Reform of Fiscal Federalism in Russia: Budget Constraints at the Subnational Level of Government and Subnational Fiscal Behavior Kingston, ON - November, Ilya Trunin Institute for the Economy in Transition Consortium for Economic Policy Research and Advice

General 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

Main Results of the Project Extension of the fiscal behavior and fiscal redistribution models we built earlier for the period of 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 3

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) 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 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 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

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 8

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 Tax on Motor Vehicles Individual Property Tax Land Tax Presumptive Tax for Small Businesses “Self-taxation” 9

Adjusted Fiscal Capacity Equalization Principle in Russia 10

Federal Grants to the Regions Since 1992 (% of GDP) 11

Tax Revenues of the Different Levels of Government in the Russian Federation (% GDP) 12

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 (see Kadotchnikov, Sinelnikov, Trunin (2002)) 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 (see Kadotchnikov, Sinelnikov, Trunin (2002)) 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 Compensation of unfunded mandates 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 13

Current 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 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 14

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 Deficiencies 15

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 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 16

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 17

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 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 18

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 19

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) 20

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 21

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 22

Main Features of the Current Reform Plans Related to Intergovernmental Fiscal Relations Elimination of unfunded mandates: normative regulation, financing and administration powers will be clearly assigned to different levels of governmentElimination of unfunded mandates: normative regulation, financing and administration powers will 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 23

Main Features of the Current Reform Plans Related to Intergovernmental Transfers 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 head of subnational governments nominated by the federal centerMaking the head of subnational governments nominated by the federal center Introduction of “negative transfers” at the sub- regional levelIntroduction of “negative transfers” at the sub- regional level 24

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 25