Report No. 25821-BUL Bulgaria Issues in Intergovernmental Relations January 27, 2004 Poverty Reduction and Economic Management Unit South Central Europe Country Unit Europe and Central Asia Region Document of the World Bank i FOREWORD This report is based on the findings o f a mission to Bulgaria in December 2002. The report was prepared by William Dillinger (Task Manager) with the assistance of Konstantin Pashev. The peer reviewer for this task i s Dana Weist. The report was produced with the participation o f a wide range o fBulgariancounterparts. These included officials and staff o f the municipalities o f Sofia, Plovdiv, Gabrovo, Lovech, Troyan, Pleven, Stara Zagora, Sevlievo, Mezdra, Cherven Briag, and Pazardjik and officials o f the Ministry o f Finance (including the Department o f Local Government Finance and the Directorate o f Tax Policy), the Ministry o f Labor and Social Policy, the Ministry o f Education and Science, the Ministry o f Health, the Ministry o f Regional Development and Public Works, and the Director o f Euro Integration and Relations with IFIs of the Council o f Ministers, the National Audit Office, the Association o f Municipalities (NAMRB), USAID, the EU, the IMF and several NGOs (including Club Ekonomica 2000, the Foundation for Local Government Reform, andthe Local Government Initiative). This report has also benefitedfrom a considerable number of recent reports on Bulgaria, including a recent World Bank Public Expenditure and Institutional Review, the IMF's Bulgaria: Selected Issues and Statistical Appendix (August 2002); USAID's Bulgaria: Comprehensive Municipal Finance and Fiscal Reform Proposal (September 2000), Municipal Credit Market Development in Bulgaria: Policy and Legal Framework (February 2000); Municipal Capital Investment Policy Considerations (March 2003) and Mid-course Review of Fiscal Decentralization: the Unfinished Agenda, as well as several Bank reports arising from lending operations inhealth, education, and water supply. .. 11 ... 111 Table of Contents ExecutiveSummary ................................................................................................................... v Introduction ................................................................................................................................ Boundaries ................................................................................................................................ 1 1 2 Regulation................................................................................................................................. Functions................................................................................................................................... 5 Revenues ................................................................................................................................... 6 Issues........................................................................................................................................... 8 UnfundedMandates, Arrears, and FiscalAutonomy................................................................ 8 Incentives to Overstaffing....................................................................................................... 12 Arbitrary Disparities inPer Capita Revenues......................................................................... 13 The Decline o fInfrastructure.................................................................................................. 14 The 2003 Reform ...................................................................................................................... 15 The Unfinished Agenda ........................................................................................................... 18 Longer-TermReforms ............................................................................................................ Immediate Reforms................................................................................................................. 21 24 Priorities.................................................................................................................................... 31 iv V EXECUTIVE SUMMARY 1. Municipalities play a large role in the Bulgarian public sector. They provide primary and secondary education. They own and operate about one-third o f the hospitals inthe country. Until 2003, they administered all the major social assistance programs (except pensions and unemployment insurance). The municipalities o f larger cities own (wholly or partially) the water companies operating within their territories. .. 11. Throughout the 1990's and into the first years o f the present decade, problems in the structure o f intergovernmental relations undermined efforts to achieve efficiency in public service provision and generate savings for investment in public utilities. Persistent deficits and bailouts underminedfiscal stability at both the central and local levels. A fundamental reform in intergovernmental fiscal relations went into effect in 2003. This has addressed many, although not all, o f these problems. The objective o f this report is to evaluate the reform, identify major remaining issues and recommendmeans to resolve them. . ... 111. Unfunded mandates. The most conspicuous issue in the structure o f central-local relations has been a dispute over unfundedmandates. Municipalities charge that the Government imposes costs without sufficient financing. The Government observes that it continues to pay off arrears only to have new ones emerge. Both are right. The Government tightly controls the resources available to local governments and limits their ability to control costs. But municipalities also routinely run up commitments in excess o f expected budget receipts in the hope o f bailouts from the Government. The Government has traditionally obliged, reinforcing these expectations. iv. OverstafJing. The structure o f intergovernmental relations has also encouraged overstaffing. Excessive staffing i s a problem in Bulgaria, particularly in education and health care, due to the legacy o f over-dimensioned facilities inherited from the Socialist era and--in the case o f schools--declining enrollment. Under the system o f intergovernmental relations that existed in 2002, the Government reimbursed 100percent o f municipal wages and social security contributions, providing no incentive to economize on staff. v. Financing capital investment. Municipalities also face problems in the financing o f capital investment. Municipal infrastructure has suffered from a decade o f deferred maintenance. Substantial new capital investment-particularly in sewerage-will be required to meet EU accession requirements. At present, municipalities and their enterprises generate virtually no current savings with which to finance capital investment. Except in Sofia, private concessionaires have expressed little interest in investing in municipal utilities. Most capital works are instead financed through the Government's annual budget, which i s in turn funded from domestic taxation, Government borrowing and donor funds. While this i s the most likely source o f funding for municipal works in the short and medium term, the current capital budgeting process fails to link available resources to highest-priority projects. While the MOF does a creditable job in analyzing the financial aspects o f project proposals, its analysis o f vi economic costs and benefits aspects is weak. And the capital budgeting process gives the Council of Ministers excessive discretion over choice o f projects to be funded in the annual budget. vi. The reform of 2003. A major reform in intergovernmental fiscal relations, effective in 2003, addressed some o f these problems. The reform substantially changed the method used to calculate municipal expenditure needs. As a result, the level o f funding for so-called delegated functions i s now based on a more accurate calculation o f costs. The mechanism for distributing funding among municipalities is more transparent. The reform also reduces incentives to overstaffing--most dramatically in the case o f health, where salaries will no longer enter into the calculation o fthe general subsidy. vii. The remaining agenda. Despite this progress, a substantial unfinished agenda remains. The reform does not eliminate the root cause o f the dispute over unfunded mandates. As in the past, the Government will continue to make its own estimate o f local spending needs and expected revenues from shared taxes, and provide budget support to fill any resulting gaps. While this calculation will now be limited to so-called delegated functions, municipalities are still likely to dispute the figures. In fact, the elimination o f actual salary costs from the calculation o f expenditure needs i s likely to increase the grounds for dispute. Municipalities may now argue that the Government i s not only underfundingnon-salary costs, but i s underfunding salaries as well. As a result, municipalities are likely to continue to run strategic deficits in the hopes o f attracting new bailouts. viii. In addition, the reform does not provide a means for local government to respond to incentives for staff reductions. While it provides a fiscal incentive to reduce overstaffing, it does not remove the regulatory constraints on doing so. ix. Inthe short term, five additionalmeasurestherefore bear consideration. 0 First, the Government should commit itselfto meeting its own budgetobligations to local governments'.It should release subsidies on a timely basis, and should regularly update the factors usedto calculate expenditure needs. 0 Second, it should assist municipalities in responding to the efficiency incentives embodied in the new general subsidy formula. Rather than resisting downsizing, the MinistryofEducationshould encourage municipalities to close underenrolled classes, by enforcing rules on minimum class sizes and assisting in the redeployment o f redundant teachers. The Ministry o f Health should relieve the municipalities o f some o f the political onus o f hospital closings by pursuing its hospital restructuring strategy more aggressively, while at the same time expanding the number o f clinical paths eligible for NHIFreimbursements. 'The 2004 draft budget law, now under discussion inParliament, provides for full funding o f the delegated functions. Shortfalls inthe funding o f delegated functions at the outset o f 2003 were covered by budget transfers later inthe year. vii 0 Third, the National Assembly should give municipalities greater control over property taxes, in order to provide them with a means to respond to constituents' demands for public services. 0 Fourth, the Government should harden the budget constraint confronting local governments to rein intheir propensity to runup arrears. While budget regulation may be helpful in this regard, cutting off the sources o f deficit financing is likely to be more effective. The majority o f deficit financing i s provided by private suppliers and contractors. They are likely to continue to extend credit to municipalities as long as they have a reasonable expectation o f being paid. The Government should puncture this expectationby refusing to provide debt reliefinthe future. 0 Finally, the Government will have to find a more effective mechanism to raise resources for investmentand link it with highpriority projects. One approach would be to rely more on the current account savings o f municipal governments and their public enterprises. Certain sectors could be made more attractive to investors willing to bring incapital. The focus o f reform, however, should be on the Government's own capital budgetingprocess, and should aim at improving the project selection process and improving the quality o f projects submitted for donor financing. There i s therefore a strong argument for tighter regulation on municipal borrowing. One approach would be to impose quantitative restrictions, such as a minimum level o f debt service coverage.2 An alternative would be to rely on local political accountability. The Government i s now considering a proposal that would require a super-majority in the municipal council, or a majority vote ina local referendum as a precondition for contracting o f municipal debt. Both approaches should be considered. X. In the longer term, the Government should seek a more sustainable solution to the conflict over unfunded mandates. One solution would be to further centralize the financing o f certain delegated functions. This has already occurred in social assistance, where the Government has now assumed full responsibility for the financing and administration o f income support. In principle, this approach could be extended to the financing o f teachers' salaries. Under such an approach, the Government would directly finance the wage and benefits o f authorized teaching positions, rather than incorporating salary funding in the general supplementary subsidy. xi. Altematively, the Government could relax its controls over the management o f some functions, allowing local governments greater control over the determinants o f costs. Municipalities could be permitted to cut excess teaching positions without prior Government approval, for example. Over the long run, the Government should also consider loosening its controls over municipal revenues. Granting municipalities the power to set property tax rates i s an important first step. But it will not be sufficient to resolve disputes over the adequacy o f Debt service coverage can be defined as the ratio of the current surplus to total debt service, where the current surplus is defined as total current revenues less recurrent non-interest expenditures, and debt service includes interest and principal repayments on the total stock of debt. viii financing, particularly for delegated functions. One candidate for liberalization would be the personal income tax. It has a number o f advantages, not the least o f which is the fact that it i s already assigned to local government. Liberalization would merely require that local governments be allowed to adjust the rate o f the tax imposed within its jurisdiction. Such mechanisms are widely used in other European countries Like most European countries, Bulgaria i s likely to eventually choose a mix o f both. The distinction between delegated and autonomous functions, introduced in the 2003 reform, i s a positive step in this direction. 1 INTRODUCTION 1. Municipalities play a large role inthe Bulgarian public sector. They provide primary and secondary education. They own and operate about one-third o f the hospitals inthe country. Until 2003, they administered virtually all social assistance programs except old age pensions and unemployment insurance. Municipalities o f larger cities own (wholly or partially) the water companies operating within their territories. Sofia owns its own district heating company. In total, spendingby municipalities accounts for about 17 percent o f total consolidated public sector spending3or about 26 percent o fpublic sector spendingnet o f social security. 2. Problems in the system for financing municipal governments have undermined efforts to achieve efficiency in public education and health, equity in social assistance, and generate savings for investment in public ~ t i l i t i e s .Schools and hospitals are overstaffed and over ~ dimensioned, wasting resources. Social assistance has been underfunded in poor jurisdictions. Infrastructure i s deteriorating, just as EU accession demands massive new investment. And a tight fiscal straight jacket imposed by the Government has been incapable o f preventing municipal arrears andbailouts. Table 1: Size Distributionof identify the next steps required to improve the efficiency o f Municipalities I I I municipal services and achieve local fiscal stability. 4. The territory o f Bulgaria i s divided into 263 municipalities (obshtini) and 28 oblasts. Municipalities are legal entities, govemed by municipal councils whose members are directly elected for four year terms. Executive power i s vested in an elected mayor. In accordance with Article 141 o f the Constitution, each municipality has its own budget and permanent sources o f revenue, as established by law.5 IRepublicofBulgaria 5. Interritorial terms, municipalities are relatively large by Eastem European standards. The vast majority o f municipalities range inpopulation from 5,000- 50,000. As shown in Table 1, only 28 municipalities--accounting for ten percent o f the total but only one percent o f Bulgaria's population--have populations under 5000. The thirteen largest municipalities--with populations over 100,000--account for about 42 percent o f Bulgaria's population. Consolidated budgetary expenditures o f central government, plus spending by local governments, net of intergovernmental transfers. Source: MOF website. See IBRD,August 2002, Bulgaria: Public Expenditure Issues and Directionsfor Reform. Oblast administrations, in contrast, are administrative units of the Government, administered by a governor who is directly appointed by the Council of Ministers. The oblasts are financed by the Government budget. 2 Functions 6. The Local Self Government Act sets out a lengthy list o f functions over which municipalities may exercise competence.6 These include education (preschool, elementary, primary and secondary); health care (outpatient and hospital care, preventive care, community care, municipal sanitation and hygiene); social assistance (social care and welfare benefits, provision o f subsidized housing and other `social work o f municipal importance'); and public works and utilities (including water supply, sewerage, central heating, solid waste management, streets, andpublic transit). 7. Education accounts for the largest single item o f municipal expenditure. As shown in the I Figure1:Trends in FunctionalCompositionof figure below and Table 2, it consumed about 35 percent o f the total in 2001. MunicipalExpenditures Bulgaria's education system consists , 1800 7 of: (i)optional pre-school education; b 8 1600 (ii) eight-yearprimarycycle; (iii) ' an a :1400 secondary cycle which, starting in the f 1200 1000 1999/2000 school year, was extended (3 800 from three years to four years; and (iv) Lu various higher education program^.^. 8 200 Primary education i s offered either in 0 eight-year primary schools, or in a 1997 1998 1999 2000 2001 combination o f "junior school", covering the first four grades, and "middle school", covering grades 5 UEducation Social Security and Welfare -1 OHousing and Public works 0Transport Health through 8. Secondary education is .General Public Service and Communication4 offered in several forms-either as Recreation, Culture Other Expenditures I general education or as vocational education in a large number of specializations. Urban areas tend to have large schools offering the complete primary or secondary cycle. Small rural communities often have separate four-year junior and middle schools, with few students ineach grade. 8. About 1,000 primary and secondary schools are designated as "national interest schools", and are financed entirely by the Government budget. These include vocational schools and schools for students with special needs-including orphans, juvenile delinquents, and students with infectious diseases. The remaining public primary and secondary schools-numbering about 2,500 and accounting for the vast majority o f enrollment-are the responsibility o f the municipalities. Competence, inthe law, i s defined as "the right o f citizens or o f bodies thereby elected, to make decisions, acting within the scope ofthe competence thereon conferred". World Bank, 2002, Bulgaria: Public Expenditure Issues and Directionsfor Reform. 3 9. Prior to the 2003 reforms, social assistance was the second largest item o f municipal expenditure. Bulgaria has an extensive system o f social welfare. During the 1990's, social protection spending averaged 12 percent o f GDP. Over 80 percent o f Bulgarians received at least one type o f benefit in 2001.' Retirement benefits are Table 2: MunicipalExpenditures by far the largest program, accounting for 65 percent o f total social assistance spending in 2001 (net o f administrative costs). This i s followed by unemployment benefits at six percent. Both are financed and administered by the Government. Until 2003, an extensive list o f benefits, however, were paid through the budgets o f local governments. These included: (i)the Guaranteed Minimum Income (GMI), a means-tested cash benefit paid to low- income households below an income threshold; (ii) family benefits paid under the Birth Promotion Act, including child allowances, maternity leave and birth grants for uninsured households; (iii) benefits, energy paid in cash to low-income households during the winter heating season; and (iv) cash and in-kind benefits for the disabled, including medical and transportation benefits. 10. Health Care.The Bulgarian health care systemhas two major components. Primary care i s provided by private practitioners operating under individual contracts with the National Health Insurance Fund (NHIF). They are paid on the basis o f patients registered (BGN 1 per patient) plus an additional fee for service rendered. Fees are governed by an annually revised National Framework Contract (NFC) between the NHIF and professional organizations o f physicians and dentists. 11. Secondary and tertiary care are provided through a system o f national, regional, and municipal hospitals. The hospital system i s in the midst o f a major reform in both organization and financing. In2000, Government- and municipally-owned hospitals and clinic facilities were reorganized as commercial enterprises. Ownership o f the 28 regional hospitals was divided between the Government (5 1%) and the municipalities within their respective catchment areas.' University hospitals and national centers (20) remained the property o f the state. Existing municipal hospitals remainedwholly owned by the municipalities inwhich they were located. As o f end-2000, Bulgaria had 385 inpatient health care institutions, with a total o f 60,552 beds". Municipalities owned 102 o fthem, with 27 percent o fthe beds and 15 percent o f the patients. 'World Bank, 2002, Bulgaria: Public Expenditure Issues and Directionsfor Reform. Municipality's ownership share of regional hospitals confers no management control. The regional hospitals are directly subordinateto the Ministry of Health. lo RobertFirestine, Local Government Initiative Borislav Tafradjiysky, Club Economica.2000 MUNICIPALITIES AND HOSPITAL CAPITAL SPENDINGINBULGARIA. 4 12. Financing arrangements are also changing. Prior to 2001, hospitals were largely financed through budgetary transfers from their respective owners, supplemented by fees. Since then, the NHIF, financed from earmarked contributions, has taken an increasing role in hospital care financing. The majority o f NHIF financing is provided on the basis o f diagnostic related groups (clinical paths, in Bulgarian parlance). The NFC identifies treatment regimes eligible for NHIF reimbursement, along with corresponding reimbursement rates. Reimbursements to each health service provider are approved only for those clinical pathways inwhich it is deemed competent, and for which each provider or hospital has contracted with the NHIF.'* At present, the health fund covers only 41 procedures (clinical paths, inBulgarianparlance). This would expand to 71 in2003, andwill eventually cover the entirerange ofservices providedbyhospitals. 13. Reforms in the health care system have resulted in a dramatic re-division o f funding responsibilities. As shown in Table 3, the municipal share o f health care spending dropped from 76% in 1990 to fifteen percent in 2001, and i s budgeted to fall to ten percent in 2003. To date, this largely reflects the changing terms o f outpatient financing. Outpatient services were formerly provided by doctors affiliated with (and paid through) municipal hospitals. The second stage o f the reform-in which NHIF will take over an increasingproportion of in-patient care- has proceeded more slowly. 14. Water Supply, Sewerage and District Heating. At present, fourteen municipalities operate their own water supply companies. Service in the rest o f Bulgaria i s provided by 29 regional water and sewerage companies (RWCs), each o f which i s organized as a limited liability company and delivers water and sewerage services to three to seventeen municipalities. The regional water companies are owned 51 percent by the Government and 49 percent by the municipalities (although municipal ownership does not confer any significant management control). Individual water companies (regional or municipal) have the authority to set their own tariffs. Municipalities are responsible for financing additions to the water distribution network even where service i s provided by a regional water company. (The Ministry o f Regional Development finances water production facilities and trunk lines). Municipalities are also responsible for extending sewage collection lines, although much o f this i s financed through earmarked capital grants. Only one municipality has its own district heating company: Sofia. Elsewhere, service is provided by Government enterprises. Tariffs, although high, are not sufficient to cover operating costs (although the Government has approved a sequence o f annual ten percent increases inthe heating tariff for the next three years). Inaddition, the Government has often failed to provide sufficient money inthe budget to fully fund the heating subsidy that district heating companies are required to provide. Robert Firestine, op. cit. l2The amount transferred from the NHIF to individual hospitals may be determined by such criteria as the following: length o f stay, by diagnostic group; relative weight o f the diagnostic group, as measured against the baseline value per inpatient for the hospital accreditation group; number o f patients by disease group; and contractual coefficients above or below average caseloads (over performance or underperformance). 5 As a result, district heating companies have substantial arrears to the Government gas company, Bulgargas. 15. Urban Housekeeping and Transport. In addition to these major functions, municipalities are also responsible for a wide range o f urban housekeeping functions, including solid waste collection and disposal, street construction and maintenance, public lighting, and traffic management. All municipalities are responsible for construction and maintenance o f local roads @e., those not part o f the state road network) and urban streets. Some provide bus transport, either through municipal companies or private concessionaries. l3Sofia owns a metro and has shares in a municipal bank, a hotel, a business center, and an exhibition hall, along with numerous smaller enterpri~es.'~ Some municipalities own housing and commercial enterprises. Stara Zagora owns 1000 apartment Box 1: Measuring The Costs of Urban units that it rents out to the poor and Housekeeping disabled. Sevlievo owns a construction company, a pharmacy, and a metal The costs of providing urban housekeeping functions--and their profitability, if any--is difficult to processing company. determine. This is in part because they are often organized as municipal enterprises, in which case Regulation expenditures financed from own-source revenues are excluded from municipal budget reports. The system of 16. While municipalities are budget classification also obscures the level of nominally responsible for these expenditures in these sectors. The Ministry of Finance functions, they have little control over uses the IMF (GFS) classification system to show the how they are provided. Management functional breakdown of municipal spending, but autonomy i s severely restricted- provides only first-level detail; e.g., "housing and particularly in the social sectors which community amenities", "transport" and "general public have consumed so large a share o f services." Housing, inGFS terms, includes slum clearing, their budgets. This was most striking-- land acquisition,the constructionor purchases of housing until 2003--in the case of social and the construction and operation of water supply assistance. While municipalities were systems (but not sewerage, which appears under nominally responsible for providing "environment"). Transport includes the construction and maintenance of roads, but not subsidies to public or social assistance benefits, it was the private bus companies. General public services includes Government that determined benefit tax administration, financial management, and interest levels and eligibility criteria. payments, It is therefore only mildly illuminating that Moreover, the director o f the spending on housing and community services accounted municipal social service office was for about 16 percent of total spending in 2001, and that (and still is) directly appointed by the spending ontransport consumedabout six percent. MLSP. As the director had the final say in determining which cases qualified for assistance, the municipalities had no role in determining either the level o f benefits or number o fpeople who receivedthem. 17. While social assistance i s now (as o f 2003) a responsibility o f the Government, a similar degree o f heavy handed control prevails inother sectors. Inthe case o f education, for example, it l3Municipalbus companies can be a major financial burden. Plovdiv's municipally-ownedbus company is grossly .overstaffed.It has 900 drivers but only 150buses. 14Binder, Brian, May2001, Bulgaria Ciiy of Sofia Creditworthiness Review: Update. 6 i s the Ministry o f Education and Science (MES) that recruits, evaluates, trains, and promotes schoolmasters and teachers. Salary levels are fixed by the Ministry," which also has the final say inthe dismissal o f teachers and the closure of schools. Centrally mandated norms specify, for each level and type o f course, the minimum and maximum class size and the minimum (and maximum) number o f teaching hours per teacher. Outside o f education, the Government also controls the wage levels o f higher level administrative staff (civil servants) and approves the salary schedule for staff employed under the general labor code.l6In principle, municipalities have a greater degree o f control over health care costs. As the hospitals and clinics are organized as enterprises, local governments can reduce staff without Government approval. Changes inthe salary structure, however, must be approved by the Ministry o f Health. Revenues 18. Transfers and Shared Taxes. Municipal responsibilities are largely financed through a complex system o f subsidies and tax sharing. The system essentially aims at calculating the expenditure needs and expected revenues o f each municipality, and provides a transfer to cover any gaps. These calculations are made duringpreparation o f the annual Government budget, and consist o fthree steps. 17 19. First, revenue availability i s determined by estimating the yield o f designated shared taxes. Until 2003, municipalities were assigned shares o f two taxes: the personal income tax (PIT) and the corporate income taxes (CIT). Both taxes were administered by the Government. the National Assembly hadexclusive authority to define the bases, exemptions, and rates o fboth. The division o f the PIT varied from year to year, as determined by the annual budget act. (In 2002, municipalities were assigned 50 percent o f the PIT). The municipal share o f the corporate income tax was fixed (at ten percent o f the base). As detailed below, the municipal tax on corporate income was abolished in2003, and the municipal share o f the personal income tax was increased to 10O%.l8 20. Expenditure needs are then calculated. The methodology for calculating expenditure needs has varied over the last several years. Prior to 1993,the Ministry o f Finance calculated the expenditure needs o f each municipality on the basis o f historical data on staffing and other operating costs. Starting in 1993, the Government attempted to introduce so-called objective factors into the calculation o f needs. These were to be introduced gradually over a five year period. The new transfer distribution formula was calculated as the sum of: (i) a declining share l5Teacher salaries are basedonthree factors: (i)basic salary, whichvaries according to qualifications; (ii) o f a years service (at 0.08 percent per year o f service); and (iii) a bonus for in-service training. l6 numberofmunicipalstaffsubjecttocivilserviceregulationsappears tobesmall, however. Fortyfour of The Stara Zagora's 192 administrative staff are civil servants, with the rest employed under the labor code. l7 thatthissectiondescribesthesystemasitexistedin2002.Reformsintroducedin2003aredescribedlaterin Note this report. l8 principal, revenuesfromthetaxeswerereturnedtomunicipalities onthebasisoforigin.The `origin' ofthePIT In was defined as the taxpayer's place o f work. The origin o f the corporate income tax was defined as the location of the company . The law required that CIT revenues be credited to municipalities inproportion to the number o f each firm's employees in each municipality. This required complicated record keeping by the regional tax offices. Inpractice, CIT revenues were often credited to the municipality inwhich the headquarters o f the firm was located. As a result, there was little correlation between the origin o f the tax and location o f the taxpayers who bore its ultimate burden. 7 o f the transfer received in the previous year; plus (ii) so-called objective indicators such various as the number o f school children and the number of hospital patients in each municipality. This formula was revisedand amended annually andbecame increasingly complex. 21. In 2001, the Government abandoned this approach and reverted to a hybrid of the two previous systems. In2001 and 2002, the wage bill was based on actual wages and social security contributions o f authorized staff in each municipality. Operating costs, however, were calculated on an increasingly arbitrary basis. First, the total amount o f the budget to be allocated to. municipal operating costs was determined through annual negotiations between the Association o f Municipalities (NAMRB) and the Government. This amount was then allocated to individual municipalities on the basis o f a 15-variable formula. O f the 15 variables, the most important were: population (33.1% o f the weight); number o fpupils insecondary schools (13.6%); number o f settlements (11.4%), number o f beds in social welfare establishments (lo%), and territory (8.7%). Intotal, general factors such as population and territory accounted for 55 percent o f the weight; secondary education, 18.6 percent; health, 13.5 percent; and social welfare, 10.5 percent. 22. The third step was the calculation o f the general supplementary subsidy. This was calculated as the difference between estimated expenditure needs and estimated revenues from shared taxes and other smaller transfer programs. If estimated expenditures exceeded estimated revenues, the Government provided a general grant to cover 100% o f the difference. Ifestimated expenditures were less than estimated revenues, the surplus was allocated to the Government. In 2001, 34 municipalities had estimated surpluses and thus became net contributors, rather than recipients, ofthe general supplementarysubsidy.' 23. In addition to the general supplementary subsidy, Table 4: Sources of municipalities received sector specific earmarked transfers. The most MuniciDal Current Revenue, important o f these were matching grants for social assistance. Starting in 1999, the Government beganpaying 50% o f the cost of I I m n I income support (i.e., Guaranteed Minimum Income benefits), child allowances and benefits for the disabled. In 2002, the Government increased incontribution rate to 75%. As discussed below, this share increased to 100% in2003. 24. Local taxes consist o f a property tax, inheritance tax, gifts and donations tax, property purchasing tax, vehicle tax, and (as of January 2002) a road tax. Together, these account for only five armarked social percent o f municipal revenues. Although these are nominally local taxes, local governments neither administer them or have any control over their bases or rates. They do, nevertheless, retain the revenue collected intheirjurisdictions. 25. Municipalities also impose a variety o f fees, including fees for the use of kindergartens, hostels, welfare homes; for markets and fairs; for household waste collection and for various other municipal services. Municipalities can set the rates for fees within the limits prescribedinthe Local Taxes and Fees Act. Untilrecently, USAIDNrban Institute, September 2000, Bulgaria Comprehensive Municipal Finance and Fiscal Reform Proposal. 8 revenues from local taxes and fees were included inthe calculation o f the general supplementary subsidy. Increased yields from local taxes therefore reduced the amount o f the general supplementary subsidy by a corresponding amount. In 2001, the formula was amended to exclude 50 percent o f the yields o f local taxes and fees. Inthe 2002 budget, they were excluded entirely. 26. CapitalReceipts.Inthe absence o f significant current account savings by municipalities or their enterprises, capital works are now largely financed capital grants from the Government, and donor funds. In addition to the annual capital budgetingprocess, Bulgaria has a system o f capital grants directed specifically at municipalities. The 2003 draft budget fixes the municipal capital expenditure grant at BGN 100million and divides it into two portions. BGN 30 million i s allocated to project-based financing, focusing on ongoing priority environmental projects selected by the MEW (Ministry of Environment and Water). These are explicitly listed in the budget, along with a requirement that municipalities give these projects priority in the use o f their capital grants. The second portion, worth BGN 70 million, is allocated to municipalities according to three size-related criteria (population, territory and the number o f towns and villages) with weights 0.4, 0.3, and 0.3 respectively. Funding i s not automatic-municipalities must submit individual projects for consideration. Municipalities receive the higher o f the two grants (project-based or size-based). Excess resources are reallocated according to the size criteria among the municipalities that do not receive project-based financing. 27. The Government also directly finances capital expenditures through the Ministry o f Regional Development and acts as an intermediary for donor funds, including EU grants. In addition, local governments now have fairly unrestricted access to domestic and external credit markets. Bulgaria relies on the market to determine the level and conditions o f municipal borrowing. To date, the market has been unenthusiastic. Three municipalities have successfully floated bonds. Sofia's Eurobond has now been retired, with the assistance o f the Government. Troyan i s indefault and i s only paying principal. ISSUES UnfundedMandates,Arrears, andFiscal Autonomy 28. The most controversial issue inthe structure o f central-local relations at the beginningo f 2003 was the presence o f unfunded mandates, accumulating arrears, and persistent bailouts. Municipalities charged that the Government imposed costs without sufficient financing. The Government observed that it continued to pay o f f arrears only to have new ones emerge. 20 29. Thisproblemwas important for two reasons. First,it underminedmunicipal management. From a mayor's perspective, municipalities were locked in a fiscal straightjacket. Municipal revenues were unpredictable. Expenditures were difficult to control. Inlate 2003, the Government hadtransferred 65 million levato cover unfundedmandates andintended to cover the remainder, subject to fiscal conditions. 9 30. Second, the cycle o f arrears and bailouts was indicative o f the Government's inability to impose hard budget constraint on local governments. For all the Government's attempts to control local spending, municipalities nevertheless managed to induce the Government into providing last minute debt relief. Given the fiscal constraints imposed by the currency board Figure 2: Trends in Municipal Revenues And Expenditures system and the Government's agreements with the IMF, these are concessions that it could ill afford to make. 2,500.0 /" 31. How big was the problem? For 2,000.0 x5 all the debate over the subject, the --trevenue -I 1,500.0 nature o f deficits and their financing is -E-expenditure not very well documented. Because 1,000.0 local governments keep their accounts 500.0 on a cash basis, data from income and expenditure statements do not show 0.0 obligations that have been accrued but 1998 1999 2000 2001 2002 not paid. As a result, reported municipal revenues and expenditure move in lock step (See Figure 2). 32. Inprinciple, it shouldbepossible to measure the size ofmunicipal deficits by comparing the stock o f arrears and outstanding debt from one year and Contractual Debt to the next. All municipalities are required to report their stock of arrears and contractual debtto the Ministryof Finance, which publishes the data periodically. As shown in Table 5, the overall level o f the stock has varied over the last several years. At the end of 2000, it stood at BGN 171.2 million, or 8.6 percent o f municipal revenues. A year later, the stock had fallen to BGN 124.25 million. By July 2002, it had returned to BGN 169.0 million. According to the most recent figures (February 2003), the stock stands at BGN 113 million. Recent declines in the stock of arrears would suggest that municipalities are runningsurpluses. 33. But this is not the case. Rather than reflecting the growth or decline of deficits, the year to year changes in the stock o f debt largely reflects the impact of Government bailouts. The amount o f individual bailouts cannot be precisely determined. The budget item 'extraordinary 10 subsidies' (which includes bailouts along with other forms o f ad hoc budget support) nevertheless gives an idea o f their scale. As shown in Table 6, the volume o f extraordinary subsidies has ranged from BGN 179 million in 1998 to BGN351 million in2000. Extraordinary subsidies in 2002 totaled BGN 333 million. Comparing the flow o f extraordinary subsidies to changes inthe stock o f arrears suggests that municipal deficits in 2001 totaled BGN 156million, and rose to BGN 323 million in2002. 34. These deficits were largely financed through arrears. As show`n in table below, the largest share o f the arrears-1 8 percent--are owed to the Government-owned electricity company. Arrears to other government utilities-district heating companies and regional water companies-constitute another eleven percent. Thirteen percent are owed to privately owned fuel suppliers. Municipalities have significant arrears to medical suppliers (six percent o f the total) and civil works contractors (four percent). The category "other current" accounts for 35 percent o f the total. Ofthis, nearly halfi s classified under the functional category "housing and community amenities". This category includes water and sewerage, street lighting, street cleaning, and waste disposal, and environmental protection. Arrears in this category are owed to suppliers o fmaterials and to firms providing these services on a contract basis. 35. The structure o f the arrears has remained roughly constant over the last four years, except inthe case of social assistance. Arrears on social assistance declined sharply between 2000 and 2003, a period that corresponds to the gradual takeover o f social assistance financing by the central Government. Beginning in 2002, the Government began to divide responsibility for the arrears between itself and the municipalities on the basis o f functional categories. Responsibility for functions delegated to municipalities-such as education-were assigned to the Government. Municipalities' own responsibilities (hereafter referred to as autonomous functions)-such as housing and community amenities-were assigned to the local level. On this basis, municipalities were assigned responsibility for sixty percent o f the February 2003 stock. 36. Who was responsible for the arrears? Both the central government and the municipalities have played a role. Much o f the recent literature on Bulgarian local finance argues that the arrears are the result o f unfunded Government mandates. This statement appears in the recent World Bank public expenditure review.21 It surfaces in the IMF's recent review o f local government finance.22 The Government itself appears to concur. According to National Accounting Office estimates, about 90 percent o f municipal expenditures in 2001 were devoted to public services and functions that are mandated by the national government, and over which local governments have little control. The Government, it i s said, imposes these costs on local governments without providing the wherewithal to finance them. This forces local government to 21 World Bank, 2002, op. cit. 22 IMF, August 2002, Bulgaria: Selected Issues and Statistical Appendix. 11 rundeficits, which are financed inthe short term through arrears and over the longterm through acrimonious Government bailouts. 37. The facts are more complicated. It i s true that there i s a very high degree o f Government control over municipal expenditures. This i s particularly true o f wages--which constituted about one-third o f municipal expenditures in 2002--and social assistance costs. At the same time, municipalities have little control over revenues, particularly those delegated by the State. Shared taxes and transfers account for 80% o f current revenues, and local taxes-imposed at centrally determined rates-account for another five percent. As of 2002, the structure o f revenue assignment and expenditure controls therefore appeared to leave municipalities in a fiscal straightjacket-unable to reduce costs or increase revenues in response to Government demands or changing economic circumstances. 38. But there is less to this argument than meets the eye. As o f 2002, while the Government controlled the wage bill, it also financed it. As noted earlier, the general supplementary subsidy was calculated on the basis o f the actual wage bill in each jurisdiction. As a result, it was the Government-not the municipalities-that bore the risk o f wage increases. By the same token, the Government also bore the risk o f any shortfalls in revenues. If receipts from the PIT (or earlier, the CIT) were below projected levels, the Government was obligated to make up the difference by increasingthe general supplementary 39. Under the system that prevailed in 2002, there were only two clear cut grounds for blaming municipal arrears on the Government. The first was that the Government may have systematically underestimated non-salary c0sts-i.e. the costs o f materials, supplies, contractual services and capital works. As noted earlier, the level o f Government funding for non-salary costs was (until 2003) derived through negotiations with the ass.ociation o f municipalities (NAMRB). Funding therefore depended on macroeconomic conditions and the relative bargaining power o f the NAMRB and the Government, rather than actual costs per se. By underestimating non-salary costs, the Govemment could underestimate total municipal expenditure obligations, and therefore underestimate the size o f the general supplementary subsidy that it needed to provide in the budget. Since allocations to individual municipalities were based on the arbitrary fifteen variable formula, even if the aggregate allocation to non- salary costs were adequate, it could easily fall short in the case o f individual jurisdictions. Second, the Government contributed to municipal arrears by failing to fund its own estimates o f municipal expenditure needs on a timely basis. The annual budget law permits the Government to retain a percentage o f the general supplementary subsidy as a fiscal buffer, to be released only ifspecific national fiscal deficit targets are met. In2001 and 2002, for example, the budget act permitted the Government to retain ten percent o f the general supplementary subsidy on this basis. While the Govemment has been scrupulous in disbursing the remaining 90 percent on a regular monthly basis, it has tended to retain the buffer until the end o f the fiscal year. Shortfalls duringthe course o fthe budget execution prompt municipalities to runup arrears inthe interim. 40. But the municipalities also play their role in building up deficits. While municipalities have limited room to control wages or increase tax revenues, they are not entirely helpless. In 23 McCullough, James, Economic and Policy Background for Bulgaria's Fiscal Decentralization Program; paper presented at a Workshop on Development of Fiscal Decentralization inBulgaria, September 2002. 12 principle, municipalities can cut spending on non-salary items to fit their budget allocations. Rather than simply originating in unfundedmandates, Bulgaria's municipal deficits are also the result o f strategic behavior by local governments-a deliberate policy o f accumulating more expenditure commitments than can be financed from expected revenues, inthe hope o f eventual financial relief from the Government. 41. The Government has inadvertently contributed to this expectation intwo ways. First, it is one o f the major financiers o f arrears. As noted earlier, arrears to Government-owned public utilities constitute 28 percent o f the February 2003 stock. Arrears on loans (predominantly from the Government) constitute another nine percent. Second, a history o fpast Government bailouts encourages private firms to continue to tolerate the accumulation o f arrears on goods and services sold to municipalities, secure in the knowledge that these debts will be liquidated once the Government comes to the municipalities' relief. On at least one occasion in the past, the Government has attempted to discourage this practice by imposing conditions on its debt relief. The 1999 bailout required municipalities to cut administrative staff by ten percent by January 2000, halt unauthorized subsidies to loss-making municipal companies, and convert municipal enterprises into companies organized under the commercial code. Medium-term measures, to be completed in March 2000, included the liquidation or restructuring o f loss-making municipal companies. These measures were never enforced, however. 42. The persistence o f municipal arrears prior to the 2003 reforms i s therefore attributable to the behavior o f both the municipalities and the Government. The Government invited municipal deficits by failing to fully fund its own estimates o f municipal expenditure needs. Municipalities abused what little budget autonomy they have in making commitments they cannot liquidate. The Government thenperpetuated this behavior by providing periodic bailouts. Incentives to Overstaffing 43. A second problem in Bulgarian intergovernmental relations was the incentive it provided to inefficiency inservice delivery-and particularly to overstaffing. As noted earlier, the formula for calculating expenditure needs in 2000-2002 was based on actual wages and social security obligations. It therefore covered 100% o f the wage bill, regardless o f over or understaffing at the municipal level. And overstaffing clearly exists, most conspicuously in education. Enrollment i s falling inboth primary and secondary schools. At the primary level, this reflects a decline in the student age population. At the secondary level, it reflects both a decline in the student age population, and a decline in enrollment ratios. Between the 1990/91 school year and the 2001/2002 school year, primary school enrollment dropped by 27.4 percent. Secondary school enrollment dropped by 14.6 percent.24 This decline in school-age population should have permitted reductions in staff, freeing up resources to raise education quality. This has not occurred. Preschool i s the only level at which the decline in enrollments was matched by an equivalent decline in schools and teachers.25In primary education, the number o f teachers and schools declined, but by considerably less than the decline in enrollments. In secondary 24 IBRD, August, 2002, Bulgaria Public Expenditure Issues and Directions for Reform. Note that National Statistical Institute data show an increase in enrollment ratios at the secondary level. This i s contradicted by evidence from the Integrated Household Survey, however. 25 Pre-primary enrollments are falling not because o f a drop in the number of eligible students but because parents can no longer pay the required fees. 13 education, the number o f teachers and schools actually increased, in spite o f the sizable decline inenrollments. These changes are reflectedinstudentkeacher ratios-by far the most important determinant o f education unit costs. Costs o f rural schools are excessive due to low levels o f enrollment and highteacher pupilratios. 44. Overstaffing--and excessive scale--is also a problem inthe health sector. Compared to the EUcountries, Bulgaria shows a relatively highnumber o f hospital beds per 100,000 citizens. In the EU,the average number o fbeds for active treatment per 100,000 citizens is 410. InBulgaria, it is 637.26At the same time, hospital resources are under-utilized. The bed utilization rate in municipal hospitals i s about 55 per~ent.~'Although comparative statistics are not available for staffing levels, anecdotal evidence suggests that municipal hospitals are overstaffed. This would certainly be encouraged by the general supplementary subsidy formula that prevailed in 2000- 2002. As inthe case o f education, it covered 100 percent o f the staffing costs o f municipal health care facilities. Arbitrary Disparitiesin Per Capita Revenues 45. Disparities in revenues among municipalites were a potential issue in intergovemmental relations at least until the end o f 2002, although not a major one. 28The system for allocating revenues among jurisdicitons was fairly effective in reducing revenue disparities in revenues among municpalities. While per capita revenues from shared taxes varied widely Figure3: Distribution of Municipalities AmongRevenue among jurisdictions, this was partly Classes offset by the distribution of general 7 subsidies. As shown in Table 7, the v) 100 standard deviation in per capita shared w 5 80 taxes (in 2001) was BGN 110, or about 1.5 times the average. But the standard 0 60 z deviation in subsidies was equally wide 2 40 (BGN 104) and tended to be inversely i 20 correlated with shared tax revenues. (The 0 correlation betweenper capita shared tax e99 99- 150- 200- 250- 300- 350- 400- 450+ revenue and per capita subsidies was - 149 199 249 299 349 399 449 0.83.) As a result. the standard deviation REVENUECLASS in total revenues was only BGN 83, or ' about 33 percent o f average per capita total revenues. As shown in Figure 3, the vast majority (82 percent) o f all municipalities had per capita revenues between BGN 150 and BGN 300. (These account for 78 percent of Bulgaria's population.) Thirty eight percent (with 36 percent o f Bulgaria's population), fall within the narrower band o f BGN 200-BGN 249. There were few stragglers--only five have per capita revenues under BGN 150-and few extremely rich jurisdictions. (Seventeen have per capita revenues above BGN350). ~~ 26 MOH, Strategy for RestructuringHealthCare (Sofia, November 2002). 27 Firestein. Robert, and Borislav Tafradjiysky, April 2002, Municipalities and Hospital Capital Spending in Bulgaria; unpublishedpaperpreparedinconjunctionwith USAIDBulgariaHealthProject. 28 As discussedbelow,reforms in the general equalizationtransfer, beginningin 2003, will further reducerevenue disparities among individualjurisdictions. 14 46. Even this much variation can be problematic given the nature o f local government expenditure responsibilities. Because o f the predominant role local governments played in services with important distributional impacts, including education, health, and particularly social assistance, variations inresources might result invariations in spendinginways that have adverse distributional impacts. It has been charged, for example, that case loads for social assistance were negatively correlated with municipal revenues, such that municipalities with the largest caseloads had the fewest resources to finance them. As a result, benefits were often paid irregularly, late, or in kind. Local governments have been also likely to shortchange some programs more than others. Inparticular, they were likely to pay family benefits under the Birth Promotion Act (BPA), while the mean-tested Guaranteed Minimum Income Program (GMI) has been consistently under-funded. In recent years, the scale o f this problem has declined as the Government's role in financing social assistance has increased. As noted earlier, the Government i s fully funding the majority o f social assistance as o f 2003. Inter-jurisdictional disparities may soon re-emerge as an issue, however. In 2004, hospitals will cease to be a delegated function. Any costs not covered by the NHIF will have to be financed from municipalities' own-source revenue. T h e Decline of Infrastructure 47. Accession to the European Union (EU) will require a massive investment in environmental repair and improvement, much o f it in landfills, incinerators, water treatment plants and other facilities at the local level. As in other countries aspiring to join the EU, the Bulgarian public sector will have to contribute significantly to these investments and to meeting the 25 percent country match required to obtain EU pre-accession s~bsidies.'~Since 1989, investment spending by Bulgarian local governments has been extremely low and is insufficient to make up for a lack o f maintenance o f existing infrastructure (such as the very high levels o f leakage in the water systems) and begin to meet European standards for environmental protection. Investment requirements inthe sector are said to be large-particularly insewerage. According to a (somewhat dated) survey o f water and sewerage companies representing 70 percent o f connections, only 18 percent o f customers are connected to sewers.3oIt i s estimated that US$2 billion will berequiredto achieve adequate coverage.31 Whether the enterprises directly responsible for much of the investment can do so i s Table 7: Variationsin Per CapitaMunicipalRevenues unclear. In general, the financial BGN, 2001 performance o f municipal public utilities i s poor. Plovdiv and Stara Zagora (both served by RWCs) standarddeviation complain o f large water losses (60 nweightedaverages I 247.31 70.51 41.41 27.91 percent in Plovdiv, 67 percent`in Stara Zagora) and high tariffs (which are in part attributable to system inefficiency-i.e., large losses.) Although they have the authority to set their own tariffs, current levels are not sufficient 29 Epstein, Peter, 2000, Municipal Credit Market Development in Bulgaria, USAIDiLirban Institute. 30 World Bank, Bulgaria Water Companies Restructuring and Modernization Project, StaffAppraisal Report, 1994. 31 According to an official communication from the Ministry o f Finance, as o f January 2003 this problemhas been `entirely addressedby the Government'. 15 to cover operating costs (ifthe term is defined to include routine maintenance) let alone generate current savings for investment. THE2003 REFORM 49. The Government is now embarked upon a new round o f reform o f the system o f intergovernmental relations. In March 2002, the Council o f Ministers (COM) created a special workgroup to elaborate a fiscal decentralization concept and implementation program. This was approved inJune 2002. The Fiscal Decentralization Concept sets out a laudable series o f reform objectives. These include: (i)consistency between expenditure and revenue assignments and responsibilities; (ii) balance between local discretion and overall hard budget constraints through defining service standards; (iii) transparency and equity in central government's subnational policies; and (iv) equitable access to public resources for securing a minimum target level o f public services. Under the program for Fiscal Decentralization 2002-2005, the division o f expenditure responsibilities between the Government and the municipality is to be defined, along with a corresponding division o f revenues. The proposed reform in municipal revenues, noted earlier, i s a first output o f this process. 50. DistinguishingDelegated and Autonomous Functions. The reform has several main elements. First, it makes a legal distinction between responsibilities delegated to municipalities bythe Government, andmunicipalities' own responsibilities. 0 Education: Government will be responsible for general (primary and secondary) schools, vocational schools, and the staffing costs o f all day kindergartens. Municipalities will be responsible for half-day kindergartens and the costs o f maintaining full day kindergartenbuildings. 0 Health care: The Government will be responsible for municipal general hospitals, and specialized pulmonary, psychiatric, oncological, and venereal disease hospitals. Municipalities will be responsible for drug addiction centers, centers for psychological health, and maintenance o f daycare building^).^^ 0 Social assistance: The Government will assume complete responsibility for most forms o f social assistance, including direct income support (the guaranteed minimum income) and the operation o f orphanages and other institutions for vulnerable populations. Municipalities will remain responsible for in-home assistance for the elderly (meals-on-wheels) and one-time aid for family emergencies. 0 Roads, water supply, solid waste management: Municipalities will be solely responsible for most o f the urban housing keepingfunctions, including water supply and sewerage, public lighting, solid waste management, snow removal and street cleaning, as well as cultural activities, transport regulation and construction and maintenance o f roads. 32 As of 2002, these functions will be transferred to the municipal list. 16 51. "Government responsibility" in this case does not mean that the Government will pay these costs directly from the Treasury. Instead, it will continue to transfer funds to the municipalities (except inthe case o f social assistance), which will continue to be responsible for paying wages to staff, suppliers, etc. In theory, the distinction will affect the system o f local finance. Delegated responsibilities are to be financed from shared taxes (the PIT) and a revised general supplementary subsidy. Autonomous functions are to be financed from the local property tax, fees, and property income. Although municipalities are permitted to use local taxes and fees to supplement spending on delegated functions ifthey so desire ,they are not permitted to do the opposite. Government funding for delegated functions cannot be used to finance local responsibilities. 52. Recalculating the General supplementary subsidy. The reform also includes fundamental changes in the formula for calculating the general supplementary subsidy. First, in estimating expenditure needs, the new formula will use normative costs and standards, ,rather than the wage bill and a figure for non-salary costs negotiated with the NAMRB. Second, the calculation o f expenditure needs will cover only delegated functions. As before, the estimate o f revenues will include only shared taxes and transfers. Thus the new general supplementary subsidy will cover only the gap between the estimated cost o f delegated functions and estimated revenues from shared taxes and transfers, leaving municipalities to finance autonomous functions from own-source revenues. 53. For education, the new formula makes a separate calculation for teachers' salaries and for operating and maintenance costs. The calculation o f teachers' salary costs beginswith a set o f standards for teacher:pupil ratios. Separate standards for teacher:pupil ratios are established for five categories o f municipalities, on the basis o f average classroom size. For example, municipalities with small classes (less than 16 pupils per class) are assigned a teacher pupil ratio of .14. Municipalities with larger classroom sizes (over 22.2 pupils per class) are assigned only .0967 teachers per pupil.Based on these standards, a normative (or `desired') number o f teachers ineachmunicipality is calculated. This is thenmultipliedbythe average teachers' salary ineach municipality in 2001, adjusted for subsequent wage increases33yielding an estimate o f the wage bill for teachers in each jurisdiction. The formula used to calculate the non-salary costs of education will be based on aggregate per pupil non-salary expenditures in 2001, adjusted for inflation. This total will be distributed among individual municipalities on the basis o f enrollment, with adjustments for classroom size. 54. The new formula also changes the calculation o f health care costs. Under the previous (2000-2002) general supplementary subsidy formula, the expenditure requirements o f municipal health care workers were calculated on the basis o f actual salaries. Operating costs were separately calculated under the 15-variable formula described earlier. Ten percent o f the amount allocated under the 15-variable formula was distributed according to the number o f patients served in general municipal hospitals, skin disease centers or psychiatric centers. Another 3.5 percent was allocated on the basis o f the number o fpatients inother types o f hospitals. Underthe new general supplementary subsidy formula, health financing will be allocated solely on a per- patient basis, using a standard national unit cost figure to cover both salary and other operating 33 Although teachers' salaries are based on a standard salary schedule fixed by MES, they can vary according to individual teacher characteristics such as length o f service. 17 costs. Municipalities will receive BGN 281 per patient admitted to general hospitals. Separate per-patient figures will be used to calculate expenditures in the three types o f specialized hospitals (lung, ophthalmology, gynecology) and four types o f dispensaries (oncological, psychological, pneumonic, and venereal). 34 55. Similar unit cost figures will be used to calculate municipal expenditures in other delegated sectors. According to the 2003 Budget Act, municipalities will receive BGN 1,448 for each place ina municipal home for the elderly, BGN 1,469 for each place ina home for retarded children, and BGN3,145 for each place ina homeless shelter. Intotal, the new formula provides non-salary unit cost calculations for 36 separate municipal functions, along with 22 staffing standards to be used incalculating salary requirementsineducation. 56. Adjustments in Taxes. The structure o f shared taxes will also change. One hundred percent o f the personal income tax will now be assigned to local governments. The local corporate income tax will be abolished. This will have little impact on the net flow o f Government resources to individual municipalities, however, as the Government will continue to calculate the amount o f the general supplementary subsidy as indicated above. During budget execution, the Government will continue to bear the risk o f any shortfall between projected PIT revenues and actual collections. It will guarantee municipalities the level o f financing for delegated functions provided for in the budget, making up any shortfall in shared tax revenues through increases in the general supplementary subsidy. Municipalities will, however, be allowed to share in any overrun. Under the 2003 budget law, the municipalities, as a group, are entitled to 80 percent o f any surplus o f PIT revenues over the amount projected in the budget. (This calculation is based on aggregate national collections, rather than performance in individual municipalities). The amount will be allocated among individual municipalities, on the basis o f their respective contribution to the aggregate surplus. 57. To finance autonomous functions, the new system will continue to assign property taxes, fees, and other non-tax revenues to the municipalities. (Municipal councils may choose whether or not to impose these taxes and fees). The rates o fproperty taxes will continue to be fixed by the Government. Because property taxes and fees are no longer included in the calculation of the general supplementary revenues from these sources will now contribute to variations intotal revenuesper capita. To offset this source o fvariation, the new law establishes a so-called general equalizing subsidy. This requires the Government to transfer sufficient funds to jurisdictions with below-average per capita revenues to bring them up to the national average. The amount o f the subsidy i s calculated as the difference between each municipality's per capita local tax revenues and the average for the country as a whole, multiplied by the municipal population. Duringlast-minute negotiations, it was agreed that Sofia would be excluded from the calculation o f the national average, and that revenues from fees would not be equalized. This substantially reduces the amount o fbudget support due from the Government. 34 Beginning in2004, hospital expenditures will no longer enter into the calculation o f the general subsidy as this function will be shifted to the municipal list. 35 Prior to 2001, 100% o f revenues from local taxes and fees were included in the calculation o f the general supplementary subsidy. The proportion declined to 50 percent in2001 and zero in2002. 18 THEUNFINISHED AGENDA 58. The reforms represent a major advance in several respects. First, the new formula for calculating the general supplementary subsidy will bemore accurate (at least with respect to non- salary costs) and less arbitrary than the one it replaces. It employs an empirical basis for the calculation o f the costs o f each delegated function, and a mechanical and transparent method for distributing funding among jurisdictions. As such, it increases clarity and transparency in the calculation o f the subsidy. Second, by eliminating the automatic reimbursement o f salaries, it reduces incentives for over staffing. And third, by shifting responsibility for social assistance onto the Government, it ensure that fundingwill no longer be subject to the vagaries o f local tax bases. 59. But several problems remain. To begin with, the reform does not eliminate the fundamental grounds for the dispute over unfunded mandates. Although in principle the Government is to assume responsibility for financing all delegated functions, in fact, Government support in 2003 will continue to take the form it has in the past. The Government will make its own estimate o f local spendingneeds (now based only on delegated functions) and expected revenues from the PIT, and include financing for any resulting gap in the annual budget. But, as in the past, nothing will prevent the Government from making what the municipalities consider to be underestimates o f costs. In fact, the elimination o f actual salary costs from the calculation o f expenditure needs is likely to increase the grounds for dispute. Municipalities may now argue that the Government is not only underfunding non-salary costs, but is underfundingsalaries as well-at least in2003. 60. This problem i s likely to be particularly acute in the case o f municipal hospitals. As noted earlier, the 2003 general supplementary subsidy formula calculates hospital costs on a standard per-patient basis. In2004, the Government intends to eliminate hospital care costs from the general subsidy calculation entirely. Municipal hospitals are legally constituted as commercial entities. Inprinciple, municipal governments have the authority to dismiss staff and close facilities they can no longer afford. But mayors have been reluctant to exercise this power. Even the Government has had little success in doing so. It was expected that an HIF accreditation process would result in widespread hospital closings, but this proved not to be the case. The 2002 Strategy for Restructuring Hospital Care reports that between 2001 and 2002, the number o f hospital beds (at all levels) has been reduced by 12.65 percent and the number of hospital staff by only six percent. 61. Over the long term, the Government intends to hnd municipal hospitals on the basis of clinical paths. As noted earlier, these will specify fixed reimbursement amounts for specific treatment regimes. When fully introduced, this will clearly improve the targeting o f health care funding. It will also discourage overstaffing, as hospitals will be forced to cut costs in order to meet NHIFreimbursement ceilings. But full coverage by clinical paths is still a long way off. 62. In the mean time, the transition has been badly handled. As new clinical paths are introduced, funding through the general supplementary subsidy has been reduced proportionately. The per patient standards for 2003, for example, were based on the assumption 19 that there would be a major expansion in the number o f clinical paths this year.36 Hospital funding through the general supplementary subsidy was been cut accordingly. It might be expected that these cuts would have been focused on hospitals where the number o f clinical paths was expected to increase. Increased funding from the HIF would therefore compensate for reductions in funding from the general supplementary subsidy. But instead the cut has been imposed uniformly on all hospitals. As a result, municipalities whose hospitals do not yet provided clinical path-reimbursable treatments will witness a decline in revenues. With the complete elimination o f funding for municipal hospitals from the general subsidy, a new round of disputes over the adequacy o f Government funding for health care i s likely to emerge. I Prior Table 8: Summary of Recent Reforms to 2001 I 2 0 0 1 I2002 I2003 Shared taxes Local share o f P I T 50% 50% 1OO%* Local share o f CIT 10% 10% 0% Risk o f shortfallsisurpluses Government Government Government** ~ during budget execution General transfer: calculation Historical share, 100%o f wage billplus 15 Standardized service o f expenditure need adjustedby variable formula costs, plus general indicator o f need equalization subsidy Central share o f social 50% 50% 75% 100% assistance % local taxes and fees 0% 50% 100% 100% exempt from revenue gap calculation * If budgeted PIT revenues exceed budgeted expenditure needs, the Government retains 100%o f the difference. ** Ifactual collections exceed budgeted amounts, municipalities retain 20% o f the surplus. 63. The mismatch in the case o f education will be less acute. Because the new formula for calculating education costs explicitly reflects differences in average classroom sizes, it will not have much impact on the level o f salary funding in individual jurisdictions. In fact, the formula has been calibrated so as to only affect municipalities with average classroom sizes below sixteen or above 22.2. As shown in Table 8, a municipality with an average class size o f 10 would receive about 40% less, per class, than one with an average class size o f sixteen. At the opposite end o f the scale, a municipality with an average class size o f 30 would receive 33% more, per class, than one with an average o f sixteen. But within the range o f 16-22 students, the level o f salary funding per class scarcely varies. A municipality with an average class size o f 22 would receive only five percent more than one with an average o f 16. (Curiously, the per classroom allocation for non-salary costs will increase steeply with classroom size under the new formula. A classroom o f 22 students will receive about 45% more, per classroom, than a classroom o f sixteen. But non-salary costs are only a small part o f total operating costs. Taking salary and non salary costs together, a municipality with an average classroom size o f sixteen 36 This has not, infact materialized, resulting in an unintended drop inoverall funding for municipal hospitals. In addition, the Government neglected to include 13 specialized municipal hospitals and several municipal dispensaries inthe calculation o f the general supplementary subsidy. It has now agreed to directly finance these facilities, and to provide additional budget support to facilities affected by the delay in clinical paths. 20 would still receive only about five percent more, per classroom, than a municipality with an average classroom size 0 f 2 2 ) . ~ ~ Table 9: Impactof New EducationFormula 64. While the formula I Funding per Student and per Class, BGN Non-salary operating I for calculating teachers' salaries will prevent abrupt cuts in revenues for most municipalities, it will also decrease incentives to reduce staff in underenrolled schools. Under the new formula, only municipalities with average classroom sizes o f under 16 will have a financial incentive to reduce staffing. And even this incentive to reduce staff may 101 100.91 40.21 141.11 0.09671 50,7351 4,9061 5,0471 151,4131 be thwarted by the Ministry o f Education. As noted earlier, municipalities cannot dismiss teachers or close schools without the concurrence o f the MES. Nor can they reduce wages or teaching hours. If the Ministry were eager to close or consolidate smaller schools, this would not be a problem. But interviews with senior staff at the MES suggest that the Ministry i s not eager. Nor i s it inclined to relinquish its authority in this area. As a result, municipalities with fewer than 16 children will have difficulty cutting their wage bills to respondto declining support through the general supplementary subsidy. 65. Third, nothing in the reform will prevent the Government from underfunding delegated functions. Inprinciple, the Government has committed itself to fully fund delegated functions, on the basis o f the standard cost factors described earlier. But already in 2003, the commitment was honored in the breach. Although the 2003 budget provided full financing for salaries and social security contributions, it only allocated half the amount required for maintenance, health care, medical aid and subsidies for non-profit organizations. According to the budget law, the shortfall was to be paid in two installments but only if doing so would not jeopardize the Government's deficit target. In the event, the first installment was paid on August 15. The second i s to be paid by November 15. For 2004, the Government intends to fully fund the costs of delegated functions. But this i s a discretionary choice o f the Government. It could be violated in subsequent years. The Government, moreover, has continued the practice o f retaining a percent o f the general supplementary subsidy as a buffer against unexpected macroeconomic events. As in previous years, the Government will release the buffer only after it i s clear that Government deficit targets will be met. 66. Finally, the Government remains vulnerable to the charge that it is underfunding municipal autonomous functions. Although the 2003 reform allows municipalities a variety o f 37The municipal standard for each of the 263 municipalities is calculated according to the formula: S, = 100.92 + (U, / 21.09 ) x 28.24 + K, x 3180, where S, is the standard in BGN applied to the municipality N; Un is average number o f students in a class in that municipality; 21.09 i s the country average; Kn i s the number o f Category IV schools inthe municipality. 21 sources o f funding for their autonomous functions, sources outside the Government claim that these will not be sufficient. Figures from the NAMRB, for example, suggest that revenues from local taxes and fees were sufficient to finance only 55%-60% o f spending on autonomous functions in 2001 and 2002, and would be sufficient to cover only 65% o f spending on autonomous functions in 2003. (Note that figures from the Department o f Local Government Finance do not support this allegation.) ImmediateReforms 67. This suggests four important areas for additional immediate reform. First, the Government should commit itself to meeting its own budget obligations to local governments. It should fully fund delegated expenditures on the basis o f standardized costs and should cease the practice o f retaining the buffer until the end o f each budget year. The Government should also immediately begin regularly updating the factors used to calculate the general supplementary subsidy, so as to provide adequate funding for delegated functions in years to come. This will help ensure that 100 percent o f the funds necessary to cover delegated functions are actually allocated. 68. Second, the Government should remove the regulatory and institutional constraints that prevent municipalities from responding to the efficiency incentives contained in the new formula. In the case o f education, the support o f the Ministry o f Education will be required if incentives for closing or consolidating underenrolled schools are to be successful. For the 2002/03 school year the Government developed a redeployment plan for teachers. This plan i s intended to reduce overcapacity in the education sector through attrition, rationalization o f teaching staff in urban areas, and consolidation o f schools.38 But such efforts have not been entirely successful inthe past. 39 Moreover, it is unlikely that a strategy that focuses on attrition and redeployment in urban areas will have a sufficient impact in rural municipalities, where the problem o f under enrollment i s most acute. The Government could also encourage school consolidation by enforcing existing regulations on minimum class sizes. Norms on minimum class size are set by the MES. Inprinciple, they are enforced by the Ministry o f Finance, which reviews each municipality's annual education budget proposal for conformity with the But the recent PEJR found that the national average studentkeacher ratios for each level of education are below the minimumpermissible class sizes. This implies that many exceptions are granted to allow class sizes below the norm. 69. Inprinciple, municipalities should be able to adjust to the proposed changes in health care financing on their own. As noted earlier, municipalities have the authority to dismiss hospital staff and close redundant hospitals. But they have been reluctant to do so. The Ministry o f Health should relieve the municipalities o f some o f the onus o f hospital closings by pursuing its Strategy for Restructuring Hospital Care more aggressively, and perhaps providing funding 38 PEIR, op.cit. 39 Between 2001 and 2002, the Government claims to have reduced the number o f teaching staff by 11,000. A detailed examination o f the evidence suggests that the figure i s closer to 2,500, most o f whom were either near retirement age or lacked minimum teaching qualifications. The discrepancy is partly explained by the Government's decision to add a twelfth year o f compulsory education in 2002. In many cases, teachers who were dismissed from lower grades were re-hired as twelfth grade teachers. 40 World Bank, 2002, op. cit. 22 for severance payments. At the same time, the Government will have to quickly expand the coverage o f NHIF-reimbursed services. Otherwise, the planned elimination o f health care financing from the calculation o f the general subsidy will merely result in new arrears and demands for central government fiscal relief. In the short term, the Government may, in fact, have to reinstate some form o f general budgetary support. 70. Third, the Government should give municipalities greater control over property taxes. At present, municipalities rely on strategic deficits to provide budget flexibility. The Government would be better o f f ifmunicipalities could instead rely on their own taxpayers. As a first step, the Government should expand the base. Second, the Government should expand the role o f municipalities in administering the tax. Only two municipalities are now collecting property taxes. This pilot effort should be expanded. Finally, municipalities should have the authority to increase the rate o f the tax. As noted earlier, the rate o f the property tax i s now fixed by the national government. (The rate is derisory: 0.15 percent o f taxable value.) Municipalities should be allowed to fix a rate within an overall range set by national legislation. (It is recognized that this will require an amendmentto the Constitution.) 71. The Government's decision to create a general equalization subsidy would complicate the last o f these reforms. As noted earlier, the amount o f the general equalization subsidy i s calculated as the difference between each municipality's per capita local tax revenues and the average for the country as a whole. Under these circumstances, a municipality that controls its own tax rate would have an incentive to set its rate at zero. This would minimize its own tax burdenand maximizes its subsidy. But this incentive canbe eliminated though a minor change in the subsidy formula. Rather than calculating the subsidy on the basis o f actual revenues (Le., the tax rate applied to the tax base), it could be calculated by applying an average or normative tax rate to the base.41 72. Finally, the Government should harden the budget constraint confronting local governments in order to rein in their propensity to run up arrears. At present, there i s some deliberate softness in the budget constraint. Under the current budget law, municipalities are permittedto budget for a ten percent deficit. Municipalities have often included such a deficit in their budgets without any realistic expectation o f contracting a loan to cover it. This loophole would be reduced under an amendment to the Municipal Budget Act now before Parliament, which would prohibit municipalities from budgeting for deficits except to finance capital investments. Since all spending must be authorized by the budget, deficit spending on current account would, inprinciple, be p r ~ h i b i t e d . ~ ~ 73. Balanced budget requirements are used in many countries, and not always successfully. One common way to evade them is to over-estimate revenues. This allows a correspondingover- authorization o f expenditures. Inprinciple, this would be difficult in the Bulgarian context. The Government's annual budget law specifies the amount o f revenue each municipality i s to receive in general supplementary subsidies. In effect, it also predetermines the revenues from shared 41 Note that under such a system, the Government would have to retain control over property valuation or ensure that uniform valuation standards are employed throughout the country. Otherwise municipalities would have an incentive to deliberately undervalue their tax bases. 42 Note that municipalities would still have the legal authority to runcash flow deficits during budget execution. Only end-of-year deficits would be illegal. 23 taxes. (As noted earlier, any shortfall between budgeted tax revenue and actual receipts i s covered by an increase inthe general supplementary subsidy). And the 2003 budget law specifies that even the budget projection for local taxes must be agreed to by the General Revenue Office.43As a result, the level o f current spending a municipality can authorize in its budget i s largely determined by the revenueenvelope dictated bythe Government. 74. But enforcement o f the balanced budget laws is likely to remain a problem. Compliance with the existing budget law is monitored through a system o f monthly and quarterly reports and annual audits. These are provided to the Department o f Local Government Finance. But the Department has no enforcement powers. It can only bring violations to the attention o f the Controller and the State Audit Office. Inprinciple, violations recognized by these organizations can result in jail sentences. But according to the NAMRB, this has never occurred. Instead, mayors are, at most, temporarily removed from office or subject to fines. To date, this has evidently been insufficient to restraintheir propensity to rundeficits. 75. Instead, the key to reducing local government current deficits i s to cut o f ftheir sources o f financing. The Government itself i s a major financier o f municipal deficits. As noted above, roughly thirty percent o f the arrears (as o f February 2003) were owed to Government-owned utilities. Inprinciple, the Government could cut o f f service to municipalities that are delinquent on their accounts. The Government could also discourage private suppliers and contractors from extending credit to local governments. Private firms are likely to extend credit only as long as they have a reasonable expectation o f being paid. In this respect, they have not been disappointed. But the Government can puncture this expectation by refusing to provide debt relief. In the absence o f Government assistance, municipalities will be unable to liquidate their arrears to private firms. Both measures will require sustained political commitment on the part of the Government. Despite pressures from unpaid teachers and angry suppliers, the Government will have to scrupulously avoid providing ad hoc financial relief to municipalities that are delinquent on their accounts.44 76. The Government has made a good start in this direction during 2003. With respect to the existing stock o f arrears, it agreed to assume responsibility for arrears only on delegated functions, requiring the municipalities to retain responsibility for the remainder. In keeping the proportion o f relief at less than 100percent, this will force municipalities to either raise revenues and cut expenditures on their own or--more likely--to default on arrears to suppliers and contractors. This, in turn, will discourage suppliers and contractors from extending credit in the future, cutting off a major source o f deficit financing at its origin. 43 Section 30 (2) o f the Transitional and Final Arrangements to the 2003 budget stipulates that "municipal budgets shall be prepared on the basis o f the budget projections for the taxes remised (i.e., transferred from the central government to local governments) in accordance with Article 8 paragraph 1 o f the personal income tax code and the projections agreed with the General Tax Directorate pertaining to local taxes, receipts from the general subsidy, the adjusting subsidy (i.e., the municipal safety net), the subsidy for targeted for capital outlays." 44 One way to make the process less painful (and therefore more likely to occur) would be to establish a municipal bankruptcy procedure which would lay out the rules for allocating losses from unpayable debts among creditors and taxpayers. 24 Longer-TermReforms 77. Evenwith these reforms inplace, the root cause o f the intergovernmental fiscal relations will remain. The Government will continue to dictate the level o f revenues available to local governments (although municipalities will have some authority at the margin to increase property taxes and fees) while expectingmunicipalities to deliver a broad range o f functions over which they have limited management control. 78. Over the medium term, the Government should therefore consider more fundamental changes in the structure o f intergovernmental relations. There are several possible approaches. One would be to hrther centralize the financing o f certain delegated functions. This has already occurred in social assistance, where the Government has now assumed full financial responsibility for the GMI and other direct transfers to households. In principle, this approach could be extended to the financing o f teachers' salaries. Under such an approach, the Government would directly finance the wage and benefits o f authorized teacher positions, rather than incorporating salary funding in the general supplementary subsidy. This i s the practice, for example, in the Czech Republic. There, although primary education is nominally a local responsibility, teachers are central government employees.45 Decisions about number o f positions, as well as wages are made directly by the Government. Table 10: EducationManagementOptic 79. Alternatively, ~~ Czech the Government could Bulgaria Rep. Lithuania Sweden Appoints school directors Govt Govt Local Local relax its controls over Selects individual teachers Govt Govt Local Local the management o f Authorizes changes in delegated functions, number of teaching positions Govt Govt Local* Local allowing local Sets teachers' salaries Govt Govt Govt Local** governments greater Decides opening, closing of control over the schools Govt Govt Local* Local determinants o f costs. Direct General payments Subsidy Local Municipalities could be suppleme to earmarked personal permitted to cut excess Financing for teachers ntary individual for income teaching positions, for teachers education tax*** example. This i s *Govt must approve staff reassignment plan. **Through negotiationsbetween local government associationand public employees union. already the practice in ***Subject to equalization. some other European countries. As shown in Table 10, local governments in Lithuania are permitted to determine their own staffing levels (although the Government must approve staff redeployment plans). They are encouraged to avoid overstaffing by a financing system, which allocates funding among municipalities on the basis o f enrollment. (Wage levels, however, are determined by the national government.) Sweden goes a step further. Swedish local governments have the authority to set their own staffing levels without Government approval. As salaries are financed from local personal income taxes, Swedish local governments are under no Government-imposed financial pressure to reduce staff (or increase it). In principle, local governments can also set teachers salaries 45 Oliveira, Joao do Carmo and Jorge Martinez Vazquez, 2001, Czech Republic: Intergovernmental Fiscal Relations inthe Transition, WorldBank Technical Paper No. 517. 25 (although in practice, salaries are normally negotiated on a nationwide basis through collective bargaining, with the Swedish Association o f Local Governments and the Federation o f Countv Councils on one side and the unions representing local government employees on the other).46 80. Over the long run, the Government should also consider loosening its controls over municipal revenues. Local governments should eventually acquire the power to decide for themselves what an adequate level o f financing is, based on their constituents willingness to pay. Granting municipalities the power to set property tax rates is an important first step. But it will not be sufficient to resolve disputes over the adequacy o f financing, particularly for delegated functions. Even Western European countries, with a long tradition o f property taxation, derive relatively little revenue from it. (As shown inTable 11,property taxes generally account for less than three percent o f total tax receipts inmost o f the countries o f the continent). 46 Note that the MES is already experimenting with "delegated budgets" which provide school directors with some degree o f fiscal autonomy within individual schools. Whether this should include the authority to determine staffing levels and salaries, and whether this authority should be assigned to mayors rather than schools directors are issues that lie beyond the scope o f this report. 26 81. One candidate for liberalization would be the personal income tax. It has a number o f advantages, not the least o f which i s the fact that it is already assigned to local government. Liberalization would merely require that local governments be allowed to adjust the rate o f the tax; specifically the rate on that proportion o f the tax retained in their jurisdictions. This is already the practice in several Scandinavian countries. In Finland, for example, local governments are allowed to impose a local income tax as well as a property tax.47 Together these comprise half o f municipal revenues. Similarly, in Denmark, local governments are allowed to set the rate o f the municipal income tax. Rates currently range from 13 percent to 22 percent. In principal, Sweden also permits local governments to determine the rate of the income tax, although this prerogative has been often overridden by central government manipulation o f the tax base and temporary freezes on rates, and i s subject to equalization. 82. In Bulgaria, there will continue to be an important role for implications, such as education and health . But the existing extent of Government in financing o f functions with important distributional revenue control contributes to the intergovernmental fiscal conflict. Greater local control over revenues, along with greater local control over expenditures, would help defuse it.48Financing Capital Investment 83. As noted earlier, Bulgarian infrastructure is suffering from over a decade o f deferred maintenance. Accession to the EU will require a massive investment inlandfills, incinerators, water treatment plants and other facilities at the local level. Many such investments are said to Ukraine have attractive economic rates o f return. Financing, however, is a constraint. Inthe absence o f current account savings, municipalities and their enterprises largely rely on grants and donor financing to finance investment. These sources are inherently limited. The Government cannot afford to increase the volume o f grants that it finances from its own taxes and borrowing, due to its own fiscal constraints. And even donor fundingrequires counterpart contributions. 84. The Government can pursue two strategies. First, it can attract additional resources, provided they do not increase Bulgaria's overall debt burden. Second, it can improve the allocation o f existing resources, so that the limited funds that are available are linked to the projects with the highestrates o freturn. 85. Private concessions. In principle, private concessions would be an attractive way of attracting new investment. Direct private investment would not increase the country's debt 47 McCullough, James, 2003, Mid-course Review of Fiscal Decentralization :the Unfinished Agenda; mimeo. 48 The Government's decision to allow municipalities to administer local taxes i s an important step inthis direction. 27 burden.Andprivate investors, with their own money at stake, are likely to seek out projects with attractive rates o f return. The Government already has a strategy o f encouraging private involvement in infrastructure sectors that have strong public sector content. Foreign participation already occurs in electricity, railways, air transport, and telecommunications. Investment in airports, seaports and energy facilities have been taken out o f the public investment program in anticipation of being executed by the private sector. Around 40 percent o f infrastructure projects involving foreign participation are self financing through concession or BOT-type arrangements.49 86. The prospects for direct private investment in municipal infrastructure is less promising. The Government has taken steps to encourage private investment in the water sector. Under an amendment to the Water Law currently in Parliament, the regional water companies are to be stripped o f their assets and converted into management companies. Production and inter- municipal transmission assets would be transferred to the Government. Distribution systems would be transferred to the respective municipalities. In theory, municipalities will have the authority to replace their current concessions with the Government-owned RWCs with other, privately owned operators. (Sofia already has a private concessionaire, and concessions are being prepared for Varna and Shumen.) The poor financial condition o f existing water companies, combined with an uncertainregulatory environment, discourage private investors. 87. Regulatory reform could improve the outlook. The Government is now considering legislation that would establish independent regulatory authorities to set tariff guidelines and monitor quality and investment. Under the Government's proposal, investment costs would be included in the calculation o f the tariff, permitting investors to recover their costs directly from consumers. Some mayors, however, insist on retaining control over tariffs, investment decisions, and the authority to cut service to hospitals and schools. As long as they persist in these demands, even large cities will have difficulty findingprivate investors. 88. EU Grants. Bulgaria is eligible for three EU pre-accession grants: PHARE (encompassing a range o f institutional, legislative, and infrastructure measures aimed at supporting the transition to a market economy), ISPA (environment and transport infrastructure), and SEPARD (agriculture and rural development). Although PHARE i s now funding some capital works, most funding for municipal investmenti s from ISPA. There are several limitations on ISPA funding. First, the supply o f ISPA funding for Bulgaria i s fixed. ISPA funding i s allocated among accession countries on the basis o f population, per capita GDP and land surface, and cannot be increased on demand.50 Second, ISPA funds are limited to specific sectors- principally sewerage, solid waste management, and international transport. Over the last four years (2000-2003), ISPA has disbursed a total o f 315.4 million to Bulgaria. Of this amount, only a third was allocated to municipal infrastructure (25 percent to wastewater collection and treatment and eight percent to landfills). Forty percent was allocated to railroads and airports (mostly the former) and 27 percent to motorways. Third, ISPA requires counterpart funding. The recipient government must provide at least 25 percent counterpart funding in order to receive ISPA grants. While ISPA can continue to be instrumental in financing municipal water, sewer, 49 Dixon and Ilieva, op. cit. 50 European CommissionEnlargement Directorate General February 2002, TheEnlargement Process and the Three Pre-accession Instruments: PHARE, ISPA Sapard. 28 and solid waste management projects, it cannot respond to investment demand in local roads, schools, or health care facilities. 89. Government Current Savings and Borrowing. Government grants and loans, financed from the Government's own current savings or borrowing, are a third potential source o f financing. This source could potentially provide the counterpart funding for ISPA investment, or could finance capital works not eligible for ISPA funding. The Government's ability to generate current savings to fund such programs, however, is limited by its own spending commitments. And its ability to borrow is limitedbymacroeconomic considerations. EUaccession requires that debt remain below 60 percent o f GDP. Bulgaria's existing debt, although falling in relation to GDP, is not far below the EUguideline, due to highlevels ofborrowinginthe mid-1980~.~' 90. Improving the allocation of existingfunding. Given these constraints, there is a strong argument to be made for improving the allocation o f existing funding, rather than relying solely on increasing its supply. In theory, Bulgaria already has an elaborate system o f capital investment planning. In fact, it has three o f them: the national economic development plan, the public investment plan and the national regional economic development plan. The Economic Development Plan (the current one covers 2000-2006) was prepared to meet EU requirements for the disbursement o f pre-accession funds. It i s intended merely to fix a macro envelope for investment. Investment projects are incorporated in the plan up to the macro ceiling without formal investment appraisal. 91. The Public Investment Plan (PIP) was prepared by the Ministry o f Finance in 1998 and was intended to cover the period 1998 to 2001. The PIP includes the investment proposals o f Government ministries, including those financed from extra-budgetary funds, as well as some larger municipal projects which draw on Government financing (such as Sofia metro) and state owned enterprises. The selection o f projects to be included in the PIP was based on a review o f the investment intentions of ministries and SOEs. As the proposals far exceeded available funding, the Council o f Ministers created an Investment and Concessions Department to select projects for funding. According to a recent IMF report52 the process for screening and prioritization was largely of a political nature. There was no systematic quantification o fbenefits or cost-benefit analysis o f the proposals. As o f 2001, the PIP had been lightly updated once and was due for another revision. 92. The National Regional Development Plan is a bottom-up investment plan, based on six regional development plans. These are reportedly drawn from district and municipal investment strategies and are updated annually.53 The process begins at the municipal level. Projects proposed by each municipally are then screened and combined into regional seven-year development plans by each o f the 28 districts (oblasts) The NRDP i s intended to incorporate: (i) subsidies from the Government budget; (ii) municipal budgets; (iii)extra budgetary funds, including the environment fund and national road network fund; (iv) own-source revenues o f 5' According to the Draft DecisionMemorandumto the National Assembly Approving the Report for the Execution ofthe State Budgetfor 2002, discussedat the CouncilofMinisters on July 3, 2003, Bulgaria's debt was equal to 56% o f GDP on December 31, 2002. (Foreigndebt was equalto 49.5% of GDP.) The ceilingfor EU accessionis 60%. 52 Tandberg, E.; February2000; Bulgaria Budget Reform: Issues Related to the Public Investment Program. 53 Ibid. 29 public enterprises; (v) extemal grants (including EU pre-accession funds); and (vi) state guaranteed loans and non-guaranteed bank loans, including those from the EIB and the EBRD. NRDP project selection is not subject to budget ceiling, although projects with secured financing are grouped separately from those without it.54 93. None o f these appears to have a direct influence on actual funding decisions, however. This is instead accomplished through the annual budget process. Inprinciple, all capital funding proposals are subject to review by the MOF's Project Investment Department (PID). While the PID is able to analyze the financial aspects o f these projects, it lacks the capacity to review their technical and economic aspects. (In mid-2001, it had only 15 staff). The technical aspects o f large projects are instead assessed by committees o f the Ministryo f Regional Development and Public Works (MRDPW).55Projects financed through Government loans and guarantees are reportedly subject to additional scrutiny. Under recently adopted regulations, such projects, once approved by the Ministry o f Finance, are submitted for approval to the Council o f Structural Policies (CSP) before being submitted to the Council o f Ministers. The CSP is headed by the DeputyPrime Minister and is supported by a Secretariat whose functions are performed by the EIRIFIDirectorate. But it is the Council of Ministers (COM) which makes the ultimate decision on which projects to finance. This i s ajealously guarded prerogative. 94. The result o f this process is a capital investment program that i s heavily influenced by inertia. Projects already under way receive priority. Projects for which final design i s not yet complete are normally rejected. It i s also influenced by the availability o f financing. Projects with identified sources o f fundingreceive priority over those that do not. And it is influenced by politics. Inthe absence o f economic analysis, political considerations are said to play a decisive role indeterminingthe allocation o f capital funding. 95. A recent review o fthe Government's capital investment budgetingprocess makes several recommendations for reform. First, it recommends that the Government establish investment appraisal guidelines which would have to be met before a project could be considered for funding. It argues for cost-benefit analyses of individual projects (while conceding that these are more useful in posing difficult questions than providing definitive rankings). It suggests improvements in the way projects in the PIP are linked to the annual budgeting process. And it recommends that the MOF's PIP be merged with the Ministry o f Public Works' National Regional Development Plan to form a single, comprehensive, regularly-updated investment planningdata base. These recommendations bear consideration. 96. Direct Borrowingfrom the Private Capital Market. In principle, direct borrowing from the private capital market would be another means o f financing municipal capital investment. It has some advantages. It would relieve the Government o f the burden o f financing municipal infrastructure through grants. And it would permit municipalities to bypass the complex and politicized process o f capital budgeting at the Government level. Municipalities instead would have a direct relationship with a lender. Intheory, this could lead to a more efficient allocation o f 54 Ibid. 55 Until recently, ISPA projects were subject to separate evaluations by the Ministry o f Regional Development, the MOF, and the EU Commission itself. The Ministry of Finance has since taken on the MRDPW's role, while the EUhas attemptedto decentralize project appraisal to its local offices. 30 investment resources. Funds would be allocated on the basis o f a municipality's willingness to borrow and a private investor's willingnessto lend. 97. These advantages are not likely to be achievable for many years, however. There are several important obstacles to development o f a private capital market for municipal infrastructure. First, most of the borrowers are not creditworthy. With their extremely thin operating surpluses and their lack o f significant autonomy over revenues and expenditures, few municipalities can be considered capable o f taking on long-term debt service obligations. Without the ability to increase their own revenues or cut major items o f expenditure, municipalities have no means to adjust to changing economic circumstances other than to default. Their track record on the payment o f arrears bears this out. Municipalities also present unusual political risks. A recent documented lender concerns about the political risks o f longer-term lending to municipalities. They were leery o f making loans that extend beyond the tenure o f the existing mayor and council, fearing that winning candidates would renege on the obligations incurredby their predecessors. 98. Third, the supply o f long-term savings is limited. While domestic banks are said to have plenty o f liquidity, most o f their liabilities are short term. Infrastructure lending requires long maturities. Engaging in infrastructure finance would expose these banks to the risks inherent in term transformation. Long-term capital i s o f course available in international markets. But it i s not clear how enthusiastic international lenders would be about lending to Bulgarian municipalities without a Government guarantee. Municipal borrowing on foreign markets presents a particular risk to the Government, even without an explicit guarantee. Intemational capital markets are not adept at distinguishing betweenthe default o f a municipal borrower and a default by its national government. Default by a Bulgarian municipality on a Eurobond, for example, could harmthe reputation o f the Government inintemational credit markets, raising the risk premium on its external debt. Some municipalities may use this to their advantage, "blackmailing" the Government into providing debt relief as the price o f maintaining its reputation ininternational markets. The Government should not give them this opportunity. 99. Finally, municipal borrowing would impede the Govemment's efforts to comply with EU ceilings on public sector debt. The ceilings imposed by the Maastricht Agreement apply to all public sector debt, not merely that o f central Governments. Any growth in municipal debt would make the Government's targets more difficult to achieve. 100. There are steps the Government can take to facilitate local access to credit over the long term. It could establish disclosure requirements specific to municipal needs that give private lenders confidence that lending to municipalities i s a manageable risk and that they can obtain the information needed for sound underwriting of municipal debt. It could allow municipal governments, as legal entities, to perfect pledges o f own source future revenues, and thus provide the legal basis for revenue bonds and Government aid intercepts-and, concurrently to move away from reliance on pledges o fphysical collateral to secure their borrowings. 57 56 Epstein, Peter, op. cit. 57 At present, Bulgarian banks typically require 200 percent collateral, either in cash or marketable municipal properties, such as pharmacies, bakeries, etc. 31 101. But in the short term there is a strong argument for toughening controls on municipal debt. Bulgaria now relies largely on market forces, rather thenGovernment regulation, to control the level o f municipal b~rrowing.~'Under the Municipal Budgets Act, a resolution o f the municipal council i s sufficient to permit a municipality to perform 'any transaction permittedby law with banks and other financial institutions'. Decree 16 regulating the execution o f the state budget for 2003, merelyrequires municipalites that have contracted debt to provide copies o f the relevant documentation to the Ministry o f Finance. There are some regulations on borrowing procedures. Municipal bond issues are regulated by the general legal procedures for the issue o f securities provided inthe Public Offering o f Securities Act. But these are largely concerned with disclosure. Some Government restrictions on collateral and foreign borrowing also exist. Under the Budgets Act, municipal bank loans must be secured by a mortgage and/or pledge o f municipal property, and cannot be settled using Government budget resources. A loan or a bond that creates (or may create) a financial obligation o f the Government towards foreign creditors must be approved by the Council o f Ministers and the National Assembly).59 But unlike many countries, Bulgaria does not impose quantitative restrictions on municipal debt. There are no ' ceilings on the total stock o f debt, the level o f new borrowing, or on debt service. 102. In principle, GovernmGnt regulation should not be necessary.60 If a loan is a purely commercial transaction between a willing lender and a willing municipality, both parties are presumably aware o f the risks and are willing to take them. But international experience suggests otherwise. This experience shows that private lenders and municipalities will willingly collude in risky lending operations ifthey have a reasonable expectation o f Government relief. Bulgaria is inthe process ofestablishing that expectation through its frequent bailouts ofmunicipal arrears. 103. There i s therefore a strong argument for tighter regulation on municipal borrowing. One approach would be to impose quantitative restrictions, such as a minimum level o f debt service coverage.61An altemative would be to rely on local political accountability. The Government i s now considering a proposal that would require a super-majority in the municipal council, or a majority vote in a local referendum as a precondition for contracting o f municipal debt. Both approaches should be considered. PRIORITIES 104. With the reforms o f 2003, Bulgaria has taken an important step to address some o f the key problems in the relationship between the central and local governments. Transfers will be allocated on a more transparent, and generally more accurate, basis. Social assistance funding will no longer reflect the vagaries o f the local tax base. The Government also deserves credit for its approach to municipal arrears during 2003. In assuming responsibility only for arrears on 58 Note that The Government i s now drafting a municipal debt act which would establish ceilings on municipal contractual borrowing. Parliament will begin deliberations o n the act inMarch 2004. 59 OECD April 2002, Fiscal Design Across Levels of Government: Bulgaria Country Report. , 6o Except in cases where the Government assumes the risk o f default through an explicit guarantee. In Bulgaria's case, regulation could also be required to ensure compliance with the Maastricht ceilings. 61 Debt service coverage can be defined as the ratio o f the current surplus to total debt service, where the current surplus i s defined as total current revenues less recurrent non-interest expenditures, and debt service includes interest and principal repayments on the total stock o f debt. 32 delegated functions, it has punctured municipalities' expectations o f unlimited Government debt relief. 105. Butthe Government should take the steps to ensure that deficits do not recur. Inthe short term, as noted earlier, this could include: (1) providing 100percent o f the general supplementary subsidy on a timely basis6*; (2) assisting municipalities to reduce staff (with the support o f sectoral ministries); and (3) authorizing local governments to set the rate o f the property tax. These measures, backed by a Government commitment to resist further bailouts, will help defuse the conflict between the municipalities and the Government. Longer term reforms, however, should aim at removing the root causes o fthe conflict, by either fully centralizing some functions (as was recently done for social assistance) or shifting more management and revenue autonomy to the local level. 62 The 2004 draft budget law, now under discussion inParliament, provides for full funding of the delegated functions. Shortfalls inthe funding o fdelegatedfunctions in2003 havenow beeneliminated.