Many developing and transitional countries recognize that excessive centralized decision-making prior to the 1990s had led to an unresponsive public sector that was ineffective in delivering adequate public services. Following the principle of subsidiarity (which states that government functions should be performed by the lowest government level that can do so efficiently), there is an important role for regional and local governments in the public sector of most countries. In fact, fiscal decentralization reform and the design of a central-local fiscal relations forms an important fiscal policy issue in many developing and transition economies.

The design of an intergovernmental fiscal system involves four distinct pillars. First, expenditure responsibilities should be assigned to each level of government in accordance with the subsidiarity principle. Second, to the extent possible, subnational governments should be assigned own and shared revenue sources with which to fund their expenditure responsibilities. Third, a system of intergovernmental fiscal transfers should be put in place to supplement the own and shared revenue sources provided to the subnational level. Finally, whenever possible, a framework for subnational borrowing should be set up that would allow qualifying local governments to borrow for capital infrastructure purposes.

However, the available evidence suggests that the success of fiscal decentralization reforms depends not necessarily on the quantity of decentralization, but rather on the quality of the decentralized financing arrangements. Because subnational governments often received a large majority of their resources from intergovernmental fiscal transfers, the reform of intergovernmental fiscal transfer systems is arguably one of the most common -but perhaps also one of the most challenging- components of fiscal decentralization reforms.