Transcript Presentation at the CEPRA seminar in Kingston,ON

Institute for the Economy in
Transition, Moscow
Ilya Trunin
Reform of Fiscal Federalism in Russia:
Fiscal Behavior at the Subnational
Level of Government
www.iet.ru
Barcelona - December, 13 2004
General Overview of the IET Activities
in the Area of Fiscal Federalism
1. Consulting services and research provided to the
government of Russia:
• Design of the budgetary system
• Assignment of expenditure responsibilities
• Assignment of taxing powers
• Design of the intergovernmental transfers system (incl.
fiscal capacity and expenditure needs estimation
models)
• Fiscal relations between the regional and municipal
levels of government
• Program-oriented and performance-based budgeting
2
www.iet.ru
General Overview of the IET Activities
in the Area of Fiscal Federalism
2. Research projects:
• Analysis of the fiscal behavior of the regional
governments
• Analysis of the redistribution and stabilization
features of the system of intergovernmental
transfers and federal shared taxes
• Modeling the budget constraints of the regional
governments in Russia
• Analysis of the institutional aspects of the
intergovernmental fiscal relations mechanisms
3
www.iet.ru
General Overview of the IET Activities
in the Area of Fiscal Federalism
3. Consulting services to the regional governments:
• Intergovernmental fiscal relations with
municipalities
• Drafting legislation for the municipal reform
starting in 2005-2006
• Elaboration of the regional development strategies
• Public finance management (public procurement,
debt management, budget institutions reform,
program-oriented budegting, medium-term
planning etc.)
4
www.iet.ru
Intergovernmental Arrangements in the
Early Transition Period
• Sharp decrease in public revenues during transition to a
new tax system
• Decentralizing public expenditures instead of cutting
them down (from about 60% GDP)
• Need for preventing the federation from decay
• Emerging of the practices of unfunded mandates as an
alternative to decreasing consolidated public
expenditures in accordance with revenue possibilities
• Using intergovernmental fiscal transfers and shared
taxes in political processes
5
Results: unstable and inefficient system of
intergovernmental fiscal arrangements
www.iet.ru
First Stage of the Intergovernmental
Fiscal Reform – a 1993 Constitution
6
• New principles of federal-regional-municipal relations –
similar to many of the modern federations
• Legislative allocation of tax revenues and taxing powers
across levels of government – to a possible extent
• New system of intergovernmental transfers with its key
element – formula-based equalization grants
• Growing amount of unfunded mandates and political
reasons (the federal government kept being dependent on
strong regions) hampered the fiscal reform process
Results: Excessive decentralization in case of reach
regions and strong centralization concerning the
majority of the subjects of the Federationwww.iet.ru
Second Stage of the Intergovernmental
Fiscal Reform – a 1998 Crisis
• The process of the federal grants allocation went out of
control
a sharp decline in tax revenue
• Introduction of new principles of equalization grants
allocation
• Refraining from changing the results of formula-based
calculations in the parliament as well as from providing
large discretionary grants
• New proportions of the tax revenue allocation between the
federal and regional budgets
• Drafting conceptual programs of the intergovernmental
fiscal relations reform
Results: A new framework for allocation of resources
across levels of government
7
www.iet.ru
Main Features of the Current Reforms in the Area of
Intergovernmental Fiscal Relations
• Elimination of unfunded mandates: normative
regulation, financing and administration powers start
to be clearly assigned to different levels of
government
• This envisages increasing role of Compensation
Grants that will finance federal mandates imposed
on regions
• Increasing fiscal autonomy of regional and
municipal governments (more on expenditure that
on revenue side)
• Simplification of the transfers allocation formula
8
www.iet.ru
Main Features of the Current Reforms in the
Area of Intergovernmental Fiscal Relation
• Actual start of the reform at the sub-regional level
(implementation of a new system of different grants
types to municipalities of 2 types)
• Need for education of regional authorities that will
implement the new transfers system in a 2-type
municipal structure
• Making the heads of subnational governments
(executives) appointed by the federal center (the
President)
• Introduction of “negative transfers” at the subregional level
9
www.iet.ru
Main Responsibilities of the Federal and
Regional Governments in Russia
•
•
•
•
•
•
10
Federal:
Monetary policy
Customs and foreign
relations
National defense and
security
Nuclear energy
Federal transport
General principles of
taxation
•
•
•
•
•
Mutual:
Health care
Education
Social security
Police
Regulation of land and
forestry use, labour,
housing, etc.
Regional (incl. municipal):
• Subnational Transport
• Municipal and land improvement
• The rest of responsibilities
Tax Reform and Intergovernmental
Fiscal Relations
Main Regional and Local Taxes
Before the Tax Reform of 2000-04
• Corporate Income Tax (in part)
• Road Tax (corporate tax on the
turnover)
• Housing and Communal tax (tax on
the corporate turnover)
• Corporate Tax on Assets (similar to
the property tax)
• Sales Tax
• Land Tax (both on individuals and
businesses)
• Individual Property Tax
• Other regional and local taxes and
fees on businesses (on school
maintenance, police etc.)
11
Main Regional and Local
Taxes After the Tax Reform
• Corporate income tax (?)
• Corporate property tax (not
effective at the moment)
• Tax on Motor Vehicles
• Individual Property Tax
• Land Tax
• Presumptive Tax for Small
Businesses
• “Self-taxation”
www.iet.ru
The Main Features of the Federal Grants to
the Regions at Present
1. Equalization Grants – a formula-based mechanism, equalization of
regional fiscal capacity adjusted for expenditure needs differentials
2. Compensation Grants – formula-based specific purpose grants
aimed at funding certain federal mandates
3. Regional Finance Reform Grants – conditional grants to regions
performing regional finance reform program
4. Social Expenditure Grants – matching grants aimed at funding
certain most important regional expenditures
5. Regional Development Grants – specific purpose grants to finance
regional public investment in infrastructure
6. Other Grants and Loans – numerous grants (road construction,
compensation for changes in federal legislation, etc) allocated mainly
12 on discretionary basis
www.iet.ru
Per Capita Tax Revenues and Expenditures
of the Regional Budgets in 2003 (rbl.)
80000
70000
60000
50000
40000
30000
20000
10000
0
Tax Revenues (incl. shared taxes)
13
Expenditures
www.iet.ru
Per Capita Tax Revenues and Expenditures of the
Regional Budgets in 2003 (rbl., adjusted)
40000
35000
30000
25000
20000
15000
10000
5000
0
Adjusted Tax Revenues
14
Adjusted Expenditures
www.iet.ru
Tax Revenues of the Different Levels of
Government in the Russian Federation (% GDP)
40%
www.iet.ru
35%
30%
Regional Budgets
25%
20%
15%
Federal Budget
10%
5%
15
0%
Off-budget Social Funds
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Regional Budgets
12,4%
14,3%
13,06%
11,9%
11,6%
12,7%
11,5%
10,4%
10,2%
9,6%
10,0%
10,0%
Federal Budget
15,8%
10,3%
11,2%
10,7%
9,9%
9,4%
8,8%
10,7%
13,2%
16,2%
18,6%
18,0%
Off-budget social funds
9,7%
10,6%
9,4%
8,2%
8,2%
7,7%
9,6%
8,6%
9,5%
8,2%
5,6%
5,7%
Adjusted Fiscal Capacity Equalization
Principle in Russia (illustration)
16
www.iet.ru
Federal Grants to the Regions Since 1992 (%
of GDP)
3,5%
3,0%
Other Formula-Based Grants
2,5%
% GDP
Compensation Grants
2,0%
Other Federal Grants
and Loans
1,5%
1,0%
Equalization Transfers
0,5%
0,0%
1992
17
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
www.iet.ru
Positive Impacts of the Reforms
• The new system has been established that has got many features
of an efficient system of intergovernmental fiscal equalization
• Federal government started to base its calculations on the fiscal
capacity and expenditure needs indicators rather than on the actual
revenues and expenditures in the previous periods
• The procedures of formula-based calculations has been elaborated
and introduced to the budget planning practices
• Compensation of unfunded mandates has been launched
• Regional (and federal) governments started to get used to the new
philosophy of equalization – unified approach on the basis of the
independent statistics instead of the case by case ad hoc agreements
18
www.iet.ru
Current Deficiencies of the IGFR System
• Limited fiscal autonomy of the regional and local
governments
• Low taxing powers at the subnational level of government:
Limits the fiscal autonomy of regional and local governments
Caused by objective reasons (expenditure obligations set by
federal mandates, quality of tax legislation)
• Lack of development at the level of municipal governments
• Growing resources allocated among regions at discretionary
basis causes soft budget constraints and strengthens political
influence of the federal center
• Uncertainty of tax and transfers allocation mechanisms
undermines the efficiency of regional and local decision19 making
www.iet.ru
Reasons for Deficiencies
• Large amount of unfunded federal mandates that
enable regions to apply for additional grants and
federation – to influence regional fiscal decisions
• Unwillingness of the federal center to lose
political control over regional governments
• Many reforms in different sectors (taxation,
natural monopolies etc.) at the same time lead to
seeking compromise in less important areas (like
IGFR)
• A real IGFR reform should follow a general
federal reform that will effectively start in 200506 only
20
www.iet.ru
Models of Subnational Fiscal Behavior
1. Traditional models that describe impact of the transfer allocation
mechanisms on the fiscal decisions of the recipients (Gramlich (1977),
Thurow (1966), Bradford and Oates (1971), King (1982), etc.).
Main hypothesis: the decision-making process of subnational governments
depends on the preferences of a representative of the voters' community
(median voter)
2. Models that describe behavior of subnational governments taking into
account the existence of the own preferences of the bureaucrats that
form the government (Niskanen (1968), Niskanen (1971), Romer and
Rosenthal (1980), Oates (1979), Break (1980), King (1984))
Main hypotheses:
• the preferences of the bureaucrats don't match the preferences of the regional
voters
• own preferences of the government could explain the flypaper effect phenomena, when empirical results of the impact of fiscal transfers don't
match the hypotheses following from the traditional models
21
www.iet.ru
Models of Allocation of the Equalization
Grants
Definition of the fiscal equalization: When tax revenues of a subnational
budget are equal to a standard value (fiscal capacity), this budget is entitled
to receive a grant, that is sufficient to finance provision of the public goods
in this jurisdiction taking into account the regional expenditure needs (King
(1980), Aronson (1977), Musgrave (1961))
Approaches to Fiscal Equalization:
1. Equalization of the actual subnational expenditures of the regional budgets
(USSR, Italy)
2. Equalization of the subnational expenditures taking into account regional
fiscal capacity (eastern Länder in Germany, annual block grants in the UK).
3. Equalization of subnational fiscal capacity (Canada)
4. Combined schemes, including theoretical (Cripps-Godley scheme, Mathews
scheme, Korea)
22
www.iet.ru
Fiscal Behavior of Subnational Governments
in Russia: the Model
Regional government utility function:

()
U E ,T
( )
  max
E ,T
Е – expenditures of the regional budget;
Т – tax revenues of the regional budget.
The budget constraint: Е  Т+Tr
Tr – fiscal transfers from the federal budget
Formula of the federal transfers allocation across regions:

T

E




Tr   E  1    E  T  1    T

– estimation of the regional fiscal capacity made by the
federal government;
– estimation of the regional expenditure needs made by the
federal government;
, ,  – parameters of the model
23
www.iet.ru
Analysis of the Model
1. Analysis of the impact of the extent to which the "fiscal gap"
between expenditure and revenue indicators is financed from the
federal budget () on the regional fiscal decisions
2. Analysis of the impact of the extent to which the transfers
allocation formula depends on the actual public expenditures of
the regions in the previous periods () on the regional fiscal
decisions
3. Analysis of the impact of the extent to which the transfers
allocation formula depends on the actual public revenues of the
regions in the previous periods () on the regional fiscal
decisions
4. Analysis of the impact of changes in the other factors on the
fiscal decisions of the regional governments
24
www.iet.ru
Main Conclusions from the Theoretical
Analysis
Signs of the partial derivatives of the optimal values of tax revenues (T*) and
expenditures (E*) chosen by the regional governments with respect to the
parameters of the model (for the recipient regions):

E
Y

T



Derivative of E*
+
+
–
+
–
?#
Derivative of T*
+
–
+
+
–
?##
• By changing the model parameters the federal government could create
different kinds of fiscal incentives for the regional governments
depending of the objectives of the federal budget policy
• When the approach towards equalization is symmetrical (α = β) - growth
in the transfer amount should cause growth in the recipient's expenditures
by the amount that is less than the amount received. At the same time the
tax revenues should decline.
• When the approach is not symmetrical (α <> β)– effects of the growth in
25 fiscal transfers are not evident a priori
www.iet.ru
Main Conclusions from the Theoretical
Analysis
Transfers allocation formula after regrouping:


 
Tri   ( Ei  Ei )   (Ti  Ti )   ( Ei  Ti )
• If the federal government uses actual
expenditures while allocating grants ( >0) it
creates incentives for public expenditure growth
• If the federal government uses actual revenues
while allocating grants ( >0) it creates incentives
for tax collection decrease
26
www.iet.ru
Main Conclusions from the Theoretical
Analysis
1. If  = then effects are similar to classic
approach
2. If  > then there are incentives to increase
public expenditures with the increase in public
revenues (if γ < 1)
3. If  <  then there are incentives for the regions
to decrease public revenues in order to get more
grants from the federal budget (as compared to
the symmetrical case). The worst incentive is to
cut expenditures after cutting tax revenues and
receiving grants
27
www.iet.ru
The Model of the Regional Fiscal Behavior:
Empirical Tests
The linear regression equation:


 
Tri ,t  a0  a1 ( E  E )i ,t  s  a2 (T  T )i ,t  s  a3 ( E  T )i ,t  s   i ,t  s , s  0, 1, 2
a3=, a1= ., a2= .
Main hypotheses:
a0=0, i.e. there is no component in the federal grant that is calculated as
a lump-sum amount for all regions;
0  a3  1, that is similar to 0    1;
0  a1  a3, taking into account that a1= . and the condition with
respect to a3 this is similar to 0    1;
0  -a2  a3, taking into account that a2= . and the condition with
respect to a3 this is similar to 0    1.
28
www.iet.ru
Main Results of the Empirical Tests
1. The federal governments while allocating fiscal transfers acts in
order to fill the gap between estimates of the regional revenue
and expenditure indicators (γ > 0)
2. Four sub-periods have been specified for equalization transfers:
1994, 1995–1997, 1998–2000 and 2000-2003.
3. The extent to which the government used fiscal capacity while
allocating fiscal transfers in general has been lower than for
expenditure needs ( < )
4. Allocation of the additional fiscal transfers (except for
equalization) has been made in accordance with less objective
criteria (our estimates of  и  are higher for the additional
transfers)
29
www.iet.ru
Main Results of the Empirical Tests
5. For the group of regions that are highly dependent on the
federal fiscal transfers the federal government used actual
revenues and expenditures to a greater extent ( and ), and
filled the larger share of the gap (), than for the other
regions.
6. While allocating fiscal transfers to the Northern regions the
federal government fills the gap () to a greater extent than
for the other regions
7. There has not been any evidence found that negative fiscal
incentives exist in Russian (decreasing the tax revenues of
the regional budgets after increase in federal grants)
30
www.iet.ru
Main Hypotheses for Estimation of the
Results of the Recent Reforms
Implementation of the formulabased procedures
Allocation of additional federal
revenues based on
discretionary mechanisms
Centralization of tax revenues
in the federal budget and
compensation of regional
losses caused by the tax
reform
31
The equalization transfers
allocation depends more on
fiscal capacity and expenditure
needs indicators than on actual
revenues and expenditures
Less importance of fiscal capacity
and expenditure needs
indicators for the total transfers
as compared to 1999-2001
period
Growth of the gap between
revenue and expenditure
indicators while the total
transfers allocation
www.iet.ru
A Soft Budget Constraint Problem – Definitions
• Economic agents could take decisions influenced by
the expectations of the additional financial resources
from the principal (similar to a moral hazard
problem)
• A multi-tier structure of government creates
incentives for the soft budget constraints (SBC)
• Two main negative effects of the soft budget
constraint:
 Bad financial discipline (accumulation of debt,
inefficient fiscal decisions)
32
 Inefficient growth of public expenditures originating
from the additional resources expectation
www.iet.ru
A Soft Budget Constraint Problem – Experiences
• Two ways of preventing the SBC problem in a
multi-tier government countries:
 Institutional – creation of the market and public
institutions that prevent emerging the SBC
 Hierarchical – mechanisms involving control by the
central government over the subnational governments
• Institutional mechanisms proved to be more
effective (USA and Canada):
 Long-term anti-bailout policy
 Devolving responsibility for the borrowing and other
fiscal decisions
 Effective political mechanisms in a federation
33
www.iet.ru
A Soft Budget Constraint Problem – Experiences
(continued)
• Mechanisms of hierarchical control could be
inefficient in large and multi-tier federations:
 Scale of problem: “too big to fail” reason (Germany)
 Political influence of subnational governments (Brazil)
• Efficient strategy in a multi-tier government structure
should include decentralization of responsibilities
(negative examples of China and Ukraine)
• Hierarchical control could be effective in small
unitary countries (Norway, Hungary)
• SBC problem could be solved (Argentina)
34
www.iet.ru
A Soft Budget Constraint Problem in Russia
• The Russian Constitution does not contain clear
division of responsibilities between levels of
government
• Lack of market and public institutions aimed at the
making subnational governments responsible for
own fiscal decisions
• Unfunded mandates makes the federal government
implicitly responsible for revenues and expenditures
of subnational governments
• Political weakness of the federal center and
compromise-seeking made the hierarchical control
mechanisms ineffective throughout the 1990-s
35
www.iet.ru
A Soft Budget Constraint Problem in Russia Mechanisms
• Existence of various kinds of discretionary transfers
with unclear mechanisms of allocation
• Nontransparent public finance system, the federal
center is unable to control expenditures for the
purposes of compensation grants when they are
mandated to regions
• Possibility of borrowing from non-market sources:
 employees in the public sector
 service providers (electricity, heating, natural gas)
• Numerous and annual examples of bailouts of
regions and municipalities
36
www.iet.ru
Further Reform Agenda
• Creating incentives for responsible behavior at the
regional and municipal levels of government
• Extensive usage of matching grants to pursuit
federal objectives at the regional level
• Creating unified system of federal grants to regions
including various kinds of present discretionary
transfers (road construction, investment programs,
ad hoc grants)
• Moving to real equalization of fiscal capacity from
grants allocation according to “normative” revenues
and expenditures
37
www.iet.ru