Draft Law on the Budget Code is not about decentralization, although it has some positive developments.

By Ilona Sologub (Kyiv School of Economics, Ukraine)

On August 8^th, the government registered the Draft Law on changes to the Budget Code concerning decentralization. The draft law has already received some complimentary as well as some negative (here and here) feedback. Since the Draft Law was supposed to become an integral part of the decentralization reform package, this post analyzes it from this point of view. The main conclusions are:

1. The proposed amendments to the Budget Code do not correspond with the logic of the reform and with the Decentralization Concept adopted by the government.
2. It seems that the main motivation behind the proposed Budget Code amendments was “making the central government look good” by transferring all problematic issues, such as cultural and ecological projects, renovation of housing, etc. to the local level while keeping the most “electorally valuable” spheres, such as education, healthcare, and social protection under the central government hand.
3. The Draft Law contains some positive developments, such as the new system of calculating inter-budgetary subsidies and somewhat eased procedures for obtaining external loans by local governments.

The more detailed analysis is presented below.

Redistribution of expenditures between central and local governments

Following the experience of other countries that introduced decentralization reforms, the Ukrainian Decentralization Concept foresees three levels of local government – community (C), raion (R) and oblast (O), with the major competences and corresponding budget expenditures transferred to the lowest (community) level. The table below compares the distribution of public functions (and corresponding public budget expenditures) between different levels of government in the current system, the decentralized system as proposed by the Decentralization Concept, and the system proposed by the Draft Law on changes to the Budget Code.

The first striking inconsistency between the Draft Law and the Concept of Decentralization is that the former actually foresees two instead of three levels of local budgets: (1) oblast (ARC, cities of Kyiv and Sevastopol) and (2) raion/city/”united territorial community”. Obviously, the authors of the Draft Law assume that given a big “carrot” in the form of higher revenue base, and an equally big “stick” in the form of depriving villages and towns from the PIT revenues, “united territorial communities” will be formed quickly on the basis of the law “On the voluntary union of territorial communities” adopted in the first reading in July 2014.

This is a very strong assumption given that, even if the law is adopted, the officials of local councils may well be reluctant to “voluntarily unite” their communities in order not to lose their jobs. Moreover, the “united territorial communities” would be financially equal to raions (i.e. have the same range of revenue sources and expenditures). Hence, their heads would demand political equality with the raion heads, which may result in prolonged local political conflicts. While these conflicts are resolved, villages and towns would remain underfinanced.  

Table 1. Distribution of expenses between budgets of different levels: C = community level (villages, towns); R = raion or city level; O - oblast level; S - state level; U - “united community”/raion/city level (proposed in the Draft Law)
public function (expenditures)	Current system (Budget Code)	Proposed system (Draft Law on changes to the Budget Code)	Decentralized system (Decentralization Concept)
Education
Kindergartens	C R	U	C
Primary schools	C R	U	C
Secondary schools	U R	U S O	C
Out-of-school facilities	C U R O	U O	C
Boarding schools and orphanages	R O	U O	R
Vocational/ technical schools	U R O	S O	O
Universities	U R O	S O	Not defined*
Post-graduate education	U O	S O	Not defined*
Healthcare
Primary healthcare	U R	U S	C
Emergency healthcare	O	O	C
Specialized hospitals	U O	S O	R O
Health resorts/rehabilitation	U O	O	Not defined*
Sanitary supervision	U O	S O	Not defined*
Social security
Payments and privileges to eligible social groups	C U R O	U S O	C***
Foster families	R	U	Not defined**
Social services for families and youth	R O	U O	Not defined**
Other
Cultural and sports facilities	C U R O	U S O	C***
Infrastructure and amenities	C U R O	U S O	C*** O
Ecological programs	U R O	U S O	O***
Administrative services	C U R O	U S O	C***
Fire security	C R	U	U
Civil security in emergency states	C R O	U	C
Police	U	U S	C ***
* presumably state and/or oblast level ** presumably local (community) level *** presumably also state (central) level

In summary, the Draft Law proposes delegation of some responsibilities from state to local level, at the same time centralizing other spheres. Namely,

• state-owned health resorts, educational (except for institutes and universities), cultural (theatres, museums etc.) institutions, as well as natural parks are transferred from state to oblast or city property;
• some state ecological programs (care for forests, liquidation of ore mines and chemical mines etc.) are transferred from state to oblast level;
• some state infrastructure programs (introduction of energy-saving technologies into communal services provision, (re)construction of water pipes and wastewater disposal systems, (re)construction of housing and street lighting etc.) are transferred from state to raion/city/ “united community” level.

Two things remain unclear, however: whether local governments get enough funding to support these programs and whether they will be allowed to decide on the distribution of these funds.

At the same time, the government centralizes financing of education (except for pre-school and out-of-school) and healthcare. Although the medical and educational institutions themselves will belong to local communities, the government will fully finance their operation through subventions. This contradicts the logic of decentralization, since a local community knows better whether to keep a given school or a clinic or to repair the road and introduce a regular bus route to the nearest town instead – and so should be able to make this decision.

A positive change proposed by the Draft Law is the transfer of responsibility to provide social security payments (to veterans, to those suffered from Chornobyl, to former coal miners and many others – the complete list is one-page long) from raion budgets to the central budget. These privileges have been granted by different laws and are financed from the central budget (raion administrations are only distributing the central budget subventions to eligible people). Hence, it is logical to pass on the administering of these payments from raion administrations to local offices of the Labour Ministry.

Redistribution of revenues

Under this new distribution of responsibilities, the government proposes redistribution of some taxes. The declared purpose of this redistribution is providing more revenues to the local budgets. However, it seems that this purpose cannot be achieved with the current Draft Law. The Draft Law proposes redistribution of the following taxes:

1. Person income tax (PIT). The primary source of local budgets revenues is personal income tax. Currently PIT revenues are fully allocated to the local budgets (except for Kyiv). The Draft Law proposes to allocate 25% to the central budget (and in Kyiv – 80%).

Table 2. Proposed redistribution of PIT revenues
Source of tax: incomes of people living in	Current distribution	Proposed distribution
- villages and towns (містa районного значення)	25% – village/town budget	0% - village/town budget
	50% - raion budget	60% - raion / united territorial community budget
	25% - oblast budget	15% - oblast budget
	0% - central budget	25% - central budget
- cities (містa обласного значення)	75% - city budget	60% - city budget
	25% - oblast budget	15% - oblast budget
	0% - central budget	25% - central budget
- Kyiv	50% - Kyiv budget	20% - Kyiv budget
	50% - central budget	80% - central budget
- Sevastopol	100% - Sevastopol budget	100% - Sevastopol budget
	0% - central budget	0% - central budget
Source: Budget Code, Draft Law on the Budget Code

 

2. Enterprise Profit Tax (EPT). Currently EPT revenues (except for EPT on communal enterprises) belong to the State Budget. The Draft Law suggests to leave 10% of EPT revenues at the oblast level (including Kyiv and Sevastopol).

3. Payments for licenses, including licenses on production and trade in alcohol are transferred from city/town to oblast (Kyiv and Sevastopol) budgets.

4. The proposed redistribution of ecological tax (except for tax on creation and keeping of radioactive waste) is shown in the following table:

Table 3. Proposed redistribution of ecologic tax revenues
Budget	Current share	Proposed share
Central	65%	20%
Village/town/city	25%	25%
Oblast	10%	55%
Kyiv, Sevastopol	35%	80%
Source: Budget Code, Draft Law on the Budget Code

 

5. Currently, the rent for extraction of mineral resources (except for oil and gas) is divided 50/50 between central and local budgets. The Draft Law proposes to leave 100% of this rent at the state level.

6. It is proposed to leave payments for administrative services that currently belong to the central budget at the raion level (except for payments for registration services that will be divided 50/50, as now).

7. The Draft Law proposes to cancel the fee for the development of orchards, wine-growing and hop-growing (currently belongs to the central budget), and to levy a 2% tax on retail sales of alcohol, tobacco and oil products, revenues from which will go to local budgets. Perhaps, entrepreneurs will be very unhappy with this new tax.

To sum up, let’s make a very rough calculation of what local budgets would gain or lose if the proposed changes are adopted (the table below uses 2012 data).

Table 4. Potential gains/losses of local budgets from proposed tax redistribution
Tax	Tax revenues, billion UAH	Current central/local distribution, %	Proposed central/local distribution, %	Possible gain/loss of local budgets, billion UAH
PIT, except Kyiv	47	0/100	25/75	-11.8
PIT, Kyiv	14	50/50	80/20	-4.2
EPT	44	100/0	90/10	+4.4
Ecologic tax*	1.3	35/65	80/20	+0.6
Rent for extraction of mineral resources	1.5	50/50	100/0	-0.75
Payments for administrative services	2.2	100/0	0/100	2.2
2% sales tax	2.5	-	0/100	2.5
Total	112.5	-	-	-6.0
Source: Treasury, State Statistics Committee data, own calculations * The government forecasts revenues from this tax to increase almost three-fold in 2015, which is (1) unrealistic and (2) does not cover projected loss of other taxes.

 

Thus, the proposed tax redistribution, holding everything else constant, is likely to result in lower local budget revenues, which, in turn, will cause underfinancing of central government programs delegated to the local level.

The main positive development of the proposed Draft Law is the new methodology for calculation of transfers from the central to local budgets. Under current legislation, transfers cover the gap between local budgets’ expected revenues and expenditures defined by the Budget Code. Therefore, local budgets can be adopted only after the central budget is adopted, since local governments don’t know in advance the volume of transfers, subsidies and subventions provided to them from the central budget.

The proposed Draft Law replaces transfers with subsidies, and the subsidies take into account only the sum of EPT and PIT revenues received by local budgets. These revenues per person are compared to Ukrainian average, and the index of taxability is formed. If the index is lower than 0.9, a region receives a subsidy - 80% of amount necessary for the index to reach 0.9. Regions, where this index is higher than 1.1, transfer 50% of excess tax revenues to the central budget. Under this scheme, local budgets can be adopted even if the central budget is not, since the approximate volume of subsidy is known in advance, and correction, if any, will be minor.

Other issues

Except for redistribution of some revenues and expenditures (which is not a real decentralization, as we have seen), the proposed Draft Law concerns other issues briefly discussed below.

1. Budgetary institutions are allowed to place own revenues and the funds of the “development budget” into banks, rather than Treasury accounts (the list of eligible banks is formed by the CMU according to the criteria of size and state property – currently, 13 banks would be eligible). However, if a budgetary institution does so, it loses the status of a “budgetary institution” and becomes an economic agent. How does this change of status happen in reality, and how does the backward change happen, is not clear. So, this “liberalization clause” is designed in such a way that no budgetary institution would be willing to use it.

2. The draft Law further develops the mechanism of financing local government investment projects from the State Regional Development Fund of the State Budget. This Fund was introduced in 2012 and should have been no lower than 1% of General Budget Fund revenues, but in reality it has been five times smaller.

The Draft Law proposes to transfer the right to select investment projects to the Ministry of Regional Development from the Ministry of Economy, and also slightly change the criteria for distribution of funds: 80% based on regional population and 20% based on regional GDP (currently the proportion is 70/30). Although theoretically this Fund is a good idea, it offers high opportunities for rent-seeking, which in Ukrainian conditions will most likely be realized.

3. A very positive thing proposed by the Draft Law is limiting state guarantees provision: they will be provided to economic agents only for implementation of investment projects, and annual amount of state guarantees would not exceed 5% of the General Budget Fund revenues.

However, there is a fly in the ointment. Currently, the law states that combined volume of state and guaranteed debt should not exceed of 60% of GDP. The Draft Law proposes to exclude guaranteed debt from this calculation. While currently this is not a problem, since Ukrainian government debt is much lower than the threshold, this may cause problems in the long run because the guaranteed debt is also a state liability.

4. The procedure of obtaining loans by local governments is somewhat relaxed (as prescribed by the Decentralization Concept) – under the Draft Law, a local government is allowed to proceed with the loan if the Ministry of Finance does not provide its objections within a month after it receives the information about local government’s intentions to borrow.

 

Conclusion

If the government really wants to proceed with the decentralization reform, changes to the Budget Code should be developed simultaneously with:

- the tax reform (to account for potential tax revenues change);

- changes to the Law on self-government (the redistribution of powers and responsibilities between different levels of local authorities, changing the role of state administrations);

- and, perhaps, the administrative-territorial reform (in our opinion, very small share of communities would be willing to “voluntarily unite”, so this process should be imposed from above).

However, some clauses of the current Draft Law, such as the new approach to calculation of central to local budget transfers, can be adopted immediately.

P.S. A cherry on the cake. The government Decentralization Concept foresees that a local budget would receive a share of EPT revenues from newly created enterprises during five years after their creation. However, there is nothing about this issue in the proposed changes to the Budget Code.