Transition to Market

Chapter 9 Fiscal Federalism and the New Independent States

Vito Tanzi
Published Date:
June 1993
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George Kopits and Dubravko Mihaljek 

Perhaps the most dramatic economic change in the disintegration of the Soviet Union involves the vertical and horizontal fiscal relations among various levels of government. In fact, there is hardly another area (money, trade) in which centrifugal forces have acted so rapidly and so powerfully since the late 1980s. Further modifications are under way; in practically all the new independent states there is an ongoing search for stable and durable intergovernmental fiscal arrangements.

This chapter highlights the most salient developments in the evolution of intergovernmental relations from those in the former Soviet Union toward the current relations prevailing among and within the new independent states. First, it provides a historical overview of the Soviet budget structure prior to the decentralization process. As part of this overview, the chapter examines the role of state-owned enterprises in intergovernmental relations. Second, it focuses on the disintegration of the former system and the creation of new independent states and, in particular, on the scope for fiscal harmonization and coordination among the states. Third, the chapter discusses fiscal relations as they have evolved within the states, identifying both innovative and unchanged features of the system. Also, an attempt is made to assess the outlook for fiscal federalism in the states.

The discussion tries to draw on broad principles of fiscal federalism-solidarity, subsidiarity, correspondence, benefit–that are reflected in criteria of interregional equity, efficiency, and macroeconomic stabilization, and to examine their relevance to the former Soviet Union and the new independent states.

Federalism in the Soviet Union


Associative arrangements among states or regional units span a range of contractual, confederate, federal, and unitary structures. In a confederation, sovereign states unite to pursue joint actions, such as defense or trade, on the basis of the principle of “the general government being subordinate to the regional governments and dependent upon them.”1 This was, for example, the case of the American Colonies’ Articles of Confederation of 1777, the 1848 Swiss Constitution, the 1867 Ausgleich (Compromise) of the Austro-Hungarian Empire, and the Constitution of the German Empire of 1867-1919. As regards the European Community (EC), the Treaty of Rome, strengthened by the Maastricht amendments, provides a contemporary example of a confederate arrangement. In contrast, a federal structure involves “dividing powers so that the general and regional governments are each, within a sphere, co-ordinate and independent.” 2 This principle is enshrined in the U.S. Constitution of 1787–as explained in The Federalist Papers by Hamilton, Jay, and Madison–and adopted by many countries around the world.

The position of the former Soviet Union was that of an extremely centralized unitary state, at the very end of the spectrum of intergovernmental arrangements. Contrary to widespread belief, the Soviet Union did not come into existence through the voluntary decision of its member states and was never a genuine federal system, its proclaimed principles of self-determination and free secession notwithstanding.3 Formally, it was established on two contradictory principles: democratic centralism as the principle of the communist party organization, and federalism as the principle of state organization.4 While the former required that decisions of central party organs–in theory democratically adopted after free discussion “from the bottom up”–be implemented loyally by regional party organizations on the basis of directives “from the top down,” federalism proper required that the powers of government be divided between coordinate, independent authorities operating on behalf of regional or local electorates. In practice, unitary party authority superseded the principle of state federalism in all intergovernmental relations; federalism provided an exterior form without substance.

Historically, the supremacy of the party principle of democratic centralism was the platform of the Soviet state founded by Lenin after the victory of the October Revolution. Lenin, as most Marxists, was a unitarist by conviction and an advocate of strong centralized states. He adopted a nominal federal structure as a way to resolve the national question after the dissolution of czarist Russia, but only as a transition to a centralized proletarian state.5 He saw the authority of the party, based on party centralism, as a safeguard against separatist forces within the Russian Empire.

The strategy pursued to install Bolshevik rule in most of the newly independent non-Russian territories was to proclaim the local Bolsheviks as the only legitimate representatives of the Ukrainian, Byelorussian, Latvian, Armenian, and other workers, lend them armed support in their struggle to overthrow the local “bourgeoisie” (non-Bolshevik governments set up locally), replace them with Soviet Bolshevik governments, and create Soviet Republics.6 At the same time, the right of individual republics to self-determination and free secession was repeatedly recognized, with the understanding that the right could be exercised only by Bolshevik governments.

In 1919, on the occasion of the VIII Party Congress, Zinov'ev noted that it would be impossible to uphold for long the contradiction of “one single centralized party alongside a federation of states,” and predicted that of the two principles, the federative principle would yield to the central hegemony of the party. Similarly, Pyatakov stressed on the same occasion the inconsistency of pursuing the economic merger of all the Soviet republics while proclaiming self-determination.7 Nevertheless, the federative principle was enshrined in the Union Treaty, signed in the Bolshoi Theater on December 30, 1922, exactly 69 years before the formal dissolution of the U.S.S.R.

Matryoshka Dolls Under the Unitary Structure 8

The state budget in the former Soviet Union was an organic and accounting consolidation of the union budget, including the social security accounts and the state budgets of the union republics. In turn, the state budget of each of the 15 union republics was a consolidation of its own budget and the budgets of all lower levels of government under its jurisdiction, which included more than 52,000 oblast, okrug, kray, rayon, city, village, and settlement budgets. Traditionally, despite the formal federal structure of public administration, the formulation and execution of fiscal policy was highly centralized to ensure full conformity with the plan.

The unitary fiscal structure in the Soviet Union was characterized by a concentric configuration of the budgets, much like a large set of matryoshka dolls, one at each government level. The minimum revenue, by category, and maximum expenditure, by program, were determined at each level of government for the budgets of the immediately lower level under its jurisdiction. The budgetary aggregates were set by the Gosplan in the context of the annual plan.9 Deficits at any level could be covered with transfers from the budget of the next higher level government. Some of the transfers from the union to the republic governments consisted of loans, subject to repayment by the republics, and of shares of the proceeds from the so-called lottery bonds. Recourse to horizontal or upward transfers was made only in exceptional circumstances. Budget surpluses were to be returned to the next higher level of government.

Regarding the mechanics of revenue assignment, each year governments at every level were allocated a certain proportion of tax or nontax revenue in a given category collected within their territory, more or less in line with expenditure needs, especially for social purposes. By 1989, the state budgets of the union republics (that is, republic plus all local budgets) obtained, on average, 86 percent of revenue from the turnover tax, 61 percent of revenue from income taxation of individuals, and 39 percent and 93 percent of revenue from income taxation of stateowned enterprises and cooperatives, respectively. Poorer union republics were permitted to retain a higher proportion of revenue (for example, turnover tax retention in Central Asian republics was 100 percent). The union budget received all foreign trade revenue, including external financing, and 61 percent of revenue from state enterprise profits. Revenue from social security contributions, assisted with general revenue, was channeled to beneficiaries through both the union and the republic budgets.10

On the expenditure side, fiscal responsibilities were divided broadly along functional lines, under tight centralized control. Union republics and the local levels of government were responsible for social and cultural expenditures (education, health, social insurance, pension and other benefits), and the union government for defense, science, justice and internal security, and subsidies to the foreign trade sector (including financing flows to abroad). Expenditures on the economy (investment, operational expenditures, price subsidies) were split in half between the union budget and republics; the latter were further split in half between the republic and local budgets.

Total intergovernmental transfers amounted to 6½ percent of the union budget in 1989, consisting of payments by the union to the republics for meat and milk subsidies (43 percent), repayments by and lending to republics (38 percent), and republic-specific grants (19 percent), channeled almost solely to Central Asian republics. Allocations were subject to yearly variations depending largely on changing needs. Both revenue sharing and transfers were subject to considerable intergovernmental negotiation and discretionary decision.

The combination of chronic commodity shortages and rudimentary financial markets provided an opportunity for covering budget deficits from unspent cash balances deposited by consumers in state banks.11 Once the size of the budget deficit was known, the State Savings Bank would finance it with the net increase in savings deposits. In addition, state-owned enterprises were obliged periodically to hold various types of government bonds. As long as the stock of forced savings was growing faster than the size of the deficit, this approach was noninflationary.

Clearly, in the unitary centrally planned framework, an all-pervasive solidarity principle was superimposed forcefully on all levels of government. Horizontal equity, defined in terms of expenditure levels, was to be ensured across union republics, oblasts, and various local governments, in line with merit wants as denned by the central party authority.12 Application of fiscal resources and responsibilities at a given level was entirely under the control of the next higher level of government. The combination of central planning and unitary fiscal structure undermined efficiency in the collection of revenue and its allocation at different levels of government. At the same time, however, the system facilitated macroeconomic stabilization.

Role of the Enterprise Sector

In the former Soviet Union, as in other socialist countries, state-owned enterprises occupied a pivotal place in fiscal policy, including intergovernmental fiscal arrangements. Recent experience shows that these enterprises also play a critical role in the transition from central planning to market economy and in economic relations among and within the successor states of the U.S.S.R. It is argued herein that fiscal decentralization in the former Soviet Union is critically intertwined with enterprise restructuring. The argument is based on four points.

First, in the Soviet Union, as in other centrally planned economies, the state budget relied excessively on revenues collected through taxation or outright confiscation of enterprise profits, largely for reallocation back to the enterprise sector. As observed in other post-socialist economies that are more advanced in the transition process, it is very difficult to maintain this reliance when enterprises are exposed to an increasingly tighter budget constraint (that is, reduced credit and subsidies) in an environment of weak tax administration and proliferating tax concessions. As a result of enterprise restructuring and decentralization of decision making, a substantial portion of the tax base can evaporate long before other reform measures bear the fruit of improved efficiency and higher growth. The revenue erosion has been particularly pronounced regarding the profit tax and turnover tax, or its successor, the value-added tax (VAT). Because in the short run other revenue sources cannot substitute for enterprise taxation, governments are forced either to accept lower overall revenues, with all the negative consequences for fiscal decentralization and macroeconomic balance, or to raise enterprise tax rates, thus stifling the process of enterprise reform.

The second point involves government ownership and control of the enterprise sector. With increased enterprise autonomy and government decentralization, the paternalistic relations between governments and enterprises become open to question. In the former Soviet Union, for example, union control at the highest level was simply replaced by republic control. As republics proclaimed their independence, they imposed full control over all property on their territory. In a number of cases, this amounted to continuation of the command economy. Republic authorities quickly took steps to regulate enterprises, retaining a higherthan- agreed share of profit taxes, and requisitioning part of their profits.13 In turn, lower level governments have also asserted their control over some local enterprises.14 With some exceptions, fiscal decentralization has thus been achieved at the expense of enterprise reform, creating a situation that is untenable in the long run as the economy embarks on market-oriented transition.

A third and related point is the high degree–probably the highest anywhere in the world–of industrial concentration of former Soviet enterprises. Prior to the breakup of the union, around one third of industrial output, including services, was produced by single-enterprise industries, and a further one third by two-enterprise industries.15 The underlying rationale for a concentrated productive structure lies not only in economies of scale and vertical integration, but, perhaps more important, in its usefulness for centralized planning, exercised directly through the industrial branch ministries. Large monopolistic enterprise structures, arching over a number of jurisdictions, or closely linked across jurisdictions, can complicate both the trend toward fiscal decentralization at all levels and the realignment of enterprise control and ownership. Progress on these fronts requires splitting up large enterprises wherever this is technologically and economically feasible.

The fourth major aspect of the relationship between state-owned enterprises and fiscal decentralization involves the provision of public services. Traditionally, socialist enterprises had supplied the population with a major share of local public goods (training programs, culture, health care, housing, child care, and other social benefits). A large portion of infrastructure supplying local public services was operated and financed by enterprises. As they have received some autonomy from the state and as they are increasingly exposed to a hard budget constraint, enterprises are trying to relinquish the burden of providing such services. Thus, some of the first victims of enterprise restructuring were day-care centers, clinics, cinemas, and other nonproductive facilities operated by enterprises. At the same time, the new laws mandated that local governments take over increased expenditure responsibilities.16 Although initially eager to take over some public services (for example, cinemas, cemeteries, company-owned housing), and in some cases to privatize them along with enterprises–partly because of the potential revenue source–many local governments discovered that they were ill-equipped to organize and finance the supply of such services.

Because enterprises are a significant source of tax revenue and economic as well as political influence for republic and local governments and because they provide basic public services and, in many cases, commodities essential for production within and outside republics, present policymakers face a difficult trade-off on the road to market-oriented enterprise restructuring and fiscal decentralization. At the same time, a discussion of intergovernmental fiscal relations in the former Soviet Union cannot ignore the traditional structure of state-owned enterprises, in particular those reaching across jurisdictions. The implications of these features for changes in intergovernmental arrangements are a recurrent theme in the following sections.

From Soviet Union to Independent States

Divorce Soviet Style, 1989-91

Fiscal decentralization in the former Soviet Union can be traced to an experiment in 1988, when a small proportion of the payments out of aftertax enterprise profits started to be transferred to local budgets. Increasing shares of various tax categories were being disposed of freely at lower levels of government, given that a proportion of union revenue, including taxes on individuals and profit taxes on enterprises subordinate to union authorities, was earmarked for republic and local budgets. In principle, these shares were intended to give the republics and local governments an incentive to raise tax revenue from enterprises and individuals, and thus to facilitate the introduction of greater financial autonomy.

The unitary system was further relaxed in the way budgets were drawn up for 1990 at various levels of government. Mounting pressures for regional fiscal decentralization led to the enactment in April 1990 of a law that stressed the primacy of the union in determining the tax system–in terms of the type of taxes and their rates–and in managing and financing various broadly defined common functions, namely, defense, debt servicing, public investment programs, and subsidies to enterprises.17 Union programs were to be financed with mandatory transfers from the republics. In return, republics gained more freedom to determine fiscal policy in their own territory, mainly in the area of public expenditure and investment, acquisition of property, price controls of certain goods, and disposal of profits. However, the republics had de facto already acquired more fiscal powers than were granted belatedly under the law. This legal catching-up has characterized the fiscal decentralization process at all levels of government ever since.

Subsequent events have shown that 1990 was the last year in which republic rights and responsibilities were subordinate to union laws and regulations. It was also in the fall of 1990 that the last attempt was made to establish a rational federal–or rather confederate–fiscal framework, predicated on a meaningful application of both principles of solidarity and subsidiarity. According to one celebrated proposal, most revenue and expenditure functions would have been allocated to the republics, which in return would have made upward transfers to the union budget to finance common expenditures on the basis of the GNP (or GNP per capita) of each republic.18 This and similar attempts were doomed to failure; by the end of the year, all union republics had declared the sovereignty of their laws over those of the union.

In early 1991, a radical restructuring of the Soviet budget system was already under way. For the first time since the establishment of socialist central planning, the union authorities prepared only the union budget, while some large republics (especially Russia and Ukraine) began to formulate their own budgets. The union retained responsibility only for strictly common functions (defense, union civil service, debt servicing), transferring other functions to republics and union extrabudgetary funds (for example, Stabilization Fund, Pension Fund, Employment Fund, Fund for Social Support of the Population). These funds were to be financed with earmarked republic transfers, social security contributions, and proceeds from privatization, which for the most part never materialized.19

Although the union tax laws still had nominal primacy over republic regulations, some republics started to determine their tax rates independently and to retain amounts well in excess of shared revenues. This practice became widespread by midyear. To compensate, union budget transfers to withholding republics were reduced or stopped altogether. Republics also overrode union regulations over republic expenditure responsibilities by pursuing independent investment, subsidy, and social support policies.

Fiscal disintegration accelerated after the failure of the August coup. At that time, virtually all the republics discontinued transfers to the union budget. An extraordinary budget for the fourth quarter of 1991 was approved but never executed, as the Russian Federation took over the central union institutions in Moscow, including the U.S.S.R. Ministry of Finance, and decided to close altogether the union budget in November 1991. In return, Russia agreed to pay for about two thirds of envisaged union expenditures for the months of November and December, both on its territory as well as common expenditures in other republics.20 Fiscal performance for the year as a whole varied sharply among republics; while Lithuania netted a surplus, all other republics incurred deficits, with the largest one faced by Tajikistan, estimated at more than one half of its GDP.21

At the end of 1991, the devolution of fiscal authority to the republics was complete. Following declarations of independence in rapid succession, the new states were drafting their first separate budgets and tax laws effective January 1992. Not surprisingly, after seven decades of absolute dependence on union authority, republic governments were technically ill-prepared to conduct fiscal policy in a consistent macroeconomic framework.

Commonwealth of Independent States

From about the middle of 1991, there was at least tacit recognition of the independence of each republic and of the need to form a new treaty among them on a voluntary basis. In late June, a draft treaty was published and endorsed by eight republics. This draft sought unsuccessfully to retain for the union the authority only to implement the union budget, issue money, and maintain foreign exchange reserves; all other responsibilities for the conduct of macroeconomic policy could fall within the sphere of joint union-republic competence. Under a somewhat looser arrangement, in October eight states signed an economic community treaty. In addition to the maintenance of a single currency, a common economic space, and a small common budget, it envisaged limits for member states' budget deficits; sums exceeding these limits were to become a debt vis-à-vis other member states. Interestingly, the proposed limit on the budget deficit seems to have been inspired by a similar fiscal rule adopted by the EC under the Maastricht accord.22 However, lacking a minimum degree of solidarity and discipline, this treaty quickly became obsolete.

Possibly the most ambitious arrangement that could realistically be accomplished at the time was the Commonwealth of Independent States (CIS), established in Minsk in December 1991 by three Slavic republics of the former Soviet Union. The Minsk accord formally recognized the dissolution of the U.S.S.R. and called for a broad framework to preserve a common economic space among member states (especially regarding trade in raw materials and other essential inputs), to coordinate economic reforms, to use the ruble in interrepublic trade, to consult prior to the introduction of separate currencies, to establish a banking union, to reduce budget deficits, to harmonize taxes, and to agree on defense and environmental issues. One year after agreement in principle by eleven states, the CIS continues to exist as an amorphous body, without a charter or an enforcement mechanism for agreements reached by its members.

Although relations between two of its most important members, Russia and Ukraine, remain uneasy, the Commonwealth’s existence does not seem to be under imminent threat.

The first few months of the Commonwealth were characterized by the euphoria of the new states over independence, which, in some cases, seems to have been unexpectedly thrust upon them. As a result, the centrifugal forces that had led to the breakup of the Soviet Union were enhanced and the remaining economic ties among the republics were further disrupted. A glance at the agreements signed by member states of the CIS seems to indicate that, depending on their willingness to maintain links with Russia–by far the dominant member–a dichotomy is emerging among the states. The inner group is comprised of Armenia, Belarus, Kazakhstan, Kyrgyzstan, Russia, Tajikistan, and Uzbekistan; the outer group is made up of Ukraine, Moldova, Azerbaijan, and Turkmenistan.23 Among the former Soviet republics, the Baltic states are the only ones not likely to join any part of the CIS.24

Fiscal Issues Among the States

As indicated in the preceding discussion, the center of gravity in intergovernmental relations has shifted over the past three years from an extremely centralized unitary state to a stage where the republics abandoned the idea of improving the “union state” and were considering instead the creation of a “union of states,” and then further to the stage of complete independence with incipient autarkic tendencies.

Notwithstanding continued tensions in trade relations, introduction of separate currencies, differential price liberalization, control over strategic supplies, and division of common assets and liabilities, there remains considerable scope for maintaining some fiscal coordination and cooperation. Specifically, in view of the existing multistate enterprises, the closer links among enterprises located in different states, the emerging social needs, and the overall costs of breaking up an open economic space, it seems to be in each state's economic interest to address rationally the interstate fiscal issues, regardless of the final form of an associative arrangement among the states. Indeed, it can be argued that recognition of these fiscal issues is instrumental for the economic welfare of the new independent states.

In its present form, the CIS is a very loose contractual arrangement that cannot be regarded as a confederation. However, the efficiency arguments for preserving an open economic space among the states are well known. Because the new states had been closely linked for a long time and had developed productive structures that are highly specialized across regions, often without regard to comparative advantage and market demand, their situation is comparable in many respects to the case of Siamese twins who cannot be separated overnight without the risk of serious or even fatal injury. To minimize this risk, it would seem essential to identify the necessary conditions for maintaining an open interstate economic space. These conditions include an appropriate interstate trade and payments mechanism as well as a degree of macroeconomic policy coordination.25 In this regard, we focus on the fiscal conditions.

As a first step, it would be necessary to eliminate any barriers to trade and factor movements that have proliferated in the recent past, mostly in an effort to protect domestic supplies. As a corollary, a certain degree of tax harmonization would help reduce tax-induced allocative distortions.26 The case for tax harmonization is especially strong given the interstate economic linkages inherited from the past. While a major market-oriented restructuring of the enterprise sector has already begun in a number of states, many large-scale enterprises operating across state jurisdictions have yet to be accommodated by a harmonized system of commodity and company income taxation. For one thing, it would be beneficial to agree on a realistic set of minimum rates for the VAT, excises, the company income tax, and payroll taxes (mainly earmarked for social security). It would be equally important to reach agreement on the definition of tax bases and on the principles of taxation that would govern cross-border commodity and factor movements.

As regards the VAT and excises, the absence of border controls and the importance of multistate enterprises (including vertically integrated ones) argues for the origin principle of taxation on interstate transactions. This approach would not preclude the application of the destination principle, as permitted by the General Agreement on Tariffs and Trade (GATT), on transactions with third countries or former republics that do not wish to participate in the common economic space. A comparable approach is expected to be adopted eventually in the EC, following removal of internal border controls. Concerning company income taxation, it might be administratively easiest to adopt the source principle, instead of the possibly more efficient residence principle with appropriate credit for taxes paid at source. A potential problem may emerge, however, in the allocation among relevant jurisdictions of multistate enterprise income, owing in part to undeveloped market-based accounting practices. In such cases, it may be necessary to apply a presumptive apportionment method.27

An additional structural issue involves the application of the benefit principle in taxation and provision of public services. In order to avoid potentially ruinous fiscal competition among states seeking to attract foreign investment–for which there are precedents in post-socialist Central and East European countries–the new states would be well advised to agree on a minimum company income tax rate and on developing, and perhaps jointly maintaining, basic infrastructure facilities. Such a qualified application of the benefit principle would prevent excessive revenue erosion and provide the basis for a favorable and stable fiscal environment for private investment.

More generally, the likelihood of preservation of an open economic space would be enhanced by broad fiscal policy coordination among states. With a single currency, there is great temptation for individual states to engage in high rates of credit expansion to finance local budget deficits and enterprise losses. As recent experience in the former Soviet Union shows, the resulting inflation-tax burden spreads quickly over the entire ruble area.28 To prevent such practices, especially in view of relatively undeveloped financial markets, it would be necessary to abide by fiscal rules in the form of tight limits on budget deficits at the state level. Although for members of a common economic space that do use separate currencies the argument for such fiscal rules may be less compelling, radically different fiscal stances would be untenable–unless accompanied by a flexible exchange rate policy–and could lead to the erection of barriers to trade and capital movements by states experiencing external imbalances.

At this stage, the principle of solidarity among the new independent states is under considerable strain. However, it is conceivable that in the medium to long term, as regional differentials in income and standard of living become more pronounced, given market-oriented enterprise restructuring and liberalization of energy prices, there could be a voluntary rapprochement, at least among states with some cultural affinity. Therefore, for equity reasons, periodic general- or specific-purpose grants could be expected from high-income, resource-rich states to states with low incomes and high dependency ratios.

Looking at the present state of interrepublic relations in the former Soviet Union, it might seem that the stage at which the new states would become interested in fiscal coordination lies in the distant future. In the absence of an obvious single right answer to the many problems of postsocialist transition, one could argue that temporary economic independence is beneficial, as multiple variants of reform processes under experimentation confer benefits of variety, comparison, and competition.29 In addition, the need for strong and accepted administrative leadership, which is essential for establishing the credibility of transition policies, can be more easily satisfied at the state level. These and other arguments in favor of economic independence notwithstanding,30 the welfare benefits of cooperation exemplified by the United States, Canada, and, more recently, the EC, are sufficiently large to make the prediction of a centripetal trend of cooperation among the new independent states a safe bet for the long run.

Intergovernmental Relations Within the States

Toward Genuine Federalism

The process of fiscal disintegration at the union level was closely paralleled by similar developments, in some instances of equal strength, within the republics.31 There too, the geographic expanse of some republics, the ethnic factor and other noneconomic variables, including deep-rooted and long-repressed national consciousness, fueled the centrifugal tendencies that have yet to climax in some regions. Much as in the interrepublic context, within many states the practice of local fiscal autonomy has been and seems to be far ahead of its statutory recognition.

Since late 1990, most states have enacted laws on local self-government even before the formal disintegration of the union. These laws, in combination with statutes on the new tax system and the budget process, represent the initial formal step toward a genuine federal fiscal structure in the newly established states. Although subject to variation across states, especially in terms of implementation, these statutes have a number of broadly common characteristics. The laws endow governments at various levels with considerable fiscal autonomy as regards budget formulation, taxation, and borrowing. At the same time, however, they perpetuate much of the previous government structure, budget process, and tax administration. In most states, this tenuous–in some aspects contradictory–amalgam of fiscal decentralization cast in the former unitary model is not likely to survive in its present form.

Under the new laws, subnational governments at the oblast, provincial, city, and village levels have the authority to formulate and execute their own budgets, disposing of own fiscal resources and of prescribed shares of national revenue. The loci of expenditure responsibilities are defined, but without precision. Outlays on defense, higher education, and major investment projects (in transportation, communication, energy, and the like) that confer country-wide benefits in terms of economies of scale and externalities, fall under national jurisdiction. In contrast, for example, lower levels of professional and secondary education, and construction and renovation of health-care facilities are to be managed at the oblast level, whereas their maintenance is the responsibility of the respective local governments. Primary schools, local roads, and other local facilities are run at the city or village level. Also, subsidies to local enterprises, as well as price subsidies, have to be financed at the local level. Thus, broadly speaking, the principle of subsidiarity–namely, of assigning government functions to the lowest possible level where they can be performed efficiently–seems applicable under the law.

In an important break with the past, the fiscal autonomy of subnational governments is explicitly protected from interference by higher government levels, unless authorized by the national legislature. Accordingly, higher-level governments are not allowed to extract surpluses from lowerlevel governments.32 Furthermore, subnational budgets no longer need to be consolidated with higher-level budgets.33

In general, revenue accrues to various levels of government through a combination of tax assignment and revenue sharing. Revenue from taxes on personal income, collective farm income, property (such as land, transport, and, in some states such as Ukraine, natural resources) is assigned entirely to subnational levels of government. Revenue from the VAT, most excises, enterprise profit tax, and taxes on foreign transactions, and in the case of Russia, natural resource taxes, accrues to the national or federal government and is shared with subnational governments. In principle, the revenue split between national and subnational levels for each tax is to be determined by the national legislature according to regional need.34 In fact, however, revenue shares are often subject to intergovernmental negotiation or unilateral adjustment and to variation even in the course of the year. As a further example of fiscal autonomy, subnational governments can authorize preferential tax treatment, including exemption from certain taxes.

In the event of vertical imbalances, that is, when the revenue from own taxes and from the earmarked share of national taxes is not sufficient, additional transfers may be provided by the higher government level, which can then participate in the expenditure decision. In addition, in a number of states, subnational governments are authorized to borrow from bank or nonbank sources to finance budget deficits at their levels. Alternatively, subnational governments may dispose of budget surpluses by depositing them (along with various forms of nontax revenue, including user fees) in own extrabudgetary funds created for that purpose. As indicated above, there are no longer restrictions on the local use of surpluses, and in particular, there is no mandatory return of accumulated surpluses to higher levels of government.

Notwithstanding fiscal decentralization and a strong drive to local government autonomy, the basic structure of government in the former republics–apart from the takeover of union-level institutions–has remained in many respects largely intact. Likewise, the process of budget preparation and appropriation at various government levels has not been altered substantially, except insofar as subnational governments do not act any longer merely as a transmission belt between the higher and lower levels of government. A notable feature left over from the past is that minimum outlays of local governments for specific activities are to be allocated on the basis of budget norms which specify in detail nominal daily expenditure per resident.35 Budget norms as well as price controls are determined by the national government (for instance, in Russia) or legislature (in Ukraine). Also, as noted, the shares of subnational governments in national tax revenue are to be set by the national legislature. Although tax administration remains centralized at the national level, effective control over branch offices–staffed mostly by local officials–in many regions rests with subnational authorities.

Outstanding Issues and Outlook

In most of the new independent states, intergovernmental fiscal arrangements are internally inconsistent and unsustainable in their present form. The inconsistency stems largely from the lack of correspondence between revenue sources and expenditure responsibilities–in part to be based on budget norms–assigned under the law to each level of government.36 While the prescribed shares of national revenue can be adjusted periodically to compensate for possible revenue shortfalls at the local level, over time the lack of correspondence is likely to be exacerbated by local pressures for increased expenditures and by inherently weak incentives for local revenue raising.

In the period ahead, there is bound to be a significant jump in claims on public services. Some tasks, such as environmental cleanup, have been altogether neglected in the past. Others, particularly social assistance, are closely related to the restructuring and privatization of state-owned enterprises which will no longer be able or willing to provide a range of social services, including employment, as in the past. Additional claims also arise from ongoing demilitarization. Although responsibility for these new expenditures remains rather vague, it is being assumed largely by subnational (mainly oblast and city) levels of government, given the regional or local nature of the needs.37 Meanwhile, attempts at updating and adhering to budget norms in absolute terms impose an additional burden on local jurisdictions.

On the revenue side, it is becoming increasingly difficult to collect taxes from a shrinking base. As in Central and East European economies in transition, revenue performance in the former Soviet Union has deteriorated owing to severe administrative shortcomings, exposure of stateowned enterprises to a hard budget constraint and market forces, and their privatization. Furthermore, local governments have been tempted to offer tax holidays or other preferences to stimulate economic activity on their territory.

As a result, many subnational governments have been unable to balance their budgets. Their response to budgetary pressures has been, in the first place, to push expenditure responsibilities upward to the national level and to negotiate for increasing shares in national taxes. At the same time, some subnational governments have found it convenient to transfer occasional surpluses or nontax revenue (for example, local privatization proceeds) to their extrabudgetary funds. In all, the incentives for efficient allocation of budgetary resources and revenue raising at the local level are very weak.

The prospect of widening vertical imbalances at subnational levels of government is considerable in most of the new independent states. In the absence of an institutional mechanism for intergovernmental transfers there is continued recourse to ad hoc and nontransparent negotiation over grants and revenue shares between different levels of government. In addition, some subnational governments want to exercise their legal right to borrow from the banking system (in part from captive local commercial banks) and nonbank sources, without regard to creditworthiness. Uncontrolled borrowing by large regional and local governments is likely to contribute significantly to consolidated budget deficits, and consequently, to macroeconomic disequilibria.

Not all subnational governments are prone to incur budget deficits. In some states there are jurisdictions endowed with oil, gas, gold, diamonds, and other mineral resources, which are likely to accumulate sizable budget surpluses, not necessarily to be shared with the national government.38 Such budget surpluses can be expected to mount particularly in the event of a domestic adjustment of commodity prices to world market levels. In this regard, a major outstanding question concerns the willingness of resource-rich regions to relinquish, in the near future, an increasing share of the resulting revenue vertically to the national government or horizontally to subnational governments experiencing deficits. The answer to this question may be intimately connected with the ethnic factor and the apparent lack of solidarity across regions. In view of the strong backlash against the former centralized structure, the creation of intergovernmental fiscal arrangements based on horizontal equity criteria seems to be a long way off. In the meantime, the very integrity of some states, especially those with the largest ethnic and resource endowment disparities, such as the Russian Federation, will be subject to considerable strain.39

The destabilizing effect of subnational government finances may not be readily apparent. In some cases, large national budget deficits mask excess spending at subnational levels. Indeed, there are preliminary indications that, in the course of 1992, subnational governments in certain states, notably in Russia, have accumulated surpluses because, relative to assumed spending responsibilities, they had ample revenue from assigned taxes and earmarked shares.40 In response, there are initiatives at the national level to shift more expenditure responsibilities (for health-care services and infrastructure projects, among others) to lower levels of government and, at the same time, to reduce the shares of national taxes (especially the VAT) earmarked to subnational jurisdictions. Elsewhere, as in Ukraine for example, some subnational governments have incurred sizable deficits financed directly by the banking system.

These developments argue, on grounds of efficiency, stabilization, and horizontal equity, for the introduction of a simple and transparent system of unrequited transfers from the central budget to oblast and local budgets. These transfers would be determined by a set of quantitative indicators, specified at the relevant subnational level, reflecting expenditure need (taking into account population and other factors) and potential, rather than actual, revenue (in terms of a proxy for value added, natural resource endowment, and so forth).41 Such a system could accommodate matching grants and bloc grants, either of a general nature or earmarked for specific purposes (for example, to maintain a minimum level of primary education or primary health care, or to finance a large-scale infrastructure project), that confer nationwide benefits through spillovers beyond the spending jurisdiction. Ideally, grants should constitute an addition to rather than a substitute for local resource use. The principle of additionality could be ensured in broad terms, mainly through formulabased equalization transfers.42 Furthermore, the aggregate level of grants would be determined as part of the overall fiscal stance, in line with economy-wide stabilization and growth objectives. Thus, the transfer scheme could address in a consistent manner horizontal inequities as well as the vertical imbalance.

Equalization transfers would partly obviate an elaborate assignment or sharing of taxes between national and subnational governments,43 albeit without precluding the imposition of subnational surcharges on the national tax bases according to the benefit principle of taxation. Consensus may be reached over time regarding the assignment of several major taxes–in particular, the VAT–44 to the national government for regional reallocation through formula-based transfers. However, it must be recognized from the outset that there is virtually no prospect for such a treatment of natural resource taxes; at most, resource-rich subnational governments may be willing to share only a portion of the latter with the national government.

The overall picture of intergovernmental relations that emerges at this time within the new independent states is that of a federal structure characterized by a fair degree of discretion and nontransparent negotiation among different levels of government. The enactment and implementation of the basic statutes on fiscal federalism are in a state of flux and subject to almost continuous review. Such review is essential before the intergovernmental relations are cast in a formal constitutional framework that is both credible and durable. Even then, as the experience of federations such as Australia and Canada shows, intergovernmental fiscal arrangements can be subject to periodic review between the national and subnational governments.

In sum, the moment of truth for the viability of existing intergovernmental arrangements within the new states will be faced only when they fully embark on market-oriented economic transformation. The transformation is likely to have a considerable differential regional incidence in some states, especially in Russia, exposing wide differences in incomes and wealth across regions. While resource-rich regions with a sparse population would enjoy a marked surge in incomes upon liberalization of energy prices, populated industrial regions would suffer from an increase in poverty and unemployment due to enterprise restructuring under hardened budget constraints–as enterprise restructuring would be, in fact, inevitable under energy price liberalization. Simply stated, the integrity of states undergoing transformation hinges on the adoption of a federal system, based on the broadest possible consensus, that combines a clear allocation of expenditure responsibilities among different government levels, taking into account subsidiarity and interregional spillovers, an explicit set of rules for assignment of tax revenue, and a transparent mechanism of regional equalization transfers based explicitly on need and revenue capacity, that will ensure broad correspondence with the expenditure responsibilities.


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George Kopits is Division Chief in the Fiscal Affairs Department, and Dubravko Mihaljek is Economist in the Central Asia Department. The authors were, respectively, the head and a member of the fiscal team in the 1990 IMF Task Force on the Soviet Economy, whose findings are published in IMF and others (1991). An earlier version of this chapter was presented at the annual meetings of the American Economic Association, Anaheim, California, January 5-7, 1993. Comments by Jon Craig, Henri Lorie, Charles McLure, Richard Musgrave, and Emil Sunley are gratefully acknowledged.
1Wheare (1964), p. 4. In German, a confederation is denoted as der Staatenbund, the alliance of states, as opposed to der Bundesstaat, the federal state.
6This strategy was foreshadowed in the following remarks by Lenin on December 5, 1917: “We are told that Russia will disintegrate and split up into separate republics but we have no reason to fear this. We have nothing to fear, whatever the number of independent republics. The important thing for us is not where the state border runs but whether or not the working people of all nations remain allied in their struggle against the bourgeoisie, irrespective of nationality.... We are going to tell the Ukrainians that as Ukrainians they can go ahead and arrange their life as they see fit. But we are going to stretch out a fraternal hand to the Ukrainian workers and tell them that together with them we are going to fight against their bourgeoisie and ours. Only a socialist alliance of the working people of all countries can remove all ground for national persecution and strife.” Lenin (1960-70), Vol. 26, p. 344.
7As quoted in Swoboda (1992), p. 769.
9In another dimension, the Gosplan, as the largest doll, contained the Ministry of Finance, which, as an administrative agency, in turn engulfed a smaller doll, the Gosbank operating largely as a payments and accounting department. For a discussion of fiscal and monetary institutions, see Kopits (1992b).
10For a more detailed breakdown of revenue by government level, see International Monetary Fund and others (1991), p. 280.
12The concept of merit wants found its full expression precisely in communist societies and has become so deeply ingrained that it now presents a formidable obstacle to reforms of social welfare and labor relations.
13In 1991, a higher-than-agreed retention of revenues by the republics was responsible for almost 60 percent (5.9 percent of GDP) of the union budget deficit; see International Monetary Fund (1992a), p. 12. As pointed out by Aleksashenko (1991), p. 23, one centralized economic system was replaced by 15 or more similar, albeit smaller, and in some cases more authoritarian, systems.
14In the short to medium run, the actual locus of government ownership and control over enterprises has, of course, important implications for the fiscal jurisdiction as well as for the consequences of privatization, including disposition of proceeds from asset sales.
16Article 7 of Russia’s Law on the Formation of the Budgets of the Russian Soviet Federated Socialist Republic of 1991, for example, stated that local budgets were responsible for financing expenditures on the maintenance and development of the local autonomy, the implementation of regional programs, and “other programs agreed upon with the appropriate bodies of power.”
17See the Law on the Fundamentals of the Economic Relations of the U.S.S.R. and the Union and Autonomous Republics. Further details on intergovernmental relations were laid down in a companion Decree on the Delineation of Powers Between the U.S.S.R. and the Subjects of the Federation.
21For a comparison of fiscal imbalances and monetary conditions in each republic at the disintegration stage, see Aleksashenko (1992).
22Whereas the economic and monetary union (EMU) agreement binds EC members to a limit equivalent to 3 percent of GDP, a draft agreement among the new independent states would have imposed a limit equivalent to 5 percent of GNP in 1992, followed by successive annual reductions down to 2 percent of GNP by 1995. It is worth noting that unlike in the EC where four large member countries are surrounded by eight relatively smaller ones, in the former Soviet Union the Russian economy is larger than all the other states combined whereby it would have had to bear the largest share of the adjustment under such rule.
24Georgia has never been a member of the Commonwealth, but the possibility of its joining in the future cannot be ruled out. The Azeri and Moldovan parliaments have not yet ratified the CIS treaty, but it seems that they have not rejected the idea of membership either.
25Recent discussions of this issue have been devoted almost solely to the trade and payments arrangements and monetary cooperation, to the neglect of fiscal relations among the states. See, for example, Fischer (1992).
26As an alternative to tax harmonization, a system of border tax adjustment would be sufficient, upon imposition of border controls among the states. For a discussion of various approaches considered under the EC’s single market, see Kopits (1992a).
27Some of the arguments involving the application of formula apportionment in developing countries may be relevant; see Kopits and Muten (1984).
31For an informative discussion of republic-local fiscal relations during the second half of the 1980s, see Berkowitz and Mitchneck (1992).
32See, for example, Article 43 of Russia's Law on Local Self-Government.
33Ukraine’s Law on Local Self-Government (Article 12) stipulates that “high-level bodies may not interfere in the development, approval and execution of local budgets.” Further, it rules out the matryoshka doll approach of budget consolidation by stating that “local budgets of single administrative and territorial units may not be included in the local budgets of other units and in the state budget of the republic.”
34In Russia, for instance, the legal subnational shares range from 60 percent to 80 percent of the tax on petroleum production, and amount to 50 percent of the vodka excise and the enterprise profit tax, and up to 20 percent of the VAT.
35For example, in Russia, in 1991, the daily hospital food intake for gynecology patients was set at rub 5.60 and for leprosy patients at rub 4.71 for each patient. For a list of healthcare budget norms, see Wallich (1992), p. 44.
36For an analysis of minimum requirements for a functioning fiscal federal system, see Hewitt and Mihaljek (1992).
37As an exception, compensation and cleanup related to the Chernobyl accident have been assumed by the central government in Ukraine, to be financed with a payroll tax earmarked for that purpose.
38In 1992, several resource-rich oblasts have adopted “single channel” arrangements whereby they unilaterally decide to withhold all taxes collected in their territory and to transfer a fixed nominal amount to the federal budget, disregarding statutory sharing provisions. See Wallich (1992).
39Although to a much milder extent–absent the ethnic factor and the need for enterprise restructuring–some strains emerged among energy-producing regions and other regions in Australia and Canada, since the oil booms of the mid-1970s and the early 1980s, which have contributed to major changes in intergovernmental fiscal arrangements.
40Also, in Russia, subnational governments were barred by decree from exercising their right to borrow.
41See, for example, Economic Council of Canada (1982) for a discussion and evaluation of the Canadian equalization programs. Other countries that rely at least partially on wellfunctioning equalization grants, based on formulas that reflect both regional need and revenue capacity, include Australia, Denmark, Germany, and Switzerland. For an early theoretical analysis of alternative forms of equalization, see Musgrave (1961).
42The difficulty of applying the additionality principle in practice cannot be overstated. See the recent analysis of the allocation of EC Structural Funds in Gordon (1992).
43For a critical assessment of the transfer scheme coupled with centralized assignment of revenue, as implemented in Australia, see McLure (1992).
44The cases of Argentina and Brazil illustrate the problems of stabilization and efficiency that can arise from a VAT assigned to, or shared with, subnational levels of government.

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