metadata: authors: 0: author: Bird, Richard
1: author: Wallich, Christine
docna: 0: docna: Fiscal decentralization and
            intergovernmental relations in transition economics : toward
            a systematic framework of analysis
docty: Policy Research Working Paper
subtopic: Tax Administration,Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Tax Law,Public Sector Economics,State Owned Enterprise Reform,Tax Policy,Public Sector Administrative & Civil
            Service Reform,Educational Sciences,Privatization,Energy Privatization,Public Finance Decentralization and
            Poverty Reduction,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The decentralization of government in
            Eastern Europe represents a reaction both from below (to
            tight central political control) and from above (to
            privatize the economy and relieve the central
            government's fiscal stress). In all transitional
            economies, the developing structure of intergovernmental
            relations is intimately related to such critical policy
            issues as privatization, stabilization, and the social
            safety net. In the fiscal sphere, tax reform, deficit
            control, and intergovernmental finance are a tripod. Unless
            each leg is set up properly, the whole structure could
            collapse. The present strategy of devolving expenditures
            downward while holding back on revenue flows and transfers
            to balance the central budget is unlikely to succeed for
            more than a year or two at best. Net spending reductions at
            the subnational level may be difficult to achieve. From 10
            to 40 percent of outlays go to the subnational sector, and
            in many countries local governments provide much of the
            social safety that makes the pain of the economic transition
            politically tolerable. And, most housing and many
            enterprises have been shifted to local ownership, with the
            maintenance and subsidy cost this implies. Since the revenue
            sources assigned to local governments cannot finance
            expected levels of local activity, the result of shifting
            spending downward is likely to be strong demands for
            increased, rather than decreased, transfers. Alternatively,
            subnational government may look to coping mechanisms such as
            holding on to their enterprises (which provide vital social
            services), developing extrabudgetary revenues, or borrowing.
            These coping mechanisms threaten privatization, reduce
            budgetary transparency, and impede stabilization policies.
            The authors describe the risks to privatization, to
            macroeconomic stability, and to an adequate social safety
            net that present policies toward local government may imply.
            Its themes are that the subnational sector needs to be more
            realistically factored into national plans - and that
            subnational expenditures be more clearly assigned and
            revenue needs more realistically assessed. Such assessments
            are likely to acknowledge a larger sphere for subnational
            governments and the need for access to more robust revenue
            sources. Giving local government a share in the personal
            income tax is one possible and perhaps desirable approach to
            meeting these revenues needs. Careful attention needs to be
            paid to the design and implementation of the
            intergovernmental fiscal transfers likely to remain
            prominent features of the intergovernmental landscape for
            years to come. Caution is also needed on borrowing by
            subnational government. Consolidating and integrating
            extrabudgetary funds at the subnational (and national)
            levels is crucial to enhanced budgetary transparency and macrostability.
repnme: repnme: Fiscal decentralization and
            intergovernmental relations in transition economics : toward
            a systematic framework of analysis
display_title: Fiscal decentralization and
            intergovernmental relations in transition economics : toward
            a systematic framework of analysis
listing_relative_url: /research/1993/03/699072/fiscal-decentralization-intergovernmental-relations-transition-economics-toward-systematic-framework-analysis
topicv3: Education m1327048 470,Privatization m1327236 1283,Fiscal Decentralization m1327382 829,Tax Policy m1327616 983,Public Administration m1327723 723
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy Research Department
no_of_pages: 92
model_extractions: **Policy R oroh|**

# **Public Economics**

WPS 1122

- This paper a joint product of the Public Economics Division, Policy Research Department, and the Infrastructure Division, Technical Department, Europe and Central Asia, and Middle East and North Afica - Regions is part of a larger effort in both departments to analyze issues relating to decentralization, and in particular, the role of subnational governments in the reform pmcess. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Bonnie Pacheco, room HI 1-065, extension 37033 (March 1993, 85 pages).

The decentralization of government in Eastern Europe represents a reaction both from below (to tight central political control) and from above (to privatize the economy and relieve the central government's fiscal stress).

In all transitional economies, the developing structure of intergovernmental relations is intimately related to such critical policy issues as privaization, stabilizatic l, and the social safety net. In the fiscal sphere, tax reform, deficit control, and intergovernmental finance are a tripod. Unless each leg is set up properly, the whole structure could collapse.

The present strategy of devolving _expenditures_ downward while holding back on revenue flows and transfers to balance the central budget is unlikely to succeed for more than a year or two at bestL Net spending reductions at the subnational level may be difficult to achieve. From 10 to 40 percent of outlays go to the subnational sector, and in many countries local governments provide much of the social safety that makes the pain of the economic transition politically tolerable. And, most housing and many enterprises have been shifted to local ownership, with the maintenance and subsidy cost this implies. Since the revenue sources assigned to local governments cannot finance expected levels of local activity, the result of shifting spending downward is likely to be strong demands for increased, rather than decreased, transfers. Altematively, subnational governments may look to "coping mechanisms" such as holding onto their enterprises (which provide vital social services), developing extrabudgetary revenues, or borrowing. These coping mechanisms threaten privatization, reduce budgetary transparency, and impede stabilization policies.

Bird and Wallich describe the risks to piivatization, to macroeconomic stability, and to an adequate social safety net that present policies toward local government may imply. Its themes are that the subnational sector needs to be more realistically factored into national plans - and that subnational expenditures be more clearly assigned and revenue needs more realistica9;y assessed. S&ch assessments are likely **tv** acknowledge a larger sphere for subrational governments and the need for accec! tm robust revenue sources. Giving local government a share in the personal income tax is one possible and perhaps desirable approach to meeting these revenue needs.

Careful attention needs to be paid to the design and implementation of the intergovernmental fiscal transfers likely to remain prominent features of the intergovernmental landscape for years to come. Caution is also needed on borrowing by subnational government. Consolidating and integradng extrabudgetary funds at the subnational (and national) levels is crucial to enhanced budgetary transparency and macrostability.

The Policy Research Working Paper Series dissemirsates the fmdings of work under way in the Bank. Anobjecii vof the series is to get **these** findings out quickly, even if presentations are less **than** fully polished. The findings, interprAtations, and conclusions in these papers do not necessarily rexesent official Bank policy.

Produced by the Policy Research Dissenination Center
FISCAL DECENTRALIZATION AND INTERGOVERNMENTAL RELATIONS IN TRANSITION ECONOMIES:

# TOWARD A SYSTEMIC FRAMEWORK OF ANALYSIS

by Richard Bird University of Toronto and Christine Wallich Country Economics Deparhnent Public Economics Division The World Bank
......................................... 1

# Table of ConLonts

# 1. INTRODUCTION AND SUMMARY .

Why 8Local1 Finance Matters Traditional vs Systmic Frameworks . ....................................... 2 Organization of the Paper .............................................. S Political/Overall Structural Reform Context ................................... 6 Borrowing .................................................. 8 Extrabudgetar Funds ................................................ 8 Infitutional Framework ............................................... 8

|II. DECENTRAULZATION<br>IN PROCESS: TRENDS AND THEMES ........................|9|
|---|---|
|A Time of Transformation .<br>............................................|9<br>|
|The End of Centra Planning: Filling The Abhorted Vacuum ........................|9<br>'|
|Political D entatization .<br>.............................................|<br>11|
|The Size and Scope of Government: How Many Levels? ..........................|15|
|Size of Government Units: Efficiency and Other Concens .........................|17|
|Supporting Subnational Government: The Institutional Setting for Subnational Governmental||
|Reform .........................|8.............<br>i|
|The Changing Role of Govermment: From Ownership to Servic- Provision ..............|19|
|Simultaneous National and Integovernmental Fiscd Reforms. .......................|23|
|Stablizadtio: The Macroeconomic Context for D sentrizaton ......................|24|

|II. WHO DOES WHAT? THE ASSIGNMENT OF EXPENDrrURES .......................<br>29|
|---|
|The Efficiency Case for Decentralized Loca GovermenL ..........................<br>29<br> <br>|
|Expenditure Asignment in Pratice ........................................<br>29<br>|
|_Local_Public Enterprise Ownehip ........................................<br>_35_|
|Provision of Social Services: Shifting the Safety Net Downstain ....................<br>_37_<br>|
|Expenditure Assignment in Principle .......................................<br>37<br>|
|Extabudgetary Funds ................................................<br>39|
|IV. FINANCING LOCAL PUBUC SERVICES THROUGH USER CHARGES .................<br>40|
|V. THE CHOICE OF SUBNATIONAL TAXES .....................................<br>42|
|Characteristics of a Good Local Tax .......................................<br>_46_<br>|
|Local Propet Taxes ................................................<br>47|
|Own Subnational Taxes versus Shared National Taxes ............................<br>48|
|VI. THE DESIGN OF INTERGOVERNMENTAL<br>TRANSFERS ..........................<br>_50_|
|Closing the Fiscal Gap ................................................<br>_50_|
|Equalization ......................................................<br>50<br>|
|Fiscal Effort ......................................................<br>52|
|Matching Grants ...................................................<br>53|
|Other Objectives of Transfers_............................................_<br>_54_|
|A Case for Conditionality? .............................................<br>_55_|
- ii -

|Determining the Size of the Grant . . . . . . . . . . . . . . . . . . .<br>..|. .. ........<br>. . . . . . . .<br>_56_|
|---|---|
|<br>Distribution of the Grant ...............................................<br>Measuring Capacity and Expenditure Need ....................................|_56_<br>_57_|
|VII. BORROWING ......................................................|58|
|Past Borrowing Pr<br>ac tic<br>e<br>s<br>...............................................|59|
|<br>Sources of Borrowing .................................................|60|
|VIII. PRIVATIZATION AND OWNERSHIP .......................................|61|
|AssetTansfers.............................|61|
|Privatization vs Entrepreneuriaism ..................................|62|
|<br>Timing of Asset Sales: Sales vs Give-aways ..................................|63|
|<br>Revenues from Privatization ..................................|64|
|IX. CONCLUSIONS ..................................|64|
|REFERENCES .................|84|

## List of Tables

|Table I Trends in Decentralization: Government Organization.|16|
|---|---|
|Table 2 Decntrlization: Scale and Size of Government..................|.............|
|Table 3 Reform and the Size of the Government Sector .22||
|Table 4 Macroeconomic Indicatorsi.2||
|Table_5_Tax Administration in Transition Socialist Economies ............................|28|
|Tabls 6 ExpenditWe Assignment to Subnational Authorities.................|.............<br>30|
|Tanle 7 A Possible Expenditure Assignment .......................................|8<br>3|
|Table 8 Revenue Assignments to Subnational Authorities...............|...............<br>44|
|Table 9 Structure of Subnational Govermment Finance .<br>.................................|1|
|Table 10 Subnational Government Borrowing.......................|................<br>59|
|Table 11 Privadzatioa Revenues: Ownership and Disposition<br>..|62|

# _Acknow_edeMents_

_We would like to thank those who commented on this paper, or who otherwise shared their insights on subnatlonal finance in the various countries, including Felix Jacob; Zelko Bogetdc, Robert Van Pulley, Thn Condon, Gabor Peteri, Shankar Acharya, Anwar Shah, Hen g-fiu Zou, Tony Pellegrin4 Jim Hicks, Luca Barbone, 7Thanos Cat sambas and Amaresha Bagchl. Research assistance of Rltu Nayyar is gratefully acknowledged. Susheela Jonnakuty providedexpert word prcessing. 7Thisis the firstin a seriesof papers under RPO BB67770M._
# FISCAL DECENTRALIZATION AND INTERGOVERNMENTAL RELATIONS IN TRANSION ECONOMIES: TOWARD A SYSTEMIC FRAMEWORK OF ANALYSIS

... A chang of government is not a chang of system, merely one of the politicdl conditions for it. Tho change of system is a historical process that seer- liksely to require a long period of time. &'

# . INTRODUCTION AND SUMMARY

Why 'Local" Fimnce Matters.

1. An important and unduly neglected aspect of the process of transition in Eastern Europe is the extensive decentralbiation, both political and fiscal, that is taiing place in many of the countries newly emerging from behind the socialist veil. Decentralization represents both a reaction ftom below to the previously tight political control from the center and an attempt from above to further the privatzation of the economy and to relieve the strained fiscal situation of the central govermnment. The aspirations of, and the role of, local government are becommg stronger in most of the transitional economies.

2. The on-going reforms in subnational finance in these economies are much more important than seems generally to be recognied. In some countries in transition, the subnational govemments (broadly defined) are quantitatively significant, accounting fur a large, and often gromwing, share of public sector activity. In aU the transitional economies, the developing structure of intergovenmental relations is intimately related to such critical policy issues as privaizaon, the social safety net, and stabiliatioL Within the fiscal sphero, tax reform, deficit control, and intergovenmental fnce constitute a tripod: unless each leg is set up properly, the entire structure may collapse.

3. Our assertion is that the design of a weU fumctioning intergovernmental fiscal system is key to almost all of the transition economies' major reform goals. Intergovernmental finances wil have a major impact on the efficiency with which the transition economies perform; on their macroeconomic stability; on the social safety net and on the success of their privatzation policies.

4. Fiscal balance at the subnadonal level is key to macroeconomic stabiliqy. Given the paramountcy of stabilization goals in almost all of the countries, the central governments have used all the tools in their meager arsenal to bring stability to the macroeconomyY One such tool has been to shift the deficit down, ensuring an - adequate revenue flow to the center oither by shifting expenditure responsibilities down or by retaining additional revenues, even where budgets at the subnatonal level are severely iupaiued Hungary and Russia come to mind, but there are others.

_5._ The results of this policy, ironically, could contribute to further instability: the budget constraint in these countries is still so soft that subnaional governments may respond by accumulating arrears, borrowing (strong- arming their enterpises to finance public expenditures sice enterprises have easier access to bank credit than do the governments themselves) or developing extrabudgetary sources of revenue. Pushing the deficit down may not reduce it, but may merely repress it. Worse, some of these 'coping mechanisms ' also reduce the transparency of budgetary operations, and make the pursuit of appropriate national budgetary policies even more difficult than it is now.

-JJanos Komai, T'he Socialist System; (Princeton University Press, 1992), p.577.

Zlbe terms subnational and 'local' are used more or less interchangeably, unless speaking of a three tier, or federal system, in which case subnational refers to all levels below the federal, and local refers to the lowest level.
6. A well-fimctiong - responsibiity for which has bee trafered 'downstairs' in a number of countries -cannot be effetively caried out by an undefund subuational sector. Where the safaty not is cridcal for the success of Iho transition to a market economy, nd it therfore a national policy objctive, -as - in Russa, and ,tguably, in Polund and other countrie the burden of finaing the safety not should not be on local governments, even though, being closer to tho people, subnationl gove ormnts migt administer it.

7. From an atlocative _prpctdve,_ the system of intove n fiscal rebltions will also dtermine in a major way the officiency with which thb eoanomies perform, and their fu omic o. Locl government ownesip of enteprs - and local ir in their revenus - will inevitably encourge domestic protectionism (e.g. 'domestic _purch_ **rqimes** and inter-jurisdictional trade bariers to protect local monopolies) harmful to economic grwth ar, so to speak, 'nation-building,' with significant finane is also crueil to future natioal existence of the Federadon. Even where national 8. Finaly, becaus some countries -notably Ruiaar, so to speak, 'nation-building,' with significant centrifual fores emanating from the ubnatonal level, inteovermentl finane is also crueil to future natioal cohesion. In Russia it may be crucial even to the contied existence of the Federadon. Even where national cohesion is not at risk, demands for greatr 'participatory democracy' have heightened demands from the subnational level. The strong desire for local politieal control and unfettered local autonomy is a natural outcome of the end of central plmning. Combined with an inadequate fiscal base, however, loal aspirations and fiscal capabilities are increasingly at odd., which is giving rise to growing tensions in a number of countries.

9. Even gvimhi2n is complicated by the current environment. Following the transfer in many countries of a significant number of anterpie to 1matonal ownership, responsibility for privatization now also rests with subnational govenments. Their interess hero ar unclear at bese they still rely on ethir I enteprises for profits and tax revenues, ad if privzd, subational govenments will hav to assume the substantial 'non-production' expenditues - for nurei_e, housing, schoob, etc.- tht will e spun off by the enterpris as they privatize. A system of inegonmeta finacs tht doe not accommoda thes shifts in expenditure responsibilities and provide coreponding revenues, will impedo the proco of privatization.

10. In sum, intergovermentl fiscal rlations - far from being merely a 'local matter' - are key to simost of a8l of the transition economies' reform goals.

# Traditional vs Systomic Frumewors

11. The traditional anaysis of intergovenmenta finance examines the fiscal functions of local and central govermments in terms of their respective roles and responsibilides for stabilization, income distribution, expenditure provision, the appropriate assignment of tax functions, and the design of a transfer system that provides appropriate incentives. The 'benefit model' of service provision suggest that local governments - whose role in - this analysis is essentially that of service provider should be financed to the extent possible by charging for the services they provide, with local taxes making up the remaining gap, supplemented as appropriate by trsasfers and, in limited degree, borrwing.

12. This perspective is of course important in the trasitional economies also. But it misses several key features of the roles, responsibilities and economic functions of subnational govemments in the former socialist economies. First, the emphasis in traditional analysis on the local goverment as a service provider ignores its important roles as produr and as wngr, as wel as the complicated relationships between enterprises and local government in most transitional eccnomios. The importunt role of local governments as owners means thst they have a major role to play, either as potential impediments to, or supporters of, Drivatization. Moreover, the asset stock recuntly trnsferred to them in the decentralition process represents a potential source of revenue (or, in some instances, of losses). The interaction of subuational finance and privatizadon thus merits careful attention in the transitional economies.
-3-

13. Second, th traditional approach ignors th shrining role of govenment. in most t itional conomies, govenment, both local avd cetral, played a major producdon role and wa the major invoeor in the economy, and - tae expendite side of the budget is clutered with expditur not only sbidies, but direct investmnt, inventory finance and wages - which in a market conomy, are not the responsibility of govemment. Unfortunately, in all des countries govemment reve is cclining mora npidly tha governmnts mo abl, to dives themsevas of thes expenditu responsibiities, thus ontributinq to u1bahinit problems. One repon in may countrie **ha** boen to try to shift the deficit downwans by mang local govemnts responsible for morm expenditure, while smtanously reducing centrl tansfers to the onatonal sctor.

14. The obvious need for flexibility in today's apidly changing envirment **bas** led many central govenmts to attempt to preservo som dogrees of freedom by continuing with the 'negotiated' tax sharng systoms of the pat. But this approch is less and lea acceptable in countries where domands for fair" treatmnt and ec2alization are strong and where local govemments are seeking gater autonomy. It is also incompatible with the efficient provision of local public services. It is theeforo especially importat to replace the presnt 'bargained' outcomes with an intergovrnmetal fiscal framework -of transfers, of local revenues, and of local expenditure responisibilities - that is both firm enough to serve as a basis for action and flexible enough to be compatible with the on-going structual changes and reform.

15. The present sftrgy of devolving exuenditures downward while holding back on tansfers is unlily to prove successfl for more than a year or two at best. Indeed, net expenditure eduction at the subnatonal level may prove very difficult to achieve. The subnational sector is significant in expendituro terms in many trasition economies -in Rusia, and the CSFR, it accounts for over 40% of total outlays. Elsewhr they account for 1030% of total outlays. At pesent, for example, state enterprises provide a wide range of social sector outlays: with privatiznton, many of these outlays will have to be taken over by local governments. Moreover, in most countries, the local government sector plays a critical role in tenn of providing a 'social sae net' which makes the pain of the wrenching economic transition more politicaliy tolerable. Since the trvenue sourcs assigned to local governments simply cannot finance the level of expected local activity in th i_mmedito fture, the result of shifting expenditures downward is likely to be strong demands for increasd, rather than reduced, transfers. In sum, as and when expenditure assignments become cleaer, and decentraliation develops further, the likelihood is that the subnational share in other transition economies wiUl also grow. This means that tho intergovernmental system wil have to be sensitive to these developments: Notable across the transition economs is the fact that there has been a general absence of concrete empirical estli **-leg** of 'correspondencew between tax and expenditure assignments and need for transfers. Legislation on intergovenmental finance relations has typicaUy been developed with no quantitative assssment of its implications.

16. Despite all the talk about *autonomy' and fiscal 'independenceo, few of the countries surveyed offer their subnational govemments much in the way of fiscal discretion on the expenditure side. Indeed, most recent legislation has focussed on codifying the revenue side of the equation -before deciding what expenditure responsibilities of subnational governments should be, putting the cart before the horse, so to speak. Expenditure 'autonomy' is enshrined in legislation, but not really effective: there are still centrl 'norms' which govern allowable expenditures in virtually every sector, and centml spending mandates remain in place.

17. The new subnaional governments wiUl also need substantial help and guidance in developing adequate lqol revnuo systems. The local *autonomy' that has been enshrined in recent legislation has often meant separating the spheres of responsibility to the greatest extent possible, so that each level of government reigns in its own sphere: in revenue terms, this translates into a pm-disposition towards *tax assignment models, and a goal of reduced *transfor dependance' on the center. The fact that in the pre-reform system, most subnational governments received revenues from 'their' enterpises has led to a strong bias towards derivation-based sharing models in which revenues go to the jurisdiction in which they are collected.

18. It is critical that subnational revenue needs and possibilities be realistically factored into national plans for tax reformL Failure to look at intergovemmental dimensions of national tax policy changes can lead to problems.
_-4-_ In Russia and Hungary, a share of major natonal taxes has boen assigned to the subnational Ilvel, and recent national tax policy changes have wrought havoc with the aggrpto subnational revenue base, with vecy eaic effects across subnational jursdictions. Secod, any thought of aasidg. ut', when the tax itself is undergoing continuous definition, is problemical. In m-y transition economie, however, local governments have come out strongly in favor of revenue assigmet under which they got 'all' the 'renues from vtheir taxes. **This** seeming revenue indepndence leaves them with sgnifict residual vulnbility to tax policy changs, however, a fact that seems genrally not to have ben recowzed. If this vunbity wore to take ito accout, as it dsould be, national fiscal policy reforms would of course be constaned. Rcent tax reforms at the national level, administrative weans and other factors havo meant significat rvenue vowlatiliy, with significant over and undershooting of budgetay tagets. This situaon obviously has implications for the desirability of 'tax assigment' models per s, and the design of sharing/transfor systms.

19. In most countries, for example, the pndcipal locaI" tax is some form of property tax: but in many cases, national governments have hamstrung the revenue potential of this tax by grting exemptions to newly privatized land, housing, and enterprises. In other instances, local governments are supposd to recive a share of certain national taxes, often on a derivation basis (e.g. origin, or residence): but such povisions raise both techcal and allocative problems, in addition to biasing national tax policy decisions in often undesirable ways. Even when the local tax base is feasible and adequate in principle, in practice it will gerally take some years before the system can be expected to produce sufficient revenues to meet perceived locw,; needs.

20. Despite al the talk about *autonomy- and fiscal independence, none of the countries surveyed offer their subnational govemvents any fiscal discretion, even over the muior taxes they ane wssigped: rates and bases continue to be set by the center, in the context of the unitary tax sysem. lho paucity of locally-controlled tax resourees in most transitional countries, when combiaed with the universl reluctnce of politicians to tax constituents too directly and openly, makes it inevitable that hard-pressed local governments wiU turn to other avenues for revenue: they will wmand increased transfers, they will try to borrow, and they will try to exploit tG the full the new assets they nave acquired as part of the decentralization-privadzation process.

21. The level, design and effects of interaovemmental fiscal transfer. thus constitute key elements in the emerging intergovemmental and local finance system. of the tnsitonal economies. There is a general absence of 'formula'- based trasfers. These remain negotiated in aggregate and by individual localities. Critical decisions must be made with respect to the overal size of such transfers (the 'distributable pool') as wel as with respect to the distribution formulas to be employed, taldng into account both the severe fiscal pressures on the central government and the vital tasks to be performed by the local govemnts in the emerging new strcture of the public sector. Practical measures of *tax capacity, *expenditure need' and perhaps fiscal effort' need to be developed for use in such formulas. Institutions must be developed at both the central and local levels to ensure that transfers (or subsidized credits) are put to the best possible use: such institutions may include, for example, at the center, agencies concerned with monitoring the perfonrance of local govemments and with providing them with needed technical assistance and support and, at the subnational level, various intermediary bodies, particularly with respect to the many very small municipalities that have been created in most countries.

22. As noted above, careful attention has to be paid to the design and implementation of the intergovemmental fiscal transfer. that seem likely to remain prominent feaure of the fiscal landscape in most countries for years to come. Caution is even more necessary with respect to borrmin by subnational goverments. A number of countries in transition have granted virtually unlimited bonowing powers to local governments without taldng adequately into account the macroeconomic necessity of monitoring and controlling such bonrwing. As yet, however, the relatively undeveloped state of financial institutions in most countries makes abuse of the borrowing power more a potential than a real problem.

23. The same is not true of the potential misuse of 'locallv owned" state assets, unfortunately, since in every country such misuse is already visible. Such local assets may represent a windfall - at least in those cases where they are not accompanied by centml policies (e.g. rent or price control) that turn them into a liability. But they may
- 5-

also often be misused, whether they are privadzed or not. A local heating plant that is privatized, for example, but remains a (local) wratural monopoly obviously raises regulatory problems: who deals with these problems, and how? What should be done with the proceeds of asst sales? Under what (very limited) circumstance **s** hould such proceeds be used to finance current local expeitur ? If an **asset** is not privatzed, but is used to geneote ongoing revenues for the local govemment (and perhp some forign partnr, with the municipality using its ownership of land or assets as its contribution to equity), the temptation to sustain and sttengthen any monopoly position is obviously again a problem, as is that of regulation. Even more damaging is the high pwbability that more speculative ventuu - examples include tourist lodge and bakeries - are likely to fail. Equally damaging may be the dissipation of scare local managerial skills on trying to squeewz money out of such entrepreneurial gambits rather than focusing on tho more essenal task of trying to provide local public services efficiently.

24. A special problem arises with reap' t to the prices cbrged by those local public enterprises to be retained in tho public sector. In the past, central governments in the socialist countries used low and fixed prices (including rents and other urban user fees) and wage controls, as part of their distributional tool kit. The now governments in these countries ar now being asked, in a reformenvironmet, to get the prices ight and to use tax policies and targeted gubsidies instead. There are two important dimensions in the transition economies: First, changes in public sector prices L.rugc ) clearly need to be coordinated with wage reform on the one hand and with more general price reforms on the other hand, in order to avoid undue impact on income and major distributional shifts (as well as on profits and hence government revenue). Second, central government price mandates -prices were typically centrally administered - need to be devolved to the subnational level.

25. Finally, in somn countries, (Russia, China, and others) price reform and other structural shifts wiU continue to bave effects on the tax base and its distribution across regions. Coal and energy price changes, for example imply potentially large shifts in the vadous tax bases, both vtilbin a tier of government in the tax bases of differet regions within a country (e.g. a gain in value added in a primary-product producing area after price libealization and a corresponding loss in the consuming jurisdiction) and botwoe levels of government depending on how taxes have been assignec or shared. Such shifts must be taken into account when designing the intergovemmental fiscal system: they may well constrain the reform of intergovernmental relations, eliminating options that might be feasible in other countries. At the very least, greater flexibility is needed than in countries where economic structures are more fixed. Intergovernmental fiscal reform clearly must be viewed as an ongoing Rrocss in countries in trnsition.

# Oreanization of the Paper

26. This paper addresses these issues of intergovenmental finance in transitional economies. It argues that a broader framework than is customary is needed to analyze decentralization and intergovernmental fiscal issues in such economies. This framework must incorporato such elements as the likelihood of continuing structural changes in the economy and continuing political shifts, t4e need to undertake intergovernmental reforms while coping simultaneously with stabilization pressures and the increased importance of the social safety net, the likelihood of continued (local) public ownership on a significant scale, the financial implications of such ownership and its possible conflicts with the overall privation objective, and continued vestiges of price and wage controls and other rigidities. A comprehensive and atcurate analysis of decentralization must take these elements into account.

27. The analysis in this paper is based on detailed recent studies of local and intergovernmental finance in Hungary, Poland, Russia, Romania, and China, and on less detailed information for the Czech and Slovak Federal Republic (CSFR - especially the Czech Repub!ic), Bulgaria, and Vietnam. Salient characteristics of the local and intergovernmental system in each of these countriesa' are presented in the main text for illustrative purposes.

21See also the following working papers: Bird and Wallich, 'Financing Local Government in Hungary, No. 869, March 1992; Bahl and Wallich, 'Intergovenmental Finance in China," No. 863, February 1992; and Wallich, Christine, 'Fiscal Decentralization: lnteraovernmental Finance in Rus&iia' Additional source materials are cited in the bibliography at the end of the paper.
_-6-_ Although the principal focus of Ae disussion is on the cental ad **at** Europon countria (especially Hungary, Poland, and Romnuia), similar tndencis and problems are visible in all th- countries mtioned and may well aWso be manifest in the other repubics of the former Soviet Union and fonne Yugoslavia, as well as in similar countries elsewhore. Komai (in Tho Socialist System) list 26 'soclist' _countes_ in 1987. If we add to this lt the 15 republics of the formr Soviet Union nd the S of fonner Yugodavia (and deduct the now-vanihd East Grmany). therm would appear to be at least 43 countries which only fiv _yar_ ago had more or les 'Socialist' syms. By 1992, howevor, is probably fair to say all but two of theme counto (Cub nd North Korea) ar now in momo 'trnsitional stage, mo tot mom or all of the daslymi of this paper ould be applicable. This paper thaefore represents eeially an intetim report on what is suro to pmve an on-going and important problem in all the trnsitonal ecoomies.

28. The paper is organized as follows: Sectin II reviews r number of geea ius with respect to the roform of governmental structure that have arisen in the **transitional** economic. This ection elabomates many of the points made above about the importance of thd changig context within which questions of local governmnt roles, responsibilities, and finances are being deided. Section 77 then ouldines briefly what appeau to be the apprpriate role of subnational government , xuch countries, with special attention to its expediture responsibilities. The remaiLder of the paper then discusses the issues relating to each of the posible methods of financing subnational government in transitiotal economies: user chages (Section IV), subational taxes (Section V), intrgovermental transfers (Section VI), subnational borrowing (Secdon VII), and the use of subuational govemment asset (Section 29. The matix below summarizes some of the salient feaour found acros the tramition socialist eonaomies.

||<br>r|<br>ern~kagmeotal Fiwa Reltion in Trmtansn Ecnm2os<br>Salient Cbarteristics|
|---|---|
|Politi|cal/Overall Structura Reform Context|
|*|Intergovemnmental<br>finances reforms are taking place in a context of golitical decentralization.|
|*|Govemnment reorganization is also taking place throughout the trnsition and socialist economies,<br>and striving for 'local autonomy', many countries appear to be eliminating the 'middle tier' of<br>government in their constitutional reforms.|
|*|Intergovermnental finances reforms are taking place in context of overalU sbinking role of|
|*|Intergovernmental finances refonns are taking place in context ofachanging role of government.|
|*|Intergovernmental finances reforms are being undertaken simultaneously with overU national In<br>reforms.|
|Stabil|ization|
|*|Intergovernmental finances reforms are taling place in context of macroeconomicinstabilityand<br>inflation, a weak fiscal NOsitiOn<br>of federal/centrd govenment, and a shrinking revenue base at<br>national level.|
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|Box|... (contnud)|
|---|---|
||*<br>stab|AMakimi ond overall mco concerns domiate the agenda so dt intergovernmental**i**f nacial<br>reform needs to take place in tdis strne<br>contoxt, but cae needs to be takn to prevent the<br>iliduaion objoctive from fully domnting the redign of th inegovermumtsl fian<br>regim.|
|||Stabilizuon concr<br>lead th center to deal with budgey<br>stin by pushing the deficit down',<br>and hoping the subiational level can do the cutting.|
||E<br>In some cas, the center has shifted (potentialy large and open-endad<br>responsibiliti-s for 'social welfare down to local level in an attempt to balamco its budget.|
|*|Expenditure autonomy' is enshuined in legislation, but not really effective: there are stillcentra<br>norms and mandate in placo, and transfer dependance also impedes autonomy.|
|*|Subsidies reprent a major item in the subnational budgets due in part to central prioe setting on<br>public sector prices.|
|*|Use ot 'norms' to define how a service should be provided ;imits expenditure autonomy.|
|*<br>Tax|Cental**'m4a'**<br>on wages, and other expenditures limits expenditure autonomy and continue to<br>be importanL<br>Assi<br>e<br>and_Iafm_|
|*|Attempts to make the subnational sector 'independent' are desired by the subnational level_md_the<br>center. center wants each tub to sit or. its own bottom", to assig taxes and be done with it, and to<br>reduce 'transfor dependance'; This is generally not possible, because the tax instruments are not<br>sufficient, and user charges not yet at a level to contribute significantly to cost recovery.|
|*|Subnational goverments want to shake off contral control, and be masters in their own house, and<br>see appeal in the apparent autonomy that 'transfer independence" provides.|
|*|Tax assignments typically under-fimd local sector: low-yielding revenue sources are assigned or<br>those which will bear fruit only in the very long term (property tax).|
|| *<br>:<br>|There is a genea absence of concrete empirical estimat of 'correspondence' of tax and<br>expenditure assignments and need for trasfers and legislation on intergoveimmental finances<br>relations is typically developed with no quantitative assessment of its implications.<br>|
|<br>*<br>f|<br>Generd absence of 'formula"- based transfers; they remain negotiated in aggregate volume and by<br>individual localities.|
||General absence of transparency in allocation of investment grants/capital financing.|
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<!-- Start of picture text --> Box .... (continued)<br>Privatization and OwnaR<br>| * Major continued role of subnational govenments in ownership ventures at a timo when<br>centr/national priorities sQupoxt privatztin This relates to the inadequat revenue bau given to<br>localities and their continued financial dependence on nterprises and tranfers for rovenue sources.<br>| * Potetlly significant negaive consequec for the budget of pnvatizaon (in some cowutres) as<br>enterpnso social expenditures go 'on budget,' and newly pnvatzed enterprises become hader to<br>tax. Subnational governments may not want to lot go of this rliable fine=.ing source.<br>* How to use the saitlry revenues from pnvatzation (debt repaymet, nvestment finance, current<br>expenditures). How to take advantage of the asset stock held by local governments.<br>| orurinD<br>* In most tansition and socialist economies, there is generous legal access of subnational<br>governments to unlimited borrowing, someimes even foreign borrowing.<br>Extrabudetav I?unds|<br>* Extabudgetay funds continue to play a major role, complicating budgetary tansparncy and<br>macro-stabilization.<br>Institud2 Famework<br>* In may transition economies, the instit>tional arrngements needed for diaogue on<br>intergovenmental issues is missing, even though the need for such dialogue is, as noted above,<br>greatr than in makdet economies.<br>Tax Administration<br>* 'Inverted. administative systems in many countres where the local administion offices may<br>have greater loyalties to local government than to central administratve systems.<br><!-- End of picture text -->
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# H. DECENTRALIZATION IN PROCESS: TRENDS AND THEMES

# A T;me of Trmnsforation

30. Perhaps th most iniportant thing to remmber about the procems of political and fiscal decentralization now engaging the countries under review is how very r it is. Apat from China, which took the first tentative steps in this direction in 1979, the subationl sytems now emeging in the transitional economies ar of very recent origin, as indcated by the dates of some of the relevant basic laws: Poland - L Self-Governmet Act, 1990 Hungy - Local Self-Goveamet Act, 1990 RomWnia - Local Govenment Act, 1991 Bulgar - Lcal Self-Govemmnt and Local Administraion Act, 1991 Rusan Fderation - Law on the Budgetary Rights of Local Self-Govamnet, 1991.

In most cases, additional important legislation came even later - e.g. to set out subnationl revenue sources (such as Poland's 1991 Act on Taxes and lA Fees) -and in many countries is stiU to com (e.g. with rspect to the precise ownership and control of some importa local assets). Key elements of the legal framework needed for efficient local goverent are stiU missing in most countries.

31. Moreover, once the basi ucue of local govemment was established, local elections still had to be held, new local governments established, and a myriad of importan administraive details determined. In Romania, for example, the first local elections woer not held until February 1992 and the new mayoa did not take office until April 1M. In the Russian Federation, the first local elections wore held in November 1990, and in Hungary in April 1991. Even after a year or two's experience, as in Hungary, Bulgaria and the Czech Republic, some mayors and other local officids, partiularly in the smaller communities, still bave littlo idea of what their real powers, re sibilities, and limitations art. Nor are matr much beuter at the central government level where, in most countries, no one really seems to be in charge of dcenrliatiadon, with the result that some key issus appear to have beon decided (or left undecided) more by accident than design, parcularly issues concerning the intercton of the new local governments with such other lements of the transitional reforms as privatition, tax reform, financial reform, preo reform, subsidy reform, and budgetary reform. Tbis neglect is now causing trouble in an number of countries not just for the local governient sector but also, to varying degrees, for the success of all these ambitious reform plans.

# The End of Central Plannina: Filling The Abhorred Vacuum

32. Unless more systematic attention is paid to these problems in the near future, muas are Ilkely to get worse rather than better. Up to now, many of the potential difficulties have been kept in check largely by the continuance, de facto if not always de jure, of the refonn m under which subnational govenments received most of their funds from central govemment budgetary transfen which wore basically allocated on the basis of negotiation and bargaining. In this process, the centnl government always has the upper hand, controlling as it does not only the total amount of such transfers, but also who gets them, and when. When combined with the continued central control in most countries of such critical determinants of local outlays as wage structures, enterprise prices, and so

-4In Bulgaria for example, laws passed eady in the reform process only spocified that local governments are responsible for 'local matters. This vagueness in the law allowed local authorities to claim all or no responsibility on convenience. This deficiency is now being corrected, and Bulgara is now in the process of preparing a series of new Acts covering territorial division, local self-government and administraton, and finance to replace the 1991 Act.
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on, and the ingrained habit of local depndence on centmal<sup>guidance, the persistence of this system bas played an</sup> important role in preventing local expenditures from exacerbating<sup>the genlly</sup> tenuous fiscal situation of the central government.

33. But this situation is unstable and will not long persit in<sup>the absence of strong central political control.Y</sup> Already, many countries are finding that the combination of<sup>th manifesdy strong desire for local political control</sup> and the unbalaced mdate - virully unfettered 'local autonomy',<sup>but a totally inadeque fiscal base -logally</sup> bestowed on the new local govenments is causing trouble.<sup>In the Czech Republic, for example, central autodities</sup> are properly concened about the national implications of<sup>both local povemment busines activities and local</sup> borrowing as weUl _as_ the fragmentation of the national education<sup>system. In Hungary, whore local gover_nN can</sup> spend their budgets, most of which come from national<sup>transfers, any way they want, simiar problems are</sup> emerging. And in Russia, which is with the CSFR<sup>the only fonmlly "federa transitional country, separtist</sup> tendencies fueled in part by fiscal pressures and imbalances are<sup>raising funamntal political problems.</sup> 34. The CSFR, of course, has already decided to split into<sup>two</sup><sup>**sparate**republics, effective in 1993. Even</sup> more dramatic, although of course largely motivated<sup>by forces stronger than those discssed here, is the cse of</sup> former Yugoslavia. These two are by no means the only countrie<sup>in central or eastern Europe to be etmically</sup> heterogeneous. It may weU be tat in the end the only<sup>way such countries will be able to hold together in a</sup> democratic fashion will be by reconstituting themsdves as<sup>vey "loon" fedrations-like Switzerland or Canada,</sup> in which the subnational units (cantons or provinces, respectively)<sup>are also 'sovereign states in some important</sup> respects. In these circumstances, central-ational negotiations become as much or more exercises in diplomacy as in the design and implementation of efficient and equitable<sup>govermental structuresAY In contrast, the discussion</sup> in the present paper assumes, as does the legal framework<sup>in every country considered here except Russia (and the</sup> soon-to-vanish CSFR), that the transition countries<sup>are organized essentily as unitary states, and that the essential</sup> role of local governments is to ensure the efficient provision<sup>of local public sevices and to act, where it is efficient</sup> to do so, as agents of the centrl government.

_35._ At present, in most of the countnes under review, those<sup>local officials who are not simply waiting more</sup> or less passively, either for orders to come down from<sup>above as they have for decades or, more hopefuUy, for their</sup> future to be unveiled for them, have understandably been<sup>using their eaergies primarly to attempt to wheedle more</sup> money out of the central government. In Romania, for<sup>example, where the entire 1992 trnsfer budget was spent</sup> by the middle of the year - largely on centrally-mandated<sup>subsidies to enterprises - it is not suprising that Bucharest</sup> city officials were to be found two or three times a week<sup>at the Ministry of Finance trying to secure more fumds.</sup> Other local officials, forhtnate enough to possess clear<sup>tide to significant assets, have been selling them off and</sup> using the proceeds for current expenditures (as in some<sup>towns in the Czech Republic) or trying to use their assets</sup> as equity in joint ventures with foreign investors (as in<sup>other towns in both Hungary and Romania).</sup> 36. On the whole, however, there is as yet little eidence<sup>at the local level of wide deviations from desired</sup> national standards in the provision of essential services,<sup>other than that resulting from the general fiscal penury</sup> afflicting all these countries. Similarly, perhaps partly<sup>reflecting the relatively undeveloped financial sector, there</sup> is also no evidence of either significant budgetary deficits<sup>at the local level or of excessive (or often, any) local</sup> borrowing. As it gets harder to squeeze muoney out of the center, however, and as it gets more difficult<sup>to get easy</sup> finance from seUing off assets, subnational governments<sup>in the transition economies are going to find it increasingly</sup> tempting to move in both these ditions.

-China, where such control largely remains in place,<sup>is of course an exception to this genemalization, although even</sup> there many of the problems discussed in this paper are<sup>manifest.</sup>

-I'For analysis relevant to such federai states, see Shah,<sup>*Perspectives on the Design of Intergovernmental Fiscal</sup> Relatiers," Worling Paper No. 726, 1991, and Bird, Federal<sup>Finance in Comprative Petpective (Toronto, 1986).</sup>
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37. With respect to education, for example, the finacial incentives in the preent Hungarian systom may in the future, unless changes are made, lead to larger towns with seondary schools being unwilling to accept stdents from smaller towns without such schools. whe completely unconditionalnature of intergovenmemtal fiscal tansfers in Hungary make it very difficult to penaliz such actions. Simily, national education standards have vanished in the Czech Republic but have not as yet been replaced by either guidelines or nrles: totalitarian education was undoubtedly an vil, but it is not obvious that anachy is better. For the fist time in decades theim is clearly a possibility that wide variations in the quality of education will eerge depending on the ficl resources available to the municipality in which a studkt lives. Similarly wide vartions may equally anse in health, in so-al welfare expenditure, and in other aue of local govenint activity as the power of the center to command vaniss. This outcome is unlikely to be caosiderd desirable by most citizens.

38. It is one thing for local expaoditure choices to reflect the wishe of local officials who have been democratically elected and who wa spending funds secured from the citim who elected them. But it is quite another when sovices with substantial juisdictional spillovers are underprovided in poor areas owing solely to lack of fiscal resources, or when trasfer monies provided by taxpayers as a whole for specific national piposes are misspent by local officials responsive only to their own local electors. Yet both of these outcomes are all too probable over time, given the virtusally unrestricted 'local autonomy' conferred by some of the new local government laws (e.g. in Hungay). For much the same easo, the almost unrestrained borrowing authority bestowed on new and untried local authorities by some of these laws carries with it the potential of eventud fiscal disaster.

39. As yet, the subnational system is too now in most countries for most of the bad things that might happen to have occurred. But ther aro enough signs to be worrying, and it is critical to use this time of transformation and reform to continue to develop the local govemmont stuct in a more positive direction in a number of important respects. It is, for example, important to carify exactly what is, and is not, meant by local autonomy and to flesh out more clearly the role envisged for local govenunents. It is also important to develop adequate institutions at the centrl level to support the many new, and often small, local govenunents that have been created. Moreover, the role and nature of institutions inrmediate betwee the central government and the local govemments has also tuned out to be both a critical issuo in many countries, and an impoant differentiating factor from country to country. Thes questions are discussed furdtr in the balance of this section.

# Political Decentralization

40. The reform of local and intergovernmental finance is taing place in the context of political decentralization and in particular a strong commitment to decentrliation of certain responsibilities and revenue to self-governing local administrationsz. In reaction to decades of over-talized<sup>1</sup> public administration (and related party control), most Eastern and Central European countries are gngaging in a process of extensive decentralization, gradually reducing the role of government in genera and the powers of central govemment institutions, and especially their planning and control apparatus, in particular.

41. In line with this tendency, autonomy and control over 'local matters, and accountability for them, is being increasingly devolved to the newly-elected local governments. The centrl government wants 'each tub to sit on its own bottom', to assign taxes and be done with it, and to reduce transfer dependance'. Local governments want to shake off central control and be masters in their own house, and see appeal in the apparent autonomy that 'transfer independnce' provides. For those and other reasons, the principle of localautonomy is now enshrined

-'In Bulgaria however, the pace of the former exceeds (and precedes) the latter. There is a risk at present of increasing fragmentation in the number of self-governing units in Bulgaria because of the perception of local governments that 'self-governing status will lead to greater budgetary transfen from the center. In order to counteract this trend, it is important that aspirations for local autonomy be tempered by specifying a threshold for self-financing/own source icvenue mobilization.
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liation, local financial in the legislation of most transitional countries. As a<sup>rle, this legislation affims d</sup> liation, local financial autonomy and the administraive 'independence'<sup>of the uunadonal level from cental control. The language</sup> differs, but the geonel intent is clearly to free<sup>subnational govenments from the 4ead hand' of centralized control</sup> and to let local democracy flounish.

of fiscal responsibilities. Some form of subnational 42. These political reforms are paralleled by dcentaliton of fiscal responsibilities. Some form of subnational govemment stucture had existed in most of<sup>the transition economies mder the socialtst regime. However, the fiscal</sup> system of this regime was essenidaly 'unitary,'<sup>with the sub-nationa</sup><sup>**l**evel being little more than an edmin</sup> unit or 'departmet' of the center, with no indepe;dnt<sup>fiscal or legisltive responsibility. Kornai (I992, op cit)</sup> sets out the former socialisS system in considerable<sup>detail. It is revealing that this lengthy study hardly refers to the</sup> existence of subnational state administrations, noting<sup>only that they are tightly cntrolled in al respects by the</sup> central bureaucrcy. In effect, local govenents were<sup>basically</sup> udeconcentrated' nits (or branch offices) of the central govermment and had little or no financial<sup>autonomy. This was true even of those countries such as the</sup> USSR, and Czechoslovalia which were formally<sup>called 'federations'. It was also true in the Russian Federation,</sup> despite the fact that Russia's 31 autonomous republics<sup>and national regions wero said to be 'autonomous' and to</sup> have independent budgetary rights. Policy-making<sup>was hence very controlled and centrHzed and local government</sup> had virtually no independent tax or expenditure powes<sup>-part of a larger picture in which the budget itself was seen</sup> only as the handmaiden of the Plan.

43. Reorganizing Governuent. Now, however, virtually<sup>every transitional country is to varying degrees</sup> decentralizing, deconcentrating, and delegadng functions<sup>and responsibilities.Y Decentalization has many merits,</sup> both in political and economic terms. It has, for<sup>example, the potential of improving the efficiency of local</sup> government by subjecting its actions to the scrutiny of<sup>the local electorate. Autonomy over local decision-making</sup> and expenditures also frees local governments from<sup>the heavy hand of centrd control. As yet, however, these</sup> benefits have not been attained for two quite distinct<sup>reasons: the persistence of the old ways and certain flaws in</sup> the new dispensation.

44. In Romsani, for example, there are at least three important reasons<sup>why local autonomy has little meaning</sup> in reality as yet. First, although the Public Finance Law clearly<sup>says that every local government is supposed to</sup> have budgetary autonomy, it also gives power to the central<sup>govment</sup> to change local budgetary allocations.9' Moreover, as noted above, the habit of deference to centrl<sup>commands, even if no longer legally binding (or</sup> enforceable) still persists in many areas. Secondly,<sup>at the present tibm local govermnments</sup> in Romania actually deliver very few services themselves. Instead, their basic role<sup>is to contract with reaies autonomies (local public</sup> enterprises) for the delivery of most local public services.<sup>These 2ngj, like al enterprises in pre-reform Romania,</sup> were of course just another part of the public sector<sup>under the previous regime. Under a 1990 Law on the</sup> Restucturing of State-owned Economic Units, these<sup>enterprises are now financially independent. Although they</sup> are legally responsible to a board comprised of me4bers of the relevant<sup>local government, they appear to be acting</sup> both more independently and at the same time more in response<sup>to the many cental controls and egulations to</sup> WDeconcentration refers to dispersion of responsibilities within the central government<sup>structure from the center to</sup> regional *branch offices', and differs from 'delegation'<sup>in which local government may execute certain functions</sup> on behalf of the central government (and be accountable<sup>to it for their performance), and 'decentralization', in</sup> which full decision making and implementation authority is transferred<sup>to local govenmment, which is accountable</sup> only to its own constituents.

2'Art. 51 of the Public Finance Law states that 'the distribution<sup>of the revenues and expenditures or categories of</sup> local budgets ... is established by the decision bodies<sup>of each county [district] and of the city Bucharest.' But Art.</sup> 22 of the same law states explicitly that<sup>the central government has decisive power in the formation of local</sup> budgets. Each year, local budgets are submitted to the Ministry<sup>of fmance no later than July 1. The Ministry of</sup> Finance examines the draft budgets and has<sup>ten days in which to "ask for the necessary modifications' in order to</sup> establish budget balance. Most importantly, 'in<sup>case of divergence the (central] Govemment is to decide'.</sup>
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which they are stil subject thn at the behest of local govemments. Finally, as in most of the transitional economies, Romania has created a large number of small, **poor** local goverments with almost no resourc0s of thoir own. Autonomy' does not mean the same tbing to a small, poor rural commune as it does to a large, rich city.

_45._ Lcal institutions are more developed in countnes such as Hungry, but these three problems - conflicting legal interoptations, tangled rmlations with enterprises, and considerable diversity in the capability of local govemments - exist almost everywhere, and cast some doubt on the real significance of local autonomy.' Moreover, even where such implementation problems do not exist, the fiudamental problem with th way local autonomy is being approache in the transition oconomies is that such autonomy is not moeningfil if it is not accompanied by capacity, and it is not desirable unless it is accompanied by responsibility.

46. To make local autonomy menjrtef, local govements need adequato locally-controiled revenues. Not only must decisions about the provision of government services with local benefits be made by local governments, but such goverments must have the resources to carry out such decisions. As developed further below, local expenditure discretion is stil limited in imponant ways: some such limitations may be good; others clearly are not. Moreover, the fimdamntal inadequacy in most couttries of the local revenue base (see later discussion), and the resulting continued dependance of local finance on ad hoc transfers means that revenue capacity is also inadequate. Greater expenditure discretion in those expenditures fiuly assigned to the subnational level and greater flexibility for sub-national govemrments to raise their own revenues seem needed in most countries. Such revenue flexibility and autonomy is a crucial step to maling local govemment more accountable to local residents, and to improving the efficiency with which local public services are delivered.

47. One meaning of local autonomy is thus that local governts should be able to raise and spend revenues from their own revenue sources in any way they wish - subject to cenain limitaions on the revenue bases to which they have access (see below). Since local governments are responsible to local taxpayers for what they do with the funds they raise, in principle it is neither necessary nor desirable for the central government to tell local govemments what they can do with their own money. If those who pay for local services financed from local revenues, the local taxpayers (and voters), are unhappy with what their locally-elected authorities do with their money, they may dismiss them.

48. On the other hand, if the centml govemment is unhappy with uwht some local government does with the money raised from local taxpayers, its unhappiess may be unfortunate from some perspectives, but it is unavoidable. What local autonomy means is precisely that there is nothing that the central government can or should do to alleviate any such distress it may feel - barring extreme cases such as corruption or when other national laws are breached.

49. Local autonomy emphatically does not mean, however, that local authorities should be able to do whatever they want with other people's money - that is, with taxes paid by other than local residents. Truu local democracy - presumably the ultimate reason why 'local autonomy' is considered desirable - means *responsible' democracy, which in turn requires full and explicit political accountabilitv to the source of local government resources for what is done with those resources. Local autonomy in this sense is thus not only consistent with, but also requires, that two important conditions be satisfied:

1. The access of local authorities to taxes that may be *exported- to non-residents should be severely restricted.

2. Subnational governments should as a rule be accountable to central government (that is, to taxpayers in general) for the use made of central government transfers.

Acceptance of these conditions, as is necessary if efficient resource use is to be achieved, has strong implications both for the design of the local tax system and for the design of transfer systems, as developed below.
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50. Th'e eenal economic role of subntional governient is to provide to<sup>local residents those public services</sup> for which they arm willing to pay. As already noted, local<sup>govemnmets must be accountable to their citizens for</sup> the actions they undertske to the extent those citizens finance<sup>those actions. Similarly, local governments mst be</sup> accountable to the central govemment to the extent<sup>they are in effect acting as 'agents' and are financed by</sup> transfers. Accountabilitv in this sense is the public sector<sup>equivalent of the 'bottom line' in the private sector.</sup> 51. Such accountability clearly requir thst subeational governments<sup>should, whenover possible, choa for</sup> the services they provide, and, where charging is impracticable,<sup>they should finance such services from taxes bomne</sup> by local residents, except to the extent that the contral government<sup>is, for reasons discussed later, willing to pay for</sup> them. Public soctor activities are unlikely to be<sup>provided officiently unless the lines of responsbiity and</sup> accountability are cleady established along these lines.

52. On the one hand, then, local govemnments need to be given access to adequate resources to do the job<sup>with</sup> which they are entrsted. On the other, they must be held<sup>responsible to those who provide these resoure</sup> - local residents or central goverments, as the case may be<sup>-</sup> for<sup>what they do with them.</sup> 53. In principle, local govemments should therefore not only<sup>have access to those revenue souces that they</sup> are best equipped to exploit - such as residential proprty<sup>taxes and user charges for local services-but they</sup> should also be both encouraged and permitted to exploit<sup>these sources as fuUy as possible, subject to certain</sup> limitations. Unless local governments are given some degree<sup>of freedom with respect to local revenues, including</sup> the freedom to make mistakes for which they are accountable<sup>to their constituents, the development of responsible</sup> and responsive local govemment in the trnsition economies<sup>is likely to remain an unaainable mirage. On the other</sup> han;, if local governmcats are given cate blauche to<sup>spend o-ter people's money, the alocationa, distuibutional,</sup> and maccc consequences will almost certainly be undesirable.

_54._ There are of course dangers in permitting local governments even<sup>limited freedom. One danger in the eyes</sup> of some is thst they will not utilize fully all the revenue<sup>sources open to them, thus allowing the level and quality</sup> of public services in some areas to deteriorate below the<sup>standard considered desirable. But this is not a real</sup> problem. If the savice in question is reaUy one of national<sup>importance (e.g. reseach) or one in which there is a</sup> strong national interest in maintaining standards (e.g. poverty<sup>alleviation), it should be nationally funded at least</sup> in part and its achievement monitored correspondingly.<sup>If it is not a matter of national interest, why should the</sup> national government be concemed? If the local electors do<sup>not like what their local govenment does, or does not</sup> do, they can 'throw the rscals out' at the next election.<sup>As noted above, the freedom to make mistakes, and to</sup> bear the consequences of one's mistakes, is an important component<sup>of local autonomy.</sup> _55._ Another danger, more salient from an economic perspective,<sup>is that local governments may attempt to</sup> extract revenues from sources for which they are not<sup>accountable, thus obviating the basic efficiency argument for</sup> their existence. To counter this inevitable tndency, central<sup>govenments should in principle deny or limit access</sup> to taxes that fall mainly on nonresidents such as most naual<sup>resoure revenues, pr-retail stage sales taxes and,</sup> to some extent, nonresidential real property taxes.

_56._ Another way to counter this problem to some extent may<sup>be to establish a uniform set of tax bases for local</sup> governments (perhaps different for different categories such as<sup>big cities, small towns, and rual areas -although</sup> this may not be politically acceptable in all countries), with<sup>a limited amount of rate flexibility being permitted in</sup> order to provide room for local effort while restraining<sup>unproductive competition and unwarranted exploitation.</sup> It is especially important to provide adequate flexibility to<sup>exploit good local tax bases to avoid creating a situation</sup> in which the only flexibility available veal governments in their struggle to cope with budgetary prssu is by exploiting such economically undesiable sources of revenue as<sup>local business taxes or, even worse, local business</sup> enterprises. As emphasized later, the business of government<sup>is not business, and enterprising municipalities should</sup> not be encouraged to develop local enterprises in order to secure<sup>the revenue they need to function.</sup>
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# Tho Size and Scope of Government: How Many Levels?

57. In the pmroform period, virtully all the countries under review had a multi-tier organizion, with the central level implemeaing its control over the local level throuh an of government. The central goverment wa responsible for the overall plan and budget, and the intenrmdiate level, variously called 'Oblast (in the Russian Fedation); *Judet (Romania); County Council (Hunguy), and *Voivodu in Poland, was the administrative, control d surveillance agency tough which o cer effected conol and implemented policy.w This middle tier ovemw tho expenditur of local governts and wa the chnol for centil fical flows to the localities. Substatvoly, however, noe of the countries discsed her was organized, from a fiscal perspective, u a federaton. Although the Russian Federotin gv nomial autnomy to its 31 'auftomous (or national) regions, okmup and republics, these sb-ntioad gove too wero nither fiscally idependent nor able to determin their own expenditur and tax policies. At the other extrme in some ropects is China, a unitary country with a vey decentralized inison.

58. At present, only Russia and Czechodova have a thre tier _fml_ systm of govemment, comprising the federal govemment, republics, and regions - and t Czech and Sloak Fedeal Republic, as it is formally called, is scheduled to septo shortly into its two componet pua. All the other countries discussed here have a uitarv system of government. A first look at the lol stucture suggests that Poland, Hungary, and Romania have a two-tier level of government (central and local), Rumds, China and Bulgaia a three-tier struture (central, provinces/county/regional and local), and Vietnam a four-tier level of goverment (czatml, provincial, municipal/district and comneighborhood) a shown in Table 1. In fact, however, matters ae not so simple anywhere. Romania, for instance, has two tier of local govemmt (the old judets and municipalities): all of the area of a judet is divided into unicipalities, but in principle each type of local government is independent of the other. In Hungary, on the other hand, whilo the old counties still exist, they really have no functions, so that there are m effect only two lovels of government, cental and locaL On the oter nd, in Budapest (as in tho citie of the Czech Republic) there are *subcity (distict, or ward) councils and goverments with elected councils and their own budgets and assets, so that thoe local level of govenmnt itsf ha two tiers - as indeed it does in the largely unrefonned stucture of Vietnam. In Bulgai, the municipalities ar the basic unit of self-government, but they have contiguous bordes and therefore both urban and ural. The municipality itslf has an elected Council and Mayor, but urban settlents within the municipaity also hav an elected Mayor (no Council) with delegated executive power, from the municipality (ie. county). This lower level is therefore a deconcentratd level of local govemment.

_59._ As a rule the middle tier of goveiunt cotinue to aist in vestigial form in most tansitional countries, but it is struggling both for a role and for legidmacy. Most coundries seem to want to shed this intermediat tier, associated with the former control economy, as if to put their past behind them. In some countries the role of the interdiat tier is now limited largely to overseeing the constitudonality and legality of local govemment oprations. lI others, its role has become one of coornanting cental government policy at the regic *al level. In most, however, there are few quesdons more in flux than the present and futre role, if any, of' intermediate lvels of government.

60. In _HAomgm,_ for example, ther are now 8 regions, 19 counties, and 3070 localities. The regions, headed by a central official called the Commissioner of the Republic, have two functions: (1) information and dissemination, which involves collecting data on local govenmet activities and providing information to local govenments to facilitat the implementation of national policies; and (2) to ensure that local government actions (e.g. on taxes) are constitutional. The functions of the 19 counties, formerly the main teritorial control instrument of the state, have also been severly restricted. counties retain some minor fee revenues and are supposed to be L' These are, strictly spealdng, decentralized branches of the central govenmment administration, not an indpendent tier. There are 88 oblasts in Russia; 9 oblasts in Bulgaria; 19 County Councils in Hungary; 49 Voivodships in Polp.nd; and 41 Judets in Romania.
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responsible for functons of an intuAunsdicional natur that servo swvral localies. In contrast, the local govemnments (almost twice the number of the former 1563 local councils) have considerable expenditure responsibilities, the right to spend national transfes and shared ta a they so fit, and amost unlimited power to borrow, own and dispose of property, and to manag, establish, or sel public eaterpises.

Table 1 Trends in cr t Governmnt Orgnization

|country<br>___________|UnitayFdal<br>_______________|# of Tiern<br>(pro-rform<br>)|Em<br>Structm|_N_of Tiers (preet)|
|---|---|---|---|---|
|Hungary|Unitary|3: central/county/<br>local|Unitary|2: cental/local|
|Poland|Unitar|2: cenral/local|Unitary|2: voivodship8/|
|Ronania|Unitary|3: central/regional//<br>local|Unitary|2: central/local<br>_<br>_<br>_|
|Bulgaria|Unitary|3: central/regional/<br>local|Unitary|3: central/oblass<br>(regions) obahina<br>(municipalities)|
|CSFR|Federl|3: central/state/<br>local|2 countries|2: republics/local|
|Russia|Federal<br>**_**_ _<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_|4: central/oblast/<br>myons/vi-t ge<br> <br>Soviet_|Fderad<br>_<br>_<br>_<br>_|3: federal/oblast/<br>rayons<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_|
|China|Unitary|3: centrl/province/<br>local|Unitary|3: central/<br>province/<br>local|
|Vietnam|Unitary|3: centDal/province/<br>local|Unitary|4: central/<br>province/<br>municipal/<br>commune.|

61. T,he stuation in Romania is quite different. Although the 41 judets continue to exist, there are now two completely different administrative structures in each judet The first, headed by an appointed prefect, is essentally the deconcentated territorial admnistaton of the state. The seoond, haded by the elected president of the judet council, is the locl govenment at the judet level of local gov ere, which is responsible for works of regional interest but which has no hieruchial authority over the 2,948 other local governmentsU.

L'Me situation where a local govemment jurisdiction coincides territorially with a deconcentrated echelon of the central government administaon can be found in other countries. T.he Romanians have basically borrowed the French local administtion system as it emaerged from the 1982 decentralization reform, at least as far as the roles of the departmt (judrte) and the communes (comune si orase) are concerned. (They did not copy the truly new feature which that reform brought about, nmely the creation of the region as an additional intermediate layer of
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62. In EgJg, the 49 vovoidahips ane esetaly deoncetred public service inmdiaes for cti central expenditures (mostly in hlth and socal welfa), although other central<sup>expenditures are camed out locally by</sup> line ministries. All local government functions ar caried out directly<sup>by the 2383 gjina governmons. Prest</sup> plans, however, ate for a new iermediat tier of local govenmet (probably about 300 units called<sup>powiats)</sup> to be put in place in 1993. Similarly, in the CzechRepublic,<sup>whoe there are at preseat over 5000 local</sup> govebmts, there ar also 7 regions and 75 districts e_nally left over ftom the preious regime, and plans are being considered for creating anything from 3 to 20 to<sup>7S "second-fierm</sup> local govamenats.

63. Finally, in tIe Russn EfSop, a sligbtly different paten is emerging, with<sup>the obast level tddng on</sup> a laorg role and emerging as an iwpota unit in its own right. ndeed, if the fiSecal reforms at the subnational level proposed in macmst logislation are implemted, the Russin Federtion will have<sup>decentlid</sup> expenditure responsibilities and to a lesser degre, rvenues, to the oblst<sup>level and will take on the character of a tme federal</sup> state.

# Size of Goveme Units: Efficiey-and Other CMgM.

64. Although the initial reaction against the previous<sup>intemediate govemments as udesrable reminders of</sup> the old regime is dendable, so is the obvious concern in many countries to put something<sup>more acceptable in</sup> their place. As shown in Table 2, most of the east European<sup>countries have created a large number of small, and</sup> probably not viable, local government units. In Hungary,<sup>for example, the averago population of local goverments</sup> (excluding Budapest) is only less than 3,000. In Romani*,<sup>half the population lives in local governnowt units with</sup> a population of less than 4.000, such units accout<sup>for 90% of all local governments, and the average population</sup> of all local govenments is only 7,500. Poand's locad govenms ar smilarly fragmented, with an average population of only about 16,000. The Czech Republic, a compact<sup>country with a little more than 10 million people,</sup> has over 5000 local govermments. In Bulgaria<sup>there are 3,984 elected local govemet</sup> units (settlemnts) with the average population of 1500. At the more aggregate<sup>level, there are 273 municipalities with the averge</sup><sup>_size_of</sup> around 30,000.

65. Such extensive iixm on may be good for getting govemment close to the people,<sup>but it also</sup> substantiaUy complicates intergovernm tal relations<sup>- it is, for example, imWposible for the central govemment to</sup> maintain direct bilateal relations with so many units -, reduces the<sup>political ~roice</sup> of local government as a whole, and in many cases yields localities that are sunply too small to<sup>provide efficiently all the public services demanded</sup> from them. At the very least, even if it is decided not<sup>to reate a formal intermediate tier of government, some</sup> mechanism for coordination and consultation is likely<sup>to prove necessary. Possible models abound in the world,</sup> e.g. the 'municipal federations that exist in many of<sup>the Nordic countries, under which localities orgaize on a</sup> voluntary basis to provide cerin local services, or the<sup>Nordic secondary commun-e, county-like bodies with their</sup> own elected officials responsible for providing services<sup>of an inteijurisdictional nature.</sup> local (regional) government). Similar situations exist in<sup>other countries, for instance, in Germany (Bavaria) where</sup> the landkroise are both local govemments (gebietskorperwhaften)<sup>and the lowest echelon of the State administration.</sup>
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Table 2 Deloizationu Scale _and_ Sie of Govenmenw

|Country|of units of local governumet|Average Size|
|---|---|---|
|Hungary|3070 municipalities|2,834|
|Poland|2383 gnas|16,000|
|Ronuia|2940 urban and rural mniucipa4itie<br>41 judeta|_7,S00_<br>S37,804|
|**Bulgaia**|273municipalties|30,000|
|CSFR|2843 cides in the Slovak Republic<br>5500cities in the Czech Republic|1,867*|
|Russia|2000 rayons<br>88 oblast|125,000<br>2,840,909|
|China|30 provincs|33 millon|
|Vietnam|44 provincs|1.47 mon|

# Note:* For the CSFR as a whole.

# Sum,orting Subnaional Government: The Ihstutional Setting for Subntioinsl Govemmentisl Reform

66. The lack of an approie contral govnnt strucr to moitor and support tho new local govanmts is a common problem in central and eastern Europe. In Poland, Hungary, and Vietnam for example, thDre exists no institution or designated person in cbare of the deentlion of the localities and the Ministty of Finance still plays a lead role in the budgetary function and other fiscal issues at the local level. In Russia the formation and implementation of fiscal polcy is done by the centrl government and three Parliamntay commisons. The budget is submitted to the Parliament for approval, the collection of revenue is done by the State Tax Service, and expenditure authorization is dr the control of the MOF. In Bulgaria, the Ministry of Regional Development, Housing Polcy and Construction is responsible for formulating the policy on terrtoral division and local administrative functions and guiding the reform progam whilo the MiniAry of Finance retains primy control over the linked issues of local govrment finance and budgeting. In Romania the formulation of decentalization policy and implementation of local government reform is tife resnsibility of tho Department of Local Governmet Affairs of the Office of the Prime Minisr and the Deparmt of Tax Administationand Local Budget Management of the Ministry of Finance and Economy. Simildy, in the Czech Republic, both the Ministry of Finance and the Ministry of Economic Policy and Development are involved in shaping the intergovernmental finance system.

67. Despite (or perhaps becue of) the involvement of a number of central govenment institutions in a number of countries, quite a lot that should be done sem to be going undone. Among the tasks for which responsibility must be clearly establied are MomitOlinl and ssg subnationd fnms both in total and individually. This task might be located in the Ministry of Finance, in a special local govemment department, or it might even be given semi-independent status with some local goverment involvement (like the US Advisory Commission on Intergovernmental Relations or the similar body in Australia). There ae pros and cons of each possible location that need to be considered carefully. But what is beyond dispute is the need to ensure that the central authonties have a better underanding of both the existing situation and the likely effects of any proposed changes than is true at present.
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68. In addition, reular and dogiled fingaial da should<sup>be maintained on subutional govenments. Ideally,</sup> this requires; (1) the establishme of uniform financial reporting<sup>(and budgetng) systms -perhaps with</sup> different degre of complexity for different categories<sup>of local governments; and</sup> (2) the desigaion of an agency responible for<sup>coUecting and procesng then data in a timely</sup> fahion (which wiU probably, in a larg and complex<sup>country, requie use of some sampling</sup> thniques as well as occasional census exercises<sup>to provide the needed frtame).</sup> The first of these quiem ts in tun requirm<sup>the development</sup> of such systeum and, much more difficult,<sup>their</sup> implementation, which will geally require subsatial trining and folow-up efforts.<sup>Developing such</sup> 'infrastricture' is neither quick nor cheap,<sup>but it is esential if substantial ad important public sector activities are</sup> to b decentlized - for whatever rsrn - without losing sight of what is going on in<sup>these importat pua of the</sup> public sector. Implementation of this recomendation may rqui additional centnl govem ntot institutions (1) to develop and maintain the<sup>reporting systems, (2) to tran and support local govenment officials,</sup> (3) to develop independent auditing procedures for local administrations and their rovenueoeaning entexprises, and (4) to run the stical side of the opation<sup>- with the latter being amain input into the work of the instituion</sup> referred to in the first recommendation above.

69. Additional training efforts are clearly needed to uagade<sup>the technical canacity of subnational overnments</sup> to carry out efficiently and effectively the expendituro<sup>functions for which they are now responsible and others with</sup> which they may be entusted in the future, whether<sup>in exercise of 'local autonomy or as delegated agencies of the</sup> central goverment In some insance. (e.g. education) the neary support should probably como from the relevant central minisy, while in other instane<sup>(e.g. road and waterworks) it may come fomthe ministry,</sup> regional agencies, universities, private sources,<sup>or some mixture of the preceding. In view of the heterogeneous</sup> nature of both the services that are (or may be)<sup>decenalized and of most countries, it is unlikely the same solution</sup> will be appropria in aU coass, but it is clealy<sup>a high-pority item to work out in detil exactly who is going to</sup> support the new lood role in each functionl<sup>area and how that support is going to be delivered. Each functional</sup> area - including the budgeting and financi<sup>rporting discussed earier -has different needs, problems, and</sup> possibilities, and will likely have to be treated<sup>diffetly.</sup> 70. Finally, an especially high-priority task for<sup>the needed central unit monitoring local finance is to analy</sup> and evaluate intermovernmental fiscal transfers.<sup>As indicated later in this paper, there are many questions that must</sup> be raised about the objectives, the design,<sup>and the effects of such transfers. There is also much to be said for</sup> encouraging much more informed and open<sup>discussion of these matters than is common in many countries,</sup> especially when the whole process is as novel<sup>as it is in the transitional economies. Regular publication of data will</sup> of course help, but one cannot rely solely<sup>on an interested party -the central govermment -to carry out, and</sup> certainly not to publish, all the analysis<sup>that is really needed in any country in which intergovemmental financial</sup> issues are important, whether in political<sup>or economic terms, or both. For this reason and others, there is much</sup> to be said for establishing as soon as<sup>possible in most countries one or more smal non-govermnental research</sup> institutes focusing on local government problems.

# The Changin Role of Government:<sup>From Ownership to Service -Provision</sup>

71. Decentralization and intergovernmental<sup>fiscal reforms are taking place in the context of a major change in</sup> the role of goverment in the trasitional<sup>economies. Ia the past, governments at both the national and subnational</sup> levels have been involved in almost every<sup>aspect of economic activity. The state owned all enterprises, from the</sup> steel plant on the 'commanding heights'<sup>of the economy to the local laundry. The state organized production,</sup> allocated labor, planned exports, and so on.<sup>The first stage of decentralization in some countries began in the</sup> 1970's, when the ownership of some smaller<sup>industrial units and the retail sector were transferred to subnational</sup>
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govemments. By the late 1980's, local goverments in countries such as China owned a substantial patt of the economy - light industry, and some manufactuning.

72. More rect reforms aim to decentralie owneip to tho privat sector. The trnusition is still far from completo. Although all the east European countries are committed to privatzing stlte assets, to liberaliang prices, and to withdrwing from the role of the state as direct pducer and prvider of ecoomic goods, many produetive assets - indudrial assets, agriculturl and urban lad, the housing stock, commrcial property - remain in govenmment hands, somedmes local, sometimes national.

73. While everything is in flux in most countries, as a nle at the local level the satus quo contasb starkly with the role local govemments generally play in maurkt ec4onmies. In the lIser, local govenmments provide basic urban inftucur and local public services (sometime through local public enterprs) and often act as local administrators of nationa policies in such area a education, health, and social sevices. In the former socialist pattern, on the other hand, enterprises owned by local govenments had their investments financed from local budget', and local budgets in tum derived revenues from Otheir eantepriss. C were close, and the distinction between enterpris functions and government functions often murky. Lcaities often asked enterprises to construct and finance such facilities as roads and schools, clinics and even sports stadia and clubs; 'donations' to the budget for one-off outlays were also com rm Jt made little difference whether such outlays were directly undertaken by the enterprise or **via** the more circuitous route of profit transfer, and funding via the government budget: the burden on the enterprise and the not budgetary position was the same. All this has now changed, or is in the process of change.

74. Until recently, for example, most local government revenue from enterprises came from 'profi: remittances'. As a result of reforms to the national tax system, and especialy of the enterprise tax system, however, these remittances have largely been replaced by taxes on ***thei** enterpriseeW. Somo countries still provide explicitly for such 'ownership' rights to enterprise taxes: in Romana, for example, local governments (iudets and municipalities) have the right to both profits and dividends taxes levied (by the central government) on their public enterprises. In Poland, prior to the racet tax reform, both profits and dividend taxes similaly went to the 'founding' sbnatidonal government, and in addition these govemnments (vovoidshipsand gmina) got specified shares of the similar taxes levied on state enterprises which had significant activities in their territories. This process was so complicated that the Polish tax administration spent almost as much time allocating enteTprise taxes among jurisdictions as it did collecting them.

75. Even where more modern systems of tax adminitraton have been adopted, as in Hungary, there is still a strong tendency for local governments to feel they have a primary claim on the tax revenues generated within their jurisdiction. This 'source entitlement approach to the allocation of fiscal revenues is of course familiar in such contexts as international taxation and the taxation of natural resources. But it is seldom so visible at the local level as it is in some of the transition economies, in part because of the obvious gross inequities that would result from allowing local governments to keep large shares of the revenues levied on firms producing for a national or world market. Of courms **e** , xactly the same problem arises, or wil arise, in the transition economies, as noted below.

76. Ownershig versus Service Provision. The fundamental change in the role of subnational governments represents a major challenge which has as yet not been fully realized in most countries in trasition. The key role of local governments is no longer as o but as saervi viders and reguators. The wrenching reforms most countries are undertakdng in order to achieve macroeconomic stabilization and to compress the state budget may easily produce perverse effects at the local level. As noted below, some central govermments, for example, have shifted additional expenditure responsibilities downwards in the hopes of improving their budgetary position. Revenue assignments and/or transfers to local governments are generally tightly budgeted for the same reason. The Uy See Tanzi, Fiscal Reforms in Socialist Economies in Transition, IMF, 1991, for a full discussion of the national tax reforms that are in process in most countries.
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result is inevitably that local govenments ar sorely tempted to rely on entises for continued budgetary oudlays, and consequantly to protect locally-owned enterprises to ensure their profitability. Unless a workable framwork for intergovernmentsl finance is put in place, budgetary stringency is thus likely to create additional hurdles to disassociating local govenments from thir enterps.

77. T'he IQ-S4t Oda facing both local and centra govements are also very difrent from the past. 'Adm trativo inteventiods', such as the detailed regulation of prices, the administation of waiting lists for housing, and the allocadon of land and mtria supplies are no longer qriropriate. Instead, what is now needed is to develop and implement an entirely now regulatory strctur to provide tho conditions within which the market can do its job e.g. reulation to avoid monopoly, prevent food adulteration, curtail financa fraud, and so on. In this vein, one essential task of the national goverment will be to set up an adequate and clear legal framework not only for the private sector but also for the deces.alized local public sector. Local govermmnts face their own unfamiliar regulatory task, particularly with respect to land use, enviromental problems, and retail trade.

78. Not only is the role of govemment changing, but its mo is changing. Intergovernmental fiscal reforms are taking place in the context of an overall shriniing role of government, with all thstresss that a smaller pie imposes on decision-makers. As shown in Table 3, the size of govenmment was much larger in the transition economies than in mulaet economies. In many cases, reforms have alrdy had a major influence on the overall "size' of the govanment sector, although much more some than in other. In China, for example, the government budget declined from 40% of GDP in 1979 to Ims than 20S of GDP in 1989; in Hungary, the similar decline was from almost 70% of GNP to about 60%. examples. In Ru via, the geneal budget was over 60% of GDP in the late '80s; the target for 1992 is only _35%._ 79. Although the figures are not always clear, on the whole it appears plausible that the shrinling of the national level has been generally pamrlled by a shrinkdng of the subnational level of government: in Hungary, for instance, subnational expenditure fell from 14.3% of GDP in 1988 to only 10.4% in 1991. Predicting future trends is difficult becus of the changing nature of the intergovernmental system in most of these countries.

80. On one hand, as already mentioned, central govenuments continue to shift important expenditure items 'downstairs' in an attompt to balance the central budget. It is not clear if the final result of this process will be reduced total expenditures, increased central trasfers, or increased local taxes - although some combination of the first and second possibilities seems most likely in most countres. On the other hand, as a rule public enterpnses continue to provide a number of basic local public services: they support the construction and maintenance of housing, keep kindergates and pre-schools, and so on. Larger entrpses may even have their own hospitals, retail outlets, and other non-production facilities. As privatization reforms impinge increasingly on the enterprise sector, pressurs to replace some of these activities by local budgetary outlays will undoubtedly be strong.

81. Thus, at the same time that localities may be reducing expenditres by shedding unnecessary and unproductive subsidies (for example, to housing) as part of the economic tranition to a market economy, they may have to take on some expenditures previously caied out by enterprise. Whether such enterprise functions will accrue to national or subnational budgets is hard to predict: it is equally difficul **t** o predict the net change, in the short term, in the size of the local government sector. In Russia, as one example, the non-production responsibilities of enterpnses are, virtually across the board, likely to be taken on by the subnational sector, thus substantially increasing its expenditure responsibilities. Indeed, such a transfer is de facto already taking place owing to the financial difficulties of many enterprises. Unfortunately, no one has either quantified the dimensions of this problem or envisaged any workable solution for it. In principle, however, the shift in expenditure responsibilities from enterprises to local govemment should be matched, at least to some extent, by a corresponding change in the revenue base of the local govemment. Otherwise, the budgetary consequences of privatization are likely to be very negative. But as a mle, that revenue base is already inadequate for the tasks demanded of it, as discussed below.
- 22 -

# Table 3 Reform and the Size of the Goveommt Sector (Expenditue as % of GDP)

|Country|Exp|Sub-nationl|Sub-nio|Total Exp. as|Sub-national|Sub-national|
|---|---|---|---|---|---|---|
||as % of<br>GDP|Exp._as %_<br>of GDP|Exp.u%<br>of total|% GDP|Exp. a%<br>ofGDP|Exp.u % of<br>Totia Exp.|
|||PrE-1989|||Post-1989||
|Hungary|62.7'|14.3'|25.4'|57.4|10.4|18.1|
|Poland|49.7|14.7|35.3|40.1|4.00'|I0|
|Romania|45.1T|3.64|11|24.67|6|10.8'|
|Bulgaina|55.2|N.A.|N.A.|43.0|25.0|23.0|
|CSFR|58.46|20.5|34.5|60.1|20.2'|34.3'|
|Russia*|1.0'|20.7 13U|16.0_1L/_|41.0'r|17.0|43.0|
|China*|271r-|14.3|53.0|22.8|N.A.|N.A.|
|Vietnam|11.3|3.4|31.0|12.3'2|3.9|33.0|

# Notes: (Seo end of paper).

82. In the past, goverments m the socalis countties employed fixed prncs (including rents, and other urban user fees) and wage controls, as essential elements in thOeir dstbuti tool kit. Now, however, as part of the reforms currently under way, the tansitional economics a required ind to 'get the pices right and to use tax policies and targeted subsidies instead. As a rule, replacing conmr price subsidies by targeted sbidies (with a much smaler budgetary impact) will require the development of new infmaion and twcng systems.W Some observers think that the targeting problem will be relatively eay in the transion economies because of the existence of a large 'control' data bas in such countries. This hope is probably naive, howevr, given (1) the flaws in that data base (e.g. in Poland several million people exist *off the **books** a far as officialdom is concemed; in Hungary and especially Romania, thern e important low-income ethnic groups Oh **a** t r smilarly lusive); (2) the dependence of official information on a local control system that is diintgatng apidly, if it has not already disappeaed; and (3) the increasing gmwth of the euphemistically-labelled 'infornmal sector.' 83. Indeed, since the breakown of cenal **planning,** ctrl governmet in most countries have surprisngly little information even about the activities of local goverments. Only in a few countries (e.g. Hungary, Poland) do local governments now appear to provide detailed financing reports to the conter. Reporting of data on extrabudgetary funds and borrowing is also deficiejti 84. Public sector pricing is likely to be one of the last areas to be reformed in most countries. While national price reforms have liberalized most private sector prices,<sup>1</sup> at the subnatioual level governments are having a much harder time adjusting prces for public sevioces, even for prvate goods provided by the public sector, such as housing rents (and such ancillary services as water and heating) and transport fares. Adjusting these prices is of I' For useful discussions of some of these problems, see the following papers presented at the recent World Bank Conference on 'Public Expenditures and the Poor: Incidence and Targeting': Milanovic, 'Distributional Incidence of Cash and In-Kind Transfers in Eastern Europe and Russia;' and Jarvis and Micklewright, 'The Targeting of Family Allowance in Hungary.'

-LPhere has been much discussion about the 'big bang' vs gradual approach to price reform, but even in countries as committed to gradualism as China there has been major price liberalization.
- 23 -

course essential both for efficiency ard to enhce local rvenues. Doing so, however, implies major changes in the cost of living and in welfiae, so tat changing such public sctor prie will entail major, and undoubtdly very unpo ar, distributional shifts if not pro)pey coordinated with other refoms. Such shifts, if too wrenching, or too quick, could upet the filo democcies tat havo only just emergod in most countries.

_85._ At the -m tm that fiscal i-a is going on, national tax ytems are also undegoing major changes. Major naionl tax reforms havo been initiate in almwt every country in a effort both to _make_ their tax sytm more compiblo wit thos of a market ecnomy and **to** pwvide a soeu source of revenues to finace essential ste budgetary outlays il the face of prvation. While there are considerable variations of dotil from country to country, as a rule tax reform involves: (i) the replaeint of profit remittances to govemment as owner with corprt income tuation (CIT) to the govement a tax colloctor, (ii) the introduction of a value-ddd tax (VAT) to replac the classical socialist *tuover tax", which is bet described as consisting of thousands of commodity-specific rates, or wedges betwoe adminisratively-st rtail and wholesale prices; (iii) the introduction of personal mcome taxes (PMl) -wage controls woe the 'mplicit tax' in tho pre-form era there wore also payroll taxes, which are geneally retained; (iv) the itroduction of propety and land tati01on i rdimentary form; and (v) the elimination of a number of ts aimed basicaly at regulating nterprise behavior (such as the excess wage tax, wage bonus tax, excem profits tax).2I 86. As theso national level taxes ar being revamped, the system of local fimucing is smultnewously being changed, both intentionally and to some extent uintendonally. In Hungay, for example, the VAT and PIT were introduced in 1990, the year the Local Self-Government Act was passed. In Russia, tho CIT was introduced in 199,1, and the VAT in 1992, the sam- year that the redsign of the intergovrnl fiscal system was to be implemented. In Romania, prepartions are underway for the ino t of the VAT in 1993, and of a global personal income tax in 1994, with initial local govemment reforms having taken place already in 1991. In the Czech Republic, the VAT is also scheduled to come into offect in 1993, dieo -m year in which a now system of intergovenmental finance is supposed to be put in place. In Bulgara, the curret VAT implnion date is July 1, 1993MI. In all of these cases, there appears to have been almost no consideation in the basic national tax reform of the fiscal needs of the local governments, even though it is clear that, given the fundamental inadequacy of the revenues specifically assigned to local governments in most countries (see below), thes govemments are likely to be dependent on some form of 'tax shaing' in some form for yeas to come.

87. As these press become manfest, further reforms are assigning to, or sharing with, local governments taxes whose design is new, whose operation is untestd, and whose administration is inevitably weak, as discussed later. Moreover, even though the national level reforms are ofte intended to be 'revenue neutral', there is little basis for revenue estimation, and hence little certity as to expected yields. The potential volatility of taxes shared or assigned to the subnational sector is compounded by these countries' overall economic cycicalityll. The difficulty of ensuring corresponden=c between the expenditure responsibilities of the local goverments under the new systems, and their assigned revenue base or share, is self-evident.

I'For fuller discussion, see Tanzi, Fiscal Policies in Economies in Transitin 1 In Bulgaria a comprehensive tax reform under preparation compnses draft profits tax law, VAT, tax administration, territorial division, and excises.

J2See D. Go, 'Revenue Uncertainty in the Transition,' CECPE, RPO# 27118, forthcoming, 1992.
-24-

# Stabtization: Mem Macoeconomic Context for D

# ion

88. The economic reform progms in the trasitioal economies have had to addre both and libsaip- n concerus. Integovenmntal fiscal roforms are tWring place in the context of a w *k overall nacroeconomic position and often a weak cntral govemnmnt fiscal postion. The move to prvate epr p has contributed to a more vital economy, but **has** accenuad tho problem of a shriking rovenue base at the national level, as many of the smaller new private enterprises elude the grasp of tde tax net and ptesnt major challenges to compliance and tax adminisa . The filing state-owned entpise sctor no longer prvitdes th revenue base of earlier days. The tax refoms dencribed above are undoubtdly deirable for maket effici ency, but unt experience with the new system is gained, reven shortfalls seem all too likely. The expediture side of the budget continues to be burdened by heavy outlays for both consumer and producer suidies, as well as often generous cash benefit program and now and sometimes large outlays to support failing enteprises and to restucture or recapitalize banks.

89. In Hungry, the consolidated deficit of the general gove_nxt reaed 4.3 % of GDP, with inflation of 32 %, in 1990, tho year tho new system of local self-government was introduced. In the Rusasia Federation the fiscal deficit is variously measured as either 15% or 30% of GDP in 19912W, and a likely deficit of over 10% of GDP is expected for 1992; inflation is soaring. In Romaia, the mesurd budget deficit has been rather small, but an inflation zate of 161% in 1991 reflects an unstable macro-economy, and suggest that the fiscal accounts understate the deficit: the central bank carres out heavy qasi-fiscal opeaons, and the banking system finances expenditures that are fiscal in nature. Only in China, with its gradual economic reform (and continued tight political control), is there rough budgetary balance and comparatively moderate increass in the prce level (See Table 4).

90. For these reasons, stab and **o** veral acro-eco ic concoms often domiate the national agenda. - Reducing fiscal iwn%aances both those at the center, and those potentially emaging at the subnational level, is invariably a fimdamal rquiemt of the adjustrnt progrm to which most transtional counties have agreed. The curlm t stuation provides a shp contst with public fic in the pro-rform penod, when the uaitary fiscal system imposed close adherence to the Plan in the implementationand execution of the budget, which, together with stict controls over the financs of enterprses helped sure broad balance in public sector finances.A' In paticular, under the old rgim, the finaces of subnadonal govemment had few macroeconomic consequences. Revenue sharing served only as an administrative device to simplify a system of central resource allocation. Expenditures were guided by planning norms. The result ws tat in an accounting seam at least the budgets of the suboational governments were always in balance, with any necessary adjustments being made simply by accounting tmnsfers.

'Ihe difficulty in measring the Russian deficit relates inter aLia to the tretent of the Union expenditure responsibilities taken over by the Russian Federation beginning in November, 1991, following the dissolution of the USSR. The higher number cited rofers to a 'notional' deficit, which assumes that Russia had financed Union expenditures for the full year.

2"As discussed in the present section, ther are clearly potential macroeconomic problems that may arise from suhnational finance. Nonetheless, it is important to note that subnational governments cannot on their own cause such problems since they cannot 'print money (unless the central govenmet lets them do so e.g. through locallycontrolled banks): in the end, it is invariably the validation of subnational deficits by central governments that is the proximate cause of national deficits and the ills that so often ensue. In this, as in -any other ways, national govenments ultimately get the local governme they deserve.

_V_ Of course, one should not exaggerate the robustness of the budget in pre-rform times, since there were clearly many fiscally unsustainable elements from a long-term poerpective in most countries.
-25 -

Table 4 M nmi Indicators

|Country|Deficit as a<br>% of<br>GDP (1990)|Subnational<br>Deficit as a<br>9 of GDP|laflation<br>(1991r|Current Account<br>Balance as<br>%<br>ofGDP(1990)|M3 growth<br>(1991-2)|
|---|---|---|---|---|---|
|Hunguy|-4.3|-.4|32.0|+1.0 l.|29.3|
|Poland|-2.4|N.A.|249.0|+4.8|45.0|
|Romania|+0.9|+.3|161.1|-12.4|100.8|
|Bulgaia|-13.0 _/|-.8|334.0|-2.7|N.A.|
|CSFR|-2.0 I/|+.0|54.0|+2.7|26.7|
|Russia|-20.6|N.A.|382.0|-7.2 I/|75.6 I/|
|China|-1.8|N.A.|_5.3_|+3.7|26.7|
|Vietnam|-4.1|N.A.|36.4 2/|-2.0|19.6|

# Source: Recent Economic Indicators, IMF.

1. For 1991; 2. Average inflation for 1990. The end of period inflation for 1990 = 67.2%; 3. For 1M. 4. For Bulgaria a more meaningful measure is the cash deficit (net of foreign interest arreanrs) which was _8.5 %._ 0 Most receat year after price libmlization.

91. Shiftina Ex&enditure Responsibilities sDownstairs". Current stabilization concoens have led the central government to view fiscal decentaization as an opportunity to reduce centra expenditures. This is being done in two ways: First, by spinning off expdiiture rsponsibilities to the subnational level, thereby reducing its own deficit, and second, as an opportunity to reduce fiscal tnsfs, purpordly to make local governts more "idependent, but with the welcom side offect of reducing centl outlays. In paricular, a number<sup>of countries</sup> are trmsfernng icresing responsibility for social expenditures and the social safety net to local govemnt. In Hungry, for example, the responsibility for "welfari expeditures was tansferred to the localities. In Russia, the contral government trmnsfered social expenditurs equivalent to some 6 % of GDP M992) to the local level by this means, with the objective of "pushing the deficit downa, presmably in the hope that the subnaional govemnents would perform the politically painfiul utting required - even though the demand for these services is likely to grow with the worning conomic situation. More rcnly, responsibility for key national, interurisdictional investments (e.g. in transport)- has al8o been transferred to the subuational sector.

92. Even some of the extensive asset tansfers to local govenmments that have taken place in most countries appear to have been partly motivated by budgetay concerns. Some of tho 'assets' transferred - notably housing - and some entepises a really liabilities given the heavy burden of maintenance and operation of these units and the fact that rental income (last adjusted in the Russian Federation in 1928!) does not cover even a small<sup>part of thes</sup> costs.

93. Reducing Untersovemmental Tansfers. _The_ fiscal difficulties at the national level have also led some Finance Ministries to focus on reducing intergovernmental transfers as one way out.<sup>Transfers have been seen as</sup> the ,compressible dimnion" of the federal budget. The principle of "budgetay<sup>independence" mentioned above</sup> has been interpreted to mean that subnational governmets should be financialy self-sufficient,<sup>which in turn implies</sup> that direct transfers should be reduced and even eliminated. In reality, however, in most of the transition economies central transfer to local goverment sector are very large, reflecting both the rudimentary tax base available to local - govemnments and the center's reluctance again to avoid fiscal vulnerability<sup>-</sup> to part<sup>with any of the major tax</sup>
-26-

bases and to assign them to the sublationdl level. As a nle, however, the amount and distribution of those _trasfrs_ is determined each year on a discretionary basis in accordance with central fiscal exigencies.

94. While such budgeta flexibility is clearly desiable from the cental govenment's short nn view, it is a mistake to view t _fers_ as a completey *comprusble' poion of the national budget, as appears to be the case in countries such as Hungary and Romania. Many of the soevices provided by ubational goverments, particularly in view of the **'pas-down'** phenomennn already discused, contitute estia expeditues for political **stability** or for futre ecomic deveopmt There is no way that th mny small local govements that have been crated in most countries con finace the provision of thoeo servce _at_ an adequate level out of their own rsouc. Even from a short-nm dtbilizaton prspective, an undefunded subnaltional sctor in the curmt environment is all too likely to **result** in a sitution in which the only way local governme can cope with budgetary presre is by using economically undesiable sources of revenue sucha profits derived from the exploitation of incomeming assets transferred to them and from diret public ownership of local busine . At the same time, local governments' open-ended expediture responibility for 'social **asuistmce'** is liklUy to sult in emorgency recurrec to the ceral govnent for additional funds, or simply the unnal accrual of aruas tough short-term borowing. Arrears have been a problem in China in the recent past and are cuntly a major problem in Russia. One way or another, intergove n transfers are thus likely to be an important component of the central budget for years to come in most transitional countries.

_95._ Deficit Control . Placing limits on the subnadonal deficits is of course an obvious way in which centml governments can ensure that the subnational sector does not give ise to additional or unexpected m nomic pressures. Such limits are in place in Russia and China, for example. In an overall framework of hard budget constraints, such provisions may make sense, but this is unlikely to be true when budget constraints are still "soft* in other sectors, notably the aeteprise sector.

96. The combination of controls and soft constants may give rise to perverse outcomes.W In response to the apparent surplus in overall local budgets, for example, Russia has, as alrady mentioned, sought to squeeze the subnational sector by tranferring expenditures downwards, re-adjusting tax shares and minimizing traDfers.W Since local governments by law cmnot mn deficits, however, nor for the time being can they borow even for liquidity reasons, there is almost by definition a 'surplus' at least sufficient to meet the *cash on hand requiements of monthly local outlays. Reduced revenue shares or transfers can never eliminate this surplus: on the contrary, since the system canot be in deficit, such measures will only lead to measued expenditures far below normal levels and increasing cumulative arrears.

97. Budgetarn Autonomys. Although local govenmunts in most transitional countries (1ruland, Hungary, Czechoslovakia, Bulgaria and Romania, for example) have thoir own budgets, quite separte from the state budget, this nominal independence by no means implies the absence of central controls. In Romania, local budgets are subject to the central govemment's implicit approvaW. The central govemment has the final say, especially if k'For examples of dysfunctional incentives for economic liberalization as a result of fiscal d lion policies in earlier Chines experience, see e.g. Wong, 'Fiscal Reform and Local utrialization, Modern Clina April 1992, and *Central-Local Relations in an Era of Fisal becline,- China Ouarterlv, December 1991.

WThe budget surplus, meured on th report _csh_ basis" for the subnational sector amounted to 1.2% of GDP in the first quarter of 1992. See Walich et al; Intergovernmental Finance in the Russian Federations; forthcoming, 1992 W(According to both the Law on Local Adm ion and the Law on Public Finances the authority that approves local budgets is the municipal council for municipal budgets, and the district (judet) council for the district budget. Budgets have to be balanced by law. The role of the prefect, as reprevntstive of the State, is to ascertain, ex-post, that local govemments abide by this legal requirment. Ihere is a disguised direct control of local goverment
-27 -

the budget i unbwaed. In conbt, in Russia sc budgetry approval is implicit in the system of negotiated tax sharing and transfers, whose levels ar conditional on an approved level of expenditues. On the other hand, China and Vietnam slill have a unfiedbud, in which central and subnational plans and accounts ae jointly presented. In China the local budget must be approvod by the provincial goverment, and the budget of the provincial government must be approved by the cewr.

98. More generally, even though the local govermts have been given autonomy in pnnciple, in practice they lack it in my areas The lalc of tnsparency or claity of laws further e rbat the problem. e rel degree of expenditure autonomy of localies is often limited. In China, for example, local gove_nts have little formal or legal independence with rospect to etheor local taxes or the level and compoition of expenditu. In almost all the countri under eview, ce expenditur noms and **enl** spending and wage mndats continue to Carry weight in many u. Tndee, in Roumaia thes facton stil weigh so heavily that thero is hrdly any real local expenditure discreton **as** yet. In the Czch Republic and Hungry, on the other hand, ther appears to be much looser control on the expenditure ide. On the oter and, the lack of veue atnmyis seere w eveywhore. The center usually stipulates caps on local taxes and in some cas even spocifies the tax rates and tax base.

99. Tax Administration as a Sowce of Vuleabil . Fiscal d talion, and the political decentrlization that accompanies it in this now environment ha left some cOentl governments **c** -o caly vulnerble for another important eson To ensure macroconomic stabiliation, the feded goverment must be able to contain its budgetary deficits, which means relying on its own budgetary revenues. In some tansition economies, however, tax adminition is decenulized, that is, aubnaional governments collect revenues on behalf of the center, and transfer them upwards 'we Table _S).PI_ In Russi, in the CSPR, in China, and Vietnam, all revenues other than customs and trad taxi ar collected by local a ons. As the experience of the former USSR (and the former Yugoslavia) suggstb, delegation of collection responsibility, with its potential for non-compmiance, or worse, reliance on contibutions from member publics, are only vible means of fincing the centrl govermment so long as central political control reman strg (as in China and Vietnam). The potential withholding of tax revenues from the fedeal budget threatens Russia today; even in China non-compliant loCal administrtn, and the revenue contracing' system this gave rise to, have been the source of m_cnomically cyclical federal revenues. 2-' expenditure magent because all expenditur involving the use of centrl govenment resources requres the exante approval of the Miistry of Finances' local trsury office, and, since fiscal tnsfers represent up to 90 % of local resources, the Govemment, legal arrangements notwithstanding, continues to actually exert a close to total control.

3 Strictly sealing, the tax dministrations am doconconat arms of the federal or central administration. De facto, however, tax officials may have strong ties and loyalties to the local governments which often provide their housing and fringe benefits: ther is conideablo evidence in some countries (e.g. Russia) that local tax offices respond to local policy.

Uv See Szapary and Blejer, _'The_ Evolving Role of Fiscal Policy in Centally Planed Economies under Reform: The Case of China,- IMF Woring Paper 407, 1989; and Bah and Wallich, "Intergovenmental Finance in China". World Bank WoDkng PaPr Series No.863, 1992.
- 28 -

Table 5 Tax Admunistraton in Trulstion Soci;at E3c9;lp

|Country|"Inverted|Centmalzed|
|---|---|---|
|Hungary||x|
|Poland||xi|
|Romania||x2|
|Bulgaria||x2<br>l|
|CSFR|x||
|Russia|XI||
|China|x|l|
|Vietnam|x||

# Notes:

1. In Poland, all national domesic taxes, and some local taxes and fes are colUected by treauy offices and then transferred to state and local budgets. Other local taxes and fees are paid directly to Gmias.

2. In Romania and Bulgaia, the local goverments do not have their own administrton. All local taxes are collected by local branches of the MOF.

3. The State Tax Service is in the proce of centalifzing.

100. liDcations for The Lonuer Tern Intergovemmenbl Svstom Although intergovernmental fiscal reform _is_ necessuily takig place in this strned macroconomic context and hence inevitably reflects changing short-term fiscal needs and psures, care must be taken to prevent the stabilition objective from fully dominating the redesign of the intergovemmental finances megime. A major challenge facing the trmnsitional economies is to develop an intergovernmental fiscal system which is an optimal combination of mles ad di - one dbt wiU be both flexible enough to be compatible with macroeconomc stabdilization and the major structural shifts which are taking place in the economy, and at the sam time provide a stable framework for the effective operion of both central and sub-national govemments in the lcnger termL 101. One solution along these lines that has been adopted in some market economies, for example, pivots around a system of intergovernmental transfers in which the totl is flexible with cbanging macreconomic circumstnces - for example, some percengta of total central taxe - while the distribution of this total among diffent subnational govemments is Oformula-driven", with the amount received by different localities depending on such factors as potential "fiscal capacity' and **assessed** need. This approach repreents a compromise, in which the center gives up some degree of control over its revenue but also insulate itself from ad hoc and possibly escalating demands from localities, while localities avoid discretionary cutbacks in local trasfers to meet stabilizaion objectives, with all the expenditure dislocations that this implies. In most of the countries under review, thus regularizing the overall size and distribution of the tanmsfer, like strengthening local finances by broadening the local tax base to improve local tax yields, represent high-priority reforms. This point is developed further below.
- 29 -

# m. WHO DOES WHAT? THE ASSIGNMENT OF EXPENDlTURES

## The Efficieno Cae for Deeentized _Local Gt._

102. Whilo local governmmnts may have some effect on stabilization policy and some role in distributive policyLW, their mn-or economic role is clealy with respect to the alocation of resources. From an efficiency point of view, the basic rulo of expenditure asignment is to assign each function to the lowest level of government consistent with its efficient performance. So long as thm are local variations in tses and costs, there are clearly efficiency gains from carrying out public sector activities in as decenraized a fashion as possible - and these gains are larger the lower the price elasticity of domad for these services.

103. In principle, therefore, the only services that should be provided centrally - or, in some instances, regionally - are:

- serviees for which there either are, or are for overching political reasons presumed to be, no significant differences in demands in different localides (e.g. national defense; public health);

- services with substantid 'spillovers betwoen jurisdictions that cannot be handled in some other way such as by contracting, or by grant design (e.g. interlocal tmnsportation; air and water quality); and

- smervices for which the additional costs of local adminisraon are sufficiently high to outweigh its advantages (e.g. administration of income taxes).

Apart from the last of these three cases, even these soervics can often be delivered most efficiently at the local level, although they may well be financed in whole or part by central transfers. In short, in principle, moat public services should be delivered at the local level, with local decision-makers deciding what services are provided, to whom, and in what quantity and quality. To put this the other way, the only services that should be provided centrally are those for which there are no differences in demands in different localites, where there are substantil 'spillovers between jurisdictions that cannot be handled in some other way, or those for which the additional costs of local administration are sufficiently higher to outweigh its advantages.

## Expenditure Assinment in Practice

104. As noted earlier, under the previous socialist regime, since local governments basically acted as units of the centrlized administration, local expenditures were included in the unified budget of the central govemment. There was no question as to who did what. the central govenment did everything, sometimes directly and sometimes through its local administrative units. Under the new local government laws in most of the countries under review, however, specific expenditures have been assigned to the local level of government as shown in Table 6. In the Czech Republic, Hungary and Poland, for example, local goverments have detailed expenditure responsibilities in the area of education (primary and kindergarten), transportation (local or urban streets), environment (garbage collection, disposal, industrial waste), housing and related services, and health and welfare. In Russia, on the other hand, there is no legal definition of expenditure assignments at the local level, except for WSince local governments are governments as well as service agencies, they are inevitably interested in the distributive as well as the allocative effects of their policies. Income redistribution at the local level may be swverely limited by the openness of the local economy, but if a goverment is not concenied with distribution, it is not a government at all but simply a service agency. Nonetheless, within-jurisdiction distribution is ignored here as unimportant relative to the importance of setting up the basic mles of the local finance game so that each local govemment is fully accountable for its actions.
- 30 -

Table 6 Expenditure Assignment to Subnational Authortiei_

||Hungary|Poland|Romnia|CSFR|China|Vietnam|Bulgara|Russia|
|---|---|---|---|---|---|---|---|---|
|Defence<br>|No local<br>responsibility|No|No|No|No|No|No|Military bousing|
|Justicetatemal<br>security<br>|Enforcement of<br>rights of national<br>and ethnic<br>minorities|No|Public<br>securityis<br>provided by<br>local<br>_branches of_<br>the Minidry<br>ofInterior||No|No|Secwity of<br>_farmingesas_||
|Foreign Econotnic<br>Relations<br>|||||No||No||
|Education<br>|Ptimary and<br>secondary only<br>including day care<br>and high schools|Kindergarten<br>and pre-<br>elmentafy<br>chools only|None|Partid<br>tesponsibility in<br>the Czecb<br>Republic|All schools<br>primary througb<br>university level.<br>Local<br>governmenta<br>cover all salaries,<br>mainten nceof<br>school fciliies,<br>adminitration and<br>scholarhips||A<br>expeadisues<br>(epil<br>and<br>current) of<br>pnimary and<br>econdary<br>schools. Sone<br>kindergartens.<br>Some technicd<br>and vocational<br>schools|Several special<br>vocatiol<br>schools.**Wages,**<br>operation<br>contmction and<br>maintenance of al<br>primary and<br>seondary<br>chools.<br>Local enterprises<br>build ome<br>facilities|
|Culture and parks|Supponting<br>cultural activities||Over-lapping<br>responsibility<br>for cultura<br>activities||Cultural activities<br>such as cinemas<br>and broadcasting||No|Some museums<br>with oblast<br>significance. All<br>recurrent<br>expenditures of all<br>sport and park<br>facilities And al<br>othcr culural<br>facilities.|
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- 32 -

|Libannes|Hungary|_Poland_<br>|Romania<br>|CSFR<br>|China|Vietnam|Bulgau|Ruoo|
|---|---|---|---|---|---|---|---|---|
|||Partial<br>peogmbliy|No(book<br>purchase<br>thimh the<br>budgs of the<br>Miniiry of<br>_OdhnC_<br>_)_|No|No||Lal<br>iaui|Speci ibaqy<br>aevicca**at**tde<br>**eblM**levde an<br>mml<br>ibay<br>ices at he<br>isyo lve-ld.|
|Poke<br>ccs<br>Sitti||||_No_|-<br>--||Sofia has a<br>Withdie<br>Wiliti; ed_er|Road (rafic)|
|anaon<br>garageclection)<br>__________________<br>S|Garbaecollection<br>|Ownerhipand<br>Provisionof<br>coldwaterat<br>~~~~~~all<br>levels<br> <br>|||Rcflu colection|||Patofgarbage<br>colgcticurat_both_<br>oebband rayou<br>levels.|
|ewge<br>|Garbage coLection<br>and<br>eleme<br>clekanig<br>_ _ _ _ _<br>_ _<br>_<br>_<br>|Owneri<br>ad<br>pwviaoaof<br>ewage evceo<br>_ _<br>_<br>_<br>_<br>_<br>|Sewage<br>colhecti<br>_<br>_<br>_||_<br>_<br>_<br>_||Gar<br>clectioGand<br>i<br>wm<br>b<br>ln die<br>se_mea<br>_<br>_<br>_<br>_|Moat of the<br>epetcioa<br>e<br>_pendluSt doe<br>rayon leveland<br>some op_Son<br>_ezpendiuresat_<br>the<br>~~~~~~~~~~<br>levd|
|Public utiies (ps.<br>electricity, and war)<br>-________________|Water<br>snanaeetand<br>rmuenance of<br>public<br>cemteries|Supply me<br>ligh<br> _|Ditict<br>heating_and_<br>wtder||||Wdcarspply<br>iDn_uctn.<br>.|Subsdi_to_<br>hmboJs (nt<br>cep_e)<br>**at**the<br>yonlev|
- 33 -

|_________________<br>|Hungary<br>_|Poand|Roasua|CSFR|Chn|VKtnam|Bum|Russ|
|---|---|---|---|---|---|---|---|---|
|Housing<br>_<br>_<br>_ _<br>_<br>_<br>|Housing<br>mgement<br>_<br>_<br>_<br>_<br>|Sha<br>eqpibilty<br>_<br>_<br>_|_Haiwng_<br>evices<br>_<br>_<br>_|No|Builliqg<br>_h|_|Ma<br>a<br>of<br>ea_<br>pasurssa<br>OdIu2ScI<br>Pq.tY<br>Fuming.<br>_buildingsl_<br>subvdifrinfoe<br>re"ade<br>-.|Maie<br>e isde<br>oq<br>of<br>te evof<br>govammsern<br>r<br>e<br>_efi<br>bousing.<br>Cqita<br>expenditures<br>axr<br>iacdeunls<br>athesalse<br>oed.|
|Priceandohw subsidies|Restsubsdin|Rem|Eer<br>uWies to<br>huehold<br>ndpb<br>transport<br>,ubsidies|Dict subsidies<br>toagrullual<br>cooetive,<br>and sbidies to<br>eutpst<br>t<br>e ot bIvolved<br>in tde<br>poducfioof<br>lbcalubric|Ysn<br>||MasDanc t<br>I dmug.<br>sadyto<br>_me-lge<br>bw<br>srvie within<br>unicipaities.<br>Hatigvabg dy<br>isce1992.|For.eels,Muss<br>tnot<br>nd<br>food saca<br>bred,alk_and_<br>afinas<br>**a_**<br>**tedi**<br>nyonlevel.Also<br>remt sbdies|
|Socil Welfae<br>|Social care<br>ffciies<br>sch as<br>old_e_an<br>handicapped<br>hames<br>|Voivodship<br>r<br>obilitis|||Welfare<br>expeu<br>for<br>ede<br>who s-<br>chids,<br>ophanagcs, die<br>disbled dec.||Homles<br>disebled ad<br>o<br>_ad_|Part obist<br>oVeammt<br>o<br>_yand_<br>rayon kvel<br>n<br>nt<br>of<br>pwrgantanded<br>byupperlevd|
|New Public enterprie<br>(productive secto)|Can esablih new<br>domestic joint<br>vente|Can ablih<br>new domesi<br>joint ventu|Can ablih<br>ne<br>dometic<br>joint<br>ventures|Cm establish<br>m domestic<br>jowt vewn|Can etablis_aw_<br>domneacjoint<br>vesra|Can<br>estblis<br>nw<br>domestic<br>joint|Can esablish<br>_ne_domestic<br>joist ventos|Capacity to ivest<br>il joist Vema;nts<br>(pSOpewea<br>of privatization<br>proced if ryo<br>Al th ayon lee<br>ths asoIincIud<br>10 percentofany<br>subordination|
- 34 -

|Eit|Hungary<br>|Poland|Romania|CSFR|China|Viem|Bulgaria|Russ|
|---|---|---|---|---|---|---|---|---|
|nvronman<br>Sd|Proection of tae<br>nvkionent<br>||||Envimeat<br>prtction Outlays.<br>_<br>**_**||Measue to<br>iwmrne aNd<br>wehabiritate<br>the<br>envkoseit<br>_<br>_<br>_|RexOsibl for<br>el<br>_environmental_<br>pblems, e.g.<br>pri rvation of<br>~~~~~~~foca|
|tate-owne Enterpriss|Major local<br>ownerhip<br>responsibilities|Local<br>ownership<br>reponibilities|Loca<br>ownership<br>reqnibiliti<br>**es**|Major local<br>ownerhip<br>rsponsibilities|Major ownerhip<br>esponsibities of<br>lght and heay<br>indusries.<br>Prvide subsidies<br>tocderprisefor<br>technia<br>upgding d<br>building of<br>temaporary<br>warbousel|Local<br>ownership<br>respotibi<br>lities||-*Gmup<br>C-<br>enterses<br>e.g.<br>locallight<br>inuy,<br>housg<br>condruction an<br>food indury.<br>Rayon<br>ronibility<br>exis only if dhe<br>eepid<br>is<br>transftrd to the<br>loal klvel|

Nftes: i Jo Victnam, local governmentc are responsible for al of th abov activiti f ey s fi uderthrdit diction. at, each klve ofgovem tis reponibl for thaa activiie which fals und their juisdiction. / '-' implies no infonnstion. 3 'No' implis no applicable to ubaniol governments.
**35** -

social progrms (which account for a major pat of expenditure). In effect, tradition and inrtda have eablished expenditur ssignmets i Rusia which i many cases roughly correpond to best practice (benfit) _areas._ Unformnatly, pehps owing **in** part to the lack of legal clarity in ths area, it appears tht thes pincipleare<sup>being</sup> inreasngly violated in the courn of the on-going chages in the ietgovemntal finance system.

105. Although in some ways it is not typical, Romuiia provides an intereng example of some of the things that are going on in tho a of expenditur assigment in tho tnsitioatl conomies. At first glance, for example, the new local govomment law appeas to asign local govenments exclqsive technical and financial responsibility for many more fimetions (e.g. policing) than those that are _actually_ exercised. In _fact,_ however, this asgnment is only on condition tht nationa **l** aws or '[centrall govemment decisions' do not specify otherwise. That is, in practice, local govenments do only what the centraI authorities wat them to do. The main financa responsibilities so far actually asumd by local goverm ts in Romania are basically for vaious mor activities in social assistance, municipal service, cultwre and arts, public investment, and maintenance. **_A_** A rogars local transportation and district heating, local govemments simply serve as conduit C3r the channelling ok coetral government subsidies to the public service enterprises (regie autonome) delivering there two services. Witth the gradual elimnation of consumer subsidies (to be completed in 1993) and the tnusfer of legal ownersip of these entetprises to the local govemments (to be completed in 1992) the situation may change, though it is far from clear how, finacially, the local goverments will handle the problem **s** temming from the now responsibilities.

106. Romana is thus unusual in the extent to which some important expenditures usually considered to have strong 'local benefit' characteristies are still at the centrl level. In particular, and in contrast to most other transitional countries, education and health remain the sole reponsibility of the contrhl govemment in Romania, reportedly to ensue a minimum standard in the provision of these important services. Recently, however, increasing financial pressure on the central govenmmnt has led to the proposal for some of these expenditures be delegated to localities. As is not uncommon in the transition economies - though highly unusual in western countries - both public scurity and fire protection ar also provided throughout Romania by local branches of a central Ministry.

107. Overlapping responsibilities between the center and localities with respect to culture and social assisance, on the other hand, are common to y countries. For example, local museums are often financed by local budgets and national museums financed by the central govemment budget; but books for both local and nationa **l** ibraries are purchased by the Ministry of Culture. Similarly, both local and centra governments fund programs related to children. Such' h -h-ring *xtdit '-i.., with diffeent levels of govnmt responsible for different subfunctions of particular expenditure activities, or with more than one level of government playing an important role in financing, regulating, and providing particular services-is a common characteristic of multi-tiered governmental structures: it may sometimes be efficient, but it almost always obscures the key question of precisely who is responsible, and accountable, for what.

# Local Public Enterpriso Ownership

108. Romaia also provides an extreme instance of a problem found to varying degrees in most of the transitional countries: the importance and complexity of the tnangular relations between the new local governments, the public enterprises providing local services, and the centrl govenunenLt In some ways, it is not too much of a caricature to characteriz the local government system now functioning in Romania as amounting to little more in fiscal terms than a conduit between centrd government and these enterprises (or relies autonomies, as they are called in Romania). If one asks: 'What do local governments per so do in Romania?', the answer at the present time is: Not much.' Excluding the rngj local govermnm **e** nt xpenditures appear to consist of littlo more in most cases than minor outlays on social assistance, cultur, and gener administrativ **e** xpenditures. Most service delivery activities have been hived off to the various mge. leaving the local government as a place that does little more than collect dog licenses and register marriages. These may be essential activities, but they do not require a large revenue base - and indeed in many instances would best be financed by fees and charges (as discussed later).
- 36 -

109. In principle, of course, thern is nothing necesarily wrong with having local govenments that do not themselves deliver out of thei own resours many services to local reidens, just as there is nothing wrong with having local govenments deliver nationally-finaced and naonay-detmned semvices to local residents (see lator discussion) or with having most local sevice activities caried out by local public enterises with septo budgets and managemmats. All these systems can be found in one country or another and may work perfectly satifctorily. Indeed, given the extrm degreo of cenhalizion characteizing the trsitional economies in the past, the present system in Romania, one of the Ist of theso countries to reject the old system, may be not only acceptable but desirable.

110. Nonetess, it is critical to the financial health of both the local govomments and local public enterprises that the precise elionship between the two should be set out clealy. At present, in a number of countries tha lines distinguishing activities that should be performd by local gov _ents, local public enterprise, and commercial enterps are undesirably confused. Unless these questions arm disentangled, senous problems may occur both in setting up properly functioning local governments and local public enterprise and with respect to privatization more generally. A few examples from field work in several countries illustra the point: In some areas, local governments are responsible for certain activities (e.g. parks); in others, local enterprises; Some activities (e.g.bakeries) are commercial in some areas; others are nru as adjuncts to local public enteprises; It is also important to clarify the relationships between differant public enterprises e.g. at regional and local levels as well as betwen enterpriss and governments, especially when an enterpnse is located in one area and serves other areas as well.

:11. On the whole, municipal enterprises should be confinod to traditional local public service activities (water and sewer, heating [traditional in eastn Europe, at least], tansit, perhps solid waste collection and disposal). All essentially commacal activities now conducted by such enteprises such as bakeries, laundries, and construction companies should be sold off as soon as possible. Finally, in some instances certain activities (e.g. parks) for which there seems no appaent rationale for adoptig the enterpnse form of organiation should probably be folded back into the local government proper.

112. Where it is decided to organize some local public service in the form of a public enterprise, any subsidy paid from generad local government revenues should be set on an ex ante basis to establish the hard budeet constraint needed for efficient operation. Moreover, such enterprises should be subject to all normal tax laws (central and local), and in general they should be run like commercial enterprises e.g. setting prices and terms of services - although presunably within a natioally-esblished regulatory framwork (which as yet does not exist in most countries). At present, local authorities essentially have either no guidance in setting enterprise prices, or too much guidance in the sense that these prices are still being set by centrd authorities.

113. The budgets of local public enterprises should also not be consolidated with local government budgets per se: only any explicit subsidy and any profits transfer should appear in the goverment budget. Of course, enterprise budgets should be annexed to the local budget and submitted - not for approval but for information - to the appropriate cental agency, as noted earlier. Mhe numerous somewhat anomalous decentralized institutions found in many transitional economies (e.g. Hlouses of Culture) should either be organized as enterprises and treated like other enterprises or, if they are to be treated as component parts of local govenments, consolidated with other local expenditures and revenues.

114. It is especially important, both for good govemnment and for good business, that local governments should get out of commercial business activities as soon as possible. The business of local government is not business, and the sooner local governments begin to concentrate on their central task of providing as efficiently as possible the
-37 -

local public servi&as their inhabitats desir<sup>the better it will be for both busine and the local inhabitants.</sup> Although intentions in this respect are cleady<sup>good in most countries, there does not apper to be adquate</sup> recognition of the danger of d lintion becoming an obstacle to the privaizton process, as is already happening to some extent in Hungary, Bulgaria,<sup>Russia, and pehas elswwhere (see later discussion).</sup> 115. As emphasized earlier, countries tat decentalize<sup>subntal</sup> expditure responsibilities to local govemnmts that either do not have access<sup>to adequate local tax sources, or that are not capable (technically or</sup> politically) of admnting thos taxes to which they have access, run this<sup>risk, especially when sver fiscd crises</sup> reduce central tanse to local governmnts. Whln the major source<sup>of governmnt rvenue has traditionally been,</sup> and is still to a lar extent, entrrse, the temptation for local govenmes to extract<sup>more revenue from those</sup> enterprise in thdir control can be overwhelming<sup>-and will invariably be most unforunate from an efficiency point</sup> of view.

# Provision of Social Services: Shiftina the Safety Net<sup>'Downstairs'</sup>

116. Most public enterprises are engaged in providmg<sup>such 'hard services as water, electricity, and transport.</sup> In addition, however, particularly close attention<sup>needs to be paid to the role of local governments in te transition</sup> countries in delivering and financing services in<sup>at least three important 'people' areas -social assistance, health,</sup> and educadon.

117. First, while the present role of municipalities<sup>with respect to socid assi</sup> varies from country to country, being qmute restricted in Romania, for<sup>example, but much broader in Hungary, this are is all too likely</sup> to become a major problem in all countries<sup>in the future as a result of two unpleasant but likely developments - the</sup> weakening of the naonal cacity to minin ociad protection at the present level and the<sup>growing need for such</sup> assistance as a result of economic restuctunng.<sup>Even if the need for this bottom layer of the social safety net</sup> becomes greater, however, it is far from obvious<sup>that the municipa</sup><sup>**l**evel - while it may be the appropriate executing</sup> agency - should be responsible for financins such<sup>assistance. In many western countries, for example, it was</sup> precisely the unsusamably heavy load on municipal<sup>welfare systems resuldng from the interwar depression that lead</sup> to social welfare becoming mainly a national, rather<sup>than a local, responsibility. It is thus ironic, and potentially</sup> dangerous, that so many transitional countries<sup>seem to be moving in the opposite direction just as the need for such</sup> services is rising sharply as part of the adjustment<sup>process.</sup> 118. Second, health and education are already controlled<sup>in large part at the local level in a number of</sup> transitional countries. Experience in many countries<sup>around the world shows that people are willing to pay local</sup> taxes to have their children educated. Hence,<sup>carrying out some education at the local level is one instance in</sup> which a devolution of expenditure responsibility<sup>may, at least in principle, be matched by a corresponding</sup> devolution of financial responsibility. On the other<sup>hand, there are also strong reasons for central involvement both</sup> in ensuring adequate investment in human capital<sup>throughout the country, regardless of local fiscal capacity, and</sup> to some extent in financing a higher level of such<sup>expenditure than localities would be likely to do on their own</sup> (See also the later discussion of trsfers).

# Exnenditure Assinmment in Princiglo

119. . In the long run, a desirable assignmet of expenditures<sup>to local govermments in many transitional</sup> economies might be something along the lines<sup>shown in Table 7, perhaps with the local' share being further</sup> divided between different tiers of local government<sup>along benefit area lines. As Table 7 indicates, there are only</sup> a very few functions - national defense, purely<sup>local services -that should be clearly assigned to one level of</sup> government or the other. Most expenditure functions<sup>are likely to be shared between levels of government, as</sup> indicated to some extent by the breakdowns shown<sup>for a few of the functions in the table: similar detailed</sup> subfunctional categories could of course be set<sup>out for e.g. health and tansport.</sup>
- 38-

> 120. It is also importa to unstand that Table 6 refer to _the_ level of govenumW dt a paticular service. Who finM it is a diffent quesin. Moover, ther is no prsmption that any or all of thee ser must be Qgrducd by public setor agencies, although it is atuud that the public sector ust indeed to some extent be responsble for thoe pgMjg of such services if anything clos to the opbtal mnmt is to ' a provided. Wbat matters to people in what servces ar provded, not who provides thm. Ilded, may 'public sector' services ar ae-tually caried out by non-governmet ntities in diffrent comtries.

TABLE 7 A Possible Ex=<diWur Amsin=

||Local|Center|
|---|---|---|
|National Museums||X|
|Local Musem||X|
|Community centers|X||
|Social Assistance|X|X|
|Municipal Services|X||
|<br>Transporaon|X|X|
|Telecommunications||X|
|Health|X||
|Educatic:n|X||
|Kindergarts|X||
|<br>Primary Schools|X||
|<br>Secondary Schools|X||
|<br>Higher Education||x|
|Protection:|||
|Local Police|X||
|Fire Protection|X||
|National Police||x|
|National Defense||X|

121. To iUustate, aternatives to direct public production by genal-pose local goverments that may be found in one country or another include:

- Various forms of contracting with prvate firms e.g. compeotive bidding for time-limited franchise (often with the local govenment contiuing to own the assets, but turing to prvate sector firms - or possibly cooperatives of former public sector workes - to manap them);

- Establishing standards for required sevice and leaving it up to consmers to select private vendors and to purchase the required level of service;

- Issuing vouchers to (some or aUl) _citizens_ and allowing them to purchase the required service from any authorized supplier,

- Contracting with other government units (e.g. disticts, other municipalities, enterprises, central goverment) to provide the serice;
- 39 -

- Producig some seres, whilo purchang othm fiom other govenment agcies or pnvat firms;

- Estabishing on a voluntary basis limited (Oneighhorhood) govenmnts employing user charges (and posbly limited tax powers) to gsneate rveaue;

- Eblisbing limited-purpos ind dent govmentl unts cverng mom thn one general-pose local govemn (spca disict) finnced by bnefiay chag of onemo or another,

- Establshing specia tax (imprve_t) ars within a given g -puros loca governt to provide services to areas which are willing to pay for thm

122. Of course, the _mer_ possibility of such varied augr nme to provide particular savica does not imply either that these arangments will be easier to manage tha a mr conventional organizaton of public sector activities or that they will yield officient and equitable semce delivery. Noeltb s, one of the more striking omissions in the on-going discussion of local govemment in the tranti eonomis is the fidure to keep straight the cntical distinctions between who owns what, who _Daynfor_ what, and who 4 whatL Contrary to the meage many countries in transition sem to have absorbed from their prior expenence, namely, that ownership- is eveything, in the pubhic sector who owns an **asset** does not necessrily determine who regules the use of the asset, who opoaes it, or who finances it - and these fa ar, as a nle, much morm important in determining both what is done, and what the fiscal and other implications are, than is ownership alone.

123. A striidng feature of local government finances in most trnsitional eonmomies is the prolifeation of extrabudgetary funds (EBFs). In Hungary, in additiin to the lag national-level EBFs for social security, housing and solidaritya, thee are a large number of off-uidget accounts at the local level to which oarmaioe finds devolved. Such 'inherited emarndg' is also a promint faotur in th CSPR. In Russ, the right to set up these fnds was accompanied by the assgnment of a number of non-tax rvenu sou to local governments. Bulgaria and China so permit such funds to be st up, and in the latter thoy conatitute an important parallel budget at the subnational level.

124. The geness of theso extabudgtay funds is complex. In par they rep t an attempt to escape the "control mehanism? of tho cantrl govenment. Insmuch as local budgets in some countries are not really autonomous and remain subject to smutiny from above, EBFs ovade this scruy on the expenditure side. Ia countries whoe the loca govenmments ae transfer- dependent, and whr transfers are allocated not by formula but by bargaining and negotiaton, puttig rnsourcea off-budget into EBFs is a means of concealig the true resource base of the locality from the center. Some local governmmats _themslves_ claim dtt oxtrabudgetary funds reduce the uncertainties of the budgetary process. Moreover, to tho oxtent the rvenue system remains basically unitary - that is, the tax base and tax rate of most, if not all, taxes are defined by the center, with revenues allocated to the local level, EBFs may provide the only window for any local revenue initiative. Lastly, in countries such as Russia and China, whero local governments must share any revenues they coUlct with higher level govemments, EBFs, being off-budget, are not thus shared, a fact which gives them considerable added attraction from a local point of view.

125. On the other hand, such funds present serious problem for effective budgetary magement at the macroeconomic level. They also reduce the tanwparency of budgetary operations and complicate assesment of the impact of fiscal policy. In practice, extrabudgetay funds function as parallel accounting systems which, for all intents and purposes, basicaly constitute full paradll budgets not subjoet to the strictures of conventional budgetary procedures. In addition to being a clearly inefficient budgetary practice that permits public sector operations not legally approved through the proper channels, the loss of control and information asing from the presence of such multiple budgets is bound to undermine the ability of the government to use fiscal policy as an efficient macroeconomic instrument. Without discussing the specific merits of each EBF, as a geneal rule legitimate revenue
-40-

sources should be fully incorpoated into thoe reulr budge **t** o provide full accountability of fiscal opaions, and if this is not possble, full information about the sours and use of extrabudgetay funds at sub-national<sup>levels</sup> should be proWvided to the centrd fiscal authorities.

# IV. FINANCING LOCAL PUBLUC SERVICES THROUGH USER CHARGES

126. Th prvious sction noted that in mos **t** rational cownomie many local public sector activities ar caried out through public etaps. Such terpis ar coma., for example, in trort, in houng, in garba collection, in watr and sewap, in electricity, and a on. Evae with prvatiuzato!a,<sup>my sch entrprises ae likely</sup> to continue to exist in most countrias. The quesdon of how local public entepris<sup>**_arm_**to be fiaced is therefore</sup> of critical importane to the health of the local public sector. The answer suggested<sup>by the benefit approach to local</sup> government finnce outlined earier is tht as a genal rule, such enterpises<sup>should be self-financing, that is, they</sup> should be paid for by those who rceive the services they provide. To put this<sup>another way, the first rule of local</sup> financo should be: Wherever possible, charge.' For efficiency, chages<sup>should be levied on those who receive</sup> the benefits: the direct recipients, whether businese or 'thingas (real property) should<sup>thorefore be charged.V</sup> 127. Although the ultimate incidence of such charges is of no more interest<sup>in principle thn the ultimate</sup> incidence of the price of cheese, studies in difforet countri have shown that the distributive conseqm c of charging for local public services is not necessrily regressive. In any<sup>case, attempting to rectify fundamental</sup> distributional problems through inefficiently pricing scarce local resources is almost<sup>always a bad idea, resulting</sup> in little if any equity being purchased at a high price in efficiency terns. As noted earlier, however, particular care will need to be tken in adjusting local public service prices (including rents) in the<sup>transitional economies because</sup> of the important role such prices played in offecting distribution policy under<sup>the old regime.</sup> 128. While user charges are most likely to be viewed by hard-pressed local<sup>officials as a potential additional</sup> source of revenue, their main economic value is actually to gmoto economic-efficienv<sup>by providing demand</sup> information to public sector suppliers and by ensuring that what the local<sup>public sector supplies is valued at least</sup> at (marginal) cost by citizns. This efficiency objective is particularly importat at<sup>the local governmnt level since</sup> the main economic rationale for local govemment in the first plac is, as noted earlier,<sup>to improve efficiency. There</sup> is thus a presumption that, whenever possible, local public services should be charged<sup>for rather than given away</sup> (unless, of course, they are pure local public goods or the explicit intention is redistributive).

129. For example, when local govemments provide services though local public<sup>enterprises such as water,</sup> power, gas, and public transit, these services should generally be charged<sup>for at prices that will recover the cost</sup> of providing the service from the uses or buyers of the service either i;mmdiately or over time.2 The price of water should reflect the cost of piping it to the homes (or standpipe) as well<sup>as the cost of mantaining the pipes,</sup> treating the water, and so on. Bus fare should cover the cost of purchasing<sup>buses and maintaining and operating</sup> them. In principle, such prices should be set at the competitive private<sup>level, with no tax or subsidy element</sup> included - except when doing so is the most efficient way of achieving<sup>public policy goals (and even then, as noted</sup> earlier, it is best if the tax-subsidy element is accounted for separately).

130. Unfortunately, in most countries much less use is made of charging<sup>at the local level than seems desirable,</sup> and many of the charges that are levied are poorly-designed from an<sup>efficiency point of view. Weak accounting</sup> IZ'I view of the substantial importance of locally-provided intermediate goods to business, some limited local taxation of business may thus be warranted, but, as emphasized elsewhere, it is important to constrin the ability of local governments to *export' tax burdens to non-residents.

-there are, of course, many well-known qualifications to this statement,<sup>but it is sufficiently accurate for present</sup> purposes.
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systems that do not clearly identify costs is one reason for the prevalet under-pricing of these semces. Another rason is the historical hangover of the previous distributional role of such prices. And _a_ third is the simple political difficulty that newly-elected local goverments have inposing subsmtnt increases n srvce prces on those who have just electe them.

131. Lca governments also obtain revenue from *som&o fes uch as licens fes (mariage, busine, dog) and various small charges levied essenially for performig specific services - reg ng this or providing a copy of that - for identfiable individuals. In effect, such fes costitueost imbement from the private to the public sector. indeed, in some budgetary systems, such cost twcoveries are neted out and only net (of recovenes) expenditures sowd Chargig people for something they are required by law to do may not always be sensible - for example, if the benofit of (say) regisation is general and the cost is specific -but on the whole there is soldom much harm, or much revenue, in thus reovering the cost of providiog the service in question.

132. Another category of charge revenue encompasses what may be called *wgafic benefit taxes (or chures).' Such revenues are distinct from service fees and publie enterpise pries becau they do not arise from the provision or sale of a specific good or service to an identifiable private individual. Unlike 'prices' which are voluntarily paid - although like 'fee's which are paid for services that may be required by law - taxes reptesent compulsory contrbutions to local revenues. Nonetheless, specific benefit taxes are (at least in theory) related in some way to benefits received by the taxpayer. In contast to such genel benefit taxes as fuel taxes levied on road users as a class or local taxes in general viewed as a price paid for local collective goods (see below) - specific benefit taxes relate to the specific benefits supposedly received by specific taxpayers.

133. For example, if as a result of a new road, better street lights or a new sewer system, property values increase, or busine sales dse, a 'benefit levy' might be introduced. This could tame several different forms; (a) a 'special as nt'; (b) a **'land** value increment tax'; (c) an 'improvement tax'; and (d) a 'supplenentary tax', etc. Most such chargs are imposed either on the assessed value of real property or on some charateristic of that property - its aea, its frontage, its location. A common benefit-related charge is the development charge (or 'beterment tax') - a lump-sum charge designed to recover the cost of infiastructr developmet from beneficiaries. Thus, those whose land is near newly-installed stet lighting would be charged to help pay for the cost of the iation. A development charge may cover only ono project-for example, a neighborhood road paving scheme or the construction of a sewage canal-or it may cover the full development of a new area. Such a method of financing may be not only efficient but equitable, since those who benefit from development pay for its cost. Two paricularly successful systems of development charges are land readjustment in East Asia and the 'valoriation systm' in Latin America. While such shemes are most obviously useful in rapidly-growing uban areas, there may nonetheless be some role for them in at least some cities in the transitional economies.

134. In any case, the importance of charging for public services in these various ways is, as emphasized earlier, much greater than the relatively small amounts of money most countries can or do collect from such levies. To the extent that a local government is viewed primarily as a provider of services, as it should be, and the benefits of those services can be attributed specifically to individual citizens, properties, or busneses, the appropriate policy is clearly to charge the correct (roughly, marginal cost) price. Only thus will the correct amounts and types of service be provided to the right people, that is, those willing to pay for them. Correct pricing in this way helps public officials make sensible judgements as to how to match scarce resources with rising demand. When the true cost (and the related user charge) rises so high that demand falls, the costs of the service exceed its benefits in the opinion of the public. The signal is quick and clear. A decision is then needed as to whetier to: (a) increase the price and serve fewer people; (b) cut back on the cost and standard of service to keep it affordable; or (c) subsidize the service from general revenues. In the absence of such price-generated demand information, supply decisions can only be made by bureaucratic rather than market-oriented processes.
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# V. THE CHOICE OF SUBNATIONAL TAXES

13S. I ea **s** il p upose of loal ta xs to fineo locally-provided collective public goods for local _reiden_ If such goods a tuly 'public in te ss of accnung equally to all rsiden of the jurisdiction, **Mn** if edisribution to ote tha natna standards is not aim of local public policy, ad if admiisrative (ad compliac) cost am left out of accm , tho be ource of local mven migh prahp be an equal per cap levy _suck_ theo 2LU, which _aWs_ hs dke vitu of beg economially nautrl or officiet in the _sense_ of giving to no exces buni 136. **At loest an** ounty, Huny, **aclly** has introdced a form of **local poll** tax, **called eo** ta In view of the high **propot** of publi housing in Hungay - a proportin **dth** will undoubtedly deli **but** is **lbly** to remai **sigficant** - an argumt c indeed be o for levying aome form of local poll tax an public hosing tents.W Altough tis tax my prove _mor_ difficul **t** o administer in Hungary's i ney mobile socie than _sem_ to be geneally u_ lim h a tax, while it is n r liely to yield nuch rven, may thusbavo a minor role to play in local finc From this persctvo, however, it would be prefble if te rate of such _a_ tax wo set locally rathe imposd unifoimly by n al legiooas in Hunguy. Although such differuatal local poll toxes are eay to ovade by movig, tis pobiliy may be viowed - creaing a not undesiable check on their rates. Of course, ven those who do not floe may be had to tax: the low officincy costs of th, poll tx m likely to be purhasd at the expns of high admiittve _d compliance costs.

137. More fundamtlly, thoa is **good** n to beive tat in many coa some local renidets - portyowners, people with school ag cbildn, or whoever - benfit more thanors frm the provision of local public goods. That is, while thee may be no ron to levy cfic benefi **t** axs thre may be good rson for some local residents to pay m than otrs 138. If, for example, the deand for local public goods is incom laadic, a benefit cas can be made for a loal income tx - or, more feasibly pehap given the high adminative costa of separate local icome t , a local surhage on the cental income t& If the enoymet of such goods is amocied wi consuptin (rahe than reddence), a benefit cas can dmilady be made for a oxl tax an consumption, which would in practice almost cerinly have to take the form of a rotil sales tax. And finally, if the benfits of local public goods ar enjoyed in proportion to the value of real property there is obviously a cas for a local propety tax.

139. Under-flmdnd. .md.EimJIy D _tdm? In practice, th fisca sitaton ficing most central govermnt in transitional count is such tht vitually no major revenues we ceded to subsional govenments. Many couns - esily those ith a stonmg regional tradition suck _as_ Rsia and the formor republics- aig the tax revenues (other than the coporate tax) from locally owned enterprs to the local government, givUg them strong cntlisntc incetives to protect ad maitai the monopoly position of ter entepis. Thi is likely to have cosequences for futre economic growth, especially where localities arn swcessuy 'protctiniat. In mny of the countrie surveyed, the strong financial interest of local government in locally owned enterpris rm . This is a holdover from the old fiscal system under which enterpnse profits accrued to the level of govemnt that owned them (i.e. profits of locally owned entuprises weA to the local govenment; profits (and later, taxes) of centrally owned entprises went to the central government; and provincial govemments received the profit of their enteises).

tt is of course asumed that any desired general income support is provided primarly through national sources: as argued earlier, local goverments should not misprice their servces for distributive reasons.

&Such a surcharge is, for example, proposed in Bird and Wallich,<sup>3</sup> Financing Local Govemment in Hungary. a and in Wallich, Fiscal Decentralization:Interovernmental Finance in the Rusian Federatio.' See also the lter discussion in this section.
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140. Of all the countries surveyed, only Hungary and Russia give subnational governments as large share of certain non-enterprise revenues. In Hungary, local governments get a share of the personal income tax (PMI - initially 100%, then 50%, now 25%. In Russia, subnational governments get some 20% of VAT, 100% of PIT and 60% of the corporate profits. More generally, in most of the former USSR republics -the present CIS - the personal income tax is assigned to the subnational level, a holdover of the old Union days in which the PIT was a "local tax' assigned to the oblast level and passed through to rayons/cities. Generally, subnationai govermments in transition economies are under-funded, and overly transfer dependent (See Tables 8 and 9).

141. The only 2tentiallv (but not preseatly) significant tax these countries have assigned directly to local governments is usually the 29z txJu, as in Hungary, Bulgaria, Poland, Romania, and Russia. In Romania, for example, the property tax is levied on all privately owned real estate. The tax rates are differentiated and, in an undesirable carry-over from the old rgime, varied with the 'social characteristics' of the property owners: 1% on the value of the property in the urban area owned by workers and employees of commercial societies; _1.S%_ on the value of property owned by individualbusiness like independent professionals, self-employed individuals, and family associations of ro more than ten employees; a lower rate of 0.7S% is levied in rural areas. The taxable value of property is reportedly based on inranco assesmnents, sales contracts and construction costs and appears as a rule to be grossly underestimated. Moreover, all buildings owned by public institutions are exempted from this tax and, in another featue seemingly guaranteed to keep the yield of this tax low in a country privatizing its housing stock, all houses and apartments bought by individuals from the state are exempted for ten years. Even apart from this serious structual defect, the difficult and costly task of updating property valuations (and keeping them current) means that while this tax may become an important source of local revenues in the long run, it would appear mistaken to rely on it for substantial revenue in the near future.

142. Matters are not much better in Hungary, where the property tax is levied at a more uniform rate - 3 % of "corrected sales value' (which usualy means about 25% of market value) - or, alternatively, at a flat rate per square meter. As a rle, the only information local governments seem to have in practice on which to base such taxes is the area - and even with respect to area the exemptions specified in the law (and carried over from the old system) ensure, as in Romania, that not much revenue is likely to be collected from this source for some years.3" Substantial national assistance in developing an adequate valuation base seems necessary if the property tax is to become an important component of Hungarian local finance.

143. Another tax granted to local governments in some countries has been the old tax on individual business. essentially an income tax on small private enterprises. This tax has been assigned to localities in Romania, for example, on the grounds that it is easier for them than for the central government to check and collect such a tax. With increasing privatization in urban and rural areas, it might appear that considerable revenue might be expected from this tax. In fact, however,even in cases where, as in some larger cities, there are already computerized systems of information on tax bases, tax rates, exemptions, population and family structures, it is by no means clear that it will be easy to keep these data bases up to date, as economic activity moves increasingly out of the direct control of the govemment. For small communes in rual areas, family visits by tax collectors are now the most common way to collect direct taxes in many transitional countries. Again, however, it is unclear how much weight this system - which grew up under and was long supported by the totalitarian regime - will be able to sustain in the more democratic, and less controlled, circumstances now prevailing. In any case, with the growth of the private, and especially the informal, economy, the level of evasion with respect to local taxes seems more likely to rise than to fall over the next few years. In reality, experience throughout the world suggests that the only kind of business taxes local governments can collect efficiently are low-rate and relatively crude levies.

L There is little to be said for using area as a basis for urban property taxes. The case in different in rural areas, however, where taxes such as that in Romania - a differentiated rate ranging from 35 lei to 400 lei per hectare, depending on ferlity and location - may make sense, provided the present fixed per hectare levies are adjusted annually (or more often) in accordance with an approprate price index. Unfortunately, those who have received land under the land reform are exempt from land taxes for 8 yean in Romania, thus severely weakening this potential source of local revenue.
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# Tabl S _Revme A _ime_ to Submiol Authorties

|_____~~~~~~~Ri<br>Trover tax<br>(er<br>VA)|Hungar<br>(1991)|Polan<br>(I991)|-_lonkR.<br>Romania<br>(19"l)<br>0|Czech R.<br>(1991)<br>|Slovak<br>(1991)<br>|_~<br>a. asiml<br>(195)<br>|_<br>--<br>_Vi_etam)<br>(1991)<br>|u<br>-<br>guia<br>(1991)|__<br>11,1,inse<br>(19)|
|---|---|---|---|---|---|---|---|---|---|
|<br> <br> <br>CTruoqteincoA<br>tax|0|X|<br>0|L0<br>|N.I.<br>|100%<br>|100%<br>|O_/fi_|20%|
|<br> <br>Peuionl<br>ome itax|<br>25%I/|<br>30%/|<br>0|N1<br>|N.I.<br>|IOO%<br>|100%<br>|50X/<br>|_<br>_60%|
|<br>Tx on Ppetty of|<br>0|_<br>100%|<br>_95%2_<br>_/_|_N.I._<br>|N.l.<br>|100%<br>|100%<br>|70%<br>|100%<br>|
|<br>Lcally Owned SOEs<br>Exciwes|<br>-I<br>0|<br>0|<br> <br>0|SO<br>|IO<br>_<br>|tO<br>_<br>|0<br>|_V-._|100%|
|Wage tax|<br>0|30%I/|<br>0|N.I.<br>|N.L<br>|0<br>|0<br>||61.1%|
|<br>Small and Medium ErAJ|<br>NA|<br>50%|<br>0%|0<br>|13%<br>|0<br>|0<br>|0||
|<br>Collves<br>bnometax<br>Local<br>Taxe:|..|||N.L|N.L|100%|N.L|N.L|_NA_<br>||
|<br> <br>- real es<br>tax|100%|100%|100%|_<br>||||||
|<br>- autolroad tax|<br>100%|<br>IOOX|<br>100%|100%<br>NL|100%<br>|N.L<br>|NJL<br>|100%<br>|100%<br>|
|<br>_-_s1ma busisa|<br>100%|<br>100%|<br>|.<br>|N.L<br>|N.l.<br>|Nl.<br>|N1|100%|
|<br>-agriculturaltx|<br>0%|<br>1OX%|_N_<br>100%|_.A.L_<br>|N<br>|N.L<br>|NX.<br>|N.L|_N.A._|
|<br>-pontax|<br>100%|<br>NA|<br>NA|N.<br>|100%<br>|100%<br>|100%<br>|100%|NA.|
|<br>Natuml Reaauce Tax|<br>NA|..<br>NA|..<br>NA|NAL<br>|N.A.<br>|N.A.<br>|N.A.<br>|_NA._|N.A.|
|<br>Odiet|..<br>touim &|..<br>i|..<br>|N.A.<br>|NA.<br>|100%<br>|N.A.<br>|NA.|100%|
||<br>misc.|ms.|Mile.|_NA._|N.A.|N.A.|N.A.|NA.|21 misc.<br>taxes|

Soume: Misc. BRD domaents. See biligaphy. Noe: PN in **1992** _jI_ and hared according to a Reduced fom 100% (1990); **85X** 50% (cexral (1991).; **_-_** 15% (ocal) traio.; 3/ Unot 1M tax **_I** eform.; To be inrodud in 1993.; I/Alo coaidad as property income tax.; **2/** 100% of **ech** tax **acnus** if Tobe abo to die le le of in 992.; of in 992.; in 992.; **goveetneutownigth** 11 To be usneftmned istoa mmr effective **end** by provinciafy owned SOEs _accrues_ to **the** pvincial budgd.; **_I/_** 40% **from** unkiipal enterprises and 10% from **stente** pries.; NJL: No hfomation.; N-.: **_Not_** aplicable.

le of in 992.; of in 992.; in 992.; **goveetneutownigth** 11 To be usneftmned istoa mmr effective **end** eprie; eg. VAT **pdd**
_- 45 -_ 144. Just such a tax ha been creted in Hungay in the local tax on busnor. Unfortuately, this is a bad tax. Although the pesnt low rate (3 per mill) on business tumover is not likely to do much ecomiic damage, such a cumlative busuie tax of course poduces precisely the s- kind of tax cascading an Hugary has tied to eliminate at the naiooal level by adopting a VAT. This problem will become more srious if, a is lky, the increaing prsu on local finace leads to inea in tax rates in the future. Moreover, a premuly designed (with the explicit exclusion of retil sleo fiom the tax base) this tax encoraes both tax exporting and local attaemts to maipuate the tax sysmI for incentive reasons. Tax exporting is of cours the antitheis of aional local finance, and local fisca ;entives to production have a dml record tumghou the world, so nehr of thes features of the tumover tax is desirable.

145. Another bd tax that **has apped** in a umber of countries is some form of local Ourist. Touit establihmt (inluding second homs and cotta) should of couse be suvi*ac **t** o geneal local bunes and property taxes. And of coumes should be chaged fully for the costs they im on the envinmet ad on local public services. But tde seem no reason to encourage fiscal irsponsibility by maling it especia y aractive for local govemments to imprse taxes on noresidm: as a nle, they need to be restrained from such actions, not encouragedl.

146. Another possible local govenment tax, in contrast, deserves more atenion than it seem to have so far received in most trsnsitional economies: the taxation of motor vehcls. At present, it appers that only about 7 % of vehicles in Hungary, for inance, ar subject to the relatively small and not particularly well-desiged *duties levied by local gover_ments., Many counties similaly have widepd exemptions from their exing vehicle taxes e.g exempting not only aU vehicles used by public institutions finnced by the state but those used by war veteran and so on. None of these exemptions, of cours, mo.m any sene given the basic benefit rtinalo of this tax. As vehicle ownersip beomes more widespread vebicle taxes (tedesigned to be less vulneable to inflation and perhap more in line with envirnmeta needs) might in timo become an important revenue source for **at** least the larger localities. In principle, ul vehicles should be subjwcted to taxes designed to some extent to offset the social costs attributable to vehicles. While such taxes should probably be dosignd and imposed uniformly thrughout the nation to avoid obvious administatve problems, there is no reson why these revenues should not be assigned in whole or in part to the local governts in which the vehicles ar registered.

147. Although both vehicle taxes and espocially the property tax clearly have significant long-term revenue potentid, particularly in larger urban areas, on the whole the local tax packge bestowed on local governts in most transitional economies leaves much to be desied. Often, for example, local tax rates and tax bae are estblished in central govemment tax law, and at most a range of rates is provided within which local govenmts can choose. Many of the taxes thus established have rates fixed in nominal cunmcy, thus making them highly vulnerable to erosion through inflation. Others are minor nuisance levies which may weU yield less in revenue than they cost to colect. None pi .ides an adeque fihcd foundation for an active and viable local goverment WIt has been argued that tounsm taxes (krtaxeon or taxes de tournse) should be seen more as a globalized user charge than a fiscal levy. Resorts with annually widely fluctuating populations have to assume expenditure, both for operations and capital investment, of a type and amount that cannot and should not be recovered from the (often few) permanent residents but from the acual beneficiaries of these services. If not, the unavoidable consequence is that resort areas turn to the central government with a demand for increased fiscal resource transfers and that at the end tourism activities get, in one way or another, subsidized by the central govenment as, for instance, happens in Turkey.

ain Romania, in another undesirable hangover from the old regime, initialy, some motor vehicle taxes (levied at flat ates, by type of vehicle) went to the central govenment, depending on the nature of the taxpayer. Since August 1992, these now go to municipalities (individually owned cas) or to disticts (cars owned by corporations).
**-46 -**

148. In moms counries (me Table 5) at preen, all the ceal govenumt<sup>ta</sup> ar collected by **a** _ **dJj** tax Although sich dual loyalties can obviously caon problems,<sup>it soem unlikluy that bhvig locl</sup> taxes collected by local governzmnt will<sup>help mtters muck in the r fture, given te sevee so</sup> of trid tax adui_nor. In Vietnam, the MOF **ha** eblished a Geeral<sup>Tax Deatm_t to ovetsee the aciVitie of a11</sup> provincil tx d_etmu. in China tha amr two orguai-mn: the Tax<sup>Bureu and tie Fiac</sup> Depatmn which have sparae d _atmt with detiled functio at each level of city,<sup>county and province. Rom</sup> is ao an the procos of crating two orgatios to hndlo fince and tax admintaon at the<sup>local a woe</sup><sup>**a**ntn</sup> level. in Russia, tax admnitration it responsibilityof te Stae **Tax Semrice**<sup>(STS) which</sup><sup>**hu an orgaional**</sup> sucur at all throo lvela of govem t, **and** is an saunomou agecy with<sup>initial</sup> rning.

149. A *uy JItrx miht pehop be dfnd one (i) aseosd by local gover t, (ii) At rte decided by local gvota, (iii) collected by local govanins, and (iv) with its poceeds _auing to local gov bnts. In the ral woldd, however, many taxes possess aoly one<sup>or two of hes charactstics. In sm cases, for</sup> oxample, a tax accros in whole or in par to local govemnts,<sup>but its re</sup> ae sot by tho ntionl gpv _nit, which also **asoss** nd coUects it. Insted<sup>of a local tax, for many puposes suh a tax might be conidered to</sup> be really a cental gvenint grant allocated to local gove_nnts in prportan<sup>to the amount of natiOna in)ome</sup> tax colected locally. On the otdr had, what<sup>looks like a cntral tax and a rlated tafr</sup> proa m reyaly be a local tax. Some i ovrl trasfe, for example, in effect smply rer taxes to the regios in which they wero collected in the first place. If the local<sup>govermet detmn</sup> the tax base and rate and receives all the rvenues, **the only** role **th cntal** goverment plays<sup>is a a collection agen: it may even be rembud</sup> for its worc, for ince, by beiong allowed to reta a sal percentage of coUctions. Proe bly,<sup>the cntrl</sup> gover_it ha a comparve advantae in tax collection, and<sup>the local govenunet has conacted for its service</sup> in this reopect. In this case, there is no intergovenmntl<sup>tranfer at all, except in tho narrowest accountng ss.</sup>

# Characteristics of a Goo Loca Tax

_150._ The following are among the chaacteristics that may<sup>be sought in an 'idedl local tax:</sup>

[1 The tax base should be reltively immobile, to allow<sup>locd authorities</sup><sup>**soms**loony in vaying rates</sup> without losng most of their tax bas.

- [21 The tax yield should be adequate to meet local<sup>needs and sufficiently buoyant over timo (i.e., it</sup> should expand at least as fast as expenditu).

- [31 The tax yield should be rlaively stable and predictable over time.

- [41 It should not be posible to expost much, if any, of<sup>the tax burden to non-residit.</sup>

- _[51_ The tax base should be visible, to aesur accountability.

- [61 The tax should be perceived to be reasonably fair by<sup>taxpayers.</sup>

- [7 The tax ould be relatively easy to admns efficiently and effectively.

Not everyone would agroe that all those charcteristics<sup>are necessarily desirable - e.g. is it unequivocally good that</sup> local govements should be insuladd from either the tax base consequcs of their tax rate choices or from inflation? In any case, it is unikcely that sufficient<sup>taxes possesng</sup> most of **the** c _aestics will be md available for locl use. In fact, as already noted,<sup>the so-cailed "local* taxes in most trnstion</sup> countries are controlled in varying degrees by cental governmmets e.g.<sup>with respect to the deermintion</sup> of tax base, tax rates, and/or tax aminisa Noneteless, unless ther is a significant degree of 122<sup>freedom of choice with respect</sup> to some or all of these matters - so that local govenments<sup>can change the level and conosidtion of their rovenues -</sup> it is not very maningful to talk about *locl autonomy.<sup>a</sup>
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# _LAA_ vt Taxes

151. How doe te pmprty tax score in the tus? In t firs pace, a experica in **a** number of cowies **ha** sow in nrcet yea, theres often wideopred resistance to the poperty tax whe too muh _veue is sought_ from this soumc. One mum is prcisely becauu it is **a** very visble tax, for vl reaso. First, ulie the incomn tax, the popery tax is not deduct at ouce but generally **ba** to be paid dicly to the nundiciplity by txpaye i periodic lump vum payments. Taxpayeo who pay taxes directly to goveant tend to be _mo awar_ of the size of thiir tax bill th thos whos tke-hom pay is eduoed by wedky or montly tax deductions. Mm need to make such penodic larg paymint ny woU add to th accouiHtbty a reposbility of local govemint, but it alo gry incrums the nmativity of taxpayer. to even noinal inces in taxe.

152. Seooodly, the ineltcity of the property tax **ha** a smilar effcL Since tho bas of this tax doe not u a rule mcra autonacally over time, the penodc nominal incs i property tax bills needed to mintain el reoven whe price levels rie reqr inad tax rat. In tunn of political accountability, tis need to confron **t** he people with the cost of govenint again reprents a vitu of the property tax; agin, however, tho **downside** (from the local government's point of view at least) is the heightmed visibility of nominal tax _increases_ and the accompanying political resstance.

_153._ Thirdly, local proprty taxes of course finance such municipal servicae as ducadon, roads, and grbage collection. The quantity and quality of thee servicas (or their absnco) is thus _readily_ linked to the prperty tax. When potholes devlop in their eet, taxpayers are nd daly quick to question the taxes that supposy finance stret pir. Once again, the very faor that _makes_ the property tax a good source of local goverment revenmu in piciplmoa it ospecially vulnerble to political restance in ptce.

_154._ Oter problems result from prperty tax administrton. As _a_ nle, property is supposed to be **aaosed** an the basis of its maret value, usually defined a the prce struck between a willing buyer and a willing sller in _an_ arm's length trnsaction Exacdy how this is to be implemented in countries in which private propety is in the procems of beig established in law for the first time in decade is not anirely clear. At the very least, therw is a substantial valuation task required before much fiscal yield can realistically be expected from propert taxs in most transitional economes. Moreover, even in countres with well-developed property tax systems, discrepae usually aise beween messed values and markt values within classes of property, between classes of property, and across unicipalities for both political and technical reasons. Since taxpayers can easily compare their propeaty taxes wi=th those of milar pwperties in their neighborhood, such discrepancies lead both to spocific asse appeals and to general parsr for tax reief.

_155._ In short worldwide experience suggests that there are at least thre substantial constraints on the use of propety taxes for local finance:

*First, although the administration ofthe tax can certainly be improved in the tannsition countries, there wil always remain sver problems in administering it in a horizontally equitable fashion, particularly when prices are changing rapidly.

*Second, the temptation to the inevitably rather fragilo new local goverments to indlge in politically painless but economically inefficient 'tax exporting' means that severe constraints should be placed on the degree to which local goverments are permitted to tax busineses more heavily than residential taxpayers if the property tax is to be an economically desirable sourc of local revenues.

wrhird, both becausn of its fults and its virtues, heavy reliance by local goverments on the property tax probably ensures that, as is the case in most countries where the propefty tax is the main local tax, they will either continue to be heavily dependent on intergovenmntl grants to finance their activities, or they **will** not carry out many actvities.
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_156._ D _it these_ politicaland adminisaive problem, the promty **taremains a potaly sigificntsourc** of revenue for local govemments in trnsitional countries. Moreover, there ae<sup>good reasons for taxing real</sup> proprty both a a local tax and as a tax in genal. A tax on rel propety may, for example, mao good ose as part of th tax system as a whole: although relivoly expensive to adminiter, such a ta<sup>scores quitewoe in</sup> terms of both its efficiency and its equity aspects. Moreover, if loeved<sup>at the local level, a pperty</sup> tax can, **as** empized above, seve as a good men of fnacing local public goods - subject, however,<sup>to three imp_ont</sup> provisos: (1) An adequate nationl fmwork law is estblhed (to prevent unwarranted local manipulatio of the bas and rate suctu and in particular undue loading of the tax burde on nonsidmns).

(2) Loc govermmnts _ore_ providod sufficient technical upport to carry out their ed of the administrative process (which should probably not include valuation).

(3) Local gov remnts are pemitted (within the paramte set out in the framework law) to vay the tax rate anmually. Such rate flexibility is esetial if the tax is to be adequately responive to local needs and decisions.

Unfortunately, none of the proprty taxes recently creed in the trnsition ecanmies apper to atsfy thes critnia.

# Own Subnational Taxes versus Shared National<sup>Taxes</sup>

_157._ On the whole, if there is an obvious alternative (or supplement) to propety tuaxs it is likely to be some form of local income tax, probably levied as a supplement to national income taxes. The cas for<sup>rdying on</sup> property tas, especially taxes on residential property, as an importat soumr of local govemment finance strong. Since, however, property taxes can only be pushed so far, if more local 'own-source' rvenue<sup>is desired -</sup> - either to expand the size of local activities or to make local govemments more self-reliant<sup>-</sup> thr is much to be said for supplemtary ('piggybacked') local income taxes.

158. Of cours, property taxes do not even come close to financing the needs of the subnational<sup>sector where</sup> these have sgnificant expenditue responsbilities. Thus, in some countries, notably Russia<sup>-</sup> wher the subational sector fina close to _50%_ of public expenditur - access to major national taxes, probably the pernl inconm tax, will be needed.

159. Like the property tax, such a tax, if appropriately designed, would be visible and hence in principle stisfy the criteria of political responsibility and accountability. However, the fact that income tax revenues tend to grow with less political fuss, while presumably good news for local officials, suggests<sup>that ineas</sup> reliance on local income taxes might be viewed with mixed feelings by some. On the other hand, since an income tax<sup>is usually</sup> perceived as more progressive than a property tax, it scores higher than the latter on equity goWunds.

160. The principal argument against local income taxation is administratve. Most of the<sup>other arguments</sup> sometmes raised against this proposal have no merit. One such argument is that there is sometiing<sup>inherny</sup> *bad in efficiency or equity terms about allowing local govemments direct access to the income tax.<sup>Some local</sup> governments, for example, probably have no income tax base. It might therefore<sup>be argued that it is somehow</sup> unfair or inequitable to let those local governmente that have such a base exploit it. But the logic of<sup>this agumet</sup> is not apparent (and of course the basic unequal distribution of local tax resources is procisely what<sup>the equalization</sup> grants discussed later are designed to deal with).

161. Similarly, arguments that local income taxes reduce national fiscal flexibility or induce inefficient fiscd competition or inefficient resource allocation are at best incomplete and in general<sup>misleading. The functions local</sup> govenments are supposed to carry out are essential, these expenditures have to be financed<sup>somehow, and the local</sup>
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income tax approach seems more likely than most alternatives to free the national government from the responsibility of financing some such services while still leaving it a free had to alter its own tax system as it sees fit.

162. Moreover, assuming the benefit' model of local government postulated abovs is followed, such taxes simply constitute the price of local public services and have no adverse effects on resource allocation or on fiscal competition. On the contray, their allocative effects are desirable as is any competition they may induce among local goveombt in lower-cost provision of desired public services (including the intermediate services entering into production functions).

163. Whatever merits swh arguments may have, the prevalence of plans for local saresh in national income tax revenues in countries such as Hungary and Russia probably reflects more the influence of the historical patern under which the revenues (like the expenditures) of both levels of government wOer unified than of economic logic. In Hungary in 1991, for example, localities received S0% of the revcnues collected from the personal income tax, allocated on the basis of residence. These funds accounted for about 13 % of total local revenues.

164. An alteroative to the Hungarian sysem would be to allow local governments to impose their own income taxes in the form of a surcharge on the national tax.<sup>2</sup> ' This option has two unique advantages:

*It is likely to lower the level of income taxes in Hungary without exacerbating the budget deficit.

*It is also likely to induce more efficient local expenditure than would otherwise be the case.

Such advantages do not come costlessly, however. The major argument against this approach is undoubtedly that it would be relatively costly administrtvely and in particular would render the alredy difficult task of efficiently administering the national tax system even more difficult. Nonetieless, the prospct of achieving both a more efficient (and democratic) system of local revenues and expenditures and a more efficient (and lower) level of total expenditures and taxes is sufficiently atrctive to suggest that this option deserves careful consideration.

_16S._ This proposal could be simply implemented in Hungary: for example, cut the national income tax by _SO%_ - the share going to local governments in 1991 - and allow local goverments to impose a flat-rate surcharge on the (remaining) national income tax, to be collected by the national govenment and remitted to the local government in question. Local govemments would thus continue to have access to PIT revenues, but now they would have to face local voters and justify their local income tax rates. In all likelihood, many local governments would initially choose to levy lower taxes (surcharges of less than 100 %). The result would then be to lower both total taxes and total expenditures, since the total amoumt local governments have to spend would be lower to the extent they levy less than a 100% surtax.2y In order for local governments to justify levying taxes as high as (or higher than) those foregone by the national goverment, they would presmably have to be able to demonstrate to their voters that they are spending the money efficiently and in a dsired way. Suwh a check on local spending seems especially desirable in a situation like that in Hungary tcday in which central transfers are likely, for political reasons, to remain basically unconditional.

166. Allowing local govermments to impose such income tax surcharges has at least two major advantages:

# IfSee Bird and Wallich,'Financing Local Government in Hungary.'

M'Of course, this exposition abstracts from the possibility of local borrowing as well as local exploitation of business enterprises. As noted elsewhere, however, local borrowing should in any case be tightly regulated and controlled, and local recourse to business enterprises for revenue purposes should be heavily restricted.
e so (1) Local govermments - at least the richer ones - will have access to a broad tax base so that they can more adequately finance out of local resources the extensive range of services they are supposed to provide.

(2) Whether taxes go up, down, or stay the sam, the accountability of local governtnts, and the efficiency of their expenditurs, should icrease.

Assuming the functions local goveranmts are supposed to carry out are essential, the local income tax approach seems more likely ta most altenatives to free the national governmnt from the responsibility of financing some such serv-ces while sdll leaving it a free hand to alter its own tax system as it sees fit. The altenatve of local surchargus on value-added taxes or on enteprise income taxes are much less desirable on both techmical and economic grounds.

# VI. THE DESIGN OF IPTERGOVERNMENTAL TRANSFERS

167. Russia, China and Vietnam are the only transitional countries with no explicit arrangment for intergovemmental transfers. In all three countries, there exist upwartd transfers' from provinces to the cenul government. In most other transitional economies, while transfers ar generally the most important source of local government revenue, most such intergovernmental fiscal flows are basically discretionary and "negotiated in natue. The exception is Hungary, whero there is an explicit formula for the so.called normative grant." A somowhat similar grant formula is currently under consideration in the Czech Republic. In Russia, where there is an ad hoc intergovermental grant, there is no evidence that it is equalizing.

168. In themselves, transfers are neither good nor bad. what matte from a policy perspective are their offelc on the outcomes of interest, such as allocativo efficiency, distibutional equity, and macroeconomic stability. An additional essential element of an adequate system of transfers from the point of view of both centrl and local govemments is Sau!parm=xy as when the transfer system is driven by rules or a formula rther than by discretionary political decisions. It is clear from Table 9 that in most countries subeational govements are highly transfer-dependant. On avenge, some 70% of revenues, and often more, comes from trnsfers. Generally speaking, the concept of grants for capital finance, matching grnts and other standard approaches are little known.

# Closing the Fiscal Gan

169. Intergovernmental fiscal transfers play several disit roles in most countries. In the first place, such transfers generaly constitute the principal way to achieve what is sometimes called 'vertical fiscal ballance, that is, ensure that the actual income and outlay of subnational levels of govermment are approximately equal. For various reasons, both economic and politica, central governments usually have much greater revenue-ising capacity than do local governments. One way to transfer some of the revenues accruing to the center to finance the deficits of lower levels of government is through intergovemmental tansfers. Of course, such fiscd *gaps' may also be closed, and vertical fised balance restored, by trsferring revenue-raising power to local govermments, by transferring responsibility for expenditures to the central goverment, or by reducing locd expenditures or raising local revenues. In virtully all countries, however, there invariably remains sufficient mismatch in the revenues and expenditures assigned to different levels of government for an important 'balancing' role to be assigned to intergovenmental fiscd transfers.

# EqaBlization

170. Equally important in determining the role and design of transfers is what is called 'horizontal fiscal balance" or equaization. This is a controversial policy objective in many countries, and the design of such transfers requires carefil thought. The basic economic case for such 'equalization' transfers shculd be understood clearly. On the one hand, such a trnmsfer may be needed to enable 'poorer' local governments - 'poorer' in terms of their capac;ty to raise resources out of local taxes imposed on local residents (and not in terms of how high the private
> - 51 -

Table 9 Stuc,ture of Subnational Government Finance (recent year)

|_<br>|Hungary|Poland|Romania|Czech R.|_<br>Slovak R.|China*|Vietnam|Bulgaria|Russia|
|---|---|---|---|---|---|---|---|---|---|
|Own Resources<br>|18%|50%|25%_2I_|9%|71%|15%|N.I.|4.4%|-|
|Sliared Tax<br>|13%<br>|25%|0%|6%|4.7%|85%|N.J.|49.4%|95%|
|Total Local Resources<br>|31%<br>|_75%_|25%|15%|76%|100%|N.J.|53.8%|95%|
|Transfers from Centrl Government<br>|68.5%<br>|25%|75%|85%|24%|0%|N.J.|46.2%|5%|
|Souce Mic.IBRD documents. See biblio<br>N 1I 514%|-gf-apu<br>||-<br>|||||||
|otes: . as grants and 17.1% as Soc<br>from aggregate figures; deemed negligible.; N|al Security F<br>.J.: No infor|unds trans<br>mation.|fers.; 2/ Exp|ected to decl|ine to 20% in|1992.;'|For 1985.|Also transf|ers not separate|
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- incomes of those residents or the output of the locality may be) to respond adequately to central transfers intended to generate the appropriate level of public goods (as discussed below). On the other hand, an equalization transfer may be needed to enable govemments that are poor in the sense just defined to provide an adequate 'minimum bundle' of local public services to citizns. The argument in this case, similar to the familiar 'basic needs' argument, is broadly that all citizens should be entitled to some basic level of such services, regardless of where they happen to live.

171. If horizontal fiscal balance is interpreted in the same 'gap-filling" sense as vertical fiscal balance, equalization implies that sufficient transfers are needed to equalize revenues (including transfers) and the actual expenditures of each local govermment. Such "fiscal dentistry" makes no sense, however. Making up al gaps between actual outlays and actual own-source revenues for all local governments, like equalizing the actual outlays of local governments in per capita terms (that is, raising all to the level of the richest local govemment), ignores differences in local preferences for public and private goods and thus vitiates the basic economic rationale for local govemment in the first place. Moreover, such extreme equalization ignores local differences in needs, in costs, and in own revenue-raising capacity. Finally, equalizing actual outlays clearly discourages both local revenue-raising effort and local expenditure restraint, since under this system those with the highest expenditures and the lowest taxes would get the largest transfers.

172. For these reasons, in all countries with formal systems of equalztion transfers, the aim is either to equalize the capacitv of local governments to provide a certain level of public services or the actual performance of this level of service by local governments. The performance criterion, which adjusts the transfer received in accordance with the need for the aided service (and which may also allow for cost differentials) is in principle more - attractive to central governments or those concemed primarily with the provision of certain services such as education or social assistance - since the level of service to be funded is determined centrally and the transfer can be made conditional on the provision of that level of service. Unfortunately, this approach suffers from the same disincentive effect on the revenue side as equalizing actual outlays, since that goverment which tries least again - gets most unless adjustment is made for differential fiscal capacity.

173. In principle, then, any sound design for equalization transfers pivots on some notion of revenue canacity. At one extreme, the aim might be to provide each local government with sufficient funds (own-source revenues plus transfers) to deliver a (centrally) predetermined level of services. Because such capacity-based transfers are generally based on measures of ootential revenue-raising capacity and not on actual revenues, no disincentive to fiscal effort is created by this approach. Differentials in the cost of providing services may or may not be taken into account. Of course, transfers based solely on capacity measures do nothing to ensure that the recipient govemrnments will in fact use the funds they receive as the centml govemnment might wish - unless, as noted above, receipt is conditioned on performance (and compliance is monitored in some way).

# Fiscal Effort

174. While the evidence on the effects of transfers on local fiscal effort is far from clear in any country, there is some empirical evidence that transfers often tend to discourage such effort. Nonetheless, it is generally not a good idea to include an exlici fiscal effort element in a transfer formula. Suppose, for example, that a transfer is made directly dependent on the relation of the effective tax rate in the recipient municipality to the average national effective tax rate. One problem with this proposal is that the measurement of fiscal effort is considerably more - complex than usually seems to be realized even if, as suggested earlier should be done, local govemments<sup>are</sup> largely restricted to non-exportable taxes. If, for instance, tax bases are sensitive to tax rates, then the<sup>usual</sup> measures overestimnte capacity in low tax-rate areas (and hence underestimate the effort needed to increase tax rates) because the base will decline if the rate is increased.

175. More importantly, putting too much weight on fiscal effort in allocating grants unduly penalizes poorer areas, in which, by definition, a given percentage increase in effort (as usually measured) is more difficult to achieve. The problem giving rise to the need for equalization in the first place is that the capacity (tax base) of poor
-53 -

areas is too low, not that their tax rates are too low. Most fiscal effort measures inevitably<sup>reward the richer</sup> recipient governments, which find such tests easier to meet. Imposing such an additional penalty<sup>on poor regions</sup> in a transfer program that almost invariably falls far short of fully equalizing fiscal capacity<sup>seems hard to justify.</sup>

# Matchino Grants

176. A final component of many transfer systems is what is called a matching (conditional)<sup>grant, in which the</sup> central governumt pays only part of the cost of crtain expenditures carried out by local governments. (At the extreme, where the cental government pays all the cost of work carried out by a local governmnt acting<sup>as its</sup> agent, what is really happening is of course simply cgot reimbursement.) Several r-ionales for such transfers may be distinguished, each with different implications for program design, as discussed below.

177. Matching gants in principle have important economic and fiscal advantages in terms of both allocative efficiency (spillovers) and the efficient use of scarce centrl govermnent resources to attain desired<sup>levels of certain</sup> services. In addition, while of coure rendering local govemments more susceptible to central influence and control, matching grants may have the inportant political advantage of introducing an elemnent of local involvement, commitment, accountability, and responsibility for the aided activities. Moreover, properly-designed mathing grants may contribute to equalization (horizontal fiscal balance) and, like all other transfers, they help<sup>to resolve</sup> any basic fiscal mismatch (vertical fiscal balance) problem. Such grants may be particularly important with respect to capital investment projects (where they may substitute for, or supplement, subsidized loans).

178. The rationale for matching grants with the strongest basis in the economic literature is that the benefits<sup>from</sup> the local activity in question may spill over to other jurisdictions, that is, provide benefits to<sup>localities other than</sup> those which decide whbther to undetake the activity. Since such externl benefits will not be taken into account by any particular local governmet in deciding how to spend the funds at its disposal, in general too<sup>little such</sup> externality-inteansive activity wil be undertaken unless the local government receives a unit subsidy just equal to<sup>the</sup> value at the margin of the spilover benefits.

179. The correct matching rate (m), or the proportion of the total cost paid by the central government,<sup>is thus</sup> in principle set by the size of the spillovets. This rate may decline as the level of expenditure<sup>rises, if the</sup> externalities diminish. It may also vary across localities if there are reasons to expect greater externalities<sup>in some</sup> places than in others or if there is reason to expect a higher local price elasticity of demand for<sup>the service in</sup> question in some a&ss as opposed to others. Basicaly, however, a matching grant program designed<sup>to encourage</sup> the optimal provision of public services would be expected to vary primarily with the nature of the<sup>activity, that is,</sup> depending on the level of associated extenalities.

180. Since no country has achieved full equaeization of local fiscal capacities, a uniform matching level offering, in effect, the same price to different local governments wil discriminate against poor regions.<sup>Indeed, even if</sup> revenue bases were fuUy equalized, thetr might stdl be grounds in terms of need or cost<sup>differentials for including</sup> an equalization element in matching grant formulas. For example, per capita grants<sup>for roads in sparsely populated</sup> and mountainous regions should generally be larger because the per capita cost of achieving any particular<sup>standard</sup> of road service will obviously be higher.

181. A quite different rationale for matching grants may arise from the existence of a centml government<sup>budget</sup> constraint. If the central government wishes to use its scarce budgetary resources to attain<sup>given standards of</sup> expenditure on certain services provided by local governments, **it** should pay only as<sup>much of the cost as is needed</sup> to induce each local govermment to provide that level of service. With a grant of m percent of cost,<sup>the effective</sup> price to the locality is 1-m. To ensure maximum total (local plus central) expenditure on the service<sup>in question,</sup> given the size of the centml govermment contribution, the optima way to allocate<sup>a given total transfer among</sup> localities will then be inversely to the price elasticity of local demand for the service<sup>(assuming no cross-price</sup> elasticity effects).
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182. Matching grants should as a rule be inversely correlated to the income level of the recipient govenmment. The purpose of such transfers is essentially to ens that all local govermmnts, regardless of their fiscal capacity, provide a similar level of certain specified public services to their residents. The idea is simply to set the pQce of the service (1-m) to each local goverment in such a way as to neutrlize difference in capacity by varying the matching rate (m). Th higher the income elasticity, the higher the matching rate needed for low-income recipients (to offset the higher local expenditues on the aided sevice in higher-inokom areas), and the higher the price elasticity, the lower the matching rato needed to achieve a given level of total expenditures. In practice, there is thus a case for varying matching rates inversely with income levels even when only the incenutive offcts (and not the distributionad effects) of matching grants are considered.

183. Unfortunaely, neither thoory nor available empitical studies provide clear guidelines to determine the precise matching rate appropriato for particular expenditure progrms, lot alone how those rates should be varied in accordance with the charcteristics of different local governments. Nonetheles, a possible approach might be to consider the matching rate for each progrnm as having two components. The basic matching rate for eah service would then reflect the degree of centrl goverment interest in the provision of that service whether that interest is motivated by concem over spillovero, the *merit good natre of the activity, or simply the desire to implement some plan). This basic rate could then be increasod inversely to a uniformly determined measur of capacity. Th matching rate faced by any particular locality for any particular prgram would then be higher the greater the degree of central interest and the lower the (expected) degree of local enthusiasm (price-elasticity) and ability (incomeelasticity) to support that progrmL Though data limitations mtn that such refinmets are most unlikely to be relevant in any transitional economy for many years, these principles should nonetheless be kept in mind in developing an intergovernmental trasfer system - or any system of subsidized municipal credit, where exactly the same considerations are relevant.

# Other Obiectives of Transfers.

184. In addition to the economic ar _ments for transfers discussed above, there are of course also important political arguments for transfers in all countries:

* It may be necessay, for example, to transfer some resources to jurisdictions that do not, strictly speaidng, need them in order to make it politically feaible to transfer needed amounts to other jurisdictions.

* It may also be essential to transfer resources simply in order to keep some economically non-viable - loc,t govenmments (eg., small riral governments) alive for political reasons to salvage regional pride, to provide jobs for local supportes, or for some other mason.

In both these cases, the main design problem is to minimie any collateral damage to the presumed economic objectives, both by achieving the political ends in as cost-effective a way as possible and by trying to ensure that the design of such transfers offsets the good features of other trasfers as little as possible.

185. In summary, the main substantive aim of a well-designed transfer program is to 'get the prices right' in the sense of facing local decision-makers with the full consequences of their actions. The first step in getting the right incentives from intergovemmental transfers is, as argued ealier in this paper, to establish the local public finance system itself as much on a benefit basis as possible. Ideally, local own-source revenues should come entirely from local taxpayers. Local governments should not have acces to taxes that they can export to non-residents (except to the limited extent such taxes may offset the provision of local public goods that lower production costs).
_5ss_ -

# A Caso for Conditionaliq?

186. Given such a system, the next step is to tecogpi that (in a non-fedral systm) local auorities must fundamntally be responsible to the ceaml authorities or, mor accuatly, to taxpyers at Inrge, when they are spending cental funis. Ther is thus **il** prnciple little role for completely unconditiona trnfe - except, perhaps, to the extent that such "tnsfers are not really tuane at all but rather simply centm ral for locally-executed central prjocts or else result from centrl colloction of local taxes (for example,<sup>because it</sup> would not be cost-effective to set up separate local tax adminisratons). Since any other unconditional<sup>transfen in</sup> this system are essentially motivated by politics, the concern these case is primaily to limit the damage done - to policy outcomes for example, trnsfer. that simply finace local deficits or that age entirely disretionay<sup>**in**</sup> naure are invariably bad.

187. On the other hand, transfers intended to encourage "rending on a specific local service, whether because **-** it generates exteanlities or because it is more efficient to a 'he service locally, shutld genenrly require some local contribution (matching) and should of course be cono..Aonu on the performance of the service in question in accordance with specified standards.A' Both the detemination of the appropriate matching rates and the extent of central support and monitoring of local performance (see also the ealier discussion of this subject) require close study with respect to each substantive area in which such grnuts (or their analytical equivalent, subsidized loans) are to be established.

188. So far there appears to have been little considertion in the trasitional economies of what would appear to be a strong case for some degree of conditionality in centa transfers. In Hung=v. for instance, which has by far the best-developed transfer system, the normatve gnat has three important charactiics. In the first place, the total to be distributed to local govemments through this grant is tirely discretionary. Secondly, the fomula for distributing this total in turn contains two components. The first conponent, which may be thought of as the equalizion component of the grnt, is essenially an equal per capi tranfr. _Tho_ secwod, _and_ lager, part of the grant, however, is distibuted basically in accordance i largely based on a mease of expecdituro needs', particularly with respect to education. Finally, the grant is completely unconditional: local govenments can spend the money however they see fit.

189. In principle, there seems little rationda for bestowing such large unconditional grants on so many small local goverments. As with some other featues of the Hungarin local govenment finance system, it appears that the understandable desire to reject completely the centrally-dominated model of past intergovemnmenar ations may **l** have resulted in, so to speak, throwing out the baby with the bathwater. The centrl government - that is, taxpayers in general - have a legitimate interest in what is done with grants to local govemments. Moreover, the country as a whole also has a legitimate concer to ensure that services such as education and health are available throughout the country at least at minimum standards. There is therofore a strng case for at least limited conditionalit, for instance, by requiring that the grant funds should be spent on e.g. education or hellthU' or requiring local govemments receiving such grants to provide services of at least a specified quality and level.

LNo matter how closely supervised, the inherent fungibility of financial transfers means, of course, that there is no guarantee that conditional tr usfers will not in whole or part simply replace locally-financed expenditures that would have been made in any ca . On the other hand, the available empirical evidence in a number of countries suggests that to at least some extent conditional funds do indeed astickl, that is, result in an increase in total spending on the aided function.

Wlof course, such legal requirements are inevitably to some extent only pro forma. The fungibility of money and the ability of local governments to alter other expenditures and taxes mean that requiring a grant to be spent<sup>on a</sup> particular activity does not necessarily imply that tota1 (centrally-finded plus locally-funded) expenditure on the activity has gone up proportionally. Indeed, in most cases it will not.
- _56_ -

190. Compliance with any such conditions could be monitored, as suggested earlier,<sup>through requireme for</sup> uniform and timely local financial reporting and tirough periodic national inspecdons and audits<sup>of local facilities.</sup> Although tn the current situation in Hungary it is probably politicaly inadvisable<sup>to alter the present unconditionality</sup> in any important way, at the very least the national govenment should make evely<sup>reasonable effort to</sup><sup>**improve**</sup> local financial reporting - for example, making the provision of such reports a condition<sup>for receiving grants -as</sup> well as attempting to improve its information basn on what is going on with respect<sup>to the provision of local public</sup> services.

# Deterininnin the Size of the Ora.

191. Another feature of the normative grant that requires further consideration is the determination<sup>of the tot</sup> size of the grant. At present, this determination is in effect entirely up to the central govemment.<sup>While budgetay</sup> flexibility in this respect is obviously desirable from the centrl goverment's short-run point<sup>of view, it is a mistake</sup> to view cental transfers to local govements as constituting an entirely 'compressible'<sup>portion of the national</sup> budget. On the contrary, many of the services provided by local govenmments constituto<sup>essential inftucture</sup> for future development. Moreover, since it is unlikely that most of the small local governments<sup>created in Hungary</sup> can ever finance the provision of such services at an adequate level out of their own resources,<sup>either now or in the</sup> foreseeable future, centrl grants to local governments will remain an important, and<sup>largely non-compressible,</sup> expenditure item in the central budget of Hungary, as of most transitional countries.

192. In these circumstances, there may be much to be said in favor of establishing a formula-driven<sup>total e.g.</sup> as a specified percentage of national revenues or of some particulr national tax or taxes. This procedure<sup>has</sup> subs antial advantages from the point of view of both centra and local budgeting.<sup>Since the amount of the local</sup> transfer is determined, the central govermment is to some extent insulated from pressure to<sup>increase it support of</sup> local govenments. On the other hand, local governments can budget with much greater<sup>certainty when they know</sup> that the total level of central support wiU vary with e.g. income tax coUlections (distributed in accordace<sup>with a</sup> known formula) than when they are totally at the mercy of discetionary contral<sup>policy. Again, in the transition</sup> scialist economies, the grants are typically fixed in an ad hoc way, both in **aggregate** volume, and in terms<sup>of the</sup> allocation across individual governent units, which are negotiated and bargained between<sup>center and locals.</sup> Hungary is the only exception here: the grant volume is detemined annuaUy by MOF,<sup>but its allocation is by a</sup> complex (some might say overly complex) formula. This complexity can be explained in part as<sup>a reaction to the</sup> imprecision and bargaining by which the previous allocation system worked: over-precision is an attempt to move as far as possible from this approach.

# Distribution of the Grant.

193. However these two points - the unconditienalitof the grant and the determination of<sup>its total - are settled,</sup> the distributive formula of the grant also needs to be addressed. As noted above, at present<sup>there are two elements</sup> in the present Hungarian formula: equalization (per capita) and needs. As agued above,<sup>a third essential element</sup> in any general grant formula is to make some explicit allowance for<sup>the revenue-raising capacity of local</sup> governnents. That is, the basic formula of the normative grant should be altered<sup>to some version of the following</sup> general formula:

# Gt = eE1 - tRl

where G is the amount of the grant, i refers to a particular municipality, E to some<sup>measure of 'need' (for example,</sup> the present normative grant formula, population, or anything else that seems<sup>appropriate), e is an assumed level of</sup> expenditure for each unit of measured need, R is a measure of revenue capacity, and<sup>t is the assumed rate at which</sup> this capacity is tapped (or taxed).

194. Asuming for the momentthat the tota _G_ to all i is equal to the prest normative grmt and t the 'needs" measure is that used in the present formula - as noted earlier, both<sup>of these assumptions can be changed</sup>
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in any desired way without affecting the general argument! - the introduction of the capacity element has three important effects. First, it will shift grant funds from high-capacity to "low-capacity recipients. Second,<sup>it will</sup> stimulate all recipients, regardless of their estimated capacity, to tax that capacity at the assumed rate (for example, the national average rate), because if they do not do so, the gant they receive will be reduced precisely<sup>by the</sup> amount they fall below the assumed rate. Finally, on the other hand, if any recipient chooses to levy higher<sup>taxes</sup> than those assumed in the grant formula it gets to keep all the extra revenues - that is, it is not 'taxed by having its grant reduced.

# Measuring Canacit and Expenditure Need.

_195._ Clearly, the most critical element in this formulation is the measurement of capacity and need. Such calculations are difficult in any circumstances and perhaps particularly difficult in the changing circumstances<sup>of</sup> the transitional economies. Nonetheless, some relevant information exists: for example, on collections from the old duties, on PIT liabilities, and on the 'turnover' basis for the business tax. Moreover, there appear to be considerable information in some countries - notably Hungary and the Czech Republic - on the basic characteristics of the new local governments: their population, its demographic characteristics, their economic bases, and so on. It should therefore be possible to construct a number of estimates of revenue capacity (defined so that the estimate is not subject to local manipulation)W' and expenditure need in order to experiment with variations of this formula and to determine whether the resulting distribution of the gant makes sense in light of needs and the aims of the new local finance system.& 196. In contrast to the relatively well-developed Hungarian grant system, in Ro for example, the present tmnsfers to local goverments are entirely discetdonary and negotiated. The same is true of Russia, and most of the former union republics, now the CIS. On the other hand, like the Hungarian case, this transfer appeas to be lump-sum, that is, it would appear that local govermets can spend it, once they get it, free of all conditions and constraints. In fact, however, as under the old regime, the local branches of the Ministry of Economy and Finance continue to supervise the implementation of local budgets closely and to make sure that the targets specified in local budgets are achieved. Most of the transfer has in recent years been used to cover the losses incurred by the regies owing to the large heating and transportation subsidies. In 1991, for example, these two subsidies accounted for more than 32 billion lei out of a total transfer of 65 billion lei. By September 1993, however, these two subsidies are supposed to be gradually phased out, folowing a 25% subidy cut on May 1 1992, and similar cuts on September 1, 1M, May 1, 1993 and September 1 1993. Coreponding to the cut in subsidies, the cental trnsfer to local govemments will appatly be cut proportionally, although that this would happen was by no means clear to some local govermment officials.

197. The basic criticisms that may be made of the present transfer system in Romania (and other countries as well) are thus three. First, it encourages recipients to be wasteful and lax - and thus run bigger deficits and get bigger transfers. Second, the system may of course also be criticized for its lack of transparency and for the considerable amount of negotiation that may (at least potentially) be hidden in it. Third, even if these defects were corrected - as they largely have been in Hungary - it would basically deliver funds derived from taxpayers in general tihe same is true with respect to the expenditure level per unit of measured base: it may, for example, be taken as the average national level of expenditure on the chosen item, or as some desired or minimum level<sup>of</sup> expenditure.

LwNote that the estimates of tax capacity required for implementing a grant formula such as that suggested in the text are estimates of the ability of localities to raise revenue and not necessarily estimates of the ability of local residents to pay taxes. Both the wrichness' of the locality relative to others and its taxing power are critical to such calculations.

EFor preliminary explorations along these lines, see Bird and Wallich, 'Financing Loal Government in Hungary.'
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to officials in particular localities to spend as they see fit, thus vitiating the essential democmtic (and efficiency) principle of accountability.

198. In eality, of course, the existing Romaian systm offers almost no room for local incentive effects since in fact it is still the old central control system in a slightly different guise. That is, instead<sup>of unconditional transfers</sup> - set in some undetermined but apparently 'gap-fllling way - in fact up to now local govermnrets<sup>have (regardless</sup> of what the law appeas to say) acted as though their expenditure too wern fixed (e.g. with respect to sali, number of employees, levels of services provided, and so on). If the level and composition of local expenditure is, de facto, deUmined centrally, it doss not matte that the level and composition of local revenues is similady dete_rmie there is no effective local autonomy. As such autonomy begins to become real, however, and tbho is evidence that this is now happening in at least some are of Romania, the bad design of the present tras system will become increasingly unsatisfactory.

199. For this reason, it is important that the future development of tansfers in Romania (and other trnsitional economies) should take more explicitly into account the basic principles of a good transfer system. For exaple, the size of the total transfer to local govemments from th centrl govemment (the Adistibutable j2jgk) might be set as a fixed percentage of totd central taxes. This is desirable to provide both budgetary stability - to insulate the - central budget to some extent from local problems and to provide a *hard' budget constraint for local governts as well a sufficient budgetary flexibility over time to accommodate the reasonable growth of local finances. Moreover, experience suggests that it may be preferable to set the size of the *distributable pool' with refernc to all taxes rather than as a percetage of a particular tax or taxes in order to avoid distorting central tax policy decisions.

200. In addition, as suggeted above, the distibution fbEnulshould in principle be based on some feasible, and acceptable, measures of a aciy nd necd and the transfer payments should be made conditional on _performance._ Although in the end the extent to which any transfers are equalizing' in any country is inevitably essentially political, it is critical to have an adequae quatitative base in order both to be able to design such equalition features propedly (e.g. with respect to mathing grants) and especidly to assess their probable effect. A critical research need in most transitional economies is therefore to derive such measures of capacity and need and to develop a system for monitoring performanc. Close attention must be paid to the supervision, acounting, and monitoring of trnsfers, and associated local expenditurs. This question is also important with relation to both local borrowing and any use of matching funds e.g. for investment purposes. As noted earlier, a transfer fomula properly designed in terms of needs, capacity, and performance will also encourage local fiscal<sup>efforL Finally,</sup> although for political reasons, it may prove necessary to bas distribution in part on derivation or to make the transfers payments partly or wholly unconditional, it is essential from the point of view of both efficiency (in resource allocation) and accountability (in public sector decision-maling) that these elements be minimized.

# VII. BORROWING

201. In most transition economies, a striking feature of subnational finances is the generous<sup>legal access of</sup> subnational governments to unlimited borowing, sometmes even foreign borrowing. In Hungary, the Local SelfGovernment Act penrits unresticted domestic borrowing (for current and capital expenditures) to aU local governments. In the Russian Fderation, the law on Rights of Local Self-Govenment permits the same for oblast and rayon level govemnments. In Bulgara, the municipalities can borrow from banks, and in addition,<sup>under the</sup> existing law they have an unrestricted right to issue bonds. In Poland, borrowing authority is more limited: by<sup>law,</sup> localities are not allowed to bonrow more than _59%_ of current budgeted expenditures. In Romamia, local governments can borrow in unrestricted fashion, as an element of their *autonomy", provided they can prove their creditworthiness and amortization capacity. In China, provincial govemments have until recently had unrestricted access to foreimi borrowing through provincially-owned development banks,; this access has recently been teduced through a new law on foreign exchange management and debt registration. Local govemments in China cannot
_59_ borrow domestically, however, at least directly, although they do so indirectly through enterprises they own and through local financial intennediaries which float bonds designated for local government projectsaL'. In the CSFR, the two republics have restricted access to borrowing through T-bills issued on an agreed basis and amount by the Federal Ministry of Finance. By and large, however, despite these liberal provisions, local government borrowing has so far not been significant, as table 9 shows.

# Eat Borrowing Practices.

202. In some countries, however, the heritage of debt from the previous regime has become a problem. In the pre-reform situation, in which the national credit plan was designed to finance investment and other expenditures called for in the Plan, to the extent that in the unified framework of the Plan, local governments required loans, borrowing was not only permitted, but indicated. Th loans wero made by one or another of the State Banks, whose lending was wholly plan-directed. In Hungary, for example, my localities borrowed under the credit pla in the pre-reform period, with each loan being guarnteed by a higher-level authority. In the Slovak Republic the ind_btedness of the local (municipal) government to tho banking sector is espocially high: some 30 municipaities have been able to pay neither principal nor interest on these loans. In Poland, it has been reported that almost 900 geminas (40% of all local governments) are in debt, as a result of borrowing, mainly from banks, under the prereform regime.

203. The facilities for borrowing provided to local govenments in the post-reform legislation thus have roots in the planning period. In present day circumstances, however, such generous and virtually uncircumscribed access by local govemments to loan finance seems out of place. Such acces is restricted even in most western countries for several reasons. First, the centrl government uses debt finance as a stabilization tool, and it does not want local govemments acting in such a way as to cAmntor its policies. Second, local borrowing may in some cirumstances crowd out private sector borrowing which may be more economically beneficial to the country. Third, to the extent central govenumnts wish to avoid local govemments becoming bankrupt they in effect implicitly guarantee local govenmuent debt, so that local governmnt borrowing becomes a potentially open (and destabilizing) door to the national treasury.

Table 10 Subnational Goverment Borrowing

|Country|Local Borrowing Authority|Borrowing % of total<br>revenue in recent years|
|---|---|---|
|Hungary|Yes (unlimited in law)|some municipalities have<br>past debts|
|Poland|Yes (limited in law)|1.4%|
|Romania|Yee"|N.A.|
|Bulgaria|N.A.|N.A.|
|Czechoslovakia<br>____<br>_<br>___|Yes<br>__<br>___<br>___<br>___<br>___<br>___<br>___<br>___<br>___|significant past debts<br>O Utst nding|
|Russia|Yes (unlimited in law)f'|'|
|China|Nay|0|
|Vietiam|N.A.|N.A.|

Notes: _[/_ Even though local govemments in Romania are pemitted to borrow in principle, in reality ther exists no borrowing -just arrsea (non-payment of bills); _21_ This was suspended in 1992; 3/ Sometimes borrowing takes place through enterprises (see text).

_IL_<sup>_1_</sup> _See_ 'China: Revenue Mobilization and Tax Policy', World Bank Country Report, Washington DC, 1990, and -China External Trade and Capital, World Bank Country Report, Washington, DC, 1988.
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204. For these reasons in virtually every developed country local government access to capital markets is strictly controlled. Among the methods used to control local borrowing are: (i) permitting borrowing only for approved capital projects; (ii) requiring prior approval of local taxpayers for borrowing above a certain amount; (iii) requiring prior approval of central authorities for borrowing; (iv) restricting the amount of debt to some percentage of local revenues; and (v) permitting borrowing only from a cental mnunicipal fund.' All such restrictions obviously reduce local autonomy. On the other hand, it is also common to provide some capital assistance to local governmnta, in the form of matching grants (as discussed earlier) or in the analytical equivalent of explicitly or implicitly subsidized borrowing conditions.

205. The precarious macroeconomic situation in many transitional economies malkes the case for limiting local access to capital markets even stronger than usual. Additional reasons to be concerned with problems that might arise because most of the new municipal governments have no experience with financing and are in many instancs not yet capable of preparing and presenting complete and meaningful projects. Nor, for that matter, are most of the financial institutions in transitional economies capable of evaluating long-term risks or hantling long-tem financial instruments.

206. Nevertheless, to the extent that benefits from some projects are enjoyed in the future, it seems both fair and efficient that future residents share in the cost of financing such projects. Borrowing for local capital projects may thus have a sound theoretical base. Moreover, borrowing may someedmes be the only practical way to finance large capital outlays without huge, and undesirable, variations in local tax rates from year to year. There is thus, in principle, a strong case for financing capital projects at the local level through debt finance.

# Sources of Borrowin .

207. In the short term, however, there should probably be imited or no local borrowing in most such economies for macroeconomic reasons. In the longer run, however, some facilities for limited sub-nadonal borrowing will be needed. Long-term borrowing by local governments should be restricted to the financing of capital projects, perhaps with regional goverments and large cities having a little wider discretion in using debt At all times, borrowing from the central bank should be prohibited.

208. A common view in some of the transitional economies appears to be that local governments should be tapping the financial markets for capital funding, thus serving the dual aims of developing capital markets and financing long-gestation projects. However, only the very largest such govemments are ever likely to be able to access financial markets directly. M.'oreover, only in the U.S. are financial markets the major source of debt finance for local governments. Commercial banks are a more likely source of funds in transitional economies - and they may well reman the main source, as **in** Germany. Bond issues might come later, if ever, once markets for such financial instruments are developed, and sub-national governments establish creditworthiness.

209. For most local govermments, however, the only way to access capital markets may be through some such device as municipal development banks, especially if they are not set up by the central government, but spring up as cooperative efforts of, for instance, groups of cities. Such banks (or funds) could give technical assistance to the individual govermments in this new field of borrowing, would take up deposits from them and lend them the necessary amounts. Local govermments should not, of course, receive subsidized credit through any such source (except when the national government explicitly wishes to subsidize particular types of municipal investment, for reasons similar to those discussed earlier in conjunction with matching grants). In view of the tangled relations between governments and enterprises discussed elsewhere, it is equally important that such credit not be extended indirectly through borrowing by goverrunent enterprises.

210. The history of special MuniciRal Develooment Fundsa in other countries is in some respects not very encouraging (Columbia is an exception). Few of these funds have developed a capacity for sustained (continued)
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assistance to municipal goverment and investment on the scale needed.9 Most have been undercapitalized. As a rule, they have tended to play a narrow and passive financing role, applying little technical or financial appraisal to the schemes they have funded, and offering little positive assistance to municipalities other than capital finance. Those designed to provide technical assistance have tended to concentrato skills and resource on the direct execution of capital works, which are handed over to municipalities for operation and debt service. While this apprch **hs** added to the stock of urban infiastructure, it does little to promote the capacity or commitment of municipalities to operate or expand that infatructuo effectively, or to recover costs. Too many municipal development _fmdas_ have tolerated substantil arars, with poor repaymnet records leading to weak institutins and incentives for localities not to repay. For al thm reasons, are must be exercised in sotting up specid municipal financing institutions in transitioald economies.

# VIII. PRIVAT[ZATION AND OWNERSHIP

211. A striking feature of the fiscal landscape in the transitional economies in the continued significant owne_ ip role of subnational govemments at a tirm when center/national priorities support privatization. One reason is of course the transfer of assets to them in the process of 'decentrlization of ownership described earlier. Another reason arises in some degree fom the inadequate revenue base given localities and their continued financial dependance on enterprise revenues. If the privatization process is to be completed, getting local govenments out of business, and into the business of government' is crucial. In the course of this process, important quetions remain to be answered, relating to the use of the tmnsitory revenues from privatization, and how best to take advantage of the asset stock held by local governments.

# Asset Transfers

212. One of the most important initial features of fiscal denalizaton has boen the transfer of asset to loca governments. Local govenments are increasingly becoming owners of enterprises, housing, vacant uban land and retail establishments, as these assets are transferred from the center. In Hungary, the 'Act on Property Trnsfer' (1991) gave local govemnments ownership of the housing stock previously owned by the central governmmt. In Romania, local governments have been given all fonnerly 'statew (centrally) owned properties within their territories, ranging from public doman ptoperty (parks) to private domain propetty such as enterprises. In Russi enterprises have long been owned by each level of government, and housing and land has been transferred to municipal and rayon level governments beginning in 1991. In China, decralization of enterprise ownership from the state to provincial and local ownership was a key feature of the overall decentalization of economic decision making, and took place as early as the mid-1980's. Housing has always been a municipal or enterprise responsibility (See Table 10).

213. Such asset transfers can be a mixed blessing. While consistent with decentraliation and rhetoric about local autonomy, such transfers also fit with the center's aim of reducing its involvement in the economy. Indeed, _one_ motivation for transfers of enterprises, land and public housing, has likely been to avoid the fiscal burden (such as subsidies, maintenance and repair) that ownership responsibilities carry. Local governments wiU thus be fhced with these major maintenance and subsidy burdens, unless costs can be quickly recovered. Privatization of the houwing stock in particular is a priority (see discussion below on timing of sales) as is sale of locally-owned enterprises.

> 42/ See Ktn Davey, 1990; Municipal Development Funds and Intermediaries"; PPR Working Paper No 32; World Bank
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Table 11 Privatization Revenues: Ownehip and Disposition Recent Traosfers of Ownrshp

|Country<br>Housing<br>_<br>_ _<br>_<br>_ _<br>_<br>_<br>_ _ _<br>_ _<br>_ _|Reail Units<br>_<br>_<br>_<br>_<br>_<br>_|Domstic Industrial<br>_Enterprises|
|---|---|---|
|Hungary<br>_Lal_|Local|Centrl, Local|
|Poland<br>_Local._|LoAM|Central, Lca|
|Romania<br>__Al_<br>_ _|_caW__|CntUrl, Local|
|Bulgaria<br>Local I/|Locale|_Centratl, LoA_|
|CSFR<br>Local|LOc|Cental, Local|
|Russia<br>Local,Enterprise|LoLcal||
|China<br>Local,Enterprise|Local, Central|Contl, Local|
|Vietaln<br>Lcal,Enterprise|Local, Central|Centrl, Local|
|Notes: In Bulgara only Q-T1<br>t<br>of<br>t<br>tothlc<br>85-90% is now privatey owned.;*almost exclusivel|h<br>y local.|s ot local authoriies.<br>l<br>her|

# Privatization vs Entmreonoeudlism

214. Unforuately, in at least some countries just the opposite appa to be taling place. There is conideble evidence that this process of proprty transfer is giving broader scope to thoe enrpreneulal ambitions in the local governments as they use their now property rghts to activateo idle property. A womsomo patten in vitually all transition economies has been the involvement of governments at different levels in joint economic venure i purely private maket oriented activities. Romania's law puts it best, but is not exceptional: * Local gove m_U are authorized to rerae, contrbute 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 foteign or domestic parlners.

215. Localities appear to be excessively optimistic about their abilities to enhance reveaue from this source. One vehicle some hope to use is to establish joint ventures with a domestic or foreign parbter, or nothr state enterpise, using local assets as the locality's equity share. In those localities well endowed with land, ths appeas to be the preferred equity contribution, and loclities appear also to see potential in developing and seiricing _empty_ land so as to enhance its value as equity. Of course, real estate development and financing is of course One of the riskiest business areas in maket economies, and it is not likely to be a better bet in the transitional economie. In Hungary, toursm lodges, recreational facilities and golf coures were cited as examples of such venturesin-process, and in localities which inheited important real properties similar potential was sen in developing thom as contributions to industral joint ventures such as bakeries, construction firms, and food processing. In Russa, virtually all rayon governments visited in the course of field work indicated the noed to develop and exploit their asset base through domestic joint ventures, and looked forward to the revenue flow from the projects, one completed. Similarly, in Poland, the provision of private services as a means of eaming additiond revenues apper to have strong support, with housing and real estate development, food and furinitu manufacure cited as exampls.

216. From the prspective of locd government, there are good reasons for government involvement in these new market ventures. With available land that can only with difficulty be privatized, the cost to govrment of contributing this resouce to a joint venture may be perceived as very low. Also many local public officias understandably wish to create buiness employment opportunities in their jurisdictions, which are often oca'omically
-63 -

depressed and lackng privao e preneurship.0 However, tho hope for profits from such ventur my quickly tum into demnds on govemmet budgets to cover losses. Experienc **e** verywher shows thtu the perspectives and goals of public officibl tend to Make them poor busins managers. In piculr, it is very hard for a govrnmt to close a faling bum, especiay whe the local mploqynt iSaion is fa from halthy. There is also the risk that the local govaunat ald their locallyownd businesses wll udcut privat competitors, possibly by playig rogulatory pmes to protect locd monopolies, with the reoult t te trole of govement in the econmy will not diminish. And, of course, if local governmen own busines, thy may fail prey to the ridsk of ownerhip. In the indusil market economies, te rats of small busine failu is high: only on in five of such busins survive their first three yea. Thee is no ran to expect tt the tranitionl eonomies can beat theom odda.

217. More impotty, in addition to being ddy, rur activity by local goveanmt is fundaimay inconsistent with the privatiuon drive, and reprets a bottteck to tnuo denrl o-that is, d aliton, not from the state to local govenments, but fiom govenment to the private octor. Local etrepreneuria ty is neither privadtiaonnor tru de ition.Suchb entrdeuaiaHsm sows down even reverses, tho prooe of privatization - the long-term goal of getting govenmt out of toe activities that can be handled by the private sector.

218. It is thus critical in reforming socilist economiae to provide adequa revenue instruments and flexibility at the subnationa **l** evel. If the only flexibility available to local govermnts in their stuggle to cope with budgetary pressure is by using economically undeirable sources of revenue such as profits derived frm direct public ownership of local busnes, thy will do so. Municipalities should not be encouraged to develop local monopoly enterprise in order to secure the revf A they need to function, just as they should not be forced to establish small taxes on a wide nmre of proutsb and activities which ae expeive to adminise, genate widesrad public ressnc, and typically yield littlo. Some local aconss to a robust national tax base (trough tansfers), the ability to levy local surcha on ctai national tax whero approprate, and especlly some significant rvenue sourcs under Ilocal control are thus essential, if the struggle for local revenue is not to delay and perhaps dstroy prvatization reforms.

# Timine of Asset Sales: Sales vs Give-wava

219. Potentially, selling the assets (housing, entorpdses, land) held by local govemments could yield syigficat evenues. There is, however, considerable controversy over how this procoss should take place, and even over whether assets should be sold or given away. The metods being employed in diferent countries range fom auctions to 'spontaeous privatztion' to voucher systm In mxst of the countris under study, at the local level assets are being sold, not given ay: In Hunguy, _such_ are th responibility of the Stato Prperty Management Company (for large enteprises). For smal entepns as wel u locally owned houing, in both Hungary and Polsnd, local governments have responsibility. In Russi, the housing stock and locally-owned facties are a subject to sba. CSFR's privatization prognm combines give-aways (through vouchers for aU citizens) with revenue-generating sales. Most enterpis will be sold by the two republics; the role of the local govemmonts within theso republics is not clear. Bulgada, and Romunia have yet to devise concrete privatization progams, but they are likely to include both give-aways through vouchs and sales.

220. Maximining the yield from asset sales isa major challeng. Should they be sold now or later? Selling assets now, when markets for ownership and prperty rights are underdeveloped, may mean that they do not bnog a good price for the local governm t - a process, as oam analysis put it, akin to using the beat furnitur to **uWel** !WA note of caution is also needed with repoct to the apparent desire of many local govemments to use fiscal incentives to bolster private business in their judsdictios. he record of such 'local development policies is not very encouraging in any country, and efforts in this direction are all too likely to degenerate into a zero-sum game for local governments unless great care is exerted. On the whole, this is yet another ares in which a national 'fnmework law- - a binding cael arrangement - seems needed.
- 64 -

the boiler on a ship running out of fuel'. But at the same time, government needs revenues now. Selling **aM** later may improve yields, but such yields will come at a time when other local financing sources<sup>will also be</sup> available. Complicating this decision is the fact that many locally-owned properties are presently costing<sup>much more</sup> to operate and maintain than they are realizing in rents an, hence constituto a major drain on subnational<sup>public</sup> finances. Getting rid of this burden is a high priority. Unfortuately, in almost all countries, the<sup>pocem of saeling</sup> locally-owned enterprises, and especially housing, is slow, impeu by the absence of credit (especially mort finance), and the absnce of a legal framework.

# Revenues from Privatization

221. What should local goverments do with the proceeds from the privatization of public enteprise and tdo sale of other assets? First, it is importnt to remember tha hes rvenues are 'non-recurring' and do not rpret permanent sources of financing for any local govemment Efforts thus have to be made to develop adequae tx sources in addition to user charges for the future, when the revenues from asset sales disappear. That said, should such asset revenues be capitalized in special funds or invested on capital projects, or should they be used to finance current expenditures?

222. In practice, there appear to have been no special strings attached to the use of revenues from privatization. Te unsurprising result is that the most common practice appeass to be the use of these funds as an additional source of revenue in the recurrent budget. This is not all bad: indeed, it may be both distributily attractive as well economically efficient (less dead-weight loss) to raise revenues from privatization than from taxes. But, as noted earlier, one cannot live forever by selling the furniture. Sometimes such revenues have been kept in exrabudgetay accounts. in Hungary, for instance, rents from locally-owned housing accrue to off-budget accounts, while sles proceeds from locaUy-owned housing accrue to the general budget, but are not earmarked for any partculwr purpose. In the case of privatization of locaUy-owned enterprises, the proceeds also accue to the budget, with no restctions on use. In Poland and Russia, revenues accrue to the budget, with no restrictions on their use.

223. A more conservative principle of public finance would cal for the investment of these proceeds in longterm assets to alow local govenmerts to draw income from assets over a long period of time. Altenatively, revenues could be used to repay debt.44 In Hungary, revenues from privatization involving foreign joint ventr and generating foreign exchange are channeled through the State Property Management Agency (SPMA) to repay Hungary's external debt. In the Russian Federation, where most privatization has been domestic, it has<sup>been</sup> recommended that the stock of domestic govemment Treasury debt should be reduced this way. In Poland, revenu from privadzation are being used to finance current operations, and to compensate for inadequate tax yields. In China, no commitment to privadzadon is as yet apparent.

# IX. CONCLUSIONS

224. Subnational finance and local government policies are emerging as crucial elements of the ongoing refors in transitional economies. Subnationai governments play a large role in overall economic activity, account for a large share of public sector outlays, and own a significant share of public enterprises and the public housing stok Recent attempts to strmlne government budgets have led to increased local government responsibility for such crucial matters as health, education and safety net expenditures, including unemployment and entepis.

X'See Newbery, D. 'Reform in Hungary: Sequencing and Privatization,' E Economic Review. No 35, 1991, pp 571-580. Newbery argues against a rapid, 'fire-sale' or giveaway approach becas many of the assots may have been financed with debt (as noted earlier, many local govemments in transitional economies have<sup>substantial</sup> liabilities), in which case the proceeds should be used to pay off this debt, rather than burdening preset and<sup>future</sup> local taxpayers with debt service.
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Underfimded local govermments arn seleing coping mechanisms,<sup>not all of them constructive, to meet these new</sup> challenges.

225. This paper has descibed the risks to privatizaon, to macroeconomic<sup>stability, and to an adequate social</sup> safety net that present policies towards local governmnt<sup>may imply. Our themes are that the subnational sectr</sup> needs to be m realistically factored into national plans, and that subnational<sup>expenditures be more clearly</sup><sup>**aigned**</sup> and revenue needs more realisticaly aessed. Such _ are likely to acknowledge * larger sphero for subnational govermments and the need for access to more<sup>robust revenue sourcs. Giving local government a dsre</sup> in the personal income tax is one possible and perhaps desirable<sup>approach to meeting these revenue noeds.</sup> 226. Careful attention also needs to be paid to the desip and implementation<sup>of toe intergovenmental fisa</sup> transfers that are likely to remain prominent features of the<sup>intergovermental landscape for years to come. Caution</sup> is also needed with respect to borrowing by subnational<sup>govemment</sup> Consolidation and integration of extrabudgetary funds at the subnational (and national)<sup>levels is crucid to enhanced budgetary transparency and</sup> macro stability.

227. Finally, proper funding of the subnational sector<sup>is a necessary (albeit perhaps not sufficient) condition for</sup> the successful privaization of enterprises now held by local<sup>governments. In its absence, local goveanments will</sup> continue, as at present, to seek gains from keeping these enterprises,<sup>and to add to their revenues by setting vp new</sup> commercial enterprises and impeding privatization.

228. In short, local govemment finance is not a 'local matter', but<sup>is crucial to asmost all of the key reform</sup> goals of stabitization, safety net and private sector development