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Fiscal federalism in Russia: a Canadian perspective.


This paper does not provide a detailed examination of the complex and evolving characteristics of the Russian Federation. Its aim is rather simply to consider some of the key instrumental components of intergovernmental fiscal relations that arise in the Russian Federation--expenditures, revenues, transfers, borrowing, and institutional arrangements --in comparison both to Canada's lengthy experience with federalism and to a framework developed on the basis of previous work on fiscal federalism in a variety of transitional and developing countries. Unsurprisingly, from either of these perspectives fiscal federalism in Russia seems clearly to be a work still in progress.


Six basic questions arise with respect to intergovernmental finance in any country: (1) Who should do what?--the question of expenditure assignment; (2) Who should levy what taxes?--the question of revenue assignment; (3) How should any imbalance between the revenues and expenditures of subnational governments that results from the answers to the first two questions be resolved?--the question of vertical imbalance; (4) To what extent should fiscal institutions attempt to adjust for the differences in needs and capacities between different governmental units at the same level of government?--the question of horizontal imbalance, or equalization; (5) What, if any, rules should exist with respect to subnational borrowing?, and, finally, (6) How are these questions answered?--the institutional framework within which the technical and political problems of fiscal federalism are resolved.

Each of these questions must be interpreted and analyzed with respect to the specific circumstances of each country. For example, the relevant policy objectives for a particular country may include not only the normal public finance trio of efficiency (allocation), equity (distribution), and stabilization but also economic growth as well as, importantly, such nebulous but politically resonant goals as regional balance and maintaining national integrity and political stability. Moreover, in the case of transitional countries such as Russia, additional important objectives may include the development of market-facilitating institutional infrastructure (property rights, rule of law, etc.) as well as a public sector that is viably separate from private market activity. Not only may some of these objectives conflict in theory and practice, but there are also often important differences between local and central perceptions of the weights that should be attached to them. Moreover, intergovernmental fiscal policies have to take into account both political constraints (such as the strength of different regions and groups in political decisions) and economic constraints (such as the level of development of financial markets). Finally, policy change in any country must of course start from where it is. The fiscal institutions in pla ce generally reflect the results of an accretionary process of policy change over time, and the inertia inherent in such institutions must not be underestimated. To understand, let alone to resolve, the intergovernmental fiscal puzzle in any country thus requires substantial institutional as well as analytical knowledge.

Since all countries are different, and no federal country is exactly like any other country, international comparisons of federal financial arrangements are both difficult to make and hard to interpret once made. In Canada, for example, the "two worlds" of federal-provincial and provincial-local fiscal relations are almost totally different in most relevant respects, and the federal government has very little direct interaction with local governments (Bird and Chen, 1998). In contrast, in Russia, not only does the federal government's role extend much more deeply into the local government sector than in Canada (Meekison, 2000), but governments at all levels remain deeply involved in what in most countries would be considered private sector activities. Nonetheless, despite the difficulties of comparing one country to another, it can be useful to consider the experience of one country in light of the experience of other countries. If a country wishes to understand itself better, one approach is to study others--both their successes and their failures.

In this paper I discuss some aspects of the fiscal structure of the Russian Federation in light both of Canada's lengthy experience with federal finance and the experience of federal states more generally. For background, I draw heavily on extensive previous work on both Canada and on international comparisons of federal finance, although this work can obviously not be reported in depth here. (2) I should emphasize also that the paper in no sense purports to present either an in-depth discussion of Russia or a complete and accurate account of that country's complex and constantly changing reality. For the most part, the references made to specific features of the Russian situation are drawn from a few secondary sources, such as Treisman (1999) and especially Martinez-Vazquez and Boex (2001) although I have also drawn upon earlier work on fiscal decentralization issues in transitional countrie s in general. (3) My aim is not to analyze the specifics of the Russian situation but rather simply to reflect upon what experience elsewhere appears to suggest about the Russian case.

The paper is organized as follows. Sections 2 through 5 review the key instrumental components of intergovernmental fiscal relations in any country--expenditures, revenues, transfers, and borrowing. Section 6 considers several institutional aspects of decentralization that seem particularly important in the case of the Russian Federation. A brief Section 7 concludes.


In many ways, the basic requirement for efficient and effective subnational government is what may be called the "matching principle." (4) Ideally, to the extent possible, benefit areas should be matched with financing areas, as in the benefit model of local finance. In addition, expenditure responsibilities should be matched with revenue resources. Most importantly, revenue capacities should be matched with political accountability. It is with respect to the last of these matches that Russia, like many countries, seems to have the greatest difficulties.

Assigning Expenditures

The basic rule of efficient expenditure assignment is often taken to be to assign each function to the lowest level of government consistent with its efficient performance. A well-known manifestation of this principle is the rule of "subsidiarity" in the European Union. In the economic literature, much the same idea is expressed in the so-called "decentralization theorem" (Oates, 1972). (5) So long as there are local variations in tastes and costs, there are clearly potential efficiency gains from carrying out public sector activities in as decentralized a fashion as possible. Local decision-makers should decide what services are provided, to whom, and in what quantity and quality, and--importantly--local taxpayers should pay for the services provided. Of course, if the service in question is one of national importance (research?) or one in which there is a strong interest in maintaining national standards (education?), it should presumably be funded (and its performance monitored) by the central government. Moreover, it is seldom appropriate to delegate major redistributional responsibilities to lower levels of government. (6) Canada has this allocation largely right at the federal-provincial level (if not, in all provinces, at the provincial-local level), because the major interpersonal redistributional policies (pensions, employment insurance, child benefits) are at the federal level. Russia, however, seems to have it wrong to the extent that a considerable amount of social welfare expenditure is still supposed to be financed by regional and local governments. As Martinez-Vazquez and Boex (2001) note, redisributive programs such as school meals for poor children and shelter for the elderly should in principle be provided locally but financed federally.

Of course, even an "ideal" approach to expenditure assignment does not guarantee that the bundle of services assigned to any particular level of government will be matched by the set of revenue instruments assigned to that same level. On the contrary, in virtually every federal country a fundamental imbalance arises in the vertical assignment of expenditures and revenues. Intergovernmental fiscal transfers are needed to close the budgetary gap. Canada and Russia both illustrate this rule. (7)

In principle, governments at all levels should be accountable to their citizens for their actions. Such accountability is the public sector equivalent of the "bottom line" in the private sector. Four conditions need to be satisfied to achieve subnational accountability:

1. Subnational governments should, whenever possible, charge for the services they provide. (8)

2. Where charging is impracticable, subnational governments should finance such services from taxes borne by local residents (Section 3), except to the extent that the central government is, for whatever reason, willing to pay for them through transfers (Section 4).

3. Where the central government does pay, as a rule subnational governments should be accountable to the central government to at least some extent (Section 6), and central governments should in any case not bail out improvident local governments (Section 5).

4. Fiscal transparency is thus necessary both to implement condition (3) and, combined with mechanisms of democratic accountability, to ensure that conditions (1) and (2) have the effects they should--that is, they impose a "hard budget constraint" on subnational governments (Section 6).

Although no country strictly applies all these rules, it seems fair to say that they are probably less closely observed in Russia than in any developed federal country. For example, an essential first step is to establish clear lines of responsibility and accountability. Unfortunately, despite some useful clarifications in the course of the 1990s, on the whole such clear lines still do not appear to exist in practice in the Russian Federation. The problem is much deeper than the "unfunded mandates" stressed by Martinez-Vazquez and Boex (2001), (9) since many more expenditure functions are shared in Russia than in Canada or most federations (Meekison, 2000). (10) Moreover, not only are the lines between governments ambiguous, but also those between government, quasi-government, and private activities are still often too ambiguous for comfort in Russia.

Of course, even if there were perfect clarity of assignment--in the sense that the services for which each governmental agency is responsible are clearly specified--this is only part of the story. Clarity must be matched by accountability as well as by authority in terms of both the ability to manage expenditures and to determine (within limits) revenues. Even in the best of all possible worlds perfect clarity in expenditure assignment in this full sense may never be fully attainable.

With respect to many important spheres of public sector activity--for example, education--different jurisdictional levels may play critical roles in principle, as in practice. (11) A particular service may be "assigned" to a particular level of government, but much of the relevant policy and regulatory framework, and indeed much of the financing, may come from higher levels of government--and the actual service delivery may be at a lower institutional level. Such apparently complex divisions of functions may work well in practice so long as it is clear to all exactly who is responsible for doing precisely what. The present situation in Russia appears to be deficient in this respect, particularly at the regional-local level. For example, a study of the Leningrad region (Bahl et al., 1999) found that the lack of clarity in expenditure assignment resulted in prolonged disputes between regional and local officials about who was responsible for paying teachers' salaries. Although Canada is by no means a model of clarity in this sense--even the federal-provincial level is not divided into "watertight boxes" (Meekison, 2000)--its expenditure structure is certainly much better structured to facilitate relatively responsible government than is Russia's.

In this regard, it is important to understand that clarity in expenditure responsibility does not mean that someone--usually taken to be the central government--must be in charge of coordinating the efforts of others. The principal argument for decentralization in economic terms is that the central government is not delivering the goods, or at least not delivering the right goods in the right quantities to the right people. What may at first glance appear to be undesirable duplication or overlapping of functions may sometimes reflect either useful redundancy in a complex system or even a certain degree of desirable governmental competition. (12) On the other hand, the level of confusion as to who is responsible for what that still seems apparent in some policy areas in Russia today suggests that better intergovernmental coordination is needed. It is therefore perhaps understandable that in recent years the central government seems to be attempting a certain degree of recentralization (as did China in its 1994 reforms). (13)

Nonetheless, experience suggests that in the long run the correct approach in a country as diverse as the Russian Federation is unlikely to be to revert back to, in effect, the discredited central planning approach of control from above. A better approach would be to establish as hard budget constraints as possible for all relevant decision-makers, and to make the operation of the system as transparent as possible. "Letting 100 flowers bloom" in the form of relatively uncoordinated decentralized public sector suppliers striving to meet clearly specified and publicly accountable mandates seems more likely to lead to better public sector services than any conceivable centralized alternative. Although Canada's federal-provincial system could certainly be more transparent than it is, and is of course not without its own problems, on the whole it appears to do surprisingly well in terms of establishing the right economic incentives at the margin to induce relatively sensible fiscal behavior by the provinces. Interestingly, the much more centralized provincial-local system does no better in this respect (Bird and Tassonyi, 2001).

Managing Expenditures

No matter where subnational governments get their funds, they are unlikely ever to have enough to do all their citizens want and expect. Scarce public funds should of course be managed as efficiently and used as effectively as possible. Both financial honesty and political accountability require budgeting and financial procedures to be properly established and implemented. Budgeting, financial reporting, and auditing should be comprehensive, comprehensible, comparable, verifiable, and public--easy to say but surprisingly hard to do. Moreover, budgeted resources should be applied as efficiently and effectively as possible to achieve desired public outcomes. Adequate and appropriate procedural norms are important in any financial system. But substantive outcomes are what really matter.

Proper public expenditure management has to control the total level of revenue and expenditure, appropriately allocate public resources among sectors and programs, and ensure that governmental institutions operate as efficiently as possible (World Bank, 1998). To achieve these goals, subnational governments need both incentives and sufficient authority to manage both the expenditure and revenue sides of their budgets within a consistent and comprehensive framework. As argued in Section 3 below, it appears to be especially important in this respect that effective subnational governments have significant revenue sources for which they are economically and politically responsible under their control. Moreover, they must also be able to predict with considerable certainty the intergovernmental transfers that they can anticipate in any financial period. In contrast to Canada and most developed federations, the current situation in Russia in both these respects seems still far from satisfactory (Martinez-Vazquez and Boex, 2001; Open Society Institute, 2000). Although federal transfers to regions became much more systematic and objective over the 1990s, many local governments still cannot count reliably on a flow of transfers, and both regional and especially local governments have only limited control over their "own" revenues.

On the expenditure side, for instance, excessive earmarking (like the related process of "mandating" subnational governments to spend in accordance with central preferences rather than their own) significantly reduces the scope subnational governments have to manage their expenditures effectively, even if they had both the will and the capacity to do so. (14) As World Bank (1996) shows, this was a major problem in Russia in the early 1990s, and it still is to a considerable extent. Indeed, to some extent, the Russian Federation's current fiscal structure, with its "shared" taxes, obscure transfers, and duplicative expenditure roles, almost seems designed to frustrate rather than to facilitate effective subnational government. While similar problems are not unknown at the highly centralized provincial-local level in Canada (Locke and Tassonyi, 1993), they are miniscule in scale compared to those in Russia.

Ideally, subnational budget law should be uniform and clear, and it should be enforced. Moreover, expenditures should be subject to external audit to ensure that the law is followed. A strong central hand may seem needed to ensure that the rules are in place, and complied with. But it is easy to overdo this point. While the central government should establish a "framework" budget law and require adequate external audit (such as by a private sector firm), it should not, for example, require subnational budgets to be subject to prior approval, or the whole point of decentralization is lost. (15) On paper, as Meekison (2000) notes, Russia would seem to have in place some of the key requirements suggested here--apart from its "unitary" budget. In practice, however, as Martinez-Vazquez and Boex (2001) show, there remain many deficiencies arising from "mutual settlements," inadequate debt accounting, and many other problems. (16) Russia clearly still has far to go in all these respects compared to Canada and other developed federal countries.

A consistently applied budgeting and financial system satisfies two essential requirements of good government. First, it establishes the basis for financial control. Second, it provides accurate, uniform, and timely financial information. Such a system is needed in Russia. Even the best set of financial procedures, however, can do little to ensure that scarce public resources, even if properly spent and accounted for according to law, are spent in the best possible way or as efficiently as possible. Nor does even the best-enforced set of budgetary procedures ensure that aggregate fiscal discipline will be adequately maintained. To attain favorable outcomes in these respects, additional important fiscal institutions need to be put in place.

For example, as discussed in Section 5 below, subnational governments must not be able to depend on central government "bail-outs" of imprudent financial decisions, such as unsustainable borrowing or expenditure increases. On the other hand, subnational governments should be able to increase expenditures--provided that the full fiscal consequences of such increases are borne by local residents. Equally importantly, local governments should be able to reduce expenditures: they should not, for example, be required to pay salaries that are determined by other levels of government.

Allocative efficiency further requires that managers at all levels must receive adequate and accurate information on the effectiveness and social outcomes of the programs for which they are responsible--for example, through the revenues produced by properly-designed user charges and/or through participatory interaction with clients at both the budgetary and implementation stages. Moreover, they must have strong incentives to respond to these signals, for example, by facing a predetermined spending limit that can be altered only if they can "sell" more services that their client groups are willing to pay for. (17) Canada, like most countries, clearly has much to do in these respects, but Russia has immeasurably more to do to set the stage for a sound reform of intergovernmental finance. A good federal fiscal system, for example, is one in which both central and regional governments are restrained. In Russia, however, as de Figuiredo and Weingast (2001) show, many problems have arisen from the lack of "appropriately defined limits on the central government," which has had too much power to change the rules and act without restraint in its own interests--for example, dumping expenditure responsibilities on the regions in the early 1990s without adequate funding and subsequently continuing to control basically all tax and regulatory powers.


A completely subnational tax may be defined as one that is (1) assessed by subnational governments, (2) at rates decided by subnational governments, and that (3) is also collected by subnational governments, (4) with of course its proceeds accruing to subnational governments. In the real world, however, many taxes may possess only one or two of these characteristics, and who "owns" them may be unclear.

In Brazil, for example, states impose and collect their own VATs, but the rate of the tax is set centrally and (basically) uniformly. On the other hand, in Canada most provinces have traditionally not levied their own personal income taxes, but rather imposed surcharges on the federal income tax, with the tax actually being collected by the federal government and remitted to the provinces. As a third example, in Russia although the VAT base and rates have always been set centrally, VAT proceeds were for some years shared with the regional governments on a derivation basis, and the (variable) federal share remitted--not always in a timely fashion--to Moscow (Wallich, 1994). In which of these three cases is subnational tax power the strongest? Theory and experience suggests that it is in Canada, the only one of the three in which most regional governments do not in fact collect the tax in question. Why? Because the most critical aspect of subnational taxing power is who is politically responsible for setting the tax rate.

This important factor has been neglected in Russia, perhaps in part owing to some carry-over of the old central planning system of treating all revenues physically collected in a jurisdiction--for example, because a head office is located there--as "belonging" to that jurisdiction. A city with a vodka distillery or a region with an oil well, for example, feels "entitled" to all the fiscal proceeds derived from these sources, even though in economic terms most of the taxes thus collected are in fact being paid by consumers elsewhere. It is thus common for subnational governments to count all the money flowing from their territory as "their" contribution to the central government, netting these outflows against explicit federal inflows in order to assess whether they are gainers or losers in the federal fiscal game. While such "balance-sheet federalism" is not unknown in Canadian political rhetoric, (18) it makes no sense to ignore the real economic incidence of taxes and expenditures, as such calculations invariably do. What matters in efficiency terms is not who collects (or receives) the revenue, but who decides and who pays. These are very different questions.

Principles of Revenue Assignment

Two basic principles for assigning revenues to sub-national governments may be suggested. First, "own-source" revenues--defined as those for which a government is politically clearly responsible (for example, because it sets the tax rate)--ideally should be sufficient to enable at least the richest subnational government to finance from its own resources all locally-provided services primarily benefiting local residents. (19) Second, to the extent possible, subnational revenues should be collected only from those who benefit from local services. A critical component of sound intergovernmental policy is to establish a clear connection between those who decide, those who pay, and those who benefit (Bird et al., 2003). Canada is fortunate: these principles are (roughly) approximated. (20) In Russia, however, it does not seem too harsh to say that they are hardly satisfied at all.

Of course, in any country in which some areas are rich and others are poor, applying the principles just suggested would result in exacerbated regional disparities, so they are normally modified by transfers or by treating different areas asymmetrically in some other way. Every federation has asymmetry in its fiscal system to some degree (Watts, 2000). As Bird and Vaillancourt (2001) demonstrate, Canada is certainly no exception: in fiscal as in other ways, Quebec is certainly not a province "comme les autres." Martinez-Vazquez (2002) discusses the extent and nature of asymmetry in Russia, noting--as does Treisman (1999)--that differential treatment of different regions may have been essential to national survival, at least in the early 1990s, but that it arguably went too far, thus justifying to at least some extent the post-2000 partial recentralization of Russian finances. The question of the desirable, or tolerable, level of asymmetry, like that of the consequences of differential treatment, has as yet been little explored in the literature. (21)

Leaving this issue aside, the general approach to revenue assignment suggested above derives from two simple ideas. First, close attention ought to be paid to matching expenditure and revenue needs at different levels of government. In particular, all governments should bear significant responsibility at least at the margin for financing the expenditures for which they are politically responsible. Second, subnational taxes (like all taxes) should not unduly distort the allocation of resources.

Unless subnational governments have significant freedom to alter the level and composition of their revenues, neither autonomy nor accountability is meaningful. In particular, as noted earlier, subnational governments should be able to set tax rates (albeit perhaps within limits). (22) Such rate flexibility is essential if a tax is to be adequately responsive to local needs and decisions, while remaining politically accountable to their citizens. Canada and Russia are at almost the opposite ends of the spectrum with respect to this critical aspect of fiscal federalism at the regional level.

In a democracy, if local electors do not like what their government does, they can (try to) throw the rascals out at the next election. The freedom to make mistakes, and to bear the consequences of one's mistakes, is an important component of local autonomy in any country. Unless local governments are given some freedom with respect to local revenues, including the freedom to make mistakes (for which they are accountable to their citizens), the development of responsible and responsive subnational government is likely to remain an unattainable mirage. Of course, if the essential conditions of effective democracy and adequate information are not satisfied, or if those who fail to collect local taxes or to spend revenues efficiently are bailed out by discretionary transfers, the "rascals" may not be thrown out, but rather re-elected for their success in obtaining a larger share of other people's money. Countries that fail to set up an appropriate intergovernmental fiscal structure in these respects are, as Russia illustrates (Zhuravskaya, 2000), likely to have both problems in managing decentralization and unsatisfactory policy outcomes.

Subnational governments may of course attempt to extract revenues from sources for which they are not accountable, thus obviating the basic efficiency argument for their existence. The access of such governments to taxes that fall mainly on nonresidents--such as most natural resource levies, pre-retail stage sales taxes and, to some extent, nonresidential real property taxes--should therefore be limited, if at all possible. The importance of this consideration with respect to natural resource revenues was stressed with respect to Russia by Wallich (1994), for example, and has frequently also been a matter of concern in Canada (e.g., Courchene, 1999). But similar problems arise also with many other taxes. Even most so-called "retail" sales taxes, for example, fall to a considerable extent on business inputs: In Canada, for example, one study found that up to 50 percent of the retail sales tax base in some provinces consisted of such inputs (Kuo, McGirr, and Poddar, 1988). (23) Similarly, a high proportion of local property taxes levied on businesses are likely exported to other jurisdictions in Canada (Ballentine and Thirsk, 1982). The critical connection between spending and revenue-raising is thus broken.

Such concerns seem especially relevant with respect to enterprise taxes at the subnational level (Wallich, 1994). In Russia, the main regional taxes are those on enterprise profits, sales, and enterprise assets. In practice, many of these taxes --even the retail sales tax--are likely to fall on producers' goods (e.g., computers, vehicles) and hence may to some extent be shifted. (24) If inappropriate tax bases are assigned to subnational governments, wasteful competition and undesirable tax exporting are likely to result over time. Those who think that subnational enterprise taxes are undesirable in any case might not worry if they are "bid down" by competitive forces, but in fact all but two of Russia's regions in 2002 appeared to apply the enterprise profits tax at the maximum allowed rate and all but six did the same with respect to the enterprise assets tax (Martinez-Vazquez, 2002). Although this may suggest that tax competition may not be thriving at the moment in the Russian Federation, since the only real rate authority that regional governments have in Russia is with respect to potential reductions in the enterprise profits tax, the potential for distorting tax competition seems high in the long run--as, indeed, it clearly is also in Canada, perhaps more than any other developed federation. One way to deal with this problem, if it is considered to be one, may be to establish a uniform set of tax bases for local and regional governments (perhaps different for different categories such as big cities, small towns, and rural areas), with a limited amount of rate flexibility being permitted in order to provide room for local effort while restraining unproductive competition and unwarranted exploitation. At present, however, not only is there a significant vertical imbalance between expenditures and revenues in Russia, with consequent implications for autonomy, efficiency, and accountability, (25) but in addition subnational governments have little accountability because they have little rate authority. Canada's provinces, of course, are in exactly the opposite position, with essentially unlimited authority to set their own tax rates on both income and consumption taxes. The present confused and confusing subnational tax system in Russia also results in significant costs--costs of administration, costs of compliance, and costs arising from tax-induced inefficiencies in the allocation of scarce resources.

Improving Regional and Local Taxes

The most immediately important subnational revenue issue facing Russia thus seems to be to develop a satisfactory revenue base for regional governments (the "subjects of the federation"), that is, one for which those governments are politically responsible. While more can likely be done in the form of regional excise taxes, especially on vehicles and fuels (Bird, 2000b), if regional governments have significant expenditure responsibilities, there appear to be only two important revenue sources that can be levied relatively efficiently at the subnational level--a surcharge on the central personal income tax (PIT) or a surcharge on the central value-added tax (VAT). If a country wants its local governments to be both large spenders and less dependent on grants, as seems to the case in Russia, it must provide them with access to national tax bases. "Piggybacking" through surcharges seems to be the only viable way to do this while retaining an important element of political accountability.

In Canada, of course, PIT surcharges (in various forms) have for many years been a key source of provincial revenues. In a sense the same route seemed also to have been chosen in Russia in the 1999 budget, when regions were empowered to levy a rate of up to 35 percent in addition to the federal PIT rate of 13 percent. This allocation presumably reflected that fact that, until then, 100 percent of the PIT had gone to the regions. In 2000, however, the attempt to follow the surtax route was dropped, and most (84 percent) PIT revenue was allocated to the regional governments, with the balance to the federal government. Since 2000, PIT has been imposed at a flat rate of 13 percent, with no surcharges, and all revenue going to the regions. (26) In any case, the income tax itself is far from robust in Russia, so it is by no means clear that the ultimate answer to regional revenue problems lies in the income tax. (27)

A potentially more promising alternative answer for subnational revenues may turn out to be a surcharge on the VAT. Such a tax already exists and works well in Canada (Bird and Gendron, 1998). In principle, it may be feasible to implement such surcharges in some instances even in countries with less well-developed tax administrations. (28) Although this path to increased responsible regional taxation in Russia would by no means be straightforward, it may warrant further exploration. With the assignment of all VAT proceeds to the federal government in 2001, however, and the introduction of the new regional sales taxes, this potential route to a sounder subnational revenue system seems to have been closed for the time being.

Turning to local as distinct from regional taxes, apart from user charges, there seem to be only two major possibilities--a revised, and revived, property tax and some better form of local business taxation. In principle, there is much to be said for property taxes as a source of local finance. Unfortunately, it is also likely to be many years before this tax can provide consistent and significant revenues in Russia, as in most transitional countries, in part since the ownership of much of the potential tax base is still murky. (29) Even if these problems could be overcome, although the property tax is certainly a potentially important source of local revenue, it is unlikely to provide sufficient resources to finance local public services in the near future in Russia. Indeed, even countries with well-established property taxes have been hard-pressed to maintain revenues in the face of inflation and political difficulties.

Major policy reforms are needed to turn the property tax into a responsive instrument of local fiscal policy in Russia. First, and most importantly, as emphasized earlier, local governments must be allowed to set their own tax rates, probably within some limits. Secondly, the tax base must be maintained adequately. Property assessment is both a technical and a controversial matter, and much effort and considerable resources are required to establish and maintain the tax base. Finally, as with all taxes in Russia, major procedural reforms are needed to improve collection efficiency, valuation accuracy, and the coverage of the potential tax base (Timofeev, forthcoming). None of these steps is easy, but there are no short cuts to successful local property taxation (Kelly, 1994).

A more immediately critical problem in Russia is to reform the various unsatisfactory sub-national taxes on business. While the ability to distort market conditions through such taxes should, if possible, be restrained--for example, by establishing a uniform national base for local business taxation (probably with a minimum and maximum rate)--there is both an economic (benefit) case for some regional and local taxation of business and, it seems, often an overwhelming political need for local leaders to impose such taxes. Indeed, given the restrictions on other taxes and the unreliability of central transfers, local business taxes may sometimes provide almost the only way in which local governments in countries like Russia are able to expand revenues in response to perceived local needs.

Unfortunately, most forms of local and regional business taxes found around the world--corporate income taxes, trade taxes, business taxes, differentially heavy non-residential property taxes, and even so-called "retail" sales taxes (which are in practice often levied in the form of levies based on estimated gross receipts) may introduce serious economic distortions. One way to reduce such problems that has recently been suggested is through imposing a so-called "business value tax" (BVT)--in essence, a relatively low rate flat tax levied on an income-type value-added base. (30) In contrast to the earlier suggestion of a possible regional VAT surcharge, which was motivated mainly by the desire to provide more adequate "own" revenues to regional governments and hence to encourage greater fiscal responsibility and accountability, the BVT is intended primarily to improve the allocative efficiency of sub-national revenue systems. A tax on these lines may not find a welcoming political audience in Russia--or, for that matter, in Canada. Nonetheless, such an approach may offer a potentially promising alternative to the proliferation of increasing, and distorting, subnational business taxes that otherwise seem likely to continue to play an important role in Russia. (31)


Regardless of the revenue sources made available to subnational governments, transfers from the central government will undoubtedly continue to constitute an important feature of public finance in Russia, as in Canada. If subnational governments do not have the capacity to finance services at adequate levels, or if there are externalities associated with the services in question, or if a country wishes to take inter-regional differences in needs into account, transfers are needed. A well-designed system of intergovernmental transfers inevitably constitutes an essential component of any decentralization strategy.

No simple, uniform pattern of transfers is suitable for all circumstances. Since transfers reflect closely the nature of a country's political system, their inherently political nature must be taken into account without being hamstrung by it. One way to do so that has been suggested is simple, if somewhat artificial: focus on the effects, rather than on the instruments used to achieve them (Bird and Smart, 2002). Transfers as such are neither good nor bad. What matters are their effects on such policy outcomes as allocative efficiency, distributional equity, and macroeconomic stability.

The ideal is thus to "get the prices right" in the public sector by designing transfers so that they do not weaken the hard budget constraint that exists if local citizens not only determine what services they get but also have to pay for them (at least at the margin). Even if, as is likely to be the case in Russia for some years to come, local democracy is neither all that perfect nor all that well-informed, it is still critical to ensure that transfers do not worsen outcomes by bailing out the incompetent and the irresponsible.

In reality, of course, some transfers are intended primarily to achieve broader political goals, such as securing and maintaining stability either by rewarding friends or buying off enemies. Such objectives are by no means unimportant or irrelevant, as Treisman (1999) has demonstrated for Russia. Nonetheless, from the economic perspective taken here, it is important to minimize the collateral damage done to efficiency objectives by such "political" transfers.

The Design of Transfers

Three key factors in the design of intergovernmental fiscal transfers are the size of the "distributable pool," the basis for distributing transfers, and conditionality. An important characteristic of any good system of intergovernmental grants is stability. Another is flexibility. Three ways to determine how much money is to be distributed through intergovernmental fiscal transfers are (1) as a fixed proportion of central government revenues or some other "macro" basis, for example, as a percentage of GDP; (2) on an ad hoc basis, that is, in the same way as any other budgetary expenditure; and (3) on a "formula--driven" basis--for instance, as a proportion of specific local expenditures or in relation to some general characteristics of the recipient jurisdictions. Variants of these methods are found around the world. (32)

If the central government's budget is constrained, or if it wishes to maintain maximum political and budgetary control, the best system from its point of view is one in which the total amount to be transferred is determined annually in accordance with budgetary priorities. Though the "pool" in Russia is supposedly set as a percentage of taxation, the annual variations in the percentage (and the taxes included) appear to reflect such pressures. Under such a system, however, subnational governments are neither able to budget properly nor do they face an appropriately hard budget constraint.

A better way to provide both some degree of stability to local governments and some degree of flexibility to the central government may by establishing a fixed percentage of all central taxes (or current revenues) to be transferred for a period of, say, three years or so. Sharing specific national taxes (such as VAT) is less desirable than sharing all national taxes because over time central government tax policy will inevitably become biased, as governments understandably tend to increase more those taxes which they do not have to share. One reason for the creation of federal surtaxes on Canada's federal personal income tax, for example, was because simple rate increases would have automatically increased provincial taxes--which were imposed as surtaxes on "basic" federal tax--as well.

If national taxes are very sensitive to external shocks (such as a fall in export prices), the approach just suggested, although it may still be justified as sharing the pain between levels of government, may provide insufficient stability if such vital human capital development services as education and health are carried out at the subnational level, as is true in both Russia and Canada. In such circumstances, it may sometimes be desirable either to base the total transferred on a more stable macro measure such as a moving average of GDP growth--as is done with respect to the Canada Health and Social Transfer (CHST) in Canada--or perhaps to finance such services separately through a system of capitation grants. While the latter approach would not be acceptable in Canada, with its long history of provincial "autonomy" in such areas as health and education, it would seem quite appropriate in Russia given the much stronger role--at least constitutionally--of the federal level in these important spending areas. (33)

A sound transfer system distributes funds among recipient jurisdictions on the basis of a formula. Discretionary or negotiated transfers are undesirable in principle and have virtually disappeared from Canadian practice at the federal-provincial level (Bird, 1987). The essential ingredients of most formulas for general transfer programs (as opposed to "matching grants" which are intended to finance narrowly-defined projects and activities) are needs and capacity. Needs may be roughly proxied as in Canada's equalization system by population, or some more refined measure might be used, as in some other countries such as Australia. (34) A more difficult problem is how best to include a measure of the capacity of local governments to raise resources, given the revenue authority at their disposal. To remain transparent, formulas should not be too complex, but any desired degree of inter-jurisdictional equalization can be built into such a formula.

One way to structure a good transfer system, for example, might be to provide each local government with sufficient funds (own-source revenues plus transfers) to deliver a (centrally) predetermined level of services. Because capacity-based transfers are in principle based on measures of potential revenue-raising capacity (not on actual revenues), no disincentive to fiscal effort is created by this approach, which is of course that used for equalization in Canada. (35) The 2000 reform of Russia's transfer system to include measures of both revenue capacity and expenditure needs was clearly a move in the right direction. As experience in many countries has demonstrated, however, it is all too easy to turn a simple, transparent formula into an obscure one, subject to manipulation, so it is to be hoped Russia will avoid this pitfall.

Once the amount to be distributed has been decided, and the basic distribution formula determined, the key remaining question is whether the transfer should be made conditional on the provision of certain services at specified levels. Two approaches may be taken. If the primary objective of transfers is to ensure that all regions have adequate resources to provide services at acceptable minimum standards, simple unconditional lump-sum transfers will suffice. This is essentially the practice at the federal-provincial level in Canada, and it also appears to be the case in Russia. This approach essentially assumes that the fact that the funds flow to locally-responsible political bodies will ensure sufficient accountability, so that it is neither necessary nor desirable for the central government to attempt to interfere with, or influence, subnational expenditure choices.

On the other hand, if the central government is, in effect, using subnational governments as agents in executing such national policies as providing primary education at a specified level, then it makes sense to make the transfer conditional upon the funds actually being spent on education or on the attainment of some level of educational performance. This approach is common in Canada at the provincial-local level and seems to be favored ("targeted grants") by Martinez-Vazquez and Boex (2001) for Russia. Such expenditure conditionality ensures that grant funds are spent on the specified service. Of course, since money is fungible, there is no guarantee that grant funds do not simply displace revenues that would otherwise have been spent upon the servic e in question, and the extent of such substitution may vary greatly from service to service (Slack, 1980).

Performance conditionality, which focuses on outputs rather than inputs--for example, the proportion of students achieving certain standards rather than the amount spent on education--has recently been put forth by some as an alternative to expenditure conditionality. This approach has considerable merit. For example, it focuses on what is presumably the real policy objective such as education. But this approach also makes much greater demands on the central government to interpret the inevitably incomplete (and perhaps biased) information it receives. While it is useful to attempt to develop such indicators, it seems unrealistic to make this a high-priority goal in transitional countries such as Russia, in which such attempts are inevitably reminiscent of the old central-planning system's reliance on (often capacity-related) "norms" (Bird and Banta, 2000).


An interesting aspect of the recent move to decentralize public sector activities in many countries around the world has been the revival of an old worry--that subnational governments, left to their own devices, will act in a macro-economically perverse fashion. The fear is that increased national transfers will induce subnational governments to cut their own taxes while simultaneously expanding expenditures both through increased transfers and through "leveraging" increased borrowing on their new (transfer) revenue base. Subnational deficits, and hence total public sector spending and the overall public sector deficit, will thus expand. As a result, many transitional countries have imposed controls over subnational borrowing (Bird, Ebel, and Wallich, 1995), as have many developing countries.

There is reason to be concerned about this problem. In practice, central governments often provide implicit (if not explicit) guarantees to subnational borrowing. So long as the budget constraint imposed on subnational governments is not completely hard, they undoubtedly have some incentive to misbehave. If some subnational governments are too economically significant or too politically important to let them fail, it is necessary to keep the door to the treasury under lock and key in order to obviate the possibility of local profligacy. Such practices are common even in developed countries. In Canada, for example, although there are no restrictions on provincial borrowing, the provinces severely restrict local government borrowing in a number of ways: the amount of debt, the type of debt instrument, the length of term, the rate of interest, and the use of debt funds, are all, as a rule, strictly controlled. Some provinces require provincial government approval before debt is issued; others require the specific approval of local electors. Sometimes the restrictions are different for different categories of municipalities or for short-term as opposed to long-term debt. But in no case are local governments allowed to borrow as they wish (Amborski, 1998).

Subnational governments may borrow for many reasons, some more defensible than others. In some cases, for example, local officials may reap the political benefits of expenditure financed by borrowing, while leaving the political pain of debt service to their successors. One way to reduce such behavior might be to prohibit governments from raising their own salaries. Legislatures could of course vote salary increases for themselves and their officials--but no such increases could take effect until after the next election.

In other instances, subnational governments may have been almost forced to borrow (even illegally) because they are so constrained by central rules that borrowed resources are the only ones they can freely allocate at the margin in response to constituent demands. Martinez-Vazquez and Boex (2001) raise this possibility in Russia. (36)

Finally, borrowing may of course be the economically appropriate way to finance capital outlays. As every public finance textbook notes, in terms of both allocative efficiency and intergenerational equity, it often makes sense to finance long-lived investment projects by borrowing rather than relying solely upon either current public savings or manna from above (transfers).

There can thus be good subnational borrowing as well as bad. It is as important to facilitate the former as to block the latter, not least in countries like Russia that clearly need substantial infrastructure development. Imposing too strict and arbitrary central limits to subnational borrowing may have perverse results, in part because debt limits and similar controls raise moral hazard problems precisely because they prevent market discipline from being applied. Potential lenders to sub-national governments should reasonably be expected to be sufficiently capable and motivated to find out what risks they are running with their money. If such loans have received a seal of approval from above, not only are they relieved of this task but they are also in effect provided with an implicit guarantee that the central government will back up its judgment. The result may be more risky lending--particularly when, as is the case in some instances in Russia, subnational governments in some instances in effect control public sector financing institutions.

If a hard budget constraint is to be effectively imposed by capital markets, not only must there be a credible no-bailout rule, but there must also be full transparency so that lenders have full information on borrowers, and local residents have both full information on the consequences for them of local borrowing and the ability to influence local decision-makers. To the extent that democracy and markets work together in bringing about responsible fiscal behavior, the process is likely to take time. Perhaps, as has been argued with respect to Canada, the hardest budget constraints may be not those set out in legislation but those forged in the fires of experience (Bird and Tassonyi, 2001). If countries learn through experience that careful attention needs to be paid to subnational borrowing to avoid serious problems, then such problems are more likely to be avoided--whether by redesigning intergovernmental fiscal relations to reduce the temptation to borrow irresponsibly or by establishing a set of rules or signals constraining such borrowing. In the end, what matters more than the specific solution adopted is clear recognition of the problem and of the consequences if it is not dealt with properly. Most mature democracies went through decades, even centuries, of difficulty before working out the ways in which they presently cope with the potential problems arising from relatively autonomous sub-national governments. Perhaps Russia can shorten this painful process by learning from the experience of others, but in the end it will have to follow its own path.

Limits on Borrowing

Allowing subnational access to capital markets should in the long run strengthen rather than weaken fiscal discipline, but the long run may be quite long. In the interim, it seems sensible in countries like Russia to limit such access to some extent. One way to do so, for example, might be to introduce something like the Colombian system of "traffic lights," under which subnational governments can borrow freely (green light) when debt is below a specified threshold, but require central approval (yellow light) when debt levels are higher (Dillinger, Perry, and Webb, 2003). Another approach may be the introduction of something like the "Maastricht criteria" of the European Union, under which deficits and borrowing cannot exceed certain numerical limits.

Given the impossibility of formal bankruptcy proceedings in the public sector, reducing the moral hazard that will remain in any case requires in addition the institution of a credible review/control system for debt "work-outs," perhaps along the lines suggested (but not implemented) for Argentina in World Bank (1996a). (37)

No matter how well intergovernmental fiscal rela tions are designed, there is likely to remain a serious short-term problem with respect to those subnational governments that fall into the deficit trap. Emergency central support may sometimes be needed to resolve such debt problems. (38) Any such support should carry with it the obligation to introduce and make effective any necessary reforms under the supervision of a review board.

Special problems may arise from foreign borrowing by subnational governments such as the Eurobonds issued recently by some jurisdictions in Russia. A sensible precaution might therefore be to require explicit prior approval from the central government before any such loans may be contracted. (39) In any case, to ensure accountability, all subnational borrowing should be reported publicly immediately and in a transparent fashion, so that no government can shift hidden debts onto the next administration and both local voters and the central government can understand more clearly what is going on. Moreover, since the only good case for local borrowing is to finance capital investment, no borrowing should be permitted for other purposes. (40)

To sum up, when there is inappropriate borrowing by subnational governments, the situation reflects more basic underlying inadequacies with the intergovernmental fiscal system in general. Once that system is cleaned up by such measures as the reassignment of revenues (and perhaps expenditures), a revised transfer system, the introduction of transparent, timely, and reliable reporting systems, and the establishment of a stable, accepted periodic review process, the problem of unsustainable subnational borrowing should largely be solved in principle. Of course, as noted above, it may take considerable time before the problem vanishes in practice, and in the interim certain specific rules and limits may need to be put into place to reduce the likelihood of undesirable outcomes.

In principle, however, only two basic ex ante limits on subnational borrowing seem needed. First, as Martinez-Vazquez and Boex (2001) state, borrowing should be permitted only for investment purposes--a restriction that may not always be easy to enforce given the fungibility of money, especially in the absence of strictly segregated and meaningful capital budgets. Second, explicit national approval should be required for borrowing abroad. In Russia, however, given the continued dependence of many subnational governments on central transfers as well as political realities, somewhat stronger restrictions than these on borrowing may be warranted for some years--for example, limiting debt service to a small percentage of current revenues. Certainly, there is little to be said for the relative freedom from control that has existed up to now in some cases.

In the long run, unless subnational governments are able to save themselves from fiscal crises by drawing on their taxing powers, their only options are bankruptcy or bailouts. The fiscal root of this problem is the limited taxing powers available to subnational governments that are expected and required to carry out a much wider range of functions than they can finance on their own without extensive reliance on central support--either directly through transfers or, less desirably, indirectly through bailouts (Eichengreen and von Hagen, 1995). The political root of the problem, however, lies in the continuing expectation by all players--citizens, subnational and national politicians, and lenders--that in the end the central government will come to the rescue. So long as central actions, ex post, reinforce this expectation, ex ante administrative controls on borrowing such as requiring prior central approval or limiting debt service to a certain proportion of current revenues may have to remain in place.


One problem that has bothered many observers in Russia, as in other transitional countries, has been the apparently poor quality of many subnational administrations. While there is often good reason for such concern, to a considerable extent countries get the subnational governments they want, and deserve. Subnational politicians and officials, like those at the central government level, respond to the incentives with which they are faced. If those incentives discourage initiative and reward inefficiency and even corruption, it should be no surprise to find corrupt and inefficient local governments. The appropriate response is to adjust the incentives, both formal and latent, affecting local (and central) decision-makers to make it attractive for honest, well-trained people to make a career in local government. Given appropriate incentives--in terms of heightened expectations of improved services from their constituents and access to resources for which they are politically responsible--even very small local governments in poor developing countries have demonstrated significant improvements in administrative capacity within a relatively short time (Fiszbein, 1997). With the much higher educational levels and human resources of Russia, similar results should, in principle, be within reach there also--if conditions are right, which they obviously have not been up to now in many cases.

Accountability and Information

As emphasized earlier, if decentralization is to work properly, those charged with providing local infrastructure and services must be accountable both to those who pay for such services and to those who benefit from them--two groups that may not be identical. Enforcing accountability is not easy. It requires not only the establishment of an intergovernmental fiscal system that provides clear and correct incentives to all relevant decision-makers but also the provision of adequate information to local constituents, as well as the opportunity for them to exercise some real influence or control over the service delivery system--for example, through a democratic political process. In the political and social circumstances of a country such as the Russian Federation, it will clearly be a considerable challenge to introduce any significant degree of responsiveness into formal governmental organizations at any level.

Nonetheless, improved accountability in this sense is the key to improved public sector performance. Improved information is one key to accountability. The systematic collection, analysis, and reporting of information that can be used to verify compliance with goals and to assist future decisions is critical to successful decentralization.

Such information is essential both to informed public participation through the political process and to the monitoring of local activity by the central agencies that are responsible for supervising and (usually) financing such activity. Unless local "publics" are aware of what is done, how well it is done, how much it cost, and who paid for it, no local constituency for effective government can be created. Unless central agencies monitor and evaluate local performance, there can be no assurance that functions of national importance will be adequately performed once they have been decentralized, although care must be taken to avoid the use of such information for inappropriate control purposes.

Unfortunately, the lack of an appropriate structure to monitor and support subnational governments is a common problem in transitional countries (Bird and Banta, 2000). Although constitutionally restrained to some extent in a federal setting, the national government should keep a close eye on the finances of subnational governments, both in total and individually. Often, central authorities do not have a very good understanding of either the existing situation of subnational governments or of the likely effects of any proposed changes in their finance. Even if, as in Russia, there are uniform financial reporting and budgeting systems, an appropriate agency--perhaps preferably one with a certain degree of political separation from the central government--needs to be made responsible for collecting and processing these data in a timely fashion so that it is comprehensible to a wider audience. In Canada, for example, this role is played in part by the federal agency Statistics Canada and in part by such private non-profit agencies as the Canadian Tax Foundation and a variety of private (e.g. bond-rating firms) and academic commentators.

Of course, different countries have different cultural understandings and political conditions with respect to the desirable level and nature of accountability. Whatever standards and practices of accountability are considered desirable, however, formal reporting and evaluation systems inevitably constitute essential components of any workable accountability system--whether to users, to local taxpayers, or to the central government, depending upon the source of financing. An adequate system of collecting and assessing information is required not just for accountability but also to establish a "public" to whom to be accountable.

Institutionalizing Decentralization

Decentralization is a dynamic process. No country ever gets it right on its first try, or even its second, or third. Circumstances change, and the nature and design of intergovernmental fiscal relations should change also. An important component in establishing an adequate institutional framework for decentralization in any country is thus to build in an "error-correction" mechanism, that is, to permit and encourage the adaptive development and evolution of the system in response to changes in needs and capacities.

Several possible mechanisms along these lines are suggested by experience around the world:

* One approach, for example, might be to build in "sunset" provisions into any transfer program, that is, to provide that transfers are subject to renewal in a specified number of years, provided they pass some kind of independent evaluation of their performance.

* Another approach might be to use the likely need for some centrally-supported access to capital markets for infrastructure finance not only as a screening device to reject obviously flawed projects but also as an evaluation system to build up "ratings" of local capacity and effort.

* Yet another approach, emphasized above, is to assemble and publicize reliable comparative information on local government performance.

* Finally, many democratic federal countries--though conspicuously not Canada at the formal level (41)--have developed specialized institutions that serve on the one hand to integrate to some extent the fiscal decisions of governments at different levels and on the other to provide the informed public with some useful and trustworthy (non-partisan) information on what both levels of government are doing, separately and together.

More informed and open discussion of these matters than now prevails in most countries is needed. Regular publication of relevant data would of course help, but one cannot rely solely on an interested party--the central government--to carry out, let alone publish, all the information needed for informed public discussion. In countries in which intergovernmental fiscal issues are important, consideration might therefore be given to establishing a small non-governmental research institute focusing on local government problems. (42)

Until all relevant actors are better informed of the real alternatives and choices facing them, the long-run sustainability and outcome of decentralization seems questionable in Russia. Indeed, a move back towards greater centralization as in China in 1994 (Bahl, 1999) seems not at all unlikely in the near future, at least as a temporary matter as the central government tries to get its own finances back under control. As noted earlier, however, it is questionable whether renewed centralization provides a sustainable long-term answer in Russia's circumstances.

Achieving Fiscal Transparency

Whether centralized or not, fiscal transparency is fundamental to sound public policy. Such transparency is needed not only to improve the working of the executive and legislative branches of government but also to improve the level of public discussion and understanding of policy issues. The capacity to accept and absorb policy change in the public at large needs to be strengthened in countries such as Russia in which people have already suffered much from change but do not as yet seem to have absorbed such basic lessons of economics as that one cannot get something for nothing and that change is not inevitably a zero-sum game. In general, the more open and transparent the public policy process, the more likely are policy decisions to be grounded in fact rather than fantasy, and the more policy outcomes should coincide with stated policy intentions. Such arguments are of course now well accepted in theory, and to some extent supported by empirical studies and experience in a variety of countries (Kopits and Craig, 1998, Alt, Lassen, and Skilling, 2000).

Of course, fiscal transparency is inherently a difficult concept for politicians and officials to accept in any country, whether Canada or Russia. In no country, for example, has any central government yet admitted that full disclosure (transparent accountability) should apply also to its own actions as they affect intergovernmental fiscal relations. Decentralization is a two-sided street, however, and the central role of central governments in determining the outcome of this complex process needs more attention than it seems so far to have received. As Breton (1996) argues, however, for the potential benefits of increased governmental competition to be realized, governments at all levels must become more transparently comparable and hence accountable for their actions.

The need for transparency, and for more informed public input into, and discussion of, fiscal matters, is nowhere greater than when the responsibility for governance is divided between two (or more) tiers or levels of government. Not only must citizens in federal countries know exactly who is responsible for precisely what if they are to hold governments accountable through the electoral process (or in other ways), but it is also critically important that each level of government be well informed of the intentions, actions, and outcomes of the other levels. To achieve efficiency in a decentralized setting, not only must the rules of the game be clear but all players must also have access to broadly the same information base.

As always, each country will deal with these matters, or not, as it sees fit. Nonetheless, experience around the world suggests that several different roles might be envisaged for a body concerned with intergovernmental finance issues. Depending upon what is politically desired and feasible, some of these roles may, or may not, be incompatible and may or may not be combined in the same institution.

An important institutional requirement for effective decentralization is a cadre of competent fiscal and policy analysts at all levels of government. These persons need to be trained not only in the mechanics of analysis but also in working together, from their different perspectives, towards the common goal of making the complex political and administrative system work. One possible role for a special intergovernmental commission or agency, for example, might be to serve as a link between the political and executive branches in the centre and the regional (and perhaps local) governments--to build to at least some extent the "trust" that is so conspicuously missing in Russia today. A special institution might achieve this aim in such ways as (1) providing a non-partisan forum within which various relevant actors may get to know one another in a non-confrontational setting; (2) providing a common informational basis to all parties that is (one may hope) trusted by all parties; or (3) training, both formally and informally, a cadre of expertise in fiscal and financial areas

Other ways in which an intergovernmental agency might, if desired, serve a formal political role might be by making annual or periodic reports on "The State of the Federation" (43); by determining, or reporting on, the appropriate basis for grants; by providing "federalism impact statements" indicating clearly the impact on subnational governments of central actions; (44) by working with central banks and departments of finance in developing comparable public finance data (for example, on borrowing); or by going further and, like the Australian Loan Council, serving as a formal coordinating mechanism for public sector borrowing. (45) The substantive content of most of the tasks listed might perhaps best be achieved by a body whose main formal role was educational rather than political. For example, a common accounting framework could be developed and utilized for monitoring the fiscal performance of all levels of subnational government. Such reports might be more credible if the agency did not have a formal "reporting" role to the central government, and its output was accepted as the work of competent and politically neutral analysts.

In the hurly-burly of emerging democratic politics in a country such as the Russian Federation, such suggestions may seem to be either naive or hopelessly idealistic. Nonetheless, if a decentralized system is to work well, people need to understand not only what is going on but also the real possibilities and constraints facing governments at all levels.

Experience in such developed federal countries as Canada suggests (1) that transparency is needed for good fiscal management, (2) that good fiscal management is needed if a decentralized political structure is to work relatively effectively and efficiently, and (3) that some sort of specialized agency (or agencies) to perform at least some of the functions sketched above may play a vital role in this process. Good, relevant, timely analysis of intergovernmental fiscal relations, training good analysts, facilitating and encouraging productive technical exchange between and within governments, and providing neutral, competent input to the public discussion of intergovernmental fiscal and financial policy--such intangible but critical institutional factors in the end play a vitally important role in making decentralization work in any country. If fiscal federalism in Russia is to prove sustainable and beneficial in the long run, steps need to be taken to foster the development of such an institutional framework..


This paper has covered a wide range of topics. Many of the aspects of intergovernmental fiscal relations that have been touched on here can of course only be worked out specifically only in the context of each individual country. The extent to which the ideal structure of intergovernmental fiscal relations sketched here is currently approximated in Canada, for example, is arguable and clearly depends upon constitutional restrictions, political realities and an array of specific contextual factors. Such factors are of course even more salient in Russia, and it will undoubtedly be many years, if ever, before some of the ideas suggested above are seriously discussed in that country. The real science and art of designing and implementing better intergovernmental fiscal systems inevitably lies mainly in the hands of those who must apply these (or other) principles locally.

As Canadians have long known, and Russians are presumably beginning to understand, good principles are easy to expound but applying them in practice is much more difficult. Developing a workable intergovernmental fiscal structure in a federal system is, Canadian experience suggests, a difficult and never-ending task. Martinez-Vazquez and Boex (2001), for example, argue in their excellent study of fiscal federalism in Russia that the country desperately needs a consistent strategy of decentralization. They may be right. Canada, like most long-standing federations, has never had such a strategy or vision, however. It has instead, as it were, muddled along from crisis to crisis and has somehow managed to survive so far. It is of course not clear that the leisurely, incremental process of change and adjustment that has thus far characterized Canadian history is a luxury that can be afforded in the current circumstances of the still youthful Russian Federation. As always, only time will tell.


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(2) See, on Canada, Bird (1987, 1993), Bird and Chen (1998), Bird and Tassonyi (2001), Bird and Vaillancourt (2001) and Vaillancourt and Bird (2002), and on international comparisons, Bird (1986), Bird (1994), and Bird and Vaillancourt (1998).

(3) See, in particular, Bird, Ebel and Wallich (1995), Bird and Banta (2000), and Wetzel (2001).

(4) This argument is set out in detail in Bird (1993a). Note that the term "subnational" is used in this paper to encompass both regional (provinces in Canada and oblasts, krays, and other "subjects of the federation" in Russia) and local levels of government. Of course, in a federal state, as a rule there are major differences in the legal, political, and economic status of these two levels of subnational government, with regions generally having much more autonomy in all dimensions, but such subtleties cannot be adequately discussed here.

(5) For an interesting comparison of the decentralization theorem and the subsidiarity principle, see Breton, Cassone, and Fraschini (1998).

(6) For a useful recent review of some of the relevant literature on decentralization and redistribution, see Ravaillon (2000); see also Bird and Rodriguez (1999).

(7) For a detailed comparison of the size of the "fiscal gap," and the role transfers play in closing it in developed western federations (Australia, Austria, Belgium, Canada, Germany, Spain, Switzerland, and the United States), see Bird and Tarasov (2002).

(8) The role (and limitations) of user charges are not further considered here: for the Canadian case, see Bird and Tsiopoulos (1997). In Russia, for the most part, fees and charges do not appear in subnational budgetary revenues at all, but are rather simply retained by the collecting agency. This is not good budgetary practice.

(9) Martinez-Vazquez and Boex (2001) suggest that the recurrent disputes in Canada and other federal countries such as Germany and Australia over the federal "spending power" are analogous to the situation in Russia, but this analogy seems, at best, tenuous: see Watts (1999).

(10) The 1998 Budget Code, for example, defines a broad list of activities--including law enforcement, social protection, support of industry, etc.--that are "jointly financed."

(11) For example, the central government may set national standards for graduates and for teachers and may also establish the basic curriculum to be covered. Regional governments in turn may, within this framework, develop their own policy goals--for instance, with respect to school facilities--and deploy appropriate regulatory instruments in an attempt to achieve them. Local governments may be responsible for actually paying teachers and maintaining facilities. And, of course, educational services are finally delivered by schools which will, experience suggests, produce better outcomes if they have a substantial degree of budgetary autonomy and hence can react to input from teachers, parents, and the local community. Three or more levels of government may thus play important roles in delivering educational services, as well as many other public sector activities. In contrast to Canada, where education is clearly constitutionally a provincial subject, in Russia the federal government sets curricula and textbooks, although most education is supplied by the regional and, especially, the local authorities. Moreover, as Bahl et al. (1999) show, regional and local governments do not always agree on who is responsible for what.

(12) For further discussion of fiscal decentralization and competitive governments, see Breton (1996) and Bird (2000a).

(13) See Hayhurst (2000) for an account of President Putin's attempts to reassert central authority over regional governors, as well as Martinez-Vazquez (2002). The Chinese case is discussed in detail in Bahl (1999). Wetzel (2001) notes that the failure to design intergovernmental fiscal relations to minimize coordination problems and to establish effective coordinating institutions (Section 6) has been a general problem with fiscal decentralization in transitional countries.

(14) See Thirsk and Bird (1994) for a review of earmarking in Canada and Bird (1997) for a broader analysis.

(15) See Litwack (2002) for further discussion of this issue, from a different perspective.

(16) Kurlyandskaya (2001) discusses the complex sub-regional budgetary system in Russia. On similar problems in Ukraine, see Szyrmer (2000).

(17) There is considerable experience in some parts of the world (including Canada) with such techniques as client surveys, participatory budgeting, performance budgeting, and user financing. Shifting the emphasis in public finance from inputs to outputs in this way is in principle an essential step in improving policy outcomes at any level of government (World Bank, 1998). But the process is clearly risky, not least because it implies a much higher degree of transparency and clear political responsibility than most governments are willing to assume. No country really shines in this respect, and it is by no means clear how best, or to what extent, this shift can be accomplished in the difficult circumstances facing Russia and other transitional countries. While such concerns are important to those concerned with improving the performance of government in countries such as Canada, with respect to Russia, which has so many more immediately critical problems facing it, such matters seem more for the future than the present day.

(18) Some years ago, for example, there was a well-known "battle of the balance sheets" between the Quebec and federal governments as to whether federalism was profitable in this sense for Quebec. Surprisingly, even such reputable analysts as Courchene (1999) have occasionally given credence to this approach, despite its obvious inadequacies in economic terms (Bird, 2003).

(19) The question of the extent to which "local" taxes should be locally administered has recently been discussed in detail by Mikesell (2001). Since, as noted above (with respect to the Canadian PIT), local administration is not the critical issue in any case, this matter is not further discussed here.

(20) The most important exception arises from provincial control over natural resources: it is not a coincidence that Alberta, Canada's oil province, is the only province with no sales tax and also has the lowest income tax. Revenue from natural resources has also been a critical issue in Russia, of course, but this important point cannot be further discussed here: (Bosquet, 2002).

(21) Bird and Stauffer (2001) explore some aspects of these questions in several countries.

(22) A minimum rate is needed to prevent distorting "tax competition" (with richer jurisdictions--those with larger tax bases--lowering rates to attract still more tax base). A maximum rate is needed to prevent distorting "tax exporting" (as when jurisdictions in which breweries or gas distribution pipelines are located impose especially heavy taxes on such facilities in the expectation that the taxes will ultimately be paid by persons not resident in the jurisdiction).

(23) Ring (1999) shows that the same is true with respect to retail sales taxes in the United States.

(24) The new (2000) Russian tax system is described in Alm, Martinez-Vazquez and Wallace (2001).

(25) This imbalance is greater than the numbers indicate since, although part of the proceeds of many taxes accrue to subnational governments, those governments have little or no say over the rate or base of such taxes, so that from most perspectives what is going on is really that a central tax is levied and then transferred to the region in which it is collected. As Martinez-Vazquez and Boex (2001) stress, this statement is not entirely true since the "dual subordination" of the tax administration in Russia means that the actual collection effort is to some extent responsive to local as well as national pressures. Nonetheless, regional governments in Russia are clearly much more dependent on central tax policy than in Canada.

(26) In addition, in 2002 the regions also received 100 percent of domestic excises (50 percent of excises on alcohol), and 69 percent of profits taxes (a figure which includes the yield of a 2 percent local profits tax). In 2003, the regional share of the excise on oil products was set at 40-percent. Such continual adjustments by the center simply underline the basic point made in the text about the lack of much real subnational revenue autonomy in Russia.

(27) For a recent discussion of the possibilities and problems of local income tax surcharges in transitional countries, see Davey and Peteri (1998).

(28) See, for example, Varsano (2000) and the discussion by McLure (2000), Keen and Smith (2000), and Bird and Gendron (2000).

(29) As Martinez-Vazquez and Boex (2001), p. 55, put it: "The lack of real estate markets, land ownership, and multiple institutional constraints are powerful obstacles for the development of an ad valorem real estate property tax in Russia." For a recent review of such taxes around the world, (see Bird and Slack, 2002).

(30) The history of this idea, and various partial examples found around the world, are set out in detail in Bird (2003a). Empirical application of this approach to Canada may be found in Bird and McKenzie (2001).

(31) Reportedly, the recent Kozak Commission has emphasized the need for more adequate funding of subnational governments, but it is not clear what exactly this may mean for subnational revenue autonomy (Martinez-Vazquez, 2002).

(32) See the country discussions in Shah (1994), Ahmad (1996), and Ter-Minassian (1997). Canada's equalization system follows the third approach listed, with the size of the "pool" being determined in effect by the own-revenues collected by a subset of provinces.

(33) For an example of a grant system along these lines in a unitary, but highly decentralized, setting, see Bird and Fiszbein (1998).

(34) The criticism in Martinez-Vazquez and Boex (2001) of the largely capacity-related "norms" common in Russian formulas, reflecting prior planning practice, is sound. Greater refinement of such norms may not mean better measures. For further discussion, see Bird, Ebel and Wallich (1995).

(35) For critiques of the Canadian formula, see Bird and Slack (1990) and Smart (1998). Although this point cannot be discussed in detail here, it should perhaps be noted that effort can be adequately taken into account in a capacity-based formula, although the difficulty of making good capacity"estimates should not be understated. A useful recent discussion of this issue in Ukraine may be found in Fiscal Analysis Office (1999).

(36) For a useful discussion, see also Freinkman, Titov, and Treisman (1998).

(37) For an interesting set of country case studies on these problems, see Rodden, Eskeland and Litvack (2003).

(38) Note that this does not necessarily imply subsidization. In Canada, for example, as a rule the full cost of any needed financial restructuring is in principle borne locally in the form of reduced services for a period of years until the debt is cleared. The rule is clear: "your mistake, you pay." The central (provincial) government supervises the review and adjustment process, but it does not subsidize it except very occasionally when the default was clearly beyond the control of the locality (for example, a forest fire that destroys the resource base of a rural community) so that the problem is one of solvency not liquidity.

(39) In Canada, in contrast, up until the last decade or so, only provincial governments borrowed abroad, with all federal debt being placed domestically. One possible rationale for this curious situation was that foreign capital markets may have imposed harder budget constraints on the provinces than might otherwise have been politically possible, although this is far from clear.

(40) Of course, some arrangements may have to be made to permit borrowing to smooth out cash flows over the budgetary year. Although some have expressed concern about the ability of local governments to borrow on the basis of the increased cash flow as a result of transfers (or, for that matter, royalties), it is not clear why this should be a problem--provided, of course, that such borrowing is not subsidized. To the extent that transfers (royalties) constitute revenues that local governments can spend as they wish, if private agents are willing to lend money based on this security they should be free to do so, provided that they also bear the consequences if the loan goes bad.

(41) As Meekison (2000) emphasizes, Canada's "executive federalism" in practice works through a variety of well-established institutional interchanges between governments. Neumann and Robinson(2001) discuss this system at the federal-provincial level in detail, with some reference to Russia.

(42) The Open Society Institute in Hungary has done useful work in that country, and elsewhere, along these lines. See, for example, Horvath (2000).

(43) In Canada, this is done by the Institute of Intergovernmental Relations at Queen's University.

(44) This idea is suggested in part by Martinez-Vazquez and Boex (2001) with respect to unfunded mandates. Something like this has also been proposed in the United States by Inman and Rubenfeld (1998).

(45) For a recent discussion of this body, see Courchene (1999).

Richard M. Bird (1)

University of Toronto

(1) International Tax Program, Rotman School of Management, University of Toronto, Petro-Canada Scholar, C.D. Howe Institute, and Distinguished Visiting Professor, Andrew Young School of Policy Studies, Georgia State University. This paper is based on a study originally prepared for the Institute of Intergovernmental Relations, Queen's University and developed further in Bird (2001, 2002). The present version has benefited greatly from the comments of several anonymous reviewers, as well as from those of Robert Conrad and Jorge Martinez-Vazquez. Despite all this help, I have found it difficult to cover the topic of this paper without appearing at times to make ex cathedra pronouncements on complex and difficult questions. At the risk of excessive self-reference, I have therefore included a number of references to earlier work in which some of the evidence and arguments alluded to here are developed in more detail.
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