reform of fiscal federalism in russia: budget constraints at the subnational level of government and...

Reform of Fiscal Federalism in Russia: Reform of Fiscal Federalism in Russia: Budget Constraints at the Subnational Budget Constraints at the Subnational Level of Government and Subnational Level of Government and Subnational

Fiscal BehaviorFiscal Behavior

Kingston, ON - November, 22 2004

Ilya TruninIlya Trunin

Institute for the Economy in Institute for the Economy in TransitionTransition

Consortium for Economic Policy Consortium for Economic Policy Research and AdviceResearch and Advice

www.iet.ruwww.iet.ru

General Overview of the ProjectGeneral Overview of the Project• Review of the recent reforms in the area of fiscal

federalism in Russia (2001 – 2003)• Analysis of the impact of the reforms on the fiscal

behavior of the regional governments in Russia• Analysis of the redistribution and stabilization features

of the system of intergovernmental transfers and tax sharing since 2001

• Modeling the budget constraints of the regional governments in Russia

• Analysis of the institutional aspects of the intergovernmental fiscal relations mechanisms

• Recommendations and economic policy options for the next stage of reform starting in 2005

www.iet.ruwww.iet.ru22

Main Results of the ProjectMain Results of the Project

• Extension of the fiscal behavior and fiscal redistribution models we built earlier for the period of 2001-2003

• Analysis of the soft budget constraint problem as applied to subnational governments behavior, its factors, effects etc.

• Analysis of the soft budget constraint problem in different countries

• Analysis of theoretical models of subnational budget constraints and empirical estimates for different countries


Main Results of the Project (continued)Main Results of the Project (continued)

• Theoretical model of subnational government budget constraints based on the game theory approach

• Empirical estimates of the budget constraints of the regional governments in Russia

• Review of the institutional features of the fiscal federalism systems

• Policy options and recommendations for economic policy in Russia (in work)


Intergovernmental Arrangements in the Intergovernmental Arrangements in the Early Transition PeriodEarly 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 decrease consoldated public expenditures in accordance with revenue possibilities

• Using intergovernmental fiscal transfers and shared taxes in political process

Results: unstable and inefficient system of Results: unstable and inefficient system of intergovernmental fiscal arrangementsintergovernmental fiscal arrangements www.iet.ruwww.iet.ru55

First Stage of the Intergovernmental First Stage of the Intergovernmental Fiscal Reform – a 1993 ConstitutionFiscal 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 Results: Excessive decentralization in case of reach regions and strong centralization concerning the majority of the and strong centralization concerning the majority of the

subjects of the Federationsubjects of the Federation www.iet.ruwww.iet.ru66

Second Stage of the Intergovernmental Second Stage of the Intergovernmental Fiscal Reform – a 1998 CrisisFiscal 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 reformResults: A new framework for allocation of resources Results: A new framework for allocation of resources

across levels of governmentacross levels of government www.iet.ruwww.iet.ru77

The Main Features of the Federal Grants to The Main Features of the Federal Grants to the Regions at Presentthe Regions at Present

1.1. Equalization GrantsEqualization Grants – a formula-based mechanism, equalization of – a formula-based mechanism, equalization of regional fiscal capacity adjusted for expenditure needs differentialsregional fiscal capacity adjusted for expenditure needs differentials

2.2. Compensation GrantsCompensation Grants – formula-based specific purpose grants – formula-based specific purpose grants aimed at funding certain federal mandatesaimed at funding certain federal mandates

3.3. Regional Finance Reform GrantsRegional Finance Reform Grants – conditional grants to regions – conditional grants to regions performing regional finance reform programperforming regional finance reform program

4.4. Social Expenditure GrantsSocial Expenditure Grants – matching grants aimed at funding – matching grants aimed at funding certain most important regional expenditurescertain most important regional expenditures

5.5. Regional Development GrantsRegional Development Grants – specific purpose grants to finance – specific purpose grants to finance regional public investment in infrastructureregional public investment in infrastructure

6.6. Other Grants and LoansOther Grants and Loans – numerous grants (road construction, – numerous grants (road construction, compensation for changes in federal legislation, etc) allocated mainly compensation for changes in federal legislation, etc) allocated mainly on discretionary basison discretionary basis www.iet.ruwww.iet.ru88

Tax Reform and Intergovernmental Tax Reform and Intergovernmental Fiscal RelationsFiscal Relations

Main Regional and Local Taxes Main Regional and Local Taxes Before the Tax Reform of 2000-04Before 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 Main Regional and Local Taxes After the Tax Taxes After the Tax

ReformReform• Corporate income tax (?)• Corporate property tax• Tax on Motor Vehicles• Individual Property Tax• Land Tax• Presumptive Tax for Small

Businesses• “Self-taxation”


Adjusted Fiscal Capacity Equalization Adjusted Fiscal Capacity Equalization Principle in RussiaPrinciple in Russia


Federal Grants to the Regions Since 1992 (% Federal Grants to the Regions Since 1992 (% of GDP)of GDP)

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

% G

DP

Other Federal Grants and Loans

Equalization Transfers

Compensation Grants

Other Formula-Based Grants


Tax Revenues of the Different Levels of Tax Revenues of the Different Levels of Government in the Russian FederationGovernment in the Russian Federation (% (% GDP)GDP)


0%

5%

10%

15%

20%

25%

30%

35%

40%

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%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Regional Budgets

Federal Budget

Off-budget Social Funds

1212

Positive Impacts of the ReformsPositive Impacts of the Reforms• The new system has been established that has got many features The new system has been established that has got many features of an efficient system of intergovernmental fiscal equalizationof an efficient system of intergovernmental fiscal equalization

• Federal government started to base its calculations on the fiscal Federal government started to base its calculations on the fiscal capacity and expenditure needs indicators rather than on the actual capacity and expenditure needs indicators rather than on the actual revenues and expenditures in the previous periods (revenues and expenditures in the previous periods (see see Kadotchnikov, Sinelnikov, Trunin (2002)Kadotchnikov, Sinelnikov, Trunin (2002)))

• The procedures of formula-based calculations has been elaborated The procedures of formula-based calculations has been elaborated and introduced to the budget planning practicesand introduced to the budget planning practices

• Compensation of unfunded mandatesCompensation of unfunded mandates

• Regional (and federal) governments started to get used to the new Regional (and federal) governments started to get used to the new philosophy of equalization – unified approach on the basis of the philosophy of equalization – unified approach on the basis of the independent statistics instead of the case by case ad hoc agreementsindependent statistics instead of the case by case ad hoc agreements


Current Deficiencies of the IGFR SystemCurrent Deficiencies of the IGFR System


• Large amount of unfunded federal expenditure mandates denies fiscal autonomy of the regional governments

• Low taxing powers at subnational level of government:Limits the fiscal autonomy of regional and local governmentsCaused 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

1414

• 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 only

Reasons for DeficienciesReasons for Deficiencies


Main Hypotheses (a Fiscal Behavior Model)Main Hypotheses (a Fiscal Behavior Model)

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

The equalization transfersThe 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 transfersthe total transfers as compared to 1999-2001 period

Growth of the gap between the gap between revenue and expenditure revenue and expenditure indicatorsindicators while the total transfers allocation


Main Hypotheses (a Redistribution and Stabilization Model)Main Hypotheses (a Redistribution and Stabilization Model)

Growth of the inter-regional differentials in the real per capita GDP

Centralization of the tax revenues induces by extraction of oil and other natural resources

Growth of the fiscal transfers progressivity with respect to the gross regional income

Growth of the federal taxes progressivity with respect to the gross regional income

Growth of the federal taxes progressivity with respect to the regional tax revenues

Growth of the federal net tax (federal taxes less federal transfers) progressivity with respect to regional income


A Soft Budget Constraint Problem – DefinitionsA 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 has incentives for a 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


A Soft Budget Constraint Problem – ExperiencesA Soft Budget Constraint Problem – Experiences

• Two ways of preventing the SBC problem in a multi-tier government countries: InstitutionalInstitutional – creation of the market and public

institutions that prevent emerging the SBC HierarchicalHierarchical – 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


A Soft Budget Constraint Problem – Experiences A Soft Budget Constraint Problem – Experiences (continued)(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)www.iet.ruwww.iet.ru2020

A Soft Budget Constraint Problem in RussiaA 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


A Soft Budget Constraint Problem in Russia - A Soft Budget Constraint Problem in Russia - MechanismsMechanisms

• 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


Main Features of the Current Reform Plans Related to Main Features of the Current Reform Plans Related to Intergovernmental Fiscal RelationsIntergovernmental Fiscal Relations

• Elimination of unfunded mandates: normative Elimination of unfunded mandates: normative regulation, financing and administration powers will regulation, financing and administration powers will be clearly assigned to different levels of governmentbe clearly assigned to different levels of government

• This envisages increasing role of Compensation This envisages increasing role of Compensation Grants that will finance federal mandates imposed Grants that will finance federal mandates imposed on regionson regions

• Increasing fiscal autonomy of regional and Increasing fiscal autonomy of regional and municipal governments (more on expenditure that municipal governments (more on expenditure that on revenue side)on revenue side)

• Simplification of the transfers allocation formulaSimplification of the transfers allocation formulawww.iet.ruwww.iet.ru2323

Main Features of the Current Reform Plans Main Features of the Current Reform Plans Related to Intergovernmental TransfersRelated to Intergovernmental Transfers

• Actual start of the reform at the sub-regional level Actual start of the reform at the sub-regional level (implementation of a new system of different grants (implementation of a new system of different grants types to municipalities of 2 types)types to municipalities of 2 types)

• Need for education of regional authorities that will Need for education of regional authorities that will implement the new transfers system in a 2-type implement the new transfers system in a 2-type municipal structuremunicipal structure

• Making the head of subnational governments Making the head of subnational governments nominated by the federal centernominated by the federal center

• Introduction of “negative transfers” at the sub-Introduction of “negative transfers” at the sub-regional levelregional level


Further Reform AgendaFurther Reform Agenda

• Creating incentives for responsible behavior at the Creating incentives for responsible behavior at the regional and municipal levels of governmentregional and municipal levels of government

• Extensive usage of matching grants to pursuit Extensive usage of matching grants to pursuit federal objectives at the regional levelfederal objectives at the regional level

• Creating unified system of federal grants to regions Creating unified system of federal grants to regions including various kinds of present discretionary including various kinds of present discretionary transfers (road construction, investment programs, transfers (road construction, investment programs, ad hoc grants)ad hoc grants)

• Moving to real equalization of fiscal capacity from Moving to real equalization of fiscal capacity from grants allocation according to “normative” revenues grants allocation according to “normative” revenues and expendituresand expenditures


reform of fiscal federalism in russia: budget constraints at the subnational level of government and...

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