In Poland and Hungary, for instance, the local governments were ... elements of the transition as privatization, tax reform, financial reform, price reform, subsidy ...
Environment and Planning C: Government and Policy 1994, volume 12, pages 263-276
Local finance and economic reform in Eastern Europe1
R M Bird Department of Economics, University of Toronto, Toronto, Ontario M5S 1A1, Canada C Wallich World Dank, Washington, DC 20433, USA Received 16 October 1993; in revised form 23 February 1994
Abstract. Extensive decentralization, both political and fiscal, is taking place in many of the countries newly emerging from behind the socialist veil. Decentralization represents both a reaction from below to the previously tight political control from the center and an attempt from above to further the privatization of the economy and to relieve the strained fiscal situation of the central government. Although there are of course many variations in this process from country to country, some important common elements arise from the similar institutional starting point in all countries and the common transitional problems most of them are facing. The on-going reforms of subnational finance in the transitional economies arc more important than seems generally to be recognized. The design of a well-functioning intergovernmental fiscal system is key to many of the major reform goals of the transition economics—macroeconomic stability, privatization, and the social safety net. The end of the beginning? One of the most important characteristics of the process of decentralization now taking place in the transitional countries of Eastern and Central Europe is how very recent it is. In Poland and Hungary, for instance, the local governments were established in their present form in 1990, in Romania, Bulgaria, and in the Russian Federation in 1991, and in Albania in 1992. Key elements of the legal framework needed for efficient local government are still missing in most countries, and further structural changes (for example, the introduction of regional governments) are still under consideration in countries such as Poland and Bulgaria. The evolution of local government has clearly begun in all the transitional countries, but it has by no means ended anywhere. At best, in Churchill's phrase, some countries may be near the "end of the beginning". Even after the basic structure of local government has been established, local elections still have to be held, new local governments established, and a myriad of important administrative details determined. In Romania, for instance, the first local elections were not held until February 1992, and the new mayors did not take office until April 1992. In the Russian Federation, the first local elections were held in November 1990, and in Hungary in April 1991. Even after a year or two of experience, mayors and local officials in some countries, particularly in the smaller communities, often have little idea of their real powers, responsibilities, and limitations (Peteri, 1993). Although the extent of decentralization varies from country to country, all too often no one really seems to be in charge of the process. Some key issues appear to have been decided (or left undecided) more by accident than design—particularly t This paper is largely based on Bird and Wallich (1993a). For an earlier version of some of this material, see Bird and Wallich (1993b). The authors are grateful to many colleagues and consultants at the World Bank for the extensive field research that has, in part, been drawn upon here.
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issues concerning the interaction of the new local governments with such critical elements of the transition as privatization, tax reform, financial reform, price reform, subsidy reform, and budgetary reform. Such neglect bodes ill not just for the local government sector but also, to varying degrees, for the ambitious reform plans in train in all these policy areas. Many potential difficulties have been kept in check largely by the continuance (de facto if not de jure) of the prereform system. Under this system, local governments received most of their funds from central government budgetary transfers which were basically allocated on the basis of negotiation and bargaining (Kornai, 1992). The central government always has the upper hand in this process, controlling not only the total amount of such transfers, but also who gets them, and when. The continued central control in most countries of such critical determinants of local outlays as wage structures and enterprise prices, and the habit of local dependence on central guidance (which remains particularly strong in such countries as Bulgaria and Romania), means that, in effect, this system continues to operate to a certain extent in most countries of the region. In the absence of strong central political control, however, this situation seems unlikely to continue in the long run. Already, some countries are finding that the combination of strong political forces urging more local control and the unbalanced mandate—virtually unfettered 'local autonomy', but a totally inadequate fiscal b a s e that has been legally bestowed on the new local governments is causing trouble. In Hungary and the Czech Republic, for example, central authorities have been concerned about the national implications both of local government business activities and of local borrowing as well as the fragmentation of the national education system. And in Russia, the only formally 'federal' transitional country, separatist tendencies fueled in part by fiscal pressures and imbalances are raising more fundamental political problems (McLure, 1994). At present, in most of the transitional countries, those local officials who are not simply waiting for orders to come down from above have understandably been using their energies primarily to attempt to wheedle more money out of the central government. In Romania, for example, where the entire 1992 transfer budget for localities was spent by the middle of the year—largely on centrally mandated subsidies to enterprises—Bucharest city officials were to be found two or three times a week at the Ministry of Finance trying to secure more funds. Those local officials fortunate enough to possess clear title to significant assets have been selling them off and using the proceeds for current expenditures (as in some towns in the Czech Republic) or trying to use their assets as equity in joint ventures with foreign investors (as in other towns in both Hungary and Romania). Although there is as yet little evidence that decentralization has resulted at the local level in wide deviations in the provision of essential services, other than those resulting from the general fiscal penury afflicting all the countries in the region, some evidence of marked regional inequality in service levels is emerging in Russia (Martinez-Vazquez, 1994). The pattern of subnational revenues and expenditures under the old, centralized, system was surprisingly unequal in per capita terms from region to region (Bahl and Wallace, 1994). Such problems seem likely to loom larger in the future both because of the growing importance of local governments as service deliverers and because of the pressure transition imposes on the 'social safety net', which is increasingly in some countries in the hands of local governments.
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Fiscal decentralization and transitional reform Political decentralization in all countries of the region has been paralleled to some extent by decentralization of fiscal responsibilities. In most countries, autonomy and control over (often ill-defined) local matters* is increasingly being devolved to local governments. Central governments in most countries seem to want "each tub to sit on its own bottom", that is, to assign taxes, reduce transfer dependence, and be done with it. Local governments, which want to shake off central control and be masters in their own house, are similarly attracted by the lure of autonomy. Most of the new local government legislation thus affirms decentralization, local financial autonomy, and the administrative independence of local governments from central control. The rhetoric is surprisingly similar in every country, although the reality differs from place to place. The general intent is clearly to free local governments from the dead hand of central control and to let local democracy flourish. It is far from clear, however, that the local fiscal systems being established will achieve this goal—at least not without compromising the attainment of the broader reforms under way in the transitional economies, such as price liberalization and privatization. Some form of local government structure had of course existed in most of the transition economies under the socialist regime. However, the fiscal system of this regime was essentially unitary, with local governments being little more than administrative units or 'departments' of the center, with no independent fiscal or legislative responsibility. Policymaking was controlled and centralized, and local government had virtually no independent tax or expenditure powers—part of a larger picture in which the budget itself was seen only as the handmaiden of the plan (Kornai, 1992). Now, however, virtually every transitional country is to varying degrees decentralizing, deconcentrating, and delegating functions and responsibilities, ^concentration' refers to dispersion of responsibilities within the central government structure from the center to regional 'branch offices'. It differs sharply from 'delegation' in which local government may execute certain functions on behalf of the central government (and be accountable to it for their performance), and 'decentralization', in which full decisionmaking and implementation authority is transferred to local government, which is accountable only to its own constituents. Decentralization has many merits, both in political and economic terms. It has, for example, the potential of improving the efficiency of local government by subjecting its actions to the scrutiny of the local electorate. It may also, however, complicate considerably the design and implementation of other important policy changes taking place in the transitional economies. The interaction of fiscal decentralization with some of these changes needs particularly close attention at this critical time. Although the data are far from satisfactory, table 1 indicates both the differences among countries in the size of the subnational sector and the nature of the post-transition change in process.(1) The traditional analysis of intergovernmental finance examines the fiscal functions of local and central governments in terms of their respective roles and responsibilities for stabilization, income distribution, expenditure provision, the appropriate assignment of tax functions, and the design of a transfer system that provides appropriate incentives. The benefit model of service provision, for example, suggests that local governments—whose role in this analysis is essentially that of service providershould be financed to the extent possible by charging for the services they provide, M Table 1, like the other tables in this paper, is based largely on unpublished World Bank documents. Detailed sources may be found in Bird and Wallich (1993a).
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Table 1. Reform and the size of the government sector. Country
Expenditure pre-1989
post-1989
total subnational (% GDP) a (% GDP) a Hungary Poland Romania Bulgaria CSFRC Russia d
62.7 49.7 45.1 55.2 58.4 51.0
14.3 14.7 3.6 na 20.5 20.7
subnational (% total) b
total (% GDP) a
subnational (% GDP) a
subnational (% total)b
25.4 35.3 11.4 na 34.5 16.0
57.4 40.1 24.6 43.0 60.1 41.0
10.4 4.0 6.1 25.0 20.2 17.0
18.2 11.0 10.8 23.0 34.3 43.0
a
As percentage of GDP. As percentage of total expenditure. c Czech and Slovak Federal Republic. Since 1993 the Czech Republic and the Slovak Republic. d Formerly the USSR, now the Russian Federation. na not available. b
with local taxes making up the remaining gap, supplemented as appropriate by transfers and, perhaps, some limited borrowing (Bird, 1993). This perspective is of course important in the transitional economies also. The obvious need for flexibility in today's rapidly changing environment, however, has led many central governments to attempt to preserve some degrees of freedom by continuing with the 'negotiated' tax sharing systems of the past (Bahl and Wallace, 1994). But this approach is not likely to be acceptable for long in countries in which demands for 'fair' treatment and equalization are strong and local governments are seeking greater autonomy. It is also incompatible with the efficient provision of local public services. It is therefore important to replace the present 'bargained' outcomes with an intergovernmental fiscal framework—of transfers, of local revenues, and of local expenditure responsibilities—that is both firm enough to serve as a basis for action and flexible enough to be compatible with the on-going structural changes and reform. Local government roles, responsibilities, and economic functions differ in several respects in transitional economies. First, the important roles of local government as producer and as owner, as well as the complicated and critical relationships between enterprises and local government in most transitional economies, must be taken into account. Local governments have a major role to play as potential impediments to, or supporters of, privatization. Moreover, the asset stock conferred on them in the decentralization process represents a potential source of revenue (or, in some instances, loss) (Aim and Buckley, 1994). The interaction of local government finance and privatization thus merits careful attention in the transitional economies. Second, the traditional approach ignores the shrinking role of government. In the old system, government, both local and central, played a major production role and was the major investor in the economy, and the expenditure side of the budget is cluttered with expenditures—not only subsidies, but direct investment, inventory finance, and wages—which in a market economy are not the responsibility of government. Unfortunately, in all the transitional countries government revenue is declining more rapidly than governments are able to divest themselves of these expenditure responsibilities, thus contributing to stabilization problems. One response in many countries has been to try to shift the deficit downwards by making local
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governments responsible for more expenditures, while simultaneously reducing central transfers to the subnational sector, This approach, however, is unlikely to be long sustainable. Third, although the present role of local governments with respect to the so-called 'social safety net* varies from country to country, problems are likely to arise in the future because of the combined effect of weakening central government capacity to maintain social protection and a growing need for such assistance as a result of economic restructuring. Even if the need for the bottom (local) layer of the social safety net increases, however, it is unlikely that local governments, even if they may sometimes be the appropriate executing agencies, should or can be responsible for financing such assistance. Indeed, as the revenue sources assigned to local governments in most countries cannot even finance the expected level of other local activities, one result of shifting responsibility for distributional expenditures downward may be, paradoxically, an increased demand for intergovernmental transfers. Decentralization and privatization In the past, governments both at the central and at the local levels were involved in almost every aspect of economic activity in the socialist economics. The state, broadly defined, owned all enterprises, from the steel plant on the Commanding heights* of the economy to the local laundry. The state organized production, allocated labor, planned exports, and so on. Recent reforms aim to decentralize ownership to the private sector. Two aspects of this process deserve emphasis, however, First, the transition is still far from complete in any country. Although all the transitional countries are committed to privatizing state assets, to liberalizing prices, and to withdrawing from the role of the state as direct producer and provider of economic goods, many productive assets—industrial assets, agricultural and urban land, the housing stocky commercial property—still remain in government hands, sometimes local, sometimes national. Second, what is required for the development of an effective private sector is not just the transfer of ownership but also the creation of a clearly defined, and separate, public sector. This process too is far from complete, whether viewed from the perspective of setting out a clear set of rules within which private economic agents may act or, equally important though much less discussed, from the perspective of setting out a clear set of rules under which public sector agents such as local governments may act to seek their own best interests without harming the common good. Dismantling the command economy not only requires the creation of a new private sector; it also requires the creation of a new public sector. In market economies local governments provide basic urban infrastructure and local public services (sometimes through local public enterprises) as well as acting as local administrators of national policies in such areas as education, health, and social services. In the former socialist pattern, on the other hand, enterprises owned by local governments had their investments financed from local budgets, and local budgets in turn derived revenues from 'their' enterprises. Government-enterprise relationships were close, and the distinction between enterprise functions and government functions murky (Martinez-Vazquez, 1994). Localities often asked enterprises to construct and finance such facilities as roads and schools, clinics, and even sports stadia and clubs; 'donations' to the budget for 'one-off outlays were also common. It made little difference whether such outlays were directly undertaken by the enterprise or via the more circuitous route of profit transfer and funding via the government budget: the burden on the enterprise and the net budgetary position was the same. All this is now changing.
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Until recently, for example, most local government revenue from enterprises came from 'profit remittances'. As a result of reforms to the national tax system, and especially of the enterprise tax system, however, in most countries such remittances have largely been replaced by taxes on 'their' enterprises (Tanzi, 1992; 1993). Some countries still provide explicitly for such 'ownership' rights to enterprise taxes. In Romania, for example, local governments have the right both to profits and to dividends taxes levied (by the central government) on local public enterprises. Local governments are becoming owners of housing, vacant urban land, and retail establishments (table 2). In Hungary local governments obtained ownership of the housing stock previously owned by the central government (Aim and Buckley, 1994). In Romania local governments have been given all formerly 'state' (centrally) owned properties within their territories, ranging from public domain property (parks) to private domain property such as enterprises. In Russia enterprises have long been owned by different levels of government. Most enterprises owned by the former USSR were transferred to Russian ownership, and the subnational governments (oblasts and rayons) not only retained their 'own' enterprises but also, in the case of the oblasts, became owners of enterprises formerly owned by the Russian Republic. Table 2. Privatization revenues: ownership and disposition. Country
Housing
Retail units
Domestic industrial enterprises
Hungary local local central, local Poland local local central, local Romania local3 local3 central, local Bulgaria localb local3 central, local Czech Republic local local central, local and Slovak Republic Russian Federation local, enterprise local local3 3 Almost exclusively local. b In Bulgaria only 10%-15% of the total housing stock is in the hands of local authorities. The remaining 85%-90% is now privately owned. Such asset transfers may be a mixed financial blessing (Aim and Buckley, 1994). Although consistent with decentralization and the prevailing rhetoric about local autonomy, one motivation for asset transfers in some instances may well have been to avoid the fiscal burden (such as subsidies, maintenance, and repair) that ownership responsibilities carry. Local governments will thus be faced with major maintenance and subsidy burdens, especially for housing, unless privatization proceeds apace. Quite apart from this potential problem, a worrisome pattern in virtually all transition economies has been the involvement of governments at different levels in joint economic ventures with respect to purely private market-oriented activities. Romania's 1991 Local Government Act puts it best, but is not exceptional: "Local governments are authorized to create, contribute equity and/or take shares in commercial enterprises formed with their assets belonging to or transferred to their ownership, including the possibility of forming joint ventures with foreign or domestic partners". If the privatization process is to be completed, getting local governments out of the business of business (and into the 'business of government') is crucial. Unfortunately, in at least some countries the process of property transfer appears to have given undesirably broader scope to the entrepreneurial ambitions of local governments.
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In almost every country some misuse of local assets is already visible. Local assets may represent a windfall—at least in those cases where they are not accompanied by central policies (for example, rent or price control) that turn them into a liability. But they may also often be misused, whether they are privatized or not; (a) A local heating plant that is privatized, for example, but remains a (local) *natural monopoly* may obviously raise regulatory problems; who deals with these problems, and how? # , (b) What should be done with the proceeds of asset sales? Under what (very limited) circumstances should such proceeds be used to finance current local expenditures (Ncwbery, 1991)? (c) If an asset is not privatized, but is used to generate on-going revenues for the local government, the temptation to sustain and strengthen any monopoly position is obviously again a problem, as is that of regulation. (d) Even more damaging is the high probability that more speculative venturesexamples include tourist lodges and bakeries—are likely to fail Also deplorable is the dissipation of scarce local managerial skills on trying to squeeze money out of such entrepreneurial gambits rather than focusing on the more essential task of trying to provide local public services efficiently. Too many local authorities in transitional countries appear to be excessively optimistic about their abilities to enhance revenue from their assets. Some hope to establish joint ventures with a domestic or foreign partner, or another state enterprise, using local assets as the locality's equity share. In those localities well endowed with land, this appears to be the preferred equity contribution. Other localities appear to see potential in developing and servicing empty land so as to enhance its value as equity. In Hungary, for example, tourism lodges, recreational facilities, and golf courses are examples of joint ventures-in-process. In localities which inherited important real properties, similar potential was seen in developing these as contributions to industrial joint ventures such as bakeries, construction firms, and food processing facilities. In Russia, virtually all subnational governments want to develop and exploit their asset base through domestic joint ventures, and anticipate a positive revenue flow from the projects, once completed. Similarly, in Poland, the provision of private services as a means of earning local revenues appears to have strong support: housing and real estate development, food and furniture manufacture are cited as examples. From the perspective of local government, there may seem to be good reasons for government involvement in such market ventures. With available land that can only with difficulty be privatized, the cost to government of contributing this resource to a joint venture may be perceived as very low. Many local public officials understandably wish to create jobs in their jurisdictions, which are often economically depressed and lack private entrepreneurship. All too often, however, the hope for profits from such ventures may quickly turn into demands on government budgets to cover losses. Experience everywhere shows that the perspectives and goals of public officials tend to make them poor business managers. In particular, it is hard for government to close a failing business, especially when the local employment situation is far from healthy. There is also the risk that local governments and their businesses will undercut private competitors, possibly by playing regulatory games to protect local monopolies, with the result that the role of government in the economy will not diminish. And, of course, if local governments own businesses, they may fall prey to the risks of ownership. In the industrial market economies, the rate of small
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business failure is high: only one in five of such businesses survive their first three years. In particular, real estate development and financing is one of the riskiest business areas in market economies. There is no reason to expect that the transitional economies can beat these odds. In addition to being risky, entrepreneurial activity by local governments is fundamentally inconsistent with privatization, and represents a bottleneck to true decentralization—that is, decentralization, not from the state to local governments, but from government to the private sector. Local entrepreneurial activity is neither privatization nor true decentralization. Local 'entrepreneurialism' may slow down, even reverse, the process of privatization—the long-term goal of getting government out of those activities that can be handled by the private sector. One implication of this argument is simply that it is critical in the transitional economies to provide adequate revenue instruments and flexibility at the local level. If the only flexibility available to local governments in their struggle to cope with budgetary pressure is by using such economically undesirable sources of revenue as profits derived from direct public ownership of local businesses, they are likely to do so. Municipalities should not be encouraged to develop local monopoly enterprises in order to secure the revenue they need to function, just as they should not be forced to establish small taxes on a wide range of products and activities which are expensive to administer, generate widespread public resistance, and typically yield little. Some local access to the national tax base (through transfers), the ability to levy local surcharges on certain national taxes where appropriate, and especially the establishment of at least some significant revenue sources under local control (Kelly, 1994) thus seem essential, if the struggle for local revenue is not to delay and perhaps destroy privatization reforms. Decentralization and stabilization The wrenching reforms most transitional countries are currently undertaking in order to achieve macroeconomic stabilization and to compress the state budget may also produce perverse effects at the local level. Some central governments, for example, have shifted additional expenditure responsibilities downwards in the hopes of improving their budgetary position (Martinez-Vazquez, 1994). Revenue assignments and /or transfers to local governments are generally tightly restricted for the same reason (table 3). Unless a workable framework for intergovernmental finance is put in place, the current budgetary stringency seems likely to create additional hurdles to disassociating local governments from their enterprises. Central governments in most transitional countries appear to view fiscal decentralization as an opportunity to reduce central expenditures in two ways: by spinning off expenditure responsibilities to the subnational level and by reducing fiscal transfers—purportedly to make local governments more 'independent', but with the welcome side effect of reducing central outlays. In particular, some countries are transferring increasing responsibility for social expenditures and the social safety net to local government. The most dramatic case is that of Russia, where the central government transferred social expenditures equivalent to some 6% of GDP (1992) to the local level, with the objective of "pushing the deficit down" (Wallich, 1992). The hope seems to have been that the subnational governments would perform the politically painful cutting required even though the demand for these services seems more likely to grow than to shrink, owing to the worsening economic situation. More recently, responsibility for key national, interjurisdictional investments (for example, in transport) has also been transferred to the subnational sector in Russia.
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Table 3. Revenue assignments to suhnationnl authorities (source: Bird and Wnllicli, 1993a), Hungary Poland Romania Bulgaria Czech Slovak Russian (1991) (1991) (1991) (1991) Republic Republic Fcdcr. (1991) (1991) (1992) Turnover tax (or VAT) (%) Corporate income tax (%) Personal income tax (%) Tax on properly of locally owned SOEs (%)cf Excises (%) Wage tax (%) Small and medium enterprises/collectives income tax (%) Local taxes real estate tax (%) auto/road tax (%) small business taxes (%) agricultural tax (%) poll tax (%) Natural resources tax (%) Other'
0 0 25 e 0
0 5 30" 100
0 0 0 958
0« 50 b 70 ni
ni ni ni 50
ni ni ni 100
20 60 100 100
0 0 na
0 30 h 50
0 0 0
0 0 ni
ni 0 ni
ni 13 ni
61 0 na
100 100 100 100 100 0 100 100 na na na tourism, misc. misc.
too
100 ni ni 100 na na na
100 ni ni ni na na na
100 ni ni 100 na na na
too
100 na 100 na na misc.
• Introduced in 1993. b 40% from municipal enterprises and 10% from state enterprises, c Reduced from 100% (1990) to 50% (1991). d Transformed into a more effective personal income tax in 1992 and shared according to a 85% (central)-15% (local) ratio.
100 100 na na na 100 21 misc. taxes
e
SOE state-owned enterprise. Also considered as property income tax. s Until 1992 tax reform. h Abolished in 1992. 1 misc. miscellaneous. Feder. Federation, ni no information. na not applicable. f
In contrast, in Albania, although responsibility for social assistance has also been pushed 'downstairs', the central government has retained primary responsibility for financing such assistance. A strategy of devolving expenditures downward while cutting back on transfers is unlikely to prove successful for long, however. Indeed, net expenditure reductions at the subnational level may prove very difficult to achieve. At present, for example, state enterprises provide a wide range of social sector outlays: with privatization, many of these outlays will have to be taken over by local governments. Because the revenue sources assigned to local governments in most countries simply cannot finance the level of local activity that seems likely to be required in the immediate future, the result of shifting expenditures downward may be increasingly strong demands from politically stronger local governments for increased, rather than reduced, transfers. An additional caution concerns the risk of excessive recourse to borrowing by hard-pressed local governments. A number of countries have granted virtually unlimited borrowing powers to local governments without taking adequately into account the macroeconomic necessity of monitoring and controlling such borrowing. As yet, the relatively undeveloped state of financial institutions in most countries has limited abuse of this borrowing power, but it remains a potential danger. Fiscal difficulties at the national level have also led some countries to reduce intergovernmental transfers. The principle of 'budgetary independence' has been
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interpreted to mean that subnational governments should be financially self-sufficient, which in turn implies that direct transfers should be reduced and even eliminated. In reality, however, in most of the transition economies central transfers to local government sector remain very large (table 4), reflecting both the rudimentary tax base available to local governments and the center's reluctance—again to avoid fiscal vulnerability—to part with any of its major tax bases or even to give local governments access to them. As a rule, the amount and distribution of intergovernmental transfers in most countries continue to be determined annually on a discretionary basis in accordance with central fiscal exigencies. Such budgetary flexibility is clearly desirable from the central government's short-run view. Nonetheless, it is a mistake to view intergovernmental transfers as an easily compressible portion of the national budget. Many of the services provided by subnational governments, particularly in view of the 'pass-down' phenomenon already discussed, constitute essential expenditures for political stability or for future economic development. The many local governments that have been created (table 5) in response to political pressures in most countries cannot finance the provision of these services at an adequate level out of their own resources. In the current macroeconomic environment an underfunded local government sector seems likely to result in a situation in which the only way local governments can cope with budgetary pressure is by using economically undesirable sources of revenue such as profits derived from the exploitation of income-earning assets transferred to them and from direct public ownership of local businesses. At the Table 4. Structure of subnational government finance (source: Bird and Wallich, 1993a). Hungary Poland
Romania Bulgaria Czech Slovak Russian Republic Republic Feder.
Own resources (%) 18 50 25 Shared tax (%) 13 25 0 Total local resources (%) 31 75 25 Transfers from central government (%) 68.5 a 25 75 a 51.4% as grants and 17.1% as Social Security Funds Feder. Federation.
4.4 49.4 53.8
9 6 15
71 5 76
95 95
46.2 85 transfers.
24
5
Table 5. Decentralization : scale and size of government. Country Hungary Poland Romania
Number of units of local government
Average size
3070 municipalities 2 834 2383 gminas 16000 2940 urban and rural municipalities 7500 41 judetse 537804 Bulgaria 273 municipalities 30000 2843 cities in the Slovak Republic CSFR a 1867 5 500 cities in the Czech Republic 2000 rayons 125 000 Russian Federation 88 oblasts 2840 909 a Czech and Slovak Federal Republic; since 1993 the Czech Republic and Slovak Republic. Figure for average size is for the former CSFR as a whole.
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same time, local governments' open-ended expenditure responsibility for social assistance in some countries may result in emergency recurrence to the central government for additional funds, or simply the unsustainable accrual of arrears through short-term borrowing, as is currently happening in Russia. One way or another, intergovernmental transfers thus seem likely to be an important component of the central budget for years to come in most transitional countries: it is therefore critical that such transfers be well designed and implemented (Bird and Wallich, 1992), Decentralization and the social safety net In principle, local governments in all the transitional countries should of course be reducing expenditures by shedding unnecessary and unproductive subsidies (for example, to housing) as part of the economic transition to a market economy. At the same time, however, they may, as noted earlier, have to take on some expenditures previously carried by enterprises. Whether such enterprise functions will accrue to national or local budgets is hard to predict; it is equally difficult to predict the net changes, in the short term, in the size of the local government sector. In Russia, as one example, the nonproduction responsibilities of enterprises are, virtually across the board, likely to be taken on by the subnational sector, thus substantially increasing its expenditure responsibilities (Martinez-Vazquez, 1994). Indeed, such a transfer is de facto already taking place owing to the financial difficulties of many enterprises. Similar problems, though less severe, arc occurring in other countries. In principle, the shift in expenditure responsibilities from enterprises to local government should be matched, at least to some extent, by a corresponding change in the revenue base of the local government. In practice, however, that revenue base is already inadequate and is not being increased as needed. A special problem arises with respect to the price charged by those local public enterprises that may properly be retained in the public sector.(2) In the past, governments in the socialist countries used low and fixed prices (including rents and other urban user fees) as well as wage controls, as part of their distributional tool kit. Governments are now being asked, in the reform environment, to 'get the prices right' and to use tax policies and targeted subsidies for distributional purposes instead. Massive changes in prices across a wide range of activities—heating, water, transport, rent, etc—will, however, inevitably have a major impact on household budgets, and neither the tax nor the transfer systems in transition countries can easily handle the downside of such impacts. Moreover, changes in public sector prices (user charges) clearly need to be coordinated with wage reform on the one hand and with more general price reforms on the other hand, in order to avoid undue impact on income and major distributional shifts (as well as on profits and hence government revenue). Just how to design and sequence such a complex series of reforms in a rapidly changing political and economic environment is far from obvious. Public sector pricing thus seems likely to be one of the last areas to be reformed in most countries. Whereas national price reforms have liberalized most private sector prices, at the local level governments are having a much harder time adjusting prices for public services, even for private goods provided by the public sector, such as housing rents (and such ancillary services as water and heating) and transport fares. Adjusting these prices is of course essential both for efficiency and to enhance local revenues (Aim and Buckley, 1994). Doing so, however, implies major changes in the cost of living and in welfare, so that changing such public sector W In Romania such enterprises {regies autonomes) are clearly distinguished from other 'commercial' enterprises, but this distinction is not so clear in other countries.
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prices will entail major, and undoubtedly very unpopular, distributional shifts if not properly coordinated with other reforms. Such shifts could upset the fragile democracies that have only just emerged in most countries. Partly for these reasons, local freedom to set local public sector prices remains heavily constrained in most countries. One approach may be to replace consumer price subsidies by targeted subsidies (with a smaller budgetary impact); but this requires the development of new information and tracking systems. Such 'targeting' might seem relatively easy in the transition economies because of the existence of a large (prereform) 'control' database, but in fact not only were there surprising gaps in that database but it is weakening daily owing to the dependence of official information on a local control system that is disintegrating rapidly, if it has not already disappeared. The increasing growth of the euphemistically labelled 'informal sector' has not made data gathering any easier. Indeed, since the breakdown of central planning, central governments in most countries have surprisingly little information even about the activities of local governments. Only in a few countries (for example, Hungary, Poland) do local governments now appear to provide detailed financing reports to the center. Reporting of data on extrabudgetary funds and borrowing is especially deficient. Such informational gaps need to be closed before either the fiscal or the social reality, and potential, of local distributional policy can be adequately assessed. Implications for local government finance What do the concerns expressed above imply for the design of local and intergovernmental fiscal systems in the transitional economies? In the first place, the level, design, and effects of intergovernmental fiscal transfers obviously constitute key elements in the emerging intergovernmental and local finance systems of the transitional economies (Bird and Wallich, 1992): (1) Critical decisions must be made with respect to the overall size of such transfers (the 'distributable pool') as well as with respect to the distribution formulas to be employed, taking into account both the severe fiscal pressures on the central government and the vital tasks to be performed by the local governments in the emerging new structure of the public sector. (2) Practical measures of 'tax capacity', 'expenditure need', and perhaps 'fiscal effort' need to be developed for use in such formulas. (3) Institutions must be developed both at the central and at the local levels to ensure that transfers (or subsidized credits) are put to the best possible use. Such institutions may include, for example, at the center, an agency concerned with both monitoring the performance of local governments and providing them with needed technical assistance and support and, at the subnational level, various intermediary bodies, particularly with respect to the many very small municipalities that have been created in most countries. The new local governments also need substantial help and guidance in developing adequate local revenue systems. Moreover, it is critical that subnational revenue needs and possibilities be realistically factored into national plans for tax reform, price reform, subsidy reform, and financial reform. Too often, local and intergovernmental finance decisions have been made hastily, in the absence of critical information, and without taking adequately into account their interdependence with other policy areas. In most countries, for example, the principal local tax is some form of property tax (Kelly, 1994). But in too many cases (for example, Romania), national governments
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have hamstrung the revenue potential of this tax both by granting exemptions to newly privatized land, housing, and enterprises and by fixing a uniform national tax .rate. In other instances (for example, Hungary) local governments are supposed to receive some share of certain national taxes, often on a derivation basis (for example, origin, or residence) (Bird and Wallich, 1992). Such provisions often, however, raise both technical and allocative problems, in addition to biasing national tax policy decisions in unfavorable ways (Bahl and Wallace, 1994). Even when the local tax base is feasible and adequate in principle, realistically it will take some years before the system can be expected to produce sufficient revenues to meet perceived local needs. Many local expenditures cannot be postponed until the revenue side is fixed up. The increased pressure on the social safety net and the understandable desire of newly elected local officials to provide services to their constituents will not wait. Even if local expenditures arc rationally assigned, and designed, the paucity of locally controlled tax resources in most transitional countries, when combined with the universal reluctance of politicians to tax constituents too directly and openly, makes it almost inevitable that hard-pressed local governments will turn to other avenues for revenue. They will demand increased transfers, they will try to borrow, and they will try to exploit to the full the new assets they have acquired as part of the decentralization-privatization process (McLurc, 1994). Each of these paths carries with it dangers for the transition process as a whole. A broader framework than usual is thus needed to analyze fiscal decentralization and local and intergovernmental fiscal issues in the transitional economics. This framework must incorporate such elements as the likelihood of continuing structural changes in the economy and continuing political shifts, the need to undertake intergovernmental reforms while coping simultaneously with stabilization pressures and the increased importance of the social safety net, the likelihood of continued (local) public ownership on a significant scale, the financial implications of such ownership and its possible conflicts with the overall privatization objective, and continued vestiges of price and wage controls and other rigidities. Comprehensive and accurate analysis of decentralization in the transitional countries must take these elements adequately into account if either decentralization or some of the other key transitional reforms discussed above are to be achieved fully, or very soon. Each transitional country is different, and each will need close examination to determine the precise structure of the relevant incentives, constraints, and opportunities in order to design as 'hard' a budget constraint as may prove acceptable. In some ways, what seems most needed to improve policy with respect to subnational finance in most transitional countries is simply to slow down as much as possible (given the political pressures to 'do something') and to move empirically and with caution in designing and implementing new local and intergovernmental fiscal systems. The issues are complex, technical, and place specific (as well as highly political) and the knowledge needed to determine the effects of various alternatives is often lacking. In these circumstances, good analysis based on sound local knowledge may potentially have a major impact on improving the design of the systems that are put into place—and hence, perhaps, help to improve the lives of the millions of Europeans undergoing one of the major upheavals of our time, the move from a command to a market economy.
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References Aim J, Buckley M, 1994, "Decentralization, privatization, and the solvency of local governments in reforming economies: the case of Budapest" Environment and Planning C: Government and Policy 12 333-346 Bahl R, Wallace S, 1994, "Revenue sharing in Russia" Environment and Planning C: Government and Policy 12 293-307 Bird R M, 1993, "Threading the fiscal labyrinth: some issues in fiscal decentralization" National Tax Journal 46 207-227 Bird R M, Wallich C, 1992, "Financing local government in Hungary", WP WPS 869, World Bank, Washington, DC Bird R M, Wallich C, 1993a, "Fiscal decentralization and intergovernmental relations in transition economies" WPWPS 1122, World Bank, Washington, DC Bird R M, Wallich C, 1993b, "Moving from command to market economies: local finance and economic reform in Eastern Europe", in Local Government Taxation: International Report 1993 Ed. C Farrington, IRRV Services Ltd, 41 Doughty Street, London WC1, pp9-16 Kelly R, 1994, "Implementing property tax reform in transitional countries: the experience of Albania and Poland" Environment and Planning C: Government and Policy 12 319-331 Kornai J, 1992 The Socialist System (Princeton University Press, Princeton, NJ) McLure C E Jr, 1994, "The taxation of natural resources and the future of the Russian Federation" Environment and PlanningC: Government and Policy 12 309-318 Martinez-Vazquez J, 1994, "The challenge of expenditure assignment reform in Russia" Environment and Planning C: Government and Policy 12 277-292 Newbery D, 1991, "Reform in Hungary: sequencing and privatization" European Economic Review 35 571-580 Peteri G, 1993, "Local governments: what are they good for?" Local Democracy and Innovation Project, Budapest, January; available from H-2094 Nagykovacsi, Kolozvar utca221a, Hungary Tanzi V (Ed.), 1992 Fiscal Policies in Economies in Transition (International Monetary Fund, Washington, DC) Tanzi V (Ed.), 1993 Transition to Market: Studies in Fiscal Reform (International Monetary Fund, Washington, DC) Wallich C, 1992 Fiscal Decentralization: Intergovernmental Relations in Russia (World Bank, Washington, DC)
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