Because subnational government taxation is not a viable option in many low-income countries, the financing of decentralized services often comes down to the choice between an unrestricted grant and one with conditions laid down by the higher level government. The central policy question that arises, and is explored in this paper, is how this choice does or does not compromise the success of fiscal decentralization.

We begin with some definitional issues and with empirical evidence about the revenue dependence on transfers in low income vs. OECD countries. Then we discuss the theoretical and practical advantage of conditional grants vs. unconditional grants in developing countries and give an illustrative review of the practice.