RUSSIA: SUBNATIONAL GOVERNMENTS’ FISCAL RESPONSE TO THE ECONOMIC DOWNTURN RUSSIA: SUBNATIONAL GOVERNMENTS’ FISCAL RESPONSE TO THE ECONOMIC DOWNTURN December 15, 2016 Acknowledgements This report, a product of the Macro and Fiscal Management Global Practice of the World Bank Group, was written by a team led by Apurva Sanghi and Birgit Hansl (Lead Economists, World Bank). The team was comprised of William Dillinger, Galina Kurlyandskaya, William Dillinger, Galina Kurlyandskaya and Daria Andreeva. We are grateful to the following individuals and organizations for meeting with the team and providing valuable information and insight: Mr. Vladimir Petrov (Deputy Chairman of the Federation Council Committee on Budget and Financial Markets), staff of the Federal Ministry of Finance, and staff of the City of Moscow, Moscow Oblast, the City of St. Petersburg, Leningrad Oblast, notably Gatchina Raion (Leningrad Oblast), and Vologda Oblast. We would also like to appreciate Ms. Natalia Zubarevich (Lomonosov Moscow State University), Ms. Karen Vartapetov and Ms. Ekaterina Ermolenko (Standard and Poor's Ratings Services), Mr. Alexander Puzanov (General Director at the Institute for Urban Economics, Urban Institute), and Messrs. Leonid Limonov and Denis Kadochnikov of the Leontief Center. The team would like to thank Stepan Titov, Ruslan Yemtsov, Aleksandra Posarac, Olga Emelyanova, Tatyana Shadrunova, Tigran Shims, and Sevil Salakhutinova of the World Bank Moscow Office for their guidance and support. CONTENTS 1. Introduction . ................................................................................................................................................. 1 Structure and functions of subnational governments ........................................................................................... 1 Functions ......................................................................................................................................................... 2 Financing ............................................................................................................................................................... 5 Taxes . .............................................................................................................................................................. 5 Transfers . ........................................................................................................................................................ 9 Regional variations in per capita revenues...................................................................................................... 11 2. Fiscal performance . ..................................................................................................................................... 13 Debt . ............................................................................................................................................................... 15 3. The prognosis .................................................................................................................................................. 19 Short-term measures . ........................................................................................................................................... 19 Revenues ......................................................................................................................................................... 19 Expenditures . .................................................................................................................................................. 19 Long-term measures............................................................................................................................................... 20 LIST OF FIGURES Figure B1: Subnational spending, percent of general government............................................................................ 2 Figure B2: Subnational spending, percent of GDP..................................................................................................... 2 Figure 1: Composition of subnational expenditures ............................................................................................... 2 Figure 2: Composition of subnational revenues...................................................................................................... 5 Figure B3: Sources of municipal revenues . ............................................................................................................... 12 Figure 3: Trends in subnational deficits................................................................................................................... 13 Figure 4: Trends in subnational revenues................................................................................................................ 13 Figure 5: Trends in subnational expenditures ......................................................................................................... 14 Figure 6: Subnational deficits .................................................................................................................................. 15 Figure 7: Trends in subnational debt ....................................................................................................................... 15 LIST OF TABLES Table 1: Distribution of principal tax revenues among subnational tiers of government ...................................... 8 Table 2: Trends in composition of federal transfers................................................................................................ 10 Table 3: Variations in regional per capita revenues (thousands of rubles)............................................................. 11 LIST OF BOXES Box 1: Russian federalism in the international context ....................................................................................... 2 Box 2: Functional assignments ............................................................................................................................ 3 Box 3: Sharing the corporate income tax............................................................................................................. 7 Box 4: Russia’s equalization transfer: Good practice?.......................................................................................... 9 Box 5: Municipal government revenues . ............................................................................................................ 12 Box 6: Non-contractual liabilities......................................................................................................................... 16 Box 7: Debt regulations ....................................................................................................................................... 17 Box 8: Functional reviews: a mixed track record ................................................................................................. 20 1 INTRODUCTION The aim of this note is to present and analyze subnational fiscal trends in Russia in the context of overall slowing economic growth and falling oil prices over the last few years. In particular, in 2015, GDP fell by 3.7 percent. Despite efforts to cut expenditures, the federal deficit increased to 2.4 percent of GDP. Subnational governments were also affected by the economic slowdown. Aggregate subnational revenues declined, in real terms, by 6 percent between 2014 and 2015. Revenues from taxes (including shares of federal taxes) fell by 4 percent while federal transfers fell by 13 percent. Nevertheless, the aggregate fiscal performance of subnational governments actually improved over this period. The nadir of subnational government finances occurred in 2013, when the consolidated subnational deficit reached 0.9 percent of GDP. Since then, it has shrunk. In 2015, the deficit was equal to only 0.2 percent of GDP. This was largely achieved by drastic cuts in spending. Spending in the social and infrastructure sectors both fell by 9 percent in real terms between 2014 and 2015. This note examines the fiscal prospects of subnational governments in Russia, focusing particularly on the nature of these spending cuts and whether they are sustainable over the medium term. STRUCTURE AND FUNCTIONS OF There are more than 2,000 first-tier municipalities SUBNATIONAL GOVERNMENTS comprising more than 500 cities and more than 1,800 raions; and there are more than 20,000 second-tier 1. Russia has a complex structure of subnational municipalities, comprising more than 1,600 townships government. At the top level, the country is divided and more than 18,000 rural communities.2 into over 80 federal subjects, termed oblasts and federal cities. Territorial subdivisions also include krais 3. Under the current legislation, all municipalities (administrative territories), republics, autonomous (including rural settlements with small populations) okrugs (territorial divisions), and autonomous oblasts. are required to establish local governments, employ The administrative units are grouped into eight federal municipal office staff, formulate and execute budgets, districts, each headed by a presidential plenipotentiary appointed by, and representing, the President of the and conduct an independent debt policy. The law Russian Federation, who monitors the performance assigns a set of expenditure responsibilities to each of the regions in each federal district. Hereafter, all tier of municipal government (See Box 2). In practice, these top-level geographical units will be referred to municipalities tend to be highly dependent on their as “regions”.1 respective regional governments. They have limited taxing powers and are largely dependent upon transfers 2. The territory of each regional government is in and shared taxes from their respective regions; as turn divided into what might be termed “first-tier detailed below, the only major federally-designated municipalities”. These consist of large cities (formerly source of revenue for municipal governments is a known as cities of oblast subordination) and rural share of the personal income tax (PIT). As a result, the raions (districts); the latter contain a variety of forms of municipalities tend to function as spending agents of small towns and village governments, which this report their respective regions, rather than an independent will refer to collectively as second-tier municipalities. tier of governments. 1 IMF Article IV Consultation, July 2010. 2 The federal cities are also divided into municipalities. Recent (2014) legislation permits other large cities to do the same. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 1 BOX 1: Russian federalism in the international context In aggregate terms, the degree of fiscal decentralization in Russia is similar to that of other large, middle-to- high income federal countries. The first figure below shows the share of total general government expenditures that are accounted for by subnational governments in Canada, the U.S., Australia, Russia, Brazil, and Germany. As shown, Russia is not unusual. It is less decentralized by this measure than the U.S. or Canada but roughly on par with the other three comparators. Another way to measure decentralization is to look at the size of subnational government as a share of GDP. Again, Russian subnational governments are not as large as those in Canada, but they are roughly on par with those in the U.S., Germany, and Brazil. Interestingly, the split in Russia between spending at the regional level and at the local (municipal) level is also similar to that in the U.S., Brazil, and Germany. Figure B1: Subnational spending, percent of general Figure B2: Subnational spending, percent of GDP government 30 80 70 25 60 20 50 15 40 10 30 20 5 10 0 Canada USA Brazil Germany Russia Australia 0 Province Local Canada USA Australia Brazil Russia Germany Source: Federal Treasury of the RF. Source: Federal Treasury of the RF. Note: data is based on IMF Government Finance Statistics (except US, where it also incorporates data on local finance from the US Census of State and Local Governments). Expenditures by central and provincial government are net of transfer to subordinate levels of government. Provincial government are net of transfer to subordinate levels of government. Functions 5. As shown in Figure 1, the social sectors— 4. The functions of each tier of subnational education, social protection and health—together government are set out in federal legislation, account for just over half of total subnational specifically Law 131/2003 as amended. Subnational expenditure. (Figure 1 shows the consolidated functions are broad ranging. They include the provision expenditures of all three tiers of subnational of social assistance, education (kindergartens and government, with transfers from oblasts to raions and grades 1-11), and the operation of health care from raions to second-tier municipalities netted out). facilities (although general hospitals are largely Figure 1: Composition of subnational expenditures funded by the regional divisions of the national health 2% 2% 1% 1% insurance fund). In the infrastructure sectors, their 3% responsibilities include regional and intra-city roads. 6% Education 26% Transport Subnational governments are also responsible for Social protection the provision of public utilities (e.g., district heating 9% Health and water supply) and public transportation. In total, Housing, utilities subnational governments account for about one-third Administration Culture of total government expenditure.3 14% Sport Debt service 3 In calculating this percentage, the total is calculated as the sum of federal expenditures, regional and municipal expenditures, and Law enforcement expenditures of federal extra-budgetary funds (the pension fund, 20% Other social security fund, and the medical insurance fund together with its regional divisions). Due to intergovernmental transfers between 16% these entities, when estimating the shares of each entity, all intergovernmental fiscal transfers are netted out. Thus, for example, Source: Federal Treasury of the RF. subnational spending on hospitals, financed through the national health insurance fund, are not included in ‘subnational expenditures’. 2 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn BOX 2: Functional assignments The following functions are assigned to the three tiers of subnational government, respectively: Regional: • Providing health care in specialized hospitals (for tuberculosis, cancer, psychiatric conditions, and so on) • Providing funds to municipalities for preschool, primary, secondary, and afterschool education • Providing vocational education • Protecting the environment and nature reserves • Preventing disasters and emergencies and dealing with their aftermath • Providing fire protection • Providing veterinary control and anti-epidemic activities • Providing welfare services to senior citizens and persons with disabilities • Paying allowances to families with children and to low-income households (for housing and utilities) • Supporting rehabilitated persons subjected to repressions and workers in defense enterprises during World War II • Providing medical insurance for the unemployed, children, and senior citizens • Running orphanages • Preventing terrorism • Constructing and maintaining regional roads and other infrastructure • Providing intercity public transportation • Maintaining regional public libraries and regional museums • Organizing cultural and sports events. First-tier municipalities: • Protecting the environment • Managing waste disposal • Maintaining raion libraries and museums • Organizing recreational, cultural, and sports events in favor of all citizens of the raion• Providing electricity and gas • Constructing and maintaining intersettlement roads • Providing intersettlement public transportation. Second-tier municipalities: • Delivering housing and utilities (electricity, heating, water, gas, streetlights) and providing waste collection • Constructing and maintaining housing for low-income households • Providing basic fire protection • Maintaining cemeteries • Maintaining parks and gardens • Maintaining settlement libraries • Organizing recreational, cultural, and sports events in favor of the particular municipality’s citizens • Constructing and maintaining intrasettlement roads • Providing intrasettlement public transportation. 6. Education is the largest single functional of the general revenues of regional governments, category sector of subnational government although the federal government recently announced expenditure. Spending in this sector accounted a $US50 billion financing program for new school for 26 percent of total subnational expenditure in construction. 2015. Spending on general education (grades 1-11) is financed out of the general revenues of regional 7. Health care accounts for 14 percent of governments (as opposed to earmarked federal grants subnational expenditure. In principle, the burden or municipal revenues). Funds to cover the recurrent of financing subnational health care facilities falls costs of salaries and supplies are transferred through on the national health insurance fund (HIF), which earmarked grants from the regional government to makes payments to territorial (regional) health funds, first-tier municipalities (raions and cities of oblast which in turn transfer funds to individual health care subordination) on the basis of formulas that largely institutions. Funding is allocated on a case basis—i.e., reflect enrollment. Individual schools are managed by according to the number of cases treated by each first-tier local governments, which are also responsible institution, with levels of payment varying according for paying for their utility costs. In 2015, responsibility to the nature of the case (there are reportedly more for financing kindergartens was transferred from than 5,000 separate categories of treatments). second-tier local governments to the regional The HIF is funded from two sources: (1) employee governments, which now provide the necessary funds contributions (deducted at source), and (2) payments to their respective municipalities. By and large, capital by regional governments on behalf of people who are costs (new school construction) must be financed out not required to make contributions due to their status: Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 3 the young, the old, the disabled, and the registered Regional governments, at their discretion, can make unemployed. The latter account for 50-70 percent of up the difference between the amount of the federal regional government health expenditures (in Vologda, pension and the official ‘subsistence’ income, which payments to the HIF account for Rb 5 billion of the 8 varies by region. billion that the oblast spends on this sector). 10. Other forms of social assistance include utility 8. It is reported that payments from the HIF are subsidies and transport subsidies. In the case of public largely sufficient to cover the recurrent costs of health utilities (district heating and water supply), these care facilities (supplemented by official and unofficial subsidies take the form of individual reimbursements: out-of-pocket payments by patients and their beneficiaries pay the normal tariffs to their respective families). This was not always the case: The current utilities and then seek reimbursement from their situation reflects federal decisions over the last four regional governments. In most cases, such subsidies years to sharply increase the level of health insurance are means tested. For example, in Vologda Oblast premiums. HIF payments are not, however, sufficient (as in most other regions), households are entitled to cover the costs of new medical equipment or new to partial reimbursement for their district heating facilities. Such costs must be financed out the general bills only if the bills exceed a certain percentage of revenue of regional governments, although the federal household income. In the case of public transport, government previously provided funding for hospital subsidies are provided in the form of discounted renovations and purchases of medical equipment tickets to eligible groups, including honored citizens, under a program that has now expired. Regional senior citizens, school children, and families with governments are also responsible for financing the three or more children. Subnational governments also operating costs of certain specialized hospitals out provide social assistance in the form of cash payments of their own budgets. These include facilities for the to eligible groups. These include top-ups to the federal treatment of tuberculosis, cancer, alcohol and drug childbirth grant and child allowances, as well as addiction, AIDS, and mental illnesses.4 payments to ‘labor heroes’. Some of these are means tested or capped, while others (including payments to 9. Social assistance accounts for 16 percent of labor heroes) are not. total subnational expenditure. Spending in this sector largely consists of payments or subsidies to specific 11. Transport (under the budgetary rubric of categories of beneficiaries (rather than, for example, ‘national economy’) accounts for 20 percent of the running costs of old age homes and orphanages). subnational expenditure. Much of this consists of Some social assistance programs are mandated and spending on roads, which is financed from earmarked financed by the federal government. Federal law, for regional road funds. Subnational governments are also example, mandates specific benefits for veterans responsible for public transport, including the metros of WWII and their surviving dependents. These are of Moscow and St. Petersburg. It is reported that tariffs financed from the federal budget and transferred are generally high enough to cover the operating costs through the regional budgets to final beneficiaries. of these systems (although as noted above, certain But federal law also requires subnational groups of passengers receive discounted tickets at governments to provide social assistance benefits to the expense of their subnational governments). The other groups, without necessarily specifying the level costs of these subsidies are classified in subnational of those benefits or providing any funding to pay budgets as social protection rather than as transport. for them. One of the largest (i.e., costliest) benefits (judging from evidence from the city of Moscow) 12. Housing and communal services: Russia’s consists of top-ups to (federally financed) pensions. housing stock has largely been privatized. Owners of flats in apartment blocks are required to either 4 The exclusion of these facilities from HIF financing is more a result join homeowners’ associations or make other of history than of policy. Over time, the HIF has been expanding the types of facilities it covers but it has not yet reached the specialized arrangements for the operation and maintenance of hospitals. 4 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn building exteriors and common facilities, including 15. Taken together, these five sectors--education, elevators. As a result, subnational government social protection, health, transport, and housing- spending on the construction and maintenance -account for 85 percent of total subnational of housing for the population at large is limited. expenditure (in 2015). As shown earlier in Figure 1, the Spending in this sector instead consists of three major remainder is largely accounted for by administration subcategories. (6 percent), culture (3 percent), and sports (2 percent). Debt service, treated as a separate sector, accounts 13. The first subcategory is capital subsidies for only 1 percent of subnational expenditures. to municipal utilities. In Russia, services such as water supply, sewerage, and district heating are FINANCING typically provided by municipal unitary enterprises 16. The general budgets of all three tiers of (MUEs). These are owned by city governments and subnational government (regional, and first and are subject to oversight by municipal departments second-tier municipal governments) are financed for housing and communal services. In the main, from a combination of shared taxes, exclusive local these enterprises raise sufficient revenues from taxes, non-tax own revenues, and intergovernmental tariffs to cover their operating costs.5 (As noted transfers. All taxes are administered by the federal tax earlier, subnational governments do provide indirect service with revenues returned in whole or in part to subsidies to these enterprises in the form of subsidies the jurisdiction in which they were collected. Table to certain groups, but these expenditures are 1 below lists the taxes assigned to each subnational classified under social protection rather than housing tier, along with the share of each tax that each tier is and communal services). However, tariff revenues are allowed to retain. reportedly not sufficient to cover the costs of major capital investments such as network extensions into Taxes unserved areas and the replacement and upgrading 17. Shared taxes are the largest source of of equipment (e.g., new boilers for district heating subnational government revenue. Two of them—the plants). These investments are instead financed from personal income tax (PIT) and the corporate income the general revenues of city governments, along with tax (CIT)—account for over half (53 percent) of total grants from the federal government. subnational revenues (in 2015) (Figure 2). 14. The second subcategory consists of spending Figure 2: Composition of subnational revenues on the construction of apartments for (or subsidies 4% 2% 1% to) particular categories of citizens such as families 4% CIT 23% PIT with children and teachers in rural areas, along with 7% Excise fuel subsidies to low-income households and grants Property taxes to municipalities for similar purposes. The third 8% Other taxes subcategory consists of spending on ‘beautification’ Non tax revenues (e.g., maintenance of parks and gardens). Together, Unconditional grants 8% these three subsectors accounted for 35 percent, Matching grants 32 percent, and 25 percent of total spending in the Compensation grants 30% sector, respectively. ‘Other issues’ accounted for the 8% Other transfers remainder of spending. 5% Other revenues Source: Federal Treasury of the RF. 5 This has not always been the case; In the 1990s, tariffs were set far below levels sufficient to cover operating costs, but since 1997, the federal government has set national norms for the percentage of total costs of communal services to be recovered from household bills. According to the World Bank’s 2006 infrastructure report, the norm was gradually raised from 35 percent in 1997 to 100 percent in 2005. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 5 18. Personal Income Tax (PIT): The PIT is the largest 20. Regional governments are allowed to adjust the single source of subnational revenue, accounting for rate of the CIT within a range of 13.5 to 18 percent8 30 percent of the total in 2015. PIT revenues are the (they have no control over the rate of the PIT). Tax exclusive purview of subnational governments—the reductions can be targeted at specific firms. Vologda federal government retains none of it. Proceeds of the Oblast, for example, recently provided a five-year PIT are divided among the regional and subregional reduction in the CIT rate (to the minimum 13.5 (first and second-tier) municipalities on the basis percent) to a new fertilizer plant. of percentages. At present, regional governments retain 85 percent of the personal income taxes 21. Property taxes: Another eight percent of (PIT) collected in their jurisdictions. Cities (of oblast subnational revenues are derived from various forms subordination) retain the remaining 15 percent (See of property tax. By far the largest form of property Table 1). In areas of raion jurisdiction, PIT revenues are tax, accounting for 77 percent of the total in 2015, divided between the raion government and second- is the corporate asset tax (Налог на имущество tier municipalities. In urban settlements, raions retain организаций). This is imposed on movable and 5 percent of PIT generated in those jurisdictions, with immovable property owned by registered companies. the settlement retaining the remaining 10 percent. In Methods of assessment are currently under reform. rural settlements, raions retain 13 percent, with the Previously, the tax was assessed on the basis of settlement retaining only 2 percent.6 book value. With the encouragement of the federal government, regions are now gradually introducing 19. Corporate Income Tax (CIT): The CIT accounts ‘cadastral’ (market) values for particular groups of for 23 percent of total subnational revenues. At taxpayers. St. Petersburg and Vologda Oblast claim present, regional governments retain 90 percent of that they are now valuing certain categories of the CIT, with the federal government retaining the corporate property according to its ‘cadastral’ value. remainder. 7(Prior to 2009, the regional governments’ (In Vologda, it is only office and commercial space share had been 73 percent.) Until recently, proceeds of that is valued at market rates, not factories.) The most the CIT were retained in the jurisdiction in which they recent Russia-wide cadastral valuation was performed were collected. As a consequence, a disproportionate in 2012 and used a complex (50 variable) form of mass share of the CIT was retained by the City of Moscow, appraisal. The next cadastral valuation is scheduled where corporate headquarters tended to be located. for 2018.9 Regional governments have the authority to At present, corporate income taxes paid by vertically set the rate of the corporate asset tax within a range integrated companies with operations in more than fixed by federal legislation. In Vologda, the rate is 2.2 one region are distributed among the regions where percent (if assessed at book value) and 2 percent (if the company does business according to the value of assessed on the basis of cadastral value). Small firms the company’s assets and employees’ salaries in each were formerly exempt, but are now subject to a rate region. This has resulted in a reduction in Moscow’s share of 0.5 percent. of the CIT and a corresponding increase in the shares of other regional governments. Even so, CIT revenues are still concentrated in Moscow. With 8 percent of Russia’s population, the City of Moscow accounts for 24 percent of total subnational CIT revenues. 6 The percentage of the PIT retained at the regional level has varied over the years. Prior to 2009, the tax was imposed at a rate of 24 percent, with the regions retaining 73 percent of the proceeds and the federal government retaining the remainder. In 2009, the aggregate tax rate was dropped to 20 percent and the regional share was increased (slightly) to 75 percent. As shown in Table 1, 8 In 2017 – 2020, the range will be 12.5 to 17 percent. the regional share is now 85 percent, with first-tier and second-tier 9 The cadastral evaluation is performed by independent companies municipalities retaining the remainder. authorized by the federal government, and the methodology is 7 In 2017 - 2020, regional governments will retain 85 percent of CIT, unified across the country. The regions can only check if the data on with federal government retaining the remainder. the entry is correct. 6 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn BOX 3: Sharing the corporate income tax Russia is unusual in sharing such a large proportion of CIT with subnational governments—and sharing it on the basis of origin. Most countries in the region only share the PIT. While some (such as Germany) share the VAT, sharing is not on the basis of origin, but rather on the basis of population and other factors. The most obvious argument against sharing the CIT on the basis of origin is that CIT revenues tend to be concentrated in a few large cities where most companies are registered. As a result, the CIT does not provide much revenue to other places. But there is a more fundamental drawback: As a general principle, the taxpayers of one jurisdiction should not be allowed to impose the costs of the services they consume on taxpayers who live elsewhere. CIT sharing allows them to do so. Although CIT revenues are collected from companies, the ultimate burden of the tax is shifted—backward onto stockholders or labor, or forward onto consumers. There is no reason to believe that these stockholders, workers, or consumers are located in the jurisdiction where the company is registered. As a result, sharing the CIT on the basis of origin allows the residents of places where companies tend to be registered (e.g., Moscow and St. Petersburg) to extract implicit subsidies from residents of other jurisdictions. The current arrangement, in which CIT revenues are partly distributed on the basis of the location of company assets and labor, goes some way to addressing this, but not entirely. One solution to this problem would be to entirely abolish CIT sharing on the basis of origin. Instead, the subnational share of CIT revenues could be folded into the pool of resources used to finance the equalization transfer. In this way, the equalization transfer would aim to reduce per capita disparities only in the PIT. 22. There are two other forms of property of maximum rate of residential properties is extremely exemptions and rate reductions for certain classes low: 0.1 percent.11Federal law also permits a long list taxation. The first is on land. This tax is imposed on of exemptions and rate reductions for certain classes both urban and rural plots of land (except forests). of taxpayers (e.g., pensioners and veterans) and types Since 2014, land has been valued on the basis of its of property. As a result, the building tax accounts for cadastral value. Proceeds are retained at the municipal only 3 percent of property tax revenues and only 0.3 level, and municipal governments (including the percent of total subnational revenues. cities of Moscow, St. Petersburg, and Sevastopol) are permitted to set the rate of the tax, subject to a ceiling 24. Then there are the subnational shares of of 0.3 percent on agricultural and residential property certain excise taxes—on alcohol and gasoline. Taken and 1.5 percent for land in other uses. The land tax together (with other excises), these account for 5 accounts for 20 percent of property tax revenues, percent of total subnational revenues. As shown in although only 2 percent of total subnational revenues. Table 1, revenues from the excise on alcohol is divided 50:50 between the federal and regional governments, 23. The second is a tax on buildings. This is imposed with the regional share allocated on the basis of origin. on residential and commercial property owned Eighty-eight percent of the excise tax on gasoline by individuals (as opposed to corporations). Since is retained by regional governments. Gasoline tax 2014, the tax has been assessed on the basis of revenues are distributed among regions on the cadastral values10 and is retained at the municipal basis of road mileage, and regional governments are level. Municipal governments are permitted to set obliged to share 10 percent of the tax with municipal the rate of the tax, subject to federal ceilings. The governments on this basis of road mileage. 10 How accurate and up-to-date these cadastral values are is subject to some dispute. The valuations in Vologda Oblast were reportedly based on norms developed in the 1970s and 1980s, which have been periodically adjusted to reflect inflation. St. Petersburg and Vologda This ceiling applies to residential properties that are assessed on 11 are both contemplating improvements in their methodology for the basis of cadastral values. The maximum rate for residential valuing building for tax purposes. Both jurisdictions also note that properties valued on the basis of book value is 0.3 percent. Note there has not been an inventory of taxable properties for several that the maximum rate for office buildings and shopping centers is years (since 2013, in the case of Vologda). As a result, recently considerably higher: 2 percent. All other properties are subject to a constructed buildings are not being taxed at all. maximum ceiling of 0.5 percent. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 7 Table 1: Distribution of principal tax revenues among subnational tiers of government Percent share retained by each tier as of 2016* First tier municipalities Second tier Federal Regional Cities Raions municipalities Corporate income tax 10 90 Personal income tax 85 15 5 or 13c 10/2d Corporate property (asset) tax 100 Individual property and land taxes 100 10 Vehicle tax 100 Gambling taxb 100 Retail trade taxc Excise on alcohol 50 50 Excise on hard liquors 60 40 Excise on low-alcohol drinks 100 Excise on gasolined 12 88 Excise on fuel for domestic furnaces 100 Reservoir use tax 20 80 Simplified tax on imputed income 100 100 Simplified tax on small businesses 100 Single agriculture tax 100 50 or 70e 30 Mineral Resource Extraction Taxes -Tax on extraction of common minerals and diamonds 100 -Tax on extraction of other minerals excluding hydrocarbons f 40 60 Notes: a. Urban second-tier municipalities retain ten percent of the PIT; rural second tier municipalities retain two percent. Raions retain the remainder of the 15 percent share assigned to municipalities in total.. b. Where permitted c. Only in federal cities d. Gasoline tax revenues are distributed among regions on the basis of road mileage, not origin. e. Urban second-tier municipalities retain 50 percent; rural second tier municipalities retain 30 percent. Raions retain the remainder e. 100% of taxes on extraction of hydrocarbons are retained by the Federal Government 25. Subnational governments also generate income of common minerals and the tax on ‘other minerals from a variety of other taxes. Together, these account excluding hydrocarbons’. The former is fully retained for about 8 percent of subnational revenues. The by the regions, while the revenues from the latter most important of these (accounting for one-third of are shared between the regions (60 percent) and the total) is the transport tax. This is an annual tax on the federal government (the remainder). These taxes vehicle ownership, based on the power of the vehicle. are not major revenue sources from an aggregate Subnational governments also retain the proceeds of standpoint but are important in certain regions such taxes on small-scale economic activity: the simplified as Sakha-Yakutia, a diamond-producing region. In tax on small businesses (which is currently entirely addition, the three federal cities are permitted to retained at the regional level), the simplified tax on impose a tax on retail trade. To date, the tax has only imputed income (entirely retained by the first-tier been imposed in Moscow. municipalities), and the single agricultural tax, which is divided among first-tier and second-tier municipalities 27. Non-tax own-source revenues are non-trivial. as shown in Table 1. (This list of excise taxes is not As shown in Figure 2 above, they account for about exhaustive). 8 percent of total revenues. According to the budget code, non-tax revenues include revenues from the 26. Regions are also entitled to revenues from sale or lease of property owned by subnational certain mineral resource extraction taxes, namely governments (including property owned by their the tax on the extraction the tax on the extraction enterprises), revenues from services rendered by 8 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn BOX 4: Russia’s equalization transfer: Good practice? In most respects, Russia’s current equalization transfer represents good practice. It has a logical target (bringing the per capita discretionary revenues of all regions up to a uniform percentage of the national average) and is based on objective, readily measurable variables. The general design of the formula for determining the level and distribution of the transfer is fixed in law and is therefore stable and relatively invulnerable to short term political pressures. The system does, however, have its critics. Some would argue that it is too complex, given the variety of adjustment factors and the two-stage process for calculating the amount due to each region. Others would say that it places too much of the risk of economic fluctuations on the federal government (as noted in the main text, the transfer represents an open-ended commitment by the federal government to bring the per capita revenues of each regional government up to the target level, regardless of the amount required). Some would say it is insufficiently equalizing, noting the wide variation in per capita revenues that remains even after the transfer is distributed. But these characteristics represent policy choices; tradeoffs between equally desirable objectives. The complexity of the transfer formula represents an effort to reflect variations in the unit costs of services among regions. The open-ended nature of the federal commitment reduces regional governments’ vulnerability to economic turbulence. The existing degree of equalization also represents a tradeoff. On one hand, it can be argued that regional taxpayers should be the ones who benefit from the taxes they pay; e.g., that the taxes paid by the people of Moscow should remain with the Moscow City Government. On the other hand, it can be argued that many of the services provided by subnational governments have implications that extend far beyond the boundaries of a single jurisdiction. One would not want the quality of education in a poor and remote region to depend solely on the strength of its tax base. In evaluating a transfer system, the relevant question is whether it strikes the right balance between these competing objectives. budget-financed institutions, and fines and fees. government—is an equalization grant. This grant is Interviews with Moscow City and Vologda Oblast designed to raise the per capita budget revenues of suggest that the majority of revenues under this rubric poorer regions (those with per capita revenues below are derived from the rent or sale of property owned the national average) up to a target percentage of by the respective jurisdictions. the national average. In calculating the equalization target, the 10 richest and 10 poorest regions are Transfers excluded. Adjustments are also made to reflect 28. Transfers from the federal government (i.e., variations in the strength of tax bases among different money distributed to regional governments on a regions, as well as differences in factors that affect basis other than origin) accounted for 17 percent of the costs of providing services (for example, labor regional revenues in 2015. The Russian budget code costs, living costs, and population density). The total distinguishes three types of transfers: dotacii, subsidii, amount of the transfer is determined endogenously; and subventsii. i.e., the federal government is required to contribute whatever sum is needed to achieve the equalization 29. Dotacii: Transfers that are not earmarked— target. Roughly three-quarters of the regions receive i.e., those that can be spent at the discretion of the equalization grants.12 recipient—are referred to as dotacii. As shown in Table 2, dotacii account for 40 percent of total transfers. Starting in 2016, the transfer allocation rules guarantee that regions 12 The largest dotacii—and the largest single transfer whose revenues from the equalization transfer are at least 10 percent greater than their other revenues shall receive no less than 90% of from the federal government to the regional tier of the previous year’ amount. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 9 30. In 2015, equalization grants accounted for about were adversely affected by the economic crisis 75 percent of total dotacii. Of the remainder, about (although the revenue declines were not the direct 20 percent consisted of federal transfers to support result of federal policies). More recently, the federal increases in the salaries of teachers, doctors, and government provided partial compensation to certain certain other categories of subnational employees.13 jurisdictions for revenue losses arising from the The salary increases were instigated by a presidential change in the methodology for distributing revenues directive advising14 regional governments to raise the from the CIT (see above). average wages of subnational teachers, doctors, and certain other employees to the average prevailing wage 32. Subsidii are federal matching grants. These in their respective regions. The directive was issued in support a wide range of federal programs, some— but 2012, with increases to be phased in over 2013-18. not all—of which involve capital investments. There As originally envisioned, the federal government was are reportedly dozens of such programs, many with to pay one-third of the cost of the increase during their own subprograms. (For example, the cattle the transition period, with subnational governments program has a subprogram for dairy cows and another financing the remainder on their own. Officials in a for beef cattle.) The typical matching arrangement is small number of oblasts and cities interviewed for this 14 percent federal/30 percent regional, although this report claim that the targets for specific categories varies. According to interviews in Vologda Oblast, of employees in their respective jurisdictions have the procedure for applying for these grants and the been achieved. However, recently, the target has been conditions attached to them are so arduous that adjusted downward, by excluding certain higher paid many regional governments do not even make the occupations (e.g., police) and including others (e.g., attempt—or at least are very selective in making small businesses) from the calculation of the prevailing such attempts. regional wage. 33. Subventsii: The third major category of 31. Other dotacii include grants to cities under transfers consists of compensation for functions special regimes: cosmodromes and cities built around that subnational governments perform on scientific centers and defense industries. The federal behalf of the federal government. These include government also makes ‘adjustment grants’ under unemployment subsidies, rent subsidies granted to this heading. First introduced in 2004, these grants certain categories of federal beneficiaries, such as compensate regions for short-term reductions in tax war veterans or victims of radiation catastrophes, revenues or increased expenditure burdens that result benefits paid to blood donors, and the costs of from federal policies. In 2009, the federal government running civil registration offices. used this instrument to assist regions whose revenues Table 2: Trends in composition of federal transfers Transfers 2009 2010 2011 2012 2013 2014 2015 General grants (dotacii) 39 37 34 32 40 46 40 o/w Equalization grants 25 28 24 24 28 26 30 Capital grants (subsidii) 36 30 31 35 34 25 25 Grants for federal mandates (subventsii) 19 27 20 18 18 19 21 Other transfers 6 6 14 15 7 10 14 Source: Federal Treasury of the RF. 13 Although these transfers were intended to achieve a specific purpose, they are nevertheless classified as dotacii (unearmarked). 14 Although subnational governments have the legal authority to set the wages of their employees, federal directives have a strong influence on these decisions. 10 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn Regional variations in per capita revenues several cases, it also reflects unusually high revenues from 34. These aggregate figures for Russia as a whole equalization transfers (dotatsii) presumably because the conceal substantial variations across regions— equalization formula recognizes the unusually high costs both in terms of levels of aggregate revenues (per of providing services in these regions. capita) and composition. The table below illustrates the variations in per capita revenues among regions. 36. The second ‘group’ consists of the cities of (Note that the table does not include all regions.) Moscow and St. Petersburg, with per capita revenues The figure for each region includes the own source of Rb 137,000 and 86,000, respectively. These (again) revenues of subordinate jurisdictions. Thus, the figure derive unusually high revenues from own source represents the consolidated per capita revenues of revenues, including the corporate and personal all subnational governments in that region, from the income taxes. Neither derives significant revenues regional government itself to the smallest second-tier from federal transfers. municipality. Revenues are expressed in thousands of rubles per capita and include both own source 37. The third group consists of all the other regions, revenues and transfers from the federal government. where per capita revenues range from Rb 30,000 (Dagestan) to RB 87, 000 (Murmansk). As a group, 35. In essence, the regions fall into three groups. these regions derive about 75 percent of their income The first group consists of the eight (generally) sparsely from own-source revenues—the corporate income populated oil/gas/gold producing regions located in tax, personal income tax, and other taxes and non- the far North and East (Siberia) of the country. These tax revenues. Only about 10 percent is derived from are the richest regions in per capita terms, with per equalization transfers.15 As a result, variations among capita revenues ranging from Rb 150,000 to 555,000. individual jurisdictions largely reflect variations in This is due, in part, to unusually high levels of revenues their respective tax bases. The correlation between (per capita) from own source revenues—including the per capita own-source revenues and total revenue corporate income tax and the personal income tax. In per capita is 0.68. Equalization transfers do have some Table 3: Variations in regional per capita revenues (thousands of rubles) Rich natural resource based regions 88 - Chukotka Autonomous Okrug 555 90 – Yamalo-Nenets Autonomous Okrug 255 61 – Sakhalin oblast 457 38 – Kamchatka Krai 205 84 - Nenets Autonomous Okrug 426 Moscow, Saint Petersburg 73 - Moscow 137 St. Petersburg 86 All others 77 – Altai Republic 79 28 - Vladimir oblast 41 07 – Komi Republic 78 27 – Bryansk oblast 40 19 – Krasnoyarsk Krai 74 63 – Smolensk oblast 40 48 - Moscow oblast 73 52 – Omsk oblast 40 22 – Khabarovsk Krai 68 55 – Penza oblast 36 23 – Amur oblast 64 15 – Chuvash Republic 36 11 – Tatarstan Republic 63 10 - Republic of North Ossetia-Alania 35 78 - Jewish Autonomous Oblast 61 33 – Ivanovo oblast 35 34 – Irkutsk Oblast 53 60 – Saratov oblast 35 80 - Republic of Khakassia 53 04 – Republic of Kabardino-Balkaria 34 14 – Republic of Ingushetia 53 21 – Stavropol Krai 33 57 – Pskov Oblast 41 03 – Republic of Dagestan 30 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 11 impact in offsetting variations in per capita own source regions in the south and west of Russia tend to have revenues. Revenues from equalization transfers are higher per capita revenues than those in the north and negatively correlated with own- source revenues east. But with few exceptions (such as the Chechen (r=-.55). But the scale of equalization transfers is too Republic), this is again largely due to variations in small to offset variations in own-source revenues. The regional tax bases. BOX 5: MUNICIPAL GOVERNMENT REVENUES Regional governments have considerable discretion over the financing of their municipalities, subject to general guidelines in the Budget Code. The Code authorizes regional governments to use two instruments to provide general budget support (as opposed to earmarked funding for functions such as education) to their municipalities. First, they may assign a fixed percentage of their own taxes (including their shares of the personal income taxes) to their subordinate jurisdictions. As noted earlier, municipalities are legally entitled to 15 percent of the PIT revenues collected in their jurisdictions. (In the case of jurisdictions with two tiers of municipal government, the upper-tier’s share is 5 percent of the PIT in urban jurisdictions and 13 percent in rural jurisdictions.) However, regional governments may increase these percentages on their own cost, provided the shares are uniform for all municipalities and are distributed on the basis of origin. Second, they may establish formula-based Figure B3: Sources of municipal revenues equalization transfers. The Code envisions that 5% these will be allocated on the basis of tax capacity 18% and cost drivers (for example, the socioeconomic 0% status and age profile of the population, climate, PIT and so forth). It also allows for ‘negative transfers.’ Other shared taxes If a municipality’s per capita revenues are more 13% Own revenues than twice the average for the region, the regional Transfers Other government is permitted to take up to 50 percent of 64% the excess and reallocate it to poorer jurisdictions. In their intergovernmental fiscal relations with municipal governments, regions may also combine Source: Roskazna. shared taxing mechanisms and transfers. As shown in the figure above (Figure B3), shared taxes (consisting almost entirely of the PIT) constituted 18 percent of municipal revenues in 2015. Transfers (including equalization transfers and earmarked transfers) constituted 64 percent. As noted earlier, municipalities are also entitled to 100 percent of the revenue from the simplified tax on imputed income, the building tax, the land tax, and the single agricultural tax revenues (municipalities do not administer these taxes but are allowed to set their rates). Together with various non-tax revenues, these account for 13 percent of municipal revenues. 12 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 2 FISCAL PERFORMANCE and only subventsii (and the modest category ‘other 38. At an aggregate level, subnational governments transfers’) increased. In aggregate, federal transfers seem to be weathering the current slowdown in the economy fairly well. Figure 3 shows the overall Figure 4: Trends in subnational revenues 3,500 balance of consolidated subnational governments as a percent of GDP since 2004. As shown, the 3,000 CIT Constant Rub billions of 2015 PIT aggregate subnational balance reached its nadir in 2,500 Excises 2013 (at 0.9 percent of GDP), just as the slowdown Property taxes 2,000 Other taxes in the economy as a whole was beginning (Russia’s Non-tax revenues GDP was still growing in 2013, albeit at an anemic 1,500 Unconditional grants Matching grants 1.3 percent). In 2014, the GDP growth rate shrank to 1,000 Compensation grants 0.7 percent. As noted earlier, the economy shrank by 500 Other transfers Other revenues 3.7 percent in 2015, but the aggregate subnational 0 balance improved over this period, with the deficit 2012 2013 2014 2015 declining from 0.6 percent of GDP in 2014 to just 0.2 Source: Roskazna. percent of GDP in 2015. As a percent of revenues, the consolidated subnational deficit declined from 8 declined by 10 percent over the period.15 40. The adjustment instead occurred on the Figure 3: Trends in subnational deficits expenditure side. As a group, subnational governments 0.6 managed to cut expenditures by 9 percent in real 0.4 terms between 2013 and 2015—5 percentage points 0.2 more than the cuts in revenues. Percent of GDP 0 0.2 41. The largest cuts, in absolute terms, were in education. As shown in Figure 5, total spending on this 0.4 sector fell 11 percent in real terms between 2013 and 0.6 2015 (increasing only 6 percent in nominal terms.) This 0.8 is somewhat surprising, given the federal directive to 1 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 increase the salaries of teachers during this period (see Source: Roskazna. above). If subnational governments were struggling to achieve the target before the deadline, this would percent to only 1.8 percent. suggest that education spending would increase 39. How was this possible? It was not due to rather than decrease over this period. It is not possible improvements on the revenue side. As shown in to precisely measure trends in the education wage bill Figure 4, aggregate subnational revenues declined, over this period. In the Russian budget classification in real terms, by 4 percent between 2013 and 2015. system, subnational spending on teachers’ salaries While CIT revenues increased modestly (3 percent is subsumed in the category ‘transfers to municipal over their 2013 levels), PIT revenues declined by 5 institutions’. It is instructive, nevertheless, that percent in real terms. In total, subnational tax revenues spending in this category fell by 7 percent in real terms (including revenues from property, excise and over the 2013-2015 period, accounting for nearly half transport taxes) declined 2 percent over the period. of the total decline in spending in the sector. Spending Aggregate transfers from the federal government 15 As discussed below, the decline in transfers was partially offset by an declined even more sharply. Dotacii declined by 10 increase in federal transfers to the Federal Medical Insurance Fund (MIF), which allocates these funds to regional MIFs. This enabled a percent, subsidii dropped by a remarkable 34 percent, decline in subsidies for health care from regional budgets. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 13 on capital investment also fell dramatically--30 percent their financial support of such facilities. in real terms-accounting for another 17 percent of 44. The increase in HIF financing was financed the reduction in total spending. (Cuts in spending on by a federally mandated increase in employers’ direct labor costs and ‘other’ account for most of the contributions to the HIF. As employers, regional governments had to increase their contributions as Figure 5: Trends in subnational expenditures well. Subnational contributions to the HIF increased 3,000,000 over this period—by 9 percent in real terms. But 2,500,000 overall, regional governments presumably gained more than they lost under the reform. While they were Transport 2,000,000 required to increase their contributions to the HIF, Rbs Bns of 2015 Housing, utilities 1,500,000 Education they were no longer required to finance the maternity Health wards and emergency rooms that had formerly been 1,000,000 Social protection under their purview. Other 500,000 45. One might expect that spending on social - 2012 2013 2014 2015 assistance would increase in the face of an economic Source: Roskazna. slowdown, but that was not the case. Spending on social assistance remained roughly constant over the remainder.) period. The explanation may lie partly in the nature 42. Cuts in health care were more modest, falling 4 of social assistance benefits in Russia. As noted percent in real terms over the period 2013-2015. As earlier, some benefits are not means-tested and are in education, one might expect that the wage bill in instead allocated on the basis of status; e.g., WWII regional health care institutions would have risen veterans and labor heroes. Such benefits would over this period in response to the federal directive not be expected to increase in the face of declining on salaries. Again, one would be stymied by data incomes. Other benefits are means-tested but in constraints. As noted earlier, the recurrent costs of ways that are more sensitive to changes in policy the majority of regional health care institutions are than actual changes in household income. The level largely financed by the national Health Insurance of pension top-ups, as noted earlier, is based on the Fund. The majority of subnational spending on difference between an individual’s federal pension health care takes the form of payments to the HIF on and the official subsistence income for each region. behalf of those who are not required to contribute If the official subsistence income is not increased (to directly and payments to specialized medical account for inflation, for example), the level of the institutions that are not covered by the HIF. Data on pension top-up would not increase either. It should the wage bill of subnational health care institutions also be emphasized that regional governments have per se is not available. considerable discretion in designing their own social assistance programs. As long as federal guidelines are 43. The majority of the cuts fell on facilities that, satisfied, regional governments may cut benefits to at the outset, had been directly financed by regional fit their own budget constraints, and they may have governments. Subnational health care spending, responded to the decline in their revenues by doing net of HIF contributions, fell by 23 percent over the exactly so. period. Capital spending alone fell by 32 percent. But parts of these cuts were offset by an expansion in the 46. In addition to the cuts in social spending, scope of facilities covered by the HIF. Over the period, subnational governments also made substantial the HIF added maternity wards and emergency rooms reductions in spending in the infrastructure sectors. to the list, permitting regional governments to reduce Spending on the ‘national economy’ sector (largely 14 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn roads) fell by 5 percent in real terms. In particular, including the above-mentioned Magadanskaya. capital spending (which accounts for about 20 percent Debt of total spending in the sector) fell by 15 percent. 48. Subnational deficits, particularly during the first Spending in the housing and communal services economic crisis (2009) and the more recent nadir of sector fell even further: 16 percent. Capital spending 2013, have resulted in growing levels of subnational (which accounts for about 30 percent of spending in debt. As shown in Figure 7, the level of subnational the sector), fell by 22 percent. Subsidies to companies, debt peaked (in constant terms) in 2014, but has since which account for 16 percent of spending, fell by 24 stabilized. Subnational debt totaled Rb 2,318 billion percent. In total, cuts in spending in the infrastructure at the end of 2015. This was equal to 33 percent of sectors accounted for 41 percent of the total reductions subnational discretionary17 revenues and 2.9 percent in spending (in real terms) between 2013 and 2015. Figure 7: Trends in subnational debt 47. While the aggregate subnational deficit in 3,000 2015 was fairly modest (0.2 percent of GDP and 1.8 2,500 Constant Rbs Bns of 2015 of consolidated revenues), there are signs of fiscal 2,000 distress in some jurisdictions. Figure 6 shows the number of jurisdictions in each of the four deficit-size 1,500 classes, along with the number of jurisdictions with 1,000 surpluses. As shown, 30 regions have modest deficits, 500 in the range of 0-5 percent of revenues. Another 25 have deficits in the range of 5-10 percent of revenues. - 2005 2006 2007 2005 2008 2009 2005 2010 2011 2012 2013 2014 2015 But 22 have deficits of over 10 percent of revenues. Bonds Bank loans Federal loans Mordovia, Magadanskaya, and Kaliningradskaya top Source: Minfin. the list, with deficits of 23 percent, 20 percent, and 19 percent, respectively.16 Only nine jurisdictions had of GDP. budget surpluses in 2015. These include the republic 49. While the aggregate level of subnational debt cities of Moscow, St. Petersburg, and Sevastopol. As a (33 percent) is not large, relative to revenues, some group, the rich oil/gas/gold producing regions tend to individual regional governments are highly indebted. outperform the national averages; Four of the seven Five regional governments have debt-to-revenue regions had balanced budgets or small surpluses ratios in excess of 100 percent. Over half of them in 2015, and a fifth had a deficit of only 1 percent have debt-to-revenue ratios in excess of 50 percent. of revenues. However, two had substantial deficits, As discussed below, the carrying costs of this debt is Figure 6: Subnational deficits generally low, but its short-term nature represents a significant rollover risks in some jurisdictions. 35 30 50. Roughly half of subnational debt (44 percent) N of Jurisdicitons 25 takes the form of short-term loans from commercial 20 banks.18 Data from the 13 regions, accounting for 15 about 40 percent of total debt (as of January 1, 2016), 10 shows that 45 percent of this debt was due by the end of 2016, 20 percent by the end of 2017, and 20 5 percent by the end of 2018. Rating agencies consider 0 20%+ 10-20% 5-10% 0-5% SURPLUS much of this debt to be speculative. Of the 20 regional Deficit as percent of revenues Source: Roskazna. 17 Discretionary revenues are defined as total own-source revenues (including shared taxes) plus unconditional grants. 16 However, these regions do not violate the 15 percent deficit 18 These banks are not, strictly speaking, private. Commercial bank restrictions imposed by the Budget Code because these restrictions lending financing of subnational governments is dominated by two do not apply to deficits covered by federal loans. state-controlled banks: Sberbank and VTB. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 15 BOX 6: NON-CONTRACTUAL LIABILITIES The explicit fiscal difficulties of subnational governments are exacerbated by their implicit liabilities. These liabilities include: (1) public employees’ wage arrears, (2) deferred payables to suppliers of utilities to government institutions, (3) deferred payables and debt of regional and municipal public enterprises, and (4) liabilities of joint stock companies in which regional governments possess shares. The scale of these liabilities cannot be determined with the data at hand. Information on these liabilities is not collected and published on a regular basis by the federal government or by the regions. It would be worthy, nevertheless, of further investigation. governments rated by Fitch since the start of 2016, 54. Despite the growth in the stock of subnational only four were rated ‘marginally good’ (BBB). Eleven debt, the cost of servicing debt is not a significant were in the speculative range (BB- to BB+), and five burden to subnational governments. Interest were rated as highly speculative.19 The City of Moscow, payments on regional government debt consume, on which was rated in November 2015, was accorded a average, only 1.6 percent of budgetary expenditures.21 marginally good (BBB-) ranking. (For municipalities, the figure is only 0.6 percent.) The more pressing problem, at least for some jurisdictions, 52. Commercial banks have been increasingly is the debt’s payment structure. Because the majority reluctant to roll over their existing loans to subnational of commercial debt is short-term, subnational governments, charging high interest rates if they are governments continue to face a rollover risk. While willing to roll them over at all. In response, the federal the federal government has (so far) been willing government has stepped in. Following in the tracks to finance the rollover of commercial debt, it is not of its response to the 2009 fiscal crisis, the federal clear how long this can continue. The government has government is now offering to refinance subnational placed a Rb 310 million cap on the volume of loans it commercial loans with loans of its own. These loans will extend to subnational governments in 2016. Once generally have a maximum maturity of three years.20 this ceiling is reached, the federal government may be forced to raise the ceiling or face the prospect of 53. The current interest rate on them is 0.1 percent, subnational defaults. and with inflation running at 13 percent, the rate is strongly negative in real terms. Federal loans now account for one-third of subnational debt. The five are: Kostroma, Ryazan, Volgoskaya, Mordovia, and Karelia. 19 The exceptions are federal loans provided for special purposes such 20 There are exceptions; In Vologda, for example, debt service costs 21 as constructing the 2018 Football World Cup infrastructure. reached 5 percent of total expenditures in 2014. 16 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn BOX 7: DEBT REGULATIONS If subnational deficits persist, could borrowing get out of control? At present, subnational borrowing is controlled by a tight system of regulations. The current Budget Code sets out the regulations on subnational borrowing. These include three types of debt ceilings. The first refers to deficits. Budget deficits of regional governments may not exceed 15 percent of annual revenues. For municipalities, the ceiling is 10 percent. In both cases, the calculation of revenues excludes all intergovernmental transfers. In the case of municipalities, it also excludes revenues from shared regional taxes. Even tighter limits are placed on regions that are highly dependent on transfers. For regional governments that derived more than 40 percent of revenues from transfers during two of the three previous years, the deficit may not exceed 10 percent of revenues, excluding intergovernmental transfers. For municipalities that derived more than 50 percent of revenues from transfers, deficits may not exceed 5 percent of revenues (again, excluding transfers and shared regional taxes). The second ceiling refers to debt stocks. The Budget Code stipulates that the outstanding debt of a region or municipality may not exceed 100 percent of its annual revenues, excluding intergovernmental transfers. For transfer-dependent regions and municipalities, the ceiling is 50 percent. The third ceiling refers to debt service. The Budget Code stipulates that the debt service of a region or municipality may not exceed 15 percent of expenditures of the relevant year. Taken together (or even individually), these ceilings would appear to be quite restrictive. By excluding intergovernmental transfers (and shared taxes, in the case of municipalities) from the calculation of revenues, the ceilings severely limit borrowing by jurisdictions that are dependent on these sources. (Technically, a region that depended entirely on transfers would not be able to borrow at all.) Recent calculations of the debt-to-revenue ratios of each regional government indicate near-universal compliance with the Budget Code ceilings. But the ceilings have one loophole: until 2017, they do not apply to federal refinancing loans. If those loans are included, 18 of Russia’s 85 regions would exceed the ceilings; 12 of the regions subject to the 100 percent ceiling and six of the transfer-dependent regions subject to the limit of 50 percent. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 17 3 THE PROGNOSIS 55. While subnational governments have, so percent. Unless the ceilings are raised, neither tax is far, successfully adjusted to the recent economic likely to generate much revenue. downturn, it is not clear how sustainable this adjustment is—whether it can endure in a purely 58. Other countries in the region are often fiscal sense—and what its implications are for the encouraged to increase tariffs on utilities and public services that subnational governments provide. The transport as a means of generating revenues (or 10 percent (real) cut in spending on education and the cutting subsidies). But Russia has already taken 20 percent cut in capital expenditures (across all five advantage of these opportunities. Unlike in Warsaw major sectors) suggest that Russia is failing to invest or Bucharest, for example, tariff levels on the subway in its future. The failure of increasing social assistance systems of Moscow and St. Petersburg are already spending in the face of falling household incomes close to full operating-cost recovery levels. The same suggests that some of the costs of adjustment are is true of district heating companies. While there falling on the poor. may be cost-savings measures in both sectors, the opportunity to reduce the fiscal burden that transport SHORT-TERM MEASURES and district heating companies impose on the budgets Revenues of their owners has apparently already been seized. 56. What can be done? In principle, there are 59. In principle, of course, the federal government a range of measures on the revenue side that could help. It could, for example, increase the level individual jurisdictions could take on their own, of transfers to subnational governments. This was within the framework of existing legislation. To start the federal response to previous crises. But since the with, regional governments could raise the CIT rate to federal government now has fiscal problems of its own, the maximum 17 percent and refrain from granting this option is unpromising. The federal government exemptions and tax reductions to individual firms in could also increase the rate of the personal income the future. Given the importance of the CIT, this could have a significant impact on revenues, particularly in tax. As noted earlier, the rate of the PIT is fixed in the the more industrial and urbanized regions. Regional federal tax code even though all PIT revenues accrue governments could also accelerate the shift from book to subnational governments. That rate is currently a value to market value as the basis for assessing the flat 13 percent for most forms of income. Raising taxes company asset tax. in the middle of a recession is a questionable strategy from a macroeconomic perspective, however. The 57. In principle, subnational governments could same applies to the other revenue-side measures. also increase the yields of other taxes. They could, for example, accelerate the shift to market values as the Expenditures basis for assessing the land tax, the building tax (the 60. On the expenditure side, subnational property tax on physical persons), and the corporate governments could continue to pursue what property tax. But the federal ceilings on the rates appears to be their current strategy—cutting capital of these taxes are so low22 that the fiscal impact of expenditures and restraining the wage bill.23 This doing so would be very small. As noted earlier, the is a common adjustment strategy—for both central maximum rate of the land tax (on agricultural land) and local governments—in much of the region. is only 0.3 percent, and the maximum rate of the As a short-term measure, it can work well. On the building tax (on residential buildings) is only 0.1 capital spending side, new starts on capital works The maximum rate on the corporate property tax is a substantial 2 22 As noted earlier, direct evidence of reductions in the wage bill is not 23 percent. But corporate property is largely assessed on the basis of its available as subnational expenditures in labor-intensive sectors, such book value, which is typically far below market value. as education, are classified as ‘transfers to municipal institutions’. can be readily postponed. But suspending ongoing 63. These strategies are only sustainable in the capital works is more problematic, as half-completed short-term. Eventually, capital spending must be works can fall into ruin long before funding becomes resumed to permit the expansion or replacement of available to complete them. Overall, the fiscal impact infrastructure. Wages have to be increased in order to of cutting capital spending is not likely to be large. This attract and retain qualified staff, and recruitment must is because capital spending represents only a small be resumed to fill key positions. proportion of total subnational spending (in Russia, the proportion in 2015 was about 10 percent). LONG-TERM MEASURES 64. In the longer run, fiscal sustainability will require 61. Cutting the wage bill is likely to have a more fundamental changes aimed at improving much larger effect, due to the large proportion of public sector efficiency. Experience in other countries subnational spending that is (presumably) devoted suggests several possible targets. At the most to salaries. In principal, there are two immediate ways general level, regional governments could undertake to cut wage spending. The first is by freezing nominal functional reviews to identify activities that could be wages. This can have a substantial and immediate dropped or privatized. As described in Box 8, such impact. With the inflation target of 4 percent, which efforts have shown some success (at least at a national the central bank strives to reach by end 2017, a freeze level) in other countries. Regional governments could on current nominal wages would reduce the wage also pursue reforms in specific functional areas; e.g., bill by a proportionate percent per year in real terms. capital investment selection, construction contract This could, of course, run afoul of the federal directive administration, or procurement reform. requiring the salaries of certain professions, such as teachers and health workers, to equal the prevailing 65. Regions could undertake more targeted wage in each region. But if regional wages are also methods to restrain their wage bills. Department- falling, even this obstacle might not exist.24 level functional reviews could help identify redundant positions that could be eliminated. Regions might also 62. The second technique is to reduce staffing undertake pay and grading reforms. Such exercises are numbers. Efforts to do so on a large scale can be aimed at adjusting the salaries of individual positions difficult. In most European countries, confirmed to reflect labor market conditions. It is certainly civil service employees are typically protected from conceivable that regional governments are paying too dismissal except for cause (public sector unions also much for some positions while paying too little for play a role in restraining downsizing). A more palatable others. Pay and grading reforms would allow regional approach is to freeze new hiring. This can take time governments to increase salaries in occupations that to have an impact, however, as net reductions in staff have been difficult to fill while constraining (or even cuts do not occur until existing staff retire. Another reducing) salaries in occupations where regional approach is voluntary separation—where employees governments are now paying more than the labor leave in return for financial compensation. But this can market requires. be expensive, and employees can also raise problems of adverse selection. Only staff with good prospects of 66. Specific efficiency reforms can be found in finding alternative employment may take advantage individual sectors. The education sector would appear of such programs, and they tend to be the most skilled to be a likely candidate. At a first glance, it appears and hard working employees—the very employees that substantial savings could be achieved through that subnational governments would like to keep. school network rationalization. As in Eastern European In the health sector, the direct impact of reducing real salaries 24 countries, Russia has experienced a decline in the would be limited. As noted earlier, regional governments are directly responsible only for financing specialized hospitals. The HIF is number of school-age children. In principle, this should responsible for financing the operating costs of all other health care allow for a reduction in the number of classes and a facilities. Cost reductions in those facilities would not directly reduce the premiums that regional governments are required to contribute consequent reduction in the number of teachers. The to the HIF, although the resulting savings could result in a reduction in premiums over the long term. available evidence suggests that this opportunity has Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 19 BOX 8: FUNCTIONAL REVIEWS: A MIXED TRACK RECORD Some of the most ambitious efforts to right-size the public sector take the form of functional reviews. The scope of functional reviews varies. Some look broadly at the role of the public sector in order to identify functions that could be abandoned, privatized, or transferred to subordinate levels of government. Functional reviews also vary in terms of the units of government they cover. Some look at the entire public sector, while others look at specific ministries or even specific programs to see how existing functions could be performed more efficiently. The record of functional reviews is, at best, mixed. Several former socialist countries have used functional reviews to identify government activities that could best be performed by the private sector. This has led to the privatization of a wide range of formerly state-owned commercial and industrial enterprises. But efforts to right-size the residual functions of government—defense and internal security, public education, and health care—have been less successful. There are cases of ostensible success. One of the most widely cited is the Canadian comprehensive program review of 1994/95. The Canadian effort, launched after years of half-starts and in the midst of a fiscal crisis, required each agency of the federal government to review its own programs to determine which could be offloaded onto the provinces, the private sector, or abandoned altogether, or—if none of the above— performed more efficiently. The Canadian effort reportedly resulted in a 19 percent reduction in the federal workforce (although many positions were merely transferred to the provinces), reduced the number of ministries from 35 to 23, and eliminated 73 government agencies/boards. New Zealand’s functional review, while also focusing on paring down the role of the central government, attempted to increase accountability in the functions that remained. It restructured the government into departments whose functions could be quantitatively measured. Targets were then specified for each department and incorporated in performance agreements, whose results were monitored and, if met, rewarded. A very extensive set of sector-specific functional reviews has recently been completed in Romania. Eastern Europe has also seen more modest efforts such as the functional review of the Latvian Ministry of Agriculture. This identified and evaluated 161 separate functions within the ministry, of which nine were pegged for privatization, 40 for rationalization, and 12 for transfer to other ministries. already been seized to some extent. According to the network rationalization may exist but will need to be World Bank’s recent review of the education sector,25 reviewed carefully. a large number of small schools have either been closed or consolidated in recent years, particularly 67. There may also be opportunities for increased in rural areas where the number of schools has cost-savings in the health care sector. A 2011 report decreased by almost 25 percent. But many of these by the European Observatory on Health Systems ‘closures’ involved only a reclassification of existing and Policies26 found that the Russian health system schools. They ceased to be independent legal entities is significantly biased toward expensive inpatient and became branches of other schools. In physical (hospital) care at the expense of more cost-effective terms, they continued to exist. As a result, no cost- primary care services. According to the report, savings were achieved. Thus, further opportunities for hospitalization rates are significantly higher in Russia World Bank, 2012, The Education System in the Russian Federation, 25 European Observatory on Health Systems and Policies, 2011, Russian 26 Education Brief. Federation Health System Review. 20 Russia: Subnational Governments’ Fiscal Response to the Economic Downturn than in other countries of the WHO European Region. remarkably sanguine about the fiscal prospects of The federal government is reportedly taking steps to their respective jurisdictions. Most of them budgeted close redundant hospitals and expand primary care for small deficits in 2016 but insisted that this merely services.27 But according to the European Observatory reflects their own conservatism rather than any report, there is no evidence yet that this policy has serious expectation of a fiscal shortfall. They intend to been successful. muddle through in the hopes that the economy will improve or the federal government will come to their 68. Regional governments could reduce spending rescue. on social assistance, exercising the discretion granted to them by federal legislation. A logical strategy would 70. Outside experts are more concerned. Staff at be to improve targeting. As noted earlier, some social one leading debt rating agency argue that subnational assistance benefits are not means tested at all (e.g., governments have exhausted their budgetary flexibility benefits to labor heroes). In other cases, targeting and have no more room to adjust. In particular, they is imprecise. The housing allowance, for example, note that capital spending has been reduced to the fails to target the poorest of the poor. This is in part bone, that the prospects for increased federal support because much of it is paid out to households in larger are poor, and that some jurisdictions are therefore cities (which have higher housing costs) and partly likely to follow Novgorod Oblast into default. because the amount of the payment is based on the proportion of household income spent on utilities, 71. The most plausible scenario probably falls a highly problematic way to identify the poor. To somewhere in between. It is true that subnational address this problem, a recent (May 10, 2016) World governments have little opportunity to make Bank draft report on social protection28 recommends adjustments on the revenue side. Within existing mapping and consolidating programs awarded to federal constraints, they have limited ability to increase specific categories of population (e.g., labor heroes) the yield of the CIT and virtually no opportunity to and changing their eligibility criteria so as to focus on increase revenues from the PIT. But they do have individuals/ households with lower incomes. It cites opportunities to reduce expenditures. This has been pension top-ups and subsidies for housing and utilities their strategy so far. How far they can go without as ‘low-hanging fruit’ for such reforms. collateral damage is contingent on how they make the cuts: this depends on whether they rely largely on cuts 69. Without such reforms, are subnational in the real salaries of front-line service providers and governments inexorably heading toward a crisis? There capital spending, or whether they focus on measures appear to be two views about this. The subnational aimed at improving efficiency of individual services. government officials interviewed for this report were 27 According to the State Statistical Service, the number of district hospitals in rural areas fell from 2,631 to only 124 between 2005 and 2013. But at the same time, the number of local health clinics fell from 7,404 to 2,561. As in the case of schools, these closures often represented only a change in legal status: the facilities ceased to be independent legal entities and became branches of other health care facilities. In physical terms, they continued to exist. As a result, no cost-savings were achieved. 28 Aleksandra Posarac, Zoran Anusic, and Ruslan Yemtsov, May 10, 2016, “Russia SCD: Social Protection”, Draft report. Russia: Subnational Governments’ Fiscal Response to the Economic Downturn 21 The World Bank 36/1 Bolshaya Molchanovka Str., 121069 Moscow, Russia T: +7-495-745-7000 F: +7-495-745-7002 www.worldbank.org/eca/rer www.worldbank.org/russia