Report No. 25466-LV Latvia Beyond Territorial Reform August 1, 2003 Infrastructure and Energy Sector Unit Europe and Central Asia Region Document of the World Bank CURRENCYEQUIVALENTS (Exchange Rate Effective as of February 14,2002) CurrencyUnit -Lat US$1.00=.640 LVL FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES The Metric Systemis used throughout the report. ABBREVIATIONSAND ACRONYMS DRG Diagnosis Related Group EU European Union GMI Guaranteed Minimum Income IBRD International Bank for Reconstruction and Development ISPA Instrument for Structural Policies Assistance MOW Ministry of Social Welfare PIT Personal Income Tax PUC Public Utilities Commission SAO State Audit Office ULRGL Union of Local and Regional Government of Latvia Vice President: ShigeoKatsu Country Director : Roger Grawe Sector Director: Hossein Razavi Sector Manager: Sumter Lee Travers Task Manager: William Dillinger FOROFFICIAL USEONLY FOREWORD This report is based on the findings o f two missions to Latvia inApril and August, 2002. The report was prepared by a World Bank team comprised o f Messrs. William Dillinger (Task Manager), Signe Zeikate (Consultant) and Gailius Draugelis (ECSIE) underthe supervision o fLee Travers, Urban Sector Manager, ECSIE. The peer reviewers for this task were Mila Freire, Urban Sector Manager, Latin America and Caribbean Region, and RobertEbel, Lead Economist, WBIPR. The report was produced with the assistance of a wide range o f Latvian counterparts. These include Aija PoEa, Adviser to the Prime Minister; Janis BunkSs, Saeima Deputy and Member o f Commission on State and Local Government Affairs; Andris Jaunsleinis, Chairman of the Union of Local Self Governments; Andris K " s , Advisor to the Director, Department o f Local Self Government Affairs and Inguna Sudraba, Deputy State Secretary, Ministry o f Finance as well as senior officials o f the Ministries o f Finance, Economy, Education, Welfare, and Environment and Regional Development. The mission wishes to particularly acknowledge the assistance renderedby the officials and staff of the seven small municipalities--Incukalns, Ligatne, Puze, Tukums, Tume, Sabile, andUgale-which were analyzed indepthfor this report. This documenthas a restricted distributionand may beused by recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed without World Bank authorization. Table of Contents Executive Summary................................................................................................. i 1. INTRODUCTION.................................................................................................. 1 EXISTING STRUCTURE...................................................................................... 1 MUNICIPAL FUNCTIONS................................................................................... 2 REVENUES............................................................................................................ 6 2. TERRITORIAL REFORM................................................................................... 10 GOVERNMENT'S PROPOSAL.......................................................................... 11 3. HOW SMALL IS TOO SMALL?........................................................................ 15 INTERNATIONAL PRACTICE.......................................................................... 15 STUDIES OF OPTIMAL MUNICIPAL SIZE..................................................... 17 4. THE LATVIAN CASE......................................................................................... 22 ARE SMALL LOCAL GOVERNMENTS INCOMPETENT?........................... 23 DO THEY SPEND TOO MUCHONADMINISTRATION?............................. 26 PUBLIC GOODS AND SCALE ECONOMIES.................................................. 27 FISCAL DISPARITIES........................................................................................ 29 COORDINATION................................................................................................ 31 5. AFTER AMALGAMATION ............................................................................... 31 COMPLEMENTARYPOLICY REFORMS ....................................................... 32 INTERMEDIATELEVELSOF GOVERNMENT.............................................. 36 CONCLUSIONS................................................................................................... 41 EXECUTIVE SUMMARY 1. Latvia i s a sparsely populated country with a large number o f local governments. Many o f these are extremely small. Over half have fewer than 1,500 people. Their responsibilities, nevertheless, are considerable. These include the provision o f primary and secondary education, social assistance, water supply, sewerage, district heating, solid waste management, and road maintenance. 2. The Government o f Latvia is now attempting to implement an extensive consolidation o f these local governments. Starting with the existing 542 jurisdictions, its intention i s to reduce the number to 102. While amalgamation has many potential benefits, one is indisputable. It will reduce the need for the array o f inter-municipal agreements that local governments now rely on in providing services subject to economies o f scale. As a result, conflicts and negotiations that formerly occurredbetween jurisdictions will now take place within jurisdictions, where they can be more readily addressed. T here is also evidence that amalgamation will enable 1oca1 governments t o attract more highly qualified staff. 3. But further reforms will berequiredto achieve the improvements inlocal services that the Government seeks. To prompt the closure o f underenrolled schools, the Government will have to raise--and then enforce--its rule on minimum class sizes. It will also have to change the basis for financing teachers' salaries to one which more accurately reflects enrollment. To rationalize the allocation o f hospital funding and facilities, the Government will need to proceedwith the introduction o f price-volume- quantity and DRG-based hospital reimbursement systems, as well as its plan to reduce the number o f general hospitals. To meet EU standards for solid waste management, the Government will need to establish intermunicipal or regional institutions to operate the eleven proposed landfills. To meet EU standards for water supply and wastewater treatment, it will need to encourage regulators to increase water tariffs and encourage enterprises to improve operating efficiency. And to provide sufficient financing for social assistance benefits, it may need to provide additional financing in areas where poverty levels are unusually high. 4. The Government should also consider changes in the organization and functions of intermediate levels o f government. After amalgamation, the existing units o f intermediate government--the rajons--will be largely redundant. But newly consolidated units o f local government-the novads--may be too small to take on the rajon's vestigial functions: organizing public transport services, managing funding for roads, and operating retirement homes and orphanages. The Government should consider assigning these functions to a larger unit o f subnational government. The five recently-created planning regions might be an appropriate basis for such a level of government. 1 1. INTRODUCTION 1.1 Latvia i s a sparsely populated country with a large number o f local governments. While roughly half the population live in Riga and six other `republic' cities, the remaining 1.23 million Latvians are scattered over an area o f 64,000 km2,a territory roughly the size o f Ireland. This territory i s divided into 535 towns and rural municipalities.' Many o f these are extremely small. Over half have fewer than 1500 people. Their functions, nevertheless, are considerable. These include the provision o f primary and secondary education, primary health care2, social assistance, water supply, sewerage, district heating, solid waste management, and road maintenance. 1.2 The Government of Latviais now attempting to implement a radical consolidation o f these local governments. Starting with the existing 542 local governments (including the republican cities), its intention i s to reduce the number to approximately 102. The move to consolidate i s ostensibly motivated by several technical concerns. It is thought that the small size o f the municipalities results inlocal incompetence, due to the difficulty o f attracting qualified professional staff to small jurisdictions. It i s believed to run up the costs o f public services, due to the absence o f scale economies. The proliferation o f municipalities is also said to make planning and coordination difficult and result in the expensive duplication o f administration and service delivery. The example o f neighboring countries to the west has also spurred interest in consolidating local governments. Denmark, Sweden, and Germany all amalgamated their local governments inthe sixties and seventies andthis appears to havehad some influence inLatvia. 1.3 To date, the consolidation effort has run into some political opposition, particularly among the smallest jurisdictions. While the necessary legislation has been in place since 1998, so far only 21 municipalities have taken advantage o f it. Under the law, municipalities have until December 31,2003, to voluntarily amalgamate. After this date, amalgamation will be compulsory. This report assumes that the Government's proposal will proceed as planned. The report's aim is to identify complementary changes in the financing, organization, and functions o f local governments that will enhance the impact o f consolidation on the efficiency and equity o f local public services. EXISTINGSTRUCTURE 1.4 Latvia has two levels of local government. Governments in the first tier are variously known as towns (pilseta), villages (pagasts), and novads. Latvia's seven ' Including 15 amalgamated municipalities, termed novads. Local governments may provide facilities or other incentives to attract physicians. Operating costs, including physicianremuneration, are paid by the Health Insurance Agency. 1 republican cities are also assigned the rights and responsibilities o f local governments. With the few exceptions noted below, the legislation on local govemments applies uniformly to all o f them. All municipalities are governed by elected councils, which in larger cities are elected at large by party list. In small pagasts, groups o f candidates form their own slates (Le., without party affiliation) and run at large. Once elected, the councilors elect a chairman (mayor), who acts as a chief executive. Under the local government 1aw, c ouncils are supposed t o appoint a n executive director (based onthe recommendation o f the chairman). In small pagasts, the chairman himself may act as executive d i r e ~ t o r . ~ 1.5 The second tier consists o f 26 rajons, or districts. (The seven republican cities are rajons in their own right.) Until 1997, rajon councils were directly elected and had a political identity separate from the municipalities. At present, they are governed by councils comprised o f the mayors o f the local governments within their territory. As discussed later, they perform a largely coordinating role and have few independent functions o f their own. MUNICIPAL FUNCTIONS 1.6 Education: The local govemment law assigns a wide range o f public sector responsibilities to municipal governments. As shown in Table 1.1, education accounts for the lion's share o f spending. Under the General Education Law o f 19994, each municipality has the `obligation to provide children residing within its administrative temtory with the possibility o f acquiring pre-school, primary, and secondary education'. In2002, mandatory preparation o f 5-6 year old children for school was added to this list. Under Latvian law, parents are permitted to choose the jurisdiction inwhich their child will attend school, subject to approval by the headmasters o f the origin and destination schools. Parents residing in remote parts o f a municipality may therefore choose to send their children to a school ina neighboringjurisdiction. 1.7 Municipalities enjoy a high degree o f autonomy in the management o f their schools. Although the rate o f teachers' pay i s set by the Government, municipalities have the legal authority to appoint school directors and teaching staff. National law does require school teachers to meet certain qualifications. Pre-school and primary school teachers must have an advanced professional degree in education. Secondary school Article 67 o f the L a w "On local Govemments". As paraphrasedinUNESCO, 2000, TheEducationfor All 2000 Assessment Country Reports: Latvia www2.unesco.org/wef/countryreportslLatvialrapport~1.html. 2 teachers must have an advanced degree in the subjects to be taught. But the law allows persons not meeting these criteria to be hired on a fixed-term basis. The proportion o f teachers failing to meet the standard i s increasing. While 80 percent o f teachers with over ten years experience have advanced degrees, only half o f more recent hires (with 1ess than two years' experience) do.' In principle, municipalities also have the authority to open or close schools. The 1999 law grants them the authority to `establish and close pre- schools, primary schools, and secondary schools, subject to the agreement o f the Ministry o f Education and Science. This authority i s constrained, however, by minimum-class-size standards imposed by the Ministry. In principle, the Ministry will not permit a class to open ifit has fewer than eight students.6 1.8 Social Assistance: Local governments are responsible for providing municipal social benefits and social services to the residents o f their territories. These benefits and services form part o f a larger system o f social welfare, which includes social insurance and Government support for specific vulnerable groups. Social insurance ensures the replacement o f lost income to persons in situations o f social risk, such as old age, disability, sickness, and unemployment. These costs are paid from Government social insurance funds, which are in tum derived from individual contributions. Government benefits, including family benefits, child birth and child care benefits, and payments to foster parents, are paid from general Government revenues. The Government i s also responsible for providing residential institutions for the retarded, the blind, orphans and disabled children, and for the rehabilitation o f abused children and the disabled. (Local governments, however, are responsible for day care and in-home care for the mentally ill.) 1.9 Municipalities provide a variety o f supplementary social assistance and services. Under the Law on Social Assistance in effect in 2002, municipalities were authorized to provide a `poor family social assistance benefit', consisting o f a cash payment to be allocated to families meeting certain income and wealth criteria. They could also provide a housing benefit-generally inthe form of a subsidy for rent or utilities-and subsidies for food costs and medical assistance. Only the poor family social assistance benefit was explicitly income tested, and the amount o f funding was relatively small. In 2002, an average o f only 8.91% o f the budgets o f pagasts, novads, and small towns was assigned to this program. UNESCO, 2000, op.cit. Ingrades 1-4,two grades canbe combined inorder to meet this threshold. 3 Prior to the recent change inthe law on social services, local governments enjoyed a high degree o f autonomy in the way they administered social assistance programs. While the former law set out a classification system for municipal social assistance, it did not require municipalities to fully fund any Table 1.2: Spending on Social Assistance, 2000 particular level o f benefits. The former law goveming the social assistance benefit to needy families did, however, define conditions for eligibility and Child care benefit 11.59 procedures for allocating the benefit. State social security benefit 4.83 Foster parent subsidy 4.59 Matemitv benefit 2.73 1.10 Health care: Municipal Other state benefits I 4.51 governments also play a major role in Total state benefits I 58.6 health care. (Because most o f it i s MunicipalBenefits through regional health funds, it does not Housinrr benefit I 4.55 appear as a major expenditure item o f -rent and communal services 3.94 municipal expenditure in Table 1.1). Food benefit 3.35 Latvia has a single-payer system o f -free lunches inschools and kindergartens 2.26 national health insurance which covers Medical services subsidy 1.5 Social assistance to needy families 1.06 primary and secondary care. It i s Other municipal benefits 3.79 organized on the basis o f eight regional Total municipal benefits 14.26 funds. 0utpatient specialist services are largely provided on a fee-for-service basis by private doctors registered with the regional funds, while primary care services are paid on a capitation basis (a fixed amount per person enrolled, adjusted for age). Local govemments own and manage the majority o f hospitals and clinics (excluding some specialized facilities in Riga). Secondary care provided by municipally-owned facilities i s financed on a bed-day basis by the regional funds.7 Until recently, budget support for hospital care was financed on the basis o f inputs, with separate allocations for personnel, supplies, and other items. Inprinciple, the allocation o f funds at the regional level is now done on a risk-adjusted per capita basis, although allocations are still influenced by the location o f existing facilities. Because o f limited funding from the central government, municipalities also play a significant role in financing capital improvements for the facilities which they own. 1.11 Water Supply: As shown in Table 1.3, the majority o f water supply and sewerage networks are provided by municipal govemments, either inthe form o f municipal departments or as wholly-owned municipal enterprises.. While the departmental form o f organization i s more common, it predominates in smaller jurisdictions. The majority o f customers are served by enterprises. A new commercial law requires municipalities to re- constitute their enterprises as legal entities govemed under a more transparent set o f rules. The Law on Regulators o f Public Service (as amended September 27, 2001) IBRD,October, 1998; ProjectAppraisal Document on a Proposed Adaptable Program Lendingfor a Health Reform Project, revised o n the basis o f information providedby the current task manager. 4 establishes a new framework for regulating municipal services. Under the new framework, municipalities can establish an independent municipal regulator for water supply and sewerage (as well as other services).* The regulator has the authority to: (i) license public services; (ii) tariffs in accordance with relevant regulations; (iii) set assist with initial resolution o f disputes; (iv) promote competition and supervise compliance with conditions o f the license; (v) provide information to central authorities and the public; and (vi) issue administrative guidelines that are binding on regulated providers.' Services organized as departments, however, are exempt from these provisions. 1.12 At present, municipalities enjoy a high degree o f management autonomy in managing their water operations. Local government departments operate on the basis o f charters and regulations adopted by the local government council. The council appoints the head o f the institution, approves its budget, and sets its tariffs. The financial operations o f water departments can be commingled with those o f the municipal general budget.loWhile water operations that are organized as municipal enterprises are required to keep separate accounts, their boards are also municipally appointed. Their tariffs are set by the council, although once the new municipal regulators are inplace, the councils' influence may decline. 1.13 Roads and Public Transport: Municipalities manage 39,592 km o f roads, o f which 13 percent are paved and 87 percent are gravel roads." Judging from the interviews undertaken for this report, most road construction and maintenance is performed by private firms under contract to local governments, rather than by force account. Local passenger transport i s provided mainly by enterprises, both public and private. Licenses for bus transport are issued by the Motor Transportation Directorate but permits for given routes are issued on a competitive basis by republican cities and rajons.12 1.14 Solid waste collection and disposal is also a municipal function. In smaller jurisdictions, waste management is provided by municipal departments, private companies, or municipal companies from other, larger municipalities. In larger municipalities, private contractors predominate.l3Illegal dumping, operation o f landfills beyond their lifecycle, and lack o f sorting o f wastes are some common characteristics o f landfills inLatvia. There is about one landfill for every 4,200 inhabitants, suggesting that several landfills serve less than 2,000 inhabitants. About 160 o f the estimated 558 ~~ ~ Section2, paragraph3 Law on Regulators of Public Services (as amendedSeptember27, 2001). The law was adopted on October 19,2000, and came into effect June 1, 2001. Section9, 16-21,Law on Regulators of Public Services (as amendedSeptember 27,2001). lo Vilka,Development of LocalGovernmentRegulatoryModels,(Riga:FinalReport,June 15,2001). Inga Latvian RoadAdministration, 2002. l2 Blezurs Consultants, Ltd. (for World Bank), "Summary of the Existing Institutional Set Up", Latvia Multi-sectoral Regulatoly Project, Awareness-Raising for the Municipal Regulatory Component (Riga: May 2001), 12. l3 Ministry of Environmental Protection andRegional Development, Report on Environmental Investments 2000, (Riga: 2001), 13. 5 landfills have been"closed for a long time" and several are no larger than 1ha, accepting an average o f 100-1,000 m3o fhousehold waste annually.l4 1.15 Housing and Housing Maintenance: Municipalities own approximately 20 percent o f the residential housing stock in Latvia. On average, over 50 percent o f these buildings are over 25 years old and have had no major renovations during their lifecycle.l5Inaddition, prefabricated buildings, comprising nearly 59 percent o f the urban housing stock, were constructed in the past 30 years using large panel technology with low thermal insulation.I6 Soviet-era apartment blocks exist even in very small municipalities. Interviews with municipal officials revealed that in many cases the three/four story apartment buildings in their jurisdictions have been vacated by former employees o f now-bankrupt factories and other government employees now transferred elsewhere. The vacated apartments are used for low-income shelter or even as a benefit offered to prospective employees, particularly teachers. Municipalities set the rent or maintenance fees on these structures. These are reported to be about one-third o f the amount needed to adequately cover maintenance costs.l7Municipalities also provide maintenance services to privatized housing. According to a survey conducted by the Union o f Local and Regional Governments, about 60 percent o f housing maintenance i s performed by local government institutions and enterprises and the remainder by individuals. REVENUES 1.16 Municipal governments derive their revenues from three major sources.18By far the largest is the personal income tax, which accounts for roughly half o f total recurrent revenues (see Table 1.4). (Municipalities receive 71.6 percent o f PIT revenues, with the remainder transferred to the health insurance fund.) The Government sets the PIT base and rate. Administration (except in Riga and the port cities o f Ventspils and Liepaja) i s carried out by the State Revenue Service. Real estate taxes account for about ten percent o f total revenues. The Government defines the legal base and rate o f the real estate tax and assesses the value o f individual property. Local governments, however, are responsible for billing and collection, and have limited authority to grant reductions inthe tax rate in specific cases. Indirect taxes on goods and services-including taxes on lotteries and gambling-constitute the remainder, but account for only 0.3 percent o f local government budget revenues. l4 Vilka,Developmentof LocalGovernmentRegulatoryModels,(Riga:FinalReport,June15,2001), Inga 20. l5SashaTsenkova, Riga: Housing Policy and Practice- A Frameworkfor Reform (Riga CityCouncil: 2000), 6. l6 Tsenkova,op.cit. Sasha l7 WorldBankisworkingwiththeLatvianGovernmentonhousingfinancereform.SeeWorldBank, The Latvia Housing Project Appraisal Document (Washington: April 25, 2002). l8 thatthissectiondiscussesonlybudgetaryrevenues, andexcludesrevenuefrommunicipal Note enterprises as well as capital receipts such as loans and proceeds from the sale of assets. 6 1.17 Revenues from the PIT and the property taxes are not retained in the jurisdiction inwhich they are collected but are instead subject to a fraternal equalization system.The calculation o f contributions is made during the budget process. The process begins with a projection o f the aggregate yield o f the PIT and real estate taxes inthe forthcoming year, based on historical trends and aggregate economic forecasts." The share that will be collected in each municipality from the PIT i s then calculated on the basis o f each municipality's share o f actual collections two years earlier. 1.18 Aggregate expenditure needs are calculated on the basis o f total municipal expenditures in the preceding year, adjusted for inflation. (The figure is further refined during negotiations with the Union o f Local Governments.) The projection o f aggregate spending i s then divided between republic cities and other local governments on a 45-55 basis. Within each o f these two groups, the relative expenditure needs o f each municipality are then calculated on the basis o f six criteria: population, number o f children ages 0-6; number o f children age 7-18, population above retirement age, number o f children in orphanages and number o f elderly in retirement homes. If a given municipality's projected revenues exceed its projected expenditure needs by more than 10 percent, the municipality i s subject to a revenue cap. Forty-five percent o f the surplus i s taken away and allocated to an equalization hnd. I f projected tax revenues are less than 90 percent o f estimated expenditures needs, the gap is fully met, using proceeds from the equalization fund. (Any shortfall between contributions into the equalization fund and payments out o f it are to be covered by the Government.) The Government guarantees the level of projected revenues. During budget execution, any shortfall between projected revenues and actual revenues is covered by a Government grant if an agreement to this effect has been reached during annual negotiations with the ULG. If not, the Government only guarantees the subsidy fixed inthe state budget law. 1.19 Earmarked grants are the second largest source o f local revenue, providing an average o f 23 percent o f the total. Grants for teachers' salaries constitute most of Table 1.4: Sources of Municipal Revenue this category. As noted earlier, parents are /Townsand1Republican I permitted to choose the jurisdiction in which their children will attend school, subject to approval by the headmasters o f the source and destination schools. Fundingfor teacher's salaries follows the student, albeit in a convoluted manner. Each budget year, funds for teachers' pay are allocated as a lump sum to each o f the 26 rajons. Inprinciple, each rajon's share i s based on the number o f authorized teaching positions (termed `basic ratesy2') in the rajon. The number o f teaching positions, in turn, i s supposed to be based on enrollment. l9 Riga,Ventspils,andLiepaja, revenueavailabilityisdeterminedduringbudgetexecution,basedon In actual receipts. 2o The basic rate consists o f 21 hours per week. Actual teaching loads vary among individuals. While the average teacher teaches 1.3 basic rates, the range varies from 0.5 to 2.1. 7 Inpractice, hold-harmless provisions inthe allocation systempreventthe Government from reducing allocations to any individual rajon. These specify that while allocations to a rajon can be increased from year to year, no rajon's allocation can be cut. At present, the allocation o f the salary budget among rajons therefore reflects history more than it does enrollment. 1.20 Rajons, in tum, are supposed to allocate salary funding among individual schools on the basis o f enrollment. Again, the practice is more complicated. In order to ensure that individual t eachers are actually paid, allocations are based on c ontracted t eaching loads, rather than pupils. There is only a rough correspondence between the two. The Ministry o f Education will not permit a class to open if it has fewer than eight students. This sets a lower bound on the pupil: teacher ratio. But pupi1:teacher ratios can range as highas 30:1.An increase inthe numberofpupils therefore does not automatically trigger an increase in salary funding. But if a sufficient number o f children transfer from one school to another, salary allocations will eventually follow suit. 1.21 Allocations for operations, maintenance, and other non-salary education costs also follow the student. The law requires municipalities that send their students to other jurisdictions to provide compensation for these expenses.2' The amount o f this compensation i s fixed (per pupil) by the Government. The mechanism reportedly works fairly well. A Local Government Finance Equalization Board, composed o f four representatives o f local governments and representatives from the Ministries o f Education, Welfare, Finance (including State Treasury), and the Department o f Local Government A ffairs s ewe as a c ourt inc ase o f disputes. Municipalities indefault c an have their arrears deducted from their tax revenues. As shown in Table 4, these intermunicipal transfers account for about two percent o f municipal gross income. 21UNESCO, 2000, op.cit. 8 1.22 Non-tax revenues Figure 1.1: Structure of Local GovernmentRevenuesAccording comprise around 10 percent to Size of Municipality o f local governments' 100% revenues. This category 90% includes revenues from the 80% sale o f land and property as 70% well as income from fines 60% and penalties. In some 50% cases it includes revenues 40% from the provision o f 30% public services, such as 20% water supply, solid waste or heating (the three largest I 10% services in terms o f 1 0% Municipalities Municipalities Municipalities Municipalities Municipalities 10000 1 turnover). As noted earlier, ______- ClOOO c2000 c5000 _ _ _ ~ _ _ <10000 1 0PersonalIncomeTax t!J Real estate tax on land where services are ElReal estate tax on buildings OIntemal taxes on goods and sernces Bh'on tax revenues OPayments for education I organized as enterprises, Payments for social services OOther payments Grants E m k e dgrants tariff revenues are not 0Grantsfromequalizationfund 0Paymentsfromotherbudgets I I included in general ~~ ~- Source: Ministry of Finance,2002 Plan. budgetary revenues. But where services are organized as departments o f the local government-`institutions' in Latvian parlance--tariff revenues may be included as general budgetary revenues. 1.23 The structure o f local government revenues varies for different types o f local governments. As shown in Table 1.4, republic cities derive a considerably larger proportion o f revenue from the PIT than smaller jurisdictions. The latter, intum, derive a significant share o f revenues from the equalization fund. This distinction extends down the population-size scale. As shown in Figure 1.1, municipalities with populations over 10,000 derive half their revenue from the PIT and the majority o f the remainder from earmarked grants. At the opposite extreme, municipalities with fewer than 1,000 inhabitants derive only about one quarter o f their revenues from retained PIT revenues and another quarter from earmarked grants. The gap i s largely made up by revenues from the equalization funds and the proceeds from local real estate taxes. This pattem reflects the positive correlation between economic activity and population density. The more populous, urbanized, municipalities have a higher proportion o f economic activity subject to the personal income tax and higher levels o f wages. The reliance o f smaller, more rural, municipalities on equalization transfers reflects the success o f the equalization system intransferring revenues from richerjurisdictions to poorer ones. 9 2. TERRITORIAL REFORM 2.1 The current boundaries o f municipalities date from a more rural era in Latvia's history--the late 1gth century--when the Czarist government created local units o f administration shortly after freeing the serfs. This structure persisted during the first period of independence and was adopted during the Soviet era, when municipal boundaries were adjusted to match the boundaries o f collective farms. These boundaries remained intact after the re-establishment o f independence, although the collective farms themselves no longer exist. 2.2 Much of Latvia is now sparsely populated. Since the re-establishment o f independence, the population has declined in absolute terms (from 2.6 million in 1990) and now numbers only 2.35 million. One-third o f this population lives in Riga. Another four percent resides in the nearby cities o f Jelgava and Jurmala. The two port cities of Leipaja and Ventspils and the eastern city o f Daugapils account for another 13 percent o f the population, leaving the remaining 1.23 million Latvians scattered across an area o f roughly 64,000 km2,a territory the size o f Ireland. This population tend to reside in widely dispersed settlements. This i s reflected in the characteristics o f the municipalities. As shown inTable 2.1, only 25 jurisdictions have populations over 10,000. Another 23 have populations between 5,000 and 10,000. Seventypercent o f the municipalities have less than 2,000 inhabitants and filly one-third o f them have less than one thousand. These smallest municipalities do not account for a large proportion Of Latvia's population. Less than 20 percent Figure 2.1: Current PopulationDistributionof Towns and Pagasts o f the national population lives in jurisdictions with fewer than 2,000 people. The territorial reform issue i s nevertheless directly relevant to a large share o f Latvians. Roughly one-third o f the nation's population lives in 10,000 jurisdictions with fewer than t 5,000 people. In the absence o f amalgamation, - the number of very small municipalities i s likely I J to increase. Between 1989 and 2001, Latvia's population declined by 13 percent. Much o f this loss occurred in rural areas. If these trends continue, the population o f rural municipalities will continue to decline. 10 GOVERNMENT'SPROPOSAL 2.3 The small size o f Latvia's local government is a source o f concem to the Government. According to the Government's Handbook on Amalgamation22, this concem is "rooted in the dissatisfaction o f a large proportion o f Latvia's politicians, the heads and s taff o f 1oca1government and the inhabitants, int he e conomic c ondition o f many o f the existing local governments and the inability o f concrete local government institutions t o affect, plan, and implement processes related t o the development o f t he territory, to ensure effective implementation o f the functions entrusted to local governments." It goes on to charge that local governments lack financing for the implementation o f the most essential measures prescribed by law--"to ensure education according to up-to-date requirements, provide quality services in the field o f utilities, provide social assistance to the poor"--and that "the present small units have tended to be very unequal interms o f financing, administrative capacity, and possibilities to provided needed services to their inhabitants." 2.4 Inresponse, the Govemment has embarked upon an effort to encourage smaller jurisdictions to amalgamate. The process began in 1998 with the passage o f the Law on Administrative Territorial Reform. The Act defines the aim o f the reform: "to establish administrative territories with local (and regional) authorities able to develop economically and provide quality services to inhabitants." To coordinate this effort, the law created a council for administrative and territorial reform (hereafter - Territorial Reform C ouncil), c omprised o f representatives f r o m t he Union o f Local and Regional Governments and the Government. The Department o f Local Government Affairs under the Minister for State and Municipal Reform was designated to spearhead the effort. 2.5 The department's work began with the commission o f studies in all 26 rajons. Under terms o f reference approved by the Territorial Reform Council23,these studies were to cover a wide range o f topics. These included: (1) land area and use; (2) population and social indicators (personal income, numbers o f unemployed, age profile, birth and death rates, migration trends); (3) housing conditions; (4) transportation infrastructure (road, bus, rail, and telecom); (5) intermunicipal pattems o f commuting and shopping; (6) social infrastructure (number o f schools and social care facilities, numbers o f family doctors, use o f health facilities outside the municipality); and (7) economic infrastructure, including consumption o f power and gas, water supply, sewage treatment systems and solid waste management. The studies were to survey economic conditions, including the number o f currently operating businesses, 22 EUPHARE program, 2000, "Handbook on Local Government Amalgamation inLatvia". 23 Government o f Latvia, Territorial Reform Council "Methodology Instructions for the Researching Regional Administrative Units". 11 classified by form o f ownership, type o f activity, and number o f employees. Data on municipal governments was to be gathered, including: (1) a breakdown o f municipal revenues (with particular focus on intermunicipal payments); (2) expenditures disaggregated by function; (3) organization showing the number o f deputies and municipal staff along with their respective educational backgrounds, work experience, and performance evaluations; and (4) a checklist o f functions performed by the municipality, along with their volume and quality. 2.6 Inprinciple, this mass of data was to be the basis for defining the boundaries of the amalgamated municipalities. Article 10 o f the Law stated that territorial reform was to be based on: "(i) long-term development prospects o f the municipality area; (ii) the the relation between the number of inhabitants and the size o f the area, with indices o f economic development; (iii) the revenue base; (iv) the level o f infrastructure requiredto perform municipal functions; (v) demographic characteristics; (vi) economic, geographical, and historical unity; (vii) accessibility o f municipal s ervices; (viii) other conditions." Not surprisingly, the inter-municipal economic relationships revealed in the studies were not necessarily applied to the definitions o f boundaries. The commuting and shopping pattern survey undertaken in Tukums rajon, for example, revealed that residents of the rajon travel to Tukums (town), Kandava, and Jaunpils for education, health services, and cultural events. For major purchases, they travel as far as Riga. But only Tukums would be included in the proposed Tukums novad. Faced with the task of defining the boundaries o f over 500 existing jurisdictions, four criteria prevailed: (1) a minimum population o f 5,000; (2) a developed center o f settlement with at least 2,000 inhabitants; (3) frontiers no further than 30 km from the center o f settlement; and (4) road access connecting all parts of the municipalityto the center o f settlement. 2.7 This process was the basis for the so-called "102 proposal" consisting o f 93 consolidated pagasts and towns (termed novads) and nine cities (including the seven existing republic cities.) Under the proposal, the number o f small municipalities would be drastically reduced. As shown in Table 2.2, no novad would have a population less than 4,500. Half would have populations between 4,500 and 10,000. Another one-quarter - - would have populations between 10,000 and 20,000. Figure2.2: PopulationDistributionof Novads The impact o f amalgamation is shown graphically in the two charts below. Figure 2.1 ranks each o f the existing 542 jurisdictions according to population size, excluding the seven republic cities. Figure 2.2 ranks the novads according to the same criteria, again excluding the republic cities. As shown, the entire ranks o f the smallest municipalities--those with populations under 4,500-would be eliminated under the proposal, forcing 91 percent o f the existing jurisdictions to amalgamate. The number o f larger jurisdictions would remain essentially unchanged. 12 2.8 With the completion o f the initial boundary proposal, the Law calls for the preparation o f specific amalgamation plans for each novad. Inter alia, these studies are to evaluate the improvements in staff quality and fiscal performance that would be expected from amalgamation. The process i s just beginning. Only one plan--for Tukums novad-- was available for analysis for this report.24 The Tukums report, unfortunately, does not provide a credible basis for evaluating the merits o f amalgamation. To determine the impact o f amalgamation on staff quality, it relies merely on an opinion survey o f municipal chairmen. (The chairman o f Dzukste pagast reported that all his staff have "adequate educations" but that "there i s a need for additional courses". The chairman o f Semes pagast stated that his municipality has one vacancy and that existing employees need to have some computer and legal classes.) The report's fiscal analysis i s limited in scope and somewhat mechanical in approach, focusing on administration costs and borrowing. Administrative costs are found to be as high as 18 percent o f revenues in several o f the smaller pagasts. The report calculates that this proportion will fall to ten percent after amalgamation. This calculation i s not based on an identification o f positions that could be cut, however. It i s merely the arithmetic result o f adding up the administrative costs of each o f the municipalities that would comprise the proposed novad, and dividing it by their combined revenues. The report also finds that the novad would have an increased borrowing capacity. This conclusion is based solely on the assumption that the novad would pursue more aggressive borrowing policies. Several o f the smaller pagasts have not borrowed up to the limit permitted by law. The report assumes that the new novad will do so. The report also argues that the novad will make better use o f financial resources, because budget allocation will be centralized and possibly more objective. N o evidence for this assertion is provided. 2.9 The report does provide an estimate o f how much the Government should expect to spend to make the 102 proposals effective. Under the rubric o f next steps, the report identifies a major capital works program (LVL 6.7 million) to focus on education, housing, and communal services. It also provides a timetable. The process o f amalgamation itself is expected to take a total o f 22 weeks, allowing eight weeks for the preparation o f `concepts' for social and communal services and the optimization o f schools and cultural institutions, six weeks for a resolution o f the Cabinet o f Ministers establishing the novad, and two weeks for the election o f chairmen and heads o f committees; preparation o f administrative structure, and other legal measures, and an additional four weeks for the legal demarcation o f boundaries. ~ 24 Note that state subsidies for the elaboration of amalgamation plans have been granted to thirty groups o f municipalities comprising 23 1 local governments. These were not available at the time this report was drafted. The Tukums report may not be representative o f the studies as a whole. 13 2.10 The amalgamation proposal has run into some opposition. Since the 1998 Legislation was put in place, only 21 municipalities (less than four percent o f the total) have been abolished through amalgamation. This is partly due to resistance from municipal councilors and council chairmen, many o f whom will lose their jobs. But it also reflects a lack o f support by the rural population, who fear losing contact with familiar officials who can assist them in dealing with government bureaucracy. According to a recent public opinion survey (see Table 2.3), rural residents also fear that their interests will be submerged once their pagasts are merged into the larger novads. Roughly two-thirds feared that the prospects for solving local problems would decrease. Twenty to fifty percent feared that existing municipal centers would decline, small schools would close and job losses would occur. Few saw the benefits o f amalgamation-particularly in public services. Less than 20 percent expected improvements in education, social and health care, andpublic utilities. 2.11 To offset these concerns, the Law on Administrative Territorial Reform requires the Government to provide a one-time payment to municipalities that undertake amalgamation. The amount o f the subsidy depends on when the amalgamation occurs. Municipalities amalgamating before 2001 received a grant equal to five percent o f their budgets.This percentage fell to four percent for 2001 and 2002. In2003 and 2004, it will be three percent. Judging from the slow rate of amalgamation to date, this incentive has not been particularly effective. The Government i s now planning to address the specific concerns o f smaller municipalities through a program o f public works. This would include rural road improvements and investments in telecommunications and internet access. 14 3. HOW SMALL I S TOO SMALL? INTERNATIONAL PRACTICE 3.1 Who i s right? In the absence o f definitive of Municipalities in Selected evidence from the available novad studies, several alternative sources can be brought to bear on this question. The first i s the experience o f other countries. Unfortunately, international comparisons do not provide Sweden 30,040 much guidance. Even among wealthy western countries, The Netherlands 27,559 there is wide variation in the size and structure o f local Denmark 18,760 governments. The U.K.,for example, has only 540 local Belgium 16,960 governments, serving a population o f 59 million. France, Poland 15 ,561 Finland 10,870 with the same population, has over 36,000 communes Norway 9,000 (along with 96 departments and 22 regions). As shown in Italv 7 .lo5 Table 3.1, the average size o f municipalities varies 1Estonia I 5 .713 widely inEurope, from France (with an average o f 1,580) 5,575 to the U.K (with 126,128.). Latvia-in this context-is Latvia 4,400 not an outlier. With an average municipal population of 4,930 4,400, Latvia's municipalities are, on average, larger than Austria those o f Spain, Austria, Hungary, Switzerland, the Czech Republic, and France. 1,659 3.2 Averages, o f course, disguise variations within the distribution o f municipalities among size categories. Cooperation and Municipal Mergers in Switzerland"; Honvath, T. (2000) Local The average for Latvia, for example, i s distorted by the Govemments in Central and Eastem large population o f Riga. Table 3.2 shows the distribution Europe "Decentralization: Experiments o f municipalities in six size classes in selected Baltic and Nordic countries. As shown, Latvia does have a disproportionate number o f very small (less than 5,000 population) municipalities compared to other countries in the immediate vicinity. Due to data constraints, data for other European countries-particularly those whose average-sized jurisdictions are similar insize to Latvia's--cannot be provided. 15 3.3 Municipalities vary in terms o f the functions assigned to them. One might expect that countries with very small local governments would keep the major responsibilities- at least those subject to scale economies-at the central level. There i s some evidence for this. Education in France, for example, is highly centralized. There, the central Government administers personnel at all levels and makes overall plans for the location o f educational establishments. The municipal role i s limited to the construction and maintenance o f school premises and paying for non-teaching operating costs. Lithuania, with its relatively large municipalities, takes the opposite tack. Local governments administer the payroll and have at least nominal control over recruitment and promotion o f staff, as well as responsibility for the construction and maintenance o f facilities. 3.4 But small size does not rule out large responsibilities. In France, for example, local governments are responsible for the provision o f water supply and sewerage. (See Box 3.1, below.) Small jurisdictions provide this service by contracting with large scale private sector management Table 3.3: Changein the Number of Municipalitiesin companies. In Germany, small gemeinden (municipalities) Country Number of Number of Change contract with county Municipalities Municipalities in Now governments to provide primary and secondary schools. Municipalities can also form joint services companies or reach inter-municipal sharing agreements in which one municipality agrees to provide Austria 3 999 (1992) 2 301 -42% services to another at an agreed Norway 744 (1992) 439 -41% price. Finland 547 (1993) 455 -17% Spain 9214 (1992) 8 082 -12% 3.5 Trends in territorial Latvia (1990) 570 2002 542 -4% reform are similarly I France 11945) 38 814 (1990) 36 763 -5% Switzerland I inconclusive. Since the 1960s, many Northem European I Czech Reo. I (1990\4104 I 1994 I 6230 1 +51% I countries reduced the number o f Data Source:Council of Europe, 1995, and up to date country reports of the local governments. As shown in Council of Europe; Local governments in Centraland Eastem Europe "Decentralization: Experiments and Reforms" May, 2000. Table 3.3, Lithuania, Sweden, and Denmark all reduced their local governments by over 80 percent. Britain reduced its local governments by 77 percent over this period, and abolished an entire tier o f subnational government in Scotland, Wales, and metropolitan areas o f England. Germany has reduced the number o f gemeinden by half. (Under the consolidation reforms o f 1965-1977, small gemeinden were either merged into larger units or grouped into associations o f municipalities under joint administration.) Spain, 16 France, Switzerland, and Italy, on the other hand, have made no significant reductions in the number o f their local governments. The Czech Republic has increased its local governments by 50 percent. ~~~ ~~ Box 3.1: PrivateParticipationinWater Supply The FrenchCase - France has three standard forms o f private participation in municipal services: management contracts (of varying forms); affermage and concessions. The main differences are inthe allocation o f risks and responsibilities and the duration o f assignments. However, there are hybrids where the private sector takes commercial risks in management contracts or makes investments under lease arrangements. Managementcontracts: There are two forms o f management contract: gerance and regie interessee. Under gerance, the private operator is paid a fixed fee with no profit sharing or productivity bonus to fully maintain and operate a system, normally for a duration o f five years. Inthis case, the operator does not provide any working capital or investment funds. The typical client i s a municipality which i s not capable o f running one o f its treatment plants. The regie interessee i s a form o f management contract where there i s an element o f productivity or profit-related remuneration. Under this form, the operator i s responsible only for operating the network and has no role inplanning or undertaking capital investments. Affermage: This is the most common form of private s ector participation inFrance. The municipality retains ownership o f the assets and i s responsible for making investment decisions (though with advice from the operator) and financing capital expenditure. The private operator is responsible for maintenance, renewals and rehabilitation ina ddition to operation. The municipality may separately contract the private operator to implement capital investment decisions. The private operator is paid directly by the consumer with a proportion paid to the municipality to recover capital costs. The typical duration o f the contract i s 12 years. Concession: In a concession, the private operator is responsible for financing new investment in the network and treatment facilities over the life o f the contract, though the assets nominally remain on the books o f the municipality. The control over the assets reverts to the municipality at expiration o f the contract. The concessionaire i s remunerated directly by consumers and pays a portion o fthe amount collectedback to the municipality to cover its expenses or other services it provides. STUDIES OF OPTIMAL MUNICIPAL SIZE 3.6 Technical analyses o f optimal municipal size have been scarce. One might expect that the territorial reforms in Northern Europe and Britain would have been based on technical studies whose conclusions could be applied to the Latvian case. One would be half-right. There have been studies. But they have not yielded conclusions. The British reforms, in particular, were subject to extensive preliminary study. The first such study 17 was undertaken by a Royal Commission on Local Government in Greater London (hereafter Greater London Commission) from 1957-1960. Among other things, it surveyed Government ministries as to their views on optimal municipal size within their areas of responsibility. The Ministry o f Transport recommended a minimal size o f 200,000 on the grounds that fragmentation into smaller authorities would hinder traffic control. The Ministry o f Health believed that local authority performance could be adequately provided with a population o f between 100,000 and one million. The Home Office recommended that authorities have a population o f at least 200,000 so as to be able to fill children's homes efficiently. But inthe end, the Commission concluded that it was impossible to say there was an optimal size authority: "None o f the various criteria o f size expressed in terms o f population.. .can be regarded as scientific.. .. There i s a reasonably wide range o f population within which the functions.. .can be effectively di~charged."~~ The Commission ultimately proposed a minimal population for the purposes o f personal health andw elfare, housing and environmental s ervices o f about 100,000. It accepted, however, that smaller authorities might in some cases require joint appointments and joint use o f accommodation half-right. There have been studies. But they have not yielded conclusions. The British reforms, in particular, were subject to extensive preliminary study. The first such study was undertaken by a Royal Commission on Local Government inGreater London. 3.7 A wider range o f jurisdictions-all England-was covered by a Royal Commission on Local Government in England (hereafter Local Government Commission) in 1966-1969. At the Commission's behest, the Greater London Group o f the London School of Economics and Political Science statistically analyzed four services: education, childcare, welfare and housing. "The general impression (the Commission) gained was o f the difficulty o f establishing a demonstrable relationship betweensize andperformance. Scale appeared to have little measurable relationship with performance except in certain fairly limited fields such as management aids and some aspects o f education, childrens' homes and the mental health services." Ultimately, the findings o f the Loca1 Government Commission reiterated those o f the Greater London Commission. The commission concluded that "within a certain (unspecified) population range, size didnot seem to matter." 3.8 More recent studies have produced similar conclusions. A 1992 study by the BritishAudit Commission found that "although there maybe some relationships between size and efficiency, which for particular serviceslfunctions give encouragement to both large and small authorities, the overall picture gives no leads in either direction. Much more important would seem to be the quality o f process and management which makes the difference between authorities."26 In 1993, a group o f experts at the London School o f Economics found that "the evidence from existing local authorities in England does not suggest a straightforward and consistent link between population size, costs and 25Royal Commission on Local Governments in Great London (HerbertCommission), 1957-60, Report, (London: HMSO, 1960). 26The Audit Commission, August 1992. 18 effectiveness. There are some statistical 1inks between population size and c ost and/or effectiveness. But such links can point either way."27 3.9 German research has come to similar though more guarded conclusions. One researcher concluded, Ithink that territorial reorganization plans show a considerable " variety o f minima, optima and maxima. Some o f the variety may presumably be attributed to different structural and territorial variables. Yet Idoubt whether this alone `can explain such differences."28 Similarly, an ex-post analysis o f the German experience found that "the territorial and functional reforms o f local government in the last two decades brought great changes to the administrative landscape, but...their actual effects have only been comprehended to a limited extent by empirical research. Assessments o f the reforms are still just as ambivalent about whether and to what extent the principal objectives o f improving performance and bringing administration nearer to the citizen were achieved."29 At the same time, a survey o f German parliamentarians in the 1980s revealed a general consensus that "the reform had raised permanently the cost o f local government. 3,30 3.10 An examination o f the Danish case found that the combination o f consolidation and Government decentralization ultimately led to an increase in public sector expenditure. "When decentralizing, the state administration should logically shrink. It did not! Inthe place o f activity areas that had vanished, new ones emerged. A series o f newly developed "directorates" and "agencies" under the ministries made the state administration grow instead"31On the other hand, the Danish Minister o f the Interior has characterized the Danish reforms as a huge success. "Almost all the ambitions have been fulfilled: (i) the size o fmunicipalities and regions have proven viable; (ii) countryside the has developed quickly; (iii) widespread decentralization o f tasks was achieved; (iv) a better and more modern local government financial system has been carried through; (v) a local government equalization system has prevented big inequalities and transferred funds from richer to the poorer areas; (vi) a professional local government administration has been developed; (vii) local government administration has proven to be efficient; (viii) the resultant distribution o f tasks and responsibilities between the state, regions and municipalities i s rational and functions well." 3.11 Evidence from countries that have chosen not to amalgamate i s similarly inconclusive. "The cost-benefits o f regrouping communes have not been much studied" according to one professor o f Political Science inParis.32This i s inpart due to opposition from national politicians and senior officials who are often mayors or members o f local councils themselves. Two articles by political scientists from the French Government's ''Travers,T., Jones, G. and Bumham, J. (1993) The impact ofpopulation size on local authority costs and ef ectiveness, York: Joseph Rowntree Foundation. 28Frenkel, M.(1980) Optimizing what? Some considerations onfederalism, comparative research, and optimal size of federal units, Riehen: Forschungsinstitut fir Foderalismus undRegionalstrukturen. 29Dieter Schimanke, Buchbesprechungen, Archiv fur Kommunalwissenchaften,198712, p.290. 30Gunlicks, Local Government in the German Federal System, p. 64. 3'Pyndt, H.(2002) Reasonsfor the Danish Local Governments Reform - and their applicability for local government administrative - territorial reform in Estonia, LGDK. 32 Yves Many, Professor o f Political Science at the Institut d'Etudes Politiques inParis. 19 regional development agency, DATAR, rejected size as a problem and suggested other approaches to reform. "No geographer or economist knows how to define the optimum size o f a general purpose authority. It could be done service-by-service but their boundaries would not coincide."33 The consequences o f the small size o f Swiss municipalities also does not appear to concern government or scholars. Amalgamation in Switzerland, where it has occurred, has been motivated by the peculiarities o f the Swiss system o f local finance. Under the Swiss system, local governments are largely dependent upon revenues collected within their own territories. Declining rural areas have, therefore, been forced to amalgamate with wealthier jurisdictions to avoid a breakdown o f services. With these exceptions, there has been no movement toward amalgamation in Switzerland. 3.12 Education: Empirical evidence for specific sectors is somewhat more helpful. The international literature on school costs, for example, tends to support the argument that per-pupil costs fall as classroom size increases, as salaries are typically the largest component o f education costs. Extensive analysis o f overhead costs in U.S. schools shows that entire schools are also subject to economies o f scale. Per-pupil costs tend to follow a Ushaped curve, initially falling as school size increases, then rising again due to the increased administrative costs o f controlling a large number o f students. For elementary schools (grades K-6), scale economies tend to be exhausted in the range o f 300-400 students. For high schools (grades 9-12), they are exhausted at 400-800 students.34 3.13 But there are limitations to these findings. First, they ignore the transportation costs that would be implied by consolidating schools. Novads could indeed close small rural schools, transferring their students to larger schools and fuller classrooms. But this implies higher costs inboth monetary and human terms. Children who formerly walked to school would have to be bused. Children who used to ride four or five miles per day would have to ride twenty or more miles to reach the centrally-located school. 3.14 Second, there i s evidence (again based on U.S. research) that larger schools produce lower levels o f achievement, particularly after taking socioeconomic status and per-student expenditures into account. Curiously, the literature on classroom size i s ambiguous. While some researchers have documented a positive relationship between smaller classes and increases in student achievement, other researchers have concluded that class size was o f little importance in determining student achievement. Increasing school size, on the other hand, i s strongly associated with declining performance. This effect seems to fall particularly hard on poor children. An emerging line o f evidence, in fact, finds that small schools provide an achievement advantage for impoverished 33 Cited in Travers, T., Jones, G. and Burnham, J. (1993) The impact ofpopulation size on local authority costs and effectiveness, York: Joseph Rowntree Foundation. 34 Williams, D. T. (1990). The dimensions of education: Recent research on school size. Working Paper Series. Clemson, SC: ClemsonUniversity, StromThurmond Institute of Government and Public Affairs. (ERIC Document Reproduction Service No. ED 347 006). 20 students, but not for affluent students, who may fare better in larger schools.35 Small schools may therefore be o f greatest benefit to Latvia's rural poor; the very group whose schools would be targets for amalgamation. Whether the benefits o f fuller classrooms and larger schools would outweigh the increased transportation costs they imply and their possible adverse effects on performance i s not clear. But the very small scale o f some pagast schools suggests that the cost savings from consolidation would be substantial. By the same token, the very small size o f the average Latvian class suggests that the benefits o f small class size, if any, have already been exhausted. On balance, the benefits o f school consolidation appear to outweigh its drawbacks. 3.15 Social Assistance: Judging from the literature survey undertaken for this report, there i s no similar body o f literature linking municipal size and technical competence for social services. Anecdotal evidence from neighboring transition economies, however, suggests that large size alone is not a guarantor o f the effective social assistance provision. Neighboring Lithuania i s one o f the few transition economies that has already implemented a large scale amalgamation o f local governments. At present, the country has only 60 municipalities, o f which only six are smaller than 20,000. (The majority fall into the 21,000-90,000 range). The principal social assistance program administered by municipalities i s a guaranteed minimum income (GMI). Lithuania's GMI i s available to people in low paid jobs, registered unemployed, those caring for small children or disabled family member, elderly or disabled, and those infull time education. A family i s eligible if the total household income (net o f taxes and social insurance contributions) i s less than a fixed percentage o f the costs o f the so-called state supported income, which in tum is based on the costs of the minimumfood basket. (The actual benefit is 90 percent o f the difference between actual household income and the state supported income.) The large scale o f Lithuanian municipalities has not eliminated administrative problems inthe administration o f the GMI. Underreporting o f income from informal employment is a particular problem.36Some officials estimate that ineligible recipients account for over 50 percent o f the total. 3.16 One might expect that corruption would be more common in smaller municipalities: the smaller the municipality, the closer the person allocating benefits i s to the personreceiving them. This is often a fertile ground for fraud. But conuption is also a problem in the distribution o f social assistance in the comparatively large municipalities o f Bulgaria. (The average Bulgarian municipality has a population o f 32,335.) In Bulgaria, a potential beneficiary must submit an application for review by a municipal social worker, who proposes a benefit according to specific norms fixed by the Government. But even this straightforward approach is subject to abuse. Applicants understate income, by hiding income from informal employment. Social workers favor their acquaintances by undercounting their assets (which typically consist o f farm animals). Administrative constraints are also a problem. People living in outlying settlements do not register because it is too difficult. Staff in local governments are too busyto visit them. 35 Friedkin & Necochea, 1988; Howley, 1996;Plecki, 1991. 36 Yu, Xiaoqing, 2002, The Social Protection System in Lithuania. 21 3.17 Overall, the sectoral evidence suggests that population size i s not the decisive variable in determining the cost or quality o f public services. The benefits and costs o f scale seem to vary according to sector and even according to specific management policies within sectors. International practice, by the same token, suggests at least two viable models. The first consists o f large local governments, which perform a wide range o f functions with their own staff, capturing most scale economies within their own administrations. The alternative model consists o f small local governments that rely on contracting out and intergovernmental cooperation to capture scale economies and address problems o f coordination. 4. THE LATVIAN CASE 4.1 In the absence of definitive conclusions from international experience or empirical research, it i s necessary to examine the Latvia case on its own merits. Intheory, there are s everal reasons t o believe t hat 1arger scale municipalities c an provide higher quality services at lower unit costs. 4.2 Indivisibilities: The first arises from indivisibilities in staffing-the notion that skills come in minimum packages o f one person. Advocates o f amalgamation argue that small local governments have incompetent staff. They say that small pagasts often lack professional social workers, leaving this task to be performed by other, untrained staff. Budgetpreparation and execution is performed by amateurs. But the relationship between population size and staff competence i s complicated. Competent staff presumably exist in the labor market. They would presumably be available for a price. The core o f this argument is that small local governments cannot afford to hire such staff because their workload i s too small to justify what it would cost to retain them. Only large municipalities, according to this line o f argument, have a workload sufficient to justify paying the wages-and provide the opportunities for advancement-needed to attract and retain skilled staff. 4.3 Public goods: A second argument arises from the notion ofpublic goods: that the benefits o f a particular good or service do not diminish as the number o f people consuming it increases. National defense is the classic case o f a public good. But it also applies, to an extent, to some services provided by municipalities. Primary education is a case inpoint. Within some range o f classroom sizes, the amount of teaching consumed by one student does not diminish the amount available to others. A single teacher can provide the same quality o f education to twenty pupils as to ten (or so it i s argued) at half the cost per pupil. Increasing teacher:pupil ratios can therefore save money without reducing education quality. 22 4.4 Economiesof Scale: Large municipalities can also take advantage o f economies o f scale. Refuse disposal sites, for example, are subject to declining marginal costs. Amalgamation would permit small local governments to reduce costs through the joint use o f a single site. 4.5 Equity: Large scale can also confer other kinds o f benefits. It can, for example, reduce disparities in per capita revenues. Municipalities in Latvia vary inthe strength o f their tax bases. Left to their own devices, the quality o flocal services would vary with the strength o f the local tax base. This would be a particular concern in the financing o f services with important distributional implications, such as education and social assistance. Amalgamation would merge the tax bases o f small municipalities with those o f largerjurisdictions, reducing these disparities. 4.6 Coordination is a final potential benefit o f amalgamation. Fragmented local governments have difficulty making joint decisions. Municipalities must agree upon priorities for improvements to the intermunicipal road network. Landfill sites must be chosen. The location o f specialized medical facilities must be negotiated. This i s a particular problem in multi-jurisdictional metropolitan areas, where commuting and shopping patterns crossj urisdictions. Amalgamation could reduce the transaction costs associated with reaching decisions on these issues. ARE SMALL LOCAL GOVERNMENTS INCOMPETENT? 4.7 Empirical evidence to back the theoretical arguments for amalgamation in Latvia is mixed. The indivisibilities argument would suggest that small municipalities either Figure 4.1: Staff Qualifications and Population Size suffer from incompetent staff or pay excessive salaries. Evidence .- o f the competence o f local staff 2 80 - ~ _ _ _ * * 4 * i s limited. Background papers .e40 60 - for the Government's 102 A A v 50 --- * .g - * - A --- *-* - I I proposals provide a basis for assessing the correlation 30 - 2.% 10 * 20 between population size and 1 staff qualifications for two areas: the proposed Tukums novad and in the Aizkraukles rajon. Figure 4.1 compares senior staff qualifications with population size. The vertical axis shows the percentage o f staff in senior managerial positions37in each municipality who have college degrees. The horizontal axis shows population. There appears to be little correlation between the two variables, at least among municipalities with populations under 5,000 ( ~ 0 . 1 ) . In Vietalva pagast (population 1,113), four o f the five senior staff have university educations. In nearby 37 These include chairman, executive directors, accountants, heads of social assistance and communal services departments and rural courts. 23 Aizkraukle pagast (population 1,286), only one o f the six staff i s similarly qualified. It is noteworthy that if the two largest jurisdictions in the sample (Aizkraukle town and Tukums town) are included in the sample, the correlation between size and education rises to .34. This suggests that while large population size guarantees qualified staff, small size does not guarantee a lack o f it. 4.8 Information on compliance with accounting and auditing procedures also tends to belie the argument that small jurisdictions are incompetent. Since 2001, local governments have been required to submit annual budget statements to the State Treasury, together with a n opinion issued by the State Audit Office (SAO). The S A 0 Local Government Audit Department issues its opinion based on the analysis o f the budget statement by sworn auditors or an audit company. In its first round o f opinions, the SA0 issued an unqualifiedpositive opinion on the accounts o f 209 municipalities and a qualified positive opinion on another 334. It issued negative opinions on only 29. O f that group, however, 28 hadpopulations under 5,000. 38 4.9 Sectoral evidence suggests that very small municipalities lack qualified staff. A 1995 survey (cited in the 2001 Social Report) found that only h a l f o f the pagasts and towns had separate social services department, and that the number o f social assistance professionals in towns and pagasts totaled only 571. A 2000 survey o f social workers' education backgrounds found that only seven percent hadhigher education and only four percent, specialized secondary education. 4.10 But are non-professional staff incompetent? It is clear that there is a fundamental policy difference between the Ministry o f Social Welfare (MOW)and many o f the small municipalities. The Ministry would like to see all municipal social assistance allocated on an income-tested basis, according to explicit, objective criteria.39 It argues that the existing approach is too subjective, and often results in benefits going to specific social groups rather than to the most needy. According to MOWstatistics, municipal spending on basic income support has declined sharply over the last five years, while spending on school lunch subsidies and other benefits `related to the upbringing and education o f children has largely taken its place.40 During interviews undertaken for this report, the Ministryalso charged that municipalities are usinghousingbenefits (subsidies for heating and water supply) to subsidize their own municipal enterprises and food vouchers to direct businesses to municipallyowned stores. (This would appear to be borne out by the data reported earlier inTable 1.2). 38 The SA0 refused to render an opinion o n another five local governments, o f which one was Riga and another, the city o f Kuldiga. 39 Under Regulations o f the Cabinet o f Ministers No. 75, a family is considered poor if: (1) i t s per capita income during the last three months does not exceed 75 percent o f the crisis subsistence minimum established by the Cabinet o f Ministers; (2) it has no cash savings in excess o f LVL 200; (3) it does not own property with a value in excess of LVL 3000; (4) it has no providers who can provide food; and (5) it has no other arrangement for obtaining food. 40 Note that this i s based on national aggregates. The available data do not distinguish between the practices of small municipalities and those o f large ones. 24 4.11 Some municipalities reject this view. They view the GMI as unworkable. They say that potential clients routinelylie about their incomes and employers lie about wages (all claiming to pay the minimum wage in order to minimize wage-based social contributions). They argue that they `know their people' and their difficulties: who is eaming money under the table through casual labor or fraud, who i s perfectly capable o f working but merely lazy. As a result, they reject any precise income-based calculation o f need. They would prefer a more discretionary approach to identifying eligible clients--in effect relying on social workers--trained or otherwise--to identify the `deserving poor'. And they consistently distrust their clients' ability to handle benefits paid in cash, preferring instead to provide benefits in kind. As a result, municipalities offer part-time municipal jobs to people whose unemployment benefits have expired. They provide vouchers for the purchase o f groceries at specific stores and subsidies for district heating or water supply. They provide free school lunches for children from poor households and part-time home care to the elderly or disabled. But among the eight municipalities visited by the mission, none offers cash without at least some form o f quidpro quo. 4.12 The dispute between the Ministry and some of the municipalities appears to be more about policy than competence, however. Certainly amalgamation alone will not achieve the results the Ministry seeks, or allay the misgivings o f the municipalities. As discussed earlier, difficulties in targeting exist in the much larger municipalities o f Lithuania. When pressed, even the MOW i s willing to admit that even the smallest municipalities would be technically capable o f administering a GMI, if they were inclined to do so. 4.13 The competence issue also arises in one final area: the preparation of infrastructure projects. EU accession requirements will impose great demands on municipalities. It i s estimated that municipalities will need to invest approximately LVL 180-200 million to meet the EU's landfill directive by 2015.41 While 77 percent of the population is connected to centralized wastewater treatment, only 64 percent o f wastewater i s subject to appropriate treatment in 2000.42 To meet EU directives on drinking water and urban wastewater, municipalities will need to invest approximately LVL 571 million. While there are no EUheating directives, EUair quality directives and environmental regulation adopted by Latvia may force municipalities to invest in upgraded equipment. 41 There are severalrelateddirectives, such as the PackagingandPackagingWaste Directive (94/62/EC), the Waste FrameworkDirective (75/442/EEC), andthe HazardousWaste directive 91/689/EEC), butthe LandfillDirective (9913l/EC) requiresa significant andrepresentative portionof local government investments inthe sector. 42Ministry of ForeignAffairs, Addendum to the Position Paper of the Republic of Latvia Chapter 22: "Environment CONF-LV-60/00,(Riga: 2001), p. 29. 25 4.14 It is argued that local government staff are not capable o f preparing projects that meet EU requirements. Central Government officials complain that the lack o f capacity among municipal officials causes costly delays in planning and implementing investment projects. Critics also argue that small municipalities have insufficient capital budgets to meet the minimum investment size criteria demanded by the EU. The minimum size o f EU- financed ISPA for example, i s 5 million euro (LVL 2.8 million) with a minimum25 percent municipal contribution. As shown inTable 4.1, municipalities with populations below one thousand have average budgets o f LVL 78,000. Even if such municipalities devoted the legal maximum (15 percent o f revenues) to debt service and obtained highly advantageous terms (say 7 percent with 15 years to maturity), their maximum counterpart contribution would be LVL 105,000, or only 15 percent o f the minimum contribution required by the EU. Lack of local technical capacity and insufficient project size need not be an insuperable obstacle to EU financing, however. Local governments can combine subprojects into larger packages sufficient for EU financing. They can contract for project preparation services from private providers. The Government has already established cooperative mechanisms to help municipalities plan and implement investment projects (including solid waste management systems and water projects inLatgale) although their track record to date has been disappointing. DO THEY SPENDTOO MUCHONADMINISTRATION? 4.15 Are municipalities avoiding incompetence by paying excessive salaries? The flI side o f the indivisibilities argument is that small Figure4.2: Spendingon Administration 40%l- local governments avoid (YOof revenues) incompetence by hiring a 50% -- _ _ _ _ - - - I- full complement o f highly skilled staff, even when - *. ~ _ _ _ -_ their workloads are insufficient to keep them fully employed. This is difficult to test. One indicator i s spending on administrative overhead. 0% 1 I Whereas a teacher might be fully employed in a classroom with only ten pupils, a lawyer 43 Average size o f the municipal budget revenues excluding earmarked grants. 44 ISPA, the Instrument for S tructural Policies for Pre-accession, is o ne o f t he EuropeanUnion's three financial assistance programs set up to assist the candidate countries in Central and Eastern Europe to prepare for accession. 26 or accountant might find themselves at a 1oose endina municipality w ithonly a few hundredresidents. Municipalities that respond t o invisibilities by hiring full time staff whenpart time staffwould do would be expected to have highadministrative costs. 4.16 There is some evidence o f this. Figure 4.2 shows the percent o f revenues spent on administration in each o f the 542 municipalities (including the republican cities). Municipalities are ranked by population size (from smallest on the left to largest on the right).A s shown, there is a s light inverse c orrelation betweenpopulation size andthe proportion o f spendingon administration. Small municipalities spend a higher proportion on administration than 1arge ones. (The c orrelation b etween population and percent o f revenues spent on administration is 0.10.) On average, municipalities with populations under 1,000 spend 18 percent of their budgetso n administration. This proportion falls systematically as population size increases, reaching 8.3 percent in municipalities with populations over 10,000. But wages are lower in smaller towns. As a result, while spending on administration in absolute terms declines with size, the relationship is not very strong or very steep. (The correlation between population and absolute spending i s only r=-.06. See Figure 4.3.) The reasons are not far to seek. Judging from the municipalities visited for this report, municipalities are not constrainedby indivisibilities. Instead, they combine severaljobs in a single position or hire part time staff. Several o f the municipalities visited by the missionhad no executive manager, for example. The chairman performed this role (and was reportedly elected on the strength o f his ability to do so). The treasurer doubled as a tax collector. The secretary doubled as a registrar o f births and deaths. A private lawyer was kept on retainer. On closer examination, the indivisibilities argument is not as strong as it might appear. PUBLIC GOODSAND SCALE ECONOMIES 4.17 At first glance, the public goods argument for amalgamation would appear to be indisputable-at least in the case o f education. As noted earlier, intemational evidence suggests that education costs drop as classroom size increases-and not necessarily to the detriment o f educational quality. This could be a significant source of cost savings inLatvia. The population o f school age children inrural areas i s declining. This i s due in part to declining fertility rates and the departure o f the Soviet army families. In some rural areas, it also reflects the economic decline that accompanied the closure o f collective farms. As a result, school enrollments are falling. Pupi1:teacher ratios are falling along with them. Table 4.2 shows the pupi1:teacher ratios inthe republic cities (as a group) andintowns andpagasts (as a group). As shown, pupil: teacher ratios in towns and pagasts average only 9.7 in primary schools, 8.1 in basic (grades 1-9) schools and 11.9 infull scale (grades 1-12) schools. Intheory, amalgamation 27 could affect the quality and cost o f education inLatvia by helping to address the problem o f small class size. 4.18 But in fact there is nothing in particular about the small size o f Latvian municipalities that forces pupi1:teacher ratios to be so low. As noted earlier, parents are free to send their children to the school o f their choice. If an under-enrolled class in a small municipality were to close, there would be no impediment to its former pupils transferring to a school ina neighboringjurisdiction. A relatively well functioning system o f financial compensation exists to ensure money follows the pupil (in the sense that if a teacher i s dismissed from one school and employed in another, the system ensures that salary costs will eventually follow the teacher.) And the system o f intermunicipal compensation works to ensure that the recurrent non-salary costs literally follow the student. 4.19 Why, therefore are classes so small? There are three likely reasons. First, the minimum class size imposed by the Ministry o f Education and Science i s low. At eight students per class, the threshold puts little administrative pressure on municipalities to close under-enrolled classes and consolidate under-enrolled schools. Second, there is evidence that even those minimum thresholds are not enforced, due to opposition from parents who do not want to put their small children on buses. Finally, the hold-harmless provisions in the system for allocating teacher salaries among rajons ensure that there are no adverse fiscal consequences to keeping under-enrolled schools open. None o f these factors would be changed by amalgamation. 4.20 Would amalgamation permit local governments to exploit economies o f scale? The argument varies by sector. In the case o f water supply and sewerage, few scale economies would be achieved through amalgamation. Because the networks o f each small municipality are distant from each other, no e conomies o f s cale (inpumpingor water treatment) could be gained by connecting them. Costs might be reduced through the joint administration o f services and bulk purchase o f equipment, chemicals, and the provision o f specialized technical support from a centralized location, but this could be just as well accomplished without amalgamation. 4.21 The case o f solid waste is more complicated. I n principle, amalgamation could yield scale economies in both collection and disposal. Collection costs could be reduced through the more efficient use o f specialized equipment. Disposal costs could be reduced because landfills are subject to economies o f scale. But economies in the use o f specialized equipment have already been exploited. Based on a broad survey o f municipalities by the Union of Local and Regional Governments, 26 percent o f surveyed municipalities already have joint cooperation arrangements for the collection o f 28 household wastes.45 In larger jurisdictions, private firms provide this service. (Although municipally-owned companies account for 95 percent o f the firms in the sector, they account for only fifty percent o fwaste co~lection).~~ FISCAL DISPARITIES 4.22 Latvian municipalities do vary widely in the strength o f their tax bases, with stronger tax bases generally correlated with larger population size. Left to their own devices, small municipalities would lack the resources to provide services with important distributional implications, particularly social assistance and the non-salary component o f primary and secondary education. Inprinciple, amalgamation would merge the tax bases o f small municipalities with those o f larger jurisdictions, reducing these disparities. But, as noted earlier, Latvia already has a well-developed system o f inter-municipal revenue equalization, inwhich municipalities with `surplus' revenues are forced to transfer-part o f it to municipalities whose I expenditure needs exceed FIGURE4.4: IMPACT OF EQUALIZATION ONPER CAPITA TAX REVENUES the amount of taxes - _ _ __ ""- - _ _ collected within their jurisdictions. This formula sharply reduces disparities ~ in per capita revenues. Figure 4.4 shows the variations in municipal per capita tax revenues before BEFORE _I and after equalization. A F T E R Municipalities are ranked in order o f pre-equalization per capita revenues, to facilitate comparison. Pre-equalization tax revenues vary from a low o f LVL 17 per capita (Lauderu pagast) to a high o f LVL 232 (Ventspils City), with a standard deviation o f LVL 29. The equalization formula drops the standard deviation to LVL 16. It largely eliminates variations in per capita revenues among the 85 percent o f municipalities with per capita revenues below the minimum subject to equalization. Disparities only appear among the net contributors to the fund, as they are allowed to keep a proportion o f their excess revenues. 4.23 Because taxes are the principal source o f revenue, the sharing system has the effect o f flattening out disparities altogether. Figure 4.5 compares variations in post- equalization tax revenues and post-equalization total revenues. While disparities once again assert themselves, they are not necessarily a cause for concern. The largest source 45 Tamas M.Horvath and Gabor Peteri (Eds.), Andrejs Balcuns, Mudite Priede, Maris Pukis, Agita Strazda, "Chapter 5: Latvia", Navigation to Market: Regulation and Competition in Local Utilities in Central and Eastern Europe, (DFID-LGILocal Government Policy Partnership Program, Budapest: 2001), 249. 46 Ministry o f Environmental Protection and Regional Development, Report on Environmental Investments 2000, (Riga: 2001), 13. 29 o f variation i s in earmarked grants per capita (standard deviation=28.56), which presumably reflect variations in the allocation o f teachers' salaries. Variation in non-tax revenues are also significant (standard deviation =13.8). While this may reflect variations in local tariff revenues, it Figure4.5: Variations in Per Capita Revenues may also reflect variations in the organization o f 400 1 I-- (as 350 I-- municipal services enterprise income i s not * . 300 , . . .. counted as general 250 I* --.. budgetary revenue) and in *- I Taxes local accounting practices. l Total Revenues Neither revenue source i s ______ correlated with population size. (The correlation coefficient for earmarked grants .024; for non-tax revenue, .018). 4.24 While the equalization system flattens inter-municipal disparities in the general revenues o f municipalities, it does not, o f course, flatten similar disparities in the revenues o f municipal enterprises. The financial condition o f many water entities is precarious. Falling demand for water and declining wastewater effluent loads, together with insufficient tariff increases, have resulted in lower cash flows for operations. As a result, maintenance as well as larger capital investments have been deferred for several years.47 The problem i s particularly acute in smaller jurisdictions. A recent sample survey indicated that about 15 o f the 36-39 facilities operated by municipalities with populations between 2,000 and 10,000, and 4 o f the 10 facilities operated by municipalities with populations between 10,000 and 15,000 were in bad or badisatisfactory ~ondition.~' Investment needs are also particularly acute in smaller jurisdictions, due to relatively low levels o f coverage and rudimentary treatment facilities. 4.25 Amalgamation would permit smaller municipal water entities to merge with those o f larger towns. This would allow them to spread the burden o f these investments over a larger customer base. But inthe absence o f any efficiency gains, amalgamation would not reduce the cost o f supplying services or investing in network expansion or treatment facilities. 47 Moreover, current revenues generally covered only O&M costs. Typically, "annual production costs o f communal utilities include provision for amortization funds (depreciation, repair). However, amortization funds (ifany) are very oftenjust `paper money' as the old production equipment has been depreciated long ago and the accumulated cash - is being inflated or used up for repairs." Ministry o f Environmental Protection and Regional Development, National ISPA Strategy: Environmental Sector, (Riga: M a y 30, 2000), 15-16. 48 The number o f facilities varies by study. These figures are based o n an assessment in Government of Latvia, LAT-108 Final Report Appendix VI (Report prepared by Soil and Water, Ltd., Riga: October 1999), p. 35-38. 30 COORDINATION 4.26 The strongest argument for amalgamation is the last one: coordination. The small size o f local governments in Latvia means that problems o f sectoral coordination are difficult to resolve within individual municipalities. Because small municipalities are scattered and isolated, coordination is not the problem that it would be in more densely populated countries. Except in the Riga region, Latvia does not have conurbations. But the large number o f small local governments may still impede efforts to rationalize the allocation o f shared facilities-particularly in education, health, and solid waste. Inthe case o f education, parents (as noted earlier) can send their children to schools in neighboring jurisdictions, with financing following the pupil. But these independent decision by parents are unlikely to result in a cost-effective allocation o f school facilities, particularly given the overall decline inthe student population. Parents are likely to resist the closure o f small local schools. 4.27 Health care i s subject to the same phenomenon. Like students, patients can cross municipal boundaries. With financing provided by the sickness funds, financing follows the patient. But individual decisions by patients are unlikely to result in a cost-effective distribution o f health care facilities. Again, patients and their local elected officials are likely to resist the closure o f local facilities. Amalgamation would allow such decisions to be made on a larger scale. In solid waste disposal, similarly, independent decisions by individual local governments are unlikely to result in an efficient allocation o f landfill sites. 5. AFTER AMALGAMATION 5.1 Judging from this analysis, the principle benefit o f amalgamation will be to facilitate the coordination o f facilities and services that are subject to economies o f scale. While s uch economies c an be c aptured through the existing sy stem o f inter-municipal agreements, amalgamation will make the task easier. At present, such arrangements require agreements between municipalities. After amalgamation, they will involve agreements within municipalities. Disputes over which school to close or which road to improve will take place within municipal councils instead o f between them. (Because Latvian councilors are elected at large rather than by individual districts, the preferences o f more densely populated areas are likely to prevail). But the Government needs to take additional measures to ensure that the benefits o f amalgamation are fully reflected in the quality o f services providedby local authorities. 31 COMPLEMENTARY POLICY REFORMS 5.2 Education: After amalgamation, the problem o f under-enrolled classrooms and over-dimensioned sc hools may be easier t o address, but will n o t be s olved. The same pressure to keep under-enrolled schools open in small towns and rural areas will remain. Only now it will be focused on novad mayors, rather than on the mayors o f pilsetas and the Ministry o f Education. As noted earlier, municipalities have the legal authority to determine whether to keep schools open. But the Government can exert pressure, in two ways. 5.3 First, the Government can use its regulatory power to force under enrolled classes to close. The Government already has the legal authority to impose minimum class size. The Ministry o f Education can refuse to allow a class to open if it has too few students. But at present, the threshold is extremely low: eight pupils. And it is not applied consistently. The Government should consider raising the minimum and applying it in all jurisdictions. 5.4 Second, the Government should modify the system for allocating teachers' salaries. As noted earlier, teachers' salaries are now effectively allocated on the basis o f authorized teaching loads. Although there is a loose linkbetween salaries and enrollment, the link i s weak. Teacher:pupil ratios vary widely. Teachers in near-empty schools can continue to be paid as long as their teaching loads are a ~ t h o r i z e d .The ~ ~ Government should consider adopting an allocation rule that better reflects the distribution o f students. There are several ways to accomplish this. One option would be to simply allocate salary funds on a per pupil basis. This approach, recently introduced in Lithuania, shifts the onus o f downsizing onto individual municipalities. Faced with a sudden drop in salary reimbursements, municipalities with under-enrolled schools would be forced to close them or pay salaries from their own general revenues. Government aid may be needed duringthe transition, to assist inreassigningteachers to otherjurisdictions. Municipalities can also work with the Government to ease the difficulty o f transition by arranging early retirement incentives or work sharing (Le., reducing the number o f hours taught by each teacher while keepingthem all on the payroll). 5.5 The system for financing non-salary recurrent costs does not require change (other than the general adjustments in weighting factors described below). Unlike the teacher salary subsidy, the fraternal revenue sharing formula is based on numbers o f children, rather than number o f teachers. (For republic cities, 28 percent o f revenue sharing is allocated on the basis o f the number o f school age children; for other types o f municipalities, the share i s 25.7 percent). Falling enrollment-r at least declines in the numbero f school age children-thus triggers a drop inrevenue sharing. 49 The hold-harmless provisions in salary allocations i s particularly problematic. Since the absolute amount o f salary funding allocated to each rajon cannot be reduced, individualrajons are under no pressure to cut salary allocations to under-enrolled schools. 32 5.6 Hospitals: The Government can take a more direct approach to the problem o f over-dimensioned municipal hospitals. It i s unlikely that novad mayors will have any more desire to close under-used hospitals than they have to close under enrolled schools. But the Government is in a position to force them to do so. The Government is in the process o f reforming its health financing s ystem. Although the allocation o f funds t o each o f the eight health regions i s made on a risk-adjustedper capita basis, allocations to individual hospitals are still influenced by the location o f existing facilities. The Government i s introducing price-volume-quantity and diagnosis-related-group (DRG) based hospital reimbursement systems.jO Once the system is in place, money will follow the patient. Underusedhospitals will see a sharp decline inrevenues. Inefficient facilities unable to survive on the basis o f DRG reimbursements will be forced to close. Rather than rely on incentives alone to bring this about, the Government has developed regional plans and a national master plan, based on inputs from health providers as well as municipal representatives, to rationalize the allocation o f hospital services. Under the plan, the Government will reduce the number o f general hospitals from 130 to 60, converting the rest to nursing homes. If implemented successfully, these reforms will largely eliminate the problem o f over dimensioned and underused health care facilities. 5.7 Solid waste management: Government backed reforms will also eliminate the problem o f under-sized solid waste disposal sites. Under EU prodding, the Government has designated eleven new landfill sites which will serve the entire country. Once these sites are ready, all municipalities will be required to close their existing sites and use the new ones. By law, the new sites are to be managed and operated by inter-municipal companies. According to the Government's position paper on the environment, the restructuring o f the sector will include "creation o f centralized collection and transportation system o f municipal solid waste, elaboration o f unified tariff system, foundation o f regional institutions for municipal solid waste management, construction o f regional municipal solid waste landfill and closure (with following remediation) o f existing dumps.'" * 5.8 Social assistance: It i s unlikely that amalgamation alone would prompt local governments to abandon the current, idiosyncratic approach to social assistance. As noted earlier, the reluctance o f small local governments to adopt the GMI is more a matter o f philosophy than competence. A law mandating universal adoption o f the GMI was adopted inlate 2002 and became effective on January 1,2003. The revised Law on Social Services and Social Assistance requires local governments to fully fund the GMI from their social assistance budgets. Each year, the Council o f Ministers is to determine the level o f the GMI and the principles according to which the GMI will be calculated, allocated, and paid. The law nevertheless leaves some local discretion intact, allowing local governments to provide other forms o f social assistance, ifthey `satisfy the eligible poor person's request for the GMI.' Municipalities are free to supplement the GMI, up to a ceiling based on the national social insurance benefit, and can provide non-means tested aid in cases o f emergency. As the law has only recently been enacted, it is too soon to tell 50 "...Health Reform Project, opcit. j` Ministryo f Foreign Affairs, A ddendum to the Position Paper of the Republic of Latvia Chapter 22: "Environment" CONF-LV-60/00, (Riga: 2001), p. 27. 33 whether it will successfully displace the previous, more idiosyncratic approach to allocating social assistance. 5.9 The Government may also have to change the way social assistance is funded. At present, there is some dispute over the costs o f introducing the GMI. The Government argues that it would be budget neutral, as additional spending on the GMI would be offset by cuts in other forms o f social assistance. The Union o f Local and Regional Authorities argues that funding would have to be substantially increased. This question cannot be answered within the scope o f this report. But it i s clear that the burden o f the GMI will fall more heavily on some novads than others. Poverty levels vary widely across Latvia. In 2000, the unemployment rate in the city o f Riga was 4.2 percent, for example, while the rates in the republican cities o f Daugapils, Liepaja and Rezneke exceeded eleven percent. Unemployment was over twenty percent in four rural rajons. The present system o f social assistance financing does not reflect these variations. Social assistance i s paid out o f the general revenues o f each municipality. And although the equalization formula succeeds in reducing variations in municipal revenues per capita, it does not attempt to reflect variations inlevels o fpoverty. 5.10 There are several different solutions to this problem. One would be to include a poverty indicator in the fratemal revenue sharing formula. Another would be to provide separate funding for social assistance, rather than including it in the services to be financed from local taxes and fratemal revenue sharing. This would permit the Government to target social assistance to those areas where it is most needed and to ensure that funding for the GMI i s in fact usedfor that purpose. 5.11 Water and Sewerage: Regulatory reforms will also be required to meet EU wastewater standards in fonner small pagasts. As noted earlier, 1ow t ariffs are mainly responsible for the lack o f funding for maintenance and capital improvements in the water and sewerage sector. Until recently, tariff setting has been the exclusive responsibility o f individual municipal councils. Tariffs have been suppressed for political reasons. Recent reforms could change that. Under the Law on Regulators of Public Sewices (as amended September 27, 2001), municipalities are authorized to establish independent municipal regulators for water supply and sewerage (as well as household waste management and heat supply where electricity is not produced.)52 Implementation has been slow, however. Under the law, municipalities were to establish regulators by September 2001, but this objective has not been met. The process appears to be rather unsystematic. Interviews in west Latvia revealed that several municipalities are transferring the regulatory function to their larger neighbors, Liepaja or Ventspils. Other small municipalities have yet to arrange for a regulator. 5.12 This is partly due to legal loopholes that allow municipalities to evade the legislation. It i s also due to the small size of local governments. The legislation allows for a 0.2 percent fee on the turnover o f public services companies. Analysis suggests that one-fifth to one-half o f all municipalities would have to jointly contribute in order to 52 Section 2, paragraph 3 Law on Regulators of Public Services (as amended September 27, 2001). The law was adopted on October 19, 2000, and came into effect June 1, 2001. 34 generate enough revenues to support a single multi-utility regulator.53The creation o f novads will substantially reduce that figure. But individualnovads would be far too small to support their own regulators. 5.13 To reduce political involvement in the tariff setting process, existing legislation should be amended to prohibit local governments from opting out o f regulation. In addition, the Government should take steps to encourage novads to establish joint regulators. Model charters, establishment guidelines and inter-municipal payment clarifications would be useful in this regard. The Public Utilities Commission (PUC) could provide technical assistance to new regulators. Alternatively, municipalities could ask the PUC to provide regulation on their behalf, transferring the regulatory fee to the PUC. 5.14 Assistance in contracting i s needed to enable the smaller novads to exploit benefits o f contracting out. As a local government sets out to find a suitable private sector partner, it needs t o s ort through a s eries o f isues that w ould help it determine which private sector arrangement maximizes its value to the local government, to the company and to the customer. A common mistake in designing lease or concession contracts is the tendency to specify the size o f the investment to be undertaken. Instead, the arrangement should be designedaround objectives with time bound performance standards designed to meet this objective. Some o f these performance measures could be the number o f complaints in a year, the average time to resolve complaints, and technical measures in district heating, for example, the ability to maintain system temperature, and reduction o f water and heat losses. A starting point in determining objectives i s to analyze the state o f the existing utility. 54 5.15 Equalization: Except as noted above, amalgamation would not require major adjustments in the current system o f revenue sharing. The benefits and drawbacks o f the current system will continue to exist after amalgamation i s completed. Amalgamation would not, for example, reduce the need for equalization. As shown in Table 5.1, amalgamation will reduce the range o f variations in pre-equalization per capita tax revenues. Under the present structure o f local government, pre-equalization tax revenues (per capita) range from LVL 17 to LVL 232. After amalgamation, they would range from LVL 33 to LVL 169. This i s still considerably wider 53 Inga Vilka, Development of Local Government Regulatory Models, (Riga: Final Report, June 15, 2001), 72; and T a m s M. Horvath and Gabor Peteri (Eds.), Andrejs Balcuns, Mudite Priede, Maris Pukis, Agita Strazda, "Chapter 5: Latvia", Navigation to Market: Regulation and Competition in Local Utilities in Central and Eastern Europe, (DFID-LGILocal Government Policy Partnership Program ,Budapest: 200l), 291. j4Cowen, Penelope et .al., "Toolkit 3: What a Private Sector Participation Arrangement Should Cover," (World Bank: 1997). 35 thanthe range inper capita tax revenues produced under the current equalization system. Post-equalization, per capita revenues now vary from LVL77 to LVLl76, with a standard deviation o f 11. After amalgamation, revenue sharing would therefore still be required to achieve the level of equalization achieved under the current system. 5.16 There is a need to recalculate the weights used in the fraternal revenue sharing system-prompted not by amalgamation but by obsolescence. The current weights assigned to each o f the six factors were calculated in 1998 on the basis o f patterns in municipal expenditures in 1996 and 1997. These no longer reflect current spending, particularly in the case o f old age homes and orphanages. The weights for these two factors were dictated by the Ministry o f Welfare which wanted to: (1) increase overall spending on these services, while (2) encouraging municipalities to explore non- institutional options for these clientele. The formula i s therefore based on the number o f people residing in old age homes and orphanages, but only counts those admitted before 1998-thus removing any bias toward the institutionalization o f new clients. As the number o f such pre-1998 admittees has fallen, the value attached to each o f the remaining ones has increased far out of proportion to the costs o f providing services to them. As such it constitutes a windfall for municipalities that still have pre-1998 admittees under their care. This pair o f factors should be eliminated from the equalization formula, and replaced by a targeted transfer based only on the actual costs o f serving this declining population inthe municipalities where they reside. INTERMEDIATELEVELSOF GOVERNMENT 5.17 I s a second tier o f local government required? If the principal benefit o f amalgamation i s to reduce the need for inter-municipal coordination in services subject to scale economies, it is necessary to examine whether novads will be big enough to do so. As noted earlier, half the novads will have populations in the 4,500-10,000 range. Another 40 percent will have populations ranging from 10,000 to 30,000. This may be too small. 5.18 In effect, the Government has already determined that novads are too small to provide their own hospitals and landfills. As noted earlier, the Government itself is undertaking a rationalization o f the hospital network, with the aim o f reducing the total number to sixty. This is equivalent to 40,000 persons per hospital, approximately eight times the size o f the smallest novad. To comply with EU directives, the Government has a plan to promote the formation o f eleven cooperation based inter-municipal solid waste disposal institutions, with a n average o f 2 15,000 persons per 1andfill. Orphanages and nursing homes will also have to be shared. At present, Latvia has only six orphanages (one for every 400,000 people). Novads also appear to be too small to operate their own systems o f utility regulation. 5.19 Will novads be bigenough t o operate the full range o f primary and s econdary education? Latvia has three types o f general education schools: primary schools (grades 1-4); basic schools (grades 1-9) and secondary schools (grades 1-12). Given existing 36 classroom sizes, even the smallest novad has a sufficient population to support at least one secondary (grade 1-12) school. The average number o f students ina full (1-12 grade) school i s now 623. The average ratio o f pupils to population in Latvia i s about 0.15:l. The average secondary school would therefore require a catchment area population o f only 4,100; comfortably below the population o f the smallest novad. But enrollment in the upper grades would be small. A significant proportion o f basic school graduates do not go on to secondary school. The average ratio o f secondary school pupils to population is 0.027:1, suggesting that the upper three grades in one o f the smaller novads would have an enrollment o f only 135 students-forty-five students per grade. This compares to an average o f 426 students in the upper three levels (and the two- year HF leve1)j5 in Denmark. If the Government wishes to provide a broader range o f course offerings at the secondary level, it might be necessary to assign secondary education to a higher level o f government. 5.20 Rajons: This could be the rajons. As noted earlier, rajons are vestigial remnants o f aprinkis, a district level of Government first formed in the nineteenth century. They are headed by a council o f municipal mayors, in which the voting strength of each council member i s proportionate to the population o f the municipality he or she represents. The council elects the chairman, who i s charged with ensuring `the performance o f the functions prescribed by law and functions delegated by the (municipal) governments, observing the interest o f the State and the residents o f the relevant rajon administrative territory.'j6 5.21 At present, rajons have few major functions. Under the 1994 Local Government Law (as amended in 1998), they are specifically assigned only four permanent roles: development planning and management, organizing public transport services, ensuring representation o f local governments in the regional sickness fund, and organizing continuing education for teaching staff and pedagogical methodology work. Rajons also play a role in the distribution o f certain funds among the municipalities within their jurisdiction including (as noted earlier) teachers' salaries and funding for retirement homes, orphanages, and roads.j7. Under the 55 Counties in Denmark are generally responsible for upper secondary schools (Gymnasia and other institutions leading to the Higher Preparatory Examination -HF). 56 Local Government Law, Chapter 1, Section 3. 57 At the time the previous World Bank report was written, serious consideration was given to strengthening the 26 rajons as an alternative to amalgamating the municipalities. In 1999, there was a short- lived proposal to create nine regions, which would take over the existing functions o f rajons plus certain functions o f Government ministries: primary and secondary health care (from the Ministry o f Welfare); 37 1999 education law, rajon governments were also given the authority to establish or close certain specialized schools. They also operate some old age and nursing homes on behalf o fmunicipalities. 5.22 As presently constituted, rajons appear to be large enough to provide a secondary school body o f at least 400 students. As shown in Table 5.2, the population ofrajons (excluding the coterminous republic cityhajons) ranges from 14,530 (Ventspils) to 144,500. At this scale, even Ventspils rajon could offer the upper three grades with an enrollment o f nearly 400. 5.23 SpecialDistricts:After amalgamation, however, the average rajon would contain only 3.5 municipalities. As a unit o f territorial administration, rajons would appear to be redundant. Consideration might therefore be given to abolishing the rajons, and shifting their functions to a larger unit o f administration. One option would be to create special, sector specific districts. Ineffect, Latvia already has special districts for health (the eight sickness fund regions). Existing rajon functions-such as nursinghomes or transportation planning could be organized along similar lines. Secondary education-if the Government chose to organize it as such-could also be provided by special districts, as could public utility regulators and inter-novad water operators. 5.24 Multi-purpose Regional Government: The alternative Figure 5.1: Population of Aprinkis would be to assign these functions to a multi-purpose unit o f regional 400,000 government. There i s already a 350,000 legal basis for such entities in 300,000 Latvia. The Law "On 250,000 Administrative Territorial Reform" provides that the state shall be 200,000 divided in regional units, termed 150,000 Aprinkis. The Law specifies that an 100,000 aprinkis shall be an administrative 50,000 territory that includes novads, 0 towns, pagasts, and republican APRINKIKURZEM XPRINKI RIGA ZEMGAL VIDZEME LATGAL XPRINKI - -APRINKI - APRINKI - cities, except the capital city Riga. It does not define which functions should be allocatedto this 1eve1but states that the subsidiarity principle shall be observed when allocating functions between state administrations, regions, and novads. regional transport and roads (from the Ministry o f Transport), the public investment program (for investments o f regional importance) from the Ministry o f Economy, and regional higher education and secondary general education from the Ministry o f Education and Science. In November 1999, seven ministries signed a memorandum o f understanding, identifying functions to be delegated or decentralized from the State to the rajon level. The Ministry o f Finance was put in charge o f costing out these functions and making proposals for their financing. Withthe decision to adopt the amalgamation option, this proposal has been postponed indefinitely. 38 5.25 Based on this Law, the Department o f Local Government Affairs devised a draft law "On the Establishment o f Aprinkis Local Governments" .58 The drafted Law defines the boundaries o f the aprinkis on the basis o f Latvia's historic districts (Kurzemes, Rigas, Zemgales, Vidzemes, and Latgales). Aprinkis councils are to be elected in closed, direct, and proportional elections for five year terms, and each Aprinka Council will consist o f 20 deputies. As shown in Figure 5.1, the population o f Aprinkis would range from 200,000 to 400,000 inhabitants (without the city o f Riga). If Riga city is included, Rigas Aprinkis would have apopulation o f955,317. 5.26 The Law proposes that the Aprinkis will have the following permanent functions: (i) prepareandadoptAprinkisterritories developmentprograms(economic, social, to environment protection, and cultural heritage protection); (ii)to prepare and adopt territorial planning in accordance with the development programs; (iii)to execute investment policies (needs determination, preparation o f programs, co-financing, project management and supervision); (iv) to implement roads and traffic policies; (v) to promote tourism; (vi) to execute cultural policies; (vii) to execute health policies in accordance with Aprinka social development programs (popularization o f healthy life style, establishment and maintenance o f sport schools and other additional educational establishments); (viii) to provide social care (establish and co-finance nursing homes, social services and rehabilitation for persons with mental problems, nursing homes for the people with mental problems, and establish and finance orphanage homes); (ix) to execute general education policies (proposals for the optimization o f education institutions, establishment and maintenance o f boarding schools, institutions for education support, and teachers additional education); (x) to execute professional education policies; (xi) to execute employment policies; (xii) to execute health policies (coordination o f primary and secondary health care, establishment o f regional sickness funds, organizationof s econdary health c are); (xiii) to execute environment protection policies (solid waste collection and disposal). 5.27 The Seima has yet to approve this legislation. InApril 2002, it did approve a Law on Regional Development creating regional Planning Region Development Councils in each region. As specified in the law, these would be responsible for the elaboration o f regional policy and its implementation through the planning and coordination o f regional development measures including those co-financed by the EUstructural instruments. The Council would `ensure the co-ordination o f the development o f the planning region in line with basic principles...identified inthe regional development plaming documents; manage and supervise the formulation and implementation o f the development program.. ., ensure cooperation o f local governments and the cooperation o f the planning region with national institutions in implementing the regional development support measures, and assess the compliance o f the National Spatial Plan, the National Development Plan and the national and sectoral development programs with the 58 The draft law o f 08.21.2002 "On Aprinkis Local Governments Establishment". The draft was in i t s very early preparation stage by the Department o f Local Government Affairs and at that time was not circulated among other government offices. The draft was prepared based o n the L a w "On Administrative Territorial Reform" that envisage to establish regional level o f governments -Aprinkis. 39 development programs and spatial plan o f planning region.'59 The councils would be elected by the chairmen o f the municipal councils within their respective territories. 5.28 The Law, in turn, directs each Development Council to establish a Planning Region Development Agency, which would be charged with formulating the development program and spatial plan o f the planning region in co-operation with local and district governments and with territorial offices o f state institutions, ensuring their compliance with the National Spatial Plan, the National Development Plan and national or sectoral development programs, as well as ensuring the management o f their implementation; co-ordinate and promote the formulation, implementation, monitoring and evaluation o f regional development support measures o f the planning region. The Agency would also evaluate and issue opinions on the project applications submitted by local governments and legal and natural persons for receiving the regional development state support. 5.29 There i s ample precedent for such multi-purpose second tier governments in neighboring countries. Three o f the four Nordic countries (Sweden, Norway, and Denmark, but not Finland) have regional levels o f government. Their average sizes are similar to that proposed for Latvia's regional planning jurisdictions. (See Table 5.3.) InDenmark, counties are responsible for hospitals, secondary education, and regional physical planning. In addition to these functions, counties inNorway are also responsible for vocational training, child welfare institutions, institutions for the care o f drug and alcohol abusers and the construction and maintenance o f regional roads and the provision o f local public transport. In both Denmark and Norway, the regional level o f governments are responsible for the upper secondary education or high school education (grades 10-12). 5.30 Unlike the proposed planning districts, the regional governments in other Nordic countries have directly elected councils. There i s a strong argument for doing the same in Latvia. Directly elected councilors would be more easily held accountable than counselors chosen ex-officio from each novad. They are also more likely to take regional interests into account, rather than becoming captive to the parochial interests o f individual novads. In this respect, the regional governments would have the political characteristics o f the proposed uprinkis, rather than the regional planning agencies. 5.31 In principle, the aprinkis could take on the vestigial functions performed by rajons, organizing public transport services, managing funding for roads, and operating retirement homes and orphanages for the novads within their jurisdictions. They could 59 Note that the L a w provides that the Cabinet o f Ministers shall establish the procedure for allocating the regional development funding and for managing the financing from the European Union structural funds. 40 also operate large scale secondary schools on behalf o f the novads. With a minimum population o f 200,000, they are also o f a sufficient size to absorb the tasks o f the eleven inter-municipal solid waste management institutions and the eight regional sickness funds. CONCLUSIONS 5.32 Amalgamation i s clearly only one o f many reforms the Government can undertake to improve the efficiency and equity o f public service provision in Latvia. The principle benefit o f amalgamation will be to change the venue inwhich decisions on local services are made. Decisions that formerly involved c onflicts and negotiation between jurisdictions will now take place within jurisdictions. There i s also some evidence that amalgamation will enable local governments to attract more highlyqualified staff. 5.33 But improvements in other aspects o f municipal services will require further reforms. To prompt the closure of underenrolled schools, the Government will have to raise--and then enforce--its minimum class size rule, and change the basis for financing teachers' salaries to one which more accurately reflects enrollment. To rationalize the allocation o f hospital funding and facilities, the Government will need to proceed with the introduction o f price-volume-quantity and DRG-based hospital reimbursement systems, and its plan to reduce the number o f general hospitals. To meet EUstandards for solid waste management, the Government will need to establish the proposed inter- municipal agencies t o operate the proposed e leven 1andfills and manage the c ollection and transportation o f solid waste. It will have to create inter-novad regulatory agencies for water supply and other local public utilities. And to provide sufficient financing for the social assistance benefits, it may need to provide additional financing in areas where poverty levels are unusually high. 5.34 The Government should also consider changes in the organization and functions o f intermediate levels o f government. After amalgamation, the rajons will be largely redundant. But novads may be too small to take on their vestigial functions: organizing public transport services, managing funding for roads, and operating retirement homes and orphanages. They would also be too small to operate full-fledged secondary schools-i.e., schools with a wide range o f course offerings in the upper grades. The Government should therefore consider assigning these functions to a larger unit o f subnational government. The five existing regional planning regions are an obvious candidate. These might also take on the functions o f the eight health regions, and the eleven solid waste management regions, and the political structure o f the proposed five Aprinkis. 41