Compensatory Mechanisms in Local Finance Reform
In March 2022, the Institute for Market Economics released a film called ”2% in your municipality”, which presents the concept of financial decentralization and investing a fifth of income tax revenues in local economies. A key theme in the film is interregional inequalities and opportunities for compensating those in the proposed new model. Given that the Parliament has finally managed to pass the budget for 2022, one can focus once again on finding long-term solutions to issues in local finances. The big concern regarding financial decentralization, which needs addressing, is the problem of regional disparities.
The proposed local finances model has two main aspects, which are crucial for the regional development of the country. On the one hand, there is the redistribution of a fifth of income tax revenues toward the municipalities (a sum of around 850 million leva in 2021), which would incentivize significantly regional development and would also boost the potential of economic centers throughout the whole country. On the other, there is the reform in the compensatory subsidy (330 million leva in 2020), which would redirect funds from the larger and more prosperous municipalities towards the smaller and less wealthy ones. The increased financial autonomy of municipalities would allow for a genuine reduction of regional inequality.
IME’s paper analyses the effects of existing compensatory mechanisms in the budget relationships between the municipalities and the central government and outlines a clear path towards reforming the compensatory subsidy in the model, which would feature sharing income tax revenues. Calculations show that at least seventy municipalities would not need a compensatory subsidy, should the new model be introduced, as they would collect higher revenues based on their own resources. These include most municipalities with populations above 30 000 people, as well as some smaller ones with higher concentration of economic activity.
For the remaining municipalities, where funds from the subsidy would exceed those received under the reform, additional 115 million leva would be needed to close the gap. This sum would ensure that smaller municipalities with declining populations would receive just as much funding as they do under the current model. In fact, with around a third of the current subsidy, the poorest municipalities could be given the same level of support as they do now. In the paper, the Institute also presents a simplified model, which aims to show that the money saved from the subsidy could be targeted toward closing regional disparities.
An additional proposal is a balancing mechanism, fitted within the reform. It would redistribute up to 20% of revenues gained from the reform towards smaller and poorer municipalities. This balancing mechanism could supplement or partially replace the compensatory subsidy by providing resources for equalizing transfers directly from the sharing of income tax revenues. Such mechanisms exist in other countries in Central and Eastern Europe with experience in decentralizing tax revenues and could boost the financial autonomy of local governments in Bulgaria.