Most countries spend public money at more than one level of government, and how money flows between levels — who taxes, who spends, and how the gap is bridged — is the field of intergovernmental finance. With Kenya's 2010 devolution among the world's more ambitious, this is a live, high-stakes topic. It builds on the fiscal-federalism theory of the Public Finance and Governance courses and turns it toward the budget machinery.
The assignment problem and vertical imbalance
Fiscal federalism starts with assignment: which level of government should tax what, and spend on what? The theory (Oates) assigns spending to the level that best matches local preferences (local services local, national public goods national) and assigns the most mobile and unevenly-distributed tax bases (corporate, income) to the centre, leaving immovable bases (property) to localities. The result is a structural mismatch: subnational governments are assigned substantial spending responsibilities but only limited own tax bases, so they spend more than they can raise. This vertical fiscal imbalance — the gap between subnational spending and subnational own revenue — is the reason intergovernmental transfers exist: the centre, which controls the productive tax bases, must transfer resources down to fund the services it has assigned to localities.
Types of transfer
- Unconditional / general-purpose (the equitable share) — money transferred for the subnational government to spend at its own discretion, usually by a formula. It funds the assigned functions and equalises capacity, while respecting local autonomy.
- Conditional / specific-purpose grants — money tied to a particular use (a health grant, an education grant), used where the centre wants to ensure a national priority or minimum standard is funded, or where there are spillovers across jurisdictions. They direct spending but reduce local autonomy.
- Equalisation transfers — money targeted to poorer or higher-need jurisdictions to offset differences in fiscal capacity and need, so that citizens get comparable services regardless of where they live (Kenya's Equalisation Fund is an example).
- Matching grants — the centre funds a share of subnational spending on something (matching local effort), used to stimulate spending on activities with positive spillovers.
The revenue-sharing formula
Sharing by formula
Unconditional transfers are typically allocated across subnational units by a formula, to make the division transparent, predictable, and insulated from political bargaining. A formula weights indicators of need and capacity — population (the biggest driver of service demand), poverty/equal share, land area (cost of serving sparse areas), and sometimes fiscal effort or specific costs. Kenya's Commission on Revenue Allocation (CRA) designs the formula that divides the counties' equitable share. The design choices are deeply political — every weight is a transfer from some counties to others — which is why the formula is fought over each review period, and why placing it with an independent commission (rather than annual political haggling) is meant to depoliticise and stabilise it. The formula embodies the same trade-offs as the calculus-of-consent: agree the rule behind a veil, and the per-period fights are contained.
Own-source revenue and the soft budget constraint
Two chronic problems shadow intergovernmental finance. First, the own-source revenue problem: subnational governments that are funded mainly by transfers have weak incentives to collect their own taxes (why do the hard, unpopular work of taxing local property and businesses when the centre's transfer arrives regardless?), so own-source revenue is chronically under-collected — and with it, the fiscal-contract accountability that local taxation would build (the tax course's theme). Second, the soft budget constraint: if subnational governments believe the centre will bail them out when they overspend or fall into debt (because the centre cannot let services collapse), they have an incentive to be fiscally irresponsible, and the centre's implicit guarantee becomes a fiscal risk. This is why subnational borrowing is usually tightly restricted and why hard budget constraints (no bailouts, enforced) matter for the discipline of the whole system.
Kenya's devolution
Kenya's 2010 Constitution devolved significant functions (health, agriculture, local infrastructure) to 47 counties and guarantees them a share of national revenue — the equitable share — of at least 15% of the last audited revenue (Article 203), divided among counties by the CRA formula, plus conditional grants and an Equalisation Fund for marginalised areas. It is a textbook case of this module: large vertical imbalance (counties spend far more than they raise), reliance on the equitable share, a hard-fought formula, chronic under-collection of own-source county revenue, and live debates about county borrowing and bailouts. The accountability and capture trade-offs were covered in the Governance course; here the lesson is the machinery — the assignment, the transfers, the formula, and the incentives they create — that determines whether devolution is funded coherently or lurches from crisis to crisis.
Exercise
A country devolves health and local infrastructure to regional governments, funding them mainly through an unconditional, formula-based transfer. After a few years: regional own-tax collection has collapsed, poorer regions complain the formula shortchanges them, and one heavily-indebted region demands a central bailout. (1) Explain the vertical fiscal imbalance that necessitates the transfer. (2) Diagnose the collapse in own-source revenue and propose a fix. (3) Explain the tension in designing the formula between population and poverty/need weights, and why an independent commission helps. (4) Analyse the bailout demand as a soft-budget-constraint problem and state how to respond.