Budget incentives for local governments in the Republic of Bashkortostan to develop economy and to improve providing  of public goods

Zoulkarnaev Ildar

Background
This report concerns a problem of “good” budget incentives for local governments to develop local economy, to increase tax base and to improve providing of public goods in the Republic of Bashkortostan (RB).  Bashkortostan is one of the 89 subjects of the Russian Federation (RF) and is one of the greatest and most developed regions among them with the population of 4 million people, 1 million of which lives in Ufa, the capital of the republic; with a territory which is approximately equal to that of  Greece.  65 percent of the population lives in cities, 35 percent – rural population. It is  a multi-ethnic republic represented by about one hundred nationalities. Among them are Russians, Bashkirs and Tatars who compose the majority of the population, but there are also Ukrainians, Germans, Jews, Chuvashs, Maris, Mordvinians, and others. In cities and towns the ethnic groups are mixed rather evenly, but in many rural jurisdictions some ethnic groups are in the majority. Besides, Bashkortostan has some specific peculiarities such as significant shares of petroleum-refining and agriculture industries, a relatively high level of ecological problems, a relatively low level of development of social and educational spheres in comparison with other regions of the RF.

There are two levels of local self-government in Bashkortostan. The upper level includes 62 local governments, which are the so-called “State local governments” of cities, towns and rural territories. Some of them cover a rural territory and a town within this territory: for example, the city of Belebey and the  Belebey rayon have got one and the same government. In the other cases a rural rayon and a city that stands on its territory have separate local governments. The rural rayons which don’t have cities cover territories with the population rates from 15,000 to 52,000. 20 cities and towns have population rates from 20,000 (the town of Agidel ) to one million people (the city of Ufa ). Cities in Bashkortostan have also local governments which cover city districts and they refer to the lower level of local self-government. The topic of this paper is investigation into the problem of intergovernmental fiscal relations between the Bashkortostan government and the 62 local governments, which are on the upper level of local self-government.

The problem of perverse budget incentives in the Russian Federation is inherited from the Soviet times, when all expenditures were planned mostly in a top-down way and negotiations with upper governmental bodies with the lower ones. With the start of the reforms in 1992 the negotiated constituent in intergovernmental relations was increased. However, the federal government tried to introduce a formula-based system of allocation of financial support and since 2000 this mechanism has been introduced in relations of the Federal government with the subjects of the federation. The main part of the federal support is allocated among 88 regions according to a formula-based scheme  from the “fund of financial support of regions”. The support for the Chechen Republic is calculated by count-up. There is also a fund for financing the federal mandates which uses different formulas for funding every mandate from a group of the main federal laws on social support. These measures  with introduction of the Tax Code and the Budget Code in 2000 established certain budget incentives for subjects of the federation to develop economy and improve delivering of public goods.

The further steps of the federal government concern  intergovernmental relations between regional and local governments. Thus, in 2001 the federal government adopted “the Program of development of budget federalism in the Russian federation until the year 2005”. This program concentrates on clarification of local governments’ status, perfection of assignment of functions and revenuer sources between different levels of government aimed at gaining transparency of local budgets and  introducing  effective budget incentives for local governments to develop local economy and to improve delivering of  public services. In the framework of this program in 2000, the RF Ministry of Finances issued Interim Methodological Recommendations on Regulating Intergovernmental Relations in the Regions of the Russian Federation (further referred to  as the RF MoF Recommendations). This document proposes to the regional governments a certain algorithm of allocation of resources among local jurisdictions as well as the  key elements of the formula which the regional governments are to elaborate  for computation of financial support of localities. Roughly speaking, the RF MoF Recommendations propose the same mechanism for subregional allocation of resources that the federal government has been using in relations with the regional governments since 2000. Many regional government officials say that the mechanism, which is good for allocation of  resources by the federal government can’t be used in allocation transfers by the regional governments among local jurisdictions.

Thus, the RF MoF Recommendations suggest to the regional governments that they should use indicators of expenditure needs such as the share of the  population, which  is unemployed, elderly, disabled and so on. Actually, the Bashkortostan government’s policy is aimed at allocation of resources according to the existing infrastructure. Officials of the Bashkortostan’s MoF say that direct implementation creates many problems on local levels, because of the unproportional arrangement of infrastructure delivering public goods. This fact arouses the resistance of subnational governments to RF MoF Recommendations. 

Thus, there exists a  problem of introduction of “good” budget incentives on subregional levels and there are  certain contradictions between the federal and regional officials concerning intergovernmental policy. I have been  trying to clarify this question while working on the project supported by the Joint NASPAA - NISPAcee Policy Research and Management Studies Project. The main project goal is elaboration of propositions for creation of budget incentives for local governments in the Republic of Bashkortostan to develop economy and to improve providing of public goods on their territories. In this project I have been receiving pieces of advice from Dr. Robert MacNab, a NASPAA consultant, and Dr. Sergii Slukhai, a NISPAcee consultant.
In this paper I am going to present the intermediate results of the Project obtained by the present moment. Thus, this manuscript explains the first two points of five objectives that the Project pursues within its main goal mentioned above: 
•	to show advantages and disadvantages of the present system of allocation transfers and subsidies among local governments in Bashkortostan;
•	to  investigate critically to what extent the RF MoF Recommendations are applicable for the Bashkortostan conditions; 
•	to carry out a formula-based equalization scheme which is the most appropriate for the Republic of Bashkortostan for the present; 
•	to gain some level of transparency of intergovernmental fiscal relations in Bashkortostan;
•	to stress on relations between Bashkortostan’s budget and the budget of Ufa – the capital of Bashkortostan where one fourth part of Bashkortostan’s population lives
At the end of this report I will also formulate some questions concerning the ways of solving the above-mentioned problems, which are not clear for me and I should like to discuss them at this conference.
Chapter 1. Estimation of the current situation with budget incentives in Bashkortostan
1.1. Bashkortostan budget strategy
During the 1990-es the strategic objectives of economic and budget policy the Bashkortostan government were as follows: 
a)	budget support of economy (agriculture in particular);
b)	investments into development of industrial infrastructure (mostly in road-building and reconstruction of roads, but also into the construction of the petroleum and chemical plants, which were started by the Soviet government before disintegration of the USSR;
c)	social security – mitigating social problems caused by the market reforms.

Bashkortostan had the structure of republican and local government expenditures shown in tab.1. It is easy to see that local governments spent about thirty percent of budget expenditures on educational needs and over 17 percent on public health service needs. Apparently, this is a typical picture for all years, and local governments didn’t have their own revenues enough to maintain these needs and needed financial support of the republican government. Thus, the republican government spent a third of the budget on financial support of local governments in 2001, and a quarter of the budget in 2002.

Table 1: Structure of republican and local expenditures in the Republic of Bashkortostan
 in 2001 and 2002 (percent)	
	Republic budget	Local budget	Republic budget	Local budget	
Government	          3,0	          5,1	          2,9	          4,9	
Agriculture support	          5,3	          2,8	          7,7	          1,3	
Industry&Construction	        34,7	          8,5	        22,3	          5,8	
Housing&communal services	          0,3	        14,6	          0,5	        10,6	
Education	          2,6	        30,0	          2,8	        40,9	
Culture	          1,0	          2,8	          1,3	          3,2	
Public health	          4,4	        17,1	          7,1	        19,8	
Public security	          1,7	          2,9	          4,2	          0,3	
Communications&roads	        11,3	          4,1	        14,6	          3,2	
Public assistance	          2,7	          8,1	          3,2	          9,6	
Support of other governments	        29,7	          1,7	        25,7	          0,0	
Other expenditures	          3,3	          2,4	          7,7	          0,3	
Total	      100,0	      100,0	      100,0	      100,0	
Source: Author’s computations on the basis of the Laws on execution of the budget of the Republic of Bashkortostan for 2001

Source: Author’s computations on the basis of the RF MoF data

Figure 1 demonstrates the results of all kinds of financial support of local governments by the republican government of Bashkortostan in 2001. All local governments are put in the order of growing of their per capita own revenues, that include collection of local taxes and taxes ceded to local governments by the upper governments (line L&Ctax in Figure 1).  Local governments received three kinds of financial support:
•	tied grants computed according to the number of consumers, for example children’s allowance (Line “L&Ctax +TiedGrant” on Figure 1 shows the local revenues with this grant);
•	untied transfers (Line “L&Ctax +TiedGrant+Tr” on Figure 1 shows the local revenues with this grant);
•	compensations of additional expenses caused with regional mandates for the year (Line “L&Ctax +TiedGrant+Tr+AddSupport” on Figure 1 shows the local revenues with this grant);

One can see that tied transfers such as children’s allowance slightly increased local revenues but didn’t change the picture of disparity of localities in revenues. Untied transfers and compensations for additional expenditure mandates made the significant contribution into equalization of revenues, lifting per capita total revenues up to 3500-5000 roubles for the majority of localities.

As Table 2 illustrates, horizontal equalization policy allows to mitigate the difference of budget revenues among rayons and cities of Bashkortostan. In 2001, before equalization, the ratio between the minimal and maximum value of the per capita own revenues (tied transfers inclusive) was 1 to 16, after allocation of equalization transfers – 1 to 2,5  and after allocation of compensations for additional expenditure mandates 1 to 2.

 Table 2: Horizontal equalization in the Republic of Bashkortostan: Per capita revenues before and after equalization in 2001
 	Revenues before allocation of tied transfers	Revenues, tied transfers included	Revenues, tied and equalizing transfers included 	Total revenues (with compensations of mandates)	
Min value (USD)	10,5	40,8	74,4	108,0	
Max value (USD)	164,7	170,0	177,3	216,8	
Mean value (USD)	54,2	75,9	114,8	150,9	
Coefficient of variation	0,85	0,49	0,22	0,19	
Source: Author’s computations on the basis of the RF MoF data

1.2 Problem of perverse budget incentives for local governments
The current intergovernmental relations within Bashkortostan suffer from all shortcomings that are inherent to the majority of the RF regions: nontransparenceness; negotiated way of allocation of financial support from regional to local governments; instability in sharing  taxes, and as a consequence, absence of budget incentives for local governments to develop economy and tax collection on their territory. Only about a dozen regions of the RF have introduced formula-based systems of allocation of financial support.

The main principles of allocation of resources in Bashkortostan are the following (RB MoF, 20021):. :
•	the Bashkortostan government tries to provide every local jurisdiction with funds up to the level of minimal expenditure needs;
•	the expenditure needs of the localities where customers receive funds directly, are computed on the base of the number of customers, for example, the number of children who are to receive children’s allowance;
•	the expenditure needs of the localities where customers receive public goods  delivered to them by some infrastructure, are computed on the basis of actual expenditure needs of this infrastructure. As it can be seen from the RB Law On Bashkortostan Budget for 2003, in relationship between the Bashkortostan budget and the budgets of rayons and cities, MoF based on “the current net of institutions of budget sphere and their actual average expenditures” (RB MoF, 20021):. 

There are at least two problems of perverse incentives here:
•	local governments try to show more expenditure needs than they actually need according to their infrastructure so that to receive more funds from the Bashkortostan government;
•	local governments try to increase infrastructure by the way of negotiations and personal informal contacts so that to have more opportunities to demand additional funds.

The Bashkortostan government concentrates mostly on decision of the first problem. Until 2002 financial support was based mostly on estimations of local governments that they gave to RB MoF and on the correction of actual expenditures of the previous year for the new year by coefficients that reflected different changes in economy and legislation. The Ministry of Economy  collected information about all expenditure needs of all organizations in Bashkortostan, which provide public services. They also collected information about expenditure norms explained in Laws, Ministry instructions and other federal documents. At present every school, hospital and other institution has a passport with information concerning premises, needs in electric energy and heat, and other needs. And since 2003, MoF of RB has been trying to estimate expenditure needs of local governments using those passports and expenditure norms. 

In the recent years higher Bashkortostan officials spoke about the low efficiency of local finances, the necessity to reform local governance, to develop local self-government and so on. But they accent on administrative measures and don’t pay attention to development of budget incentives for local governments. This is especially striking in view of redistribution of shares of revenues between the federal and Bashkortostan governments in favour of the Centre. If the share of the Bashkortostan consolidated budget at the end of the 1990-s was approximately two third of its total revenues, in 2002 – about a half, in 2003 this share is expected to be 37 percent. 

Under the present conditions of diminishing the share of Bashkortostan in tax revenues the government is especially concerned about the problem of increase of revenues. RB MoF sees the following ways of solution of this problem in 2003 (RB MoF, 20022):
•	to compensate the decreasing of tax revenues by increasing non-tax revenues (if the share of non-tax revenues is 9 percent of the total revenues of the Bashkortostan consolidated budget in 2003, this share is planned to be 11,5 percent for 2005);
•	to intensify administration of tax collection where tax rates are diminished;
•	to institute a searching scrutiny of infrastructure of delivering public goods, so that to attack inefficiency and waste.
In addition to these measures the government of Bashkortostan pays a certain attention to budget incentives for local governments to develop economy. Thus, Main Principles of Calculation and Provision of Financial Support of Local Governments in 2003 (RB MoF, 20021) says that “the intergovernmental relations in 2003 are based on conservation of the current system of distribution of expenditures between the republican budget and the local budgets … that allows to interest the local governments in development local tax base”. 

Figure 2 and figure 3 show dynamics of changing tax rates for the period from 2000 to 2003 for two local governments:
•	the local government of the Krasnokamsky rayon, the rural jurisdiction  with the population of 27,000 people and very reach oil production;
•	the local government of the city of Ufa, the capital of Bashkortostan, which gives about half of tax revenues of the consolidated budget of Bashkortostan. 
In these figures we can see changes of EPT, PIT rates, and the rate of tax of real estate, assigned by upper governments to local governments; and also local government’s shares of hydrocarbon excises, city land and agricultural land taxes taken a tenth so that they would be comparable with other tax rates in the figures. As one can see from these figures the tax rates and the tax shares assigned to the local governments were changed considerably  from 2000 to 2002. An especially considerable influence on local revenues was  a result of EPT, PIT and hydrocarbon excises because they constitute the greatest amounts of tax revenues of the consolidated budget of the Republic of Bashkortostan, as one can see it from figure 4 (hydrocarbon excises constitute the largest part of mineral resource payment). And actually, the EPT, PIT rates, the rate of tax of real estate, and the share of hydrocarbon excises, assigned to the local governments in 2003 are the same as in 2002. Local shares of land taxes in 2003 are slightly different form the ones in 2002. It testifies to the tendency to stabilize tax system in Bashkortostan. These conclusions can also be drawn for the other 60 local governments of the upper level, where the dynamics of tax rates changes were very similar to those discussed above. 

Source: Author’s computations on the basis of the Laws on the budget of the Republic of Bashkortostan for 2000, 2001, 2002 and 2003.

Source: Author’s computations on the basis of the Laws on the budget of the Republic of Bashkortostan for 2000, 2001, 2002 and 2003.

Source: Author’s calculations based on RB Statistical Department (2002) 

Unfortunately, nothing is said in the government documents of Bashkortostan concerning other possible measures aimed at providing the local governments with incentives to develop local economy and to improve delivering of public goods.

Chapter 2: Analysis of the federal recommendations to the subjects of the federation how to overcome perverse budget incentives
2.1. The RF MoF Recommendations
First, the RF MoF Recommendations suggest that the regions should elaborate a clear cut distribution of responsibilities between the regional and local levels. However, the 1998 RF Budget Code has already taken into account distribution of expenditure responsibilities (articles from 84 to 87). All this arouse  questions:
•	Is there any room for further delimitation of responsibilities by the regions?
•	Does the distribution correspond to three principles of delimitation mentioned in point 2.4 of the Recommendations: 1) principle of territorial correspondence of benefits; 2) economies of scale; 3) subsidiary principle

Second, the RF MoF Recommendations suggest that the regional governments determine the ratio among the main government objectives:
•	Equalization of budget provision with revenues;
•	Direct financial incentives for local governments so that they pursue objectives significant for the subject of the federation;
•	Active economic policy of the regional government to be carried out with the help of tired subsidies in framework of special programs: local governments must compete for these grants and propose their own investment programs on the competitive base.

According to the federal government understanding of the problem of overcoming perverse budget incentives it is necessary to allocate resources using a formula-based scheme. This is also the position of the Georgia State University and the World Bank experts (see for example, Jorge Martinez-Vazquez&Jamerson Boex (2001)). Main requirements of the RF MoF Recommendations on introduction of a formula-based scheme of allocation of resources are as follows:
1.	With the purposes of equalization the fiscal capacity of municipalities should be estimated not on actual collection of the taxes from their territories for the last years, but depending on the size of the taxable resources, i.e. with the help of the tax potential parameter, taking into account the degree and the structure of economic development of the territory. 
2.	The expenditure needs of the municipalities are calculated on the basis of the number of the consumers of budget services in view of local peculiarities accounted for by distinctions in demand for budget services and costs of budget services in different municipalities.
3.	All kinds of the non-tied financial support are allocated among the localities by a uniform technique. The problem of the channels to be used for this – direct transfers or through the mechanism of the sharing taxes will be solved after total amount of the financial support to each municipality is determined.

It is recommended to use the following formulas for computation of fiscal capacity of local governments:

FCi- the tax potential in locality i;
Bij- tax base of tax j in locality i;
tj - the average representative rate of tax j;
Rij - actual tax collection of tax j in locality i; 
К - number of taxes;
L - number of localities

For computation of the index of budget expenditure the RF MoF Recommendations offers the formula below 

Where NEDUi, NHEALTHi, NSOCIALi-the numbers of consumers of educational, health, and social services in locality i;
EEDU, EHEALTH, ESOCIAL, EOTHER, E- expenditures for educational, health, and social services and the others in the RB;
NEDU, NHEALTH, NSOCIAL- the numbers of consumers of educational, health, and social services in the RB;
Ni, N - the numbers of inhabitants in locality i and in the RB

As a basis for computation of financial support the RF MoF Recommendations propose to use the factor of per capita budget provision which has to be calculated by the formula

Further, the RF MoF Recommendations suggest different ways of equalization which every regional government should choose according to their preferences:
•	Absolute equalization: filling to the full the gap between the fiscal capacity and the expenditure needs calculated according to the number of customers;
•	Partial equalization: partial filling of  the gap between the fiscal capacity and the expenditure needs calculated according to the number of customers;
•	Relative equalization: proportional reducing of  the gap between the per capita budget provision in each locality and some certain level, for example, the average level of the per capita budget provision in the region;
•	Combination of partial and relative equalization;
•	The use of partial or/and relative equalization in combination with provision of a certain minimal level for the worse provided for localities.

If we compare the federal policy of allocation of resources among the regions with that foreseen in the   RF MoF Recommendations, we can see that the latter recommends to the regions practically the same principles and the scheme of intergovernmental fiscal relations and allocation of transfers, which in fact has been used for the present by the federal centre in its fiscal policy for the regions: allocation of transfers on the basis of the so-called tax potential (fiscal capacity) and the use of the index of expenditure needs. The difference lies only in the fact that the RF MoF uses GRP for estimation of fiscal capacity of the regions, which is impossible for localities and it recommends to use major tax bases for estimation of fiscal capacity of the local government. And during the last three years the federal government has also been using one policy from above-mentioned policies - it is the relative equalization with ensured provision of a certain minimal level for worse provided for localities. The question is whether the RF MoF Recommendations can be effectively realized in Bashkortostan.

2.2 Emulation of some formulas of the RF MoF Recommendations with Bashkortostan data for the year of 2001

In this section I present the results of the emulation of the formulas showed in the previous section for the data of the local governments of Bashkortostan in 2001. The first question one can ask is how great are the disparities between the local expenditure needs computed according to the number of customers and the expenditure needs of the current infrastructure. As it is very difficult to repeat the RB MoF’s computations of expenditure needs of the infrastructure I relied on the fact that the Bashkortostan government equalizes the local government revenues up to the level of the minimal expenditure needs and according to the current infrastructure. Therefore, it is possible to use actual expenditures of the executed budgets of the previous years as an estimation of normative expenditure needs of the infrastructure. Using the formulas of the RF MoF Recommendations I received a balance between the normative expenditure needs computed according to the number of customers, and the actual expenditures of the local governments in 2001. These actual expenditures include localites’ own revenues as well as all kinds of financial support. Because the difference in total expenditures among local governments is considerable, it is reasonable to compare the relative values of the balance. The ratios of the balance to the total actual expenditures of the local governments in 2001 are shown in figure 5.

 Figure 5 allows to draw a few interesting conclusions. First, the deviations of the balance are very considerable. Thus, the standard deviation here is 0,14, whereas if infrastructure was arranged proportionally to the population, the standard deviation would be zero. One third of local governments have exceeds in actual expenditures, two thirds – exceeds in normative expenditure needs. 25 local governments have deviations of more than 10 percent, 10 localities – of more than 20 percent. The greatest deviations belong to the Krasnokamsky rayon where the actual expenditures exceed the normative expenditures by 44 percent; and to the city of Meleuz where on the contrary, the actual expenditures are less the normative expenditures by 35 percent. 

Source: Author’s computations on the basis of the RF MoF data

This emulation confirms the above-mentioned opinion of the Bashkortostan MoF that full implementation of approaches suggested by the RF MoF Recommendations can cause under-funding of schools, hospitals and other infrastructure objects in the majority of local jurisdictions in Bashkortostan. For example, a hospital in one rural rayon also delivers health services to the population of the neighbouring rayons. If expenditure needs are calculated on the basis of the number of budget service customers of the rayon, that hospital won’t receive funding enough to deliver the service on the actual level. The fact that local governments don’t have adequate fiscal capacity for delivering educational services, and schools and  hospitals were spread very unevenly across localities in the Soviet times, now accounts   for the resistance of Bashkortostan’s MoF to follow the federal recommendations. 

The general position of the Bashkortostan government in implementation of economic reforms can be formulated as the following: 
•	There is no need to reject the old system before a new one has been thoroughly considered and proved to be better; 
•	A new system has to substitute the old one gradually, as one Bashkir proverb which Murtaza Rakhimov, the Bashkortostan President likes to repeat, says “Don’t destroy the old house before you build a new one”. 

Therefore, it seems reasonable, that a new model of inter-governmental relations in Bashkortostan has to satisfy the following requirements: 
•	financial support has to be allocated among localities on the basis of the formula, which should create good budget incentives as soon as today; however, this allocation should not  cause under funding of organizations, which deliver budget services;  
•	this formula should include gradual transformation into another formula   described in the RF MoF Recommendations, i.e.  the formula that  in the  countries, where localities receive the financial support according to the quantity of the consumers;
•	under the new conditions the recommendations for local and republican authorities as to how to reorganize the work and financing of  their infrastructures (schools, hospitals, etc.) are needed. For example, it could be recommended that the local governments reach an agreement among themselves on joint financing of schools and hospitals on their territories and be able to provide services for their neighbors. 

As far as the problem of localization of the infrastructure, which does not correspond to the number of customers is concerned, it remains a common problem for post-communist countries. The situation is the same in any region in any country, not only in that of the Russian Federation. The difference lies only in the degree of actual disparity. Therefore, it would be very interesting in this NASPAA-NISPA Joint Project to use other post-communist countries’ experience concerning their introduction of formula-based mechanisms of allocation of resources. 

2.3. Federal legislation and federal tax policy as a framework of introduction “good” budget incentives
The other side of “good” budget incentives is to fix legislatively, on a long-term basis the sharing of  taxes throughout  the Republic of Bashkortostan so that localities could predict their incomes. Actually, it is a part of the formula. The RF MoF Recommendations suggest that regional governments should assign revenue sources to local governments for 3 years instead of the current practice of yearly changes. The regional legislators, in their turn, can’t elaborate such a regional law in view of the fact that the main tax proceeds, which the regional government allocates to local governments, are federal taxes, and the federal government regulates sharing of not only the federal taxes, but also of some regional and local ones. Thus, as one can see from figure 6, subnational rates and shares of the main taxes – EPT, PIT and VAT were changed rather frequently and to a considerable extent during the last ten years. Instability in tax sharing between the federal and regional governments caused annual fluctuations in regional and local budget revenues. And only during the last three years we can see stabilisation of these taxes. However, with regard to other taxes and excises, which influence subnational revenues, one can see that the changes are still on. Thus, in 2003 some new changes in the taxes have already been introduced (road tax was changed to the transport tax). Sales tax is to be abolished in 2004, and other changes in tax legislation are being discussed by the federal government, for example the reduction of VAT rate from 20 down to 14 percent. If the changes in VAT don’t influence local revenues, abolishing of the sales tax will be a very grave factor of destabilization of local finances because this tax gives a considerable share of locality’s own revenues. For example, in 2001in Bashkortostan this sales tax equalled to 6 percent of the localities’ own revenues. A question now is whether the Russian Federation’s tax system during the recent years has been stable enough, for Bashkortostan to accept such a long-term sharing of taxes for its local jurisdictions. 

Source: Author’s computations on the basis of the RF MoF data

At this point it is reasonable to discuss the question of connection of stability of tax system on the national level and realization of the formulas on subnational levels, basing on investigations of the similar experience in other countries.

Chapter 3: Possible approaches to creating budget incentives for local governments to develop economy
As one can see from the previous chapters, there are two main problems in the matter of elaboration of budget incentives:
•	the problem of instability of tax rates and sharing taxes in federal and Bashkortostan legislation; 
•	the problem of under-funding schools, hospitals and other infrastructure objects will arise in many local jurisdictions if the resources  are allocated proportionally to customers, because there is a considerable difference between the actual expenditures (the minimal expenditure needs of the current infrastracture) and the expenditure needs computed on the basis of actual number of customers.

3.1 Possible amendments to tax system
Fist, it is necessary to stop the yearly changes in the federal tax system. Well, tax system is not perfect and needs perfection, but as it seems to me, it would advisable to do it in the following way:
•	the Federal Constitution or a constitutional federal law has to establish a rule, that any amendments to the Tax Code and the Budget Code should be done only once  within at least three years;
•	during the period when one tax and budget arrangement is in force, a new arrangement to be introduced may be discussed on all-Russian level, and after that a new tax and budget arrangement is to come in force as a single legislative act for a period of no less than three years;
•	so that regional governments might have time to prepare amendments to regional legislation, there should be a period of about a year from the moment of adoption of the new amendments  to bringing them into force on the federal level. 
This arrangement should allow regional governments to adopt regional tax and budget codes with tax rates and tax sharing assigned for three years.

As far as perfection of tax and budget arrangements is concerned, it seems as reasonable to foresee the following measures:

All taxes on small business should be assigned to local governments because the development of small business depends on the institutional conditions, which are mostly formed by local governments. Thereupon, it is necessary to introduce amendments to the federal legislation. Today federal legislation institutes the tax rate on imputed earnings as large as 20 percent of imputed earnings, 33 percent of which will be a federal share of tax collection for firms,  and 25 percent for  individual entrepreneurs. Similarly, according to the federal legislation at present the uniform tax on the gross receipt is shared in proportion of 33,33% to the federal government and 66,67 to the subnational governments. If these taxes had been assigned to local governments, tax collection from small business would have been 0,9 percent of total Bashkortostan’s local revenues for 2000 and 1,05 percent for 2001. But in fact, tax collection from the gross receipt came only up to 0,28 percent of the federal total revenues and to 0,08 percent of Bashkortostan budget revenues. Therefore, taxes from small business fail to play a significant role as fiscal instrument for the federal and regional governments. However, small business actually plays a significat part in forming local revenues. The fact is especially striking when local own revenues are taken into consideration. If these taxes had been assigned to local governments, the tax collection from small business would have been 1,7 percent of Bashkortostan’s local own revenuers for 2001. Obviously, this tax collection can’t create considerable incentives for local governments to develop small business, and it is unreasonable to diminish these incentives. 

Therefore, I think, it would be reasonable to introduce amendments to the Federal Tax Code, where 100 percent of the collected tax on gross receipt and the tax on imputed earnings should be assigned to the subfederal governments. In its turn Bashkortostan should assign 100 percent of these taxes collection to the local governments by regional legislation. Obviously, these measures must be supplemented with educational/training program for local government officials because they traditionally don’t pay a due attention to small business as a potentially important source of tax revenues. As a result, many entrepreneurs complain about the adverse institutional conditions, especially those in rural rayons and towns. Educational/training programs have to prove actual considerable contribution of small business into development of local economy and increase of the tax base on examples of foreign countries and some Russian regions. For example, in Moscow small business yields up to one third of total tax revenues of the Moscow city government.

3.2 Possible ways of introduction of  formula-base mechanism of allocation of resources
Even if   the problem of stabilization of tax system is solved, the problem of unproportional arrangement of infrastructure will remain. There are different ways to solve the problem which arise the course of implementation of the RF MoF Recommendations. 

One way is to shift some functions/expenditure responsibilities from local up to regional level. At present, the federal legislation assigns the expenditure responsibilities on maintaining primary, secondary schools and public health service institutions to local governments. However, the majority of localities collect very little revenues of their own (see figure 1), which makes it impossible to satisfy the adequate fiscal capacity principle. Thus, acting in this way, on 16 May, 2002 Bashkortostan’s Parliament submitted to the RF Parliament a bill on changing the FL On the General Principles of Self-Government in the RF(1995). This bill contained a proposal to reduce the number of local mandatory functions from 30 down to 20 excluding 10 of them, which include maintaining primary, secondary education and vocational schools, and public health service institutions. This bill was not adopted by the federal parliament, but the RF MoF Recommendations allow the local governments to pass their functions to the regional government on interim basis. If this way is followed, it will be possible to introduce a formula based scheme of allocation of support as well as to escape under-funding of schools, hospitals and culture objects because they are funded directly by the Bashkortostan government. For this interim period, say, three or five years, the latter will be able to implement measures aimed at reorganization of infrastructure in accordance with the normative expenditure needs of customers. 

The other way is to use opportunities to arrange horizontal agreements between local governments and set up alliances of local governments to solve their common problems, as has been suggested by federal and Bashkortostan legislation. Thus, the disproportion between actual expenditure needs of the infrastructure and those of customers can be regulated by the horizontal budget agreements among neighboring local jurisdictions.

A third way is to carry out reorganization of the local infrastructure as a first step and after a few years – to introduce a formula-based scheme of allocation of resources to the full and supplement it with horizontal agreements of local jurisdictions.

In addition to a formula-based mechanism of allocation of financial support, the RF MoF Recommendations offer to institute a fund in every subject of the federation in order to gain objectives, which are significant for the region. One can see from the discussion in the previous section, that the local governments don’t have effective incentives to develop small business. At present taxation of small business gives less that 1 percent of the locality’s own revenues in Bashkortostan. However, the potential of small business as a source of revenue is much greater.  Therefore, one may say that development of small business’ tax base is a priority-driven task for Bashkortostan and it is very reasonable to intensify “good” budget incentives in this area. For this, Bashkortostan must institute a special fund for allocation of grants proportionally to collection of taxes from small business. This measure in combination with the above-mentioned tax measures could provide local governments of Bashkortostan with effective incentives to develop small business’ tax base aimed at increasing the localities’ own revenues. 

3.3 Other possible ways of introduction of budget incentives for local governments to develop economy and to improve delivering of public goods
Above we have discussed the problem of introduction of a formula-based mechanism of allocation of resources prescribed to regional governments by the federal government. However, the area of the problem of introduction of “good” budget incentives is wider and it also includes other approaches. And there is one more question: how well is the Federal Program of reforms grounded?  What I mean is that a very rigid, formula-based scheme of assigning transfers like the one in Russia can be good in Germany, which is not large, and it is a developed, relatively homogenous country with social priorities. China as a transitional and large country with the strategies to build the effective market and to modernize the industry, uses the single-channel tax system. The USA as a developed and large country but with the economic development priorities uses a policy with a low level of equalization, giving it to the market to distribute funds and human resources in an optimal way. May be Russia being also a large country which needs to built the market economy and modernize the industry should use the Chinese or American models? At this point it is reasonable to ask a question: is it possible to realize a fiscal policy on the regional level which is essentially different from the policy on federal level?

I don’t see any serious reason for introduction of a formula-based mechanism of allocation of resources in all the regions of Russia, especially in the narrow framework of the RF MoF Recommendations. I think, according to the principle of Federalism, the federal government should confine itself only on intergovernmental relations of the federal government with the governments of the subjects of the federation. Whereas, at present the federal government tries to interfere with the intergovernmental relations within the regions of the federation. It seems, the problem of intergovernmental relations within the subjects of the federation is an internal problem of each region. For example, one region could introduce RF MoF Recommendations, another one could implement a formula-based mechanism, which is rather different from the federal recommendations, still others could follow the old Soviet model, or the Chinese model, or the American model.  If they implement different models of intergovernmental relations, they will have different economic results and the competition among them will show which model is better. Besides, this approach will allow to reflect regional preferences determined by economic, ecological, ethnic, climatic and other differences of the regions.

The discussion of other possible ways of introduction of “good” budget incentives is especially actual in view of the fact that Bashkortostan tried to build intergovernmental relations with the federal government according to a single-channel tax system and had experience of bilateral agreements from 1992 to 2000.

References

Martinez-Vazquez, J. & Boex, J. (2001). Russia's Transition to a New Federalism, World Bank Institute

RB Government (20021). “Основные принципы предоставления и расчеты финансовой помощи бюджетам нижестоящих уровней на 2003 год” (Main principles of calculation and provision of financial support to local governments in 2003) in Проект Закона Республики Башкортостан о республиканском бюджете Республики Башкортостан на 2003 год (Bill of the Republic of Bashkortostan on  republican  budget of the Republic of Bashkortostan for 2003), Ufa: 129-138 

RB Government (20022). “Основные направления бюджетной и налоговой политики Республики Башкортостан на 2003 год” (Main trends of budget and tax policy of the Republic of Bashkortostan for 2003) in Проект Закона Республики Башкортостан о республиканском бюджете Республики Башкортостан на 2003 год (Bill of the Republic of Bashkortostan on republican budget of the Republic of Bashkortostan for 2003), Ufa: 126-128 

RF MoF (2000a). “Временные методические рекомендации субъектам Российской Федерации по регулированию межбюджетных отношений” (Interim Methodological Recommendations to the subjects of the Russian Federation on regulation of Intergovernmental Relations), from http://www.minfin.ru/fvr/vmr.htm

RF Government. (2001). “Программа развития бюджетного федерализма в РФ на период до 2005 года” (Program of fiscal federalism development in the RF for a period until 2005). Одобрена постановлением правительства РФ от 15 августа 2001 года (Approved by the Decree of the government of the Russian federation of August 15, 2001),  #584. From http://www.minfin.ru