Reform of Fiscal Federalism in Russia: Fiscal Behavior at the Subnational Level of Government

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Reform of Fiscal Federalism in Russia Fiscal
Behavior at the Subnational Level of Government
Institute for the Economy in Transition, Moscow
Ilya Trunin
www.iet.ru

• Barcelona - December, 13 2004

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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

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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

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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.)

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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
• Results unstable and inefficient system of
  intergovernmental fiscal arrangements

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First Stage of the Intergovernmental Fiscal
Reform a 1993 Constitution

• 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
  Federation

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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

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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

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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
  sub-regional level

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Main Responsibilities of the Federal and Regional
Governments in Russia

• 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

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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.)

• 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

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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 on
   discretionary basis

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Per Capita Tax Revenues and Expenditures of the
Regional Budgets in 2003 (rbl.)
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Per Capita Tax Revenues and Expenditures of the
Regional Budgets in 2003 (rbl., adjusted)
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Tax Revenues of the Different Levels of
Government in the Russian Federation ( GDP)
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Adjusted Fiscal Capacity Equalization Principle
in Russia (illustration)
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Federal Grants to the Regions Since 1992 ( of
GDP)
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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

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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 decision-making

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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
  2005-06 only

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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

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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)

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Fiscal Behavior of Subnational Governments in
Russia the Model
Regional government utility function
? expenditures of the regional budget ? tax
revenues of the regional budget.
The budget constraint ? ? ?Tr
Tr fiscal transfers from the federal budget
Formula of the federal transfers allocation
across regions
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
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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

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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)
• 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 (a ß) - 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 (a ltgt ß)
  effects of the growth in fiscal transfers are not
  evident a priori

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Main Conclusions from the Theoretical Analysis

• Transfers allocation formula after regrouping
• If the federal government uses actual
  expenditures while allocating grants (? gt0) it
  creates incentives for public expenditure growth
• If the federal government uses actual revenues
  while allocating grants (? gt0) it creates
  incentives for tax collection decrease

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Main Conclusions from the Theoretical Analysis

• 1. If ? ? then effects are similar to classic
  approach
• 2. If ? gt? then there are incentives to increase
  public expenditures with the increase in public
  revenues (if ? lt 1)
• 3. If ? lt ? 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

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The Model of the Regional Fiscal Behavior
Empirical Tests
The linear regression equation a3g, a1a .g,
a2b .g Main hypotheses a00, 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 ? g ? 1 0 ? a1 ? a3, taking
into account that a1a .g and the condition with
respect to a3 this is similar to 0 ? a ? 1 0 ?
-a2 ? a3, taking into account that a2b .g and
the condition with respect to a3 this is similar
to 0 ? b ? 1.
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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 (? gt 0)
• 2. Four sub-periods have been specified for
  equalization transfers 1994, 19951997,
  19982000 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
  (? lt ?)
• 4. Allocation of the additional fiscal transfers
  (except for equalization) has been made in
  accordance with less objective criteria (our
  estimates of ? ? ? are higher for the additional
  transfers)

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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)

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Main Hypotheses for Estimation of the Results of
the Recent Reforms

• 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

• Implementation of the formula-based 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

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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)
• Inefficient growth of public expenditures
  originating from the additional resources
  expectation

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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

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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)

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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

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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

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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

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