Budget Code: New Approaches and Old Problems

Th e Budget Code (BC) proposed four important structural changes in intergovernmental fi nance.

Th ese changes comprise a rational set of expenditure and revenue assignments among diff erent types of government, a targeted transfer program for certain kinds of social protection, and a formula-based trans-fer system connecting the state budget to all local governments, oblasts, cities, and rayons.

To meet their obligations, state and local budgets have distinct sources of revenue. Th e most important revenue sources prescribed by the BC for local govern-ments are: local taxes and duties; PIT and land tax (shared between levels of subnational government);

EPT of enterprises of communal property; incomes from selling communal property; own incomes of budgetary entities and organizations; industry tax;

and taxes on owners of motor vehicles.

For fi nancing expenditures calculated using budget norms, a basket of revenues has been defi ned to fund the budgets of territorial communities. Th is revenue basket comprises all of the proceeds raised in a local jurisdiction from the PIT, stamp duties arising from court actions, fees collected for issuing licenses and trade patents, for registering business entities, and fees generated from fi nes and penalties for legal infractions (except those collected by the state road patrol). Th e elements of this revenue basket are the logical components of a rationally designed local tax

base because they all represent taxes and fees paid by local residents rather than by “outsiders” (though the current PIT does not fully meet this criterion and is to be eliminated by the future Tax Code). Th e composi-tion of these taxes is in agreement with internacomposi-tional practice and supports a linkage between the payment of local taxes and locally provided public services that will strengthen the accountability of local govern-ment offi cials to local taxpayers. A fraction of PIT, 25 percent, collected on the territory of an oblast or the AR Crimea will be allocated to fund, at least in part, the expenditures of regional budgets. In addition, the state establishes a special algorithm for the distribu-tion of the PIT among towns, villages and settlements on the one hand, and rayons on the other—25:50 (the remaining 25 percent, as mentioned above, is paid to oblast budgets). For the cities of Kyiv and Sevastopol, their budgets will receive 100 per cent of the revenue basket. Th e full amount of other revenue sources in the defi ned “basket” is used to fund territorial com-munities. In this way, every subnational government will have access to a pool of locally generated revenue that, depending on the size of the tax base in an area, may or may not be adequate to fi nance transfer-related expenditure responsibilities. Transfers play a residual fi nancial role in balancing local budgets in situations where the pool proves to be either inadequate or, in some cases, more than adequate.

To provide towns, villages, and settlements with some degree of revenue independence, rayons are required to leave no less than 25 percent of the PIT paid by citizens who work in the respective territo-rial unit. Th is distribution algorithm set for the most promising revenue source of local governments is designed to provide the communities with some fi scal autonomy.

Local governments receive 75 percent of the land tax (60 percent for towns, villages, and settlements) and some other minor sources for funding expendi-ture assignments that are not calculated on a norm basis and hence are actually own expenditures that are intrinsic for local self-government. It is important that the above-mentioned sources are not included in the “main” revenue basket and thereby are excluded from the base for transfer calculations. In other words, in contrast to the current practice, each “additional”

UAH of local revenue does not “crowd out” transfer-related UAH from local revenues.

D I L E M M A S A N D C O M P R O M I S E S : F I S C A L E Q U A L I Z A T I O N I N T R A N S I T I O N C O U N T R I E S

Some of the weaknesses of this revenue source pattern can lead to perverse incentives for the local governments of sub-rayon level. Relations of prop-erty are defi ned on the upper (rayon and/or oblast) governmental level, and very often decisions are not made in the interests of the local community. Even now there is no clear framework for municipal prop-erty, especially that of the basic local community level. Meanwhile oblast administrations are de facto owners of many state and communal enterprises and property. Another source of disincentives is the fact that local government revenues are determined by, and managed from, the rayon and oblast levels; thus many services—like land cadastre, city construc-tion and planning, sanitary and ecological control, etc.—are concentrated in oblast centers and as a rule are subordinated to rayon or oblast administrations, or central agencies.

BC also sets a framework for the fi nancial activ-ity of local governments: oblast, rayon, cactiv-ity rayon and settlement budgets must be adopted without defi cit in the operational budget (Article 72). To cover gaps in the execution of budgets, subnational governments are permitted—after the decision of related councils—to take short-term loans by upper-level subnational governments. Maximum time of crediting is three months and a loan must be repaid within one budget period. Other loans from one budget to another are prohibited. Such regulation limits the opportunities for local governments to attract additional resources, investments, or to raise their tax bases by working with real estate, land improvement, constructing new property and making contributions to infrastructure and human resources development. Instead, such limi-tation, preserved by BC, causes perverse incentives and hampers provision of public services and local economic development. It is especially harmful for poor and small local governments, which have very few possibilities to develop their revenue bases and in-crease the welfare of their citizens. Moreover, in con-ditions of arrears and unfulfi lled obligations by the central government, such regulations—prohibition to adopt defi cit budgets and restrictions on the use of fi nancial market instruments—push local govern-ments to nontransparent negotiations with the upper level of power and other shadow and unfair activities.

Adoption of a defi cit budget would mean fi rst of all formalization of needs, and could be a stimulus to

look for resources to cover this defi cit, in such forms as borrowing on the fi nancial markets and horizontal cooperation. On the contrary, with such regulation, the BC legitimizes hidden defi cits, at a time when lo-cal governments are interested in showing unreason-ably exaggerated expenditure needs, in an attempt to establish a stronger position in shadow negotiations.

In fact, the limitation preserved by the BC in this area pushes LGs away from fi nancial management of municipal resources with the goal of increased own revenues, toward the old Soviet scheme of intergov-ernmental relations within centralized planning.

Th ere are some changes in expenditure responsibi-lities of SNGs. Delegated expenditures are prescribed for the rayons and cities of oblast signifi cance: on the state management (for cities of oblast and towns of rayon signifi cance, for self-government bodies of rayon signifi cance); education (preschool and secondary, residential schools, and other state education pro-grams); health care; state programs of social provision and protection; implementation of the governmental policy towards children, youth, women, and family.

SNG spending is divided into three separate ex-penditure “pots”: for oblasts; for cities and rayons; and (a smaller one) for towns, villages, and settlements.

Th e content of each expenditure pot is diff erent. Each pot is designed to have a comparative advantage over other “pots” in carrying out the functions that have been assigned to it. Choice concerning the content of each pot is guided by the principle of subsidiarity, or assignment of a particular task to the type of govern-ment capable of eff ectively carrying it out. Th e BC does not use the word “level of government” with respect to SNGs as the document is steeped in the ideology of subnational independence and autonomy.

Expenditures which potentially aff ect all residents of an oblast have been assigned by the new BC to ob-last budgets (e.g., specialized secondary educational institutions for disadvantaged students; secondary boarding schools; vocational and higher education institutions; general hospitals of oblast signifi cance;

specialized medical services; specialized social protec-tion facilities for orphans, disabled persons, and the elderly; hospices; and specialized sports programs).

Expenditures whose scope of benefi ts does not ordi-narily extend beyond the boundaries of the local area have been assigned to city and rayon budgets (e.g., general secondary education, general health care

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133 ices including health education programs, and social

protection programs that provide physical services to the socially disadvantaged residing in a local area such as residential home care for the elderly). Expenditure tasks of purely local signifi cance have been assigned to the budgets of towns, villages, and settlements, all of whom will be responsible for preschool education, primary medical care off ered through local clinics, fi rst aid and obstetric centers, and cultural and en-tertainment programs. Larger towns with secondary schools and district hospitals will be responsible for the services provided by these facilities. Of course, cities will also undertake other responsibilities as de-scribed in the previous item.

Kyiv and Sevastopol take all of the expenditure responsibilities that are assigned to oblasts, cities and rayons, and towns, villages and settlements, taking into account other laws of Ukraine which defi ne their special status.

For social protection programs that are of a cash nature and have a nationwide scale of benefi ts, cit-ies and rayons provide the mandatory benefi ts to be compensated by targeted subventions from the state budget. Aid to families with young children, subsi-dies for communal services, and benefi ts to war and labor veterans are examples of the targeted transfer that will be provided to local budgets from the state budget.

All of the expenditure tasks that have been men-tioned are transfer-related whose funding is calculated on the basis of fi nancial norms of budget suffi ciency.

In other words, the state plays an important role in defi ning those resources that are designated to fund these functions, since the state is interested in pro-viding these services at comparable levels in terms of volume and quality across administrative-territorial units. Th e state has the authority to regulate budget-ary performance in these areas, as well as the respon-sibility to ensure that the areas are adequately funded through a combination of assigned tax revenues and either targeted or non-targeted transfers.

Th ose expenditure tasks that are left at the discre-tion of local governments and hence are not taken into account in defi ning the amounts of transfers, involve public services that are of a housekeeping na-ture such as water and sewerage supply, roads, refuse removal, and the general maintenance of local public sector infrastructure.

From the perspective of the budgetary process, at the stage of preparing their budgets local govern-ments must strive to fi nance their total expenditures from their own source revenues, transfers, and the basket of revenues designated to fund transfer-related expenditure assignments. At the stage of budget ex-ecution, however, all moneys fl ow into a common revenue pool and can be used to fi nance any type of expenditure.

Within the limits of available resources, adjusted per capita expenditure norms (adjusted for geographic diff erences in the cost of providing social services as well as regional and local variations in socioeconomic conditions, climatic, environmental and other natural factors) are established for each type of delegated ex-penditure responsibility and guaranteed by the state.

One article of the BC proposes a mechanism for the reconciliation of relations between the budgets of rayons and cities (which serve at the same time as centers of rayons). In practice, residents of a rayon may use services provided by entities funded from the relevant municipal budget. In the past no payments from the rayon budget were made, and this led to confl icts. Th e BC has provided for both contract-based reconciliation of such cases and for transfer liabilities (if budget-funded entities of the rayon or city are not capable of providing funds in the needed amount). It should be noted that both the MoF and local fi nancial departments were to consider this problem when preparing the 2001 budget, but there is always some room for improvement and this will be demonstrated by the 2002 budget.

Among unresolved issues, one in particular is worthy of note: the BC’s forbidding execution of expenditures during one budget year from sources within more than one government budget. Th is prohibition refl ects the unstable situation with pro-perty relations (transfer of propro-perty from one tier of government to another) and the changing respon-sibilities of diff erent local governments for this or that kind of expenditures. Th e roots can be traced back to the Soviet legacy, when public services were very often tied to the facilities of enterprises, not to local governments. Now upper levels of power try to keep the “better pieces” and to “get rid” of the less attractive ones. But the interests of commu-nity are not a decisive factor in the midst of these turbulent changes. Th e decision to exclude the oblast

D I L E M M A S A N D C O M P R O M I S E S : F I S C A L E Q U A L I Z A T I O N I N T R A N S I T I O N C O U N T R I E S

level from provision of some services in these condi-tions has made the issue even more complex. Oblast administrations have not been distanced from pro-perty relations. Moreover, OSAs are in fact main communal property owners; they are also co-owners and corporate managers of main state enterprises, like electric power stations, heavy industry, and communications infrastructure. Th erefore, the posi-tion of the oblast level in property and intergovern-mental fi scal relations is very strong. Facilities and related expenditure responsibilities are distributed with the participation of OSAs. But at present the OSA is not engaged like local government but rather as an “invisible power,” usually playing on the side of interests groups and using informal relations within the vertical of power (between the apparatus of oblast and rayon governments). Together with the above-mentioned reduction in fi nancial autonomy of local governments, the unstable property relations lead to the deterioration of infrastructures because small and poor local governments cannot maintain facilities, that belonged before to oblast or rich enterprises.

Improved quality and eff ectiveness in the delivery of services requires strong political will and increased local government capacity, as decisions concerning the adjustment of old facilities and the development of infrastructure require strategic skill and program management techniques. At present local governments are inclined toward populist decisions, or those that have been dictated by shadow interests.

Th ough it initiated many positive changes, the introduction of the BC raised many questions which have yet to be answered. Th e optimization of intergovernmental fi scal relations cannot be achieved solely by shifting the LG distributive function from oblast to rayon level. Just like some years before, when informal bargaining was topical on the relations between oblast and sub-oblast levels, such bargaining is now timely for the relations inside rayon levels because MoF does not defi ne expenditures for govern-ments of small communities. According to the BC, in regard to revenue base and the collection of re-venue, rayons are disaggregated into rural and urban settlements and towns of rayon signifi cance. At the same time, these sub-rayon governments are lumped into a single administrative-territorial unit when transfers are calculated. In respect to expenditures,

the BC has rayon governments divide expenditures within their territories amongst other self-govern-ments. Interviews with authorities of small local governments reveal that very often expenditures and revenue distribution is done in an arbitrary and nontransparent way. In fact, there is a continuation of the “budget within budget” approach or the matryoshka relations, on the rayon level.