Current State of Intergovernmental Fiscal Relations

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very considerable. In some localities the actual expen-ditures exceed the normative ones by up to 40 percent;

and there are a few localities where, on the contrary, the actual expenditures are less than the normative ones, again, by up to 40 percent. Th us, the standard deviation here is 0.14, whereas if infrastructure were arranged in proportion to the population, the stand-ard deviation would be zero. Th is simulation confi rms the above-mentioned opinion of the Bashkortostan MoF that full implementation of the approaches sug-gested by the RF MoF may result in underfunding of schools, hospitals, and other infrastructure in a majority of local jurisdictions in Bashkortostan. Th is explains the regional governments’ reluctance to fol-low the federal recommendations.

Both approaches (the current one and that recom-mended by the RF MoF) have advantages and disad-vantages. Nonetheless, the second approach is more favorable. Th e best path of development seems to be an evolutionary transition from the fi rst approach to the second. It seems reasonable that a new model of intergovernmental relations in Bashkortostan satisfy the following requirements:

• Financial support has to be allocated among locali-ties on the basis of a formula, which should imme-diately create good budget incentives. However, the allocation should not result in underfunding of organizations that deliver budget services.

• Th is formula should gradually transform into an-other formula described in the recommendations of the RF MoF.

• Under the new conditions local and republican authorities need recommendations on how to reorganize the work and fi nancing of their infra-structures (schools, hospitals, etc.). For example, one recommendation might be that LGs reach an agreement among themselves on joint fi nancing of schools and hospitals on their territories; with LGs able to provide services for their neighbors.

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to solve this problem Russia needs to clarify the distribution of powers according to the subsidiary principle. Only then will an eff ective equalization procedure be possible. Further, federal legislation provides for the separation of expenditure respon-sibilities, but not for the separation of functions and tasks for the delivery of public services. For example, Article 87 of the 2000 Budget Code as-signs to LGs the construction and maintenance of public health institutions but not the delivery of public health services. As a result, local gov-ernments do not have incentives to improve the delivery of public services and goods. Th e other consequence is the eruption of confl icts between local and upper level governments as to which government must bear the expenses for a certain expenditure need. Th us, federal legislation, in particular the Budget Code and Tax Code, could be developed in the direction of the distinct sepa-ration of federal, regional, and local functions in the provision of public services. It is also necessary to avoid contradictions and ambiguity in the as-signment of expenditure responsibilities. Th is can be achieved on the basis of the conclusions of the RF Presidential Commission on the development of suggestions for delimitation of responsibilities among federal, regional, and local governments.

However, some changes in responsibility assign-ments are obvious. Road construction and main-tenance should be vested to the appropriate level of government depending on the location and primary purpose of the road in question: federal roads should be federal responsibility; regional roads should be regional responsibility; and local roads should be local responsibility. And, obvi-ously, they should be formulated as functions.

Fire protection should not be the subject of joint responsibilities and should remain exclusively a local responsibility. If sub-regional government has insuffi cient funds for road maintenance or for fi re protection, this problem then needs to be solved within the framework of horizontal equali-zation policy.

2) Today, subjects of the federation do not have their own laws on the assignment of functions and re-sponsibilities, which prevents local governments from forecasting their own revenues and from pursuing their own fi nancial policy. For their part,

regional legislators cannot elaborate such regional law in view of the fact that the main tax proceeds, which the regional government allocates to LGs, are federal taxes and FG regulates the sharing of not only federal taxes, but also some regional and local taxes. Irregularities in tax-sharing between the federal and regional governments cause an-nual fl uctuations in regional and local budget revenues, in view of which regional governments cannot practice a formula-based regional equali-zation policy. Th us, for regional governments to elaborate and adopt regional legislation, which would serve to defi ne the fi nancial base of local governments, the following measures are advis-able:

• Th e Federal Constitution or a constitutional federal law should prescribe that amendments to the Tax Code and the Budget Code may be done only once within a three-year period.

• Before its introduction, a new budget and tax arrangement should be discussed on all governmental levels within the Russian Federation. Th e new tax and budget arrange-ment should then come into force as a single legislative act, for a period of no less than three years.

• To ensure that RGs have time to prepare amendments to regional legislation, approxi-mately one year should elapse from the moment a new amendment is adopted to its enforcement on the federal level.

To improve the federal tax system, it would rea-sonable to:

• Eliminate the practice by which the federal government regulates regional taxes: the base, the rate, and the sharing of regional taxes must be defi ned only by the regional govern-ments.

• Simplify the so-called ceded taxes and the system of sharing federal, regional, and local taxes among three or more levels of the budget system. Th e federal budget obtained 9 percent of its total tax revenues from local taxes, and 3 percent from regional taxes. It is necessary to move in the direction of tax separation: one tax for one government (federal, regional, or local).

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Horizontal Equalization Policy of the Federal Government

1) Th e tax-sharing system continues to cause inter-regional distortions: collection of EPT is based on the location of corporate headquarters, collection of VAT is based on the place of sales, collection of PIT is based on a taxpayer’s place of employment and there is no system for the redistribution of these taxes according to the economic activity of regions. It is necessary to elaborate and to intro-duce a formula-based mechanism of redistribution for at least some part of VAT and EPT proceeds, among the subjects of the federation according to their economic contribution. Indicators such as the number of employed, productivity, and so on, could be used. Such redistribution would cer-tainly provide incentives to the regions to develop their economies, but may lead to considerable in-terregional distortions in their own revenues. Th is negative consequence can be off set with equaliza-tion transfers from the FFSR.

Such redistribution is especially signifi cant in view of the fact that VAT proceeds have been assigned to the federal budget since 2001. Th e federal center promised to redistribute an addi-tional 15 percent of VAT revenues through the FFSR. FG planned to collect 516 billion rubles in VAT in 2001, and 15 percent of this (77 billion rubles) was to be additional federal income that, according to the arrangement of 2000, would go to subnational governments. However, the FFSR was 57 billion rubles in 2000 and grew to only 100 billion rubles in 2001—instead of the planned 134 billion rubles. Th is is evidence that the “centralization of revenues for equalization”

actually leads to increased federal expenditures for other goals and to an undermining of RG incentives. It would be reasonable to redistribute the additional federal VAT revenues (15 percent) among the regions in proportion with the GRP of each region. Th e FFSR must be formed from revenue sources that were used until 2000 as a percentage of the total tax collection. Figure 3.22 shows the results of a simulation. In the fi gure, a part of the funds has been extracted from the FFSR for 2001, amounting to revenue of as much as 77 billion rubles, and was redistributed as the

additional VAT revenue among the regions in proportion to GRP. In this case, only the three wealthiest regions would not receive these funds.

Th e other part, 23 billion rubles, was allocated according to the 2001 methodology. Th is meth-odology does not show a signifi cant diff erence in results from those for 2000, but does have the ad-vantage of intensifying incentives for RGs. Th us, in the simulation only 13 regions are equalized up to the minimal level in 2001, whereas the actual number of equalized regions was 38 in 2001 and 31 in 2000 (the minimal levels in Figure 3.16 and Figure 3.22 are approximately the same).

2) Over the last two years (2001–2002) the method-ology for the computation of horizontal transfers has stabilized, due largely to the implementation of well-known recommendations in the fi eld of equalization:

• For estimation of fi scal capacity modifi ed GRP is used, which takes into account the specifi cs of regional economies. Th ese data are corrected by the index of budget expen-ditures that refl ects the expenditure needs of the region. Computation of this index is based on indicators of needs such as the share of population that is unemployed, elderly, disabled, and the like. However, the formu-las used in the 2001–2002 methodology are more sophisticated than that of the 2000 methodology, with the obvious disadvantage of being absolutely incomprehensible without deeper analysis. Th ey can be represented in a simplifi ed and more understandable form.

• Among the indicators employed there are some glaring absences, such as indicators of needs for higher education and some other needs that are funded directly by the federal government. Th is arrangement then preserves interregional diff erences in the delivery and consumption of certain public goods.

• Th e allocation of transfers serves to create incentives for regions with a low level of own revenues to develop their economies. Th us, 80 percent of the FFSR funding consists of transfers that are computed in proportion to the gap between normalized own revenues and the average level of revenues. And only 20

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percent of that funding can be recognized as transfers that raise up to some minimal level the total revenues of those regions with low-est own revenues. However, incentives in the transfer allocation system prove not to be very great—about 40 percent of all regions receive transfers from the second part of the FFSR, but gain only a minimal level of revenues.

Th us, the remaining 60 percent of regions have incentives to develop their economies and tax collection systems. A better solution would be to choose the number of regions which must have incentives and then to dis-burse the FFSR into two parts. For example, if 80 percent of regions were to have incen-tives, then 14 percent of the FFSR should be allocated in 2001 to raise up to some minimal level the total revenues of those regions with the lowest own revenues.

Figure 3.22

Simulation of Fiscal Equalization in 2001: With Additional VAT Revenues of the Federal Government Allocated in Proportion to GRP

Source: Author’s simulation on RF MoF data.

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 Per capita tax revenues

[USD]

Regions 0

100 200 300 400 500 600 700 800 900 1,000

Per capita own revenues After allocation of transfer 1 After allocation of transfer 2

• Th e size of the FFSR varies with every com-ing year which makes it an unpredictable funding source for regional governments.

Improvement to the system could be had if the funding rate were to be fi xed legislatively for a period of several years and further altera-tions could only be justifi ed in the case of a stipulated emergency.

• Since its introduction in 1994 the FFSR has served diff erent targets. Th e FFC, designed in 2001, released the FFSR from seven of these specially targeted needs. However, the 2002 FFSR continues to consist of subsidies for a few special needs, which together comprise about 10 percent of the fund. It is necessary to separate out tied grants from the FFSR, leaving it only one function—the allocation of equalization transfers.

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