Reform of Fiscal Federalism in Russia: Fiscal Behavior at the Subnational Level of Government Barcelona - December, Ilya Trunin Institute for the Economy in Transition, Moscow

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 systemDesign of the budgetary system Assignment of expenditure responsibilitiesAssignment of expenditure responsibilities Assignment of taxing powersAssignment of taxing powers Design of the intergovernmental transfers system (incl. fiscal capacity and expenditure needs estimation models)Design of the intergovernmental transfers system (incl. fiscal capacity and expenditure needs estimation models) Fiscal relations between the regional and municipal levels of governmentFiscal relations between the regional and municipal levels of government Program-oriented and performance-based budgetingProgram-oriented and performance-based budgeting 2

General Overview of the IET Activities in the Area of Fiscal Federalism 2. Research projects: Analysis of the fiscal behavior of the regional governmentsAnalysis of the fiscal behavior of the regional governments Analysis of the redistribution and stabilization features of the system of intergovernmental transfers and federal shared taxesAnalysis 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 RussiaModeling the budget constraints of the regional governments in Russia Analysis of the institutional aspects of the intergovernmental fiscal relations mechanismsAnalysis of the institutional aspects of the intergovernmental fiscal relations mechanisms 3

General Overview of the IET Activities in the Area of Fiscal Federalism 3. Consulting services to the regional governments: Intergovernmental fiscal relations with municipalitiesIntergovernmental fiscal relations with municipalities Drafting legislation for the municipal reform starting in Drafting legislation for the municipal reform starting in Elaboration of the regional development strategiesElaboration of the regional development strategies Public finance management (public procurement, debt management, budget institutions reform, program-oriented budegting, medium-term planning etc.)Public finance management (public procurement, debt management, budget institutions reform, program-oriented budegting, medium-term planning etc.) 4

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 5

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 6

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

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 governmentElimination 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 regionsThis 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)Increasing fiscal autonomy of regional and municipal governments (more on expenditure that on revenue side) Simplification of the transfers allocation formulaSimplification of the transfers allocation formula 8

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)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 structureNeed 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)Making the heads of subnational governments (executives) appointed by the federal center (the President) Introduction of “negative transfers” at the sub- regional levelIntroduction of “negative transfers” at the sub- regional level 9

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 taxationMutual: Health care Education Social security Police Regulation of land and forestry use, labour, housing, etc. Regional (incl. municipal): Subnational Transport Subnational Transport Municipal and land improvement Municipal and land improvement The rest of responsibilities The rest of responsibilities 10

Tax Reform and Intergovernmental Fiscal Relations Main Regional and Local Taxes Before the Tax Reform of 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” 11

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 12

Per Capita Tax Revenues and Expenditures of the Regional Budgets in 2003 (rbl.) 13

Per Capita Tax Revenues and Expenditures of the Regional Budgets in 2003 (rbl., adjusted) 14

Tax Revenues of the Different Levels of Government in the Russian Federation (% GDP) 15

Adjusted Fiscal Capacity Equalization Principle in Russia (illustration) 16

Federal Grants to the Regions Since 1992 (% of GDP) 17

Positive Impacts of the Reforms The new system has been established that has got many features of an efficient system of intergovernmental fiscal equalization 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 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 The procedures of formula-based calculations has been elaborated and introduced to the budget planning practices Compensation of unfunded mandates has been launched 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 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

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 19

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 only Reasons for Deficiencies 20

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 Models of Subnational Fiscal Behavior 21

Definition of the fiscal equalization: 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) Models of Allocation of the Equalization Grants 22

Fiscal Behavior of Subnational Governments in Russia: the Model 23 Е – expenditures of the regional budget; Т – tax revenues of the regional budget. Tr – fiscal transfers from the federal budget – estimation of the regional fiscal capacity made by the federal government; – estimation of the regional expenditure needs made by the federal government; Regional government utility function: The budget constraint: Е  Т+Tr Formula of the federal transfers allocation across regions: , ,  – parameters of the model

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

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 policyBy 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 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 fiscal transfers are not evident a prioriWhen the approach is not symmetrical (α <> β)– effects of the growth in fiscal transfers are not evident a priori Y  Derivative of E*++–+– ? # Derivative of T*+–++– ? ## 25

Main Conclusions from the Theoretical Analysis Transfers allocation formula after regrouping: If the federal government uses actual expenditures while allocating grants (  >0) it creates incentives for public expenditure growthIf 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 decreaseIf the federal government uses actual revenues while allocating grants (  >0) it creates incentives for tax collection decrease 26

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  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

The Model of the Regional Fiscal Behavior: Empirical Tests The linear regression equation: a 3 = , a 1 = . , a 2 = .  Main hypotheses: a 0 =0, i.e. there is no component in the federal grant that is calculated as a lump-sum amount for all regions; 0  a 3  1, that is similar to 0    1; 0  a 1  a 3, taking into account that a 1 = .  and the condition with respect to a 3 this is similar to 0    1; 0  -a 2  a 3, taking into account that a 2 = .  and the condition with respect to a 3 this is similar to 0    1. 28

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 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

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

Main Hypotheses for Estimation of the Results of the Recent Reforms 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 transfers The equalization transfers allocation depends more on fiscal capacity and expenditure needs indicators than on actual revenues and expenditures the total transfers Less importance of fiscal capacity and expenditure needs indicators for the total transfers as compared to period the gap between revenue and expenditure indicators Growth of the gap between revenue and expenditure indicators while the total transfers allocation 31

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 32

A Soft Budget Constraint Problem – Experiences Two ways of preventing the SBC problem in a multi-tier government countries: Institutional Institutional – creation of the market and public institutions that prevent emerging the SBC Hierarchical 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

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

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

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

Further Reform Agenda Creating incentives for responsible behavior at the regional and municipal levels of governmentCreating incentives for responsible behavior at the regional and municipal levels of government Extensive usage of matching grants to pursuit federal objectives at the regional levelExtensive 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)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 expendituresMoving to real equalization of fiscal capacity from grants allocation according to “normative” revenues and expenditures 37