Local Debt in the Slovak Republic

Local Debt in the Context of Decentralisation and Reform:

The SlovakRepublic

Phillip J. Bryson

MarriottSchool,

BrighamYoungUniversity

Prepared for the 14th Conference of NISPAcee

May, 2006

Contact Information:

616 TNRB, MarriottSchool

BYU, Provo, Utah, USA

Tel. 801 422-2526

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Local Debt in the Context of Decentralisation and Reform: The SlovakRepublic

Chapter 1. Introduction

Subnational debt in the Republic of Slovakia must be understood in the context of fiscal decentralization and intergovernmental fiscal relationsgenerally. Municipal debt represents an important source of funds for local infrastructure development and would be expected to be part of the financial portfolios and capital budgets of autonomous, local governments in the process of development. But it is only one piece of a fiscal mosaic that contains elements related in important ways to the whole financial picture. This introduction will attempt to place debt in its larger fiscal context in the transition era of the SlovakRepublic.

The republic began its transition to democratic and market orientationfollowing the “Velvet Revolution” in late 1989 as a part of Czechoslovakia. Together with the Czechs, Slovaks helped establish common institutions that preceded the “Velvet Divorce” of 1993.That fiscal system was more similar to those of Western Europe and less similar to those of central planning.

In the first decade after the decline of the central planning regime, the pattern of public expenditures for both countries was a familiar one. As in the other “OECD post-transition economies,” the preponderance of social transfers and of a huge public sector wage bill were notable (Gönenç and Walkenhorst, 2004). In spite of modest wages, the aggregate wage bill ballooned due to the exceptionally high level of government employment. Social transfers, especially in the form of health care costs were likewise to become a source of serious fiscal concern. (The health care system of the communist era had also been expansive, but was far less expensive.) Total spending in both countries reached levels higher than those typical of lower income OECD countries. The large public expenditures are the more dramatic in the case of Slovakia with its lower per capita income.

The two independent republics had other transition tasks that required a lot of attention, so the first years of the transition saw little noticeable change in their fiscal systems. It was ultimately Slovakia’s reforms which began to move away from the joint institutions of Czechoslovakia. This occurred as a part of reform efforts associated with the pursuit of membership in the European Union. The pre-accession efforts included a reform of public administration in both nations,but Slovakia was more serious about the process of fiscal decentralization which it saw as a sine qua non for the public sector transition away from the excessive centralization of central planning. Slovakia simply carried the reforms further than the Czech Republic, establishing a “flat tax” system (with a single rate of 19% for individual and corporate income taxes, as well as for the VAT).

These later forms of divergence from the common original system were dramatic and well publicized. But earlier divergence had also been important for the twin republics.Slovakiaunavoidably developed a system of greater municipal autonomy for two reasons. First, the Mečiar regime made it clear that the cities and towns of Slovakia would have to fend for themselves financially. There would be no liberal flow of transfers, grants and shared taxes to the municipalities. Second, the Slovak municipalities would have independent management of their property tax.

In the CzechRepublic, legislation was established that has kept the property tax strictly symbolic and fiscally insignificant. As opposed to the decentralized practice in Slovakia, the Czech central government even manages the collection of the property tax, which produces a moral hazard problem (Bryson and Cornia, 2003). The state has no incentive to produce copious revenues from this tax; it does not receive any share of its revenues, which are returned to the municipalities. In the SlovakRepublicthe property tax remains only a significant potential revenue source; it currently provides only modest revenues, although they are significantly larger than the nominal revenues produced in the CzechRepublic.

Nor have the municipalities of either country had autonomous management of user fees for public services. National law specifies the local “charges” (sometimes user fees, sometimes local taxes) which can be assessed, leaving little flexibility in rate variation for local administrative preferences. With no property tax and no independent user fees, the municipalities have no access to independently generated revenues. Given the centralist traditions that are a legacy of the earlier central planning regimes, there has been only modest fiscal autonomy at the local level. Basically all funding comes from the centre and the outside perception is that, generally, too many strings have been attached (Oliveira and Martinez-Vazquez, 2001). Slovakia has worked with the same governance mentality and fiscal institutions, but there has been greater independence with the real estate tax and revenues have been more seriously and effectively collected by the cities and towns themselves. More recently, the centre has begun to be substantially more generous to the municipalities than in the early transition. As part of the recent reforms, the process of devolution has continued, and this has included an apparent opening of the door to independent municipal action with regard to both property tax and local user fees.

To an important extent, the heavier, historic centralization prevailing in both countries is a result not only of communism’s legacies, but of the practical fact that both republics have been sympathetic to the strong local desire for municipal independence. Under the centralism of the previous era, municipalities were unhappily forced into local government amalgamations to simplify governance activities. After the Velvet Revolution, local governments were freely permitted to declare their individual autonomy and the result was the creation of many small municipalities in both the Slovak and Czech Republics. No other country in central and east Europe has anything approximating this number of municipalities, the downside being that the smaller ones lack the manpower, managerial and other resources to cope with the possibilities of autonomous action. The central governments, which are capable of managing the local governments of these small countries much better than could ever be done in, say, Russia, are willing simply to continue that management. But the EU agrees with the standard observation of the literature on fiscal decentralization that democracy requires more than just competent central management of local governments, even when they are not that many kilometres from the capital.

This paper addresses local debt as a reflection of the fiscal institutions and situations currently pertaining in the SlovakRepublic. Considering the insufficiency of autonomous revenue sources, one would expect the possibility to access credit markets to be an appealing one for the towns and cities of Slovakia. If autonomous preferences cannot be satisfied by the revenue flows produced in the centralized fiscal systems, leveraging local projects might provide an opportunity to express municipal developmental preferences while avoiding the strings attached to centrally funded projects.

There is also another source of pressure on municipal authorities to embrace credit sources for local development. As newly acceded members of the European Union, they are encouraged to access EU funds provided for regional integration policies. But subnational governments receiving funds for capital investments mustmatch those funds. Credits empower local governments to take advantage of EU transfers.

This paper will investigate municipal indebtedness as a part of the institutional development of the SlovakRepublic in the process of fiscal decentralization. Section II will consider local debt as a part of the historical development of the fiscal decentralization reforms of recent years, considering also how it relates to the pre-accession reform of public administration. Section III will review the actual financial situation of Slovakia in the transition process to the present. An evaluation of the debt burden, including the various criteria the Slovak government employs to evaluate the potential hazards associated with various levels of municipal indebtedness will be provided in Section IV. The SlovakRepublic’s municipal debt regulation will be the focus of Section V, which will be followed by conclusions in Section VI.

Chapter 2. Local Debt in the Transition of the SlovakRepublic

After the decline of the communist regime in December, 1989,Czechoslovakia restored local self-government through Municipal Law 369/1990, which established a dual system of local public administration including “state administration” and self-government.This system divides municipal governance into tasks for municipal and for central administration. No one in the twin republics seems to object to the national government’s retention of responsibility for all municipal functions it does not “delegate” to the municipalities themselves. To carry out the federal responsibilities for municipal activities, 38 districts (okresy) and 121 sub-districts(obvody) were established. The regional administrative units (kraje) were abolished, so that only the municipalities represented “territorial self-government.” These municipalities grew quickly in number in the early 1990s, as mentioned above.

Slovak cities and towns have remained financially dependent on the central government in the transition era. Each year, the state budget has contributed about a third of municipal revenues through shared taxes and transfers. After a period of lobbying for increased transfers from the central coffers, allocations from the state budget are announced when that budget is made public. Specific municipal shares have been determined by parliamentary action each year; only the municipal share of the road tax is stable and predictable prior to the unveiling of the state budget.Because the state budget is frequently approved late, around the end of the year, municipalities have been notified about what they would receive only at the last minute. That situation has rendered orderly financial planning nearly impossible (Kling and Nižňanský, 2004, p. 183).

After the Velvet Divorce, Slovak municipalities encountered very hard financial times as the Mečiar regime granted them rather significant autonomy in some respects, but with only very sparse revenue transfers (Bryson and Cornia, 2004). Later on, the SlovakRepublicbegan introducing reforms of public administration. These reforms were followed by the adoption of a“flat tax”[i](as in Russia and a few other countries),the main provisions of which were publicized bythe Finance Ministry (2004). The achievement of fairness and simplicity in the tax code and the elimination of double taxation were the stated principle objectives of the reform.

By 2000, Slovak municipal debt was an established part of the fiscal scene. At that point in time, the municipalities did not bear heavy responsibility for the delivery of many services. The new system was designed to strengthen revenue collection for municipal finance and to establish sources of revenue for the revived regional governments.Stage I of the decentralization of public administration consisted of transferring competence from central administration to these sub-national units, which was basically completed from January, 2002 to January, 2004 (Majerský, 2005).

As the process ofdecentralization accelerated in 2002and numerous additional functions were transferred to themunicipalities, new problems were encountered. Most significantly, the transfer of financial resources lagged behind the transferof powers. Funds transferred from centrally collected taxes did not empower local governments to meet their new fiscal responsibilities. (Kling and Niznansky, 2004, p. 219). The “decentralization subsidy” was insufficient to operate schools,hospitals and other programs adequately.Moreover, the law prevented local governments from achieving more efficient service provision, because funds savedin one area cannot be transferred to another.

It was also burdensome that properties beingtransferred to local governments were encumbered not only with operational but also capital costs. Being in a poor state of physical repair, apartment and other transferred buildings badly need costly, long-overdue renovations. The most critical repairs were usually undertaken unsystematically and the underlying structural and technical problems were not addressed. The local governments which now own these properties will not receive transferred resources to cover the costs.Although the centralgovernment has undertaken financial reforms to speed up economic development,advocates of fiscal decentralization fear that priorities have shifted away from that process. This problem, combined with the management deficits of the municipalities, threatens the fiscal operation of many of the local governments.

Of greater significance, the Finance Ministry announced that the personal income tax would henceforth be an “own” source of sub-national government revenues, with the municipalities receiving 70.3% and the regions 23.5% of the revenue from that tax. Only 6.2% of its revenue would remain a part of the national budget. Generally, the intent was that about one third of municipal revenues would be derived from personal income tax transfers, one third would come from central government and EU grants and one third would come from municipal “own” revenues – from property tax, local user fees, and the privatization of publicly-owned assets.[1]

Of the numerous considerations motivating the reforms of local finance, an important one was that the municipalities derive only sparse revenues from the real estate tax as compared to numerous of the OECD and EU countries. Property tax was scarcely the centre of the reform, but the Ministry of Finance nevertheless favoured a strengthening of that tax as a part of the whole package of fiscal decentralization changes. It was hoped that the new system would stabilize revenue flows to local governments and make it easier to engage in multiple-year financial planning.

From January 1, 2005, Slovak municipal governments were empowered to set “tax rates” (a term applied, interestingly, not only to the real estate tax, but apparently also to the limited number of current user fees) and to introduce new local “taxes.” The municipalities were authorized to adjust the old system rates and apply exemptions reflecting their own preferences. Also, it was potentially very important that the municipalities were granted management of property tax policy. They could use the funds raised through the property tax, like those transferred to them from the personal income tax, autonomously.The state abdicated any right to specify the uses of these revenues.All the old laws specifying coefficients for property classifications under property tax administration are now extinct. The municipalities can use the property tax independently. Along with the donation tax and the inheritance tax, the real estate transfer tax was eliminated as a part of the tax reform (Zachar, 2004: 38). A new Act on Real Estate Tax was to create the legal basis for real estate taxation based on market valuation.

With the adoption of the regions as “higher territorial units,” the Parliament transferred additional spending responsibilities to the sub-national governmentsamounting to approximately 4.5 per cent of GDP. Municipalities, previously in charge of waste disposal, drinking water, public lighting, and maintenance of local roads (where they spent 2.9 per cent of GDP in 2000) received additional responsibility for social assistance, roads and communication systems, environmental protection, territorial planning and building permits, primary schools, sports and some health care. The regional governments assumed responsibility for territorial planning, regional development, secondary education, social assistance, health care, cultural events, regional roads, communications, civil protection, and some additional functions to be coordinated with institutions of the European Union. Total sub-national spending, including both traditional and new responsibilities was expected to reach 20 per cent of total general government spending by 2005.

The approval and management of these decentralized budgets will be by the elected representation of the regions and municipalities. Municipalities will not be required to submit budget proposals to central authority. The regions will submit their proposed budgets each year both to Parliament and to the Ministry of Finance. It will be difficult to control capital expenditures when regions and municipalities remain under their borrowing caps. As a result, planning and implementing general government finances will remain difficult even with safeguards against excessive overspending.. Centralizers wonder whether central government funds should be turned over to sub-national discretion for general use within a given program.Doing so could leadto improper maintenance of capital assets where there is a political bias favouring civil service employment and wages (Gönenç and Walkenhorst, 2004, p. 26).