A quarterly magazine of the IMF

September 2001, Volume 38, Number 3

Although Russia is legally a federation, it has experienced serious problems in developing and maintaining satisfactory fiscal relations between its central government and regional and local governments. How have these problems arisen, and what steps might make Russia's fiscal federalism work better?

Federalism's beginnings

After the disintegration of the Soviet Union, the federal form of the Russian state was legislatively fixed in its constitution in 1993. (Russia consists of 89 federation members including 21 republics (Chechnya is one of these), 50 oblasts (provinces), 6 krays (territories), 10 autonomous okrugs (areas), the cities of Moscow and St. Petersburg, and more than 12,000 local governments (of rayons (administrative subdivisions of regions or large cities), villages, settlements, cities, and districts within cities).) A decree by the President of Russia (2000) created seven new administrative macro-regions in the federal hierarchy to help enforce federal laws.

Russia's constitution is based on the principles of territorial integrity of the country, unity of the system of state authority, differentiation of responsibilities and power among governmental structures, and the equality and right of self-determination of all Russians. It provides for division of expenditure responsibilities between the federal and regional governments. The legal mechanism that should have given practical effect to the principle of division of rights and responsibilities, and thereby brought about a reasonable balancing of interests between the center and federation members in fiscal matters, was not created, however. Consequently, some researchers (see, for example, Bird, Ebel, and Wallich, eds., 1996) question whether Russia actually is a federation. In fact, Russia's federal system is too centralized (especially regarding taxation), although its regional governments appear to be decentralized.

The fundamental contradiction between the highly centralized formal system and informal subnational autonomy is a major source of problems in fiscal federalism in Russia (see Lavrov, Litwack, and Sutherland, 2001). Budget decentralization in the regions appears in expenditure authorities and financial plans. Subnational governments retain considerable scope to develop and carry out their own informal fiscal policies. Consequently, there is a lack of transparency in the fiscal policies of subnational governments, which are not fully accountable to either their electorates or the federal government.

During 1994-96, an unfortunate effect of Russia's economic transition was that the federal government delegated to the regions—to which allocations of funds were made—a wide variety of responsibilities to provide services and make payments, such as child care and veterans' subsidies, to citizens without granting the regions new opportunities to collect revenues. These responsibilities were delegated as they had been during the era of central planning, principally according to their natural and climatic conditions and natural resource endowments. This has placed many regions in extremely difficult situations. Simultaneously, in accordance with agreements reached between the center (that is, the federal government) and individual regions, some members of the federation have managed to convince the federal government to grant them special privileges. The rich regions—among which are Moscow and St. Petersburg; the Nizhegorodskaya, Samarskaya, and Tymenskaya oblasts; the Khanti-Mansisky and Krasnoyarsky regions; and the Republic of Sakha (Yakutia)—have become known as "donors" (net generators of revenue) and managed to strengthen their positions, compared with those of other members of the federation, during Russia's financial crisis in 1998. Since the collapse of the Soviet Union, differences among the regions in per capita budgetary income have increased significantly. The ratio of maximum to minimum budgetary incomes per person among regions increased from 11.6 in 1991 to 30 in 1998.

In response to these regions' opposition to transferring the taxes they collected to the federal budget and to their bans on exporting food products, the central government routinely sought their political support by giving them advantages over other regions. In contrast, the poorer members, whose economic development has been lagging, have not been able to influence the central government and have sharply criticized the country's asymmetric growth, which they believe will lead to disorder and disintegration of the federation.

One of the main reasons for these serious difficulties is that since the beginning of Russia's economic transition, the federal government has not formulated a long-term strategy for the social and economic development of the country that would enable it to coordinate the economic and fiscal activities of all members of the federation. As a result, Russia's efforts to achieve real decentralization have been piecemeal and have fallen short of experts' expectations.

The main shortcomings in achieving successful reform of intergovernmental relations have been (1) the absence of an objective normative basis for allocating budget revenues, (2) the lack of interest shown by local and regional governments in developing their own revenues and cutting their expenditures, and (3) the federal government's practice of making transfer payments to federation members without taking account of the other state subsidies and grants they receive. The lack of transparency of, and the federal government's dearth of knowledge about, the structures and functions of regional governments have been important reasons for confrontation in intergovernmental fiscal relations.

Further developments

After the first stage (which began in 1994) of intergovernmental fiscal relations between the center and the regions was completed, the second stage began in 1998. The Three-Part Commission comprising representatives from the Russian government, the Council of the Federation, and the State Duma subsequently made proposals for reforming interbudgetary relations in Russia. Its main ideas, including new methods for providing transfers (grants) and distributing taxes among the three principal levels of government, were implemented by the federal government in the "Concept of Reforming Intergovernmental Relations for 1999-2001," which was approved on July 30, 1998, and in the 1999 federal budget.

According to the Law on Foundations of the Tax System of the Russian Federation (Articles 19-21) and the General Part of Russia's Tax Code, which became effective January 1, 1999, the main federal taxes include the enterprise profit tax, the value-added tax (VAT), excises on specific goods and raw materials, the personal income tax (in 2001, 99 percent of the proceeds of this tax will go to regional budgets), the tax on extraction of minerals and raw mineral ores, customs and state duties, and contributions to state extrabudgetary funds (Part 2 of the Tax Code renamed this tax the consolidated social tax). Regional taxes include taxes on property of organizations, sales, real estate, roads, transportation, and gambling enterprises; and regional license fees. Local taxes include the land tax; individual property, inheritance, and gift taxes; the tax on advertising; and local license fees. For each year, the Law on the Federal Budget provides the revenue-sharing proportions between budget levels. In fact, more than 90 percent of subnational revenues come from federal tax sharing. Revenues actually raised by regional and local governments account for less than 15 percent of their expenditures.

The legal system covering intergovernmental fiscal relations remains excessively centralized. The clear inability of subnational governments to meet their legally mandated spending obligations has encouraged them to shift basic political and financial responsibilities to the federal center while reserving practically unlimited informal "shadow" powers for themselves.

There is also the issue of bilateral contracts between the central government and the governments of individual federation members. Russia's constitution provides an opportunity for differentiation among regions based on such contracts. Thus far, 46 of these contracts have been entered into, thereby increasing the federation's asymmetry. The inevitable result is that federation members not entering into such contracts are disadvantaged.

During the development of the above-mentioned intergovernmental contracts, more than 200 separate agreements were reached in various spheres of activity, including financial matters. Eleven of them directly concerned the central government's differentiation among federation members with respect to intergovernmental relations and taxation. Many of these agreements have only codified existing situations in intergovernmental budget relations, but others have created fiscal disparities and contradictions in the central government's attitudes toward the governments of different federation members.

Russia's Ministry of Justice has analyzed the constitutionality of such agreements and determined that the contracts between the central government and Leningrad; the Khabarovskii kray; and the Irkutskaya, Permskaya, Sakhalinskaya, Sverdlovskaya, and Tverskaya oblasts and other regions were, to some extent, unconstitutional because they were inconsistent with the norms used to determine the structure and size of the central government's and subnational governments' budgets.

The Federal Law "On Principles and Rules of Delimitation of Objects of Jurisdictions and Authorities Between Bodies of State Authority of Federation and the Subjects of Russian Federation," which entered into force in mid-1999, stopped the drawing up of new contracts and agreements and established a three-year period for reducing the numbers of existing contracts and agreements. However, the permanence and enforceability of this law remain uncertain.

Another problem is the lack of a comprehensive system to coordinate all financial aid to the regions. Because of this, it was impossible for the federal government to support the regions' capital and current expenditure needs in accordance with centralized policies that are guided by the differences among the regions. The mechanism used to determine intergovernmental fiscal relations was not stimulating the economic and social development of Russia's regions and localities. The financial support usually provided was aimed only at current expenditure and did not provide for investment. Until recently, the grants provided by the central government through the Federal Fund for Financial Support of the Subjects of the Federation (FFPR) have not had specific aims (except those going to the northern regions, including Arkhangelskaya oblast and the far east, and some other subsidies in the federal budgets for 2000 and 2001). Grants are given to the regions, which are generally free to use them to finance their own plans. Because the federal government cannot control how regions use this money, it cannot exert influence on regional policy.

The methodology of accounting for central government grants for the regions is very complicated. It changes every year and includes a lot of coefficients and deflators, whose reliability is uncertain. The mechanism for intergovernmental relations does not take into account important economic changes that affect various regions differently. Under such circumstances, it is very difficult to estimate the efficiency of budgetary equalization and provide a budgetary and tax policy that will be agreed to by all regions.

Possible improvements

Some possible ways of improving Russia's system of intergovernmental fiscal relations are the following:

• strengthening intergovernmental relations by enacting special laws, including measures to prevent conflict between the various levels of government and their respective regulations;

• distributing tax revenues to allow the regions to meet their essential expenditures;

• ensuring that the combined budget balance is transparent, reflecting all financial flows among the federal, regional, and local governments; and

• defining the functions of, and creating budgetary income bases for, local governments.

Until recently, there were at least two scenarios for reform of intergovernmental fiscal relations (see Lavrov, 2000): (1) complete and prompt refusal of the federal center to interfere with subnational expenditure authorities; and (2) provision for long-term financing of numerous federal mandates through the regional budgets, with assets provided by the federal budget.

The first scenario makes it possible to give up all federal mandates for subnational authorities—for example, by

• eliminating all social privileges and grants in cash (including, over the long term, transition to the common grant on poverty, which is paid to citizens directly from the federal budget);

• giving regional or local authorities the right to determine independently the criteria for such assistance and to provide it from their own funds;

• canceling federal regulation of wages paid to workers employed in the state (budgetary) sector in self-governing regions and localities; and

• sharing taxes based on the principle of "one tax, one budget," thereby ensuring the complete tax independence of regional and local authorities.

The second scenario provides for keeping the existing financing of federal mandates and privileges through the FFPR and for preserving the regulation of wages paid to government workers from subnational budgets. Furthermore, it envisages the federal treasury maintaining control over the execution of regional and local budgets. Both scenarios foresee the division of tax administration authority among different levels of government; under either of them, however, the volume of regional and local tax revenues collected would remain insufficient.

Each of these scenarios has advantages and drawbacks. The first scenario would help create the best conditions for economic growth in Russia's most advanced regions and large cities. But this outcome might lead to regional conflicts and economic distortions both among the regions and between urban and agricultural areas.

Under the second scenario, the territorial redistribution of budgetary resources might hinder creation of optimal conditions for economic growth, but social tensions would be defused. In addition, the leveling of regional and local budgets would make it easier for the federal government to ensure that its budget provided for meeting its social commitments to the country's entire population.

The existing situation in Russia gives one grounds to conclude that neither of the scenarios is likely to be selected and implemented in pure form. Still, there are reasons to believe Russia's central government prefers the first scenario (see Larov, 2000).

Since 2000, the central government has begun to cut nonfinancing federal mandates (which total about 8 percent of Russia's GDP). To provide for some large direct federal mandates (social subsidies for veterans, child allowances, and benefits for disabled persons) in the federal budget for 2001, the central government created a special compensation fund (in addition to the Fund for Regional Development and the Fund for Development of Regional Finance) amounting to 33 billion rubles.

A new stage of budget federalism

A new, third stage in the development of interbudgetary relations in Russia began in April 2001, when the government of the Russian Federation submitted to the Federal Assembly its draft Budget Federalism Development Program for the period until 2005. This program is a continuation of the Concept of Reforming Intergovernmental Relations for 1999-2001. The program provides for certain positive reforms of the budgetary system—in particular, the transformation of financial relations among different levels of government concerning revenue and expenditure authority in their budgets. It also includes a strategy for the financial support of governmental budgets aimed at further equalizing subnational budget prosperity (the ratio of maximum to minimum income per person among regions will decline to not more than 5 or 6).

On May 23, 2001, the federal government approved this draft program. At the same time, many experts have noted that the instruments offered in the program cannot stimulate economic growth and implementation of social and economic reforms in Russia's regions. Basically, the program limits the strategy of budget federalism development to the interbudgetary problems of distribution and redistribution of financial resources at all governmental levels and to the differentiation of responsibility for implementation. The program mainly covers norms for sharing revenues from taxes and tax collections among budgets of different governmental levels (to provide financial support for regional budgets). Although the program's title refers to "budget federalism," it is really aimed at interbudgetary relations. It also assumes a federal government role in resolving the entire spectrum of problems in budget federalism, including improving political and economic relationships between the center and the federation members, seeking compromises among different social groups, changing budget and tax regulation, setting up a balanced budgetary structure in the country, and so on.

The draft Budget Federalism Development Program for the period until 2005 has met with numerous critical comments. Two serious shortcomings of the program are that it lacks the necessary financial and economic basis and that draft bills on changes and amendments to the federal laws for which the program calls do not yet exist. An action plan including measures designed to implement the program is also necessary. In addition, a number of contradictions between the program and the Constitution of the Russian Federation, Russia's Budget Code (enacted effective January 1, 2000), and the Federal Law "On the Principles and Procedure of Differentiation of the Russian Federation Subjects Regarding Responsibilities and Authority Among Levels of the Government of the Russian Federation" will need to be addressed.

Teresa Ter-Minassian, ed., 1997, Fiscal Federalism in Theory and Practice (Washington: International Monetary Fund).

Nadezhda Bikalova, who was a Visiting Scholar in the IMF's Fiscal Affairs Department when the paper on which this article is based was prepared, is an Advisor to the Committee on the Problems of the Northern Regions and Far East of the Russian State Duma, of which she was formerly a member.