WORLD BANK DISCUSSION PAPER NO. 417 WDP417 Work in progress May 2000 for public discussion Hungariy Loaeoin iziiia tie Sit bnationli Go ver/i- nt i S.stlem JfLiha{,4 Krpanvi, sS'amilj El Dh/er Deborah Jf-tzc/ ,11ith('/A"'oe/ Alita/ Papp Recent World Bank Discussion Papers No. 344 Transport and the Village: Findings from African Village-Level Travel and Transport Surveys and Related Studies. Ian Barwell No. 345 On the Road to EU Accession: Financial Sector Development in Central Europe. Michael S. Borish, Wei Ding, and Michel Noel No. 346 Structural Aspects of Manufacturing in Sub-Saharan Africa: Findings from a Seven Country Enterprise Survey. Tyler Biggs and Pradeep Srivastava No. 347 Health Reform in Africa: Lessons from Sierra Leone. Bruce Siegel, David Peters, and Sheku Kamara No. 348 Did External Barriers Cause the Marginalization of Sub-Saharan Africa in World Trade? Azita Amjadi Ulrich Reincke, and Alexander J. Yeats No. 349 Surveillance of Agricultural Price and Trade Policy in Latin America during Major Policy Reforms. Alberto Valdcs No. 350 Who Benefits from Public Education Spending in Malawi: Results from the Recent Education Reform. Florencia Castro-Leal No. 351 From Universal Food Subsidies to a Self-Targeted Program: A Case Study in Tunisian Reform. Laura Tuck and Kathy Lindert No. 352 China's Urban Transport Development Strategy: Proceedings of a Symposium in Beijing, November 8-10, 1995. Edited by Stephen Stares and Liu Zhi No. 353 Telecommunications Policies for Sub-Saharan Africa. Mohammad A. Mustafa, Bruce Laidlaw, and Mark Brand No. 354 Saving across the World: Puzzles and Policies. Klaus Schmidt-Hebbel and Luis Serven No. 355 Agriculture and German Reunification. Ulrich E. Koester and Karen M. Brooks No. 356 Evaluating Health Projects: Lessons from the Literature. Susan Stout, Alison Evans, Janet Nassim, and Laura Raney, with substantial contributions from Rudolpho Bulatao, Varun Gauri, and Timothy Johnston No. 357 Innovations and Risk Taking: The Engine of Reform in Local Government in Latin America and the Caribbean. Tim Campbell No. 358 China's Non-Bank Financial Institutions:Trust and Investment Companies. Anjali Kumar, Nicholas Lardy, William Albrecht, Terry Chuppe, Susan Selwyn, Paula Perttunen, and Tao Zhang No. 359 The Demand for Oil Products in Developing Countries. Dermot Gately and Shane S. Streifel No. 360 Preventing Banking Sector Distress and Crises in Latin America: Proceedings of a Conference held in Washington, D.C., April 15-16,1996. Edited by Suman K. Bery and Valeriano F. Garcia No. 361 China: Power Sector Regulation in a Socialist Market Economy. Edited by Shao Shiwei, Lu Zhengyong, Norreddine Berrah, Bemard Tenenbaum, and Zhao Jianping No. 362 The Regulation of Non-Bank Financial Institutions: The United States, the European Union, and Other Countries. Edited by Anjali Kumar with contributions by Terry Chuppe and Paula Perttunen No. 363 Fostering Sustainable Development: The Sector Investment Program. Nwanze Okidegbe No. 364 Intensified Systems of Farming in the Tropics and Subtropics. J.A. Nicholas Wallis No. 365 Innovations in Health Care Financing: Proceedings of a World Bank Conference, March 10-11, 1997. Edited by George J. Schieber No. 366 Poverty Reduction and Human Development in the Caribbean: A Cross-Country Study. Judy L. Baker No. 367 Easing Barriers to Movement of Plant Varieties for Agricultural Development. Edited by David Gisselquist and Jitendra Srivastava No. 368 Sri Lanka's Tea Industry: Succeeding in the Global Market. Ridwan Ali, Yusuf A. Choudhry, and Douglas W. Lister No. 369 A Commercial Bank's Microfinance Program: The Case of Hatton National Bank in Sri Lanka. Joselito S. Gallardo, Bikki K. Randhawa, and Orlando J. Sacay No. 370 Sri Lanka's Rubber Industry: Succeeding in the Global Market. Ridwan Ali, Yusuf A. Choudhry, and Douglas W. Lister No. 371 Land Reform in Ukraine: The First Five Years. Csaba Csaki and Zvi Lerman No. 373 A Poverty Profile of Cambodia. Nicholas Prescott and Menno Pradhan No. 374 Macroeconomic Reform in China: Laying the Foundation for a Socialist Economy. Jiwei Lou No. 375 Design of Social Funds: Participation, Demand Orientation, and Local Organizational Capacity. Deepa Narayan and Katrinka Ebbe No. 376 Poverty, Social Services, and Safety Nets in Vietnam. Nicholas Prescott No. 377 Mobilizing Domestic Capital Markets for Infrastructure Financing: International Experience and Lessons for China. Anjali Kumar, R. David Gray, Mangesh Hoskote, Stephan von Klaudy, and Jeff Ruster (Continued on the inside back cover) WORLD BANK DISCUSSION PAPER NO. 417 Hungary Modernizing the Subnational Government System Mihaly Kopanyi Samir El Daher. Deborah Wetzel Michel Noel Anita Papp The World Bank Washington, D.C. Copyright C 2000 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W, Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing May 2000 Discussion Papers present results of country analysis or research that are circulated to encourage discussion and comment within the development community. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. The World Bank encourages dissemination of its work and will normally grant permission promptly. Permission to photocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational classroom use, is granted by the World Bank, provided that the appropriate fee is paid directly to Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, U.S.A., telephone 978-750-8400, fax 978-750-4470. Please contact the Copyright Clearance Center before photocopying items. For permission to reprint individual articles or chapters, please fax your request with complete information to the Republication Department, Copyright Clearance Center, fax 978-750-4470. All other queries on rights and licenses should be addressed to the World Bank at the address above or faxed to 202-522-2422. ISBN: 0-8213-4653-9 ISSN: 0259-210X Mihaly Kopanyi is senior financial economist in the World Bank's Hungary Country office in Budapest, Hungary. Samir El Daher is financial adviser in tthe International Finance Corporation's Urban Development office. Deborah Wetzel is senior economist in the Poverty Reduction and Economic Management Sector Unit of the World Bank's Europe and Central Asia Region. Michel Noel is manager of the Private and Financial Sectors Development Sector Unit of the World Bank's Europe and Central Asia Region. Anita Papp is an economnist at the World Bank's Hungary Country office in Budapest, Hungary. Library of Congress Cataloging-in-Publication Data has been applied for. CONTENTS FOREWORD ....... ............................................................. iv ABSTRACT .....................................................................v PREFACE ....... ............................................................. vi EXECUTIVE SUMMARY .................................................................... viii INTRODUCTION .....................................................................1 1. SUBNATIONAL MODERNIZATION CHALLENGES ..................................................................2 II. MODERNIZING THE INTERGOVERNMENTAL FINANCE SYSTEM ..................................4 INSTITUTIONAL, LEGAL AND REGULATORY FRAMEWORK .....................................................................4 INTERGOVERNMENTAL RESOURCE ALLOCATION .................................................................... 10 PATHS TO FURTHER MODERNIZATION OF THE INTERGOVERNMENTAL SYSTEM .................................... 15 III. STRENGTHENING LOCAL MANAGEMENT CAPACITY .................................................... 19 INSTITUTIONAL, LEGAL AND REGULATORY FRAMEWORK FOR SERVICE DELIVERY ............ ................. 19 FINANCING THE DELIVERY OF LOCAL SERVICES: LOCAL REVENUES ........................... ......................... 23 STRENGTHENING MANAGEMENT AT THE LOCAL LEVEL .................................................................... 27 IV. DEVELOPING A COMPETITIVE SUBNATIONAL FINANCE MARKET ........................... 34 THE LEGAL AND INSTITUTIONAL FRAMEWORK FOR THE SUJBNATIONAL CAPITAL MARKET ......... ........ 34 MEETING THE DEMAND FOR SUBNATIONAL INVESTMENT FINANCE IN THE MEDIUM-TERM MACROECONOMIC FRAMEWORK .................................................................... 38 SUPPLY OF SUBNATIONAL INVESTMENT FINANCE .................................................................... 42 REFERENCES .................................................................... 48 iii Foreword Modernization of the public sector, reforming intergovernmental fiscal relations, enhancing the local capacity in implementing local strategies, and developing the legislative and institutional framework for efficient delivery of public services are still among the biggest challenges in transition economies. Even the relatively advanced countries are faced with serious challenges in creating a modern sub-national system at the turn of the 21st century and at the door of the European Union. This note has been prepared under the Hungary Subnational Development Program (SNDP) a joint program of the Bank PREM (ECSPE), Enterprise and Financial Sector Development (ECSPF), and Infrastructure-Urban Development (ECSIN) sector directorates. Our staff has been working together with the Government of Hungary in assisting the legislative and policy development of Hungary as it prepares to join the European Union. The uniqueness of the SNDP program and this report is in the crosscutting analysis linking intergovernmental fiscal relations, local urban management, and competitive credit markets. The findings, interpretations, and conclusions are the authors' own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries. Roger Grawe Director Czech Republic, Hungary, Moldova, Slovak Republic, and Slovenia iv Abstract This paper discusses key findings and policy proposals for modernizing Hungary's subnational government system the perspective of fiscal decentralization, local capacity building, and development of a competitive credit market. Hungary has been a pioneer in local government reform among transition economies; it has decentralized the state administration, re-established the full autonomy of local governments, and tightened budget constraints. The public and private sectors are already bound to each other in public utility supply, and NGOs are also undertaking a growing role in providing social services. Despite the recently reinforced intermediary levels of government the very fragmented municipal system constrains public service efficiency and apparently restraints capacity of subnational entities in absorbing EU funds. The first decade of transition has proven the merits of a profoundly decentralized municipal system, though a medium term modernization program is instrumental to build a 21st century intergovernmental system geared toward a market economy and EU compliance. The efficiency and coverage of public services relies, inter alia, on vertical and horizontal re- composition of the system of public service delivery, in tandem with restructuring both the current and capital grant system. Increasing local own source revenues, first of all local taxes (e.g. introducing value based property tax) are key factors in meeting the demand for local services and in enhancing accountability and creditworthiness. Augmenting local capacity in strategic planing, financial and asset management are key factors in effective fiscal management and efficient utilization of EU funds. Enhancing local capacity is a key factor in improving the ability of various subnational entities to absorb private debt and equity. The robust financial sector is able to assist in financing local developments; however, a specialized private intermediary would be instrumental in serving for small municipalities. The Hungary Subnational Development Program is a good example of an effective and efficient cooperation of three sector units (ECSPE, ECSPF, and ECSIN) that has proven the merit and synergic value of an integrated approach to subnational modernization. v PREFACE The Hungary - Subnational Development Program has been carried out as a partnership of ECSPE, ECSPF, and ECSIN sectors with the aim of addressing the subnational modernization challenges and developing policy proposals in an integrated and consistent way by building on each sector's perspective. This Synthesis Note has been prepared by Mihaly Kopanyi, Samir El-Daher, Deborah Wetzel, Michel Noel, and Anita Papp based upon the following notes: the Fiscal Policy Note prepared by Deborah Wetzel and Anita Papp (ECSPE), the Local Management Policy Note, prepared by Eugene Gurenko (ECSIN) and Jozsef, Hegedus (MRI), and the Developing a Competitive Municipal Credit Market - Policy Note prepared by Samir El Daher (TWUDR), Michel Noel and Mihaly Kopanyi - Team Leader - (ECSPF). It has been prepared under the general direction of Hafez Ghanem, Sector Leader (ECSPE), Margret Thalwitz, Sector Leader (ECSIN), Eham Zurayk, Sector Leader (ECSPF), Roger Grawe, Regional Director for Czech Republic, Slovak Republic Moldova, Hungary, and Slovenia, and Laurens Hoppenbrower, Director for Hungary (ECO07). The SNDP has benefited from a successful partnership with bilateral, donor and consulting agencies including USAID, the Urban Institute, the British Know-How Fund, the Canadian Urban Institute, and the Metropolitan Research Institute Budapest. These institutions have provided extensive financial and technical support by assisting in the preparation of thorough empirical background studies. The team would like to express its gratitude for this assistance. The paper has also benefited from the valuable assistance, comments, and advice of Zsofia Hertelendy, Gabor Peteri, Jozsef Hegedus, and Kenneth Baar. Ms. Kusztos Edit Nyitrai, Messr. Peter Szegvari and Istvan Varfalvi senior specialists of the Hungarian Government, have provided invaluable feedback and assistance. Finally the notes have been discussed with a number of national and local government representatives at conferences held in June 1998 and June 1999. vi CURRENCY AND EQUIVALENT UNITS 1 EURO = 259 HUF US$1 = HUF 242 WEIGHTS AND MEASURES Metric System GOVERNMENT FISCAL YEAR January 1 to December 31 ACRONYMS AND ABBREVIATIONS ABO Accrued Benefit Obligation DB Defined Benefit GDP Gross Domestic Product HUF Hungary Forint IPD Implicit Pension Debt MATAV Hungarian Telecommunications Company MOL Hungarian Oil Company NBH National Bank of Hungary (central bank) NDC Notional Defined Contribution OECD Organization for Economic Cooperation and Development OTP National Savings Bank PAYG Pay As You Go vii Executive Summary Hungary - Subnational Modernization Hungary has been a pioneer in local govermnent reform among transition economies. Through a series of legal reforms introduced since 1990, Hungary has decentralized the state administration, re-established the full autonomy of local governments, delegated to local governments broad responsibilities in delivering local public services, implemented a legal and regulatory framework to enable private participation in local infrastructure and services, and tightened budget constraints by regulating municipal bankruptcy. The public and private sector are already bound to each other in public utility supply, and NGOs are also undertaking a growing role in providing social services. Hungary has recently reinforced the intermediary levels of government by establishing Regional Development Councils and has tried to promote municipal associations, however, the issue of the very fragmented municipal system of 3200 municipalities is still unresolved. Over 1990-1998 general government expenditures have declined by 31 percent and local revenues by 33 percent as locally generated revenues (including borrowing) did not counterbalance the reduction in general government transfers. Hungary's local governments used their privatization revenues to finance local investments, to cover their operational losses, and to retire their debts (mostly long-term bank loans). At the same time, local governments managed to maintain local service delivery while maintaining an overall fiscal balance. However, this macroeconomic adjustment conceals growing microeconomic tensions. The renewal of local assets has been repeatedly postponed and the quality of several public services has deteriorated. Municipal investments as a result are well below replacement rates and - a fortiori - well short of the rate that would be required to meet EU standards. Localities have adjusted heroically to the changing circumstances, but are reaching the limit of their adaptive capacity within the current intergovernmental framework. Without systemic change in the fiscal framework this situation threatens an increased reliance by localities on budget transfers. Although political and economic autonomy has been granted to local governments by law, the latter are constrained by sectoral regulations. Efforts to improve accountability, transparency and service delivery have resulted in unnecessary micro-management of local governments by the center. The growing number of norms and discretionary resource allocation has distorted local decisions and discouraged local initiatives, but have not lead to adequate monitoring nor quality assurance. The present transfer system focuses on inputs as opposed to outputs, inefficiently combines financing and equalizing functions, and results in high transaction costs and low predictability. The overall response of local governments to the mounting fiscal pressures has been mixed. On the expenditure side, while significant progress has been made in improving cost efficiency of local services and streamlining local public sector, in many instances, cost reductions were achieved by virtually eliminating local budgetary surpluses, reducing capital investments below replacement levels and cutting on both quality and quantity of many local services. On the revenue side, local governments have made little effort to raise more own revenues. As a result, between 1993-98, the overall share of locally generated revenues only slightly increased giving reasons for concern with regard to the sustainability of fiscal adjustment at the local level. The development of local government management and institutional capacity has not kept pace with new challenges and service responsibilities brought about by rapid fiscal decentralization. The present local financial management capabilities are inadequate for absorption of potential EU funds. Many local governments can no longer reduce operating costs and handle new service responsibilities without the investment needed to build their institutional capacity. viii Financing gap. Municipalities and public service companies would need to turn to the private market for the financing of their investments as investment rates increase as part of EU integration strategy, and as asset sales vanish as a source of investment finance. The vast majority of municipalities is too small to undertake investment projects at an economically viable scale; sporadic demand, low service fees, and lack of expertise are additional constraints to securing private finance. There is no economic base for attracting private providers (particularly FDI) into new public service developments. The regional service associations of municipalities lack capital, and are thus economically non-viable market entities. There is a lack of specialized financial instruments and financial intermediaries to meet investment demand of municipalities and public service enterprises. Investment finance in terms of debt maturity is limited to 3-5 years at present. Although the Municipal Bankruptcy Law is a strong instrument to limit moral hazard, there remain weaknesses in the prudential framework for municipal borrowing, in the financial sector regulatory framework for sub-national debt, and in the budgetary framework to support municipal borrowing. Hungary is at a crossroads: whether to continue reforms on the present path of partial uncoordinated, corrections, or to address the challenges in a framework of a coherent medium-term modernization program with emphasis on local initiatives. This report summarizes the key policy options and proposals that can be implemented individually - though, it is better to combine them into a comprehensive medium-term program to be accomplished in the next 4-5 years, since changes in one part of the system inevitably affect other areas. The program aims to strengthen local autonomy, improve service delivery and to continue to accommodate bottom-up development. A systemic modernization program should address fiscal issues at both the central and local level, local management capacity building, and subnational credit market issues with the aim of: (i) enhancing the institutional, legal, and regulatory framework; (ii) reforming expenditure assignments; (iii) augmenting local revenue generation; (iv) reforming the system of intergovernmental transfers; (v) strengthening strategic planning and financial management locally; (vi) meeting the demand for subnational investment finance; and (vii) enhancing the supply of subnational finance. Institutional, legal, and regulatory framework Defining the role of intermediate levels of government. The legal status of various intermediate levels of governments (both large and micro regions) should be clarified and their capacity to develop and implement specific functions should be established. These should be set out on the basis of economic criteria ("functional regionalism") and should be well integrated into the public service delivery system (by sectors). In addition, intermediate levels of government should have appropriate own source revenues first to finance service delivery, second to build their capacity to absorb external funds (both from the EU and capital market). Making central and sectoral legislation more consistent. The intergovernmental finance and sectoral laws should be harmonized. The scope of the latter should be limited to basic national standards and quality assurance without micro-management in order to connect local decision making authority with available local resources. Strengthening the legal and regulatory framework for outsourcing and public-private partnerships. For effectively supporting alternative methods of service delivery, it is critical that localities have the expertise to enter into public- private partnership. It is also necessary to review and revise exemptions from the Act on Public Procurement. Information on public procurement contracts and the basis for pricing needs to be made accessible in order to establish transparency, stronger competition as well as the basic information that is required for accountability to hold in the provision of public services. Strengthening the prudential framework to enhance municipal borrowing ability while limiting moral hazard. The definition of public debt should include guarantees and other contingent liabilities of local governments. The central government may need to issue legislation stating that it will not, as a matter of principle, issue sovereign guarantees for sub-national transactions. As market signals take hold, the existing limits on local government borrowing may need to be re-assessed based on the long-term debt servicing capacity of local governments. In what relates to the subnational segment of the domestic credit market, the main development issues pertain to the followings: (i) the underwriting, distribution, registration, settlement, and market-making capabilities in secondary markets for municipal securities; (ii) the capital adequacy ratios and disclosure standards for underwriters and market-makers for municipal securities; and (i.i) the benchmarks for pricing debt obligations of municipal entities. ix The financial sector legal and regulatory framework needs to improve market transparency and disclosure by local government borrowers. It is necessary to set up a central debt registry to record all sub-national debts including, contingent liabilities, and assets pledged as collateral. These records need to be updated in a timely manner and be accessible to all market participants. The format of the annual financial report required by local government bond issuers needs to be defined. Budgetary conditions for local government borrowing. To enhance local borrowing, there is a need to distinguish recurrent and capital budgeting, to regulate local revenue collateralization, asset registration, valuation, and collateralization, and to improve external auditing of local government budgets. A municipal finance information service would be instrumental to provide creditors with relevant, reliable, and standardized information on local governments (such as debt service to revenue, current revenues to expenditure ratios). Developing the institutional capacity to monitor financial and expediency decisions of local governments. The future role of monitoring institutions: State Audit Office (SAO), TAKISZ, Regional Public Administration, and Treasury Offices, and the National Council of Municipal Association should be carefully reconsidered. It is equally important to enhance both the legal framework and the enforcement of local monitoring by internal and external audits, NGOs, and other forms of citizens' monitoring over local governments, their organizations, and public service suppliers. Expenditure assignment The appropriate level of government for delivery of public services should be re-evaluated in order to reduce the current fragmentation and to make service provision more cost effective, while maintaining accountability and local incentives as priorities. Regions will play a significant role in service delivery. There may be a need for different combinations of policy measures and local initiatives in the four areas of major responsibility for local governments: provision of physical infrastructure (e.g. water, sewage, solid waste, and district heating), human infrastructure (e.g. education and health care), economic and regional development, and public administration. The lack of clarity over the type of service responsibilities assigned to local governments and the minimum level of services expected from the local service providers often create confusion and frequent tensions between different levels of goverrnent. Numerous sector-specific laws and regulations not only set out the tasks of local governments, but also rigidly prescribe how these services should be delivered. As a result, the process of local fiscal adjustment in such important sectors as education, health and social care is an outcome of conflicting and frequently changing sectoral rules and policies of different ministries over which local governments have little or no control. Local revenues Mandatory task assignment must be accompanied by adequate funding. This can be provided for, not only in form of transfers, but through local taxes. The PIT surcharge (a fraction under local discretion), value-based property tax, vehicle tax, and business tax are expected to become gradually the major revenues at local discretion. (The first and the latter could serve also as own revenue for intermediate government tiers). This would increase the ratio of revenues subject to local discretion, and hence enforce local accountability, improve tax collection, and provide a revenue base for attracting external resources. Because payroll tax and VAT rates should be reduced in the course of EU accession to maintain the country's competitiveness, fiscal transfers to municipalities are expected to decline in order to maintain or even reduce the overall tax burden. These ideally could be part of a tax reform package. Nevertheless, a large number of small municipalities will rely on central transfers even in longer term. With few exceptions, local governments have failed to take full advantage of the taxing powers given to them by law due to either the lack of political will, insufficient institutional incentives or weak tax administration capabilities to increase local taxes. For these reasons, only a few local governments levied taxes on households, which currently account for only 10 percent of total municipal revenue, and virtually none resorted to value-based property taxation to enhance local revenue base. Since tight budgetary constraints are unlikely to disappear in the near future, local governments will be increasingly forced to raise more revenues locally and focus on improving the efficiency of their tax administration. The system of transfers x Reconsidering the system of grants. It is of critical importance to enhance the efficiency of the grant system, by reconsidering the determination of the overall amount to be transferred, and the method of allocation amongst different localities. To obtain predictability and fiscal stability, the overall size of transfers could be linked to fixed proportions of state revenues or expenditures, preferably for a multi-year basis. The grant structure is overly complicated and, due to frequent changes, leaves no room for rational cost adjustments at the local level. The system of capital investment grants frequently distorts municipal investment choices, making local governments implement investment projects of low local priority. For the system of current grants, a systematic approach should aim at diminishing discretionary resource allocation (e.g. centralized appropriations), reducing the large (and still growing) number of norms, separating equalization and task-financing tools and adjusting current grant financing to the revenue generation capacity of localities. These goals can be achieved through various measures, inter alia, direct reduction of the number of norms, and introduction of a grant allocation formula that combines municipal own revenue capacity and expenditure need. An extensive modernization would pool the current transfers into a single grant designed to finance current expenditures and compensate for both vertical and horizontal imbalances using only a few basic parameters (e.g. number of citizens, age- and employment composition). The grant formula and the benchmarks should be left in place for several years to assure the stability of the allocation mechanism over time. The mechanism for investment grants also needs to be enhanced while ensuring support of both national priorities and equalization purposes. Fragmentation and administrative costs should be reduced. Incentives for localities to focus their efforts on obtaining grants from the center (as opposed to increasing their own revenues and improving budget management) should be eliminated. These goals can be obtained by enforcing local contribution and risk sharing. Alternatively, revenues currently allocated to local investments could be pooled into a single investment grant mechanism. In addition, cross sectoral coordination and stringent evaluation criteria need to be implemented in order to ensure that selected projects are economically viable, serve efficient service delivery, and are the highest priority. Local versus Central Government borrowing and macroeconomic risk. Central and local governments constitute the general government sector and public debt levels should be kept consistent with macro-economic stability and objectives. Local government borrowing should be a substitute to central government borrowing, not an added burden to the national public debt (inter alia, to comply with the Maastricht criteria). The pay-off justifies the shift from central to local borrowings or vice versa, cheap money might turn to be expensive. Sovereign borrowings imply the lowest interest rate, and central government transfers financed from borrowings are instruments to reduce horizontal imbalances and control fiscal policy. However, there are significant transaction costs of intergovernmental transfers, they create adverse incentives for local investments, entail full sovereign risk, hamper mobilizing long term (e.g. 20 years) resources, reduce incentives for private sector participation in local infrastructure, and also reduce opportunities for non-recourse finance of local investments. Direct borrowing by local governments and public service enterprises, by contrast, encourages a closer fit between local investment choices and citizen's priorities; it reduces sovereign risk exposure and risk for contingent sovereign liabilities; it also increases opportunities for non-recourse and term finance. Local Strategic Planning and Financial Management The capacity to create and implement local development strategies needs to be augmented. Municipal strategies and development programs should be ideally linked to the strategies of the respective small and big regions, however, the latter strategies have not been used in Hungary so far. Municipal strategic plans should determine key priorities and serve as conceptual framework for their medium and short-term economic plans, from which the annual budget plan can be derived. Currently, three types of planning documents are mandatory at the local government level: a long-term urban development strategy, a zoning regulation in compliance with physical planning regulations, and a rolling plan and annual budget. The long-term development strategy should serve as a basis for developing a four-year economic plan to be approved ideally right after the municipal elections. The Act on Public Finances also requires that a "rolling" plan should be prepared and approved along with the annual budget for an additional two-year-period. However, the local governments neither widely nor consistently use medium and long-term plans. Local development strategies are often sketchy, casual, and sometimes mixing elements of local, regional, and national targets. In addition, the xi investment grant allocation system has a big impact on local goals, this does not result in a sensible and sound approach to economic development. Overall, formal rules for budgeting and reporting procedures are properly set in Hungary. However, it is not recognized widely that budgeting and financial reporting is not simply a set of procedural rules for spending public money but is a potential building factor of modem public expenditure management. Budgeting may be used as a tool to implement policies according to local needs and reporting might serve as an institution to provide feedback on outcomes of policies. A sectoral or program type approach to budgeting promotes allocative efficiency, i.e. allocation of resources from less to higher priority sectors or programs. Application of performance indicators or output measures supports operational efficiency through providing information about cost-efficiency of the service provider units. Deficient financial management, caused by the lack of trained personnel and rudimentary systems of financial control, often results in misallocated public investments, and, as happened on several occasions, municipal bankruptcies. The current local government accounting practices do not account for guarantees and other contingent liabilities frequently disguising serious financial problems. In many cases, local property management lacks any coherent conceptual underpinning, is highly fragmented, and is one of the most underdeveloped areas of local financial management. Meeting the demand for sub-national investmentfinance One key challenge on the demand side is the issue of a multitude of small local governments. In accordance with the concept of functional regionalism, the creation of ad-hoc associations such as "special purpose entities" may be one solution. While this would avoid tampering with political and administrative sub-divisions, the approach would ensure that services are delivered more effectively with the desired economies of scale. The government may want to encourage (through incentives if need be) the establishment of special purpose entities for the exclusive purpose of delivering services. The laws should provide that these entities: (i) be legal units vested with powers to enter into contracts, borrow, levy fees against services provided or betterment taxes against improved property values; (ii) be adequately capitalized; and (iii) be able to pledge project revenues as security for borrowings. Local investment demand, a risk to fiscal and current accounts. Local public investments contracted during the second half of the nineties are projected to increase progressively over the medium-term, as local infrastructure is modernized as part of the EU accession strategy. In parallel, profound changes are envisaged in the structure of local investment finance. Private funds will play a growing role, which will ease fiscal burden, but will have an impact on the current account. Local government finance will remain tight, because physical asset sales and privatization revenues are projected to decline rapidly, central government transfers to be reduced, and matching capital grants to increase progressively (required for inflows of EU funds). As a result, net borrowing of local governments, which amounted to -0.7 percent of GDP in 1997, is roughly estimated to increase to about 0.5 percent by the time of accession and onwards. In parallel with a moderate increase in municipal investments, about two thirds of the projected increase of the investment rate in the economy will be accounted for by public service enterprises over the medium-term. Investments by companies providing local public services are projected to increase to about 3.2 percent to GDP by the time of accession, and remain at that level from there on. Meanwhile the net operational surplus of public service enterprises is projected to increase progressively as a result of the introduction of cost recovery measures. In addition, capital grants to public service enterprises are projected to increase progressively in line with projected inflows of EU pre-accession and structural funds as well as FDI. Hence, the net borrowing requirement of public service companies, which amounted to 1.0 percent to GDP in 1997, is projected to increase to about 1.5 percent to GDP by the time of accession and onwards. Supply of sub-national investmentfinance The supply of funds has been growing as a result of the increased mobilization of savings, availability of new financial instruments, and growth of domestic capital markets with entry of new institutional investors (e.g. pension funds). These provide a growing funding pool for local government investment finance. Government policies should focus on enhancing the development of a range of financial/debt instruments involving direct access to the bond xii market or through financial intermediaries (including credit enhancement tools such as revenue collateralization) to allow better management of risks. Local government access to credit markets. One constraint to local government access to credit for infrastructure finance pertains to the limited availability of long-term lending, as loan maturity to local governments rarely exceed 5 years. This situation arises from lenders' concerns regarding interest rate and credit risks. Government policies could provide an environment and guidelines for: (i) credit risks to be reduced through credit enhancement, including lending secured by project recurrent revenues (user fees or incremental tax revenues), that would encourage longer-term commitments by potential creditors; and (ii) for interest rate risks to be mitigated, as they have been so far, in pricing loans on an indexed, floating rate basis, further mitigated through fixed income portfolio diversification techniques (for which guidelines may need to be provided). Specialized financial intermediaries for local government investments. In Hungary, it would not be feasible for a vast majority of small and medium-sized local government entities to have access to credit through direct bond issues. The use of financial intermediaries that could tap private credit markets on behalf of local governments could be one way to foster market access for such borrowers through pool financing arrangements. This would entail leveraging the intermediary's equity funds through bond issuance. Lending would be for: viable, revenue-generating infrastructure investments that would meet debt service out of revenues; and public goods investments able to generate fiscal resources needed for debt service. The policy challenges in establishing market-based specialized financial intermediaries, further feasibility analysis would be required, would relate to: (i) the institutional framework conducive to establishing market-based financial intermediaries that would issue debt without government guarantee; (ii) the main features in terms of products range (loans, guarantees, underwriting, etc.); and (iii) the funding, product pricing and risk management policies needed to support financial sustainability. xiii Introduction Hungary has been a pioneer in local government reform among transition economies. Through a series of legal reforms introduced since 1990, Hungary has decentralized the state administration, re-established the autonomy of local governments, delegated to local govermments broad responsibilities in delivering local public services, implemented a legal and regulatory framework to enable private participation in local infrastructure and services, and tightened budget constraints. The public and private sectors are already bound to each other in public utility supply, and NGOs are playing a growing role in providing social services. Hungary has recently reinforced the intermediary levels of government by establishing Regional Development Councils and has tried to promote municipal associations. However, the issue of the fragmented municipal system of some 3200 municipalities is still unresolved. Decentralization has highlighted the need for improving the capabilities of local governments to carry over their new responsibilities in delivering local services, maintaining assets and promoting economic development. The successful completion of fiscal decentralization is a joint responsibility of both central and local governments that would require concerted efforts in national regulatory reforms and institution- building at the local level. Only by removing regulatory impediments to local efforts to improve cost efficiency of municipal service delivery and to make it more responsive to local needs - by increasing local revenue generation capacity, and addressing the deficiencies in local capacity building - can the desired effects of fiscal decentralization at the local level be fully realized. Hungary faces a medium-term challenge to increase both private and public investment to support economic growth and modernize infrastructure, while maintaining internal and external macroeconomic equilibria. Investment needs in local infrastructure have been growing against a background of tight fiscal policies that have constrained budgetary transfers from central to Subnational levels of government especially since 1995. The funding sources for municipal investments have included local operating surpluses, central government transfers, and proceeds from asset sales (the latter coming to an end). Municipal borrowing for investment purposes has been negligible. Nevertheless, a significant financing gap is envisaged in the coming years even when EU structural funds are taken into account. This financing gap could only be filled through private sources including FDI. This report raises the policy issues that would need to be addressed to develop and implement a comprehensive program of local government modernization in Hungary. This report is a summary of the Fiscal, Local Management, and Municipal Credit Market Policy Notes prepared in June 1999, under the Hungary - Subnational Development Program. Section I briefly describes the main challenges associated with subnational modernization; section II examines the issues of modernizing the intergovernmental finance system; section HI examines the issues of strengthening local management capacity; and section IV examines the issues of developing a competitive subnational finance market. 1 I. Subnational Modernization Challenges In 1990, in the euphoria of the outset of the transition from a command to a market economy, a highly decentralized bipolar government system was created. The 3200 municipalities must fulfill their responsibility for the provision of local public services in the context of tightening fiscal constraints and increasing citizens' demand for quality services at the door of the European Union at the turn of the 21st century. The experience of Hungary's decentralized government system over the past ten years has proven the merit of democratically elected and cautious autonomous local governments as well as the effectiveness of local initiatives. The decade's historic events, correction measures, fiscal squeeze, and growing local management expertise now give good reason for an assessment of Hungary's subnational system to identify the major challenges and the best way for implementing the modernization tasks during the period of EU accession. These challenges include: Continuing the restructuring of the role of the public sector and local governments. Localities have adjusted to changing circumstances, but are reaching the limit of their adaptive capabilities within the current intergovernmental framework. Substantial changes in the system of intergovernmental finance are required in order for localities to adjust further and use their resources more effectively. Service delivery should be based on a notion of functional integration or "functional regionalism" where delivery of the service is done at the level that implies the most efficient use of resources. Supporting the autonomy of local governments. The political autonomy granted to local governments has not been matched by economic autonomy due to their overwhelming reliance on central transfers. Efforts have been made to improve accountability, transparency and service delivery. But the success of these efforts has been offset by sectoral legislations that limit local decision-making authority through unnecessary micro-management of local govermnents. Economic autonomy is also limited by a system of grant allocation that constraints local government initiatives. Assuring balanced and equitable development. Since 1990, the changes in public resource allocation aimed at managing revenue disparities across municipalities and providing standard public services have been only partially successful. In addition, they have contributed to unpredictability, high administrative costs and reduced the incentives for local governments to strengthen local revenue bases. Reductions in inequality between small and large, urban and rural municipalities, and across geographic regions require reconsideration of the current system of grants allocation and distribution. Meeting the requirements for EU accession. There are critical aspects of EU accession that will affect local governments. Meeting EU standards in infrastructure, environment and other areas will require large investment, part of which will take place at the local level. One challenge will be the effective absorption of EU funds to support accession. However, the magnitude of investment needs is such large that they cannot solely be met through public funds. Therefore the challenge will be to provide municipalities with an intergovernmental framework that supports local government efforts to access capital markets in order to finance investment needs. Providing services efficiently and effectively. There are three efficiency challenges: ensuring further reduction of cost of services, obtaining optimal scale in service delivery, and exercising effective regulation and supervision over private providers of services. While local governments have been able to improve cost efficiency there are a number of constraints to further improvements. The micro- management by sectoral ministries and the system of transfers hinder medium-term local planning and seeking the most cost effective service delivery. The limited local management capacity and expertise in contracting out and pricing services severely influence the overall quality of service delivery. Hence, not only municipalities can be blamed for poor management practices, but also ministries and national agencies that have not adjusted their functions to the new decentralized environment. 2 Strengthening the capacity and base for local revenue generation. From a policy perspective, the ability of local governments to raise revenues locally is an important indicator of their fiscal strength. Three aspects need to be considered: the sustainability of revenues, the ability to generate revenues through taxes or service fees, and the degree to which local tax increases have been accompanied by municipal accountability to taxpayers. In Hungary, local revenues are becoming increasingly important components of the fiscal strategy despite the fact that localities still tend to rely heavily on central resources and to pursue a policy of minimum local taxation. In 1998 grants accounted for 68.4 percent of total local government revenues. Strengthening strategic planning and financial management at the local level. Local financial management has improved significantly particularly in the area of current budgeting and cash management. Local government financial management capacity, however, has not kept pace with the changes that have taken place in the overall municipal legal framework. Suboptimal financial management, lack of trained personnel, and weak financial controls, often result in misallocation of public investments. It is necessary to strengthen local capacity in a range of areas including budgeting, financial reporting, and auditing, asset and debt management, and the effective use and regulation of land. This will be critical to ensure the effective use of resources including EU structural funds. Securing adequate financial resources. Where essential services - that are not provided through private operations and concessions - cannot be funded by operating surpluses and central transfers, the financing gap needs to be filled through private borrowing. In the coming years, this gap may become significant even when EU structural funds are taken into account since proceeds from asset sales which have been an important source of finance, are rapidly coming to an end. Enhancing the legal and institutionalframeworkfor subnationalfinance. Subnational entities are ranked among the most risky borrowers in Hungary. Although the Municipal Bankruptcy Law is a useful instrument, there remain weaknesses in the financial sector regulatory and prudential framework for subnational debt, and in the budgetary framework to support municipal access to private credit. Reducing demand side impediments for municipal access to private finance. A key factor in developing a competitive and sustainable Subnational market for local infrastructure finance in Hungary would be to enhance local governments' ability to access capital/credit markets in a way consistent with macro- economic stability. The vast majority of municipalities are too small to undertake investment projects on an economically viable scale, which presents a major constraint, inter alia, to non-recourse finance schemes. The regional service associations of municipalities lack capital, thus they are economically non- viable market entities. Enhancing financial intermediation and instruments to subnational entities. Unlike the development of Hungary's private financial markets in terms of competitiveness, depth and liquidity, the municipal credit market has remained underdeveloped. Falling inflation and interest rates alone will not resolve the issues resulting from a lack of modern capital market financing instruments and structures in the subnational sector. There is a lack of specialized financial instruments and financial intermediaries to meet the projected growth in investment demand of municipalities and public service enterprises. 3 II. Modernizing the Intergovernmental Finance System The overall framework for intergovernmental finance creates the context in which localities operate and to a great extent determines the incentives for local government behavior. Effectively strengthening local government capacity and developing a competitive subnational financial market are both greatly facilitated by a stable and predictable system of inter governmental finance. Although Hungary has made good progress in modernizing its system of intergovernmental finance, the system constantly needs to adapt and change in order to meet changing circumstances and to improve performance of service delivery. The various components of the system are highly interrelated and are particularly influenced by political and institutional factors. Making changes to one part of the system invariably has an impact on other areas, which may or may not be intended. Table 2.1: Local Government Accounts, 1993-98 (in % of GDP) 1993 1994 1995 1996 1997 1998 Total Revenues 16.1 15.9 13.6 13.0 12.8 12.0 Own Current Revenues 3.0 2.8 2.6 3.0 3.3 2.9 Revenue Sharing with Central 1.4 1.5 1.7 1.6 1.7 1.9 Govt. Transfers from Central Govt. 7.7 7.3 5.7 5.0 4.3 4.2 Transfers from Other Public 2.8 2.9 2.4 2.4 2.4 2.2 Sector Capital Revenues 0.7 0.9 0.8 0.6 0.6 0.5 Other Revenues 0.5 0.5 0.4 0.4 0.5 0.3 Total Expenditures 17.2 17.4 13.9 13.0 13.1 12.7 Current Expenditures 13.5 13.7 11.5 10.9 10.5 10.2 Capital Expenditures 3.1 3.3 2.4 2.1 2.6 2.4 Other Expenditures 0.6 0.4 0.0 0.0 0.0 0.1 Balance -1.1 -1.5 -0.3 0.0 -0.3 -0.7 Net Financing 0.5 1.0 0.2 0.3 0.3 0.4 Privatization Revenues 0.2 0.3 0.5 0.7 1.0 0.5 Net Borrowing 0.3 0.7 -0.2 -0.4 -0.7 -0.1 Residual Balance -0.6 -0.5 -0.1 0.3 0.0 -0.3 Memo Item: Borrowing/Borrowing Cap (in %) 117 167 81 27 19 30 Source: Ministry of Finance Institutional, Legal and Regulatory Framework The institutional, legal and regulatory framework for fiscal federalism both defines the structure of government and shapes the context and incentives for interaction between different levels of government. An effective system of intergovernmental finance requires that levels of government be clearly defined and that existing institutions encourage transparent, predictable and responsive decision-making at each level. In addition, accountability at each level is essential - without it, the gains from decentralization are unlikely to materialize. The present fragmented system of municipalities and public services has coincided with unclear roles and a vague legal and financial status of intermediate layers of government. There are three areas in which further work in developing the institutional, legal and regulatory framework can have an important impact on the improving accountability and incentives: resolving lack of clarity over the intermediate levels of government; making central and sectoral legislation more consistent; and strengthening the legal and regulatory framework for contracting out the provision of public services. 4 Reducing Fragmentation and Steps Toward a Multi-Laver Subnational System Resolving the lack of clarity over the intermediate levels of government and choosing a path forward is an important aspect of improving the current system. Evolving legislation has tried to address the issues of fragmentation and efficient service delivery by strengthening the role of intermediate levels of government, (e.g. establishing county and regional development councils), as well as by legislation fostering municipal associations and other forms of corporations to encourage service delivery at a more efficient level. However, the existing legislation leaves a very unclear view of the specific functions of these levels of government and how they relate to each other. In addition, with undetermined legal status, none of these intermediate levels has the possibility for developing own resources of revenues and most do not have the authority for cost recovery, to receive grants independently or to borrow. This limits their accountability and ability to provide services. There is a common view that it is politically impossible to merge micro municipalities hence to reduce their number from 3200 say to 150. Thus, one option is for the central government to mandate a specific intermediate level, either through amalgamation of the old structures, formalization of the regional councils, or creation of new administrative units. Such a route may also be politically difficult and would take several years to develop, consolidate and implement. A second option is for the government to support the ongoing, continuous evolution of associations. Such associations can evolve in different ways either for the delivery of specific services, such education as is the case with the special purpose districts in the United States, or for the provision of a range of activities. Generally, integration is pursued on the basis of the appropriate economic scale [Davey, K - Peteri, G.: 1998/a.] for a given function and can be referred to as "functional integration " or "functional regionalism". The current grant structure provides incentives for cities to request funds as part of an association. More could be done to help such associations by providing them with a proper legal definition and therefore the capacity to act as an entity, be it to receive grants from the government, to raise their own resources through user fees or to borrow. Although the evolution of such associations is already well underway [Nyitrai E.: 1998], implementation of this option requires improving incentives for such associations and clarifying their legal status. Both approaches have pros and cons. Formal Table 2.2 Number of Regulations by Sectors mandating of an intermediate level has a balance of Number of pros and cons with respect to meeting economic Sector Regula- efficiency objectives. It is stronger in meeting tions equity and fairness and macro stabilization Health care and social services 58 than the functional approach, Public administration (interior) 42 objectives than the functional integration approach, Agriculture 42 but weaker in addressing issues of political Industry, commerce, tourism pricing 35 accountability. In terms of administrative Administrative (justice) 34 efficiency, the first option lends itself to clearer Transport, telecom, water management 33 accountability and assignments of responsibilities, Finance, fiscal management 31 accountability ~ ~ ~ ~~~~~~i Environmental protection, regional 30 also to more comprehensive and integrated development policies. Functional integration, on the other hand, Labor 27 has greater flexibility, may help to promote greater Culture and public education 21 competition and responses that are more tailored to Local and minority governments 8 competition ~~~~~~~~~~~~Defense 3 specific needs. It also lends itself better to the Source: P^teri, G. 1998 traditional mechanisms of citizen participation in . Hungary, which have become increasingly important during the transition. 5 Overwhelming Sectoral Regulation Distort Decentralization An important aspect of improving intergovernmental finance in the future is to consider the overall package of central and sectoral laws and the degree to which they are coherent and consistent with overall intergovernmental finance objectives. The Law on Local Governments provides a large degree of autonomy to municipalities in service delivery and standards. In practice, however, many sectoral laws constrain that autonomy by defining many of the specific terms and conditions under which localities must operate. Clearly central government sectoral laws have a role in setting nation-wide standards, normatives and a general regulatory framework. [Palne-Kovacs, I.: 1998] Sectoral laws often go far beyond their core mission to enforce national standards and support priorities. They may allow for too much micro-management of localities from the center and therefore undermine an effective system of intergovernmental finance because they separate decision-making authority from available local resources and push the system towards reliance on normative grants (see below). It makes local governments less responsible for their decisions and for their performance. If decentralization is to be meaningful, such laws must leave decision-making authority in the hands of the appropriate level of government Alternative Methods in Service Delivery Imply Regulatory Challenges An issue of equal importance to the appropriate government structure and a consistent legislative framework is an environment that effectively supports alternative methods of service delivery, including outsourcing and development of public-private partnerships. Hungarian local government are very open towards public-private partnerships. In Hungary, it has become common for local governments to outsource certain activities including solid waste disposal, park and street maintenance services and in some cases water and more recently district heating provision. It is likely that such activities will increase in the coming years given that private participation is often needed to obtain the financing of capital improvements. However, they often overvalue the benefits and underestimate the risks and respective regulatory challenges [Baar: 1998, Baar: 1999]. There are a number of measures that the government should consider in order to strengthen the environment for outsourcing and public-private partnerships. First, it is necessary to review and revise exemptions from the Act on Public Procurement. The concept that there should be an exemption or less stringent rule because the payment for a public service comes directly from the private users rather than from public funds, or that the service goes directly from a private company to the user is misguided. The interests of the citizen in securing the benefits of the Procurement Act are the same whether the service and/or payment for the service are directly between the government agency and the citizen or via the contracting party. Second, information on public procurement contracts and the basis for pricing needs to be made accessible in order to establish transparency, stronger competition as well as the basic information that is required for accountability to hold in the provision of public services. This is also important in helping communities to develop independent expertise in contracting and pricing and to make informed price setting decisions. Third, it is critical that localities have the expertise to enter into and implement the contracting out of services. In light of the small size of many communities, as well as limitations on the budget, the government may wish to develop at either the national or at the regional level a unit to provide expertise and assist local governments with expertise on public procurement issues, contracting issues, pricing, etc. 6 Box 2.1 Inconsistent Decentralization in Health Care? In 1990, local governments became owners of municipal hospitals, outpatient policlinics, and GPs' offices and employers of the healthcare staff. They are by law responsible to provide virtually all kinds of public health-care services. The previously tax financed health system was replaced by a health insurance framework. An "autonomous" Health Insurance Fund (HIF) was subsequently established to cover the recurrent expenditures of health service providers based on output and case mix (DRG) normatives. Local governments have become responsible for financing capital expenditures from their own budget including earmarked capital grants and general-purpose transfers. Local service providers are usually legally independent municipal institutions with a significant level of managerial autonomy. There are three clusters of expenditures: current expenditures (e.g. wages, medicines, supplementary materials, heating, and electricity); capital expenditures on machinery and equipment (e.g. electric, computer, and medical tools); and capital expenditures on real estate (building and renewal). All expenditures are virtually financed by the local government owner of the respective service units, and the local government must ultimately bear the cost in case of default. The management of the service units (e.g. hospitals) is delegated to the appointed unit managers (e.g. senior doctors) who act with full authority on behalf of the local government. In practice, however, there are three different financing tracks, mostly beyond the control of the local governments that present a number of sober governance and game theory challenges. Current expenditures are mainly though not exclusively financed by the HIF through monthly reimbursement of DRG transfers. There are several issues. First, hospitals tend to report always the most complicated version of a given illness to maximize revenues. As a response the HIF devalues the DRG unit transfers in order to keep its monthly budget cap. Second, key cost factors (e.g. wages, price of medicines) change beyond the control of hospital management and local government. Healthcare staff are employees of the local government as public servants, hence difficult to lay-off; their compensation is negotiated at national level, while the respective cost should be covered locally. Third, service providers reduce services with low grant-to-cost ratio, while high grant-to-cost ratio induce overuse of expensive services (e.g. CT) sometimes in out-source form (called functional privatization) to maximize the received transfers to the detriment of other hospitals. Fourth, producers' agents encourage doctors to use new and sometimes disproportionately expensive treatments and medicines. Finally, cost overrun is temporarily rolled over through regular or forced credit, or has to be taken over by the owner local government in case of open default. By the end of 1999, a dozen of hospitals have defaulted; localities managed to resolve most of the cases. Municipalities handed over three troubled hospitals to the counties, rather than resolve the problem. Capital expenditures on machinery and equipment are mainly financed through addressed and targeted grants, though private foundations and local governments are playing a growing role. Municipalities have constitutional rights in application for targeted grants, though they often do not receive them. In 1999, Ministry of Health (MoH) allocated about HUF6bn. targeted grants directly to the health institutions, while about HUF24bn. investment was financed by local resources, at least half of which received as earmarked or general purpose grants also from the state. This system of distributing investment funds is the most powerful control in the hands of MoH over the health sector. Under the surface of an earmarked financing there is a quasi-feudal system of discretional support where directors are very dependent on the MoH. If someone is in bad terms with the ministry, his hospital might not receive even the necessary replenishments. In case of good relations, however, he might receive a brand new CT even if a hospital across the street has already two CTs. Investments are either approved on the basis of real needs, or reflect political relations. Capital expenditures on real estate renewal and development (e.g. buildings, roads) are financed either by the state through addressed subsidies or by the localities from local revenues, but very often omitted or postponed. In sum, local governments have very limited control over financing one of their most important mandatory services. Financing health services is particularly problematic in institutions that have excessive regional service responsibility since current expenditures are mostly but not fully covered and capital expenditures are only partially covered by central transfers. Hence there is significant cost in the owner municipality while neighbors may free ride on these services. Enhancing decentralization by vertical service reallocation, a combination of local and regional service system with respective finances would be a good response to the above mentioned challenges. 7 Service Delivery Provisions and Expenditure Assignments Clear and consistent expenditure assignments that lay out the responsibilities of the different levels of government comprise a fundamental component of an effective system of intergovernmental finance. Conceptually expenditure assignments are based on a number of factors. First is the distinction between private and public goods. Some important services, such as defense and street lighting, are such that their provision cannot be limrlited to a single individual and the benefits of the service accrue to the community as a whole. The private sector alone would typically under-provide such services and there is thus a role for the public sector at some level. Second is the scope of the benefits or costs of providing a given service. Some public goods may be national in scope, some may be regional in scope and some may be local in scope. Ideally, the aim in expenditure assignment is to match the responsibility to the level of government that most closely corresponds to the scope of service delivery. Third is the economy of scale that may be inherent in the delivery of a service. [Hermann, Z. and others; 1998; Hegeduis, J. 1998] Some services can be provided much more cost effectively for 10,000 people than for 200 and this should be a factor in determining the level of government that should provide a service. A fourth consideration in expenditure assignment is the fact that governments often have redistributional objectives in order to improve equity within a country. Typically, expenditures that have a redistributional nature should be managed at the central government level to assure consistency with other policies (tax policies for example) and to assure that there is coherence across the regions and/or municipalities. Finally, the degree of political accountability and administrative efficiency at the different levels of government also play an important role in determining the most appropriate level for the provision of a service. The Law on Local Governments defines a Table 2.3 L cal expenditure assignments wide range of potential local government Nordics Southern Hungary functions. Hungary combines the system of Kndergaens Europe' the Nordic countries' with the dispersed Primary Education X X* municipalities typical in Southern Europe Secondary Education X X [Kopanyi, M.: 1998]. hn Hungary, 74 percent Health Xe X* of municipalities represent 17 percent of Social Welfare x X* population and 8 percent of municipal Public Safety X X Public Lighting X X X expenditures. These contradictions result in Roads X X * further efficiency losses. In addition, there are Water x x X* mandatory services including the provision of Sewerage X X X Garbage Collection X X X potable water, kindergartens, primary Fire Protection X X education and daily child care, health care, Parks & Recreation X X welfare services, public lighting, local roads, Housnmg x X X* cemeteries, and protecting the rights of Minority rights X* national and ethnic minorities. However, in 1) For municipalities below 5,000 2) *Indicates practice most of municipalities provide compulsory Source: Gibson and Batley 1993, and Hermann et al (1998) voluntary services, while they ormt or transfer to the county some of their mandatory services. This can be done easily because even the mandatory services are financed only partially by the center. Thus making it easy to refer to the insufficient current transfers and lack of local resources to supplement, or to simply say that there is not sufficient demand for them. 8 Box 2.2 Decentralized Social Assistance for the Poorest? In Hungary, there are four major clusters of social assistance. (i) Universal benefits are provided for people who are easy to identify nationally. The central government by law finances cash benefits (e.g. unemployment insurance, maternity and child-care benefit [GYES], and family allowance) from the central budget through deconcentrated state agencies. (ii) Mandatory local social assistance (with earmarked and normative grants) is by law provided by the local governments when accurate information for means-testing are locally accessible. Earmarked matching funds support a few important social services when localities serve virtually on behalf of the state (e.g. cash benefits for 160,000 long-term unemployed, child-care support [GYET], and aged allowances). (iii) Normative grants are transferred to the local governments for supporting a dozen mandatory social services, that are financed from the local budget. These include inter alia, regular social assistance for hundreds of thousands whose eligibility for long-term unemployment benefit has expired and regular child protection benefit for about 900,000 children because the per capita income is less than the minimal pension insurance in their family. (iv) Voluntary local social services often supplement the mandatory services. Universal benefits and earmarked-fand supported local assistance are services of highest national priority. Earmarking aims to ensure the maximum accessibility, while shared financing with say 25 percent local contribution is an appropriate tool to reduce moral hazard, to ensure that localities properly identify eligibility (otherwise uneasy to measure), hence do not induce unnecessary cost to the central budget. These social services are performing well in Hungary. Normative transfers support services when it is even more complicated to measure the eligibility, the magnitude, and the nature of social assistance, hence local information, priorities, and considerations are of crucial importance. Normative grants assume higher (e.g. 50 percent or more) local financial contribution, however, do not imply tight spending obligations, hence they are by nature similar to general-purpose grants. Therefore, if a local government values some sectors (e.g. education) more than social assistance, it is free to re-allocate funds accordingly. A recent survey shows that some localities spend 40 percent more on social assistance than the received normative grant while others redistribute as much as 90 percent of the received social normative grants to other services [Konig 1998]. Non-mandatory local social assistance has been growing. Some localities offer additional assistance, while others offer nothing or only a few benefits. For example, Ozd, a small town in Northeast Hungary, offers 9 major types of social protection benefits while the Ferencvaros district of Budapest offers 20 different kinds of assistance for the poorest people e.g. housing maintenance, public burial, public health insurance. On the one hand, the voluntary social services that are administered and financed locally further increase differences in social assistance across municipalities. On the other hand, they represent local interest and priorities in fighting poverty hence, are important supplementary elements of every social assistance system. Dilemmas: Due to their small size and minor budget a big group of local governments seem to be financially and professionally unprepared for providing social services particularly to take care of the poorest people. Financing social programs from general-purpose grant leads unquestionably to inconsistent poverty alleviation across the country, due to high variations in payment levels both from one case to another, and from one local authority to another. Taking good care of the poorest social groups is a key moral obligation of local governments. A few steps could be made in order to enhance the incentives in using social normative transfers for social purposes and to ensure some minimal social services for the poorest even from very tight local budget. Some assistance may need to be moved from the normative to the earmarked group [WDR 1999], though they may induce significant burden to the central budget. Local civic organizations could also play an important role in articulating and representing the interest of the poorest who hardly have any lobby power. 9 Service Delivery and Expenditure Assignments to be Enhanced A first measure that can contribute to improved expenditure assignment is to reduce the discretionary nature of the intergovemmental system that allows municipalities to decide whether they will undertake certain activities. As seen above, there are a number of services that are not mandatory for localities so there is some discretion as to service provision between levels of govemment. Combined with this, municipalities have the option to take over some activities from county govemment or to transfer activities that they cannot manage to county govemments. While this is intended to provide a degree of flexibility to the system, its effect is to simply reduce the clarity and predictability of the system. It makes it much more difficult to know which level of govemment is accountable for the delivery of a given service and whether a service is being delivered economically. Chart 2.1 Distribution of Municipalities by Size, by Expenditure, and by Population I 00 U 1 N u m b er of 80.0 - / _ Local 60.0 - / fCGovernments 40.0 - Total 20.0 _ Expenditure 0.0 i. - . . cumulative % gp q>99 999 oOO oS j2>°' Share of ~~~' 0~~~~c 4 population _ ' o°°° o° &J0 cumulative % Source: Ministry of Interior A second measure for the Government is to assign expenditure functions to the level of government that can provide the service most efficiently and effectively. There are four major types of municipal tasks that vary in nature. These include public administration tasks; provision of human infrastructure (education, health, social assistance); provision of physical infrastructure (water and sewerage, solid waste) and economic/regional development. The Govemment needs also to consider the specific characteristics of each of these services when determining the appropriate level of service delivery. For example the provision of solid waste management is assigned to local levels of govemment, when given economies of scale in the industry suggest that it might be more effectively provided at the county level. Data on expenditures by size of locality indicate that small govemments allocate a relatively small share of resources (Chart 2.1). The data also suggest that administrative expenditures are dis-proportionately higher in the small govemments than in larger ones. The evidence on economies of scale also indicates that local expenditure for public infrastructure is carried out at a level that is not economically efficient. All of this points to the need to promote a further degree of integration for delivery of key services. Such integration is by necessity linked to the approach that the Govemment pursues toward intermediate levels of govemment that is discussed above. Intergovernmental Resource Allocation Since the central and the local governments are equally parts of the public finance system, equity and efficiency considerations might be the key factors in deciding where to collect, how to reallocate, and in what channel to collect public revenues. In this respect, local taxes are altematives to intergovemmental 10 transfers, they are also alternatives (not supplements) to central taxes. In a decentralized world, local revenues (taxes, fees, and general transfers) represent a large share of public resources. As opposed to earmarked subsidies and discretionary transfers, taxes and general transfers represent one way of fiscal decentralization. The level of decentralization, however, is better signaled by the share of fees and taxes administered locally, although they may still be collected centrally. Hungary's decentralized municipal system is in contradiction with the low level of local revenues and high share of intergovernmental transfers. Local Revenues A key building block of a strong system of intergovernmental finance is a system of revenue raising that helps localities to finance the provision of services that are assigned to them. There has been a general sense in Hungary that the situation with respect to local taxes is unsatisfactory - yields are low in comparison with other countries and local autonomy over taxation remains limited. However, there is also concern about high overall levels of taxation and the need to reduce these levels of taxation in order to be competitive globally and within the context of the EU. There are two dimensions to the situation. First given the tight fiscal squeeze of recent years and efforts to reduce the deficit, it is felt that higher local tax revenue might reduce the burden of local expenditures on the State budget and therefore help to support the contraction. This is the fiscal argument for enhanced local taxation. Second, it is also argued that local governments do not take enough responsibility in raising the resources that they spend and therefore do not spend wisely. The quality and efficiency of financial management would be improved if mayors and councils had to make harder decisions over revenue generation and had to answer directly to taxpayers over the use of a higher proportion of the budget. This rnight be referred to as the accountability argument. [Bahl, R.: 1999] The fiscal argument implies that local taxation reforms should not increase the overall level of local taxation (but any increase in the local tax burden would be offset by a reduction in central government taxes). This could be achieved in a number of ways. One is encouraging local authorities to exploit existing local tax sources by levying taxes that they currently ignore, increasing designated tax rates and/or improving assessment and collection. As overall tax levels are already high, particularly in terms of direct taxes on individuals and businesses and latter is exacerbated by the high level of social security taxes. This means that any additional taxation should preferably be on consumption rather than on income and profits, and that further direct taxation should be selective and progressive in its incidence. Meeting the accountability objective requires a shift in responsibility from central to local government for deciding tax rates. This could be achieved by transferring taxes from the central to the local government or by reducing the rates of some national taxes to and allowing local authorities the right to use a surcharge. An important consideration is that if accountability is to be improved, the amount of revenue subject to local government discretion cannot be insignificant. This means that taxes selected for transfer to localities or for a surcharge need two attributes. First, they must raise substantial revenues, preferably 1 percent of GDP or more. Secondly they must be subject to local variations in rates - it must be possible for those administering the tax to identify the location of the payer and apply a variable rate and rate variation should have no serious distortionary consequences. The impact of local decisions should fall upon people within the jurisdiction, and not be "exported" to consumers or shareholders elsewhere. Shiftfrom Central to Local Taxation Hungary has been very progressive in introducing tax systems common in developed countries. Major impediments of both a technical and a political nature have prevented the country from enforcing the tax rules. The challenges of the accession to the EU and the lessons learned from the systemic inefficiencies 11 in the intergovernmental transfer system suggest that greater emphasis be placed on measuring local tax revenues. Three measures are likely to have the greatest impact on local government revenue: the value- based property tax, motor vehicle tax, and the PIT surcharge. First, the implementation of a value-based local property tax system has the potential to be a much stronger source of local revenue [Balas G. - Kovacs R.: 1999; Lados M.: 1994]. The current yield of property taxes is very low in comparison with other countries where these are levied. Comparisons with other countries suggest that a target yield of about 0.8 percent of GDP might be attainable and at such levels the property tax could raise up to 7 percent of local government budgets. However, implementation of a value-based property tax would need a major change in the current systems of assessment and support for development of the administration of the tax [Garzon, H.: 1998]. The current system of flat rates per square meter, varying only by land use and neighborhood, does not reflect differences in the market or rental value of real estate sufficiently to bear higher rates of taxation. The potential exists for improving the organization of information and implementing systems of mass assessment that could make the value -based property tax feasible. Consideration also needs to be given to the deductibility of local property taxes from national income taxation. Second, there is scope for increasing the intake from the motor vehicle tax. Based on comparisons with EU countries, there is a prima facie case for a gradual upward revision of minimum vehicle tax rates on: 1) the larger types of vehicles operating in international freight which will face the pressure of EU directives when Hungary joins the EU: 2) larger cars, in the interest of progressive augmentation of local revenues. The Government may also wish to consider allocating a greater share, and perhaps all, of this tax to local governments. Third, in order to improve local government accountability the Government may wish to implement a PIT surcharge [Davey, K - Peteri, G.: 1998/c.]. A change from PIT sharing to local surcharging would not require a major modification of existing procedure as far as the Government is concerned and the existing tax administration seems capable of managing the modifications needed. The main administrative burden would be on employers who would have to apply differential rates of tax to their withholding. It would be easier to introduce surcharging if the impact on both taxpayers and municipalities is neutral at a given standard rate. This would mean a reduction in the national level of PIT taxation and municipalities imposing a flat percentage surcharge on all PIT obligations. Municipalities would however be free to impose rates above or below the standard with consequent gains or losses to their budgets. This discretion might be total, or within a prescribed range either side of the standard rate. A shift to the PIT surcharge would increase local accountability, as the percentage of revenues subject to local discretion would rise from 28 percent to near 36 percent. It would also stabilize local governments' share of PIT yields and avoid the uncertainty and contention, which surround the present system of annual negotiation and decision. The System of Transfers The fourth building block of the system of intergovernmental finance is the system of transfers. Transfers between different levels of government help to address vertical imbalance that results from a mismatch between expenditure responsibilities and revenue raising capacity at local levels of government. The system of transfers also helps to address inequalities across municipalities or regions ("horizontal inequalities") that may result from the differing economic conditions and capacities of different regions. Key aspects of the system of transfers that influence the overall system of intergovernmental finance are its predictability and the equity and efficiency incentives that it creates for lower levels of government. The Hungarian transfer system can be summarized as follows: very large by international standards, ad hoc in both aggregate size and distribution and administratively complex [Fox W.: 1995, 1998]. The transfer structure has significant effects on local government accountability, incentives to raise local revenues, and 12 motivations to select the best investment projects. Generally, governments are held more accountable for revenues that they raise through their own sources and thus the large role played by transfers in Hungary implies less accountability. Unpredictability in the amount and allocation of transfers makes it more difficult for localities to plan and although there is a formula, it is highly complex and changes significantly from year to year. Hungarian local governments have disincentives to raise their own source revenues. One reason is that the small size of own source revenues means that big relative increases in local taxes have only a modest effect on total revenues. Local officials see little value in confronting the political consequences of higher taxes when effects on local service delivery will be limited. Another is that local governments have a disincentive to raise revenues if they believe that transfers will fall as a result. This negative tradeoff can occur in two ways. First, if all local governments raise more revenues, the central government can respond by lowering the amount of transfers and leaving the overall local sector with no additional resources. Local governments generally are apprehensive that the central government will respond this way, and are using it as an excuse not to raise own source funds. Second, in some cases there is a direct tradeoff between the revenues generated by specific local governments and their transfers. For example, deficit grants are a disincentive for local governments to impose their own taxes. The aggregate size of deficit grants is small, but many (and perhaps most) local governments receiving these grants are not using their maximum capacity to levy local taxes. Four aspects of the transfer system need to be addressed in modernization of the system [Davey, K - P6teri, G.: 1998/a.].: the determination of the overall amount to be transferred; the allocation of the total amount of transfers amongst localities; strengthening the system of investment grants and assuring that a mechanism exists for effectively using EU structural funds. Enhance Predictability of Current Transfers With greater fiscal stability in sight the Hungarian government might consider linking the overall size of transfers to fixed proportions of state revenues or public expenditures, preferably on a multi-year basis. The overall pool of resources available to local governments is determined by annual decisions by Parliament over the state budget for which there are no basic ground rules. Setting the share of local government grants as a percentage of major taxes, as is done in a range of countries (France, Japan, and Netherlands), would improve both the stability and predictability of the system. As an illustration, the 1998 normative grants equate with 21 percent of the combined estimated yields of VAT, PIT and Corporate Income Tax (a decline from 38.6 percent in 1992). Meanwhile, the proportion of the central transfers in the municipal revenues has hardly changed (fell from 74 to 68 percent). A range of possibilities exists for improving the system of transfers from introducing a system of block grants to improving the functioning of the formula. The most extensive alteration of the system would replace the present system of current transfers with a single equalization grant designed to compensate for both vertical and horizontal imbalances, including differences in expenditure need, service costs and revenue potential [Davey, K - P6teri, G.: 1998/e.; Horvath, T.: 1998 ]. Under such a model, PIT shares distributed by origin would continue to be paid to municipalities as at present (unless replaced by the income tax surcharge discussed above.) The rest of the current transfers (including the PIT equalization component) would be included in a block grant. The total grant would be divided by national population to yield a standard capita allocation, which would be attributed to each municipal area after adjustment upwards or downwards to reflect local variance from national norms in the major factors affecting local revenue capacity and expenditure needs and costs. One advantage of such an approach is that it would simplify the current system of grants (Table 2.4) by folding into the same mechanism the PIT equalization component, earmarked operating grants and deficit grants. It would also clarify the determination of allocation by simplifying the basic formula used to 13 allocate grants. An additional advantage of this approach is that it could be varied either nation-wide or in each area to cover the introduction of districts or regional associations. For example, if five municipalities form an Association, their respective adjusted per capita allocations could be divided between them and the association according to their respective shares of their combined expenditure. If more extensive change is not feasible, the Government should implement alterations to improve the system of current transfers as it now stands. One aspect of this is simplification of the current formula. A simplified grant formula could make revenues more predictable and could reduce administrative costs. Revenues would also be more predictable if the grant formula was developed and left in place for several years and if the factors used in the formula were not changed on a yearly basis. The formula could have the basic structure of G = r (E-R), where G is the grant amount, E is a limited number of expenditure needs, R is revenue capacity, and r is the amount that the grant rises and falls with capacity. The normative system currently operates like part of the equation, where the E reflects the different normatives and the r is the values assigned to each normative [Davey, K - Peteri, G.: 1998/d.]. The Government has recently introduced a measure of revenue capacity into the formula. A key difference from the existing system is that a much smaller number of expenditure need indicators would be included in the formula. Table 2.4 Categorization of Grants Local Control Over Funds Financing Source Earmarked Flexible Ad Hoc Theater Deficit Grants Fire Brigade Most Normatives Ethnic Education Normatives Centralized Appropriations Most Extra-budgetary Funds Accumulation revenues inside the state budget Funds from budgetary institutions Shared Tax Road Fund Derivation Based PIT Land Tax Motor Vehicle Tax Selected Normatives Source: Hegedus, J., 1998 A second area for moderate change involves deficit grants. Any incremental changes to the system should aim to minimize if not eliminate the use of this grant, given the adverse incentives that it creates for local govermments. In 1999, more than 30 percent of municipalities applied for deficit grant and the total amount requested quadrupled in one year. The combined system of local revenues, grants and revenues shares should be arranged so that deficit grants are needed only in the most exceptional of cases and not as a regular form of financial transfers. Strengthening of the System of Investment Grants The system for financing investment grants is highly fragmented, has substantial administrative costs and creates incentives for localities to focus the bulk of their efforts on obtaining grants from the center as opposed to increasing their own source revenues and improving budget management [Hegedus, J.: 1996]. The most extensive option for the government to consider in improving the system of investment finance would be to pool all the resources currently allocated to investment grants into a single investment grant mechanism to which all localities would apply. Such a consolidated approach would allow more consistent selection criteria across sectors and would help to assure that resources are allocated effectively. Tighter selection criteria and more detailed review processes should be developed by the national government to ensure that selected projects are economically viable and are the highest priority. 14 The number of applications must be reduced if the review is to be more than cursory and tighter application criteria can be an important step in this direction. For example, limitations could be made more stringent on which local governments or projects will be considered for targeted grants. Second, local financial contributions, a frequent expectation of Hungarian grants, must be large enough to ensure that local governments are forced to consider the economic costs of each project. In practice, the local government's matching share is often very small, causing access to national financing to dominate local decisions on which projects to consider. A more moderate, but similar route, is to continue to strengthen the implementation of resolution on harmonizing the investment grant allocation across ministries. More is needed in order to improve the coordination of information and evaluation of projects. At this point Ministries have different willingness to cooperate in the disbursement of grants, with some wanting an improved process and others wanting to maintain their independent ability to influence the grant making process. Under any reform scenario for capital grants, the Government will need to strengthen the monitoring system for execution of the grants. Enhance Ability to Absorb EU Structural Funds A mechanism for receiving and using EU structural grants must also be put in place. An effective system for investment grant allocation and development of regional strategies is a major expectation of EU entrants. To meet this requirement, Hungary has taken the initial step of forming a regional development structure. The structure is still in its infancy, so the responsibilities and working methods of these organizations are not fully delineated. As with domestic investment grants, good use of EU structural funds requires a method for identifying optimal investment projects. The existing complex, disjointed system for selecting the specific projects to be funded is unlikely to lead to optimal choices. Greater reliance on local revenue sources including user fees, stringent evaluation of projects in terms of economic viability (cost benefit analyses, etc.), and tighter application criteria (to reduce the number of applications) would all enhance the prospects for receiving EU funds project selection process and increase the chance that EU structural funds would be targeted to the highest priority areas and would be used for the best projects Paths to Further Modernization of the Intergovernmental System The various components of the system are highly interrelated and are particularly influenced by political and institutional factors. Making changes to one part of the system invariably has an impact on other areas, which may or may not be intended. So while changes may be made in each of the above areas individually, a more effective approach to addressing intergovernmental finance issues is likely to be the development of a coherent program of changes that can be implemented over a four to five year period. Here we draw together the findings and recommendations discussed above to lay out some potential options for the path ahead. In each area discussed above, the options for reform can be viewed from the perspective of a spectrum: ranging from minimal change from the current system to extensive or more radical change. Given the number of areas and the range of possible actions in each area there are a wide variety of possibilities for moving the system forward. The Government thus must respond to a series of choices that it faces, which in turn affect the system as a whole. Here we will consider three possible alternatives as illustrations: Extensive Change; "Moderate Change" and "Minimal Change". 15 Extensive Change In the "extensive change" path, the key starting point is the determination of the appropriate approach for strengthening the intermediate level of government. In this case, the government amalgamates on a functional basis the many small cities in Hungary into larger units that are able to deliver services more efficiently. It results in precise definitions of the levels of governments and specific assignment of expenditure to each level. In Hungary's case the choice might be made to further strengthen the new regional levels of government developed under the Regional Development Act (in continuing the 1999 November amendment), or to reinvigorate the role of the counties. Such a change would clearly require revisiting the legislation to set out revised structures and responsibilities and also to assure consistency between general and sectoral laws. Assignments would also need to be determined in a way that clarifies the roles of the various levels of govermment in service delivery (e.g. which level is the appropriate one for setting standards and regulating, which for service provision, which for monitoring performance, etc). With new expenditure assignments set to correspond to amalgamated localities, it also becomes necessary to adjust revenue assignments. As a start, the government would need to replace the current derivation- based component of the PIT tax sharing, with an income tax surcharge provided to localities and also potentially to a regional or county level of government. Alternatively, each level of government could have a surcharge on a different tax, for example, municipalities might have a surcharge on the PIT, counties a surcharge on the motor vehicles tax, etc. The important thing is that each level of government has a source of "own revenue". Under such a system it would be desirable to try to develop a value-based property tax, although it is important that there is some degree of oversight to assure that the overall tax burden does not increase. While such a system would create a better balance between the revenues and expenditures of local governments, an equalization grant would still be needed. In this "extensive change" case the amount allocated through the system of grants would be based on a fixed share of revenue overall or of specific taxes in order to assure that transfers to localities remained stable. The current range of grants would be consolidated into one simple equalization grant based on adjusted per capita allocations as discussed above. Such a system could be developed based on detailed analysis of the most appropriate indicators of expenditure need and revenue capacity. The extensive case would also move the system of investment grants toward a consolidated pool of funds in which decision on grants are coordinated across sectors and based on closer scrutiny and allocation to those activities with the highest rate of return. Pursuing such a path would basically address the fragmentation that currently exists in the system and would rebalance the revenue side of the intergovernmental system to give more weight and accountability to lower levels of government. That being said, the system would be more rigid in terms of assignments and service delivery and amalgamation of localities is likely to prove politically difficult. Nevertheless such measures would improve both the predictability and stability of the system - important objectives for moving the system forward. Moderate Change In the "moderate change" case there continues to be a substantial number of very small localities that try to increase the efficiency of service delivery through the creation of special districts or municipal associations, development regions and the like. As was discussed above, there are many such associations developing in the current system. This reflects what might be called a "bottom up" strategy although the center may maintain relatively tight control over activities through regulation, monitoring and through financial support to the process. 16 Such an approach requires Hungary to develop the legal and fiscal mechanisms to support cooperation among different units and to support units of different sizes. Such associations need to be given status as legal entities so that when the circumstances are appropriate they are able to create and sign contracts, put up collateral for borrowing, receive grants and under some circumstances perhaps even collect tax revenues. It is particularly important that the legal framework fully supports the transparency of public procurement and pricing decisions so that a different service provider has the information to operate effectively. This approach also requires more flexibility in terms of expenditure assignments because different units of different sizes will deliver different services. While this makes the system administratively more complex, it has the advantage of supporting greater competition and better overall resource use. In this "moderate change" scenario the most important factor on the revenue side is to assure that municipal associations, special districts and the like are in a position to have some source of own revenues. In many cases this may be accomplished through direct cost recovery, but implementation of an income tax surcharge, potential other surcharges, increases in the motor vehicles tax and development of the property tax are an important component of this alternative as in the "extensive change" case. For municipal associations and districts to be accountable for a specific source of revenue over which they have some control is essential. Under the "moderate change" scenario it would be possible to replace the current system of transfers with a single block grant as discussed above and transfers could be provided to associations and the like based on their share in provision of a given service. Alternatively, it would be necessary to streamline and revise the current transfer system so as to use a simpler formula which relies more on need based measures (rather than user based measures) and to strengthen the use of revenue capacity. In addition, it would be essential to make it possible for municipal associations, special districts and the like to receive grants directly rather than indirectly through the constituent municipalities of the association. With respect to investment grants, there is also a need to improve the direct access of associations to such grants. Under the "moderate change" case it is unlikely that consolidation and unification of the current investment grant system would be possible, so efforts would have to be made to strengthen the current mechanisms including tighter selection criteria and more detailed review of projects on the basis of economic and social criteria. The government may also wish to change the allocation criteria to emphasize achieving economies of scale to a somewhat greater degree than it does now in order to encourage associations. Pursuing this path would not do much to help address the administrative complexity of the current system. Units of different size and organization would provide different services and therefore such a system is more difficult to manage and does not resolve the issue of improving the clarity of expenditure assignments. However, the flexibility of such a system is likely to make it more responsive to users and in theory should improve overall resources allocation. Such an approach also has the important advantage that it is much more participatory and to a certain degree less politically difficult to implement. The key aspect of pursuing this route is to make sure that associations and districts have the legal means and fiscal resources to carry out the functions that are required of them. Minimal Change A third potential route is one, which more or less preserves the status quo and implies little in the way of any changes. No institutional or structural changes of the system are envisaged under this path. There would be some passive/reactive establishment of legal mechanisms for supporting the evolution of associations and voluntary regions as they now exist. There would also be some attempts to address at least the most egregious inconsistencies between general laws and sectoral laws. As a very minimum, 17 public procurement contracts should be made accessible in order to encourage transparency and further development of contracting out as a means of service delivery. In terms of expenditure assignments some attempt should be made to reconcile existing legislation and to clarify the relation between the mandatory and voluntary assignments. On the revenue side, the minimal change case still envisages greater emphasis on increasing own revenues, through the further development of the property tax, although it is expected that the implementation of a value-based system would take not be as rapid as under other scenarios. Motor vehicle taxation would also be increased to improve own revenues. With respect to transfers, even without institutional change there is a strong need to simplify the system and reduce the number of normatives in the fonnulas currently being used. More generally the normatives need to be reduced and better focused in order to reduce the administrative burden placed on localities. In addition, it would be desirable even in this framework to provide countries as service units governments with access to an own source revenue and to support existing associations by allowing them to receive grants too. On the investment grant side, efforts need to be made to strengthen the allocation mechanism in order to make allocation of investment grants more coherent and effective in terms of achieving Hungary's objectives. While minimal change may have some marginal impact on the system it is unlikely to address some of the larger underlying issues in the system of intergovernmental finance in Hungary, such as fragmentation of the system, imbalance between expenditure and revenue assignments and an ad hoc system for the allocation of investment grants. To address these underlying issues it is necessary to take some of the bolder steps outlined above. 18 III. Strengthening Local Management Capacity Since the early 1990s, breadth of new local government responsibilities and reduced central government funding has put heavy pressure on municipal budgets. Most of the local governments have managed to keep balanced budgets because they have reduced their expenditures, increased their own revenues (mainly from asset sales), privatized and contracted out services, and increased the efficiency of their operations. Local governments have virtually eliminated local budgetary surpluses, reduced capital investments, under-financed the maintenance of municipal assets, and have only partially utilized local taxes. The increasing role of locally administered revenues has deepened the disparities between large and small, urban and rural municipalities and across geographic regions. There are huge differences among innovative, progressive municipalities and those, who lack expertise and "enterprising" spirit among local decision makers. These two groups of municipalities might help each other if there are properly organized institutions and procedures for information exchange, professional cooperation and joint policy design. Institutional, Legal and Regulatory Framework for Service Delivery According to the 1990 Act on Local Governments the 3200 municipalities are similarly mandated to provide all kinds of local services in compliance with the main democratic objective of fiscal decentralization. However, local public services are in practice provided by the state, by counties, by cities with regional competency, regional associations of municipalities, and within the municipalities by divisions of the mayor's office, local budgetary organizations (e.g. schools, hospitals), public-private companies, private entities, and NGOs (e.g. churches). Local governments are also mandated to be the basic regulators of local services in compliance with the national legal and regulatory framework. National regulations, however, go far beyond the role of protection of national standards and support of national priorities. They often determine the financing input factors while providing on average 70 percent cost coverage even for the mandatory services (known as quasi task-financing). From the perspective of the municipalities, the present legal and regulatory framework creates serious impediments to improved cost efficiency. Inconsistency of Regulations Efficient use of resources is limited by contradictory and overwhelming regulations concerning service delivery. Today, almost 67 percent of local government expenditures in Hungary are dedicated to social services such as education, health, and social care [Peteri, 1999]. These services are provided through local budgetary organizations and are subject to national rules and regulations over which local governments have little or no control (see chapter II). As a result, the process of local fiscal adjustment in these sectors is contingent upon numerous, sometimes conflicting, unachievable, and/or frequently changing sectoral rules, regulations, and policies of different ministries. For instance, the regulation on salaries dictates to local governments to increase the minimum level of salaries for public employees without providing incremental financial resources. Local governments fail to comply with the ever-increasing number of government regulations on local services. This indicates that their institutional capacity is no longer sufficient to keep up with increasingly complicated regulatory framework. It also points to the fact that the current legal process does not sufficiently take into account local needs and incentives. In the housing sector, for instance, housing still remains subsidized by municipal budgets due to restrictive central government regulations that prevent municipal authorities from raising rents and tariffs to cost recovery. Municipalities frequently disregard some regulations under the pretext of insufficient resources. While sectoral transfers are generally 19 earmarked for certain services, the pressure on local governments to provide services differs across the sectors owing to the rigidity and enforcement of sectoral regulations. As a result, in practice, local governments frequently draw resources from less rigidly regulated sectors such as social services or housing to cross-subsidize the provision of politically more sensitive and more tightly regulated services such as education. Grant-to- Cost Ratio versus Local Needs Local governments are assumed to strictly follow local Box 3.1 Conflicting Rules in Education service priorities and, if required, supplement central In the education sector, the normative grant allocation grants accordingly. Despite some recent increase in rules prescribe the maximum number of students per emphasis on local priorities, local resource class, which rises from 21 in grades I through 6 to 30 in grades 11I through 13. This formula causes problems management and service delivery are still excessively for schools, because in practice, the number of students determined by the system of grants. The overall per class drops in higher grades. The regulation economic response of local authorities to changes over particularly hurts schools in smaller settlements with time in the transfer allocation rules and reduced limited possibilities to reorganize their operations or to government transfers has been mixed. On the one raise extra funds. The essence of the problem is that the govemment transfers has been mixed. On the one allocation of normative grants also follows the formula hand, many localities discontinued or minimized the defined by the law, which in turn translates into the provision of services with low grant-to-cost ratios. number of classes organized or the number of teachers Local capital investment is also largely driven by to be hired. As a result, lower grades are consistently access to targeted grants. On the other hand, there is underfunded, while the provision of education in some evidence that despite financial difficulties, local higher grades is overfunded. Yet, neither the schools some evidence that despite financial difficulties, local nor the localities have the flexibility to make the government spending has been on the rise in sectors of needed internal adjustments. high local priority (e.g. primary school), despite reduced central government funding. The response of local governments to the grant allocation system can be described as optimal when they discontinue or minimize the provision of services if both the grant-to-cost ratio and the local priority in question are low. However, grant-to-cost ratios can be low, not only because of insufficient grant financing but due to over-capacity or bad management. In cases in which municipalities discontinued the provision of services that were badly needed by the community, but received insufficient grant financing, their economic behavior can be considered distorted. An extension of this type of distorted behavior occurs when municipalities reduce the scale or quality of important local services, typically by neglecting adequate maintenance or renovation work. For example, in the early 1990s, instead of downscaling, they closed nursery schools due to the lack of grant financing and partly because of a decrease in the number of eligible kids. Another form of municipal response to low grant-to- cost ratio for certain local services has been to Box 3.2 Inconsistent Decisions or Local transfer the responsibility for the delivery of these Priorities? The city of Tatabanya transferred the operation of the services to the county level. In principle, vertical hospital, two high-schools, and a youth hostel to the rationalization of local service delivery is a good county, but it decided to continue the operations of a step. In practice, however, this does not comply with sports facility and the local archives, and it opened a a regional strategy hence may result in a lower new higher education college. While the city of quality of services. Fr st,itis a one-sided deision of Szentes where the education services overburdened quality OI services. First, it iS a one-sided decision of the local budget, the municipality still preferred to a municipality aiming at - getting rid of an continue to finance high-schools rather than transfer underfinanced institution. Second, a county today them to the county. has usually less disposable funds required to I supplement the insufficient current transfers received from the central government. Variation in local government response to central government transfers can be explained, at least partially, by the rigidity of grant allocation rules. From the local governments' point of view, grants can 20 be characterized mainly at the level of spending flexibility. The two extremes of this characteristic are general purpose and earmarked grants. The larger the percentage of grant distributions that falls in a formula-driven earmarked category, the more rigid the grant allocation system, and the more distortion its effect on the local resource allocation process. From 1993 to 1998, there was a significant shift from a general-purpose grant allocation system toward a more rigid task-financing system. While in 1993, 37.3 percent of all grants were unconditional general-purpose grants, in 1998 their share dropped to 23 percent. As a result, municipalities now have very few disposable revenues. Although, the nornative grants are not earmarked by law, in the practice local service organizations claim "their share", which is provided by the national budget. The current design of a special "deficit grant" program provides another example of an impediment to the fiscal adjustment process at the local level. A municipality is eligible for a deficit grant if its revenues prove to be insufficient to cover the local mandatory services. This grant program is widely seen as distorted for encouraging many local governments to seek a solution to their fiscal problems by claiming "deficit grants" rather than through local fiscal and structural reforms. Although the amount of deficit grants remains relatively small (around 0.1% of GDP in 1997), the number of local governments applying for these additional grants has increased to almost 30 percent of all municipalities in 1999, indicating serious flaws in the current design of the transfer systein (see section II). Large Disparities in Service Coverage Although, they are not statistically Table 3.1 Special Services in Sample Cities representative, the city case studies carried n Or Sze Tb Nk Szo out under the SNDP indicate that there is a Higher education s s s s good degree of variation among local Swinmung pool + + + + governments with respect to the coverage Public transport + governments ~~~~~~~~~~~Hospital + c c c c of services and in the range of special Elderly home E:+ + services delivered by local govenmments. Elderly care + + + + Table 3.3 indicates some large differences Housing allowance + + Recreation + + + + + in urban infrastructure service coverage. Archives + For example, 3 of the six cities considered Theater + =_ cover only about one-third of the Comnmunity Art Center + + + + + settlement with sewer services whereas Fire-fighting + + + + + + Libtary + ++ + three of the cities the settlement with cover Museum + + three-quarters of sewer services. In gas s\ Service provided by the State, c\ by the County; the blank boxes supply and garbage collection, there are indicate services in non existence or provided beyond the city border Pu: Puspokiadany, Or: Oroshaza, SZe: Szentes, Th:Tatabanya, Nk: varying degrees of coverage, whereas in all Nagykanizsa, SZo: Szolnok cities, about two-thirds or more of roads Sources: Local Governments Program; Ministry of Interior, 1998 are taken care of by the city. There are three major factors behind these figures: (i) inherited service networks from the "socialist industrialization" (Szolnok, Nagykanizsa), (ii) successful navigation on the cobweb of investment grants; and (iii) local priorities including significant citizens' financial contribution in network investments [Jokay et al. 19991. 21 Table 3.2 Urban Infrastructure Service Coverage (1996) Oros- Szolnok Tata- Nagy- Piispok- Szentes National nahza b§nya kanizsa ladiny average* Sewer in house 32.4% 76.3% 81.8% 76.2% 25.9% 33.0% 47.4% Gas supply 76.7% 80.1% 11.5% 100.0% 52.0% 67.7% 60.4% Covered roads 60.4% 75.9% 94.7% 87.0% 66.7% 81.1% 63.7% Garbage 74.0% 960% 100.0% 99.2% 20.3% 75.5% 76.7% collection While the six cites selected for an SNDP study are not representative of all Hungarian cities, they provide a good spectrum of sizes, economiic and social characteristics, and geographic locations. They also differ in terms of their economic policies and management capabilities. Two of them, Tatab'nya and Szolnok, are county capitals with more than 70,000 inhabitants. Tatabanya, Szolnok, and Nagykanizsa also have county rights, which puts them among the 23 most important cities of Hungary. The other three cities of the sample are small- or medium-sized. Oroshaza and Szentes have close to 35,000 inhabitants, and Piispdkladciny has 16,000. [Sebok - Kovacs 1999, and Meszaros - Pata,i 1999]. */ National Average of Cities. Source: Central Statistical Office County Yearbooks, 1997 Differences exist in the provision of special services. Nagykanizsa and Szolnok provide a wide range of special services, whereas, other cities offer a more limited range (Table 3.1). Part of the explanation of the above differences is that in the mid 1990s, changes in the organizational forns of local service provision started taking place under the influence of (i) sectoral laws that introduced new local service responsibilities, (ii) tax incentives for private service providers, and (iii) local lobbies advocating alternative forms of service delivery. Alternative Organizational Forms in Service Delivery Hungarian local governments have been very innovative in introducing alternative forms of service delivery. This has played a key role in reducing the size of the public sector while maintaining or even enlarging the scale of local service delivery. Improved cost efficiency and better quality of services are usually the mnain rationale for experimenting with different institutional vehicles, in some cases, other objectives are no less important. The latter are usually driven by the attempts of local governments to avoid coverage by certain government regulations (e.g. public procurement rules), which can be achieved by changing the institutional structure of the service provider. For instance, municipally owned service provider budgetary organizations are subject to government cash-accounting rules and cannot obtain refunds from the VAT. But, a service provider structured as an independent company can obtain a VAT refund (this itself makes possible a 20 percent cost saving) and, in general, receives a more favorable tax treatment. Such companies also enjoy a greater degree of flexibility, which enables them to avoid profit taxation through cross-subsidization of services. New forms of service delivery include limited liability companies, foundations, and public corporations owned and controlled entirely by the local government. These units operate outside of the local government administration and are exclusively subject to laws and regulations applicable to private companies. Their business plan is subject to approval by the local assembly, which also appoints the manager, however, local government assemblies and officers are powerless in controlling the management of municipal enterprises. Typically a limited liability company with municipal ownership serves as an umbrella organization, providing a wide range of services. Among others, it has the authority to prepare proposals for fees, tariffs, and user charges (subject of the approval of the municipal assembly). The main concerns with this form of local service provision are that it is frequently used for cross- subsidizing certain activities in a non-transparent way, allows avoidance of profit tax, and may expose them to commercial risks. For example, it is typical that the rents from non-residential property are 22 subsidizing residential rents, which may divert the attention of the local administration from achieving cost recovery in the housing sector. The local government budgetary service organizations (e.g. schools) have their Traditions are Boxy3.rNGg s in Service Traitins revery strong in municipal service provision, own personnel policy, the right to meaning that the local goverunent units prefer to provide subcontract, and the right to use services themselves. One reason is that the image of the municipal assets under their management "caring" local government lives on in the minds of citizens. in the way that they see fit. They can also The other reasons are that they can directly influence the seek external funding and can even start service provision itself. Therefore, local governments and some entrepreneurial activities. While the their institutions tend to establish their own quasi-nonprofit local government assembly appoints the forms (i.e. public foundations), that then will be in director of such an institution, there is a competition for clients and donors with the other service very vague operational control in the provider NGOs. This presents a serious challenge for "real" hands of the local administration. hI NGOs locally. [Agh et al. 1999] general, local government budgetary service organizations account for 60 to 70 percent of total local government spending, which means that the efficiency of local governments very much depends upon the right incentives being given to these entities. In their efforts to reduce the costs of local service provision, local governments also have taken advantage of various competitive contracting-out opportunities. They are regulated to comply with the new procurement standards, modeled after the standards set forth in EU procurement directives [Baar 1998]. In 1997 alone, the Hungarian municipalities awarded 135 billion HUF in contracts through tenders, which amounts to almost 15 percent of their gross expenditures. Public service providers also awarded tenders in the amount of HUF 81 billion. In addition, an unknown amount of contracting out was done without tenders or through procedures not governed by the national procurement act. The general experience is that contracting out results in a more cost-efficient delivery of local services, while usually not providing for a sufficient local government control over the service providers. Privatization, BOT or management contract type arrangements are not commonly used yet. In cases in which significant capital investments are required, such as refuse collection or water services, the role of these forms of service delivery will increase. By 1997, for instance, three big cities (Budapest, Szeged, and Szolnok) contracted out water services, which account for about 10 percent of all water services in the country. These undertakings are being closely scrutinized by other local governments because of their somewhat mixed results. In Szeged, for instance, the problems stemmed from a weak local government capacity to evaluate long-term service contracts and relatively undeveloped legislation on the BOTs. However, there are good examples of contracting out water services as well (e.g. Kaposvar). Box. 3.4 The Six Studied Cities Indicates Big Differences Local revenues have declined in real term in Puspokladany a backward rural region by 40 percent, while the industrialized Szolnok lost only 18 percent. In the context of rapidly decreasing revenues, mainly due to a large drop in central transfers, the mobilization of local revenues, mainly asset sales, has become an important survival strategy for many local governments in Hungary. The main objective of these municipalities still is to obtain necessary resources to finance the provision of local services without overburdening local taxpayers and taking unjustified political risks. In many respects, complying with the ehgibility criteria for central grants became an important revenue generation strategy at the local level. [USAID/MRI/WB city Case Studies 1999] Financing the Delivery of Local Services: Local Revenues From 1993 to 1998, local government revenues nationwide decreased in real terms by more than 20 percent. The ability of local governments to raise more resources is in many respects determined by (i) 23 their authority to introduce local taxes and user fees, (ii) their political will to levy local taxes and increase user fees, and (iii) the local capabilities to administer local taxes and fees. Also, at least in the short-term, the local revenue generation process is a function of municipal asset disposition policies. Local Taxes Local Governments can make greater use of their taxing and rate setting authorities. Although Table 3.3 Relation of Average Tax rate to Maxdmum Rate Set by Central it is the central government that -Government in S lected Munkicpalities (%) has the authority to establish local taxes and joriy proedrablsh Local Taxes 1991 1992 1993 1994 1995 1996 1997 local taxes and major procedural_ _ _ regulations with regard to user Tax on Buildings/a - 16.6 16.6 16.6 30.5 17.0 17.0 fees and charges, it is local governments who have the Tax on Plots/a 10.0 15.5 15.5 15.5 7.5 7.5 discretion to make use of them _ and set the rates within the range CommunalTax/b 100.0 100.0 100.0 100.0 100.0 100.0 established by the law. In this sense, local governments have Business Tax/C 100.0 66.6 71.9 84.4 95.8 77.7 86.1 some degree of autonomy with a Tax on buildings and tax on plots are per sq. m., commiunal tax is per employee, regard to local taxation and rate ICbusiness tax is a percentage of revenues setting. However, there is a great Source: Garzon, H. 1999 deal of variation in the local governments' taxation and revenue raising policies. Some local governments levy all the taxes and use all of the rate setting possibilities they legally can; others levy no local taxes or choose tax rates well below the maximum rate allowed by law (Table 3.3). Despite ample room for additional local taxation, there is general recognition that overall tax levels, particularly business taxes, are already high in Hungary and are becoming an impediment to business development and the creation of new jobs. Indicative of this situation is that in the last few years, the share of municipal revenues from the local business tax, levied on the net turnover, was higher than that from the personal income tax. There is a widely held view that any additional taxes, including local taxation, should preferably focus on wealth rather than on income or profits and should be selective and progressive in its incidence, falling on those best able to pay [Davey, K. - Peteri, G.: 1998]. Fees and Charges Fees and charges on services that are not contracted out have been declining and Local governments will need to make a greater effort at cost recovery. In the case of municipal user fees and charges for services other than those that were contracted out, during 1993 to 1998, the significance of these sources of revenue for municipal budgets has been rapidly declining. While revenues from local user fees and tariff revenues accounted for 61 percent of locally generated revenue in 1993. By 1997, this share dropped to a mere 46 percent. In the case of the six cities selected for the study, only one city, Szolnok, managed to raise the share of tariff income in local revenues from 32.4 percent to 50.3 percent (Table3.4). In contrast to their limited taxing authority, local governments in principle have full discretion to set their own tariffs. The tariff setting process varies a good deal around the country from a situation of "no local control" to a limited decision-making authority. There are also services in which practically no state control exists, such as rentals for non-residential space. In the case of a typical municipal company, user 24 charges are, without pro forma pricing rules, generally agreed upon by the board of directors of utilities or other public service providers in which the local government is the main owner or shareholder. Table 3.4 Tariffs, User Fees, and Charges for Six Cities as a Percentage of Total Locally Generated Revenue, 1993-1997 Oroshaza Szolnok Tatabanya Nagykanizsa Piispok- Szentes National ladany Average 1993 47.59% 32.39% 44.68% 72.05% 54.53% 35.94% 61.08% 1994 57.87% 49.10% 30.19% 70.71% 41.42% 43.56% 58.72% 1995 42.93% 43.53% 36.47% 62.83% 71.53% 30.16% 54.75% 1996 36.88% 48.75% 30.54% 51.95% 67.66% 24.62% 46.13% 1997 38.62% 50.31% 13.06% 50.75% 44.79% 16.75% 46.15% Source: Local Govemment Program, Ministry of Interior, 1998 The table is computed by dividing operating revenuesfrom municipal service providers by total municipal operating revenues. Tariffs on major municipal services have remained virtually flat in real terms, thus flagging potential problems with financing the replacement of dilapidated infrastructure and the mounting pressure on municipal budgets. Typically, municipalities set user charges at a level that does not provide for the coverage of replacement costs in the expectation that those costs would eventually be financed by central government grants. In Nagykanizsa, for instance, the charge for garbage collection covers the operation costs and administration of services but excludes depreciation costs. The cost of new investment is the responsibility of the municipality. The case of Nagykanizsa is not unique. Generally, the utilities cover the costs of maintenance and operation, while reconstruction and capital financing remain the responsibility of the municipality [Jokay et al 19981. While tariffs remain below the cost recovery level when capital costs are taken into account, Hungarian local governments and private providers of public services enjoy an exceptional level of collection, which over the last few years was as high as 94 percent. Another indicator of good payment discipline in municipal services is a low level of household payment arrears to service providers, which over the last 5 years remained relatively flat or decreased in real terms. Nevertheless, arrears continue to be an issue in low-income urban areas, where improvement in collection cannot be achieved without special programs. Sustainability of Local Revenues The analysis of the revenue structure of Hungarian municipalities over the last five years reveals that while recurrent revenues dropped by almost 10 percent between 1993 and 1998, this drop was mostly offset by a substantial rise in capital revenues from asset sales, which started to subside in 1997. Capital revenues have become fairly important for the cities analyzed in the case studies. In 1998, Szentes and Tatabanaya derived almost 26 percent to 30 percent of their total revenues from capital revenue sources, which are comprised of revenues from asset management, sale of assets, targeted subsidies from the central government for capital outlays, and, in a few cases, bond issues. However, reliance on sales of municipal assets is becoming less sustainable. A recent precipitous decline in local revenues in Puspokladany was the outcome of reduced capital revenues from asset sales. If local recurrent revenues from taxation, tariffs, and user fees remain flat, as they have been over the past few years, the continuing decline in capital revenues will soon translate into a rapid deterioration of local governments' financial performance. Several policy implications emerge from the analysis of the local revenue structure. First, the current financial situation suggests that local governments need to look for alternatives to capital financing, different from sales of municipal assets, which is no longer sustainable. One obvious strategy for local governments is to strengthen their recurrent revenue sources. This, however, requires making much 25 greater use of local taxes and modernizing them. For instance, the property tax is based on the physical size of the properties rather than on their market value. In addition, the property tax is levied on non- residential properties only. In addition, the vehicle tax, which is a national tax shared with local governments, is based on the weight of the vehicles rather than on their market value. More importance should be given to user charges, fees, and benefit levies for locally provided services. To the extent that local governments are free to set such charges, they should be strongly encouraged to do so. Introduction of an income tax surcharge can also provide an important stimulus to local fiscal effort (see section II). Tax Administration Capacity Tax administration capabilities of local governments need to be strengthened. The ability of municipal governments to raise more revenues locally is in many respects determined by their tax administration skills, i.e., identification of tax payers, tax assessment, tax collection, and enforcement capabilities. In principle, taxpayers have the obligation to register and report their tax obligations to the local tax administration. This is the case for the tax on building, the tax on idle urban land, communal taxes (on private individuals and entrepreneurs), the tax on tourism, and the tax on business. The same rule applies to the owners of vehicles, who are responsible for a vehicle tax. In practice, however, the responsibility of self-registration is not fully effective as not all owners comply. The number of potential local taxpayers or taxable assets is generally unknown. Tax administrators are supposed to determine the tax liabilities for every taxpayer for each one of the local taxes. In practice, this step usually requires a verification of the self-assessment submitted by the taxpayer for the particular tax. The current tax on buildings requires the verification of the size of the properties rather than their market value. This verification has to be done at least once directly in the field. The same applies to the tax on idle urban land, which is also based on size rather than on market value. Out of 3200 Hungarian local governments, only two municipalities-Nyiregyhaza and Nemetker-use market valuation data in deterrnining local taxes levied on business properties. Tax arrears, an important indicator of tax collection, fluctuate broadly from one municipality to another. In the cities surveyed, they ranged from 11 percent of current local tax revenues to 2 percent [Garzon, H. 1999]. It should be noted, however, that arrears refer only to those of taxpayers who have made partial payments of their tax obligations. They do not include the arrears of those who are registered but have made no payments at all or those who have not even registered. Therefore, the potential magnitude of unpaid tax obligations is greater than the arrears reported by the cities. In general, the sanctions for non-payment are strict. The first sanction for a non-payment is to levy a delay fine. In principle, a failure to pay after a certain period may be sanctioned through the immediate collection of the total tax due, and if this does not work, the procedure for withdrawing a business license may be initiated. For the vehicle tax, the sanction is the cancellation of the vehicle's registration plates. For communal and building taxes, the possible sanctions are the garnishment of benefits, wages, and pensions, or the confiscation of mobile assets. In cases involving large amounts of tax arrears, the taxpayer's property can be mortgaged or the local government can file a foreclosure request. In practice, however, these sanctions have rarely been used in any of the studied cities. The major constraints on local tax administrations are the shortage of qualified staff, weak computer capabilities, and tax collection expertise, which reduce the effectiveness of tax collections. In a sense, tax payments to local governments become practically voluntary. Frequently, there seems to be a lack of commitment by the mayor's office to strengthen the local tax administration. There are no support agreements between municipalities to learn from one another's experiences. Each local tax administration develops its own collection and verification techniques. Finally, political will does not seem to be strong to improve collections by enforcing payment discipline. It is clear that more revenues may be mobilized at the local level through more effective tax collection and better enforcement. There is a need for greater 26 support of local tax administrations through the training of local staff and the modernization of computer equipment. Strengthening Management at the Local Level Significant achievements and a steady learning curve occurred in the field of municipal management over the last two decades. Locally managed investment programs have been carried out since the early 1980s (e.g. water, telecom and gas supply development associations joined the financial efforts of local governments and the citizens to improve their local living circumstances). In 1990, municipal governments became elected self-governing bodies and received full mandate and responsibility for: developing and implementing local strategies (including urban development and physical planning); managing local fiscal and financial issues; exercising ownership rights over local public assets; providing virtually all local public services; and regulating and supervising local public services. Municipal governments are also the deconcentrated units of the public administration system. Success in improving the effectiveness of service delivery, increasing local revenues, and responding to the local challenges is conditioned upon having the necessary capacity to manage these activities at local level. Needfor Local and Regional Development Strategies The capacity to create and implement local development strategies needs to be augmented. Municipal strategies and development programs should be ideally linked to the strategies of the respective small and big regions, however, these strategies have not been used in Hungary so far. Municipal strategic plans should determine key priorities and serve as conceptual framework for their medium and short-term economic plans, from which the annual budget plan can be derived. Currently, three types of planing documents are mandatory at the local level. Local governments are required to produce a long-term urban development strategy and zoning regulation [Baar - Locsmandi 1999] in compliance with physical planning regulations (Act LXXVIIIV 1997). The strategy is then used as a basis for developing a four-year economic plan to be ideally approved after the municipal elections. The Act on Public Finances also requires that a "rolling" plan should be prepared and approved along with the annual budget for an additional two-year-period. However, the local governments neither widely nor consistently use medium and long-term plans. As a response to the dispersed municipal system, missing intermediate layers of governments, and EU accession challenges the Law on Regional Development was adopted in 1996. A system of sub-county, county, regional (NUTS2), and national regional development councils was put in place. The councils include delegates of respective local governments, the national government, Chamber of Commerce, employers' and employees associations, and NGOs. The regional councils were thought of as the main channel for managing local economic development in a coordinated way. However, there has not been sufficient progress towards regional planning since 1997. Instead, the development councils practically limited their activities to the local allocation of central funds earmarked for regional development, a very small amount of resources so far. The Regional Development Act was amended in November 1999. The NUTS2 big regions were redefined and from their simply statistical role they turned to be strategic development units. The composition of the regional development councils has also changed towards a profound centralization. The share of state representatives has significantly increased, while the council members delegated formerly by the sectoral chambers, civic organizations, employers and employees organizations have received only a consultative status. Local governments particularly in the large and medium settlements are keen to prepare and implement local initiatives, though local development strategies are often sketchy, casual, and sometimes mixing elements of local, regional, and national targets. For instance, although it is not a municipal task to build national freeways bypassing the settlements, local governments frequently compete for such projects and 27 are even willing to make certain financial sacrifices. The most common local economic development strategies involve public investment in local infrastructure and direct marketing of locations to foreign investors. For instance Tatabanya created an industrial park from an unused industrial area and has attracted 15 foreign investors and about US$75million capital in the last four years [Kovacs - Sebok 1999]. An important element of local government strategies to attract public investments is their stand on certain "unattractive" activities, such as incinerators and landfills. Subsidies, tax holidays, municipal guarantees, or any other form of financial assistance to entrepreneurs are less common techniques. Local goals and strategies are often distorted by the investment grant allocation system (see in section II). Local governments attempt to use all the means they can to influence the allocation of central grants, which frequently result in intense competition among the localities (hundreds or a few thousand grant applications are prepared in each of the cities annually). It does not always result in a sensible and sound approach to economic development. In a decentralized state, local investment priorities do not always coincide with direct service provision responsibilities. The goals of local economic development differ by the type of settlement. In cities, with a more favorable environment for domestic or foreign investors, direct investment is the primary objective. In rural areas hit by unemployment, job creation is the most important task. Local strategies are hard to define in the 2500 smaller municipalities; instead creating out of them about 150-200 small regions for development and efficient service delivery purposes is inevitable. Development programs should be financially sound and should comply with international standards. The already available PHARE grants have been under-utilized due to the lack of strong project proposals. Efforts to strengthen local government capacity for creating and implementing municipal and regional economic development strategies should focus on building strategic planning skills such as assessment of potential growth areas, prioritization of activities, financial management, and performance oriented results management. Municipal Budgeting and Financial Reporting Closely linked to effective economic development and efficient use of public resources is the improvement of municipal budgeting and financial reporting practices. Preparation of local budgets and financial reporting are two important and intricately connected parts of local fiscal management. In Hungary, both processes are subject to strict national regulations and are determined by the information needs of the national budget preparation process. Line-item budgeting is used for planning expenditures by organizational units to calculate inputs of the service. Local government fiscal information is based on the chart of accounts for budgetary (public) organizations. Local governments determine the level of detail for local financial reporting within the general framework established by the law. Box 3.5 Budgeting Rules The annual local government budgeting procedures, their contents, and the forms of presentation and reporting are strictly regulated by the law and govemment decrees. There are fixed deadlines for preparing local budget concepts (November 30), the presentation of budget proposals (February 15), the approval of budgets (within 30 days after presentation), semi-annual (September 15) reports, and annual reports (within 4 months). The form of budget classification is also standardized: Budgets should be structured by organizational units and by special groups of expenditures (salaries, operating expenses, welfare payments, capital expenditures) within each unit. By law a balanced budget must be prepared. However, as municipal budgets are still heavily dependent on central grants and transfers, which are unstable and non-predictable (section II), the opening and the closing local budgets are usually very far from each other. Local government budgetary organizations follow double-entry bookkeeping and cash-based accounting. Accrual accounting is used to account for municipal budget-related activities. Special rates of depreciation for the public sector are used for tangible assets. The municipal financials are comprised of a balance sheet, a cash-based budget report, a report on cash reserves or savings, a profit and loss statement, and supplementary annexes. The latter contains several output indicators of municipal functions and services. 28 Overall, formal rules for budgeting and reporting procedures are properly set in Hungary. However, it is not recognized widely that budgeting and financial reporting is not simply a set of procedural rules for spending public money but a potential building factor of modem public expenditure management. Budgeting may be used as a tool to implement policies according to local needs and reporting might serve as an instrument to provide feedback on outcomes of policies. A sectoral or program type approach to budgeting promotes allocative efficiency, i.e. allocation of resources from less to higher priority sectors or programs. Application of performance indicators or output measures supports operational efficiency through providing information about cost-efficiency of the service provider units. Although local governments have full authority to allocate recourses within their budget totals, only a few of them set sectoral plans. In the absence of strategic view, local governments use budgeting as a vehicle to allocate funds among existing service organizations. This traditional line item budgeting method prevents local govermments from having a broader view of service delivery. Furthermore, input budgeting is poorly connected to the level of services or financial performance of the service providers. As a result, local budgets frequently serve primarily the purpose of recording rather than directing expenditures. In sum, local budgeting and reporting systems face the following problems: (i) lack of strategic vision in the budget preparation process, (ii) lack of regional and sectoral scope, (iii) inconsistent reporting and budgeting of activities of local budgetary institutions and municipal companies, (iv) limited access to comparative information on municipal finances and service delivery, and (v) shortage of staff trained in modern budgeting techniques. The above-mentioned problems are interconnected. In the absence of a clear strategy for service delivery, the output (performance) criteria cannot be identified and without performance indicators, no measurable service goals and standards can be quantified. Most of these problems cannot be solved by simply introducing new regulations. Innovative approaches and methods should be disseminated and learned by professionals and local practitioners. One possible option is to move away from the present organization oriented, input-based budgeting methods towards output-oriented budgets. An important step in this direction would be to develop and introduce key service delivery indicators, to ensure that these are presented in both the budget plans and the annual reports and that information on outputs is fed back to the budget of subsequent year. A promising venue to move towards a budgeting, which is set into a strategic framework, is to supplement traditional budgets with functional (sectoral) or program budgets. There are already experiments in Hungary to develop program- and zero-based budgeting methods, which help to design budgets by functions or programs. Experience from Szentes and Szolnok showed that transparent information on sectoral spending alone modified policy priorities tremendously. Program budgeting however, would require technical assistance to train local financial officers in new budgeting methods. A further necessary step to improve local policy-making and asset management is the presentation of current and capital expenditures and revenues as two separate statements. This separation serves only demonstration purposes, as cross financing between current and capital budgets is allowed in Hungary. However, this separation of current and capital budgets provides useful information on the general trends in local government finances and the use of municipal assets. Finally, a problem area is the publicity and accessibility of municipal fiscal data for the general public. Information on the local municipal budgets and the budgets of municipally owned service providers, including balance sheets and property registration data, is collected by the local offices of the County Government Finance and Public Administration Information Service (TAKISZ). Although, several hundreds of expenditure and revenue variables are collected annually by the government for fiscal monitoring purposes, this information is kept confidential at the national level. Only two ministries-the Ministry of Interior and the Ministry of Finance-have access to detailed actual fiscal data on municipalities. While some comparative averages are produced from these data for public use, they are not sufficient for any comprehensive policy evaluation purposes. 29 Capital Budgeting and Capital Investments A key issue confronting local governments in Hungary today is the lack of skills and knowledge with regard to capital budgeting and capital investments. It is imperative that local staff and elected officials learn new techniques in planning, appraising, negotiating, and implementing capital investments. Most municipalities have little experience in selecting and preparing investment projects, undertaking feasibility studies, and monitoring and evaluating project outputs. As a result, as suggested by the six city case studies, many local governments failed to make the best use of the privatization revenues and invested in unduly risky and ill-conceived commercial real estate development projects. During the recent years, financing recurrent spending became the highest priority of local governments and the bulk of capital expenditures fell mostly on urban areas. Hundreds of smallest municipalities are facing major economic and managerial disadvantages in preparing and implementing investment projects. The transformation of the system of financing local capital investments has modified the methods and techniques of capital investment management. The former municipal investment departments changed their roles. They no longer operate as project implementation agencies of local governments. Their current functions are mainly to identify and market local capital investments and to perform a coordinating role at each stage of the investment process-from tendering to monitoring a contractor's performance under the project agreement and often have to work in cooperation with neighboring municipalities. The expected development of project financing (see section II) will further modify the current relationships among local governments, operating companies, and project lenders. While national budget grants still have a strong influence on the local choice of capital investments, municipal investment behavior will change, too, as private sources of financing gain in importance. Concession agreements and BOT schemes will require comprehensive contractual arrangements between local governments and operating companies. On the financing side, the diminishing share of central government financing in capital investment projects will make local governments involved in financing capital investments subject to increasing financial scrutiny by commercial project lenders. This, in turn, generates a need for information on local governments' borrowing capacity, knowledge about developing investment strategies, project appraisal techniques, and comprehensive comparative fiscal data for evaluating the risk/return profile of municipal project sponsors (see section IV). A critical challenge ahead is the urgent introduction of an adequate investment planning and capital budgeting process. Such a process will necessitate stricter and more thorough investment selection criteria. It may also improve the targeting of investments through a careful project appraisal and evaluation by making municipal investment decisions a subject of closer public scrutiny. An example of such an investment process, although a simplified one, can be found in Tatabanya. When considering capital investments, the municipality ranks projects according to their potential to generate external co- financing. Projects with a sizeable number of central government grants or private equity investments are preferred. A preliminary calculation of investment returns is made before a project is approved. Another important aspect of the current municipal capital budgeting process is the strong influence of central government investment objectives on local investment priorities. Based on the case studies, several distorting effects of central government investment subsidies can be outlined [Jokay et al 1998]. Perhaps among the most pronounced ones are cases of over-investment and the financing of capital investment projects of low local priority. Lacking own resources, many communities are forced to implement centrally funded projects only, instead of pursuing their own investment objectives. In Szentes, for instance, the decisions about whether the investment project will be implemented are almost entirely determined by the availability of central government financing. Only in exceptional cases are the municipal capital investment decisions influenced by the local demand for the service. 30 Central subsidies often encourage local governments to over-invest, i.e., to build capacities that they cannot afford to operate in the long run. Also, central transfers frequently subsidize financially unhealthy investments, which leads to operational difficulties and unjustified indebtedness. The grant application does not require precise cost calculations, and local governments do not take into account the financial costs associated with future projects. Since consumer fees in many instances do not cover increased operating costs, financing has to be provided by the municipality. Reducing over-investment should be sought not only at the municipal level but also at the central level, as unnecessary capacity building increases central costs, too [Hegedus et al 1996]. Beyond the recently tightened selection criteria and a more detailed review process, local financial contributions must be large enough to ensure that selected projects are economically viable, are of the highest local priority, and local governments are forced to consider the real costs of each project. Managing Municipal Assets Hungary's municipalities own a significant part of public assets. They received land, residential and commercial housing units, and assets of physical and human public services mostly in 1990. Real estate, securities, and other shareholdings were transferred to them as compensation proceeds from privatization after 1991 (see chart 3.2). Most of their present material assets are by law non-tradable, because municipalities subsequently have divested most of their sellable land, fixed assets, and housing units, and invested mostly into core physical and human infrastructure properties. The national aggregates of municipal assets show a rather outdated "book value" and in fact are assumed to be overall much bigger than accounted. A huge part of the material assets are accounted as zero book value either because of improper accounting of depreciation and rehabilitation, or because some assets (e.g. land) are accounted in the previous regime as zero value. Nonetheless, a part of invested assets are overvalued, when shareholdings or securities accounted at face value belong to enterprises, which are stripped, under liquidation or in non-existence. Since 1994, local governments have been required to prepare their annual asset Chart 3.2 Municipal Assets HUF bn. ledgers and financial statements. 2 Tct anet mm However, these two sets of records are not inter-linked. Municipal accounting 21 Arsss_aatTfor regulation must be amended in order to 1 _ Ffiras provide a framework for consistent asset 1m management [Kasso, 1999]. The + I I I I I I _ s regulation requires registration of assets ' a imT -a market value as well as a functional 191 19X 1s3 1994 1S5 1W6 197 description and physical characteristics of Source: Ministry of Interior, National Tax Office (SZTADI) assets. In practice, however, the required *Sebok and Kovacs, 1999, and Meszaros and Pataki, 1999 market value data are not readily available, as the valuation of certain type of property is complicated by the lack of market comparable and undeveloped valuation techniques. Various clusters of local assets such as (i) cash and other liquid assets; (ii) securities and ownership stakes in non-service enterprises; (iii) land, housing and other real estates; and (iv) assets of public services with limited marketability require very different strategy and management. Decisions on sale or contracting out should be based on clear considerations about the present and future value, options of short and long-term costs and benefits related to the assets in question. These kind of considerations have been often ignored, overruled by political goals, short term gains, with the aim to get rid of management difficulties (e.g. the sale of housing stocks). 31 The usual institutional setup of local asset management follows the lines of the public administration or service supervision units of the local administration. The administration offices have very limited managing and monitoring competency, instead the effective decisions are made by politicians in various committees or by the mayor and his/her deputies. There is usually neither institutionalized nor informal relations between the management of the various asset categories. Therefore, key asset decisions often seem to be result of ad hoc, politically driven or even fraudulent decisions without accountability or personal responsibility. In Hungary, in many cases local asset management lacks coherent conceptual underpinning, is highly fragmented, and perhaps is one of the most underdeveloped areas of local financial management. Decisions are often made by the local politicians and frequently are professionally questionable. The maintenance of the assets is nobody's responsibility. Even if there are municipal institutions assigned to maintain the assets, they do not have the resources to maintain them; at the same time, local capital expenditures for maintaining existing assets is among the lowest budget priorities. In general, there is an acute shortage of asset valuation experts and professionally trained property managers capable of organizing the proper management of municipal assets. Local governments are very passive owners of securities and other holdings even if they Box 3.6 Municipal Treasuries Improve Efficiency own majority stakes in joint ventures. Even The overall financial outcome from improved treasury operations at the local level has been extremely positive. the fully or majority owned municipal Following the first quarter of operations, the municipalities, companies are, in most respects, treated as which introduced independent treasuries, reported that their fully independent private entities. Although, budget deficits were reduced by 10 percent to 15 percent. the management of these entities are Instances of budget overruns, frequent in the past, were -pitdb the local goverment's reduced to a minimum, and through a better managed procurement process, according to some observers, the actual assembly, the latter does not exercise costs were cut by 20percent while liquidity became more effective ownership control over the predictable. Nevertheless, despite the obvious advantages of management. Enterprise plans and annual local treasuries, the lack of professional staff, inadequate reports are mostly submitted to the local technical support systems, and the low level of awareness currently impair their widespread introduction by municipal government, but they are neither authorities of their potential benefits. [Barati-Peteri 1977] consolidated with nor attached to the annual report of the municipality. Managing the core assets of human services (schools, hospitals, and elderly homes) is one of the most problematic areas of local management. Since these are not fee-based services, their assets are of limited marketable nature hence managed in the forms of local budgetary organizations. Most of them received very high level of institutional independence. As a result, teachers and medical doctors are dealing with the investment management preparing grant applications, procurement, and contracts with developers. Troubles rooted in the central transfer system (see Chapter II) are often coincide with poor financial management of local budgetary organizations. A few municipalities have separated the professional and the financial management of their budgetary organizations. A Financial and Technical Service Firm (GAMESZ) provides asset management services with the mandate to cover all operational, maintenance, and development activities of the local budgetary organizations [Kasso 1999]. As a response to fiscal pressures, many municipalities have set up so called Municipal Treasury Organizations (MTOs). The mandate of these MTOs vary from a minimal consolidated cash management of the budgetary organizations to the case when in addition to simple bookkeeping, account management, and related financial analysis, MTO is entrusted with the budget preparation and management of actual costs [Barati - Peteri 1997]. Since MTO obtains detailed financial information on municipal service providers, it gives them a strong incentive to improve the financial efficiency of their operations and the quality of comrnmunity services as well. 32 Monitoring and Supervision of Municipal Activities There is no effective decentralized municipal system without efficient monitoring that provides for economic/financial control before the conmnitment is made, accounting control before payment is made, and audit after the conclusion of the action. National, local, and market institutions provide monitoring over Hungarian municipalities. Today, only the State Audit Office which reports directly to Parliament can exercise direct and unlimited supervision over municipal activities. Since 1990, more and more national watchdogs have started to oversee municipalities. Line ministries monitor sectoral standards and national priorities while regional treasury offices control and execute intergovernmental transfers in the frame of net financing. Finally the Regional Public Administration Offices exercise legislative control. In Hungary, all the major elements of local control are in place though not performning equally. Local government, municipal organizations and companies are supervised by the local assembly, local committees, and internal and extemal audit (the latter for cities having bigger than HUF100 million annual budget). In addition, there is room for NGOs' feedback and there are rules for making documents of key public service decisions accessible to local citizens. In principle the local assembly is the best tool for monitoring and supervision of local government, its organizations, and municipal companies. Finally, the Municipal Bankruptcy Act serves as a key framework for exercising market control over municipal activities by private enterprises and financial entities. The present local government monitoring and supervision system has five major problems: (i) lack of capacity at the State Audit Office (SAO) to efficiently conduct external audits at the local level; (ii) lack of ability of local assembly and its committees to exercise operational control and to enforce accountability and responsibility; (iii) undeveloped practice of using audits; (iv) shortage of trained local staffs; and (v) vague transparency and citizens' control and biased feed back by NGOs. Municipal plans, financial reports, and contracts on public services by law are of public domain. The transparency rules, however, are often ignored, misinterpreted or overruled (e.g. in the concession contract by making it as confidential in a special clause [Baar, K. 1999]). The conmmunication between NGOs and local governments is very poor. In a few cases, NGOs successfully influence and monitor local policy through their representatives in local councils and cornmittees [Agh et al 1999]. There are ideas to enlarge SAO's capacity and to use the regional statistics units of the Interior Ministry (TAKISZ) to tighten control over municipalities' financial flows. While national institutions are easy to use a centralized controlling system limits decentralization, focuses on financial input rather than performance measurement, and ignores efficiency in public service provision. In parallel, it is crucial to improve the quality of local government audit through developing the professional capabilities of internal and external auditors and to establish transparent processes for their selection maybe through the chambers of auditors and local government organizations. For small local governments, regional audit services shared by several municipalities should be established. 33 IV. Developing a Competitive Subnational Finance Market In Hungary, investment needs in local infrastructure have been growing against a background of tight fiscal policies that have constrained budgetary transfers from central to subnational levels of government. Competing claims for scarce budgetary resources led to large funding gaps for local infrastructure investments. Private capital would be required if local infrastructure services were to be brought to standards that support growing household and business demand and meet EU accession requirements. At the same time, responsibility for the provision and financing of services is being increasingly decentralized with local governments assuming expanded roles in the provision of services. Yet the ability of local governments to finance and deliver services is often constrained by limited institutional capacity and financial resources which may affect the level and quality of municipal investments. The Legal and Institutional Framework for the Subnational Capital Market The development of an orderly and efficient subnational finance market depends critically on the overall legal, regulatory, and institutional framework in which the various market participants operate. The role of this enabling environment is to provide the foundation for the emergence of a market where private investors and financial intermediaries compete to mobilize financial resources from savers, while correctly pricing subnational credit and efficiently allocating capital among subnational investments through a wide range financial products tailored to the needs to the various types of subnational entities. The legal, regulatory, and supervisory environment for the subnational finance market should seek to strengthen market governance and transparency, establish and maintain a level playing field on the market to avoid distortions between players and instruments, and limit moral hazard. Conceptual Frameworkfor Subnational Capital Market Regulation In a system of subnational borrowing regulated by market discipline, excessive borrowing would be prevented by rising premia or outright exclusion imposed on subnational borrowers by the market. Strict reliance on market discipline requires, inter-alia, the following: (i) no sovereign guarantee for subnational borrowers; (ii) market for subnational securities; and (iii) full disclosure of financial position of subnational creditors borrowers. Absence of explicit or implicit government guarantee for subnational borrowing. A growing number of governments are making it clear that they will not issue sovereign guarantees for sub-sovereign transactions, both as a matter of sound fiscal policy and in order to reduce moral hazard. While the adoption of such legislation constitutes major progress toward separating sovereign and non-sovereign risks, the credibility of no government bailout of subnational entities requires adopting additional regulations governing the treatment of creditors in case of municipal default. Openness of capital markets, in particular absence of regulations pertaining to the holding of government and/or subnational securities by financial intermediaries. Many governments have made significant progress in liberalizing capital markets although restrictions continue to hamper the free movement of capital, such as minimum holding requirements for government securities, or regulations preventing the issuance of specific types of financing, guarantee or hedging instruments by subnational entities. Full disclosure and access to information on the financial position of subnational borrowers. Despite progress in some countries, the mechanisms for reporting and monitoring financial information including subnational debt are generally absent or, when in place, remain deficient. 34 In a system of direct, ex-ante administrative controls on subnational borrowings, govermments could be tempted to rely instead on models ranging from case-by-case approval procedures to outright ban on borrowing. Under this system, central government may exert control over subnational borrowing by: (i) using a detailed process of approval by the central government or its agents; and/or (ii) restricting the sources of borrowing by subnational entities (e.g. allowing local governments only to borrow from the central government for special purposes). Direct controls on subnational borrowing by central government suffer from two drawbacks, however. First, they can lead to politically motivated and economically inefficient credit allocation decisions by the central government. Second, case-by-case approvals of subnational transactions by the central government may strengthen creditors and debtors assumption of an implicit sovereign guarantee, and make it more, rather than less, likely that the central government will have to intervene in case of default by a subnational entity. In the middle of the spectrum, there is a third, rules-based model in which the subnational capital market is allowed to play its resource mobilization and allocation role in the economy, and is underpinned by a legal and institutional framework designed both to maintain macro-economic and fiscal stability and ensure market efficiency and transparency. This legal and institutional framework rests on three pillars. First, a prudential framework designed to limit central government exposure to liabilities incurred by subnational entities. Second, an institutional framework to support borrowing by subnational entities. And third, a financial sector legal and regulatory framework governing the issuance, disclosure, and settlement of subnational debt, and a supervisory framework to ensure that market participants follow these regulations. Prudential Framework for Subnational Borrowing The main components of the prudential framework for subnational borrowing pertain to the definition of public debt, borrowing limits, sovereign and intermediate government guarantees and local government bankruptcy regulations. Definition of public debt. The definition of public debt in Hungary includes all recourse-based direct obligations that a public entity may enter into. Consistent with EU legislation, public debt includes the liabilities of the general government (central government, social security funds, and local governments) in currency and deposits, bills, short-, medium-, and long-term bonds and loans. However, guarantees and other contingent liabilities (such as promissory notes) of the central government, social security funds, and local governments are not included in the definition of public debt. Budget regulations stipulate that guarantees and other contingent liabilities are counted as current budget expenditure by the time they are called. The yearly central government budget contains a provision against guarantees that might be called upon. An alternative system would consist of counting guarantees and other contingent liabilities as a specific category within public debt, subject to rating. This would require that local rating agencies have sufficient capacity to rate all guarantees and contingent liabilities issued by the central government, social security funds and local governments. Borrowing limits. The Act of 1995 on the Supplementary Budget introduced a limit on the amount of new medium and long-term debt of local governments. According to the Act, the value of the medium and long-term debt to be issued by local governments in the course of 1995 could not exceed seventy percent of the own adjusted current income of the local governmentl. For the purpose of calculating the borrowing limit, medium and long-term debt includes guarantees and other contingent liabilities incurred by local governments. This borrowing limit was integrated in the legislation as an Amendment to the Local Government Act and is currently in force. ' Adjusted own current income is the sum of current own revenues (such as local taxes, fees) minus the annual amortization payment of short and long term liabilities. 35 Sovereign and intermediate government guarantees. The current legislation does not contain a specific limitation to the issuance of sovereign guarantees to sub-sovereign transactions. However, as a matter of policy, the central government does not issue sovereign guarantees to subnational transactions. Exceptions to this policy can be made by the government on a case-by-case basis for loans by international financial institutions (IBRD, EIB). However, in practice, these cases are rare, generally involving projects of national importance undertaken in the capital city. These guarantees are counted against the yearly ceiling imposed on guarantees in the annual Budget Law. The credibility of this policy is further reinforced by the existence of a municipal bankruptcy law. The current legislation does not contain a specific limitation to the issuance of sub-sovereign guarantees by local governments, frequently issued on behalf of municipal (and sometimes private) companies. Local government insolvency and bankruptcy regulations. Hungary is the only country in the Region that has introduced a regulation governing local government insolvency and bankruptcy. The Act XXV of 1996 regulates the debt clearance procedure of local governments. Under the Act, a debt clearance procedure may be generated by the local government and by its creditor if the local government or the budgetary organization financed by it falls behind its debt obligations by more than 60 days. Since the law entered into force in 1997, there have been 8 municipal bankruptcy cases, of which 2 are under way. The causes for the bankruptcies range from: investment in failed business activities; guarantees issued without the knowledge of the council; and local public investment programs (linked with gas supplies) beyond the financial capacity of the municipality. No cases have occurred because of current operations of the municipalities, reflecting the role of deficit grants in preventing such cases. All cases have led to debt restructuring. All municipalities that have emerged from the procedure are in stable financial condition. Policy recommendations. Key recommended policy adjustments should seek to: (i) integrate guarantees and other contingent liabilities, first by the central government, and over the medium-term by local governments, into general government debt; (ii) require full financial disclosure by local government; (iii) introduce an amendment to the public finance law explicitly prohibiting the use of sovereign guarantees for subnational transactions, with exceptions requiring approval on a case-by-case basis by Parliament; and (iv) over time, as market signals take hold, the existing limits on local government borrowing may need to be reassessed based on the long-term debt servicing capacity of local governments. Auditing and Collateral Issues for Subnational Borrowing Auditing. Auditing of local government finances by the State Audit Office is of two types. Theme audits focus on a specific type of operations for a sample of local governments. Recent theme audits have focused on public utilities and on social services. Audits of financial and economic operations focus on the management of targeted grants and investment subsidies. Revenue collateralization. The Act on Local Governments limits revenue collateralization by local governments to own revenues, defined as local taxes, profits, dividends and interest income, local duties, a proportion of environmental penalties, and other revenues of the local government. Budget regulations allow for the creation of sinking funds that are earmarked to service a particular debt incurred by a local government. Asset collateralization. Asset collateralization by local governments is mainly conditioned by: the registration system for real estate assets; the valuation system for real estate assets; and the designation of local government assets that can be used as collateral. The registration system for real estate assets, developed over the last twenty years, records property ownership, quality, use, protection and book value in the case of land. The system is up to date nationwide with two major gaps. First, 600,000 rural landowners from privatization are not yet registered. Second, Budapest has a three-year backlog in recording modifications in registration resulting from sales of property. The Property Registry Department estimates that the backlog of rural land registrations as a 36 result of privatization will be cleared. There is currently no deadline for clearing the backlog of registration changes in the city of Budapest. The valuation system for real estate assets differs for buildings and building plots on the one hand, and for rural land on the other hand. To enhance the present tax regulation for buildings and building plots, a draft Act on value-based property tax has been recently prepared, but failed to receive government support required for submission to Parliament. Thus the issue of valuation of buildings and building plots remains open. These underline the proposal for elaborating a medium term tax reform focusing not only on the property tax but parallel introduction of various changes consistent with the EU requirements. There is currently no system of land valuation for two reasons. First, land privatization is not scheduled to be completed before year 2000. Second, the absence of land tax provides no incentive to set up a land valuation system. In addition, land values are likely to remain depressed even following the completion of privatization, given the small size of individual property areas. (The Government is planning a land- restructuring program to create larger units.) The designation system for real estate assets that can be used as collateral by local governments is contained in the Local Government Act which distinguishes between primary and secondary assets of the local government. The Act gives the power to the local government to declare as primary assets those assets that serve directly the delivery of compulsory duties and the authority of the local government for the enforcement of public rights and powers. The Act distinguishes between two types of primary assets. First, non-salable primary assets, including local public roads and their structures, squares and parks, as well as other assets to be designated by an Act or by a decree of the local government. Second, primary assets salable in a limited way, including public utilities, institutions and public buildings, as well as real property and movables designated by the local government. Disposition of salable primary assets can be made in accordance with an Act, or in a decree of the local government. The local govermment act prohibits local governments from using primary assets as collateral. Policy recommendations. Key policy reforms to improve the framework for subnational borrowing would need to: (i) strengthen the capacity of the State Audit Office to carry out specific audits of local govermnent creditworthiness and asset/liability management; (ii) allow the collateralization of salable primary assets, or alternatively to introduce three categories of assets, i.e. primary assets (not salable, not collateralizeable); secondary assets (salable under certain regulations, collateralizeable); and tertiary assets (freely salable and collateralizeable); (iii) implement an accelerated program of action to clear the backlog of registrations of property changes in Budapest; (iv) establish a system for the valuation of buildings and building plots; (v) implement an accelerated program of action for the early completion of the registration of new land owners in the land registry; and (vi) design and implement a system of land valuation (once land registry is completed). Financial Sector Regulatory/Supervisory Frameworkfor Subnational Borrowing The main components of the regulatory and supervisory framework for subnational borrowing pertain to issuance, registration, disclosure, and supervision rules. Issuance. The Securities Act2 is in conformity with EU directives, in particular the March 1979 Council Directive on the listing of securities on exchanges, as well as subsequent Council Directives regarding information disclosure and mutual recognition (March 1980). In the case of a public offering on the Hungarian market, the publication of the prospectus and the announcement of the public offering are subject to approval by the Supervisory Commission. Appendix IV to the Securities Act details the required contents of the prospectus to be prepared by the local government. The Securities Act does not 2 Bond issuance by local govemments is authorized by Law-Decree No. 28 of 1982 - Section 3 - c. Issuance and trading of local government bonds is regulated by the Act CXI "On the Offering of Securities, Investment Services and on the Stock Exchange" of 1996 that became effective on January 1, 1997 (hereafter "Securities Act"). 37 contain any additional regulations regarding the public offering of securities by local governments, either in Hungary or abroad. The Securities Act does not regulate the private offering of securities by central or local governments, although specific regulations have been subsequently introduced by the Supervisory Commission at the State Financial and Capital Market Supervision - SFCMS) to regulate private issues by local governments. These regulations provide that: private issues must be at a minimum HUF5 million; investors must be specified in advance (since June 1998, these are required to produce a letter of intent); and local governments must use the services of a brokerage firm and produce "relevant information" to the investors. Registration. Local government borrowings (loans, bonds) as well as guarantees and other contingent liabilities are recorded ex-post by the Local Govermment Department of the Ministry of Finance as part of the yearly submission of the budget execution by local governments to MOF. Bond issues by local governments are registered with the SFCMS. For public issues, the obligation of notification is part of the process of prior authorization of the bond issue by the Supervision. For private issues, which do not require prior authorization by the Commission, the obligation of notification has been in place since January 1, 1997. The Ministry of Interior maintains a systematic, real-time notification system for local government loans, local government guarantees and other contingent liabilities. There is no system for real-time notification of borrowings, guarantees and other contingent liabilities by municipal companies. Disclosure. For public offerings, issuers are required to disclose regular information on their financial and income position and operations. The information is to be provided in the form of annual minute sheets and annual reports. Local governments are not required to prepare annual minute sheets. Issuers are required to ensure the inspection of their annual reports by investors, and announce the time and place of such inspection in a national daily newspaper and the exchange journal. The annual report has to be sent simultaneously to the SFCMS. Except for government securities, issuers are obliged to send to the SFCMS and publish in a daily newspaper and in the exchange journal all information directly or indirectly affecting the value or return of the securities. Save for the exemption from the obligation to prepare annual minute sheets, the Securities Act contains no additional disclosure rules in the case of public offerings by local governments. For private offerings, the Security Act contains no specific disclosure rules including the type of information to be supplied by local governments to investors, as this is considered to be part of the due diligence process of the investors themselves. Supervision. The issuance, trading and settlement of securities are under the purview of the Supervision Commission established under the Act CXII of 1996 on Credit Institutions and Financial Undertakings. With few bond issues by municipalities to date, experience with supervision is limited. The SFCMS has so far taken a passive approach toward the supervision of public issues by local governments, limiting its overview to ensuring that issuance procedures and supporting documentation are in accordance with the law. Policy recommendations. Priority actions for strengthening the financial sector legal, regulatory and supervisory framework for subnational borrowing should provide for the following: (i) the SFCMS should establish detailed disclosure rules for public issues by local governments, beyond the publication of the annual minute sheets; (ii) the SFCMS should strengthen its capacity to carry-out both off-site and on-site supervision of local government as borrowers; and (iii) the Ministry of Interior should establish a system of real-time notification of borrowings, guarantees and other contingent liabilities by municipal companies. Meeting the Demand for Subnational Investment Finance in the Medium-Term Macroeconomic Framework As it sets its sights on EU accession by the year 2003, Hungary faces a considerable challenge to increase both private and public investment to support economic growth and modernize its infrastructure while 38 maintaining internal and external macro-economic equilibria. Local governments and municipal companies would be called upon to play a critical role in this context, as they are responsible for undertaking a substantial portion of the infrastructure investments required. The implied increase in the investment rate of local governments and municipal companies will have implications on the composition of the general government's fiscal program, and the structure of its financing including the financing of the current account over the medium-term. Subnational Investment Back to its Track Over the past decade, local government investments have contracted from an average of 3 percent to below 2 percent of GDP at present. The decline has been particularly noticeable since 1995. Over the 1991-1997 period, local governments financed these investments from the following sources: current balances including net interest revenues (45% of the total), investment grants from central government and capital transfers (47% - of which 23% passed on to local service companies), and asset sales and privatization revenues (48%). This allowed municipalities to retire debt incurred in the late eighties, as shown by their negative net average borrowing (-17%) during the period. As a consequence of contraction of transfers and adverse investment incentives, local government's investments have lagged behind replacement rates in the nineties. There is strong evidence that local investment decisions have been distorted by the investment grant system. The availability of capital grants has largely driven local investment decisions, while privatization revenues, borrowings, and private equity have not been adequately utilized [see section II and Jokay et al 19983. For example proceeds from asset sales and privatization were often invested in government securities or bank deposits, while key renewals were postponed [Ilona Pal-Kovacs 1998]. Privatization has aimed at cash generation rather than rationalizing or developing public services through public private partnership. In 1997, municipalities still owned a non-service "portfolio" of about 1.0 percent to GDP, including shares of manufacturing and other companies (for example, hotels and shops). This can be divested and potentially used for financing service development. Local government investments are also well below what would be required to meet EU infrastructure standards over the pre-accession period. As local infrastructure will be modernized, local investments in basic human and physical services are expected to increase progressively from 2.2 to 3.0 percent of GDP between 1997 and the time of accession. This significant increase may be attributed to two factors: core assets and market penetration. First, present regulations classify the basic elements of the human and physical infrastructure as non-marketable "core" assets. Therefore development, replacement, and renewal of these assets should be financed out of municipal budgets. Second, in Hungary, telephone, electricity, and gas supply, which are characterized by low unit costs and are not associated with negative externalities, are well developed and have been taken over by the private sector. By contrast, sewage and solid waste systems involve large unit costs and negative externalities. Increasing, therefore, the level of service provision from around its present 20 percent level would requires considerable investments. Shift toward Municipal Companies and Private Providers In parallel, profound changes are anticipated in the structure of local investment finance in terms of sources of funding. Indeed, private funds are expected to play a growing role, which would ease the fiscal burden, but would have an impact on the current account (see Table 4.1 and Chart 4.1). The current balance of municipalities is expected to remain constant over time (at 0.8 percent to GDP). However, there would be a change in the composition of the balances. First, current transfers from the central government will decline in line with the necessary changes in tax rates (see section II). Second, local financial revenues, mainly interest income, will dry out, as 39 municipalities will no longer hold large deposits as privatization revenues decline. Third, local own revenues (taxes and fees) are expected to grow, to make up for the declining current transfers and local financial revenues. 17. In the future, two kinds of grants (government and EU) will be accessible for local investment purposes. The bulk of EU transfers available for Hungary's investment purposes is assumed to flow to local governments (1.5 out of 2.0 percent of GDP) [CEM 1999]. It is also understood that these funds will partially finance public utility investments carried out in public private partnership at the local level. From the EU funds about 0.7 percent to GDP is to be channeled to these local investments, while about 0.8 Chart 4.1. Local Investment Finance as a Percentage of GDP 7.0% 6.0%- ElBorrowing 5.0% *FDI (new inv) 4.0% - Asset sales 3 0% - Capital grants 2.0% NEU grants t 0% E3 Savings 1997 2003 Source: SNDP. World Bank percent would be available to finance other service developments. In line with a contraction of central government grants capital transfers to local governments (including contribution to local companies) are expected to decrease from 1.1 percent of GDP in 1997 to 0.7 percent by the time of accession. On the one hand, transfers from local governments to municipal companies are expected to decline. On the other hand, a significant share of local government funds will be used as the necessary matching part to EU funds (e.g. a 0.8% to GDP EU transfer requires a 0.3% to GDP matching share under the present 25% matching rule; moreover the matching share might subsequently be increased to 40 or 50 percent). Furthermore, Table 4.1. Local Investment Finance proceeds from asset sales and Local Governments Public Utilities privatization will dramatically As share of GDP 1997 2003 1997 2003 TtlInvestment 2.2% 3 0% 1 6% 3 2% decline (from 1.6 percent in 1997 to Investment fnancing roughly 0.2 percent of GDP by the Savings (current revenue-current expenditure) 08% 0.8% -03 0.2% Fmancing requirement external to the sector 1 4% 2.2% 1 9% 3.0% time of accession), as the bulk of of with marketable assets have already been General Govermment Captal grants 00% 0.8% 06% 07-% privatized during the 90s. As a Asset sales 16% 02% 0% 0% 11 ~~~~~~~~~~~~~FDI 0.0% 0.0% 0% 0.% result, local governments would Borrowing -0.7% 0.5% 1.3% 20% need to borrow the equivalent of Source: SNDP, World Bank about 0.5 percent of GDP by the year of accession, after having been mostly net lenders in the nineties. Companies providing local public utility services invested on average about 1.1 percent of GDP over the 1991-1997 period. Unlike local governments, public service companies generated operating deficits (0.3% to GDP in 1997) due to low user fees. Hence, their investments had to be financed out of capital grants from central and local governments as well as from borrowings (see table 4.1). EU funds will primarily support infrastructure (utility) investments. Thus, close to half of the projected increase in the investment rate in the economy would be accounted for by municipal companies (1.6% out of the total increase of 3.5% to GDP) over the medium-term. As a result, investments by municipal companies are projected to double (from their 1.6 percent 1997 level to about 3.2 percent) by the time of accession. 40 These investments will partially be financed from the net operating surplus of municipal companies which is expected to increase as a result of improved cost recovery policies. Capital grants to municipal companies are projected to increase slightly, financed primarily by EU funds (0.7 percent of GDP by accession). As the concept of functional regionalism materializes (see section II), a significant amount of FDI would be expected to contribute (and supplements borrowing) in the development of the public utility sector (roughly estimated at about 0.3 percent to GDP). As a result, net borrowing requirement of municipal companies, which amounted to 1.3 percent of GDP in 1997, are projected to increase to about 2.0 percent to GDP by the time of accession. 41 Supply of Subnational Investment Finance Hungary's municipal finance markets began to emerge in the eighties, though they remain small and lag behind the development of the financial sector as a whole. Municipal demand for medium-and long-term finance has been limited with borrowings concentrated mainly in a few large cities. Apart from Eurobond issues by the city of Budapest (DM150 million 1998-2003), there has been no international bond issue by Hungarian municipalities or municipal companies. Debt service as a share of municipal revenues has been well below the authorized limit of 70% of own-source revenues. The Determinants of Growth of Subnational Credit Market Through the mid-nineties, Hungary's municipal finance market was dominated by the National Savings Bank (OTP) which had been offering short and medium-term lending instruments for municipal clients. Municipalities held their accounts with OTP that also acted as underwriter for municipal bond issues. Since 1994, OTP's exclusive market dominance declined slightly (from 100 to 92 percent) as new private banks, such as Raiffeisen and Citibank, were competing for market share. A small market for municipal company finance started to develop following the incorporation of municipal companies in 1991. Despite increased market competition, the range of debt instruments available to municipalities remains limited, with no debt refinancing, bond pooling or insurance, or partial risk/credit guarantee instruments. Currency hedging instruments do not extend beyond six months, and have yet to be used by municipalities or municipal companies [Makay, M: 1998]. There is potential and scope for municipal credit market growth and diversification in Hungary based on the policy changes introduced in the financial sector. Yet in examining the prospects for the supply of finance to subnational entities there is a need to assess the determinants and sources of supply including the various types of instruments offered by banks and non-banking capital market intermediaries. There is also a need to address the constraints that may hamper the supply of subnational finance, and to highlight mechanisms (e.g. non-recourse project finance options) and products (e.g. securitization) that enhance local government ability to mobilize private resources. In this context, it will be important to review the options for local governments to access private credit in a way consistent with macro-economic stability; the role of local operational entities distinct from political sub-divisions; the links of local government finance with broader capital market issues; the impediments to local government access to credit markets; and the role of specialized financial intermediaries for local government investments. In the context of the EU integration strategy, Hungary could look at the broader European financial market as a funding source for Hungary's investments including municipal infrastructure. Sources of Funds for Local Government Investments and Potential Needfor Credit The funding sources for municipal and municipal company investments have included local government current account savings, central government grants and proceeds from local asset sales. The contribution of current account savings to local infrastructure finance varied significantly over time; it also varied across municipalities in function of size. The ability of municipalities to increase operating savings is contingent upon local capacity to generate own revenues (including tariffs adequate for cost recovery) and optimize expenditures. Investment grants, when available, represent a main source of funding for local government investments, especially for smaller municipal entities with limited asset base and marginal creditworthiness. The size and composition of investment demand has been correlated to the availability of investment grants. Proceeds from municipal assets sale have also provided a funding source for local government investments. This funding source is however temporary and rapidly coming to an end as 42 municipalities are left with non-tradable core assets and participation in municipal companies that might not be easily reduced. Should their present funding sources, in aggregate, fall short of investment requirements, local governments would need to fill the gap through market borrowing. Local government borrowing has been a central subject of the intergovernmental fiscal relations' debate. A contentious issue has been the potential impact of subnational borrowings on macro-economic stability and the conditions under which such borrowings may be consistent with macro-economic policy objectives. Subnational Borrowings and Macro-economic Risks: Tax or Revenue-based Debt Local governments can have access to credit from a number of sources. One such source has been borrowing from the central government. Local governments can also incur liabilities in running arrears to suppliers and delaying salary payments. Another, transparent, way is to borrow on private credit markets. Long-term borrowings to fund long-term assets may be appropriate to promote inter-generation equity and allow for (long-dated) costs to be spread throughout the period over which (long-term) benefits are expected to accrue. However, local government borrowing should be based on good economic and financial principles, which should be the focus of policy measures. Foremost amongst these principles is that borrowing by local governments should be a substitute to borrowing by central government, not an added burden to the national public debt. Borrowing should be dedicated to funding capital rather than current expenditures (to this end a clear distinction must be made between the two expenditure categories). Borrowing may be justified to finance investments that generate rates of return above the cost of capital. Borrowing aimed at financing operational deficit should be precluded. At the time of borrowing it should be established that debt service would be affordable when measured against local government income. Borrowings must be based upon strict investment criteria, optimal financing schemes and reliable project risk/return benchmarks. The potential effect of local indebtedness on macro-economic stability (moral hazard issues) should be duly assessed. In this regard, Hungary has over the past few years introduced laws and regulations that provide some deterrent against implicit sovereign guarantee of municipal debt. Amongst these is the municipal bankruptcy law that defines debt workout procedures in case of municipal default. In assessing the potential for creating contingent liabilities at the sovereign level, there would be a need to make a distinction between two different local government-borrowing schemes: tax-supported and revenue-based debt. When in need to borrow, local government entities should first seek budget neutral, non-recourse project finance options that would reduce claims on fiscal resources. Tax-based financing. In tax-based financing, local government debt service would be met out local government general revenues [Bahl, R.: 1999]. These borrowings, part of local government general obligations, would be appropriate to fund investments for "public goods" the cost of which may not be charged directly the individual consumers. In this case however, it would be essential to demonstrate that the public goods so financed would have a positive impact on local economic development in supporting growth, and eventually increasing local tax receipts out of which debt would have to be serviced. (For instance, borrowings based on "tax increment districts" have been used in some countries to fund the development of run-down areas and where debt is serviced out of the "incremental" tax receipts brought about by improved property values). Local government tax-based borrowings should carry no central government guarantee. Yet even without such "explicit" guarantee, such general obligation debt may conceivably create contingent liabilities at higher government levels should creditors perceive that local government indebtedness would always entail "implicit" central government insurance. Revenue-based financing. In revenue-based financing, local debt service would be met out of the revenues of a specific project, when such revenues are directly levied from consumers. Revenue-based 43 financing may be structured on a "non-recourse" basis, where private creditors' rights and claims are limited to the project's specific revenues or, at most, project entity's assets. These revenues and assets would be segregated from all other local govemment assets, with creditors having no claims to the latter. This non-recourse finance should, a fortiori, extend to the sovereign level and shield central govemment from implicit liabilities associated with local government debt. In addition to reducing contingent liabilities at the sovereign level, revenue-based finance can also entail credit enhancement structures that could lower the interest costs of borrowings (even conceivably below the reference cost of central govemment debt). A credit enhancement feature commonly used is to pledge specific project revenues on a senior basis to creditors. To do so, revenues would be channeled through a segregated account managed by an independent trustee whose sole role is to ensure that debt holders are being paid on a priority basis. The corresponding debt could be secured by the dedicated income streams - to the extent these are sufficient - of such projects as water/sanitation facilities and mass transit. (Municipalities are allowed to pledge future streams of income as security, although the concept of such pledges remains largely unfamiliar). Political Jurisdictions or Operational Entities To address the issue of a multitude of small local govemments, the creation of "special purpose entities" may be an appropriate and practical solution. Local governments are political/administrative entities in charge mainly of service delivery. There are however clear cases where a service could be delivered more effectively by a grouping of such entities - for instance to improve economies of scale and as a result, the viability of public investments. Some countries occasionally resort to outright mergers of administrative entities in order to deliver services more efficiently. Other countries refrain from tempering with the political sub-divisions but encourage ad-hoc associations of such sub-divisions for the purpose of delivering services. In terms of policy measures, the Govemment may want to encourage the establishment, through incentives if need be, of such special purpose entities. These would be legal units vested with powers to enter into contracts, with clear authority to borrow, levy fees against services provided or betterment taxes against improved property values. Such a corporate entity, owned by the association of municipalities would be exclusively dedicated to the operation of a public utility scheme, and would be able for instance to pledge project revenues as security for borrowings. Borrowings by special purpose entities separate from local govemments are less likely to create (implicit) contingent sovereign liabilities. Finally, such entities may also be assigned credit ratings, which might be unrelated to - sometimes better than - the ratings of participating municipalities. Local Government Finance and Broader Capital Market Issues The framework related to municipal debt issuance is an important determinant of access to credit by local governments. In Hungary, local government borrowings have been limited and largely confined to commercial bank loans in addition to a small number of bond issues by large cities (these sometimes carrying central govemment guarantee). There are no restrictions on financial institutions to hold local government securities. Existing institutional savings can provide a potential funding pool for investments in local govemment projects, as debt securities issued by local government entities might fit well in the portfolios of institutional investors (insurance companies, pension funds, investment funds) seeking diversified long-term uses for their resources. Despite an overall friendly regulatory environment, local govemment financial transactions will need to be supported by specific regulations as well as effective instruments and institutions. In focusing therefore on the building blocks for a resilient local govemment finance sector, financial policies should seek to foster the development of long-term debt instruments that can narrow local govemment resources gap and 44 meet the long-dated requirements of infrastructure investments. The broader capital market development issues, which might call for policy adjustments, relate to five factors. First, the underwriting, distribution and market-making capabilities in secondary markets for municipal securities. This cover inter-alia prudential issues such as capital adequacy ratios for underwriters and market makers for municipal securities. Second, the registration, settlement and custody of local government securities. Third, the disclosure standards for financial institutions and other market players involved in local government securities. Fourth, the benchmarks for pricing debt obligations of municipal entities in reference to central government securities yield curve; the existing pricing structure in the various credit market segments (such as government and corporate debt, financial institutions' certificates of deposit, etc...) should provide the base references for pricing local government debt obligations - although the absence of long- dated government securities would not allow straightforward results at the end of the maturity spectrum. Fifth, credit enhancement structures (securitization, guarantees, bond insurance, bank letters of credit, convertible debt, derivative products) which confer preferential credit status on local government debt obligations, diversify and transfer risks and increase market acceptance of local borrowing. In this latter regard, the nascent domestic credit rating capabilities in Hungary would provide prospective investors/creditors with a useful tool for the credit assessment of subnational borrowers. Impediments to Local Government Access to Credit Markets One constraint in terms of local government infrastructure finance pertains to the limited availability of long-term lending, as loan maturities to local governments rarely exceed 5 years - a serious predicament given that long-dated debt instruments are required for infrastructure finance. This situation arises from concerns regarding credit and interest rate risks. In this regard, policy measures should foster an environment to reduce both credit and interest rate risk. Credit risk could be reduced through credit enhancement mechanisms - such as lending secured by the income stream of revenue generating projects, put options for bond issues, callable loans by financial institutions, etc. - that would encourage longer- term commitments by potential creditors. Interest rate risks - which in a high interest rate environment do deter borrowing - might be mitigated in pricing loans on an indexed, floating rate basis; from the investor standpoint, interest rate risk might be further mitigated through portfolio diversification techniques (for which guidelines are usually established on a case-by-case by institutional investors). Moreover, the unpredictability and ad-hoc nature of financial transfers between various government tiers is an added impediment to building local government capacity to attract private credit. As securing central grants is sometimes influenced by local government lobbying, the ad-hoc nature of the grants makes it difficult for prospective investors to assess local government creditworthiness particularly for medium and long-term funding commitments (see section II). Local Government as a Potential Borrower 176. In assessing the conditions for municipal finance market development, one focus should be on the factors that may impede, from the demand side, the municipal sector's access to credit. One such impediment is the limited effective demand resulting from the weakness of small and medium local governments to structure investment proposals that meet the due diligence requirements of private lenders. When planning to access private capital markets, areas of critical importance that call for Govermnent attention and support relate to project selection/preparation, financing strategies and financial management (that underpin creditworthiness). Local governments need to strengthen project selection processes through quantitative criteria based on economic priority, relevant return benchmarks or least cost solutions. 45 Essential to the analysis would be the assessment of the affordability of fees ("capacity to pay") that a project may have to charge to be able to service debt. Moreover, local governments need to develop financing strategies involving in particular, project finance options on a non-recourse basis that reduce claims on fiscal revenues. The development of multi-year investment plans would allow local governments to assess better the implications of pledging fixed assets as collateral for borrowing for a given project whereas such assets may become necessary as a pledge for another project in the pipeline. Finally, local governments need to improve/optimize financial management including, current expenditure, asset/liability and liquidity management. As a matter of policy, financial disclosure for all municipalities should be improved to provide investors with reliable and standardized information; to this end, consideration should be given for the establishment, at the national or provincial level, of data bases with relevant indicators and ratios on local government finance (such as ratios of debt service to revenues, current revenues to current expenditures, share of local to total revenues, share of local taxes to total revenues, etc...). This would also constitute a useful basis for credit rating, for which local government entities should get prepared. Fostering competition and private provision of local infrastructure should be an integral part of city development strategies. To this end and, there is a need to promote closer financial partnerships between local governments and providers of services and capital - commercial banks, securities firms, institutional investors, infrastructure funds, rating agencies, utilities operators - that have complementary interests in private finance and local infrastructure investments. Specialized Financial Internediaries for Local Government Investments Market borrowings by local governments may entail direct bond issues or loans/lines of credit from commercial banks. Another way for local governments to mobilize long-term resources could be through specialized financial intermediaries that provide a vehicle for debt pooling for local investments. In the US, municipal bond markets have been a primary vehicle for local infrastructure finance through debt funding supported by the taxing power of local governments, and revenue bonds secured by project earnings. Other industrialized countries have relied more on financial institution including specialized financial intermediaries to provide credit for local governments. Financial intermediation and bond markets are not mutually exclusive funding channels for local investments: as they could play complementary roles in serving two segments of the local government financial market. In Hungary, it would not yet be feasible for a large number of small and medium-sized local government entities to have direct access to long-term credit markets. The use of financial intermediaries that could tap private credit markets on behalf of subnational borrowers could be one way to foster market access. Lending to municipal entities would be achieved in leveraging the intermediary's equity funds through bond issuance in the private credit markets without government guarantee. The regulatory and institutional environment in Hungary would allow a role for market-based specialized financial institutions operating within the country's competitive financial sector. Lending would be mostly to viable, revenue-generating infrastructure investments. Lending can also be on a balance sheet basis and be directed to public goods investments if the lending intermediary can establish - and shoulder the risk - that local borrowing entities would be able to generate the fiscal resources needed to service debt. The in-built diversification of the intermediary's portfolio resulting from the variety of sub-sectors and borrowers would: provide a good security for, and strengthen the credit quality of, the debt issued by the intermediary; and allow the use of credit enhancement mechanisms such as bond insurance, which may be brought to bear only in the case of an expanded and diversified pool of debt. Further analyses related to the feasibility assessment of specialized financial intermediaries would need to address, inter alia, (i) the structural and institutional arrangements needed to establish market-based financial intermediaries that would operate in a competitive environment and issue debt without 46 government guarantee; (ii) the main operational features in terms of products range (loans, equity participation, guarantees, underwriting,..) offered by the intermediary and the diversification of its portfolio between sectors and borrowers; and (iii) the rnain financial parameters related to the intermediary's funding, lending and product pricing policies (including credit and interest rate risk management) needed to ensure financial sustainability. 47 References 1. Agh, Annamrria: Relationship and Cooperation Between Nonprofit Organizations and Local Governments in Hungary (WB, June 1999.) [Agh, A.: 1999] 2. Baar, Kenneth - Locsmrndi, G.: Review of Regulations of Urban Land Development (WB, 1999) [Baar, K - Locsmandi, G.: 1999] 3. Baar, Kenneth: Contracting Out Municipal Public Services Transparency, Procurement, And Price Setting Issues The Case Of Hungary (UWMRYIWB, 1998) [Baar, K.: 1998] 4. Baar, Kenneth: Financial and Regulatory Challenges - District Heating in Hungary (WB, 1999) [Baar,K.: 1999] 5. Bahl, Roy: Intergovernmental Transfers in Developing and Transition Countries: Principles and Practice (WB January 1999) [Bahl, R.: 1999] 6. Balas Gabor - Kovacs R6bert: Az drtekalap6 epitmlnyad6 bevezethetosege Magyarorszagon [Value based property tax - the chance for its introduction] (VaroskutatAs Kft. 1999) [Balas G. - Kovacs R.: 1999] 7. Barati, Izabella: Building Municipal Credit Markets - Barriers to Creditworthiness for Hungarian Municipalities (CUI/CIDA, 1999) [Barati, I.: 1999] 8. Barati, Izabella - Peteri, Gabor: A Penny Saved is a Penny Earned, About the City Treasury System in Hungary. (CCMI/CUI, 1997) [Barati, I. - Peteri, G.: 1997] 9. Barati, Izabella - Peteri, Gdbor: Local Treasury - Consolidated Cash-Cost Management for Local Public Service Organizations (WB-EDI 1999) [Barati, I. - Peteri, G.: 1999] 10. Bird, Richard - Wallich, Christine: Financing Local Government in Hungary. (WB, 1992.) [Bird, R. - Wallich C.: 1992] 11. Davey, Kenneth - P6teri, Gabor: Local Govermnent Finance: General Issues (KHF, 1998) [Davey, K - Peteri, G.: 1998/a.] 12. Davey, Kenneth - Peteri, Gdbor: Local Govermment Finance: Options for Reform (KHF, 1998) [Davey, K - Peteri, G.: 1998/b.] 13. Davey, Kenneth - Peteri, Gdbor: Local Taxation: Options For Reform (KHF, 1998) [Davey, K - Peteri, G.: 1998/c.] 14. Davey, Kenneth - Peteri, Gdbor: Transfers: Policy Options (KHF, 1998) [Davey, K - Peteri, G.: 1998/d.] 15. Davey, Kenneth - Peteri, Gdbor: Transfers: Radical Options (KHF, 1998) [Davey, K - Peteri, G.: 1998/e.] 16. Davey, Kenneth - Peteri, Gdbor: Two current issues In city management: 1. Management of overdue debt in utility services 2. Designing an industrial park (KHF, 1999) [Davey, K - P6teri, G.: 1999] 17. Davey, Kenneth: Delivering Municipal Services (KHF, 1998) [Davey, K.: 1998/a.] 18. Davey, Kenneth: Structures and Competencies - The Institutional Context of Local Government Finance (KHF, 1998) [Davey, K.: 1998/b.] 19. El-Daher, Samir - Kopdnyi, Mihdly - Noel, Michel: Finance Policy Note: Developing a Competitive Sub-national Finance Market Policy Issues and Challenges (WB, June 1999.) [El-Daher, S. - Kopanyi, M - Noel, M.: 1999] 48 20. El-Daher, Samir: Local Govenmment Finance - A framework for Enhancing Financial Management and Creditworthiness (WB, 1998) [El Daher, S.: 1998] 21. Fox, William F.: Intergovernmental Finance In Hungary: Summary And Evaluation (UIVMRI, 1998) [Fox W.: 1998] 22. Fox, William: Intergovernmental Finance in Hungary: Background Paper and Recommendations for the Public Sector Adjustment Loan. (WB, 1995.) [Fox, W.: 1995] 23. Garzon, Hernando: Local Revenues And Policy Implications (USAID/UI, 1998) [Garzon, H.: 1998] 24. Gurenko, Eugene - Hegedus, J6zsef: Policy Note: Local Management in Hungary: Fiscal and Structural Adjustment at the Local Level in the Context of Economic Transition (WB, June 1999.) [Gurenko, E - Hegeduis, J.: 1999] 25. Hegeduis, J6zsef: Organizational And Financial Structures Of Municipal Service Delivery (U/IMRI, 1998) [Hegeduis, J.: 1998] 26. Hegedius, J6zsef: The Subsidy System of Municipal Infrastructure Developments. (MRVCUI, March 1996.) [Hegediis, J.: 1996] 27. Hernann, Zoltan - Horvath, M. Tamas - Peteri, Gabor - Ungvari, Gabor: Allocation Of Local Functions: Criteria And Conditions (FDI-CEE/OECD/WB, 1998) [Hermann, Z - Horvath, T. - P6teri, G. - Ungviri, G.: 1998] 28. Hertelendy, Zs6fia - Kopanyi, Mihaly: Municipal Enterprises (WEB, 1999.) [Hertelendy, Zs. - Kopanyi, M. 1999] 29. Horvath Tamas M.: Institutional Changes for the Reform of Transfers (KHF, 1998) [Horvath, T.: 1998] 30. J6kay, Karoly - Kalmin, Judit - Kopanyi, Mihaly: Municipal Infrastructure Financing In Hungary: Four Cases (WB, 1998) [J6kay, K. - Kalmin, J. - Kopanyi, M.: 1998] 31. Kass6, Zsuzsanna: Vagyongazdalkodas: nyflvantartas 6s menedzsment (Budapest XI. keriulet) (WB, 1999) [Kass6, Zs.: 1999/a] 32. Kass6, Zsuzsanna: Vagyongazdalkodas: nyilvantartas es menedzsment (Nyiregyhaza) (WB, 1999) [Kass6, Zs.: 1999/b] 33. Kopanyi Mihaly: Az eur6pai onkornAnyzati rendszerek (Local governments and their finances, Chapter I., Consulting Rt. 1998 ) [Kopanyi, M.: 1998] 34. Kopanyi, Mihaly: Hungary - Subnational Development Program Country Assessment and Issues Paper (WB, 1998) [Kopanyi, M.: 1998] 35. Kovacs, R6bert - Seb6k, Orsolya: Financial Management In Hungarian Cities: The Case Of Oroshaza (USAID/UI, 1999) [Kovacs, R. - Seb6k, O.: 1999] 36. Kovacs, R6bert - Sebok, Orsolya: Tatabanya: A Case Study (USAID/UI, 1998) [Kovacs, R. - Sebok, O.: 1998] 37. K6nig, Eva: Mire elegend6 a szociAlis normativa? (Eseny Periodical Bulletin, 1998) [Konig, E.: 1998] 38. Kusztosne, Nyitrai E. editor. Helyi onkormanyzatok es penzugyeik (Local governments and their finances). (Consulting Rt., 1998.) [Nyitrai E.: 1998] 39. Lados, Mihaly: Property Taxation in Local Government Finances. (MTAIRKK/EDO, 1994.) [Lados, M.: 1994] 49 40. Laszl6, Csaba: Twists and Turns: The History of the Hungarian Public Finance Reform (WB, 1998) [Laszl6 Cs.: 19981 41. Long, Millard - Kopdnyi, Mihaly: Hungary - Financial Sector Development ch. 4. in Hungary On the Way to the EU (Country Economic Memorandum) The World Bank 1999 [Long - Kopanyi 1999]. 42. Makay, Matyas: Financing Municipal Utility Projects by Capital Market Instruments - Revenue Bonds (WB-PHRD, 1998) [Makay, M.: 1998] 43. Meszaros, Regina - Pataki. Zsolt: Financial Management In Hungarian Cities: The Case of Nagykanizsa (USAID/UI, 1999) [Meszaros, R. - Pataki, Zs.: 1999] 44. Noel, Michel: Municipal Finance Initiative In Europe And Central Asia Suggestions For A Country Program (WB, 1998) [Noel, M.: 1998] 45. Palne-Kovacs, Ilona: The Legal-Regulatory Background Of Fiscal Decentralization And The Specific Features Of Operation In Hungary (WB-PHRD, 1998) [Paln6-Kovacs, I.: 1998] 46. Peteri, Gdbor: Institutional Component of SNDP: City Management. Background Paper for the World Bank City Management Policy Note. [Peteri, G.: 1999] 47. Piroska Pergerne-Szab6: Property Management Policy of P6cs, a city with rights of a county (WB, 1999) [Pergerne-Szab6, P.: 1999] 48. Szalai, Akos: Alternative Service Delivery - Providing Options for Hungaian Municipalities (CUIWCIDA, 1999) [Szalai 1999/a] 49. Szalai, Akos: Value Based Property Taxation (CUI/CIDA, 1999) [Szalai 1999/b] 50. Vagi, Marton - Szakadat, Laszl6: The Possibility For Capital Market Financing Of Municipalities (WB-PHRD, 1998) [Vagi, M. - Szakadat, L.: 1998] 51. Vigvari, Andras: Municipalities in Hungary. (BB, 1995.) [Vigvdri, A. 1995] 52. Wetzel, Deborah - Papp, Anita: Fiscal Policy Note: Progress, Challenges and Options for Further Modernization of Intergovernmental Financial Relations (WB, June 1999.) [Wetzel, D. - Papp, A: 19991 53. World Development Report 1999/2000 - Entering the 21st Century (WB, 1999) [WDR: 1999] 54. World Bank - Country Economic Memorandum: Hungary - On the Road to the European Union (WB, 1999) [CEM 1999] 50 Distributors of World Bank Group Publications Prices and credit terms vary from CZECH REPUBLIC INDIA Eulyoo Publishing Co Ltd PERU SWEDEN country to country Consult your USIS, NIS Prodejna Allied Publishers Ltd 46-1, Susong-Dong Eddorial Desarrollo SA Wennergren-Willams AB local distributor betore placing an Havelkova 22 751 Mount Road Jongro-Gu Apartado 3824, Ica 242 OF 106 P 0 Boo 1305 order. 130 00 Prague 3 Madras - 600 002 Seoul Lima 1 S-171 25 Solna Tel. (420 224231486 Tel (91 44 852-3938 Tel- (82 21734-3515 Tel: (51 14( 285380 Tel. (46 8705-97-50 ARGENTINA Fun (420 22423 1114 Fax. (91 44) 852-0649 Fax (62 2) 732-9154 Fax (51 1 ) 286628 Fax (46 ) 27-00-71 Av Cordobati 77 URL blIpI/wwmnamcv INDONESIA LEBANON PHILIPPINES E-mail mall&wwiso An20 Ciudad de 1 uenos Aires DENMARK Pt Indira Limited Librairie du Liban International Booksource Center Inc. SWITZERLAND Te12 Cua d Bn Aims SamftindsLitteratur Jalan Borobudur 20 PO Box 11-9232 1127-A Antipolo St, Barangay, Librairre Payot Service lnsUtutionnel Tl. (5411(4815-8156 Rosenoerns Alte 11 PO Box 181 Beirut Venezuela C()tes-de-Montbenon 30 Fu (54 11(4615-6156 DK-l1i 97Prederiksberg C Jakarta 10320 Tel: (961 9( 217 944 Makati City 1002 Lausoanne E-mail wpbooksn@nfovia com.ar Tel (45 351942 Tel- (62 21 2390-4290 Fax (9613) 217 434 Tel. (63 2) 896 6501, 6505, 6507 Tel. (41 21 341-3229 AUSTRALIA, FIJI, PAPUA NEW Fan (453 1 357822 Fax. (622 ) 390-4289 E-mail hsayegh@llbrairie-du- Fax (63 2) 8961741 Fax (41 2 ) 341-3235 GUINEA, SOLOMON ISLANDS, URL hUp / www sl cbs dk IRAN liban.com.lb POLAND ADEO Van Diermen VANUATU, AND SAMOA ECUADOR Ketab Sara Co Publishers URL, httpJ/www librairie-du- International Publishing Service EditionsTechniques D A Information Services Libri Mundi Khaled EslamblIt Ave,- 615 Street liban com lb Ul Piekena 31/37 Ch de Lacuez 41 648 Whitehorse Road Libreria loternucinnal Delatrooz AlleyANo 8 MALAYSIA 00-677 Warzawa CH1807 Btonay Mitcham 3132, Victoria PO Box 17-01-3029 PO Box 15745-733 University ofMalaya Cooperative Tel- (462) 628-6089 Tel (41 21) 9432673 Tel (61) 3 9210 7777 Juan Leon Mera 851 Tehran 15117 Bookshop, Limited Fao: (42) 621-7255 Fax (41 21) 943 3605 F-aix (61(392107708ec co u Quito Tel (9821(0717610,0716104 P0 Don 11 27 E-ma'il books%ips66kp.atrn corn pi THAILAND URL hp //www dadirect7corn Tel 0 93 2) 521-606, (593 2) 544- Fax (98 21) 8712479 Ja5as Pantai Dar URL. Central B.nkoDisnTHon 1 ~~~~~~~~E-mail keetab-sara@neda netir 59700 Koala Lumpur blIp //www ipocg warn plAips/export 306ra Biorns RoDisnu AUSTRIA Fax (5932) 504-209 Ko6 Sb Publish Tel (603 756-5000oa Gerold and Co E-mail ibrimn1@fibnrimmomdco c PDBn15561Fax (6063(755-4424 PRUA ago 00 Weiburoldand e 26 E-madl librimu2*11brimund comC PO Box 1U95755s11Fax(603)7554424 Linraria Portugal Tel. 662) 2336930-9 AWei0burogase 20 E-mail hrimu2@librimondi cor ec Tehran E-mail- umkoop@tm,net my Apartodo 2681, Rua Do Carm Fax (66 2) 237-8321 -tol 4Wino 47310 CODEU Tel. (9821) 258-3723 MEXICO o70-74 Tel (431(512-47-31-0 Ruiz de Castilla 763, Edit Expocolor Fax (9821)258-3723 INFOTEC 1200 Lisbon TRINEDAD4 CTOBAGO FRL h(431(512-47-31-29 nhe Ptme Quito , f#RLN An San Fernando No 37 Tel ()1 347-4902 Systernatics Studies Ltd. URL Bp//aww.gernld,c/atoniQne Primert Goo,vOf #2 IREAND ency Col Toriella Guerra Fan )t( 347-0264 St Augustne Shoppiog Center BANGLADESH Tel/Fax (592 2 507-383, 253-001 GoeAnE tSuplhaie Agenc 14050 Mexico, 0 F Micro Industnes Development E- impsat net ec 4aroutL road Tel (2tern Main Road, St. AugoLtine AsisanDe SDannoy Th MIDASasOseve 43 Yoaa aadarcor Road e Tel (52 5) 624-2680 TrinidadtV Po 1624 i0 Rd An du Roi 202 Ce0 ( 307 Fax (52 F) 514-6799 9a, Kolpachniy Pereulok Kaml Ia 106 Dm 1 2 e Tel (20( 2 393-9732 Fan (972 3( 5265-397 NEPAL Moco 18 Tel6 256 41? 291 467 ael (3226 800401-7365 ron 206 Old Hope Road, (20 2) 393-9i7z 6 len a Everest Media Intemsational ServicesTn 7 0 9 Pan ( 49 251 46 Fax (32 2P 53808416 Fax 87 370909170 E-mail. goseowiftoganda corn BRAZIL INADP0 Ben 13056 GmOBo 5443 NoimarinFglasnet en UNITED KINGDOM Publicuacnes Tecnicus 3nternacionais Akateeminen Kireakauppa Tel Aviv 61130 ohnnsbrnde SMicroindo Ltd P0 Box 128 Tel (972 3) 640 9469 K Pt, Boon 3,a OmegaGA Fade, Ao 5 LIda F-4 HiF i 36 9Tel (977 1K) 416 026MYANMAR, BRUNEI HP6ohi3 G 035 PG Rua Peixoto Gomide, 209 n Helsnk Fax 45245 65 GU 2 10 01409 San Paulo, SP Tel (3580 121 4410 E-mail ioyhonenision net i Fa- (9771224431 Hemisthere Publication Services E F x '57 285 2798 Fax (5809) 121344358 URLhTtpel wwwroyncoi41 Kalla( Padding Road #04-03x TEl4 (44 142 Fan (55 ,1( 258-6990 Fan ( 1U /w c NETHERLANDS Golden [heel Building F (44 142 aTe (95 11 259-6844 E-mail. dktelaus Dstoeckmannt Palestinian Authority/Middle But De Lindebgom/rnternatinnale Singapore 349316 E-ai- 89809 E-mail postrnaster@piti vol hr UJRL http/ivwakateeminen com ondes lotormaon Services Fublicaties be- -Tel (65) 741-51660 R-m4 wank@mlcroinfo,co ak URL http//wwmwaol br FRANCE PO.B 19502 Jerusanlem RD Doe 202, 7460 AE Haaksbergen Pan, (69) 742-9356 URLEhtp-//wwmicrointo co oh CANADA Editions Eska, 2 6- Tel (972 2) 6271219 Tel, (31 53 574-0004 E-mail aohgate@ooianconnect.com The Stationery Office Renouf Publishing Co Ltd 46, mue Gay Lassac Poe (972 2) 6271634 Fax- (31 ) 572-9296 SLOVENIA ,t Nine Elms Lane 5369 Canotek Read 75005 Paris ITALY, LIBERIA E-mail. lindebooworldonline nl L ndon SWB CR Ottawa, Ontario KlJ 9,3 Tel (33-1 55-42-73-0So m o n URL bttp/-wwkorldonline n/-ho- Tel (44 171 873-8400 Tel (6135745-26692 Via Duca Ei Calabrin, 1u1 deboo Ounaska cesta a Fax ( 873-8242 Fan (61) 745-7660 GERMANY Casella Fostale 592 NEW ZmaLAND 1000 Llubljana URL. httpl/wwwlthe-statisnery- E-mail UNO-Verfag 50125 Firenze Tel (38661(133 83 47, 132 12 30 ota ice co ukn order dept@renoulbooks corn Poppelsdorfer Allee 59 Tel (39 59 65-41 5 EBSOD NZ Ltd Fan 1386 61()133 80 30 VENEZUELA URL StIp /1 maim reneutbooks corn 53115 Bonn ~~~Fax (3959(41-57New Market Bg904E-ma'rl repansekl@gvestnik si Tecnl-Ciencia Libros, S A CHINA Tel (49 228) 949020 E-mail licosa@ttbcc it AclnSOTARI,BOS NA Centm Cuidad Comercial Tamanco' China Financial & Economic Fn(92(142RLbp/mwtIcilcoa Tel (64 9(524-81 1 9For single tIdles- Nivel 02, Curacas Publishing House URL htOp //www von-verlag do JAMAICA Fan (64 9) 524-0067 Oxtord University Press Southern Tel- (98 2) 959 5547, 5035: 001 6 8. Do Fo Si Dong Joe E-mail uneverlag@aol corn Inn Poodle Publiohers Ltd Africa Fan (90 2) 959 5636 Beijing GHANA 206 Old Hope Road. Kingston 6 Oasis Official Vance Boulevard, Goodwood ZAMBIA Tel (86 10( 6401-7305 Epp Books Services Tel 076-927-2005 P0 Bon 3627 PO Duox 12119, Ni City 7463 University Bookshop, University of Fan (86 10) 6401-7305 PO Eon 44 Fan 876-977-0243 Weiiington Cape Town Zambia China Boek Import Centre TUG E-mail irpl@colis corn Tel (64 4) 499 1551 Tel (27 21) 995 4400 Great East Road Campus PO0Boxe2825 Telr 222 763JAPAN Fan (644()40991972 Fan (27 219595 4430 PO 8oxo32379 Beijing Fan 223 21 779099 Eastern Book Service E-mail oasis@actrixogen no E-mail oelord@oup co z6 Lusaka Chinese Corporation fur Promotion Fx23179093-13 Hongo 3-chome, Bunkyo-ku URL hotp//www oasiobDoks co 0z/ For snbscdption orders Pan- (260 1( 252 578 of Humanities GREECE Tekyo 113 NIEI nternational Subscription Sernice Fa (201 5 5 52. Yon Fang Hu Tong, PapioetriitySAPTels613)308-0061PO Boo 41099 ZIMBABWE Xuan Nei Da Jie 35, Stounrara St r Fan. (81 3) 3818-0664 UnvriyFeoLmtdCraighall Academic and 8aobab Dunks (Pot) 106082 Athens E-mail erders@svt-ebs co IF Three Crowns Building Jencho t Teli810j 024iTln31,6-02gR Pnvate Mail Bag 5905 Johannesbarg 2024Lt Telin '8 0 6 244Tl(01 6-86UL libadan Tel- (27111 080-1448 4 Conald Read, Graniteside Fan (86 10) 660 72 494 Fax (30 1) 364-8254 http /I/mww bekkoame or ,p/-svt- Tel: (234 22141-1356 Fx, 18064 PO Duox 567 COLOMBIA HAITI ebs Fan- (234 21) 41 -2056 E-ma~i issdisco za Harare Intoeniace LIda Cultnre Diffusion KENYA SPAIN Tel 263 4 755035 Carrera 6 No 91-21 5, Rue Capeis Afroan Book Service (E A ) LId PAKISTAN Mundi-Prensa Libros, S A Fax 263 4781913 Apantado Aeren 34270 CYP 257 Quaran House, Mfangano Street Mirza Book Agency CasteIlo 37 Santaft de B ti DCPort-on-Prince PO Boo 45249 65, Shahrah-e-Ouaid-e-Azam 28001 Madrid SanalddoDogta 0 e 5023 9200 Nairobi Lahore 54000 Tel- (34 91) 4 363700 Tel (57 1(265-2790l 59' 345 Fan (57 1( 265-2790 Fun (500)245 Tel (2942, 223 641 Tel (92 42, 735 3601 Fn(415 753998 COTE OP/DOIRE HONG KONG, CHINA; MACAD Pan (2542()330 272 Fan (92 42( 576 3714 E-mail24ibgre)ria@mundiprensa.es Asia 2000 Ltd Legacy Books ~~~~~~~~~~URL- hotp//rnw mundiprensa.com/ Center d'Edition et do Diffusion Asa20 teayBosOxfnrtt UJniversity Press Mundi-Prensa Barcelona Africaines (CODA) Sales & Circulusono Department Leita House S Boangalore Town Cneld et 9 04 BP51302 Seabird House Mezzanine 1 Shaa Faisluelen, 9 Abida P041 22-28 Wyndham Street, Central P0. Boo 68077 P0 Booe 13033009areln 0 Box 13033 ~ 0809Baceon ATilu 025)4650245 Hong Kong, China Nairobi Krci730Tl 3 )4839 Fan (225( 25 0567 Tel (65212530-1409 Tel (2541 2-330853, 221426 KaFci75x,Tl (343 488-34592 Fay (052( 2526-1107 Fan (294) 2-330854, 561654 Tl(92 21) 446307 CYPRUS E-mail- sales@usia20oO corn hk E-mail- Legacyvdform-net corn Fax (92 2 (4547640 E-mail barceluna@mundiprensa es Centr fr Aplie Reearh UR hfp./wwwaia20()cem hk E-mail oappak@The0ffice.net SRI LANKA, THE MALDIVES Center forlpliedg eserh SLhfJi ai20 KOREA, REPUBLIC OP Lake House Bookshop Cypru Collgene Stetnoi HUNGARY Dayang Booko Trading Co Fuk Bank Corporation 100, Sir Chittnmpalam Gardiner 6,DognsSre,Egi Euro Into Service International Division Aziz Chambers 21, Queen's Road Mawatha RDBoo 2006 Margttszgeti Europa Han 783-20, Pangha Boo-Dong, Lahore Colombo 2 Nicosia H-li1 38 Budapest Socho-ku Tel (92 42) 636 3222, 636 0885 Tel- (94 1(32105 Fax (357 2)96-20730 Tel (38 1(350 80 24, 350 80 25 Seoul Fax: (62 42) 836 2320 Fun (91432104 Fan (357 2) 60-2051 ~~~Fax (36 1( 350 90 32 Tel (02 2) 536-9555 E-mail, pbc@brain net pk E-mail. LHL@uri tasks net E-mail euroinfo@mail matav hu Fan (82 2) 538-0025 E-mail- searnap@chollian net Recent World Bank Discussion Papers (continued) No. 378 Trends in Financing Regional Expenditures in Transition Economies: The Case of Ukraine. Nina Bubnova and Lucan Way No. 379 Empowering Small Enterprises in Zimbabwe. Kapil Kapoor, Doris Mugwara, and Isaac Chidavaenzi No. 380 India's Public Distribution System: A National and International Perspective. R. Radhakrishna and K. Subbarao, with S. Indrakant and C. Ravi No. 381 Market-Based Instrumentsfor Environmental Policymaking in Latin America and the Caribbean: Lessonsfrom Eleven Countries. Richard M. Huber, Jack Ruitenbeek, and Ronaldo Ser6a da Motta. No. 382 Public Expenditure Reform under Adjustment Lending: Lessonsfrom World Bank Experiences. Jeff Huther, Sandra Roberts, and Anwar Shah No. 383 Competitiveness and Employment: A Frameworkfor Rural Development in Poland. Garry Christensen and Richard Lacroix No. 384 Integrating Social Concerns into Private Sector Decisionmaking: A Review of Corporate Practices in the Mining, Oil, and Gas Sectors. Kathryn McPhail and Aidan Davy No. 385 Case-by-Case Privatization in the Russian Federation: Lessonsfrom International Experience. Harry G. Broadman, editor No. 386 Strategic Managementfor Government Agencies: An Institutional Approach for Developing and Transition Economies. Navin Girishankar and Migara De Silva No. 387 The Agrarian Economies of Central and Eastern Europe and the Commonwealth of Independent States: Situation and Perspectives, 1997. Csaba Csaki and John Nash No. 388 China: A Strategyfor International Assistance to Accelerate Renewable Energy Development. Robert P. Taylor and V. Susan Bogach No. 389 World Bank HIV/AIDS Interventions: Ex-ante and Ex-post Evaluation. Julia Dayton No. 390 Evolution of Agricultural Services in Sub-Saharan Africa: Trends and Prospects. V. Venkatesan and Jacob Kampen No. 391 Financial Incentivesfor Renewable Energy Development: Proceedings of an International Workshop, February 17-21. 1997, Amsterdam, Netherlands. E. Scott Piscitello and V. Susan Bogach No. 392 Choices in Financing Health Care and Old Age Security: Proceedings of a Conference Sponsored by the Institute of Policy Studies, Singapore, and the World Bank, November 8, 1997. Nicholas Prescott, editor No. 393 Energy in Europe and Central Asia: A Sector Strategyfor the World Bank Group. Laszlo Lovei No. 394 Kyrgyz Republic: Strategyfor Rural Growth and Poverty Alleviation. Mohinder S. Mudahar No. 395 School Enrollment Decline in Sub-Saharan Africa: Beyond the Supply Constraint. Joseph Bredie and Girindre Beeharry No. 396 Transforming Agricultural Research Systems itn Transition Economies: The Case of Russia. Mohinder S. Mudahar, Robert W. Jolly, and Jitendra P. Srivastava No. 398 Land Reform and Farm Restructuring in Moldova: Progress and Prospects. Zvi Lerman, Csaba Csaki, and Victor Moroz No. 400 Russian Enterprise Reform: Policies to Further the Transition. Harry G. Broadman, editor No. 401 Russian Trade Policy Reform for WTO Accession. Harry G. Broadman, editor No. 402 Trade, Global Policy, and the Environment. Per G. Gredriksson, editor No. 403 Ghana: Gender Analysis and Policymaking for Development. Shiyan Chao, editor No. 404 Health Care in Uganda: Selected Issues. Paul Hutchinson, in collaboration with Demissie Habte and Mary Mulusa No. 405 Gender-Related Legal Reform and Access to Economic Resources in Eastern Africa, Gita Gopal No. 406 The Private Sector and Power Generation in China. Energy and Mining Sector Unit, East Asia and Pacific Region, World Bank No. 407 Economic Growth with Equity: Ukrainian Perspectives. John Hansen, editor No. 408 Economic Growth with Equity: Which Strategyfor Ukraine? John Hansen and Diana Cook No. 409 East Asian Corporations: Heroes or Villains? Stijn Claessens, Simeon Djankov, and Larry H. P. Lang No. 411 Making the Transition Workfor Women in Europe and Central Asia. Mamia Lazreg, editor No. 412 Intellectual Property Rights and Economic Development. Carlos A. Primo Braga, Carsten Fink, and Claudia Paz Sepulveda No. 413 Management and Resolution of Banking Crises: Lessonsfrom the Republic of Korea and Mexico. Jose De Luna-Martinez ; 8 at.r 5 X Z v f << , -w Ir . -r - 'C k - ~ ~~~~~~~~~~~~ _~~~~~~~~~~~~~~~~~~~~~~~ _n _ Z_D