Fiscal federalism in rentier regions: Evidence from Russia

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Journal of Comparative Economics 33 (2005) 814–834

www.elsevier.com/locate/jc

Fiscal federalism in rentier regions:Evidence from Russia✩

Raj M. Desaia,∗, Lev Freinkmanb, Itzhak Goldbergb

a Edmund A. Walsh School of Foreign Service, Georgetown University,37th & O Streets, NW, Washington, DC 20057, USA

b The World Bank, Washington, DC 20433, USA

Received 12 January 2004; revised 9 August 2005

Available online 10 October 2005

Desai, Raj M., Freinkman, Lev, and Goldberg, Itzhak—Fiscal federalism in rentier regions: Evidenfrom Russia

When does sub-national fiscal autonomy prompt regional growth and recovery and, under whations, does it have adverse effects? We argue that unearned income streams, particularly in therevenues from natural resource production or from budgetary transfers from the central governmenform regions dependent on these income sources into rentier regions. Governments in these reguse local control over revenues and expenditures to shelter certain firms, i.e., natural resource por loss-making enterprises, from market forces. Using fiscal data from 80 Russian regions from1999, we test this hypothesis in both cross-sectional and panel specifications. Our results indicateretention, which is a proxy for fiscal autonomy, has had a positive effect on regional reform and invesince the break-up of the Soviet Union. However, we also find that this effect decreases as rentablestreams to regions increase.Journal of Comparative Economics 33 (4) (2005) 814–834. Edmund A. WalsSchool of Foreign Service, Georgetown University, 37th & O Streets, NW, Washington, DC 20057,The World Bank, Washington, DC 20433, USA. 2005 Association for Comparative Economic Studies. Published by Elsevier Inc. All rights reserv

JEL classification: H2; H7; P2

Keywords: Taxation; Intergovernmental relations; Socialist systems

✩ The findings, interpretations, and conclusions presented in this paper do not necessarily represent the vieWorld Bank, its Executive Directors, or the countries they represent.

* Corresponding author.E-mail addresses: [email protected](R.M. Desai),[email protected](L. Freinkman),

[email protected](I. Goldberg).

0147-5967/$ – see front matter 2005 Association for Comparative Economic Studies. Published by Elsevier Inc. Allrights reserved.doi:10.1016/j.jce.2005.08.004

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http://dx.doi.org/10.1016/j.jce.2005.08.004

R.M. Desai et al. / Journal of Comparative Economics 33 (2005) 814–834 815

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1. Introduction

The ability of rulers to tax local capital arbitrarily can limit significantly new investmenteconomic growth. By contrast, stable and predictable tax policies have often presagedcally the spread of the rule of law and the rise of modern capital markets(North and Weingast1989). For theorists such asMadison (1941)andMontesquieu (1989), the separation of powernot merely between branches of government, but between levels of government providesstitutional check on the capacity of central authorities to expropriate local wealth. As Maunderstood, governments at all levels are capable of expropriation; a fiscal division of pbetween central and sub-national government is necessary to constrain the powers of eaca potential consequence of fiscal federalism is to afford sub-national governments incenpromote local economic growth.

Following the massive fiscal decentralization in Russia in the early 1990s, economic rand recovery has varied widely across sub-national regions. As the regional governmentto exert greater authority over local resources, enterprises, and fiscal policy, the federal gment’s ability to police the common market came under considerable strain. Although sregions have liberalized their economies, enforced hard budget constraints, and protectedproperty, others have actively resisted these reforms despite efforts in recent years to rfederal authority.

The diverse Russian experiments in decentralization afford an opportunity to understaconditions under which federalism promotes local reform and growth. This paper idesome of the conditions under which federalism is, alternatively, market-preserving or msubverting in the Russian Federation. Our argument is an extension of the rent-seekreform discussion found in models of self-interested governments byDalmazzo and de Blasio (2001)and Esanov et al. (2001)applied to Russian regions. Our central premise isgovernments face a choice between appropriating rents and protecting investors. Becacal firms’ tax and wage payments are the main sources of regional revenue and emplogreater fiscal autonomy may encourage local governments to limit their own rent-extrfrom these firms. However, we posit that, where regional economies depend less on lgenerated revenues and more on appropriable rents from resource extraction or from butransfers from the central government, the fiscal incentives to protect investors disappearand regional governments are more likely to pursue these rent-seeking opportunities afirms as sources of political benefits. In sum, we hypothesize that those regions that rgreater share of locally-generated taxes will be more likely to reform and grow and theffect of fiscal autonomy on regional economic performance will be declining as approprents expand. Cross-regional and regional panel data from 80 Russian regions support tguments.

The next section outlines our basic argument. Section2 summarizes the evolution of integovernmental fiscal relations in Russia. Section3 examines the effects of rentierism on regioreform and economic performance. Section4 presents our findings from cross-sectional dSection5 extends these results by correcting for possible endogeneity and by examiningrelationships in panel data. The conclusion draws policy implications for continuing reof inter-governmental relationships in Russia and presents a brief comparison of RussChinese reforms.

816 R.M. Desai et al. / Journal of Comparative Economics 33 (2005) 814–834

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2. Fiscal federalism in the Russian Federation

The devolution of power to the Russian regions following the collapse of the USSRprimarily a response to a weakening central government that could no longer meet exture obligations(Lavrov, 1996). Under these conditions, regions lobbied for greater autonthrough specific agreements with the center, while the federal government continued tits own expenditure responsibilities. Partly due to this spontaneous decentralization in th1990s, the actual degree of fiscal autonomy varies across regions in the Russian FedThrough these agreements, regional governments have been afforded significant, butcontrol over local tax and non-tax revenue and over local spending.

In the second half of the 1990s, the degree of fiscal autonomy varied considerably.over, fiscal autonomy was not associated closely with regional enterprise reform in thatFigure 1shows the relationship between fiscal autonomy and the change in the average senterprise subsidies in budgetary expenditures between 1996 and 1999. Decreases inare positive, while increases are negative, to proxy for the hardening or softening of rebudget constraints. In this diagram, we rank regions by their average tax retention ratiolowest to highest, for the period 1996 to 1999. On this basis, we calculate each regioncentile rank in the sample, which is shown along the horizontal axis so that the sampleare easily visible. We then construct a ten-region rolling average of changes in subsidiesthe first observation inFig. 1 is the mean for regions 1 through 10 and the second is the meregions 2 through 11, and so on. Finally, this rolling average is plotted against the regioncentile rank in tax retention. Overall, no significant correlation between the change in suband the retention rate is observed.

We argue that fiscal autonomy should benefit regional economic performance. Fiscalomy creates powerful incentives for local governments to expand the local tax base by proenterprise reform, by restraining their own rent-extraction from firms, and by policing againset stripping by firm managers and owners. However, these incentives may be weakenepresence of two different types of appropriable rents, namely, income from natural resoutraction and budgetary transfers from the central government. Regions dependent on theof income have been transformed into rentier regions, in which the incentives to reforoutweighed by the benefits of ensuring that firms become a permanent source of rents. Tditions under which large, usually formerly state-owned, enterprises have influenced laweconomic policies in ways that reward these firms are discussed inHellman et al. (2003). Firmsengage in this type of rent-seeking behavior in order to perpetuate the regimes that restentry into their markets, to preserve their opportunities for arbitrage between reformed anformed parts of the regional economy, and to protect themselves from regulatory interferethe central government. In many cases, Russian regional governmental policies are charaby this form of state capture, in which policies and regulations are enacted to benefit inflenterprises(World Bank, 2004).

Regional politicians are not pure captives of these firms, nor do they merely collect pbenefits in the form of campaign contributions in return for their provision of favorable polOn the contrary, they are typically active participants in a mutual relationship in which, thlaw, regulation, or intimidation, firms may be forced to provide concrete political benefiregional governments in the form of employment and non-wage benefits for both employethe general public(Desai and Goldberg, 2001). In particular, the absence of a well-functionisocial safety net, either nationally or sub-nationally, has prompted regional governmentsfirms as surrogate sources of social services. Given the fiscal legacies of the Soviet state,

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3. Rentier experiences and fiscal autonomy

A rentier state is financed not from the domestic tax base but from externally generatenues or rents. If income from these rents constitutes a significant portion of total goverevenues, the rentiers wield considerable political influence. Public officials will maintain tselves by appropriating these rents for public expenditures, as well as for private use, alittle incentive to expand the local tax base by reforming the local investment climate foreasons. First, a high degree of unearned income is likely to prompt more intense rent-sbehavior among politicians, whose incentives are influenced by these potential income sEmpirical assessments of this voracity thesis, e.g. byTornell and Lane (1999), show that sudden terms-of-trade improvements, the new discovery of natural resources, or a large stforeign aid can prompt a gold rush in which competition over newly available rents crediversion from more productive activities in the economy. Second, revenues from rents cato the detachment of public institutions from their tax base. As the income streams frombecome the primary source of public revenue, public institutions are less likely to rely on scredibly-constrained, tax policies and more likely to become predatory in nature, relyingexpropriation of these income streams(Levi, 1988). Rather than being a boon to the state,lief from the need to develop a sufficient local tax base leads to unaccountable, inefficieuninformed bureaucracies.

The economic and political consequences of rentierism are observed most commonlynatural resource curse. However, similar effects are found in countries that derive signincome in the form of remittances from foreign workers or from foreign aid flows.Sachs andWarner (2001)show that resource-abundant countries have historically had lower growththan economies with fewer resources.Leite and Weidmann (2002)andRoss (2001)demonstratethat these countries tend to be governed by more corrupt, less democratic polities. Stating on either natural resource income or the remittance income of foreign workers alsohave poorer-functioning fiscal institutions, asChaudhry (1997)discusses. If the sources of pulic revenue are few and concentrated, especially strong incentives for collusion arise betwstate and those who control income sources in order to maintain the status quo, asMoore (1998)argues. Moreover, since natural resource endowments represent specific assets, rents frassets are more readily captured by local elites than would be the case for more mobile(Collier and Hoeffler, 2002). Finally, recent assessments show that foreign aid flows createlar adverse incentives for public officials in aid-dependent countries.1

Two major rentable sources of income, namely, revenues from the production and exnatural resources and revenues from budgetary transfers from the central government,

1 Excessive dependence on foreign aid makes national governments less financially dependent on their own tThus, such dependence may generate similar incentive distortions as do natural resource rents. Respective gomay find it more efficient to spend more resources on extracting additional aid from the international communitydeveloping their own tax base, asMoore (1998)argues. Similarly, cross-national evidence suggests that foreign aierode the quality of governmental institutions in heavy borrowers, asKnack (2001)shows.


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portant for the Russian regions.2 At the sub-national level, potential resource rents are largethe oil, gas, and mineral-rich regions, where both private and state-owned resource comprovide significant private benefits to politicians and significant non-wage benefits to thepopulation. Indeed, the Russian government is believed to under-tax the country’s majorand fuel companies.3 Consequently, a relatively small fraction of natural resource rents aretured by the public sector in the Russian Federation. Most of these rents are appropriateprivate interests that control the natural-resource firms, asPopov (2001)andEsanov et al. (2001describe.

On the other hand, transfers are primarily a reflection of the central government’s eto reduce cross-regional income differences through redistribution to the poorer regionder Russian inter-governmental revenue sharing rules, shortfalls in regional expenditucompensated for by transfers from the central government. Although formula-based inple, these arrangements have been applied with greater variability across regions. In psince constitutional elaboration of the revenue-sharing mechanism is minimal, the Russitem lacks a stable set of predictable rules for tax sharing, transfers, and expenditure assigInstead of being based on ex ante specified rules, inter-governmental finance in the Russeration is based primarily on the bargaining capacities of the individual regions(Freinkman etal., 1999). During the 1990s, fiscal arrangements between regions and the center channually. Through a combination of extortion, bribing, and lobbying, certain regions managsupplement their resources with additional funds from the federal government. Particularpable were the autonomous republics and okrugs, the regions that contain Russia’s ethlinguistic minorities and whose governors often used the implicit threat of local Chechnyasecessionist movements to extort greater sums from Moscow, asTreisman (1999)documents. Atleast until 2001, a large portion of the total flow of transfers was determined by regional inflpeddling, according toSinelnikov et al. (2001).

Transfer-dependent regions commonly have considerable social liabilities and a depenterprise sector. The largest ultimate beneficiaries of federal transfers in these regionslarge loss-making firms, which are typically voucher-privatized or partially state-ownedthat require some form of budget subsidy for survival. Such enterprises remain the largeemployers; they are run by manager-owners who, with the support of regional governmentshielded their firms from competition. Thus, the collusion between administrators in poogions and managers of bankrupt enterprises is funded mainly from the federal budget throinter-governmental transfer system. In other words, local coalitions in support of the statare strengthened by the acquisition and distribution of federal transfers among local const

Research on the economic impact of regional fiscal policies in Russia is divided on the sof fiscal federalism. On the one hand, several empirical analyses find that sub-national auimproves the economic performance of regions.Berkowitz and DeJong (2003)conclude thatdecentralization, combined with reformist preferences among regional governments, spuenterprise formation and economic growth.Ahrend (2002)suggests that dependence on fedetransfers distorts the incentives of regional governors; those who have a comparative ad

2 Similar rents were available to local apparatchiks in the USSR when large highly profitable firms, e.g. metalplants, were established in regions through a system of investment grants funded by the national budget. Wfirms became a dominant source of regional budget revenue, their role was not much different from the major oilextracting companies in the resource-abundant regions today.

3 In 2000, the Russian Federation generated approximately one half of the tax revenues per ton of extractedof OECD oil producers, i.e., Denmark, Norway, and UK, according toSpeck and Matusevich (2002).


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in getting transfers devote less effort to protecting their local tax base. Transfers leadgrowth, but this effect disappears when geographical and political factors are added. At thtime,Kuznetsova (2001)finds little evidence of a robust link between the incidence of subsin regional budgets and regional growth. A recent survey of 200 firms in 20 regions bCenter for Economic and Financial Research(CEFIR, 2003)shows that local inter-governmentfiscal relations within regions, in particular, the extent to which additional local revenues ataxed by the regional-level budgets, reduces the local regulatory costs of business. ConZhuravskaya (2000)argues that limited fiscal autonomy encourages governments to over-taover-regulate local firms.

On the other hand, several analyses find that fiscal autonomy enables sub-nationalments to perpetuate soft-budget constraints for local enterprises.Litwack (2002)argues thaimperfect central control of sub-national budgets may drive regional governments towardsrent-seeking. Similarly, in a survey of over 800 public officials in the Russian regions,Stoner-Weiss (2005)finds that regional governments have acquired significant autonomy fromcenter, often granted to dampen secessionist tendencies, that limits the capacity of thestate to govern the provinces. However, politicians and enterprise insiders in several oregions have used their independence from Moscow to stall, and even reverse, reformsmaintain local firms as sources of rents for both politicians and managers.

On average, about one-third of total regional and municipal expenditures in the middle1990s were linked to the financing of various enterprise subsidies, according toFreinkman andHaney (1997). The main recipients of these benefits were concentrated in the housing,transport, and agricultural sectors; they were typically among the largest region-specific cnies. Consequently, sub-national governments have actively obstructed enterprise restrby the perpetuation of soft budget constraints and, in some cases, through formal limitatparticular enterprise activities, asMcKinsey & Co. (1999)documents. Regional subsidies mtake the form of preferential tax treatment, discounts on utility bills, and favored status inprocurement. All of these are intended to prevent companies from shutting down and layemployees and to place potentially productive companies at a cost disadvantage.

Similarly, Lavrov et al. (2001)claim that complicated informal agreements between regiadministrations and the largest local enterprises have been the general rule during theSuch enterprises are subject to implicit taxation in the form of mandatory financing ofpublic services, e.g., health, education, housing, and road maintenance. In return, theseceive various privileges, such as explicit and implicit tax exemptions, debt relief, and protagainst bankruptcy and competition. Finally,Radayev (1996)describes another form of implicsub-national taxation, namely, volunteer contributions to various extra-budgetary funds (which are established through the sponsorship of sub-national governments. Local smmedium enterprises face a higher risk of being forced to make payment to these fundsEBFs are technically illegal, governments have been using indirect forms of control ovfunds for several years. Finally, wealthier regions spend relatively more on subsidies tenterprises and richer regions have pursued less efficient policies, notably higher tax baccording toKuznetsova (2001). Nevertheless, little empirical analysis confirms the impacpolicy-induced distortions on the incentives of Russian sub-national governments. With tception ofZhuravskaya (2000)and a report by the Center for Economic and Financial Rese(CEFIR, 2003), both of which examine revenue-sharing schemes between local and regovernments, most research consists of case studies of particular regions. What has nexamined systematically is the impact of fiscal decentralization on private sector develoand growth across regions.


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4. Data and basic results

Our sample covers 80 Russian regions between 1996 and 1999.4 The fiscal data, includingthose on retention rates and inter-governmental transfers, were provided by the Moscowfor Fiscal Policy, which generated these indicators based on the original database of theMinistry of Finance. All other regional indicators are obtained from the Russian FederaState Committee for Statistics (Roskomstat).

To investigate cross-regional variation in regional economic performance based on redata, we use the following form for our regressions:

(1)y = β0 + β1R + β2Q + β3(R × Q) + β4X + ε,

wherey is an indicator of regional performance,R is the tax retention rate,Q is a measure orents from non-tax revenue,X is a vector of control variables, andε is a random disturbanceIdentifying a single informative and regionally-comparable indicator of reform progress islematic. For example, the rate of regional economic growth reflects some short-term effpolicy reform. However, in Russia a major portion of regional growth has been driven by anumber of the largest firms in the energy and natural resource sectors. This growth dodepend much on sub-national policies but rather on oil and mineral prices, as well asprivatization of these firms. The changes in enterprise subsidies provided by regional gments are a useful proxy for the nature of budget constraints on local firms, and more bfor the degree of regional policy distortions. However, during the 1990s, the main sourcebudget constraints in Russia was not subsidies from regional governments, but rather thegovernment’s tolerance of tax and utility-payment arrears, asPinto et al. (2000)demonstrate.

Enterprise privatization is considered a core component of the transition, but even thicator is flawed. Privatization through vouchers, which was the instrument used for the mof medium and large Russian firms before 1996, may be a useful proxy for regional refospite some evidence of poorly-functioning corporate governance arrangements for thesin Black et al. (2000). However, privatization using a range of other methods, in particularnon-competitive tenders and trade sales employed for the largest firms, may not reflect retendencies at the regional level. Finally, other outcome variables, such as levels of foreigninvestment (FDI) or small-medium enterprise (SME) penetration, have their own limitagiven the peculiarity of the Russian industrial structure. In Russia, FDI inflows have beecentrated in the energy sector and the linkage between FDI and regional economic polunclear. Similarly, while claims are made that SMEs have been an engine of growth in traeconomies,Slinko et al. (2005)show that SME development and regional policy reform areclosely related in Russia.

With these caveats in mind, we choose four indices of regional performance. First, we cothe cumulative change in gross regional product (GRP) between 1994 and 1999 deflathe regional price deflator. Second, we take the difference in the average share of ensubsidies in regional budgetary expenditures between 1996 and 1999 with decreases in sbeing positive and increases negative. Third, we use the number of privatized companies b1996 and 1999 as a percentage of registered companies in 1996. Finally, we consider thcumulative foreign direct investment per capita from 1996 to 1999. Cross correlations for

4 The sample excludes the Chechen Republic and eight autonomous okrugs, which are the smallest Russiahaving limited statistical coverage.


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Table 1Cross-correlations of dependent variables

Regional recovery Decline in subsidies Private companies Foreign direct inves

Regional recovery 0.0209Decline in subsidies 0.23650.027 0.0771Private companies 0.05880.624 0.39030.001 0.0101Foreign direct investment 0.29010.012 0.24260.037 0.31550.008 1.6536

Notes. (i) Thep-values for correlation coefficients are superscripted. (ii) Variances are listed along diagonal.

dependent variables are reported inTable 1. The relatively low correlations suggest that eavariable accounts for some particular aspect of overall regional performance and reformRussian Federation.

We examine the effects of two different sources of rents, namely, natural resource prodand transfers from the federal budget in separate estimations. The former, denoted Reis proxied by the percentage of regional output from fuel and energy production, accordtheRoskomstat sectoral classification. The latter, denoted Transfers, is the share of regionaget revenues from federal transfers; it includes all main channels through which federawere transferred to regions, namely, equalization transfers and smaller federal programas budget subventions.5 For the whole sample, the non-weighted average share of the esector in industrial output is about 20%, but, for 31 regions, this share exceeds one thirdlarly, although the average Russian region received 16% of its budgetary revenues fromtransfers, this share was above one third for 18 regions. The control variables are the loregional population, denoted Population, to control for size, the regional export-to-GRPdenoted Exports, and the log of per-capita GRP in 1994, denoted Income. We also incadministrative-status dummy variable, denoted Autonomous, which is coded 1 if the regioautonomous republic or okrug and 0 otherwise. The retention rate, transfers, and export-are expressed as averages for the period from 1996 to 1999.6

Our variable for fiscal incentives is the retention rate of tax revenues, denoted Retwhich measures the share of locally generated revenues kept with the regional budget. Hthis variable reflects only official taxes, which are collected and accounted for in regular gment budgets. Because a high incidence of informal regional taxation remains off-budgretention indicator underestimates the degree of regional control over the local tax basewe are interested in the impact of inter-governmental fiscal arrangements on regional incto support growth, revenues hidden from the federal government outside of the regular rbudget are likely to have limited impact on growth incentives because of their unstable anporary nature. Large EBFs could help regions to solve particular current budget or ecoproblems but any incentive effect is likely to be negative. Regions with large EBFs woumore inclined to invest their resources in diverting tax revenues from the formal to infosystem of public finance and be less concerned about expansion of the local tax base. Raverages for retention rates, resource wealth, and transfers, are presented inAppendix Table 1.

5 The regional budget variables relate to the consolidated regional budget; this figure includes both the bregional governments and budgets of municipalities located within the region.

6 We also considered a range of other control variables reflecting different demographic, social, and industriateristics of the regions, such as age structure, the share of urban population, R & D employment, and the availhousing. However, all such variables were statistically insignificant.


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Table 2Natural resource wealth and regional performance: basic cross-regional results

Dependentvariable

Regionalrecovery

Regionalrecovery

Decline insubsidies

Privatizedcompanies

Foreign directinvestment

(1) (2) (3) (4) (5)

Population 0.0308 0.0384* 0.0007 0.0545** 0.1264(0.0220) (0.0224) (0.0105) (0.0205) (0.2020)

Retention 0.6693*** 1.1788** 0.3212** 0.4639* 3.0924*

(0.2053) (0.4608) (0.1484) (0.2689) (1.6338)Resources 0.0799 0.9215* 0.3444* 2.9696*** 19.7100*

(0.1079) (0.5364) (0.1876) (0.9014) (11.6496)Retention× Resources −1.2886** −0.4324* −4.4603*** −28.7285

(0.6017) (0.2066) (1.3492) (17.6684)Exports 0.0294 0.0351 0.0048 −0.0186 0.2819

(0.0230) (0.0236) (0.0063) (0.0161) (0.1852)Autonomous −0.0617 −0.0647 −0.0094 −0.0521 0.1775

(0.0427) (0.0423) (0.0149) (0.0319) (0.4061)Income 0.0614 0.0635 0.0442** 0.0969*** 1.3153***

(0.0462) (0.0453) (0.0218) (0.0352) (0.3953)

Observations 77 77 74 68 70R-squared 0.1988 0.2121 0.2095 0.3390 0.1957Root MSE 0.1432 0.1431 0.0505 0.0859 1.2416F -test 4.58 5.58 3.06 6.84 4.07(prob.) (0.0006) (0.0000) (0.0075) (0.0000) (0.0010)

Notes. (i) Robust standard errors are presented in brackets. (ii) The coefficients on the intercepts are not reporte* Statistical significance at the 10%.

** Idem., 5%.*** Idem., 1%.

Table 2contains the results of ordinary least squares (OLS) estimations. Column one pa benchmark regression equation without interactive terms. The retention rate coefficientexpected positive sign, but the effect of regional natural resource wealth is not significantsecond specification, we add the interactive term. The sign on the retention coefficient rpositive and significant and the resources coefficient now has a positive and significant ssuggests a positive relationship between natural resource wealth and regional growth. Hthe negative sign on the interactive term indicates that the effect of fiscal autonomy is deing in natural resource wealth, as hypothesized. Ceteris paribus, an increase of one sdeviation in the tax retention rate, which is the difference between the Novosibirsk Oblathe autonomous Chuvashia Republic, boosts the regional recovery rate by 10 percentagSimilarly, increasing resource wealth by one standard deviation with no other changes, wequivalent to the difference between the Ryazan Oblast south-east of Moscow and the rerich region of Tyumen, increases cumulative economic recovery by over 20 percentageHowever, the combined effect of these increases in both retention rates and resource weato a 25 percentage points decrease in the recovery rate.7

7 The percentage increases or decreases in these performance indicators are calculated as follows. Usinginteractive regression (Eq.(1)), we calculate a predicted value by setting all variables to their sample means inThen, we increase only the retention rate by one standard deviation and recalculate the predicted value. Resretention rate to its mean, we recalculate the predicted value this time increasing only the resource or transfer


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In addition, column (2) ofTable 2indicates that larger regions are also associated with grrecovery rates. Subsequent specifications inTable 2consider alternative regional reform mesures. Greater tax retention and greater resource wealth are associated with greaterin producer subsidies, more privatization, and more foreign direct investment.8 However, themarginal effect of retention on hardening budget constraints and on privatization declinegreater regional resource wealth. Combining one standard-deviation increases in retentiand resource wealth increases the portion of regional budgets devoted to enterprise sub8 percentage points and decreases the percent of privatized firms by over 30 percent.

Rents from the extraction of natural resources and budgetary transfers from the centrernment serve similar fiscal functions is that they allow sub-national authorities to raise rewithout increasing their reliance on the tax base or improving tax collection. InTable 3, wereplace the natural-resource wealth indicator with a measure of transfers. The direct eretention rates on regional recovery and hard budget constraints remains positive. The etransfers is also positive when the interactive term is included, although it is not significarecovery. Once again, the interactive term is strongly significant and negative for these tw

Table 3Budgetary transfers and regional performance: basic cross-regional results

Dependentvariable

Regionalrecovery

Regionalrecovery

Decline insubsidies

Privatizedcompanies

Foreign directinvestment

(1) (2) (3) (4) (5)

Population −0.0474** -0.0420** −0.0085 0.0096 −0.1138(0.0197) (0.0195) (0.0085) (0.0236) (0.2453)

Retention 0.2985** 0.6903** 0.3241*** −0.2986 −0.5396(0.1454) (0.2873) (0.1103) (0.2297) (2.4756)

Transfers −0.8976*** 0.0751 0.4417** −0.5913 −5.9580(0.1299) (0.5749) (0.2188) (1.3448) (4.5767)

Retention× Transfers −1.3900* −0.7961*** 0.6956 6.0490(0.7792) (0.2993) (1.9022) (6.5459)

Exports −0.0173 −0.0063 0.0027 −0.0343 0.1797(0.0179) (0.0215) (0.0055) (0.0211) (0.1987)

Autonomous 0.0045 −0.0088 −0.0047 −0.0386 0.1388(0.0352) (0.0362) (0.0154) (0.0342) (0.4281)

Income 0.0386 0.0343 0.0438* 0.0888** 0.0002***

(0.0385) (0.0389) (0.0232) (0.0370) (0.0001)

Observations 78 78 75 72 74R-squared 0.4177 0.4336 0.2481 0.2048 0.1696Root MSE 0.1217 0.1209 0.0490 0.0965 1.2449F -test 17.62 15.98 5.41 3.13 3.76(prob.) (0.0000) (0.0000) (0.0001) (0.0066) (0.0017)

Notes. (i) Robust standard errors are presented in brackets. (ii) The coefficients on the intercepts are not reporte* Statistical significance at the 10%.

** Idem., 5%.*** Idem., 1%.

by one standard deviation. Then, we estimate the result when both the retention rate and the appropriate rent vaincreased simultaneously by one standard deviation.

8 In subsequent estimations, we also include the log of average SME output per capita from 1997 to 1999 asfor SME penetration. These specifications do not alter our basic results so that they are not reported.


to thatcentagetentions enter-

ian sys-ces. In

ly bar-publicsen uses

nifi-e ratious. Toes

(3) of95 forretainsecondon, butsoftens

ermay beere de-g power

terprise

are de-region.lation,uencesugh thes over

e basiceen

ssransfer

sures. An increase in transfers from that of the relatively independent Samara provinceof the more transfer-dependent Tuva Republic increases economic recovery by 12 perpoints. However, the combined effect of increasing both transfer-dependency and tax reby one standard deviation lowers output recovery by 19 percentage points and increaseprise subsidies by over 11 percentage points.

5. Robustness and extensions

Using transfers as a regressor leads to a potential endogeneity problem. In the Russtem of revenue sharing, transfers are designed to alleviate longer-term income differenaddition, reforms in the system of inter-governmental finance failed to eliminate completegaining over transfers by central and regional authorities. For example, autonomous rewith ethnic minorities exact greater transfers than oblasts, and the central government ofttransfer funds to co-opt wayward regional governors, according toTreisman (1996). Moreover,Sinelnikov et al. (2001)show that the transfer allocation in Russia contains a statistically sigcant bias that benefits regions located in the far northern parts of the country. Hence, thof total transfers received to the overall current revenue is not likely to be strictly exogenocorrect for this potential source of bias we re-estimate Eq.(1) using a two-stage least squarregression in which we instrument the transfers variable.

The results inTable 4focus on estimations that yield significant results inTable 3, i.e., regionalrecovery and decline in subsidies. In the first two columns, we re-estimate columns (2) andTable 3using lagged values of transfers, specifically, average transfers during 1994 to 19each region as an instrument. Retention retains its positive effect and the interactive termits negative sign, although only the first of these is significant for regional recovery. In the scolumn improvements in hard budget constraints are aided by greater local tax retentithe combined effect of greater retention with greater federal transfers to regions actuallybudget constraints due to the interactive term.

In columns (3) and (4) inTable 4we drop two variables with insignificant coefficients, i.e., pcapita regional income and the administrative status dummy variables. Moreover, theseuseful instruments for transfers. In Russian inter-governmental finance, federal transfers wsigned to support depressed regions but were often obtained due to the greater bargaininof autonomous regions. The transfer formula also incorporated the extent to which the ensector was already subsidized, asFreinkman and Haney (1997)pointed out.9 In columns (3)and (4), we use as instruments those variables from which actual transfers to regionsrived, namely, initial income, the level of subsidies, and the status as an autonomousConsequently, we include per capita income in 1994, budgetary subsidies in 1996, popuand the administrative-status dummy in the second equation to examine their possible inflon budgetary transfers, either through a formula-driven revenue-sharing scheme or throleverage of poorer, high-subsidy, autonomous regions in bargaining with federal authoritiethe size of annual transfers. When we allow for the possibility of endogenous transfers, thresults reported inTable 3hold. Tests of over-identification do not indicate correlation betwthe instruments and the error term; hence, the instruments are valid.

9 The evolution of the transfer system from one based entirely onad hoc negotiation to one based on a more or leexplicit formula may also make the patterns of transfer allocation in only 1994 to 1995 a poor instrument for tdistributions in the later period.


equations during

nistrativebrackets.

rictions.

getaryto

k in theone formongmore

modifyegions

q.nd es-we

f-ese

Table 4Budgetary transfers and regional performance: two-stage least squares

Dependentvariable

Regionalrecovery

Decline insubsidies

Regionalrecovery

Decline insubsidies

(1) (2) (3) (4)

Population −0.0503*** −0.0104 −0.0517*** −0.0102(0.0183) (0.0085) (0.0184) (0.0083)

Retention 0.6179** 0.3070*** 0.6529** 0.3001***

(0.2682) (0.1050) (0.2607) (0.1096)Transfers −0.1981 0.3791* −0.1675 0.3628*

(0.5070) (0.2116) (0.4703) (0.2124)Retention× Transfers −0.9779 −0.7011** −1.0580* −0.6823**

(0.6651) (0.2902) (0.6236) (0.3010)Exports −0.0068 0.0025 −0.0067 0.0022

(0.0207) (0.0051) (0.0218) (0.0050)Autonomous 0.0323 0.0438

(0.0375) (0.0217)Income −0.0002 −0.0026

(0.0339) (0.0145)

Observations 77 74 77 74R-squared 0.4301 0.2473 0.4235 0.2470Root MSE 0.110 0.046 0.110 0.046F -test 16.68 5.31 21.11 6.37(prob.) (0.0000) (0.0001) (0.0000) (0.0000)Sargan–Hansen 0.610 2.569 1.104 3.981(prob.) (0.4349) (0.1090) (0.8936) (0.2635)

Notes. (i) The coefficients are obtained from a two-stage least squares estimation using a covariance matrix of theerrors adjusted for small samples. (ii) The instrument in columns (1) and (2) is average federal transfers to region1994 to 1995. The instruments in columns (3) and (4) include: lagged transfers, per-capita regional income, admistatus, and the share of enterprise subsidies in regional budgets. (iii) Robust standard errors are presented in(iv) The coefficients on intercepts are not reported. (v) The Sargan–Hansen test is a test of over-identifying rest

* Statistical significance at the 10%.** Idem., 5%.

*** Idem., 1%.

All of our central explanatory variables, i.e., retention rates, resource income, and budtransfers, are highly time-variant. InFig. 2, we rank all region-year observations accordingprivate investment-to-GRP and rescale all observations according to their percentile ransample. We construct two 40-observation rolling means, one for resource wealth, andbudgetary transfers. AsFig. 2 indicates, resource wealth and transfers appear to increase athe top quartile of regions ranked by private investment to GRP, but the effect overall isambiguous. As a test of the robustness for specifications with time-variant variables, weEq. (1) to estimate regional investment for cross-regional time-series data covering 80 rbetween 1996 and 1999. We use the following autoregressive equation:

(2)Iit = β0 + β1Rit + β2Q + β3(R × Q)it + β4Xit + β5Iit−1 + εit ,

whereI is the ratio of private investment to GRP and all other variables are defined as in E(1).We include a lagged dependent variable to control for serial correlation of the errors, atimate Eq.(2) using two different methods. First, using OLS with two-way fixed effects,model the error term asεit = ηi + µt + νit , whereη andµ are time- and region-invariant efects, respectively, andν is a random disturbance. Along with the regional dummies in th


re par-l andto

controlnomousnclude10,000

tment,ubsidies.1996ure ofrce

ply thetary

These,

Fig. 2. Resource wealth, budgetary transfers, and private investment.

specifications, we include year dummies to control for unobserved time effects. These aticularly important in 1998 and 1999 following the ruble devaluation and the resulting fiscamonetary adjustments. Second, we estimate(2) using pooled OLS, but correct the error termsreflect contemporaneous correlation across panel cross sections, as suggested byBeck and Katz(1995, 1996).

In these specifications, we include three separate dummies for administrative status tofor any unexplained differences in investment rates across autonomous republics, autookrugs, and the two largest cities, i.e., Moscow and St. Petersburg. In all regressions, we ias a proxy for human capital endowment the number of university-educated students perpersons, denoted University. To account for the effect of subsidies on firm-level inveswe also include enterprise subsidies as a percent of budgetary expenditure, denoted SFinally, we include a time trend to control for unexplained trends in investment betweenand 1999.Table 5reports the coefficients for estimations using resource wealth as a measrents. These results corroborate those inTable 2. Higher tax retention rates and greater resouincome increase investment, but the combined effect remains negative. Finally, we apinstrumental variables approach used inTable 4to these data in order to test whether budgetransfers substitute for the rentier effect of resource wealth. As inTable 4, we control for possibleendogeneity of transfers by instrumenting this variable using lagged values of transfers.results exhibit remarkable similarity to some of the cross-regional results inTable 4. As expected


fers as anstandardts are not

d effect

ives ofince the

Table 5Natural resource wealth and regional investment: panel results

Two-way fixedeffects

Two-way fixedeffects

Panel-correct std.errors

Two-stage leastsquares

(1) (2) (3) (4)

Population −1.4168*** −1.5520*** 0.0377*** −1.9514***

(0.3035) (0.2768) (0.0063) (0.3164)Retention 0.6011** 0.5856** 0.1628** 0.6254**

(0.2618) (0.2407) (0.0848) (0.2509)Resources 0.7149* 0.8032** 1.0880***

(0.3850) (0.3663) (0.3091)Transfers 1.7458***

(0.6115)Retention× Resources −1.7419*** −1.7499*** −1.4783***

(0.5478) (0.5084) (0.4241)Retention× Transfers −2.7181***

(0.8422)Subsidies −0.0898* −0.0740 −0.1107* −0.0563

(0.0484) (0.0468) (0.0639) (0.0479)University −0.0945

(0.1108)Exports 0.0262

(0.0167)Republic 0.1117***

(0.0311)Okrug 0.0128

(0.0120)City 0.0808***

(0.0294)Trend −0.1412*** −0.1495*** −0.1229*** −0.1432***

(0.0159) (0.0106) (0.0178) (0.0087)Private investmentt−1 0.0422*** 0.0425*** 0.0804*** 0.0426***

(0.0092) (0.0091) (0.0157) (0.0096)

Regions 78 79 79 79Observations 228 234 234 237R-squared 0.7365 0.7313 0.6218 0.7157Wald/F -test 43.79 57.55 101.70 3115.80(prob.) (0.0000) (0.0000) (0.0000) (0.0000)

Notes. (i) The dependent variable is private investment to GRP. (ii) Two-stage least squares uses lagged transinstrumental variable for transfers. (iii) The standard errors for columns (1) and (2) and the panel-correctederrors for column (3) are in parentheses. (iv) The coefficients on country and time dummies and on the intercepreported.

* Statistical significance at the 10%.** Idem., 5%.

*** Idem., 1%.

the coefficients on the retention rate and transfers variables are positive, but their combineremains negative.

6. Conclusion

In this paper, we find statistical evidence to support the hypothesis that fiscal incentthe Russian regions are an important determinant of regional economic performance. S


deration,eformsof inter-ted taxf locallyonomiclso findstment.ntivesmore

ove thering. By

t uni-fromns. Wemely,ns thategionaldgetaryffect on

ties.by therience,eurshipem that

ource ofa result,overn-base.vern-ve taxol overxation,

inste chaosn, thetors iste in-

t,uthor-d to fill

th bothbined

stable

mid-1990s, some degree of centralized control has been reasserted in the Russian Fealong with more uniform rules for revenue sharing and expenditure assignment. These rhave achieved mixed results. In general, re-centralization has improved the transparencygovernmental fiscal relations, but it has increased federal control over regionally generarevenues. Our results indicate that an increase in the retention rate, which is the share ogenerated taxes that are left with the regional budgets, is accompanied by stronger ecgrowth, harder budget constraints, and greater private investment in most regions. We aevidence that greater retention is associated with more privatization and more foreign inveThis confirms the view that tax sharing arrangements play a critical role in establishing incefor regional development and reform. Regions facing a higher retention rate tend to beinterested in developing the local tax base and, consequently, they are more likely to imprbusiness environment and to support new business entry and genuine enterprise restructucontrast, excessive fiscal centralization is detrimental to regional reform and investment.

Our results also indicate that the impact of expanding regional fiscal autonomy is noformly beneficial for the local economy. If a large portion of regional revenues are derivedunearned income streams rather than local taxation, the effect of fiscal autonomy weakehave identified two types of regions facing this risk of excessive competition for rents, naregions with high shares of revenues derived from the fuel and energy sectors and regioare highly dependent on federal transfers. In both cases, the effect of fiscal autonomy on rgrowth declines as the share of non-tax revenues in the form of resource production or butransfers rises. Our results indicate that increasing tax retention rates has the strongest eregional economic performance in regions that are relatively free of rent-seeking possibili

The diverging economic performances of China and Russia may be explained partlyincentives created by inter-governmental financial policies. In contrast to the Russian expeprovincial authorities have supported market reforms and have promoted local entreprenin China. According toMontinola et al. (1994)andJin et al. (in press), China’s remarkable ratof economic growth over the past twenty five years is due to Chinese-style fiscal federalisgives strong fiscal incentives to the sub-national governments to develop a sustainable slocal tax revenues by supporting new private businesses and enterprise restructuring. Aslocal firms in China avoid excessive administrative interference because sub-national gments shield firms from predation and over-regulation in order to protect their local taxIn contrast, Russian inter-governmental financial policies have failed to provide local goments with any effective degree of control over revenues. Thus, their incentives to improcollections or expand the local tax base have been weak. Therefore, limited local contrlocal finances has impeded the growth of new firms that have fallen prey to predatory taregulation, or corruption.

According toBlanchard and Shleifer (2001), Chinese economic reforms have occurred agathe backdrop of political centralization, whereas reform in Russia proceeded alongside thof political decentralization and democratization. In China, unlike the Russian Federatioparty-state nexus remains intact and its ability to reward and punish sub-national acundiminished. More importantly, the capacity of the central government to collect accuraformation from provincial governments remains high, asHuang (1994)documents. By contrasinter-governmental relationships in Russia are characterized by overlapping divisions of aity, instability, and opaqueness because both regional and central politicians have strugglethe void brought about by the collapse of the Soviet state. Our findings are consistent wiexplanations of the success in Chinese-style fiscal federalism, i.e., local autonomy comwith political centralization. As Chinese provinces have benefited from higher and more


vinces

dentormnue-etrical

quirerictionsontrolernal

quiredoorer

rojects

er foreiristancey therants, Johnpan, and

tax retention, the central government has preserved administrative control over these prby strictly limiting opportunities for rent seeking.

Our results identify certain limits of fiscal autonomy in resource-rich or transfer-deperegions. The main policy implication is that fiscal autonomy may be insufficient to transregions in federal Russia into truly market-preserving entities without improvements in revside management in the regions. Our results may support an argument in favor of an asymfederalism across regions based on differing economic conditions.10 Although additional fiscaautonomy is justifiable for most Russian regions, regions that are prone to rent-seekingspecial fiscal regimes. For transfer-dependent economically depressed regions, some reson fiscal autonomy are useful to create an opportunity for broader central governmentover their expenditure policy. This recommendation is consistent with proposals for exfiscal management of fiscally depressed and bankrupt regions.11 In the case of resource-wealthregions, a much higher degree of centralization of natural-resource revenues may be rat the federal level. In addition, these revenues should not necessarily be distributed toregions as budgetary transfers; rather they should be used to finance public infrastructurein low-income regions through federal investment programs.

Acknowledgments

The authors are grateful to Galina Kurlyandskaya and Natalia Golovanova from the CenFiscal Policy in Moscow, and to Boris Kopeikin from the Institute of Urban Economy forconsiderable help in collecting the fiscal data. Jorge Ugaz provided invaluable research asand Zakia Nekaien-Nowrouz edited the final manuscript. Financial support was providedEdmund A. Walsh School of Foreign Service and the World Bank’s research preparationprogram, RPG No. RF-P074267-RESE. The authors thank Harley Balzer, Jackie CoolidgLitwack, Alexander Morozov, Helga Muller, Anders Olofsgård, Alexander Plekhanov, STitov, Dana Weist, Deborah Wetzel, Tarik Yousef, the participants of a World Bank seminatwo anonymous reviewers for their comments on earlier drafts.

Appendix Table 1Basic indicators for Russian regions: averages from 1996 to 1999

Region Admin.status

Population(thousands)

Resourceproduction

Tax retentionrate

Budgetarytransfers

Adygeya 2 450 6.1 67.3 45.8Agin Buryat 3 79 40.7 69.8Altay 1 2667 20.5 69.2 31.2Amur 1 1019 48.3 70.9 33.5Arkhangel’sk 1 1485 23.7 73.2 13.6Astrakhan 1 1027 60.8 60.0 24.1Bashkortostan 2 4113 48.4 75.1 1.4Belgorod 1 1488 10.5 66.5 6.6Bryansk 1 1460 10.4 58.4 20.7Buryatia 2 1043 46.9 68.9 28.6

(continued on next page)

10 Lapidus (1999)andBahry (2001)discuss the concept of asymmetry in Russian fiscal federal relations.11 Yasin (2002)discusses various such proposals.

o

nfe

mlret

cty

ep

p

tthsbgeter


Appendix Table 1 (continued)

Region Admin.status


Resourceproduction

Tax retentionrate

Budgetarytransfers

Chuvashia 2 1359 16.3 67.9 15.6Chelyabinsk 1 3679 13.4 74.7 6.9Chita 1 1273 45.6 71.5 23.2Chukotka 3 79 44.5 79.7 40.7Dagestan 2 2110 43.0 69.1 52.5Evenkia 3 19 75.5 46.4Gorny Altay 2 203 38.9 45.7Ingushetia 2 357 82.2 23.6 51.1Irkutsk 1 2768 25.7 67.7 5.6Ivanovo 1 1240 22.4 67.1 28.5Kabardino-Balkaria 2 792 21.0 70.0 44.9Kaluga 1 1090 14.9 59.9 26.1Kaliningrad 1 945 27.5 63.9 9.2Kamchatka 1 393 21.3 73.7 31.1Karelia 2 774 10.7 79.1 14.4Kalmykia 2 317 71.5 33.5 45.9Karachay-Cherkessia 2 436 14.2 63.0 38.6Kemerovo 1 3015 42.6 69.8 14.0Khabarovsk 1 1539 31.3 64.4 16.9Khakassia 2 583 25.6 78.2 11.6Khanty-Mansi 3 1358 55.6 1.2Kirov 1 1607 15.5 65.0 18.2Komi-Permyak 2 1155 65.8 6.7Komi 3 154 8.3 63.3 45.4Koryak 3 31 76.4 36.5Kostroma 1 794 35.8 69.0 29.0Krasnodar 1 5071 22.2 62.2 16.1Krasnoyarsk 1 3069 12.8 73.7 2.2Kursk 1 1331 26.8 65.5 12.6Kurgan 1 1103 22.2 71.2 23.1Leningrad 1 1679 37.4 63.3 6.2Lipetsk 1 1246 10.9 75.0 1.5Magadan 1 243 24.5 76.9 26.8Mariy El 2 762 21.1 63.1 27.2Moscow 1 6550 11.9 51.3 5.7Mordovia 2 941 13.1 64.3 31.6Moscow City 4 8632 16.6 45.0 3.1Murmansk 1 1008 18.0 71.7 21.2Nenets 3 47 69.8 21.7Nizhegorod 1 3687 10.8 56.7 4.9North Osetia 2 667 15.1 65.8 43.9Novosibirsk 1 2748 19.2 62.3 8.9Novgorod 1 736 11.8 70.7 24.6Omsk 1 2173 34.3 63.6 11.4Orenburg 1 2228 51.0 62.0 16.9Orel 1 905 14.2 65.1 18.3Penza 1 1544 18.9 64.4 23.7Perm’ 1 2982 31.0 60.6 4.1Primorsky 1 2206 24.7 68.9 24.0Pskov 1 815 19.9 65.9 35.0Rostov 1 4392 30.5 62.8 17.6

(continued on next page)


(ii) Alltion is thef regional

egions’

tan

merican

ss-section

ic Re-

hat went

ussia.

Appendix Table 1 (continued)

Region Admin.status


Resourceproduction

Tax retentionrate

Budgetarytransfers

Ryazan’ 1 1301 41.8 56.8 16.8Sakha 1 615 48.0 64.8 25.1Sakhalin 2 996 22.1 73.5 22.0Samara 1 3306 16.7 52.7 1.8Saratov 1 2721 33.1 62.1 16.5Smolensk 1 1151 23.0 65.7 13.4Stavropol’ 1 2684 34.7 61.7 22.1St. Petersburg 4 4738 10.3 57.4 2.3Sverdlovsk 1 4645 13.5 66.5 2.7Tambov 1 1286 18.6 64.0 20.9Tatarstan 2 3775 45.6 82.9 2.1Taymyr 3 44 79.4 19.2Tomsk 1 1072 38.7 64.1 11.0Tula 1 1776 14.6 64.7 17.0Tuva 2 311 36.8 74.9 49.2Tver’ 1 1625 32.5 67.4 17.2Tyumen’ 1 3210 93.2 71.0 7.4Udmurtia 2 1636 31.1 59.4 16.2Ul’yanovsk 1 1480 16.0 63.0 12.4Ust’-Ordunsky Buryat 3 144 75.6 50.1Vladimir 1 1625 15.3 62.8 18.5Vologda 1 1335 8.5 74.5 6.6Volgograd 1 2694 29.4 61.9 10.9Voronezh 1 2480 21.4 62.1 15.9Yamalo-Nenets 3 496 62.5 0.7Yaroslavl’ 1 1430 27.0 56.2 9.7Yevreyskaya 2 204 24.3 75.4 42.8

Sample Averages 1687 29.7 65.2 21.2

Source: State Committee for Statistics and Ministry of Finance, Russian Federation.Notes. (i) Administrative status codes are as follows: 1 is for oblasts; 2 for republics; 3 for okrugs, and 4 for cities.averages are for 1996 to 1999 and are expressed in percentages, except where noted. (iii) Resource producshare of fuel and energy production in regional output. (iv) Transfers are budgetary transfers as a percentage ogovernmental revenue.

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Fiscal federalism in rentier regions: Evidence from Russia

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