The Economics of Centralism and Local Autonomy: Fiscal Decentralization in the Czech and Slovak Republics

The Economics of Centralism and Local Autonomy

The Author’s Previous Books Scarcity and Control in Socialism: Essays on East European Planning The Consumer under Socialist Planning: The East German Case Planning Refinements and Combine Formation in East German Economic “Intensification,” with Manfred Melzer End of the East German Economy, with Manfred Melzer The Reluctant Retreat: The Soviet and East German Departure from Central Planning

The Economics of Centralism and Local Autonomy Fiscal Decentralization in the Czech and Slovak Republics

Phillip J. Bryson With the Assistance of Gary C. Cornia

the economics of centralism and local autonomy Copyright © Phillip J. Bryson, 2010. All rights reserved. First published in 2010 by PALGRAVE MACMILLAN® in the United States - a division of St. Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Where this book is distributed in the UK, Europe and the rest of the World, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN: 978–0–230–10429–7 Library of Congress Cataloging-in-Publication Data Bryson, Phillip J. The economics of centralism and local autonomy : fiscal decentralization in the Czech and Slovak Republics / Phillip J. Bryson. p. cm. Includes bibliographical references and index. ISBN 978–0–230–10429–7 1. Intergovernmental fiscal relations—Czech Republic. 2. Intergovernmental fiscal relations—Slovakia. 3. Decentralization in government—Czech Republic. 4. Decentralization in government— Slovakia. I. Title. HJ1070.B79 2010 336.4371—dc22 2010002664 Design by Integra Software Services First edition: September 2010 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

To my wife, Patricia, and to our grandchildren, Kristi, Cohen, James, Grant, Kristina, Phillip, Dallin, Marie, Andrew, Jordan, Madison, Sydney, Jackson, Chelsey, Jonathan, Anthony, Taylor, Ammon, Preston, Nathan, Gracelynn, Shaidyn, Tyson, and Lexie.

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Contents

Preface

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Part I Property Tax and Fiscal Decentralization in the Twin Republics: Launching the Transformation to Market Democracy 1 “State Administration” vs. Self-Government in the Slovak and Czech Republics 2 Taxes on Real Property in the Czech Republic 3 Land and Building Taxes in the Republic of Slovakia 4 Moral Hazard in Property Tax Administration: A Comparative Analysis of the Czech and Slovak Republics 5 Fiscal Decentralization in Economic Transformation: The Czech and Slovak Cases

3 23 37 53 65

Part II Sources of Czech and Slovak Local Revenues 6 The Property Tax, Grants, and Other Sources of Local Revenues 7 User Fees in Local Finance: Performance and Potential in the Czech Republic and Slovakia

83 95

Part III Toward the Close of Transition in the Czech and Slovak Republics: An Interim Assessment of the Fiscal Decentralization Effort 8 Local Budgeting in the Czech and Slovak Republics 9 A Survey of Perspectives on Intergovernmental Relations: A Comparative Analysis of the Czech and Slovak Republics 10 Decentralization and Local Finance in the Czech Republic: With an Update on the Property Tax

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11 Slovakia’s Surge: The New System’s Impact on Fiscal Decentralization

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Part IV Financial Crisis and Global Recession: The Impact on Europe, the Czech Republic, and the Slovak Republic 12 The Global Crisis: Origins and Arrival in Europe 13 Subnational Finance Today and Tomorrow in the Czech Republic: Impacts of the Financial Crisis and Global Recession 14 Subnational Finance Today and Tomorrow in the Slovak Republic: Impacts of the Financial Crisis and Global Recession

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Notes

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References

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Index

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Preface

The communist system, one more correctly designated by the countries involved as Marxist-Leninist socialism, met its end in East Europe with the opening of the Berlin Wall, the “Velvet Revolution” in Czechoslovakia, and the demise of the Communist Party and the dismantling of the Soviet Union in Moscow. It became necessary for Russia and East Europe to build new institutions and to decentralize the public power concentrated in the central government. It was widely known that communist regimes tended to maintain highly centralized power relationships, so with the decline of central planning, fiscal decentralization became the order of the day. Scholars researching the transition of the Central and East European countries to market economics and democratic government have generally been concerned with the privatization of the omnipresent state-owned enterprises and industries of the former regime. But the transition of the public sector is also of critical importance to successful transition, which features especially the devolution of political power from the center to regional and municipal governments. This process has continued in transition countries since late 1989, and as its history has now extended over two decades, it can be viewed in some respects as already complete. The accession of numerous of the participants of the transitioning countries to the European Union in 2004 was symbolic in many ways of the closing of the transition era. Economic transition is, of course, a very multifaceted process rather than an event, so although many Europeans would be satisfied with the level of decentralization that these two transitioning republics achieved by the time of the accession to the EU, the Czechs and Slovaks still seem involved in the pursuit of outcomes that reflect greater and more effective decentralization. This process may well continue for a time. In 1993, after regaining independence, the former Czechoslovakia split into two separate republics through the famed “Velvet Divorce.” The new, twin Czech and Slovak republics represented small but important nations in the heart of Europe; their combined peoples had sought consistently to gain

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independence from their European neighbors for centuries. Having achieved it early in the twentieth century, they slipped back into the shadows of the past, becoming captives of the communist movement for another forty years. These countries, with well-educated and creative peoples, are finally in a position among democratic neighbors to seek their own place in the sun. With great interest, we watch them seek to establish for their peoples the human rights, dignity, and prosperity that we associate with the successful market democracies of the modern world. In 1996, I returned from a nonacademic, three-year stay in Prague, the Czech Republic, to Brigham Young University to resume my academic career. I was interested in a new research project to replace my earlier comparative economic systems research on the central planning systems of East Germany and the Soviet Union, since these were no longer extant. At that juncture a colleague and friend, Gary Cornia, suggested that we collaborate on researching the process of fiscal decentralization in the Czech and Slovak republics. He suggested that with his public finance experience and my experience with East Europe and its transition from central planning, we should look jointly at the processes of fiscal decentralization in the Czech and Slovak republics. The research we undertook on this topic proved to be interesting and productive; there appeared to be a demand for information on and analysis of this topic. The twin republics had just recently experienced their famed Velvet Divorce, which created two republics from one in 1993. Here was an excellent opportunity for comparative economic research; both countries shared similar languages, common institutions, history, traditions, and economic and political systems. Changes in their institutional structures and economic performance could be traced more or less directly to newly divergent policies. After our project was up and running, we began to produce some papers for presentation at conferences and for publication. A number of chapters in this book have appeared over the last decade as individual papers in journals or collections of papers. But the content of the diverse topics included in this book were not randomly pulled together as an afterthought. We undertook this effort with an eye to telling a complete story. After investigating several aspects of the overall problem, I had decided to research the basic issues of fiscal decentralization in the two republics as completely as possible. That process has taken several years, but developing the relevant subtopics as individual research projects proved most helpful in the preparation of the present book. It exposed our work to the criticism and suggestions of reviewers with expertise in the field. Our goal was to describe and analyze the initial conditions and institutional constraints prevailing in both countries and the impact of those conditions on the development of new fiscal systems. We sought to determine

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and reveal the relationships between the various sources of revenues and the expenditures necessary to provide basic public services and to respond to the constituencies providing funding. We considered the traditional revenue sources and their potential for the future of the twin republics. We reviewed the roles of the central and local governments and their interaction. We probed the perceptions of local leaders through the analysis of a survey of Czech and Slovak mayors and other local officials to see how their perspectives might differ from the suppositions of outside observers. We investigated the impact of the reform movement begun at the arrival of a new millennium to modernize public administration and to form regional governments in preparation for membership in the European Union. Through the whole history, we followed the budgeting processes and the struggles of the municipalities to obtain sufficient funding to provide basic public services, to satisfy the mandates of the center, which provided the lion’s share of funds essential to run the many (and often small) cities and towns of the Czech and Slovak republics. I am greatly indebted to Gary Cornia for his having recruited me to a study that has absorbed much of my research time over the past several years. Having helped me to launch a new research direction, Gary then gradually moved on to other projects and administrative tasks. He is currently serving as dean of the Marriott School at Brigham Young University. But from time to time he has continued to give me encouragement, support, and assistance. Gary coauthored a number of the studies ultimately published in diverse journals and collections of scholarly articles, so I acknowledge with gratitude his work on many parts of this completed document. Thanks must also go to others. I am appreciative of the publishers of professional journals and books who have granted permission to republish articles already appearing under their titles. In each of those chapters that have previously appeared in similar or identical form elsewhere, I have given credit for the original publication. In parts of this work, otherwise duplicative sections or passages are omitted, and some updating has occurred, although that has also occurred quite naturally as later papers updated earlier ones. A small number of additional colleagues have joined me in preparing contributions to this research effort. Their contributions are acknowledged where they appear. Special thanks go to Alena Holmesová of the Czech finance ministry and Lucie Sedmihradská of the Prague University of Economics, Soˇna ˇ Capková of the Univerzita Mateja Bela in Banská Bystryca, Slovakia, and Miloš Konˇcek, formerly of the Ministry of Finance, Republic of Slovakia. These specialists helped us find data and served as very helpful consultants in our preparation of two articles for a World Bank collection. Our colleague, Scott M. Smith of the Marriott School, Brigham Young University, provided

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great assistance in writing papers on the perspectives of Czech and Slovak local finance officials, especially in the analysis of the survey results. One of those papers is included in this book. The Marriott School of Brigham Young University provided strong research support of about all kinds—financial help for travel and research assistance, excellent computational support, and a positive and supportive research environment. Gary and I are also appreciative of very helpful financial support from the Lincoln Institute of Land Policy in Boston. Joan M. Youngman and Jane H. Malme of the Lincoln Institute were especially helpful and were the editors of the World Bank collection mentioned above. The Network of Schools and Institutes of Public Administration in Central and Eastern Europe (NISPAcee) meets each year somewhere in Eastern Europe. The last few years I have participated with a working group that has focused on the problem of local finance in the European transitioning countries. I am grateful to the group, especially to its leaders, Zeljko Ševiˇc and Lucie Sedmihradská, for this small but greatly helpful research community and to the larger NISPAcee organization for the opportunity to share ideas and be made aware of trends in local finance among other transitioning countries in the region. Finally, my thanks for the index to Jesse Maughan. As always, I am grateful to my family for their love and sustaining support. My wife, Pat, has always provided a foundation of happiness for my life and my work. That happiness now includes our seven children, their spouses, and twenty-four grandchildren; to Pat and the latter, this book is lovingly dedicated.

PART I

Property Tax and Fiscal Decentralization in the Twin Republics: Launching the Transformation to Market Democracy

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CHAPTER 1

“State Administration” vs. Self-Government in the Slovak and Czech Republics∗

Introduction Under the central planning institutions of communism in Czechoslovakia, local governments were largely just symbolic and did not enjoy selfdetermination. The national party made all decisions impacting local governance; at the local level, central agents commissioned to perform “state administration” (státní správa) implemented these decisions. This was strict hierarchical management with complete central government control over local decisions. Central planning in Czechoslovakia collapsed two decades after the Prague Spring of 1968. The Warsaw Pact invasion of Prague brought the hopes of that spring to an end by the restoration of the regime’s dictatorial control, but in 1989 the central planning regime did finally disappear. That enabled a renaissance of local self-government (samospráva) in Czechoslovakia. Following the “Velvet Revolution” of December 1989, the Czechs and Slovaks continued their uneasy partnership in the endeavor to achieve an economic and political transformation of Czechoslovak society. In that period very early in the transition, both peoples made unequivocal demands for local autonomy by reorganizing many independent towns and villages. Under central planning, decisions regarding the delivery of local public services had ∗

This chapter appeared as “ ‘State Administration’ vs. Self-Government in the Slovak and Czech Republics,” Communist and Post-Communist Studies 41, no. 3 (2008), pp. 339–358. Copyright permission from Elsevier Limited. Registered Office: The Boulevard, Langford Lane, Kidlington, Oxford, OX5 1GB, United Kingdom, Registration No. 1982084 (England and Wales).

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been made exclusively by the central government. Although district and local governments had remained in place, they could not function independently; local officials did no more than administer, facilitate, and promote the central government’s policies. The institutions of intergovernmental finance had been designed to prevent the exercise of any form of local autonomy. Funding for police, public utilities, fire protection, and education—not to mention subsidies provided for housing, food, and medical care—were provided by the center and financed by indirect enterprise taxes. The “Velvet Divorce” of 1993, completed by Slovak politicians without resort to the citizenry (no plebescite or vote of any kind was held), established the two contemporary republics. It also provided an interesting case for comparative studies. Two essentially identical political and economic systems suddenly emerged; by watching their gradual institutional and historical divergence over time, we can see the impact of the countries’ cultural differences as well as the impact of the policy and strategy divergencies that gradually developed. In the course of the pages to follow, it will be observed that most of the changes occuring since the Velvet Divorce were initially only of marginal impact. Only after 15 years of such change did some substantial differences become apparent as Slovakia showed a flair for the dramatic in the adoption of fiscal reforms. But, as one would expect, many things remain unchanged even after the passage of nearly two decades. After the 1989 revolution, local governments were again charged with the independent delivery of public services. Since extreme centralization had been oppressive to both the Czechs and Slovaks, the initial decentralization initiatives were bold. Many municipalities that had earlier been forced into amalgamation were dismantled. As of 1990 it was permitted to form new local governments, which soon numbered 2,781 in Slovakia and 6,234 in the Czech Republic. Initially, neither country established an intermediate level of government between the center and the municipalities, but both did so later, as we shall see. Because so many of these municipalities are very small and lacking in human and other resources, the Czech and Slovak central governments have remained convinced that authority simply cannot be devolved, that prerogatives and resources cannot be vouchsafed to local government personnel. The towns and villages have no capacity on their own to generate sufficient revenues for their needs; “own revenues” include those derived from a property tax, a small and rather trivial assortment of local fees and other taxes, and from the sales of state-owned properties that were transferred to local governments after 1989. These represent only a very small fraction of local budget receipts; most of the local government revenues come through grants or shared taxes from the central government.

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If all such transfers were unconditional, one could speak appropriately of municipal autonomy. In fact, their financial situation leaves municipalities little independence, since when financial transfers are made, there are usually strings attached. Moreover, the municipalities have many mandated tasks to perform, and funds transferred are hardly enough to cover the bases. Without independent financial resources, there is in fact little financial independence in the twin republics. The financial situation is hardly the sole determinant of municipal dependence. The very structures of governance from the beginning of the transition era have reflected the institutions of the previous regime with the continuation to the present of the tradition of “state administration.” This social arrangement says to the municipalities precisely how they will be responsible for “governing themselves.” A more or less arbitrarily limited set of activities are declared to belong to local jurisdiction. Constitutional law declares the remainder of the many activities that the independent municipal governments of many countries undertake to perform to be activities and public services for which the central government alone is responsible. True, the central government may choose to delegate some of those tasks to the municipality and might even provide compensation for the performance. But all decision-making prerogatives for this function remain vested in the central government. Mayors, therefore, are not responsible for all municipal functions. They are responsible only for those functions that the constitution and the central government tell them they may or must perform. All of those other functions performed by mayors in many democratic countries belong to agents of the central government housed in an office down the street from the Czech or Slovak mayor and managed by someone receiving instructions from Prague or Bratislava. Before these two former partners became members of the European Union (EU) in 2004, they were persuaded that they needed to implement “reforms of public administration.” That could have drastically changed the complexion of state administration, and it did affect intergovernmental relations, since it introduced a new level of government, the region (kraj). But the old system was durable enough so that state administration continued. This chapter addresses questions about why and how the institution of state administration was constructed and why it has been so durable in countries that have for a decade and a half given lip service to self-government (samosprávy). The chapter is also concerned with the question of the impact that such institutional arrangements have on the functioning of subnational governments. The reasons why state administration lived on after the disappearance of communism will also be considered, and the reader will observe

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that state administration seems to be the natural offspring of that system. One section of the chapter will review the constitutional basis of the system of state administration. The changes in intergovernmental relations introduced from the beginning of the transitional era will be reviewed and traced on through to the present. The chapter will then demonstrate that there was a constant, if not terribly effective, pursuit of fiscal decentralization in that process. Somewhat more effective was the introduction of institutional reforms designed to rationalize and modernize public administration, as shall be shown. Finally, we shall look to the future and draw some conclusions about intergovernmental fiscal relations in the Czech and Slovak republics. The Many Small Municipalities of the Twin Republics For the first 10 years of the transition, the governmental and administrative systems of both the Czech and Slovak republics, including the fiscal organization, were composed of only two tiers, the central and municipal governments. The number of independent municipalities in both republics has increased significantly since 1989. Many towns and villages that had been forced into larger, more convenient administrative units during the communist period were permitted to reclaim their independence after 1989, and they did so with an enthusiasm reflective of a strong demand for local autonomy. One cannot help but notice here that of the total of 6,230 Czech municipalities, 3,760 (60.3 percent of the total) consist of less than 5,000 inhabitants. Only 66 municipalities (1.1 percent of the total of 6,230) have 20,000 or more. Slovakia has similar numbers of municipalities for a population roughly half as large as that of the Czech Republic. In 1950 the Slovak Republic consisted of 3,344 municipalities, of which only 0.06 percent had more than 50,000 inhabitants. Only 0.7 percent of them had from 10,000 to 49,999 inhabitants, and only 1.2 percent had from 5,000 to 9,999. By way of contrast, 75.2 percent of those municipalilties had less than a thousand inhabitants; 44.6 percent had less than 500 inhabitants. Fifty years later in 2000, there were 2,883 municipalities in the republic and the distribution of city and village sizes was very similar. Only 4.3 percent of these municipalities had more than 5,000 inhabitants, and 68.5 percent of all municipalities had less than a thousand inhabitants. One must keep in mind that the number of municipalities per million inhabitants is substantially larger in these two republics than anywhere else in the region. Hungary has about half as many municipalities for its population size, but Hungary too has a substantially greater number of cities and towns than other countries in the region.

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The strong demand for local independence has historical roots in both these republics (Lacina and Vajdova, 2000). In the mid-nineteenth century the Czechs were striving to achieve a more modern concept of local governance. At an 1848 congress in Kroméˇríž an antifeudal, democratic strata of the population advocated municipal self-determination and demanded the free election of representatives and the right to organize municipal police and to inform the citizenry of municipal economic activities. As subjects at that time of the Habsburg Empire, there was no chance that all of these demands would receive a positive response. The constitution of the empire, however, did proclaim some important rights for municipalities. The independent municipality was recognized as the basic unit of a free state, even though democratic approaches were not to be implemented in the 1850s. From 1918 to 1938 the newly independent Czechoslovak Republic seized the opportunity to strengthen local governance as a part of establishing democratic principles of public administration. Three tiers of local government— municipalities, districts, and regions—were introduced with representatives chosen by free election. The constitution and laws of the republic secured their independence from state administration. The Nazi occupation of the republic and creation of the “free Slovak state” in 1939 interrupted the normal democratic development of local governance until 1945. After 1948 and the arrival of communism, the highly centralized economic planning system of Marxism-Leninism replaced the local government system in the Czechoslovak Republic. Municipal rights and prerogatives were severely restricted, especially regarding financial issues. As has been observed above, a new democratic system of local government began to be rebuilt after the Velvet Revolution, and the number of municipalities, already large, again began to increase. Managing Small Municipalities in the Czech Republic The problem with the large number of small municipalities is that it is very difficult to provide competent administration for them. Resource and personnel limitations were the common stumbling blocks in the effort to transform the municipalities into functioning, independent units of administration. The World Bank (2003) insists that excessively small communities cannot fully benefit from a regime of fiscal autonomy, since their tax bases are not sufficiently large; they lack technical and administrative capacity beause they are unable to retain qualified staff; they cannot exploit economies of scale in the delivery of public services, since privatizing or outsourcing the underdeveloped local services is not possible. One possible answer to excessive municipal fragmentation might lie in the notion of specialization and division

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of labor growing out of alliances of small communities. Regrettably, as the World Bank correctly observes, municipal cooperation in service delivery has to this point remained very limited. The Czech and Slovak republics have unswervingly remained convinced of the essential dependence of municipal governance. It is simply assumed that the Czech and Slovak peoples desire fiercely to have municipal independence rather than to exercise genuine local autonomy. The central government seems to infer that as long as the citizenry may live in a town or village with its own name and identity, it will not be upset if the central government must basically take over a large share of the management issues. The lack of resources and capacity, according to conventional wisdom, implies the necessity of state administration for the republic’s towns and villages. It is important to note, however, that the center has also not hesitated to intervene in larger municipalities that are lacking in neither workforce nor resources. But the World Bank paper cited above indicates some of the options that may mitigate municipal fragmentation. The first is considered the most expedient, but it is what both republics abhor—forced amalgamations of local governments. Experiences in the 1960s and 1970s with such were generally viewed as unrepresentative and arbitrary. The second option is voluntary amalgamation, which might avoid social tensions and reflect local preferences. But this could prove to be a costly approach requiring costly financial incentives to encourage towns and villages to join associations or special districts to deliver public services with greater scale economies. A third option would be an asymmetric assignment of resources and responsibilities to local governments. Most of the responsibilities currently assigned to small communities would be transferred to “designated” or “statutory” towns on the one hand or to the new self-governing regions on the other. In the Czech Republic, this challenge seems to have evoked a dual response. We have seen the administrative reorganization of state administration by reassigning tasks from the old districts to “towns with expanded functions” on the one hand and to the newly created regions on the other. Over the past few years Czech authorities have undertaken an administrative reorganization and reform involving the establishment of 11 new regional administrative units, the Kraje. The new regions have assumed some of the administrative functions of the center and some of those of the municipalities, but the latter are not vertically subordinated to the regions and still report directly to the center. The regions have not received a mandate to assist small municipalities lacking the resources to manage their administrative functions independently. But there has been a tendency for the smaller

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municipalities to begin to look for alliances with neighboring towns or villages to specialize and divide the labor of social, educational, and other public service functions. Managing the Small Municipalities of the Republic of Slovakia Nemec, Berˇcík, and Kukliš (2000) observe that the many small municipalities of the Slovak Republic represent a very nonintegrated structure resulting from historical developments after 1989. At that time, the political situation did not permit measures that would have provided the incentives to induce mergers of many small municipalities to produce a more integrated structure. The total number of municipalities actually increased through the 1990s because of the division of municipalities. Nižˇnanský (2006), the Slovak Republic’s spokesman for fiscal decentralization, discussed his since-replaced government’s intent to continue to pursue power devolution, but in describing the role of self-governing bodies in public administration, he failed to indicate any substantial movement away from state administration. The regulation of public responsibilities by “self-governing bodies” occurs only within the framework of their territory and competence, and local sovereignty is only conceivable “in compliance with the constitution and the law.” Because the state is the legislator, it seems logical to Nižˇnanský that the state will endeavor through the law to provide limitations on self-government. It is necessary, therefore, to ensure the status of self-governing bodies through the institutional, financial, and constitutional provisions. Institutions must assure choice through elections and the regulation of all relevant issues within the legal framework. Financial provisions must ensure municipal and regional access to revenues from state taxes. This is in contrast to the thought that local governments would benefit most from being able to generate their own revenues to assure more independent action. Finally, because of the EU’s influence, the Slovaks are now planning more actively to address and adjust horizontal and vertical income imbalances across municipalities and regions. Slovakia’s many small municipalities are self-governing, Nižˇnanský emphasized, because of the establishment of regional self-governing bodies in Slovakia. He is convinced, however, that the establishment of the new regions to assist in the provision of municipal services is not all that is necessary for local self-government. If a small local government is not able to provide public services on its own, they could be provided by a diversity of “voluntary partnerships, common councils, companies, and agencies operating on the basis of contractual agreements.” Sometimes it will be possible for

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larger municipalities to provide contractual services to smaller municipalities in their proximity. The Durability of State Administration Czech Republic Before accession to the EU, beginning at about the turn of the millenium, the Czech and Slovak republics responded positively to the need for a reform of public administration. The most apparent change required for the Czech Republic was the establishment of “regional territorial units.” The Slovaks were willing to push beyond that need and do some other things (Bryson and Cornia, 2006), in need of no further discussion at this point. With those reforms basically completed to the EU’s satisfaction (accession was granted and then achieved in May 2004), there remained no substantial pressure to carry those reforms further thereafter. State administration as a governing principle was not overthrown at that point, so the EU seems to have accepted the traditional wisdom that the smallness of municipality size requires both regional governments to help perform state administration and the central government to continue to play a role in what local sovereignty would do for itself. Just prior to the accession, in March 2004 the Czech government issued resolution 237 indicated “the progress and main directions of the reform and modernization of central state administration comprising the solution of the management and organisational support” (Vidláková, 2006). The vision for the reform was the achievement of “a flexible and better functioning of central state administration” rather than an enhancement of local governance capacity. An important emphasis was on good governance with professional and impartial civil servants. This was largely, in Vidláková’s view, to target a reduction in corruption in the Czech Republic before EU accession. The five “main directions” of the reform cited by Vidláková were: 1. 2. 3. 4.

rationalization of central state administration processes; improvement of central state administration management; quality improvement of central state administration; implementation and improvement of civil service in central administrative authorities; and 5. rationalization of central state administration financing. A discussion about the implications of fiscal decentralization and the limitations of state administration continues in some quarters, but without prospect

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of further steps toward the establishment of local sovereignty and the elimination of central government’s ongoing management of whatever share of municipal affairs are written into the constitution and laws. In the Slovak Republic An official paper of the Government Office (2000) introduced the objectives and design of the Slovak reform of public administration. Interestingly, this document listed areas of governance that would remain under local state administration after the reform. It was announced that the central government was to continue to provide for local police, criminal investigation, military administration, the state veterinary office, the state hygienist office, the environmental office, the cadastral office, the land and forest office, the social office, and the tax office. This is a most imposing list of subnational activities for which Slovak municipalities and regions continue to have neither responsibility nor managerial prerogatives. So state administration retained its lock on the Slovak policy mentality, even in a reform that did begin to make some important additions to the activities reflecting local autonomy. But the level and the organization of state administration were affected by the reform of public administration. An indication of the resources committed by the central government to state administration is given by the relevant figures on employment. Before the reform, state administration employed 287,817, or 84.7 percent, of total government employment. Only 52,100 were employed in self-government at the local level, which was only 15.3 percent of total government employment after the reform was implemented. The number employed in local self-government increased from ca. 15 percent to 63 percent. The Slovak reforms were further reaching. Local governments received the right from the beginning of 2005 to set their own “tax rates” (a term applied not only to the real estate tax but also to the limited number of user fees and local taxes already extant). They were also allowed to introduce new “taxes.” The municipalities received full discretion to adjust those old system rates and apply exemptions according to their own preferences. These are certainly genuine measures of fiscal decentralization, but it may be even more significant that municipalities were granted policy control over the property tax. The applicable legislation pertaining to real estate taxation (Parliament, 2004) came into effect in January 2005. It transferred responsibility for the establishment of binding regulations on taxation rates for buildings, land, apartments, and nonresidential premises to local selfgovernment bodies. Those rates are to be set according to the specific local conditions prevailing in the municipality. Of particular interest is the fact that

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the use of centrally established coefficients on the use and area of the land and structures taxed has been eliminated. The system of state administration, although reorganized and somewhat more limited in scope, is alive and well in the Slovak Republic. The reform of public administration eliminated the District Offices for state administration and transferred those activities from these offices to designated cities and regional governments. State administration in the Slovak Republic was thereby “modernized and reformed,” but clearly this was done with the intent to render state administration sufficiently serviceable to be retained indefinitely.

Power, Governance, and Intergovernmental Relationships The Czech Republic The democratic constitution of Czechoslovakia and the critical legislation addressing the subject of power in today’s republic were drafted by members of the central government. These foundation documents came into being in the light of liberated hopes but in the shadow of the previous, highly centralized regime. In Chapter 1 of the Czech Constitution (1992), under “Fundamental Provisions,” Article 2 declares that “the people are the source of all power in the State; they exercise it through bodies of legislative, executive and judiciary power.” According to paragraph 3 of Article 2, “state power shall serve all citizens and may be applied only in cases, within limits and by methods defined by law.” In Article 8, “self-government of territorial self-governing units” is guaranteed. Article 99 declares that the Czech Republic “shall be divided into communities, which shall be fundamental self-governing territorial divisions, and regions, which shall be superior self-governing territorial divisions.” Article 100 guarantees “citizens inhabiting a particular area, . . . have the right of self-government.” Article 101 promises that a “community shall be independently administered by a community assembly,” that a “superior self-governing territorial division shall be independently administered by an assembly of representatives,” that self-governing, subnational units “are public-law corporations which may have their own property and which operate according to their own budget,” and that “the State may intervene in the activities of self-governing territorial divisions only if such intervention is required by protection of the law and only in a manner defined by law.” Observation of what subnational governments may do does not necessarily reveal the very important substance of what they may not do. The

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“independent administration” spoken of in these passages pertains only to those particular functions allowed by the constitution and laws. Article 104 gives some indication of the powers “delegated to” lower territorial “self-governing” bodies. Paragraph (2) indicates that “a community assembly shall decide on matters of community self-government save in cases where these matters are entrusted to the assembly of a superior self-governing territorial division.” The constitution neatly avoids the transfer of many local functions normally regarded as a part of local governance to the municipalities and regions. But local assemblies, according to paragraph (3), may issue binding ordinances only “within the scope of their jurisdiction.” Article 105 limits the exercise of state administration “to territorial selfgovernment bodies only when so provided by law.” Local government may perform local functions only when the constitutional law and other legislation permit. In fact, the power that resides in the people resides in them only through their central government, not their local representatives. Before admission to the EU, the Czech and Slovak republics were encouraged to modify the high degree of centralization built into their traditions through reforms of public administration. The EU’s Phare program (1998), designed to assist pre-accession countries to prepare for membership, reminded the Czechs that in addition to traditional services provided by public administration (municipal, health care, school, transport services, etc.), some “classical” administration activities are also included in advanced countries. These include such things as issuing licences, documents, permits, certificates, providing information, and so on. Phare intoned that a number of such activities are no longer viewed as the exclusive domain of the state. “Our new experience shows that many operational tasks, professional decision-making, execution of supervision, testing etc. can be decentralized and transferred to self-government or to private entities.” After the reform had been implemented, Ježek, Marková, and Váˇna (2004) would write that the state delegates its power and public administration functions differently to different municipalities. All of the 6,258 municipalities (extant in 2004) execute self-government with the same basic scope of operations that the state delegates to them. To more than 380 municipalities the state extends additional delegated authority. The greatest scope of delegated authority is to 205 of these 380, which perform state administration for the central government while also governing themselves within the sphere granted by the constitution and legislation. In fairness, it should be noted that critical comments regarding the local autonomy enjoyed by muncipal governments in the Czech and Slovak republics should be understood from a comparative perspective. When one compares these two governments to those of other transition countries,

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especially a number of those once a part of the Soviet Union, they must be praised for the admirable degree of independence they have provided for local governments. But because these countries have entered with enthusiasm into formal associations with the most advanced countries, their achievements are compared here with the best of governmental practice. This comparison is obviously going to be less favorable for the Czechs and Slovaks. Kameniˇcková (2003) admits that local self-government is still relatively weak in the Czech Republic for reasons other than the degree to which authority is delegated or retained by the central government. Local autonomy and authority are a financial issue as well. Kameniˇcková emphasizes the lack of local taxes in the Czech Republic and that constitutional authority adopted a tax-sharing principle rather than empowering subnational governments to generate any substantial portion of their own funds. As a result, local governments cannot influence their own tax revenues, the most important source of local receipts. She indicates that local governments do have some limited influence on the yield of real estate tax and local fees, whose parameters are designed by the state. But they can merely choose within the bounds that the state indicates. The significance of these revenues in the total budget is, Kameniˇcková concedes, “somewhat negligible.” It is claimed that Czech municipalities enjoy substantial spending autonomy, but little revenue-generating autonomy. Realistically, however, if municipalities are unable to raise their own revenues and funds transferred from the center are not sufficient to meet an assortment of pressing needs, including infrastructure needs, the municipality is in a difficult position. Nor is the difficulty greatly ameliorated when transfers have few strings attached. The municipality is forced to fund what is most desperately needed and the opportunity cost of the decision to spend on any given item will foreclose other highly desirable alternatives. If infrastructure needs have been growing for 40 years, there will be a compelling need to spend on the most pressing infrastructure issues. To make the claim that infrastructure spending is an indication of local autonomy is to assume that infrastructure spending is chosen freely among possible alternative projects. As the backlog of needs declines, of course, and as transfers become more generous, the choices are less difficult. The less the scarcity, the greater the autonomy. The perception of autonomy on the part of municipal officials in the Czech Republic is not such as to support the claim that the abundance of transfers has ever eliminated the need for hard choices by the subnational governments. Oliveira and Martinez-Vazquez (2003) indicate that in the 2000 reforms of intergovernmental fiscal relations, the distribution of shared taxes was essentially shifted from a derivation principle to a per-capita distribution.

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Doing this has not yet met the remaining challenges of “overcoming municipal fragmentation, strengthening municipal borrowing, and promoting transparency, autonomy, and accountability, . . . transferring fiscal powers to the self-governing subnational units, equalizing fiscal opportunities, and restoring incentives for local taxes.” These experts assess the situation optimistically, noting that reform is a process rather than an event and that it will take time to reach the point that the Czech government wishes to reach. A problem that must be overcome is that “reforms made line ministries responsible for defining the functions to be transferred to the new regions, but it is unclear whether the central authorities are prepared to relinquish fiscal decisionmaking powers to lower-level authorities. In addition, it is unclear whether the central government and Parliament are committed to transferring significant revenue and spending autonomy to regional and local authorities.” With regard to the provision of opportunities for the local governments to function with greater independence in fiscal matters, Oliveira and Martinez-Vazquez (2003) assert that “there appears to be wide consensus on the need for and possibility of restoring incentives to mobilize local revenues—without undermining the central government budget. One way is through property taxes, by better defining and expanding their base and by providing regional and local authorities with limited discretion to establish property tax rates. A second possibility is to introduce a regional or local individual income tax, with a proportional rate that piggybacks on the national (progressive) individual income tax.” This conclusion follows clearly from the nature of the problem analyzed. Genuine fiscal autonomy cannot be achieved by municipalities fully dependent on the central government for their funds. In my view, there is also no guarantee of “partial autonomy” for the Czech case based on dependence regarding revenues and independence regarding budget expenditures. The Slovak Republic The situation in Slovakia before the government’s specialist on fiscal decentralization, Viktor Nižˇnanský (2000), aptly described the reform was that the central government directly and indirectly (through the district and regional offices of state administration) provided roughly 90 percent of all public services. Funding decisions about them were made at the central level; district and regional offices had no notable decision-making power or even influence on the amounts or destinations of centrally provided funding. Moreover, regional self-governing bodies were not yet operational, and local self-governing bodies remained tightly constrained in their policy and budget decisions on major public services such as education, social care, health care services, culture, and transportation.

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Slovak authorities on local government, Nemec, Berˇcík, and Kukliš (2000), point to Law 221/1996 on the territorial and administrative organization of the republic as establishing the legal framework for the exercise of local self-government. The municipality is alleged to be the basis of independent and representative local self-government. The law also calls for the creation of counties, of eight regions and of 79 districts, all authorized for state administration. Municipalities and military counties may also do so as prescribed by law. The authority and capacity of the regional and district offices were expanded significantly over time. State administrative tasks were carried out in 32 areas of activity by the end of 1998. They managed budgetary and semibudgetary matters in about 7,500 organizations and facilities in education, 370 in social care, 95 in health care, and 39 in cultural affairs. These offices employed in excess of 135,000 employees, and the administration and workforce requirements of regional and district offices employed another 20,000. The state administrative functions exercised by regional and district offices include state defense; general internal administration; trade licenses and consumer protection; civil protection; environmental management; fire protection; finances, prices, and management of state property; regional development; agriculture, forestry, and hunting; state veterinary care; public transportation and road management; public and concession procurement; health care; education; social affairs; culture; regulation; and international operation (Csanda, 2000, p. 307). On the basis of the European Charter of Local Self-Government, Csanda sets forth some of the main problems and negative experiences in local selfgovernment in the Slovak Republic from the perspective of the municipalities. He indicates first of all problems of subsidiarity, the concern that the state performs many functions that could better be performed for local citizens by local government. He further lists the right to the administration of matters concerning the municipality’s territory, as well as those concerning all the inhabitants of Slovak cities and townships. He is concerned about the independent administration of matters and issues addressed by Article 67 of the Constitution of the Slovak Republic. The document states that “in matters concerning territorial self-government, the municipality makes its independent decisions; responsibilities and constraints may be imposed on it only through an act of law.” Csanda explicates the basic problem as follows: the creators of the legislation on municipalities did not take into account historical domestic and foreign experience and custom in defining the competencies of municipal bodies. Self-governing bodies in the Slovak Republic thus far have not been vested with the rights and abilities to manage a

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substantial portion of the public administration in their territories—as if our legislature looks upon the self-governing bodies that are closely connected to the local community and its everyday problems with a certain mistrust. (p. 387)

As was mentioned in the Czech case, an important part of local government autonomy is fiscal autonomy. From the perspective of Nižˇnanský (2000), financial adjustment ought to provide municipalities and cities with the necessary resources to enable them to perform their functions, but state assistance is usually fraught with a serious problem. It must not interfere with the diversity of financial powers that accrue to autonomous municipalities. “If a financial adjustment, for example, were to cover differences 100%, territorial self-governments would lose interest in using their own taxation authority and would instead rely totally on adjustment mechanisms” (pp. 6, 7). Elections in 2006 revealed that the Slovak citizenry had much less respect for Slovakia’s decentralizing government than outside agencies and observers had. They voted it out, selecting a new coalition that left the continuity of policy somewhat open to question. The central government, for which Nižˇnanský was the plenipotentiary on matters of fiscal decentralization, considered state power from a very unusual perspective for this part of the world. Its view was that the state’s role in public administration should be defined in terms of what it should not undertake to perform. The state’s recommendation for reform of public administration in Slovakia has been to pursue fiscal decentralization while anticipating a marked decrease in the role for state institutions in public affairs and a transfer of most public service responsibilities to regional self-governing bodies. It was not as confident about transfering such responsibilities to the municipal level. The state’s role in public administration should not go beyond supporting, controlling, and organizing tasks with respect to external independence (foreign policy, national defense, and civil protection); maintaining law and order (e.g., selected areas of security, education, trade, water supply, medical and hygienic supervision); protecting freedom and civil rights; social legislation; and national economic policy. The central government and regional offices should perform these tasks. All remaining tasks should be the responsibility of local and regional self-governing bodies. This ideal, especially given the altered political situation in the country, appears somewhat utopian at this point. The Impact of Reform and Development on State Administration As time passes, attitudes of voters and policymakers toward even basic institutions of governance gradually change. Moreover, as dissatisfaction becomes

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focussed and reforms are undertaken, even basic institutions can change, although the process is seldom a rapid one. As we have seen in previous sections, the dynamics of governance, the exigencies of preparation for accession to the EU, the experience with governance, and other factors have had an impact on basic institutions in both the Czech and Slovak republics. This section is designed to pull together the essence of how reforms and the passage of time have come to change the basic institutional arrangements of state administration. Much of what needs to be said in that regard has already been discussed above, so the need here is simply to summarize and elaborate on a few points. Outsiders have tended to call to the attention of the Czechs and Slovaks that, although the new fiscal system established after the Velvet Revolution was designed to be more like Western systems in general, the heritage institutions of central planning still affected its final complexion rather strongly. The anticipated solution to residual centralization was the adoption of reforms of public administration. These reforms added a regional level of governance in both countries and went even further in Slovakia. The Czechs, more concerned with the management of national deficits and debt, did not pause to reconsider the fine points of intergovernmental finance that the Slovaks found important. As we saw, the Slovak Republic empowered municipalities to set their own local tax rates and user fees and to introduce new taxes and fees. Incidentally, it appears that actions proposed in the Czech Republic in April 2007 could lead to some innovations similar to those of Slovakia, including a 15 percent flat tax for the income tax. But at the time of writing, this development is still in the process of political review. In Slovakia, municipalities were also granted greater discretion over their use of the property tax. New regulations transferred responsibility for the establishment of tax rates for buildings, land, apartments, and nonresidential premises to local self-government bodies. These changes were often overlooked by the media, which were intrigued with Slovakia’s adoption of the 19 percent single tax rate for the value-added tax as well as for the corporate and personal income tax. But in both cases, the attempt has been to rationalize and modernize state administration rather than to move toward its elimination. Reforms have attempted to establish more clear lines of authority and improve hierarchical relationships at the various levels of state administration (Lacina and Vajdova, 2000). Reforms have attempted to improve the relationships between the state-appointed, centrally managed organizations delivering state administration services on the one hand and the elected local officers performing “self-government” tasks, some of which need to be coordinated and correlated with centrally managed activities, on the other. Whether this is seen as organizational tinkering or rationalizing human resources institutions, it

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is not to be understood as pursuing a path of eliminating central management of local affairs. Langšádlová (2003) has provided information and data that give the reader a good sense of the cost effects of shifting tasks of state administration from district offices to selected municipalities. At the beginning of 2003, 205 municipalities assumed the performance of delegated functions of state administration when the district offices were eliminated. They were empowered by new laws of public administration reform to do so; other tasks formerly assigned to district offices were transferred to the new regional governments. Municipalities with delegated functions received transfers in the amount of 4,337 billion CZK to perform 12,984 functions. It is fascinating to see the EU modernize its policies, especially in the form of the relatively new Lisbon Program. Some expect the Lisbon approach to economic development, which moves away from the traditional programs of regional subsidies to a less costly promotion of information technologies and telecommunications as the high-tech vehicle, to promote progress within the community as a whole. The Czech Ministry of Finance (2005) has expressed that country’s determination to pursue that path toward development. The Lisbon program is seen by the Czech government as “a means of changing the European economy with the effort to catch up with the most developed world economies. More likely it is an attempt to fulfil the European vision of future, based on modernisation of EU economy while maintaining the particularities of its social model.” Yet this same modern EU seems to have accepted as “reform” a mere paring down of state administration and a shifting in the organization charts of where this central work is performed. The Czech and Slovak central governments’ fairly complete management of local governance remained even after the reform of public administration. The standard defense of state administration in the Czech Republic has been that it is the unavoidable solution to the problem of the many small municipalities. The Slovak Republic is less complacent about the problem of local governance and is seeking other solutions, as we have seen. When the Slovaks discuss the fundamentals of the question, the most obvious solutions are all listed. Some, not being perceived as being politically realistic or credible, are not discussed at length. We return to this issue in the conclusions below, but note here that the EU appears satisfied with this rationalization of these centralist institutional arrangements. Conclusions As a part of its reform of public administration, the Czech parliament passed an Act on the Establishment of Municipalities on April 12, 2000. Paragraph 19, section 1, of this act provided for the merger of two adjacent

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municipalities, which action must first be “discussed” with the District Authority. Section 3 allowed a municipality to join a neighboring one. Paragraphs 46 and 50 described possibilities for legal cooperation between Czech municipalities. Such cooperation may proceed on the basis of a contract to perform a particular task, or a voluntary association of municipalities may be formed for such purposes, or, finally, a legal entity may be formed by two or more municipalities to pursue joint interests. Paragraph 50 spells out the kinds of activities an association of municipalities may pursue, for example, education, social care, health, culture, fire protection, public order, environmental protection, tourism, and care for animals. Cooperation is legal and by implication desirable where the many small municipalities of limited resources wish to ensure “the cleanliness of the municipality, management of vegetation and lighting in public places, collection, removal and safe treatment, use or disposal of domestic refuse, water supply and sewage disposal and treatment, installation, expansion and improvement of main networks and public passenger transport systems to provide transport services.” A number of other such activities are listed in the sections of this paragraph. In the Czech Republic, this challenge seems to recommend the administrative union of small groups of villages. But the work of establishing municipal alliances is just beginning, and it is apparent that this is the method by which greater local autonomy could be achieved. There has been a tendency for the smaller municipalities to begin to look for alliances with neighboring towns or villages to specialize and divide the labor of social, educational, and other public service functions. It should be emphasized that the alliance of small units provides for a larger base of resources with which to pursue an enhanced delivery of public services. But it is also very important that it provides for specialization and division of labor in local public service functions. Of the various public services that could be provided by an alliance of small municipalities, a given mayor could spend a more substantial amount of timegaining skills and information in the provision of a single service that is of interest to his town as well as to the other towns in the alliance. One practical and fascinating example of this kind of development is that of the town in southern Bohemia, Hluboká nad Vltavou, which is a part of an alliance of seven or eight neighboring villages. The mayor of Hluboká serves in that same capacity for the other allied villages as well. It was suggested some time ago (Bryson and Cornia, 2001) that assuring the competent administration of small units, given their obvious resource and personnel limitations, would require either the administrative union of small groups of villages, the establishment of an intermediate level of administration to assist the villages in interacting with the center, or both. The

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recommendation to establish territorial regions to assist the municipalities with their administrative challenges has already been adopted, as has been explained. The municipalities were not vertically subordinated to the regions by the reforms that created the latter, and the municipalities still report directly to the center. Nor have the regions received a mandate to assist small municipalities lacking the resources to manage their administrative functions independently. Perhaps this lack of an assisting link between regions and the many small municipalities was deliberate in the reform effort, so that the continued paucity of resources in the small towns will continue to be justification for the traditional centralism favored in Prague. However, given the practical and sensible nature of the Czech people, it seems apparent that as the municipalities develop local capacity, the center will support greater local autonomy. If the municipalities are to achieve a situation permitting greater local autonomy, it appears they will have to do it on their own. The center does not wish to force amalgamations, which would be distasteful to the Czechs in general. But it could greatly assist that outcome by providing the appropriate incentives. Many financial techniques can make transfers, tax sharing, and grants more generous for the municipalities that demonstrate their willingness to enhance their capacity to provide public services by becoming part of an alliance of municipalities. Most of what has been concluded for the Czech Republic applies as well to the Slovak Republic. Of numerous Slovak references to unions of small municipalities, it is sufficient to cite Nižˇnanský (2000, p. 4). This astute observer insists that if it is not efficient for a small municipality to provide public services on its own, such services can be delivered via diverse forms of voluntary partnerships, common councils, companies, and agencies operating on the basis of contractual agreements with municipalities. In some cases, larger municipalities can provide services through contractual agreements with smaller municipalities in the same proximity. As in the Czech case, Slovak municipalities will move toward alliances as is helpful. Appropriate incentive structures for intergovernmental fiscal policies could provide encouragement to do so.

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CHAPTER 2

Taxes on Real Property in the Czech Republic∗ Historical Background Early on, the Czech Republic was perceived as a leader among the Central and Eastern European nations making the transition from central planning to a market orientation. Czech economic and fiscal accomplishments, the progress of local self-government (samospráva), and the role of the property tax in local government finance illustrate important aspects of the transition. Until the end of World War I, the Czech lands of Bohemia and Moravia were part of the Austro-Hungarian Empire. They had been permitted limited participation in self-government and demonstrated notable industrial development (Wolchik, 1991, p. 8; see chapter 1 for a succinct review of recent Czech history). When the empire was broken up in 1918, Slovakia was joined with Bohemia and Moravia to form the federal state of Czechoslovakia. An early experiment in federalism offered the opportunity to experience democracy and begin a tradition of local self-government. The Economy in the Communist Era Czechoslovakia’s development was disrupted by the Nazi invasion and World War II. The subsequent 40-year communist period held Slovakia’s strong nationalist sentiment and the principle of samospráva in abeyance. The ∗

This chapter was originally published in a collection for the World Bank. See Phillip J. Bryson and Gary C. Cornia with Alena Rohlíˇcková (2001), “Taxes on Real Property in the Czech Republic,” in Jane Malme and Joan Youngman (eds.), The Development of Property Taxation in Economies in Transition: Case Studies from Central and Eastern Europe (Washington, D.C.: The World Bank), pp. 39–50. Copyright permission was granted by The International Bank for Reconstruction and Development, The World Bank.

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Czech lands retained the integrity of their relatively advanced, pre-communist industrial development, while the traditional, structurally disadvantageous industrial projects of the Soviet developmental style were imposed on a Slovakia that had been predominantly rural (Frydman, Rapaczynski, and Turkewitz, 1998, p. 49). The central planning philosophy of the communist era was extended to the provision of local government services, almost all of which were funded by central government grants as a result of indirect taxes and transfers imposed on retail and industrial activities. In addition, the central government controlled the quality and type of local services. There was a general feeling that the process of allocating funds to local governments was influenced by political or party connections rather than by legitimate needs for public services. This approach to grants distribution generated a great deal of mistrust of the central government at the local level. The Transformation Era The collapse of the centrally planned social system in Czechoslovakia followed by two decades the Prague Spring of 1968, when the attempt to achieve political and economic liberalization led to the Warsaw Pact invasion of Prague (Frydman, Rapaczynski, and Turkewitz, 1998, pp. 52–58). Beginning with the Velvet Revolution in December 1989, the Czechs and Slovaks began their journey down the path of economic and political transformation. Their joint endeavors did not last long, but between 1990 and 1993 they installed a number of common institutions, including a more Western-style tax system. The nationalist aspirations of the Slovaks led to an agreement to dismantle the federation in the Velvet Divorce of 1993.1 With the end of Soviet control of the economy, reformers faced numerous complex problems. Housing for the most part had been publicly owned and subsidized. Rural land had been combined into large agricultural collectives. Most retail trade was conducted in state-controlled stores. Industrial activity was a function of central ownership and planning. In short, there was no market to establish scarcity prices or to indicate the value of homes, farms, and businesses. In general, the Czech Republic has been successful in casting off the central planning system and has been heralded as the most effective economic system to embark on the path of transformation. It achieved relatively low inflation and unemployment and succeeded in avoiding significant budget deficits (OECD, 1996, p. 100). Strong economic performance followed the 1989 revolution because of an early liberalization of prices, a far-ranging privatization effort, an opening of the market to international trade, a reorientation of foreign trade to the European Community area, and generally effective macroeconomic policies. The Czech Republic was the first post-communist member of the Organisation for Economic

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Co-operation and Development and was among the first transition states qualifying for accession to the EU (CIA, 1998). The process of industrial restructuring has not been completed despite successes in the privatization program. Opposition political parties have sought to take power by promising to alleviate the transformation through more gradual transition policies to help shield unproductive firms from market costs. The Ministry of Finance and the banking system have not learned how to function in a market environment that attaches importance to creditworthiness for loans. In the new environment, a go-slow transformation policy administered by the Ministry of Finance simply permits the credit policies of the large, state-owned banks to keep less-than-profitable firms in business (see Frydman, Rapaczynski, and Turkewitz, 1998, pp. 72–79 for a discussion of the banking system in the former Czechoslovakia and in the Czech Republic). While this analysis is oversimplified, we understand that some bank loans were made for risky projects early in the transition process and that some nonperforming loans were associated with the collapse of the Soviet bloc’s Council for Mutual Economic Assistance (OECD, 1996, p. 52). Early in the transition era, firms that should have been closed down made massive, reciprocal inter-enterprise credits. The Czech reputation for transformation success suffered in late 1997, when the premiership of Vaclav Klaus, a respected leader of the Czech recovery, ended in a campaign finance scandal. Through that period, the finance ministry and the Czech government tended to ignore economic pressures to move ahead with the large banks’ privatization. Since that time, progress has been steady, if not rapid. The banking sector, important because it will remain the primary source of investment funds in Eastern Europe for some time to come, is now approaching full privatization (Frydman, Rapaczynski, and Turkewitz, 1998, p. 72). The state of the banking sector has important implications for the development of the real estate market and the use of the property tax. Because investment funds are scarce yet vital for the investment processes that will promote development, little money is available for a home mortgage market. At the same time, the development of a real estate market has been slow, perhaps because of reluctance on the part of the Czech population to take on the obligation of long-term mortgages, thereby constraining the development of demand in this market. Privatization Because so many of Czechoslovakia’s state-owned enterprises were not viable in market terms, privatization was perceived as a priority when the

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transformation began. Private ownership was to be the means of restoring productive efficiency, providing market rewards to motivate managers and workers, and offering incentives for entrepreneurs to leave dying markets and penetrate viable ones (Brada, 1996, p. 68). Privatization is exceedingly important in any discussion of the potential for property taxation in transitional countries. Transferring state-owned industry or housing from the public to the private sector increases the base of taxable properties. If privatization is successful, a more productive market performance by property owners produces not only more private wealth but also greater tax revenues and a more beneficent public sector to enhance the citizens’ lives. The first phase of the Czech Republic’s privatization process was probably the most successful. It involved the sale of (or in a few cases leasing rights to) state properties, especially small service establishments, such as shops and restaurants. Between 1990 and 1992, 26,000 such establishments were auctioned, producing revenues of 3.4 percent of gross domestic product and 4.7 percent of government expenditures for 1991 (OECD, 1993, p. 70). The privatization of industry in Czechoslovakia began in October 1991 with two waves of voucher privatization. About 700 state enterprises having an estimated value of about CZK 175 billion were earmarked for the first wave. Formal projects or proposed privatization plans were required for the state-owned enterprises that were prepared to transform themselves into corporations. Outsiders could submit privatization plans for enterprises.2 About 1,500 competing projects were presented, representing an average of nearly four competing plans for each firm being privatized. The Czech National Property Fund designated CZK 206.4 billion (943 joint stock companies) for voucher privatization, and Slovakia’s National Property Fund designated CZK 90 billion (484 joint stock companies) for the project. These projects elicited the participation of 5.9 million Czech citizens and 2.6 million Slovak citizens (Mikloš, 1997, pp. 103–119). This process successfully privatized from 65 percent to 90 percent of all Czech state-owned assets, a significantly higher proportion than for neighboring countries. Because the voucher scheme permitted 77 percent of eligible citizens to participate in the first wave, and even more in the second wave, the process was quite popular. A major problem was that investors turned over 72 percent of their voucher points to investment privatization funds in the first wave and 64 percent in the second. The largest 14 of these investment groups managed 55.5 percent of all available first-round vouchers. Most of the investment privatization funds were established by banks, and they emerged from the process with extensive, interlocked industrial and banking

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holdings. This feature makes the Czech ownership structure similar to those of Germany and Japan (Brada, 1996, p. 73). Fiscal Affairs and Tax Reform While the transformation process has brought the Czechs some successful changes, their fiscal and governmental systems remain essentially a two-tier democratic republic consisting of the national center and the municipalities. There are 6,234 independent municipalities in the Czech Republic, a number that has increased notably since 1989. Liberated from the socialist era of central planning, small communities strongly desired and were permitted to assert their individual independence. As we have seen, the number of municipalities increased substantially as previously forced mergers were dismantled. The challenge of assuring the competent administration of these small units, given their obvious resource and personnel limitations,3 suggests either the administrative union of small groups of villages, the establishment of an intermediate level of administration to assist the villages in interacting with the center, or both. As a step toward resolving this problem, the subnational portion of the system will adopt about 14 regional administrative units to assume some central government and municipal functions. A fundamental question in fiscal matters is the degree of centralization of the taxation system. The Czech system has been highly centralized through recent decades, although since the revolution there has been a tendency to consider and pursue measures that would promote more genuine independence for the municipalities. As is common in the transitional countries, the central government still plays a dominant role in intergovernmental relations and in the determination of policies normally made by the local government in industrial countries. Likewise in tax affairs, the mechanics of implementation remain almost exclusively the domain of the Ministry of Finance and the Ministry of the Interior. The fiscal system is changing, nevertheless, through the rediscovery of its history of capitalism and democracy between the wars, beginning in 1918. At the end of World War II, normalization was just being approached when the communist takeover put market economics on hold. Since the liberation of 1989, there has been a strong consensus in Czech society that a market-oriented economic order should be reestablished. Although there may be disagreements about how such a system can best be achieved and the pace of the transition, the development of democracy and local self-government is a high priority for Czechs in general.

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The tax system of Czechoslovakia, like that of other centrally planned economies, was unsuited to make a successful transition, so a comprehensive tax reform was instituted in 1993. The new system, typical of other former communist countries, largely imitated Western European fiscal systems. It attempted to respond to Western tax conceptions, but inevitably reflected some of the old system’s legacies (see Holzman, 1992, pp. 233–255). The early tax reforms did attempt to introduce elements of Western-style decentralization, but the result has been “a highly complex, uneven and distortionary system” (Holzman, 1992, p. 234). An altogether separate question is whether the Czech and other transitional tax systems were geared toward generating sufficient revenues. When the Czech system was introduced in 1993, there was a balanced reliance by the policy designers and policymakers of the republic on direct and indirect taxes. After the socialist period, in which taxes were by and large hidden, it took some administrative courage to introduce direct taxation to a reluctant populace. The most prominent indirect tax in the Czech Republic is the value-added tax. It has two rates, 5 percent for necessities and 22 percent for other commodities and services. The top rate is the second highest among transition countries (Martinez-Vazquez and McNab, 1997, p. 60). Other indirect taxes include an excise tax (applied to gasoline, tobacco, and alcoholic beverages) and customs duties. Czech direct taxes include personal and corporate income taxes. The personal income tax, introduced in January 1993, has been gradually reduced, with the 1999 rates ranging from 15 percent on an annual tax base up to 102,000 Czech crowns (CZK) to 40 percent on an annual base greater than CZK 1,104,000. Each taxpayer is allowed a personal deduction of CZK 34,920, CZK 19,884 for a spouse, and CZK 21,600 for each dependent child living with the taxpayer. The corporate income tax rate is 35 percent. Since 1996, 20 percent of the corporate income tax yield is returned to the locality where it is collected. These taxes represent additional revenues to replace 36 percent of the wage tax yield, which is to be transferred from local budgets to the central budget. The interjurisdictional sharing of tax revenues is an established practice, as elsewhere in the region, although it is often based on the misdirected assumption that all tax revenues should be restored to the area in which they were collected.4 Other important forms of direct taxation in the Czech Republic are a road tax and the property tax. The Property Tax In many countries, notably the English-speaking ones, the property tax is the most important source of revenue for local governments (Bird and

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Slack, 1991, pp. 83–97). It has the potential to be an important tax for municipalities in the transitional countries, although it has proven difficult to implement. The Czech Republic has a property tax, but it provides very little revenue. Decentralization and the Property Tax Implementation of the property tax requires an assignment of policy and administrative functions. Policy issues consist of the types of property to include in the base, the level of assessment, the revenue importance, and the tax rate. Administration is concerned with the property valuation, recordkeeping, and collection of the property tax. Countries must also make explicit decisions on which level of government will be responsible for each of these general areas. In the United States, the property tax process has been decentralized for both policy and administrative issues. In some countries, such as the United Kingdom, only part of the process has been centralized, whereas in the Czech Republic and some other countries both functions have been centralized at the national level. All four approaches have advantages and disadvantages. The major disadvantage of the decentralized approach is that local governments may not have the technical ability to administer the property tax. The disadvantage of centralization is that the central government does not receive any revenue directly from the property tax, so policy and administrative issues may not receive priority attention. General Problems with the Property Tax Aside from the challenge of identifying the appropriate degree of devolution, administration of the property tax can be quite difficult and costly and often encounters widespread resistance (see Bird, 1993, pp. 215–216). One problem for this type of tax is its visibility. It is not deducted in small installments, but usually must be paid directly to the municipality in a lump sum. When inflationary pressures require upward adjustment of the tax to enable continued provision of increasingly costly services, taxpayers become even more aware of these increments, as well as the services. Should services financed locally by the property tax (such as roads, garbage collection, and often education) be of poor quality, the taxpayers wonder why they are paying good money for poor services and come to resent the tax. Finally, for both technical and political reasons, assessed values will diverge from market values within classes of property. Taxpayers can compare their property taxes with their neighbors’, thus giving rise to politically and financially costly

30

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Property Tax and Fiscal Decentralization in the Twin Republics

assessment appeals, as well as strong sentiment for tax relief. In any case, public disenchantment with property tax increases can be expected, especially in inflationary times, whether the increase results from higher rates applied to an unchanged set of assessed values, unchanged rates applied to higher assessed values, or a combination of the two. Strengths of the Property Tax Despite the public’s tendency to oppose the property tax, there is much to recommend it. A tax on real property might well “make good sense as part of the tax system as a whole . . . the property tax scores quite well in terms of both its efficiency and its equity aspects” (Bird, 1993, pp. 215–216). If fiscal decentralization is to be successful, municipalities must receive a reliable source of revenues supplied independently of the state and have a measure of independence in policy determination on local fiscal issues. Anything less leaves municipalities excessively dependent on the state, underfunded, and incapable of rendering services to the level of demand. Even if the low level of the property tax were increased to provide genuine assistance in the delivery of municipal services, the taxes and user fees commonly perceived in the transitional countries to be appropriate for local governments are insufficient to perform all the necessary tasks. Hence, some revenue transfers from the central government will continue to be necessary, unless the mix of taxes used by local governments is enhanced strongly, presumably by shifting some kinds of taxation from central to local jurisdiction. Another reason for transfers would be the need to deal with externalities. Furthermore, genuine local self-government is not consistent with central control over policy setting in municipal fiscal affairs. In the Czech Republic, Kameniˇcková (1996, p. 16) has described the tax system as one in which “there are no local taxes.” The center, either the national administration or parliament, determines the decisive policy prerogatives of all taxes.5 Municipalities have little opportunity to affect tax revenues by their own choices. They are, of course, able to sell properties that have accrued to them through transition processes or to make loans in the event of revenue shortfalls. Property is a nonrecurring revenue source, however, that will not provide a sustainable cash flow indefinitely, and loans must be used with prudence. Intergovernmental Organization Property tax policy in the Czech Republic is the parliament’s responsibility, but tax administration and long-run strategic policy issues are highly centralized in the Ministry of Finance. The ministry’s district financial offices, located throughout the country, look after the day-to-day administration.

Taxes on Real Property in the Czech Republic

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31

As a result, alternatives to change the property tax system generally originate with the Ministry of Finance. One advantage of this centralized approach is that suggestions for improvement rest with one agency. International consultants, for example, have to deal with only one governmental entity, which is likely to have professional staff familiar with the reforms being recommended, and the solicitation and coordination of alternatives are less likely to be caught up in local politics. One disadvantage is that proposed changes in the property tax may not have the support of local political leaders, because they were not involved in the process. The second disadvantage is that a centralized process may ignore the economic and social differences among the more than 6,000 local governments. Finally, centralized policymaking may not account for the administrative competencies of the local governments. In this case, policymakers apparently felt that successful property tax implementation required a strong role for the central government. Tax Base and Rate The tax base and rate determine the tax yield on real estate. Both land and buildings are included in the property tax base, but the valuation of each is made separately. The tax base reflects primarily the area of land plots and the floor space of buildings. The process by which a property’s actual value is determined is established by national law. Tax rates are also centrally determined, and there are separate rates for land and for buildings. Valuation Although the property tax valuation of land and buildings is based on the area in square meters, local tax administrators can make some modifications as a function of the city’s size and the type of land or buildings in question. Thus local authorities do have some input in the determination of actual tax revenues, but the leverage is not significant enough to augment local revenues effectively. The taxpayer completes valuation of properties and is also responsible for the actual calculation of taxes due. Self-reporting of data is uncommon in most countries, and self-determination of taxable value is even less common. Interestingly, the amount of this tax, even when combined with the inconvenience of filling out the forms and determining the actual tax due, has not led to excessive noncompliance or complaints from taxpayers. The property tax form is included in a manual that directs taxpayers in valuing each parcel of property and type of building. For example, the formula for determining the taxable value of a building is as follows: the tax

32

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Property Tax and Fiscal Decentralization in the Twin Republics

base equals the area of the building in square meters multiplied by a coefficient related to the size of the city where the building is located.6 Thus the taxable value is primarily a function of the land or building area in square meters rather than the market price. This non-market-based value system reflects the lack of a normally functioning real estate market and of professional property tax administrators. The system also reflects the traditional use of the property tax that was imposed on private residences and farms during 40 years of communism. We have been unable to determine how the values of coefficients were established, but the use of the coefficients for local purposes is more apparent. Municipalities can adjust their coefficient down three levels or up one level, and the city of Prague can apply a coefficient of 5 to certain well-located properties. For buildings with multiple levels, a factor of 0.75 of the ground floor base is added for each level and the total square meters are multiplied by the appropriate coefficient. To determine the amount due to the Ministry of Finance, the taxpayer multiplies the base by a specified rate. For buildings, the rate is stated in Czech crowns and ranges from CZK 1 to CZK 10 per square meter of floor space. For each class of property (land), the owner is instructed to multiply the base in square meters by both a rate and a coefficient. These determine the amount of the tax, reflecting the attributes of the land (that is, location, size of the parcel, and use). This system applies to yards and buildings; vacant plots; residential parcels; sites for garages; summer cottages; and industrial, commercial, and service institution property. Exceptions are made for agricultural land, forests, and fishponds. The tax on agricultural land is based on estimates of the average productivity of the land in the cadastral region, as determined by the Ministry of Agriculture and reported to the Cadastral Office. The Ministry of Finance issues the official values as a price decree. After calculating the tax due, the taxpayer files the return and makes payment directly to the district financial office of the Ministry of Finance, which then returns property tax revenues to the taxpayer’s city. The district office enters data from the tax form in the ministry’s computerized recordkeeping system, which is itself a significant accomplishment. The property tax burden is relatively light. The burden is heaviest on improvements to land relative to the tax on land, reflecting the political power of the farming sector in the economy and perhaps a misunderstanding of the potential benefits of taxing land at rates at least equal to those imposed on improvements. Exemptions The Czech property tax system grants exemptions separately for land and buildings, as is standard in other countries. Land exemptions include

Taxes on Real Property in the Czech Republic

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33

state-owned parcels and plots for military use, schools, and natural preserves. An interesting exemption is forest land used for the transmission of natural gas and electricity, which in most countries represents a substantial portion of the taxable value of gas and electric utilities. Exemptions on buildings include those allowed for state- and city-owned structures, churches and schools, and publicly owned housing, which makes up about 50 percent of all housing. The property tax is used to encourage private residential construction by exempting new homes from the property tax for 15 years.7 To encourage the transition to market ownership, lowincome older individuals in residences restored to private ownership through restitution are also granted a 15-year moratorium from the property tax. All exemptions must be applied for annually. Owners of land and buildings who believe they are exempt from the tax must complete the normal forms and request the exemption from the Ministry of Finance. However, local authorities clearly have some autonomy in granting specific exemptions. For example, in some parts of larger cities the exemptions granted by the local authority represent a major portion of the potential tax revenues, causing concern that social welfare considerations may endanger tax revenue adequacy (Holzman, 1992, p. 242, indicates that the Czech Republic also grants exemptions on the value-added tax for consumer goods “with detrimental consequences for tax revenue”). Sources of Information Although the Czech Republic has a self-reported and self-assessed property tax system, compliance appears to be quite good. Fiscal authorities obtain information on compliance through two methods. Annual estimates of potential property tax receipts are conducted using cadastral data, which, as described below, are certainly not above suspicion. The estimated potential receipts are compared with actual, aggregate receipts. The Ministry of Finance also compares corporate tax returns with the filed property tax returns. Because the property tax payments of small businesses are deductible from the corporate income tax, an electronic comparison of the two files by the Ministry of Finance allows non-filers to be identified. Little enthusiasm is apparent for auditing, and from our observations, none is systematically made. One problem with the level and quality of information is the cadastral system, which was adopted in the 1870s and operated with few interruptions until World War II and the communist era, when it was basically ignored. The decline of the system was notably severe in the rural areas, where farms were formed into state-owned collectives and legal boundaries became unimportant. In 1964 the cadastral system was revised and property rights

34

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Property Tax and Fiscal Decentralization in the Twin Republics

began to be recorded, but the reporting requirement was voluntary and was generally ignored. An attempt was made in 1976 to computerize the cadastral office, but by 1990 there was only one central computer and one database. After the Velvet Revolution, the cadastral system was reconstituted in 1993. At present, 77 computerized district cadastral offices with 6,000 employees are improving the quality of land records. The goals of the Cadastral Office are to record descriptive information, to develop digitized maps, and to maintain archival data on all parcels. None of these is a minor task, and decades of neglect complicate the process. The office must first identify the ownership of millions of parcels of land. The cadastral system had records of 13 million parcels in 1993, but there are estimates that 8 million to 10 million parcels have never been recorded. The Cadastral Office and the Ministry of Finance report an excellent working relationship, but a system that is missing data on millions of parcels undermines the credibility of the property tax system. Even if data were accurate and complete, the cadastral system is not linked electronically to the Ministry of Finance and does not include information on buildings or improvements, a serious omission that needs correction. On a more positive note, efforts are under way to correct the problem of unrecorded parcels by developing an online system linking the Cadastral Office and the Ministry of Finance. Appeal Procedures There are formal mechanisms for submitting appeals at the district offices of the Ministry of Finance, but there is little activity. Because taxpayers determine their own status and tax liability and the tax rates are low, there is little more to protest than the legal declaration of property classification. Revenues The property tax holds the key to raising sufficient revenues to provide services for subnational governments. While the property tax had a tradition in the former Czechoslovakia, it was apparently largely symbolic and was assessed only on single-family homes and agricultural land. Since the revolution, the property tax has not yet become a substantial part of the fiscal scene, but time has demonstrated the need for an autonomous source of local revenues. As the central government’s need for revenues increases and the limits of other tax revenues are approached, it appears anxious to retain a larger proportion of these yields, while encouraging the subnational units to generate a healthier share of their own income.

Taxes on Real Property in the Czech Republic Table 2.1

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Revenues of Districts and Municipalities of the Czech Republic (Millions CZK)

Total Revenues Tax Revenues Other Taxes Real Estate Taxes Non-tax Revenue Transfers State Budget

1993

1994

1995

1996

1997

1998

101,326 35,970 32,949 3,021 19,143 17,000

110,985 53,243 49,435 3,808 21,453 15,483

129,115 70,679 66,880 3,799 18,401 16,306

161,681 72,670 68,652 4,018 21,333 16,840

147,070 76,093 72,150 3,943 23,546 18,020

161,801 83,320 79,212 4,108 24,708 17,913

District and Municipal Revenues as a Percentage of Total Revenues

Real Estate Taxes as % of total revenues Real Estate Taxes as % of total tax revenues Real Estate Taxes as % of other tax revenues Real Estate Taxes (% of non-tax revenues) Real Estate Taxes (% state budget transfers)

1993

1994

1995

1996

1997

1998

2.9

3.4

2.9

2.5

2.7

2.5

8.4

7.1

5.4

5.5

5.2

4.9

9.2

7.7

5.6

5.8

5.5

5.2

15.8

17.7

21.0

18.8

16.7

16.6

7.8

24.5

23.2

23.8

21.9

22.9

ˇ ˇ Source: Data from Statistická Roˇcenka Ceské Republiky (Praha: Ceský statistický uˇrad, 1997), featuring our calculations and data arrangement, and using OECD guidelines for 1997 and 1998.

Although the share of real estate tax in the revenues of the subnational governments is not insignificant, it is certainly modest when compared with individual income taxes. The property tax has been quite level in recent years, although some growth in tax receipts has been experienced through other taxes (Table 2.1). Nevertheless, finance authorities have begun to perceive that the property tax represents a less than fully tapped source of funds for local services. A new tax law proposed by the Ministry of Finance to pursue these potentially larger revenue yields could increase the significance of the property tax by as much as a factor of 3. The political crisis that ended Vaclav Klaus’s tenure as prime minister intervened in the legislative process. Discussions continue about the introduction of a market-based property tax, but consideration of concrete proposals has been repeatedly postponed. Current Issues Other issues under discussion have implications for the property tax. First, there is a proposal to reclassify the fees charged for local government services

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Property Tax and Fiscal Decentralization in the Twin Republics

as taxes and to expand their range, thus providing some increase in current revenues as well as a modest source of new revenues. Second, an effort is being made to limit local debt, which has grown quite rapidly in the past few years in a number of municipalities. Third, the distribution of taxes from the central government will be modified to reduce the disparities in the distribution of shares of taxes transferred to local governments. Finally, as noted above, the Czech Cadastral Office is working aggressively to update the system and link it electronically with the Ministry of Finance. The overriding consideration in fiscal developments is the flow of resources to the municipalities. The central government has been willing to share responsibilities for the provision of services without an equal willingness to share the revenues that those services would require. While the national government is concerned with local resource requirements, and is prepared to discuss and pass legislation to improve the situation, the municipalities have been unable to count on funds for other than current operations. On a continuum from simple non-market-based systems to systems whose taxable values are derived from actual market data, the current Czech system is much closer to the non-market variant because the emerging privatization process has not yet yielded a real estate market to generate scarcity prices. These markets are evolving slowly, but many issues remain to be resolved. In housing, rents are largely regulated, especially on nonprivatized dwellings, and the banking sector is not organized to enable the financing of private housing. Although the Czech property tax is modest, it represents several notable accomplishments. Its design and implementation, developed in an orderly manner, have been geared to create a system that can be administered in the context of the resources available to public officials. The goal of improving property tax administration is seen as a key step in the development of public finance. The government, by moving slowly in its efforts to change the property tax system to a value-based tax, has taken a long-term view of the process and has established a foundation that should contribute to a successful transformation.

CHAPTER 3

Land and Building Taxes in the Republic of Slovakia∗ Historical Background Slovak culture and traditions have developed in the shadows of the country’s neighbors: the Czech lands and Austria to the west, Hungary to the south, Poland to the north, and Ukraine to the east. Freed from Hungarian occupation at the end of World War I, Slovakia shared federal status with the Czechs as part of Czechoslovakia from 1918 to 1993.1 A Slovak state was established under Nazi tutelage in March 1939 (Wolchik, 1991, p. 13). When World War II ended, democracy made a faltering new beginning, and the federation continued into the period when the communists seized power. Czechoslovakia was part of the Soviet bloc as a member of the Warsaw Pact and the Council for Mutual Economic Assistance. Since late 1989, both the Czech and Slovak republics have been developing democratic and market systems. In 1993 the two republics separated, in what was known as the Velvet Divorce. Restoring local autonomy and using the ∗

The original article that became this chapter was Phillip J. Bryson and Gary C. Cormia ˇ with Soˇna Capková and Miloš Konˇcek (2001), “Land and Building Taxes in the Republic of Slovakia,” in The Development of Property Taxation in Economies in Transition: Case Studies from Central and Eastern Europe, edited by Jane Malme and Joan Youngman (Washington, D.C.: The World Bank), pp. 51–66. Copyright permission for republication was given by the International Bank for Reconstruction and Development, World Bank. The original article has become dated with respect to a few details. In a discussion of Slovakia’s cadastre, for example, one could correctly observe in about 2000, at the time of writing, that it was in need of some work. Since that time, of course, cadastral progress has been significant. Moreover, the original paper did not take notice of organizational changes (especially of plans to implement a public administration reform) in Slovakia that were then still largely in the planning stage. The dramatic changes that reform would bring about are addressed in later chapters, which will document how the Slovak reforms continued to develop.

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Property Tax and Fiscal Decentralization in the Twin Republics

property tax as part of the overall system of financing municipal services are vital elements of developing democracy and a market economy in Slovakia. An effective property tax must be based ultimately on the market value of property, but such a system is still not possible in Slovakia, for both economic and political reasons. To understand the potential role for the property tax, together with the historical roadblocks to the development of a normally functioning real estate market, it is necessary to review the limitations on the development of the new market system in general. These include the legacies of the socialist era and the constraints inherent in the state of Slovak development, the process of privatization of property, and the political and economic circumstances constraining the development of local self-government. Socialist and Developmental Legacies During the communist era, democracy was left on hold for 40 years as central planning attempted to mold economic development. Slovakia was thoroughly integrated into the Soviet bloc’s Council for Mutual Economic Assistance market (Frydman, Rapaczynski, and Turkewitz, 1998, pp. 48–49), and the structural damage done to Slovak industry was significant. The mix of industrial products, heavily biased toward armaments, and the trade connections established by Soviet-type planners complicated the transition to a market economy. After the Velvet Revolution in 1989, Slovakia launched some successful market-oriented reform efforts, but in 1992, without any formal consultation with the Slovak people, political leaders unilaterally decided to break from the federation. In the Velvet Divorce in 1993, Slovak leaders were rejecting not only a partnership with the Czechs but also the Czech preference for rapid transition to a market orientation.2 Before and after the opening of the reform era, the Slovaks were substantially less comfortable with departure from the order and security of Soviet ways than the Czechs. Nevertheless, the Slovak self-government and fiscal systems today still closely resemble those developed jointly with the Czechs in the twilight of the Czechoslovakian era. However, the Slovaks have clearly defined the geography of regions (oblasty) and laid the groundwork for a system that could alter the existing two-tier governmental landscape, consisting of the central government and the municipalities. Reemergence of Local Governments Following the Velvet Revolution, the desire to establish local governments was strong in Slovakia. Under socialist rule, from 1950 until 1989, the autonomy

Land and Building Taxes in Slovakia

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39

of local governments had largely been lost because the central government, based in Prague, directed decisions about the quality and types of public services. Regional governments did exist, but their role was merely to administer and facilitate central government policies. The autonomy of local government was further compromised by intergovernmental finance. Virtually all revenues for local government operations were funneled through the central government, and local governments had little leeway in the provision of public services. There was a sense that funding decisions were based on political and party influence and had a limited relationship to needs or demands, especially capital expenditures. Many of the functions normally provided at the local level were carried out by the central government, for example, police, public utilities, fire protection, education, housing, and medical care. Under central planning, local governments became almost moribund, a situation that ran counter to the Slovak tradition. The new freedom that arrived in 1989 allowed the reemergence of local governments. There are currently 2,781 municipalities in Slovakia. A few cities have populations over 50,000, and the capital city of Bratislava has a population of 452,000. Most of the cities have fewer than 500 inhabitants, and many have fewer than 100. Slovakia and the Czech Republic have significantly more cities per 10,000 citizens than any of their neighbors. The country that comes closest is Hungary, which shares many traditions with its neighbors. The number and the limited size of Slovakia’s cities and towns raise the question whether too many small governments exist given the personnel and resource limitations for the administration of such small municipalities. Several supportive organizations have emerged to facilitate the development of a core of professional local public managers. About 125 cities have created the position of city manager, similar to that in American cities, except that Slovak elected officials also play an important role in the day-to-day operations of the city. The Slovak Republic also has an organization of city finance directors, which operates much like the Government Finance Officers Association in the United States.3 Local governments have also formed the Organization of Cities and Towns of Slovakia, which represents about 90 percent of all the municipalities in dealings with the central government.4 State of the Slovak Economy Slovak economic development has been surprisingly strong, especially considering the political environment and the demanding requirements of the transformation process. As a result, citizens should expect a gradual growth

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Property Tax and Fiscal Decentralization in the Twin Republics

not only in private sector welfare but also in the volume and quality of public goods and services at the national and local levels.5 Slovakia adopted, at first under Czech tutelage, the standard strategies of price liberalization, restrictive monetary and fiscal policies, and the liberalization of foreign trade. Following the liberation from central planning, signs of economic progress began with growth in construction, increased domestic demand, and greater export productivity. As development progressed, government, household, and gross fixed capital investment spending also increased. Within five years, 95 percent of prices were unregulated, the most notable exception being rent control in housing. The National Bank of Slovakia’s restrictive monetary policy successfully countered the expected explosive inflationary effects of these actions. Slovaks argue that no other transitional state surpassed their fiscal management performance. These initial economic successes were due in large measure to a mini-boom in exports. Prosperity and expansion in Western markets provided demand, and the shift was made from old Council for Mutual Economic Assistance markets to the EU markets that are so important. The Slovak Republic’s ratio of exports to gross domestic product (GDP) was roughly 65 percent in 1995 (OECD, 1996, p. 115), and the mix of exports was showing a tendency to reflect a more favorable industrial structure for the long term. By mid-1997, 27.7 percent of Slovak exports were purchased by the Czech Republic, 23.3 percent by Germany, 6.5 percent by Austria, 5.6 percent by Poland, and 5.5 percent by Italy; members of the EU received 44.9 percent of Slovakia’s total exports (Slovak Economic Sheet, 1997). Growth in exports to these countries exceeded total import growth. Nevertheless, this trade progress could still be insufficient for Slovakia’s needs.

Privatization Potential Benefits Privatization today does not seem as promising for transitional economies as it did at the outset. However, it has signaled the emergence of property ownership and guaranteed the “irreversibility of the political changes carried out after the year 1989” (Mikloš and Žitˇnanský, 1997, p. 88), and it has provided newly restructured firms with some insulation from state intervention. Early in the transformation process, the hope was that privatization would transfer low-productivity properties from the state’s financial and managerial burdens to the lists of higher-productivity taxable properties. Privatization was to grow the private sector and return economic competitiveness to Slovakia. The theory remains fine, but practice in the former Czechoslovakia and elsewhere

Land and Building Taxes in Slovakia

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41

suggests that endogenous growth through the development of small start-up firms is far more promising. Privatization can promote fiscal decentralization by contributing to the revenues of Slovak municipalities as larger private sector holdings increase the base of the property tax. Unfortunately, the current privatization achievement is probably not an important factor in the generation of local government revenues, because the property tax is rather inconsequential in terms of its yield. History Slovak privatization initially paralleled that of the Czechs and can be viewed positively. A first round of small-scale privatization in 1992 auctioned off smaller production plants, retail stores, restaurants, and so on, and a second round permitted foreign buyers to bid for previously unsold properties. A first wave of large-scale privatization from 1991 to 1993 focused on the denationalization of small-scale firms from retail and the trade services branches, as well as some dwellings. A total of 678 Slovakian state enterprises were sold for revenues of SKK 169 billion (Mikloš and Žitˇnanský, 1997, p. 88). The denationalization of more large-scale industry, construction, agriculture, transportation, health care, financial institutions, and so on was the intent of a second wave of voucher privatization, initiated in September 1993. The voucher method permitted, for a nominal sum, the participation of all interested citizens. Each could purchase coupon booklets for investment privatization funds for a direct claim on that national wealth that was to be privatized or let their points be used by private agents. In September 1993 state bonds replaced the voucher system, slowing and changing privatization dramatically. The bond compensation program provided each registered citizen with a bond for SKK 10,000 maturing in five years. The bonds could be traded for shares sold by the privatization agency or used toward the purchase of individual apartments (Mikloš, 1997, p. 108). From 1994 through 1996, privatized properties went from just under 29 percent to about 50 percent of formerly state-owned property.6 In numerous cases, direct sales of national property were in the form of management buyouts, with the sales being made “exclusively to individuals and companies close to or recommended by government coalition party structures” (Frensch, 1997, p. 91). It has been estimated that the SKK 18 billion revenues on 1996 sales had a book value of around SKK 50 billion (Frensch, 1997, p. 21). At such prices the sale of large volumes of property should have been simple.7 The share of GDP produced by the private sector also indicates the extent

42

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Property Tax and Fiscal Decentralization in the Twin Republics

of privatization. By the end of 1996, this share in industry was 68.2 percent (an increase in that year of 3.6 percent); construction, 83.2 percent (1.4 percent increase); retail sales, 94.6 percent (2.9 percent increase); transport, 82 percent (19.9 percent increase); and agriculture, 86.1 percent (4.3 percent increase) (Marcinˇcin, 1996, p. 130). Substantive complaints about the government’s privatization policies have included the following issues: ●

●

●

●

●

The process is nontransparent. The media, the public, and the political opposition are not permitted to scrutinize the government’s privatization actions. State-owned property sales have almost always excluded foreign buyers.8 A relatively large number of enterprises designated as being of “strategic importance” is withheld from privatization altogether.9 The coalition government’s privatization process has not restructured industries. Monopoly positions held under the previous regime have been retained (Marcintin, 1996, p. 24), which will likely “preserve soft budgetary constraints even in privatized firms.” Some of the actions undertaken by the National Property Fund have been illegal. In some instances, transactions were closed before the property in question was in the possession of the privatization agency. Thus, according to Kolarikova (1995, p. 13), the agency “was dealing with somebody else’s property.” The privatization agency will almost certainly not have the funds to honor the privatization bonds (whose market prices have come to reflect that expectation) when they come to maturity (Vaskoviˇc, 1995, p. 4), although the Organisation for Economic Co-operation and Development (OECD, 1996, p. 66) has more positive expectations. Numerous property sales have been made opportunistically, to enrich private parties of interest to the governing coalition or to reward parties loyal to the coalition.10

Privatization and Aggregate Economic Performance Slovak economic performance would have been even better had politics and privatization contributed in a more positive way. Because privatization has favored insiders and political supporters, it has deflected potential foreign investors, who face selling prices far closer to market values. Where such investments are undertaken, there is presumably a lag time between contracting and experiencing the full productivity-enhancing effects. Therefore, to the extent that other countries are more successful in attracting such

Land and Building Taxes in Slovakia

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43

investments, the difference in growth rates, observed only with the time lag mentioned, will be more apparent in the future. The state has retained indirect but significant influence on industry through state-owned banks, essentially permitting industry to continue the soft budget constraints of the previous era through bank credit and collections policies. Financially supporting industry through liberal credit policies keeps marginal firms functioning and prevents a politically undesirable swelling of unemployment rolls. Therefore, the state has not been anxious to privatize the banks, despite pressures to do so.11 The persistence of privatization problems, the slowing of the process, and the related slow progress toward effective industrial restructuring have several effects: retaining inflated state-owned, inefficient, and noncompetitive private industrial sectors; keeping state expenditures higher than they need to be; constraining productive performance; keeping tax revenues below the levels needed to meet local public service demands; and failing to promote local self-autonomy. Privatization, Markets, and Real Estate Values This privatization situation affects, among other things, industrial development, the fiscal development of local governments, the property tax, and the development of the real estate market. We are particularly interested in the requirements for the establishment of a real estate market, and these include the following elements (see Zapletalova, 1997 for a somewhat different perspective): ● ● ● ●

●

A banking system that has the capacity to fund real estate mortgages The private ownership of property An active real estate market in all principal types of properties The elimination of price controls in the housing market assuring that market forces establish values The elimination of subsidies (such as for housing and utilities) that affect the real estate market

Because these characteristics have not yet been created or achieved in Slovakia, current real estate prices cannot be said to reflect market forces or provide the basis for uniform taxation. The government is attempting to address some of these issues by raising housing rents by an additional 70 percent, liberalizing certain previously controlled prices on electricity and gas for residential and commercial customers, and increasing other fees and charges (EIU, 1999). These measures were adopted to counteract disappointing revenue yields, but

44

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Property Tax and Fiscal Decentralization in the Twin Republics

their implementation will improve the conditions for market-based decision making and market information. Taxation in the Transition Period Immediately after the Velvet Revolution, Czechoslovakia began to prepare for the adoption of a tax system that borrowed heavily from Western Europe. It was based on the kinds of taxes prevalent there without reference to whether such a system was truly optimal even for the countries using it, whether it could work well in the very different transitional economies, or whether the tax revenues would be sufficient for these countries. The four most important governmental revenue sources in Slovakia are, therefore, the value-added tax, personal income tax, corporate income tax, and an income tax on unincorporated businesses. Although the central government collects these taxes, all revenues except the value-added tax are shared with local governments. These transfers are the primary revenue source of the local governments. In the short period since the Velvet Divorce, Slovak legislation and policy pronouncements have emphasized a desire to achieve decentralization and to develop self-government for the municipalities. In practice, however, in this early phase of the transition the Slovaks evinced a stronger tendency to retain the old central planning ways than the Czechs. Taxes on Land and Buildings The property tax in the Slovak system of local self-government remains a product of Czechoslovakian policy and legislative development. Although the tax systems of the twin republics have not diverged greatly, we expect that over time they will. In both republics the central government establishes property tax policy, but the day-to-day administration of the property tax is largely the domain of the municipalities, most of which are very small. Some of the small units in the Slovak Republic lack the personnel and other resources that would permit effective administration. The taxation of land is based on the area of each individual parcel, and the taxation of buildings is based on the number of square meters of a structure’s floor space, including the land area under the buildings. The tax rates for land and buildings have been established separately. Adjustments in the property tax formula account for the location of land and buildings and for the utilization of the taxed unit. These piecemeal efforts to approximate a property’s actual value for tax purposes represent a limited substitute for market valuation. Slovak officials have begun to give some consideration to the

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adoption of a value-based system of taxation, but a number of obstacles must be overcome before adoption of an ad valorem system. Data on per capita land and building taxes show a significant pattern of revenue generation in the Slovak municipalities. As the size of the municipality increases, per capita revenues from the tax on land decline, but the opposite situation is evident for tax on buildings. The implication is that the land tax, which is applied to a resource that cannot be removed from the region to avoid the tax, is underutilized in the cities, thereby badly reducing needed revenues to levels below their potential. Exemptions Property tax law grants explicit exemptions for state-owned, cultural, religious, and other such properties. An individual owner of commercial real estate is taxed at a rate of about one-third of the rate applied to commercial organizations. All property owners applying for exemption must complete a form annually for each eligible parcel. In the larger cities, these exemptions represent a substantial portion of the potential property tax base. The transitional countries generally tend to pursue exemption policies that severely limit the tax system’s revenue-generating capacity (Holzman, 1992, p. 242). Presumably to promote private housing construction, explicit 15-year exemptions are granted for newly constructed and recently renovated homes and to owners of restituted buildings. Because the current property tax base and rates do not produce a large yield, the incentive effect of this policy on the current tax level is not significant. Residential property tax exemptions are granted to citizens who are at least 70 years old and to taxpayers able to convince the local government council that their property tax burden is excessive relative to their income. This form of tax relief appears to have little impact on the revenue yields from land and building taxes, except for the 12 percent exemption on land tax in the capital city of Bratislava. For the smaller cities and towns, the percentage of tax relief granted for land and building taxes ranges only from about 1 percent to 3 percent of the tax obligation. A larger measure of tax relief is likely enjoyed through simple tax evasion. Intergovernmental Organization Public administration includes both state administration and selfgovernment. Subnational government officials can be engaged in both kinds of administration, because state administration includes service tasks

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Property Tax and Fiscal Decentralization in the Twin Republics

delegated by the center to local units. Because the same officers with the same equipment and materials perform many of the self-government and state administration services, isolating the costs of such services into local and central government components would be impossible. For the property tax in particular, policy and administration are split between the central and local governments. The central government controls property tax policy and law, establishes the base for land and for buildings, and sets the tax rates for each specific type of land and building. Local governments are responsible for the collection of property tax data and taxes. They must rely on the centrally operated cadastre for information pertaining to the ownership of properties. Sources of Information Information, including the square meter area of the land and buildings situated on it, is collected on forms designed by the central government and filled out by the taxpayer. A readily understandable instruction book that contains both explanations and examples accompanies the forms. The taxpayer submits the form to the municipality. About 40 percent of municipalities have no computers, so the data must be recorded by hand. Specific information pertaining to land areas is available from the cadastre, but that institution provides limited help in identifying land ownership and no help in assessing the tax on buildings. The current quality of the cadastre is quite poor, especially in rural areas and smaller towns. Moreover, the information received from taxpayers about taxable land and buildings cannot be matched or verified against the cadastre. Despite this problem, the Ministry of Finance does not publicize any concerns that property tax compliance is a serious problem. However, any restructuring of the fiscal system to increase property tax yields substantially would doubtless have a negative impact on compliance. Taxable Base and Rates Property taxation is not based on market-generated property prices, and land is treated separately from buildings. Land’s taxable base depends on its area and use. There are eleven classifications of land, for eight of which the assessed tax value adjusts for land quality, as estimated by the Ministry of Agriculture. For agricultural land the data collected on quality and potential productivity are remarkably detailed, and parcels in close proximity can have substantially different estimated productivity.

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There are six classes of buildings, ranging from residential housing to industrial buildings. The basic tax rate ranges from SKK 1 to SKK 10 per square meter and increases by SKK 0.75 for each floor. The rates can be adjusted annually. The tax on buildings allows for two additional adjustments that allow city administrators a modest degree of flexibility in taxing differential qualities of location within their jurisdiction. First, data on the size and type of a building can be multiplied by a coefficient, which is determined by the population of the community where the building is located. The coefficient for the largest cities is greater than that for the smallest towns by a factor of 4.5. Second, the local administrator may apply a final coefficient to the formula reflecting the quality of the location of a taxable property within the city. The administrator can, therefore, increase the tax bill by an amount as large as 150 percent or reduce a tax bill by an amount up to 50 percent. With an area-based tax, one would expect to find a close relationship between the area of the land or the building and the tax revenues produced, but this is not the case in Slovakia. Certain classes of land are taxed far more heavily than others; for example, building plots in cities produce more revenue per square meter than arable land or forests. The same is true for the taxes on improvements. Industrial and commercial buildings produce much greater revenues per square meter of area than do agricultural or apartment buildings. Apparently, the heaviest tax burden is on commercial and industrial activities, or on capital. Casual observation suggests that smaller towns and cities are inclined to tax built plots more heavily than arable land; forests, perhaps seen as less productive of revenues than farmland, are subject to even less tax than farmland. In towns of up to 1,000 inhabitants, for example, the ratio of land tax levied on built plots is about eight times as high as that of arable land, and higher yet than of forests. The ratio declines inconsistently for large cities and is approximately 2 for Bratislava. The ratio for arable land is more consistent and substantially lower, at around 1.25 for towns and smaller cities, though it is only 0.14 in Bratislava. The smaller towns, for which the property tax is a unique source of independent revenue, tend to put the burden of tax revenues on buildings rather than on land. Commercial and industrial buildings have consistently higher taxes than buildings for other uses. In the communist era, apartments and agricultural buildings provided services and products, which were viewed as necessities of life and were subsidized to keep their prices, and thus their taxes, very low. By contrast, industrial and commercial buildings were the sources of governmental revenue, and this tradition continues. Note, too, that the relatively greater importance of the property tax to municipalities is structured so

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that the ratio of tax to square meter of building space increases monotonically and significantly as the tax jurisdiction or municipality becomes smaller. Tax Collection The tax is collected from the property owner. In cases of uncertain ownership, users of the property are responsible for the tax. Data obtained from the Ministry of Finance suggest the existence of a serious lag in the collection of the property tax, especially in the small communities where arrears may exceed 40 percent from land and approach 20 percent for the more heavily taxed buildings. The problem of uncollected property tax declines as the size of the city increases, although one would assume it to be unacceptably large from the standpoint of the revenue-hungry municipalities. In Bratislava, the reported number seems too low. Appeal Procedures Appealing a property or building tax assessment in Slovakia is attempted first through the local administrator. If an appeal is denied, the taxpayer may appeal to the District Council and then to the Ministry of Finance, but only if new information has become available since the original appeal or if information used in the original appeal is found incorrect. All appeals and decisions must be in writing, and all matters are confidential. Appeal procedures have been established in detail by legislation. The most active area of appeal is against taxes on agricultural land, and many owners are now turning to private firms to prepare appeals on the value of the productivity coefficients estimated by the Ministry of Agriculture. Other Taxes on Property There are three additional property-related taxes: the estate tax, the transfer tax, and the gift tax. The value of the base for all three has been specified by a price decree of the Ministry of Finance. When property is transferred, administrators can choose the higher of either the reported sales price or the assessed price as the basis of the tax. Assessment is done by a small corps of fee appraisers, who report their values to the cadastre. The first SKK 500,000 of appraised value is exempt from estate and gift taxes when people under age 18 inherit land. Inheritance tax rates increase progressively for individuals more distantly related to the decedent who made the bequest. Immediate family members face a rate of up to 5 percent,

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extended family members are assessed up to 10 percent, and nonrelatives may be assessed up to 40 percent. In 1996, these three taxes generated a revenue of SKK 896 million (1997 interview with Ministry of Finance official). Revenues The property tax yield is low relative to total tax receipts of all levels of govermnent, total tax receipts of local governments, GDP, and other possible measures. Table 3.1 shows that local governments will not gain autonomy and financial self-sufficiency through the current property tax. The current real estate tax does not provide a level of funding that could satisfy the service needs of subnational governments, so municipalities have had to rely on revenue-sharing subsidies from the national government and fees raised locally (see Table 3.2). Many local governments have had to resort to selling assets to finance current operations, and some have resorted to deficit finance. The assets in question are mostly housing and businesses not previously privatized; they are transferred to the municipalities from the state. These properties represent an important asset for the newly enfranchised cities and towns, but they can also represent a burden, because their deteriorated physical state suggests the need for heavy investments that the municipalities can scarcely afford. The central government could view this situation as healthy and one that motivates the municipalities to promote privatization. Unfortunately,

Table 3.1

National Budget, Republic of Slovakia (Billions SKK)

Indicator

1993

1994

1995

1996

1. GDP: current prices 2. GDP: 1993 prices 3. Total revenues of public budgets of which: 4. National budget 5. Local budgets 6. Slovak republic total tax revenues of which: 7. Tax revenues, national budget 8. Tax revenues, local budgets 9. Total revenues of local budgets 10. Real estate tax

369.9 369.9 169.8

441.3 388.1 158.1

518 416.7 184.2

581.3 443.3 190.5

150.3 19.5 91.2

139.2 19 115.2

163.1 21 139.7

166.3 24.2 150.3

82.2 9 20.1 1.6

105.6 9.6 20.1 2

131.1 8.6 22.2 2.1

140.1 10.2 25.4 2.9

Source: Data arranged and compiled by the authors from Statisticka Roˇcenka Slovenskej Republiky 1997 (Bratislava: Vydavatel’stvo Slovenskej akadémie vied, 1997).

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Table 3.2

Property Tax and Fiscal Decentralization in the Twin Republics Real Estate Tax, Slovak Republic

Indicator

1993

1994

1995

1996

0.43 0.94 1.75 7.96 17.78

0.52 1.27 1.74 9.95 20.83

0.5 1.14 1.5 9.46 24.42

0.65 1.52 1.93 11.42 28.43

Real estate tax as a percentage of 1. GDP in 1993 prices 2. Revenues, public budgets 3. Total tax revenues 4. Total revenues, local budgets 5. Tax revenues, local budgets

Note: Differences in sums and ratios result from rounding the data. Source: Data compiled by the authors from Statisticka Roˇcenka Slovenskej Republiky 1997 (Bratislava: Vydavatel’stvo Slovenskej akadémie vied, 1997).

numerous difficulties retard the privatization process. The central government might also consider this asset stock as a reason not to provide revenues for the municipalities to the extent desired. For the next few years, the option of selling assets provides a potential revenue source that partially relieves the central government from the burden of providing for the financial needs of subnational governments. Current methods of finance do not provide the municipalities with sufficient resources to assure successful fiscal performance. The state, facing financial crises of its own, has tended to reduce the resource flow to the local level. It also appears anxious to transfer to local government’s service provision responsibilities that had been managed centrally, such as the school system. The central government is considering the advantages of turning K-12 education over to local governments, which makes much sense from the standpoint of local autonomy, but only if the necessary funding is also transferred. The local governments look at their current budgets and have the impression that the tax system, through transfers, subsidies, and local fees, provides nearly enough to meet all their operating responsibilities. If primary and secondary education were to be added to the list, however, it would soon become apparent that local budgets are incapable of providing adequate funding. General Policy Issues The fiscal and administrative autonomy of local governments are hallmarks of democracy. Unfortunately, these remain inadequately developed in the Slovak Republic because of the insufficient property tax yield. Moreover, the municipal fiscal system suffers an annual crisis initiated by the central government’s budget announcement, which follows an extended period of uncertainty and

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inability to complete subnational planning processes. A fully functioning property tax would reduce the fiscal dependence of the municipalities on the state and create the greater autonomy advocated by many of Slovakia’s political leaders. Local self-government not only suffers from this lack of fiscal autonomy but was particularly at risk under the coalition that President Mechiar had formed and that pursued a process of recentralization by redesigning privatization procedures to secure personal and political gain. The election of a new regime and the public’s later refusal to elect Mechiar as president have given renewed hope to Slovakia’s political development. Equity and efficiency could be enhanced in the property tax system by moving to market valuation of properties. Currently, the Ministry of Finance is contemplating this move, but lack of market data will continue to hamper the aspiration. Residential rental rates remain under state control, and the government owns more than 50 percent of residential properties, although ownership has been transferred from the central government to the municipal level. In the absence of market data, refining the existing valuation process by better accounting for the location and quality of assessed properties would be both possible and advisable. This approach would be unlikely to achieve complete uniformity of assessments, but would be a step in the right direction, also providing substantial additional revenue to the local governments. Increasing rates, coupled with new valuation procedures, would clearly enhance tax yields. The administration of the property tax is also of great importance. At issue is whether or not the municipalities should continue to collect it. Roughly half of the 2,853 cities and towns have access to computers, and only about one-third have full-time administrators. Although considerable efforts are being made to train municipal officers and plans are being considered to increase the number of municipalities authorized to hire full-time workers, local resources are insufficient to administer local fiscal activities effectively. Privatization, especially of specific (e.g., technical) tasks also may be a possibility. Currently, the cadastral system is also a roadblock to the administration of the property tax. During the previous era, the cadastre was rendered nearly inoperable by the communist regime’s disregard for private land ownership and the corresponding conviction that the records were of limited value to the state. Efforts are under way to improve the cadastral system, and there are plans to digitize the entire national database. The functioning of the cadastre also presents an apparent moral dilemma. Because it cannot be monitored by the municipalities, to which it is

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responsible for the identification of taxable properties, the cadastre has little incentive to assist rigorously the client municipalities that need to make sure that taxable properties are identified and on the tax rolls. In conclusion, Slovakia has struggled with political uncertainty and has experienced privatization captured by opportunistic elements. Given the extant legacies and constraints, it has done about as well with fiscal decentralization as could have been expected. The property tax has not yet played a significant role, but as Slovakia moves from its hasty adaptation of a perceived standard Western taxation system to a more specifically designed system attuned to contemporary fiscal needs, the tax system may well continue to develop in such a manner as to provide independent revenues for local autonomy.

CHAPTER 4

Moral Hazard in Property Tax Administration: A Comparative Analysis of the Czech and Slovak Republics∗ Tax Policy, Tax Administration, and Moral Hazard A federalist country adopting a tax must decide which level of government will design tax policy, which will administer the tax, and which will collect the revenues. Often, the same level of government performs all three functions, just as the federal income tax is handled in the United States. Of course it need not happen this way. In Taiwan, the value-added tax is largely administered at the provincial level, policies governing its use are set by the national government, and the revenue is split between the two government levels. In the United States, state governments establish property tax policy and local governments administer the property tax, but the majority of the revenue goes to school districts, which have no policy or administrative role in the process. Sound arguments can be made either for combining policy and administration at one level of government or for separating them. There are also arguments for centralizing and for decentralizing the two functions. Consider first arguments for centralizing most of the property tax’s policy and administrative activities. In developing and transitional countries, ∗

This chapter’s essence first appeared as Phillip J. Bryson and Gary C. Cornia, “Moral Hazard in Property Tax Administration: A Comparative Analysis of the Czech and Slovak Republics,” Comparative Economic Studies 45, no. 1 (2003), pp. 44–62. Because it was redundant in this collection, the introduction to this paper has not been reproduced here. Palgrave MacMillan graciously granted copyright permission to reproduce the essence of the article in this chapter.

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for example, centralization of policy and administration usually assures more abundant fiscal and administrative resources (Malme and Youngman, 2001). Centralization would increase access to policy resources, including technical expertise, computers and information, more sophisticated technologies, and international advisors. It would also enable overall tax policies harmonization. Another reason for policy centralization is the key issue of establishing policy safeguards to assure property tax uniformity, both between tax jurisdictions (harmonization) and within them (uniformity). A centralized set of policies would describe the types of property to tax, the manner in which valuations are made, the level and frequency of property assessment, the tax rate applied, the use of the funds, and the required degree of transparency (Kelly, 2000). The need to create harmonization and uniformity safeguards is an issue for every tax, especially the property tax. For all other taxes the taxable value, or tax base, is established in an arm’s-length, market transaction. However, market valuation is not possible for the property tax in transition economies, since property is sold or exchanged so infrequently that individual parcels with market-determined values cannot be seen as representative. Thus, a tax administrator must estimate a market and a taxable value for each parcel, and there is a strong chance that political or other less relevant issues can influence the process of estimation. Even in developed countries the lack of property tax uniformity can be a serious problem (Sirmans, Diskin, and Friday, 1995). The challenges to the property tax can be even more fundamental than inept estimation. Unfettered local governments acting in a self-interested manner may decide to leave certain types of property out of the mix while including other types, or they may tax some types of property very heavily and reduce the burden on other types. Similar arguments can be made with respect to equity and stability. There exists a strong potential for a race to the bottom in terms of what kinds of property to include in the tax base and a race to undervalue some properties. Centralized policy design could prevent many of these potential abuses, so there is a very legitimate case for centralization. Considering the major administrative functions of a property tax, there is also much to be said for centralization. Administration must include a process to discover taxable properties and to inventory and organize propertyspecific information, a system to estimate the taxable value of the property, billing and tax collection systems, and an audit process to ensure tax compliance and tax equity (Eckert, 1990). As is the case for policy design, almost all of the administrative functions benefit from the additional resources

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expected to accompany a centralized approach. Table 4.1 lists a variety of administrative functions and describes the potential advantages accruing to central government performance. The case for decentralized administration begins with the observation that property values estimation is accomplished more effectively at the local level. In the case of an ad valorem tax, local appraisers would have a feel for the Table 4.1

Centralization vs. Decentralization of Property Tax Administrative Tasks

Administrative function

Appropriate administrative level

Explanation of outcome

Property discovery

Subnational

Local officials have better knowledge of land and improvements to land. Better knowledge of ownership and use of land and improvements.

Valuation skills

Central

There are few valuation experts at either level of government. Simple valuation techniques minimize the problem. Local officials are more easily influenced by political pressure to keep values low.

Technical support

Central

Central administration will have access to better technical support and international experts. It will also have better access to information technology, GIS, and modeling techniques.

Resources

Central

Central administration will have access to more financial resources, including resources from international agencies.

Scale economies

Central

To the extent that economies exist, the central government will be in the best position to exploit them.

Administrative innovation

Central

Central government has greater access to international experts and opinion leaders.

Appeal

Central

Central administration is less likely to be influenced by politics during appeals.

Audit

Subnational

Local units will be more motivated to audit performance and compliance with the property tax.

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economic nuances of the local market. Even in cases in which technology is used for the appraisal process, accuracy would improve if appraisers were to review results and make modifications according to appropriate subjective criteria. The same logic can be used with respect to discovery and audit, both of which are also advantageously performed at the local level. It would be of interest to know whether the seemingly omnipresent problem of corruption is more serious under local or central government management in a transitional country. If the property tax were a more significant part of the fiscal mix, it would assume an importance that would more likely tempt corruption than under the current situation in which the property tax is nominal. On balance, opportunities for corruption would seem to be more likely a problem under local management than when the property tax is under central administration. A form of duplicity that may or may not be less egregious is the problem of local governments offering tax advantages to private entities to influence their location decisions, a part of the “race to the bottom” phenomenon (Musgrave, 1997). One must recognize that local administration can be expected to fall short in a variety of administrative and technical areas. It does, nevertheless, have the important advantage that the actors involved are informed about local economic, political, and fiscal conditions (Dillinger, 1992), which are especially important for the limited functions of discovery and audit. Once again, centralization may render less strident some of the political opposition to the property tax. Finance Ministry officials in the Czech Republic often assert that local government personnel in that country want nothing to do with property tax administration, since centralization insulates them from political opposition. Coming from the old central planning environment, this is a direct and very visible tax (Bird, 1993). California’s Proposition 13 reminds us of the hostility that many feel toward this form of taxation even in the United States. Moral Hazard Arguments for centralization almost assume away policy or administrative conflicts between central and subnational governments and view the incentives of the different governmental levels as essentially identical. In the real world, of course, conflicting motivations are common. We generally view these as principal/agent conflicts; doing so provides a fruitful way of thinking about the issues involved, even if potential limitations do not encourage formal modeling. In tax administration, as elsewhere, agents may well be expected to pursue their own interests rather than those of other interested parties.

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If we think in those terms about property tax administration, who is the agent and who is the principal? Variations on these assumptions have been used fruitfully in the literature. Bale and Dale (1998), Pratt and Zeckhauser (1985), and Moe (1990) describe principal-agent relationships, for example, between senior bureaucrats and subordinate bureaucrats and also between citizens, politicians, and governmental levels. For most purposes, we would consider the local government the principal, since it is closer to the citizens and is to some extent their proxy in sharing the desire for sufficient revenues to provide good schools, community infrastructure, and so on. The less proximate Czech central government, engaged to collect the tax for the subnational governments, becomes the agent.1 The principal (local government) thus receives tax revenue as a result of the agent’s (central government’s) actions. For its efforts the agent receives none of the revenues collected. In some instances, there will be a collection fee for this service, but in the Czech case there is none. This relationship creates an obvious opportunity for a moral hazard problem to arise. Why would there be moral hazard? It is because the agent understands the opportunity costs (scarce workforce, computer and information systems, and even political capital) required for property tax collection. Nor is the agent prepared to ignore obvious considerations of self-interest. Subnational governments can only hope that their agent will maximize the collection effort. They may well have a sense of the revenue potential of the property tax, but are not in a position to monitor the use of available resources in the central agent’s collection effort. Thus, the yield is very likely to correspond to the agent’s efforts – it will be less than it could be. This realistically describes the situation in the Czech Republic. Local governments there have not shared property tax data for at least 50 years, and there is no evidence of any local officials monitoring the Czech state administration’s tax collection activities. The fact that the principal will receive less property tax revenue may encourage the agent to offer greater revenue transfers from other taxes or revenue sources, so that the local governments are financially no worse off. Since this holds for the Czech Republic, one cannot view the fiscal situation too dimly. For the time being, because of the current problems of assessment and valuation in property tax administration, this outcome is not troubling. In the long run, however, as these problems are overcome, the property tax should become a more significant part of the mix of tax instruments. As we have noted, a pressing concern with the source of revenues available to the municipalities and regions is whether such funds come with mandates on how transferred funds are to be used. In the Czech Republic, the central government does not attempt to control the decision about how transferred

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property tax revenues are to be used. At the end of the day, however, when transferred funds are exhausted, and all mandated tasks are not fully funded, anyone desiring to satisfy local preferences must still wonder where to find funding. In the Slovak Republic, funding local government is no less problematic, perhaps it is more so, but at least the municipalities may apply whatever efforts they choose to enhance revenue collection. Fortunately, in both republics, there is no question about the “ownership” of property tax revenues. They are conceded by their respective central governments to belong to the municipalities. The only issue here is the administrative effort put forth to collect the revenues. A brief description of the administrative processes in both republics should help to clarify our assumptions with respect to moral hazard. As noted, both countries have identical (area-based) valuation laws and identical rates. They both use self-reported returns supplied by the property owners (Bryson and Cornia, 2001a, b), and such returns produce a need for discovery and audit. In these two functions, moral hazard is most likely. In the Czech Republic, the central Ministry of Finance receives the property tax returns, enters the data in an electronic inventory system, and remits to local governments the property tax revenue based on the property owner’s situs. No efforts are made to find underreported values or nonreported parcels. In contrast, self-reported returns in Slovakia are submitted to local finance departments, which attempt to verify (audit) reported data and also match reported data with other records (discovery). In both countries, the existing cadastral records were outdated and inaccurate following the socialist period, so discovery and audit would naturally require more effort. In the larger cities of Slovakia, that is, Bratislava and Košice, local finance offices are further decentralized into municipal districts with substantial fiscal autonomy, thus enhancing the decentralization effort. The potential for policy and administrative success and the inherent potential for moral hazard problems are described in Table 4.2. Clearly, the central government has a role, especially in the development of policy guidelines. Nevertheless, centralization of administration creates the potential for incentive incompatibilities and the eventual failure of the property tax. Even attractive, smart policy, and administrative designs cannot assure that a tax will succeed in the face of inept incentives (Tanzi, 1991). Fiscal Transfers An additional potential for moral hazard problems emerges when the central government transfers revenue to local governments. Fiscal redistribution is appropriate when (a) the distribution of local resources is skewed and

Moral Hazard in Property Tax Administration Table 4.2

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Moral Hazard: Property Tax Policy and Administration

Administration

Policy administration Central government

Subnational government

Central government

Complete centralization benefits from resources, technical support, and policy experience. There is little incentive to improve administrative outcomes. The result is a lagging effort on the part of central administrators. Discovery and audit are especially underdeveloped. Likelihood of moral hazard problems is high.

Subnational governments have substantial input on policy issues, but there is less opportunity to monitor the behavior of the administrator of the property tax. The potential for moral hazard problems is moderate.

Subnational government

Centralization of policy facilitates development of policy. Local governments benefit directly in the outcomes of the administrative processes. Revenues collected can be used by the local government. The potential for moral hazard problems is low.

Complete decentralization diminishes the uniformity between taxing jurisdictions and creates potential for tax wars. It has uneven resources assigned to policy. To overcome potential policy problems administrators rely on strong administrative responses that only exacerbate the problems of the tax. Likelihood of moral hazard problems is high.

(b) when subsidies promote expenditures that the center particularly values (Musgrave, 1961). In considering (a), both republics obviously allowed the creation or re-creation of many very small local governments that would not be able to function without fiscal assistance from the center. However, if the redistribution process provides central funds that merely offset revenues that the municipalities could reasonably have raised locally, we encounter an additional twist on the moral hazard problems described above. The transferred revenues carry no dangerous political transparencies for local officials. With a more transparent tax such as the property tax, local officials would run the risk of opposition to the tax and become the target of any political repercussions accompanying its implementation. This is a particularly significant problem in transition countries where, for the first time, taxes have become visible and direct and have the potential to impact local elections. When such transfers occur, the municipalities generally abdicate fiscal power to the central government; they relinquish a certain degree of

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self-determination for the convenience of revenue provision. They cede to the center the responsibility and political pressure for revenue collection and are willing simply to accept whatever funds the center will provide. Oliveira and Martinez-Vazquez (2001) have also suspected Czech transfers of having “led to negative incentives for revenue mobilisation at the local level” when the central government “was perceived as reducing the level of discretionary transfers at any time that local governments increased their own revenues” (p. 56). The consequence of these actions is to diminish the importance and effect of the property tax and to diminish the potential for local fiscal autonomy. The real question is which government, Czech or Slovak, has been most successful in terms of local finance, and why? As we have noted, the Slovak Republic has administered its property tax locally; the Czech Republic has done so centrally. The Czechs have chosen a centralized approach to property tax administration and transfer substantial amounts of funds from the national to the local governments, but the Slovaks do not. Financing Municipalities Any successes enjoyed in the general process of economic transformation will be reflected in public sector data. The macro situation and economic growth in the economy will impact both national and subnational budgets. After taking account of price inflation, both the Czech and Slovak republics have experienced growth that permits expansion of state and local budgets. Budget data are presented in Table 4.3. Under the central-planning regime and beginning around 1984, local budgets in the Czechoslovak federation experienced a gradual, long-term reduction in subsidies from the central government. Since 1969, subsidies had constituted nearly 60 percent of total local receipts. The opening to market economics and democracy did not reverse this decline. Although there was a brief expansion of transfers from 1990 to 1992, the decline continued. After the mid-1990s, subsidies represented no more than approximately 25 percent of the total receipts of Czech and Slovak municipalities (Peková, 1996). Table 4.3 reports the financial situation basically from the end of central planning through the year 2000. We observe from the data that Slovakia’s municipal budgets are substantially more modest than those of the Czech Republic. From 1993 on, after the federal neighbors parted ways, Czech municipal budgets were more than twice as large as those of Slovakia, even if one does not consider the greater value of the CZK. The per capita public services expenditures for Czech citizens have been more than three times those of their Slovak counterparts (Bryson and Cornia, 2000). Local

Moral Hazard in Property Tax Administration Table 4.3

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National and Local Budgets: Czech and Slovak Republics SLOVAK REPUBLIC

∗

Local budgets Local as % of national budget State grants to local budgets∗ Total local revenues∗ Local budget expenditures∗ Real estate Tax∗

1993

1994

1995

1996

1997

1998

1999

2000

19.5 12.97

19 13.65

21 12.88

21.5 13.2

23.5 13.37

22.7 12.68

21.3 11.9

24.8 11.07

1.5

1.1

1.2

1.3

1.8

2.08

21 19.3

20.1 19.1

22.2 18.9

22.9 21.9

26.7 25.3

1.6

1.79

1.73

2.14

2.61

25.9 25.8

2.24 24.2 23.9

2.77 27.4 26.5

2.4

2.72

2.87

1998

1999

2000

CZECH REPUBLIC 1993

1994

1995

1996

1997

Local budgets∗ 91.1 111 129.1 161.72 145.3 157.2 187.7 181.8 Local as % of 25.45 28.43 29.34 33.5 30.3 30.8 30.9 32.6 national budget State grants to local 27.03 29.25 33.28 59.44 35.87 37.39 41.43 46.05 budgets∗ Total local revenues∗ 101 111 129 162 147 162 188 181 Local budget 90.1 112.1 132.3 171.1 150.5 158 173 190 expenditures∗ Real Estate Tax∗ 3.021 3.808 3.799 4.018 3.943 4.108 4.248 4.437 ∗ Except

for percentages, all figures are in billions of SKK and CZK. Note: State grants to local budgets in 1991 and 1992 were 1991: 7.961 and 1992: 2.385 billion crowns. They were provided by the Czechoslovak government in Prague, not by the Slovak Republic which came into existence in 1993. Source: Data from Federal Ministry of Finance, Czech and Slovak republics; arrangement and calculations are our own.

budgets in Slovakia comprise only about 13 percent to 14.5 percent of the total national budget. In the Czech Republic, the aggregate of local budgets ranges annually from one-fourth to just over one-third of the national budget. A comparison of the grants from the respective central governments to the municipalities reveals the reason for the relative poverty of the Slovak local governments. The much smaller national grants in Slovakia started at SKK 1.5 billion in 1993; they ranged from a low of SKK 1.1 billion in 1994 to SKK 2.77 billion in 2000. The grants transferred by the Czech central government to the municipalities ranged from just over CZK 27 billion in 1993 to over CZK 40 billion in the later years. The CZK 59.5 billion in 1996 was a one-time aberration. It is instructive that in the years just prior to

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Slovak independence (1991 and 1992), the government in Prague provided grants of 7.9 billion and 2.4 billion crowns, respectively, for the neighboring Slovaks. Independence also separated the Slovak Republic from the Czech central budget. Budget transfers from the center seem to give the Czech local governments considerably more options than their counterparts in Slovakia enjoy. What is less obvious is that, because so much of Czech municipal funding comes from the state, budget autonomy is tightly constrained. By contrast, although national independence resulted in the impoverishment of Slovak municipalities, bringing a hard and binding budget constraint, it also brought a large measure of budget autonomy from the center. By forcing Slovak municipalities to be more responsible for their own revenues, the Slovak Republic made it essential for the municipalities to increase the property tax yield, which should be a primary source of local public revenues in any case. In contrast, the Czech Republic has other priorities for the provision of municipal funds. It has not utilized the property tax as an important source of independent revenues. More generous provision of fiscal grants and transfers to Czech municipalities has obviated the need to develop the property tax as a more independent revenue source; at the same time, it has not provided the basis for genuine autonomy for local government. Table 4.4 shows the relative importance of the property tax and fiscal transfers. Although the table offers only eight data points, these are worthy of note. They suggest that the property tax has never been an important source of revenue for local government in the Czech Republic. Under the current system there is only modest

Table 4.4 Republics

Local Property Taxes and Transfers from Central Governments: Czech and Slovak

Property tax as % of local budget

Fiscal transfers as % of local budget

Year

Czech Republic

Slovak Republic

Czech Republic

Slovak Republic

1993 1994 1995 1996 1997 1998 1999 2000

2.99 3.43 2.95 2.48 2.68 2.53 2.26 2.44

7.62 8.91 7.79 9.34 9.78 9.27 11.24 10.47

29.67 26.35 25.77 36.75 24.68 23.79 22.07 25.33

7.69 5.79 5.71 6.05 7.66 9.16 10.52 11.17

Source: Federal Ministry of Finance, Czech and Slovak republics, and own calculations.

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reason to expect that it will ever change. In contrast, the relative importance of the Slovak real estate tax is highlighted by its increasing trend. The Czech property tax as a share of local budgets may even be going in the opposite direction. The trends are less distinct with respect to fiscal transfers from the center; there has been a decline in the relative importance of transfers from the Czech central government and an increase in those from the Slovak central government. The most notable distinction is the significant difference between the level of the financial transfers to the Czech and Slovak local governments. Local governments in both republics face increasing revenue needs for current operations, not to mention the backlog of needed investments, which has been building over several years. Up to the present, local governments in both countries have been able to sell off assets in the form of the public housing and commercial facilities transferred to them by central government at the outset of the transition. This has been a significant revenue source, but with the completion of privatization, it is drying up. This demonstrates the principle that one-time revenue sources should not be used to fund current and ongoing expenditures. Even with this source of funds, there have been ongoing revenue shortfalls in the municipalities. Without additional revenue, the problem can only become more serious. In recent years, the national governments of both republics have been confronted by their own fiscal crises. The response has been to reduce revenues to the municipalities, while transferring additional, centrally managed services to the local governments. The localities are always concerned about unfunded federal mandates, although it is only fair to indicate that the Czechs have been less guilty of that offense than most other transition countries. In the Czech Republic, even when funding is made available for centrally mandated expenditures, state influence over the use of central funds can be assumed, which impairs further development of local autonomy. Until recently, Slovakia struggled with a serious political liability in the form of the Mechiar coalition, which put the development of self-government at risk by pursuing a process of recentralization. Given the prevailing legacies from the planning era and the constraints of the Mechiar era, the Slovak Republic has done about as well with fiscal decentralization as could have been expected. And the Mechiar government’s withholding of revenues placed the Slovak municipalities on the path of serious search for improved property tax revenue yields. In Slovakia, if the property tax continues to develop in a healthy fashion into the new political era, a transfer of additional services to the local governments could be a part of the acquisition of autonomy and local control, both vital elements of decentralization.

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Conclusions The Czech and Slovak republics have openly committed to political decentralization. Whether or not they have continued to pursue their municipalities’ independence, they began their history beyond the Velvet Revolution by allowing the emergence or reemergence of a large number of municipalities. The record on decentralization is not as strong with respect to fiscal reorganization. In our view, the attempt to decentralize created opportunities for principal/agent conflicts. In at least one regard, these conflicts have been reduced, because the Slovaks have assigned the responsibility for tax administration to local government. Thus, whether or not as a coherent strategy, the Slovak Republic has adopted some noteworthy policies. In spite of the low levels of transfers from central government to the local governments of Slovakia, there have been some very positive outcomes in that country’s recent fiscal history. The assignment of property tax collection to local governments, specifically the discovery and audit functions, has proven beneficial. In a historic irony, the Mechiar era’s financial neglect of local governments also had its positive aspect, namely, necessitating the municipalities to pursue their own funds as vigorously as possible. We conclude that the Slovak Republic is on a long-run path that will lead to stronger local government because local governments have at least limited access to an autonomous revenue source and have had to accept responsibility for their own fiscal situation. Although the Czech Republic has been more generous with its municipalities and may for the foreseeable future have more affluent local governments than in Slovakia, those Czech subnational governments will not likely enjoy the same political independence. Many questions remain regarding the fiscal transformation of the two sister republics. Generalizing from the Czech and Slovak experiences, however, the assignment of property tax administration to the local level does in fact lay the foundations of a stronger, more independent fiscal system.

CHAPTER 5

Fiscal Decentralization in Economic Transformation: The Czech and Slovak Cases∗ Introduction The successful economic transformation of the former Soviet Union and Soviet bloc cannot yet be taken for granted. Hungary, the Czech Republic, and Poland, moving toward recovery and membership in the EU, can apparently be expected to succeed. But these countries, as well as others in the transition process, must yet grapple with serious problems, one of the most significant of which is the transformation of the public sector and the establishment of local self-government. There have been, of course, serious cyclical kinds of difficulties in the transformation environment as Russia to the East and Europe to the West have endeavored to avoid the infection of the Asian malaise at the close of the first decade of transitional effort. The private sector in the Czech and Slovak republics has gradually gained strength by building slowly upon improvements brought about by privatization, foreign investment partnerships, and general reorientation toward the West. But we are still wondering whether the public sector is establishing sufficiently effective patterns of taxation, budgeting, service provision, and interactive support of the private sector so as ∗

The materials in this chapter were published in Europe-Asia Studies. See Phillip J. Bryson and Gary C. Cornia, “Fiscal Decentralisation in Economic Transformation: The Czech and Slovak Cases,” Europe-Asia Studies 52, no. 3 (2000), pp. 507–522. Taylor and Francis, the publisher, whose website is http://www.informaworld.com, has kindly granted permission to republish here. Some of the introductory materials from this article, already discussed in previous chapters of this book, are not included here.

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to equip these states for long-term economic and political viability in the post-communist order. In their rush to reestablish strong fiscal systems, parliaments of the transition countries passed early tax legislation modeled after the Western systems. The concurrence of Western governments was clearly a prerequisite for accession to Western economic and political organizations. The new systems, however, too often ignored whether tax institutions and legislation would ensure sufficient revenues for the reconstruction of a decades-long neglected public sector (Holzman, 1992, p. 234). Moreover, new institutions proved unable adequately to nurture the local autonomy that the EU sees as essential for the establishment of genuine democracy (EU, 1997). When central planning ceased in east and central Europe, meaningful selfgovernment did not exist for the municipalities. The need for local autonomy had certainly not been eliminated under the reign of Marxist-Leninist systems: for many purposes the best government is still the government that is closest to the people, an arrangement that requires the decentralization of power. Fiscal devolution permits a portion of public needs to be provided by government agents known to and selected by local people. Local government can be more acceptable because its agents are more accessible and are more clearly accountable than those who remain at greater distances politically and geographically. Strong local government requires decision-making autonomy for local agents as well as resource autonomy for essential tasks and projects. Finally, devolution requires transparent local decision making on fiscal issues (World Bank, 1997). A rationale for local government can be derived from both economic and political considerations. From the standpoint of economics, local governments can be responsive to the citizens’ aspirations rather than merely to central planners’ directives. Because preferences for the menu of local public services as well as for the patterns of their delivery vary geographically, allocating public resources through agents directly responsible to the citizens affected is politically more efficient (Bird, 1993). The transition process by its very nature requires the development of new governmental functions; new laws and regulations must be established to support the nascent market economy. A number of these functions must be exercised at the level of local governments to ensure the possibility of economic viability and growth. Local governments in transition must learn to provide more than just the traditional public services such as street lights and garbage collection. They must also enable local entrepreneurs to get business licenses, provide the opportunities for business lending from reliable banks, and ensure the availability of a legal system that enforces contracts independent of side gratuities. The public goods of market and communist economies are not the same, and

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corruption and bureaucratic interference in the business environment (characteristic of the Russian transformation, for example) are in direct opposition to the long-term support for a market economy that is required of all levels of government. Successful transition requires the establishment of fiscal federalism, including an acceptable and effective tax system. Local governments that meet the needs of their constituents generally must not only impose the taxes constituents pay but also make the expenditures enabled by such proceeds (Schleifer and Vishny, 1998, pp. 252, 253). The Czech and Slovak republics have begun the reform processes necessary to realize these conditions, but they are far from having completed them. This chapter reviews their progress. It addresses the attempted delivery of public services and the generation of the enabling funds in the Czech and Slovak republics. Both countries have done quite well in making a transition toward market allocation, although the latter has struggled with some serious political difficulties. Our objective is to compare attempts to achieve decentralization and to reestablish local self-government as a part of the relatively successful economic transition both countries have thus far experienced. A common political and economic past since the establishment of the Czechoslovakian federation in 1918 and some dramatic instances of divergence since separation in 1993 make these two republics excellent foci for comparative analysis. The next section emphasizes the significance of fiscal decentralization as a part of the general economic development of the Czech and Slovak republics from historic and current perspectives. It considers the effort to privatize major sectors of the economy as a part of the process of establishing local autonomy in transition states. The following section addresses the fiscal affairs of the Czech and Slovak republics in the decentralization process, especially investigating the flows of funds to the townships. The following section suggests some implications of insufficient funding and some general conclusions pertaining to the fiscal situation in the municipalities. Decline and Renewal of Fiscal Federalism Czechoslovakia, formed by the union of Slovakia, Bohemia, and Moravia in 1918 at the breakup of the Habsburg Empire, launched a relatively early experiment in federalism. The founding of the federation provided an opportunity to experience democracy and begin a tradition of local self-government. Nationalism and self-government (samospráva) developed unevenly through the fascist occupation and were held in abeyance during the communist period. But aspirations for independence survived even in the

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smallest municipalities and an explosive reemergence of local governments followed the demise of the communist system. Central planning philosophy affected the provision of public services. The central government controlled the variety and quality of local services; they were merely implemented through the “state administration” of local governments. Funding, administered through central grants, was sustained by indirect taxes imposed on retail and industrial activities. There was a general feeling that the allocation of funds to local governments was influenced more by political or party connections than by actual public demands for services. This approach to grants distribution generated strong mistrust at the local level. The failure of the centrally planned social system followed the Prague Spring by only two decades. From the Velvet Revolution of December 1989, the Czechs and Slovaks began their common journey down the path of transformation. Their joint endeavors were not of long duration, but between 1990 and 1993 they were successful in installing a number of common transformation institutions, including a more Western-style tax system. The nationalist aspirations of the Slovaks led to the Velvet Divorce of 1993, an agreement to dismantle the federation. The Slovak Transformation and Fiscal Decentralization With the end of the Czechoslovak federation in 1993, Slovak leaders rejected not only a state partnership with the Czechs but the Czech aspiration for a rapid transition as well (Valko, 1997). There have been significant persistent problems in Slovakia’s transition, but many of these had to do with the unfortunate administration of former Prime Minister Vladimir Meˇciar (Mechiar), whose recent departure from government enhanced the country’s political, economic, and transformation prospects. The primary problems of the regime were a tendency to intervene too readily in economic affairs and a penchant for morally hazardous privatization activities. Fiscally, Slovakia has encountered rougher waters in recent years. The national budget has produced growing deficits, partly because of high social security expenditures and large infrastructure investments. The 1996 budget ended with a deficit of nearly SKK 27 billion, or 4.4 percent of the GDP. Expenditures grew 12 percent as revenues increased 2 percent. (In 1998, ca. 34 Slovak crowns [SSK] traded for one US dollar.) The Slovak Republic would prefer, in principle, to abandon its East European tradition of two-tier government. Slovak regions (oblasty) would be strengthened in their hierarchic position between the center and the municipalities. In the central planning period, public services were in the

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exclusive domain of the central government. Regional (district) “governments” remained extant, but their role was merely administrative. They implemented federation policies rather than their own from 1950 to 1989, a time in which Slovak desire for local autonomy was effectively suppressed. Slovakia announced its support of complete autonomy for the municipalities promptly after the new beginning of 1989. Independent municipal governments proliferated in that period, coming to number 2,781 today. Most of the country’s cities have fewer than 500 inhabitants, and many of them fewer than 100. Both Slovaks and Czechs have substantially more cities per 10,000 inhabitants than their regional neighbors (Bird et al., 1995). From the standpoint of efficient administration, Slovakia probably has too many municipalities. Personnel and other resource limitations make administering small units difficult. Supportive organizations have facilitated the training of professional local public managers, especially the Organization of Cities and Towns of Slovakia (Združenie Miest A Obci Slovenska, ZMOS), which also represents the cities of Slovakia in dealings with the central government. The Slovak Republic has applied for full membership in the EU, but the organization’s commission identified “a gap between the letter of constitutional texts and political practice” in Slovakia (EU, 1997). It is a euphemism to say that the approach of Mechiar’s ruling coalition to government was opportunistic. In the area of privatization, direct management buyouts “to individuals and companies close to or recommended by government coalition party structures” (ibid.) was traditional. The opposition parties viewed the process as “family circle privatization,” since it channeled public funds to select private parties. The approach to the banking/financial sector has also had an impact on fiscal decentralization. To the extent that banking performance supports firms of low productivity, tax revenues remain below their potential, that is, below levels needed to meet public service demands in the municipalities, thus providing a barrier to the development of local self-autonomy. The Czech Transformation and Fiscal Decentralization The Czech transformation has been relatively successful in comparison with most neighboring countries. Fiscal decentralization has occurred in an environment strengthened by generally positive economic performance, attributed to early liberalization of prices, relatively far-ranging privatization efforts, and openness of Czech markets to international trade. Low levels of public debt produced during the planning era and the subsequent exercise of prudent fiscal principles (Organization for Economic Cooperation

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and Development, 1996) made it possible to maintain a nearly balanced budget. Political crisis and budget difficulties converged in late 1997 to terminate the premiership of Vaclav Klaus. The Klaus government had used the still publicly owned banking sector to support nonviable firms so as to minimize unemployment. Retention of soft-budget constraints under the aegis of state banking promoted bloated payrolls and inefficiency; noncompetitive firms loaded state banks with bad debt while avoiding ubiquitous unemployment (Frydman, Rapaczynski, and Turkewitz, 1998). The provision of bank funds to marginal enterprises denied the use of those funds to other, more productive activities. In the Czech Republic, as in other transition states, banks will be a primary provider of scarce investment funds for some time to come. Unfortunately, those funds will not be sufficient for all legitimate needs. For example, the development of a real estate market for the provision of private housing will be delayed for some time because investment funds are badly needed for other purposes. The creation of a modernized public sector capable of delivering desirable services cannot derive the resources it needs from the overall economic process immediately. But where the transition takes more time than absolutely essential, some development projects must remain underfunded or completely unfunded. Privatization is also an important component of fiscal decentralization. When performed properly, privatization generates revenues for the state while attracting foreign investors to the industrial restructuring effort. The transfer of properties from the public to the private sector increases the base of taxable properties. This holds both for state-owned industry and the huge state investment in public housing. If privatization succeeds, greater agricultural, industrial, and service-sector productivity creates more wealth for private citizens and greater public tax yields. Two of the prominent characteristics of public goods provision under Marxism-Leninism were, first, a nontransparent, indeed, quite invisible system of taxation and, second, the provision of numerous public goods directly through the state-owned enterprises, which were the source of much housing, health care, nursery care, vocational training, general education, recreation, and even sports and vacation facilities directly to their workers. In the transition, East Europeans faced the loss of employment through the processes of tightening budget constraints, new and ostensibly heavy taxation, and, through privatization and marketization, the elimination of the generous service provision of state-owned enterprises. Naturally, it could be argued (and in private it probably has been by policy directors in transition countries struggling with national budget problems) that the citizenry will willingly forego generous public goods provision

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for a time, if their demands for private goods receive the greater emphasis during the first part of the new era. Socialism was more generous with public than private goods, and consumers might be expected in the transition, at least for a time, to forego excellent schooling and wait patiently for more adequate housing if other goods painfully absent under the old regime (e.g., automobiles and electronic goods) are supplied more abundantly in the transition.

Transforming the Fiscal System Slovak Fiscal Decentralization After the Velvet Divorce a process of fiscal divergence ensued in the new republics. Early on, Slovak legislation and policy pronouncements might have led one to expect that country to pursue fiscal devolution more expeditiously than the Czechs. In any case, Slovakia asserted an intention to decentralize and develop municipal self-government (samospravy). The evidence, however, does not indicate strong performance in this regard. Nor would one expect the achievement of a more thorough-going decentralization, given Slovakia’s penchant to avoid bold marketization initiatives. An important indication of a government’s intent to decentralize is the extent to which it makes revenues available for decentralization purposes. In the English-speaking economies, an important source of revenue for local public finance is the property tax. The yield of this tax in the Slovak Republic is low relative to the total tax receipts of all levels of government, relative to the total tax receipts of local governments, relative to (or as a share of ) the GDP, and relative to other possible measures. As is apparent from Table 6.1, in the next chapter, local governments in Slovakia will certainly not gain autonomy and financial self-sufficiency through the current real estate tax. How, then, does Slovakia’s government fund public services for its cities and towns? Mostly, it has shared central tax revenue yields and provided additional fiscal transfers for specified purposes. But the revenues shared have not been sufficient for local government needs. To finance current operations, municipalities have had to sell assets (i.e., privatize housing and businesses transferred to them from the state), and a number of them have also felt it necessary to incur debt. Properties transferred from the center represent an important asset for the newly enfranchised cities and towns, but at the same time they can represent a burden. Their generally deteriorated physical state suggests the need for heavy investments that the municipalities can scarcely afford. The center could view this situation as healthy because it motivates the municipalities

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to privatize, partially relieving the center of providing for the financial needs of the townships. Numerous difficulties retard the privatization process, but for the next while, an important share of local revenues will continue to be derived from the sale of assets and from municipal debt. Czech Fiscal Decentralization The Czech fiscal and governmental systems are still composed basically of two tiers, the national center and the municipalities. There are currently 6,234 independent municipalities in the Czech Republic, significantly more than in 1989. Shortly after the Velvet Revolution, small communities desired and were permitted to assert their independence. As mentioned above regarding the Slovak situation, ensuring the competent administration of many small units is a challenge. Resource and personnel limitations are the problem common to transformation municipalities (Houerou and Rutkowski, 1996). In the Czech Republic, this challenge seems to recommend either the administrative union of small groups of villages or the establishment of an intermediate governmental tier to assist the municipalities with their administrative challenges. Czech authorities expect the center to address this problem by adopting about 11 regional administrative units, Kraje, to assume some of the center’s functions and some the municipalities’. The degree of centralization of the taxation system is another fundamental fiscal question. In spite of the postrevolutionary objective to achieve greater municipal independence, the Czech system has not yet completely emerged from the centralist era. The central government still often plays a dominant role in intergovernmental relations and in the determination of local policy. In tax matters, policy design and implementation remain almost exclusively the domain of the Ministries of Finance and Interior. Nevertheless, the Czech fiscal system is changing. Watching contemporary reconstruction efforts is a little like rediscovering history. The 1918 introduction of independence, democracy, and capitalism preceded the fascist occupation by scarcely more than two decades. After World War II, the old system had not been reestablished before the MarxistLeninist takeover put market economics on hold again. Since the liberation of 1989, the Czech consensus has been that a market-oriented economic order should be reestablished. Although there are disagreements about how this can best be achieved and how quick the transition should be, the development of democracy and local self-government has been a high priority for Czechs. For many, of course, attachment to markets and even to local self-government may not be as important as being tied to the EU, but the latter attachment implies the former.

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Postrevolution Tax Reform The transition to markets required a more robust tax system than that of prerevolutionary Czechoslovakia. The command-oriented fiscal systems of the previous era were ineffective for contemporary purposes and required thorough revamping (Holzman, 1992). Preparation for a comprehensive tax reform, undertaken while today’s two republics were still united, was instituted in 1993. The new system incorporated elements of decentralization, modeled as it was after the fiscal systems of Western Europe. Although it was a clear improvement, the result was a complex system fraught with potential distortions. It was designed without careful consideration of the size of revenue flows required for national and local needs. As is typical in West Europe, the Czech fiscal system attempted to balance direct and indirect taxation. After the planning era’s generally invisible taxes, it took considerable administrative courage to increase dramatically the impacts of direct taxation on the sensitive citizenry. Direct taxes produce 46 percent of the central government’s revenues even today, while indirect taxes generate 54 percent. The highly visible personal income tax, introduced in January 1993, has rates ranging from 15 percent on an annual tax base up to CZK 84,000 and up to 40 percent on an annual base greater than CZK 756,000. The general corporate income tax rate is 39 percent. The potentially most significant tax for local governments, especially for small ones, is the property tax. Of great importance for the autonomy of local governments in the English-speaking economies, the property tax provides financial independence in both design and implementation. In the Czech and Slovak republics, it has not as yet played the role that it could, providing a reliable source of revenues with minimal distortion of private allocation processes (Oates, 1996). But even if the “real estate tax” were increased from low, rather symbolic levels to those which would permit it to play a significant role in the delivery of municipal services, transition governments could still not depend on it to fund all the necessary tasks. Nevertheless, the subnational governments would have more meaningful control over local fiscal affairs and satisfy an important requirement of genuine self-government. The Czech fiscal system has been described as one in which there are no local taxes, because all policy prerogatives belong to the center. It is true that in the course of the transition the central government has transferred significant properties to the Czech municipalities, which can to some extent be sold off to secure needed revenues. Property sales are a nonrecurring revenue source, however, that will not indefinitely sustain an adequate cash flow. The municipalities can also incur debt to overcome revenue shortfalls, although loans must clearly be used with prudence. The

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Czech finance ministry’s concern about the growing prevalence of leveraged municipal activities will be addressed below. The Ministry of Finance has proposed a new tax law to address unsatisfied revenue needs. The proposal also suggests the possibility of more serious application of the property tax, targeting increased yields by as much as a factor of 3. The ministry has further proposed that the “fees” charged for local government services be reclassified as “taxes” and that their levels be increased to generate greater revenues. The finance ministry is also engaged in an effort to limit the amount of debt local governments are permitted to carry. Deficits have grown quite rapidly in the past few years for a number of the municipalities. Finally, the distribution of taxes from the central government will be modified. The share currently accruing to the municipalities varies substantially by tax type, but there is growing sentiment to provide uniform revenue shares from all tax sources for the local governments. The flow of resources to the municipalities must be reliable and sufficient for socially agreed purposes. The national government has sometimes been willing to delegate service provision to subnational governments without sharing the revenues that those services require. The center has its own substantial transition burdens, of course, and is very concerned with its responsibility of ensuring that local resource requirements are satisfied. Nor is the national government unwilling to accept its responsibility to implement ameliorative legislation. Nevertheless, the situation remains difficult for the municipalities. Some complain that in recent years they have received funds only for current operations, and even these have frequently been insufficient. Transformation success for these nations has allowed for economic growth taking into account the moderate price inflation both have experienced. This growth has translated into incremental enhancement of public (state plus local) budgets as well. In the case of Slovakia, per capita municipal budget expenditures are strikingly below those of the Czech Republic. Czech municipal budgets were more than twice as large as those of Slovakia from 1993 through 1996 (and we must also remember that the price of the SSK is somewhat less than that of the CZK). Czech citizens enjoyed per capita public services expenditures over three times as large as those for the Slovak citizen in 1996. As a share of the national budget of the Slovak Republic, local budgets range from about 13 percent to 14.5 percent. In the Czech case, local budgets range from one quarter to just over a third of the national budget. Slovak municipal governments received much smaller grants from the state (i.e., national) government, ranging in amount from 1.1 billion SKK in 1994 to 1.5 billion SKK in 1993. Grants transferred from the Czech central

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government to its municipalities ranged from a low of just over 27 billion SKK in 1993 to 59.5 billion SKK in 1996. In the years 1991 and 1992, before Slovakia achieved its independence from the Czechoslovak Republic, it had received grants of 7.9 billion and 2.4 billion crowns, respectively. The arrival of national independence brought immediate impoverishment to Slovak municipalities in comparison with the Czech situation and relative to their own past as a part of Czechoslovakia. Immediately after the Velvet Revolution Slovakia’s central government committed itself to samospráva for the republic’s subnational governments. Apparently because it was disinclined to share revenues with the comparative largesse of the Czech government, the state was in fact prepared to permit the townships greater independence in raising their own revenues. Although the rate and base of property taxes were the same for both republics, having common Czechoslovak origins, the Slovak municipalities became significantly more successful in raising funds through real estate taxation. That would imply more effort and better results in property tax application than that achieved by their Czech neighbors. Slovak real estate tax as a share of the aggregate of local budget revenues in 1993 and 1994 was over three times as high as in the Czech Republic and in 1995 and 1996 was over four times as high. Naturally, because the property tax base is low in both countries, even multiples of such sums do not represent large absolute amounts. Current Problems and Issues As we have seen, both of the republics under investigation are well aware of inadequacies in their similar fiscal systems. Two current concerns of the Czech Republic are the growing disparities in the material well-being of their municipalities and the increasing willingness of municipalities to incur debt. Some Czech townships are enjoying an increasing per capita share of total municipal revenues, while the share of less fortunate municipalities declines. With respect to tax receipts, the wealthiest municipalities became 15 percent wealthier in the five-year period ending in 1999, while the poorest five townships have maintained a very low share (Kameniˇcková, 1998). Matoušková (1998) recently examined the revenue structures of seven small townships of 800 to 1,000 inhabitants, an important exercise because there are so many small local governments. The largest township in this study, Brloh, has only 175 more citizens than Vedrovice, with 820. There are significant differences among these municipalities with regard to revenue receipts, the volume of expenditures, the willingness to incur debt, the share of revenues used for operating expenditures, and so on. From 1995 to 1997, all

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Property Tax and Fiscal Decentralization in the Twin Republics

of these municipalities resorted to debt for some part of their activities; only Sloup was completely debt-free in 1997. For the three-year period, four of them had increasing debt, two of them had long-term per capita debt that was basically constant, and in one township debt use declined each year. Debt service in these townships was still at reasonable levels in spite of the finance ministry’s concerns about the increasing tendency of the municipalities to resort to deficit finance. Receipts from property sales are uniformly quite low, and one suspects that these townships would be very willing to sell off more properties, but that on the supply side many are not in good condition for sale and that on the demand side buyers are not readily available. In larger municipalities one would expect that the sale of property might be a more practicable policy. One cannot help but notice that there is a large difference not only in the total receipts of the small townships investigated here but also in the per capita operating expenditures of the largest and smallest townships of this small sample. We do not have the data to support the tempting inference that even a small absolute difference in size makes it easier for small townships to compete for the funds that have become so scarce in Slovakia since the separation of the two republics. We surmise that this small positive advantage in population size also makes a significant difference in the collection of property taxes and public service fees. The larger towns have begun to address the problem of neglected public services by incurring more substantial debt. Some indication of the problem’s magnitude can be perceived by referring to Table 5.1. As we observe, the local debt of 1996 and 1997 represented a comparatively large proportion of the total revenues of the municipalities for those years at 7 percent of total revenue in 1996 and 4.3 percent in 1997. Generally speaking, in a developed economy, debt around 5 percent to 6 percent of revenue is all one would like to see. Without the ability to create money, such debt can be difficult for a municipal government to pay off. Simply rolling it over is not completely painless, since municipal borrowers generally pay relatively high (double-digit) interest rates on their loans. Moreover, how they are spending the money is not clear. If it is for infrastructure, there was no large problem for these years. But if the operations budget were absorbing the expenditures, that would naturally be poor practice. Whether the debt is growing, and if so whether at an increasing or decreasing rate, is too early to say from these figures. In any case, we know that the Czech finance ministry is very concerned about the growth of deficit finance by the subnational governments. The fundamental fiscal problem of small Czech townships is finding the means to invest in basic infrastructure at an acceptable level. Some local

Fiscal Decentralization in Economic Transformation Table 5.1

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77

Local Government Budgets, Czech Republic (Millions of CZK)

Total revenues and grants Total revenue Tax revenue Non-tax revenue Grants Expenditure and net lending Total expenditure Current expenditure Capital expenditure Lending minus repayments Financing Abroad Domestic Local government debt

1993

1994

1995

1996

1997

91,908 64,059 37,624 18,584 27,859 89,648 89,648 58,028 31,620 0 −2,260 0 −2,260 NA

112,241 81,261 54,428 20,633 30,980 112,112 111,040 69,696 41,344 1,072 −129 7,294 −7,423 NA

130,041 95,238 68,167 21,746 34,803 132,134 131,796 81,459 50,337 518 2,273 0 2,273 NA

163,831 102,327 72,134 22,190 61,504 171,112 168,747 117,701 52,046 1,365 7,281 0 7,281 32,184

145,342 109,470 76,092 24,677 35,872 150,109 150,505 99,657 50,848 −396 4,767 256 4,511 41,456

Source: Czech Ministry of Finance, 1998. Data taken from the Finance Ministry Website.

finance personnel observe with poignancy that subsidy levels no longer permit essential capital expenditures. Nevertheless, a glance at Table 5.1 also demonstrates that capital expenditures have approximated one-third of the total expenditures of the municipalities, presumably being a residual of the total after current expenditures have absorbed their share. Czech fiscal observers believe that the development of any municipality will hinge on its ability to secure financial subsidies. They seem not to perceive that municipalities could secure funding for public services and the development of infrastructure independently of the center. For all its goodwill and intent to provide sufficient funds on an equitable basis, the state has been grappling with financial crises of its own. It has tended to respond to them both by reducing transfers to the municipalities and by transferring to local governments some of its own service provision responsibilities. The school system, a most significant public service currently being provided from the central budget, is currently being reconsidered. Certainly, significant benefits could be gained by turning primary and secondary education over to local governments, especially from the standpoint of local autonomy. But municipal agents must ask with some terror in their hearts whether funding would also be transferred at sufficient levels. The fiscal and administrative autonomy essential to the development of local governments in a democratic system remain inadequately developed in the Slovak Republic as well. Many of the same problems shared with

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the federation partner until 1993 persist and need no lengthy discussion. The quintessential difficulty with the Slovak municipal fiscal system is that a crisis begins with the center’s annual budget announcement. An extended period of uncertainty and inability to complete subnational planning processes follows. Slovak municipalities can rely on relatively stable revenues from centrally received, shared tax revenues. The share of the municipalities is, unfortunately, not particularly generous. Note that only about a quarter of the revenues of the cities and townships comes from the central budget as their share of the national tax yield. In addition to this share, of course, they receive grants from the state. Before the separation of the two republics, Slovakia received a much more handsome share of their total revenues (49.2 percent in 1991 and 31.9 percent in 1992) from Prague. After the separation, grants received from Bratislava were drastically reduced, starting in 1993 at 10.6 percent and declining continuously to the 1996 low of 7.5 percent. This decline has been dramatic and, perhaps, tragic since independence. Revenues from grants have been replaced by “other” revenues, which include those from sales of properties and from debt. Whereas these are very legitimate revenue sources, they are strikingly high. Until recently, local autonomy also suffered badly because the Mechiar coalition’s pursuit of recentralization was undermining the whole system. It might seem only a subtle difference that the Czechs provide better funding for their municipalities while the Slovaks provide fewer obstacles to municipalities in pursuing their own funding. The significance of this difference can be made apparent by reference to the Russian case described by Schleifer and Vishny (1998). They compare Russian municipal finance to the Polish case, in which the main source of municipal funding is local taxes and fees, especially property taxes. In Poland, shared taxes and grants from the center are less significant than in Russia, and those they have are designed to encourage local businesses. Polish local politicians have more incentive to broaden the tax base to increase revenues, that is, to promote new business formation and employment. Russia, which is similar to the Czech Republic, transfers more than twothirds of municipality revenues from the central government. While the local governments’ share of the tax take is ostensibly fixed, it must in reality be negotiated between governmental levels. The Russian fiscal system produces detrimental effects, since local governments have little incentive to broaden the tax base and promote small business. Rather, they focus their efforts on negotiations with Moscow for enhanced transfers and grants. The Czechs especially have a serious principal/agent problem here; the federal fiscal agent raises the local funds required by the municipal principal. The inability of the principal to monitor the process, and the agent’s pursuit

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of personal objectives rather than those of the principal, represent a classical problem of moral hazard. Discussions with local Czech officials reveals the process of valuing property and of locating unregistered properties to be the exclusive domain of the cadastre, that is, of the central authorities to whom the central cadastre and its regional offices report. Officials would deem it inappropriate to inquire of the center or of the cadastre whether particular properties are on the tax rolls or whether properties are seriously reviewed for taxation purposes. In Slovakia, local officials have reported to us that they can and do check property records for taxation purposes. Conclusions Maintaining soft budget constraints for state enterprises and private firms allowed the Czechs to avoid serious unemployment problems and thus postponed some transition agonies, but the day of reckoning came. The debt portfolios of Czech banks could not be ignored indefinitely. In Slovakia the opportunistic privatization program of former Prime Minister Mechiar was pursued in lieu of effective public policy. The huge financial needs of both these central governments in transition have resulted in severely constrained budgets for the nominally autonomous municipalities. The local budgets that we have been examining are really quite minuscule compared with those of the more prosperous Western democracies. Nor can they be expected to improve substantially in the coming few years. The Czech local governments remain dependent on a central government that dominates municipal and transfers the modest amounts to local jurisdictions. The latter complain that responsibilities for the provision of public goods and services transferred from the center are not always accompanied by funding. Local governments respond as they must to the shortfall of shared revenue: they incur debt, they sell assets, and they charge fees for as many services as possible. After much preparatory experience from central planning times, they make do with little, applying patiently to the finance ministry in Prague for grants. They see no prospects for greater revenues through independent use of a much more significant property tax, not believing that to be realistic. Still, the Czechs demonstrate the sincerity of their fiscal decentralization efforts by supplying more generous funding than their Slovak counterparts. The finance ministry has studied and proposed tax modifications that would promote more autonomous local funding through increased taxes for local services as well as a more realistic property tax. The pragmatism with which Czech authorities are comfortable is likely sooner or later to move them toward the greater local autonomy that accession to the EU requires.

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Local Slovak governments face similar problems and share the same legacies. They are less dependent on Bratislava, largely because they receive next to nothing from their central government. This somewhat greater fund-raising independence sets them apart from their Czech counterparts. Being left basically to their own devices has forced Slovak towns to be more effective in raising funds, but whether or not they can take full advantage over time of the opportunity thus provided remains to be seen. This greater potential independence effectively opens a door to overcoming the moral hazard problem that characterizes the Czech case. While laboring under central planning legacies and being constrained by detrimental political conditions, the Slovak Republic has done about as well with fiscal decentralization as could be expected. As it moves from its hasty adaptation of a standard Western taxation system to one more specifically geared to contemporary fiscal needs, general economic development could ultimately produce substantially increased, independent revenue for local autonomy. That a new political administration may permit Slovakia to come closer to fulfilling its promise than it has in the past is also encouraging.

PART II

Sources of Czech and Slovak Local Revenues

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CHAPTER 6

The Property Tax, Grants, and Other Sources of Local Revenues∗ Comparative Municipal Fiscal Performance We would now like to apply the theoretical considerations discussed in previous chapters to the Czech and Slovak fiscal situations and ask which of the two governments has been most successful in terms of local finance, and why. The Slovak Republic has administered its property tax locally; the Czech Republic has administered it centrally. The Czechs have transferred considerable revenue to the local governments, while the Slovaks have been far less generous in providing transfers. The Czech Republic, having chosen a centralized approach to property tax administration, transfers substantial amounts of funds from the national to the local governments, while the Slovak central government has been far less generous. The relative success enjoyed in fiscal decentralization will be reflected in public sector data. The macro situation and economic growth in the economy will impact both national and subnational budgets. After taking account of price inflation, both the Czech and Slovak republics have experienced growth permissive of expanding state and local budgets. Budget data are presented in Table 6.1. Under central planning, the Czechoslovak federation’s local governments derived roughly 60 percent of their total receipts from subsidies from the late sixties on. From around 1984, they experienced a gradual decline in central ∗

This chapter first appeared as Phillip J. Bryson and Gary C. Cornia (2004), “The Property Tax-a Missed Opportunity for Fiscal Decentralization in Transition Countries? The Czech and Slovak Cases,” in B. Michael, R. Kattel, and W. Drechsler (eds.), Enhancing the Capacities to Govern: Challenges Facing the Central and Eastern European Countries (Bratislava: NISPAcee), pp. 193–223. Because it was redundant in this collection, the introduction to this paper has not been reproduced here.

84 Table 6.1

National and Local Budgets: Czech and Slovak Republics SLOVAK REPUBLIC 1993 ∗

Public budget TR National budget∗ Local budgets∗ Local as % of national Budget state grants to local Budgets∗ grants as % of local Budgets total local revenues∗ Local budget expenditures∗ Real estate tax∗ RE tax (% of local revs.)

1994

1995

1996

170 158 184 273 150.3 139.2 163.1 162.9 19.5 19 21 21.5 12.97 13.65 12.88 13.2

1997

1998

1999

279 287 324 175.8 179 179 23.5 22.7 21.3 13.37 12.68 11.9

2000 371 224 24.8 11.07

1.5

1.1

1.2

1.3

1.8

2.08

2.24

2.77

7.69

5.79

5.71

6.05

7.66

9.16

10.52

11.17

24.2 23.9

27.4 26.5

2.4 9.27

2.72 11.24

2.87 10.47

1998

1999

2000

21 19.3 1.6 7.62

20.1 19.1 1.79 8.91

22.2 18.9 1.73 7.79

22.9 21.9 2.14 9.34

26.7 25.3 2.61 9.78

25.9 25.8

CZECH REPUBLIC 1993

1994

1995

1996

1997

Public budget TR∗ 422 472 536 585 562 595 626 651 National budget∗ 358 390.5 440 482.8 479.6 509 538 557 Local budgets∗ 91.1 111 129.1 161.72 145.3 157.2 187.7 181.8 Local as % of 25.45 28.43 29.34 33.5 30.3 30.8 30.9 32.6 national Budget state grants to local 27.03 29.25 33.28 59.44 35.87 37.39 41.43 46.05 Budgets∗ grants as % of local 29.67 26.35 25.77 36.75 24.68 23.79 22.07 25.33 Budgets Total local revenues∗ 101 111 129 162 147 162 188 181 Local budget 90.1 112.1 132.3 171.1 150.5 158 173 190 expenditures∗ Real estate tax∗ 3.021 3.808 3.799 4.018 3.943 4.108 4.248 4.437 RE tax (% of 2.99 3.43 2.95 2.48 2.68 2.53 2.26 2.44 local revs.) ∗ Billions

SKK, CK Slovak state grants in 1991: 7.961; 1992: 2385 Source: From data published by the Federal Ministry of Finance, Czech and Slovak republics; the present authors made appropriate calculations and compiled this table.

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government subsidies, a trend that extended beyond the opening to market economics and democracy. Although there was a brief expansion of transfers from 1990–92, the decline continued. After the mid-1990s, subsidies represented no more than about 35 percent of the total receipts of Czech and Slovak municipalities (Pekovà, 1996). Table 6.1 shows the financial situation from the end of central planning through the year 2000. The data indicate that Slovakia’s municipalities are substantially poorer than those of the Czech Republic. From 1993 on, after the Velvet Divorce, Czech municipal budgets were more than twice as large as those of Slovakia, even if the greater value of the CZK is not taken into consideration. The difference between the two is best illustrated by a per capita comparison of grants from the respective central governments. By the end of the period, per capita public services expenditures for Czech citizens were three times greater than those for their Slovak counterparts. Local budgets in Slovakia are only about 14 percent of the total national budget. In the Czech Republic they are as high as one quarter to just over one-third of the national budget. A comparison of central government grants to municipalities reveals the reason for the relative poverty of Slovakian municipalities. Grants in Slovakia ranged from SKK 1.5 billion in 1993 to SKK 1.1 billion in 1994. The grants paid by the Czech central government to the municipalities ranged from just over CZK 27 billion in 1993 to CZK 59.5 billion in 1996. Interestingly, in the years just prior to Slovak independence (1991 and 1992), the government in Prague provided grants of 7.9 billion and 2.4 billion crowns, respectively, for Slovak municipalities. Independence from the Czechs turned out to be a shock for the municipalities of the Slovak Republic, for it separated them from the Czech central budget. The municipalities soon discovered that the strange politics of the Mechiar era would also separate them from the Slovak central budget. Mechiar was interested in the “family privatization” of Slovak industry, but not in helping solve the problems of Slovak towns, cities, and regions. He let them know that they would be forced to solve their own fiscal problems, for there would be no significant revenues flowing to them from Bratislava in the near future. The Czech System of Intergovernmental Grants In the Czech case, the central government’s ongoing efforts to fund the cities and towns are expressed primarily through revenue sharing and financial grants. Table 6.2 provides data for an overview of these efforts. Note especially the tax revenues accruing to local governments as a share then declined for three straight years, reaching a low for the period of 12.8 percent in 1997. Increasing over the next three years, it reached an all-time high in 2000 of 15 percent.

86

Table 6.2

Local and State Tax Revenue Sharing, Czech Republic (Millions of CZK) 1994

1995

1996

1997

1998

1999

2000

Tax revenues, state Tax revenues, local Consolidated budgets, total Local share in %

349,027 54,428 401,503 0.135561

391,228 68,167 457,022 0.149155

439,186 70,000 506,202 0.138285

464,087 76,091 592,474 0.128429

495,232 83,319 575,836 0.144692

524,765 87,011 608,585 0.142973

544,142 95,807 636,618 0.150494

Local PI tax revenues National PI tax revenues Total PI tax revenues Local as % of total

48,716 5,804 54,520 0.893544

60,096 8,491 68,587 0.876201

50,818 29,726 80,544 0.630935

54,503 33,378 87,881 0.620191

58,581 36,339 94,920 0.617162

60,078 35,224 95,302 0.630396

63,501 34,771 98,272 0.646176

Local CI tax revenues State CI tax revenues Total CI tax revenues Local as % of total

128 63,624 63,752 0.002008

3,145 63,337 66,482 0.047306

14,139 47,676 61,815 0.228731

13,361 42,202 55,563 0.240466

16,232 51,324 67,556 0.240275

18,773 51,343 70,116 0.267742

23,470 52,322 75,792 0.309663

30,980 24,003 6,977

34,803 21,747 13,056

61,504 48,882 12,622

35,839 23,958 11,881

37,355 24,982 12,373

41,374 27,658 13,716

45,939 30,429 15,510

112,241 504,283 0.222575

130,041 522,753 0.248762

163,831 562,792 0.291104

145,342 487,655 0.298043

157,178 637,656 0.246493

187,700 688,844 0.272485

181,814 707,844 0.256856

National government grants Current Capital Local revenue and grants total Consolidated public Budgets Local share

Source: Data from Government Financial Statistics: Fiscal Data for the Czech Republic, Ministry of Finance, Czech Republic, and authors’ arrangement and calculations. This Data was previously online at the ministry websites.

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In the early years the center transferred to the local governments a considerable share of the personal income tax revenues that it collected. In 1994 and 1995, municipal governments received 89 percent and 87.6 percent, respectively, of those revenues. In 1996 the share dropped to 63 percent and remained at that level. Corporate income tax followed a contrasting pattern, with the center initially transferring only a small portion to the municipalities. In 1994 only two-tenths of 1 percent of corporate income tax revenues accrued to local budgets, increasing quickly to the level of over 20 percent. It increased only gradually up to 26 percent from 1996 to 1999, reaching 31 percent in 2000. Federal grants have been an important and increasing source of funding for Czech municipalities. They have represented roughly a quarter of the budgets of the local governments since 1994. They constituted 22 percent of total accessible funds in 1994 and 29.8 percent in 1997, declining to around a quarter of the total for the remainder of the decade and holding at 25.7 percent in 2000. Over the past decade, the joint contribution of transfers and shared taxes has remained at roughly 70 percent of local government revenues, but it remained true that a “meaningful degree of tax autonomy for local authorities was still missing” (Oiliveira and Martinez-Vazquez, 2001). Compared with most other European countries, including other transition countries, the Czech Republic is unique in that it offers no equalization grants to districts or municipalities. Nor did reforms in 2000 make any provision for such grants. There is instead a complex system of conditional grants and subsidies, which transfers funds to promote central government policy objectives. Since they are targeted for specific purposes, local governments must follow directives and report on the specific uses for which the funds were spent (ibid., p. 48). One should note, however, that the relative importance of earmarked subsidies is declining, providing only 24 percent of all subnational government revenues in 1999. Earmarked Grants Earmarked grants currently in use are of two types. The first type, categorical grants, is for funding tasks delegated by the center to municipalities. They must be spent on specific, well-defined programs and require no matching funds from the municipalities. Distributed generally on a “per head” basis, they cover outlays for social assistance, early education, hospital and assistance institutions, fire brigades, and the execution of general government services, including registration and permits. Central governments use categorical transfers inter alia for redistributing fiscal resources, countering

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externalities, adjusting for vertical imbalances, and promoting local government expenditures in support of national programs. If unconditional grants were used rather than categorical transfers, central authority would demonstrate greater respect for the decision-making autonomy of local government officials. The nearly exclusive use of earmarked grants suggests the central authorities’ belief that they have identified all local level priorities and that they simply possess better information on needs than local officers do. Capital transfers represent the second type of earmarked grant. They originate from the central government general budget and from the State Environmental Fund to accomplish a variety of purposes, including fire protection, natural gas distribution, schools, development of industrial zones, hospitals, water and sewerage treatment plants, and public transport. Matching funds are required of the municipalities for all centrally supported capital infrastructure projects, except for the building of new social care institutions. Capital transfers from the State Environmental Fund are for environmental purposes, for example, to fund water supply systems or to introduce gas, flood control, and energy conservation measures. Matching funds of at least 20 percent are required of the subnational governments at rates set by the state agency. In 2001 the State Environmental Fund transferred a share of about 7 percent of the Republic total for that year. Specific transfers have been funded in such a way as to supply a negative incentive for municipal revenue generation. The central government apparently reduces the level of discretionary transfers systematically as local governments increase their own revenues. The allocation of grants conditionally and at the discretion of central authorities tends to be less efficient and fair than through the use of objective formulas or well-publicized legislative procedures and criteria. Discretionary central systems can be distorted by pressures from lobbyists representing local governments or by parliamentary members defending or lobbying for local interests. Oliveira and Martinez-Vazquez suggest, as an alternative to project-by-project application processes, that local governments develop comprehensive expenditure plans for evaluation and funding to the extent of the center’s budget possibilities. Clearly, budget transfers from the center give the Czech obci considerably more options than are available to those of Slovakia. Nevertheless, because such a large share of Czech municipal funding comes from the state, Czech municipalities enjoy less budget autonomy. Although local independence plunged Slovak municipalities into poverty, it also placed them under a hard budget constraint with a large measure of budget autonomy from the center. By forcing them to be more responsible for their own revenues, the Slovak Republic caused its municipalities desperately to pursue increased property tax yields for their revenue needs.

The Property Tax, Grants, and Local Revenues

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89

In contrast, the Czech Republic has tapped resources other than the property tax to generate municipal funds. More generous provision of fiscal grants and transfers to Czech municipalities appears to avoid the need to develop the property tax as a revenue source. But in the meantime, the Czech government has failed to provide any foundation for genuine local autonomy. Grants and the Future Over time, local governments in both republics will face increasing revenue needs for current operations as well as a heavy backlog of needed investments. To this point, local governments in both countries have sold off assets in the form of the public housing and commercial properties the central government transferred to them early in the transition. These sales have been the source of considerable revenue, but a disappearing one as assets capable of being privatized become scarcer. Even this source of funds has not permitted municipalities to avoid ongoing revenue shortfalls. The problem will continue to become more serious until the municipalities are vouchsafed more adequate sources of revenue. Since the transition period began, both republics have struggled with periodical fiscal crises. A natural response has been to reduce revenues to the municipalities, while transferring additional service provision responsibilities to the local governments. Numerous unfunded federal mandates merely reflect this kind of transfer of responsibility from the center. In fairness, the Czechs have not been as guilty of that offense as most other transition countries. But even when the Czech government funds centrally mandated programs, it retains strong influence over the use of central funds, thus subverting the development of local autonomy. In Slovakia, which has about exhausted the possibilities of the current property tax system, further fiscal development would require a more serious property tax. Transfers from the central government are unlikely to satisfy local financial requirements, since they have to this point represented no more than about a tenth of the local budgets. It is very important, therefore, that the Slovaks continue to develop local autonomy through the establishment of a more substantive property tax. Given the relative largesse of the Czech Republic toward its subnational governments, one might view the lack of a serious property tax as being of no large consequence. The fiscal needs of the Czech regions, districts, and municipalities could be amply covered through transfers from the central government and other revenue sources. Compared with a number of transition countries, the Czech Republic has in fact been fairly generous in supplying funds for this purpose. It appears that the EU accepts this fact as

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evidence for the proposition that the Czech Republic is developing satisfactorily as a modern democracy and should ultimately be admitted as a full member. In our view, this perception is too narrow. In the first place, the fiscal needs of the municipalities have not been properly taken care of, even though the needs are not as great as those of Slovakia and some other transition countries. And there are other significant problems in the fiscal decentralization process of the Czech Republic. The central government takes a paternalistic attitude toward the municipalities, and agents probably feel that they are securing financial security for the cities and towns. To the outsider, the perception is that the central government is prohibiting the independence of the municipalities and regions (Bryson and Cornia, 2000). The center has not gotten far beyond the tendency of the central planning era to rely only on local agents for state administration. The center generally establishes the policies, allocates funds, and gives very specific directions on how local officers are to utilize them. The spirit of intergovernmental relations can be observed from the administration of public housing. After the Velvet Revolution in 1989, the central government turned public housing over to the municipalities. The buildings were of notoriously poor quality and in need of major expenditures, but they were transferred without the funds to maintain or repair them. Housing units have been privatized to some extent, and that provides a supplementary revenue source for the municipalities, but housing rents and tariffs on such public utilities as water and gas are still regulated by the central government and are held at levels below full cost recovery. Likewise, the central government controls local government employees’ salaries (Martinez-Vazquez, Jorge, and McNab, 1997). So the central government’s policy preferences can constrain the municipalities to operate in the red. Under democratic governments, municipalities generally have the responsibility to develop their own capital infrastructure. In the Czech Republic, however, local governments remain fully dependent on the central government to fund capital expenditures. Such funding takes the form of various grants and subsidized loans. Municipalities can often suggest projects that they would like to see funded, but the center will determine which projects are selected and establish the terms and conditions upon which the funding is contingent, that is, perform state administration. Local Debt in the Czech and Slovak Republics In the Czech transition, the relatively modest flow of resources from the center to the municipalities and the limited independence of local government

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have been lingering problems. Given the scarcity of resources for the kinds of investment projects in the public sector that would secure the future of local governments, local debt has, not surprisingly, become a more visible issue. If the center cannot provide sufficient resources and local revenue sources fail, likewise, to do so, raising funds becomes a serious concern for the local governments. The fear of the central government and the Ministry of Finance in the Czech Republic is that the municipalities might be tempted to leverage more of the desirable projects that they want to finance. But the issue of local debt is troublesome for the central government for yet another reason. The EU strictures on deficits and debts include all government levels, so that local debt is seen as a part of overall national debt. If local governments leverage their development, the central government can make use of debt correspondingly less. The issue of local debt can be treated succinctly, because of the surprisingly high level of fiscal responsibility shown by local governments in both the Czech and Slovak republics. Only a very small number of municipalities have actually incurred excessive debt. Both central governments monitor local debt very carefully and have built in restraints that have held in check any impulses that would suggest future problems. Ježek, Marková, and Váˇna (2004) conclude that the appropriate method for controlling the growth of local debt would be to strengthen local governments’ financial independence. By enabling local governments to influence their own revenues through autonomous powers of taxation, municipalities and, to some extent, regions would be motivated to increase their fiscal effort. This would amount to a diminution of the problem of moral hazard addressed previously. Through genuine fiscal decentralization and greater visibility, citizens would know how their taxes are used, become more interested in how their local government operated, and be involved in monitoring and influencing local spending (Bryson and Cornia, 2003). The actual debt burdens of the Czech Republic have been carefully evaluated (Bryson, 2007a), and various criteria for assessing the potential hazards of local debt in the republic have been reviewed in the literature. The local debt of the Republic of Slovakia is also a reflection of the fiscal institutions and situations currently pertaining there. Considering the insufficiency of autonomous revenue sources, one would expect deficit finance to appeal to Slovak municipalities. Leveraging local projects might provide an opportunity to pursue 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. As newly acceded members of the EU, they are encouraged to access EU regional development funds. But they must also raise matching funds of their own to participate.

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The Slovak Republic, like its Czech counterpart, uses various criteria and techniques to evaluate and to regulate local debt (Bryson, 2007b). The central government has been successful in promoting fiscal responsibility among the local governments, so only a small handful of the many municipalities of the republic have had any problems at all with the consequences of leveraging too many of their activities. Public debt in the Slovak Republic is largely central government debt, but local debt has begun to increase significantly, especially for the largest cities of Slovakia. Smaller cities and towns have used debt very prudently, since they have long been under subtle, long-standing cultural norms that discourage debt. Inept local debt management experience has surfaced but has also been publicized. The central government has put debt regulation into place, so there is no reason for serious concern about any future fiscal problems related to local deficit spending in Slovakia. Henceforth, any debt problems are likely to be national problems. The Advent of Regional Government Recently, regional governments were established in the Czech Republic; previously this had actually been a two-level system of government. The kraje are now being phased in and, for a transition period, will be funded by transfers from the state budget. The regions have not yet been assigned clear expenditure responsibilities, but they are intended to inherit some of the state’s responsibilities, including secondary education, regional planning, and inter-city transport (ibid., p. 6). They will doubtless provide assistance to municipalities, especially small ones lacking in resources and administrative potential. One can be sure that centrally provided directives and mandates will guide this activity. The functioning of the new kraje will likely become an important part of subnational governments’ activity, but this functioning will not necessarily enhance local autonomy. Meeting Fiscal Requirements vs. Promoting Local Autonomy These kinds of intergovernmental relations, and worse, have been the general experience of transitional countries; local governments have often been able to function only as administrative agents, too frequently with unfunded mandates burdening their activities. The assignment of responsibilities without the corresponding resources frustrates local governments, which are already dependent on the state for financial transfers. In the years since the transition began, municipalities have become accustomed to having no independent operations based on revenue sources that are significant and under their jurisdictional control. They have thus never broken free of their dependence on the state.

The Property Tax, Grants, and Local Revenues

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According to Oliveira and Martinez-Vazquez (2001, p. 26), this situation is mitigated to some extent because the Czech Republic has generally avoided the imposition of substantial unfunded mandates on local governments. Delegated functions usually obligate the Czech central government to guarantee full funding for any new expenditures. There have been exceptions to these rules, for example, when a recent transfer of the responsibility for issuing personal identification cards and passports was transferred to local governments without funds for the project. A more high-profile case was the transfer of public housing referred to above. Retention of control over the pricing of transferred service responsibilities is tantamount to another unfunded mandate, adding insult to injury. But the center’s unwillingness in such cases to demand normally appropriate fiscal performance, when their own policies make such impossible, explains why soft budget constraints develop for local governments and why bailouts are occasionally needed. Subnational governments cannot be expected to meet financial obligations if the financial requirements of tasks assigned to them exceed the available funds. The municipalities become hostage to their administrative directors in central government, but avoid full financial responsibility by partnering in their administrative practices. The EU and Ongoing Czech Centralization The EU could easily place pressure on the Czech Republic to provide genuine autonomy for local governments. We have seen that since the end of the central planning era the Czech system has retained its centralized character with local governments unable to function with the autonomy foreseen by fiscal decentralization. The level of funding has not been bountiful by Western standards, but the Czechs are not unwilling to share the gains of economic growth with the localities. As a nascent democracy, the central government must respond to the elected leadership, so there is pressure from within the country to increase the level of local funding. The Czech government is also accustomed to responding to pressure from the EU. The EU is in a position to dictate reforms to countries aspiring to membership. Indeed, EU membership requires that a country achieve ●

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stability of institutions guaranteeing democracy, the rule of law, human rights, and respect for and protection of minorities; a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union; acceptance of membership obligations and of political, economic, and monetary union.

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Clearly, a guarantee of democracy’s implicit demands for local autonomy would be an appropriate demand of the EU for prospective accession countries. To expect fiscal reforms on the transition countries seeking membership would be well within EU’s rights, and the Czech Republic is one of the countries that one could expect to respond favorably to such demands, given its strong aspirations for membership. Unfortunately, it cannot be said that the EU requires fiscal decentralization. In its initial country report, the Czech Republic was recommended for ultimate accession. The budgetary and finance systems were addressed, but questions about them were limited to the financial control system. Concern was expressed only about the Supreme Audit Office, which the Czechs had created in 1993; it was observed that the system of internal financial control did not correspond to European Commission (EC) provisions for member states. When the Czech government expressed its intention to improve budgetary control, the EC declared itself satisfied (Agenda, 2000). In the 2000 Regular Report (EC, 2000) by the Commission on the Czech Republic’s Progress towards Accession, the Czech Republic is commended for strengthening value-added tax controls through additional information technology (IT) equipment; is acknowledged for its Act on Budgetary Rules, June 2000, which established the legal framework for the country’s management of budgetary relations with the EC; is admonished to further efforts to strengthen its financial control functions at all levels; is berated for ongoing weaknesses in the finance ministry in the areas of tax collections and analysis of capital investment programs; and is faulted for poor management of EC pre-accession funds, having proved slow in formally requesting available funds and in the use of funds granted. The more serious, long-term failure to enable or promote the development of local autonomy is not mentioned by the EU as a subject of concern. The problems of unfunded mandates, the nature of financial transfers from the center to local governments with extensive strings and controls attached, and disinterest in the property tax as a means of independent financial leverage are all testimony to the failure to take seriously the problem of local autonomy. On the basis of a continental tradition lacking in concern about hypercentralization, the EU finds the Czech fiscal system adequate for membership. It elects to ignore the lack of local or regional autonomy and the failure of recent reforms to address the problem. The Czech tradition of fiscal centralization can now be celebrated as having a half-century tradition.

CHAPTER 7

User Fees in Local Finance: Performance and Potential in the Czech Republic and Slovakia∗ Introduction User fees are a part of the local public finance arsenal of both the Czech and Slovak republics. To understand their use, their capacity for revenue generation, and their potential contribution to public finance in the twin republics, user fees must be considered within the context of the Czech and Slovak transition to market democracy. The attempts of the two republics to transition to market economics began before they were separated by their Velvet Divorce in 1993. The central governments of both countries have been inclined at times to retain too much of their centralist traditions. At times, the flow of revenues from the center to the subnational governments has been too sparse. As a result, the Czech and Slovak public sector transitions may have been even more difficult than those of their private sectors. Czechoslovakia established the basic institutions of municipal finance after the disappearance of communism in late 1989, but before the Czechoslovak union ended in 1993. Even after the split, public finance institutions remained quite similar in the new republics for some time. As the Slovak Republic began to prepare for accession to the EU, however, it developed ∗

This article first appeared as Phillip J. Bryson, “User Fees in Local Finance: Performance and Potential in the Czech Republic and Slovakia,” Eastern European Economics 46, no. 2 (2008), pp. 5–28. Permission to republish was granted from EASTERN EUROPEAN ECONOMICS. c 2008 by M.E. Sharpe, Inc. Reprinted with permission. All rights reserved. Copyright  Not for reproduction.

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some widely publicized financial innovations as a part of a “Reform of Public Administration” in the early 2000s. The reforms ultimately extended to the realm of intergovernmental finance with local governments receiving the right, beginning January 1, 2005, to set their own “tax rates.” This term was applied, interestingly, not only to the real estate tax but apparently also to the limited number of local user fees and taxes already extant. Municipalities were also authorized to introduce new “taxes.” They had already been empowered to adjust rates and apply exemptions to the traditional fees according to their own preferences. To this point, the Slovak municipalities have not perceived the new legislation as an invitation to immediate change, but the invitation to pursue independent action is a huge opportunity, and one can be expect that Slovak municipalities will not remain idle indefinitely. A Reform of Public Administration was also undertaken by the Czech Republic prior to EU accession, but that effort was basically focused on organizational changes rather than fiscal innovations; mainly, it created new political regions, transferring the functions of the former districts to selected larger towns and cities and to the new regions. These changes were sufficient to get the Czech Republic into the EU, but it has recently been more focused on national financial issues than on intergovernmental fiscal relations. The budgetary viability and fiscal independence of both Czech and Slovak municipalities would benefit greatly if independent financial sources (e.g., property tax and local user fees) produced more robust revenue yields. User fees currently generate only a miniscule share of the receipts of local budgets. The Organisation for Economic Co-operation and Development (OECD) (1997, p. 11) laments that Czech “own tax revenues” derived from the real property tax and a number of “low yield taxes” are “very limited.” In transitional states trying to cope with a backlog of needs for local and national infrastructure and for ongoing public services, one must ask whether such revenues could not be increased. Underlying this question is the more philosophical one about what the objective of user fees is or should be in the Czech and Slovak republics. A common view is that the acceptable rationale for the prices of public goods and services is cost recovery (Oum and Zhang, 1990; Griffin, 1987). Policy may justify charging less than full cost recovery, but in some instances it may also seek more than the recovery of the full cost (Kaiser, 1988; Lee and Wilson, 1991). In transition countries user fees are frequently administered in the hope of providing a contribution to general revenue, and this is true of the Czech and Slovak republics (Bryson and Cornia, 2003; Sedmihradská, 2005). The focus of this investigation is the set of “poplatky” currently in use in both the Czech and Slovak republics. These might well be translated as “fees,” but in a more technical sense they would be better referred to as “charges.”

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The list of poplatky is reasonably short and does include actual user fees. Because of the properties of user fees, which will be discussed below, they represent an important source of autonomous revenues for local governments. Where a clear service is provided, those receiving the service are usually happier about paying for it than taxpayers simply obeying the tax code. This is an opportunity for local governments to provide positive services and, through appropriate pricing, produce revenues for the general good. At the same time, the Czech and Slovak republics impose some local taxes, likewise classified as poplatky, that have become a part of the commercial culture. As long as they are on the books, they too should be considered potential revenue sources. Where the local government does not provide a service, there is generally little more to say for a tax than that that it generates revenue. Naturally, the tax may be designed to affect resource allocation, but the function of revenue generation is in any case significant. In the course of the transition to market orientation, services that are sometimes publicly provided have been turned over to the private sector in both republics, for example, water, sewage, electricity, and heat. The consumer/citizen renders payment to the providing private firm directly. Those firms are subject to the same industrial regulations, provided by the Czech Ministry of Industry and Trade, as other private firms. Since services provided privately are not the focus of this chapter, neither their regulation nor their revenues will require further discussion. But the private sector should never be totally overlooked when the delivery of “public” services is being planned. Private firms may in some instances provide greater benefits where municipalities’ rights are transferred to private economic units against concession payments. Friedrich, Gwiazda, and Nam (2003) include in this category the rights to provide energy, to organize markets, to organize passenger traffic, to use the municipal territory for storage, and to use urban properties for manufacturing, housing, electricity, gas lines, and communications infrastructure. The provision of public services is seen as both a duty of public administration and a source of public revenue. Generally, privately provided services have characteristics that suggest the use of prices, while publicly provided services have characteristics that suggest the use of fees. The Czech and Slovak republics have yet seriously to address a menu of public services that have some of the characteristics of private ones and for which fees could be charged and revenues produced. This chapter focuses on the need to apply user fees much more liberally and much more independently of central direction. It is not the first to do so, of course (see Friedrich, Kaltschuetz, and Nam, 2004), for doing so would imply the benefit of more abundant public services where they are

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badly needed and would involve the subsidiarity principle (Frenkel, 1986; Hyman, 1993) with the associated greater local autonomy that would be so beneficial to the twin republics. The review begins with the fiscal parameters prevailing during the transition period prior to the adoption of reforms of public administration and the accession by the twin republics to the EU, showing why that period produced very little in terms of user fees revenues. This chapter will review the services for which fees are imposed in the twin republics, as well as the small number of local taxes applied beyond the property tax. It will then review the revenue implications of such public services for local budgets. The potential and the growing significance of user fees globally will be considered; these suggest the possibility for heavier reliance on them in the twin republics. The key question of charging user fees not only as a means of cost recovery but as a technique for providing budgetary relief for hard-pressed local authorities in the economic transition of the Czech and Slovak republics will also be discussed; that discussion will be followed by conclusions. User Fees in the Czech and Slovak Republics In the Czech Republic, charges are levied for only nine general service categories (Jiráskova and Šneberková, 2002, p. 7). The list is short when compared with the large menu of services provided for fees in locations where local governments have become serious about charging directly those who benefit from many of the public services provided. For the Czech Republic, modest receipts reflect both the limited list of services for which fees are charged and the extremely modest (basically symbolic) fees charged for them, as well as the likewise modest local taxes. That menu includes 1. 2. 3. 4. 5. 6. 7. 8. 9.

fees on the utilization of public properties for parking and other uses, permits to drive in the city center, garbage collection, value-added fees for real estate plots where the municipality has made available water and sewage hookups, dog licenses, fees on casino gambling and slot machines. recreation and spa fees, fees on local housing accommodations, and fees on admissions to ticketed entertainment.

The first four of these are genuine user fees, since the municipality provides some service for the charge assessed. The fifth and sixth could be classified

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as quasi fees, since the municipality provides at least the service of managing externalities involved in the activities of owning dogs and gambling apparatus and activities. The charges for items 7 through 9 represent local taxes, although some might perceive a nominal element of externality management in these “services” as well. The Law of the Slovak National Council on Local Fees of April 29, 1992, provides the same basic list (Zakon, 1990). Although there have been a small number of changes in these municipal fees stemming from 1990 in both the Czech and Slovak republics, they remain very similar to the present. The right to apply user fees in both republics, which precedes their division in 1993, was granted by the national parliament through law. Individual municipalities, however, have no prerogative to adopt new fees or alter those currently in use according to their own preferences. They can implement only the fees specified by central legislation and only within the specified parameters. If Czech or Slovak municipal authorities decide to charge an approved fee at a particular (approved) rate, they will post a notice on the municipal bulletin board announcing when it will be implemented. A review of only a small sampling of these local fees and taxes provides a sense of how limited they are with respect to scope, revenue generation, and creativity. Fees for Dog Licenses. Review of specific provisions pertaining to user fees makes the legislative intent apparent. For the dog license fee, one intent is to regulate external effects. When citizens in a large apartment building own a dog, those effects are usually negative and are ostensibly discouraged by the fee. When fees are exempted for specially trained dogs for the blind, helpless, or handicapped persons, another intent is apparent (Jiráskova and Šneberková, 2002, p. 21). Since handicapped individuals’ elasticity of demand for canine assistance would be low and the willingness to pay greater if higher-than-normal license fees are applied, we are not talking about normal price discrimination. Whether necessary or not, federal legislation invites the Czech or Slovak municipality to subsidize the handicapped. The municipality can also extend the exemption for dogs to other owners of dogs with special qualifications, for example, guard dogs or hunting dogs. Fees on Entrance Charges for Public Events. The purpose of this fee extends beyond revenue generation. It also gives municipalities the opportunity to influence what cultural, sport, and other ticketed activities are held within the municipality. As we saw earlier, the law indicates that fees shall not be paid for admission to activities whose entire proceeds are intended for a charity or public service (ibid., p. 38). When it is charged, the fee may not exceed 20 percent of the total amount of the entrance charge, but this amount would permit the municipality to enjoy a reasonable share of the net revenues.

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Table 7.1

Sources of Czech and Slovak Local Revenues Revenues from Czech Local Fees: 1997–2002

Dog fee Resort and recreation fees Fee on public space use Fee on entry tickets Fee on recreational units Motor vehicle entry fee Fee on gambling machines Cancelled local fees Total

1997

1998

1999

2000

2001

2002

6,876 8,157 34,422 2,830 2,970 1,016 0 1,853 58,125

7,273 8,671 31,558 2,775 2,800 1,233 0 32,465 86,775

7,773 9,019 30,595 2,978 2,872 1,331 28,173 3,299 86,040

8,146 9,918 27,574 2,797 2,945 1,366 30,838 13,094 96,678

8,419 10,707 26,335 2,836 3,019 1,363 33,978 4,478 91,135

8,777 10,184 26,250 2,660 2,999 1,489 35,574 6,964 94,896

In U.S. dollars ($1 = CZK 24.54 as of January 2006). Source: Czech Ministry of Finance.

The breakdown of actual fees receipts from 1997 to 2002, as well as the aggregate of these fees for those years, is reported in Table 7.1. Initially, fees for the use of public space yielded the largest revenues, while those for resorts and recreation were rather substantially behind, but in the second place. Those were followed closely by the fee for dog licenses. With the introduction of the fee on gambling machines in 1999, revenues exceeded those of all other fees by the year 2000. The total amount of revenue from fees is a source of considerable importance for the municipalities, but of course it could be much larger. Fees in the Republic of Slovakia The fees applied in Slovakia are quite similar to those already discussed. Local fees were established by Law 544/1990, which came into effect on January 1, 1991. The law has been modified in minor ways on ten occasions since. Revenues from these fees (not including revenues from the fee for collection of communal waste and the fee for placement of nuclear facilities) reached $32 million in 2001. A closer look at the small number of the fees applied in Slovakia provides a sense of their limited scope and revenue potential. Only 13 fees are applicable in the municipalities of the republic. They are for use of public space, an apartment or part of one used for purposes other than dwelling, lodging, a dog, a spa town or tourist site, an entrance fee, the sale of alcohol or tobacco, motor vehicle access to restricted areas, advertising in a public area, an entertainment machine, vending machines, placement of nuclear facility, and for collection, transport, and processing of communal and small construction waste.

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At one time, the fee for the sale of alcoholic beverages and tobacco products accounted for about 50 percent of the total revenues derived from local charges in Slovakia. However, the EU prohibits the establishment of multiple taxes (federal and local for example) on alcohol and tobacco. Before its accession to the EU, the Slovak Republic realigned its national value-added tax to conform to EU specifications, and this particular charge was repealed. The fee for usage of public space yields the second-largest share of total receipts, the top revenue gains being generated by the fee for collection of communal waste, which yields 20 percent of total municipal revenues. The fee on placement of entertainment machines has had a strong tendency to yield declining revenues, largely because the machines are subject to vandalism and the municipalities are often unwilling to have them available. Some fees are perceived to be inequitable. The fee on lodging has the character of a property tax, for example, but restaurant capacity is not taxed. Until the recent adoption of the “single tax” in Slovakia, the gain from the principal seven national taxes was 400 times larger than the gain from Slovakia’s ten local fees. So there is the question whether, from a strictly financial point of view, repealing them would not be better. The significance of local fees, however, lies in the fact that the municipality independently decides which it will impose and how the revenues they yield will be used. They represent a small but important part of the independence of Slovak local governments. Recent Legislative Change on Fees in the Czech Republic The first major revision of the original Czech law on local user fees, Law 565/1990, was the enactment of Law 229/2003 on July 31, 2003 (“Mistni poplatky”, 2004). Changes in the law were allegedly motivated, at least in part, by the desire to increase local fees. The changes suggest the law was more of a response to the creation of the new regional governments, which will also require revenues to perform their assigned tasks. The new law will have no impact at all on (1) fees for driving in restricted municipal areas, (2) fees for the use of slot machines, (3) fees for use of the communal waste system, and (4) fees on constructions sites enhanced by water and sewer connections. The very low fees in effect are relics surviving from the communist period, when prices were held at artificially low levels for the few goods and services the system made available. Pricing in the transition period in both republics has been a patchwork of the low prices surviving from the past and the cost-covering, substantially higher market prices necessitated by the new conditions of the transition. It is also an unfortunate reality that the incomes of a large share of the population have not kept pace with the rising costs of imported and new products and

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services. While members of parliament would like to provide more abundant revenues to municipalities, they insist that they must remain cognizant of the situation of the taxpayers. They lack a perception of the possibility of harvesting substantial revenues from fees expressing willing payment for legitimate services received as an application of the benefit principle. Although the legislative intent was that the new law provide some financial advantages for the municipalities, the low fees generated by these changes provide little relief. Still, the door has now been opened to municipalities to increase the rates of several of the fees they implement. Unfortunately, the envisaged change will represent only a small instalment on the kinds of revenue increases that would be necessary to alleviate municipal financial problems. Revenues from User Fees in Czech and Slovak Municipal Budgets In this section the revenues from user fees will be considered for the two republics. It will show that revenues from “charges,” only a part of which are user fees, are important although they are really miniscule, regardless of the source that reports them. They are important because they are “own revenues,” providing the possibility of independent action on the part of subnational governments. They are also important because they have the potential to become much more significant revenue sources than they are at present. Finding data on the subject is difficult, especially for the Slovak Republic. The Slovak finance ministry does not report online the municipal revenues derived from user fees. Nor does a visit to the finance ministry guarantee the provision of detailed data on the topic. An officer of the finance ministry in Bratislava suggested that user fees represent only 5.6 percent of the total budget revenues of the municipalities. Reported data from different sources are not always consistent in either republic. Czech Republic revenues from user fees in 2001 and 2002 were actually larger than property tax receipts. This does not mean, unfortunately, that such fees represented a significant amount of revenue; rather, it is a comment on the insignificant property tax yield. Local fees for the years reported here represented only 2.9 percent and 3.8 percent of total municipal receipts. We observe likewise that property tax receipts for the two years as a share of total receipts amounted to only 2.5 percent and 2.2 percent, respectively. The combination of both local fees and property tax are appropriately considered together because they are normally the most important sources of a municipality’s “own” revenues and represent a proxy measure of a municipality’s fiscal autonomy.

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In an e-mail of December 23, 2003, Dr. Zdeˇnka Jirásková of the Czech finance ministry reported local fees revenues for 2002 to be a much smaller than $94 million (CZK 2.306 billion) and also indicated that the gains for local fees for communal waste, which are recorded separately, were another $85.5 million (CZK 2.1 billion) for 2002. With respect to user fees, as also for property tax receipts in the Czech Republic, municipalities can have no pronounced sense of fiscal autonomy. The process of fiscal decentralization has not been successful in terms of providing independent financial resources for subnational governments (Bryson and Cornia, 2003). Nor have user fees contributed significantly to fiscal autonomy. The Potential Contribution of User Fees in the Twin Republics When one considers Czech and Slovak user fees with finance ministry officials, one gains the impression that the two republics are doing what can be done to permit municipalities to raise badly needed revenues through the use of fees. One notes, of course, that next to nothing is published about such fees in these countries, except for an occasional mention that it would be sensible to use them more extensively, especially in health care and pension reform (OECD, 2004). Numerous online OECD papers suggest their use in other areas as well. When one considers the growing reliance on user fees internationally and the associated scholarly literature on user fees in various countries, it becomes apparent that much, much more could be done with them in the twin republics. Doing so would enhance efficiency, promote social justice, and enable more generous provision of public services through the increased municipal budget revenues that could be realized (Besley, 1991; Bird and Tsiopoulos, 2004; Downing, 1992). When the International Monetary Fund (IMF) became concerned about the Czech Republic’s deficit spending, it observed that deficit reduction would have to be pursued mostly through restraint on the expenditure side of the budget. Taxes, it was argued, should be kept within the levels required for harmonization with the EU. The IMF team felt, however, that the use of small user fees for some public services could enhance the public sector’s efficiency and reduce the need for tax financing (OECD, 2001). In recent years user fees have played a much greater role globally, thus implying much greater potential use in the Czech and Slovak republics. Increased reliance on user fees has come about in the United States as state and local governments experienced severe fiscal problems in the last recession. With constricted revenue sources and the increased exigencies of homeland

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security, local governments increasingly turned to user fees to enhance budgetary revenues. California had actually discovered the redeeming potential of user fees after the passage of Proposition 13 in 1978 seriously impacted local budget revenues. The California case reminds us that the use of fees is not a new phenomenon, although it has been increasing rapidly in recent decades. Downing (1992) defined a measure of user-charge reliance (UCR), as current charges divided by general revenue from own sources, and determined that the UCR for the average U.S. city increased by 48 percent from 1967 to 1987. At that time there was considerable potential for further expansion of the role of user charges in municipal finance. If cities were uniformly to adopt charges for water services as well as for other services not typically provided on a fee basis, and if such charges were to cover full marginal costs, Downing estimated that the prevailing UCR of 20 percent at that time could increase to 60 percent or more. It is difficult to imagine any such dramatic development for the Czech and Slovak republics. They could clearly enhance their revenues through greater use of fees, but the conceptual possibility would take time to realize. Political attitudes and institutions would have to be modified, which would require considerable education. Public perceptions of the potential benefits would have to be altered, along with the belief that such change is politically unrealistic. Although the scope of general economic change over the past 15 years of the transition has been considerable, basic institutions and attitudes generally change slowly. Despite the objection heard frequently in the Czech and Slovak republics that user fees are just taxes in disguise and that the poor cannot afford them, they offer relief to local officials desperate for revenues but anxious to avoid increasing property taxes, downsizing the public sector workforce, or eliminating popular public services. And fees are more readily accepted than additional taxes, since they are paid by those who directly benefit from the attached service. The objective of improving the lot of those with low incomes generally seems to recommend the redistribution of income; the same objective also recommends the application of user fees. Besley (1991) argues that free provision of publicly provided goods or services is rarely optimal. If governments do not have optimal lump-sum transfers available as a policy option for increasing welfare, they will certainly be interested in all reasonable possibilities for politically acceptable redistribution of incomes. An important possibility is through publicly provided goods and services. If fees are attached to their use, the scarce resources involved can be rationed, leaving more for the disadvantaged. Efficient use would then suggest that the poor be given

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subsidies with which to pay the fees rather than providing the scarce services to all comers on a gratis basis. Canada is one of a number of countries that would be an example to the Czech and Slovak republics of increased application of user fees, which are seen (Bird and Tsiopoulos, 1997 and Montreal Economic Institute, 2004) as an alternative to privatization. If privatization of government services occurs, an industry’s supply will be rationalized by private companies charging scarcity prices. Where privatization, however, does not occur, and the government chooses to charge fees for public services, it is possible to achieve nearly the same efficiency. Where governments neither privatize nor charge fees, a variety of inefficient and wasteful outcomes must be anticipated. The upshot is that Czech and Slovak taxpayers will always pay more for the same menu of services and products than private consumers would. Charging user fees is also beneficial because users are persuaded to consider the value of the product or service at the specific point in time they choose to use it. Therefore, telecommunications companies have adjusted their rates according to the time of use and hotels set varying rates for highand low-season reservations. Encouraging some users to select off-peak periods to enjoy lower rates and save money is of great advantage. Vernon Smith’s work (2002) on the energy crisis in California suggests that simple peak-load pricing could go a long way toward solving the problem. The way users react to fees for public services, as in other countries, could signal local Czech and Slovak governments about the value those users place on such services. User reaction could be a more effective and objective signal than the noise emanating from lobby groups. For these and other reasons, the imposition of fees supports the process of channeling public resources to activities in the greatest demand while moving public choice away from activities that may be of ostensible value, but that people choose to forgo. Bird and Tsiopoulos (1997) discuss the need to make user charges more transparent, more clearly articulated, and better understood by the public. Their first challenge is to overcome the misperception of vocal groups who view user fees as just another tax with no benefits attached. The second is to overcome the managerial concern that the imposition of a user fee will alienate clients from public providers who fear that the loss of business will lead to budget cuts. The third challenge is the technical one of setting the precise fees to be charged (ibid., p. 3). A bottom-line consideration expressed by Bird and Tsiopoulos is that “whenever possible and desirable, public services should be charged for rather than given away” (p. 4). The use of user fees ensures more efficient use of scarce public sector resources, and such efficiency is highly desirable when budget revenues are tight. User charges can reveal the actual market value of public services and create a market test in which public

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managers must respond more directly to their citizen-clients and use budgeted resources as efficiently as possible (p. 4). Slovaks and Czechs have spent over a decade adjusting to the post-communist notions that taxation is natural and legitimate, that public services are not “free” goods provided by a communist party wishing to secure legitimacy, and that everyone will enjoy certain free services because some are not sufficiently well off to pay for them. The transition to the user fee mentality should not be far behind the transition of perceptions that has already been occurring. Questions sometimes arise regarding the equity of user fees. These may reflect a failure to consider carefully the benefit/cost differences between the use of fees and normal taxation, which implicitly represents a zero-price policy. Many are not aware that upper-income households usually enjoy disproportionately large benefits from the consumption of public services provided either gratis or at low cost. Bird and Tsiopoulos (p. 9) provide the apt example of low storage and landing fees supplied at local airports and docks, which disproportionately benefit the relatively small number of households that own private airplanes and yachts. Most upper-income families likewise enjoy subsidized higher education benefits. The common assumption that zero-priced services are the best way to redistribute wealth is not well founded. User fees are likewise shown to be beneficial (Dewees, 2002) in that they can hold demand in check in times when expanding the supply of a public service proves difficult and expensive. User fees are of particular benefit to an agency that is not in a position to meet vociferous public demands for more services. Or, they can help cope with demand that is strongly variable over time, since the pay requirement can temper those variations. Policy analysts are strongly supportive of user fees, but with the caveat that they be applied to goods and services with characteristics similar to those of the goods and services suited for private markets. User fees are appropriate where services provide specific benefits for a clearly identifiable consumer who can be asked to pay the fee and who can choose to respond to a price by purchasing less or by completely forgoing the service. Strictly public goods and services with the standard characteristic of nonexcludability or those that have external effects for which private markets do not tend to produce optimal outcomes still need to be provided by public agencies. A classic example is education, a service for which there are obvious and important externalities, which lead us generally to support substantial public subsidization of the activity. To be supportive of user fees is not to support user charges for all public services. Thus, Czech and Slovak policymakers may rest assured: a public sector will always be needed, and all public services cannot be provided for a fee.

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There are numerous classic examples of the growing use of fees in recent economic history that clarify their general utility as a part of the public sector’s economic toolkit. Newbery (1988 and 1988a) and Vickrey (1969) contributed heavily to the literature on the use of road user charges. The former conducted analyses commissioned by the United States Federal Highway Administration and its state counterparts just as the interstate highway system was reaching a ripe age and was in need of major upgrading. His studies were designed to measure road use costs and design a system of road user charges. The World Bank also completed a comprehensive study of highway design and maintenance and of road user charging. The use of toll roads can be considered, at least in part, a result of the effectiveness of these and many other scholarly studies. The continuing use of toll-free highways, however, reflects to some measure the remaining sentiment that highways still bear important public goods characteristics. In transition countries such as the Czech and Slovak republics, relatively few citizens have traditionally had the opportunity to use their own vehicles on the public highways. As the more favored come to appreciate the privilege, especially as they observe the use of toll highways in more affluent neighboring countries, they will be more prepared to accept the notion of user fees in transportation. Adopting changes of this sort can also be facilitated by entry into the EU with the more widespread and growing perception that fees are a part of life in other countries. Gertler and Hammer (1997) have demonstrated that user fees can improve efficiency in the use of public health care facilities and of the entire health care system. Nevertheless, potential gains should be weighed against evidence that unwarranted increases in fees could compromise the goal of improving health care for low-income groups in the Slovak and Czech republics. The literature has tended to emphasize the possibility of increasing the public health system’s revenues, but a more important effect is likely to be the guidance of resources. Gertler and Hammer (p. 2) conclude that user fees applied at the point of service can indeed serve an important role in co-financing health care, but insist that they should not be the primary means of finance. They stress user fees for public health, because this field currently claims a large share of the total of public resources and its claims will continue to grow. The Czech and Slovak republics have already experienced public health care as an item that has put tremendous pressure on public budgets. They are now grappling with the fact that the level of care they have aspired to provide is beyond their fiscal capability. Fees will be essential both to help finance and to ration the scarce resources available for health care. The classic approach to resource mobilization is to increase user fees for a public service to generate revenues for improvements in the quality of that service or other needed services. Thus,

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charging user fees for public medical services has spread throughout much of the world (Griffin, 1987; Nolan and Turbut, 1995; Jimenez, 1996). The notion of health care as a public prerogative is not new for the former East European countries, but the notion of quality health care is. In the next few years, Czechs and Slovaks will be coping with the historically recent notion that health care is a primary responsibility of and challenge to governments (rather than to the notion, gradually becoming archaic, that health care is a private market service for which citizens bear individual responsibility). Now is the time to introduce them to the timelier notion that fees coexisting with public health care combine social justice with enhanced revenue generation and can help fund enhanced health care services. Pricing to Achieve Increased Budget Revenues One encounters policymakers in both the Czech and Slovak republics who are concerned about the feasibility and practicability of user fees. If they are properly designed and administered and if they are set at the appropriate level, fees will indeed be both feasible and practicable. As we saw above, the function of pricing is a key element of success. Actual user charges on government facilities are often set at inefficient levels. Local officials need assistance or training in the establishment of fees, since the principles are not always intuitive. A part of the huge literature on pricing in general pertains to this specific area. Lee and Wilson (1991), for example, examine efficient user charges on governmentally provided facilities in the presence of rent seeking. There is also a rich tradition of pricing theory in the German language that would provide important guidelines for the development of optimal fee revenues in different municipal situations and for diverse market structures. As indicated by Friedrich, Kaltschütz, and Nam (2004), the specific fees attached to particular public service provision are determined by such factors as “a welfare function, consumer’s willingness to pay, sales, costs, indicators for success in competition such as market shares, outputs, indicators as employment, production, migration, growth rates, budget sizes, political indicators such as number of votes, etc.” (p. 38). Additional important factors include the objective functions of management and owners in fee-generating industries. Market structures in terms of vertical and horizontal competition, as well as the competitive situation in the specific regions and municipalities involved, are also significant for public firms. These authors find, as do I, that the assumption of normally increasing marginal costs in a monopoly pricing situation for a public service will yield an optimal fee. It apparently also satisfies the condition that the fee per service

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unit be the same as the marginal cost and allow profits (Bös, 1986; Lösenbeck, 1963; Oort, 1961; Thiemeyer, 1964 1970). In such a situation, principles of peak-load pricing also apply (Bätz, 1979; Wirl, 1991). Although the pursuit of profit maximization is restricted in some countries and regions for public enterprises (Friedrich, 1969; Detig, 2004), some public enterprises in the industrial sector do in fact pursue such goals. Feng and Friedrich (2004) consider the case of a monopolistic public enterprise applying profit optimization principles. When properly applied, the potential of user fees is great. In a clever paper Vickrey (1999) shows how user charges can be applied to solve parking problems, to achieve effective use of the highways, to ameliorate types of pollution problems, to achieve more optimal airport use, and to reduce noise, congestion, and pollution while increasing highway speeds as congestion in large city centers increases. The key to these desirable outcomes is using price discrimination in transportation activities and pricing according to marginal social cost considerations. All of the issues Vickrey analyzed are of relevance to the Czech and Slovak republics, just as they are to other transitioning countries. As external effects increase with the growth, urbanization, and modernization of these countries, the need will increase proportionately to alleviate them with techniques such as those considered here. Although the first concern for public prices is cost recovery, policy and circumstances may also permit a municipality to charge less than the full cost of service provision or to seek the recovery of more than the full cost. Czech and Slovak municipalities should at least consider pricing that offers maximum potential contribution to general revenues. On occasion, traditional taxation considerations will prohibit the use of revenue-maximizing fees. But where appropriate, they should certainly pursue greater revenues through appropriate pricing techniques. Likewise, pricing techniques should reflect not only differing demand elasticities in separable markets but also (1) whether the service provided meets an essential human need and (2) whether cost differentials in diverse market segments reflect choices responsive to higher incomes. It is not necessary here to review the broad array of pricing considerations that have been developed in the literature (see Timothy, 1991; Bird and Tsiopoulos, 1997; Dewees, 2002; Downing, 1992, etc.), but it would be helpful to briefly discuss pricing of a type appropriate for the fees systems of the twin republics, demonstrating the potential for revenue generation where this is acceptable for public purposes. There are two basic situations in which appropriate pricing techniques should be a part of user fee applications. In the first case, the municipality itself is the sole provider of a service and at one extreme could price as

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a monopolist would. There are instances in which, for social and political considerations, the municipality would wish to provide an essential service inter alia to low-income groups whose consumption it wishes to subsidize. Here, it would be wise to subsidize where appropriate, while also charging revenue-generating, optimal prices. The kinds of services municipal officials of the Slovak and Czech republics could provide with revenue optimization in mind include some of the fees (qua taxes) currently implemented, namely, those charged for dog licenses, garbage collection, parking, and public housing. In these cases the Slovak or Czech municipality acts as a monopolistic provider of services. In the second instance, the municipality becomes a silent but important partner of a private firm providing, for example, entertainment or lodging. In the case of entertainment, the municipality may provide the site for the activity (e.g., public land for a traveling circus). It may simply be providing oversight to quasi-private activities. They are not completely private because of the potential external effects monitored and, if necessary, regulated or prohibited by the municipality. In any situation of partnering with a private firm, a municipality essentially taxes the revenues generated by attaching a fee to them. Examples are some of the specific kinds of fees used in both the Czech and Slovak republics, for example, recreation and spa fees, the fees on local housing accommodations, fees on admissions to ticketed entertainment, and those on gambling and slot machines. Fees Attached to Partnering or Quasi-Private Activities Consider the case of an ad valorem fee. If too low, such a fee will fall short of the revenues that it could have obtained. If excessive, it can drive away the entertainment or other activity that it would tax; if the municipality’s revenue yield is so great that it removes from the private activity the revenues that would have represented profit or even have covered cost, the fee will prove destructive. Even if these kinds of fees are not extreme, they will distort resource allocation. The fee should incorporate characteristics of a lump-sum tax. The firm providing gambling or slot machine revenues, or selling tickets to a concert or other form of entertainment, may be assumed to establish ticket prices that maximize net revenues. The municipality, then, simply lays claim to its share of the take without causing the firm to change its optimal price and quantity results. If the firm were to try to “pass the fee on” to the consumer, raising ticket prices would merely reduce sales and generate a smaller profit pool, from which the predetermined amount would still have to be turned over to the municipality. This is easily seen in the standard way. The firm’s

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demand function is the usual P = a + bQ. Total revenue, TR = P(Q), or TR = (a + bQ) Q = aQ + bQ 2. . Marginal Revenue, MR = dTR/dQ = a + 2bQ. On the cost side, average cost, AC = c + dQ. Here we add the fee, ζ , to the fixed cost, so AC = c + ζ + dQ. Total cost, TC = AC(Q) = (c + ζ + dQ) Q = cQ + ζ + dQ 2 , so MC = dTC/dQ = c + 2dQ. Note that the differentiation yielding MC does not change by adding the fee. As a part of fixed cost, the fee cannot be passed on through a higher price and the optimal outcome cannot be reached by selling a different quantity. Conceptually, the municipality will estimate the potential net revenues a project held on public property could generate and then decide what share of the net revenues it will appropriate for the public coffers as a lump-sum tax. It would then levy the fee as a lump-sum tax in the form, say, of a license to perform. If the municipality felt constrained to simulate the more traditional per-ticket fee, it should divide the total revenue anticipated by the number of tickets sold ex post and collect an average revenue per ticket. In any case, the private firm should know a revenue total that it will have to turn over from the ticket sales and not think of it as a per-ticket amount that must be attached to each ticket sold. If the fee is incorrectly treated as an excise or unit tax, a higher ticket price would result in suboptimal sales. Where the objective of such action is fee maximization, pricing should follow this strategy. Assume that local authorities needed to calculate potential revenues for a circus requesting permission to perform in the city. Figure 7.1 shows the maximum potential net revenue for a given performance. In this P

Slope = MC TCat

TR TC

NR NRat 0

Qs Qo

Figure 7.1

User Fee Maximum Potential Net Revenue

Q

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instance, the otherwise variable costs for an evening’s single performance can, for the sake of simplicity, be treated here as fixed. If the principles explained above are applied, the municipal entertainment fee will simply appropriate revenues by shifting downward the net revenue function from NR to NRat , the net revenue after tax. It will do so without changing the price of a ticket or the number of tickets sold. It will simply confiscate a share of the profit at Qo through the lump-sum fee described. On the same diagram we can consider an “excise” fee that would cause the new, after-tax TC function, TCat , to slope up to the right, showing that increased sales imply increased costs when the tax is added. In this case, the firm would optimize its returns by operating where MC = MR, where the slope of the TR curve is the same as that of the TCat curve as it still slopes upward (implying that it cannot have obtained its maximum point at which its slope is zero). This will result also in suboptimal ticket sales, Qs , with smaller net revenues, smaller tax take, and smaller profits. There is no reason that a municipality supplying a service or selling a license, for example, cannot use pricing techniques that will permit it to maximize its receipts. As reforms allow individual Czech and Slovak cities and towns to establish their own fees, licenses could still retain their regulatory function, but they could also maximize revenues. For a linear demand curve extended from axis to axis, they would do so for an essentially no-cost activity by producing at the midpoint between the vertical axis and the demand curve’s interception of the horizontal axis so that MC = MR = 0. A somewhat more sophisticated and productive revenue effort would incorporate price discrimination, charging somewhat smaller fees for senior citizens, low-income groups, and so on. In applying local user fees, Czech and Slovak municipalities apply methodologies that will help generate the greater revenues needed. The case is simple, but compelling. In the appropriate instances, those who receive services are the ones who should pay for them. Where social considerations suggest that low-income groups should not be deprived of particular public services, it would be better to subsidize their participation while retaining the fees that will provide not only social justice but also revenues for the community. This realization has not come as yet to the Czech and Slovak governments, national or subnational, but fiscal decentralization suggests that it is overdue. Conclusions The Czech and Slovak republics have made only the most tenuous beginnings in the area of user fees. As we saw above, the fees already in place were established by fiscally timid transition governments over 15 years ago. The

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municipalities of both republics do not have the actual independence to adopt user fees on their own, as all such fees as are allowed are stipulated in federal regulation. But the Slovak subnational governments have been promised the opportunity to develop “new taxes” independently. In small countries such as those examined here, where regions and municipalities are monitored and centrally managed with much greater ease than would be possible in the United States or Russia, the temptation to manage centrally is much greater and local officials become accustomed to managing in a much different environment from that of a large city in a remote state or a region of a very large republic. Local managers in such environments do not have the luxury of leaving to central officials the question of what fees may be applied and what kinds of taxes may be implemented. To this point, Czech and Slovak municipalities can only adjust fees modestly within centrally prescribed limits. The tentative steps taken toward power devolution, most recently through “reforms of public administration,” have been insufficient to acquaint the municipalities with genuine fiscal independence. Nor can it be intimated that the local governments have the resources they need to provide public services elsewhere regarded as desirable or even essential. The not-for-profit sectors developing in the twin republics will help generate a climate in which user fees could prosper. As early as 1996, Slovakia’s not-for-profit sector (excluding religious organizations) had operating expenditures of $256 million (SKK 7.6 billion). That represented only 1.3 percent of the country’s GDP, but was not an insignificant amount. Behind these expenditures lies a sizable workforce that included more than 16,000 fulltime equivalent paid workers representing 0.9 percent of all nonagricultural workers in the country. The 16,000 full-time workers involved represented 1.4 percent of service employment, and 2 percent of all federal, provincial, and municipal government workers (Woleková et al., 1999, p. 356). The nonprofit sector derives most of its revenues neither from private philanthropy nor from the government, but from fees and charges for the services these organizations provide. This revenue source accounts for 55 percent of all nonprofit revenues. Development of the nonprofit sector in the Czech Republic was also very respectable after the Velvet Revolution in 1989, especially in the areas of recreation and culture. By 1995 it had operating expenditures of $800 million, involving a workforce of 74,200 full-time equivalent paid workers (not including another 4,000 workers from religious organizations) and representing 1.7 percent of all nonagricultural workers in the republic, 3.4 percent of service workers, and 6 percent of the total of all federal, provincial, and municipal government workers (Friˇc et al., 1999, p. 289). The not-for-profit

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sector of the Czech Republic, like that of Slovakia, derives a large share (47 percent) of its revenues from fees and charges. Unlike its counterpart in Slovakia, the sector enjoys solid support from the government. Payments from the public sector amount to 39.4 percent of Czech nonprofit revenue, which represents a high degree of support relative to central Europe as well as other areas of the world. Friˇc et al. describe the public financial system taken over from the communist era as excessively centralized and lacking a clear plan for the development of the nonprofit sector. In the fields of health, social, and civic services, the Czech government retains the dominant role in financing nonprofit action and generates in excess of half of the total revenues in those fields. As not-for-profit fees become more customary in both the Czech and Slovak republics, citizens are becoming accustomed to paying for public services. Like citizens elsewhere, Slovaks and Czechs could become supportive of far greater reliance on user fees in the public sector at all levels. With proper educational efforts and appropriate pricing techniques, the subnational governments of the fraternal twin republics would be prepared to provide more of the public services of contemporary cities and towns. Moreover, they could do so in a manner beneficial for citizens and productive of revenues for the public coffers.

PART III

Toward the Close of Transition in the Czech and Slovak Republics: An Interim Assessment of the Fiscal Decentralization Effort

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CHAPTER 8

Local Budgeting in the Czech and Slovak Republics∗

Introduction To understand more completely the process of fiscal decentralization in the transition countries, it is important to determine how local decisions are made and what constraints are binding upon those decisions in the process of preparing municipal budgets. Planning for effective allocation of whatever revenues cities may anticipate, whether those cities are large or small, will have common aspects. In cities where effort is being made to overcome the excessive centralization of the central planning legacy, some unique commonalities will be associated with the process. This is the case for the Czech and Slovak republics, both of which have spent a decade and a half attempting to establish anew the principles of local government autonomy. Under the regime of central planning associated with Marxist-Leninist socialism, all governance decisions for cities and towns were made at the center by the party. Peripheral local governments had only one role to play, which was to carry out delegated tasks (pˇrenesené p˚usobnosti) of “state administration” (státní správa) that the central government assigned to them. The point ∗

The first five pages of this chapter appeared as “A Leontief Model of Municipal Budgeting,”Journal of International Business and Economics 8, no. 1 (2008), pp. 123–127. The remainder of the chapter was written for this book with materials from a survey given to mayors of Czech and Slovak municipalities. This survey will be presented and analyzed in greater detail in chapter 10.

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of fiscal decentralization is to achieve local self-government (samospráva) on the basis of autonomy. This chapter will review the process of local budgeting in the Czech and Slovak republics, which are ideally suited to model as a comparative study. The two republics were paternalistically joined under communism and had become a federation after the Prague Spring of 1968. When the Velvet Revolution came in 1989, the two countries began their joint transition to a democratic market orientation by modifying their fiscal systems, ostensibly to provide for greater local autonomy. They established joint legislation and institutions for their financial systems, which were in place when the Velvet Divorce set them on separate paths in 1993. For some time they retained the legislation and institutions with which they began the transition, but before joining the EU in 2004, they each pursued reforms of public administration as a part of the accession process. With these reforms they began their first substantive diversion from their common beginnings. The deviation from the common path was undertaken primarily by the Republic of Slovakia, which initiated reforms in local finance that began to produce divergent financial outcomes in 2005. This evaluation of Czech/Slovak local budgeting, therefore, was undertaken at the end of the common transition era when the historic similarities of the two countries were likely the greatest. A simple theory of local budgeting is presented in the next part of the chapter, where a modified Leontief model is used to consider local revenues as financial inputs and local expenditures as financial outputs. The model contains a method of measuring the degree of local autonomy as part of the budgeting process. Then, an attempt will be made to determine how local budgeting in the Czech and Slovak republics actually functions, and responses to a questionnaire revealing the perceptions of Czech and Slovak local government officials about their financial relations with the central government will be reviewed. The questionnaire probes the process by which local Czech and Slovak officials pursue financial strategies on the basis of available resources. The questionnaire was presented to mayors, city managers, and financial officers in late 2005. The last part of the chapter provides an analysis of the responses to the questionnaires and draws some conclusions about the implications of those responses. A Leontief Model of Local Budgeting Municipal budgets consist of diverse receipts and expenditures. Because in transition governments few of the revenue sources are “own revenue” sources, the municipality is bound to accept the strings-attached revenues (SARs) with

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a commitment to honor the specified expenditure obligations to which grants and some transfers commit local officials. Such funds come not only from the central government but, since the process of accession to the EU began (culminating successfully in 2004), from the EU as well. This model is designed to show the sources of revenues and measure the extent to which municipal budget officers are constrained to expend transferred budget funds or grants in specific ways, although they may think that those funds could be better used for other purposes. Interestingly, gaining access to EU funds is expected in the Czech Republic to increase the tendency of cash-hungry municipalities and regions to take credits so as to benefit from the EU’s regional development programs. To exploit these development funds will imply increased municipal debt (Eliáš, 2003). According to banking sector estimates, a twofold growth of debt finance is expected. In 2003, the year prior to the EU accession, local debt grew by CZK 70 billion ($2.95 billion), while the debt of Prague alone amounted to nearly half of that sum (CZK 33.5 billion or $1.41 billion). The model is designed to account for the complex interplay between expenditures and receipts, the general equilibrium impacts of varying types of expenditures, and the fiscal constraints associated with strings attached to grants and transfers. We begin by assuming two categories of budget receipts: (1) receipts from various tax revenue transfers, grants from the center, or grants from the EU, Yn , and (2) receipts from “own revenues,” ORn . For purposes of illustration, own revenues consist of property tax revenues, user fees, and sales revenues from privatized municipal properties and assets. Expenditure types are A, B, C, D, and O, “other.” A could be expenditures for education, B for public health, C for roads, D for general government administration, and O for such things as police protection, public transport, and water and sewage. Let α be the coefficient representing the mandated share of a given total revenue source assigned or specified by either the central government, national law, or EU regulations to be spent for a given project. Thus, α is an assigned value (AV) or budgeted amount to be spent on a particular activity expressed as a percentage of a total revenue source. The municipality may, for example, plan to spend 40 percent of the total amount of personal income tax revenues transferred to it by the center for elementary education, so that α( Y1 ) = SKK 40,000, where α = 0.4 and Y1 = SKK 100,000. A first potential measure of municipal autonomy would be the ratio of mandated expenditures to the total of funds spent. Mandated expenditures would be any spending assignments that the municipality receives from outside, either the center or, for example, EU regional development programs,

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which specify the purposes for the transferred funds contractually or even in an informally binding manner. This simple measure would simply sum the αs representing mandated expenditures and divide the total by total expenditures to determine the ratio of assigned values to total expenditures. As will be observed below, the Republic of Slovakia recently increased the transfer of shared taxes to its municipalities in a substantial way, implying that these funds were to be spent as determined by the municipalities. At the same time, it mandated that those municipalities would henceforth be responsible for funding and administrating elementary education. Whether or not the contractual arrangements are clear, when additional funds are supplied in conjunction with a new spending mandate, the attached strings are apparent and one can legitimately speak of informal spending assignments. The coefficient β represents the share of the revenue source actually spent by the municipality for a given activity. It is the chosen expenditure (CE) level of the municipality, money actually spent, and may deviate from the AV or α. The actual β will reflect, though not necessarily with precision, the preferences of the municipal authorities. A matrix of local expenditures can be constructed with budget receipts listed horizontally across the top and with expenditure categories listed vertically down the left-hand side of the matrix. Reading downward in a given column we observe the expenditures funded from the revenue source listed at the top of that column. Reading along any given row horizontally we see the specific amounts spent on a particular public service from various revenue sources, appearing as below. Here, we have the matrix as planned by the central government, the coefficients representing the αs, or AVs. Y1 A B C D O

αY1 = 0.3Y1 0.7Y1

Y2

Y3

Y4

OR1

OR2

0.3Y4 0.6Y2 0.2Y3 0.6Y3 0.4Y2

0.2Y3 0.5Y4 0.2Y4

A matrix can also be written showing |α − β|, the differences between mandated spending and the level of expenditures actually chosen. This assumes, of course, the possibility that a mandate will not be contracted with precision, will not be fully binding, or will be subject to imperfect monitoring, any of which conditions will permit some discretion on the part of recipient municipalities. Adding the β values to Figure 1 would show the difference between mandated allocations and the municipality’s chosen expenditures level.

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If we had perfect knowledge of local preferences, or if local preferences were revealed (and expressed as α  , the desired level of expenditures for a particular task), we could calculate the following values based on α, α  , and β: A coefficient of incongruity, CI = |α − α  | A coefficient of compliance, CC = 1 − |α − β|, and A coefficient of autonomy, CA = 1 − |β − α  | At first blush, the coefficient of autonomy may appear contradictory, since it emphasizes a difference between chosen municipal expenditures and actual preferences. But the two values will on occasion actually diverge, since local officials may feel pressured or actually be constrained to choose levels of expenditures they do not prefer. Assume three different municipal administrations characterized as Milquetoste, Intrepid, and Median. All have the same preferences in the face of a particular α mandate from the center, but the first conforms perfectly to the mandate, the second is at complete defiance, and the third is between the two extremes. The coefficients use absolute values because the local administration may want to spend either more or less from a particular revenue source than the center mandates, as can be seen through the following simple example: α

β

α

CT

CC

Milquetoste

0.4

0.4

0.1

0.3

1.0

0.7

Intrepid Median

0.4 0.4

0.1 .25

0.1 0.1

0.3 0.3

0.7 .85

1.0 .85

CA

We would get the same results, of course, if we had values reflecting municipal preferences to spend more on a public service than the center mandates, as seen below. α

β

α

Milquetoste

0.2

0.2

0.5

Intrepid

0.2

0.5

0.5

Median

0.2

.35

0.5

In the absence of revealed local preferences, we can gain less detailed but nevertheless helpful information simply by looking at the coefficient of compliance for the various categories of local public expenditures. We observe

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that in instances where the center transfers untied or nonmandated funds, it is essentially adopting local preferences in the action, so that α is assumed to be the same as β and CC = 1.0. Across all expenditures, this will raise the average CC. In general, this simple methodology is interested in finding a matrix of the absolute values of the differences between coefficients of assigned values and chosen expenditures, |α − β|. The absolute values of these differences, |γ | = (AV − CE) + (CE − AV), declines as autonomy increases. We have no measurement of the coefficient of autonomy as defined above, but can only measure differences as expressed in the coefficient of compliance. In summary, we have [ αij ] −[ βij ] = |γij |, where [ αij ] is a matrix of the coefficients of spending mandates. These are rules for the use of transferred funds or state grants. The matrix represents the available constrained funds designated for essential spending programs or projects. Planned spending is represented here as a share of a total expenditures budget, which could also be viewed as an average of spending among similar communities. [ βij ] is a matrix of actual municipal spending choices. It represents the actual sum spent for a program or project. [ γij ] is a matrix of differences between mandated and actual expenditures. An Investigation of Local Budgeting Processes This part of the chapter reviews some of the results of a questionnaire developed to illuminate perceptions of local Czech and Slovak officials pertaining to local budgeting and other issues of intergovernmental fiscal relationships. The questionnaire was developed over time and ultimately benefited from extensive input from the Association of Towns and Cities in Bratislava (Združenie miest a obcí Slovenska, or ZMOS) and the Union of ˇ Towns and Municipalities of the Czech Republic (Svaz mˇest a obcí Ceské republiky, or SMO). Local Czech and Slovak officials took the questionnaire online in December 2005 at the Surveyz.com/Qualtrics.com website. Mayors represented the lion’s share of the participants. There were 84 responses to the Slovak language version and 456 to the Czech language version. Respondents were asked whether they agreed, agreed strongly, disagreed, disagreed strongly with, or were neutral (unwilling or unable to respond) regarding various statements pertaining to the most significant fiscal issues. Some of the survey’s questions were designed to compare some of local leaders’ perceptions to views commonly discussed in the scholarly literature on fiscal decentralization. The first question on local budgeting was stated as follows: “If expenses for one function, e.g., social care, increased rapidly, we could meet those costs by

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spending less for one or more other functions, e.g., education, sport, culture or transportation, according to our own preferences.” The obvious intent of this statement is to determine whether local officials feel they have flexibility in the uses of funds from various sources, although almost all of their funds come from outside the municipality in the Czech Republic as grants, shared taxes, and so on, with not more than approximately 5 percent of “own” revenues. In the Slovak Republic, own revenues would generally be about twice those of the Czech Republic. Of the Czech local officials responding to this question on the flexibility of budget expenditures, 45 percent agreed and another 4 percent agreed strongly that if costs for an important project increased, they could draw funds from other sources to fill the budget gap. Thirty-two percent of the respondents, however, disagreed. These 32 percent (and another 9 percent who strongly disagreed) saw no opportunity to transfer funds freely from one function to another according to their own preferences. Apparently, 49 percent felt that they had significant budget flexibility with the use of funds from various sources for purposes of expressing their own preferences. Such flexibility would be an important component of fiscal autonomy. On the other hand, 41 percent had no sense of such flexibility/autonomy. Among local Slovak officials, only 23 percent agreed (and another 5 percent strongly agreed) with this statement. A larger 49 percent disagreed and were joined by another 12 percent who strongly disagreed, so that a total of 61 percent of local Slovak officials saw no real possibility to substitute expenditures across categories freely according to their own preferences. The share of Slovak officials expressing a feeling of significant budgetary flexibility or autonomy was a substantial 21 percent less in the Slovak Republic. Another question was whether municipalities simply pool all the funds received from diverse sources and then spend them according to local preferences. This extends the previous question by asking implicitly whether local budgeting is completely unconstrained in the use of funds. Perhaps no budgeter anywhere should expect to spend all funds without constraint, but this question inquires about that issue. The question reads as follows: “In making budgetary decisions, we pool all revenue sources to determine the total amount available for all expenditures, and then we spend the entire pool on activities and projects according to our own discretion.” Only 5 percent of Czech respondents disagreed with the statement that they pool all their revenues to make their budget expenditures. Aside from the 1 percent unwilling or unable to agree or disagree, 68 percent agreed (and 27 percent strongly agreed) with the revenue-pooling hypothesis. In retrospect, this question may well have been interpreted loosely to mean merely

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that officials first very carefully consider all the revenues (i.e., how much revenue they have to work with) before allocating expenditures. Under this interpretation, the respondents may not have had the feeling that they were responding to a revenue-pooling question at all, although the second clause of the question hoped to emphasize the pooling interpretation. Otherwise, it would be very difficult to explain why strong unity appeared to exist regarding the proposition that local Czech officials can spend their funds as they want, regardless of whence they emanate. The unwarranted conclusion would otherwise appear to be that there are no funds with strings attached in the Czech Republic. Fortunately, this was not the only question regarding budget flexibility as an aspect of budget autonomy.

Czech officials Slovak officials

Strongly agree

Agree

Neutral

Disagree

Strongly disagree

27% 19%

67% 73%

1% 5%

4% 3%

1% 0%

We are constrained to call upon the same reasoning to explain why 73 percent of the respondents from the Slovak Republic agreed with the assertion of budget pooling and were joined by another 19 percent who strongly agreed. Only 3 percent disagreed and none disagreed strongly. The totality of the survey responses we received do not permit an interpretation of these data to mean that budget strings are completely absent from the grants and transfers that these republics enjoy. The sources and distributions of municipal funds were also addressed in the questionnaire. One question presented budgeting with an actual input-output appearance; the vertical entries in columns represented budgetary expenditures financed by various “inputs.” The horizontally presented data of the rows represented the financial sources used to finance individual projects or public services. Respondents were then instructed as follows: Examples of some expenditures your municipality makes are listed below. From the revenue sources listed at the right, choose those sources which have been used in your municipality to fund the different activities and functions on the left. For example, if you use own-revenues and state grants to fund health care, you would write that on the line by Health Care.

The responses do not, of course, indicate specific amounts spent by municipalities from the sources listed: state subsidies, transferred taxes, own revenues, or debt. They only show what percentage of respondents indicated

Local Budgeting in the Czech and Slovak Republics Table 8.1

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Sources and Uses of Funds, Czech Republic Sources of Funds

Programs and Expenditure Shares (%) Basic education Health care Sport/culture General administration Communications Social welfare Local transport Telecommunications Fire Police Water/sewage Municipal wages Other public services

State subsidies

Shared taxes

Own revenues

Debt

36 16 13 31 20 31 19 5 21 17 19 14 7

36 42 38 40 35 35 41 47 37 42 30 46 43

27 41 47 29 37 32 39 47 41 41 38 40 46

1 2 3 1 7 2 1 1 1 1 12 0 3

that they had used funds from a named source to finance a particular activity. Looking at Table 8.1 for the Czech Republic, for example, 36 percent of the responses indicated that they had used transferred taxes to fund elementary education, 27 percent had used the municipality’s own revenues for that purpose and 1 percent had used credits. Table 8.2 below gives the same data for Slovakia. One notices immediately that deficit spending for these basic municipal functions is very low in Slovakia. The problem of municipal indebtedness applies to only a small minority of the smaller cities and towns, although a number of the larger cities have made more extensive use of leveraged funds to finance infrastructural development, clearly much more complex and expensive than that required for small municipalities. The Slovak municipalities are seen here as being even less reliant on credits than their Czech counterparts. Another significant difference between the two republics is that the share of subsidies and shared taxes as a revenue source in municipal budgets is smaller in Slovakia, which means that Slovak municipalities must rely more on “own revenues” than do the Czech cities and towns (Bryson, Cornia, and Wheeler, 2004). This is noticeable particularly in the own revenues column. The average own revenues response in the Slovak Republic is 47.36 percent, which is 7.36 points higher than the Czech average of 40 percent. The final question related to budgeting was worded as follows: “In your budget do you use the same funding sources to finance particular expenditures each year?”

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Table 8.2

Toward the Close of Transition in the Czech and Slovak Republics Sources of Local Funds Sources of Funds

Programs and Expenditure Shares (%) Elementary education Middle schools Higher education Public health Social welfare Sport/culture General administration Highways Communal transport Telecommunications Fire protection Police Garbage collection Water/sewage Municipal wages Other services

State subsidies

Shared taxes

Own revenues

Debt

53 100 50 23 33 7 40 9 5 8 5 3 3 15 39 18

29 0 0 18 37 24 35 38 45 27 24 35 29 17 30 35

18 0 50 59 30 67 25 52 50 65 71 62 67 67 30 45

0 0 0 0 0 1 0 1 0 0 0 0 1 0 0 1

Of the Czech respondents, 86 percent indicated that they did use the same funding source to finance particular expenditures each year. Ninety percent of the Slovak respondents indicated that they used the same funding source each year to do so. In both cases, this demonstrates that funding from particular sources is dedicated to specific projects that often require funding over a period of multiple years. The constraints of mandated spending are obviously binding in many instances, as these responses reflect. All this suggests that the model described above for municipal budgeting is relevant. The questionnaire is unable to establish precisely the coefficients of the model or reveal in any detail the local officials’ preferences. But the responses are a good indication that local officials must consider the implicit and explicit obligations associated with the receipt of funds transferred from the outside. Conclusions Treating local finance as a matter of revenue inputs and expenditure outputs envisions local finance as a response of municipal officials to their own budgeting preferences. These preferences must, of course, take account of the demands of constituents as well as the financial constraints imposed by granting authorities whose modus operandi is frequently to transfer funds

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with spending mandates attached. As a result, actual spending patterns will not perfectly reflect the preferences of the local officials, since they would sometimes prefer to do things that they perceive they cannot do and in fact avoid doing. Nor are local preferences necessarily revealed preferences. We have the public record only of actual revenues and expenditures, which may not perfectly reflect either local preferences or even transferred spending mandates. It would therefore be difficult to test these questions, or the theory as presented, empirically. What we can do is interrogate local officials on general principles reflecting their budget choices. This was done in a questionnaire that asked municipal officers whether they felt their budgeting processes provided them the opportunity to draw freely from different revenue sources to fund diverse projects and public services according to their own preferences, whether they felt they could simply pool all their revenue sources at the beginning of the budget year and allocate the pool according to local preferences. They were then asked if they consistently used certain revenue sources to fund given projects and activities over several budget periods, to which 86 percent of the Czech and 90 percent of the Slovak officials responded in the affirmative. A large majority of the respondents see no possibility of transferring funds freely from one use to other uses that might be more in line with their own preferences. It is not clear, however, why a large majority of local officials in both republics seemed to respond to the survey that they could pool all funds from whatever sources and spend from the pool. It was speculated that this question could have been misinterpreted; the respondents may have felt (in spite of the effort to make the question unambiguous) that the question was really just whether they carefully considered all (the total amount of ) their revenues before beginning to allocate funds for specific purposes. None of the other responses indicated that there could simply be a pooling of all revenues (without reference to sources and spending mandates) to be expended on any purposes preferred locally. The more liberally local authorities can draw from various financial sources for whatever expenditures they wish to make, the greater we assume financial autonomy to be. Where funds come to the municipalities with specific expenditure mandates, limiting spending to specific projects and activities, the municipalities find their fiscal autonomy seriously limited. Outside observers have commented on the abundance of spending mandates characteristic of transfers in these republics. The responses of local Slovak and Czech officials to our survey confirm that they are in fact in this restrictive fiscal situation.

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CHAPTER 9

A Survey of Perspectives on Intergovernmental Relations: A Comparative Analysis of the Czech and Slovak Republics∗ Introduction The transition from Marxist-Leninist socialism to market-oriented democracy has been difficult for most of the countries of East and Central Europe. Many observers view that process as consisting largely of the privatization of state-owned enterprises and the establishment of market relations in the countries involved. But the transition of the public sector in countries once managed by central planning regimes has also been a very important and difficult part of that historic development. The public sector under central planning was highly centralized so that the party could maintain a tight monopoly over all levels of the country’s decision-making powers. Thus, democratization has required a process of fiscal decentralization to restore some autonomy to local government. The importance of Marxist-Leninist socialism’s legacy for transition countries was that it made moving on difficult. At least some of the reasons for such difficulty will become apparent in the development of the analysis. Bryson and Cornia (2000) outline the development and difficulties of the initial, somewhat lukewarm attempts of the Slovak and Czech republics to pursue fiscal decentralization. The efforts of other transition states, reviewed by the ∗

This article first appeared as Phillip J. Bryson, Scott M. Smith, and Gary C. Cornia, “A Survey of Perspectives on Intergovernmental Relations: A Comparative Analysis of the Czech and Slovak Republics,” Europe-Asia Studies 61, no. 4 (June 2009), pp. 685–709. Taylor & Francis, the publisher, whose website is http://www.informaworld.com, has kindly granted permission to republish the article here.

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OECD (2002), show Hungary, for example, with somewhat greater success than the Czechs and Slovaks have enjoyed, but all the transition countries have struggled in this endeavor. The total level of subnational revenues and expenditures as a share of GDP has been lower in the transitioning countries than in the earlier members of the EU. The expenditures of the transitional, newer EU members have averaged only 8 percent of GDP, whereas they represent 16 percent of GDP for the older EU members; the differences in subnational revenues are smaller, but similarly skewed. Subnational revenues represent only 19 percent of the transitional countries’ GDP, but 27 percent of the older members’ GDP (OECD, 2002, p. 4). The Czech and Slovak republics began the process of fiscal decentralization together, but separated in 1993. They then continued along their separate but similar paths, and both countries apparently required additional efforts to devolve power. The EU therefore encouraged them to undergo “reforms of public administration” before their 2004 accession to the community. For both countries, that period was characterized by intergovernmental fiscal institutions that reflected a rather high degree of centralism. Consequently, one observes in the Czech and Slovak republics that transfers from the center represent almost a totality of the revenues of local budgets, revenue generation reflects low local fiscal effort, and “own revenues” yields at the level of subnational government are very modest. Both of these young democracies have acknowledged the importance of fiscal decentralization, but the actual accomplishments have been modest. The “reforms of public administration” achieved some positive organizational change in the Czech Republic, but ultimately accomplished little more than the establishment of regional governments (the kraje). In the Slovak Republic reforms were more comprehensive and observers expected a good deal from them. They will be discussed later, but elections and the arrival of a new political coalition in Slovak governance evoked some uncertainty about where decentralization initiatives would go. In both countries, the legacies of socialism and the general European disinclination to insist on decentralized political institutions have resulted in the survival of some of the centralism of the previous era. The center’s concern for the many small local governments, which lack the resources adequately to provide for their own management, has been at least partially responsible for the development of a fiscal system that can scarcely be described as having achieved fiscal decentralization. In studies sponsored by the World Bank, we find municipal governments in both republics enjoying only limited autonomy from 1989 to about 2000 (Oliveira and Martinez-Vazquez, 2001; Bryson and Cornia, 2001).1 The authors believe that the results of this survey provide an indication about whether municipal experience has provided positive pressures for, or

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obstacles to, fiscal decentralization. We will return to this point in our conclusions. Moreover, the results we report will reveal that in some instances differences in the responses of the municipal officers of the Czech and Slovak republics are statistically significant, while in other instances no statistical differences can be found. Given the similarities in the cultural, historical and systemic backgrounds of the two countries, such differing views are likely attributable to policy differences generally arising subsequent to the division of Czechoslovakia. The Property Tax in the Czech and Slovak Republics We first turn to a brief orientation on the fiscal situation prevailing in the twin republics. We should like to provide a perspective that will illuminate the causes and implications of the responses that local officials in the two republics gave to our questionnaire. The primary cause for the lack of genuine municipal autonomy in both republics is the lack of an independent source of revenue. The survey focused at several points on the Czech real estate tax, which is as close to a Western property tax as the republic has been willing or able to come. As a potential independent revenue source, the property tax is a most significant tax for local governments. Although it can give municipalities more autonomous control over their own fiscal affairs, it has not been developed to its potential in either the Czech or Slovak Republic, although the latter has shown a greater willingness to consider serious change in the property tax. It has failed to provide adequate revenues, which it could do with minimal distortion of private allocation processes. Because this tax is highly visible and because MarxistLeninist regimes were of limited credibility, it was retained at strictly nominal levels during the socialist era. But in spite of this legacy and the natural tendency of any citizenry to oppose property taxes, there is much to recommend them. A tax on real property will make good sense as part of the tax system as a whole because of its efficiency and equity aspects (Oates, 1996). The country-specific fiscal institutions involved play a major role in determining the effectiveness of a property tax. Who establishes tax policy and who administers the tax are both very important questions. The Slovak Republic retained the basic institutions of the real estate tax after the Velvet Divorce in 1993, one of the most important being that the design of the tax is by the central government. The other important characteristic of the task is that, unlike the Czechs, the Slovaks permitted the municipalities to be responsible for collection of the tax. In the Czech Republic, the center collects the tax without having strong incentives to do it well (since all the revenue goes to the municipalities). This unsatisfactory outcome reveals a problem of moral hazard (see Bryson and Cornia, 2003). Slovakia’s municipalities harvest their

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own property tax revenues much more effectively. If all revenues are generated from the center, will they be made available without the accompanying influence of the center? Can one speak of genuine fiscal decentralization if local governments enjoy only limited fiscal autonomy? Central and East Europe’s countries in transition have perceived a fairly standard set of taxes and user fees to be well suited for their local governments. The Czechs and Slovaks have not generally felt that the property tax should be increased from the low, rather symbolic, levels of the communist period. Current levels, however, are not sufficient to fund municipal services or perform the necessary administrative tasks. If municipalities in the twin republics wish to augment available revenues, they must seek opportunities from sources other than taxation. They may generate revenue from the privatization of public properties or they can incur debt. But the privatization of public properties exploits a nonrecurring revenue source and cannot yield a sustainable cash flow; municipal loans can become dangerously burdensome. The base and the rate determine the real estate tax yield of both republics. Both land and buildings are included in the base, each being valued separately. National law prescribes the process by which the actual value of property is to be determined; the tax base reflects the floor space of buildings and the area of land plots. Also determined by the center, tax rates differ for buildings and for land. The taxable value of land plots and buildings is basically a function of their areas in square meters, so valuation is not based on market prices. This may have been unavoidable for much of the transition period, but the real estate market has now developed to a point where that could be changed. The tax rate and coefficient for real estate parcels reflect their size, location, and use. These characteristics determine the amount of the real estate tax that will be assessed. In parts of some larger cities, such exemptions represent a major share of the potential tax revenues. There are other instances in the tax policies of transition countries where social welfare concerns have led to exemptions that might imperil the sufficiency of tax revenues.2 Table 9.1 provides a brief history of Czech budgets, both national and local. Although Czech municipal budgets are fairly well funded compared with other transition countries, Czech cities and towns certainly do not enjoy soft budget constraints. The municipalities of the Slovak Republic have enjoyed greater autonomy, but also enjoy far less revenue. The aggregate of Czech local budgets represented no more than 25 percent of the national budget in 1993. That share grew rather continually, although it stagnated at about 30 percent from 1997 through 1999, reaching a high of 32.6 percent in the year 2000. What stands out in the data of Table 9.1 is the relative insignificance of the real estate tax in the Czech Republic. The state is unwilling to change

Table 9.1

National and Local Budgets for Select Years: The Czech Republic

Year

1993

1995

1996

Local Budget (% of national budget) State grants to local budgets Grants as % of local budgets Total local revenues Local budget expenditures National budget tax revenues Local budget tax revenues Real estate tax Real estate tax (% of local revenues)

25.45 27.03 29.67 101 90.1 224.6 35.97 3.021 2.99

29.34 33.28 25.77 129 132.3 255.4 70.68 3.799 2.95

33.5 59.44 36.75 162 171.1 283 72.67 4.018 2.48

1998

1999

2000

2004

2005

30.8 37.39 23.79 162 158 495 83.32 4.108 2.53

30.9 41.43 22.07 188 173 524 87.01 4.248 2.26

32.6 46.1 25.3 181 190 544 95.8 4.44 2.44

29.13 24.96 8.08 309 231 963 166.7 4.92 1.59

28.78 31.6 9.44 335 246 1060 216.1 4.966 1.48

2006 35.2 137 38.5 219 361 933 173 4.97 1.4

ˇ Source: GDP: Data from the Czech statistical office according to authors’ arrangement and calculations. See Statistická roˇcenka Ceské republiky 2007 (Czech Statistical Yearbook). Available at http://www.czso.cz/csu/2001edicniplan.nsf/publ/10n1-01-2001. May 14, 2010.

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the property tax, which remains only symbolic and at low levels of revenue. Nor do the local governments successfully apply any pressure on the center to increase its collection efforts. Simply accepting the revenue sharing and grants that the central government offers is easier. Because the state provides all the revenues for municipal investment projects, it alone determines which projects will be funded. Hope for municipal political independence, obviously a function of the accessibility of independent financial sources, cannot be derived from current Czech intergovernmental fiscal relations. Only in 1994 did real estate tax provide in excess of 3 percent of the total revenues available to local governments. Otherwise, from 1993 to 2000 its share was between 2 percent and 3 percent. After 2000 the declining proportion fell below 2 percent. Other municipal revenue sources have increased while the real estate tax decreased. It is important to keep these facts in mind when reviewing local perceptions of intergovernmental fiscal relations; regardless of those perceptions, local Czech budgets provide for as little autonomy as they do for “own funds,” that is, for independent funding sources. For the Republic of Slovakia, the fiscal story is similar to that of the Czechs; the total revenues going to Slovakia’s cities and towns as transfers of shared taxes and grants from the center have been considerably less generous. Changes in data categorization after 2000 in Slovakia make it impossible to present data in the form of Table 9.1 for Slovakia after that date. The general proportions up to 2000 were similar, but the most significant differences in the two countries’ local budgets were that state grants to municipalities were several times smaller in the Slovak Republic from 1993 to 2000 and that real estate tax revenues in the Slovak Republic were growing significantly as a share of total local revenues (from 0.08 percent to ca. 0.11 percent) in Slovakia, while they declined during that period in the Czech Republic (from 0.05 percent to 0.03 percent). Over those same years, Czech local budgets grew from roughly one quarter of the size of the national budget to one-third. Slovak municipal budgets were only about 13 percent of the national budget. Being in charge of their own property tax collections, aggressive Slovak municipalities have generally derived around 10 percent of their budget revenues from the real estate tax. The recent reforms of the Slovak government, beginning with the reform of public administration, have been substantially bolder than those of the Czechs. Additional legislation related to fiscal decentralization was produced in September 2004 (Ministry of Finance, Republic of Slovakia, 2005). According to the Act on Budgetary Definition of Tax Yield, municipalities receive as their share of the personal income tax 70.3 percent of the revenues of that tax, while the regions (“Upper-tier Territorial Units”) 23.5 percent, and the central government retains only 6.2 percent. Previously considered subsidies, these are now considered the subnational

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governments’ own revenues. The real estate tax was scheduled to reach about 14 percent of the revenues of municipal budgets for 2007 and the door was opened to greater independence for municipalities in designing their own property tax systems (Bryson and Cornia, 2006).

Genesis of the Survey In the course of researching issues of fiscal decentralization and intergovernmental fiscal relations in the twin republics, we had numerous opportunities to hear the views of finance ministry and other central government officials. But it seemed important also to gain an understanding of how municipal officers perceived these issues. In our limited contacts with them we had received impressions of dissatisfaction with the level of funds they were receiving and with their dependence on the center for nearly all their revenues. With the help of the associations of cities and towns in the two countries, a questionnaire was developed for mayors and city managers that would reveal some of the important local perceptions and preferences on these fiscal issues. We proceed now by introducing the questionnaire and discussing the participants. We then address four core issues, each being represented by a small set of individual questions: 1. The perceptions of municipal officials on their autonomy and the sufficiency of funds available to them, 2. Whether public services are provided by the appropriate level of government, 3. The potential benefits of adopting a serious rather than a nominal property tax, and 4. The issue of budget flexibility in Czech and Slovak cities and towns. These issues are addressed in two parts. In the next section of this chapter we consider survey questions that revealed statistically significant differences between Slovak and Czech responses, whereas the following section reviews questions for which the responses of Czech and Slovak officials did not differ with any statistical significance. Because the two countries began as one, the historical legacy, the laws, customs, and traditions that formed many of the municipal leaders were the same. Therefore, differences in attitudes on particular issues would rather closely reflect more recently developing differences in policy and the unique texture of intergovernmental fiscal relations within each of the two countries. Some interesting and important differences are indeed observed in the responses of local officials of the two countries, but the

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histories, traditions, financial situations, and backgrounds are similar enough to produce statistically comparable responses in a number of instances. The Survey and the Respondents A survey of some of the local perceptions of intergovernmental fiscal relations in the Czech and Slovak republics was designed to solicit the responses of local officials. The questionnaire developed over time and ultimately benefited from extensive input from the Association of Towns and Cities in Bratislava (Združenie miest a obcí Slovenska, or ZMOS) and the Union of ˇ Towns and Municipalities of the Czech Republic (Svaz mˇest a obcí Ceské republiky, or SMO). Local Czech and Slovak officials took the questionnaire online in December 2005 at the Surveyz.com/Qualtrics.com website. The lion’s share of the participants consisted of mayors. There were 84 responses to the Slovak language version and 456 to the Czech language version.3 Respondents were asked whether they agreed, agreed strongly, disagreed, disagreed strongly with, or were neutral (unwilling or unable to respond) regarding various statements pertaining to the most significant fiscal issues. Some of the questions of the survey were designed to compare some of the perceptions of local leaders with views commonly discussed in the scholarly literature on fiscal decentralization. The literature on the fiscal situation of subnational governments in the countries transitioning from central planning regimes to market democracy reports a high degree of fiscal centralization. In the twin republics, transfers from the central government are the dominant, nearly exclusive source of revenues; low local fiscal effort and very meager “own” revenues generated at the municipal level are characteristic. Since the economic transition began in Europe over 15 years ago, fiscal decentralization has been viewed by the transition literature as essential to democratic development. It is one of the primary means of ensuring the efficiency of public services as government is brought closer to the people (Litvak, Ahmand, and Bird, 1998; Tanzi 1991). Decentralization elicits heavy support from the public finance, public choice, and public management literatures (Bish and Kirk, 1974; Tiebout 1956) because it makes public decision making more transparent and accountable; it permits citizens to participate effectively and at reasonable cost in local governance (Oates 1998). Bryson and Cornia (2001a, b) have written of the socialist and developmental legacies in Slovakia and of the transformation era in the Czech Republic, emphasizing the centralist traditions of Stalinist economic planning from the previous era and the tendency of most transitional central governments to retain a good deal of directive control. The survey’s primary

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objective was to determine how participants at the municipal level view intergovernmental relations, that is, whether from the perspective of local authorities a substantive measure of fiscal decentralization has actually been achieved. The participants of the survey were from cities and towns of widely diverse sizes; accordingly, the budgets involved ranged from small to very large. Many more respondents were, however, from smaller cities and towns than from very large cities. Two of the survey’s final questions addressed these issues. Here, as in the sections that follow, an analysis of the response follows each question presented. Question 19. The anticipated receipts of our municipality this year will be approximately _____________ CZK (or SKK). Last year’s receipts were __________ CZK or (SKK).

Of the Czech respondents, 363 gave an estimate of municipal receipts expected for the year 2005. The average of total anticipated receipts for the Czech Republic’s participating cities and towns was approximately 238 million CZK,4 at the time just under $10 million. The highest reported receipts were a little over CZK 58 billion, while a few of the very lowest receipts were from around a quarter million CZK to half a million. For the previous year, average reported receipts had been well over CZK 349 million, so these officials were anticipating smaller receipts for 2005 than for the previous year. Of the 54 local officials from Slovakia responding to this question, average anticipated receipts for the year were just less than SKK 90 million. A small number reported receipts as low as about a quarter million SKK, while the highest reported was SKK 657 million. Average receipts for the previous year had been a little over SKK 85 million. From these budgets one observes that we are discussing in this survey the responses of officials, on average, from smaller cities and towns, often with modest, usually somewhat underfunded budgets, especially in Slovakia. And aside from Prague, Bratislava, and a small number of larger cities, this is a pretty representative picture of the twin republics. Question 20. My position in the municipality.

Of the Czech respondents, 83 percent were mayors, 2 percent were city managers, 5 percent were financial managers, and the remaining 10 percent held other positions. The larger share of the Slovak respondents, 61 percent, consisted of mayors. Another 7 percent were city managers, 21 percent were economists, and the remaining 11 percent filled other positions.

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The Differences in Slovak and Czech Responses In this part we will be concerned about the responses that reflect fundamental perceptive and attitudinal differences between the respondents from the Czech and Slovak republics. We will observe that the differences are not generally reflective of fundamental variation in the cultures of these cousin countries, but are usually determined by policy differences in specific situations.

Perceptions of Local Autonomy and the Sufficiency of the Funds Available to Local Officials In this section responses relate to the perceived autonomy of the participants and to their views about the adequacy of their municipality’s level of funding. Since the responsibility of local officials for generating revenues is rather light, especially in the Czech Republic, they need not be terribly concerned about their own fiscal effort in generating revenue yields. They are far more concerned about whether the funds transferred by the central government in the form of shared taxes or grants are sufficient for the provision of public services. A major concern is the provision of funds from the center to pursue mandated projects and activities. Where demands for services place heavy pressures on local officials, one would expect that they would consider loans, credits, and deficit spending as possible means of overcoming fiscal shortfalls. These will also be discussed in this section. In the Czech Republic the traditional wisdom of central government officials is that since law prohibits unfunded mandates from the center, they simply don’t occur. The response to question 6 of our survey presents a more realistic picture as seen in Table 9.2. When asked whether this traditional question 6. In my experience, no mandates from the central government have been given unless public moneys were transferred to fund them. (The Czech Table 9.2

Unfunded Mandates, Question 6

In my experience, no mandates from the central government have been given unless public moneys were transferred to fund them. (The Czech version added: “This question does not refer to tasks of state administration.”) CZ:

SA: 4%

A: 7%

U: 9%

D: 52%

SD: 28%

SR:

SA: 5%

A: 33%

U: 14%

D: 37%

SD: 11%

SA: Strongly Agree; A: Agree; U: Undecided or unwilling to say; D: Disagree; SD: Strongly Disagree. These percentages represent the share of respondents to our survey answering as indicated.

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version added: “This question does not refer to tasks of state administration.”) wisdom fits their experience, 52 percent of local officials disagreed and another 28 percent strongly disagreed with the statement. Only 48 percent of Slovak respondents disagreed with the observation. Of Slovak local officials, 38 percent agreed that they had not experienced unfunded mandates (as opposed to 11 percent of Czech respondents). For this question, a t-test of country differences indicates a statistically significant difference in the means between the Czech and Slovak republics. Inspection of the significance of Levine’s test for equality of variances in Table 9.3 also shows a statistically significant difference in the variance of the two samples. Unfortunately, there are gaps between the reality and the theoretical literature strongly endorsing fiscal decentralization and prescribing at least some measure of local fiscal autonomy as the essential outcome of decentralization. Local governments in transition countries have been widely perceived as facing burdensome unfunded mandates with woefully inadequate funds (Bahl and Wallace, 1994). Officials of the Czech finance ministry deny that unfunded mandates are given to the subnational governments of the republic, basically because it is against the law. To “delegate” new responsibilities without transferring the necessary resources to perform them simply increases the demand for transfers or subsidies in whatever form. Doing so also tends to keep the municipalities dependent on the central government. Oliveira and Martinez-Vazquez (2001) agree that the Czech Republic has a generally good record for avoiding substantial, unfunded mandates on its local governments. Some projects and activities have been funded through specific grants, which would not have been supplied in some of the other transitioning countries. There have been, as we note by the responses to the survey, obvious exceptions to the favorable Czech performance. When the responsibility for issuing personal identification cards and passports was transferred to local governments, they objected because the funds were not transferred. Probably the most important case of unfunded mandates in the Czech Republic occurred at the outset of the Table 9.3

Test for Equality of Variances, Question 6 Levine’s test equality of variances

Question Number

Test assumption

6. Mandates are tied to funding

Unequal variances assumed

t-Test for equality of means

F

Prob.

T

df

Sig. (2-tailed)

Mean difference

Std. error difference

5.02

68.667

.000

.81

.161

.488

1.131

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transition period when the central government transferred the responsibility for and privatization of public housing to local governments. No funds were transferred along with the responsibility to maintain and upgrade the seriously substandard housing stock. Moreover, retaining control over the pricing of transferred service responsibilities only added insult to injury; in effect, it simply supplied another form of unfunded mandate. This kind of policy selection helps explain the soft budget constraint that has to develop for local governments in such a situation as well as the occasional need for bailouts.5 Underfunded municipalities cannot be expected to meet financial obligations if imposed financial requirements exceed available funds. They become hostage to their administrative directors in central government, but at the same time they also avoid full financial responsibility for program failures. The responses to this question are exceptionally interesting. We would have expected that the more generous Czech government would be far less inclined to issue unfunded mandates than the Slovak government. But the Czech respondents far more emphatically disagreed with this survey question’s assertion that mandates are not unfunded than did their counterparts from the Slovak Republic. That would mean either that the Czech offenses are more egregious than we would have expected or that Czech officials, less accustomed to the more severe financial struggles of the Slovaks, have a more negative perception than justified by the reality. When Czech local leaders were asked whether they had sufficient revenues to cover their municipality’s operating costs, 63 percent agreed (and another 11 percent agreed strongly) that they did. As the response to question 4 shows, only 50 percent of Slovak local leaders agreed (and another 2 percent agreed strongly) that their revenues covered operating costs, while 40 percent disagreed. It is significant that 25 percent of the Czech respondents complained of budgets too small to cover question 4. From all financial resources, we receive at least enough revenue to cover our annual operating costs. The Slovak Republic’s budgets, smaller yet, caused 40 percent of respondents to claim inability to cover operating costs from their budgets. That represents substantial deviation from the Czech responses. This is the first question to which the Czech and Slovak local official responses differed significantly. Moreover, this is the first of the questions for which a t-test of country differences indicates a statistically significant difference in the means between the Czech and Slovak republics. Levine’s test for equality of variances Table 9.4 CZ: SR:

Resources to Cover Operating Costs

SA: 11% SA: 2%

A: 63% A: 50%

U: 1% U: 8%

D: 20% D: 40%

SD: 5% SD: 0%

Perspectives on Intergovernmental Relations Table 9.5

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Test for Equality of Variances, Question 4 Levine’s test equality of variances

Question Number

Test assumption

4. Revenue to cover operating costs

Equal variances assumed

F

Prob.

.118

.732

t-Test for equality of means

T

df

−2.752 437

Sig. (2-tailed)

X dif.

SE dif.

.006

−.416

.151

reported in Table 9.5, however, shows no statistically significant difference in group variances. Whether the Mix of Public Services Assigned to Government Levels Is Appropriate This section of the survey also inquired whether the local governments of the twin republics supply some services that would be more logically and effectively provided at a higher governmental level. On the other hand, central governments sometimes provide services that would be better provided by subnational governments. This issue is addressed by questions 8 and 9 (see Tables 9.6 and 9.7), which, interestingly, could have been expected to encounter controversial views among the respondents, since in both countries the state routinely performs local service provision functions under the rubric “state administration.” Question 8. My local government never supplies services that would be better supplied by the central or regional government. (In the Czech Survey: “This question does not include tasks of state administration.”) Question 9. The central and/or regional governments supply no public services that would be better to supply through independent, local governments.

The foundation documents of both countries define state administration as the set of municipal and subnational governance functions assigned to and performed strictly under the direction of the central government. Municipal Table 9.6 CZ: SR:

Question 8 SA: 7.2% SA: 10%

A: 47.4% A: 42%

U: 23.4% U: 17%

D: 19.8% D: 28%

SD: 2.2 SD: 3%

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Table 9.7 CZ: SR:

Question 9

SA: 6.9% SA: 7%

A: 48.7% A: 22%

U: 21.7% U: 33%

D: 20.6% D: 33%

SD: 2.1% SD: 5%

and regional “self-government” (samosprávy) consists of the remainder of the local functions actually assigned to the subnational governments to perform. It is important to recognize that the sovereignty of subnational governments is restricted to the performance of that limited set of constitutionally assigned functions and services. It is thus somewhat ironic that 22 percent of Czech respondents thought that some of the services their municipality supplied would be better supplied by regional or central government. Fifty-four percent felt that none of the services they were supplied could be better supplied by a higher level of government. Of Slovak local officials, a similar share, 31 percent, thought that some of their services would be better supplied by regional or central government. A much larger 52 percent felt that none of the services they were supplied would be better supplied by the central or regional governments. Only 29 percent of local Slovak officials felt none of the services supplied could actually be better supplied by a higher level of government. That a strong minority of the officials of both countries believed that they were supplied some services that should be supplied by higher levels is indicative of the thorough entrenchment of the notion of state administration. These people would even extend the list of municipal tasks confiscated by the central government from local jurisdiction. Even more surprising is the fact that substantial minorities in both countries saw some services that they believed would be better supplied by the regions or by the central government. t-Tests of the means of the samples of the two republics demonstrated a statistically significant difference, as expected, since a glance at the two country responses shows nearly 80 percent of Czechs disagreeing or disagreeing strongly with the statement that local governments never supply services better supplied by the central or regional government. Levine’s test is significant (F = 3.938, P = .048, Mean.cz = 2.63, Mean.sl = 2.73, Slovakia’s standard error is large). The Potential Benefits of Adopting a Serious Rather Than a Nominal Property Tax It is unlikely that a country’s municipalities could enjoy fiscal autonomy while remaining totally dependent on revenues provided by the central government. The center may be willing to provide such revenues, but it may well attach

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spending directives to them. The attached strings imply less local autonomy. This section reviews how a property tax of considerably greater significance than the almost strictly symbolical one currently imposed in the Czech and Slovak republics might be received and perceived by local authorities. Both republics have basically three sources of own revenues: the real estate tax, a limited menu of local taxes and fees, and the sale of public properties. As currently constituted, none of these provide significant amounts of revenues; local fees provide well under 5 percent of total local revenues, and the sale of public properties cannot continue indefinitely to provide revenues. Therefore, if a genuine, substantive property tax were introduced in these countries, autonomous local revenues would clearly be increased. The fundamental question here is whether a local authority has a revenue source or sources independent of the central government. A rough indication of that is suggested by question 13 of the survey. Roughly what share of total revenues is derived from transfers from the central government? This item is designed to give an indication about the level of accessible own revenues municipalities enjoy. A fairly large number of the survey participants, both Czech and Slovak, failed to respond to this question, although the request was for an approximation or even an impression rather than an accurate, documentable answer. For the 310 Czechs who did respond, however, the mean of the estimates was that 56.9 percent of total revenues came through transfers from the central government. Taking an average of the responses of 53 local officials from Slovakia, 58.5 percent of their municipalities’ total revenues came in the form of central government transfers. What Share of the Total Transfers Received Could Be Spent Strictly at the Discretion of Local Officials? We were tempted not to report on question 13, since only 31 Czechs and 22 Slovaks responded. One has to reflect on why so few responded to such an important question. Perhaps many had not really thought about this issue. Perhaps some felt that they could not answer accurately with the precision that they might have felt the question deserves. Some may have simply wanted “not to go there” because the question is a sensitive one. Statistically speaking, there were enough responses to review. The average of their subjective estimates of the nonmandated expenditures was 51.3 percent. The 22 responding Slovak local officials provided an average estimate of the share of those transfers not encumbered by mandates of 36.6 percent. Levine’s test for equality of variances in Table 9.8 showed statistically significant differences between the Czech and Slovak groups’ responses (F = 5.604, P = .018).

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Table 9.8 Test for Equality of Variances, Question 13 Central Government Revenue Percentage Levine’s test equality of variances Question Number

Test assumption

13. Central government revenue percentage

Unequal variances assumed

F

Prob.

t-Test for equality of means

T

df

5.604 0.018 −3.59 77.752

Sig. (2-tailed) .001

X dif.

SE dif.

−15.92 4.43277

An inquiry concerning impressions about what shares of transfers carry mandates is likely to produce a rather subjective response. In some instances a mandate will not explicitly accompany a transfer, but will nevertheless be understood and generally adhered to. The less fiscally humble Czech municipal officers may be more prepared on occasion to give their government the benefit of doubt. If this survey was such an occasion, the statistical difference might reflect an impression more than a reality. But such subjectivism aside, we have evidence here of a significantly smaller portion of transfers in the Czech Republic bearing mandates. Question 12. If we had a real estate tax similar to that in England or the United States, it should be administered by local government, regional government (not included in Czech version), or central government. Czech Republic: local government, 63 percent; central government, 37 percent. Slovak Republic: central government, 0 percent; regional government, 10 percent; local government, 90 percent.

The difference in these responses is large. Over a third of the Czech respondents did not believe that a property tax should be locally administered. This is doubtless because the Czech central government administers the tax, collecting the revenue and redistributing it to the municipalities. And the Czechs receive only nominal revenues from the property tax, but receive enough other revenues from the center to feel compensated on net. Their response seems to reflect the view that own revenues are not a concern if the government provides sufficient revenues from other sources. The Slovaks collect their own property tax and have made strong efforts to maximize the revenues thus derived. None of the Slovak respondents felt that the central government should administer the property tax and 90 percent felt

Perspectives on Intergovernmental Relations Table 9.9

145

Test for Equality of Variances, Question 12 Levine’s test equality of variances

Question Number

●

Test assumption

12. Locally Unequal administered variances real estate tax assumed

F

Prob.

226.9

.000

t-Test for equality of means

T

df

12.348 121.29

Sig. Mean Std. error (2-tailed) difference difference .000

.548

.044

that local governments should do so. As seen in Table 9.9, the t-test for mean differences in the two samples reveals a statistically significant difference in the two countries’ responses. Moreover, Levine’s test of difference in sample variances shows that equal variances likewise should not be assumed. Thus, the Czech and Slovak responses to this question were as from two distinctly separate populations. It would appear that local politicians generally accept the institutional rules of the game as played in their country, sometimes even coming to the point of view that such local institutions are unquestionably right and proper. Still, consensus thinking is that successful decentralization requires more than just forming subnational governments; it also requires that those governments have access to funding for basic services and even to a local and autonomous source of funding (Kelly, 1994). This implies that local governments should administer the property tax. The public finance literature suggests that the property tax embodies the positive characteristics required of a local tax. It is the economist’s local tax of choice because its base is immobile, its revenue is stable, economically it is potentially neutral, and politically it is visible (Musgrave, 1993 and Oates, 1996). The tax assignment literature accepts the property tax as the ideal local tax (McClure, 1983). Not surprisingly, over a third of Czech municipal offers are not averse to the current system, which requires no fiscal effort on their part. Having become accustomed to having their funds simply appear and bearing responsibility only for expenditures, many feel that this is the way the world should work. Virtually none of the Slovak respondents felt that central government should bear the responsibility of managing the property tax, although 10 percent would not be averse to having the regional government accept the responsibility. The fundamental question is whether a local authority has a revenue source or sources independent of the central government. When confronted by question 11 about the property tax,

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Table 9.10 CZ: SR:

Question 11 SA: 19% SA: 12%

A: 47% A: 55%

U: 24% U: 26%

D: 9% D: 7%

SD: 1% SD: 0%

It seems logical to me that, as in England or the United States, a real estate tax, effectively designed and administered, could be a source of considerable revenue for local governments.

47 percent of Czech officials agreed that it has the potential of being a source of “considerable revenue” for local governments, and another 19 percent said they strongly agreed (see Table 9.10). A large 24 percent, however, declared they were unable or unwilling to say whether they were in agreement or disagreement. An almost identical 67 percent of Slovak local officials felt the property tax could be a source of considerable revenue, with 12 percent strongly agreeing. An almost identically large group of 26 percent agreed with the 24 percent of Czech respondents who were unable or unwilling to say. Only 18 percent of the Czech respondents disagreed with the proposition that revenues from a property tax would have greater value (assuring greater autonomy) than the same amount of shared taxes transferred from the central government (with probable strings attached). As reported, 42 percent agreed and another 10 percent agreed strongly about the potential value of the real estate tax; a large 29 percent were undecided (see Table 9.11). Of the Slovak respondents, who have been far more dependent on property tax revenues than the Czechs, only 34 percent agreed that the revenues from a decentralized property tax would be of greater worth than shared taxes transferred from the center, whereas 36 percent of Slovak local officials disagreed (twice as large a share as in the Czech Republic) that such revenues would be better than shared taxes, and 31 percent were undecided. An informed interpretation of these responses would have to take into account that the Slovaks have been heavily dependent on property tax yields and have actually been Table 9.11 CZ: SR:

Question 14 SA: 10% SA: 10%

A: 42% A: 24%

U: 29% U: 31%

D: 16% D: 29%

SD: 2% SD: 7%

Question 14. Revenues from a property tax planned and designed by local selfgovernments would have a higher value to us than the same amount of revenues offered from the central government in the form of shared taxes.

Perspectives on Intergovernmental Relations Table 9.12

●

147

Test for Equality of Variances, Question 14 Levine’s test equality of variances

Question Number

Test assumption

14. Higher value of locally 15. Planned tax

Equal variances assumed

t-Test for equality of means

F

Prob.

T

df

Sig. (2-tailed)

X dif.

SE dif.

0.569

0.451

−2.931

433

.004

−.401

.137

involved in the collection of the revenues. To be spared the heavy effort thus expended would be appreciated. In this respect a large, costless transfer of funds from the central government would be a better outcome. The symbolic cost of significant tax revenue efforts may be artificially high for the Czechs, not having ever actually been forced to make them. A property tax may be of more value to those who perceive that it allows greater decision autonomy. For the responses to this question, a t-test for divergent means reveals a statistically significant difference in the mean responses of the two countries. The Levine test (Table 9.12) did not show a significant difference in variance (F = 0.569, P = .451). The Similarities in Czech and Slovak Survey Responses Perceptions of Local Autonomy and the Sufficiency of Funds Available to Local Officials Our discussion in this section will follow the same ordering of the core issues or complexes of questions. We now address a different set of responses, namely, those showing no statistically significant differences between the local officials of the Czech and Slovak Republics. For the responses of this section, t-tests for differences in means revealed no significant difference in sample means for Czech and Slovak respondents. The first question, reviewed in Table 9.13, is the most general one posed on the issue of municipal autonomy. It appears to have been, without considerable reflection, interpreted as: “Despite any potential action of the center, do I have a meaningful job to do? Do I have important decisions to make?” No less than 67 percent of all Czech respondents agreed with this statement (27 percent of these did so strongly). Of all the Slovak local leaders, 67 percent were also in agreement (11 percent of these strongly).

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Toward the Close of Transition in the Czech and Slovak Republics Questions on Local Autonomy Views on Autonomous Operation

Question 1. Although our municipality receives most of our revenues from the central government, we operate with complete autonomy. CZ: SR:

SA: 14% SA: 11%

A: 53% A: 56%

U: 3% U 2%

D: 24% D: 27%

SD: 6% SD: 3%

Dependence on Financial Transfers Question 2. Our municipality could operate with much greater independence if we were not so dependent upon financial transfers from the central government to fund our activities. CZ: SR:

SA:33% SA:25%

A: 51% A:55%

U: 5% U:8%

D: 10% D: 8%

SD: 1% SD:3%

Sufficient Funds for Budget Autonomy Question 10. Although we face many required expenditures, we still have enough funds to make me feel that we have budget autonomy and discretion. CZ: SR:

SA: 4% SA: 7%

A: 48% A: 33%

U: 3% U: 3%

D: 36% D: 47%

SD: 9% SD: 10%

“Sufficient” Funds Question 3. Our municipality always has sufficient funds to accomplish the tasks expected of us. CZ: SR:

SA: 1% SA: 0%

A: 11% A: 12%

U: 2% U: 3%

D: 52% D: 58%

SD: 34% SD: 27%

Funds for Capital Investments Question 5. In the past ten years, funds we have received from all sources have permitted us to make investments in capital facilities that will enable us to provide necessary functions such as schools, social services, and garbage collection, at a satisfactory level in the future. CZ: SR:

SA: 3% SA: 5%

A: 23% A: 16%

U: 3% U: 7%

D: 51% D: 61%

SD: 20% SD: 16%

Table 9.13’s more specific questions 2 and 10 appear to have stimulated more reflection, and the focus of these questions was not seen as the decision functions of the local leaders but as the system that gave them less autonomy than they would like. Of Czech respondents, 84 percent agreed (33 percent strongly) that their autonomy would be “much greater” if they were not so dependent on the center for financial flows. Only 11 percent disagreed with this assertion. Slovak local leaders were likewise in agreement (55 percent agreed and another 25 percent agreed strongly), so that a total of 80 percent thought independence would be much greater if financial dependence were less.6 Transition history suggests that little real decentralization had been achieved through most of the transition period and that the municipal

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governments of the Czech and Slovak republics from 1989 to 2000 or so enjoyed little autonomy, with the picture changing somewhat in terms of its promise since then. Pushing forward on the theme of local autonomy, question 10 evoked a 52 percent Czech response that, despite facing many required expenditures, they have sufficient funds to enjoy “budget autonomy and discretion.” A strong 45 percent could not agree that they have budget autonomy. This is in clear contrast to the response to question 1. In part, this question was to test whether some local officials might confuse autonomy with budget sufficiency, which some appear to have done. Of local officials in Slovakia, only 40 percent felt they had such autonomy. Once again, we see the impact of the smaller Slovak municipal budgets on local officials’ views in that country. Autonomy is, of course, largely a subjective perception. Local governments enjoying fiscal autonomy will likely experience a significant measure of political autonomy. There may be instances, however, where a healthy measure of political autonomy is possible even without independent fiscal resources. Given a substantial democratic tradition like that, for example, of the Netherlands, local authorities will confidently insist on political autonomy, even if they receive most of their funds from central authority. Central authority will rarely attempt to mandate its own preferences on local provision of public goods and services. But where the tradition is a centralist, nondemocratic one, it is far less likely to be overcome by having the center provide all the funding of local goods and services. Central authority in formerly communist countries was not accustomed to restraints on powers and preferences, and local authorities were not inclined to demand the autonomy they lost for 40-60 years of central planning (Bryson and Cornia, 2002). Question 3 intentionally lacks precision. Its focus is on a subjective perception, so it is not significant precisely what tasks were to be accomplished or who held the expectations mentioned. Of the Czech local leaders 52 percent disagreed with the assertion and another 34 percent disagreed strongly. Only 12 percent agreed that they always had sufficient funds. Of the Slovak respondents, 85 percent disagreed with the query (of these 27 percent disagreed strongly). As with municipal officials generally, there is clear insistence here that the budget is too small, and the Czechs, whose budgets are considerably larger, obviously felt no less strongly than the Slovaks. The public finance and fiscal decentralization literatures likewise refer to the scarcity of resources available to subnational governments, a condition holding especially in the Slovak Republic during the transition period. The condition stems back to the legacies and fiscal patterns established in the central planning period (see

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Bird, Ebel, and Wallich, 1998, and Matoušková, 1998). It has already been established that a problem of moral hazard affects local fund-raising efforts negatively when municipalities can neither monitor nor influence central collections efforts (Bryson and Cornia, 2003). The public finance and fiscal decentralization literatures likewise make reference to the scarcity of resources available to subnational governments, especially in the Slovak Republic, during the transition period. The condition stems back to the legacies and fiscal patterns established in the central planning period (see Bird, Ebel, and Wallich, 1998) and (Matoušková, 1998). As mentioned earlier, a problem of moral hazard affects local fund-raising efforts negatively when municipalities can neither monitor nor influence central property tax collection efforts (Bryson and Cornia, 2003). When queried whether funds from all sources have permitted investments in capital facilities for “necessary functions” (question 5), only 26 percent of Czech local officials were in agreement. A total of 71 percent disagreed, of which 20 percent were in strong disagreement. Of Slovak local officials, only 21 percent agreed that they could make such investments. Seventy-seven percent of them disagreed (61 percent disagreed and another 16 percent disagreed strongly) with the proposition. Here again there is divergence for the two countries. The more modest Slovak budgets left Slovak local officials slightly more strongly in disagreement with this proposition. Nevertheless, t-tests of differences in means and variances on the responses to this question by the two countries were not significantly different. So even though the Czech municipalities have enjoyed significantly greater resources from transferred taxes and subsidies, they have not perceived themselves to be better endowed with funds for investments in capital facilities. An explicit comparison of the municipal and central government budgets of the two republics in the transition period shows that the Czech municipalities have enjoyed substantially greater revenues through transfers and subsidies than their less affluent Slovak counterparts (Bryson and Cornia, 2003, and Bryson, Cornia, and Wheeler, 2004). Question 7 (see Table 9.14) on the debt burden of the Czech Republic lies outside the question sets on core issues, but as one of the pillars of Table 9.14

Question 7

The debt burden of our local self-government is appropriate and payments of principal and interest during the repayment period do not cause significant problems with fulfillment of financial obligations which accrue to us by extant legal norms. CZ: SR:

SA: 23% SA: 15%

A: 60% A: 62%

U: 3% U: 7%

D: 12% D: 12%

SD: 2% SD: 5%

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fiscal decentralization has obvious significance in its own right. Of Czech respondents, 83 percent considered the level of local debt not to be excessively large. They indicated that current debt levels are not problematical in the fulfillment of municipal financial obligations (23 percent agreed strongly that this is the case). Only 14 percent saw local debt as a financial problem for the municipalities. In Slovakia, 62 percent of those responding to the questionnaire felt that debt was not a significant problem for municipalities and another 15 percent felt that way strongly. Only 17 percent saw municipal debt as a significant problem for local governments. The Czech government has shown some concern about local debt and has established regulations limiting deficit local finance, but this is because of a more general concern with the national debt (which under EU restrictions includes local debt). There is also specific concern for a very small number of local cases where debt has been imprudently incurred and managed (Bryson, 2006 and 2006a; Ježek, Marková, and Váˇna, 2004; Kling and Nižˇnanský, 2004). The debt burden has generally been quite small, but it has grown somewhat over time. The potential benefits of adopting a serious rather than a nominal property tax All of the responses to questions in this core issue had answers with statistically significant differences. The issue was budget flexibility in Czech and Slovak cities and towns. One view of budget flexibility and autonomy is that as resources available to municipalities increase over time, municipal officials have more choice. They have an increased ability to provide the most urgently needed public services and can spend more time making choices about what to do with additional funds that can provide greater amenities. At an early stage of development, the concern is with finding funds sufficient to provide even the most essential mandated services. Over time, greater funds provide greater budgetary choice and a sense of greater autonomy in the selection of services desired by the local citizenry. This seems to explain the perspective of many of our survey respondents. The authors, however, consider autonomy to be a function of making choices at every level of development, with fiscal independence being reflected in the disposition of funds without any strings attached, and funds raised by the municipality itself. Here, too, affluence provides greater budget flexibility, but we add the consideration that own revenues provide some additional space for autonomy. For a detailed review of the survey’s findings on budget flexibility, please see the previous chapter.

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This concludes the discussion of the survey questions. Interestingly, the answers were generally very reflective and provided grist for considerable contemplation and analysis. But in a few cases the respondents’ answers were shaded by emotional rather than reflective perceptions, as when both Czechs and Slovaks generally responded that they functioned in a wholly autonomous manner but that it would be nice if, in effect, their budgets were not hedged about with such extensive controls, limits, mandates, and constraints. Many of our suspicions were confirmed through these responses, and many new insights gave rise to new questions that can direct future research. Conclusions The most significant differences in the responses of the Czech and Slovak local officials were as follows: The Czechs were more strongly convinced that they were victims of unfunded mandates. A larger share of the Czechs agreed that the funds transferred to them by the central government were sufficient to cover their current operating costs. A slightly larger share of Slovak officials felt that they were supplying some public services that the central government should supply. A larger percentage of Czech respondents felt that their central government supplied no services that the municipalities should be supplying. Czech respondents believed that a larger share of transferred funds could be spent at their own discretion than did respondents of the Slovak Republic. A larger share of the Czech officials (37 percent) felt that the central government should administer a more significant property tax than did Slovak officials (0 percent). A larger share of the Czech respondents were convinced that the revenues from a property tax planned and designed by local selfgovernments would have a higher value to them than the same amount of revenues offered from the central government in the form of shared taxes. No statistically significant differences were found between the Czech and Slovak respondents (it was as though they were from the same statistical population) regarding the following issues: Both expressed the sentiment that municipalities could operate with much greater independence if they were not so dependent on financial transfers. A strong majority of both groups disagreed with the statement that their municipality always had sufficient funds to accomplish the tasks expected of them. Strong majorities from both countries’ respondents agreed that funds received from all sources had not permitted them to make investments in capital facilities that would provide such things as schools, social services, and garbage collection at a satisfactory level in the future. Strong majorities from both countries felt that municipal debt burdens did not provide significant problems for their financial situations. The majority of respondents from both countries felt that they had the budgeting flexibility to substitute expenditures from other areas if funds fell

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short in a particular area of expenditures. Very large majorities in both countries expressed the flexibility to pool all receipts and draw from the pool to make desired expenditures, yet almost all the respondents indicated that they used the same funding sources to finance particular expenditures each year. Testing the general themes of fiscal decentralization against the perceptions of local officials in the Czech and Slovak republics was an instructive exercise. The responses to the survey were a reflection of fiscal reality from the viewpoint of the insider as opposed to the outsider. The outside view has been that fiscal decentralization was an absolute necessity after the hypercentralization of the former era. The successive central governments of both republics representing diverse political persuasions have paid lip service to the need for devolution of power, which was necessary to work with interested political influences emanating from Western institutions, especially the EU. But sometimes policy and, even more especially, policy implementation have not clearly promoted fiscal decentralization. To understand these countries, their central governments’ political views must be considered. But possibly an even more important input is that of local officials expressing their perception of intergovernmental fiscal relations and subnational views on particular issues of fiscal decentralization. It is extremely important to realize that the central government’s dominating role is constitutionally guaranteed in the twin republics. The rather arbitrary assignment of “state administration” to the center, that is, the assignment to the center of many tasks normally considered municipal tasks, unnaturally limits the role of municipalities to performing the residual menu of functions characterized as “self-government” (samosprávy). This was presumably done because of the concern of national policymakers that many municipalities are too small and resource poor to function effectively. When local officials are asked about the performance of their functions, it is apparent that the concept of state administration is thoroughly rationalized in their psyche. In some respects they are perfectly content with having the center perform all traditional functions that mayors (or governors) elsewhere would deem their rightful political domain. Such public officials are usually pleased to be relieved of difficult tasks, such as assigning and collecting taxes from local constituents. But the question of sovereignty and ownership of rights may nevertheless ultimately arise. The central government, for example, will not only reduce the local officials’ burdens by simply transferring funds they have collected for the municipalities, but also choose to intervene in the use of such funds, and possibly in the timing, placement, planning, and monitoring of local expenditures. Sometimes local officials are delighted with having the center responsible for performing tasks they could be “stuck with,” but chafe at the basic nature or even the particulars of central intervention.

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The survey revealed that, according to the perceptions of local officials, their political autonomy is related to the availability of sufficient funds both to meet contractual needs (such as the implementation of specific projects or the delivery of particular, contracted public services) and to be able to have some choice in the selection of the activities and services on the agenda. In the Czech and Slovak republics, most of the transition period since 1989 has been characterized by the availability of very few resources that had not been supplied by central government. The lack of own funds seems to the present authors to imply precious little autonomy, something supported by the fiscal decentralization literature focusing on these two countries. But this is not apparently a huge problem for municipal officials there. They would like more funds and apparently perceive that as the key to more choice; they are far less anxious to have substantially increased their own revenues to enhance choice, especially if they have to provide the fiscal effort to produce such funds. There are, of course, many local officials who would not fit this general description and who would be perfectly happy to accept the responsibility and the effort of pursuing autonomous sources of funding. But the overall feeling is one of acceptance of the tradition as a fact of life not subject to political alteration. A number of political implications seem to arise from these findings. Generally speaking, there is still considerable room for more serious decentralization. The Republic of Slovakia seems to be pursuing this more actively than the Czech Republic, which is momentarily preoccupied with pressing fiscal items at the central level; excessively ambitious pension and health care aspirations caused budget strains that pressed against EU institutional restraints. The Slovaks have similar problems, but pursued them with more creative fiscal innovations that were widely reported in the public media. There is plenty of room for the adoption of a variety of additional user fees and a more serious property tax. Both of these are less likely for the intermediate term for the Czech Republic. We should observe in conclusion that as we have heard and read the results of other studies pertaining to transitioning countries in East and Central Europe, our distinct impression has been that the results of other transition countries can be related to these. The Slovak Republic has been more impressive than most of the other transitioning countries in terms of its willingness to modify intergovernmental fiscal institutions. The Czech Republic has been more similar to other governments in the region in terms of shying away from bold institutional change. At the same time, it has been more generous in its intergovernmental transfers and grants than is generally the case for other transitioning governments. But some serious additional research would be required to confirm such impressions.

CHAPTER 10

Decentralization and Local Finance in the Czech Republic: With an Update on the Property Tax∗

Part I: A Review of the Trials of Czech Fiscal Decentralization The Czech public sector pursuit of decentralization to achieve local selfgovernment (samospráva) or local autonomy has probably been the greatest challenge of the country’s post-communist development. The EU considered the achievement sufficient to justify membership under criteria demanding democracy and market economics of member countries. The objective for this chapter is to review the process of decentralization since the Velvet Revolution and the end of central planning in Czechoslovakia. We will note the fiscal changes that began in 1993 and have continued to the present. We have evaluated the effort in previous chapters, reviewing the process from both organizational and budgetary perspectives, finding that the process has failed to generate complete or genuine local selfgovernment. Many observers find this situation of little concern, since the Czech Republic is small enough to be managed quite well from the center. We have maintained, however, that the proof of the real strength and independence of local governments is demonstrated by the extent to which local governments have their own, original sources of revenue. For local governments, autonomy in every respect other than fiscal autonomy is a situation waiting for political autonomy to happen. Before undertaking a review of ∗

Part I of this chapter was written for this book. Part II was coauthored with Lucie Sedmihradská, the lead author, for the annual meetings of the NISPAcee (Network of Institutes and Schools of Public Administration in Central and Eastern Europe), held in Bratislava in May 2008.

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the property tax and its role in Czech fiscal affairs, therefore, we consider briefly the history underlying the post-communist attempt to achieve local self-government. Central Planning and Public Sector Performance Bohemia and Moravia ceased to be part of the Austro-Hungarian Empire at the end of World War I. They had previously enjoyed limited self-government and already launched their industrial development. In 1918 Slovakia also joined Bohemia and Moravia to form the federal state of Czechoslovakia. That early and interim experiment in federalism gave the new federation the opportunity to experience democracy and begin a tradition of local self-government. The Nazi invasion and World War II disrupted the development of local autonomy in Czechoslovakia. Unfortunately, the disastrous war period was followed by 40 years of communist rule, during which strong nationalist sentiment in Slovakia and the principle of samospráva were held in abeyance in both parts of the federation. Central planning of Marxist-Leninist socialism controlled the assortment and quality of local government services, which were funded by grants from the central government. Funds were generated by indirect taxation and transfers imposed on retail and industrial activities. During that period the allocation of funds to local governments was more frequently influenced by political or party connections rather than by actual demands for public services. This kind of distribution generated a great deal of mistrust of the central government at the local level. After the decline of central planning, the peoples of the Czech and Slovak republics both demonstrated their demands for local independence by establishing many new, independent municipalities where a large number had already existed. The collapse of central planning in Czechoslovakia came two decades after the Prague Spring of 1968, which had culminated with the Warsaw Pact invasion of Prague. There was rejoicing in the hope of samospráva in Czechoslovakia because the former regime had retained nearly all power at the center. There were neither meaningful local governments nor selfdetermination; central agents commissioned to perform “state administration” implemented locally all central decisions taken by the party. This was strict hierarchical management with complete central government control over local decisions. For a brief interlude following the December 1989 Velvet Revolution, the Czechs and Slovaks continued their partnership along the path of economic and political transformation. During that period, the Czechs and Slovaks demonstrated unequivocal demands for local autonomy by proliferating

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the number of independent towns and villages and began the new era by continuing their previous partnership. But Czechoslovakia was not to last for long. The Beginnings of Fiscal Reform In their joint attempt to democratize, they inaugurated between 1990 and 1993 a number of common institutions, including a more Western-style tax system. Then, pursuing long-latent nationalist aspirations, the Slovaks got their accommodating neighbors to dismantle the federation in the Velvet Divorce of 1993. At the withdrawal of Soviet troops, reformers still faced many serious problems. The majority of retail trade was conducted in state-owned stores. The ubiquitous, publicly owned and subsidized housing was in poor repair. Large, inefficient agricultural collectives had not disappeared from the rural areas. There were no functioning markets to establish scarcity prices or to indicate the value of homes, farms, or businesses. From that juncture, economic change was commendable and the Czech Republic embarked successfully on the path of transformation. Low inflation and unemployment helped the Czechs avoid significant budget deficits. Strong economic performance and rather effective macroeconomic policies were launched after 1989’s Velvet Revolution; prices were liberalized early, a far-ranging privatization effort was implemented with fair success, and Czech export endeavors were reoriented toward the EU. Importantly, the legal foundations of decentralization were established in Czech legislation. Laws on the municipality and, more recently, on the new regions were supplemented by many other acts that provide the basis for local autonomy and also for a more recent, extensive effort to reform public administration in a country being admitted to the EU. We will review below the nature of the relationships between the municipalities, the regions, and the central government; the attempt to provide more legitimate autonomy for local governments; and the outcomes deriving from those programs in the Czech Republic. But even after 15 years of transformation efforts, much remains to accomplish. The process of industrial restructuring has been an extended one in the Czech Republic in spite of early successes in voucher privatization. For a time, political forces sought to avoid transformation agonies through more gradual transition measures, intending to shield noncompetitive firms from market shock. The Ministry of Finance and the banking system were not quick learners in a market environment that attaches importance to creditworthiness for loans. The finance ministry permitted the large, state-owned

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banks to keep less-than-profitable firms in business. This ultimately damaged the Czech reputation for transformation success in late 1997 when the tenure of Vaclav Klaus as prime minister terminated in a campaign finance scandal. The Czech government and its finance ministry tended to ignore pressure to proceed with the privatization of large banks. Since that time, progress has been steady, if not rapid. The banking sector, important because it will remain the primary source of investment funds in Eastern Europe for some time to come, has been successfully privatized. The state of the banking sector has important implications for the development of the real estate market. Because scarce investment funds are vital for investment processes promoting development, relatively little money has been available for a home mortgage market. The Czech Central Government’s Relative Largesse: Is It a Substitute for Local Autonomy? The failure to implement a serious property tax is not generally seen as a problem for Czech local autonomy. The common view is that the municipalities have not needed independent revenues because the central government has in fact supplied adequate funds. Compared with a number of transition countries, the Czech Republic has been relatively generous in supplying funds for the needs of the regions, districts, and municipalities. The EU apparently saw this as evidence that the Czech Republic was developing satisfactorily as a modern democracy and was therefore prepared to become a full member of the EU. Reservations in this regard were addressed through the “reform of public administration” in the early years of the last decade. We take the position that this view was too narrow. There are significant problems in the fiscal development of the Czech Republic’s subnational governments. The earlier chapters have shown that the central government was quite slow in developing fiscally independent municipalities and regions; it maintained offices at all political levels for “state administration” to perform under strictly central discretion many tasks routinely considered local tasks in Western countries. Even for the tasks rather arbitrarily designated by the center as activities for “self-government,” the center too often establishes the policies, allocates the funds, and directs the local officers how to spend the money. Numerous examples of policies and actions demonstrate the center’s inclination to oversee or even manage local activities. Local governments had public housing (of poor quality and in need of major expenditures) turned over to them without the funds to maintain or repair them. Housing units may be privatized as a supplementary revenue source, but such activities are

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hardly the domain of local decision makers. The central government still regulates housing rents and tariffs on such public utilities as water and gas, and they are held at levels below full cost recovery. Likewise, the central government controls local government employees’ salaries.1 Under democratic traditions, municipalities are responsible for developing their own capital infrastructure. In the Czech Republic, local governments still depend on the central government for the financing of capital expenditures, which is provided in the form of earmarked grants and subsidized loans. Regional governments, only recently established in the reform of public administration, are now being phased in. They have been funded in the transition period by transfers from the state budget. To begin with, they inherit some of the state’s former responsibilities, for example, secondary education, regional planning, and intercity transport.2 In numerous transitional countries, local governments have been constrained to become mere administrative agents as unfunded mandates have been assigned to them. In the Czech Republic, the general mandate of local public service provision is covered by centrally provided funds, which do not quite cover all the needs, although the Czechs have generally been good about assigning new mandates only when basic central funding is also provided. The presence of basic, traditional tasks, together with the assignment of new responsibilities (both requiring expenditures from municipalities lacking any substantive, independent funds), keeps local governments dependent on the state for transfers in whatever form. In the years since the transition began, municipalities have become accustomed to having no independent operations based on substantive revenue sources under their own jurisdictional control. Thus, they have never broken free of their dependence on the state. Accession to the EU: Compromises and Missed Possibilities Because of the Czech Republic’s commitment to join the EU, this institution could easily have pressured the Czechs to provide genuine autonomy for subnational governments by mandating fiscal decentralization. One might have almost expected this, given the EU’s requirement for accession countries to develop democratic institutions and functioning market economies. Unfortunately, the Czech system retained its centralized character even after abandoning central planning. Local governments have continued to perform little beyond “state administration,” that is, to act as an agent of central administration of delegated tasks. Admittedly, the Czech central government provides an acceptable level of transfers of funds so that subnational governments can provide essential

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public services. The Czechs have been more generous to local governments than most of the transitioning countries. In any case, the EU found Czech intergovernmental fiscal performance acceptable for membership. But that acceptance reflected a continental tradition unconcerned about a high degree of centralization. The EU ignored the lack of local or regional autonomy until it began to press for a “reform of public administration.” Unfortunately, the reforms failed to address the problem of local fiscal autonomy directly. The EU cannot be said to require fiscal decentralization of accession countries, although it pays lip service to the idea. In its monitoring of Czech progress, the EU has shown concern about only the Supreme Audit Office created by the Czechs in 1993 and its system of internal financial controls.3 In the 2000 Regular Report by the Commission on the Czech Republic’s Progress towards Accession,4 the Czech Republic was enjoined to strengthen its financial control functions at all levels and make other institutional preparations to interact financially with the EU. But the more serious, long-term problem of failure to provide for local autonomy was not mentioned as a subject of concern. The nature of financial transfers from the center to local governments with strings and controls attached and disinterest in the property tax as a means of independent financial leverage are testimony to the failure to take seriously the problem of local autonomy. Public Administration Reform: Is It a Substitute for Fiscal Decentralization? As observed above, the EU has shown little interest in promoting fiscal decentralization in the Czech Republic. On the other hand, the EU has insisted that the acceding countries establish democracy on surer foundations in assuring greater local autonomy through a different but related initiative, an organizational “reform of public administration.” Let us consider in this section whether these reforms represent a legitimate alternative to fiscal decentralization. The reorganization of the subnational territories has been the main thrust of organizational reform. The former districts (okresy) have been eliminated and new regional governments (kraje) have been established in the Czech Republic,5 which had previously been a two-tier system of government. The kraje were initially funded by transfers from the state budget and inherited some of the state’s former responsibilities, including secondary education, regional planning, and intercity transport.6 By 2000, the Czech Republic had begun7 a comprehensive reorganization of the institutions of governance, moving from two-level to four-level government. Regional government was established between the municipal and

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central levels. The new, fourth tier became the EU in Brussels. The Czech Republic’s joining the EU with the required responsiveness to government in Brussels is not the subject of this chapter. We wish here merely to consider some of the implications of the organizational reforms within the Czech Republic. The goal is to modernize central administration and provide “territorial public administration” to improve the quality of the public sector’s products as a whole.8 New regional governments are intended to “bring state administration to the people” (pˇriblížit státní správu obˇcan˚um),9 that is, to achieve greater involvement of citizens in subnational governance. This is an implicit admission that there had previously been too much centralization in Czech governance. Having policy decisions about health care centers, regional schools, land-use policies, and so on moved closer to the affected citizens implies a healthy devolution of central powers. The question is whether an institutional reorganization of the Czech Republic will obviate the need for fiscal decentralization. Can the process of decentralizing policy institutions be a substitute for granting Czech municipalities fiscal autonomy? Before the reforms, the state implemented its policies not only indirectly through cooperation with self-governing municipalities, but directly as well. It implemented its policies through district offices regionally, and at the bottom level through its own offices and through the agency of municipalities authorized and compensated to perform “state administration” (pˇrenesený p˚usobnost). On January 1, 2003, 73 Czech district offices (Okresy) were closed and their tasks were transferred to 205 newly designated “cities with expanded functions” (obcí s rozšíˇrenou p˚usobností).10 A large variety of activities was transferred to the cities with expanded functions. Specific tasks included such things as the issuing of permits, identity cards, and driver’s licenses, decisions concerning historical buildings, conscription duties, alimony payments, state social and unemployment support, and on and on.11 While the 205 towns carry out these new tasks of “state administration” as agents for the central government, they retain their own tasks of “public administration” or of self-government (samosprava). For state administration they receive compensation in part through user fees paid by citizen recipients of public services, but mostly from the central government, which also retains the responsibility for the quality of the services provided. There is no question that the establishment of regional self-government with freely elected representatives moves government closer to the people. Nevertheless, if subnational governments lack the capacity to respond to local choices in service provision, their freedom of action is severely constrained. A high-profile Czech government document suggests that the problem of

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local fiscal autonomy will not disappear. Bureš et al. tell us in behalf of the Ministry of the Interior (Ministerstvo Vnitra) that the “own revenues” of municipalities, so critical to fiscal decentralization, are available only through local users fees. This paltry source of revenue certainly cannot “fit the actual needs” of local governments. The municipalities and regions have access to independent revenues only through the privatization of their own properties and the centrally controlled and collected, nominal property tax. These authors mention the fiscal problem12 because they recognize that organizational reform can neither ignore nor compensate for the fiscal dimension of local governance. But the Czech Ministry of the Interior has no answer to the implicit but weighty questions regarding local finance. When mentioning that local governments are “temporarily financed mostly by subsidies (grants),”13 it is asserted that “the aim is to strengthen their own tax revenues,” but proposals for strengthening the tax have consistently failed. The Prague government has discussed a number of issues with significant implications for the property tax. That tax, reformed, could still represent the best possibility for financial autonomy for Czech municipalities. The finance ministry has suggested that the cities and towns could reclassify the user fees they charge for local public services as taxes and expand their current range, thus ensuring some increase in revenues. The central government has also decided to modify the distribution of taxes in its revenue-sharing activity. The share accruing to the municipalities has varied substantially by tax type, and the government is now committed to the transfer of a uniform share of all tax revenues to local governments. This reflects a desire to reduce the disparities in the distribution of shares of the various kinds of tax revenues transferred to local governments. Finally, the center has tried to convince the municipalities that excessive debt levels are irresponsible and can be hazardous. The finance ministry has wanted to limit the amount of debt that local governments are permitted to incur. Although not a problem generally, debt has grown quite rapidly in a very small number of municipalities. Czech local finance is largely a story of the central government’s effort to generate sufficient resources for the municipalities. The municipalities have been given increasing service provision responsibilities and increasing resources with which to provide them. The question is always whether the resources provided correspond to the tasks delegated. The center faces its own challenges in meeting national fiscal requirements. At the local level, the tax initiative is both small and declining. Local revenues from users fees generated by the provision of services and from local tax collection amounted to no more than 2.2 percent of GDP from 1993–96. Since then, it has fallen to 1.7 percent. This compares poorly with member countries of the EU such as Norway (12 percent), Spain (5.9 percent),

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Denmark and Sweden (17 percent), Spain (5.9 percent), France (4.4), and Hungary (3.8 percent). The reformed fiscal system “has neither provided municipalities with additional meaningful sources of revenues nor introduced the necessary reforms of the real estate tax.”14 Municipalities would have to be assisted in acquiring the ability to make market assessments of urban properties to make the tax a meaningful source of local revenues. Institutions blocking the incentives and prerogatives of local government to secure and expand property tax revenues would have to be modified. Reforming the property tax would improve the level of both the autonomy and accountability of subnational governments. The reform of revenue assignments implemented in 2000 still leaves important, unresolved issues in the Czech Republic’s system of intergovernmental fiscal relations. Of course the Ministry of Finance retains the discretionary power to make fundamental budget changes through annual budget laws. The 2000 reforms, previously implemented reforms, and reforms currently under contemplation offer no effective incentive mechanism to mobilize local tax effort, and one must expect the dependence of local authorities on the center (and the tax-sharing revenues and transfers it provides) to continue. As a result of such dependence, local authorities will have insufficient fiscal autonomy to develop and exercise full accountability to their constituencies. Moreover, as the new regional officers take up their fiscal responsibilities, they will find themselves likewise unable to enjoy greater autonomy than “tax sharing” from federally mandated, collected, and transferred funds permits, which is likely to perpetuate regional subordination to central authority as well. A worthwhile exercise promoting comprehension of the relationships involved between national and local budgets in the Czech Republic and between the various categories of revenue in those budgets can be derived through some reflection on the data provided in the chapter’s appendix in Tables 10.5 and 10.6. The comparative perspectives thus gained can help solidify the basic points made in this chapter. Part II: The Role of the Property Tax The property tax as a main source of local government revenues is not particularly a European institution, although it is used in Britain and maintains a nominal presence on the continent. It nevertheless comes into the discussion of fiscal matters rather regularly, since it is used in many countries of the world with fair success. It offers the potential not only of strong revenue flows but also the possibility of a reliable source of own revenues for local governments (LGs). For the Czech Republic it is also potentially important,

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since the Czech municipalities rely mostly on tax sharing and grants for their revenues and are lacking in own-revenue resources. A symbolic real estate tax is in place in the republic and the municipalities would benefit in terms of fiscal autonomy if it were to become a more significant source of revenue. The second section of the chapter will review the property tax setting in the Czech Republic and show why it takes its current form. The small but important role of the property tax will be reviewed and discussed in this section. The structure of intergovernmental relations is addressed as an explanation for the parallel phenomena of self-government and state administration. These things help explain the nature of government budgets and the financial situation of the subnational governments of the Czech Republic. The third section looks at the scope and characteristics of the tax and reviews its revenue flows, the role of the central government in its design and incidence, the exemptions that are possible and the latitude the municipalities have in its implementation. As observed above, the tax is area based and the valuation process and methodology are reviewed. It concludes with a discussion of some of the implications of the Czech property tax institutions, addressing for example the fact that the central government (rather than the municipalities themselves) collects the actual revenues without any strong incentives to perform the task well. A brief fourth section provides a case study of the fiscal story of the town of Beroun in the Czech Republic. It is appropriate that the reader gain the sense that the institutions discussed in this chapter apply to real municipalities with real Czech citizens whose lives are affected by the governance implicit in Czech intergovernmental fiscal relationships.

Government Structure and Intergovernmental Relations Government Structure The Velvet Revolution ended the central planning regime of communism in late 1989, and the division of the Czech and Slovak republics followed in 1993. A more Western-style tax system was also introduced in 1993 and, overlooking some minor changes, remains in effect today. The pursuit of reforms that could provide more meaningful devolution of central power has continued in the period that followed. State administration, the retention by the center of many of the functions normally carried out by subnational governments, existed in the previous era and has continued in force in the Czech Republic. It was a part of the foundation institutions of the new republic because the central government believed that many of the municipalities were too small and lacking in labor and other

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resources necessary to manage their own affairs independently. Fiscal decentralization was designed to increase the scope of local autonomy, but not to provide complete autonomy, which was perceived to be beyond the capacity of many of the small municipalities. Out of 6,249 municipalities, 78 percent have less than 1,000 inhabitants (Czech Statistical Office, 2007). Fiscal decentralization delegated some functions to “self-governing” municipalities, but district offices (not local government units but local branches of the central government) retained many functions of state administration until the end of 2002. Despite the constitution, there were no regional governments at the founding of the republic. The 14 regions, kraje, representing a second tier of subnational government, were introduced as a part of the reform of public administration in 1997. They did not really begin to function until 2001. Their creation was an additional effort to apply the principle of subsidiarity in the Czech Republic or to bring government closer to the people. Some of the larger municipalities were granted “delegated powers”, that is, additional functions of state administration performed by the districts until they were eliminated in 2002. The municipalities were divided into five categories according to the scope of the delegated powers they received. There is no definitive structure for the less significant delegated powers and no strict hierarchy of powers. Some municipalities, for example, provide building permits, but do not register inhabitants. The geographic boundaries of the networks of smaller services do not necessarily line up with those of the municipalities of second and third types, designated respectively as “authorised municipal offices” and “municipalities of extended scope” (see Hemmings, 2006, p. 13 and Ministry of Interior, 2004, pp. 33–35, for more detail). They indicate that delegated powers to the municipalities include 1,226 municipalities (of the 6,243 total), which are authorized to register inhabitants, 617 authorized to provide building permits, 388 which manage, for example, water allocation and all types of elections, and 205 of which issue driver’s licences and identity cards for the legal protection of minors. As a part of the initial devolution of power in the Czech Republic, properties were transferred from the center to municipalities, including public housing and many previously state-owned businesses. Many of these have already been privatized. This property transfer included shares in utility companies that were sold mostly in 1999–2001. Intergovernmental Fiscal Relations Let us turn now to the fiscal relationships between the central and local governments, which are best summarized in the relevant budgets. Figure 10.1

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40%

3500

35%

3000

% GDP

30%

2500

25%

2000

20% 1500

15%

1000

10%

500

0%

0

19

93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06

5%

Billions CZK

166

GDP, current price (billions CZK)

CG expenditure/GDP (as %)

LG expenditure/GDP (as %)

Social insurance funds/GDP (as %)

Figure 10.1

Public Budgets, National and Local, of the Czech Republic, 1993–2006

Notes: (1) Central government (CG) expenditures include the state budget and the state funds. The social insurance funds (i.e., health care insurance) are reported separately. (2) Until 2000, local government (LG) included municipalities and districts; after 2001, municipalities and regions. (3) 1993–95 data on public expenditures use the GFS methodology; data since 1996 on the ESA 95 methodology; data for the GDP since 1996 are revised. Source: Table 10.5 in the appendix.

displays both national and aggregated local expenditures as a share of the Czech GDP from 1993 to 2006. Through the entire period, national expenditures (including health care insurance funds) have been around 40 percent of the GDP and local expenditures increased through this period from just over 8 percent to 12 percent. So, one sees that the level of taxation and social expenditure is considerable. The increase between 2002 and 2003 was caused by the reform of public administration (eliminating districts and establishing regions). The one-time growth experienced in 1996 was caused by unexpectedly high (greater than originally estimated) revenues in those sources transferred as shared taxes to local governments. Revenue assignments were redone the following year (Sedmihradská, 2007). The grant system is quite complex and includes transfers between different public budgets. Figure 10.2 shows a summary of the amounts transferred from the state or central budget to regions and municipalities in 2006. Table 10.1 presents consolidated data about central government transfers to local governments—the data on the central government grants were taken from the revenue side of consolidated municipal and regional budgets. It should be noted here that any discrepancies in the numbers in different

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State funds

35.9 75.0

●

0.5

Regions 4.2

55.4 2.9

Municipalities

Figure 10.2

Transfers to Czech Regions and Municipalities: 2006

tables are the result of differing methodologies; sometimes the old districts are included and sometimes not. The change in the central government grants shares and volumes are closely linked to the public administration reform mentioned earlier. In 2001 the new revenue sharing began and the regions began their operations, in 2003 the regions really began to function, and in 2005 the share of regions receiving shared taxes grew from 3.1 percent to 8.92 percent and thus grants were replaced by shared taxes. The character of the grants provided is an indication of the degree of fiscal autonomy of the subnational governments, since where they are provided unconditionally, that is, without strings attached, the independence of local finance is enhanced. In the Czech Republic the significant majority of grants are conditional grants (these are grants provided through ministries, state funds, and all investment or capital transfers), the only exception are grants to municipalities for state administration, senior care homes, and specified social institutions (in 2006 CZK 26.3 billion). All of these funds are formally classified as conditional, pretty well tying all central grants and transfers to specific projects and activities. In fairness, one should note that these particular funds are referred to as contributions to the “current costs” of the municipalities and nobody checks to see how they are really used. So municipalities have some budget flexibility and fiscal autonomy beyond what one might expect through formal classifications. Composition of Local Government Revenues in the Czech Republic Municipal revenues are specified in two laws, the act on Budgetary Rules for Territorial Entities (Act 250/2000 Coll.), which lists all municipal revenues,

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Table 10.1 Central Government Grants to Local Governments (Billions CZK) 1998

1999

2000

2001

2002

2003

2004

2005

2006

652.9 40.4 161.8 94.4

660.5 31.5 194.8 96.4

681.5 51.9 190.3 100.0

799.8 72.6 195 104.7

853.1 94.0 239.6 106.7

904.3 146.7 301.9 106.8

907.7 142.9 308.9 109.7

945.4 127.2 334.7 111.9

983.0 144.3 359.5 114.7

691.6 42.8

685.0 32.7

681.5 51.9

763.9 69.4

799.4 88.1

846.5 137.4

827.2 130.2

845.2 113.7

857.4 125.9

Current price (in national currency) Expenditure of CG CG grants to LGs Revenues of LG CPI (2000 = 100) Real term (in national currency) – Expenditure of CG – CG grants to LGs Share of CG grants in CG expenditure (%) Share of CG grants in LG revenues (%)

6.2% 26.5%

4.8% 16.8%

7.6% 27.3%

9.1% 35.6%

11.0% 36.8%

16.2% 45.5%

15.7% 42.2%

13.5% 34.0%

14.7% 35.0%

Note: LG = municipalities, regions, and voluntary municipal associations (no districts). Source: Compiled by the authors from data provided by CG expenditures—Fiscal Outlook, October 2007, pp. 48–49, CPI—Czech statistical office, CG grants—ARIS (Automatizovaný rozpoˇctový informaˇcní system or Automated Budget Information System).

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Capital grants

200 Billion CZK

●

Current grants Capital revenues

150

Non-tax revenues

100 Other tax revenues

50

Property tax

0

19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06

Shared tax

Figure 10.3

Municipal Revenue Sources 1997–2006

Note: Borrowing is not included as it is not considered in our budget classification as revenue. Following the Czech classification, we do not separate shared taxes from corporate income tax receipts. They are reported together. Source: Table 11.10, appendix.

and the Law on Tax Assignment (Act 243/2000 Coll.), which specifies the revenue-sharing formula. Figure 10.3 shows the development of the main revenue sources since 1997. We observe stable nominal growth of the total municipal revenues with two exceptions. First, there was a one-time increase in 1999, when the 1998–2000 sales of shares held by municipalities in utility companies peaked. Second, there was a decline in revenues in 2005, when transfers from the ministry of education to individual schools began to pass through regional rather than municipal budgets. The years covered by this figure mark the decline of the property tax from 3 percent of the total revenues of Czech municipalities to 2 percent. This tax, viewed generally by economists and advocates of fiscal decentralization as an important source of potential revenues, and thus of fiscal autonomy for municipal governments, is of purely symbolic significance in the Czech Republic. This is of course due to the nature of the tax and the fact that its rates have not been adjusted since 1993. The adequacy of revenues that subnational governments can think of as “own revenues” makes the case for fiscal autonomy. The Czech Republic defines own revenues as tax revenues, non-tax revenues, and capital revenues. Tax revenues, however, also include shared taxes, which are distributed among the municipalities on the basis of a formula. Capital revenues, derived as was observed above from the sales of stateowned properties, represented roughly a quarter of municipal own revenues over the period. The single exception was the year 1999 when that revenue

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source surged to 50 percent of municipal own revenues. As a share of municipal total revenues, own revenues increased dramatically up to 1999 as municipalities sold their shares of the utility companies. At that point, own revenues represented nearly 44 percent of the total. After 2000, however, they settled to a level of 25 percent of municipal revenues. Shared taxes have represented a U-shaped function in municipal receipts. From a level of the low forties in terms of percentage of total municipal revenues, the revenues dropped over the next six years to the upper thirties, returning to more than 40 percent in 2005 and 2006. Grants from the center have tended to vacillate quite greatly in the Czech Republic. In the individual years 2000 and 2003, they exceeded 40 percent of municipal receipts. In 1999 they were less than 20 percent. In 2005 and 2006 they were fairly level just below 30 percent of total revenues. From 2001 through 2004, current grants surged to more than double what they had been in the preceding years because of the public administration reform. Property Tax as Revenue This section will first endeavor to analyze the Czech property tax as a part of the national tax system and as a component of local government revenues. Then, we will consider the incidence and nature of the tax. We note at the outset that the Czech property tax includes not only the real estate tax but also the inheritance tax, the real estate transfer tax, and a road tax. We focus in this chapter on the traditional property or real estate tax, and we use the two expressions as synonyms. The real estate tax was in place under the central planning regime before the end of communism. It was a rather symbolic tax, perhaps since most other taxes of that period were invisible. The property tax cannot be hidden, so it must be either well understood by a contented and not unwilling citizenry, or it must be completely innocuous, representing no serious burden on property owners. The communist situation suggested the nominal property tax. When the new era began, it was not changed in any substantive manner. No effort was made to justify a potential real estate tax burden or to transform it into a producer of municipal revenues. The tax has remained quite static, but in the face of rising incomes and budget revenues, it appears, proportionally, to decline fairly rapidly. Property Tax in the National Tax System and in LG Revenues In a number of the countries of the Anglo-Saxon world, the property tax represents the most important source of revenue for local governments (Bird and

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Slack, 1991, pp. 83–97). Potentially, it could be an important municipal tax for the transitional countries, although it has proven difficult to implement (Bryson, Cornia, and Holmes, 2001). Table 10.2 documents a very small and declining role for the Czech real estate tax as percentage of GDP and of small importance compared with other taxes, and Table 10.3 confirms the same observation regarding municipal revenues. Whether one considers the real estate tax as a share of total taxes or of total municipal revenues, they represent only a very small proportion. One sees the income tax and value-added tax as substantial shares of municipal revenues, but these taxes are transferred to the municipalities and do not represent autonomous revenue sources. The real estate tax revenues grow marginally, in terms of nominal prices, each year. The only exception was between 2002 and 2003, when flats transferred to individuals from municipalities or cooperatives were taxed (not exempted) for the first time. The main factor causing the steady growth of revenues is perceived to be the improved efficiency of audit and searching activities, especially because of improved access to data from the Cadastre of the Real Estate. The growth can also be attributed in part to the amendment to the Real Estate Tax Act, which identified the responsible taxpayer for rented lands. Czech officials believe this will contribute to a gradual clarification of proprietary relations and improved specifications in land records (Czech Tax Administration, 2007). Nature and Incidence of the Czech Property Tax The Czech real estate tax is regulated by the Real Estate Tax Act No. 338/1992 Coll. and consists of two parts: building tax and land tax. In 2006 the revenues from the building tax were CZK 3.1 billion and from the land tax CZK 1.9 billion.15 Property Tax as Procedure All buildings, flats, and nonresidential premises located in the territory of the Czech Republic are subject to building tax. A land tax is collected from all the types of land registered with the Land Register as arable soil, vineyards, hop fields, gardens, orchards, permanent grass plots, forests, water areas, building plots, and other areas. All real estate, including property descriptions, geometric specifications and positions, property and other material, and legally stipulated rights, are recorded in the Cadastre of Real Estate of the Czech Republic. Administrative authorities for the cadastre and land survey activities were set up by Act No. 359/1992 Coll. on land surveying and cadastral bodies, which also specifies their material and territorial jurisdiction.

172

Table 10.2 Tax Revenues as a Share of GDP

SSC (%) Indirect taxes (%) – VAT (%) Excises (%) Direct taxes (%) – PIT (%) – CIT (%) Real estate tax (%)

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

13.7 13.1 7.3 3.9 10.9 4.6 5.4 0.3

13.1 11.8 6.5 3.9 9.9 4.7 4.5 0.3

13.2 11.7 6.5 3.6 8.9 4.8 3.7 0.2

13.6 11.7 6.5 3.5 8.4 4.9% 3.1 0.2

13.2 10.8 6.0 3.4 8.7 4.8% 3.4 0.2

13.0 11.5 6.6 3.5 8.5 4.6% 3.4 0.2

13.1 11.3 6.7 3.2 8.5 4.5% 3.5 0.2

14.3 11.0 6.3 3.3 8.8 4.5% 4.1 0.2

14.9 10.8 6.3 3.2 9.1 4.7% 4.3 0.2

15.1 11.1 6.4 3.4 9.6 4.9% 4.6 0.2

16.1 11.6 7.2 3.5 9.6 4.8% 4.7 0.2

16.1 11.5 7.0 3.7 9.2 4.6% 4.5 0.2

16.2 10.9 6.5 3.7 8.8 4.2% 4.5 0.2

Note: SSC = social security contributions, VAT = value-added tax, PIT = personal income tax, CIT = corporate income tax. Source: Authors’ arrangement and calculations. Data from Macroeconomic Forecast, January 2002, p. 41, and October 2007, p. 46, for real estate tax Provazníková (2007, pp. 114 and 120) and since 1997 ARIS; for GDP see source for Figure 10.1.

Table 10.3 Real Estate Tax as Component of Czech Municipal Budgets (1997–2006)

Real estate tax (mil CZK) – as % of total taxes – as % of municipal revenues

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

3,943.2 0.62 3.07

4,108.3 0.62 2.99

4,247.6 0.60 2.52

4,436.5 0.60 2.75

4,568.6 0.57 2.50

4,571.1 0.53 2.22

4,827.9 0.52 2.00

4,919.4 0.47 2.00

4,966.1 0.45 2.20

4,974.0 0.43 2.06

Distribution of local taxes – particular taxes as a percentage of municipal tax revenues – Income tax – VAT – Real estate tax

82.7

82.5

82.5

76.9

6.0

5.7

5.6

5.3

48.7 33.5 5.1

50.0 32.0 4.6

49.8 31.5 4.5

50.8 31.2 4.2

49.6 33.5 3.9

47.7 34.9 3.8

Source: Authors’ arrangement and calculations. ARIS and for total tax revenues Fiscal Outlook, October 2007, p. 43.

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Digitalization of the Cadastre of Real Estates began in 1993. Part of the Czech Cadastre of Real Estate is The Information System of the Cadastre of Real Estate, implemented in 2001, which increases the quality, accessibility, and reliability of property data. It offers the option of connecting to other basic registers of state administration. Data are entered in local databases and replicated within roughly 2 hours in the central database. The system also enables remote access to the Cadastre of Real Estate, enabling up-to-date viewing of data of the cadastre throughout the whole Czech Republic. Digitization of cadastral maps proceeds less rapidly. At the end of 2006, maps of 33.8 percent of the cadastral districts were digitized (Czech Office for Surveying, Mapping and Cadastre, 2007, pp. 6–10). Taxpayers do not have to pay on buildings and land exempted from the real estate tax. There are many different exemptions. Buildings owned by the state, municipality, or region and those located in their cadastral territory or owned by churches are exempted, as are residential houses returned by restitution up until 2007. New residential buildings, houses, and flats owned by individuals are exempted for the first 15 years. Buildings serving to improve the environment and various other buildings enjoy the same treatment. Several exemptions have only been temporary. All flats transferred to individuals from the state or from municipalities or cooperatives, for example, were exempted only until 2002. Buildings with heating systems changed to gas or electricity (today only narrowly specified renewable resources) were exempted until 2000 to encourage energy savings. Among the lands exempted from property tax are those owned by the state, municipalities, and regions. These included cemeteries, public parks, and sporting facilities. Agricultural and forest lands can be exempted for a specified number of years, as can other types of land specified by the law. Of forest lands, such types are subject to taxation only where an economic function prevails. Water areas are taxed only if they are ponds used for intensive and industrial fish farming. Since the beginning of January 2008, municipalities have been able to exempt arable soil, vineyards, hop fields, orchards, and permanent grass plots from the property tax by issuing an ordinance. The tax base is either monetary (in CZK) or expressed in physical units (square meters) depending on the type of land. The monetary valuation is used for agricultural land. In the case of arable soil, hops fields, vineyards, gardens, orchards, and permanent grass plots, the tax base is defined as the product of the price of 1 square meter of the land and the real area of the land in square meters, as of January 1 of the tax period. This decree (No. 613/1992 Coll.) has been in force since 1993 and has been updated every year; however, the price change was very small.16 In the case of economic forests and ponds with intense and industrial fish farming the price CZK 3.80 can be used instead of the one published in the decree. In other types of land, the

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tax base is defined as their real area in square meters as of January 1 of the taxation period. A building’s tax base is the area of the ground plan of the building in square meters as of January 1 of the tax period. The tax base for flats and separate nonresidential premises is the surface area in square metres. Basic tax rates are differentiated according to the type of land or to the purpose of the building’s use. They may be further adjusted with regard to the number of above-ground floors (in residential houses the tax rate of individual floors increases by CZK 0.75 for each 1 square meter of finished area). The basic rate, adjusted by possible above-ground floors, is further adjusted by a socalled correction coefficient depending on the size of the municipality where the building is located. Other regulations defined by the law need not be exposited here. Because of the construction of this area-based tax, no assessment (of market valuation) is required and none is undertaken. Calculation of the actual real estate tax payable in the Czech Republic is made by the property owners/taxpayers themselves in a tax declaration. The decisive date is January 1 of the relevant taxation period. The tax declaration is submitted only in case of any changes from the previous declaration; in the remaining cases the tax authority mails payment orders to the taxpayers. If the tax does not exceed CZK 1,000, it comes due for payment as a lump sum on May 31 of the calendar year. If the tax exceeds CZK 1,000, it can be paid also in four equal payments on May 31, June 30, August 31, and November 30 of the calendar year, respectively. The Czech tax administration uses the Automated Tax Information System (Automatizovaný daˇnový informaˇcní systém, ADIS), which provides administrative and technical support with unified technical infrastructure for the entire country’s tax administration. The program provides modules for processing tax returns for individual taxpayers, as well as modules of common sectional activities necessary for the administration, registration, collection and enforcement of taxes, and the transfer of financial funds to entitled recipients. It also provides support modules for the system, including modules for the electronic processing of the documents displayed on the website of the Czech Tax Administration. Taxpayers of the real estate tax can check personal tax accounts and submit documents electronically. The number of electronic submissions grew between 2005 and 2006 from 1,773 to 2,218 (Czech tax administration, 2007, pp. 49–50). Property Tax Incidence The tax is generally paid by the owner of buildings, flats, separate nonresidential premises (hereafter referred to simply as buildings), or land. In special cases the tax may be paid by the user or the lessee of the building or land

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(e.g., on pieces of land where the owner is unknown). If more persons own, or use, the building or land, they are obliged to pay the tax jointly and severally. The scope and impact of the incidence of the real estate tax reflects its minimal burden and very limited variability in the tax rates of different municipalities. However, although the same exemptions apply everywhere, their impacts can vary substantially across municipalities. For example, the above-mentioned 15 years’ exemption of new buildings is perceived as very unfair in rapidly growing municipalities in close proximity to large cities. In such cases, only the old residents pay the tax; the new residents, those who most require new municipal investments or services, are not required to pay the tax. Most of the exemptions are not related to the taxpayer, although a few of them take into account the ability to pay. Those eligible for social welfare (pˇríspˇevek na živobytí) and handicapped people qualify for property tax exemption where they have permanent residency. The tax base and, consequently, the tax revenues of a given municipality change continuously. This may be due, firstly, to changes in ownership as a result of privatization or restitution of properties. But it has also occurred because the Czech Army was professionalized and abandoned some garrisons. It may be due, secondly, to new construction. Unoccupied land becomes buildings or streets, which can be exempt (permanently for roads or temporarily for new residential buildings). As examples of such change, consider two small municipalities on the periphery of Prague that have had no change in their correction coefficients. 1) Dolní Bˇrežany, with 2,284 inhabitants and a total area of 10.6 square kilometers (with 0.27 square kilometers of newly constructed residential housing), had its revenues from the real estate tax decline from CZK 732,000 to CZK 538,000 from 2001 to 2006. 2) Modletice, with 466 inhabitants and a total area of 3.3 square kilometers (with 0.23 square kilometers of newly constructed residential housing) on highway D1 with logistical parks, had its revenues from the real estate tax increase from CZK 863,000 to CZK 3,345,000 from 2001 to 2006. Municipalities have very limited flexibility in setting exemptions or influencing tax rates. They have no right to establish their own exemptions except for recent action permitting them from January 2008 on to issue an ordinance to exempt arable soil, vineyards, hop fields, orchards, and permanent grass plots from the property tax. Currently, they can only influence the tax rate for buildings and land by changing “correction” coefficients. These were established by law in 1992, and they range from 0.3 to 5.0, generally increasing as

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the sizes of municipalities increase. Municipalities are permitted to multiply the taxpayer’s calculated amount due on the property tax by this coefficient. Larger cities could thus charge larger amounts of tax as determined by the coefficient. From 2008 (effective in 2009), municipalities will be able to change all tax rates also by another coefficient set locally (the so-called local coefficient) with values ranging from 2 to 5. We have no data to offer here, but agree with Czech officials who are generally unwilling to believe that there is any major effort to avoid the real estate tax. Because it is a very nominal tax, evasion would seem imprudent. At the same time, the case for moral hazard on the part of the central collectors of the tax has been made. It would not be worth great expense on the part of the central government to enforce, since the additional revenues would be too small to be of consequence. So if there were evasion, the government would doubtless be inclined to ignore it. When one reviews the tax revenues and obligations from 1995 to 2006, one can see that the revenues are equal to or even exceed the tax obligations (see annual reports of the Czech tax administration, 1998–2006, available at http://cds.mfcr.cz/cps/rde/xchg/SID-3EA9846D0AECC542/cds/xsl/325.html?year=0 (accessed March 27, 2010). The tax revenues are very stable in terms of their availability for budgeting. Receipts differ across municipalities, but the share of the real estate tax in total revenues is not highly significant. The elasticity of the property tax with respect to incomes is zero, because of the design of the tax. Going to a market valuation would change this, but the current area-based valuation does not relate the tax to any income consideration. There is no administrative cost for the municipality, since the tax is collected by the central government. The collection cost for the central government has been estimated by Pudil (2004, p. 23). They assess the administration costs of the real estate tax at about 13.3 percent17 of the costs of total tax administration. On the basis of this estimate, the administration costs in 2006 were approximately CZK 976 million, or 19.2 percent of total real estate tax receipts. The average administrative costs for all tax collections, as reported by the Czech Tax Administration, were 1.41 percent. The number of real estate taxpayers is high; there were 3.3 million of them in 2006 (Czech Tax Administration, 2007), or 94,000 more than in 2005. Central Government Administration of the Property Tax Some of the problems associated with the Czech real estate tax are quite general to property tax anywhere. A country must decide first which level of government should administer the tax. Even after the appropriate degree of devolution has been identified, administration of the property tax can be

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quite difficult and costly. Moreover, one often encounters widespread resistance to the tax (see Bird, 1993, pp. 215–216). This is in part due to its high visibility. It must ordinarily be paid as a lump sum directly to the municipality. If inflation requires an upward adjustment of the tax to finance continued provision of the services taxpayers demand, they become keenly aware of both services and costs. Should the services (such as roads, garbage collection, and often education) be of poor quality, the taxpayer wonders why they are so costly. Inevitably, resentment will spread about the tax. It merely adds insult to injury when, for both political and technical reasons, property assessments begin to diverge from market values within classes of property. When taxpayers compare their property taxes with those of their neighbors, a costly process of appeals about assessments begins. It will doubtless be accompanied by growing demands for tax relief. Especially during periods of inflation, widespread disenchantment with property tax increases can be expected, whether higher rates are applied to unchanged assessed values or unchanged rates are applied to higher assessed values. Although the tendency to oppose property taxes is as unpleasant for a tax administration as it is unavoidable, the property tax retains its importance because of the undeniable strengths associated with it. A tax on real property will “make good sense as part of the tax system as a whole . . . the property tax scores quite well in terms of both its efficiency and its equity aspects” (Bird, 1993, pp. 215–216). If fiscal decentralization is the objective for intergovernmental relationships, municipalities require a dependable and autonomous source of revenues that can be harvested independently of the central government. Without such an autonomous revenue source, local government will be less likely to enjoy a measure of independence in policy. Without such a revenue source, municipalities remain too dependent on the central government, or they may be underfunded and thus unable to provide demanded services. Even if the low level of the property tax in the Czech Republic and other transition governments were increased enough to strengthen the fiscal capacity to supply municipal services, local governments would still have insufficient funding to perform all the necessary tasks. Some grants and shared taxes from the central government would still be essential. But autonomy would be strengthened significantly as a result of strengthening the property tax. Genuine self-government is inconsistent with central control over municipal fiscal matters. Kameniˇcková (1996, p. 16) has described the tax system of the Czech Republic as one in which “there are no local taxes.” The central government determines the decisive policy prerogatives of all taxes. Municipalities are, as we observed earlier, able to sell properties or to make loans if revenue falls short. But property sales represent a nonrecurring

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revenue source that will not provide an indefinitely sustainable cash flow, and dependence on loans for normal operations can be hazardous. Evidently, there is little pressure on individual taxpayers actually to comply with the demands of the real estate tax. This inference can be drawn from the fact that the system is characterized by moral hazard (Bryson and Cornia, 2003). The central government has the responsibility to collect the tax, but gains none of the revenues generated by the effort. The lacking incentives result in low and declining revenues for the real estate tax. This is apparent when one observes that the same institutional rules applied for a number of years in both the Czech and Slovak republics, simply because the system was developed before the separation of the two countries in 1993. The Slovak municipalities were much less generously supplied with funds from the center and so were much more dependent on the property tax. Since the municipalities of Slovakia were permitted to perform their own collection of the tax, they worked hard at doing so and their revenues represented a much larger share of local budgets, somewhere around 10 percent. The significantly smaller yield of the Czech property tax would seem to imply that it is not exceedingly difficult to avoid detection for noncompliance or failure to pay in full. For such a nominal tax the Czech government must see it as not economically efficient to put a lot of resources into its implementation or management, although recent years have made the effort appear somewhat more serious, as has been observed above. Still, the implication for the incidence of the property tax is that for the holders of property who pay it, the burden is almost as negligible as it is for those who own no property. A Case Study of the Town Beroun The royal town Beroun lies about 30 kilometers west of Prague on the D5 highway connecting Prague and Nuernberg, Germany, and on the confluence of the Berounka and Litavka rivers. Beroun has 17,99718 inhabitants and a land area of 3,131 hectares (31.3 km2 or 7,736.7 acres). It is a cultural, administrative, and industrial centre of the region. Because its location, it attracts new inhabitants, of which there have been 527 since 2001.19 Many new flats and family houses, new shopping centers, and restaurants have been constructed as the town has expanded in recent years. Beroun is an important center of light and middle to heavy industry after having added an industrial zone in the beginning of the 1990s. The town’s most important employers are Cembrit CZ (a producer of roof tiles), Linde Frigera (a producer of refrigeratˇ ing equipment), PAI (automobile components), and Ceskomoravský cement works, a member of the Heidelberg Cement Group. The town has a number of schools (5 kindergartens, 4 elementary schools), an assisted living home, a cinema, and a library. Established either by the

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region Stˇredošeský kraj or privately are another seven secondary schools, two art schools (both public and private), a language school, two kindergartens, and two special schools. There are also four private assisted living homes. Health care facilities include a hospital, a health center, a rehabilitation center, about 50 other practical and special medical personnel in clinical consulting practice, five pharmacies, and emergency clinic facilities (Czech Statistical Office, 2007). Figure 10.4 describes the development of Beroun’s municipal revenues and expenditures from 2000 through 2006. The rapid growth of

Revenues

Expenditures

600

600 500 500

400

400

300

300

200

200

100

100

0

0

–100 2000 2001 2002 2003 2004 2005 2006

2000 2001 2002 2003 2004 2005 2006 Capital expenditures

Transfers

Capital revenues

Non-tax revenues

Tax revenues

2000 tax revenues non-tax revenues capital revenues transfers

Figure 10.4

Budget balance (surplus +, deficit –)

2002

2003

124.8016 129.6477 132.3458 158.654 52.22275 49.17779 76.51596 51.7786 42.66529 51.26873 2000

current expenditures capital expenditures budget balance (surplus +, deficit −)

2001

189.274

Current expenditures

2004

2005

2006

175.1505 200.4741 201.3892 47.31968 30.02778 25.9031

20.12292 21.86418 34.20386 79.41261 67.63581 60.19151 70.20967 110.0476 265.8381 193.4042 117.1581 133.7189 2001

2002

2003

2004

233.8498

294.5082

437.1007

373.2511

66.21938

23.64897

34.45594

91.47211

15.46493

11.65931

11.80941 −18.0983

283.711

94.64748 100.5732 27.38845

Revenues and Expenditures of Beroun (Millions CZK)

Source: Authors’ arrangement and calculations. ARIS, own calculations.

2005

2006 301.3364 135.7412

31.0115 −15.8749

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both revenues and expenditures between 2002 and 2003 was a result of Beroun’s new status as a municipality with extended functions, helping provide public services for 57 other smaller municipalities. That growth of expenditures and receipts, especially through transfers from the central government, also reflected the town’s reconstruction after a very destructive flood in August 2002. A decline in transfers received between 2004 and 2005 was the result of changes in the financing of elementary education. Higher non-tax revenues in 2002 were due to revenues from insurance. Comparison of the shares of individual types of revenues and of per capita revenues in Beroun and in the CR shows that tax revenues are less important in Beroun than in the average municipality. This is due to Beroun’s greaterthan-normal capital revenues and slightly higher transfers; it also reflects less substantial non-tax revenues. The per capita revenues are about the same for Beroun as the national average for all municipalities. A comparison of real estate tax revenues as shown in Table 10.4 reveals that Beroun, in accordance with tax policy, has a reduced tax coefficient. The tax is assessed and collected by the Revenue Authority in Beroun (Finanˇcní úˇrad v Berounˇe) for the municipal budget. Czech law grants municipalities very limited authority to alter the specifications of the centrally designed real estate tax. These rather consistently applied real estate tax provisions, however, do not mean that the tax provides very stable revenues. Variable receipts are the result of continuous changes in the tax base, changes in ownership (Beroun has privatized housing and other immobile property), and various exemptions in the law. Thus one observes in Figure 10.5 that tax revenues in Beroun are subject to considerable variation. In the years 2000 Table 10.4 Revenue Comparison between Beroun and the Czech Republic Beroun

CR

Share in total revenues • Tax revenues (%) • Non-tax revenues (%) • Capital revenues (%) • Transfers (%) Total revenues per capita (CZK)

47.8 6.1 14.3 31.7 23,652

54.2 9.6 6.4 29.8 23,507

Property tax • Per capita (CZK) (%) • Share in total revenues (%) • Share in tax revenues (%)

290 2.6 1.2

485 3.8 2.1

Source: Authors’ arrangement and calculations. ARIS, Czech statistical office.

Toward the Close of Transition in the Czech and Slovak Republics

●

5.0%

5.4

4.0%

5.2

3.0%

5

2.0%

4.8

1.0%

4.6

Millions CZK

182

4.4

0.0% 2000

2001

2002

2003

Real estate tax (millions CZK)

Figure 10.5

2005

2006

Real estate tax/tax revenues (in %)

Real estate tax/total revenues (in %)

Real estate tax (millions CZK) Real estate tax/tax revenues (in %) Real estate tax/total revenues (in %)

2004

2000

2001

2002

2003

2004

2005

2006

4.70252

4.99392

4.6577

5.1064

4.81076

4.75133

5.17195

3.8%

3.9%

3.5%

3.2%

2.7%

2.4%

2.6%

1.7%

1.9%

1.4%

1.0%

1.0%

1.1%

1.2%

Real Estate Tax Revenues in Beroun

to 2006 reported in the figure, tax receipts went in the same direction for at least two years only, in 2004 and 2005; otherwise, they changed direction each reported year. Property tax revenues as a share of total municipal tax revenues were only about 2.5 percent to 3.5 percent. As a share of total municipal revenues they amounted to somewhere between 1 percent and 2 percent. Until December 31, 2007, municipal discretion over the property tax was maintained through only two local options: they could alter the tax coefficient and make exemptions for those, in this case, affected by floods. Beroun took advantage of both options. After January 1, 1999,20 they applied lower coefficients than originally mandated by the law (i.e., 2.0), with the coefficients varying from 1.0 to 1.6 in different parts of the town. In 2003 all properties verified as damaged by the flood were exempt from the tax.21

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Conclusions As seen in Beroun and the other municipalities of the Czech Republic, the real estate tax is calculated for land and building plots and is collected by the center and redistributed to the appropriate municipalities. It is recorded, it is paid, and it enters into the national and local statistics each year. But its existence makes little difference in terms of the funds it provides for public services, or the autonomy of local officials who have few resources to effect expenditure decisions after the major and more pressing expenditures have been made, and a good number of public service demands remain unsatisfied. The tax represents only a miniscule amount of revenue, and policymakers are not prepared to consider the political changes that would make it a meaningful tax. Theoreticians have a feeling for the tax, for its potential for revenues, for its positive welfare characteristics, and for the independence it can deliver to local governments with an incentive to provide the unique mix of public services people in the locality prefer. But their case has never been made to the satisfaction of the Czech public or of Czech public officials. Nor is there any indication on the horizon that the day will come when the tax menu will be adjusted so that some other form of tax becomes less burdensome, the real estate tax becomes more significant, and the municipalities of the Czech Republic become politically more independent. The recently approved changes in the law—for instance, the local coefficient—may increase the revenues from the real estate tax but not dramatically. However, it will be interesting to observe the mayors’ willingness to increase the tax and directly bear the political costs associated with it. Much has happened on the fiscal scene in this country since the transition to democracy and market economics was initiated in late 1989. But the expressed intent to pursue fiscal decentralization has never been realized. Motions have come before the Czech Parliament, reform movements have been undertaken with the blessing of the EU, and that community has accepted the Czech Republic as a member. But none of the political changes or reforms appear to have accomplished a true devolution of power. That has certainly not had any catastrophic implications for the citizens of the republic. Many Czechs and many Europeans do not feel that there is a great need to achieve fiscal decentralization. The tiny municipalities have expressed unequivocally their demand for an independent existence. But neither they nor the larger municipalities that do have personnel and financial resources have ever insisted that the central government give them greater autonomy to act with independence. The republic is small and the people in the finance ministry and in the parliament are competent; perhaps small countries should be able to manage

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everything from a single city, if not from a single computer. Perhaps preferˇ ences in Liberec are not significantly different from those in Ceške Budjeovice or Ostrava, so that decisions made in Prague are perfectly appropriate and applicable for all those and other Bohemian and Moravian cities. Perhaps it is not important that a decision on the salience of fiscal decentralization for the republic has never been reached. The events and vicissitudes that might have produced local autonomy seem to have come and gone. And for this country, as for much of Europe, a strong degree of centralization is neither feared nor eschewed.

Appendix to Chapter Ten Table A.1

Public Budgets, National and Local, of the Czech Republic, 1993–2006 1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

GDP, current price 1,020.4 1,182.8 1,381.1 1,683.3 1,811.1 1,996.5 2,080.8 2,189.2 2,352.2 2,464.4 2,577.1 2,814.8 2,987.7 3,231.6 (billions CZK) CG expenditure/ 33.2 32.6 31.5 34.3 31.7 32.7 31.7 31.1 34.0 34.6 35.1 32.2 31.6 30.4 GDP (as %) Social insurance 4.7 5.7 5.7 5.4 5.3 5.3 5.4 5.3 5.4 5.8 5.9 5.7 5.7 5.4 funds/GDP (as %) LG expenditure/ 8.8 9.5 9.6 12.2 9.9 9.8 9.2 9.6 10.1 11.0 13.3 12.6 11.8 12.0 GDP (as %) Notes: (1) Central government (CG) expenditures include the state budget and the state funds. The social insurance funds (i.e., health care insurance) are reported separately. (2) Until 2000, local government (LG) included municipalities and districts; after 2001, municipalities and regions. (3) 1993–95 data on public expenditures use the GFS methodology; data since 1996 on the ESA 95 methodology; data for the GDP since 1996 are revised. Source: Authors’ arrangement and calculations. GDP: Czech statistical office. Data published since 1996 is available at the ministry’s web site. For data up to 1995, see Statistická roˇcenka 2001, available at http://www.czso.cz/csu/2001edicniplan.nsf/publ/10n1-01-2001 (accessed April 13, 2010). For expenditures up until 1995, see Macroeconomic Forecast, October 2000, p. 31. For expenditures since 1996, see Fiskální výhled (Fiscal Outlook), October 2007, pp. 48–49, available at http://www.mfcr.cz/cps/rde/xbcr/mfcr/FiskalniVyhled2007Q3 (Table 5.1, accessed March 27, 2010).

185

186

Table A.2

Czech Municipal Finance, 1997–2006 1997

1998

1999

2000

2001

2002

2003

2004

2005

57,424 3,943 4,457 21,110 9,624 21,924 9,888 128,371

63,737 4,108 4,254 22,879 13,167 19,796 9,354 137,295

67,636 4,248 3,795 23,921 36,684 21,509 10,819 168,612

74,899 4,436 4,249 24,368 16,313 28,195 9,094 161,555

78,803 4,569 5,459 22,650 10,517 47,028 13,719 182,745

86,967 4,571 8,008 23,448 11,468 55,457 16,158 206,077

93,373 4,828 9,292 22,487 11,869 80,899 18,830 241,577

101,215 4,919 9,978 23,051 11,040 77,726 18,223 246,153

112,666 4,966 11,267 22,470 13,249 44,641 16,317 225,577

113,857 4,974 11,838 23,020 15,472 48,734 23,121 241,017

As a percentage of total revenues Property tax (%) 3.1 Shared taxes (%) 44.7 Own revenues (%) 75.2 Grants (%) 24.8

3.0 46.4 78.8 21.2

2.5 40.1 80.8 19.2

2.7 46.4 76.9 23.1

2.5 43.1 66.8 33.2

2.2 42.2 65.2 34.8

2.0 38.7 58.7 41.3

2.0 41.1 61.0 39.0

2.2 49.9 73.0 27.0

2.1 47.2 70.2 29.8

Shared taxes Property tax Other tax revenues Non-tax revenues Capital revenues Current grants Capital grants Total revenues

Source: Authors’ arrangement and calculations; ARIS.

2006

CHAPTER 11

Slovakia’s Surge: The New System’s Impact on Fiscal Decentralization∗ Introduction Well into its economic transition, the Slovak Republic has only recently begun to diverge in substantive ways from a path of joint development with the Czech Republic. Although the two countries shared a lot of common experience through the central planning era and even into the transition period up to the Velvet Divorce of 1993, subtle but durable differences going back to the period before World War I have remained a part of their diverse cultures. In the Austro-Hungarian Empire, the Czechs had developed a more industrial and centralized society than the Slovaks, whose associations during that period were with the Hungarians. This article attempts to show how that early tradition is currently being reasserted in the fiscal relations between central and subnational governments in the Slovak Republic. Public sector foundations of Czechoslovakia’s transition to market democracy were modeled to some extent on West European tradition. After such institutions were established in legislation, the Czech and Slovak republics agreed in 1993 to go separate ways. The Velvet Divorce opened the way for divergent fiscal developments, but for the first decade of the separation there was not much divergent activity. This chapter will report on the more recent Slovak efforts to pursue just such changes. ∗

This chapter was published as Phillip J. Bryson and Gary C. Cornia, “Slovakia’s Surge: The New System’s Impact on Fiscal Decentralization,” Post-Communist Economies 18, no. 4 (December 2006), pp. 437–457. The publisher, Taylor & Francis (website: http://www. informaworld.com), has kindly granted permission to republish this article.

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Efforts to establish fiscal decentralization in Slovakia go back to the very beginnings of the republic. Although such efforts were not always impressive in either country before the pre-accession process for EU membership began, they should be considered the foundation of the Slovak Republic’s New System. As that process continued, both republics became committed to “reforms of public administration” and to move from two levels of governance—central and municipal—to four levels. They prepared to submit themselves to governance from Brussels and also to add a regional level of government to assist in providing public services. Legislation provided for the necessary institutional changes in both countries, but in Slovakia the reform of public administration was seen as a complement to rather than a substitute for fiscal decentralization. The public administration reforms were also a part of the foundation, although in some respects they also constitute a part of the superstructure of the New System. The first section of this chapter will review the initial elements of fiscal decentralization in the Slovak Republic with special reference to the property tax as a potential source of “own revenue.” The next section addresses the divergent development of the two republics in spite of the initial institutional similarities of their fiscal decentralization programs. The reforms of public administration are addressed in the next section, along with the implications of the Slovak introduction of the “single tax” and the introduction of the New System’s local finance measures implemented at the beginning of 2005. A consideration of the macro effects of the New System and the resurgence of economic growth in the Slovak Republic follows. The final section provides summary and conclusions. Fiscal Decentralization in the Early Slovak Transition From 1918 to 1993 Slovakia1 was an unhappy partner in Czechoslovakia. With the end of World War II democracy faltered and the union continued as a Soviet-type Socialist Republic. Since late 1989, and after the end of the Soviet Union, the Warsaw Pact, and the Council for Mutual Economic Assistance (CMEA), the Slovaks, along with the Czechs, have been developing democratic market systems. But it is important to consider the fiscal foundation of local autonomy. It would have been logical to utilize the property tax and local user fees as revenue sources for the provision of municipal services based on local preferences. This would have been a natural part of reestablishing local autonomy after the long era of heavy centralization. But an effective property tax must be based on the market value of property, since the market is a non-arbitrary reflection of the incomes and the preferences that determine property values. A property tax system based on market real estate values is just now becoming a reality in Slovakia. For economic and political reasons,

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a normally functioning real estate market, like the new market system generally, has been developing only gradually. Legacies of the socialist era and constraints on the privatization of property have not been the only roadblocks. Early in the transition, the Slovak central government preferred to ignore local self-government, postponing the dramatic progress that was to emerge later. Nevertheless, transition reform efforts launched after the Velvet Revolution were rather successful. In 1992, without any formal consultation with the Slovak people, political leaders unilaterally decided to abandon the federation. Slovak leaders rejected any partnership with the Czechs, along with the Czech preference for a rapid transition to a market orientation.2 Both before and after the opening of the reform era, the Slovaks were substantially less comfortable with departure from the order and security of the Soviet ways than were the Czechs. As one would expect, however, the Slovak self-government and fiscal systems continued for a time to resemble those developed jointly with the Czechs before 1993. In the aftermath of the Velvet Revolution, both republics permitted municipalities to seek independence from some of the forced amalgamations of the previous era. Under socialist rule, local autonomy had largely been lost. From 1950 until 1989 decisions about the quality and type of public services were made by central governments in Prague and Bratislava. District governments existed during this period only to implement and facilitate the policies of the central government. Local government activity was also limited almost exclusively to such “state administration” activities. We should remember that the economic transition of these countries followed hard on the heels of an era in which centralism had been rather absolute. Funding decisions had been based on political and party influence and evinced no close relationship to the needs or demands for public services, especially in the area of capital expenditure. The central government provided many local services, for example, police, public utilities, fire protection, and education. Socialist systems also provided a number of services rarely provided by Western governments, including housing, which was produced and managed by the central government just as medical care was. Still, permitting only rather symbolic local government actually ran counter to Slovak tradition and inclination. When the transition era began in 1989 local governments increased in strength and number. There are currently 2,781 of them, and only a few have a population in excess of 50,000. The majority of Slovak municipalities have fewer than 500 inhabitants, and many have less than 100. Comparing the number of municipalities per 10,000 inhabitants in Central and Eastern European countries reveals that Slovakia has significantly more cities than other countries in the region (except for the Czech Republic, of course).

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The diminutive size of Slovak and Czech municipalities raises the question whether they have sufficient personnel and resources to administer local government effectively. Several supportive organizations have assisted in the development of a professional core of local public managers. About 125 of the cities in the republic have created the position of city manager to assist Slovak elected officials in their management functions. There is also an organization of city finance directors, whose operations are similar to those of the Government Finance Officers Association in the United States.3 In Bratislava, the Association of Cities and Towns of Slovakia (Združenie Miest a Obci Slovenska, ZMOS) represents local governments in their interaction with the central government. This association is similar to those of numerous other countries; it has over 2,700 members and thus represents over 95 percent of Slovakia’s municipalities.4 Decentralization Difficulties and the Property Tax in Transition Countries Overcoming the legacies of central planning has proved to be a difficult and slow process.5 And to say that local governments have often remained underfunded is a euphemism. Having no significant sources of independent funding, municipalities have had to wait for transfers and grants from central governments often struggling financially themselves. Central governments have generally been unwilling to abandon the centralist traditions of the previous era, which implies a policy preference for indirect and nontransparent taxes and for public services that provoke no substantive political opposition. Citizens of the localities have been disinclined to pay for public service provision; they have preferred funding through transfers from the center rather than from local taxation. Central governments are certainly not always unwilling to transfer resources to local governments, but they do have a penchant for retaining control over the programs funded (both as a matter of reflex action and governance philosophy). As the transition began, the citizens of transition countries were not always opposed to rather sparse provision of public goods, since they anticipated a larger and more readily available assortment of the private goods that they perceived to be common to market economies. Thus, they tacitly accepted their local governments’ unwillingness to pursue any substantial efforts to charge fees or impose property taxes that could finance a greater abundance of public goods based on these independent sources of revenue. As a result, local officials were rarely forced to confront their constituencies with taxes to fund needed services. When Czechoslovakia began to decentralize its fiscal system in 1990 legislation borrowed heavily from Western Europe, adopting taxes prevalent

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there without reference to whether they might prove optimal for transition countries or whether that system could generate revenue sufficient for their needs. Since the end of communism fiscal crises have been common in the transition countries and transfers of funds from the center have been insufficient to cover needs. Municipalities have been unable to enjoy genuine autonomy, because they lack sufficient sources of independent revenue. The property tax, potentially a most important source of independent local revenue, remained strictly the nominal tax that it had been under central planning. So it could not provide revenue at levels that would have promoted the autonomy of municipal governments. In the transition period the four most important revenue sources for the Slovak Republic have been the familiar value-added tax (VAT), the personal income tax, corporate income tax, and an income tax on unincorporated businesses. All of these are collected by the central government, and when they are shared with local governments, the problem of attached “strings” weighs upon municipal independence. Being dependent on these taxes (only the value-added tax produced revenue that was not shared with local governments) made the municipalities more or less completely dependent fiscally on the central government. After the Velvet Divorce, institutional inertia and preoccupation with other problems kept either republic from making substantive changes in its identical fiscal systems for some time. Ostensibly, pre-accession motivation provided by the EU convinced the Slovak Republic to launch its recent, bold reforms. But before that time the differences between the two fiscal systems were not great. The Slovak fiscal system was less inclined toward centralization than its Czech counterpart, although both countries emphasized a desire to achieve decentralization and to develop self-government (samospráva) for their municipalities. Property Tax Rate and Base Let us begin by reviewing the original transition system of intergovernmental finance that was already in place at the time of the Velvet Divorce. In this system, property tax policy was established by the central government and national legislation, but the day-to-day administration of the property tax was largely the Slovak municipalities’ domain. This contrasts with the Czech situation in which the central government collects the property tax and redistributes the revenue to the municipalities. The taxation of land was based on the area of each individual parcel; similarly, the taxation of buildings was based on the number of square meters of a structure’s floor space, including the land area under buildings. The tax rate was established separately for the two kinds of properties. In the property tax

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formula, adjustments are made for the location of land and buildings and for the particular utilization of the unit taxed. These modest, largely symbolic efforts to take account of market characteristics are a genuflection to market valuation. Of the 11 Slovak classifications of land, eight adjusted the assessed tax value for the quality of the land, which was estimated by the Ministry of Agriculture. The data collected on quality and potential productivity were remarkably detailed. Parcels in close proximity sometimes had substantial differences in estimated productivity. In the transitional property tax system basic tax rates ranging from SKK 1 to SKK 10 per square meter (adjustable annually) were applied to six classes of buildings ranging from residential to industrial. The basic rate increased by SKK 0.75 for each floor. The tax on buildings allowed for two additional adjustments: ●

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Data on the size and type of a building could be multiplied by a population-based coefficient, which for the largest cities was greater than for the smallest towns by a factor of 4.5. The local administrator could apply a final coefficient to the formula evaluating a building’s location within the city. This could increase or reduce the tax bill by as much as 50 percent, giving city administrators a modest degree of flexibility in taxing for differential location qualities.

Prior to the New System, data on per capita land and buildings taxes revealed a pattern of significant revenue generation in Slovak municipalities. With increasing municipal size, per capita revenue from the tax on land declined continuously. For tax on buildings, per capita tax revenue increased continuously with a municipality’s size. For larger cities, in other words, the tax burden was shifted more to structures. The implications of that fact were important, because real estate is a resource that cannot be removed from a region to avoid the tax. Of course, one can move away from a home or a business to avoid the additional costs imposed by such a tax. But the costs of doing so may be quite prohibitive compared with the costs of avoiding other taxes, for example, an excise tax, by simply deciding not to purchase the taxed article. In any case, the real estate tax is underutilized in Slovak cities, keeping badly needed revenue below its potential level. Moreover, although there was doubtless an intent that these taxes would be borne by businesses, in selling to local inhabitants the tax burden would ultimately be shifted to consumers. The property tax law of the Slovak Republic granted explicit exemptions for state-owned, cultural, religious, and other such properties. An exempt owner of commercial real estate was taxed at a rate of about one-third of that

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for commercial organizations. In the larger cities exemptions have represented a substantial portion of the potential property tax base, thereby severely limiting the revenue capacity of the tax system. Implementing a tax system with the capacity to generate a significant portion of the revenue needed for public services and then undermining the program with exemptions is clearly self-defeating. In pursuit of a presumed objective to promote private housing construction, explicit 15-year exemptions have been granted in Slovakia for newly constructed and recently renovated homes. Since the property tax base and rates of the transitional system did not produce a large yield, the incentive effect of this policy had little actual significance. Buildings restituted to former owners were also relieved of property taxes for a 15-year period. In the transition system local governments were responsible for the collection of property tax data and the tax itself. They relied on the centrally operated cadastre for information pertaining, for example, to the ownership of properties. Specific information on land areas is available from the cadastre, but that agency is of limited help in identifying land. Since it does not record information on building size, it can obviously provide no assistance in assessing the tax on buildings. In the Slovak property tax the municipality-taxpayer relationship has been fraught with asymmetric information. Information laws have prevented the municipalities from verifying important information through the cadastre, rendering them dependent on the taxpayer for information about taxable land and buildings. Despite this problem, the finance ministry has not publicized any concerns about property tax compliance. Restructuring the fiscal system to increase property tax yields in a substantial manner, however, would likely produce a compliance problem. It should be no surprise, therefore, that changes in property tax laws proceeded only gradually in the transition era. One might expect that with an area-based tax there would be a close relationship between the area of a plot or building and the tax revenue either would generate. Interestingly, this is not always the case in Slovakia.6 The rubric “area-based” merely distinguishes this tax from one based on market value; it does not imply that other variables play no role in the determination of tax revenue. Certain classes of land are taxed far more heavily than others; building plots in all Slovakian cities produce more revenue per square meter than arable land or forests. The same holds for taxes on improvements— industrial and commercial buildings produce much greater revenue per square meter than agricultural or apartment buildings. Apparently, the heaviest tax burden has been on commercial and industrial activities, or on capital. Smaller towns and cities were inclined to tax building plots more heavily

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than arable land; probably seen as less productive of revenue than farm land, forests were subject to even less tax than the former. This fairly extensive review of the early-transition, administrative property tax system has been designed to show what a stark contrast the New System introduced at the beginning of 2005 represents. The Property Tax and Municipal Budgets in the Transition If fiscal decentralization is to succeed, local governments must have access to an autonomous source of tax revenue, rather than be dependent on the center for all their revenue.7 The visibility of the actions of local public officials, both elected and appointed, is generally greater than that of national officials. The accountability of such officials logically increases with that visibility8 and makes a strong case for local governance and local tax. The property tax embodies positive characteristics recommending it as a local tax. Since taxpayers cannot evade it by engaging in transactions beyond a relevant political border, it is immobile. The imposition of this tax is similar in effect to a lump-sum tax and does not induce changes in the level of utilization of the services of taxed properties. An excise tax can affect the quantity of sales, with an impact on the price of a product; in contrast, the property tax is considered a neutral tax. Since it provides fairly constant revenue yields regardless of the state of the business cycle, it is stable. Relevant taxpayers are more likely to have the means and the ability to pay the property tax, since they are homeowners and property holders. This is in contrast to the case of highly popular yet regressive excise taxes, which generally represent a larger portion of lower than of higher incomes. If local public services improve and enhance property values, it is appropriate that the beneficiaries, the property holders, are required to pay for the increased value. Finally, as a direct tax, it is highly visible to taxpayers.9 There is a large literature on fiscal decentralization that could be further cited here, but let us simply note that the sources presented in this paragraph also provide substantial numbers of references explicating these now widely accepted principles of taxation. The visibility of the property tax mentioned above is a two-edged sword, of course, which has both advantageous and disadvantageous effects. Since it is direct and visible, citizens and officials are less comfortable with the property tax than with indirect taxes.10 Generally, both officials and citizens prefer excise taxes and local fees on a variety of transactions.11 Too frequently, local officials feel the heat of political problems the property tax can provoke.12 Fiscal decentralization can succeed only if the following three necessary conditions hold. First, there must be a correspondence between the expenditure responsibilities of local governments and the availability of financial resources. Second, incentives must be provided for subnational

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governments to mobilize their potential resources in the pursuit of autonomy. Third, the provision of transfers from the center must be transparent and based on objective and consistent criteria rather than negotiation and ad hoc bargaining.13 It becomes apparent that the implementation of an effective property tax regime requires close attention to institutions of governance. In countries where time and good judgment have permitted these institutions to develop properly, however, local governments have obtained the rewards of political autonomy. Moral Hazard Problems in Property Tax Administration Principal-agent conflicts can be expected when central and subnational governments share the “ownership” (in terms of policy prerogatives rather than revenue receipts) and the administration of the property. Conflicts arising from incentive incompatibilities rooted in property rights arrangements are common in transition countries, largely owing to the very divergent perspectives and incentives of local and central governments. Moral hazard problems arise when agents pursue their own interests rather than those of the principal. In Slovakia the property tax is the design of national policy, but it is collected by the municipalities themselves. There is no malingering in the collection effort of the local governments, since the revenue is badly needed. Since local authorities are in charge of the revenue-raising effort, they cannot malinger and the citizens can monitor those officials simply by observing what kinds of revenue and expenditure they generate. The significance of these institutional arrangements is apparent when contrasted to the Czech case, where the local government basically acts as the principal and central government acts as the agent. The center both designs policy and collects the tax, so that the local government principal can receive such property tax revenue as the central agent’s collection efforts provide. Not being in a position to monitor the collection effort, subnational governments can only hope that the center will exert significant effort. The data show that revenue from these taxes is in fact suboptimal, because the center lacks incentive to exert the effort and resources required to increase the yield. Smaller property tax revenues, however, can easily be offset by greater sharing of other taxes or revenues from other sources. This is certainly the case in the Czech Republic, where relative to other transition countries the central government has not been a poor provider. The Czech finance ministry would argue that the local governments do not attempt to achieve anything like optimal receipts, since they set their property tax coefficients such that their receipts are only about half what they

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could be.14 But this should be expected from the structure of incentives. Why should the locals push for greater property tax revenue when they can neither collect the revenue nor monitor the collection? Why irritate local taxpayer acquaintances, friends, and neighbors with property tax when other funds will be provided. The fact that strings are attached to such funds is nothing new; local officials have lived with such conditions previously. It is also a form of moral hazard when local government officials, acting as (insufficiently monitored) agents for the citizenry, the true “principal” in a democracy, fail to exert honest effort to produce the revenue required for the public services that citizens demand. Once municipalities become financially dependent on the central government, they become quite willing to avoid full financial responsibility by tacitly partnering in extant principalagent arrangements. They become comfortable permitting the center to take all the responsibility for raising municipal funds, thus avoiding any potential political heat that a serious property tax might generate. It is easier to conform to central guidelines, mandates, and directives than to take a stand for local preferences that clearly differ from those of the center. Still considering the Czech case, other moral hazard issues also emerge with central government revenue transfers. For example, if the distribution of resources is badly skewed across subnational governments, or if subsidies encourage local governments to pursue activities of high priority to the center, fiscal redistribution becomes very tempting.15 But transfers from the center may simply offset revenue that could have been raised locally. If the central government compensates the municipality for the property tax funds that it has failed to collect, local officials can act less transparently. Because the Slovak central government was initially far less generous in providing transfers, Slovak municipalities had to take advantage of the opportunity to collect property tax revenue for themselves. From the 1960s until the end of central planning, Czechoslovakia’s local governments derived roughly 60 percent of their total receipts from subsidies. From around 1984, however, central government subsidies began to decline. This trend extended into the transition. Although there was a brief expansion of transfers in 1990–1992, the decline continued. After the mid-1990s subsidies represented no more than about 25 percent of the total receipts of Czech and Slovak municipalities.16 The data for the transition period reveal the relevance of these moral hazard considerations. They are reviewed comprehensively for the period of transitional finance in the two republics from the end of central planning to 2000 by Bryson and Cornia.17 They show Slovakia’s municipalities to be substantially poorer than those of the Czech Republic. After the Velvet Divorce in 1993, Czech municipal budgets were more than twice as large as those of

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Slovakia. This was at least partly a result of per capita differences in grants from the respective central governments. By the end of the period, per capita public services expenditure for Czech citizens was three times greater than that for their Slovak counterparts. Local budgets in Slovakia were only about 14 percent of the total national budget, while those of the Czech Republic ranged from one quarter to just over one-third of the national budget. The difference in municipal grants shows why Slovak municipalities were comparatively quite poor. Grants in Slovakia ranged from SKK 1.5 billion in 1993 to SKK 1.1 billion in 1994. Central government grants to the Czech municipalities ranged from just over 27 billion in 1993 to CZK 59.5 billion in 1996. (One should keep in mind, of course, that the population of the Czech Republic is twice as large as that of Slovakia, but also that the CZK will purchase 1.2 to 1.25 SKK.) Interestingly, in the two years (1991 and 1992) preceding Slovak independence, Prague provided grants of 7.9 billion and 2.4 billion crowns, respectively, for Slovak municipalities. Thus independence from the Czechs turned out to be a shock for the municipalities of the Slovak Republic, for it cut them off from the Czech central budget. In that period Slovak municipalities also learned that Meˇciar politics separated them from the Slovak central budget. Prime Minister Vladimir Meˇciar, preoccupied with what the political opposition termed the “family privatization” of Slovak industry, had no interest in helping solve the financial problems of Slovak towns, cities, and regions. They knew they could expect no significant transfers or grants from Bratislava. Since they had far less substantial financial support from the central government, Slovak municipalities were much more diligent in their efforts to harvest property tax yields, and the property tax represented a significantly larger share of the total revenue of local governments. Using data from the finance ministries of both republics, Bryson and Cornia18 calculate that for the years 1993–2001 the real estate tax in Slovakia provided from roughly 11 percent to 18 percent of the revenue for municipal budgets. On average, property tax revenue represented a share of about 15 percent of the total receipts of Slovak municipalities. In the Czech Republic, with larger municipal budgets, the real estate tax ranged from 3.28 percent of total municipal revenue up to a maximum of 4.8 percent. Although property tax revenue was relatively small in 1993, the trend was toward even smaller receipts thereafter. The Slovak municipalities clearly demonstrated greater effort in collecting the property tax. The municipalities of the Slovak Republic enjoyed a much smaller share of total national budget receipts. Whereas the Czech municipalities received a share of around 30 percent of total governmental receipts, Slovak municipalities received only around

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6 percent (from 5.67 percent, the minimum, in 1999, to 7.7 percent, the maximum, in 1996). Given their relatively less favorable financial situation, it is no wonder that Slovak municipalities attempted more diligently to harvest greater property tax revenue. Both republics struggled in the transition era with periodic fiscal crises, the result of which was often a reduction in municipal revenue. The Czech government was relatively good about avoiding unfunded mandates, but it retained strong influence over the use of centrally provided funds, thus inhibiting local autonomy. The Slovak municipalities had little to work with, but seemed more independent with what revenue they did receive. Beyond the Transition Era: Emergence of a New Fiscal System in Slovakia Foundations of a new system were laid in Slovakia in the period preceding accession to the EU in May 2004. The emphasis of the EU during that stage was not on fiscal decentralization for the two republics but on a related action, the reform of public administration. In marked contrast to the Slovak case, the Czech Republic was interested in little more than a honing of organizational arrangements in its reform of public administration. The emphasis was on the creation of the new regional level of government. The goal of the reforms was to modernize central administration and provide “territorial public administration” to improve the quality of the public sector’s products as a whole.19 Regional governments are ostensibly to “bring state administration to the people” (pˇriblížit statní správu obˇcan˚um), involving rank-and-file citizens in subnational governance processes. But the question whether the reform of public administration could effectively serve as a substitute for municipal autonomy, that is, for fiscal decentralization, was not really addressed. While pursuing the mechanics of such organizational questions, the Czech finance ministry and political apparatus were busy developing a more modern social welfare state than the well-known version of the central planning era. The Soviet system provided pensions and health care and wages for a large national bureaucracy, of course, but these were all on the cheap. Health care costs were very low because the wages of health care personnel were very low and high-tech equipment was not an important part of the system. Since the transition began, two processes have been proceeding simultaneously: on the one hand, costs have begun to rise dramatically; on the other, the government has been trying to reduce the “entitlement costs” of the communist system of public goods provision (e.g., providing public transport and housing at nominal costs). But in keeping with the newly adopted model in Western Europe, the higher costs of the pensions and health care and higher salaries and wages

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of government workers, things all vastly more expensive than they had been under communism, the central government began to run large budget deficits and accumulate a growing burden of debt. It has long since recognized the impossibility of coping with an indefinite expansion of public expectations and commitments and is now desperately seeking ways to increase national revenue. The reality of the macroeconomic situation is that it will be necessary to reduce expenditure in the next few years. Unfortunately, this appropriate, even essential, focus on the national budget has at the same time removed the focus of the finance ministry and the political system from the municipal situation and the process of fiscal decentralization.20 Decentralization and the Decline of State Administration in the Slovak Republic In pre-reform Slovakia, as in the Czech case, elected municipal officials performed samospráva (local self-government). In a separate office, agents of the central government performed municipal state administration activities and programs. An inference as to the resources committed by the central government to finance and administer local affairs assigned to the center constitutionally can be made from employment figures. Before the reform of public administration in 2000, state administration employed 287,817 Slovak citizens. That represented 84.7 percent of total government employment. Only 52,100 were employed in self-government at the local level, which was only 15.3 percent of total government employment. After implementation of the reforms, employment in state administration declined from ca. 85 percent to 37 percent, while the number employed in local self-government increased from ca. 15 percent to 63 percent.21 In 2001 the total expenditure of local offices of state administration (in other words, of the central government for their local jurisdiction) were nearly twice as high as those of the local governments themselves. Perhaps without external pressure from the EU, Slovak public officials would still not have recognized the necessity for a reform of their centralized institutions. From their perspective, state administration represents little more than the state’s appropriate resolution of the problem of very small municipalities being unable to provide for their own management. The Reform of Public Administration: Foundation or Superstructure of the New System? With the EU’s encouragement, Slovakia gave much more free play to political players, the more progressive elements of the post-Meˇciar era, who were very inclined to move toward market decentralization. The reform of public

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administration and the New System were almost simultaneous phenomena. The former introduced regional governments and other institutional changes and the New System changed the taxation and finance systems, both being complementary developments building upon the efforts to achieve fiscal decentralization. The conception and design of the Slovak reform of public administration was introduced by an official paper22 listing the areas that would continue to be performed by local state administration after the reform. The central government will accordingly continue to provide for local police, criminal investigation, military administration, the state veterinary office, the state hygienist office, the environmental office, the cadastral office, the land and forest office, the social office, and the tax office. This is an imposing list of activities for which Slovak municipalities and regions will continue to have neither responsibility nor managerial prerogatives. As explained earlier, the Slovak municipality, within its range of ceded responsibilities, received little funding but rather liberal managerial authority throughout the transition era. The Slovak national government intended this situation to change, and the reforms have been bringing about the desired change in a striking manner. Reforms are also moving the municipalities toward substantive change. The Slovaks recognize what such change requires and that a modification of organizational forms alone cannot be an effective substitute for fiscal decentralization. Effective governmental organization and fiscal decentralization are policy complements rather than substitutes. The Slovak central government conceded23 that decentralization of public affairs must include “decentralization of functional responsibilities, decentralization of finances, decentralization of political power.” The complex process of decentralization is only effective “if it is implemented in all three dimensions at the same time.” The public administration reform comprises four processes: changing the territorial arrangement, reforming extant institutions and creating the new regions, decentralizing public finance powers and competencies, and modernizing the system’s legislative framework and management. One should keep in mind that the fiscal reforms to be discussed in the next section were closely related to the overall reform effort pursued over a period of several years. Nižˇnanský and Pilat cogently present the entire transition era as a pursuit of multifront reform.24 From the perspective of this chapter, the New System’s ramifications for local finance are of particular importance. Structuring the New System While they were reforming, Slovak leaders wanted more than marginal organizational change. They considered their economic future imaginatively and

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were prepared to implement significant additional adjustments. At the same time, one should not overlook the fact that Slovak economic development in the transition era has sometimes been stronger in relative terms than one would have supposed, especially considering its political situation through the Meˇciar era. The initial economic successes Slovakia experienced in its independence era were due in large measure to a mini-boom in exports. Prosperity and expansion in Western markets provided demand, and Slovakia successfully made the transition from its links to the old CMEA markets to the important EU markets. Sensible monetary policy kept inflation within bounds, and although development was spotty, leaving some regional unemployment levels high, progress was fairly steady. The introduction of reforms around 2000 came after the initial momentum of independence had waned. The Slovaks were now ready to introduce some striking policies, including a “flat tax” also adopted in Russia, the Baltics, and elsewhere. The main provisions of Slovakia’s 19 percent flat tax have been widely discussed; the finance ministry has spelt out the details of the New System,25 but its main provisions certainly deserve our attention here. From a general perspective, the principal objective of the reform was to achieve fairness and simplicity while eliminating double taxation.26 The key provisions of the New System at the national level were as follows: introducing a flat rate of income tax at 19 percent, both for corporate and personal incomes; adopting that same percentage rate for the valueadded tax; increasing consumption taxes to slightly above minimum required EU rates; abolishing taxes on dividends, on the assignment and transfer of real estate, and on inheritances and gifts; introducing a higher personal deduction for the taxpayer and a tax credit for children; and abolishing many exemptions, deductions, and distortions on efficiency in income taxation. Here it should be said that the common level of taxation would appear to be regressive—high and very high incomes being required to pay no greater income share in taxation than very low incomes (although the Slovak Republic modifies this by allowing a level of nontaxable income before the 19 percent tax applies). The basic justification is expressed well by Krajˇcír and Ódor,27 who cite the unfortunate rule in economics that “the size of the cake does depend on the manner in which it is sliced . . . people lose more of the motivation to work and to engage in entrepreneurship when each additional koruna earned is taxed heavier than the previous koruna.” Of greater concern are the design and impact of the New System at the level of subnational governments. One of the main changes initiated on January 1, 2005, as announced by the Ministry of Finance28

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was the elimination of the former method of making an annual allocation announcement in and through the State Budget Act concerning the amount of tax revenue to be transferred to the municipalities. This process was “unstable” and did not permit the cities and towns to engage in effective planning until after the announcement had been made. The new system is expected to stabilize the flow of revenue to local governments and give them an opportunity to engage in multiple-year financial planning. The finance ministry also announced that the personal income tax had now become an own source of revenue for both regions and municipalities. Of the total revenue from this tax, municipalities were henceforth to receive 70.3 percent and the regions 23.5 percent. Only 6.2 percent of its revenue was to accrue to the national budget.29 The basic reform idea was that henceforth roughly one-third of municipal revenue would come from personal income tax transfers, one-third from grants from the central government and the EU, and one-third from municipal own revenue, that is, from the property tax, local user fees, and privatization of publicly owned assets.30 Local governments also received the right from January 1, 2005 to set “tax rates” (a term applied, interestingly, not only to the real estate tax but apparently also to the very limited number of user fees and local taxes already extant) and to introduce new “taxes.” The municipalities received full discretion to adjust those old system rates and apply exemptions according to their own preferences. These are measures of genuine fiscal decentralization, but it is potentially even more important that the municipalities were also given policy control over the property tax. The applicable legislation pertaining to real estate taxation came into effect in January 2005.31 It transfers the responsibility for establishing binding regulations on rates of taxation for land, buildings, apartments, and nonresidential premises to local self-government bodies. They are to be set according to the specific local conditions of municipalities. The law thus voids the utilization of centrally established coefficients related to the specific use and area of the land and structures taxed. One perspective on the role of the property tax in the New System32 is that it was motivated in part by the realization that the share of revenue from property taxes had been considerably lower in the Slovak Republic than in numerous OECD and EU countries. As a result, the ministry intended to strengthen that tax. First, the state denied itself any right to specify the uses to which revenue from the real estate tax was to be put. Also, the donation tax, the inheritance tax, and the real estate transfer tax were eliminated as part of the tax reform.33 The objective of the new Act on Real Estate Tax was to create a legal basis for transparent taxation of real estate based on market valuation.34

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For the moment, the central government does not envisage strong increases in revenue from the real estate tax. With the passage of time, it will probably be possible for municipalities actually to implement increased property tax rates of their own (as the legislation asserts). Interestingly, the ministry’s own Financial Policy Institute has noted that “the planned valuation of real estate for the purposes of calculating real estate tax is also a step in the right direction; however, the question remains whether the related administrative costs will increase so much as to result in a net loss for the public finances.”35 Thus it would make sense to cover the relevant administrative costs by permitting the substantive property tax increases that appear now to be officially legal. The Transition within the Transition: Applying the New System It should be observed that in the short time since the inception of the new system, the property tax has not become a more important source of revenue. There have been no plans to increase revenue from this source in budgets to 2007. Early in the year of its inception, the municipal self-government appeared to have gained by these new developments. At the same time, resources seemed no less scarce at the municipal level. As the changes in rules came into effect, the larger cities felt that they gained less through the change than some of the smaller ones, but institutional change in resource allocation often produces winners and losers, requiring some modifications or institutional accommodation to the changed system. The Government of the Slovak Republic36 made its own statement of policy intent promising to protect the interests of taxpayers. It promised it would increase the tax revenue of municipalities and define the tax revenue of regions in such a way as to ensure that the tax burden on individual taxpayers and businesses would not be increased. This was to be accomplished by the creation of a special law “containing the definition and structure of tax revenue for municipalities and higher territorial units and criteria for their redistribution to municipalities and higher territorial units’ budgets.” This intended assurance does little for the proponent of fiscal decentralization, since that concept seems threatened when the central government defines tax structures for subnational governments. The finance ministry’s perception37 was that the reform of public administration and the changes connected with the accession of Slovakia to the EU were the driving forces behind the creation of the new, comprehensive legislative framework developing the budgetary process for the public sector. The finance ministry documents evince a far less distinct tone of centralism.

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A Tentative Assessment of Reform Effects The new system as applied to local governments has been in the implementation phase for only about two years at the time of writing. It is too early to say how effective the new system will be, although it is clear that the effect will depend on both the macro impact of the new national tax system on the national budget and the ability of the municipalities to leverage their new policy prerogatives into enhanced tax receipts. Since the initiation of the new tax system at the national level late in 2003 Slovakia’s economic performance has improved. The improvement has been the focus of international discussion. The republic’s recent growth rates have been strong at 5.5 percent in 2004, finishing at 5.8 percent for the final quarter of the year.38 Growth in 2005 increased beyond expectations to 6 percent, coming at a period of low growth throughout Europe generally. The IMF39 and OECD40 has found Slovakia’s strongly increased output expansion laudable and notes that the country’s fiscal and external imbalances have declined considerably in recent years. The increased transparency and greater incentive compatibilities, usually attributed to the reforms, have helped improve the business climate and attract foreign direct investment. Real GDP expanded by 4.5 percent in spite of a contraction in domestic demand in 2003. But increased activity in the domestic sector and accommodating macroeconomic policies permitted real GDP growth beyond expectations in 2004 and 2005. Further progress is still badly needed; employment gains have been uneven across sectors over the period described, and unemployment remained very high at 17.75 percent. The World Bank agrees with this assessment,41 but observes the need for Slovakia ●

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to achieve fiscal consolidation supportive of appropriate public finance management, to complete ongoing reforms in health, pensions and public finance, to develop income levels convergent with those of Europe by achieving trade competitiveness in EU and world markets, and to reduce poverty and unemployment, partially a function of Roma marginalization and the east - west development gap in the country.

In the long term these achievements may be feasible if Slovakia can continue its currently strong economic performance. Data from the Statistical Office confirm the recently strong growth, but putting it into temporal context is interesting. Table 11.1 provides temporal perspective by showing annual GDP growth from 1993 to 2004 in both current and constant

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Table 11.1 Slovakia, GDP growth, 1993–2004 (Constant prices, 1995 = 100)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Current prices

Constant prices

411,366 495,649 576,502 638,449 712,679 781,437 844,108 934,079 1,009,839 1,098,658 1,201,196 1,325,486 1,439,792

512,849 544,674 576,502 611,935 640,151 667,107 676,919 690,697 716,845 749,937 783,406 826,493 876,283

Growth over previous year (%)

6.20 5.84 6.15 4.61 4.21 1.47 2.04 3.79 4.62 4.46 5.50 6.02

Source: Štatistický úrad Slovenskej republiky and the authors’ own calculations.

prices, the latter removing the inflationary bias to provide an indication of real growth rates per annum, as indicated in the last column. These numbers show the recent positive economic performance, but are not unequivocal regarding growth as a response to the stimulus provided by Slovakia’s recent New System of national and local finance. Nor can they yet show, more specifically, that recent growth performance is a response to tax reductions. Since economic growth had been strong in the early transition period to about 1999, the return to over 4 percent growth in 2002 could be interpreted simply as some kind of economic recovery. Although European economies were largely stagnating in the slower years of Slovak economic growth from 1999 to 2002, and the U.S. recession was going on, it is not likely that this slowdown was simply cyclical. Such an explanation, however, might explain why Slovakia, in an economic environment influenced by the stagnation of some important EU players, likewise entered into a slower growth phase. It does not explain why a simple recovery beginning in 2000 and 2001 restored the Slovak Republic to its previously high growth rates in the stagnant environment responsible for the slowdown. That leaves it necessary to consider the notion that growth over the past two or three years was a function of economic stimulus arising from reduced taxes and increased foreign direct investment in Slovakia. The Slovaks see the flat tax as a stimulus for foreign direct investment and seem convinced that the tax reform should also be a catalyst for other structural reforms no

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less important to the foreign investor, who is particularly interested in the improved business milieu.42 Crediting the New System with ending the period of sluggish growth, however, does not explain what it was that made the country perform well in the earlier transition period under the old fiscal system. Such an explanation might lean on Slovakia’s reaping the benefits of a successful shift from trade with CMEA markets to EU markets, along with positive economic conditions and expectations in the region during the early transition period. These things were followed by a boom in the U.S. economy and the stimulus that phenomenon provided to the world economy in the late 1990s. Our concern here, however, is less with the macro performance of the Slovak economy in this period than with the budget performance. It is of interest for the present study that growth in the macro economy has not yet translated into higher general budget receipts. From the perspective of the Slovak government, the rationale for the New System would have to be that the elimination of some taxes and the reduction in tax levels should provide growth stimulus sufficient to offset the reductions. The finance ministry website indicates that targets for individual types of tax revenue after the implementation of the reforms were generally met. Overall, however, examining accumulated revenue and expenditure makes it appear that the growth of revenue has not matched government expenditure or general growth. The third column of Table 11.2 shows accumulated monthly receipts, while accumulated expenditure is shown in the fourth column. A simple calculation of the growth of budget receipts and budget expenditure yields results that are interesting to compare with GDP or general economic growth. To make the measurements comparable, the data are taken in current prices. We observe that government revenue from 2003 to 2004 grew at the rate of only 4.01 percent, while GDP grew at the rate of 10.35 percent, again in current prices. (Without adjusting to constant prices, we overstate growth proportionately for the general economy as well as for budget receipts and expenditure in the period in question, some of the growth being accounted for simply by price increases). So budget receipts did not grow as rapidly as the economy as a whole, reducing the advantage of the rapid economic growth from the perspective of the public sector. It is important to note, as the Slovak Republic currently struggles with national deficits and debt, that policymakers managed to bring the growth in expenditure (8.21 percent) more in line with the increased GDP growth, although it was still a little less than the growth of the economy. Whether this rate of growth of expenditure seems justified or appropriate, it still contributed to deficits and debt, since it exceeded the more modest growth rate of revenue of only 4.01 percent.

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Table 11.2 Slovakia: Budget and GDP Growth, 2003–2005 (Million SKK, Current Prices) Year 2003 2003 2003 2003 2007 2003 2003 2003 2003 2003 2003 2003 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2005 2005 2005

Month 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3

 Revenue



22,300 31,800 46,400 67,008 79,100 100,900 127,700 147,100 163,400 186,800 203,600 233,100 21,031 36,394 66,945 98,132 109,176 120,695 139,126 153,715 172,840 195,858 213,675 242,444 24,644 39,789 65,0463

Expenditure 24,000 44,800 64,200 91,600 109,600 128,600 158,800 180,200 201,100 227,200 246,400 289,000 23,689 40,818 65,770 92,409 111,446 133,150 157,677 178,501 202,262 226,386 247,753 312,732 20,334 40,897 62,246

Source: Plnenie Štátneho Rozpoˇctu, Ukazovatele Ekonomickeho Vývoja, Štatistický úrad Slovenskej republiky, 2005, http://www.statistics.sk/.

Summary and Conclusions The relatively strong start to transition Slovakia enjoyed did not translate into well-being for local governments. In this period, characterized as one of fiscal decentralization, municipalities had to work very hard to generate local revenue, which was done mostly through energetic collection of property tax revenue, the imposition of centrally specified local user fees and the privatization of state-owned assets transferred to municipalities at the beginning of the transition. The reforms of public administration, undertaken in the period prior to Slovakia’s accession to the EU, were followed closely by the adoption of a

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new system of national and local finance that caught wide attention because of the elimination or reduction of many of the country’s taxes, both national and local, and the adoption of a flat tax, or a common rate of 19 percent, for corporate and personal income tax, as well as for the value-added tax. It was hoped that this new system would encourage investment (both domestic and foreign) and stimulate economic growth. The economic growth rate did increase substantially, which was unusual given the sluggish conditions prevailing in most of Europe at the time. One might postulate that the growth of the past two or three years is just a return to an earlier, normal level of performance. But that explains neither why the early transition growth rates were not maintained nor why they were recently resumed. It seems reasonable, as was suggested in the previous section, that the original growth period ended with the incentive incompatibilities of the old finance system, the loss of early transition momentum, and the lack of dynamism in Europe in general. Growth momentum was regained when reforms were given renewed vigor early in the present decade. And growth is expected to continue. Prognosis updates performed by the Ministry of Finance confirm that the economy of the Slovak Republic can achieve a high growth in the next few years, with an average annual rate of about 5.4 percent. The growth is believed to be sustainable because of the qualitative economic changes achieved in terms of total productivity growth. Expected GDP growth for 2007 exceeds the 6 percent level in 2005 because of the expected economic growth of important trade partners of the Slovak Republic, because of the effects of foreign direct investment inflows, and because of the expected impact of greater transfers from EU programs. The recent local government provisions of the New System are bold and consistent with the changes made at the national level. They do in fact provide municipalities with greater opportunities to find their own way financially, which will enhance their political autonomy. Nevertheless, local governments remain fiscally challenged. As the state assigned the lion’s share of personal income tax receipts to local governments, it simultaneously transferred the responsibility to them to fund a large proportion of the education programs previously funded nationally. But greater opportunities were also provided for subnational governments (regions had been added to territorial samospráva) to act with greater fiscal autonomy. The state will not permit municipalities to expand local property tax efforts in a manner that will increase the overall burden of Slovakia’s taxpayers, but municipalities do have opportunities to function much more independently. The use of such independence could ultimately open the way for a substantial and badly needed increase in the revenue-generating capacity of subnational governments in the future.

PART IV

Financial Crisis and Global Recession: The Impact on Europe, the Czech Republic, and the Slovak Republic

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CHAPTER 12

The Global Crisis: Origins and Arrival in Europe∗ Introduction In recent years, the global finance system has undergone fundamental change through the development of modern technologies. This change was largely a product of financial innovations in the United States, but those innovations affected markets globally. The effects became painfully apparent when a credit crisis quickly spread across the world economy and became a global recession. That phenomenon is of interest to this book because of its impact on Europe, especially on the Czech and Slovak republics and the intergovernmental fiscal situation in these countries. In this chapter the origins of the crisis and its spread to and impact on Europe are reviewed. In the next two chapters, the specific effects of the crisis on both the Czech Republic and the Republic of Slovakia are addressed. Financial innovations made it possible in the United States not only to provide credit for low-income borrowers but also to provide loans to individuals with higher incomes who wished to invest in housing. Riskspreading finance techniques and loosening credit seemed reasonable at the time, since the ever-rising prices of homes vouchsafed increasing ownership equity; moreover, it provided the possibility for owners to refinance to avoid any financial stress that might arise. This chapter will briefly review the new financial know-how that made it possible to offer mortgages to greater shares of the American consumerate. ∗

I wish to express my gratitude to Grant McQueen and Hal Heaton of the BYU Finance Department for their tutorial and editorial assistance with this chapter. If I had heeded all their suggestions, the product would possibly have been error free. But I must retain responsibility for any remaining errors.

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Some of the inadequacies of the new finance structures will be reviewed, and it will be shown why the resultant housing bubble ultimately produced a financial crisis, which in turn created a serious recession as it spilled over into the real economy and spread globally. The Technologies of Subprime Housing Finance In the housing boom preceding the global credit crisis, risky mortgages were not viewed as terribly hazardous because of the use of sophisticated financial technologies. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to borrowers who represent greater risk to lenders. To find those lenders, mortgages were packaged as security derivatives or “risk-spreading” instruments. Securitization involves the pooling and repackaging into securities of financial assets that produce cash flows. This structured finance process involves the sale of those securities to investors. The originating bank or savings institution transfers mortgage titles to a “special-purpose vehicle,” a specialized institution that places a large set of mortgages into a package and issues “mortgage-backed securities” (MBSs), which represent claims on the returns earned by the whole package of mortgages. This process transfers the risks of mortgage finance from the originating institution to the specialpurpose vehicle and to the holders of the mortgage-backed securities. It was therefore possible for local real estate agents to sell mortgages in the anecdotal case to clients without income, employment, or assets, to collect the commissions, and to ship the mortgages off in an asset package to be purchased in securities markets, possibly even by Asian or European investors. In principle, those with finance sophistication find that shifting the risk away from the debtor and the originating institution is reasonable because (1) securitization eliminates some risk through diversification and (2) the remaining risk is transferred to the low-cost providers. Securitized subprime mortgages were financed in securitization tranches, bundles of securities representing different risk classes and often sold as collateralized debt obligations (CDOs). These often appeared on the books as market value off-balance sheet instruments.1 Derivatives of real estate mortgages produced additional subprime risk as lower-income mortgage holders would be less likely to keep the revenue stream flowing for holders of the securities. When the housing bubble burst, most investors could not penetrate this maze of securities, derivatives, and off-balance sheet vehicles so as to determine the location and size of the risks. CDOs are a type of structured, asset-backed security (ABS) whose value and payments are derived from a portfolio of underlying, fixed-income assets.

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CDOs were assigned to different risk classes, or tranches, of which the safer “senior” and “mezzanine” tranches were further removed from the risk. Junior tranches offered higher coupon payments (interest rates) or lower prices to compensate for the inherently greater default risk. Thus, interest and principal payments were made in order of seniority. As trading of the new mortgage “assets” proceeded globally, the prices of housing ultimately did the unthinkable: they ceased to rise. As mortgage foreclosures became an ever larger and more visible problem, trading in securitized mortgages ground to a halt. The Panic of 2007 arose (Gorton, 2008) when “toxic assets” in the portfolios of banks and investment banks could no longer be traded. There was insufficient information for investors regarding the extent of the risks of loss associated with those assets; no one knew what their value was or what their prices should be. There is, of course, no problem with high-risk loans per se, so long as they are priced correctly. It became painfully clear that nobody really knew what value such assets really had once a significant share of the mortgages on which the assets were based had not been paid. The market pricing mechanism, due to defaults and a lack of transparency on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages, ultimately failed. Presumably, the defaults of mortgages and the MBSs and CDOs deriving their value from mortgages should only harm those who invested directly in those assets. But CDSs (credit default swaps), permitted the mortgage contamination to “jump” to banks and insurance companies. Hence, Murphy (2008) sees the credit default swaps as playing an important role in the disaster. Conceptually, credit default swaps are rather straightforward insurance instruments. They mandate that the insuring party pay a fee to insure the debts of some corporate institution against default for a particular time period. They are not specifically labeled debt insurance contracts, because their intent is to avoid the regulation normally imposed on insurance transactions. Moreover, many of the transactions in CDSs, where the purchaser had no direct ownership interest in the object of the transaction, more closely resembled wagers on any particular firm’s survival. With life insurance, the death benefit is paid upon the death of the insured; with CDSs, the benefit is due when a borrower fails to make interest payments. Life insurance is regulated and insurers are required to hold reserves to pay out benefits when due. With CDSs, insurers were neither regulated nor required to hold reserves, since Congress felt that the investment banks, insurance companies, and commercial banks were seasoned performers who required no governmental hand-holding or oversight.

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When subprime borrowers defaulted and the prices of the collateral on their loans (housing prices) fell, investment and commercial banks and insurance companies were required to pay out the “death benefits,” but did not have the necessary reserves. So institutions that did not directly hold subprime mortgages or have indirect exposure through MBSs and CDOs were brought down because they had provided insurance to companies that did have exposure to the tainted assets. A second path for the spread of housing/subprime mortgages from the financial to the real sector was through government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. The preferred stock of these GSEs, being backed by the federal government, appeared to be very safe investments. Many banks, interested in getting 1 percent or 2 percent more on their investments, invested in the preferred stock of Fannie and Freddie. When the subprime loan defaults hit the GSEs, the price of their preferred stock crashed and many banks that had felt perfectly safe had to write down quite drastically the value of their investments and reserves. Without reserves, the banks were unable to make loans and the crisis had moved dramatically from the financial to the real economy. Powerful but questionable theoretical modeling (Hellwig, 2008 and Murphy, 2008), based unfortunately on unrealistic assumptions,2 led to serious problems in pricing CDSs in their massive, unregulated market. With the benefit of the hindsight that came with the financial crisis, it is now apparent that such CDSs were underpriced and could never adequately have covered the inherent risk associated with the mortgages involved. But the feeling of being “insured” played an important role in getting investment agents to purchase the securitized mortgages. The whole system ultimately imploded because of the catalytic increases in residential mortgage defaults. The banks that had purchased MBSs and CDOs wished to count these investments as part of their reserves. Bank regulators demanded that they do so only if they purchased insurance against defaults (CDSs). The banks dutifully did so, purchasing insurance from, for example, American International Group (AIG), which did not have the reserves to cover the unexpected defaults on mortgage-based assets. The unregulated market for credit default swaps grew astronomically from $900 billion at the turn of the millennium to over $50 trillion in 2008. With the rapid growth of the mortgage market, it would have been very difficult to market financial instruments that grew out of mortgage securitization without a means to insure against the potential losses. The availability of CDSs was one more reason to up the pace of mortgage creation and securitization without taking the time and expense to pursue due diligence for investors. CDO investors could accept uncertainties in part

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because such mortgage-backed securities were often insured against losses from default by AIG and other such institutions, using credit default swaps. Once the market collapsed, insuring firms were responsible for the coverage of trillions of dollars in tainted assets; the financial losses involved exceeded the resources of any financial institution other than the U.S. Treasury. Credit default swaps were perceived to be risk-free, since the insuring parties, including banks, federal mortgage agencies Fannie Mae (FNMA) and Freddie Mac (FHLMC), and insurance companies such as AIG, Active Mass Balance Auto Control (AMBAC), and Municipal Bond Insurance Association (MBIA), were generally granted the same (highest possible) credit rating as the U.S. Treasury at Aaa (Murphy, 2008, p. 8). A few academics, analysts, and investors warned that CDOs, other ABSs, and derivatives actually just spread risk and uncertainty about the value of the underlying assets more widely. They did not actually reduce risk through some kind of diversification. With the onset of the 2007 credit crunch, this view quickly gained adherents. Credit rating agencies, widely trusted in the bubble phase to obviate any necessity to perform due diligence, failed adequately to account for large risks, for example, the collapse of housing values across the United States, when they rated CDOs and other ABSs. The problem, once again, was that the new financial system had had no experience, empirical or otherwise, with the risks and contingencies that made the brave new world vulnerable. In the run-up to the financial crisis, all still seemed right with the world. Monetary policy provided low interest rates and filled the business environment with optimism; mortgage finance opened the way for broader participation in the housing market, which offered ever-higher housing prices and greater equity for homeowners. Relaxed lending standards opened the gate to homeownership to everyone, and attractive capital gains tax rates provided astonishing economic stimulus to home investors. From 2000 to 2003, mortgage loan originations grew at an incredible average of 56 percent per year from $1.05 trillion to $3.95 trillion in just three years (Gjerstad and Smith, 2009). But in August 2007, financial markets and institutions worldwide were hit by catastrophic developments stemming from problems in the performance of subprime mortgages in the United States. Financial institutions began to write off losses of many billions of dollars, euros, and Swiss francs. Liquidity disappeared from financial markets and stock markets plunged. Central banks began to provide hundreds of billions in funds to banks and financial institutions in support of those markets. The Fed increased the money supply and the Treasury bought the preferred stock of banks.

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A paper by Hellwig (2008)3 analyzes the causes of the financial crisis, with emphasis on the systemic elements that turned the subprime mortgagebacked securities crisis in the United States into a worldwide crisis, although the United States is only one part of the global financial system. These results were caused by both identifiable, faulty decisions and flaws in the architecture of the financial system that to some observers suggest regulatory reform. Such reforms would require going beyond the issues of individual incentives and supervision to consider how to address problems of systemic interdependence and transparency. After the onset of the crisis, market agents became increasingly pessimistic and market valuations of securities continued to decline. Earlier in banking, many of the write-offs would not have been taken at all. If a bank declared it would hold a loan or mortgage to maturity, it would have held the loan at book value so long as the debtor was deemed solvent, without consideration of what the current market valuation of the security might be. These contemporary write-offs are an artifact of the modern mark-to-market, or fair value accounting seen as part of risk management and bank regulation. Hellwig (2008, p. 5) finds it remarkable that this accounting system is used “even in situations where the markets in question have broken down.” In the housing markets, subprime loans were originated by institutions that did not generally retain equity tranches of the portfolios they had generated; with the passage of time, increasingly larger portions of mortgage-based assets were sold to outside investors. The actual probabilities that the senior and mezzanine tranches would go into default were high, since the mortgage packaging did not provide for sufficient diversification of returns on mortgage-backed portfolio assets (Hellwig, 2008, p. 16). The problem in these markets was that property values are a function of common as well as asset-specific factors. The latter, including geographic location or neighborhood characteristics, will generally be independent and can be diversified away. Common factors, such as susceptibility to interest rate changes or changes in macroeconomic conditions, are not subject to disappearance even under diversification. These common factors affect all real estate properties at the same time, so they unavoidably introduce a correlation into the default risks associated with different mortgage securities. As a single example of something that may depress property values, an interest rate increase enhanced the prospect that the loss of equity in borrowers’ property might make them prefer to walk away rather than to continue to pay their mortgage. Because of these correlations, diversification in the portfolios underlying the mortgage-backed securities was less effective, and the risk of default for senior and mezzanine tranches proved to have been vastly underrated.4

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Not surprisingly, as credit problems began to multiply, they were concentrated in the subprime segment of the market: Hellwig estimates delinquency rates at roughly 25 percent (10 percent to 12 percent for Alt-A mortgages, those worthy of an A rating or loans that have less than full documentation, and 1 percent to 2 percent for prime mortgages). Although they represented only 7 percent of the total outstanding mortgages, adjustablerate subprime mortgages accounted for roughly 39 percent of all foreclosures. Fixed-rate prime mortgages, on the other hand, representing 65 percent of all mortgages, accounted for only 18 percent of foreclosures. It is difficult to avoid the conclusion that the doubling of the foreclosure rate from 2007 to 2008 was largely a consequence of the earlier growth of subprime lending. In Hellwig’s view (2008, p. 19), these striking numbers do not prove that the system went astray. They do indicate a relaxation of credit standards and an expansion of lending to riskier borrowers, which gives rise to the speculation that there was moral hazard in the origination of mortgage loans. He points out that an advocate of the expansion of subprime lending would probably argue that earlier credit standards had been too restrictive and had denied home ownership benefits to an excessively large share of the population. The subprime lending era expanded the share of Americans living in their own homes from approximately 63.4 percent to nearly 69.2 percent. This line of argumentation finds little sympathy, however, since it has become evident that these loans should not have been made. By the summer of 2007 it was becoming apparent that the credit rating agencies had incorrectly assessed the risk factor associated with tranches of securitized mortgages and the securitization of already securitized mortgages. In that summer, those agencies frequently downgraded by multiple grades, suggesting that the analysis underlying the previous ratings had been fundamentally flawed and that, at last, the rating agencies had come to realize this (Hellwig, 2008, p. 25). The misjudgment of risk seems also to have been in part a result of the view that the ability of individual borrowers to service their debt was not of such great significance when the collateral property for the loan was continually rising in value (Hellwig, 2008, p. 25). Before 2006, increases in the property price probably more than offset the declining quality of mortgage borrowers. However, the assumption that property appreciation reduces credit risk in mortgage contracts tends to render the assessment of default risks more optimistic than is justified, especially when the property appreciation itself is overestimated. A related problem is encountered when the assessment of default risks between the different borrowers is overly optimistic. This occurs when one fails to take account of the common factors driving real estate prices. Both these flaws were at work when real estate prices

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in the United States began to turn down in 2006 and delinquency rates on recently issued mortgages rose to levels not previously observed. From 1996 to 2005, mortgage fraud had increased almost twenty times over the 1996 rate. It grew from 1,318 reported cases in 1996 to 25,989 reported cases in 2005. Annual rates of increase went from approximately 30 percent for the years 1996 to 2002, before leaping to 77 percent in 2003, 93 percent in 2004, and 41 percent in 2005. The financial crisis was the result of reckless behavior, but systemic interdependence was also a very important part of the problem. Participants did not know how great a risk they were being exposed to through systemic interdependence. Risk taking now considered excessive was a result not just of recklessness but also of insufficient information and understanding of systemic risk exposure. The Financial Crisis and the Global Recession By the time the financial crisis had become a leading news topic, the real economy was ready to get started with the long-awaited recession. The economy had been fundamentally sound to that point; low interest rates and easy credit kept things moving relatively well. The housing market was on hold and the construction industry ready to turn south when trading in tainted assets stopped globally. Investors immediately started to sell, and stock markets plunged everywhere. Because of the large losses accumulated through the acquisition of such assets and in a market full of dread and mistrust, credit dried up. Financial institutions expected that their borrowers could disappear or go under before repaying their loans. Moreover, the lack of reserves hindered lending after banks marked their tainted assets to market. When businesses could not get loans for short-term transactions needs, they could no longer make payroll or provide credit for their own customers. The response was immediate layoffs, signaling to multitudes of workers that their jobs might be in danger. The curtailment of consumption on the part of those either laid off or anticipating the loss of their job meant a rapid decline in sales, production, and economic growth. And one very important sector was already in recession when this recognition arrived. Housing and construction were the first sectors of the real economy to feel the impact of the financial crisis (Mayer, Pence, and Sherlund, 2009). The mortgage market showed its first signs of trouble in mid-2005, after which conditions deteriorated. Mortgage payments that were either more than 90 days past due or loans that were already in the process of foreclosure averaged 1.7 percent of the aggregate of such loans from 1979 to 2006.

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By the third quarter of 2008, the share of “seriously delinquent” mortgages had increased to 5.2 percent. These delinquencies preceded an expected sharp rise in foreclosures. Approximately 1.7 million foreclosures were initiated in the first three quarters of 2008, which represented an increase of 62 percent over the 1.1 million in the first three quarters of 2007 (Mayer, Pence, and Sherlund, 2009, p. 27). The recession then spread from the financial to the real economy and from this sector to other sectors. Financial Crisis, Recession, and Policy Responses U.S. economic policy attacked the recession aggressively. Without great effect, the Federal Reserve reduced interest rates to stimulate business activity. After developing a plan to buy tainted assets from major banks and struggling through two attempts to get it through congress, the U.S. Treasury then decided instead to infuse capital into banks by buying preferred stock. This policy seemed to help. The third policy approach was the fiscal stimulus package passed by Congress in 2009. The full effects of the package would not be known for some time, because of the lags between the spending allocations by Congress and the actual undertaking and completion of the many diverse projects involved, some of which might actually prove stimulative. With determination similar to that of U.S. policymakers, “stimulus packages” were introduced around the globe. The assumption was that in the face of consumer uncertainty and reluctance to spend, government spending designed to fill at least part of the consumption gap would increase incomes and employment by some Keynesian multiplier effect. That view has dominated in the United States and is also the position taken by the IMF (Spilimbergo et al., 2008). The position seems, interestingly, to ignore the disappointing experience with fiscal policy that led more or less to the abandonment of the Keynesianism of the 1960s. The amounts of the stimulus packages individual countries announced (UN Department of Economic and Social Affairs, 2009) aggregated to $1.9 trillion. The concern was expressed that they might prove too small to overcome a crisis of such scope. They amounted to more than 3 percent of world gross product, but because they were to be initiated over the next few years, their combined immediate impact could be smaller than required. A less publicized minority position (Barro, 2009) suggested that the design of the U.S. spending package was not likely (with its poorly targeted and often irrelevant spending components) to produce significant multipliers. Others join Barro in their criticism (Cogan et al., 2009), referring to the nonrobustness of the quantitative models evaluating fiscal policy.

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The Recession Arrives in Europe The Global Spread of the Financial Crisis of 2007–2009 In recent decades, the advanced economies have experienced waves of capital account liberalization, which drove the development of extensive cross-border asset trading (Lane and Milesi-Ferretti, 2008, p. 327). Financial assets originated in a small number of countries, first the United States, then the Netherlands, Spain, Italy (Mizen, 2008, p. 537), the United Kingdom, and Ireland. But they have since been traded by many countries; the investment community has long since been a global one. It was inevitable that the U.S. contagion, which crippled asset trading in 2007, would spread to Europe. We saw above how the crisis “jumped” from the financial to the real economy. This section will show how the contagion spread to the global economy. We will consider the role played by the euro in facilitating financial change in Europe and its integration into the global financial economy. New financial tools also facilitated the modernization of global capital markets. How and why the crisis spread to Europe will be discussed, focusing on EU members, both those that do and those that do not use the euro, the countries whose currencies were battered by the flight of capital after the credit crisis began and those whose currencies were dumped in a flight to “safe-haven” currencies. The important role of foreign trade in the spread of the recession is addressed. Also considered are the problems of the East and Central European countries that leveraged housing and economic development by loans from large Western European banks. The fiscal and other crisis policies of the different countries, of the EU as a whole and of other European and global finance institutions, such as the IMF, are reviewed.

The Crisis in Europe Financial Innovation and the Euro Monetary union in Europe and the rise of the euro have facilitated the integration of money and credit markets across the member countries of the EU. A much greater degree of substitutability between domestic and foreign securities across the European area is the result of eliminating currency risk among the member countries. This development contributed to a significant reduction in “home bias” and stimulated an expansion of financial trade across the euro area (Lane and Milesi-Ferretti, 2008, p. 328). The empirical results of Rahman and Khan (2009) also provide evidence of significant convergence

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among the stock markets of Germany, France, and Italy during the euro era relative to the prior period with net positive causal effects. Most of the European financial markets have been open markets in recent decades. The economic and finance literatures have long argued that trade openness and financial openness should go hand in hand (Obstfeld and Rogoff, 2001; Obstfeld, 2007), and if the literature has not driven the reality, it has certainly described it. From the perspective of risk sharing, there are benefits to be derived from international portfolio diversification. It is likely that trade linkages also improve information flows, thus generating greater willingness on the part of increasingly sophisticated agents to invest more readily in foreign assets. Default risk diminishes through tighter trade integration, and trade transactions directly produce cross-border financial flows in the form of such trade concomitants as export insurance and trade credits. The development of institutions and penchants favoring trade and capital flows within and beyond Europe assured that its countries would enjoy their benefits and endure the hazards of such flows. After a period of prosperity, the crisis arrived. Iakova (2008) reported for the IMF that a confluence of adverse shocks depressed economic activity in Europe after the onset of the 2007 crisis and that a gradual recovery was not expected until late in 2009. An easing of inflation associated with the slowdown allowed policies to focus on ameliorating the downturn. The IMF, like other international institutions, had pleaded for coordinated crisis management measures to help stabilize the global financial system. Meanwhile, the economic slowdown in the 16 euro currency nations continued to deepen. Output contracted by 5.8 percent in the fourth quarter of 2008, the worst performance for those countries since World War II. The IMF forecast was that the euro zone economy would shrink by 3.2 percent in 2009, somewhat more than the 2.6 percent contraction expected for the United States (Perry and Fidler, 2009). Rémond-Tiedrez (2009) of Eurostat, the Statistical Office of the European Communities, documented the decline in production in Europe after the onset of the financial crisis. Attention turned to real economy reductions in output as the financial crisis generated fears of a deep global recession. She used short-term business indicators to trace recent developments in a range of output measures across industrial, construction, and services sectors of the European economy. The results confirmed a considerable downward trend in output across a wide range of activities and across almost all of the 27 member states. Gross production remained unchanged in the second quarter of 2008, but there was a 0.2 percent quarter-on-quarter reduction in the EU-27’s GDP in the third quarter of 2008. This decline was followed by a 1.5 percent reduction in the fourth quarter.

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One of the most striking features of the decline in EU-27 output was the severity of the reductions at the end of 2008. Production of consumer durables and nondurables fell by 11.1 percent and 3.9 percent, respectively, between August 2007 and November 2008. Over the same period the output of capital goods and intermediate goods contracted by 9.3 percent and 11.0 percent, respectively, between February and November 2008. In the boom phase, during the credit splurge, housing and asset prices had bubbled. Double-digit growth was not unusual for housing prices, which accelerated to reach around 30 percent on an annual basis in Poland, Bulgaria, and Slovakia and over 25 percent in Russia. The boom in real estate then sparked a boom in consumption generally. Consumer spending rose quickly and household savings rates plunged, just as they did in the United States. The end of that era came with the credit crunch, which quickly staunched global capital flows. Housing and other investment assets purchased with foreign currency sank in value. One reads in the media of the consumer credit binge in several (especially East) European countries, but the corporate sector was no less willing to enjoy cheap, foreign-currency debt. By mid-2008, corporate nonfinancial, foreign-currency debt had exceeded 45 percent of all corporate liabilities in Bulgaria, over 30 percent in Ukraine and the Baltics, and over 20 percent in Hungary and Russia (Roche, 2009). When capital flows reversed, the bubble burst and local currencies began to sink on foreign exchange markets. The countries of Eastern Europe were left with huge deficits in their external accounts and massive amounts of foreign debt. Eastern European households had assumed large foreign-currency mortgages, often denominated in Swiss Francs. Companies with large foreign-currency debt began to default. The potential net losses are huge. They will represent large shares of GDP in several countries, ranging from around 5 percent of GDP in Russia, Romania, and Turkey, up to 6 percent in Poland and the Czech Republic, and from 8 percent to 10 percent in the Baltics, Hungary, and Bulgaria. Such losses would exhaust foreign-exchange reserves in Latvia and deplete those of Hungary, Turkey, Poland, the Czech Republic, and Ukraine by approximately 40 percent. International Trade as the Distributor of Recession The EA-16 countries had been very strong trade partners in the first seven years of this decade. Before the onset of the crisis, the euro area countries recorded trade deficits in only two of the eight years from 2000 to 2007 (Gambini, 2009). The United Kingdom and the United States were the largest export targets of these countries during the period. The same two

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countries were also the largest source of imports in 2000, but by 2007 China surpassed both. Euro area trade grew rapidly between 2000 and 2007 and enjoyed a surplus in six out of eight years. According to Eurostat (2009a, p. 46), the United States was the leading trade partner of the EU in most of these years. Of total EU exports, those to the United States were from the important group of trading partners whose total export purchases declined from 2006 to 2007 (from ¤269.0 to ¤261.4 billion). Thereafter, demand for imports into the United States market declined continually and rapidly, as did that of other major markets with the spread of the crisis. An inability to access cheap credit, increasing pessimism about the future of the economy, as well as the future of one’s own employment worked together to slow world trade dramatically. Trade declined substantially in both the 16 euro countries and the wider EU community of 27 members over 2007 and 2008. The estimated trade balance for the euro area (EA16) with the rest of the world for January 2009 showed a deficit of ¤10.5 billion, compared with a deficit of ¤11.1 billion in January 2008. The deficit for December 2008 was ¤1.7 billion, compared with ¤4.5 billion in December 2007. In January 2009 compared with December 2008, seasonally adjusted exports fell by 10.7 percent and imports by 7.3 percent. Deficits for these same periods for the extended, full community of 27 nations were very similar. A decline in trade has been observed globally since the onset of the crisis. If a single nation were to trade only with nations untouched by the recession directly, it would soon learn that its trading partners’ interaction with countries smitten by the recession produced declining demand for exports, reduced the income of those associated with the export industries, and in turn shrunk the trade of the nations “insulated” from the direct effects of the crisis. The global trade system is a general equilibrium system whose effects leave no participant country untouched. 1. The euro area (EA15) consisted of 15 member states up to December 31, 2008: Belgium, Germany, Ireland, Greece, Spain, France, Italy, Cyprus, Luxembourg, Malta, the Netherlands, Austria, Portugal, Slovenia, and Finland. From January 1, 2009, the euro area (EA16) also includes Slovakia. The EU27 includes Belgium (BE), Bulgaria (BG), the Czech Republic (CZ), Denmark (DK), Germany (DE), Estonia (EE), Ireland (IE), Greece (EL), Spain (ES), France (FR), Italy (IT), Cyprus (CY), Latvia (LV), Lithuania (LT), Luxembourg (LU), Hungary (HU), Malta (MT), the Netherlands (NL), Austria (AT), Poland (PL), Portugal (PT), Romania (RO), Slovenia (SI), Slovakia (SK), Finland (FI), Sweden (SE), and the United Kingdom (UK). As part of Eurostat’s guidelines for the dissemination of data when the EU or

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euro area is enlarged, the aggregate data series commented on refer to the official composition of the euro area in the most recent month for which data are available. Source: Eurostat (2009c).

Inept Policy and Its Role in the Crisis Europe’s policy and performance can be viewed as one important cause of the European disaster, but one can sympathize with the Europeans that it was the American financial collapse that brought on their crisis. This does not imply that Europe would have emerged unscathed indefinitely had the United States not pulled it into the crisis. Empirical research shows that the European Central Bank (ECB) followed the same stimulative policy as the U.S. Federal Reserve in the years preceding the crisis and set interest rates below what previous or prudent policy rules would have mandated. Interest rates in the EU case were about 2 full percentage points low, according to the analysis of Taylor (2009), and these rates stimulated the economy and, to some extent, housing, consumption, and investment booms. On the wings of cheap credit, East Europe went on a flight of spending, borrowing heavily from banks in Western Europe. Blodget (2009) indicates that Eastern Europe borrowed $1.7 trillion abroad, much of that sum being on short-term maturities. It must now repay or roll over $400 billion worth of obligations in 2009, over a third of the region’s GDP, and doing so will be nearly impossible with credit markets having dried up. So policy shortsightedness created the conditions for a financial crisis just waiting to happen. Russia incurred over $500 billion in debts based on the prospects of selling its oil at $95 per barrel. The estimate would seem conservative enough, since the price hit $145 a barrel in 2008, but fell considerably again. Poland borrowed heavily in Swiss francs for mortgages on which it based a housing boom. Poles felt secure in relying on a stable relationship between the zloty and the Swiss franc, since the new Polish membership in the EU required a fixed exchange rate to the euro. With the Polish government heavily committed to foreign exchange stability, a collapse of the zloty against the Swiss franc was unimaginable. With the onset of the currency crisis, however, small country currencies were dumped in the flight to safe-haven currencies, chief of which was the U.S. dollar. The upshot was that the zloty’s value was reduced by half vis-á-vis the franc. The impact was devastating, since 60 percent of Polish mortgages were denominated in francs. Lovasz (2009) also notes a 30 percent drop in the zloty against the Euro, which made Poland the worst-performing emerging market currency.

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Hungary also borrowed heavily in Swiss francs for housing mortgages. Its businesses likewise leveraged future development on the basis of unhedged foreign currencies. After the disastrous downturn, Ferenc Gyurcsany, the Hungarian prime minister, proposed a bailout package of up to ¤190 billion ($240.84 billion) to save Europe from the division of a “new Iron Curtain” that he saw descending on Europe. Hungary also experienced a strong decline in its exports and in the value of its forint, making it difficult to pay in euros for homes that have now sunk in value (Forelle, 2009). Hungary also petitioned the EU to speed up the process of adopting the euro. New members have had to accommodate to strict EU rules limiting budget deficits, national debt, and inflation. These strictures, designed to maintain the euro’s stability, require that countries achieve strong fiscal conditions before they can join the euro area (EA16) nations already using the common currency. Latvia and the Baltics saw their corporate sectors expanding through easy foreign-exchange credits in the phase of the cycle preceding the crisis. By mid2008, corporate foreign-currency debt had reached over 30 percent in the Baltics. Even if the economies of the region recover, the potential net losses will be from 8 percent 10 percent in Hungary, Bulgaria, and the Baltics. Such losses would totally deplete the foreign-exchange reserves of Latvia (Roche, 2009). Latvia received some financial assistance from the European Bank for Reconstruction and Development (EBRD, 2009), which has provided assistance through stabilization programs for Latvia, Romania, Russia, and Georgia. Finally, all over the Baltics, as in Poland and Hungary, consumers incurred mortgage debts in foreign currencies, especially Swiss francs. In Ukraine, as in the Baltics, foreign-currency corporate debt exceeded 45 percent of all corporate liabilities. As in other East European countries, it appeared that households with large foreign-currency mortgages and companies with large foreign-currency debt would be forced into default. Potential losses would take out around 40 percent of Ukraine’s foreignexchange reserves. A partial bailout for Ukraine was funded by the IMF, which rapidly depleted its financial crisis funds, $200 billion (¤155 billion), during the recession. Ukraine was anticipating a 12 percent contraction in GDP after watching steel prices decline precipitously. Ireland, one of the old EU members, was heavily stricken by the economic downturn. Like Spain, it had seen the bursting of a real estate bubble. Heavily indebted Italy and Greece also suffered greatly from the crisis. Before they adopted the euro, countries in this situation might have endeavored to increase competitiveness by a devaluation of their currencies, but this option is not open to them as euro area countries. Ireland’s government anticipated a reduction in GDP of 6.5 percent in 2009, after having enjoyed robust expansion over most of the past decade. Its budget deficit was projected at near

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10 percent of GDP for 2009 and the government announced immediate increases in the income tax and other taxes. Greece likewise faced a budget shortfall of 3.7 percent of GDP for 2009, and the government announced wage freezes for nearly 500,000 civil servants and tax increases for workers earning more than ¤60,000, or about $82,000 (Perry and Fidler, 2009). Iceland, early in the crisis, watched its three large banks (basically the country’s whole banking system) fail. Iceland had expanded by heavy borrowing abroad in both euros and sterling. When the credit crunch eliminated these funding sources and the Icelandic krona plunged, the country had no foreign currency to rescue its banks. It has since received IMF assistance and has joined other countries in a call for a wider opening of the path to adoption of the euro with its safety and stability (Forelle, 2009). West European Banks in the Leveraging of East Europe Erik Berglof, the chief economist of the European Bank for Reconstruction and Development, contends that Eastern Europe’s financial crisis would remain manageable so long as Western banks continue the flow of funds to their subsidiaries in the region (Lovasz, 2009). But the credit crisis quickly dashed that hope. Hungary, Latvia, and other new EU member states would not appear to be noted for any potentially large contribution to systemic risk. But given the exposure of major Western European banking houses to the aggregate of highly leveraged countries in Eastern Europe, owning some ¤1.25 trillion in debt, countries such as Austria, Belgium, or Sweden may expect disaster if (or as) people in Eastern Europe and some other highly indebted consumers in old Europe begin to default on their mortgages. Enter the Currency Crisis of the Non-Euro Countries With the arrival of the credit crisis and even the anticipation of the spread of the contagion to the real economy, investors began very rapidly to pull their money out of the capital-importing countries. Moreover, anyone holding the currencies of such non-euro countries began quickly to exchange those currencies for the safe-haven varieties. The primary safe haven is the U.S. dollar, and a secondary one is the euro. Skittish currency holders will dump all the non-euro currencies of EU countries. Denmark, Iceland, and most of the East and Central European countries are in this situation. Slovenia and Slovakia were fortunate to have begun using the euro before the crisis had begun its devastating work. The currencies of the countries that were still waiting to meet the criteria that would permit them to adopt the euro, or before they

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had decided they really wanted to be a part of the monetary union, began to fall in value precipitously in international currency markets. That is devastating particularly for countries that are committed to long-term payments in foreign currencies and that must then make their payments with depreciated currencies. When the Polish zloty or the Hungarian forint falls, Poles and Hungarians who acquired mortgages through Western banks at ostensibly favorable prices and low interest rates learn that the price of the house payment they must make now and in the future in Swiss francs or in euros can be much higher in terms of their own currencies and as a share of their incomes than originally conceived. Policy Proposals and Efforts to Overcome the Recession Beyond the IMF, the large multilateral investors and lenders in Central and Eastern Europe include the European Bank for Reconstruction and Development (EBRD), the European Investment Bank Group (EIB), and the World Bank Group. Together, these institutions have pledged to provide ¤24.5 billion in support of the region’s banking sectors and to provide credit to businesses stricken by the global financial crisis and recession. The national and European-wide financial efforts within the EU are also important. Economic and financial policy for Europe remains, however, mostly the responsibility of the 27 individual member states. There is no EU treasury, centralized EU economic policy agency, or common regulator for EU financial services. That economic coordination achieved at the EU level is undertaken through the Stability and Growth Pact, but it is directed by the representatives of the member states working jointly in the Economic and Financial Affairs Council (ECOFIN). The EU Commission presented a European Economic Recovery Plan early on in the recession, which was based on two key pillars (Commission of the European Communities, 2008, p. 3). The first pillar is the substantial injection of purchasing power into the financial system, designed to boost demand and stimulate confidence. The commission’s urgent proposal was that member states and the EU agree to an immediate budgetary stimulus amounting to ¤200 billion. This represents an injection of about 1.5 percent of euro area GDP designed to enhance demand in accordance with Europe’s Stability and Growth Pact. The second pillar represents an immediate effort to strengthen European competitiveness in the long term. The plan represents a comprehensive effort to make “smart” investments in the appropriate human capital skills that the future requires. It was hoped that the aggregate of these measures would make a difference in the European macro economy.

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CHAPTER 13

Subnational Finance Today and Tomorrow in the Czech Republic: Impacts of the Financial Crisis and Global Recession

Introduction The Czech Republic had not participated in the global market for mortgagebacked assets. When the crisis struck Europe, the country had been doing well economically, although it had experienced economic challenges, as discussed in earlier chapters of this book, associated with its transition to market democracy. It had undertaken extensive reforms in its effort to qualify for membership in the EU, and in 2004 it did accede to membership. At the onset of the financial crisis, it was still engaged in the effort to qualify to adopt the euro and was pursuing rather conservative economic and financial policies to advance that effort. Among its most significant economic challenges was the attempt to deliver modern European entitlements in the form of pensions and health care to its citizenry. Having overextended in these areas, the Czech Republic was busy applying the needed discipline to public budgets. Initially, the Czechs were not overly concerned about the global financial crisis and anticipated that its impact on their economy would not be extreme. They viewed the global crisis not only from a Czech but also from a European perspective, since the Czech government was about to assume the EU’s rotating presidency. That was to be the first time a newly admitted member of the EU and former bloc country from the central planning economies would hold the temporary EU presidency.

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This chapter will begin with a review of the economic situation in the Czech Republic both before and after the onset of the financial crisis. The fiscal impacts of the crisis, including those associated with the decline of export markets, resulted in reduced output and employment, as well as declining tax revenues. Both domestic economic policies and the policies that the Czechs advocated for the EU (in its presidency role) will be addressed. We will also consider budget management efforts designed to permit the Czech Republic to qualify for adoption of the euro, as well as the attempt to rein in current and prospective pension and health spending.

The Czech Economic Situation and the Crisis Through 2008 and into 2009, strong fundamentals helped the Czech economy respond resiliently to the global financial crisis (IMF, 2008).1 Through that period, productivity growth continued, fiscal performance improved gradually, and the republic’s participation in external trade was robust. Economic development was also supported by inflows of foreign direct investment. Although prices from the global economy for food, fuel, and utilities were not favorable, the Czech koruna helped contain inflation within the country. In the months following the onset of the financial crisis in the summer of 2007, the financial turmoil increased. The extent of the contagion and the speed of its spread, together with the depth of the downturn in the advanced economies, soon convinced the Czechs that they would be unable to sit tight and ride the recession through relatively unscathed. They hoped that speedy policy responses would help stabilize the financial situation and reduce the risk of a hard landing. After three years of exceptional growth performance, the economy was expected in 2009 to slow sharply with tightening credit at home and the deepening recession in Europe (ibid.).2 In 2008, growth slowed to about 4 percent, reflecting a slowdown in domestic demand, and the IMF projected a more severe GDP slowdown in 2009 to approximately 1.5 percent. The reduction in demand across the euro area for Czech goods, and particularly in Germany, was expected to curtail export growth and produce a strong diminution of direct investment inflows from European partner economies. The tightening credit conditions in the Czech Republic were projected as a further drag on capital spending, offsetting the stimulus provided by the new Hyundai automobile plant opened in November 2008 and by the increasing inflows of EU funds.

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The IMF projected only modest household consumption growth as wavering confidence and rising unemployment overshadowed the good news of declining inflation for real disposable incomes. However, a possible credit crunch could constrain corporate and household spending, and the Eurozone turndown could also go deeper than had been projected. During the runup to the recession, Czech economic performance resulted in considerable appreciation of the koruna, which helped the country retain a strong external position. The trade balance remained in surplus, and inflows of positive net investments financed a modest current account deficit. After considerable appreciation in the first half of 2008, the crown began to weaken. When the Czech exchange rate hit 22.97 per euro on July 21, 2008, it achieved a historic high (Czech Ministry of Finance, 2009a).3 The flight of currencies to safe havens after the onset of the financial crisis led to a “correction” of the koruna, with its December 2008 value being CZK 26.11 per euro. As of the end of July 2009, the exchange rate was CZK 24.48 per euro. The Czechs remain, therefore, relatively competitive in terms of export volumes, a situation that the depreciation of the crown in the latter part of 2008 could only reinforce. The IMF views the CZK as being broadly in line with fundamentals and consistent with external stability. It should be observed that important ongoing changes in Czech taxation have been occurring; taxation has continued to shift from direct to indirect taxes. The corporate income tax rate was scaled back from its 2008 levels of 21 percent to 20 percent in 2009. After January 1, 2009, social security contributions were reduced while real estate tax, inheritance, and gift tax changes came into force. To stimulate business and simplify the system, a comprehensive reform is being prepared for income and property taxation. The government approved a new order on November 19, 2008, simplifying administrative processes and reducing costs. The Impact of Global Financial and Economic Problems on the Czech Economy Before global financial and economic problems worsened considerably in September 2008, the Czech Republic had enjoyed comparatively favorable macroeconomic conditions. Economic growth, which had been slowing down as a result of normal cyclical impulses, had been driven largely by foreign trade under a favorably appreciated exchange rate. A current account deficit had showed very sustainable values in international comparisons and the foreign exchange debt of Czech firms had not been significant.

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It was through the decline in external markets that small, trade-dependent countries such as the Czech Republic would be expected to suffer most. Without being involved directly in the credit crisis, the Czechs actively traded with other, less fortunate countries. When the latter began to suffer from the credit crisis and the recession that ensued, their demand for Czech goods, as for all imports, began to decline. The trade balance for 2008 ended in deficit for the first time since 2004. Nominal exports fell by 13.7 percent and imports fell by 9.0 percent. For the whole year the ratio of the trade balance to the GDP fell to 2.8 percent from 3.4 percent in 2007. Thus, the slump in foreign trade became for the Czech Republic the most important aspect of the global economic recession. The decline in trade continued into 2009, and during that year’s first quarter, year-on-year exports declined by 21 percent in real and nominal terms. Given the poor outlook for the world economy, exports were expected to shrink by 7.7 percent in 2009 before returning to a growth path and expanding by 2.2 percent in 2010 (Ministry of Finance, 2009e, p. 18).4 As in some of the neighboring countries, a modest acceleration of inflation early in this period was expected to be strictly temporary. The functioning of the labor market had been improving. The finance ministry perceived fiscal and monetary policies as having quite positive effects. In the months that followed, the benefit of hindsight suggested only that the country’s specialization of commodities for exports, emphasizing machinery products, especially in cars and their accessories, had probably been somewhat excessive (ibid.).5 The overall fiscal picture of the Czech Republic is presented in Table 13.1. It is a picture of strong GDP growth from 2004 through 2008, with 2009 being the first year the global recession had a major impact on the economy. One observes that, independent of the onset of the recession, the Czech government was making a very strong effort to reduce government expenditures to make the fiscal program of the republic responsible and sustainable. One observes strong and positive trends for the growth of employment and the growth of the wage bill in the years preceding the onset of the recession. The unemployment rate says the same positive things for the economy; for a transition country, the rate is very respectable and declining. The expected growth of unemployment for 2009 and for 2010 is quite modest, given the severity of the global recession. Vaclav Klaus, an economist who guided the country’s early transition effort as minister of finance and who is currently the president of the Czech Republic, insists that his country has not as yet experienced a financial crisis, largely because the Asian financial crisis had an ameliorative impact on the country about ten years ago. That crisis forced Czech banks to become very cautious, according to Klaus (Klaus, 2008),6 and only three OECD countries refused

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Table 13.1 Main Macroeconomic Indicators, Czech Republic 2004

2005

2006

2007

2008

2009

2010

2008

2009

GDP∗◦ C∗◦ G∗◦ GFCF∗◦ Contribution of foreign trade to GDP growth∗◦ Average inflation rate∗ Employment∗ Unemployment rate∗ Wage bill∗◦ (Current account/GDP)∗

4,5 2,9 −3,5 3,9 1,3

6,3 2,5 2,9 1,8 4,6

6,8 5,4 −0,7 6,5 1,6

6,0 5,3 0,4 6,7 1,0

Est

For

For

PFor

PFor

4,0 2,9 1,5 4,5 2,9

1,4 3,2 0,5 −0,2 −0,7

2,1 3,0 0,0 2,0 0,2

4,4 3,3 1,1 5,1 2,2

3,7 3,9 0,5 4,5 0,4

2,8

1,9

2,5

2,8

6,3

1,3

2,1

6,4

2,9

−0,6 8,3 6,3 −5,2

1,2 7,9 6,9 −1,3

1,3 7,1 8,0 −2,6

1,9 5,3 9,3 −1,8

1,5 4,4 8,1 −2,8

−0,3 5,2 4,2 −1,8

−0,8 5,9 5,3 −1,7

1,6 4,4 9,5 −2,5

0,7 4,5 8,3 −2,3

Exchange rate CZK/EUR Long-term interest rates % p.a. GDP in Eurozone (EA-12)∗◦

31,9

29,8

28,3

27,8

25,0

25,6

24,7

24,9

24,7

4,8

3,5

3,8

4,3

4,6

3,8

3,8

4,7

4,4

2,1

1,7

2,9

2,6

0,9

−1,0

−0,7

1,3

0,7

Assumptions:

∗ Increase in per cent or percentage points, ◦ Constant prices Notes: Est = Estimate, For = Forecast, PFor = Previous forecast, GDP = Gross domestic product, C = Household consumption, G = Government expenditures, GFCF = Gross fixed capital formation. Source: Data from the Ministry of Finance, Czech Republic, selected and arranged by the authors.

to pump money into their financial system in response to the boom/bubble affecting the global economy before the onset of the financial crisis: the Czech Republic, Slovakia, and Mexico. President Klaus sees this is the reason that the Czechs are irritated when the West European media lump those countries together with some of the other countries of Eastern Europe that are now experiencing severe difficulties largely of their own making. Klaus expresses a fear of reforms to come, for they will increase international rules and regulations more frightening for Czechs than the crisis itself. They would merely prolong the recession’s current miseries and undermine long-term global growth potential. What the Czechs did import, Klaus observes, is the economic crisis, partly because of declining demand for Czech exports and partly because of the actions of those foreign banks that own Czech local ones. Because of recession

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difficulties, especially in their home countries, they have attempted to rebalance their portfolios, thereby dangerously restricting credits even in countries like the Czech Republic, which have avoided the financial follies that brought on the crisis. This is to be expected under the globalized, post-communist system, when state-owned banks were sold off rapidly and there was very little domestic capital at the Czech economy’s disposal. Prudential Czech Policy Preceding the Crisis The Central, Eastern, and Southern European (CESE) region had developed a relatively healthy banking sector and survived the first wave of the financial crisis (T˚uma, 2009).7 Their banks had remained solvent. Lacking a high degree of integration into global financial markets, they had seen only negligible exposure to toxic financial instruments and maintained good-quality credit portfolios (Ministry of Finance, 2009a).8 They enjoyed high liquidity and efficiency indicators and a high capital base with low delinquency ratios. According to the Ministry of Finance, as of September 30, 2008, the banking sector had adequate capital and was profitable, with the growth of profit at nearly 12 percent for the first three quarters of 2008. Banks have not succumbed to any temptation to grant major credits in foreign exchange (ibid., p. 15).9 The Ministry of Finance indicates that Czechs do not hold apartments to speculate on price growth; nor is there any general practice of financing consumption through mortgage credits (ibid., p. 16).10 Although direct foreign exchange exposures were actually relatively low, most borrowers had not hedged their loans, the aggregate effect being exposure of the banking sector to a significant, if indirect, foreign exchange risk. Fortunately for the Czechs, foreign loans to households and corporations remained at a lower level than in almost all the other Central and East European countries. Observers were concerned from the outset about the possibility of contagion settling in on the region. It could be the result of one of the CESE’s financial problems spilling over into others through the affected banking system of common lenders—aptly described as common lenders would be the banks of Austria, Italy, Sweden, and Greece. Expected Recession Developments in the Czech Republic The Ministry of Finance (2009a) published estimates of the recession’s shortterm impacts. It expected a slowdown in GDP growth to 3.0 percent in 2009 and then a gradual increase back to the 4.4 percent level of 2008. The

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anticipated slowdown in household consumption growth was considerable; at 5.9 percent in 2007, it fell to around 2.8 percent in 2008 and was expected to rise to 3.1 percent in 2009. Unemployment at 4.7 percent in 2008 was to increase to 5.6 percent in 2010.

The EU’s Evaluation of the Czech Economy and Public Budgets The European Commission (2009) has credited the Czech Republic with having entered the financial crisis with favorably modest government deficit and debt levels, and it forecasts a general government deficit of 1.6 percent and 1.5 percent of GDP in 2009 and 2010, respectively, a projection admittedly based on favorable growth assumptions for the republic. Having succeeded in establishing recent improvements in their public finances, the Czechs had also adopted a fiscal stimulus package that was viewed by the commission as being of considerable size and also in line with the EU Recovery Plan. The commission reminded of the importance of reversing those programs once economic conditions improved. The continuing global economic crisis will continue to affect general government accounts in 2009. Government budget revenues will experience the impact through an expected significant decline in the value-added tax, social security contributions, and corporate income tax as business conditions deteriorate, retail sales decline, and personal incomes and corporate profits shrink. All will fall significantly below the level of 2008. The expenditure side of the government’s budget will be burdened by both expanded social benefits and the growth of discretionary expenditures to stimulate the recession economy (Ministry of Finance, Department of Financial Policies, 2009e, p. 22).11 Two of the biggest burdens on the budget of the central government— health care and pension expenditures—have been keeping the Czechs from being able to conform to EU deficit and debt strictures and qualify to adopt the euro, and these are being pared back. Recent reforms will achieve reductions in expenditures, but there are still concerns that in the long term these remedies may not be fiscally sustainable because of the rapidly aging population and potentially ballooning health care and pension expenditures. Reform measures that should mitigate this expected trend were recently approved (European Commission, 2009, pp. 25, 26).12 Nevertheless, despite the Czech Republic’s public sector campaign to manage a conservative budget, a recession is in progress. The EU Commission has invited the Czech Republic to help combat the global recession, and specifically,

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to implement planned measures in line with the European Economic Recovery Program, to reverse adverse budgetary impacts associated with the fiscal stimulus after the economy recovers, to complement the budgetary strategy with specific measures designed to reduce appropriate expenditures in 2010 and 2011, and to continue with essential pension and health care reforms required by the projected increases in age-related expenditures so as to improve the long-term sustainability of the country’s public finances. The Czech Policy Response for the Republic

With the encouragement of the EU’s Economic Recovery Program, the IMF, the World Bank, the UN, and the United States, the Czechs also undertook a stimulus program, albeit a conservative one. The Czechs wish to comply with the EU’s fiscal guidelines to qualify for the adoption of the euro, so it has retained a restrained posture and proposes to resort to modest and strictly temporary measures to address the recession. The first subgroup of anti-recession measures undertaken by the Czech government consisted of changes stemming from the public finance reform approved by the parliament in 2007 to secure budgetary sustainability. Czech policymakers were anxious that stimulus-type tax reductions might be offset by a reduction in mandatory social expenditures. These measures are described in the documents “Convergence Programme” and “Fiscal Outlook of the Czech Republic.” Highlights of the program are reviewed in Ministry of Finance, Department for Financial Policies (2009d). Another subgroup of measures communicated to the European Commission at the end of 2008 was approved as a part of the first anti-crisis package. Expenditures of the state budget were to be cut by CZK 6.5 billion. Offsetting the reduced expenditures, social security contributions were to be reduced, faster depreciation was to be permitted in industry, and the value-added tax was to be reduced. Primary support for employment was to be provided through temporarily reduced social security contributions paid by employers, decreasing their labor costs, and reduced social security contributions for workers from 2009 to 2011. Stimulus measures also included increased state funds provided for the construction of infrastructure projects, and numerous other small measures (to be carefully monitored by the Ministry of Finance) designed not to increase the overall budget deficit. The government has consistently emphasized that the debt burden cannot be unduly increased to accommodate the short-term need for economic

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stimulus; the government simply cannot repudiate its long-term fiscal responsibilities, which include above all the reforms of health care and pensions. The Czech Policy Position for the EU The rotating, six-month presidency of the Council of the EU came to the Czech Republic during the financial crisis. This was the first time that a recently acceded, former Soviet bloc country had held the presidency. The Czech prime minister Mirek Topolánek was placed in charge; this government was prepared to assume the temporary presidency and enunciate policies for the entire EU community. On April 3 and 4, 2009, Prague hosted an informal meeting of ministers of economics and finance, as well as for central bank governors of the EU member countries, EU commissioners, the European Central Bank president J.-C. Trichet, and European Investment Bank president P. Maystadt (Ministry of Finance, Czech Republic, 2009c).13 As a part of the rotating presidency, the Czech finance minister Miroslav Kalousek chaired this event. The ministers and governors addressed the current economic situation and developments on financial markets. The Czech prime minister and finance minister also attended the G20 Summit in London in the spring of 2009, addressing the same recession issues. Unfortunately, the coalition government of the Czech Republic encountered political turbulence at home and lost a confidence vote on March 24, which called for a reorganization of the government. Prime Minister Topolánek made some ill-timed, derogatory remarks regarding the U.S. approach to crisis policy just days before the arrival of President Obama on his first visit to Prague. This was certainly embarrassing for the Czechs, especially Topolánek, in the middle of the worst economic crisis in EU history, but the lack of “credible” EU leadership over the last three months of the Czech presidency did not seem too damaging. EU states that want a sharper line between Eurozone and other EU members were expected to enjoy a firmer position after the fiasco. The Czechs were concerned that the leadership vacuum for the remainder of the Czech presidency may have nullified their strenuous efforts to present themselves in a better light than some other Central and Eastern European EU members under the stigma of financial imprudence during the run-up to the financial crisis. Czech foreign-denominated debt had remained very low, so the Czechs had avoided the agonies of the Hungarians and Poles, who borrowed heavily from Swiss and West European banks and were caught with mortgages and debts whose scope increased in correspondence to the decline in the value of their national currencies in foreign-exchange markets. The needs

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of Czech local banks had been fully satisfied by local deposits; these local banks had actually been net lenders to their foreign parent companies. The current account balance remained in positive figures, and Czech deficits and overall indebtedness were relatively low. The Czechs worried mostly that under the political chaos stemming from the financial crisis in Europe, global markets and investors would associate them with other countries in this financially unstable region. That perception implied threats for the Czech economy in terms of its ability to attract foreign direct investment. The Czech Fiscal Situation at the Subnational Level Significant changes are coming about in the fiscal system of the Czech Republic. Considering first the most significant developments on the revenue side, it should be noted that, as was expected for 2008, the flow of general government revenues was slower than in recent years. After the onset of the financial crisis, the expected growth in tax revenues for the year was reduced from 8.0 percent to 3.7 percent. With the nation’s slowdown in sales, VAT revenues are expected to grow substantially less rapidly given the decline in consumer spending. Still, the projected year-on-year growth of the VAT is currently set at a very respectable 11.9 percent, although the earlier forecast of 23.6 percent growth would have been nicer. The estimated personal income tax revenues, previously expected to decline by −0.6 percent, were later revised downward to −6.4 percent. The projected reduction in the corporate income tax, initially projected at −0.6 percent, are now forecast at −2.1 percent. With the reform of 2007 reducing the potential for revenues from the “19 percent flat” corporate income tax, the dynamics will be more modest (Ministry of Finance, Czech Republic, 2009a, p. 21).14 General government expenditures, on the other hand, will follow the pre-crisis projections more closely. The finance ministry anticipated that the government’s consumption would continue to be very thrifty, given the tight expenditure limits that the central government is committed to maintain. The ministry adjusted gross fixed capital formation expenditures downward, but it nevertheless expects them to reach nearly the 10 percent growth previously expected. It is expected that EU grants will be drawn on more vigorously. Moreover, estimates of social transfers have changed little with the arrival of the recession (ibid., p. 22).15 Dalsgaard16 sees the tax structure of the Czech Republic as divergent from the EU-15 and other countries in the region because it has been more heavily reliant on social security contributions, which in the Czech Republic are among the world’s highest; they have also drawn disproportionately on

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the corporate income tax for revenues (2008, p. 5). Compared with other European countries, the Czech Republic derives less revenue from the personal income tax, from consumption taxes, and from the property tax. The logic of tax reform focuses on increasing revenue from consumption and property and shifting from social security revenues to these underused taxes. This section shows how the attempt is being made to transform the Czech tax structure through reforms initiated in 2007. Having reviewed the impact of the global financial crisis and recession on the national economy, we turn now to the impact the recession is likely to have on subnational governments in the republic. The effects of reduced revenues, especially on the municipalities, will combine with the effects of other changes in the economy and in the intergovernmental fiscal system. In particular, we must evaluate the economic downturn in light of the reform measures undertaken by the Czech parliament and government in 2007 (ibid.),17 which could actually have more long-term effects than the global recession itself. The overhaul of the welfare and tax systems by this rather comprehensive reform effort intended a strengthening of work incentives, both by reducing personal income taxes, especially at the lower and higher end of the earnings scale, and by shifting the burden of taxes away from earned income to consumption. The latter measures should stimulate savings and investment. New excise taxes on energy consumption are targeted at cutting carbon dioxide emissions and reducing pollution. An attempt to improve the nation’s competitiveness in attracting foreign investment largely explains the logic of cutting the corporate income tax. Another important concern was to contain the ballooning costs of social programs, notably those of public health care and pensions. With this reform, the Czechs finally responded to the notoriety and favorable fiscal effects accruing to the Slovak Republic’s earlier adoption of the flat tax. The key element here is the 15 percent one-rate (“flat”) tax on personal income. Since it is to be levied on gross earnings plus the employer’s relatively large social security contribution, the real flat rate is 23 percent. Actually, there will still be multiple effective tax rates, since the system will employ tax credits, variable social security contributions, and means-tested social benefits (supplementary benefits granted to cover the gap between normal social receipts and the recipient’s actual expenses). There is to be a cap on social security contributions starting at four times the average wage or approximately 1 million CZK per annum. The corporate income tax will be reduced from 24 percent to 19 percent in 2010, while the VAT, with a 19 percent standard rate on consumer sales, will be retained. A special 5 percent rate was raised to 9 percent (ibid., p. 10).18

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The reform measures may have been even more remarkable on the spending side. First, only pensions retained automatic indexing to living costs, as all other social benefits lost the indexing advantage. The unemployment benefit was reduced along with some other ones, and family subsidies, based on the number of children in the family, will no longer be enhanced for lowerincome recipients. Family subsidies are to be discontinued above a threshold that dropped considerably as a part of the reform. Because health care benefits had been a notable cause for rapidly growing health care budgets, their finance was shifted to employers. To reduce nuisance claims, benefits paid for the first three days of a worker’s sickness were eliminated. Limited and modest copayments (from ¤1 to ¤3, i.e., ca. $1.40–$4.20) were introduced for medical services delivered by doctors’ offices, hospitals, and pharmacies. The other villain of uncontained budget expansion is the pension system, which was not fully addressed by this reform but which continues as a main topic of prospective legislative action for the future. The primary change involved movement toward an ultimate retirement age of 65 (to be achieved by 2013) by increasing the current retirement age immediately to 63. To qualify for a pension, the reform demand was for a 35-year work history; previously, 25 work years qualified. From Table 13.2 we observe that local government total revenues, including those from grants, amounted in 2007 to CZK 369.7 billion, of which CZK 134.8 billion (36.5 percent) came from grants. Of the total local receipts, another CZK 187.4 billion (50.7 percent) came from tax revenues. The greater portion of these revenues is in the form of transfers from the central government. So the share of total revenues received by Czech municipalities from the central government is very large indeed. The fiscal fate of subnational governments is a function of the largesse of the central government, which in turn is a function of the state of the economy and the fiscal institutions that have been in the process of reformation for some time. As we have seen, the Czech fiscal situation encountered difficult times for the short term. But the fundamentals were all in place for a sound recovery. In the recovered economy, Czech subnational governments will receive the resources necessary for them to meet the objectives of the central government providers. Because the subnational governments play a significant role in the delivery of health care and pensions, they will receive what they need to be able to meet the government’s objectives in that area, but not more than budgeting targets and constraints permit. In the face of an aging society, making health care and pensions sustainable over the long term is a high priority. So these important programs did not suffer deprivation greater than could be avoided during the recession.

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Table 13.2 Public Finance Data, Czech Republic (millions of CZK)

Total revenue and grants Total revenue Current revenue Tax revenue Nontax revenue Capital revenue Grants Current Capital Expenditure and lending minus repayments Total expenditure Current expenditure Capital expenditure Lending minus repayments Current balance before grants Current balance after grants Gross fixed capital formation Gross capital formation

Social security

Consolidated central government

Local budgets

Consolidated general government

202,805

1,134,552

369,729

1,359,388

155,329 155,267 153,941 1,326 62 47,476

185,591

1,084,081 1,082,816 1,044,989 37,827 1,265 50,471 26,279 24,192 1,178,188

234,865 222,308 187,429 34,879 12,557 134,864 114,133 20,731 360,315

1,310,693 1,296,871 1,224,165 72,706 13,822 48,695 24,490 24,205 1,395,860

185,591 185,121

1,188,761 1,064,271

358,809 272,100

1,402,677 1,212,196

470

124,490

86,709

190,481

−10,573

1,506

−6,817

−29,854

18,545

−49,792

84,675

−29,854

44,824

64,341

109,165

408

15,886

59,100

74,986

408

15,886

59,100

74,986

Source: Data from the website of the Ministry of Finance, Czech Republic, selected and arranged by the authors.

Budgeting reductions may be expected for other public services, but given the limited period of decline of the global economy and the resumption of economic growth and of more healthy revenues for the state budget, one need not expect an extended period of hardship for the municipalities. If the reforms of 2007 result in improving economic conditions as a result of the greater competitiveness of the country due to tax reductions and rationalization of the tax system, long-term gains should be experienced by the municipalities. If the government relies less on social security taxation and increases other kinds of taxation, such as the property tax, municipalities could ultimately experience greater revenue flows from their own independent sources and enjoy a greater measure of autonomy.

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Throughout this book the emphasis has been on the need for greater independent sources of revenue for subnational governments. The data on budget revenues and expenditures reflect the prevalent institutions and policies that determine budget outcomes and municipal financial health in the country. Czech municipalities receive significant amounts of revenue from taxes on income and wealth; this amounted to CZK 71.5 billion in 1997, following which it grew by close to 10 percent per year until it reached CZK 108.1 billion in 2007 (Ministry of Finance, Czech Republic, 2009a).19 The property tax yields far less revenue, generally less than CZK 5 billion per year, but this tax is perceived as a local tax, even if the central government has the responsibility for its collection. Most of the tax revenue on income and wealth comes to the municipalities in the form of a transfer from the central government, the actual proprietor and collector of such taxes. Naturally, those revenues are often provided with a specific target in mind, for example, social programs or education. The local government becomes an intermediary between the revenue provider and the recipient of the government-supplied service or transfer. The same can be said for revenues derived from production and imports or from sales taxes. Much of what local governments think about and attempt to do is to integrate their thoughts and actions into the central government’s objectives and plans. Considering the expenditures of the local governments, we perceive a similar phenomenon. Expenditures for categories such as social benefits, intermediate consumption, and subsidies are only possible on the basis of generous central government infusion of funds. Municipalities have very little on which to base programs in response to local preferences and aspirations. Funds for capital formation, for example, are generally provided for specific, approved projects by the central government or, in some recent instances, the EU’s programs for regional development. Thus, the subnational governments receive most of their funds from the outside (either the EU or the central government) and must learn to deal with outsiders’ subtle and less subtle expenditure mandates. They must constantly take into account the preferences, objectives, and explicit programs of the providers of the funds. Summary and Conclusions Becoming a part of the EU seems to have changed the Czech Republic in significant ways. Even up to the point of the accession, one sensed a lack of enthusiasm for the tasks required of the republic for admission. Reforms seemed to be undertaken without much resolution or commitment. Over several years of the transition process, Czech parliaments and governments ignored obvious opportunities for meaningful reform. But somehow in the

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process of becoming members in the early part of the 2000s, the Czechs began to be serious about reform, and significant progress began. The economy was doing well before the onset of the crisis. Czech consumers, bankers, and policymakers avoided some of the detrimental behaviors of their more impulsive neighbors in the region. They may also have been a little surprised by the flamboyant and ultimately successful policy innovations of the neighboring Slovaks. In any case, serious reforms finally began to be forthcoming. Attempts to rein in excessive spending for health care and pensions became innovative and serious. Economic policies were conservative and increasingly effective. Export capacity and export revenues increased. Positive prospects for the Czech economy were increasingly more apparent. The arrival of financial crisis, the decline of export markets, and the onset of the global recession came at a point when the Czech economy was on the brink of some noteworthy success. In many ways the Czechs were as well prepared for the downturn as could have been hoped. Their banks were free of tainted assets, although they were somewhat dependent on Western banks that were not. They had not pumped up a real estate market with any kind of pre-crisis bubble behaviors. They were only dependent on foreign markets in which to sell their growing exports. The downturn was difficult, but the prospects for the future remain bright. The passing of the crisis permits a return for the Czechs to the business of building their way out of the past into a brighter future. The economy still has catch-up needs requiring infrastructure investments, investments in human capital and in information and telecommunications technologies. These will still require the continued application of Czech industry, intelligence, and resourcefulness. The Czech future will also be affected by the strength of the global recovery and by the impact of the country’s foreign markets as trade and production are restored to former and, hopefully, greater levels.

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CHAPTER 14

Subnational Finance Today and Tomorrow in the Slovak Republic: Impacts of the Financial Crisis and Global Recession

Introduction Before the global recession, the Republic of Slovakia, like its Czech neighbor to the west, had not invested in modern financial innovations. Nor had it made some of the financial mistakes of the neighboring transitional countries Hungary and Poland. The pre-crisis housing boom in those countries had been based on unhedged loans of billions of euros from West European banks. When the credit crisis struck in 2008, the Slovaks had a few months to suppose that they would not feel its impact too strongly. When the credit crisis quickly leaped from financial markets to the real economy, however, the global recession was under way. Slovakia, like other small, trade-dependent economies, had to learn that the recession would spread through the global economy with devastating force because of a dramatically declining demand for imports. Before the onset of the crisis, the Slovak Republic’s economic performance had been impressive. It had struggled early in its transition away from the previous regime’s centrally planned, Marxist-Leninist socialism. But some apt reforms secured admission into the EU in 2004 and additional, bold steps described in earlier chapters gave a now-famous fillip to Slovak economic growth. This small country moved to the head of the class in its economic performance after several years of dramatic GDP growth. While much of Europe was stagnating, it achieved 10.4 percent GDP growth in 2007, the last year before the downturn’s effects reached Europe.

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In this chapter we will review the economic situation in Slovakia both before the crisis and since the beginning of the recession. We will note especially the significant role of foreign trade as the arena in which financial contagion translates into the declining exports of the recession. Since some interesting data are available, the discussion can then turn to real estate and its role in helping to generate recession, since housing bubbles and busts often accompany the general booms and downturns of the cycle. We will then reconsider the overall state of Slovakia’s effort to make over and modernize its transitional economy. After having successfully transformed itself, by overcoming the dysfunctional central planning legacy of the communist era, the country has launched an ambitious campaign to “converge” its economy with the economic productivity and living standards of the successful, modern economies. We will look at the new situation and the potential of the Slovak Republic to continue its recent, robust economic growth under the conditions of the current recession. We will be particularly interested in the public sector’s financial prospects and possibilities, especially regarding the likelihood of continued progress in its program of fiscal decentralization. The Economic Situation before and after the Onset of the Global Recession We have already seen that the Slovaks have pursued fiscal decentralization with much greater enthusiasm than their Czech neighbors, who seemed to pursue that objective and the later reforms of public administration mostly because outside pressures made it seem the thing to do. It long appeared that the Czechs were not unhappy with a high degree of centralization (similar to that of some of the original EU member countries) and were quite competent in keeping it functional, but did make ostensible efforts to decentralize their public sector to satisfy the EU sufficiently to gain membership. The Slovaks took their reform effort more seriously and worked more consistently at the effort. While the Czechs were being admitted in a routine way to the OECD, NATO, and other Western organizations, the Slovaks were struggling to make people believe that they were serious and organized enough to become a modern nation. Their continuing efforts to prove themselves had paid off by 2004 when they acceded to the EU along with their Czech half-brothers. At about this time, their reform efforts, now extending to the adoption of a “flat tax,” significantly reducing tax rates and bringing greater financial competence and independence to subnational governments, began to pay off in terms of rapidly declining unemployment rates (high ones being the legacy of central planning in transition countries) and increasing rates of GDP growth. Thus, Slovakia was adjudged ready to be admitted to euro

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membership and the currency came into circulation in January 2009. By that time, the Republic of Slovakia had become the star of EU members in terms of its growth, and it reached the level of about 70 percent of convergence, that is, the Slovak Republic had raised its citizens’ income level to 70 percent of the most advanced members of the EU. As recently as 2000, the level had been only 50 percent. The performance of the Slovak economy had achieved fairly wide recognition by 2007. It was driven in large measure by the active participation of foreign investors who had come to believe in this country of only five million inhabitants. This trend promoted GDP growth and enhanced the country’s international competitiveness and export performance (Ministry of Finance, Slovak Republic, 2008a).1 Investors anticipated that the high rate of GDP growth would continue to produce new jobs and a reduction of the unemployment rate, which forecasts indicated would decline from 11 percent in 2007 to less than 9 percent in 2011. Labor productivity growth in the Republic of Slovakia in recent years has also exceeded the rate in other EU countries. It corresponds to the growth of wages and indicates that economic growth and development are on sound footing. Two Czech economists2 have recently praised the Slovak economy highly by pointing out the positive role that economic reforms have played in the country (Horvath and Rusnak, 2009). Their objective was to increase the flexibility of both product and labor markets, which would have ameliorative effects for domestic economic growth. These authors show that prices in Slovakia have generally been driven primarily by external factors. The European Central Bank’s monetary policy has impacted Slovak prices more powerfully than has that of the National Bank of Slovakia. With regard to interest rates and interest rate policy, they are convinced on the basis of the available data that the Slovak Central Bank follows the ECB. In the meantime, they show that the “spectacular” Slovak economic growth is primarily driven by domestic factors, and this suggests that the recent Slovak economic reforms have played a very positive role. The Economic Situation after the Onset of the Crisis The glory days ended, at least for the time being, with the onset of the credit crisis toward the end of 2007. As the global economy tried to find a way to overcome the logjam of tainted assets in the portfolios of the major banks and financial institutions, other countries that had not traded in such assets continued hopefully but with a strong sense of foreboding. As the credit crisis quickly spread to the real economy, business and employment started to decline everywhere almost immediately. In the months that followed, the banks of central Europe, like large banks everywhere, reduced interest rates

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and waited for further bad news. The decline in demand for imported goods meant that the trade markets even of those countries without financial contamination were in a downward spiral that would leave no country’s markets without hurt. Statistical data have continued to show the effects of the downturn (Národná banka Slovenska [National Bank of Slovakia], 2009).3 Weakening economic activity slowed GDP growth to an annual rate of 2.7 percent by the fourth quarter of 2008. This was a dramatic slowdown after the record 10.4 percent GDP growth rate of 2007, the highest in the EU for that year. The trend had not yet reflected in employment data, and employment even continued to grow, although at a slower rate than in the third quarter of 2008. Slovakia’s exports are closely correlated with the country’s industrial output, which had been in a deepening slump. The year-on-year decline in December 2008 was 16.8 percent; the same decline in November had been only 7.2 percent. The greatest shrinkage was in the production of transport vehicles. Revenues from the sale and maintenance of vehicles declined in 2008; that year ended with production 35.7 percent lower than in the previous year. In the course of 2009, production continued to fall traumatically. Both basic and fabricated metals continued to slump, as did the manufacture of machinery and equipment. Electrical and optical equipment registered a year-on-year decline for the first time since May 2008. An unprecedented fall in production occurred in the electric industry and in several other sectors, especially hotels and restaurants. Revenues grew only in real estate (where a double-digit year-on-year increase was achieved at constant prices) and in construction, although the rate of growth of the latter slowed quite dramatically. Revenues also grew somewhat in retail trade and telecommunications. The numbers of unemployed grew by 13,300 per month, reaching 248,500 in December 2008. This represented a monthly rate of 0.6 percent for registered unemployment growth, pushing the unemployment total to 8.4 percent of the labor force in December 2008 (ibid.).4 For 2008, the Slovak Republic’s GDP grew by approximately 6.4 percent at constant prices and, since there is still some inflation in the economy, 9.5 percent at current prices (ibid.).5 The Role of International Trade in the Downturn In the year following April 2008, Slovakia’s exports had decreased by 24.3 percent to a total of ¤3,387.5 million. Total imports decreased from April 2008 through the following year by 35.9 percent to ¤3,015.1 million. The reduction in total imports was the highest since 2005. The foreign trade

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balance showed a positive surplus of ¤372.4 million, which was the highest surplus balance over the last five years. During the first quarter of 2009, compared with the corresponding period for 2008, total exports decreased by 27.3 percent to ¤12,512.9 million. For the same period, total imports declined by 30.1 percent to ¤12,187.3 million. The foreign trade balance was in surplus of ¤325.6 million (Statistical Office of the Slovak Republic, 2009a).6 The highlights of the most recent report of the Statistical Office of the Slovak Republic (2009a) come from a comparison of the trade situation in April 2009 with that in April 2008. Total revenues derived from the sale and repair of motor vehicles and motorcycles were ¤379.5 million, which amounted to a reduction of 15 percent at constant prices. The largest revenue fall-off (of 25.2 percent) was for the repair and maintenance of motor vehicles. Revenues also declined significantly, however (by 14.3 percent) for the sale of motor vehicles, while rising for automobile parts and accessories by 20 percent. Total revenues from the wholesale trade were ¤1,904.4 million at the end of 2008, having declined 28.9 percent in current prices. This outcome was at least in part an effect of declining revenues in ● ● ● ● ● ●

nonspecialized wholesale products by 48.4 percent, wholesale sales of machinery by 44.4 percent, other specialized wholesale products by 36.4 percent, wholesale on a fee or contract basis by 25.6 percent, wholesale of food, beverages and tobacco by 20.6 percent, and and wholesale of household goods by 8.9 percent.

Sales revenues actually increased for the Slovak wholesale trade in agricultural raw materials and live animals by 6.8 percent and in wholesale sales of information and communications technology products by 4.1 percent for the year (Statistical Office of the Slovak Republic, 2009b).7 Obviously the slump in export markets affected domestic production and sales in the Slovak Republic. It should be noticed, however, that the decline in domestic retail sales of 9.2 percent (especially large in the sales of gasoline, household equipment, food, beverages, and tobacco), totaling ¤1,404.7, was smaller than many of the reductions in export sales listed above. In the six years ending with 2007, the last of Europe’s healthy years prior to the recession, Slovakia managed the remarkable feat of nearly tripling its total exports. Most of its trade was with the nations of the EU, but in 2002 a respectable 10.5 percent was with nations beyond Europe. With each of its main trading partners, the Czech Republic, Hungary, Russia, Poland,

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Austria, France, Italy, the United Kingdom, and the Netherlands, Slovakia was able to increase its exports significantly. Its total exports to intra-EU-27 nations increased from ¤13.6 to ¤36.8 billion, to extra-EU-27 nations from ¤1.6 billion to ¤5.6 billion. Total exports grew from ¤15.2 to ¤42.5 billion (Eurostat, 2009).8 The abundance of Slovakia’s sales abroad enabled the country to increase its imports in a dramatic fashion as well. The aggregate of imports likewise nearly tripled and the Slovaks purchased correspondingly increasing amounts with its most important partners, except for the United Kingdom, whose sales to Slovakia increased only marginally. One observes that immediate neighbors are generally a country’s most significant trading partners. In this case, that includes Germany and the Czech Republic; small neighbors Poland and Austria are nearly as important to Slovakia as the much larger EU traders, France and Italy. While this export growth was being achieved, well into the early phase of the credit crisis and downturn of many significant economies, the inflow of foreign direct investments into Slovakia created and expanded export possibilities among the country’s trade and investment partners. After a year of the global recession, however, the Slovak government’s foreign investments agency reported that it had arranged foreign direct investment deals totaling ¤538 millionfor 2008, which was less than half the ¤1.28 billion contracted in 2007. A good share of this had already been planned by Germany’s Volkswagen before the onset of the recession. Volkswagen will invest around ¤300 million on the expansion of its new assembly plant in eastern Slovakia. It was estimated that 34 investment deals arranged over the course of the year would create 4,624 new jobs. Like many other transitioning EU countries from Central and Eastern Europe, Slovakia has felt the stark impact of the financial crisis. Businesses everywhere have reconsidered their investment plans in the face of falling demand. Among the investments Slovakia has seen disappear or be postponed was a project by Sony Corporation of Japan to expand its LCD TV factory in Slovakia, a project reported to be worth around ¤240 million. The Real Estate Market in Slovakia It was novel that the credit crisis of 2007 resulted from the failure of “modern financial technologies.” That the sector which went through boom and bust phases to lead us to the crisis happened to be real estate was not novel. Numerous crises since World War II have found their impetus from housing booms and busts. Even without modern financial technologies, some of the

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European countries experienced cyclical phenomena from their real estate markets. With their accession to the EU, Slovakia accepted the responsibility of providing quarterly data on real estate prices to the European Central Bank. To meet that obligation, the National Bank of Slovakia, the Statistical Office of the Slovak Republic, the National Association of Real Estate Offices, and other groups gather survey data and develop price indices for the republic’s real estate market. The procedures for these tasks have been developed by the ECB, which provides specific requirements for the collection and structuring of the data and work has begun on the task (Cár, 2006).9 The Národná banka Slovenska10 cites data from the National Association of Real Estate Agencies in Slovakia indicating that residential property prices averaged ¤1,479 per square meter in the fourth quarter of 2008 (p. 10). That represented a decline of 4.1 percent from the third quarter. The average prices of houses and flats increased 23.9 percent in 2007, but rose more moderately in 2008 by 22.1 percent. Those price increases would appear to reflect bubble prices, although with prevalent conditions differing from those in the U.S. real estate market, one would have to be cautious in designating them as such. Housing prices in Slovakia increased significantly from 2002 to 2009. Over those seven years, housing prices for apartments, houses, and villas all increased by more than 100 percent. For houses and flats, the inexorable rise in prices ended in the second quarter of 2008, for villas it ended in the fourth quarter. Especially for flats, the decline was rather precipitous after that second quarter. In the fourth quarter of 2008, Slovakia’s banks made loans to households totaling ¤696 million for the purchase of housing. That reflected a moderately slowing tendency; the volume of loans in the previous quarter had been ¤66 million greater. In that final quarter, home loans were being offered with an initial fixed rate for over one year and up to five years. The National Bank of Slovakia (ibid.)11 indicates that by the close of the third quarter of 2008, the share of defaulted loans reached approximately 2.27 percent of the total. During the fourth quarter, interest rates for such loans continued to rise, although the central bank had reduced its rates significantly, after which rates fell in the economy generally. But the rates on home purchase loans are more sensitive to movements in long-term rates. One indicator for long-term rates is ten-year government bond yields; those fell to some extent, but not as significantly as the short-term rates did. All these changes are the result of the arrival of the credit crisis and the recession in Europe and Slovakia.

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The Ongoing Program of Reform in the Republic of Slovakia Having considered some of the particular difficulties associated with the onset of the recession, let us consider now how that unusually harsh downturn has impacted the development of the Slovak economy in more general terms. The EU has been pleased with the strong progress of Slovakia, but it is aware that there remains much progress to make. The EU has required the republic to prepare a formal plan for the continued reform of the economy and, to some extent, of the society as a whole. Slovakia’s finance ministry delivered such a plan in the form of its “National Reform Programme of the Slovak Republic for 2008-2010” (the NRP SR) in October 2008. The program sets out the main challenges confronting the Slovak economy’s sustainable, long-term economic growth and the ways in which such challenges can be overcome. Viable, ongoing growth is to be achieved by increasing the economy’s competitiveness and continuing the country’s progress toward living standard convergence with other advanced economies. These objectives are to be achieved by increasing the quality of education and rendering R&D processes more effective throughout the economy so that they generate greater and higher-quality outputs. Emphasis is laid on reducing the level of long-term unemployment and continuing to eliminate barriers to the country’s commercial development. This is to be achieved under the conditions of globalization and as one of the Eurozone economies. Objectives are to achieve long-term sustainable economic growth, increased social mobility, and strengthened social cohesion. Slovak policy designers also consider it crucial to improve the economy’s adaptability to changes in external economic, environmental, and other conditions. The specific, wide-ranging measures specified for the reform are designed to achieve the technological modernization of the economy, especially regarding the telecommunications and information industries. The suggested reforms are thorough and extensive. They begin with essential changes in education. Numerous changes have recently been legislated and the implementation has already begun in the reform of the elementary and secondary school systems. A transparent method of financing has been introduced, the state administration system has been transformed, and a comprehensive set of final examinations for classes completing the curriculum has been introduced. “Free choice” of educational opportunity is established, an independent state school inspection has been introduced, study programs have been adapted to the requirements of the labor market and computer classrooms, and every school has been given Internet connectivity (Ministry of Finance, Slovak Republic, 2008a).12 All of these changes have been implemented with an eye to a secular increase in employment for

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the economy. The most significant legislative effort for employment in the year preceding the introduction of the National Program was the amendment of the Labor Code, which targeted the improvement of conditions for employees and the communications and interactions between employers and employees. The effort to achieve social goals, for example, jobs for disadvantaged groups and the integration of those groups in the labor market, is referred to as social enterprise. The main goal of social enterprise is to reduce regional differences in employment, unemployment rates, and labor productivity. In the pursuit of greater competitiveness, the government will strive through its labor market policies to create conditions supportive of the process of upgrading the labor force’s skills and knowledge to suit the changing needs of a more dynamic economy. The government will also try to promote greater labor mobility and flexibility of the labor response to diverse opportunities and to different workday patterns. The increased flexibility of the workday should be beneficial for employees and “facilitate a reconciliation of work and family life” (ibid.).13 A key part of the strategy to strengthen growth sustainability is the introduction of “The Informatization Strategy of the General Government,” the principal document for the central government’s plan to promote the development of electronic services. Information systems will be implemented to create the necessary conditions for better communication and interaction between the general public and public sector administration. Energy is to play an important role in the overall economy and in its reform. In April 2007, the Slovak government published its “Concept of the Higher Use of Renewable Energy Sources in the Slovak Republic.” This program is expected to increase current (approximate 4 percent) renewable energy sources as a share of total energy consumption. In July 2008, the “Concept of Energy Effectiveness in the Slovak Republic” decreed the objective of gradually reducing energy consumption through new innovations and energy efficient technologies in all sectors of the economy. Graduate programs in Slovak universities are believed by the framers of the NPR SR not to create sufficient competition among universities to gain Ph.D. students for the best research projects. The perception is that this produces a significant weakness in the country’s support of science and technology. Moreover, dissertations are sometimes not connected with the research of the thesis advisor (ibid.).14 The reform program makes the important point that there is insufficient quality interaction between institutions of higher education and other research institutes in Slovakia, such as the Slovak Academy of Sciences and the research institutes of the government’s ministries. There is likewise

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too little interaction between the research institutes and institutions that should be implementing R&D developments in actual commercial practice. Because there is insufficient cooperation between pure R&D institutions and the business sector, waste and lost opportunities are manifest. The social and economic impacts of R&D projects are far too limited and, because these are generally funded by public revenues, there persists an insufficient culture promoting innovation among the small and middle-sized entrepreneurs. Finally, capturing the power of the Internet for the consumer and for the worker is seen as a key element for the upgrading and modernization of economic and social processes. Access networks are insufficiently developed in the rural parts of the country. The public sector’s interface with the populace is also burdened with low broadband penetration. This is especially true of the municipalities, one-third of which have no Internet connection at all. Measures to increase the availability and technical support for Internet access are designed to make the Internet a fundamental part of the country’s infrastructure. The Ministry of Finance has estimated that the National Reform Program will cost, for the three year period including 2008 through 2010, nearly ¤2.5 billion (Ministry of Finance, Slovak Republic, 2008a). I have not been able to determine whether these expenditures are to be canceled or reduced as a result of the financial crisis. The structure of the outlays, involving the substantially greater expenditures for highways and “business environment,” would seem not to enhance the other expenditures for R&D, innovations, and education, which are highly relevant for the promotion of technology and innovation. This fascinating document demonstrates that Slovakia has made solid progress since the transition to market democracy began in 1990. The republic has come a long way in removing old institutional barriers to modern market economics and governance. It has demonstrated that extreme incentive incompatibilities could be overcome and economic reform could in fact start the economy rolling. That transition is now essentially complete and Slovak policy designers recognize that they must continue to build a modern, technological society of lifelong learners. Slovak leaders are beginning to explore every facet of improving their society. The key elements are providing education, combining formal education in practical ways with the private commercial sector, and spreading technological knowledge, skills, and penchants. Family life must be promoted by a flexible integration of career development and career life with that of building a functional family. Reading the NPR SR is reminiscent of the books in the United States of about 20 years ago that tried to forecast trends in

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the work arena, family life, professional involvement, educational change, and other social phenomena that generally change rather slowly in Western society. Financial Prospects for the Slovak Republic in and beyond the Recession In an economy in which the subnational governments have little capacity to affect their own revenues, their fiscal future is determined by how well the central government can generate revenues and by the center’s willingness to transfer those funds through grants and tax transfers to the subnational governments. There is no doubt that the recession will reduce the budget revenues of the republic’s central government by a significant amount. And it is obvious that subnational governments, especially the municipalities, will have their less-than-impressive individual revenue sources also restricted by the downturn in economic activity. Finance Minister Ján Poˇciatek estimated on the basis of preliminary data that the budget for 2009 would be reduced by about ¤330 million, which approximates half a percentage point of the GDP. The finance ministry (2008b) has provided forecasts of revenues from 2008 to 2011 through its Tax Revenue Forecasts Committee, which in turn draws information from the country’s Macroeconomic Forecasting Committee. Patrons of these forecasts are warned about the considerable degree of uncertainty involved in their projections, especially given the uncertainty of an economic environment in which the economic effects have been devastating. That uncertainty, the ministry argues, opens the door to suspicions that the revenues could be deliberately overestimated or underestimated by those involved in the preparation of public budgets. The Tax Revenue Forecasts Committee is legally required, therefore, to strengthen public control over the process by involving experts from the public to participate in the process. Leading experts from the finance ministry, the state treasury, the National Bank of Slovakia, the country’s leading banks, and other financial institutions participate in the development of preliminary forecasts and in their modification. An overall evaluation is also produced by this group indicating whether a conservative, realistic, or optimistic forecast has been produced. The Slovaks must adapt to public revenues that are rising, but because of the recession are less than they otherwise would have been. These increments represent growth of just over 8 percent, so this uncertain forecast shows growth not too much less impressive than that of recent years. One can observe the total tax revenues rising by increments of roughly ¤26 billion, ¤29 billion, ¤32 billion, and ¤31 billion from 2008 to 2011. Such

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increments represent growth of just over 8 percent, so this (uncertain) forecast shows growth not too much less impressive than that of recent years. All members of the Tax Revenue Forecasts Committee consider this forecast realistic with the exception of the National Bank of Slovakia (NBS). According to the NBS, the forecast is too optimistic. These data forecast revenues rising after 2007, a year in which public sector revenues were soaring along with the production of the country’s largest annual output of goods and services in its history. If accurate, the data show the country avoiding a disastrous decline in the public sector’s share of the GDP. If these figures give the impression that the Slovak government will not face too much deprivation in the months to come, they still paint a less positive picture than the republic had envisioned before the crisis. On February 3, 2009, Ivan Gašparoviˇc, president of the republic, issued a call for the municipalities and regions to step forward and communicate which contributions they would like to offer in the struggle to overcome the effects of the crisis (Nižˇnanský and Marušinec, 2009).15 Self-governing units, he asserted, should take on themselves some of the tasks that the state is currently performing, to save funds in the struggle against the crisis. Those funds could then be transferred to the municipalities. Moreover, President Gašparoviˇc suggested the necessity of eliminating the institution of state administration to transfer competence to the self-governing activities of the municipalities and regions. This would be done, of course, with the transfer from the central government of adequate financial means to perform the transferred tasks. Without that support, the subnational governments (self-management) must fund many of those activities from their own budgets. Here is a proposal born either of financial desperation, fear, or both. There has not been much discussion about having the central government of Slovakia remove itself from its constitutional role of running a good share of the activities, programs and projects that would normally belong to the municipalities and regions. In the first chapter of this book, fiscal decentralization was seen from the earlier perspective that under communism the central government, under the direction of the communist party, was responsible for all of society’s important decisions and tasks. The vehicle for such governance was the institution of state administration, which defined as the responsibility of the central government many of the important decisions and tasks that remain strictly in the realm of subnational governments in Western democracies. Because the Slovak and Czech republics are small and favored with efficient governments in Bratislava and Prague, they have routinely undertaken to do many of the tasks they are convinced that their many small municipalities are not in a position to perform. (Never mind that they

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do the same things for larger municipalities that do have the resources to perform such tasks.) Now, in the face of financial shortfalls, it occurs to the president that many central government financial burdens are shouldered by local governments (LGs) in most Western countries. He therefore acknowledges the perversity of this centralist tendency and calls for voluntary (and counter constitutional) change, asking LGs to shoulder at least some of those burdens. Such change would require a transformation in the incentives of LG personnel. These people are quite accustomed to letting the central government take many standard municipal tasks off their hands. They are perfectly willing to let the central government retain the responsibility for raising funds to finance those tasks. Why should the struggling municipalities want to take on more tasks? Even if funds for them were also transferred, LGs would have to dedicate from their staffs the workforce and time to do what previously has not been required. It would be surprising if we were to hear more of the president’s suggestions. Still, the trend in Slovakia has been to move inexorably toward fiscal decentralization, and the question of the legitimacy of state administration will likely be raised again. Conclusions The more-than-solid pre-crisis economic performance of Slovakia suggests optimism for the country’s future. Before the economic downturn, the dark night of communist central planning was on its way to becoming nothing more than an unpleasant memory. The legacies of the anti-market regime are still observable in the country, but are fading. The country still requires modernization of many of its physical structures, its labor force needs to continue to upgrade its skills, more sophisticated technologies still want introduction, and the capacity to generate new technologies needs to be increased. Because the country is making notable economic progress, it can think critically about a very promising future and work optimistically to prepare for it. The great amount of work remaining to be done is particularly evident in the municipalities, including the many small ones that linger in the shadows of the larger cities. The country still needs heavy investments in health care systems, housing, infrastructure, information and telecommunications industries, and so on. Many of the needs seem most apparent at the subnational level. But this people of great ability and resourcefulness mostly just need time and growing incomes to express their economic talents and to secure their future. They were engaged in that process when the financial crisis and the accompanying economic recession interrupted their forward thrust. Their own policies and practices had not been responsible

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for this latest misfortune, but externally delivered miseries are not fully new to them. As has been observed throughout this book, it is also important that the Slovak municipalities and regions gain fiscal independence to match the country’s political aspirations. The republic has shown itself willing and inclined to embrace the sometimes difficult reforms that will ultimately permit it to create greater subnational autonomy than some of the more established and traditional democracies among their EU neighbors. It seems unlikely that the current economic pause will be great or long for the Republic of Slovakia. The Slovaks have no control over the external demand for their globally marketable products and services, and the speed and robustness of their recovery cannot be foreseen. But the arrival of recovery finds them facing as many open doors as enticed their economy before the crisis began. As the recovery proceeds, increasing flows of funds will be finding their way even to the smallest of Slovak towns.

Notes

2 Taxes on Real Property in the Czech Republic 1. The Czech Republic has a population of 10.3 million, nearly twice the size of Slovakia’s population, and a land area of about 79,000 square kilometers, nearly a third larger. Its area is a little smaller than Austria and almost identical in size to Scotland, with a population density somewhat higher than that of most countries in Central Europe, although only about a third of Germany’s. 2. According to Brada (1996, p. 72), “On the basis of these plans, some firms were privatized by nonvoucher methods, including tenders and direct sales to new owners, including foreign investors. Ultimately, 1,491 state-owned enterprises, 988 of them from the Czech Republic, were included in the first wave of voucher privatization, which ran from October 1991 to December 1992, and a second wave, from August 1992 to November 1994, privatized a further 861 firms in the now-independent Czech Republic.” 3. In assuring the competent administration of these small units, a private corporation, Triada, has developed to provide consulting services for smaller municipalities. It currently services more than 1,000 of them, providing software for accounting and personnel and other purposes. 4. Bird, Ebel, and Wallich (1995, p. 37) write of a “tendency for local governments to feel they have a primary claim on tax revenues generated within their jurisdiction” and point out that such “source-based taxation (also known as derivation-based) is unusual at the subnational level in market economies because of the inequities and inefficiencies that are likely to result from allowing subnational governments to keep large shares of the taxes levied on firms producing for a national or world market.” 5. Kameniˇcková (1996, p. 16) writes, “As a result of this, a discord occurs in local budgets between the authority and competence of the municipality on the expense side which is rather high, and the competence on the income side which is very limited.” 6. Less than 300 residents, 0.3; 300–600, 0.6; 600–1,000, 1; 1,000–6,000, 1.4; 6,000–10,000, 1.6; 10,000–25,000, 2; 25,000–50,000, 2.5; 50,000+, 3.5; and Prague, 4.5.

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7. A construction tax is levied at the time of inspection. The rates vary according to the types of construction, e.g., residence, vacation home, commercial, or industrial.

3

Land and Building Taxes in the Republic of Slovakia

1. With a population of only 5.364 million Slovaks and an area of 49,012 square kilometers, Slovakia represents about 62 percent of the 78,864 square kilometers of the Czech lands of Bohernia and Moravia. Slovak population density approximates that of France, Hungary, and Portugal, with significantly more space for the average Slovak than that available for the counterpart Czech. Slovakia has 109 citizens per square kilometer of territory, the Czech Republic has 131, Germany has 228, France has 105, Russia has 9, the United States has 28, and the average for Europe is 32 (Medzinarodne prehl’ady 1997, p. 627–628). 2. Valko (1997, pp. 76 and 77) notes that the new Slovak constitution “establishes the possibility to stop the process of privatization and/or restrict business activities and to reverse various measures that already had been taken in this respect.” Again, “efforts were made to slow down economic reform and to reinstate state control over the economy or its disposition.” 3. The two groups conduct regular meetings for training and professional development. They are active in the development of policy relative to their financial relationship to the central government and the proper level of government for the provision of services. The emergence and the focus of these two groups appear to be a direct result of the U.S. Agency for International Development mission in Bratislava, which adopted the policy of building administrative infrastructure in local governments in Slovakia and has conducted regular workshops on personnel and financial issues germane to the management of local governments in countries in transition. 4. The organization has been active in drafting and reviewing legislation on public administration and public policy issues for subnational governments. An important issue it and the central government have been struggling with is the assignment of responsibilities for public services between these two bodies of government. The organization has also set up a foundation to train city employees in all areas of local government responsibilities in Slovakia. 5. Slovakia’s people are not happy with the sacrifices implied by the pursuit of transformation objectives. In 1993 a U.S. Information Agency opinion poll showed 47 percent of Slovaks preferring the current system to the previous communist one; 42 percent said it was worse. No less than 72 percent agreed that democracy did not fulfill their expectations; only 23 percent said it did. The economic situation in 1993 seemed better than under socialism for 22 percent, but 71 percent deemed it worse. Finally, 39 percent preferred private rather than state control of business, whereas 53 percent favored state control (Marcinˇcin, 1996, p. 11). 6. In 1994 and 1995, 17 percent of state-owned property was privatized by the “standard method” of direct sales, bringing the overall share of privatized industrial properties to 45 percent of the total (Mikloš, 1995, p. 11). In 1996

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approximately 400 direct sales were made at a price of SKK 18 billion (Frensch, 1997, p. 21), or roughly another 5 percent of total industrial properties privatized with the total task about 50 percent completed. The National Property Fund sells assets at prices significantly below book values; it does not issue any information about competing projects or the relevant sales criteria. The first installments have usually been only about 20 percent of the negotiated sales price. Generally, as much as 50 percent of the payments of the purchase price have been forgiven if the purchaser declared himself or herself ready to use that monetary equivalent for investment purposes. “In the case of Slovnaft, when 39% of shares was sold, 84% of the sale price was later forgiven” (Marcinˇcin, 1996, pp. 12–13). Furthermore, “Very controversial was an amendment to the Income Tax Law, approved in late March 1996, which freed new owners of privatized companies from paying taxes on income resulting from an NPF decision to lower the purchase price of the property. Although a forgiven payment is considered an income, the law exempts new owners from paying tax on such income if the remaining money is used for investment purposes.” Twenty-seven companies are specified in energy, the gas industry, the postal service, telecommunications, armaments, pharmaceuticals, machinery, agriculture, forestry, and water resources. Forty additional companies will be subject to privatization, but the state has assured the preservation of its right to influence them. “The state maintains a ‘so-called golden share’ (a share with special rights) in those joint-stock companies, where the majority stake has already been privatized” (Mikloš, 1997, p. 111). According to Mikloš, a former privatization minister, this golden share contradicts a constitutional principle of equality among various forms of ownership. Furthermore, it was to be implemented retroactively in firms previously privatized. Mikloš (1997, p. 25) sees the ongoing ownership of the National Property Fund of significant shares of large Slovak firms as a rather ominous situation, making it likely that two parallel “private” sectors exist in Slovakia today: “One, characterized by large monopolies, supports government, cooperates with it and affects legislation and state economic policy, by which it ensures its particular position, while the second private sector is characterized by small enterprises, without protection from state officers and monopolies.” Marcinˇcin and others have documented this assertion at length. He explains why an opinion poll published in 1995 found that “only 14% believed that the current coalition changed its privatization program for reasons other than strengthening its political power” (Marcinˇcin, 1996, p. 17). It was widely reported during the political crisis of late 1997 that an important element of Czech reform inadequacy was the inappropriate retention of state influence on the private sector. Through the state-owned banks, firms could be encouraged, through state moral suasion and lending policy, not to downsize their workforce. In the seven years since the Velvet Revolution, the legacy of labor hoarding from the previous planning regime has still not been overcome. The same can be said for the Slovak economy.

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Moral Hazard in Property Tax Administration: A Comparative Analysis of the Czech and Slovak Republics

1. The principal/agent framework is simplified here; since we do not explicitly include the role of property owners, citizens, and those who benefit from public expenditures. In a democracy, the citizen is, of course, the principal, but considering the local governments in most situations to share the citizen’s incentives highlights the core issues and significant relationships. In a federal system, the local government will have trouble monitoring the agent central government, which is problematic because of their conflicting goals. Agents are not always unfettered in their behavior. In some instances, national and subnational governments will monitor each other to the extent possible, with both attempting to promote the interests of the principal, the citizen.

9 A Survey of Perspectives on Intergovernmental Relations: A Comparative Analysis of the Czech and Slovak Republics 1. Another set of inquiries regarding the specific breakdown of municipal expenditures fell under the rubric of question 17. The responses to that complex of questions yielded a large amount of data that suggest the subject of another chapter. Including that material would exceed the publisher’s limits on the size of this book. 2. See Holzman (1992), which indicates that the Czech Republic also grants exemptions on the value-added tax for consumer goods “with detrimental consequences for tax revenue.” 3. Although differences existed in the number of Czech and Slovak managers interviewed, each question considered for analysis had a sufficient number of responses for reliable statistical testing. In addition all analyses included a test for the equality of variances, and depending on the outcome, the appropriate statistical method for testing differences between group mean values was selected and used. Unfortunately, we were not informed by the assisting associations how many municipals were requested to respond to the survey and are unable to say what the response percentage was. If the survey were sent to every municipality online, the Slovak participation rate would have been around 5 percent. All Slovak municipalities are not members of ZMOS, so with nonmembers not receiving the survey, the response rate would have actually been somewhat higher. Using the same reasoning for the Czech case, we would estimate the response rate to be around 12 percent to 15 percent. 4. By way of orientation, in 2005 the dollar exchanged for 24 crowns, whereas in 2002 the exchange rate was 40 crowns per dollar. By November 2007, the exchange rate was just under 18 crowns per dollar. In June November 2008 the euro exchanged for approximately 15.5 CZK. 5. Hagen et al. (2000) have carefully investigated the problem of bailouts, and they have illuminated some important sources of the problem in presenting four

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case studies of bailouts of subnational governments in Australia, Germany, Italy, and Sweden. Their abstract reports that “the case studies show that bailouts can occur in a diverse set of institutions shaping the relations between central and subnational governments. Surprisingly, there is little evidence in favor of the ‘too big to fail’ argument explaining bailouts. In contrast, elements of political favoritism play some role in most cases. The cases also indicate the importance of properly designing principal-agent relationships in the decentralization of public finances. Constitutional mandates for uniform provision of public services and attempts by the central government to dominate subnational governments in matters of fiscal policy seem to be conducive to bailouts.” 6. Our responses were coded with scores of 1 for SA, 2 for A, 3 for uncertain or unwilling to say, 4 for D, and 5 for SD. Of the 373 responses included in the analysis for the Czech Republic, the mean response for question 1 was 2.55 (standard deviation 1.162). For question 2 the mean response was 1.94 (standard deviation .915). The Pearson correlation between question 1 (“we operate with autonomy”) and question 2 (“we are dependent on financial transfers) was only −.059 and the significance of a 1-tailed test was .128, or insignificant at the.05 confidence level. Regressing the responses to question 1 on question 2 yields an R 2 no greater than .003, which is not significant at the .05 confidence level. This is interpreted to mean that the Czech responses to the two questions showed no statistically significant functional relationship. It was as though the two responses were from different groups, i.e., they were answered from two completely different perspectives. It was as though one group of people was explaining in question 1 that they had decision-making responsibilities and an important job to perform and another group was explaining in question 2 that their ability to function independently was curtailed significantly by their dependence on centrally provided and managed financial resources. For the Slovak case, the mean response for question 1 was 2.58 (standard deviation 1.109). For question 2 the mean response was 2.10 (standard deviation .986). The Pearson correlation between response 1 (“we operate with autonomy”) and response 2 (“we are dependent on financial transfers”) was only .101, only a little higher than the Czech case, and the significance of a 1-tailed test was also a little higher at .222, but still far from significant at the .05 confidence level. Regressing the responses to question 1 on question 2 yields an R 2 no greater than .010, which is not significant at the .05 confidence level. This analysis yields the same result as that of the Czech Republic. t-Tests of the means of samples for the two countries failed to demonstrate any statistical difference between their means.

10

Decentralization and Local Finance in the Czech Republic: With an Update on the Property Tax

1. See Jorge Martinez-Vazquez and Robert McNab (1997), Tax Systems in Transition Economies, International Studies Program, Working Paper 1–97, Georgia State University School of Policy Studies, xv.

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2. Ibid., p. 6. 3. Agenda 2000—Commission Opinion on the Czech Republic’s Application for Membership of the European Union, DOC/97/17, Brussels, July 15, 1997. 4. See EC 2000 Regular Report From the Commission on The Czech Republic’s Progress towards Accession. See the Commission’s website. 5. A similar set of reforms has been undertaken in the Slovak Republic, where the discussion (like the need for change) has been even bolder than in the Czech Republic. 6. Martinez-Vazquez and McNab, Tax Systems in Transition Economies, p. 6. 7. See Gabriela Bártíková, Ministerstvo vnitra, “Informaˇcní servis k reformˇe veˇrejné správy” (Prague, January 23, 2003). http://www.mvcr.cz/aktualit/sdeleni/2003/ reforma.html (last accessed July 22, 2003). 8. Pavel Bureš et al., Public Administration Reform in the Czech Republic (Prague, 2002), p. 8. 9. Bártíková, “Informaˇcní servis.” 10. Josef Postránecký, “Obce s rozšiˇrenou p˚usobností (Soulad správních obvody a standardizace veˇrejných služeb),” Deník Veˇrejné Správy. http://denik.obce.cz/go/ clanek.asp?id=5520002 (last accessed July 8, 2003). 11. See Gabriela Bártíková, “Zmˇeny v územní veˇrejné správy od 1. 1. 2003,” Deník Veˇrejné Správy. http://denik.obce.cz/go/clanek.asp?id=5279535 (Prague, 20.12.2002) (last accessed July 8, 2003). 12. See Bureš, Public Administration Reform, p. 21. 13. Ibid. 14. Oliveira and Martinez-Vazquez, op. cit., p. 45. 15. D˚uvodová zpráva k vládnímu návrhu zákona o stabilizaci veˇrejných rozpoˇct˚u [Report accompanying the proposal of the law on public budget stabilization]. http://www.psp.cz/sqw/text/text2.sqw?idd=11050 (7.5.10 last accessed March 27, 2010). 16. Comparison of 293 cadastral units randomly selected out of 12,998 showed the price increased between 1996 and 2008 on average by 2.9 percent, ranging from 40 percent decrease to 56 percent increase. 17. Average for the three years estimated (2001: 13.1 percent, 2002: 13.5 percent, and 2003: 13.4 percent). 18. January 1, 2007 19. http://vdb.czso.cz/vdbvo/tabparamzdr.jsp?vo=tabulka&kapitola_id=18&cislotab =MOS+A04+OB2.2&verze=2 28.4.2010. 20. Obecnˇe závazná vyhláška mˇesta Berouna o stanovení koeficient˚u pro výpoˇcet danˇe z nemovitosti cˇ. 5/98 [Public notice on setting tax coefficient, no. 5/98]. http://www.mesto-beroun.cz/ (last accessed March 3, 2008). 21. Obecnˇe závazná vyhláška mˇesta Berouna o osvobození od danˇe z nemovitostí na území Mˇesta Beroun cˇ. 2/2003 [Public notice on exemption from the real estate tax on the territory of Beroun, no. 2/2003]. http://www.mesto-beroun.cz/ (last accessed March 3, 2008).

Notes

11

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Slovakia’s Surge: The New System’s Impact on Fiscal Decentralization

1. The Republic of Slovakia has a population of 5.364 million. Its surface area of 49,012 square kiloutilizations is roughly 62 percent of the size of the Czech lands of Bohemia and Moravia. Slovak population density approximates that of Portugal, Hungary, and France, with significantly more space for the average Slovak than that available for the average Czech. Slovakia has 109 citizens per square kilometer of territory, the Czech Republic has 131, Germany 228, France 105, Russia 9, the United States 28, and Europe 32; see “Medziná rodné prehl’ady,” Štatistická Roˇcenka Slovenskej republiky (1997), (Bratislava, Štatistický úrad Slovenskej republiky), pp. 627–628. 2. See Ernest Valko (1997), “Legislation,” in Martin Bútora and Péter Hunˇcík (eds.), Global Report on Slovakia: Comprehensive Analyses from 1995 and Trends from 1996 (Bratislava: Sándor Márai Foundation), pp. 75–86. Valko tells us that the new Slovak constitution “establishes the possibility to stop . . . the process of privatization and/or restrict business activities and to reverse various measures that already had been taken in this respect” (p. 76). 3. Both groups offer regular training and professional development. They strive to influence policy relative to intergovernmental financial relationships and local service provision. The existence and activities of both groups appear to have been positively influenced by the former USAID Mission in Bratislava, which assisted in establishing local administrative infrastructure in Slovakia and in training managers of local governments. 4. The organization participates in drafting and reviewing legislation on local government administration and policy. ZMOS has also organized a foundation to train city employees to perform local government functions. 5. See Phillip J. Bryson and Gary C. Cornia, “Public Sector Transition in Post-communist Economies: The Struggle for Fiscal Decentralization in the Czech and Slovak Republics,” Post-Communist Economies 16, no. 3 (2004), pp. 265–283. 6. See Phillip J. Bryson and Gary C. Cornia (2001), “Land and Building Taxes in the Republic of Slovakia,” in Joan M. Youngman and Jane H. Malme (eds.), The Development of Property Taxation in Economies in Transition: Case Studies from Central and Eastern Europe (Washington, DC: The World Bank), pp. 51–66. 7. This point is well established by Richard M. Bird, Robert D. Ebel, and Christine I. Wallich (1998), “Fiscal Decentralization: From Command to Market,” in Richard M. Bird, Robert D. Ebel, and Christine I. Wallich (eds.), Decentralization of the Socialist State: Intergovernmental Finance in Transition Economies (Washington, DC: The World Bank), pp. 1–67. 8. See Jennie I. Litvak, Richard M. Bird, and Junaid Ahmand (1998), Rethinking Decentralization in Developing Countries (Washington, DC: The World Bank). 9. See Richard A. Musgrave (1993), “Who Should Tax, Where, and What,” in Charles E. McLure Jr., Decentralization of the Socialist State: Intergovernmental

266

10. 11. 12.

13. 14. 15.

16. 17. 18. 19. 20.

21. 22. 23. 24.

25. 26.

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Notes

Finance in Transition Economies (Canberra: Center for Research on Federal Financial Relations, Australian National University), pp. 2–19; and Wallace E. Oates, “Taxation in a Federal System: The Tax-Assignment Problem,” Public Economics Review 1, no. 1 (1996), pp. 35–60. See Joan M. Youngman and Jane H. Malme (1994). An International Survey of Taxes on Land and Buildings (Netherlands: Kluwer Law and Taxation Publishers). See Andrei Shleifer and Robert W. Vishny (1998). The Grabbing Hand: Government Pathologies and Their Cures (Cambridge, MA: Harvard University Press). See Anne Paugam (1999). Ad Valorem Property Taxation and Transition Economies, ECSIN, Infrastructure Unit Europe and Central Asia Region. World Bank, Working Paper No. 9. See Bird, Ebel and Wallich, ‘Fiscal Decentralization . . .’, p. 59. Finance Ministry interview, March 2005. See Richard A. Musgrave (1961). Approaches to a Fiscal Theory of Political Federalism. In Public Finance: Needs, Sources and Utilization (National Bureau of Economic Research, Princeton: Princeton University Press), pp. 97–122. See Jitka Peková (2004). Obce a dotace, Obec & Finance, 1(1), 28–31. See Bryson and Cornia, ‘Public Sector Transition . . .’ Ibid. See Pavel Bureš, et al. 2002, Public Administration Reform in the Czech Republic. (Prague: Czech Ministry of the Interior), p. 8. I was able to verify this in a finance ministry interview in March 2005, where it was reported to me that “vubec nic” (absolutely nothing) was occurring in the realm of fiscal decentralization or the property tax, given the extreme concern with the national budget deficits. At that time, the finance ministry was also in the process of conducting an “audit” of personnel and personnel functions as a part of the intent to reduce the ministry staff from ca. 1,400 to 1,000. See Viktor Nižˇnanský and Jaroslav Kling (2002). Slovensko 2002. Súhrná správa o stave spoloˇcnosti Verejná správa (Bratislava: Verejná Správa), p. 252. See Government Office of the Slovak Republic (2000). Ibid., p. 4. See Viktor Nižˇnanský and Jaroslav Pilat (2002). “Public Administration Reform in the Slovak Republic-Management of the Process,” in Gábor Péteri (ed.), Mastering Decentralization and Public Administration Reforms in Central and Eastern Europe (Budapest: Local Government and Public Reform Initiative Studies), 215–232. See Miroslav Kˇnako. 2002. Daˇnová reforma. Bratislava. See Ministry of Finance of the Slovak Republic. 2004. The Fundamental Tax Reform, December 2004. On this point, see the elaboration by Ivan Mikloš. 2006. Nineteen percent in Operation—the First Year of the Tax Reform, Ministry of Finance of the Slovak Republic, 18 January. http://www.finance.gov.sk/EN/Default.aspx?CatID1/4 10&id 1/4 12. The Slovak tax reform has not brought about anything radically new as far as the principles on which it is based are concerned. In fact, quite the opposite could be stated in the sense that it is only the fulfillment of the

Notes

27. 28.

29. 30. 31.

32. 33.

34.

35. 36. 37. 38.

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basic tax principles, as adumbrated on the first pages of every textbook on tax theory. These are simplicity, neutrality, efficiency, and equity. A further principle is the transfer of emphasis from the taxation of goods and creation of services (revenues) to the taxation of consumption. But the reality is that practice in this area is dramatically different in most of the world’s countries. The causes lie in particular in the gradual but successful penetration of statism, interventionism, subjectivism, populism, group interests, and similar effects into economic policy and in the subsequent, politically very difficult, process of the removal of the distortions they cause in the tax system. See Zdenko Krajˇcír and L’udovít Ódor. 2006. “First year of the Tax Reform, or 19 percent at work”, p. 8. See Ministry of Finance of the Slovak Republic. 2004. Updated Convergence Program for the Slovak Republic Covering the Period 2004–2010. Much of the data used in this paper can be found at the website of the Ministry of Finance of the Slovak Republic, the home page of which is at http://www.finance.gov.sk/en/ Default.aspx. Ibid., p. 31. This was pointed out to me by officials of ZMOS, the Slovak Union of Cities and Towns, in Bratislava in March 2005. See Parliament of the Slovak Republic. 2005. The Act on Local Taxes and Levies on Municipal Waste and Minor Construction Waste, No. 582/2004 Coll, Collection of Laws, 2004. The perspective is that of the Economics Director of ZMOS on the occasion of my interview in March 2005. See Dušan Zachar. 2004. Reforms in Slovakia, 2003–2004: Evaluation of Economic and Social Measures, INEKO, Institute for Economic and Social Reforms, July, p. 38, http://www.ineko.sk/english/publications_heso_2003_2004.pdf. In a single, stand-alone sentence, the Government of the Slovak Republic addressed the issue of the developing real estate market, the values of which would replace the old coefficient system. It said, “Depending on how realistic real estate prices become, which is a basis for the taxation of property transfers, the Government will revise the current property tax rates and adopt corresponding solutions to unify them.” If prices are “realistic,” the government will ensure realistic, unified rates. This government statement does not appear to reflect the current stated finance ministry policy of letting municipalities work out their own property tax rates. See Government of the Slovak Republic. 2002. Policy Statement of the Government of the Slovak Republic, Public Finance Reform, p. 4. See Zdenko Krajˇcír and L’udovít Ódor, “First year of the Tax Reform, or 19 percent at work”, p. 74. See Government of the Slovak Republic. 2002. See Ministry of Finance. 2004, p. 33. See Slovak Economy, ‘Slovak Economy Growing the Fastest in Central Europe Region’, Friday, March 11, 2005, http://www.slovensko.com/news/2070 (last accessed April 13, 2010).

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39. See International Monetary Fund, ‘IMF Executive Board Concludes 2004 Article IV Consultation with the Slovak Republics’, February 17, 2005. 40. See Organization for Economic Co-operation and Development. 2004. Economic Survey, Slovak Republic 2004: What Key Challenges does Slovakia Face? Paris, 2004, from an online site no longer available. 41. See World Bank. 2004. Slovakia Country Brief, September. Available at the World Bank site, which is found at http://www.worldbank.org/ 42. See Zdenko Krajˇcír and L’udovít Ódor, “First year of the Tax Reform, or 19 percent at work”, p. 7.

12

The Global Crisis: Origins and Arrival in Europe

1. Off-balance-sheet financing involves methods of fund-raising not reflected in a company’s balance sheet. The instrument or contract used, perhaps a swap or option, may change a company’s risk profile, but it appears only in the notes to the accounts and not directly as assets or liabilities. Examples would include sale and leaseback and operating leases. With an operating lease, a company would rent rather than buy assets. Since a leased asset and leasing liabilities are not shown in the balance sheet, the company’s reported indebtedness is unaffected. 2. Since the 1980s, the use of quantitative models has provided tremendous gains in the quality of risk assessment and management of financial institutions, thus making understandable (at least to “quants”) what the risk exposure of banks really is. But, as Hellwig (2009, pp. 51, 52) observes, “correlations are subject to change over time. Even with the best of data, correlations are therefore hard to ascertain empirically, and risk models are notoriously unreliable about correlations. Yet the importance of correlations is shown very clearly by . . . the common dependence of mortgage-backed securities on the factors that were underlying the development of US real-estate markets. The impact of systemic risk in the crisis, provoking a downward spiral in many markets at once, provides another illustration. The quantitative risk models had not taken these systemic risks into account. Nor could they have done so, given the lack of relevant information and data.” 3. This readable and rather comprehensive paper serves as a reliable handbook on the financial aspects of the crisis. 4. We can return to the insurance analogy to see this clearly. For life insurance the probability of two separate individuals’ deaths are independent. One insurer is generally unaffected by the death of another, and few people die on any given day. The death event can even be forecasted so that the insurance company has sufficient reserves to pay out death benefits as required. In contrast to this, consider what happens if overextended borrowers in numerous states start to go into default at the same time. Foreclosures increase, housing prices fall, CDO and MBS values plummet, and CDS insurance benefits must be paid out. Furthermore, the falling housing prices cause many more borrowers to default, since when the balance on

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a mortgage becomes larger than the current market value of a home, the incentive to pay practically disappears. Thus, unlike life insurance with its independence, regulation and reserves, the mortgage, CDU/MBS, and CDS markets were vulnerable to a particular single event, the occurrence of massive defaults that were highly correlated.

13 Subnational Finance Today and Tomorrow in the Czech Republic: Impacts of the Financial Crisis and Global Recession 1. IMF report on the state of Czech Republic’s Economy in 2008, Concluding Statement of International Monetary Fund’s (IMF) mission to the Czech Republic in the year 2008, available online at http://www.businessinfo. cz/en/article/czech-republic-business-news/imf-report-czech-republic-economy2008/1001536/51085/. 2. Ibid. 3. Ministry of Finance, Czech Republic. 2009a. Macroeconomic Forecast, Czech Republic, Department for Financial Policies, January, available at http://www. mfcr.cz/cps/rde/xchg/mfcr/xsl/macroeconomic_forecast.html, accessed April 14, 2010. 4. Ministry of Finance, Department for Financial Policies. 2009e. Macroeconomic Forecast, Czech Republic, April, available at http://193.86.123.148/cps/rde/xchg/ mfcr/xsl/macroeconomic_forecast.html 5. Ibid., p. 14. 6. Klaus, Vaclav. 2008. Europe and Its Ongoing Financial Crisis, March 16, Centrum pro Ekonomiku a Politiku, Prague, Czech Republic, available at http://www.klaus.cz/Klaus2/asp/clanek.asp?id=YVnsGyrNjVUR accessed April 15, 2010. 7. T˚uma, Zdenˇek. 2009. Nature of the crisis and its propagation in the CESE region, European Banking and Financial Forum, Prague, March 24. 8. Ministry of Finance, Czech Republic. 2009a. Macroeconomic Forecast. 9. Ibid., p. 15. 10. Ibid., p. 16. 11. Ministry of Finance, Department for Financial Policies. 2009e. Macroeconomic Forecast. 12. European Commission. 2009. The Czech Republic, European Commission assesses Stability and Convergence Programmes of Bulgaria, the Czech Republic, Denmark, Germany, Estonia, Hungary, the Netherlands, Poland, Sweden, Finland and the United Kingdom, February 18. 13. see Ministry of Finance, Czech Republic. 2009c. The Czech President, News of the Finance Ministry, available at http://www.mfcr.cz/cps/rde/xchg/mfcr/xsl/en. html accessed April 15, 2010. 14. Ministry of Finance, Czech Republic. 2009a. Macroeconomic Forecast. 15. Ibid., p. 22.

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16. Dalsgaard, Thomas. 2008. Tax and Welfare Reforms in the Czech Republic— Structural Implications and Challenges, International Monetary Fund Working Paper, March. 17. Ibid. 18. Ibid., p. 10. 19. Ministry of Finance, Czech Republic. 2009a. Macroeconomic Forecast.

14 Subnational Finance Today and Tomorrow in the Slovak Republic: Impacts of the Financial Crisis and Global Recession 1. Ministry of Finance, Slovak Republic. 2008a. National Reform Programme of the Slovak Republic for 2008-2010, October, available at http://www.finance.gov.sk/ en/Default.aspx?CatID=450, accessed April 15, 2010, p. 12. 2. Horvath, Roman and Marek Rusnak. 2009. How important are foreign shocks in a small open economy? The case of Slovakia. Global Economy Journal 9(1): Article 5, available at http://works.bepress.com/roman_horvath/3/, accessed April 15, 2010. 3. Národná banka Slovenska. 2009. Monthly Bulletin, January, available at http:// www.nbs.sk/en/publications-issued-by-the-nbs/nbs-publications/nbs-monthlybulletin/timetable-of-the-nbs-monthly-bulletin accessed April 15, 2010. 4. Ibid., p. 14. 5. Ibid., p. 15. 6. Statistical Office of the Slovak Republic. 2009a. Turnover in internal trade in April 2009, available at http://portal.statistics.sk/showdoc.do?docid=17763, accessed April 15, 2010. 7. Statistical Office of the Slovak Republic. 2009b. Foreign trade development in April and over the first months in 2009, Bratislava, Slovakia. 8. Eurostat. 2009a. 9. Mikuláš, Cár. 2006. Monitoring residential property prices in Slovakia. Bratislava: Národná Banka Slovenska (National Bank of Slovakia), pp. 9–15, available at http://www.nbs.sk/_img/Documents/BIATEC/BIA01_06/9_15.PDF accessed April 15, 2010. 10. Národná banka Slovenska. 2009. Monthly Bulletin. 11. Ibid., p. 16. 12. Ministry of Finance, Slovak Republic. 2008a. National Reform Programme of the Slovak Republic for 2008–2010, October, available at http://www.finance. gov.sk/en/Default.aspx?CatID=450, accessed April 15, 2010. 13. Ibid., p. 29. 14. Ibid., p. 21. 15. Nižˇnanský, Viktor and Ján Marušinec. 2009. Aktuality, Hospodárska politika, ˇ Komunálna a regionálna politika, Clánky a komentáre. Bratislava: MESA 10.

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Index

Note: The letter ‘n’ following locators refers to notes. A Administrative agents, see Agents Agents, (types: administrative, central, municipal, real estate, investment, market), 3–5, 8, 21, 41, 56, 66, 77, 90, 92, 156, 159, 161, 189, 195, 196, 199, 212, 214, 216, 221, 262n Amalgamation, 4, 8, 21, 189 Austria, 37, 40, 223, 226, 234, 250, 259n Austro-Hungarian Empire, 23, 156, 187 Autonomy, 3–8, 11, 13–17, 21, 33, 37–39, 43, 49–52, 58–63, 66–69, 71, 73, 77–80, 87–89, 92–94, 98, 102–103, 117–119, 121–124, 127–135, 138–139, 142–143, 147–151, 154–165, 167–169, 178, 183–184, 188–191, 195–198, 208, 241, 258, 263n B Bahl, Roy W., 139, 271 Bártíková, Gabriela, 264n, 271 Belgium, 223, 226 Bird, Richard M., 28–30, 56, 66, 69, 103, 105–106, 109, 136, 150, 170, 178, 259n, 265n, 266n Bish, Robert L., 136, 272 Bohemia, 20, 23, 67, 156, 184, 265n Brada, Josef, 26, 27, 259n Budgets autonomy, 62, 88, 124, 148–149

deficits, 24, 157, 199, 225, 236, 266n local, vii, 4, 28, 49, 50, 60–64, 74–75, 79, 83–85, 87, 89, 98, 102, 104, 117–119, 122, 125–127, 130, 132–134, 163, 179, 197, 241, 259n public, 68, 74, 84–85, 107, 159, 166, 197, 199, 202, 204, 235–236, 255 Bureš, Pavel, 162, 264n, 266n, 273 C Cadastral, 32, 33, 37, 58, 171, 174, 264n Office, 11, 32, 34, 36, 200 system, 33, 34, 51 Capková, Sona, xi, 37 CDOs (collateralized debt obligations), 212–215 Central agents, see Agents Central government, ix, 3–5, 8, 10–15, 17, 19, 24, 27, 29–31, 34, 36, 38, 39, 44, 46, 49–51, 55–64, 68–69, 72–75, 79–80, 83, 85, 87–91, 93, 95, 117, 120, 131, 134–148, 150–154, 156–159, 161–162, 164–165, 166–168, 177–179, 181, 183, 185, 189–191, 195–197, 199–200, 202–203, 235, 238, 240–242, 244, 253, 255–257, 260n, 261n, 262n, 263n Centralism, 21, 130, 189, 203

288

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Index

Central planning, ix, x, 3, 18, 23–24, 27, 38–40, 44, 56, 60, 66, 68, 79–80, 83, 85, 90, 93, 117, 129, 136, 149–150, 155, 156, 159, 164, 170, 187, 190–191, 196, 198, 229, 246, 257 Citizenry, 4, 7, 8, 17, 70, 73, 131, 151, 170, 196, 229 Cogan, John F., 219, 273 Communist, ix, x, 27–28, 37, 51, 66, 68, 101, 149, 156, 170, 198, 256, 257, 260n era, 6, 23, 24, 33, 38, 47, 67, 114, 132, 246 Marxist-Leninist, ix, 117, 129, 156, 245 party, ix, 106, 256 post-communist, 24, 66, 106, 155, 234 Cornia, Gary, iii, x, xi, 10, 20, 23, 53, 58, 60, 65, 83, 90–91, 96, 103, 125, 129–131, 135–136, 149–150, 171, 179, 187, 196–197, 265n, 266n Corruption, 10, 56, 67 Council for Mutual Economic Assistance, 25, 37–38, 40 Czechoslovakia, ix, 3, 12, 23–26, 28, 34, 37–38, 40, 44, 67, 73, 75, 95, 131, 155–157, 187–188, 190, 196 Czech Republic constitution, 5–7, 11, 12, 13, 14, 142, 153, 165, 257 parliament, 15, 19, 30, 99, 102, 183, 236, 239, 242 D Debt, municipal, 71–79, 91–92, 119–124, 126, 132, 151–152, 162, 199, 206, 212 Democracy (also democratic, democracies, democratization), vii, ix, x, 1, 5, 7, 12, 23, 27, 37–38, 50, 60, 66–67, 72, 77, 79, 85, 90, 93–95, 118, 129–130, 136, 149,

155–160, 183, 188, 196, 229, 254, 256, 258, 260n, 262n Devolution, ix, 9, 29, 66, 71, 113, 153, 161, 164–165, 177, 183 Dillinger, William, 56, 274 District, 4, 7–8, 12, 15, 16, 19, 20, 30, 32, 34–35, 48, 53, 58, 69, 87, 89, 96, 158, 160–161, 165–167, 174, 189 E East Europe, ix, x, 68, 70, 108, 132, 222, 224, 225, 226, 234 Eckert, J. K., 54, 274 Economic transition, ix, 67, 98, 136, 187, 189 Election, 7, 9, 17, 51, 59, 130, 165 Employment, 11, 43, 78, 113, 199, 204, 212, 219, 223, 230, 232, 233, 236, 247, 248, 252, 253 England, 3, 144, 146 Enterprise, ix, 4, 25, 26, 42, 70, 79, 109, 129, 214, 253, 259n, 261n Estonia, 223, 269n, 274 EU (European Union), ix, 5, 9, 10, 13, 18–19, 25, 40, 65–66, 69, 72, 79, 89, 91, 93–96, 98, 101, 103, 107, 118–119, 130, 151, 153–155, 157–162, 183, 188, 191, 198–199, 201–208, 220–227, 229–230, 235–238, 242–252, 258 Eurostat, 221, 223, 224, 250, 270n, 274–276 F Fannie Mae and Freddie Mac, 214, 215 Fiscal autonomy, 7, 15, 17, 51, 58, 60, 102, 103, 132, 139, 142, 149, 160, 163–165, 167, 169, 208 decentralization, iii, vii, viii, ix, x, 1, 6, 9, 11, 15, 17, 41, 52, 63, 65, 67–72, 79, 83, 90–94, 103, 112, 115, 117, 122, 129, 130–137, 139, 149, 150, 153, 154, 155, 159, 160–163, 169, 178, 183, 184, 187, 188, 194,

Index 198, 199, 200, 202, 203, 207, 246, 256, 257, 265n, 271n policy, 21, 40, 219, 263n transfers, 58, 62, 63, 71 Foreign trade, 24, 40, 220, 231–233, 246, 248–249, 270n France, 163, 221, 223, 250, 260n, 265n, 279 Frensch, Richard, 41, 275 Friedrich, Peter, 97, 108, 109, 275 G Germany, x, 27, 40, 179, 221, 223, 230, 250, 260n, 263n, 265n, 269n, 274, 275, 279 Global crisis, 211, 229, 268n Global recession, viii, 211, 212, 214, 218, 220, 222, 232, 234, 235, 239, 243, 245, 246, 250, 269n Grants, 4, 21, 24, 32, 33, 45, 61–62, 68, 74, 75, 77–79, 83–90, 119–124, 133–134, 138–139, 154, 156, 159, 162, 164, 166–170, 178, 181, 186, 190, 197, 202, 238, 240–241, 255, 262n Greece, 223, 225, 226, 234 H Habsburg Empire, 7, 67 Hellwig, Martin, 214, 216, 217, 268n, 276 Holzman, Robert, 28, 33, 45, 66, 73, 262n Hungary, 6, 37, 39, 65, 130, 163, 222, 223, 225, 226, 245, 249, 260n, 265n, 269n I Iceland, 247 IMF (International Monetary Fund), 103, 204, 219–221, 225–227, 230, 231, 236, 268n, 269n, 276, 277 Inflation, 24, 29, 30, 40, 60, 74, 83, 157, 201, 205, 221, 225, 230–232, 233, 248

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289

Intergovernmental finance, 16, 18, 96, 265n, 272 relations or fiscal relations, vii, 5, 6, 12, 14, 27, 72, 90, 92, 96, 122, 129, 130, 134, 135, 136, 137, 153, 154, 160, 163, 164, 165, 211, 239, 262n, 265n International trade, 24, 69, 222, 248 Investment agent, see Agents Investment funds, 25, 70, 158 Ireland, 220, 223, 225 Italy, 40, 220, 221, 223, 225, 234, 250, 263n K Kamenicková, Vera, 14, 30, 75, 178, 259n Klaus, Vaclav, 25, 35, 70, 158, 232, 233, 269n Kraj or Kraje (region), 5, 8, 72, 92, 130, 160, 165, 180 L Latvia, 222, 223, 225, 226 Legislation, 11, 12, 13, 16, 17, 36, 44, 48, 66, 71, 74, 96, 99, 118, 134, 157, 187, 188, 191, 202, 203, 260n, 261n, 265n Leontief model, 117, 118 Liberalization, 24, 40, 69, 220 Local autonomy, 3–4, 6, 13, 14, 20, 21, 37, 50, 52, 63, 66–69, 77–80, 89, 92, 94, 98, 118, 143, 148, 149, 155–158, 160, 164, 184, 188, 189, 198, 811 budgeting, 117–119, 122–123, 125 finance, xii, 58, 60, 83, 95, 95n, 118, 126, 151, 155, 162, 167, 188, 200, 205, 208, 263n officials, 11, 16, 61, 67, 69, 71, 104, 108, 113, 119, 121, 123, 126, 127, 135–139, 142, 146–150, 153–154, 183, 190, 194, 196 revenues, 15, 31, 34, 61, 72, 83–85, 118, 133, 134, 143, 162, 163 services, 7, 24, 35, 68, 79, 189

290

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Index

M Malme, Jane H., xii, 23, 37, 54, 265n, 266n Marcinˇcin, Anton, 42, 260n, 261n, 279 Marketing agent, see Agents Martinez-Vazquez, Jorge, 14, 15, 28, 60, 87, 88, 90, 93, 130, 139, 263n, 264n, 277, 279, 282 Marxist-Leninist socialism, ix, 117, 129, 156, 245 Matoušková, Zdeˇnka, 75, 150, 279 McNab, Robert, 28, 90, 263n, 264n, 279 Meciar, Vladimir, 68, 197 Mikloš, Ivan, 26, 40, 41, 260n, 261n, 266n, 271, 277, 279 Ministry of Agriculture, Czech and Slovak Republic, 32, 46, 48, 192 Ministry of Finance, Czech and Slovak Republic, xi, 19, 25, 27, 30–36, 46, 48, 49, 51, 56 Modernization, 10, 109, 220, 252, 254 Moral hazard, 7, 53–63, 79, 80, 131, 138, 177, 196–197, 250 Municipalities autonomy of, 5, 6–9, 11, 13–21, 27, 30, 59, 66, 88, 127, 131, 152, 158, 162–166, 178, 181, 202, 258 small, 4, 6, 7–9, 14, 20–21, 39, 44, 68, 164, 165, 176, 181, 190, 192, 257 Murphy, Austin, 214, 215, 281 Musgrave, Richard A., 56, 59, 145, 265n, 266n N National Bank of Slovakia (NBS), 40, 247, 248, 251, 255–256, 270n Nazi, 7, 23, 37, 156 Nemec, Juraj, 9, 16, 281 Netherlands, 149, 220, 223, 250, 266n, 269n, 274n, 285 Newbery, M. D., 107, 281

Nižˇnanský, Viktor, 9, 15, 17, 21, 40, 151, 200, 256, 266n, 270n, 278, 279, 281 O Oates, Wallace E., 73, 131, 136, 145, 266n Obstfeld, Maurice, 221, 279, 282 OECD (Organization for Economic Cooperation and Development), 24–26, 35, 40, 42, 96, 103, 130, 202, 204, 232, 246 Oliveira, João do Carmo, 14–15, 60, 88, 93, 130, 139, 264n P Peková, Jitka, 60, 85, 266n, 282 Poland, 37, 40, 65, 78, 222, 223, 224, 225, 245, 249, 250, 269n Prague, x, xi, 3, 5, 21, 24, 32, 39, 62, 68, 78, 79, 85, 118, 119, 137, 156, 162, 176, 179, 184, 189, 197, 237, 256, 259n, 264n, 266n, 269n Private ownership, 26, 33, 43 Privatization, ix, 24–26, 36, 38, 40–43, 49–52, 63, 65, 68, 69–70, 72, 79, 85, 105, 129, 132, 140, 157–158, 162, 176, 189, 197, 202, 207, 259n, 260n, 261n, 265n Property tax, 4, 11, 15, 18, 23, 23n, 25, 26, 28–38, 41–52, 53–64, 71–74, 76–79, 83, 88–89, 93–96, 102–104, 119, 131–137, 142–144, 146–147, 150–152, 162–164, 169–171, 177–182, 188–198, 202–203, 207, 231, 239, 241, 242, 262n, 263n Property tax administration, ix, 36, 53, 53n, 55–57, 60, 64, 83, 195, 262n Public administration, xi, 5–7, 9–13, 17–18, 37, 45, 96–98, 113, 118, 130, 134, 155, 157–161, 165–167, 170, 188, 198–200, 203, 207, 246, 260n Public housing, 63, 70, 89, 90, 93, 110, 140, 158, 165

Index R Real estate agent, see Agents Real estate market, 25, 32, 36, 38, 43, 70, 132, 158, 189, 243, 250, 251, 267n, 268n Reform of public administration, 10, 19, 96, 159, 160, 165 Reform of public administration, Slovakia, 11, 12, 17, 134, 188, 198, 199, 200 Russia, ix, 65, 67, 78, 113, 201, 222, 224, 225, 249, 260n, 265n S Salamon, Lester M., 275, 284, 285 Samospráva, 3, 5, 23, 67, 71, 75, 118, 142, 153, 155, 156, 161, 191, 199, 208 Sedmihradská, Lucie, xi, xii, 96, 155, 166 Self-government, 3, 5, 9, 11–14, 16–18, 23, 27, 30, 38, 44, 46, 51, 63, 65, 67, 71–73, 118, 142, 150, 152, 153, 156, 158, 161, 164, 178, 189, 191, 199, 202–203 Sirmans, George S., 54, 283 Slovak Republic constitution, 5–7, 9, 16, 142, 153, 199, 256, 257, 260n, 265n parliament, 11, 99, 267n Smith, Vernon, 105, 215 ˇ SMO (Svaz mˇest a obcí Ceské republiky, Union of Towns and Municipalities of the Czech Republic), 122, 136 Socialism, 85, 130, 260n Soviet Union, ix, x, 14, 65, 188 Spain, 162, 163, 220, 223, 225 State administration, 3, 5–13, 15–19, 45–46, 57, 68, 90, 117, 138, 141–142, 153, 156, 158–159, 161, 164–165, 167, 174, 189, 198–200, 252, 256, 257 Statistical Office of the Czech Republic, 133, 165, 168, 180, 181, 185

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291

Statistical Office of the Slovak Republic, 204, 249, 251 Subnational government, 5, 12, 14, 34–35, 45, 49–50, 56, 57, 59, 64, 73–76, 87–89, 92, 95, 102–103, 113–114, 130, 136, 139–142, 145, 149–150, 158–159, 161, 163–165, 167, 169, 187, 195–196, 201, 203, 208, 239–240, 242, 246, 255–256, 259n, 260n, 262n, 263n Survey, xi, 117n, 122, 124, 127, 129–131, 129n, 135–143, 159, 163–166, 264n Svaz mˇest a obcí Ceské republiky, 122 Sweden, 163, 223, 226, 234, 263n, 269n T Tanzi, V., 58, 136, 284 Tax excise, 28, 111, 112, 172, 192, 194, 239 exempt, 11, 32, 33, 45, 48, 96, 99, 132, 164, 171, 174, 176, 181, 182, 192, 193, 201, 202, 261n, 262n income, 15, 18, 28, 33, 35, 44, 53, 73, 87, 119, 134, 169, 171, 172, 173, 191, 201, 202, 208, 226, 231, 235, 238, 239, 261n policy, 11, 28, 29, 30, 31, 44, 45, 46, 50, 53, 54, 56, 58, 59, 72, 73, 131, 178, 181, 183, 190, 191, 193, 195–204, 234, 236, 263n, 267n rate, 11, 18, 28, 29, 31, 32, 34, 44, 45, 47, 48, 51, 54, 58, 73, 75, 96, 132, 169, 175–178, 191–193, 201–203, 208, 215, 231, 239, 246, 260n, 267n reform, 28, 73, 162, 202, 205, 239, 262n, 266n, 267n, 268n

292

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Index

Tiebout, Charles M., 136, 284 Transfers, 5, 14, 19, 21, 24, 30, 35, 44, 50, 57–64, 71, 77–79, 83, 87–90, 92, 94, 104, 119–122, 124, 127, 130, 134, 136, 139, 143, 144, 148, 150, 152, 154, 156, 159–160, 163, 166–167, 169, 180–181, 190–191, 195–197, 202, 208, 212, 238, 240, 255, 263n, 267n Transformation, 3, 24–27, 36, 39, 40, 60, 66–68, 70–74, 136, 156–158, 257, 260n U Ukraine, 37, 222, 225 Unemployment, 24, 43, 70, 79, 157, 161, 201, 204, 231, 232, 233, 240, 246, 248, 252, 253 User fees, 30, 95, 96–99, 100, 102–107, 112–114, 119, 132, 154, 161, 188, 202, 207 V Valko, Earnest, 68, 260n, 265n, 284 Vaskoviˇc, Viliam, 42, 284 Velvet Divorce, ix, x, 4, 24, 37, 38, 44, 68, 71, 85, 95, 118, 131, 157, 187, 191, 196

Velvet Revolution, ix, 3, 7, 18, 24, 34, 38, 44, 64, 68, 72, 75, 90, 113, 118, 155, 156, 157, 164, 189, 261n Vickrey, William, 107, 109, 284 Vidláková, Olga, 10, 284 W Warsaw Pact, 3, 24, 37, 156, 188 Western-style systems, 18, 24, 28, 52, 66, 68, 73, 79, 80, 93, 131, 153, 157–158, 164, 189–190, 198, 201, 224, 246, 255–257 World Bank, xi, xii, 7, 8, 23, 37, 66, 107, 130, 204, 227, 236, 265n, 266n, 268n World War I, 23, 37, 187 World War II, 23, 27, 33, 37, 72, 156, 188, 221, 273 Y Youngman, Joan, xii, 23, 37, 54, 265n, 266n Z ZMOS, Združenie miest a obci Slovenska republiky (Organization of Cities and Towns of Slovakia), 69, 122, 136, 190, 262n, 265n, 267n