Despite significant political changes in the 1990s, the former Yugoslav Republic of Macedonia (FYR Macedonia) remained a largely centralized country. The 1991 constitution (enacted following independence from the former Socialist Federal Republic of Yugoslavia) defined municipalities as the basic unit of local government (abandoning the old communal system). The constitution also established the general principles of organization, functions, and financing of local governments. The details were subsequently elaborated in the Law of Local Self-Government (LLSG) enacted in 1995. The territorial organization was redefined in 1996, significantly increasing the number of subnational governments (from 34 administrative districts, communes, or counties to 123 municipalities and the city of Skopje). Despite these steps, the degree of decentralization remained lower than under the previous socialist constitution, with a vertically structured public sector highly concentrated at the central government level; accordingly, municipalities accounted for about 5 percent of general government spending during the 1990s.
Pressures for a higher degree of decentralization grew in the late 1990s and precipitated substantial changes. The Ohrid Framework Agreement was signed in August 2001 to provide political and institutional solutions to the ethnic Albanians’ armed rebellion and to address the perceived deprivation of the Albanian minority (about one-fourth of the population of 2 million) since the establishment of sovereign FYR Macedonia a decade earlier. As a result of the Ohrid Framework Agreement, the constitution was amended in November 2001, defining a new democratic order based on the principle of multiethnicity. Although the form of government remained unitary, a higher degree of decentralization was envisaged.
FYR Macedonia: Indicators of Fiscal Decentralization
FYR Macedonia: Indicators of Fiscal Decentralization
| Type of government | Unitary | |
| Population (million, 2007) | 2.0 | |
| Area (million km2) | 25.4 | |
| Levels of government | 2 | |
| Municipalities | 84 | |
| Average municipality size (population) | 24,245 | |
| Minimum municipality size (population) | 1,331 | |
| IMF technical assistance missions on | 2002, 2004 | |
| fiscal decentralization | ||
FYR Macedonia: Indicators of Fiscal Decentralization
| Type of government | Unitary | |
| Population (million, 2007) | 2.0 | |
| Area (million km2) | 25.4 | |
| Levels of government | 2 | |
| Municipalities | 84 | |
| Average municipality size (population) | 24,245 | |
| Minimum municipality size (population) | 1,331 | |
| IMF technical assistance missions on | 2002, 2004 | |
| fiscal decentralization | ||
A new LLSG, passed in January 2002, provided a basic framework for fiscal decentralization. This core framework was supported by a new territorial organization approved in August 2004, which reduced the number of subnational governments from 124 to 84 municipalities plus the city of Skopje (partitioned into 10 additional municipalities);2 and by the Law of Financing of Local Self-Governments (LFLSG) enacted in September 2004, which regulated the sources of financing of municipalities and established the gradual implementation of the decentralization process.
IMF Advice on Fiscal Decentralization
IMF staff have provided significant technical assistance on fiscal decentralization and local government finance in Macedonia. Two missions took place in March 2002 and September 2003; some of the recommendations of these missions were echoed in the 2006 Report on the Observance of Standards and Codes on Fiscal Transparency (IMF, 2006), particularly regarding the appropriate sequencing and alignment of expenditure devolution in line with strengthened monitoring of local finances and improved capacity at the local level.
The focus of the 2002 mission was to develop a general strategy to devolve revenue and expenditure functions to local governments. This strategy was to be based on certain premises: First, a new territorial structure with a significant reduction in the number of municipalities was to be in place before decentralization.3 Second, fiscal decentralization was to be neutral with respect to total general government spending. Finally, the division of responsibilities and revenues between the central and municipal governments was to be made transparent and to be fully costed.
The basic philosophy was to adopt a phased approach to decentralization, with the devolution of powers to be implemented in stages. In each phase, specific expenditure responsibilities in specific sectors were to be devolved to the municipalities along with adequate financial resources.
Four general phases were recommended, covering the reorganization of expenditure responsibilities, financing, and structural reform needs arising in the context of fiscal decentralization. Phase Zero would start immediately, based on some restructuring and aligning of institutional incentives. In Phase I, physical assets (e.g., buildings owned by the central government) would be handed over to the municipalities to manage. In Phase II, municipalities would assume larger responsibilities for personnel and staffing decisions in specific sectors, with the central government retaining control of the overall expenditure envelope (e.g., salary levels, number of positions). In Phase III, certain expenditure functions with major outlays or national policy implications would be devolved, at least partially (e.g., the wage bill). Box 11.1 summarizes the main elements of each recommended phase.
The four phases were to be supported by institutional strengthening at all levels of government, and significant capacity-building initiatives at the municipal level. The mission recommended that a Fiscal Responsibility Law and an Internal Stability Pact (applicable to all levels of government) would provide a comprehensive framework for good fiscal management. In addition, the institutional framework was to be supported by municipal capacity building to improve public expenditure management. Other key elements included strengthening municipal budget procedures, fiscal reporting, and internal and external auditing; and introducing and enforcing legal penalty provisions for noncompliance.
The proposed explicit phasing of decentralization allowed explicit criteria to be established for advancing from one phase to the next. The mission recommended the adoption of performance contracts with conditionality, to be negotiated between the central government and municipalities as a group. The purpose was to provide a carrot-and-stick approach that would safeguard macroeconomic sustainability while setting out concrete steps for advancing with fiscal decentralization.
Based on this framework, the 2003 staff mission focused on the definition of triggers to proceed from one phase to the next. All municipalities were to implement the Phase I simultaneously. Further advances would be made on the basis of performance contracts, allowing asymmetries in the decentralization process. Progressing in this manner would allow controlled advancement of fiscal decentralization, thus ensuring maintenance of macroeconomic sustainability, a precondition for the ultimate success of the process. These contracts would be geared toward implementing the necessary administrative reforms and capacity building at the local level, before proceeding with fiscal decentralization.
Staff advice, although not fully taken, contributed significantly to guiding policy discussions and mapping policy options. The territorial reorganization of the municipal sector was successfully completed, and the LLSGF is firmly based on the concept of the phased approach recommended by staff. More specifically, the LLGF envisages a gradual devolution of responsibilities and resources, based upon specific triggers related to institutional capacity building and fiscal performance. Finally, while the option of performance contracts was not taken up, the law emphasizes the monitoring of performance, mainly through quarterly financial reports that municipalities submit to the Ministry of Finance.
Phased Implementation of Fiscal Decentralization in FYR Macedonia
The following are the main elements of the four phases recommended by the IMF technical assistance in 2002.
Phase Zero
During Phase Zero, municipalities would assume some minor additional administrative tasks (issuing building permits, managing zoning regulations) with virtually no financial implications. Still, this phase would addresses three main problems on the revenue side: (1) municipal revenues were capped and revenues in excess of the cap were subsequently reallocated using not fully transparent redistribution criteria; (2) there was no mechanism for local taxpayers to express their willingness to pay for higher levels of municipal services; and (3) municipal tax bases were volatile (including taxes on property transactions and inheritance). To address these problems, the mission recommended revenue-neutral changes in horizontal tax-sharing arrangements, aimed at strengthening the ability and interest of municipalities to exploit their existing tax bases:
Increase municipal tax collections by giving municipalities more control over the rates of municipal taxes (within a range); removing the caps on municipal tax revenues; and allowing municipalities to keep all property taxes (and part of the property transactions tax) collected in their territories.
Introduce a new equalization program based on clearly defined allocation rules to support municipalities with weak tax bases.
Phases I and II
Municipalities would assume additional expenditure responsibilities, initially related to the transfer of central-government assets and related maintenance costs, to be followed by the transfer of decision-making powers (such as hiring and firing of teachers). Control over the financial envelope (teacher salaries, number of positions) would remain at the center. The transfer of functions would require some vertical rebalancing to avoid financing gaps, notwithstanding higher municipal own-revenues secured in Phase Zero. In this respect, the main recommendations included
introducing additional horizontal equalization, and
addressing rebalancing needs by introducing limited central government—municipal revenue-sharing.
This should be done using a transparent and formula-based allocation mechanism, possibly based on the value-added tax.
Phase III
The last phase would be based on the decentralization of major expenditure functions. Decentralizing such functions would only be feasible in the longer term because it would require more-elaborate indirect control mechanisms (e.g., control of minimum standards through performance audits). Larger amounts of funds would need to be transferred in line with specific program-funding needs, using a mixture of additional revenue-sharing and specific-purpose grants, whose allocation criteria would be tailored to the program or responsibility being transferred. The specific strategies to be adopted, and their timing, would vary by sector (such as education, health, and social welfare).
Current Intergovernmental Fiscal Arrangements
The 2004 territorial reorganization significantly increased the average number of residents per municipality. Even more important, it reduced the proportion of municipalities with fewer than 5,000 residents (the minimum efficient scale) to 20 percent from 40 percent. However, population density ranges widely: some municipalities have slightly more than 1,000 residents, while others have more than 100,000.
The degree of fiscal decentralization has been increasing since 2005. Since the first phase of the decentralization process started in June 2005, the share of municipalities’ spending gradually increased and reached about 13 percent in 2008 (Table 11.2).4
FYR Macedonia: Summary of Subnational Governments’ Finances, 2008
Includes personal income taxes and value-added tax sharing.
FYR Macedonia: Summary of Subnational Governments’ Finances, 2008
| Percentage of GDP | ||
|---|---|---|
| Total subnational revenue | 2.5 | |
| Own-source revenue | 1.5 | |
| Transfers from the central government1 | 1.0 | |
| Total subnational expenditure | 2.4 | |
| Overall balance (before transfers) | -0.9 | |
| Overall balance | 0.1 | |
Includes personal income taxes and value-added tax sharing.
FYR Macedonia: Summary of Subnational Governments’ Finances, 2008
| Percentage of GDP | ||
|---|---|---|
| Total subnational revenue | 2.5 | |
| Own-source revenue | 1.5 | |
| Transfers from the central government1 | 1.0 | |
| Total subnational expenditure | 2.4 | |
| Overall balance (before transfers) | -0.9 | |
| Overall balance | 0.1 | |
Includes personal income taxes and value-added tax sharing.
The LLSG enacted in 2002 describes the assignment of competencies to municipal governments. Article 22 of the LLSG allocates shared or concurrent responsibilities for specific services (urban and rural planning, environmental protection, local economic development, communal activities, culture, sports and recreation, education, social welfare, health care, firefighting, and protection and rescuing activities in the event of natural disaster or war). Still, the LLSG leaves it up to subsequent legislation to determine the exact role of municipalities for each service.
According to the LFLSG, municipalities have several own-revenue sources. Article 4 of the LFLSG makes reference to eight different sources: local taxes, local fees, local charges, revenues from ownership, donations, fines, self-contributions, and others. Own-source revenues account for about 4 percent of general government revenues, slightly increasing their share since 2005. The most significant sources are property taxes, communal fees for use of public space, and construction permit fees.
Municipalities’ own-source revenues are complemented with shared taxes, collected by the central government. Municipalities receive 3 percent of the personal income taxes (PIT) on the salaries of natural persons in the municipalities in which they are declared to live (100 percent of the PIT of natural persons performing craft activities registered in the territory of a municipality). They also receive 3 percent of the value-added tax revenues collected in the previous fiscal year according to a distribution formula based on population (60 percent weight), surface area (27 percent), and number of settlements within a municipality (13 percent).
Municipalities also receive earmarked transfers. The amounts of these transfers—for education, culture, and social welfare—are determined in decrees prepared by the line ministries and adopted by the central government, mainly based on historical costs. Capital grants based on programs defined by the central government are used for financing investment projects. When municipalities graduate to the second phase of the decentralization process, the earmarked transfers are to be converted into block grants, granting municipalities more spending discretion.
The LFLSG allows municipalities to borrow long term for investment and short term for cash-flow management. However, limitations apply to the outstanding debt stock and debt service for long-term borrowing, as well as to the amounts to be borrowed on a short-term basis. Other safeguards require that borrowing be in local currency, from the domestic capital market, and according to a stable or declining annual repayment schedule. Foreign borrowing by municipalities requires not only a decision by the Municipality Council, but also a separate law by parliament, further increasing control and transparency.5
Remaining Challenges
The assignment of expenditure responsibilities at the central and local levels remains unclear, which is a key challenge that must be addressed to ensure political accountability. One main reason for the lack of clarity in expenditure assignments is that the current delineation of competencies was not preceded nor informed by the development of comprehensive policy frameworks in the sectoral areas to be decentralized. For instance, the legislation should clearly specify who is in charge of hiring and firing teachers and administrative staff, determining the pay scale and the equipment needs, and choosing the overall number of positions in each school. Absent such clarity, public services risk being underprovisioned, especially in a tight budgetary environment; or, at the opposite end of the spectrum, overlaps, duplication, and wasteful spending might take place.
The system lacks an objective, transparent method for arriving at the expenditure needs associated with the assigned expenditure responsibilities. This should be the next step after establishing a clear allocation of spending responsibilities. Otherwise, funding may be inadequate relative to the assigned responsibilities; for example, municipalities with the same expenditure responsibilities may have different expenditure needs depending on the size and age profiles of their populations.
Own-sources of revenues of municipalities remain below potential and insufficient to finance municipal spending. Property taxes have a very low yield (around 0.05 percent of GDP, about 10 percent of the average yield obtained in developing and transition economies). In principle, municipalities have been fully in charge of collecting property taxes since 2005; however, transfer of this responsibility from the central government Public Revenue Office has not proceeded as planned as a result of institutional problems.
The system of unconditional transfers does not provide adequate equalization. Revenues from PIT are very low, which, coupled with a 3 percent sharing rate, makes vertical imbalances difficult to correct. The criteria for the allocation of funds from the value-added tax revenue transfer only approximately reflect expenditure needs. Refinements to the formula, especially including criteria that better capture differences in the ability to provide given standards of public services, could be considered, along with possible criteria for assessing revenue-raising capacity.
The system of earmarked transfers is based on inadequate criteria, and distribution remains uneven. In many cases, earmarked transfers are based on historical patterns; in addition, basing these transfers on the existing physical facilities automatically penalizes municipalities (poorer rural municipalities) in which these facilities do not exist.
Overall, although the phased decentralization approach is appropriate, additional steps are crucial for decentralization to fulfill its promise of improved service efficiency. The process will need to continue to be carefully managed. A gradual approach in assigning responsibilities and related financing will enable the new system of financial flows to be tested and adjusted as needed. However, additional transfer of management responsibilities to municipalities or allocation of block grants on a meaningful formula basis will require significant preparatory work by ministries and municipalities.
This case study is based on Schwartz and others (2002); Clements and others (2004); and Feruglio, Martinez-Vazquez, and Timofeev (2007).
Municipal boundaries were redrawn to reflect local preferences of association. Municipal elections were held in March 2005.
At the time of the first mission, the 123 municipalities displayed large variability in population size (from 500 to 120,000 inhabitants); 51 of them had fewer than 5,000 inhabitants. It was felt that many were not viable economic entities.
The second phase of the decentralization process started in October 2007; 68 municipalities had qualified for the second phase by December 2008.
Municipal borrowing is allowed only after municipalities report continuously to the Ministry of Finance on their financial position and are free of arrears (both conditions applying for a period of 24 months).