______FWes 1122 Polly Roerch WORKING PAPERS Public Economki Policy Research Department The World Bank March 1993 WPS 1122 Fiscal Decentralization and Intergovernmental Relations in Transition Economies Toward a Systemic Framework of Analysis Richard Bird and Christine Wallich Designing a well-functioning intergovernmental fiscal system is essential to the success of all the transitional economies' major reform goals: privatization, macroeconomic stability, more effi- cient performance and economic growth, and an adequate social safety net. PoCcyRaearWoingPpcsdhsninatchehfndingpofwoinpogeaanduagctheexchangeofideuamongBankstaff*nd aflod inrcdinde copmatisauLbespapeis. dibutydbytbeRemhAdviy Stff,caythenamesoftheaugors,re&ct enl ytherviews,and shWdd and. dhBoard cfocortngly.of h ngsia nors, any ofuha emtbeh cautr n' ow.eyshould na be atiutcd to fth Wodd Bank, a Bcud of Di,cw itsu umaect, or any of ihsb membrcuin Policy R oroh| Public Economics WPS 1122 This paper - a joint product of the Public Economics Division, Policy Research Department, and the Infrastructure Division, Technical Department, Europe and Central Asia, and Middle East and North Afica Regions - is part of a larger effort in both departments to analyze issues relating to decentralization, and in particular, the role of subnational governments in the reform pmcess. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Bonnie Pacheco, room HI 1-065, extension 37033 (March 1993, 85 pages). The decentralization of government in Eastern subnational governments may look to "coping Europe represents a reaction both from below (to mechanisms" such as holding onto their enter- tight central political control) and from above (to prises (which provide vital social services), privatize the economy and relieve the central developing extrabudgetary revenues, or borrow- government's fiscal stress). ing. These coping mechanisms threaten privat- ization, reduce budgetary transparency, and In all transitional economies, the developing impede stabilization policies. structure of intergovernmental relations is intimately related to such critical policy issues as Bird and Wallich describe the risks to privaization, stabilizatic l, and the social safety piivatization, to macroeconomic stability, and to net. In the fiscal sphere, tax reform, deficit an adequate social safety net that present policies control, and intergovernmental finance are a toward local government may imply. Its themes tripod. Unless each leg is set up properly, the are that the subnational sector needs to be more whole structure could collapse. realistically factored into national plans - and that subnational expenditures be more clearly The present strategy of devolving expendi- assigned and revenue needs more realistica9;y tures downward while holding back on revenue assessed. S&ch assessments are likely tv ac- flows and transfers to balance the central budget knowledge a larger sphere for subrational is unlikely to succeed for more than a year or governments and the need for accec! tm two at bestL robust revenue sources. Giving local government a share in the personal income tax is one possible Net spending reductions at the subnational and perhaps desirable approach to meeting these level may be difficult to achieve. From 10 to 40 revenue needs. percent of outlays go to the subnational sector, and in many countries local governments provide Careful attention needs to be paid to the much of the social safety that makes the pain of design and implementation of the the economic transition politically tolerable. intergovernmental fiscal transfers likely to And, most housing and many enterprises have remain prominent features of the been shifted to local ownership, with the mainte- intergovernmental landscape for years to come. nance and subsidy cost this implies. Since the Caution is also needed on borrowing by revenue sources assigned to local governments subnational government. Consolidating and cannot finance expected levels of local activity, integradng extrabudgetary funds at the the result of shifting spending downward is subnational (and national) levels is crucial to likely to be strong demands for increased, rather enhanced budgetary transparency and than decreased, transfers. Altematively, macrostability. The Policy Research Working Paper Series dissemirsates the fmdings of work under way in the Bank. Anobjecii vof the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interprAtations, and conclusions in these papers do not necessarily rexesent official Bank policy. Produced by the Policy Research Dissenination Center FISCAL DECENTRALIZATION AND INTERGOVERNMENTAL RELATIONS IN TRANSITION ECONOMIES: TOWARD A SYSTEMIC FRAMEWORK OF ANALYSIS by Richard Bird University of Toronto and Christine Wallich Country Economics Deparhnent Public Economics Division The World Bank Table of ConLonts 1. INTRODUCTION AND SUMMARY . ......................................... 1 Why 8Local1 Finance Matters 1........................................... Traditional vs Systmic Frameworks . ....................................... 2 Organization of the Paper .............................................. S Political/Overall Structural Reform Context ................................... 6 Borrowing .................................................. 8 Extrabudgetar Funds ................................................ 8 Infitutional Framework ............................................... 8 II. DECENTRAULZATION IN PROCESS: TRENDS AND THEMES ........................ 9 A Time of Transformation . ............................................ 9 The End of Centra Planning: Filling The Abhorted Vacuum ........................ 9 Political D entatization . ............................................. ' 11 The Size and Scope of Government: How Many Levels? .......................... 15 Size of Government Units: Efficiency and Other Concens ......................... 17 Supporting Subnational Government: The Institutional Setting for Subnational Governmental Reform .........................8............. i The Changing Role of Govermment: From Ownership to Servic - Provision .............. 19 Simultaneous National and Integovernmental Fiscd Reforms. ....................... 23 Stablizadtio: The Macroeconomic Context for D sentrizaton ...................... 24 II. WHO DOES WHAT? THE ASSIGNMENT OF EXPENDrrURES ....................... 29 The Efficiency Case for Decentralized Loca GovermenL .......................... 29 Expenditure Asignment in Pratice ........................................ 29 Local Public Enterprise Ownehip ........................................ 35 Provision of Social Services: Shifting the Safety Net Downstain .................... 37 Expenditure Assignment in Principle ....................................... 37 Extabudgetary Funds ................................................ 39 IV. FINANCING LOCAL PUBUC SERVICES THROUGH USER CHARGES ................. 40 V. THE CHOICE OF SUBNATIONAL TAXES ..................................... 42 Characteristics of a Good Local Tax ....................................... 46 Local Propet Taxes ................................................ 47 Own Subnational Taxes versus Shared National Taxes ............................ 48 VI. THE DESIGN OF INTERGOVERNMENTAL TRANSFERS .......................... 50 Closing the Fiscal Gap ................................................ 50 Equalization ...................................................... 50 Fiscal Effort ...................................................... 52 Matching Grants ................................................... 53 Other Objectives of Transfers ............................................ 54 A Case for Conditionality? ............................................. 55 - ii - Determining the Size of the Grant . . . . . . . . . . . . . . . . . . . ... .. ........ . . . . . . . . 56 Distribution of the Grant ............................................... 56 Measuring Capacity and Expenditure Need .................................... 57 VII. BORROWING ...................................................... 58 Past Borrowing Pr ac tic e s ............................................... 59 Sources of Borrowing ................................................. 60 VIII. PRIVATIZATION AND OWNERSHIP ....................................... 61 AssetTansfers ............................. 61 Privatization vs Entrepreneuriaism .................................. 62 Timing of Asset Sales: Sales vs Give-aways .................................. 63 Revenues from Privatization .................................. 64 IX. CONCLUSIONS .................................. 64 REFERENCES ................. 84 List of Tables Table I Trends in Decentralization: Government Organization. 16 Table 2 Decntrlization: Scale and Size of Government ............................... Table 3 Reform and the Size of the Government Sector .22 Table 4 Macroeconomic Indicatorsi.2 Table 5 Tax Administration in Transition Socialist Economies ............................ 28 Tabls 6 ExpenditWe Assignment to Subnational Authorities ..............................30 Tanle 7 A Possible Expenditure Assignment .......................................8 3 Table 8 Revenue Assignments to Subnational Authorities .............................. 44 Table 9 Structure of Subnational Govermment Finance . ................................. 1 Table 10 Subnational Government Borrowing .......................................59 Table 11 Privadzatioa Revenues: Ownership and Disposition .. 62 Acknow_edeMents We would like to thank those who commented on this paper, or who otherwise shared their insights on subnatlonal finance in the various countries, including Felix Jacob; Zelko Bogetdc, Robert Van Pulley, Thn Condon, Gabor Peteri, Shankar Acharya, Anwar Shah, Hen g-fiu Zou, Tony Pellegrin4 Jim Hicks, Luca Barbone, 7Thanos Cat sambas and Amaresha Bagchl. Research assistance of Rltu Nayyar is gratefully acknowledged. Susheela Jonnakuty providedexpert word prcessing. 7Thisis the firstin a seriesof papers under RPO BB67770M. FISCAL DECENTRALIZATION AND INTERGOVERNMENTAL RELATIONS IN TRANSION ECONOMIES: TOWARD A SYSTEMIC FRAMEWORK OF ANALYSIS ... A chang of government is not a chang of system, merely one of the politicdl conditions for it. Tho change of system is a historical process that seer- liksely to require a long period of time. &' . INTRODUCTION AND SUMMARY Why 'Local" Fimnce Matters. 1. An important and unduly neglected aspect of the process of transition in Eastern Europe is the extensive decentralbiation, both political and fiscal, that is taiing place in many of the countries newly emerging from behind the socialist veil. Decentralization represents both a reaction ftom below to the previously tight political control from the center and an attempt from above to further the privatzation of the economy and to relieve the strained fiscal situation of the central govermnment. The aspirations of, and the role of, local government are becommg stronger in most of the transitional economies. 2. The on-going reforms in subnational finance in these economies are much more important than seems generally to be recognied. In some countries in transition, the subnational govemments (broadly defined) are quantitatively significant, accounting fur a large, and often gromwing, share of public sector activity. In aU the transitional economies, the developing structure of intergovenmental relations is intimately related to such critical policy issues as privaizaon, the social safety net, and stabiliatioL Within the fiscal sphero, tax reform, deficit control, and intergovenmental fnce constitute a tripod: unless each leg is set up properly, the entire structure may collapse. 3. Our assertion is that the design of a weU fumctioning intergovernmental fiscal system is key to almost all of the transition economies' major reform goals. Intergovernmental finances wil have a major impact on the efficiency with which the transition economies perform; on their macroeconomic stability; on the social safety net and on the success of their privatzation policies. 4. Fiscal balance at the subnadonal level is key to macroeconomic stabiliqy. Given the paramountcy of stabilization goals in almost all of the countries, the central governments have used all the tools in their meager arsenal to bring stability to the macroeconomyY One such tool has been to shift the deficit down, ensuring an adequate revenue flow to the center - oither by shifting expenditure responsibilities down or by retaining additional revenues, even where budgets at the subnatonal level are severely iupaiued Hungary and Russia come to mind, but there are others. 5. The results of this policy, ironically, could contribute to further instability: the budget constraint in these countries is still so soft that subnaional governments may respond by accumulating arrears, borrowing (strong- arming their enterpises to finance public expenditures - sice enterprises have easier access to bank credit than do the governments themselves) or developing extrabudgetary sources of revenue. Pushing the deficit down may not reduce it, but may merely repress it. Worse, some of these 'coping mechanisms ' also reduce the transparency of budgetary operations, and make the pursuit of appropriate national budgetary policies even more difficult than it is now. -JJanos Komai, T'he Socialist System; (Princeton University Press, 1992), p.577. Zlbe terms subnational and 'local' are used more or less interchangeably, unless speaking of a three tier, or federal system, in which case subnational refers to all levels below the federal, and local refers to the lowest level. 6. A well-fimctiong - responsibiity for which has bee trafered 'downstairs' in a number of countries -cannot be effetively caried out by an undefund subuational sector. Where the safaty not is cridcal for the success of Iho transition to a market economy, nd it therfore a national policy objctive, -as in Russa, and ,tguably, in Polund and other countrie - the burden of finaing the safety not should not be on local governments, even though, being closer to tho people, subnationl gove ormnts migt administer it. 7. From an atlocative prpctdve, the system of intove n fiscal rebltions will also dtermine in a major way the officiency with which thb eoanomies perform, and their fu omic o. Locl government ownesip of enteprs - and local ir in their revenus - will inevitably encourge domestic protectionism (e.g. 'domestic purch rqimes and inter-jurisdictional trade bariers to protect local monopolies) harmful to economic grwth 8. Finaly, becaus some countries -notably Ruia- ar, so to speak, 'nation-building,' with significant centrifual fores emanating from the ubnatonal level, inteovermentl finane is also crueil to future natioal cohesion. In Russia it may be crucial even to the contied existence of the Federadon. Even where national cohesion is not at risk, demands for greatr 'participatory democracy' have heightened demands from the subnational level. The strong desire for local politieal control and unfettered local autonomy is a natural outcome of the end of central plmning. Combined with an inadequate fiscal base, however, loal aspirations and fiscal capabilities are increasingly at odd., which is giving rise to growing tensions in a number of countries. 9. Even gvimhi2n is complicated by the current environment. Following the transfer in many countries of a significant number of anterpie to 1matonal ownership, responsibility for privatization now also rests with subnational govenments. Their interess hero ar unclear at bese they still rely on ethir I enteprises for profits and tax revenues, ad if privzd, subational govenments will hav to assume the substantial 'non-production' expenditues - for nurei_e, housing, schoob, etc.- tht will e spun off by the enterpris as they privatize. A system of inegonmeta finacs tht doe not accommoda thes shifts in expenditure responsibilities and provide coreponding revenues, will impedo the proco of privatization. 10. In sum, intergovermentl fiscal rlations - far from being merely a 'local matter' - are key to simost of a8l of the transition economies' reform goals. Traditional vs Systomic Frumewors 11. The traditional anaysis of intergovenmenta finance examines the fiscal functions of local and central govermments in terms of their respective roles and responsibilides for stabilization, income distribution, expenditure provision, the appropriate assignment of tax functions, and the design of a transfer system that provides appropriate incentives. The 'benefit model' of service provision suggest that local governments - whose role in this analysis is essentially that of service provider - should be financed to the extent possible by charging for the services they provide, with local taxes making up the remaining gap, supplemented as appropriate by trsasfers and, in limited degree, borrwing. 12. This perspective is of course important in the trasitional economies also. But it misses several key features of the roles, responsibilities and economic functions of subnational govemments in the former socialist economies. First, the emphasis in traditional analysis on the local goverment as a service provider ignores its important roles as produr and as wngr, as wel as the complicated relationships between enterprises and local government in most transitional eccnomios. The importunt role of local governments as owners means thst they have a major role to play, either as potential impediments to, or supporters of, Drivatization. Moreover, the asset stock recuntly trnsferred to them in the decentralition process represents a potential source of revenue (or, in some instances, of losses). The interaction of subuational finance and privatizadon thus merits careful attention in the transitional economies. -3- 13. Second, th traditional approach ignors th shrining role of govenment. in most t itional conomies, govenment, both local avd cetral, played a major producdon role and wa the major invoeor in the economy, and tae expendite side of the budget is clutered with expditur - not only sbidies, but direct investmnt, inventory finance and wages - which in a market conomy, are not the responsibility of govemment. Unfortunately, in all des countries govemment reve is cclining mora npidly tha governmnts mo abl, to dives themsevas of thes expenditu responsibiities, thus ontributinq to u1bahinit problems. One repon in may countrie ha boen to try to shift the deficit downwans by mang local govemnts responsible for morm expenditure, while smtanously reducing centrl tansfers to the onatonal sctor. 14. The obvious need for flexibility in today's apidly changing envirment bas led many central govenmts to attempt to preservo som dogrees of freedom by continuing with the 'negotiated' tax sharng systoms of the pat. But this approch is less and lea acceptable in countries where domands for fair" treatmnt and ec2alization are strong and where local govemments are seeking gater autonomy. It is also incompatible with the efficient provision of local public services. It is theeforo especially importat to replace the presnt 'bargained' outcomes with an intergovrnmetal fiscal framework - of transfers, of local revenues, and of local expenditure responisibilities - that is both firm enough to serve as a basis for action and flexible enough to be compatible with the on-going structual changes and reform. 15. The present sftrgy of devolving exuenditures downward while holding back on tansfers is unlily to prove successfl for more than a year or two at best. Indeed, net expenditure eduction at the subnatonal level may prove very difficult to achieve. The subnational sector is significant in expendituro terms in many trasition economies -in Rusia, and the CSFR, it accounts for over 40% of total outlays. Elsewhr they account for 10- 30% of total outlays. At pesent, for example, state enterprises provide a wide range of social sector outlays: with privatiznton, many of these outlays will have to be taken over by local governments. Moreover, in most countries, the local government sector plays a critical role in tenn of providing a 'social sae net' which makes the pain of the wrenching economic transition more politicaliy tolerable. Since the trvenue sourcs assigned to local governments simply cannot finance the level of expected local activity in th i_mmedito fture, the result of shifting expenditures downward is likely to be strong demands for increasd, rather than reduced, transfers. In sum, as and when expenditure assignments become cleaer, and decentraliation develops further, the likelihood is that the subnational share in other transition economies wiUl also grow. This means that tho intergovernmental system wil have to be sensitive to these developments: Notable across the transition economs is the fact that there has been a general absence of concrete empirical estli -leg of 'correspondencew between tax and expenditure assignments and need for transfers. Legislation on intergovenmental finance relations has typicaUy been developed with no quantitative assssment of its implications. 16. Despite all the talk about *autonomy' and fiscal 'independenceo, few of the countries surveyed offer their subnational govemments much in the way of fiscal discretion on the expenditure side. Indeed, most recent legislation has focussed on codifying the revenue side of the equation -before deciding what expenditure responsibilities of subnational governments should be, putting the cart before the horse, so to speak. Expenditure 'autonomy' is enshrined in legislation, but not really effective: there are still centrl 'norms' which govern allowable expenditures in virtually every sector, and centml spending mandates remain in place. 17. The new subnaional governments wiUl also need substantial help and guidance in developing adequate lqol revnuo systems. The local *autonomy' that has been enshrined in recent legislation has often meant separating the spheres of responsibility to the greatest extent possible, so that each level of government reigns in its own sphere: in revenue terms, this translates into a pm-disposition towards *tax assignment models, and a goal of reduced *transfor dependance' on the center. The fact that in the pre-reform system, most subnational governments received revenues from 'their' enterpises has led to a strong bias towards derivation-based sharing models in which revenues go to the jurisdiction in which they are collected. 18. It is critical that subnational revenue needs and possibilities be realistically factored into national plans for tax reformL Failure to look at intergovemmental dimensions of national tax policy changes can lead to problems. -4- In Russia and Hungary, a share of major natonal taxes has boen assigned to the subnational Ilvel, and recent national tax policy changes have wrought havoc with the aggrpto subnational revenue base, with vecy eaic effects across subnational jursdictions. Secod, any thought of aasidg. ut', when the tax itself is undergoing continuous definition, is problemical. In m-y transition economie, however, local governments have come out strongly in favor of revenue assigmet under which they got 'all' the 'renues from vtheir taxes. This seeming revenue indepndence leaves them with sgnifict residual vulnbility to tax policy changs, however, a fact that seems genrally not to have ben recowzed. If this vunbity wore to take ito accout, as it dsould be, national fiscal policy reforms would of course be constaned. Rcent tax reforms at the national level, administrative weans and other factors havo meant significat rvenue vowlatiliy, with significant over and undershooting of budgetay tagets. This situaon obviously has implications for the desirability of 'tax assigment' models per s, and the design of sharing/transfor systms. 19. In most countries, for example, the pndcipal locaI" tax is some form of property tax: but in many cases, national governments have hamstrung the revenue potential of this tax by grting exemptions to newly privatized land, housing, and enterprises. In other instances, local governments are supposd to recive a share of certain national taxes, often on a derivation basis (e.g. origin, or residence): but such povisions raise both techcal and allocative problems, in addition to biasing national tax policy decisions in often undesirable ways. Even when the local tax base is feasible and adequate in principle, in practice it will gerally take some years before the system can be expected to produce sufficient revenues to meet perceived locw,; needs. 20. Despite al the talk about *autonomy- and fiscal independence, none of the countries surveyed offer their subnational govemvents any fiscal discretion, even over the muior taxes they ane wssigped: rates and bases continue to be set by the center, in the context of the unitary tax sysem. lho paucity of locally-controlled tax resourees in most transitional countries, when combiaed with the universl reluctnce of politicians to tax constituents too directly and openly, makes it inevitable that hard-pressed local governments wiU turn to other avenues for revenue: they will wmand increased transfers, they will try to borrow, and they will try to exploit tG the full the new assets they nave acquired as part of the decentralization-privadzation process. 21. The level, design and effects of interaovemmental fiscal transfer. thus constitute key elements in the emerging intergovemmental and local finance system. of the tnsitonal economies. There is a general absence of 'formula'- based trasfers. These remain negotiated in aggregate and by individual localities. Critical decisions must be made with respect to the overal size of such transfers (the 'distributable pool') as wel as with respect to the distribution formulas to be employed, taldng into account both the severe fiscal pressures on the central government and the vital tasks to be performed by the local govemnts in the emerging new strcture of the public sector. Practical measures of *tax capacity, *expenditure need' and perhaps fiscal effort' need to be developed for use in such formulas. Institutions must be developed at both the central and local levels to ensure that transfers (or subsidized credits) are put to the best possible use: such institutions may include, for example, at the center, agencies concerned with monitoring the perfonrance of local govemments and with providing them with needed technical assistance and support and, at the subnational level, various intermediary bodies, particularly with respect to the many very small municipalities that have been created in most countries. 22. As noted above, careful attention has to be paid to the design and implementation of the intergovemmental fiscal transfer. that seem likely to remain prominent feaure of the fiscal landscape in most countries for years to come. Caution is even more necessary with respect to borrmin by subnational goverments. A number of countries in transition have granted virtually unlimited bonowing powers to local governments without taldng adequately into account the macroeconomic necessity of monitoring and controlling such bonrwing. As yet, however, the relatively undeveloped state of financial institutions in most countries makes abuse of the borrowing power more a potential than a real problem. 23. The same is not true of the potential misuse of 'locallv owned" state assets, unfortunately, since in every country such misuse is already visible. Such local assets may represent a windfall - at least in those cases where they are not accompanied by centml policies (e.g. rent or price control) that turn them into a liability. But they may - 5- also often be misused, whether they are privadzed or not. A local heating plant that is privatized, for example, but remains a (local) wratural monopoly obviously raises regulatory problems: who deals with these problems, and how? What should be done with the proceeds of asst sales? Under what (very limited) circumstances should such proceeds be used to finance current local expeitur ? If an asset is not privatzed, but is used to geneote on- going revenues for the local govemment (and perhp some forign partnr, with the municipality using its ownership of land or assets as its contribution to equity), the temptation to sustain and sttengthen any monopoly position is obviously again a problem, as is that of regulation. Even more damaging is the high pwbability that more speculative ventuu - examples include tourist lodge and bakeries - are likely to fail. Equally damaging may be the dissipation of scare local managerial skills on trying to squeewz money out of such entrepreneurial gambits rather than focusing on tho more essenal task of trying to provide local public services efficiently. 24. A special problem arises with reap' t to the prices cbrged by those local public enterprises to be retained in tho public sector. In the past, central governments in the socialist countries used low and fixed prices (including rents and other urban user fees) and wage controls, as part of their distributional tool kit. The now governments in these countries ar now being asked, in a reformenvironmet, to get the prices ight and to use tax policies and targeted gubsidies instead. There are two important dimensions in the transition economies: First, changes in public sector prices L.rugc ) clearly need to be coordinated with wage reform on the one hand and with more general price reforms on the other hand, in order to avoid undue impact on income and major distributional shifts (as well as on profits and hence government revenue). Second, central government price mandates -prices were typically centrally administered - need to be devolved to the subnational level. 25. Finally, in somn countries, (Russia, China, and others) price reform and other structural shifts wiU continue to bave effects on the tax base and its distribution across regions. Coal and energy price changes, for example imply potentially large shifts in the vadous tax bases, both vtilbin a tier of government in the tax bases of differet regions within a country (e.g. a gain in value added in a primary-product producing area after price libealization and a corresponding loss in the consuming jurisdiction) and botwoe levels of government depending on how taxes have been assignec or shared. Such shifts must be taken into account when designing the intergovemmental fiscal system: they may well constrain the reform of intergovernmental relations, eliminating options that might be feasible in other countries. At the very least, greater flexibility is needed than in countries where economic structures are more fixed. Intergovernmental fiscal reform clearly must be viewed as an ongoing Rrocss in countries in trnsition. Oreanization of the Paper 26. This paper addresses these issues of intergovenmental finance in transitional economies. It argues that a broader framework than is customary is needed to analyze decentralization and intergovernmental fiscal issues in such economies. This framework must incorporato such elements as the likelihood of continuing structural changes in the economy and continuing political shifts, t4e need to undertake intergovernmental reforms while coping simultaneously with stabilization pressures and the increased importance of the social safety net, the likelihood of continued (local) public ownership on a significant scale, the financial implications of such ownership and its possible conflicts with the overall privation objective, and continued vestiges of price and wage controls and other rigidities. A comprehensive and atcurate analysis of decentralization must take these elements into account. 27. The analysis in this paper is based on detailed recent studies of local and intergovernmental finance in Hungary, Poland, Russia, Romania, and China, and on less detailed information for the Czech and Slovak Federal Republic (CSFR - especially the Czech Repub!ic), Bulgaria, and Vietnam. Salient characteristics of the local and intergovernmental system in each of these countriesa' are presented in the main text for illustrative purposes. 21See also the following working papers: Bird and Wallich, 'Financing Local Government in Hungary, No. 869, March 1992; Bahl and Wallich, 'Intergovenmental Finance in China," No. 863, February 1992; and Wallich, Christine, 'Fiscal Decentralization: lnteraovernmental Finance in Rus&iia' Additional source materials are cited in the bibliography at the end of the paper. -6- Although the principal focus of Ae disussion is on the cental ad at Europon countria (especially Hungary, Poland, and Romnuia), similar tndencis and problems are visible in all th- countries mtioned and may well aWso be manifest in the other repubics of the former Soviet Union and fonne Yugoslavia, as well as in similar countries elsewhore. Komai (in Tho Socialist System) list 26 'soclist' countes in 1987. If we add to this lt the 15 republics of the formr Soviet Union nd the S of fonner Yugodavia (and deduct the now-vanihd East Grmany). therm would appear to be at least 43 countries which only fiv yar ago had more or les 'Socialist' syms. By 1992, howevor, is probably fair to say all but two of theme counto (Cub nd North Korea) ar now in momo 'trnsitional stage, mo tot mom or all of the daslymi of this paper ould be applicable. This paper thaefore represents eeially an intetim report on what is suro to pmve an on-going and important problem in all the trnsitonal ecoomies. 28. The paper is organized as follows: Sectin II reviews r number of geea ius with respect to the roform of governmental structure that have arisen in the transitional economic. This ection elabomates many of the points made above about the importance of thd changig context within which questions of local governmnt roles, responsibilities, and finances are being deided. Section 77 then ouldines briefly what appeau to be the apprpriate role of subnational government , xuch countries, with special attention to its expediture responsibilities. The remaiLder of the paper then discusses the issues relating to each of the posible methods of financing subnational government in transitiotal economies: user chages (Section IV), subational taxes (Section V), intrgovermental transfers (Section VI), subnational borrowing (Secdon VII), and the use of subuational govemment asset (Section 29. The matix below summarizes some of the salient feaour found acros the tramition socialist eonaomies. | ern~kagmeotal Fiwa Reltion in Trmtansn Ecnm2os r Salient Cbarteristics Political/Overall Structura Reform Context * Intergovemnmental finances reforms are taking place in a context of golitical decentralization. * Govemnment reorganization is also taking place throughout the trnsition and socialist economies, and striving for 'local autonomy', many countries appear to be eliminating the 'middle tier' of government in their constitutional reforms. * Intergovermnental finances reforms are taking place in context of overalU sbinking role of * Intergovernmental finances refonns are taking place in context of a changing role of government. * Intergovernmental finances reforms are being undertaken simultaneously with overU national In reforms. Stabilization * Intergovernmental finances reforms are taling place in context of macroeconomic instability and inflation, a weak fiscal NOsitiOn of federal/centrd govenment, and a shrinking revenue base at national level. -7 - Box ... (contnud) |* AMakimi ond overall mco concerns domiate the agenda so dt intergovernmentali finacial reform needs to take place in tdis strne contoxt, but cae needs to be takn to prevent the stabiliduaion objoctive from fully domnting the redign of th inegovermumtsl fian regim. | Stabilizuon concr lead th center to deal with budgey stin by pushing the deficit down', and hoping the subiational level can do the cutting. E In some cas, the center has shifted (potentialy large and open-endad responsibiliti-s for 'social welfare down to local level in an attempt to balamco its budget. * Expenditure autonomy' is enshuined in legislation, but not really effective: there are still centra norms and mandate in placo, and transfer dependance also impedes autonomy. * Subsidies reprent a major item in the subnational budgets due in part to central prioe setting on public sector prices. * Use ot 'norms' to define how a service should be provided ;imits expenditure autonomy. * Cental 'm4a' on wages, and other expenditures limits expenditure autonomy and continue to be importanL Tax Assi e and Iafm * Attempts to make the subnational sector 'independent' are desired by the subnational level md the center. center wants each tub to sit or. its own bottom", to assig taxes and be done with it, and to reduce 'transfor dependance'; This is generally not possible, because the tax instruments are not sufficient, and user charges not yet at a level to contribute significantly to cost recovery. * Subnational goverments want to shake off contral control, and be masters in their own house, and see appeal in the apparent autonomy that 'transfer independence" provides. * Tax assignments typically under-fimd local sector: low-yielding revenue sources are assigned or those which will bear fruit only in the very long term (property tax). | * There is a genea absence of concrete empirical estimat of 'correspondence' of tax and expenditure assignments and need for trasfers and legislation on intergoveimmental finances relations is typically developed with no quantitative assessment of its implications. : * Generd absence of 'formula"- based transfers; they remain negotiated in aggregate volume and by f individual localities. General absence of transparency in allocation of investment grants/capital financing. -8- Box .... (continued) Privatization and OwnaR | * Major continued role of subnational govenments in ownership ventures at a timo when centr/national priorities sQupoxt privatztin This relates to the inadequat revenue bau given to localities and their continued financial dependence on nterprises and tranfers for rovenue sources. | * Potetlly significant negaive consequec for the budget of pnvatizaon (in some cowutres) as enterpnso social expenditures go 'on budget,' and newly pnvatzed enterprises become hader to tax. Subnational governments may not want to lot go of this rliable fine=.ing source. * How to use the saitlry revenues from pnvatzation (debt repaymet, nvestment finance, current expenditures). How to take advantage of the asset stock held by local governments. | orurinD * In most tansition and socialist economies, there is generous legal access of subnational governments to unlimited borrowing, someimes even foreign borrowing. Extrabudetav I?unds| * Extabudgetay funds continue to play a major role, complicating budgetary tansparncy and macro-stabilization. Institud2 Famework * In may transition economies, the instit>tional arrngements needed for diaogue on intergovenmental issues is missing, even though the need for such dialogue is, as noted above, greatr than in makdet economies. Tax Administration * 'Inverted. administative systems in many countres where the local administion offices may have greater loyalties to local government than to central administratve systems. -9- H. DECENTRALIZATION IN PROCESS: TRENDS AND THEMES A T;me of Trmnsforation 30. Perhaps th most iniportant thing to remmber about the procems of political and fiscal decentralization now engaging the countries under review is how very r it is. Apat from China, which took the first tentative steps in this direction in 1979, the subationl sytems now emeging in the transitional economies ar of very recent origin, as indcated by the dates of some of the relevant basic laws: Poland - L Self-Governmet Act, 1990 Hungy - Local Self-Goveamet Act, 1990 RomWnia - Local Govenment Act, 1991 Bulgar - Lcal Self-Govemmnt and Local Administraion Act, 1991 Rusan Fderation - Law on the Budgetary Rights of Local Self-Govamnet, 1991. In most cases, additional important legislation came even later - e.g. to set out subnationl revenue sources (such as Poland's 1991 Act on Taxes and lA Fees) - and in many countries is stiU to com (e.g. with rspect to the precise ownership and control of some importa local assets). Key elements of the legal framework needed for efficient local goverent are stiU missing in most countries. 31. Moreover, once the basi ucue of local govemment was established, local elections still had to be held, new local governments established, and a myriad of importan administraive details determined. In Romania, for example, the first local elections woer not held until February 1992 and the new mayoa did not take office until April 1M. In the Russian Federation, the first local elections wore held in November 1990, and in Hungary in April 1991. Even after a year or two's experience, as in Hungary, Bulgaria and the Czech Republic, some mayors and other local officids, partiularly in the smaller communities, still bave littlo idea of what their real powers, re sibilities, and limitations art. Nor are matr much beuter at the central government level where, in most countries, no one really seems to be in charge of dcenrliatiadon, with the result that some key issus appear to have beon decided (or left undecided) more by accident than design, parcularly issues concerning the intercton of the new local governments with such other lements of the transitional reforms as privatition, tax reform, financial reform, preo reform, subsidy reform, and budgetary reform. Tbis neglect is now causing trouble in an number of countries not just for the local governient sector but also, to varying degrees, for the success of all these ambitious reform plans. The End of Central Plannina: Filling The Abhorred Vacuum 32. Unless more systematic attention is paid to these problems in the near future, muas are Ilkely to get worse rather than better. Up to now, many of the potential difficulties have been kept in check largely by the continuance, de facto if not always de jure, of the refonn m under which subnational govenments received most of their funds from central govemment budgetary transfen which wore basically allocated on the basis of negotiation and bargaining. In this process, the centnl government always has the upper hand, controlling as it does not only the total amount of such transfers, but also who gets them, and when. When combined with the continued central control in most countries of such critical determinants of local outlays as wage structures, enterprise prices, and so -4In Bulgaria for example, laws passed eady in the reform process only spocified that local governments are responsible for 'local matters. This vagueness in the law allowed local authorities to claim all or no responsibility on convenience. This deficiency is now being corrected, and Bulgara is now in the process of preparing a series of new Acts covering territorial division, local self-government and administraton, and finance to replace the 1991 Act. - 10- on, and the ingrained habit of local depndence on centmal guidance, the persistence of this system bas played an important role in preventing local expenditures from exacerbating the genlly tenuous fiscal situation of the central government. 33. But this situation is unstable and will not long persit in the absence of strong central political control.Y Already, many countries are finding that the combination of th manifesdy strong desire for local political control and the unbalaced mdate - virully unfettered 'local autonomy', but a totally inadeque fiscal base - logally bestowed on the new local govenments is causing trouble. In the Czech Republic, for example, central autodities are properly concened about the national implications of both local povemment busines activities and local borrowing as weUl as the fragmentation of the national education system. In Hungary, whore local gover_nN can spend their budgets, most of which come from national transfers, any way they want, simiar problems are emerging. And in Russia, which is with the CSFR the only fonmlly "federa transitional country, separtist tendencies fueled in part by fiscal pressures and imbalances are raising funamntal political problems. 34. The CSFR, of course, has already decided to split into two sparate republics, effective in 1993. Even more dramatic, although of course largely motivated by forces stronger than those discssed here, is the cse of former Yugoslavia. These two are by no means the only countrie in central or eastern Europe to be etmically heterogeneous. It may weU be tat in the end the only way such countries will be able to hold together in a democratic fashion will be by reconstituting themsdves as vey "loon" fedrations - like Switzerland or Canada, in which the subnational units (cantons or provinces, respectively) are also 'sovereign states in some important respects. In these circumstances, central-ational negotiations become as much or more exercises in diplomacy as in the design and implementation of efficient and equitable govermental structuresAY In contrast, the discussion in the present paper assumes, as does the legal framework in every country considered here except Russia (and the soon-to-vanish CSFR), that the transition countries are organized essentily as unitary states, and that the essential role of local governments is to ensure the efficient provision of local public sevices and to act, where it is efficient to do so, as agents of the centrl government. 35. At present, in most of the countnes under review, those local officials who are not simply waiting more or less passively, either for orders to come down from above as they have for decades or, more hopefuUy, for their future to be unveiled for them, have understandably been using their eaergies primarly to attempt to wheedle more money out of the central government. In Romania, for example, where the entire 1992 trnsfer budget was spent by the middle of the year - largely on centrally-mandated subsidies to enterprises - it is not suprising that Bucharest city officials were to be found two or three times a week at the Ministry of Finance trying to secure more fumds. Other local officials, forhtnate enough to possess clear tide to significant assets, have been selling them off and using the proceeds for current expenditures (as in some towns in the Czech Republic) or trying to use their assets as equity in joint ventures with foreign investors (as in other towns in both Hungary and Romania). 36. On the whole, however, there is as yet little eidence at the local level of wide deviations from desired national standards in the provision of essential services, other than that resulting from the general fiscal penury afflicting all these countries. Similarly, perhaps partly reflecting the relatively undeveloped financial sector, there is also no evidence of either significant budgetary deficits at the local level or of excessive (or often, any) local borrowing. As it gets harder to squeeze muoney out of the center, however, and as it gets more difficult to get easy finance from seUing off assets, subnational governments in the transition economies are going to find it increasingly tempting to move in both these ditions. -China, where such control largely remains in place, is of course an exception to this genemalization, although even there many of the problems discussed in this paper are manifest. -I'For analysis relevant to such federai states, see Shah, *Perspectives on the Design of Intergovernmental Fiscal Relatiers," Worling Paper No. 726, 1991, and Bird, Federal Finance in Comprative Petpective (Toronto, 1986). - 11 - 37. With respect to education, for example, the finacial incentives in the preent Hungarian systom may in the future, unless changes are made, lead to larger towns with seondary schools being unwilling to accept stdents from smaller towns without such schools. whe completely unconditionalnature of intergovenmemtal fiscal tansfers in Hungary make it very difficult to penaliz such actions. Simily, national education standards have vanished in the Czech Republic but have not as yet been replaced by either guidelines or nrles: totalitarian education was undoubtedly an vil, but it is not obvious that anachy is better. For the fist time in decades theim is clearly a possibility that wide variations in the quality of education will eerge depending on the ficl resources available to the municipality in which a studkt lives. Similarly wide vartions may equally anse in health, in so-al welfare expenditure, and in other aue of local govenint activity as the power of the center to command vaniss. This outcome is unlikely to be caosiderd desirable by most citizens. 38. It is one thing for local expaoditure choices to reflect the wishe of local officials who have been democratically elected and who wa spending funds secured from the citim who elected them. But it is quite another when sovices with substantial juisdictional spillovers are underprovided in poor areas owing solely to lack of fiscal resources, or when trasfer monies provided by taxpayers as a whole for specific national piposes are misspent by local officials responsive only to their own local electors. Yet both of these outcomes are all too probable over time, given the virtusally unrestricted 'local autonomy' conferred by some of the new local government laws (e.g. in Hungay). For much the same easo, the almost unrestrained borrowing authority bestowed on new and untried local authorities by some of these laws carries with it the potential of eventud fiscal disaster. 39. As yet, the subnational system is too now in most countries for most of the bad things that might happen to have occurred. But ther aro enough signs to be worrying, and it is critical to use this time of transformation and reform to continue to develop the local govemmont stuct in a more positive direction in a number of important respects. It is, for example, important to carify exactly what is, and is not, meant by local autonomy and to flesh out more clearly the role envisged for local govenunents. It is also important to develop adequate institutions at the centrl level to support the many new, and often small, local govenunents that have been created. Moreover, the role and nature of institutions inrmediate betwee the central government and the local govemments has also tuned out to be both a critical issuo in many countries, and an impoant differentiating factor from country to country. Thes questions are discussed furdtr in the balance of this section. Political Decentralization 40. The reform of local and intergovernmental finance is taing place in the context of political decentralization and in particular a strong commitment to decentrliation of certain responsibilities and revenue to self-governing local administrations1z. In reaction to decades of over-talized public administration (and related party control), most Eastern and Central European countries are gngaging in a process of extensive decentralization, gradually reducing the role of government in genera and the powers of central govemment institutions, and especially their planning and control apparatus, in particular. 41. In line with this tendency, autonomy and control over 'local matters, and accountability for them, is being increasingly devolved to the newly-elected local governments. The centrl government wants 'each tub to sit on its own bottom', to assign taxes and be done with it, and to reduce transfer dependance'. Local governments want to shake off central control and be masters in their own house, and see appeal in the apparent autonomy that 'transfer independnce' provides. For those and other reasons, the principle of localautonomy is now enshrined -'In Bulgaria however, the pace of the former exceeds (and precedes) the latter. There is a risk at present of increasing fragmentation in the number of self-governing units in Bulgaria because of the perception of local governments that 'self-governing status will lead to greater budgetary transfen from the center. In order to counteract this trend, it is important that aspirations for local autonomy be tempered by specifying a threshold for self-financing/own source icvenue mobilization. - 12 - in the legislation of most transitional countries. As a rle, this legislation affims d liation, local financial autonomy and the administraive 'independence' of the uunadonal level from cental control. The language differs, but the geonel intent is clearly to free subnational govenments from the 4ead hand' of centralized control and to let local democracy flounish. 42. These political reforms are paralleled by dcentaliton of fiscal responsibilities. Some form of subnational govemment stucture had existed in most of the transition economies mder the socialtst regime. However, the fiscal system of this regime was essenidaly 'unitary,' with the sub-national level being little more than an edmin unit or 'departmet' of the center, with no indepe;dnt fiscal or legisltive responsibility. Kornai (I992, op cit) sets out the former socialisS system in considerable detail. It is revealing that this lengthy study hardly refers to the existence of subnational state administrations, noting only that they are tightly cntrolled in al respects by the central bureaucrcy. In effect, local govenents were basically udeconcentrated' nits (or branch offices) of the central govermment and had little or no financial autonomy. This was true even of those countries such as the USSR, and Czechoslovalia which were formally called 'federations'. It was also true in the Russian Federation, despite the fact that Russia's 31 autonomous republics and national regions wero said to be 'autonomous' and to have independent budgetary rights. Policy-making was hence very controlled and centrHzed and local government had virtually no independent tax or expenditure powes - part of a larger picture in which the budget itself was seen only as the handmaiden of the Plan. 43. Reorganizing Governuent. Now, however, virtually every transitional country is to varying degrees decentralizing, deconcentrating, and delegadng functions and responsibilities.Y Decentalization has many merits, both in political and economic terms. It has, for example, the potential of improving the efficiency of local government by subjecting its actions to the scrutiny of the local electorate. Autonomy over local decision-making and expenditures also frees local governments from the heavy hand of centrd control. As yet, however, these benefits have not been attained for two quite distinct reasons: the persistence of the old ways and certain flaws in the new dispensation. 44. In Romsani, for example, there are at least three important reasons why local autonomy has little meaning in reality as yet. First, although the Public Finance Law clearly says that every local government is supposed to have budgetary autonomy, it also gives power to the central govment to change local budgetary allocations.9' Moreover, as noted above, the habit of deference to centrl commands, even if no longer legally binding (or enforceable) still persists in many areas. Secondly, at the present tibm local govermnments in Romania actually deliver very few services themselves. Instead, their basic role is to contract with reaies autonomies (local public enterprises) for the delivery of most local public services. These 2ngj, like al enterprises in pre-reform Romania, were of course just another part of the public sector under the previous regime. Under a 1990 Law on the Restucturing of State-owned Economic Units, these enterprises are now financially independent. Although they are legally responsible to a board comprised of me4bers of the relevant local government, they appear to be acting both more independently and at the same time more in response to the many cental controls and egulations to WDeconcentration refers to dispersion of responsibilities within the central government structure from the center to regional *branch offices', and differs from 'delegation' in which local government may execute certain functions on behalf of the central government (and be accountable to it for their performance), and 'decentralization', in which full decision making and implementation authority is transferred to local govenmment, which is accountable only to its own constituents. 2'Art. 51 of the Public Finance Law states that 'the distribution of the revenues and expenditures or categories of local budgets ... is established by the decision bodies of each county [district] and of the city Bucharest.' But Art. 22 of the same law states explicitly that the central government has decisive power in the formation of local budgets. Each year, local budgets are submitted to the Ministry of fmance no later than July 1. The Ministry of Finance examines the draft budgets and has ten days in which to "ask for the necessary modifications' in order to establish budget balance. Most importantly, 'in case of divergence the (central] Govemment is to decide'. - 13 - which they are stil subject thn at the behest of local govemments. Finally, as in most of the transitional economies, Romania has created a large number of small, poor local goverments with almost no resourc0s of thoir own. Autonomy' does not mean the same tbing to a small, poor rural commune as it does to a large, rich city. 45. Lcal institutions are more developed in countnes such as Hungry, but these three problems - conflicting legal interoptations, tangled rmlations with enterprises, and considerable diversity in the capability of local govemments - exist almost everywhere, and cast some doubt on the real significance of local autonomy.' Moreover, even where such implementation problems do not exist, the fiudamental problem with th way local autonomy is being approache in the transition oconomies is that such autonomy is not moeningfil if it is not accompanied by capacity, and it is not desirable unless it is accompanied by responsibility. 46. To make local autonomy menjrtef, local govements need adequato locally-controiled revenues. Not only must decisions about the provision of government services with local benefits be made by local governments, but such goverments must have the resources to carry out such decisions. As developed further below, local expenditure discretion is stil limited in imponant ways: some such limitations may be good; others clearly are not. Moreover, the fimdamntal inadequacy in most couttries of the local revenue base (see later discussion), and the resulting continued dependance of local finance on ad hoc transfers means that revenue capacity is also inadequate. Greater expenditure discretion in those expenditures fiuly assigned to the subnational level and greater flexibility for sub-national govemrments to raise their own revenues seem needed in most countries. Such revenue flexibility and autonomy is a crucial step to maling local govemment more accountable to local residents, and to improving the efficiency with which local public services are delivered. 47. One meaning of local autonomy is thus that local governts should be able to raise and spend revenues from their own revenue sources in any way they wish - subject to cenain limitaions on the revenue bases to which they have access (see below). Since local governments are responsible to local taxpayers for what they do with the funds they raise, in principle it is neither necessary nor desirable for the central government to tell local govemments what they can do with their own money. If those who pay for local services financed from local revenues, the local taxpayers (and voters), are unhappy with what their locally-elected authorities do with their money, they may dismiss them. 48. On the other hand, if the centml govemment is unhappy with uwht some local government does with the money raised from local taxpayers, its unhappiess may be unfortunate from some perspectives, but it is unavoidable. What local autonomy means is precisely that there is nothing that the central government can or should do to alleviate any such distress it may feel - barring extreme cases such as corruption or when other national laws are breached. 49. Local autonomy emphatically does not mean, however, that local authorities should be able to do whatever they want with other people's money - that is, with taxes paid by other than local residents. Truu local democracy - presumably the ultimate reason why 'local autonomy' is considered desirable - means *responsible' democracy, which in turn requires full and explicit political accountabilitv to the source of local government resources for what is done with those resources. Local autonomy in this sense is thus not only consistent with, but also requires, that two important conditions be satisfied: 1. The access of local authorities to taxes that may be *exported- to non-residents should be severely restricted. 2. Subnational governments should as a rule be accountable to central government (that is, to taxpayers in general) for the use made of central government transfers. Acceptance of these conditions, as is necessary if efficient resource use is to be achieved, has strong implications both for the design of the local tax system and for the design of transfer systems, as developed below. - 14 - 50. Th'e eenal economic role of subntional governient is to provide to local residents those public services for which they arm willing to pay. As already noted, local govemnmets must be accountable to their citizens for the actions they undertske to the extent those citizens finance those actions. Similarly, local governments mst be accountable to the central govemment to the extent they are in effect acting as 'agents' and are financed by transfers. Accountabilitv in this sense is the public sector equivalent of the 'bottom line' in the private sector. 51. Such accountability clearly requir thst subeational governments should, whenover possible, choa for the services they provide, and, where charging is impracticable, they should finance such services from taxes bomne by local residents, except to the extent that the contral government is, for reasons discussed later, willing to pay for them. Public soctor activities are unlikely to be provided officiently unless the lines of responsbiity and accountability are cleady established along these lines. 52. On the one hand, then, local govemnments need to be given access to adequate resources to do the job with which they are entrsted. On the other, they must be held responsible to those who provide these resoure - local residents or central goverments, as the case may be - for what they do with them. 53. In principle, local govemments should therefore not only have access to those revenue souces that they are best equipped to exploit - such as residential proprty taxes and user charges for local services - but they should also be both encouraged and permitted to exploit these sources as fuUy as possible, subject to certain limitations. Unless local governments are given some degree of freedom with respect to local revenues, including the freedom to make mistakes for which they are accountable to their constituents, the development of responsible and responsive local govemment in the trnsition economies is likely to remain an unaainable mirage. On the other han;, if local governmcats are given cate blauche to spend o-ter people's money, the alocationa, distuibutional, and maccc consequences will almost certainly be undesirable. 54. There are of course dangers in permitting local governments even limited freedom. One danger in the eyes of some is thst they will not utilize fully all the revenue sources open to them, thus allowing the level and quality of public services in some areas to deteriorate below the standard considered desirable. But this is not a real problem. If the savice in question is reaUy one of national importance (e.g. reseach) or one in which there is a strong national interest in maintaining standards (e.g. poverty alleviation), it should be nationally funded at least in part and its achievement monitored correspondingly. If it is not a matter of national interest, why should the national government be concemed? If the local electors do not like what their local govenment does, or does not do, they can 'throw the rscals out' at the next election. As noted above, the freedom to make mistakes, and to bear the consequences of one's mistakes, is an important component of local autonomy. 55. Another danger, more salient from an economic perspective, is that local governments may attempt to extract revenues from sources for which they are not accountable, thus obviating the basic efficiency argument for their existence. To counter this inevitable tndency, central govenments should in principle deny or limit access to taxes that fall mainly on nonresidents such as most naual resoure revenues, pr-retail stage sales taxes and, to some extent, nonresidential real property taxes. 56. Another way to counter this problem to some extent may be to establish a uniform set of tax bases for local governments (perhaps different for different categories such as big cities, small towns, and rual areas - although this may not be politically acceptable in all countries), with a limited amount of rate flexibility being permitted in order to provide room for local effort while restraining unproductive competition and unwarranted exploitation. It is especially important to provide adequate flexibility to exploit good local tax bases to avoid creating a situation in which the only flexibility available veal governments in their struggle to cope with budgetary prssu is by exploiting such economically undesiable sources of revenue as local business taxes or, even worse, local business enterprises. As emphasized later, the business of government is not business, and enterprising municipalities should not be encouraged to develop local enterprises in order to secure the revenue they need to function. - 1S - Tho Size and Scope of Government: How Many Levels? 57. In the pmroform period, virtully all the countries under review had a multi-tier organizion, with the central level implemeaing its control over the local level throuh an of government. The central goverment wa responsible for the overall plan and budget, and the intenrmdiate level, variously called 'Oblast (in the Russian Fedation); *Judet (Romania); County Council (Hunguy), and *Voivodu in Poland, was the administrative, control d surveillance agency tough which o cer effected conol and implemented policy.w This middle tier ovemw tho expenditur of local governts and wa the chnol for centil fical flows to the localities. Substatvoly, however, noe of the countries discsed her was organized, from a fiscal perspective, u a federaton. Although the Russian Federotin gv nomial autnomy to its 31 'auftomous (or national) regions, okmup and republics, these sb-ntioad gove too wero nither fiscally idependent nor able to determin their own expenditur and tax policies. At the other extrme in some ropects is China, a unitary country with a vey decentralized inison. 58. At present, only Russia and Czechodova have a thre tier fml systm of govemment, comprising the federal govemment, republics, and regions - and t Czech and Sloak Fedeal Republic, as it is formally called, is scheduled to septo shortly into its two componet pua. All the other countries discussed here have a uitarv system of government. A first look at the lol stucture suggests that Poland, Hungary, and Romania have a two-tier level of government (central and local), Rumds, China and Bulgaia a three-tier struture (central, provinces/county/regional and local), and Vietnam a four-tier level of goverment (czatml, provincial, municipal/district and comneighborhood) a shown in Table 1. In fact, however, matters ae not so simple anywhere. Romania, for instance, has two tier of local govemmt (the old judets and municipalities): all of the area of a judet is divided into unicipalities, but in principle each type of local government is independent of the other. In Hungary, on the other hand, whilo the old counties still exist, they really have no functions, so that there are m effect only two lovels of government, cental and locaL On the oter nd, in Budapest (as in tho citie of the Czech Republic) there are *subcity (distict, or ward) councils and goverments with elected councils and their own budgets and assets, so that thoe local level of govenmnt itsf ha two tiers - as indeed it does in the largely unrefonned stucture of Vietnam. In Bulgai, the municipalities ar the basic unit of self-government, but they have contiguous bordes and therefore both urban and ural. The municipality itslf has an elected Council and Mayor, but urban settlents within the municipaity also hav an elected Mayor (no Council) with delegated executive power, from the municipality (ie. county). This lower level is therefore a deconcentratd level of local govemment. 59. As a rule the middle tier of goveiunt cotinue to aist in vestigial form in most tansitional countries, but it is struggling both for a role and for legidmacy. Most coundries seem to want to shed this intermediat tier, associated with the former control economy, as if to put their past behind them. In some countries the role of the interdiat tier is now limited largely to overseeing the constitudonality and legality of local govemment oprations. lI others, its role has become one of coornanting cental government policy at the regic *al level. In most, however, there are few quesdons more in flux than the present and futre role, if any, of' intermediate lvels of government. 60. In HAomgm, for example, ther are now 8 regions, 19 counties, and 3070 localities. The regions, headed by a central official called the Commissioner of the Republic, have two functions: (1) information and dissemination, which involves collecting data on local govenmet activities and providing information to local govenments to facilitat the implementation of national policies; and (2) to ensure that local government actions (e.g. on taxes) are constitutional. The functions of the 19 counties, formerly the main teritorial control instrument of the state, have also been severly restricted. counties retain some minor fee revenues and are supposed to be L' These are, strictly spealdng, decentralized branches of the central govenmment administration, not an indpendent tier. There are 88 oblasts in Russia; 9 oblasts in Bulgaria; 19 County Councils in Hungary; 49 Voivodships in Polp.nd; and 41 Judets in Romania. - 16 - responsible for functons of an intuAunsdicional natur that servo swvral localies. In contrast, the local govemnments (almost twice the number of the former 1563 local councils) have considerable expenditure responsibilities, the right to spend national transfes and shared ta a they so fit, and amost unlimited power to borrow, own and dispose of property, and to manag, establish, or sel public eaterpises. Table 1 Trends in cr t Governmnt Orgnization country UnitayFdal # of Tiern Em N of Tiers (preet) ___________ _______________ (pro-rform ) Structm Hungary Unitary 3: central/county/ Unitary 2: cental/local local Poland Unitar 2: cenral/local Unitary 2: voivodship8/ Ronania Unitary 3: central/regional// Unitary 2: central/local local _ _ _ Bulgaria Unitary 3: central/regional/ Unitary 3: central/oblass local (regions) obahina (municipalities) CSFR Federl 3: central/state/ 2 countries 2: republics/local local Russia Federal 4: central/oblast/ Fderad 3: federal/oblast/ myons/vi-t ge rayons _ _ _ _ _ _ _ _ _ _ _ _ Soviet_ _ _ _ _ _ _ _ _ _ _ _ _ China Unitary 3: centrl/province/ Unitary 3: central/ local province/ local Vietnam Unitary 3: centDal/province/ Unitary 4: central/ local province/ municipal/ commune. 61. T,he stuation in Romania is quite different. Although the 41 judets continue to exist, there are now two completely different administrative structures in each judet The first, headed by an appointed prefect, is essentally the deconcentated territorial admnistaton of the state. The seoond, haded by the elected president of the judet council, is the locl govenment at the judet level of local gov ere, which is responsible for works of regional interest but which has no hieruchial authority over the 2,948 other local governmentsU. L'Me situation where a local govemment jurisdiction coincides territorially with a deconcentrated echelon of the central government administaon can be found in other countries. T.he Romanians have basically borrowed the French local administtion system as it emaerged from the 1982 decentralization reform, at least as far as the roles of the departmt (judrte) and the communes (comune si orase) are concerned. (They did not copy the truly new feature which that reform brought about, nmely the creation of the region as an additional intermediate layer of - 17 - 62. In EgJg, the 49 vovoidahips ane esetaly deoncetred public service inmdiaes for cti central expenditures (mostly in hlth and socal welfa), although other central expenditures are camed out locally by line ministries. All local government functions ar caried out directly by the 2383 gjina governmons. Prest plans, however, ate for a new iermediat tier of local govenmet (probably about 300 units called powiats) to be put in place in 1993. Similarly, in the CzechRepublic, whoe there are at preseat over 5000 local govebmts, there ar also 7 regions and 75 districts e_nally left over ftom the preious regime, and plans are being considered for creating anything from 3 to 20 to 7S "second-fierm local govamenats. 63. Finally, in tIe Russn EfSop, a sligbtly different paten is emerging, with the obast level tddng on a laorg role and emerging as an iwpota unit in its own right. ndeed, if the fiSecal reforms at the subnational level proposed in macmst logislation are implemted, the Russin Federtion will have decentlid expenditure responsibilities and to a lesser degre, rvenues, to the oblst level and will take on the character of a tme federal state. Size of Goveme Units: Efficiey-and Other CMgM. 64. Although the initial reaction against the previous intemediate govemments as udesrable reminders of the old regime is dendable, so is the obvious concern in many countries to put something more acceptable in their place. As shown in Table 2, most of the east European countries have created a large number of small, and probably not viable, local government units. In Hungary, for example, the averago population of local goverments (excluding Budapest) is only less than 3,000. In Romani*, half the population lives in local governnowt units with a population of less than 4.000, such units accout for 90% of all local governments, and the average population of all local govenments is only 7,500. Poand's locad govenms ar smilarly fragmented, with an average population of only about 16,000. The Czech Republic, a compact country with a little more than 10 million people, has over 5000 local govermments. In Bulgaria there are 3,984 elected local govemet units (settlemnts) with the average population of 1500. At the more aggregate level, there are 273 municipalities with the averge size of around 30,000. 65. Such extensive iixm on may be good for getting govemment close to the people, but it also substantiaUy complicates intergovernm tal relations - it is, for example, imWposible for the central govemment to maintain direct bilateal relations with so many units -, reduces the political ~roice of local government as a whole, and in many cases yields localities that are sunply too small to provide efficiently all the public services demanded from them. At the very least, even if it is decided not to reate a formal intermediate tier of government, some mechanism for coordination and consultation is likely to prove necessary. Possible models abound in the world, e.g. the 'municipal federations that exist in many of the Nordic countries, under which localities orgaize on a voluntary basis to provide cerin local services, or the Nordic secondary commun-e, county-like bodies with their own elected officials responsible for providing services of an inteijurisdictional nature. local (regional) government). Similar situations exist in other countries, for instance, in Germany (Bavaria) where the landkroise are both local govemments (gebietskorperwhaften) and the lowest echelon of the State administration. - 18- Table 2 Deloizationu Scale and Sie of Govenmenw Country of units of local governumet Average Size Hungary 3070 municipalities 2,834 Poland 2383 gnas 16,000 Ronuia 2940 urban and rural mniucipa4itie 7,S00 41 judeta S37,804 Bulgaia 273 municipalties 30,000 CSFR 2843 cides in the Slovak Republic 1,867* 5500 cities in the Czech Republic Russia 2000 rayons 125,000 88 oblast 2,840,909 China 30 provincs 33 millon Vietnam 44 provincs 1.47 mon Note:* For the CSFR as a whole. Sum,orting Subnaional Government: The Ihstutional Setting for Subntioinsl Govemmentisl Reform 66. The lack of an approie contral govnnt strucr to moitor and support tho new local govanmts is a common problem in central and eastern Europe. In Poland, Hungary, and Vietnam for example, thDre exists no institution or designated person in cbare of the deentlion of the localities and the Ministty of Finance still plays a lead role in the budgetary function and other fiscal issues at the local level. In Russia the formation and implementation of fiscal polcy is done by the centrl government and three Parliamntay commisons. The budget is submitted to the Parliament for approval, the collection of revenue is done by the State Tax Service, and expenditure authorization is dr the control of the MOF. In Bulgaria, the Ministry of Regional Development, Housing Polcy and Construction is responsible for formulating the policy on terrtoral division and local administrative functions and guiding the reform progam whilo the MiniAry of Finance retains primy control over the linked issues of local govrment finance and budgeting. In Romania the formulation of decentalization policy and implementation of local government reform is tife resnsibility of tho Department of Local Governmet Affairs of the Office of the Prime Minisr and the Deparmt of Tax Administationand Local Budget Management of the Ministry of Finance and Economy. Simildy, in the Czech Republic, both the Ministry of Finance and the Ministry of Economic Policy and Development are involved in shaping the intergovernmental finance system. 67. Despite (or perhaps becue of) the involvement of a number of central govenment institutions in a number of countries, quite a lot that should be done sem to be going undone. Among the tasks for which responsibility must be clearly establied are MomitOlinl and ssg subnationd fnms both in total and individually. This task might be located in the Ministry of Finance, in a special local govemment department, or it might even be given semi-independent status with some local goverment involvement (like the US Advisory Commission on Intergovernmental Relations or the similar body in Australia). There ae pros and cons of each possible location that need to be considered carefully. But what is beyond dispute is the need to ensure that the central authonties have a better underanding of both the existing situation and the likely effects of any proposed changes than is true at present. - 19 - 68. In addition, reular and dogiled fingaial da should be maintained on subutional govenments. Ideally, this requires; (1) the establishme of uniform financial reporting (and budgetng) systms - perhaps with different degre of complexity for different categories of local governments; and (2) the desigaion of an agency responible for coUecting and procesng then data in a timely fahion (which wiU probably, in a larg and complex country, requie use of some sampling thniques as well as occasional census exercises to provide the needed frtame). The first of these quiem ts in tun requirm the development of such systeum and, much more difficult, their implementation, which will geally require subsatial trining and folow-up efforts. Developing such 'infrastricture' is neither quick nor cheap, but it is esential if substantial ad important public sector activities are to b decentlized - for whatever rsrn - without losing sight of what is going on in these importat pua of the public sector. Implementation of this recomendation may rqui additional centnl govem ntot institutions (1) to develop and maintain the reporting systems, (2) to tran and support local govenment officials, (3) to develop independent auditing procedures for local administrations and their rovenueoeaning entexprises, and (4) to run the stical side of the opation - with the latter being a main input into the work of the instituion referred to in the first recommendation above. 69. Additional training efforts are clearly needed to uagade the technical canacity of subnational overnments to carry out efficiently and effectively the expendituro functions for which they are now responsible and others with which they may be entusted in the future, whether in exercise of 'local autonomy or as delegated agencies of the central goverment In some insance. (e.g. education) the neary support should probably como from the relevant central minisy, while in other instane (e.g. road and waterworks) it may come fom the ministry, regional agencies, universities, private sources, or some mixture of the preceding. In view of the heterogeneous nature of both the services that are (or may be) decenalized and of most countries, it is unlikely the same solution will be appropria in aU coass, but it is clealy a high-pority item to work out in detil exactly who is going to support the new lood role in each functionl area and how that support is going to be delivered. Each functional area - including the budgeting and financi rporting discussed earier - has different needs, problems, and possibilities, and will likely have to be treated diffetly. 70. Finally, an especially high-priority task for the needed central unit monitoring local finance is to analy and evaluate intermovernmental fiscal transfers. As indicated later in this paper, there are many questions that must be raised about the objectives, the design, and the effects of such transfers. There is also much to be said for encouraging much more informed and open discussion of these matters than is common in many countries, especially when the whole process is as novel as it is in the transitional economies. Regular publication of data will of course help, but one cannot rely solely on an interested party - the central govermment - to carry out, and certainly not to publish, all the analysis that is really needed in any country in which intergovemmental financial issues are important, whether in political or economic terms, or both. For this reason and others, there is much to be said for establishing as soon as possible in most countries one or more smal non-govermnental research institutes focusing on local government problems. The Changin Role of Government: From Ownership to Service - Provision 71. Decentralization and intergovernmental fiscal reforms are taking place in the context of a major change in the role of goverment in the trasitional economies. Ia the past, governments at both the national and subnational levels have been involved in almost every aspect of economic activity. The state owned all enterprises, from the steel plant on the 'commanding heights' of the economy to the local laundry. The state organized production, allocated labor, planned exports, and so on. The first stage of decentralization in some countries began in the 1970's, when the ownership of some smaller industrial units and the retail sector were transferred to subnational -20 - govemments. By the late 1980's, local goverments in countries such as China owned a substantial patt of the economy - light industry, and some manufactuning. 72. More rect reforms aim to decentralie owneip to tho privat sector. The trnusition is still far from completo. Although all the east European countries are committed to privatzing stlte assets, to liberaliang prices, and to withdrwing from the role of the state as direct pducer and prvider of ecoomic goods, many produetive assets - indudrial assets, agriculturl and urban lad, the housing stock, commrcial property - remain in govenmment hands, somedmes local, sometimes national. 73. While everything is in flux in most countries, as a nle at the local level the satus quo contasb starkly with the role local govemments generally play in maurkt ec4onmies. In the lIser, local govenmments provide basic urban inftucur and local public services (sometime through local public enterprs) and often act as local administrators of nationa policies in such area a education, health, and social sevices. In the former socialist pattern, on the other hand, enterprises owned by local govenments had their investments financed from local budget', and local budgets in tum derived revenues from Otheir eantepriss. C were close, and the distinction between enterpris functions and government functions often murky. Lcaities often asked enterprises to construct and finance such facilities as roads and schools, clinics and even sports stadia and clubs; 'donations' to the budget for one-off outlays were also com rm Jt made little difference whether such outlays were directly undertaken by the enterprise or via the more circuitous route of profit transfer, and funding via the government budget: the burden on the enterprise and the not budgetary position was the same. All this has now changed, or is in the process of change. 74. Until recently, for example, most local government revenue from enterprises came from 'profi: remittances'. As a result of reforms to the national tax system, and especialy of the enterprise tax system, however, these remittances have largely been replaced by taxes on *thei enterpriseeW. Somo countries still provide explicitly for such 'ownership' rights to enterprise taxes: in Romana, for example, local governments (iudets and municipalities) have the right to both profits and dividends taxes levied (by the central government) on their public enterprises. In Poland, prior to the racet tax reform, both profits and dividend taxes similaly went to the 'founding' sbnatidonal government, and in addition these govemnments (vovoidshipsand gmina) got specified shares of the similar taxes levied on state enterprises which had significant activities in their territories. This process was so complicated that the Polish tax administration spent almost as much time allocating enteTprise taxes among jurisdictions as it did collecting them. 75. Even where more modern systems of tax adminitraton have been adopted, as in Hungary, there is still a strong tendency for local governments to feel they have a primary claim on the tax revenues generated within their jurisdiction. This 'source entitlement approach to the allocation of fiscal revenues is of course familiar in such contexts as international taxation and the taxation of natural resources. But it is seldom so visible at the local level as it is in some of the transition economies, in part because of the obvious gross inequities that would result from allowing local governments to keep large shares of the revenues levied on firms producing for a national or world market. Of courmse, exactly the same problem arises, or wil arise, in the transition economies, as noted below. 76. Ownershig versus Service Provision. The fundamental change in the role of subnational governments represents a major challenge which has as yet not been fully realized in most countries in trasition. The key role of local governments is no longer as o but as saervi viders and reguators. The wrenching reforms most countries are undertakdng in order to achieve macroeconomic stabilization and to compress the state budget may easily produce perverse effects at the local level. As noted below, some central govermments, for example, have shifted additional expenditure responsibilities downwards in the hopes of improving their budgetary position. Revenue assignments and/or transfers to local governments are generally tightly budgeted for the same reason. The Uy See Tanzi, Fiscal Reforms in Socialist Economies in Transition, IMF, 1991, for a full discussion of the national tax reforms that are in process in most countries. - 21 - result is inevitably that local govenments ar sorely tempted to rely on entises for continued budgetary oudlays, and consequantly to protect locally-owned enterprises to ensure their profitability. Unless a workable framwork for intergovernmentsl finance is put in place, budgetary stringency is thus likely to create additional hurdles to disassociating local govenments from thir enterps. 77. T'he IQ-S4t Oda facing both local and centra govements are also very difrent from the past. 'Adm trativo inteventiods', such as the detailed regulation of prices, the administation of waiting lists for housing, and the allocadon of land and mtria supplies are no longer qriropriate. Instead, what is now needed is to develop and implement an entirely now regulatory strctur to provide tho conditions within which the market can do its job e.g. reulation to avoid monopoly, prevent food adulteration, curtail financa fraud, and so on. In this vein, one essential task of the national goverment will be to set up an adequate and clear legal framework not only for the private sector but also for the deces.alized local public sector. Local govermmnts face their own unfamiliar regulatory task, particularly with respect to land use, enviromental problems, and retail trade. 78. Not only is the role of govemment changing, but its mo is changing. Intergovernmental fiscal reforms are taking place in the context of an overall shriniing role of government, with all thstresss that a smaller pie imposes on decision-makers. As shown in Table 3, the size of govenmment was much larger in the transition economies than in mulaet economies. In many cases, reforms have alrdy had a major influence on the overall "size' of the govanment sector, although much more some than in other. In China, for example, the government budget declined from 40% of GDP in 1979 to Ims than 20S of GDP in 1989; in Hungary, the similar decline was from almost 70% of GNP to about 60%. examples. In Ru via, the geneal budget was over 60% of GDP in the late '80s; the target for 1992 is only 35%. 79. Although the figures are not always clear, on the whole it appears plausible that the shrinling of the national level has been generally pamrlled by a shrinkdng of the subnational level of government: in Hungary, for instance, subnational expenditure fell from 14.3% of GDP in 1988 to only 10.4% in 1991. Predicting future trends is difficult becus of the changing nature of the intergovernmental system in most of these countries. 80. On one hand, as already mentioned, central govenuments continue to shift important expenditure items 'downstairs' in an attompt to balance the central budget. It is not clear if the final result of this process will be reduced total expenditures, increased central trasfers, or increased local taxes - although some combination of the first and second possibilities seems most likely in most countres. On the other hand, as a rule public enterpnses continue to provide a number of basic local public services: they support the construction and maintenance of housing, keep kindergates and pre-schools, and so on. Larger entrpses may even have their own hospitals, retail outlets, and other non-production facilities. As privatization reforms impinge increasingly on the enterprise sector, pressurs to replace some of these activities by local budgetary outlays will undoubtedly be strong. 81. Thus, at the same time that localities may be reducing expenditres by shedding unnecessary and unproductive subsidies (for example, to housing) as part of the economic tranition to a market economy, they may have to take on some expenditures previously caied out by enterprise. Whether such enterprise functions will accrue to national or subnational budgets is hard to predict: it is equally difficult to predict the net change, in the short term, in the size of the local government sector. In Russia, as one example, the non-production responsibilities of enterpnses are, virtually across the board, likely to be taken on by the subnational sector, thus substantially increasing its expenditure responsibilities. Indeed, such a transfer is de facto already taking place owing to the financial difficulties of many enterprises. Unfortunately, no one has either quantified the dimensions of this problem or envisaged any workable solution for it. In principle, however, the shift in expenditure responsibilities from enterprises to local govemment should be matched, at least to some extent, by a corresponding change in the revenue base of the local govemment. Otherwise, the budgetary consequences of privatization are likely to be very negative. But as a mle, that revenue base is already inadequate for the tasks demanded of it, as discussed below. - 22 - Table 3 Reform and the Size of the Goveommt Sector (Expenditue as % of GDP) Country Exp Sub-nationl Sub-nio Total Exp. as Sub-national Sub-national as % of Exp. as % Exp.u% % GDP Exp. a% Exp.u % of GDP of GDP of total of GDP Totia Exp. PrE-1989 Post-1989 Hungary 62.7' 14.3' 25.4' 57.4 10.4 18.1 Poland 49.7 14.7 35.3 40.1 4.00' I0 Romania 45.1T 3.64 11 24.67 6 10.8' Bulgaina 55.2 N.A. N.A. 43.0 25.0 23.0 CSFR 58.46 20.5 34.5 60.1 20.2' 34.3' Russia* 1.0' 20.7 13U 16.0 1L/ 41.0'r 17.0 43.0 China* 271r- 14.3 53.0 22.8 N.A. N.A. Vietnam 11.3 3.4 31.0 12.3'2 3.9 33.0 Notes: (Seo end of paper). 82. In the past, goverments m the socalis countties employed fixed prncs (including rents, and other urban user fees) and wage controls, as essential elements in thOeir dstbuti tool kit. Now, however, as part of the reforms currently under way, the tansitional economics a required ind to 'get the pices right and to use tax policies and targeted subsidies instead. As a rule, replacing conmr price subsidies by targeted sbidies (with a much smaler budgetary impact) will require the development of new infmaion and twcng systems.W Some observers think that the targeting problem will be relatively eay in the transion economies because of the existence of a large 'control' data bas in such countries. This hope is probably naive, howevr, given (1) the flaws in that data base (e.g. in Poland several million people exist *off the books a far as officialdom is concemed; in Hungary and especially Romania, thern e important low-income ethnic groups Ohat ar smilarly lusive); (2) the dependence of official information on a local control system that is diintgatng apidly, if it has not already disappeaed; and (3) the increasing gmwth of the euphemistically-labelled 'infornmal sector.' 83. Indeed, since the breakown of cenal planning, ctrl governmet in most countries have surprisngly little information even about the activities of local goverments. Only in a few countries (e.g. Hungary, Poland) do local governments now appear to provide detailed financing reports to the conter. Reporting of data on extrabudgetary funds and borrowing is also deficiejti 84. Public sector pricing is likely to be one of the last areas to be reformed in most countries. While national price reforms have liberalized most private sector prices,1 at the subnatioual level governments are having a much harder time adjusting prces for public sevioces, even for prvate goods provided by the public sector, such as housing rents (and such ancillary services as water and heating) and transport fares. Adjusting these prices is of I' For useful discussions of some of these problems, see the following papers presented at the recent World Bank Conference on 'Public Expenditures and the Poor: Incidence and Targeting': Milanovic, 'Distributional Incidence of Cash and In-Kind Transfers in Eastern Europe and Russia;' and Jarvis and Micklewright, 'The Targeting of Family Allowance in Hungary.' -LPhere has been much discussion about the 'big bang' vs gradual approach to price reform, but even in countries as committed to gradualism as China there has been major price liberalization. - 23 - course essential both for efficiency ard to enhce local rvenues. Doing so, however, implies major changes in the cost of living and in welfiae, so tat changing such public sctor prie will entail major, and undoubtdly very unpo ar, distributional shifts if not pro)pey coordinated with other refoms. Such shifts, if too wrenching, or too quick, could upet the filo democcies tat havo only just emergod in most countries. 85. At the -m tm that fiscal i-a is going on, national tax ytems are also undegoing major changes. Major naionl tax reforms havo been initiate in almwt every country in a effort both to make their tax sytm more compiblo wit thos of a market ecnomy and to pwvide a soeu source of revenues to finace essential ste budgetary outlays il the face of prvation. While there are considerable variations of dotil from country to country, as a rule tax reform involves: (i) the replaeint of profit remittances to govemment as owner with corprt income tuation (CIT) to the govement a tax colloctor, (ii) the introduction of a value-ddd tax (VAT) to replac the classical socialist *tuover tax", which is bet described as consisting of thousands of commodity-specific rates, or wedges betwoe adminisratively-st rtail and wholesale prices; (iii) the introduction of personal mcome taxes (PMl) - wage controls woe the 'mplicit tax' in tho pre-form era there wore also payroll taxes, which are geneally retained; (iv) the itroduction of propety and land tati01on i rdimentary form; and (v) the elimination of a number of ts aimed basicaly at regulating nterprise behavior (such as the excess wage tax, wage bonus tax, excem profits tax).2I 86. As theso national level taxes ar being revamped, the system of local fimucing is smultnewously being changed, both intentionally and to some extent uintendonally. In Hungay, for example, the VAT and PIT were introduced in 1990, the year the Local Self-Government Act was passed. In Russia, tho CIT was introduced in 199,1, and the VAT in 1992, the sam- year that the redsign of the intergovrnl fiscal system was to be implemented. In Romania, prepartions are underway for the ino t of the VAT in 1993, and of a global personal income tax in 1994, with initial local govemment reforms having taken place already in 1991. In the Czech Republic, the VAT is also scheduled to come into offect in 1993, dieo -m year in which a now system of intergovenmental finance is supposed to be put in place. In Bulgara, the curret VAT implnion date is July 1, 1993MI. In all of these cases, there appears to have been almost no consideation in the basic national tax reform of the fiscal needs of the local governments, even though it is clear that, given the fundamental inadequacy of the revenues specifically assigned to local governments in most countries (see below), thes govemments are likely to be dependent on some form of 'tax shaing' in some form for yeas to come. 87. As these press become manfest, further reforms are assigning to, or sharing with, local governments taxes whose design is new, whose operation is untestd, and whose administration is inevitably weak, as discussed later. Moreover, even though the national level reforms are ofte intended to be 'revenue neutral', there is little basis for revenue estimation, and hence little certity as to expected yields. The potential volatility of taxes shared or assigned to the subnational sector is compounded by these countries' overall economic cycicalityll. The difficulty of ensuring corresponden=c between the expenditure responsibilities of the local goverments under the new systems, and their assigned revenue base or share, is self-evident. I'For fuller discussion, see Tanzi, Fiscal Policies in Economies in Transitin 1In Bulgaria a comprehensive tax reform under preparation compnses draft profits tax law, VAT, tax administration, territorial division, and excises. J2See D. Go, 'Revenue Uncertainty in the Transition,' CECPE, RPO# 27118, forthcoming, 1992. -24- Stabtization: Mem Macoeconomic Context for D ion 88. The economic reform progms in the trasitioal economies have had to addre both and libsaip- n concerus. Integovenmntal fiscal roforms are tWring place in the context of a w *k overall nacroeconomic position and often a weak cntral govemnmnt fiscal postion. The move to prvate epr p has contributed to a more vital economy, but has accenuad tho problem of a shriking rovenue base at the national level, as many of the smaller new private enterprises elude the grasp of tde tax net and ptesnt major challenges to compliance and tax adminisa . The filing state-owned entpise sctor no longer prvitdes th revenue base of earlier days. The tax refoms dencribed above are undoubtdly deirable for maket effici ency, but unt experience with the new system is gained, reven shortfalls seem all too likely. The expediture side of the budget continues to be burdened by heavy outlays for both consumer and producer suidies, as well as often generous cash benefit program and now and sometimes large outlays to support failing enteprises and to restucture or recapitalize banks. 89. In Hungry, the consolidated deficit of the general gove_nxt reaed 4.3 % of GDP, with inflation of 32 %, in 1990, tho year tho new system of local self-government was introduced. In the Rusasia Federation the fiscal deficit is variously measured as either 15% or 30% of GDP in 19912W, and a likely deficit of over 10% of GDP is expected for 1992; inflation is soaring. In Romaia, the mesurd budget deficit has been rather small, but an inflation zate of 161% in 1991 reflects an unstable macro-economy, and suggest that the fiscal accounts understate the deficit: the central bank carres out heavy qasi-fiscal opeaons, and the banking system finances expenditures that are fiscal in nature. Only in China, with its gradual economic reform (and continued tight political control), is there rough budgetary balance and comparatively moderate increass in the prce level (See Table 4). 90. For these reasons, stab and overal o acro-eco ic concoms often domiate the national agenda. Reducing fiscal iwn%aances - both those at the center, and those potentially emaging at the subnational level, is invariably a fimdamal rquiemt of the adjustrnt progrm to which most transtional counties have agreed. The curlm t stuation provides a shp contst with public fic in the pro-rform penod, when the uaitary fiscal system imposed close adherence to the Plan in the implementationand execution of the budget, which, together with stict controls over the financs of enterprses helped sure broad balance in public sector finances.A' In paticular, under the old rgim, the finaces of subnadonal govemment had few macroeconomic consequences. Revenue sharing served only as an administrative device to simplify a system of central resource allocation. Expenditures were guided by planning norms. The result ws tat in an accounting seam at least the budgets of the suboational governments were always in balance, with any necessary adjustments being made simply by accounting tmnsfers. 'Ihe difficulty in measring the Russian deficit relates inter aLia to the tretent of the Union expenditure responsibilities taken over by the Russian Federation beginning in November, 1991, following the dissolution of the USSR. The higher number cited rofers to a 'notional' deficit, which assumes that Russia had financed Union expenditures for the full year. 2"As discussed in the present section, ther are clearly potential macroeconomic problems that may arise from suhnational finance. Nonetheless, it is important to note that subnational governments cannot on their own cause such problems since they cannot 'print money (unless the central govenmet lets them do so e.g. through locally- controlled banks): in the end, it is invariably the validation of subnational deficits by central governments that is the proximate cause of national deficits and the ills that so often ensue. In this, as in -any other ways, national govenments ultimately get the local governme they deserve. V Of course, one should not exaggerate the robustness of the budget in pre-rform times, since there were clearly many fiscally unsustainable elements from a long-term poerpective in most countries. -25 - Table 4 M nmi Indicators Country Deficit as a Subnational laflation Current Account M3 growth % of Deficit as a (1991r Balance as % (1991-2) GDP (1990) 9 of GDP of GDP (1990) Hunguy -4.3 -.4 32.0 +1.0 l. 29.3 Poland -2.4 N.A. 249.0 +4.8 45.0 Romania +0.9 +.3 161.1 -12.4 100.8 Bulgaia -13.0 _/ -.8 334.0 -2.7 N.A. CSFR -2.0 I/ +.0 54.0 +2.7 26.7 Russia -20.6 N.A. 382.0 -7.2 I/ 75.6 I/ China -1.8 N.A. 5.3 +3.7 26.7 Vietnam -4.1 N.A. 36.4 2/ -2.0 19.6 Source: Recent Economic Indicators, IMF. 1. For 1991; 2. Average inflation for 1990. The end of period inflation for 1990 = 67.2%; 3. For 1M. 4. For Bulgaria a more meaningful measure is the cash deficit (net of foreign interest arreanrs) which was 8.5 %. 0 Most receat year after price libmlization. 91. Shiftina Ex&enditure Responsibilities sDownstairs". Current stabilization concoens have led the central government to view fiscal decentaization as an opportunity to reduce centra expenditures. This is being done in two ways: First, by spinning off expdiiture rsponsibilities to the subnational level, thereby reducing its own deficit, and second, as an opportunity to reduce fiscal tnsfs, purpordly to make local governts more "idependent, but with the welcom side offect of reducing centl outlays. In paricular, a number of countries are trmsfernng icresing responsibility for social expenditures and the social safety net to local govemnt. In Hungry, for example, the responsibility for "welfari expeditures was tansferred to the localities. In Russia, the contral government trmnsfered social expenditurs equivalent to some 6 % of GDP M992) to the local level by this means, with the objective of "pushing the deficit downa, presmably in the hope that the subnaional govemnents would perform the politically painfiul utting required - even though the demand for these services is likely to grow with the worning conomic situation. More rcnly, responsibility for key national, interurisdictional investments (e.g. in transport)- has al8o been transferred to the subuational sector. 92. Even some of the extensive asset tansfers to local govenmments that have taken place in most countries appear to have been partly motivated by budgetay concerns. Some of tho 'assets' transferred - notably housing and some entepises - a really liabilities given the heavy burden of maintenance and operation of these units and the fact that rental income (last adjusted in the Russian Federation in 1928!) does not cover even a small part of thes costs. 93. Reducing Untersovemmental Tansfers. The fiscal difficulties at the national level have also led some Finance Ministries to focus on reducing intergovernmental transfers as one way out. Transfers have been seen as the ,compressible dimnion" of the federal budget. The principle of "budgetay independence" mentioned above has been interpreted to mean that subnational governmets should be financialy self-sufficient, which in turn implies that direct transfers should be reduced and even eliminated. In reality, however, in most of the transition economies central transfer to local goverment sector are very large, reflecting both the rudimentary tax base available to local govemnments and the center's reluctance - again to avoid fiscal vulnerability - to part with any of the major tax -26- bases and to assign them to the sublationdl level. As a nle, however, the amount and distribution of those trasfrs is determined each year on a discretionary basis in accordance with central fiscal exigencies. 94. While such budgeta flexibility is clearly desiable from the cental govenment's short nn view, it is a mistake to view t fers as a completey *comprusble' poion of the national budget, as appears to be the case in countries such as Hungary and Romania. Many of the soevices provided by ubational goverments, particularly in view of the 'pas-down' phenomennn already discused, contitute estia expeditues for political stability or for futre ecomic deveopmt There is no way that th mny small local govements that have been crated in most countries con finace the provision of thoeo servce at an adequate level out of their own rsouc. Even from a short-nm dtbilizaton prspective, an undefunded subnaltional sctor in the curmt environment is all too likely to result in a sitution in which the only way local governme can cope with budgetary presre is by using economically undesiable sources of revenue sucha profits derived from the exploitation of incomeming assets transferred to them and from diret public ownership of local busine . At the same time, local governments' open-ended expediture responibility for 'social asuistmce' is liklUy to sult in emorgency recurrec to the ceral govnent for additional funds, or simply the unnal accrual of aruas tough short-term borowing. Arrears have been a problem in China in the recent past and are cuntly a major problem in Russia. One way or another, intergove n transfers are thus likely to be an important component of the central budget for years to come in most transitional countries. 95. Deficit Control . Placing limits on the subnadonal deficits is of course an obvious way in which centml governments can ensure that the subnational sector does not give ise to additional or unexpected m nomic pressures. Such limits are in place in Russia and China, for example. In an overall framework of hard budget constraints, such provisions may make sense, but this is unlikely to be true when budget constraints are still "soft* in other sectors, notably the aeteprise sector. 96. The combination of controls and soft constants may give rise to perverse outcomes.W In response to the apparent surplus in overall local budgets, for example, Russia has, as alrady mentioned, sought to squeeze the subnational sector by tranferring expenditures downwards, re-adjusting tax shares and minimizing traDfers.W Since local governments by law cmnot mn deficits, however, nor for the time being can they borow even for liquidity reasons, there is almost by definition a 'surplus' at least sufficient to meet the *cash on hand requiements of monthly local outlays. Reduced revenue shares or transfers can never eliminate this surplus: on the contrary, since the system canot be in deficit, such measures will only lead to measued expenditures far below normal levels and increasing cumulative arrears. 97. Budgetarn Autonomys. Although local govenmunts in most transitional countries (1ruland, Hungary, Czechoslovakia, Bulgaria and Romania, for example) have thoir own budgets, quite separte from the state budget, this nominal independence by no means implies the absence of central controls. In Romania, local budgets are subject to the central govemment's implicit approvaW. The central govemment has the final say, especially if k'For examples of dysfunctional incentives for economic liberalization as a result of fiscal d lion policies in earlier Chines experience, see e.g. Wong, 'Fiscal Reform and Local utrialization, Modern Clina April 1992, and *Central-Local Relations in an Era of Fisal becline,- China Ouarterlv, December 1991. WThe budget surplus, meured on th report csh basis" for the subnational sector amounted to 1.2% of GDP in the first quarter of 1992. See Walich et al; Intergovernmental Finance in the Russian Federations; forthcoming, 1992 W(According to both the Law on Local Adm ion and the Law on Public Finances the authority that approves local budgets is the municipal council for municipal budgets, and the district (judet) council for the district budget. Budgets have to be balanced by law. The role of the prefect, as reprevntstive of the State, is to ascertain, ex-post, that local govemments abide by this legal requirment. Ihere is a disguised direct control of local goverment -27 - the budget i unbwaed. In conbt, in Russia sc budgetry approval is implicit in the system of negotiated tax sharing and transfers, whose levels ar conditional on an approved level of expenditues. On the other hand, China and Vietnam slill have a unfiedbud, in which central and subnational plans and accounts ae jointly presented. In China the local budget must be approvod by the provincial goverment, and the budget of the provincial government must be approved by the cewr. 98. More generally, even though the local govermts have been given autonomy in pnnciple, in practice they lack it in my areas The lalc of tnsparency or claity of laws further e rbat the problem. e rel degree of expenditure autonomy of localies is often limited. In China, for example, local gove_nts have little formal or legal independence with rospect to etheor local taxes or the level and compoition of expenditu. In almost all the countri under eview, ce expenditur noms and enl spending and wage mndats continue to Carry weight in many u. Tndee, in Roumaia thes facton stil weigh so heavily that thero is hrdly any real local expenditure discreton as yet. In the Czch Republic and Hungry, on the other hand, ther appears to be much looser control on the expenditure ide. On the oter and, the lack of veue atnmyis seere w eveywhore. The center usually stipulates caps on local taxes and in some cas even spocifies the tax rates and tax base. 99. Tax Administration as a Sowce of Vuleabil . Fiscal d talion, and the political decentrlization that accompanies it in this now environment ha left some cOentl governments c -o caly vulnerble for another important eson To ensure macroconomic stabiliation, the feded goverment must be able to contain its budgetary deficits, which means relying on its own budgetary revenues. In some tansition economies, however, tax adminition is decenulized, that is, aubnaional governments collect revenues on behalf of the center, and transfer them upwards 'we Table S).PI In Russi, in the CSPR, in China, and Vietnam, all revenues other than customs and trad taxi ar collected by local a ons. As the experience of the former USSR (and the former Yugoslavia) suggstb, delegation of collection responsibility, with its potential for non-compmiance, or worse, reliance on contibutions from member publics, are only vible means of fincing the centrl govermment so long as central political control reman strg (as in China and Vietnam). The potential withholding of tax revenues from the fedeal budget threatens Russia today; even in China non-compliant loCal administrtn, and the revenue contracing' system this gave rise to, have been the source of m_cnomically cyclical federal revenues. 2-' expenditure magent because all expenditur involving the use of centrl govenment resources requres the ex- ante approval of the Miistry of Finances' local trsury office, and, since fiscal tnsfers represent up to 90 % of local resources, the Govemment, legal arrangements notwithstanding, continues to actually exert a close to total control. 3 Strictly sealing, the tax dministrations am doconconat arms of the federal or central administration. De facto, however, tax officials may have strong ties and loyalties to the local governments which often provide their housing and fringe benefits: ther is conideablo evidence in some countries (e.g. Russia) that local tax offices respond to local policy. Uv See Szapary and Blejer, 'The Evolving Role of Fiscal Policy in Centally Planed Economies under Reform: The Case of China,- IMF Woring Paper 407, 1989; and Bah and Wallich, "Intergovenmental Finance in China". World Bank WoDkng PaPr Series No.863, 1992. - 28 - Table 5 Tax Admunistraton in Trulstion Soci;at E3c9;lp Country "Inverted Centmalzed Hungary x Poland xi Romania x2 Bulgaria x2 l CSFR x Russia XI China x l Vietnam x Notes: 1. In Poland, all national domesic taxes, and some local taxes and fes are colUected by treauy offices and then transferred to state and local budgets. Other local taxes and fees are paid directly to Gmias. 2. In Romania and Bulgaia, the local goverments do not have their own administrton. All local taxes are collected by local branches of the MOF. 3. The State Tax Service is in the proce of centalifzing. 100. liDcations for The Lonuer Tern Intergovemmenbl Svstom Although intergovernmental fiscal reform is necessuily takig place in this strned macroconomic context and hence inevitably reflects changing short-term fiscal needs and psures, care must be taken to prevent the stabilition objective from fully dominating the redesign of the intergovemmental finances megime. A major challenge facing the trmnsitional economies is to develop an intergovernmental fiscal system which is an optimal combination of mles ad di - one dbt wiU be both flexible enough to be compatible with macroeconomc stabdilization and the major structural shifts which are taking place in the economy, and at the sam time provide a stable framework for the effective operion of both central and sub-national govemments in the lcnger termL 101. One solution along these lines that has been adopted in some market economies, for example, pivots around a system of intergovernmental transfers in which the totl is flexible with cbanging macreconomic circumstnces - for example, some percengta of total central taxe - while the distribution of this total among diffent subnational govemments is Oformula-driven", with the amount received by different localities depending on such factors as potential "fiscal capacity' and assessed need. This approach repreents a compromise, in which the center gives up some degree of control over its revenue but also insulate itself from ad hoc and possibly escalating demands from localities, while localities avoid discretionary cutbacks in local trasfers to meet stabilizaion objectives, with all the expenditure dislocations that this implies. In most of the countries under review, thus regularizing the overall size and distribution of the tanmsfer, like strengthening local finances by broadening the local tax base to improve local tax yields, represent high-priority reforms. This point is developed further below. - 29 - m. WHO DOES WHAT? THE ASSIGNMENT OF EXPENDlTURES The Efficieno Cae for Deeentized Local Gt. 102. Whilo local governmmnts may have some effect on stabilization policy and some role in distributive policyLW, their mn-or economic role is clealy with respect to the alocation of resources. From an efficiency point of view, the basic rulo of expenditure asignment is to assign each function to the lowest level of government consistent with its efficient performance. So long as thm are local variations in tses and costs, there are clearly efficiency gains from carrying out public sector activities in as decenraized a fashion as possible - and these gains are larger the lower the price elasticity of domad for these services. 103. In principle, therefore, the only services that should be provided centrally - or, in some instances, regionally - are: * serviees for which there either are, or are for overching political reasons presumed to be, no significant differences in demands in different localides (e.g. national defense; public health); * services with substantid 'spillovers betwoen jurisdictions that cannot be handled in some other way such as by contracting, or by grant design (e.g. interlocal tmnsportation; air and water quality); and smervices for which the additional costs of local adminisraon are sufficiently high to outweigh its advantages (e.g. administration of income taxes). Apart from the last of these three cases, even these soervics can often be delivered most efficiently at the local level, although they may well be financed in whole or part by central transfers. In short, in principle, moat public services should be delivered at the local level, with local decision-makers deciding what services are provided, to whom, and in what quantity and quality. To put this the other way, the only services that should be provided centrally are those for which there are no differences in demands in different localites, where there are substantil 'spillovers between jurisdictions that cannot be handled in some other way, or those for which the additional costs of local administration are sufficiently higher to outweigh its advantages. Expenditure Assinment in Practice 104. As noted earlier, under the previous socialist regime, since local governments basically acted as units of the centrlized administration, local expenditures were included in the unified budget of the central govemment. There was no question as to who did what. the central govenment did everything, sometimes directly and sometimes through its local administrative units. Under the new local government laws in most of the countries under review, however, specific expenditures have been assigned to the local level of government as shown in Table 6. In the Czech Republic, Hungary and Poland, for example, local goverments have detailed expenditure responsibilities in the area of education (primary and kindergarten), transportation (local or urban streets), environment (garbage collection, disposal, industrial waste), housing and related services, and health and welfare. In Russia, on the other hand, there is no legal definition of expenditure assignments at the local level, except for WSince local governments are governments as well as service agencies, they are inevitably interested in the distributive as well as the allocative effects of their policies. Income redistribution at the local level may be swverely limited by the openness of the local economy, but if a goverment is not concenied with distribution, it is not a government at all but simply a service agency. Nonetheless, within-jurisdiction distribution is ignored here as unimportant relative to the importance of setting up the basic mles of the local finance game so that each local govemment is fully accountable for its actions. - 30 - Table 6 Expenditure Assignment to Subnational Authortiei_ Hungary Poland Romnia CSFR China Vietnam Bulgara Russia Defence No local No No No No No No Military bousing responsibility Justicetatemal Enforcement of No Public No No Secwity of security rights of national security is farmingesas and ethnic provided by minorities local branches of the Minidry of Interior Foreign Econotnic No No Relations Education Ptimary and Kindergarten None Partid All schools A Several special secondary only and pre- tesponsibility in primary througb expeadisues vocatiol including day care elmentafy the Czecb university level. (epil and schools. Wages, and high schools chools only Republic Local current) of operation governmenta pnimary and contmction and cover all salaries, econdary maintenance of al mainten nceof schools. Sone primary and school fciliies, kindergartens. seondary chools. adminitration and Some technicd Local enterprises scholarhips and vocational build ome schools facilities Culture and parks Supponting Over-lapping Cultural activities No Some museums cultural activities responsibility such as cinemas with oblast for cultura and broadcasting significance. All activities recurrent expenditures of all sport and park facilities And al othcr culural facilities. ,I 01 i i,,i i jsi ti'31ti .1*111i _ G 0 q8t1 . _ _ _ _ _ _ _ _ ii _ _ _ _ _ _ _X_ _ _ _ __Q -_1 t 1 _ _ _ _ _ _ _ _ _ _ ii_ _ _ _ ^:i L_ 12 10t 1i <~~~~~~~~~I a IaX,1 _ __ __ _ _ _ __ _ __ l X - - 32 - Hungary Poland Romania CSFR China Vietnam Bulgau Ruoo Libannes Partial No (book No No Lal iaui Speci ibaqy peogmbliy purchase aevicca at tde thimh the eblM levde an budgs of the mm l ibay Miniiry of ices at he OdhnC ) isyo lve-ld. Poke ccs No - --Sofia has a Road (rafic) With die Wiliti; ed_er Sanitation Garbae collection Ownerhip and Rcflu colection Pat of garbage garage clection) Provision of colgcticurat both cold water at oebb and rayou __________________ ~~~~~~all levels levels. Sewge Garbage coLection Owneri ad Sewage Gar Moat of the and eleme pwviaoaof colhecti clectioG and epetcioa clekanig ewage evceo i wm b ln die e _pendluSt doe se_mea rayon level and some op_Son ezpendiuresat the _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~village levd Public utiies (ps. Water Supply me Ditict Wdcar spply Subsdi to electricity, and war) snanaeet and ligh heating and iDn_uctn. hmboJs (nt rmuenance of wtder cep_e) at the -________________ public cemteries _ . yon lev - 33 - _________________ Hungary _ Poand Roasua CSFR Chn VKtnam Bum Russ Housing Housing Sha Haiwng No Builliqg _ Ma a of Maie e is de mgement eqpibilty evices _h ea_ oq of pasurs sa te evof OdIu2ScI govammsern r Pq.tY e _efi Fuming. bousing. building sl Cqita subvdifrin foe expenditures axr re"ade iacdeunls _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ -. athesalse oed. Price and ohw subsidies Rest subsdin Rem Eer Dict subsidies Ysn Mas Danc t For .eels, Muss uWies to to agrullual I dmug. tnot nd huehold cooetive, sadyto food sac a nd pb and sbidies to _me-lge bw bred, alk and transport eutpst t srvie within afinas a_ tedi ,ubsidies e ot bIvolved unicipaities. nyon level. Also in tde Hatig vabg dy remt sbdies poducfioof isce 1992. lbcal ubric Socil Welfae Social care Voivodship Welfare Homles Part obist ffciies sch as r obilitis expeu for disebled ad oVeammt old e an ede who s- o ad o yand handicapped chids, rayon kvel hames ophanagcs, die n nt of disbled dec. pwrgan tanded byupperlevd New Public enterprie Can esablih new Can ablih Can ablih Cm establish Can etablis aw Can Can esablish Capacity to ivest (productive secto) domestic joint new domesi ne m domestic domneacjoint estblis ne domestic il joist Vema;nts vente joint ventu dometic jowt vewn vesra nw joist ventos (pSOpewea joint domestic of privatization ventures joint proced if ryo Al th ayon lee ths aso IincIud 10 percentofany subordination - 34 - Hungary Poland Romania CSFR China Viem Bulgaria Russ Environmant Proection of tae Envimeat Measue to RexOsibl for nvkionent prtction Outlays. iwmrne aNd el wehabiritate the environmental envkoseit pblems, e.g. pri rvation of _ _ _ _ _ _ ~~~~~~~foca State-owned Enterpriss Major local Local Loca Major local Major ownerhip Local -*Gmup C- ownerhip ownership ownership ownerhip esponsibities of ownership enterses e.g. responsibilities reponibilities reqnibiliti rsponsibilities lght and heay respotibi local light es indusries. lities inuy, housg Prvide subsidies condruction an to cderprise for food indury. technia Rayon upgding d ronibility building of exis only if dhe temaporary eepid is warbousel transftrd to the loal klvel Nftes: i Jo Victnam, local governmentc are responsible for al of th abov activiti f ey s fi uderthrdit diction. at, each klve ofgovem tis reponibl for thaa activiie which fals und their juisdiction. / '-' implies no infonnstion. 3 'No' implis no applicable to ubaniol governments. 35 - social progrms (which account for a major pat of expenditure). In effect, tradition and inrtda have eablished expenditur ssignmets i Rusia which i many cases roughly correpond to best practice (benfit) areas. Unformnatly, pehps owing in part to the lack of legal clarity in ths area, it appears tht thes pincipleare being inreasngly violated in the courn of the on-going chages in the ietgovemntal finance system. 105. Although in some ways it is not typical, Romuiia provides an intereng example of some of the things that are going on in tho a of expenditur assigment in tho tnsitioatl conomies. At first glance, for example, the new local govomment law appeas to asign local govenments exclqsive technical and financial responsibility for many more fimetions (e.g. policing) than those that are actually exercised. In fact, however, this asgnment is only on condition tht national laws or '[centrall govemment decisions' do not specify otherwise. That is, in practice, local govenments do only what the centraI authorities wat them to do. The main financa responsibilities so far actually asumd by local goverm ts in Romania are basically for vaious mor activities in social assistance, municipal service, cultwre and arts, public investment, and maintenance. A A rogars local transportation and district heating, local govemments simply serve as conduit C3r the channelling ok coetral government subsidies to the public service enterprises (regie autonome) delivering there two services. Witth the gradual elimnation of consumer subsidies (to be completed in 1993) and the tnusfer of legal ownersip of these entetprises to the local govemments (to be completed in 1992) the situation may change, though it is far from clear how, finacially, the local goverments will handle the problems stemming from the now responsibilities. 106. Romana is thus unusual in the extent to which some important expenditures usually considered to have strong 'local benefit' characteristies are still at the centrl level. In particular, and in contrast to most other transitional countries, education and health remain the sole reponsibility of the contrhl govemment in Romania, reportedly to ensue a minimum standard in the provision of these important services. Recently, however, increasing financial pressure on the central govenmmnt has led to the proposal for some of these expenditures be delegated to localities. As is not uncommon in the transition economies - though highly unusual in western countries - both public scurity and fire protection ar also provided throughout Romania by local branches of a central Ministry. 107. Overlapping responsibilities between the center and localities with respect to culture and social assisance, on the other hand, are common to y countries. For example, local museums are often financed by local budgets and national museums financed by the central govemment budget; but books for both local and national libraries are purchased by the Ministry of Culture. Similarly, both local and centra governments fund programs related to children. Such' *xtdit h -h-ring '-i.., with diffeent levels of govnmt responsible for different subfunctions of particular expenditure activities, or with more than one level of government playing an important role in financing, regulating, and providing particular services-is a common characteristic of multi-tiered governmental structures: it may sometimes be efficient, but it almost always obscures the key question of precisely who is responsible, and accountable, for what. Local Public Enterpriso Ownership 108. Romaia also provides an extreme instance of a problem found to varying degrees in most of the transitional countries: the importance and complexity of the tnangular relations between the new local governments, the public enterprises providing local services, and the centrl govenunenLt In some ways, it is not too much of a caricature to characteriz the local government system now functioning in Romania as amounting to little more in fiscal terms than a conduit between centrd government and these enterprises (or relies autonomies, as they are called in Romania). If one asks: 'What do local governments per so do in Romania?', the answer at the present time is: Not much.' Excluding the rngj local govermnment expenditures appear to consist of littlo more in most cases than minor outlays on social assistance, cultur, and gener administrative expenditures. Most service delivery activities have been hived off to the various mge. leaving the local government as a place that does little more than collect dog licenses and register marriages. These may be essential activities, but they do not require a large revenue base - and indeed in many instances would best be financed by fees and charges (as discussed later). - 36 - 109. In principle, of course, thern is nothing necesarily wrong with having local govenments that do not themselves deliver out of thei own resours many services to local reidens, just as there is nothing wrong with having local govenments deliver nationally-finaced and naonay-detmned semvices to local residents (see lator discussion) or with having most local sevice activities caried out by local public enterises with septo budgets and managemmats. All these systems can be found in one country or another and may work perfectly satifctorily. Indeed, given the extrm degreo of cenhalizion characteizing the trsitional economies in the past, the present system in Romania, one of the Ist of theso countries to reject the old system, may be not only acceptable but desirable. 110. Nonetess, it is critical to the financial health of both the local govomments and local public enterprises that the precise elionship between the two should be set out clealy. At present, in a number of countries tha lines distinguishing activities that should be performd by local gov _ents, local public enterprise, and commercial enterps are undesirably confused. Unless these questions arm disentangled, senous problems may occur both in setting up properly functioning local governments and local public enterprise and with respect to privatization more generally. A few examples from field work in several countries illustra the point: In some areas, local governments are responsible for certain activities (e.g. parks); in others, local enterprises; Some activities (e.g.bakeries) are commercial in some areas; others are nru as adjuncts to local public enteprises; It is also important to clarify the relationships between differant public enterprises e.g. at regional and local levels as well as betwen enterpriss and governments, especially when an enterpnse is located in one area and serves other areas as well. :11. On the whole, municipal enterprises should be confinod to traditional local public service activities (water and sewer, heating [traditional in eastn Europe, at least], tansit, perhps solid waste collection and disposal). All essentially commacal activities now conducted by such enteprises such as bakeries, laundries, and construction companies should be sold off as soon as possible. Finally, in some instances certain activities (e.g. parks) for which there seems no appaent rationale for adoptig the enterpnse form of organiation should probably be folded back into the local government proper. 112. Where it is decided to organize some local public service in the form of a public enterprise, any subsidy paid from generad local government revenues should be set on an ex ante basis to establish the hard budeet constraint needed for efficient operation. Moreover, such enterprises should be subject to all normal tax laws (central and local), and in general they should be run like commercial enterprises e.g. setting prices and terms of services - although presunably within a natioally-esblished regulatory framwork (which as yet does not exist in most countries). At present, local authorities essentially have either no guidance in setting enterprise prices, or too much guidance in the sense that these prices are still being set by centrd authorities. 113. The budgets of local public enterprises should also not be consolidated with local government budgets per se: only any explicit subsidy and any profits transfer should appear in the goverment budget. Of course, enterprise budgets should be annexed to the local budget and submitted - not for approval but for information - to the appropriate cental agency, as noted earlier. Mhe numerous somewhat anomalous decentralized institutions found in many transitional economies (e.g. Hlouses of Culture) should either be organized as enterprises and treated like other enterprises or, if they are to be treated as component parts of local govenments, consolidated with other local expenditures and revenues. 114. It is especially important, both for good govemnment and for good business, that local governments should get out of commercial business activities as soon as possible. The business of local government is not business, and the sooner local governments begin to concentrate on their central task of providing as efficiently as possible the -37 - local public servi&as their inhabitats desir the better it will be for both busine and the local inhabitants. Although intentions in this respect are cleady good in most countries, there does not apper to be adquate recognition of the danger of d lintion becoming an obstacle to the privaizton process, as is already happening to some extent in Hungary, Bulgaria, Russia, and pehas elswwhere (see later discussion). 115. As emphasized earlier, countries tat decentalize subntal expditure responsibilities to local govemnmts that either do not have access to adequate local tax sources, or that are not capable (technically or politically) of admnting thos taxes to which they have access, run this risk, especially when sver fiscd crises reduce central tanse to local governmnts. Whln the major source of governmnt rvenue has traditionally been, and is still to a lar extent, entrrse, the temptation for local govenmes to extract more revenue from those enterprise in thdir control can be overwhelming - and will invariably be most unforunate from an efficiency point of view. Provision of Social Services: Shiftina the Safety Net 'Downstairs' 116. Most public enterprises are engaged in providmg such 'hard services as water, electricity, and transport. In addition, however, particularly close attention needs to be paid to the role of local governments in te transition countries in delivering and financing services in at least three important 'people' areas - social assistance, health, and educadon. 117. First, while the present role of municipalities with respect to socid assi varies from country to country, being qmute restricted in Romania, for example, but much broader in Hungary, this are is all too likely to become a major problem in all countries in the future as a result of two unpleasant but likely developments - the weakening of the naonal cacity to minin ociad protection at the present level and the growing need for such assistance as a result of economic restuctunng. Even if the need for this bottom layer of the social safety net becomes greater, however, it is far from obvious that the municipal level - while it may be the appropriate executing agency - should be responsible for financins such assistance. In many western countries, for example, it was precisely the unsusamably heavy load on municipal welfare systems resuldng from the interwar depression that lead to social welfare becoming mainly a national, rather than a local, responsibility. It is thus ironic, and potentially dangerous, that so many transitional countries seem to be moving in the opposite direction just as the need for such services is rising sharply as part of the adjustment process. 118. Second, health and education are already controlled in large part at the local level in a number of transitional countries. Experience in many countries around the world shows that people are willing to pay local taxes to have their children educated. Hence, carrying out some education at the local level is one instance in which a devolution of expenditure responsibility may, at least in principle, be matched by a corresponding devolution of financial responsibility. On the other hand, there are also strong reasons for central involvement both in ensuring adequate investment in human capital throughout the country, regardless of local fiscal capacity, and to some extent in financing a higher level of such expenditure than localities would be likely to do on their own (See also the later discussion of trsfers). Exnenditure Assinmment in Princiglo 119. . In the long run, a desirable assignmet of expenditures to local govermments in many transitional economies might be something along the lines shown in Table 7, perhaps with the local' share being further divided between different tiers of local government along benefit area lines. As Table 7 indicates, there are only a very few functions - national defense, purely local services - that should be clearly assigned to one level of government or the other. Most expenditure functions are likely to be shared between levels of government, as indicated to some extent by the breakdowns shown for a few of the functions in the table: similar detailed subfunctional categories could of course be set out for e.g. health and tansport. - 38- 120. It is also importa to unstand that Table 6 refer to the level of govenumW dt a paticular service. Who finM it is a diffent quesin. Moover, ther is no prsmption that any or all of thee ser must be Qgrducd by public setor agencies, although it is atuud that the public sector ust indeed to some extent be responsble for thoe pgMjg of such services if anything clos to the opbtal mnmt is to ' a provided. Wbat matters to people in what servces ar provded, not who provides thm. Ilded, may 'public sector' services ar ae-tually caried out by non-governmet ntities in diffrent comtries. TABLE 7 A Possible Ex=