Fiscal decentralization in Kosovo has been, and remains, a political priority. Inspired by the Comprehensive Settlement Proposal (CSP),2 a significant body of legislation was enacted in 2008 to grant municipalities wide-ranging autonomy on a number of issues, while allowing Serb-majority municipalities a high degree of control over their own affairs through asymmetric arrangements. In addition to the constitution (which defines municipalities as the basic territorial unit of local self-governance in Kosovo), relevant legislation includes the Law on Local Self-Government, the Law on Local Government Finance (LLGF), amendments to the Law on Public Financial Management and Accountability, the Law on Administrative Municipal Boundaries, and amendments to the Law on Health and the Law on Education (Box 9.1).
Also politically motivated, the territorial reorganization of municipalities has proceeded quickly. As of end-2009, there were 36 municipalities, with two additional possibly coming on stream in the future.3 Municipal elections for municipal assemblies and mayors were held in the 36 municipalities in November 2009, but were boycotted in three of the existing Kosovo-Serb-majority municipalities in the north of Kosovo.
The move toward greater decentralization has coincided with increasing macrofiscal pressures.
Growth stagnated in 2009, and fiscal imbalances grew. After recording a surplus in 2007 amounting to 7 percent of GDP, the general government budget posted a deficit of almost 2 percent of GDP in 2009.4 The deterioration in the general government balance was mainly caused by rapidly escalating capital expenditures, which increased from 3 percent of GDP in 2007 to 9.2 percent of GDP in 2009, partly financed by a drawdown in the stock of government bank deposits. In this respect, Kosovo appears to be an outlier compared with other countries in the region, where the level of capital spending is on average 5.5 percent of GDP.
Increased financing to municipalities has led to a sharp increase in their spending at a time when serious fiscal pressures have emerged. Because municipalities cannot borrow, they need to balance their budgets. However, during 2007–09 municipal expenditures rose by almost 2 percent of GDP, to above 5 percent of GDP (Table 9.2), reflecting an increase of over 50 percent in central transfers resulting from a change in the grant formula mandated in the 2008 Law on Local Government Financing. A fiscal rule limits the annual growth of current spending for municipalities and other budget organizations, so additional funding has been channeled toward capital projects; these pressures were likely compounded by the political cycle in 2009. Thus, decentralization is creating tension between the need to ensure fiscal discipline and the demands for greater autonomy of subnational governments.
Kosovo: Indicators of Fiscal Decentralization
Kosovo: Indicators of Fiscal Decentralization
| Type of government | Unitary | |
| Population (million, 2007) | 2.2 | |
| Area (thousand km2) | 10.9 | |
| Levels of government | 2 | |
| States or provinces | None | |
| Municipalities | 33 | |
| Average municipality size (population) | 67,758 | |
| Minimum municipality size (population) | 5,000 | |
| IMF technical assistance missions on | 2007, 2010 | |
| fiscal decentralization | ||
Kosovo: Indicators of Fiscal Decentralization
| Type of government | Unitary | |
| Population (million, 2007) | 2.2 | |
| Area (thousand km2) | 10.9 | |
| Levels of government | 2 | |
| States or provinces | None | |
| Municipalities | 33 | |
| Average municipality size (population) | 67,758 | |
| Minimum municipality size (population) | 5,000 | |
| IMF technical assistance missions on | 2007, 2010 | |
| fiscal decentralization | ||
Kosovo: Summary of Subnational Governments’ Finances, 2008
Primary expenditures only (Kosovo and Serbia have not finalized an agreement on the allocation of debts of the former Yugoslavia).
Kosovo: Summary of Subnational Governments’ Finances, 2008
| Percentage of general government |
Percentage of GDP |
|||
|---|---|---|---|---|
| Total subnational revenue | 22.6 | 6.7 | ||
| Own-source revenue | 3.7 | 1.1 | ||
| Transfers from the central government | 18.9 | 5.6 | ||
| General grant | 7.4 | 2.2 | ||
| Health grant | 2.2 | 0.7 | ||
| Education grant | 9.3 | 2.8 | ||
| Total subnational expenditure1 | 21.8 | 6.8 | ||
| Wages and salaries | 10.8 | 3.4 | ||
| Goods and services | 2.1 | 0.7 | ||
| Subsidies and transfers | 0.5 | 0.2 | ||
| Capital | 7.7 | 2.4 | ||
| Overall balance (before transfers) | n.a. | -5.7 | ||
| Overall primary balance1 | n.a. | -0.2 | ||
Primary expenditures only (Kosovo and Serbia have not finalized an agreement on the allocation of debts of the former Yugoslavia).
Kosovo: Summary of Subnational Governments’ Finances, 2008
| Percentage of general government |
Percentage of GDP |
|||
|---|---|---|---|---|
| Total subnational revenue | 22.6 | 6.7 | ||
| Own-source revenue | 3.7 | 1.1 | ||
| Transfers from the central government | 18.9 | 5.6 | ||
| General grant | 7.4 | 2.2 | ||
| Health grant | 2.2 | 0.7 | ||
| Education grant | 9.3 | 2.8 | ||
| Total subnational expenditure1 | 21.8 | 6.8 | ||
| Wages and salaries | 10.8 | 3.4 | ||
| Goods and services | 2.1 | 0.7 | ||
| Subsidies and transfers | 0.5 | 0.2 | ||
| Capital | 7.7 | 2.4 | ||
| Overall balance (before transfers) | n.a. | -5.7 | ||
| Overall primary balance1 | n.a. | -0.2 | ||
Primary expenditures only (Kosovo and Serbia have not finalized an agreement on the allocation of debts of the former Yugoslavia).
Fiscal decentralization will need to be balanced against the need to restore medium-term fiscal sustainability. Further reforms in the system of intergovernmental fiscal relations can actually provide an opportunity to make all government levels—the center and the municipalities—more fiscally responsible while more-efficiently promoting growth and development. Further reforms can also prevent the burden of needed future adjustments from falling disproportionally on the central government.
Technical assistance on fiscal decentralization was provided by the IMF in the run-up to Kosovo’s unilateral declaration of independence in early 2008, and again in early 2010. An initial staff visit in the summer of 2007 took stock of the current challenges and provided advice on the overall framework for decentralization. This visit was followed by a full-fledged technical assistance mission in the fall of 2007. Partly emanating from the work of that mission and its recommendations, a short-term expert visited Kosovo in early 2008 to help draft the law on municipal finance. A number of actively involved international agencies, most notably the World Bank, the European Union, and U.S. Agency for International Development, have collaborated closely with the IMF on these issues. A second IMF mission in early 2010 took stock of progress on decentralization, and provided advice on future reforms.
Overall Framework of the IMF’s Advice
Addressing Spending Pressures
The transfer and assignment of new competencies to municipalities, as defined in the Law on Local Self-Government, proceeded rapidly. In early 2010, only a few own-competencies remained to be transferred, although progress remained to be made on “delegated” competencies.5 The transfer of “enhanced” competencies to the Serbian-majority municipalities—in particular, higher education and secondary health care—will proceed once political impediments are resolved. Although it is too early for a comprehensive assessment of the uptake of responsibilities by municipalities, it would nonetheless seem that in some cases the assignment of new responsibilities has proceeded too fast, without (1) due consideration for the public financial management capacity of municipalities, (2) an assessment of the need for qualified staff (a need that clashes with the existing hiring freeze), and (3) an accurate evaluation of the cost of the new functions.
With the expansion of municipal competencies, a fundamental tension is emerging. On the one hand, municipalities perceive that the central government is interfering excessively in areas where the Law on Local Self-Government assigns them clear and exclusive responsibilities. For example, budget allocations to central ministries for financing or cofinancing of projects in the area of municipal competencies, such as the construction of some schools, is a case in point. On the other hand, the central government feels cornered when municipalities demand additional funding for “new” competencies transferred to them, which is leading to a proliferation of ad hoc specific grants. While this could be justified as a short-term solution—as a way to mitigate the risk that municipalities may neglect (or outright refuse) to execute the transferred functions—ultimately, the costs of these functions should be assessed and folded into the grant formula when the formula is reviewed.
The Comprehensive Settlement Proposal and Kosovo’s Legislation on Municipalities
The principles set out in the CSP on municipal roles and responsibilities have been mapped in a significant body of legislation enacted during 2008.
Municipal competencies (Law on Local Self-Government)
All municipalities will have responsibility for areas affecting the daily life of Kosovo citizens, including education at the preprimary, primary, and secondary levels; public primary health care; local economic development; urban and rural planning; public housing; naming of roads, streets, and other public places; and the provision of public services and utilities, among others.
In addition, designated Kosovo Serb municipalities will have the following enhanced responsibilities: -The Municipalities of Mitrovicë/Mitrovica—North, Graçanicë/Gracanica, and Shtërpcë/Štrpce will have authority over hospitals and the provision of secondary health care in their municipalities.
-The Municipality of Mitrovicë/Mitrovica—North will have certain responsibilities with regard to the Serbian language university of Mitrovicë/Mitrovica.
-All Kosovo Serb municipalities will be responsible for the protection and promotion of cultural and religious affairs at the local level.
-All Serb municipalities will have an enhanced role in appointing local Police Station Commanders.
Municipal finances (Law on Local Government Finance)
All municipalities will be responsible for their own budgets and are entitled to their own financial resources.
A fair and transparent block grant system will be established, ensuring greater municipal autonomy in the allocation and expenditure of central funds.
The establishment of new municipalities (Law on Administrative Municipal Boundaries)
The CSP establishes six new or enhanced municipalities with Kosovo Serb majorities: Mitrovicë/Mitrovica—North; Graçanicë/Gracanica; Ranillug/Ranilug; Partesh/Parteš; Kllokot/Vërboc-Klokott/Vrbovac; and Novobërdë/Novo Brdo.
The current municipality of Mitrovicë/Mitrovica will be split into the two municipalities of Mitrovicë/Mitrovica—North and Mitrovicë/Mitrovica—South, with cooperation and coordination between them facilitated through a newly established Joint Board.
Additional municipalities for nonmajority communities may be established in consultation with the respective communities.
The CSP provisions related to the establishment of new municipalities may be reviewed and revised as necessary by the International Civilian Representative after a census is conducted.
Intermunicipal and cross-border cooperation (Law on Local Self-Government)
Municipalities will have the right to form associations and partnerships with other municipalities in Kosovo to carry out functions of mutual interest.
Municipalities will have the right to cooperate with municipalities and institutions in Serbia, including the right to receive financial and technical assistance, within certain clear parameters set by the CSP.
The tension between central control and fiscal decentralization is most evident in the limit on municipal staff ceilings. A hiring freeze, applied to all government ministries and agencies, has been in place since 2006 to stem the growth in government spending. Municipalities seem to have broadly respected these ceilings, with overall employment levels averaging around 41,000. Although anecdotal evidence suggests that some municipalities have used the goods and services budget to hire extra staff, this does not seem to be a systemic issue. However, staff ceilings have not restrained wage spending—the central government’s decision to increase wages has resulted in increases in municipalities’ wage bills (because municipalities pay for the salaries of teachers and health personnel). In the future, these ceilings could prove to be downwardly rigid. Staff levels are inefficiently locked in by the backward-looking nature of the related ceilings, and municipalities are hampered in their efforts to attract new skills to carry out new competencies.
The new civil service legislation, to be implemented in 2011, will provide the appropriate framework to remove staff ceilings and address wage issues. A new single pay and grading structure for the civil service will allow rationalization of the status of current employees. Cost implications for the municipalities will arise from the elimination of current pay differences between staff employed in equivalent positions, temporary compensation for staff whose base salary would decline as a result of the grading reform, and salary decompression to increase the pay differentials among positions of different grades. Hiring of additional staff and salary increases should await implementation of the new civil service legislation.6
Strengthening Own-Source Revenues and Incentives to Raise Them
There is scope to strengthen municipal own-source revenue, particularly property taxes. Property tax collections are low (equivalent to less than 0.3 percent of GDP in 2009) reflecting both policy and administrative shortcomings. In 2009, the average municipal property tax collection rate was just 75 percent. However, a minority of municipalities achieved a 100 percent collection rate, while others had rates well below 50 percent. Individual municipalities have full discretion in determining the level of the tax, but rates tend to be at the lower end of the permissible range. Market valuations are also difficult to determine because of the limited number of property sales and insufficient zoning methods. IMF advice focused on the need to strengthen cadastral records, progressively increase property tax rates, and strengthen procedures to settle tax arrears.
Other municipal revenue handles could be more fully used. For example, motor vehicle registration charges could be increased and indexed to inflation. The administration of construction permits could be improved, especially given that Kosovo has been enjoying a construction boom. Most important, allowing more flexibility in the use of own-source revenue would provide the strongest incentive to boost collections.
Keeping the Transfer System Simple and Transparent
The current grant system, as defined in the 2008 LLGF, has a number of desirable features. It is simple, being composed of a closed-end general grant (defined as a 10 percent share of revenue) and two open-ended earmarked grants for health and education, allocated according to specific parameters.7 Given that population is the main parameter, grants provide significant equalization. Funding to municipalities through the grant system increased significantly in 2009—the first year of implementation—by 1.4 percent of GDP. The three grants accounted for one-fourth of central government revenue in 2009.8
Increased funding has generally preceded the actual transfer and assignment of municipal competencies established in the law. The spirit of the LLGF is that the general grant should cover municipal own-competencies; however, because the pool for the general grant was defined and assigned before the actual transfer of all municipal competencies, the central government is expected to continue to grant additional funds as the process of transferring competencies is completed. Indeed, the 2010 budget includes some specific grants. Although the amounts are small, this practice is setting a risky precedent:
It creates a perception of a soft budget constraint, suggesting that every additional transfer of competency will be matched by an additional specific grant—thus creating expectations that current grant design is not sufficient to carry out mandates and weakening incentives to prioritize policies within a binding resource envelope.
It puts upward pressures on overall spending. Ideally, for each competency transferred to municipalities, the relevant central ministry should be subject to a commensurate reduction in its budget allocation (not one for one, because some supervisory and administrative functions would need to be retained at the center). The 2010 budget contained no such reductions at the center.
It undermines the integrity of the grant system. Adding specific discretionary grants, varying in nature and size every year, would only erode the simplicity and transparency of Kosovo’s grant system.
It weakens incentives to raise own-source revenue. If specific grants are conceded every time municipalities need to undertake additional spending, own-source revenues will no longer be urgent.
While municipalities demand additional funds for additional functions, the central government appears in some cases to be passing down unfunded mandates. In 2009, after the amounts for the health and education grants had been determined, the central government decided to have municipalities partially absorb the cost of teachers’ salary increases through the general grant. Similarly, municipalities were asked over the course of the year to shoulder the cost of bonuses for health workers—which were genuinely additional costs that were not taken into consideration in the mid-year budget review. These central government decisions effectively reversed the unconditional character of the general grant guaranteed in the LLGF (since municipalities had to fund additional spending requests mandated by the central government).9
The lack of updated population data hampers the application of the grant system. Grants are largely based on per capita allocations, leading municipalities to resent the lack of updated records (the population census is scheduled for 2011).10 When census data become available, significant, abrupt changes in grants entitlements should be avoided. A hold-harmless provision should be included, ensuring that each municipality is provided at least the same nominal level of transfers as in the year preceding the reform.
The Grants Commission should serve as a vehicle to mediate municipal demands, but in its existing format it does not seem to be fulfilling its responsibilities. Its operations are not fully transparent (for example, there are no public records of commission deliberations and discussions; its meetings take place too infrequently to represent the “voice” of municipal representatives). IMF advice focused on strengthening the Grants Commission’s role by defining operational procedures for it to function in line with its mandate and by publishing information on its operations and deliberations on its website.
Strengthening Public Financial Management Capacity
Municipalities are seeking to adapt their financial management capacities to the additional responsibilities associated with decentralization, requiring them to shift from the past environment, in which municipalities were treated as deconcentrated units of line ministries. While significant progress in planning, execution, and control of municipal budgets has been achieved in recent years, further improvements in public financial management are needed.
Budget formulation needs to be strengthened. Municipalities should be allowed greater input in the formulation of the Medium-Term Expenditure Framework. Municipal accounting could also be strengthened by promoting common use of the installed information management system, and by further development of internal control and audit. The recent decentralization of the payment system shows that with continued efforts and training, municipalities have the capacity to absorb new tasks.
Efforts should also focus on enhancing planning, and monitoring and evaluation of municipal capital projects, given the rapid increase of spending in this area and the continued perceived politicization of project selection. There is scope to increase the transparency of project allocations, both at the central and municipal levels. More-systematic and widespread use of the information technology application designed to manage the Public Investment Program would provide a tool to achieve better prioritization based on objective economic criteria, and would promote accountability through increased availability of information on government projects and better monitoring of those projects.
Remaining Challenges
Pending legislation on public debt will allow municipalities to borrow.11 The new Public Debt Law rightly imposes stringent conditions on the rights of municipalities to borrow and sets a limit on the stock of debt and associated debt service costs.12 It also requires municipalities to receive an unqualified audit opinion from the auditor general for the previous two years. Given the findings of the 2008 municipal audit reports (Pristina was the only municipality to gain such an opinion), this is likely to prove a considerable hurdle for the majority of municipalities in the short term and would suggest that significant borrowing will not take place in the immediate future. The law also imposes a ceiling on issuance of long- and short-term debt, equivalent to 40 percent of collected own-source revenue and general grants from the previous year. Based on the current size of these revenue streams, the impact of borrowing on the fiscal position is likely to be minor, at least initially.
A mechanism setting borrowing limits by municipality will need to be devised, to ensure that municipal borrowing does not exceed aggregate limits. This mechanism may require the imposition of nominal debt ceilings on individual municipalities, based on some equitable share of the overall limit. The Grants Commission could be the most appropriate vehicle to recommend municipal borrowing ceilings, provided its role is strengthened. The commission could also monitor municipal borrowing during the year and suggest amendments to allocations, if needed, at the mid-year budget review. The central government will also need to develop monitoring capacity to ensure that municipal debt is recorded and reported in a timely fashion. Procedures for reporting on new borrowing by municipalities, as envisaged in the Public Debt Law, will need to be established and enforced to ensure timely receipt of information.
The current fiscal rules for municipalities—limiting the growth of real current spending and imposing staff limits—have not proved to be the right policy instruments as decentralization deepens. Real current spending at the municipal level has, in fact, been growing well above the mandated rate of growth, largely reflecting central government decisions regarding salaries; although staff limits—a blunt instrument to limit municipal spending—have been adhered to, they have also created significant distortions (increasing capital spending at the margin, given the limits on current spending) and prevented efficient allocation of resources in line with municipalities’ requirements for a new skill mix. A contradiction is emerging between the spirit of fiscal decentralization—granting municipalities wide-ranging autonomy in a number of areas—and the central government’s focus on enacting controls on specific spending categories. Looking ahead, Kosovo’s dilemma is how to secure fiscal discipline in an increasingly decentralized framework. The 2010 mission recommended starting a policy discussion on designing an appropriate fiscal anchor that ensures responsible fiscal management for all government levels.
Finally, monitoring of municipal (and central) finances will need to be strengthened. As municipalities become more active fiscally, their impact on general government finances needs to be properly assessed. The basis for strong reporting is already present in Kosovo, but needs to be used to help the decision-making process and its implementation in a decentralized framework and to help build accountability and transparency over time.
This case study is based on Fedelino and others (2007); and Olden (2009).
Since the end of the conflict in 1999, various attempts have been made to secure agreement with Serbia. While the “Comprehensive Proposal for the Kosovo Status Settlement” (presented to the United Nations Security Council by Special Envoy Marti Ahtisaari in March 2007) failed to gain consensus and was subsequently withdrawn as a result of a veto threat by the Russian Federation in the summer of 2007, it has remained the linchpin of Kosovo’s political strategy. The Kosovo government unilaterally declared independence in February 2008.
The population density by municipality varies significantly; according to estimates, the largest municipality (the capital Pristina, with an estimated population of at least 400,000) would outnumber the smallest municipality (the Serb-majority Novo Brdo, with a population of 5,000) by a factor of 80.
Excluding a sizable one-of dividend payment from the telecommunications company equivalent to 5 percent of GDP, the underlying increase in the deficit was significantly larger.
The Law on Local Self-Government uses the following definitions (Article 3): “own competencies are competencies vested upon the municipalities by the Constitution or laws for which they are fully responsible insofar as they concern the local interest and in accordance with the law; delegated competencies are competencies of the central government and other central institutions, the execution of which is temporarily assigned by law to municipalities; and enhanced competencies are competencies vested upon a municipality or a number of municipalities by law.”
The 2010 Public Expenditure Review (World Bank, forthcoming) covers these issues in more detail.
Under the previous system, total grants were capped at 22 percent of revenue. This no longer applies for health and education grants; for example, if the number of enrolled students (one of the variables used to compute the education grant) increases, there will be a corresponding increase in the relevant grant.
The design of the grant system was also influenced by earlier IMF technical assistance.
These issues are further explored in Tomcynska (2009) and World Bank (forthcoming).
An annex in the LLGF sets population levels by municipality; these levels are used for the allocation of grants. The levels are based largely on data from the last census, undertaken in 1991.
At the time of writing, the draft Public Debt Law had been approved by the Kosovo Assembly and was awaiting the signature of the president.
The new Public Debt Law limits municipalities’ total stock of debt to 40 percent of the previous year’s own-revenues and general grants from central government, and short-term debt to 5 percent of total collected revenues.