Journal Issue

Intergovernmental Finance: Critical to Russia’s Transformation?

International Monetary Fund. External Relations Dept.
Published Date:
January 1993
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Intergovernmental finance is not a “local matter.” How services and goods are provided by various levels of government and who pays for them have consequences that extend throughout the economy. In transition economies, the design of fiscal federalism is crucial because it affects almost all of the key goals of reform, including macroeconomic stabilization, the effectiveness of the social safety net, private sector development, and, in the case of Russia, nation building.

Russia, like other transition economies, is facing a difficult period of economic and political transition. It is attempting to simultaneously restructure its economic system, protect the well-being of its citizens, stabilize prices, achieve external balance, and establish a system of governance acceptable to 91 regions (oblasts) whose cultural identities, natural resource endowments, and degree of economic development differ widely.

Intergovernmental fiscal reform will play an important role in the success of Russia’s reform effort. Russia’s subnational governments account for almost half of total budgetary outlays, and sound intergovernmental fiscal policies are, therefore, crucial to a successful stabilization effort. Also, with centrifugal tendencies throughout the federation, how revenues are divided among oblasts is crucial for establishing a cohesive federation. The ownership role of subnational governments also makes them crucial as players or as impediments to privatization. Finally, expenditure reform has given subnational governments important new responsibilities for the social safety net. Failure to design an appropriate system of intergovernmental fiscal relations can jeopardize all these goals; conversely, a well designed system can facilitate greatly in achieving them.

This article explores why intergovernmental fiscal relations are so critical to Russia’s national goals. It looks at how traditional public finance theory is challenged by transition economies, and at the implications—for

Russia and other transition economies— of systems that are not well designed.

The right design

An ideal system of intergovernment finances would:

  • ensure correspondence between subnational expenditure responsibilities and overall subnational resources;

  • incorporate incentives for subnational governments to mobilize revenues;

  • ensure that the macroeconomic management policies of the central government are not compromised;

  • give appropriate expenditure discretion to subnational governments, support public infrastructure development, and improve the accountability of government officials;

  • be transparent, based on objective, stable, non-negotiated criteria, as well as administratively simple;

  • be consistent with nationally agreed income distribution goals; and

  • support the emergence of a governmental role consistent with market-oriented reform.

The challenge of transition economies. In transition economies, the first step in designing a good system of intergovernment finance is to delineate the roles of the public and private sectors. During the transition to a market economy, the pervasive role of government must be significantly reduced. In countries as diverse as China and Romania, budgetary outlays as a percent of GDP have been halved over the course of reforms, as the role of government changes from owner, producer, and employer of first resort to provider of goods that cannot, because of externalities, be left to market forces.

Assigning expenditures. What are the respective roles of central and subnational governments? Traditional public finance theory suggests that an “efficient” expenditure assignment between levels of government is based on the geographic dimension of benefits. Ideally, each jurisdiction should provide and fund services whose benefits accrue within its boundaries. Responsibilities for stabilization policy are typically assigned to the central government, as is that of income redistribution (including the social safety net), since labor and capital mobility often interfere with serious attempts by local governments to affect income distribution. Until recently, Russia’s system of intergovernmental finance broadly observed these principles.

Transition economies provide a special challenge, however, because the responsibilities and nature of enterprises and government are changing dramatically. Enterprises that played an important role in providing social assets (e.g., schools, hospitals, housing, urban infrastructure, water and sewerage) must spin off these expenditures because they are not directly related to production. Some divested social assets (e.g., guest houses) could be privatized; but many other expenditure functions (e.g., schools, hospitals, urban infrastructure) have benefit areas that dictate that they be assigned to the subnational level. Experience from transition economies indicates that as fiscal decentralization and privatization occur, the expenditures of subnational governments increase, relative to those of the center. The key challenge for governments is to determine the actual costs of providing these services and design a system of tax assignments, shared taxes, or transfers that provides for sufficient revenues to meet the assigned expenditures.

Revenue and transfer policies. There are many models of how to provide subnational governments with resources. Taxes can be assigned to different levels of government or shared between levels of government. Some countries allow concurrent tax powers (sharing the tax base) by allowing local surcharges on federal taxes, such as the personal income tax. In most countries, subnational revenues are supplemented by transfers, since typically the central government gets the bulk of the revenues, and subnational governments are assigned far more in expenditures than can be financed by their own revenue sources.

Designing the transfer system is complex, not least because there are usually a number of objectives, as noted above. The first step is to determine the aggregate volume of the transfer; the second is to determine its distribution across subnational governments. Transfers can be ad hoc and negotiated or, preferably, set according to a formula-based distribution and an ex-ante agreed volume for the subnational level that would provide budgetary certainty. Typically, a distribution formula will:

  • estimate minimum or “normed” subnational expenditure needs (based on assigned expenditures and often related to population, per capita income, social indicators, or actual cost of delivering services); and

  • assess the revenues (own, assigned, or shared) available to finance these needs (often looking at the localities’ tax effort).

Depending on how much inter-regional equalization of expenditures is desired, transfers will fill all or part of the expenditure/revenue gap.

Mismatched revenues and expenditures. When subnational expenditure needs and revenue flows (including transfers) are not well matched, the subnational government is left with inadequate resources to provide needed services. In most countries, this leads to a fiscal squeeze on the local economy. In transition economies, because of the soft budget constraint, such an imbalance can lead to fundamentally different—and potentially more damaging—outcomes. Searching for ways to finance their services, subnational governments revert to “coping mechanisms” to permit services to be delivered where otherwise they could not. These include shifting public budgetary outlays to enterprises still owned by the subnational government; resisting privatization of enterprises that provide social services; and, in the peculiar soft budget environment that still prevails in the financial sector in many transition economies, encouraging government-owned enterprises to borrow (or accrue arrears) in order to be able to continue providing public services. Sub-national governments may also establish extrabudgetary funds that make the budget less transparent. As the example of Russia shows, if successful, these coping mechanisms can threaten macroeconomic stability and privatization; if unsuccessful, underfunding subnational governments can jeopardize the provision of the social safety net. In Russia, a three-tier federation with considerable diversity among regions, resource endowments, and ethnic groups, coping mechanisms may undermine national cohesion.

Fiscal federalism in Russia

Russia is at a crossroads. Since the breakup of the union, it has been seeking to define a new identity, introduce democracy, stabilize and privatize the economy, and accommodate clashing regional demands. Fiscal federalism is at the heart of this political and economic challenge and key to the tasks ahead.

Macroeconomic stabilization. The immediate objective of Russia’s economic policy is stabilization, in which fiscal policy plays a crucial role. A striking reality of Russia’s stabilization effort is the lack of revenue-expenditure correspondence at the oblast level. In the fiscal program for 1992, oblast budgetary expenditures increased as a result of the abrupt reassignment of many social expenditures and all investment outlays (including airports and military housing) to the subnational level. Oblast governments are also assuming the many public expenditures spun off by their enterprises. Social outlays should continue to rise significantly as growing unemployment and inflation lead to numbers of vulnerable people. On the tax side, despite increased expenditures at the subnational level, the 1992 budget envisaged a marked increase in taxes, which accrue mostly to the federal level. The resulting revenue-expenditure mismatch may be severe, especially in some of Russia’s poorer oblasts.

Russia’s intergovernmental system has not addressed these expenditure re-assignments, not the budgetary pressures they imply for subnational governments. The federal government’s attempts to meet its budget deficit targets have pushed more and more expenditure responsibilities to the oblast level, while retaining ever increasing amounts of revenues at the central level. The basic strategy was to push the deficit downward by shifting unfunded expenditure responsibilities to subnational levels in the hope that they would do the cost cutting. Superficially, this has served to reduce the federal budget deficit, but the central government is merely pushing its headaches down to the subnational level.

Caught without enough revenue to cover their newly assigned mandates, oblasts have accumulated expenditure arrears and, in some cases, delayed federal tax remittances; borrowed from banks and from “their” enterprises, which have easier access to credit than do the oblast governments themselves, thus adding to pressure for credit creation; and developed extrabudgetary resources. Ironically, focusing stabilization policy on the federal deficit is leading to actions that will further destabilize the economy, reduce the transparency of budgetary accounts, and, if oblasts are successful in their ability to obtain credit, subvert monetary objectives.

“The federal government’s attempts to meet its budget deficit targets have pushed more and more expenditure responsibilities to the oblast level, while retaining ever increasing amounts of revenues at the central level.”

Privatization. Efforts to reduce the budget deficit by squeezing the subnational sector also harm privatization. An important aspect of fiscal decentralization in Russia has been the transfer of enterprise ownership from central to subnational governments. Oblasts derive significant funds from enterprises they own and benefit significantly from the expenditures they finance. Hard-pressed oblasts will therefore oppose privatization and seek to reinforce their revenue base by holding onto their enterprises, in an effort to ensure the continued provision of services increasingly unaffordable to oblast and rayon governments under current intergovernmental fiscal arrangements. At the same time, by encouraging enterprises to provide social services, these enterprises become harder still to privatize.

Economic growth. A fiscal squeeze on subnational governments can also worsen resource allocation and growth. Oblasts’ vested interests in enterprise revenues and the provision of services by enterprises will, in an economy as regionalized and with as few anti-monopoly policies as Russia, inevitably encourage domestic protectionism and inter-oblast trade barriers to protect local monopolies. This will ultimately reduce economic growth, just as impeding trade between states of the former USSR has done. Evidence from a number of oblasts suggests frequent use of export barriers to ensure that revenues from origin-based sales taxes stay inside the oblast. The behavior of oblast governments plays a crucial role in determining the efficiency with which the Russian economy performs.

Social safety net. In an apparent effort to balance the budget, in 1992 the central government in Russia transferred responsibility for social protection and price subsidies—previously financed by transfers from the federal government—to the oblasts. However, it did not estimate the cost of the social protection programs and whether it could be met with revenues available in each oblast. If an adequate social safety net is a national priority during the difficult transition ahead, then subnational governments must be adequately funded to administer the programs. Local administration of these benefit programs will facilitate targeting, but federal financing would be more appropriate. Nation building. The ad hoc shifts in expenditures from the central to the subnational level—such as social outlays and capital investment—have led skeptical oblasts to wonder what expenditure functions the center performs that are sufficiently important to justify its existence. Already, the center is failing to provide macro stability. By not being concrete in assigning expenditure, and by jettisoning federal outlays onto subnational governments, the federal government could contribute to its worst fear—the disintegration of the Russian Federation.

The sense of injustice at the subnational level has risen as oblasts are left struggling with inadequate resources and frustrated by a revenue system that is not transparent. Wealthier oblasts complain that the present negotiated intergovernmental fiscal system is over-equalizing (i.e., they are subsidizing the poorer oblasts) and threaten to opt out. (Regression analysis indicates that there is not a great deal of equalization in Russia’s system, in reality.) This is not as impossible as it seems, since the system of tax administration, in which all tax revenues are collected at the oblast level and below and remitted to the federal government, makes the center very dependent on oblast compliance and, thus, vulnerable. Indeed, in early 1992, some twenty disgruntled oblasts unilaterally halted tax payments to the center. The proliferation of such behavior could lead to the fiscal dissolution of the Russian Federation, just as the failure of union republics to contribute to the union budget helped to foster its dissolution in 1991.

Dissatisfaction among oblasts is heightened by ethnic tensions and disagreements over natural resource revenues. Areas inhabited by non-Russian ethnic groups claim the right to greater fiscal autonomy. And some areas rich in natural resources feel entitled to special fiscal arrangements that allow them greater benefits from their natural resource revenue. For example, Yamal and Khanti-Mansisk, which together produce over 80 percent of Russia’s oil and gas, have prevented the federal government from capturing all export and petroleum tax revenues. And Yakutia, which is home to an ethnic minority representing one percent of Russia’s population and contains 99 percent of Russia’s diamonds, is demanding greater fiscal autonomy and retention of natural wealth. It and others have threatened to break away from the rest of Russia if their demands are not met.

The role of the fiscal system

Given the tensions between the federal and oblast governments in Russia, the importance of developing a transparent, fair, consensus-based framework for intergovernmental finances with revenue-expenditure correspondence cannot be overstated. To establish such a system would require a number of specific steps. First, one must determine the aggregate revenues required by oblasts, based on their expenditure assignments. Some proportion of these revenues must then be distributed across oblasts on the basis of origin of collections—giving wealthier oblasts with greater tax capacity greater revenues; the rest should be distributed on the basis of a transparent and fixed formula. Local taxes or surcharges and limited borrowing might also be part of the picture. Such an approach is flexible and can be adjusted to accommodate changing expenditure assignments. The relative proportions of the revenues distributed on the basis of derivation and formula (i.e., the trade-off between regional equity and growth) can also be adjusted: choosing the degree of equalization is essentially a political judgement. In Russia today, this is arguably a key issue. If the intergovernmental fiscal system places too much emphasis on equalization, wealthier oblasts—including those rich in natural resources—will be less willing to participate in the federation. The need for political unity may thus be greater than the need for equality, suggesting that the intergovernmental system should allow the wealthier oblasts to develop more rapidly by reaping the benefits of their larger fiscal capacity.

A well-designed intergovernmental system that matches expenditures and revenues while incorporating the interest of diverse regional entities can contribute to the cohesion of the Russian Federation, and lies at the heart of any solution to demands for further autonomy.

Other transition economies

The critical linkages between intergovernmental fiscal relations and key reform objectives such as macroeconomic stability, privatization, social safety net, and nation building are not unique to Russia. Indeed, these issues are found in most transition European countries and aspects of these problems are found in countries throughout the world. Countries such as Canada, India, Malaysia, and the United Kingdom have tried, with varying degrees of success, to buy the cooperation of subnational governments through the design of the intergovernmental fiscal system. In transition economies such as Bulgaria, Hungary, and Romania, the fiscal squeeze on local governments seems to be making them impediments to, rather than partners in, privatization. And it is not only in Russia that the social safety net and other outlays have been shifted “downstairs,” threatening both service provision and provoking the introduction of coping mechanisms—which contribute to further instability.

The major challenge for Russia as it develops an intergovernmental financing system is to create an integrated framework for change that will be compatible with short-term stabilization, will combine rules with discretion, and will be flexible enough to accommodate the major structural shifts in the economy, while also providing stability to subnational governments. The present represents a critical window of opportunity to introduce such refinements, inasmuch as the overall design of the intergovernmental system is still in transition. New laws on fiscal decentralization introduced in 1992—the “Basic Principles of Taxation”—attempted to introduce greater transparency and to address some of these concerns. Nonetheless, the design of the program is incomplete and additional reforms are needed. The next step for Russia is to undertake a careful, concrete empirical study of expenditure assignments, revenue options, and transfers. Also needed is a process to establish consensus on the basic directions of the intergovernmental system—the degree of equalization, the allocation of expenditures, and the rights of natural resource producers.

Impediment or facilitator?

Is fiscal federalism an impeding or a facilitating factor in the transition toward a market economy? It certainly can be either. It is easy to view intergovernmental fiscal relations as yet another technical area to be addressed. However, intergovernmental finance will have a major impact on the efficiency with which Russia and other transition economies perform on the macroeconomic front, on the safety net, and on the success of privatization policies. In sum, local finance is not a “local matter.”?

For further information, see Christine Wallich, “Fiscal Decentralization: Intergovernmental Relations in Russia,”Studies in Economies in Transition, No. 6, World Bank, and Wallich, C. (ed.), Whither Russia? Fiscal Decentralization in the Russian Federation, forthcoming, 1993.

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