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Decentralizing Fiscal Systems in Transition Economies

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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THE TRANSITION economies are in the midst of decentralizing their fiscal systems. If improperly designed, these new systems pose a risk to the adequate provision of essential services, interregional equity, and the efficient allocation of resources. The extent to which these countries follow some simple guidelines on revenue and expenditure assignments may ultimately determine how successful they are in achieving their reform goals.

Since 1989, extensive political and fiscal decentralization has been under way in almost all countries in Central and Eastern Europe and the Baltic countries, Russia, and the other countries of the former Soviet Union. The trend toward fiscal decentralization and the transfer of some revenue-raising and expenditure authority from central to lower-level and subnational governments is, in part, a political reaction from below against the long years of extensive central control. Its economic motivation relates, on the one hand, to efforts by the center to ease its own strained finances by reducing transfers and shifting spending responsibilities and, on the other hand, to a widespread recognition that public funds need to be used more efficiently.

Fiscal decentralization will be an important component of the economic transitions of these countries. If properly designed, fiscal decentralization can lead to improved allocation of public services and better accountability in providing them. If systems are not designed with forethought, however, decentralization can instead create serious problems. The transition economies find themselves midway in the process, and mistakes are already being made.

The current intergovernmental fiscal systems in the transition economies need to be modified in some key ways if they are to avoid gaps, overlaps, or regional disparities in service provision. Expenditures have been transferred to subnational governments without regard to how they will be financed. The present intergovernmental revenue structure is characterized by subnational governments’ dependence on transfers from the central government and their almost complete lack of robust revenue sources of their own. In addition, the lack of transparency of the system—which is often characterized by ad hoc arrangements between central and subnational governments that change with each annual budget—create unnecessary complexities and produce incentives for subnational governments to continue their dependency on, rather than free themselves from, the center.

Expenditure assignment

Under the system that formerly prevailed in the transition economies of Central and Eastern Europe and the Baltic countries, Russia, and the other countries of the former Soviet Union, local governments had no autonomous spending responsibilities of their own, and their expenditures were included in the central government’s unified budget. Since the transition, however, “local self-government” legislation has been enacted in virtually every former centrally planned economy in the region, giving subnational governments major responsibilities for expenditures in key areas. The subnational sector has become quite large, now accounting for an average of about 30 percent of total government spending; in Russia, it accounts for almost half.

However, the new legislation in these countries has generally not assigned clear responsibility to different levels of government for particular expenditures, and tradition or, in some cases, expediency has influenced decisions about the functions managed by each level of government. Efforts to ease fiscal strains at the center seem to have shifted important spending responsibilities to sub-national governments without sufficiently expanding their revenue sources, apparently in order to safeguard the central government’s budget. Recent legislation in Hungary and Poland, for example, has given local governments expenditure responsibilities in education, transportation, the environment, and housing without including specific plans for how they will be financed. (Poland is now reconsidering the shift.) And expediency has led Ukraine and Russia to shift responsibility for some social safety net spending “downstairs.” In Russia, expenditures—estimated at 6 percent of GDP—were suddenly shifted onto the shoulders of subnational governments. Such expenditures were probably transferred in hopes that subnational governments would make necessary but politically painful cuts in wages, social sector outlays, and in-cash and in-kind transfers. This shift in expenditure responsibilities, however, has created serious budget pressures for subnational governments, risking the crowding out of important expenditures, including those for health care and education.

The efficiency gains from decentralizing expenditures will be greatest if functions are assigned to the lowest level of government capable of properly carrying them out. Thus far, decentralization has often led to services that benefit the entire country—such as education, health, and social welfare—being transferred to subnational governments. Arguments exist for subnational administration of such services, but funding assistance should be provided by the central government. Also, since such services may be needed to make reforms more politically acceptable in the transition economies, it is unrealistic to pass full responsibility for providing them to subnational governments. Local governments often cannot provide adequate services using only their own resources, and regional differentials in service provision will inevitably emerge, with their extent depending on the resources available to each locality, unless adequate (own) financing mechanisms and/or transfers are in place.

Expenditure assignment in the transition economies is also complicated by the fact that many publicly provided goods and services—education, health care, housing, and roads and other infrastructure—have traditionally been supplied by public enterprises. In Ukraine, individual enterprises offer extensive nonwage compensation—such as free housing, child care, health services, and education, and paid vacations. In Poland, these expenditures have been estimated at 2 percent of GDP, and in Russia, they range up to 5 percent of GDP. In some regions, enterprises’ “public spending” exceeds budgetary social spending and, in a few “one-company towns,” the local government’s budget provides for only routine administrative functions. In Bulgaria, for example, enterprise clinics have provided health care for the entire populations of particular areas.

After they are privatized, enterprises cannot both continue to provide these services and compete successfully; consequently, sub-national governments may then be expected to provide some of them. Clear definitions of who will provide what have yet to be specified. If subnational spending responsibilities are to be increased, subnational revenues must be expanded, either through strengthening own-source revenues or increasing intergovernmental transfers. Without such measures, some subnational governments may find themselves unable to maintain many of the services formerly provided by public enterprises, and regional disparities in public service provision are likely to emerge.

Seven countries in transition Subnational government revenue sources in 1993(percentage of subnational government revenue)
Own taxesNontax

revenues
Transfers and

shared revenues
Albania0.00.0100.0
Bulgaria1.04.095.0
Hungary4.019.976.1
Poland26.719.354.0
Romania15.010.075.0
Russia8.81.689.6
Ukraine0.72.596.8
Source: Decentralization of the Socialist State: Intergovernmental Finance in Transition Economies, Richard M. Bird, Robert D. Ebel, and Christine I. Wallich (editors), World Bank, 1995, p. 24.
Source: Decentralization of the Socialist State: Intergovernmental Finance in Transition Economies, Richard M. Bird, Robert D. Ebel, and Christine I. Wallich (editors), World Bank, 1995, p. 24.

In some cases, local governments that are squeezed for revenue have looked to the profits from direct public ownership of local businesses for “revenue.” Some subnational governments and municipalities have gotten involved in private sector activities, sometimes even developing 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: it undercuts the transition to a market economy and it subjects the public budget to the financial uncertainties of the market. A well-defined intergovernmental system and adequate revenue instruments for subnational governments are part of the solution.

Financing local governments

The current intergovernmental revenue systems, inherited from the era of central planning, are still characterized by subnational governments’ dependence on transfers and shared taxes from the central government and an almost complete lack of their own robust revenue sources, making it impossible for them to contribute to their nation’s fiscal health by increasing their own tax effort. (See table.)

Because subnational governments have remained heavily dependent on central tax sharing, national tax-policy changes will affect the subnational revenue base, and national tax policy becomes, in effect, subnational tax policy. Most recent national tax reforms in transition economies, however, seem not to have taken their impacts on, or the needs of, subnational governments into account.

User charges. The general rule of thumb in local public finance is to charge for services wherever possible: if direct beneficiaries can be identified, user charges, not the budget, should be the first recourse. In the transition economies, however, user charges are not being applied as much as they ought to be. Many public service prices continue to be distorted by subsidies, inefficiency, and inequity. In Poland, for example, general revenues, rather than user charges, finance, in whole or in part, such budgetary items as public transport, housing, and solid waste disposal, as well as some public utilities. For 1992, it was estimated that user fees, applied at cost-recovery level to a broad range of locally provided goods and services, could finance as much as 25 percent of local expenditures in Poland, or approximately 1 percent of GDP. In Romania, local revenue from fees and user charges has been increasing, but it still only represents about 2.5 percent of all local revenue.

One reason user charges have not been applied more widely is central pricing mandates, which continue to limit local governments’ discretion in setting user charges at levels that would enable them to recover their costs. Much more important, however, has been the decline in household income experienced during the transition, which, coupled with the very substantial price increases that are needed, has made it politically difficult to raise user charges. Doubling or, in some cases, tripling the prices of heat, transport, power, gas, water, and rents would claim a significant proportion of household incomes if the price increases took place simultaneously, and would imply large changes in the welfare of some population groups. Price changes would need, therefore, to be coordinated with other reforms—notably wage and pension reforms—and/or their impact cushioned by social pricing mechanisms—such as lifeline pricing, vouchers, or in-kind or in-cash transfers for target groups. Of some consolation is the fact, drawn from a study on Poland, that the middle class consumes both absolutely and proportionately more of many of these subsidized goods than the poor do, so that introducing more efficient user charges will be progressive.

Subnational taxes. Where it is impractical to impose fees or user charges, subnational and local governments can levy taxes. In many market economies, the central government controls those taxes considered to be most redistributive or those with a cyclical revenue flow, leaving subnational governments with more stable sources of revenue. In designing their intergovernmental fiscal structures, transition economies should keep in mind two factors that should determine which taxes governments should assign to, or share with, intermediate or local governments. First, the combined revenue yield (across subnational governments) from assigned or shared taxes and transfers will need to be sufficient to finance all local expenditures. Unlike in many developing countries, where the local sector is small, in the transition economies, the subnational sector is large—often roughly 30 percent of total public expenditure or about 15-20 percent of GDP. This implies assigning, sharing, or transferring a significant proportion of the national tax base. Also, administrative feasibility must be a consideration.

Which taxes to assign? The corporate income tax (CIT) is a central tax in most market economies, although some federal systems (in the United States, Switzerland, and Canada) allow subnational corporate taxes. In the transition economies, though, the need to minimize administrative complexity and maximize efficiency suggests that corporate taxes are better left to the central government at present. Permitting hundreds of locally set corporate income taxes would generate tax competition, distort firms’ location decisions, and require complex prorating of revenues for firms having branches in various locations. In short, this would create a tax jungle for locals and foreigners alike.

The personal income tax (PIT) is generally a central tax, largely because of its redistributive and stabilization properties. In most transition economies, subnational governments receive personal income tax revenues, although they have no control over either the rate or the base. An option that deserves consideration is replacing a shared PIT with “piggybacking” a local PIT surcharge onto the central income tax, as is done in many member countries of the Organization for Economic Cooperation and Development (OECD). This would increase not only local fiscal autonomy but also accountability.

Excise taxes and single-stage retail taxes might seem to be prime candidates for subnational taxation in the transition economies, as they are in market economies. But excises on such items as tobacco and alcohol have not generally been used to finance subnational governments. Because they are levied at the producer level, excises are paid by only a few manufacturers, or sometimes only a single monopoly producer, and thus would accrue to only a few producing districts. As for local retail sales taxes, implementing them on top of the national value-added tax (VAT), while theoretically feasible (for example, Canada’s provinces use them), would be costly and complex, and might be inconsistent with the tax regimes of the European Union, which many Central European countries intend to join eventually. Excises, then, are an option for the medium term.

Most of the taxes presently assigned to sub-national governments in transition economies are “nuisance” taxes rather than potentially robust revenue sources. In Russia, the revenue yield from 21 local taxes (including taxes levied on the sale of used computers and on horse racing, the use of logos in advertising, property, and dog owners) is likely to be less than 0.5 percent of GDP, or 2 percent of subnational expenditures. In Hungary, where local taxes include the property tax, a poll tax, a local business tax, and a bed tax in tourist areas, the situation is only slightly better. In addition, effective local fiscal management is hampered by central mandates on both local tax rates and the tax base.

Role of property taxes. The role of the property tax is a major unanswered question in transition economies. Property taxes in some form have been, or are being, introduced in many of them. This is the only potentially significant tax that national tax reforms have specifically assigned to subnational governments. Although relatively expensive to administer, property taxes are an “efficient” revenue source, in that, as locally provided services increase property values, the beneficiaries of public expenditures are made to pay. Much needs to be done, however, if the property tax is to fulfill its potential in the transition economies. Why? Much of the housing stock remains publicly or communally owned, and housing markets are nascent, so that assessments must often be based on square meters of area.

Tax sharing. Bulgaria, Hungary, Poland, Romania, and the Baltic countries, Russia, and the other countries of the former Soviet Union share some or all of the revenues derived from the VAT, CIT, and PIT with subnational governments. Almost uniformly, such sharing takes place on a “derivation basis”—that is, based on the geographic origin (region/municipality) of the revenue collection—and not on the basis of a formula. Tax sharing has the advantage of simplicity and, if shares are transparent and fixed, sub-national governments are guaranteed some degree of revenue certainty. Unfortunately, in many transition economies, tax shares change from year to year, vary by region, and are often negotiated by each locality with the center. This does little to enhance local accountability or efficiency. And derivation-based sharing inherently tends to increase inequality among regions, in that more revenues go to areas with larger tax bases, exacerbating the emerging differentials on the expenditure side in service provision.

Intergovernmental transfers. Since subnational governments’ ability to raise revenue rarely permits them to meet their expenditure needs, transfers are usually required to close the gaps. In principle, such gaps could also be closed by shifting tax powers to sub-national governments, by shifting expenditure responsibilities back to the central government, or by reducing subnational expenditures and service standards. While enhancing local tax authorities is crucial, transfers can also be attractive because—depending on their design—they can allow local governments to provide services and the central government to set standards, improve equity, or influence local spending patterns.

In most transition economies, transfers are still determined ad hoc by the central government, often changing with each annual budget. Except in Hungary and Poland, revenue allocation based on specific formulas is not yet common, and fiscal flows among the various levels of government remain discretionary and negotiated, although they fund a large share of subnational spending.

A good case may be made for regularizing the volume and allocation of transfers and giving subnational governments more of their own revenue sources. In practice, however, the cutbacks in transfers that resulted from fiscal stringency and stabilization measures have not been accompanied by efforts to rationalize the system by improving the design of the transfer system or by reassigning tax bases to subnational governments or designing and targeting grants efficiently. This reflects both the center’s reluctance to give up a tool for controlling subnational governments and the failure of some local authorities to modernize tax administration and strengthen the limited revenues they do control.

“If properly designed, fiscal decentralization can lead to improved allocation of public services and better accountability in providing them.”

Once the aggregate volume of transfers is determined, the next step is determining its distribution across subnational governments. Many countries use equalizing transfer formulas, based on indicators of expenditure need, such as population or income.

How much equalization is appropriate? This is inherently a political judgment. If carried too far, equalization can penalize better-off regions, whose industrial and growth potential are arguably the greatest, as their resources are transferred to less productive, poorer areas. The transition economies have explicitly or implicitly struck balances between growth and equalization in different ways. In some homogeneous countries, the vast disparities between regions make equalization a political priority. In others—such as Russia—the need for political unity may require allowing better-off regions to pull ahead, lest resentment fueled by excessive equalization lead the better-off regions to opt out of the system altogether.

A case for conditionality. A striking feature of intergovernmental fiscal transfers in the transition economies is that they are largely unconditional. The central government has a legitimate interest in what is done with its grants. Thus, where important services such as education and health care are locally provided, the nation as a whole has an interest in ensuring that such services are available throughout the country at some minimum standard. There is thus some argument for imposing specific conditions on particular kinds of transfers.

Conclusion

The fiscal decentralization that is taking place in the transition economies has the potential to be economically beneficial. But the transition economies must put significant efforts into designing and implementing new subnational and intergovernmental finance systems. Weaknesses in the design of the present systems represent risks to their safety nets, stabilization, privatization, regional equity, and the provision of essential services. The issues are complex, both technically and politically. Institutional development of sub-national governments and the central ministries charged with supporting and framing the decentralization process will be key. Important features in refining the reforms should include increasing subnational governments’ own revenue sources, assigning them the necessary tax instruments, and designing transfers and sharing arrangements that can provide them adequate revenues to meet their spending needs; regularizing tax-sharing arrangements and transfers, so that the revenues of subnational governments are dependable; assigning expenditures clearly, so that each level of government knows what its fiscal responsibilities are; and, throughout the entire process, ensuring that the system provides adequate funding for governmental functions that are important to the nation, so that such expenditures are not squeezed out in an environment of fiscal stringency. Well-designed decentralization policies will help improve the lives of those undergoing one of the major upheavals of our time—the move from a command to a market economy.

This article is drawn from Decentralization of the Socialist State: Intergovernmental Finance in Transition Economies, Richard M. Bird, Robert D. Ebel, and Christine I. Wallich (editors), World Bank, 1995.

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