TheWorld Bank O c t o b e r PREMnotes 2 0 0 3 n u m b e r 8 0 Pu b l i c S e c to r Reforming intergovernmental fiscal relations in the Czech Republic Intergovernmental fiscal reforms are complex--they cannot be implemented in one fell swoop. The Czech Republic has largely overcome the mediate self-governing regions run by elected challenges associated with its legacy of social- representatives. These regions were intended ism, the 1993 breakup of Czechoslovakia, and to be fiscally autonomous and directly account- its transition to a market economy. In addi- able to their citizens. In addition, the system tion, the country's evolving approach to inter- for sharing tax revenue between the central Czech reforms governmental fiscal relations has addressed government and municipalities was restruc- crucial issues, including the prospect of join- tured by shifting distribution from a deriva- to ease fiscal ing the European Union and the need to tion to a per capita basis. This change was increase public sector efficiency. expected to diversify the pool of shared taxes, imbalances show distribute them more equitably, and stabi- Features of the Czech system lize tax revenue for all levels of government. great promise-- During the 1990s the Czech system of inter- Municipalities have generally followed governmental fiscal relations suffered from responsible spending patterns. Although but challenges two long-standing problems: a growing verti- district-level variations in per capita spending cal imbalance against the central government increased somewhat between 1997 and 1999, remain and increasing horizontal imbalances among disparities were lowest for basic services-- municipalities. The vertical imbalance re- such as education and water--and highest flected slower growth in central government for "economic functions"--such as telecom- revenue from nonshared taxes (such as cus- munications and financial operations. toms duties and excise and value added taxes) relative to shared taxes (especially individ- Challenges ahead ual income taxes). Horizontal fiscal imbal- Despite these improvements in intergovern- ances resulted from rising disparities in growth mental fiscal relations, significant challenges levels and social and economic conditions remain in overcoming municipal fragmen- across local governments and from the fact tation, strengthening municipal borrowing, that shared taxes were essentially distributed and promoting transparency, autonomy, and based on a derivation principle. Because the accountability. Managing implementation of Czech Republic lacks equalization grants, local the reforms will also require considerable spending reflected the uneven distribution of effort, including transferring fiscal powers to regional tax capacity. the self-governing subnational units, equal- In 2000, to support EU accession and izing fiscal opportunities, and restoring incen- advance fiscal decentralization, the Czech Par- tives for local taxes. liament approved reforms of intergovern- mental fiscal relations. The reforms replaced Overcoming municipal fragmentation the state's deconcentrated territorial admin- Most (87 percent) of the Czech Republic's istration, based on 77 districts, with 14 inter- 6,254 municipalities have fewer than 1,500 f r om th e d e ve lo p m e nt e co n om i c s v i c e p r e s i d e n c y a n d p ove rt y r e d u c t i o n a n d e co n om i c m a n ag e m e nt n e t w o r k inhabitants, and many (42 percent) have munities to "designated" or "statutory" towns fewer than 300. This fragmented adminis- or to the new self-governing regions. Resolv- trative structure has critical political and ing municipal fragmentation in the Czech efficiency implications. From a political per- Republic may require some combination of spective this structure may be justified on the these options. grounds that it may foster strong democratic representation and horizontal accountabil- Strengthening municipal borrowing ity. The downside (as also observed in Poland Complete, transparent information on and some Baltic countries) arises from the municipal debt is not readily available in financial weaknesses and economic ineffi- the Czech Republic. Still, available data indi- ciencies associated with small communities, cate that such debt increased rapidly during Resolving which cannot benefit from: the 1990s. Excluding implicit contingent lia- · Fiscal autonomy, because their tax bases bilities, municipal debt reached 24 percent municipal are insignificant. of total municipal revenue in 1999, up from · Local technical and administrative capac- 5 percent in 1993. As a share of tax revenue, fragmentation ity, because they are unable to retain qual- municipal debt grew from 11 percent to 53 ified staff. percent during the same period. These may require a · Economies of scale in public service deliv- increases reflect the fact that local govern- ery, because privatization and outsourc- ment borrowing is unregulated and munic- combination ing of local services are underdeveloped ipalities' access to credit is not formally and municipal cooperation in service restricted. of options delivery is limited. In practice, however, municipal debt is Four options may mitigate municipal restricted. The Ministry of Finance controls fragmentation. The first is mandatory amal- the supply of credit to municipalities through gamations of local governments--often con- moral suasion over the financial system. In sidered the most expedient solution. But the addition, the Commercial Code restricts the Czech Republic has rejected this approach as use of collateral by municipalities, limiting being politically impractical. Strong local their creditworthiness. Moreover, small opposition stems from experiences with forced municipalities have limited revenue capac- amalgamations of local governments in the ity, restricting their access to capital markets. 1960s and 1970s that were perceived as arbi- The Czech government is considering trary and unrepresentative. ways to promote responsible subnational The second option is voluntary amalga- borrowing and to increase municipalities' mation. This approach can avoid social ten- access to capital markets for infrastructure sions and may be more economically financing. But among other things, the gov- efficient because it reflects residents' pref- ernment must first establish regulations that erences. But this option may require costly increase transparency and competition, as financial incentives that could undermine well as preserve market incentives and hard the central government's fiscal balance, and budget constraints. These regulations should: it may be too slow or, ultimately, ineffective. · Set clear limits on municipal debt and The third option is for the central gov- debt service obligations. ernment to encourage the formation of · Strengthen bank supervision, drawing on municipal associations or special districts to internationally recommended pruden- deliver services with significant economies tial rules. of scale. This option is also likely to take a · Draft a bankruptcy law or fiscal respon- long time to mature. sibility law (or both) to govern munici- The final option is asymmetric assignment palities and regions. of responsibilities (and resources) to local · Develop public and private institutions governments. This approach could be (including private credit rating agencies) achieved, for example, by delegating most to ensure proper monitoring and avoid responsibilities now assigned to small com- moral hazard. P R E M n ote 8 0 O c to b e r 2 0 0 3 Promoting transparency, autonomy, and gruent with new (delegated) and existing accountability responsibilities. New spending responsibili- During the Czech Republic's transition to ties must be defined for the regions--and a market economy, local authorities were unlike in many unsuccessful experiences else- given substantial discretion over spending where, the Czech government will not assign decisions. Yet these authorities have little revenues until spending responsibilities have autonomy over revenue, limiting their been well defined. In the meantime, regional accountability. Moreover, predictable and government operations will be fully financed transparent preparation of local government by the central budget. budgets has been limited by lack of syn- Among the issues to be resolved in the chronization with the central government interim is the possibility that the adminis- budget, uncertainty about basic budget para- trative structure of the new regions (includ- Revenues will not meters, and insufficient information on cen- ing new staff and facilities) might grow tral government guarantees and contingent uncontrollably. That could severely threaten be assigned until liabilities. Although there have been no the country's structural fiscal balance, and major disruptions in local budget execution, could prove difficult to reverse. spending budget control and performance evaluation There is a risk that the 2000 reforms will remain weak. only slightly modify the state's previous ter- responsibilities Increasing transparency and account- ritorial administration. The reforms made ability at the subnational level will require: line ministries responsible for defining the have been well · Empowering local authorities to set rates functions to be transferred to the new (within defined ranges) for meaningful regions, but it is unclear whether the cen- defined local taxes, such as property taxes. tral authorities are prepared to relinquish · Lifting central controls on rents and tariffs. fiscal decisionmaking powers to lower-level · Increasing local freedom to mix factors of authorities. production in the most economical ways. In addition, it is unclear whether the cen- · Publicizing all approved and executed tral government and Parliament are com- transfers and guarantees. mitted to transferring significant revenue Budgets would be more predictable if basic and spending autonomy to regional and parameters (including tax sharing arrange- local authorities. Nor is there a clear com- ments and transfer or grant formulas) were mitment to promoting private participation defined in organic laws rather than the in the financing and provision of public ser- annual budget law. vices at the local level--especially housing When the Czech Parliament eliminated and education. Private participation could districts, the oversight function of munici- help small Czech communities benefit from palities (including the audit function) was economies of scale in service delivery. left undefined. Addressing this issue may One of the government's main goals is provide an opportunity to expand audits of to provide all citizens with access to public subnational governments beyond legal and services (health, education, water, sanita- procedural aspects (the input approach) tion, and so on) of similar standards, regard- to include program and performance eval- less of where they live. But the current uation (based on measurable outcomes). decentralization system may not facilitate this objective because it lacks an explicit Managing implementation of the reforms mechanism for equalization grants. The The government set a two-year transition equal per capita distribution of shared rev- period to implement the new system of inter- enues among local governments, introduced governmental fiscal relations. To avoid over- in the 2000 reforms, does not reflect the spending, fiscal imbalances, and unfunded varying social and economic conditions mandates, additional time has been taken among regions--and so does not properly beyond the two years to ensure that revenue address disparities in spending needs and sources assigned to the new regions are con- revenue capacities. Implementing a true P R E M n ote 8 0 O c to b e r 2 0 0 3 equalization scheme thus remains a major The challenges created by the Czech challenge for the near future. Republic's reforms of intergovernmental The 2000 reforms practically eliminated fiscal relations indicate that fiscal decen- incentives for local governments to bolster tralization should be conceived as a process their tax efforts. But there appears to be wide rather than as a one-time event--and that consensus on the need for and possibility continued reforms are needed to ensure of restoring incentives to mobilize local rev- that initial objectives are met. enues--without undermining the central government budget. One way is through This note was written by Joćo do Carmo Oliveira property taxes, by better defining and (Senior Economist, PREM Unit, Europe and Cen- expanding their base and by providing tral Asia Region) and Jorge Martinez-Vazquez regional and local authorities with limited (Director of International Studies, Andrew Young discretion to establish property tax rates. A School of Policy Studies, Georgia State University). second possibility is to introduce a regional If you are interested in similar topics, consider or local individual income tax, with a pro- joining the Decentralization Thematic Group. portional rate that piggybacks on the national Contact Dana Weist (x82210) or click on Them- (progressive) individual income tax. atic Groups on PREMnet. This note series is intended to summarize good practices and key policy findings on PREM-related topics. The views expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank. PREMnotes are widely dis- tributed to Bank staff and are also available on the PREM Website (http://prem). If you are interested in writing a PREMnote, email your idea to Madjiguene Seck. For additional copies of this PREMnote please contact the PREM Advisory Service at x87736. PREMnotes are edited by Paul Holtz and laid out by Suzanne Luft. Prepared for World Bank staff