General principles

10. Each level of government should have clearly assigned responsibilities and fiscal and revenue-sharing arrangements between the central and local governments should be stable and predictable. Clarity, transparency, and stability are paramount for achieving the accountability that efficient governance requires. Overlapping or unfunded mandates, and frequent legislative and regulatory changes should be avoided.

11. Revenue assignment should be fully consistent with expenditure assignment. Sufficient resources should be assigned to local governments to allow them to fulfill their duties. When new duties or responsibilities are transferred to local governments, supplementary funding should be provided. On the other hand, if duties or responsibilities are removed, transfers to local governments should be correspondingly reduced.

12. Local governments need to have a reliable estimate of the revenues available to them before preparing their budgets. Lack of predictability impedes both efficiency and financial control at the local level. Without an indication of the level of resources to be transferred to them, local governments cannot adjust their expenditures to meet perceived fiscal constraints. Accordingly, forecasts of revenues should be transmitted to local governments as soon as they are decided, and estimates of grants to local governments need to be prepared early in the budget process.

13. Certain fiscal autonomy should be given to local governments to realize the efficiency potential of decentralized governance. On the expenditure side this would translate into having budget flexibility to decide—within limits—expenditure priorities in accordance with local preference. On the revenue side, local governments should be able to set tax bases and tax rates on at least one significant local tax source in order to provide incentives for revenue raising and ensure accountability (Ter-Minassian, ed. 1997, Martinez-Vazquez, 1995).

14. Incentives should also be provided for increasing revenue collection and delivering services efficiently. Often the central government adjusts downwards its transfers to local governments when the latter achieve economies in public spending or improve their own tax collection. This can create perverse incentives at the local level. Considerations should be given to allowing local governments to keep a share in any savings they make through improved efficiency.

15. Fiscal deficits should not be passed down onto the local governments. The central government should avoid passing its financial problems to local governments through cuts in intergovernmental transfers or increased expenditure assignments, without compensatory measures.

16. In the case of local government budget overruns or accumulation of arrears, the law should stipulate sanctions or emergency measures. For example, local governments could be forced to cut expenditures or raise taxes and fees, or local budgets could be placed under the authority of the central government until the situation is stabilized.

17. A sound reporting and accounting system based on standard budgeting rules is critical. Systems for budget execution, internal management control and internal audit for local governments should be similar to those of the central government. Ideally, they should be subject to regulation by the ministry of finance. In addition, local and central governments should have a common functional and economic classification of expenditures, based on international standards.

18. Special mechanisms are needed to control local borrowing, which has a potentially important impact on macroeconomic stability. Depending on the degree of decentralization, these mechanisms may consist of grant instruments, fiscal targets set by law, or direct controls on borrowing. Local borrowing should be limited in accordance with clear and transparent principles that take into account the debt servicing capacity of the local governments.

Levels of government

19. Bulgaria is a unitary state with two levels of government—central and local. The local governments are made up of 263 municipalities, which are the principal administrative territorial units at the level of which local self-government is practiced. Municipalities are legal persons, entitled to own municipal property, and have their own separate budgets, which are consolidated with the central government budget. The municipal council and the mayor are directly elected by the citizens.

20. In addition, the territory of Bulgaria is divided into 28 regions which are administrative territorial units of the central government. The regions are arms of the central government and have no autonomous budgets. They are entrusted with the conduct of regional policy, the implementation of state policy at the local level, and ensuring the coordination of national and local interests. Each region is headed by a regional governor, who is appointed by the Council of Ministers.

Expenditure assignment

21. A review of the current expenditure assignment in Bulgaria indicates that there is no gross expenditure mismatch. Typical central government functions which have a national dimension, such as defense, are assigned to the central government while many services with local benefits, such as primary education, local road maintenance, and garbage collection, are assigned to local governments. The health reform launched in 1999 took the responsibility for financing pre-hospital health care establishments from the municipalities and in 2001 the financing of regional hospitals and orphanages, which services have an inter-municipal dimension, became a responsibility of the Ministry of Health.

22. Nevertheless, current expenditure assignments are not sufficiently clear and stable. Many services in Bulgaria are assigned to municipal governments on a shared basis with the central government, including education and health care, which are the largest components of municipal expenditures. This sharing frequently leads to confusion and conflict over accountability and financial responsibility.⁵ Stability has been compromised by frequent and ad hoc changes of expenditure mandates (often without respective revenue assignments), especially in the course of a budget year, creating disincentives for prudent financial management and resulting in accumulation of arrcars and reduced service delivery. Clearly, local governments need more predictability for efficient management of their resources.

23. Unclear delineation of responsibilities over regulation, financing, and implementation—especially in the case of shared responsibilities—have resulted in the proliferation of unfunded mandates. These mandates have served to limit the effective budgetary autonomy of local governments and added demands on their already strapped budgets. According to an estimate of the MoF in 2002 unfunded mandates represent 0.2 percent of GDP.

24. The central government has until recently complicated sound financial management by imposing priorities for municipal expenditures and placing strict limitations on municipally-financed capital investment. Such arrangements have created the perverse incentive to drive up current expenditures and increase lobbying for central government capital subsidies. Also, at the end of the fiscal year, municipalities are often authorized by the MoF to finance current expenditures with the unused portion of the targeted investment subsidy (which cannot be carried over), leading to increased current expenditures to the detriment of investment. To tackle these issues, the government has, beginning in 2001, eliminated the system of mandatory priorities and raised the spending limit on investments (above the targeted subsidy for capital expenditure) from 10 percent to 25 percent of the municipalities’ own revenues in 2002.

25. Expenditures which have a redistributive objective should be the mandate of the central government. However, until recently Bulgarian municipalities were funding 50 percent of social welfare payments from their own revenues. This created significant disparities in expenditure needs across municipalities and especially burdened municipalities with limited local revenues and large dependent populations. With the 2002 state budget the government has partially addressed this problem by lowering the part of social welfare payments financed by municipalities’ own revenues to 25 percent, with a view to funding fully these payments with central government revenues by 2003.

26. Finally, there is a lack of correspondence between the funding and the usage of key mandated services. Many municipalities pay for facilities that serve the population of surrounding municipalities, particularly schools and social care facilities. The funding for these services does not recognize the nature of the inter-jurisdictional costs. In the health sector, this issue is being addressed by removing most health care expenditures from the municipal budgets. However, such distortions will remain for health care facilities, which are still owned by the municipalities, and in other sectors, such as education.

Revenue assignment

27. In general, the assignment of tax bases to governments in Bulgaria is in accordance with public finance principles. Mobile tax bases are generally assigned to the central government budget and immobile tax bases to local budgets. Municipalities have three main sources of revenue: (i) shared taxes; (ii) central government subsidies (general subsidies and targeted subsidies for investment and social assistance); and (iii) own-source revenues, including local taxes, fees, and other non-tax revenues.

28. Shared taxes represent a very large source of municipal revenue—around 40 percent of total revenues in 2000, but vary significantly across municipalities. They are comprised of corporate profit tax and personal income tax, while indirect taxes accrue to central government. Revenues from the personal income tax are allocated 50:50 between the central and local budgets and are paid to the municipal budgets according to the taxpayer’s place of work.⁶ This method of payment poses problems when residents of one municipality work in another, because these people use public services according to their residence but pay taxes to another municipality. The municipal corporate profit tax share is 10 percent of the accounting profits adjusted for tax purposes. Like the personal income tax, the current allocation of the corporate profit tax is based on the location of company, which results in a windfall to some municipalities and a disadvantage to others, especially those where the workers reside.

29. Overall, Bulgarian municipalities have an adequate range of local revenue sources assigned to them. The basic structure of the local tax base is sound, comprised of property tax, vehicle tax, inheritance tax, a new road tax, and a patent tax that covers local business activity. There has been a steady increase in the importance of own revenues in local budgets; own revenues have doubled as a share of total revenues since 1997, to around 18 percent in 2000. A notable feature of the Bulgarian local tax system is the insignificance of the property tax which accounts for only around 4.5 percent of total municipal revenues owing to low tax rates and irregular updates of tax base assessments, both of which are controlled at the central level. Local fees and non-tax revenues are far more important revenue sources for local governments than the property tax, although many of these fees are also controlled from the center.

30. The need for the central government to control its deficit under conditions of high current account deficits and public debt has so far limited the central government in granting more revenue-raising autonomy to local governments. Despite growth in local revenues, autonomy over local taxes is limited by central government restrictions over tax bases and rates, which discourages municipalities from increasing revenues. Also, being uniformly set, the tax rates cannot address the different circumstances across municipalities. Municipalities have only very limited powers in setting the rates of certain local fees within certain ranges set by the law.

31. The practice of central government sequestration of any additional revenues raised by municipalities (and the fact that budgeted local tax revenues are based on forecasts of the central government) has reduced transparency in intergovernmental relations and created disincentives for revenue mobilization. According to the 2002 State Budget Act, municipalities have to pay back to the central government shared tax revenues in excess of central budget forecasts while the central government has to give compensatory grants when collected shared tax revenues are lower than the forecasted levels. Such a provision provides little incentive to increase revenues. Although the centralized shared tax revenues in excess of budget forecasts are subsequently redistributed among municipalities the reallocation mechanism is often discretionary and non-transparent. This has deprived municipalities of revenue predictability and stability and decreased their ability to budget and plan expenditures.

32. At present the collection of local taxes and certain fees is done by the MoF regional tax offices on behalf of the municipalities. It is an open question as to whether a shift to municipal control of local tax administration would produce higher revenues. Centralized tax collection is often less costly to administer owing to economies of scale. Also, given the size of the country and the on-going project for setting up the Unified Revenue Agency, which is expected to strengthen the revenue collection process, it may not be desirable for municipalities to assume fully independent local finance administration.

Central government transfers

33. Central government transfers have been an important source of revenues for municipalities, ranging from 35 percent to 43 percent of total municipal revenues during 1997–2000. Central government transfers consist of: (i) general purpose grants (unearmarked block grants); (ii) targeted grants for capital expenditures (for centrally approved projects); and (iii) special purpose grants for social assistance. The specific transfer amounts are determined every year in the State Budget Act where only the general grant’s calculation is based on a formula. In 2002, the MoF reduced the total subsidy by 0.3 percent of GDP (reflecting the removal of certain health care expenditures from the municipal budgets) and shifted larger proportions of the total subsidy into the social welfare and capital investment components.

34. The general grant formula in the 2002 budget addresses, in part, the disincentive to municipalities to raise higher revenues. Previously, the higher the own revenues (tax and non-tax) expected for a given municipality, the lower was the subsidy provided to it. In 2002, the formula excludes the full amount of non-tax revenues, with the purpose of limiting central government intervention in determining the amount of non-tax revenues and how they are spent. The current transfer formula is clearer than the formulae used in the past, and has the advantage of taking into account mandatory expenditures and (by excluding nontax revenues) provides municipalities with additional resources which can be used to finance the operations and maintenance of non-mandatory activities.

35. Nevertheless, further improvements are needed. The provisions of funds covering the full amount of wages (which are part of the mandatory expenditures) risks fixing the distribution of current spending between wages and non-wage expenditures. Further, the system of transfers should have explicit objectives and grants should be explicitly budgeted ex-ante and allocated according to objective and transparent criteria. Also, the transfer formula should be further improved to provide incentives to stimulate local revenue collection, and ensure that local revenue is not replaced with equalization grants. Finally, the central government should try to avoid ad-hoc and gap-filling transfers and restrain from changing the formula’s methodology from year to year which makes the system of central government transfers less predictable and transparent.

Municipal borrowing arrangements

36. Local government borrowing has clear ramifications for macroeconomic management and control. Although the current level of municipal borrowing is not very high, the lack of effective monitoring and enforcement and the absence of adequate bankruptcy procedures for defaulting municipalities poses important risks. Also, there is at present no clear reporting on the full outstanding debt and contingent liabilities of local governments. The moral hazard created by the practice of granting loans by the central government that are eventually forgiven is another important threat to local budgetary discipline.

37. Concerns about the lack of responsible fiscal management at the local level and its impact on macroeconomic stability at the national level have led to the introduction of limits on local borrowing. Bulgaria has enacted legislative limits on local budget deficits as a share of local budget revenues, but the current legal framework is inconsistent with respect to the purpose for which municipalities are authorized to borrow. According to the Municipal Budgets Act the authorized level of municipal budget deficit is 10 percent of total budget revenues, which is interpreted by many municipalities as authorization to borrow for financing current expenditures. At the same time the Local Self-Government Act prohibits borrowing to fund general operating expenses. Clearly, these conflicting provisions need to be reconciled.

Reform proposal

38. Bulgaria’s program for fiscal decentralization aims at “delivering public services of quantity, quality and price that are affordable and correspond to citizen needs, on the basis of sustainable and durable balance of expenditure responsibilities of municipalities with stable revenue sources, and effective citizen control.” In achieving this objective the government intends to follow the subsidiarity principle of assigning expenditure and revenue authority to the lowest efficient level of government; match expenditure responsibilities with revenue sources; impose strict financial discipline on municipalities and enhance their financial management capacity; seek transparency and equitable treatment of all public sector actors; provide fair access to resources for delivery of minimum level of public services; and establish a balance between local discretion and macro-financial stability by developing and ensuring certain minimum standards for public service delivery.

39. The government will seek changes in the following four broad areas: (i) defining and delineating the expenditure responsibilities of the state and the municipalities; (ii) funding of state expenditure responsibilities mandated to municipalities; (iii) funding of municipal expenditure responsibilities; and (iv) improving the legal framework for the municipal budgets preparation and execution process.

40. Reform measures in the first area are targeted at a clear assignment of expenditure mandates especially in education, health care and social assistance as well as clearing the municipalities’ arrears for 2001. These measures include defining clearly in the 2003 budget framework the state and municipal responsibilities toward accumulated arrears and giving priority to developing cost standards (including for staffing levels, average wages, and maintenance) for public service delivery in the education, social welfare, culture, and health care sectors. In the medium term, the government plans to develop a special law for the city of Sofia that will take into account the specific fiscal status of the capital city where there is considerable concentration of publicly provided goods and services.

41. The proper funding of mandated responsibilities is key for the municipalities to be able to carry out the assigned public service delivery and avoid further accumulation of arrears. The assigned mandates shall be financed through a combination of shared taxes and grants. With the 2003 state budget the government intends to remove the current municipal tax and the municipal corporate profit tax share as municipal tax revenue sources, compensating in full with proceeds from the personal income tax and subsidies from the state budget. In order to provide incentives to municipalities to increase shared-tax revenues the government plans to review the regulatory mechanism for year-end reallocation of the eventual surplus of shared tax revenues (in excess to the budget forecasts) among municipalities and give opportunity for part of this surplus to stay with the them.

42. Expenditure mandates will be further clarified and funding provided accordingly. The expenditure responsibilities for provision of social assistance will be covered in full by the central government and the expenditures for social services provided by the municipalities. The formula for calculating intergovernmental transfers will be entirely revised with the 2003 State Budget Act and made in accordance with the respective assignment of revenue and expenditure responsibilities between the municipalities and the central government. It will be transparent and accessible to the municipalities in advance of the municipal budget preparation process.

43. The third set of reforms seeks to secure adequate municipally-controlled revenue sources to meet the demand for local public services. The measures are directed at giving authority to municipalities to set rates of local taxes and fees, and determine tax bases. As a first step, the government will work out a program for gradual reduction and clearing of that part of municipal arrears for 2002 related to municipal (discretionary) responsibilities, with municipal own revenues as a major source of financing, in the course of executing the current state budget. By amending the Local Taxes and Fees Act municipalities will be given autonomy in determining local fees. Taxes that enter municipal budgets will be clearly separated according to the respective assignment of expenditure responsibilities and following the principle that shared taxes finance state expenditures and local taxes finance municipal expenditures. If a political consensus is achieved in the parliament the scope of local taxes will be broadened in the medium-term. For municipalities which are not able to finance local public services at a minimum required level with their own revenues an additional subsidy will be distributed from the central budget. In the medium term, the program envisages amending the Constitution so that municipalities can alone set local taxes.

44. Finally, the legal framework would be improved with respect to municipal budget preparation and execution and to enhance the municipalities’ financial management capacity. Reforms will seek to establish legally sound budget and accounting practices, improve transparency of, and conditions for giving, central budget loans to municipalities, and develop a solid normative base for the municipal credit system and municipal insolvency procedures. A clear distinction between operational (current) and capital budgets will be made in the Municipal Budgets Act. Debt financing will be allowed only for acquisition of long term fixed assets and rules for application, approval, repayment, and writing off of interest free municipal loans granted by the central government will be developed. The government will also establish legal procedures to ensure observance of strict financial discipline by municipalities as well as for determining the conditions and measures to be taken when they fall in financial distress or insolvency. Further, an incentive/penalty system will be put in place to encourage/limit the implementation of good/bad management practices. Finally, legislative procedures for municipal debt issuance, pledge of collateral, credit rating, disclosure and accounting as well as the central government’s role in the process will be developed in the medium-term.

Some remarks on the proposed reforms

45. The proposed reform of the intergovernmental fiscal relations has a number of advantages. It achieves greater clarity and simplicity in determining the fiscal relations both at the national and municipal level. All municipal activities will be divided into centrally mandated services and municipal services provided at local discretion, with the centrally mandated services funded at a basic level by central government transfers, shared taxes, subsidies, and state fees, while municipal services are financed with municipal own source revenues. The costs of mandated services will be based on centrally developed minimum standards while the expenditures for services provided at local discretion will be constrained to the level of municipal own source revenues. Further, removing the corporate profit tax and retaining the personal income tax as the only shared tax will add stability and predictability to the system and increase horizontal balance across municipalities. The suggested revision/removal of the shared tax surplus redistributive mechanism and eliminating the sequestration of any surplus municipal revenues will reduce disincentives for revenue mobilization. A move in the right direction is also the intended full funding of social welfare payments by the central government.

46. However, further improvements can be made to more fully achieve the decentralization reform objectives. Horizontal equity, for example, can be further improved by moving away from the current method of allocating the personal income tax based on taxpayer’s place of work to allocation based on taxpayer’s residence, which will limit the distortions between revenue allocation and expenditure needs. Capital expenditure responsibilities could also be better clarified by making municipalities responsible for the capital infrastructure needed to provide those services assigned to them. The responsibilities of municipalities for investment budgeting and programming should be increased in line with the functions assigned to them. The 2002 budget includes measures that go in this direction—50 percent of the targeted subsidy will be allocated among projects by the municipalities themselves. However, before the transfer of full capital budgeting responsibilities to local governments is implemented, it is essential to carry out an extensive training program for local budget officials covering multi-year budgeting, project appraisal techniques, tendering, and contracting.

47. In Bulgaria, a possible next step towards greater fiscal autonomy would be to give municipal governments limited authority over one highly productive revenue source, such as a revamped property tax, and possibly some other local taxes like the vehicle tax and the patent tax. Some degree of authority could be granted over tax rates and bases, and municipalities could be given the authority to determine the services on which they will charge fees, the types of fees to be imposed, the rates, the base, and the collection process. Implementing a comprehensive reform of the local revenue system will guarantee access to adequate level of revenues and induce local governments to increase revenue collection.

48. Finally, the envisaged strengthening of the legal framework for local government borrowing is worthy but additional rules for monitoring and enforcement of the already existing limits may need to be put in place. A golden rule that limits municipal borrowing for investment purpose and requires current budgets to be balanced could be desirable in Bulgaria, but additional control and/or rules may also be needed to ensure compliance with the central government fiscal targets. Central coordination of the external debt policy is required, and its impact on the balance of payments must be taken into account. Approaches to foreign capital markets and negotiations with international financial institutions need to be coordinated. Moreover, foreign lenders, when lending to local governments, generally require an explicit or implicit guarantee from the central government. Therefore, at a minimum, lending operations made abroad by municipalities should comply with conditions set by the central authorities.