The Fiscal Equalization Fund

Dario Runtic, NALAS Network of Associations of Local Authorities of South-East Europe

Relevance of the Practice

The local government fiscal equalization practice directly addresses some of the key questions of urban-rural relations, specifically the differentiation of a financing system to take into account the size and fiscal capacity of local governments. The practice responds directly to the challenge of increasingly depopulated rural local governments (RLGs) experiencing a decrease in taxpayers.

Description of the Practice

The equalization system is conceived as a simple mechanism which provides funding to local governments of different size and unrelated to fiscal capacity in order to enable them to provide public services of the same level and quality to their residents. Croatian RLGs are facing depopulation due to lack of jobs, quality education and limited social infrastructure, all of which are the responsibility of RLGs. Prior to establishing an actual fiscal equalization system, difference in fiscal capacity for public service provision was 1:29 in rural areas and 1:6 in urban areas.

With such a tremendous difference in funding levels many rural and some urban local governments were struggling to sustain basic public services, while others were able to provide good public services, economic incentives and develop social infrastructure. This motivated taxpayers from underdeveloped RLGs to relocate either abroad or into more developed local governments thus leaving underdeveloped RLGs with even less taxpayers – a downward spiral which led to even greater depopulation.

On the other hand, the relocation of taxpayers to the economic centers and the ability of these centers to boost the local economy, including tourism activities, created in some cases enormous pressure on communal and traffic infrastructure, health and education facilities and distorted real-estate markets. Supposedly, road traffic congestion coupled with substandard public transport and the lack of quality of social infrastructure inhibits relocation of taxpayers to adjoining or surrounding municipalities with more affordable housing but significantly lower fiscal capacities.

Increase of fiscal capacities of underdeveloped local governments could supposedly lead to improvement of social infrastructure for residents and creation of economic stimulus for expanding companies to relocate outside of centers of economic activity with more affordable and available land and real estate thus relieving economic centers of pressure on infrastructure and institutions.

Up until 2017 there was a quasi-fiscal equalization mechanism in place. Personal Income Tax revenues were redistributed between three levels of government through a complex set of shares depending on the local government development index with the aim of equalizing funding levels, enabling economic development and addressing demographic issues in underdeveloped local governments. This effort was coupled with higher tax credits and other tax incentives for residents. However, the scarce evidence available did not support the efficiency of this mechanism. The local government development index, the backbone of the system, was highly criticized for misinterpreting the actual development capacity of individual local governments.

In 2016 and 2017 the Ministry of Finance worked with research institutions, academia, local government associations and other branches of government on restructuring the fiscal equalization mechanism. In 2017 the parliament legislated changes to the Law on Local Government Financing to simplify PIT redistribution and introduce a non-earmarked Fiscal Equalization Fund. As of 2018, local governments receive 60 per cent of PIT collected in their jurisdictions area; regional governments 17 per cent; another 6 per cent are allocated to local/regional governments for decentralized functions and 17 per cent are paid into the Fiscal Equalization Fund. Central government does not receive any share of the PIT.

Fiscal Equalization Fund is an automatic redistributive transaction account which delivers funding to the recipients daily, based on individual shares of local and regional governments in the Fiscal Equalization Fund which are set in advance of the budget year. Individual shares are calculated based on the type of local government (urban, rural or regional) and its historical five-year fiscal capacity (PIT revenue per capita) as compared to national averages (target PIT revenue per capita). Target fiscal capacity for rural local governments is currently EUR 262 per capita and EUR 343 per capita for urban local governments.

All key elements of the Fund (total funding, target levels, share calculation formula, automatic distribution) are prescribed by national legislation which is a subject to urgent review by the Constitutional Court should a local government unit address it. Benefits of such a system, aside of eliminating PIT revenue disparities, are transparent and predictable revenue streams, improved liquidity of local governments, better advocacy position for Local Government Associations and efficient judicial protection. The national government’s budgeting process and individual bylaws have virtually no influence over the Fund, but economic trends and national taxation policies can affect funding levels.

Assessment of the Practice

Currently, EUR 283 million (7.5 per cent of total local government revenue) gets distributed through the fiscal equalization mechanism. According to the data from the Ministry of Finance, in the first year of operation of the fiscal equalization fund, differences in fiscal capacity were reduced from 1:29.1 to 1:6.8 in rural municipalities and from 1:6 to 1:3.2 in urban towns.

Whether or not the fiscal equalization achieved aforesaid goals may be too early to tell just yet, but this certainly needs to be thoroughly researched. According to data from the Ministry of Finance processed by the Association of Cities in Croatia, 4 out of 92 towns who currently participate in fiscal equalization will no longer receive equalization funding in 2020 and funding levels will decrease for additional 13 towns compared to 2019 projections. Data on municipalities was not processed. This data alone implies that those 17 towns are on upward economic trajectory and 4 of them have already crossed the national average PIT revenue per capita. However, further research should take into account other relevant indicators such as relocation of taxpayers and (creation of new) businesses, investments in social infrastructure, demographic trends, etc.

The apparent success of the fiscal equalization system can be attributed to the fact that it solely observed fiscal capacities of local government units and provided local governments with autonomy in setting their own spending priorities, unlike measures which tried to solve a number of issues with a one-size-fits-all solution for 566 different urban and rural local governments. The Ministry of Finance played a pivotal role in the creation of the successful system by merging existing equalization funding streams into one and providing additional funding on top of it.

This practice has a direct impact on some of the issues tackled in other report sections. Fiscal capacity is prerequisite for local governments in Croatia to request devolution or decentralization of functions from regional or national governments. There is anecdotal evidence of municipalities already requesting decentralization of education function but the formal evidence is yet to surface. Media outlets report that local governments are providing additional social welfare support for elderly citizens, constructing new nursery facilities or providing fiscal incentives for young families, an effect of that is yet to be researched.

Participatory budgeting had been present to varying extent in Croatian local governments over the last 20 years or more, but struggling local governments were not engaging in it due to very limited funding available and local demographics. Some of the local governments which are beneficiaries of fiscal equalization are taking a proactive stance in participatory budgeting.

References to Scientific and Non-Scientific Publications

Legal Documents:

Law no 127/2017 on Financing of Local and Regional Self-Government Units (Zakon o financiranju jedinica lokalne i područne [regionalne] samouprave)

Scientific and Non-Scientific Publications:

A Bajo and M Bronić, ‘Fiskalna decentralizacija u Hrvatskoj: problemi fiskalnog izravnanja’ (2004) 28 Financijska teorija i praksa 445

—— Bronic M and Primorac M, ‘Oblikovanje modela vodoravnog fiskalnog izravnanja u Republici Hrvatskoj’ (Association of Cities 2012)