Decentralization of Intergovernmental Finance in Transition Economies

ACES Panel Paper

Decentralization of Intergovernmental Finance in Transition Economies

Richard Bird University of Toronto

Caroline Freund

and

Christine Wallich World Bank

Extensive political and fiscal decentralization is now underway in almost all countries in Central and Eastern Europe and the former Soviet Union. How it evolves will be central to the achievement of these countries' reform goals. Fiscal decentralization involves transferring some authority over expenditure responsibilities and financing from central to subnational government units. Politically, , decentralization reflects both a reaction from below to the extensive central control and an attempt by the center to relieve its strained fiscal situation. Economically, decentralization has been moti- vated by the imperative to utilize public resources more efficiently.

Decentralization and the Transition Economies

Decentralization is a key dimension of the transition from a command to a market economy. Not only must the structure of tax and transfer mechanisms be reconsidered, and expenditure responsibilities realigned among different levels of government, but fundamental views as to what governments can and should "do" must change. The total level of public sector activity must be dramatically reduced, but at the same time the new subnational governments must be allowed to take on appropriate responsibilities and build institutional capacities in a manner that makes them capa- ble and accountable for their final decisions.

Comparative Economic Studies 149 Vol. 36, No. 4, Winter 1994

150 BIRD, FREUND AND WALLICH

A recent study of fiscal decentralization in seven transition economies (Bird, Ebel and Wallich 1995) examines relevance of traditional analyses of intergovernmental relations: fiscal functions of subnational and central governments such as macroeconomic stabilization, income distribution and resource allocation. In any economy, intergovernmental finance affects the degree to which the public sector can mobilize resources. Fiscal decentralization, if appropriately designed, will lead to improved public service provision. In transition economies, the importance of decentralization policies goes well beyond these resource mobilization and efficiency concerns. The BEW (Bird, Ebel and Wallich 1995) study suggests that the framework needed to analyze decentralization and intergovernmental fiscal issues in the transition economies must incorporate such elements as the likelihood of continuing structural changes in the economy and continuing political shifts; the need to undertake intergovernmental reforms while coping with stabilization pressures; and the increased importance of the (locally financed) social safety net during the transition; the likelihood of continued (local) public ownership on a significant scale; the financial implications of such ownership and its possible conflicts with privatization; and continued vestiges of price and wage controls and other rigidities, especially in the public sector. In short, the analysis of fiscal decentralization in transition economies is fundamentally different from the corresponding analysis in market economies. We look below at why this is so, based on a survey of the decentralization experiences, since 1989, of Hungaty, Poland, Bulgaria, Romania, Ukraine, the Russian Federation, and Albania.

Expenditure Assignment

The primary economic role of subnational governments in a market economy relates to the delivery of (local) goods and services. In socialist economies, subnational governments had no spending responsibilities of their own; subnational expenditures were included in the unified budget of the central government. Now, "local self-government" legislation affirming decentralization has been enacted in virtually every transition economy, giving the subnational level major and broad new rights and responsibilities. On average, the subnational sector in the countries studied has become quite large. Subnational spending accounts for about 30% of total spending; in Russia, it accounts for about half. However, this legislation remains murky in assigning expenditures.

Tradition, or in some cases, expediency, , has governed the actual choice of functions managed by each level of government since the end of the command period. For example, macroeconomic stabilization often dominated

DECENTRALIZATION IN INTERGOVERNMENTAL FINANCE 151

national and intergovernmental agendas thereby influencing expenditure assignments. Desire to reduce fiscal imbalances seems, in many cases, to have led to a significant transfer of spending responsibilities to the subnational levelwithout a corresponding shift in revenue sourcesapparently to safeguard the central budget. Recent legislation in Hungary and Poland has given local governments expenditure responsibilities in education, transpor- tation, environment, and housing and related serviceswithout specifying how these will be financed. Expediency has led the Ukraine and the Russian Federation to shift responsibility for the social safety net "downstairs."

These spending assignments, whether traditional or expedient, are not always consonant with best practice. The benefit area approach to local finance tells us that each function should be assigned to the lowest level of government that encompasses all or most of the service benefits. However, in the transition economies studied, decentralization has led to the transfer of a number of services with major benefit spillovers (education, health, and social welfare, for example) to the subnational level. While the administration of these programs by local governments may be appropriate because they are closer to the people, the many small local governments that have been created as a result of the strong political push for decentralization cannot likely provide these services at an adequate level from their own resources. Unless service standards and funding for such services are addressed via the intergovernmental system, they may be underprovided, or provided very disparately, depending on the resources available to each locality. Such emerging differentials in service provision is already a hallmark of the decentralization process-cum-fiscal stringency in Russia and Ukraine. Albania has avoided it to some degree by continuing to centralize provision of services such as health and education.

Expenditure assignment in the transition economies studied, and in transition economies 'generally, is significantly complicated by the fact that many public goods and services (education, health, roads, housing and infra- structure) have been traditionally supplied by public enterprises. Estimates of such expenditures by enterprises in Russia range up to 5% of GDP. In some regions, enterprises' "public" spending exceeds budgetary social spending and, in a few "one-company towns" there is no public spending by the budget at all on non-administrative functions. Enterprises will not provide these services after they are privatized, and responsibility may fall onto subnational governments to finance them. But local governments will need revenue sources to finance the additional burden. 1 The BEW study suggests that subnational governments, in response to budgetary pressure, may oppose privatization if it means that enterprises can no longer provide key public services. Alternatively, in some of the countries studied, local


governments looked to the profits from direct public ownership of local busi- nesses for "revenue." Thus, some regional governments and municipalities have become engaged in private sector activities even to the extent of devel- oping local enterprises using their own land and buildings as a contribution to "public-private joint ventures"a reverse privatization of sorts. This creates two problems. First, it undercuts the transition process, impeding rather than furthering the municipalities (and the nation's economic viability. Second, it subjects the public budget to the financial uncertainties of the market.

Financing Subnational Governments

The intergovernmental revenue system that has been inherited from the command era urgently needs reform. To date, it is characterized by heavy transfer dependency and the almost complete absence of robust own revenue sources for the subnational sector. The latter makes it virtually impossible for local governments to contribute to the nation's fiscal health by increased own tax effort. And the lack of a transparent system of intergovernmental transfers creates incentives for subnational governments to resort to, rather than free themselves from, central dependency and its implicit control of their fiscal decisions.

National tax reform has been initiated in every country in the study to make the tax system more compatible with a market economy and to provide a secure source of revenue for essential budgetary outlays. More recently, tax changes have been driven by a desire to harmonize fiscal regimes with the European Union. In most cases, these national tax reforms do not seem to have taken the fiscal needs of subnational governments into account. Given the inadequacy of the "own source" revenues specifically assigned to subnational governments in the transition countries studied, these governments remain dependent on central tax sharing for a large part of their resources, as well as on transfers. Because of this reliance, national tax policy is also subnational tax policy, but this fact has not been explicitly taken into account so far. For example, when Hungary's personal income tax, or Russia's VAT were reformed, even though subnational governments receive significant shares in both, little account was taken of the effects that the proposed changes in the tax rate or tax base would have on the amount or the distribution of revenues that would be received by subnational governments.

Financing through User Charges

Governments in the command economies traditionally used fixed prices and wage controls as essential elements of their distributional tool-kit. Health


services and education were nominally free. As a part of the social con- tract under socialism, governments also provided some private goods, including rents, many urban services, transport, utilities, food, and sometimes clothing at a low price or for free. The objective was to rectify fundamental or perceived distributional problems; in fact these measures resulted in little equity being purchased at a high price in efficiency terms. With sub- sidies available to all, leakages to the non-poor represented a major fiscal cost. As part of their stabilization and adjustment programs, transition economies are being urged to correct public sector prices and to use national tax and expenditure policies and targeted allowances to achieve their distributional aims. But for the time being, many user prices for public services remain a classic combination of subsidy, inefficiency and inequity.

The benefit approach to local government finance suggests that, where possible, services should be paid for by those who benefit from them. While the prices of most goods in the private sector have been liberalized in the transition economies studied, governmentsboth local and centralare having trouble adjusting prices for public services, even for private goods provided by the public sector such as housing rents, water, heating and transport fares. For example, among the transition economies, including those studied, only Albania and Croatia, in mid-1994, set household electricity tariffs at levels that approached economic costs.

Why is greater use not being made of user charges? One reason is central pricing mandates. Centrally controlled user charges continue to be a

problem for subnational governments in many transition economies. In Albania, for example, water charges are set at nationwide uniform rates even ihough provision costs differ across districts. In Russia, transport fares were fixed in nominal terms at a uniform rate for all localities until late 1993. Some progress is being made in Hungary, however, where authority for setting sewer and water management fees has recently been transferred from the central government to municipal companies.

But much more important is the fact that household incomes have declined substantially in the transition; by as much as 30-50%, depending on the country. This, coupled with the fact that prices often have to be increased substantially, make it politically challenging to raise prices. Further, it is often not just one user charge that needs to be raised, but several (transport, power, gas, water, heat and rents, for example). Jointly, these can add up to a significant proportion of household incomes if the price increases were to take place simultaneously. In Poland energy outlays (priced on average at about half of economic cost) account for about 10% of households' spending. When housing and transport are included, where the subsidy is far greater, the proportion rises to about 20%. Doubling, or in some cases


tripling these public sector prices would imply significant changes in the cost of living and welfare, and will result in large distributional shifts if not coordinated with other wage and pension reforms and properly sequenced and/or possibly compensated with some kind of social pricing mechanism. The good news is that, in at least one of the countries studied, the middle class consumes absolutely and proportionately more of these subsidized goods than do the poor, so that introducing more efficient user charges will be progressive: equity and efficiency objectives coincide. Nonetheless, it will be a political challenge since so many are affected. Not surpris- ingly then, the traditional dictum of local public finance, to rely pri- marily on user charges for financing public services and to finance truly public goods with taxes, may need a slower introduction for the transition economies.

Subnational Taxes

Where it is impractical to impose fees or levy user charges, theory tells us that services should be financed by taxes levied on local beneficiaries. "Local taxes" are those over which local authorities have some control, for example, they set the tax rate, determine the tax base and receive the tax revenue.

WI:lich taxes to assign? The question is not easy for transition economies. In many market economies, the central government controls those taxes considered to be most redistributive, such as personal income taxes, and the cyclical corporate income tax, leaving more stable revenue sources levied on a consumption base or property to the local level. This pattern is not ap- parent in the transition economies studied, nor is it clear that it is immedi- ately feasible. For example, the VAT, a tax on consumption, represents perhaps the most stable flow of revenues and, from this perspective, might be suitable for local government. But the VAT, to be administratively feasible, must be levied at uniform national rates. (Since VAT is levied on the "destination principle," imports are taxed and exports are zero-rated, non- uniform tax rates would create distortions, incentives to falsify the value of goods traded between regions and require complex cross-border crediting mechanisms such as in the European Union, but for hundreds of small localities.) It cannot, therefore, offer fiscal discretion and is, therefore, unsuit- able as a "local tax," although its revenues might well be shared with local governments by some formula.

The cotporate income tax is a central tax in most market economies, although some federal systems (the U.S., Switzerland, Canada) allow subnational corporate taxes. For the transition economies, considerations of


both administrative complexity and allocative efficiency suggest that subna- tionally levied corporate taxes should be avoided at the present time. Permit- ting the many small subnational governments in the transition economies to set corporate tax rates (or adjust the tax base) will allow substantial tax competition and differentiation in enterprise taxation, influencing enterprise location decisions in perhaps undesirable directions. Given the current soft budget environment, such tax competition is likely to be detrimental for stabilization as well. And the complexities involved in prorating hundreds of different corporate taxes for those companies that operate in more than one jurisdiction will be prohibitive. A "tax jungle" is not needed at the present time in the transition economies, neither for domestic enterprises nor for the foreign investor.

Mach of the literature on tax assignment argues that the personal income tcvc (PIT), generally one of the more important taxes in revenue terms, should be retained by the central government, largely for redistributional and stabilization reasons. In most of the transition economies and in all the countries studied, however, some or all personal income tax revenues are currently directed to subnational governments; although in no case do those governments have any control over the rate or base of the tax. In fact, the PIT is an "in-between" taxthere are arguments for both central and local PITsand "piggybacking" (surcharging) a local PIT onto the central income tax also works well and is used to finance local governments in many OECD countries including Belgium, Canada, many U.S. states and Switzer- land. For transition economies, combining a uniform national base and national collection with locally set rates makes such "local" income taxes administratively feasiblehundreds of locally administered PITs would probably not be. Moreover, it is consistent with their present practice of giving local governments a share in the PIT; switching from a share to a

surcharge would make the PIT a more truly local tax. Compared to most OECD countries, there is much less labor mobility in transition economies, owing in part to housing problems and in part to tradition, so the potential effects of variable local income taxes on location are reduced.

In some ways, excise taxes and single-stage retail taxes would seem to be prime candidates for subnational taxation in the transition economies just as

they are in market economies, especially if the taxing locality is large enough to avoid revenue loss from consumers crossing the border to regions with

lower tax rates. (Such taxes thus seem more suitable for larger intermediate governments than for small local governments.) But, in the transition econo-

mies studied, excises, for example on tobacco or alcohol, have not been used as a means of financing subnational governments so far, although most of the

transition economies levy such taxes at a national level and are an important revenue source. Why? For administrative convenience, these taxes have been


levied at the producer level, not the retail level; and in the transition economy context this often translates into a tax on a few manufacturers (in Russia, for example, there are cigarette factories in only 21 of its 2000 raions), or sometimes on the single monopoly producer. Thus, only a few producing districts would benefit from levying these taxes and revenues from them would accrue to only a few localities. Assuming the center would give up this robust revenue source, unless such taxes are redesigned to be paid at the retail level by consumers, for which substantial administrative reform would be neces- sary (there is virtually no local tax administration at the local level outside the property tax) they will not be a broad-based source of local funds. As for local retail sales taxes, implementing them on top of the VAT, while theoretically feasible (Canada's provinces use them), would be costly, complex and inconsistent with the tax regimes of the European Union, which many central European countries intend to eventually join.

Most of the taxes at present specifically assigned to subnational governments in transition economies are what might be labelled "nuisance" taxes rather than potentially robust own revenue sources. Examples are a tax on the resale of used computers, on horse racing, on the use of logos in adver- tising, and on dog owners. In Russia they have been estimated to yield less than 0.5% of GDP annually; and in Hungary they produced about 0.7% of GDP; or less than 5% of local expenditures in 1993. Even for these taxes, a ceiling is set by the center on the tax rate, and subnational governments have no autonomy with respect to definition of the tax base.

What role for the proper tax? The role for the property tax is a major un- answered question in transition economies. Property taxes in some form have been or are being introduced in many transition economies, including those studied: Albania, Bulgaria, Hungary, Poland, Romania, Russia and Ukraine. Indeed, it is the only potentially significant tax that national tax reforms have assigned directly to subnational governments. Although relatively expensive to administer, property taxes have good efficiency characteristics compared to most other potential sources of local revenue. To the extent locally provided services increase property value, the beneficiaries of public expenditures are made to pay. In practice, however, the revenue performance of the property tax in the transition economies studied has been poor and much needs to be done if it is to fulfill its potential. Why? First, because most housing remains either publically or communally owned. Of the countries studied, the private housing stock is significant only in Hungary. Further, the absence of housing markets and, therefore, housing values, means that assessments are made based on the area (square meters) of the property. In addition, cadastral sur- veys and registration are poor or non-existent. As with all other taxes in these


generally unitary tax systems, the property tax rate in transition economies is

set by the central government, preventing any fiscal discretion on the part of the local government. Finally, the tax bases are often riddled with centrally mandated exemptions. In Hungary, for example, the central government mandates full exemptions lasting ten to twenty years for any privately owned housing that has had certain improvements. A tax on vehicles, however, is a

potentially attractive local revenue source.

Tax Sharing

Tax sharing refers to a system in which one government (usually the central government, but in some transitional economies the subnation) collects revenue from a tax and shares it with the other levels of government. In the transition economies studied, such tax sharing universally takes place on the basis of the geographic origin of the revenues (the so-called "derivation" basis). Tax sharing is common to all of the countries studied and is designed to supplement the meager own revenue sources that are formally assigned to the subnational level. Hungary, Poland, Romania, Bulgaria, Russia, Ukraine, and all of the other former USSR republics, share some or all of the VAT, CIT and the personal income tax (PIT) with the subnational level.

Tax sharing has the advantage of simplicity and, if shares are transparent and fixed, subnational governments are guaranteed some degree of revenue certainty. Unfortunately, in many transition economies studied, the tax shares change from year to year, vary by region and are often negotiated by each locality with the center. This makes any assessment about the equity impact of transfers or their effects on local revenue effort difficult. A general disadvantage of tax sharing is that it does little to enhance local accountability or efficiency. Localities receive revenues regardless of their tax effort and have no discretion to set the tax rate or base. If they view these revenues as costless, their incentive to spend efficiently is lessened. The result may be undue expansion of subnational spending.

In the transition economies shared taxes are allocated rely on a "derivation basis." Shared taxes are retained by (or accrue to) the jurisdiction in

which they are collected. This differs from most market industrial and de- veloping economies where shared taxes (like the VAT in Germany) may be shared through a formula based on factors such as population, per capita income, urbanization or other factors. Derivation-based sharing as a rule channels resources to high income areas where the tax base and, therefore, revenue collections are largest. It is thus inherently counter-equalizing. This may be a problem in countries where regional inequities are serious and where the intergovernmental system lacks other instruments (such as


transfers) to address such imbalances. The alternative of sharing revenues on the basis of an equalizing formula (used in many countries) could be used in the transition economies to the same end that transfers are used elsewhere.

Intergovernmental Transfers

Since it is unusual for the revenue-raising capacity and the expenditure needs of subnational governments to be perfectly matched, fiscal transfers are usually required to close the resulting gap. Such fiscal deficits could also be closed in principle by shifting tax powers to subnational governments by assigning expenditure responsibilities back to the central government or by reducing subnational expenditures and service standards. Transfers may be preferable to these approaches in part because they allow local governments to provide services and the central government to set standards. Transfers can be used to influence spending patterns at lower levels of government in line with higher-level priorities, to limit inequali- ties in the quality and quantity of regional services, to ensure that neces- sary services are provided, and to stimulate subnational tax effort.

In most transition economies the aggregate volume of transfers is determined entirely ad hoc by the central government, often changing with each annual budget. Rule-based allocation formulas are not yet common in the transition economies. Apart from Hungary and Poland, where an explicit formula for the normative grant includes an equalization component and a complex formulation of expenditure needs, most intergovernmental fiscal flows continue to be essentially discretionary and negotiated. Another major shortcoming is the role of expenditure "norms" to distribute central-local transfers. Designed to cover the recurrent costs of existing facilities, they are capacity- rather than needs-oriented. As such, they serve to perpetuate the inefficiencies of central planning.

A good case may be made for reducing the role of the old command system's discretionary and negotiated approach to transfers and to increase the role of own source revenues. The old system perpetuates the socialist structure of deconcentration, where functions were carried out by local branches of central ininistries, and works against the development of responsive and efficient subnational goveriunents. It practice, however, the cutbacks in transfers that have taken place as a result of fiscal stringency and stabilization have not been accompanied by any attempt to rationalize the system through a reas- signment of tax bases to subnational governments or to efficiently design and target grants. In all countries, central transfer to subnational governments fund a large share of subnational spending. In 1993, tax sharing and transfers together accounted for 100% of subnational revenues in Albania; more than


90% in Bulgaria, Russia and Ukraine; and more than 75% in Hungary and Romania. This reflects both the center's reluctance to give up a tool for con- trolling subnational governments and the failure of some local authorities to modernize and strengthen the limited revenues they do control.

Establishing a specified percentage of national revenues, or a share of some particular national tax or taxes, to be transferred has substantial advantages for both central and subnational budgeting. With this system, central government is somewhat insulated from pressure to increase its support of local governments, and subnational govermnents can budget with greater certainty knowing that the level of central support will vary with a known formula and is not subject to discretionary central policy.

Once the aggregate volume of transfers is determined, the next step is de- termining its distribution across subnational governments. Conceptually, if not always politically, this step too should be as transparent as possible. One approach would be to estimate minimum expenditure needs of each locality based on objective demographic or economic indicators (population, per capita income or social indicators), to estimate local own-source, assigned or shared revenues available to finance these needs, and to provide a transfer related to the difference. Depending on how much interregional equalization of expenditures (and thus services) is desired such transfers may fill all or part of the estimated revenue gap.

How much equalization is appropriate? This is inherently a political judgment. Equalization, if carried too far, can penalize better-off regions whose industrialization and growth potential are arguably the greatest as their resources are transferred to less productive poorer areas. The transition economies studied have explicitly or implicitly balanced this tradeoff between growth and equalization in different ways. In some countries there are vast disparities between regions, and equalization is a political priority. In others the need for political unity may require allowing better-off regions to pull ahead based on their own resource base. In Russia, for example, better-off oblasts may simply opt out of the sharing system if too many resources are taken from them and shared with poorer regions.

A case for conditionality? A striking feature of transfers in the transition economies is that they are largely unconditional. Though this has its merits, a good case can be made for some conditionality in intergovernmental fiscal transfers in transitional economiesthe central government has a legitimate interest in what is done with its grants and the country has a legitimate need to ensure that services such as education and health are available throughout the country at some minimum standard. Standards might include,


for example, adherence to national curricula or hiring only credentialet1 med- ical personnel or teachers. Another approach is to impose conditions on transfers. For instance, support for health services may depend on whether residents from other localities have access to treatment. Matching grants can also be used to augment subnational spending for a specific purpose. If non- residents enjoy a percentage of the benefits in principal, a matching grant equivalent to that percentage would ensure that the good is supplied suffi- ciently. They may also increase tax effort by the local government as the opportunity cost of not raising revenues increases. But for these incentive effects to take hold, subnational govenunents need to have some spending autonomy and taxing discretion. In transition economies neither may be suffi- ciently the case.

Conclusion

Given the clear political pressures to decentralize and the potential economic advantages of doing so, the transition economies must put significant efforts into the design and implementation of new, subnational and intergovernmental finance systems. But they should be cautious. The dangers of poorly designed decentralization programs are clear: the safety net, stabilization, privatization, regional equity and the provision of essential services could be at risk. The issues are complex, technically and politically. How alternative policies will impact local development is often difficult to assess. Much more concrete analysis, based on sound local knowledge and data is needed to improve the design of the systems that are being put into place. Institutional development of the local governments themselves and in the central ministries charged with supporting and framing the decentralization process will be key. Well-designed decentralization policies will help improve the lives of those undergoing one of the major upheavals of our timethe move from a command to a market economy.

Note

1. Indeed, a recent World Bank project in Russia proposes to give ti ose local governments strongly promoting privatization a one-time allocation to facilitate the regional divestiture of such services.

Reference

Bird, Richard, Robert Ebel and Christine Wallich, eds. 1995. Decentralization of the Socialist State, Washington, D.C.: World Bank, forthcoming.

Decentralization of Intergovernmental Finance in Transition Economies

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