms of a provinceís overall capital stock rather than sector specific stock the onus is then upon the province to decide on the priority sectors that require urgent attention. The conditions for utilisation of the grant should target infrastructure backlogs in the delivery of basic services in education, health and socio-economic inequalities.

The Commission also notes that the proposed grant scheme does not ignore on-going capital expenditure needs for provinces with no severe infrastructure backlogs. The model also allocates an equal per capita amount to all provinces irrespective of whether or not a province has been defined as having backlogs or not. Furthermore, the model offers provinces the discretion and option for more effective prioritisation and planning. More importantly, it has a built-in mechanism for Government to monitor whether provinces are progressively eliminating infrastructure backlogs, building new and maintaining old infrastructure in order to provide CMBS and promote provincial growth and development.

Following consultations with National Treasury and other stakeholders in 2004 the Commission introduced weightings into the model to take account of relative cost disabilities and disparities specific to each province. This new version of the model was presented to Government and Parliament in January 2005 as a supplement to the FFCís 2004 annual submission.

While the Commission accepts the concerns about data, it should be noted that such data problems become compounded when allocations are based on sector-specific allocations. To address this problem National Treasury is consulting the Commission on the possibility of the FFC coordinating a research project that will assess the availability of capital stock data in all provinces and for all sectors.

2.3.2 Other Conditional Grants

The Commission submitted its preliminary observations on the use of conditional grants and how these grants may be made more effective. Government noted the Commissionís observations and generally agrees with the challenges highlighted by the Commission. However, government warned that some of the Commissionís observations had the potential for the introduction of inequity in the conditional grant system if pursued aggressively. It noted, rather that a more supportive approach should be adopted where there is evidence of lack of capacity in the relevant department administering the grant. This, government argues, would ensure that reduction in allocations would remain only a short-term measure to discourage under-spending.

The Commission will be making specific recommendations on conditional grants in the Submission for the Division of Revenue 2006.

2.4. The Local Equitable Share

2.4.1 Agreement on a Components Based Approach

In general, government agrees with the Commissionís approach to the review of the local government equitable share (LES) formula, Government agrees with Commission, in particular, that the windows approach to LES allocations should be avoided. Government has now adopted the broad component based structure of the formula proposed in 2002 by the Commission. Thus the revised LES formula specifically incorporates the Commissionís principal proposal that the provision of funding for municipalities should take account of the key cost drivers for basic municipal services

2.4.2 Cost Disabilities

The Commission welcomes the decision taken on this principle in guiding the review of the local equitable share formula. Government also agrees with the Commission that different types of delivery methods for basic services should depend on the appropriateness and cost of technology. Geographic and population density considerations do require different technologies for the delivery of similar basic services.


2.4.3 Revenue Raising Capacity and Spill-over Components

The Commission proposal for the need to incorporate a revenue-raising component is supported by government. The new LES formula from National Treasury has a component for the direct measurement of the revenue raising capacity of municipalities. This is in line with the Commissionís recommendations.

The Commission submission emphasised that a revenue raising capacity measure will be difficult to directly determine in the short term because of reforms to local government revenue sources, e.g. RSC levies, property rates, and the electricity distribution industry reforms. In the interim, government introduced a proxy revenue raising capacity measure into the formula. The Commission, in principle agrees with the use of the proxy measure and will continue with its current work to identify an appropriate measure for revenue raising capacity.

Governmentís response indicates that the Commission proposal for a spill over component in the formula does not show how this component should be defined and designed. The Commission notes this observation and will further investigate the criteria that should be used to define this component. However, several areas that require further clarification are discussed below.

2.4.4 Measuring Basic Municipal Service Expenditure Needs

The following paragraphs highlight some areas of the governmentís response to the FFCís proposal that require further clarification and explanation.

Firstly, Governmentís new LES formula makes provision for municipalities that offer higher levels of service (e.g. water borne sanitation as opposed to more basic sanitation). It is unclear whether or not the new formula will provide funding for municipal services irrespective of the standard/level of service that a municipality chooses. It would be more appropriate to stress that the LES should ensure funding for basic municipal services and any costs above that is borne by own revenue sources. In this respect, and as indicated by government, the Commission is continuing with its work on municipal service costs. Progress on this work will be advanced if government provides greater clarity on what constitutes the basket of basic municipal services.

Secondly, while it is in agreement with the Commission that a more accurate measure of expenditure needs for municipalities should be developed. Government suggests that such research should be for purposes of modelling and analysis rather than for allocations. This statement is unclear, as the Commission believes that any research on expenditure requirements is always undertaken to inform its recommendations on allocations.

Thirdly, Government states that it will not amend the MFMA in order to protect the equitable share from being ceded by municipalities as collateral for obtaining loans. The Commissionís recommendation in this regard was based on legal opinion. The legal opinion indicated no procedures and rules exist that regulate the ceding of the LES for municipal borrowing. [In particular, all of the procedures in Section 45 of the MFMA relate to the selling of municipal capital assets needed for delivering basic services]. Despite governmentís position, there is no fundamental disagreement, as Government did not disagree with the other option proposed by the Commission. The Commission welcomes the fact that Government accepts that the provision of constitutionally mandated basic services should not be compromised through inappropriate borrowing activities of municipalities.

Finally, on the Commissionís recommendation proposing that policies on tariff subsidies should be assessed to ensure that all residents have access to a minimum level of basic services, Government states that it cannot prescribe on the use of the equitable share. This assertion seems to misinterpret the Commissionís proposal. In this proposal the Commission is pointing to the fact that municipalities are expected to provide free basic services. However, many of them may not be able to do so outside of their equitable share allocations since they have negligible or no other source of revenue to enable cross-subsidisation. The Commission is therefore highlighting the need for government to ensure sufficiency of transfers for the provision of free basic services.

2.5. Conclusion

It is widely recognized that, over the past 10 years, the Commission has made and will continue to make significant contributions to the development of South Africaís intergovernmental fiscal relations system. Guided by the prescripts of the Constitution and the mandates thereof, the Commission constantly seeks to fulfil its obligations in a manner in which it not only applies sound financial and fiscal principles of public finance. In addition, it seeks to ensure the relevance of its recommendations to the problems and challenges posed by poverty, unemployment, governance, and the delivery of services, and the imperative to refine the intergovernmental fiscal relations system. Key to this task is the submission of advisories and recommendations to government, annually, based on sound research and national and international best practice.

Thus, the Commission welcomes governmentís acceptance of most of its recommendations for the Division of Revenue 2005. Acknowledging certain problems raised by government, the recommendations that have been accepted by government will enhance the allocation system and set the foundation for further and on-going constructive engagement in the development of South Africaís intergovernmental fiscal relations system.