News

10 days ago, IME published its Alternative Budget for 2019. As part of the presentation, we made it clear that we are facing a wave of local tax increases, which has also become a major focus of the event for the media (see here and here). To date, ideas for increasing local taxes are already a fact, with the largest municipalities - Sofia and Plovdiv also joining the race. Undoubtedly the biggest focus falls on Sofia Municipality, since the increase is the first in at least 10 years and usually media attention is focused on the capital.

Why are local taxes rising now?

Traditionally in Bulgaria local taxes closely follow the political cycle. Taxes are raised in the first and second years of the term of office, after which there is a quiet period until local elections are held (see local tax history here). Local taxes are specific - they are not automatic deductions (such as income tax or VAT), but are actually paid in the municipalitis by each citizen, which makes them extremely unpopular. In 2017 and 2018, for example, pension contributions were raised by 1 percentage point, which costs more than any increase in local taxes on an annual basis, but there was almost no public reaction. The situation is more complicated in the municipalities - any increase leads to a very negative reaction, which means that no one would do it right before local elections.

IME's review on local tax policy over the years shows about 60-70 examples of local tax increases in the years following the elections. The situation is likely to be the same now - in 2020 and 2021 at least half of the municipalities will take some steps to increase local taxes. Note that in this account we exclude the household waste tax, which will also go up. This wave of higher local taxes will, in a sense, respond to the call of the finance minister - municipalities to use their power over taxes more actively, but at the same time it will not dramatically change the structure of municipal budgets. Dependence on the state budget and European funds, on the one hand, and the lack of adequate resources for public investment, on the other, will remain the same. The topic of fiscal decentralization - the transfer of 1/5 of the income from the income taxation of individuals to the municipalities not only will not disappear, but will increasingly appear on the agenda. Financial autonomy cannot be achieved only with property taxes - 10 years of efforts to raise rates and increase collectability clearly prove it.

What happened in Sofia?

Anyone who closely follows the activities of Sofia Municipality knows that a rise in local taxes was on the verge of happening last year. The reason for that not to happen then was entirely tied to the election – looking at the results now it seems possible that a tax increase a year ago would have turned them in favour of the other candidate. The proposal now focuses on the acquisition of property and the taxation of vehicles. However, the two topics are not identical and it is better to comment on them separately.

One of the challenges that Sofia Municipality is facing is how to finance its investment program, especially in the new neighborhoods, where there is a lack of adequate infrastructure. And, if possible, this will happen as more burden falls on these new neighborhoods. There are two ways this can happen through taxes - one through changes in the property tax base, the other through a higher transaction tax rate. If the first cannot be done, you lean towards the second. This is happening in Sofia too.

The problem with the tax base of real estate

The real estate tax in Sofia is based on a very complicated formula for tax assessment of the property, which is based on the zoning of the capital. Depending on the area in which your home is, the coefficient for location varies from 28.1 to 93.6 per square meter - this is more than 3 times difference in taxes between neighborhoods. The current boundaries of the zones in Sofia were determined in 1998. These areas are undoubtedly out of date both because of the change in the dynamics of some of the old neighborhoods and because of the development of new neighborhoods which had a completely different look 30 years ago.

The big problem in the taxation of property in the capital is precisely in the tax base and specifically in zoning. However, change is politically difficult. The last proposal for such a reform was Minko Gerdzhikov’s in 2011. The proposal for a new zoning then caused a scandal and led to his resignation. Decision like that is difficult to make, but there is more to it. Municipalities (not only Sofia) expect that there will soon be legislative reforms that will change the formula for the tax assessment of real estate and/or directly link the tax to the market valuation. This would solve the city's problem with zoning, and especially when it comes to the new prestigious neighborhoods, without making a big deal out of it. However, waiting can also become a trap - postponing a decision because of expected legislative reforms, which can also always be delayed.

The environmental component in cars was introduced because of Sofia

While taxing transactions are connected with raising the tax burden, the situation is slightly different when it comes to taxing vehicles. The legislative reform at the end of last year changed the taxation of cars - the tax is now being formed in a completely different way, including the environmental component. This environmental component should be more of a burden to those with a low environmental category and should ease those with a high category. However, in Sofia, as in most municipalities in the country, for the current 2019, the levels of the environmental component remained minimum. They range from 0.40 to 1.10, which means that almost everyone receives a tax discount, with the exception of the Euro 1 and 2 categories, which receive a coefficient of 1.10 and EUR 3 (a coefficient of 1). In 2018, most of Sofia's vehicles pay a lower tax than in previous years. This is also evident from the half-yearly report of the municipality - BGN 6.5 million less are collected from vehicle tax for the first 6 months of 2018, and by the end of the year the difference will reach about BGN 10 million.

The proposal now takes advantage of the legal possibilities and raises the taxation of low-category vehicles (with a maximum legal rate of 1.40), eliminates the discount for cars with euro 4 (instead of 0.80 it becomes 1.00) and maintains discounts for euro cars 5 and 6.

And while these changes were anticipated - the law was changed mainly for the sake of Sofia Municipality, and it was clear that the capital would make the most of the differentiated rates - a little more surprising is the change in taxation and power, while affecting  everyone over 74 kW. Thus, the only ones unaffected by higher taxation will be cars up to 74 kW that have a Euro 5 or 6. Compared to 2017, if a car has a Euro 5 or 6, even the more powerful ones will probably not pay higher tax. The weight in this case will fall mainly on cars with Euro 1 and 2 and high power.

The role of regional mayors

All that has been said so far is trying to explain the general framework and specifically the situation in the Sofia Municipality. Higher taxes may not be good news for taxpayers, but in many places they were expected. Without fiscal decentralization and with poorly made property tax base, all municipalities have an incentive to push transaction tax upwards - it's no coincidence that this is the only tax at which municipalities go massively at the maximum rate (3 percent). The effect of the higher transaction tax in Sofia will be about BGN 20 million in additional revenue. In this case, it is at least a good idea regional mayors to spend half of the money collected - so there would be some competition as to who and how is coping with the public resource. Sofia municipality, in this case, is ready to take some steps for decentralization in the direction of regional mayors, and it is state’s turn to make changes in the line state budget - municipal authorities.

12 November 2019

TO

BOYKO BORISOV

PRIME MINISTER

COPY TO:

TOMISLAV DONCHEV

DEPUTY PRIME MINISTER

VLADISLAV GORANOV

MINISTER OF FINANCE

Open Letter

In relation to

The necessity of remising part of the revenue from personal income taxation to municipalities

Dear Mr. Borisov

We believe that a consensus exists as to the goal of achieving rapid regional development in Bulgaria and the continuous rise in the living standards of Bulgarian citizens, regardless of their location. During your recent travels around the country you must have noticed both the large discrepancy between the wealth of different municipalities, and the severe dependency of localities on constant financial transfers from the central government. Inevitably, the following question arises: Why do all municipalities, even regional centers with nearly no unemployment, regularly find themselves faced with financial troubles and are unable to independently influence the public environment and the lives of their own citizens?

With this letter, we would like to direct your attention to this exceptionally important tax reform whose essence is the remising of part of personal income taxation revenues to the budgets of municipalities. This reform goes beyond the financial framework of the budget and concerns a wider set of issues, including the very functioning of democracy in Bulgaria. A hospital in a regional center that lacks necessary equipment is not merely a budget matter, but a large problem for the entire health system of the country. A social housing that is on the brink of closure in a small municipality equally is not just a fiscal issue. Insufficient local budget for the provision of local transport undermines regional development and deters access to work, social and health services. Resources’ availability in regions, or lack thereof, impacts each aspect of our lives.

In 2018, regional level spending in Bulgaria reached 7.2 billion leva. Almost 5 billion of that amount are not regional resources – about 4 billion leva are transfers from the central government and roughly 1 billion is EU funding. The remaining 2.3 billion are municipalities’ own income, only 1 billion of which comes from taxes. In practice, of 7 leva spent at the regional level only 1 is revenue from local taxes. All the rest comes from state transfers, EU subsidies and non-tax revenue. This breakdown clearly illustrates the vast structural problem that faces local budgets in Bulgaria – municipalities have no adequate own resource and are entirely dependent on transfers (from the central government) and subsidies (from the EU taxpayer).

The want for sufficient own resources prevents municipalities from pursuing reasonable independent policies and makes them largely unresponsive to the needs and priorities of their populations. The problem is legally founded – the lack of free public resource is not the result of local governments’ failure. Revenues from taxation of incomes, profits and consumption which are generated at the local level are almost exclusively handed over to the central government. There are some exceptions but they are insignificant – patent taxes, levies on tourism, etc. Municipalities collect their own revenues, primarily through property taxes, which are highly insufficient for their needs, even when measures for improved tax collection have been enacted. Paradoxically, in the recent years of stable economic growth and budget surpluses, municipalities still suffer from lack of resources and expect governmental aid.

We believe that the moment has come for municipalities in Bulgaria to receive a share of the generated tax revenues from the economic activity of their own citizens. Discussions throughout the last 10 years have convinced us that the most effective means for solving this issue is for parts of tax incomes’ revenues to be ceded to municipalities. Thus, regional budgets will be way more connected to the condition of the local economy, the number of employed and their wages – What is a better stimulus for local governments to work to attract further investments and jobs?

Our proposal, which is well-known and has been widely embraced and shared by a number of other experts, is that 1/5 of the revenues from personal income taxation be automatically handed over to municipalities, as ‘money follow the personal ID’ – when an individual’s permanent address is in a given municipality, 1/5 of their income tax shall stay there. According to our own estimations, this would amount to about 800 million leva which would nearly double municipalities’ own tax revenues without any tax increases – we suggest a restructuring of revenues rather than heavier taxation. Naturally, this would allow for and require changes in the equalizing subsidy and municipalities’ responsibilities that we are prepared to discuss as experts. The goal is clear – that municipalities receive more own resources without anyone losing from the reform.

We are hopeful that fiscal decentralization shall be recognized as a central priority by the government. We find that the reform can be elaborated and supported by all interested parts within half a year and be completely applied with the correspondent legislative changes and the voting of the state budget for 2021. It is no coincidence that we send this letter a week after the local elections in the country. We did not want the question to be politicized and so decided to wait for the cooling of political passions. Presently, there are legitimately elected local governments – let this be the beginning of the change which would allow them to work successfully and in the interest of their citizens.

With respect,

Petar Ganev

Senior Research Fellow, Institute for Market Economics

(to be translated)

The translation will be available by end October 2019.

Unlike previous years, when the publication of open data on matriculation results was delayed almost until the end of the year, this time they were published much earlier. This, in turn, enables the IME to calculate the average grade at the municipal level, which is not formally published by the Ministry of Education, but is a useful comparative metric for the performance of students at the lowest regional level.

The map below shows the average grade of the state matriculation exam in Bulgarian Language and Literature (BLL) for 2019 at the municipal level. The calculation of the average grade of a municipality is based on the average grades of the schools in it, weighed in accordance with the number of students who took the exam in each of them. We only present the BLL exam results since it is mandatory and all final-year students take it.

Map 1: Average grade at the BLL matriculation exam in 2019 at the municipal level

The trend continues whereby the number of municipalities with an average BLL grade under 3 rises – while they were 5 in 2018, they are now 12, two of which have an average of exactly 3.00. Only one municipality achieves an average grade of 5.00 – Tran, although higher results are often achieved in municipalities with few students taking the exam which leads to great annual variances in the average results there. Most municipalities’ results fall between 3.70 and 3.90. The majority do not experience significant changes compared to previous years and where there is a notable difference, it is mainly due to a very small number of students attending the exam. Where results are different, they are slightly higher but not significantly so.

This year’s data confirms the conclusion that results are a function of the size of the municipality and generally bigger schools in larger municipalities score better. The only exceptions are municipalities with few students taking the exam but there results vary greatly between the years. Conversely, the biggest municipalities – Sofia-city, Plovdiv, Varna, Burgas, - where the country’s leading schools are, continuously rank among the best.

Provoking interest are the results of some smaller municipalities which have been in the leading positions in the recent years, – Chelopech (4.74), Zlatograd (4.61), Rudozem (4.32), and Buzhurishte (4.85) – since there is no evident factor in common between these.

There remain a few uncertainties as to the methodology according to which the Ministry of Education and Science evaluates the grade average for the country. Because the data at the school level allows us to make an independent evaluation, we find that for 2019 the average BLL grade measured as the average at the school level weighed according to the number of students is Good 4.13, rather than the official Good 4.06. The difference is not significant, but it remains clear that the Ministry must be using a different method.

With local elections approaching, there has been increasing talk of the formation of industrial zones in different regions of the country. The mayor of Sofia announced that she is planning to build four new industrial zones, the largest in the northern regions of the capital - Kremikovtzi, Novi Iskar and Vrubnitsa. Simultaneously, the mayor of Sliven presented a project for what is to be ‘the biggest industrial zone in Bulgaria’ situated between Sliven and Yambol. On his side, Deputy Prime Minister Tomislav Donchev spoke of the need of 7 to 10 new industrial zones in the country and said that there is great potential for a zone be established between Gabrovo and Sevlievo. Even though these news’ appearance right before local elections is hardly a coincidence, they are undoubtedly grounded on long-term economic processes in the country.

The leading factor is the shift in the Bulgarian industry which took place over the past 10 years. After the financial crisis the once traditional sectors of Bulgarian manufacturing, such as clothing production, have been losing their share – both in terms of exports and in terms of the number of employed – to the benefit of higher value added production – e.g. electrical appliances, automobile parts, machines and equipment. These processes are clear indicators of the need for the establishment and development of new industrial zones capable of accommodating the novel production.

Another important factor is the unequivocal success of the prime investment regions in the country – Sofia and Plovdiv. The bottom of the number of employed in manufacturing was hit in 2013 when these were around 490 000 people. By 2017 that number has grown by about 32 000 workers but this rise is not equally driven by the different regions. The most significant increase in manufacturing laborers has been concentrated in the two leading centers – with 9 000 more employed in the region of Plovdiv and more than 6 000 more in the region of Sofia and Sofia-city. Plovdiv and Sofia are the two centers that combine a big city with a wide periphery and developed industrial terrains. These are also the two regions which have been working for years over their presentation as centers for foreign investors.

While the development of zones around the capital is hardly a surprise, the change in Plovdiv provokes more interest. The collaborative work of a few municipalities and the unification of the industrial zones around Plovdiv under the Thracian Economic Zone brand is a success and has caused other big towns to pursue the foundation and promotion of their own industrial terrains. But whereas the foremost factor in Plovdiv is private initiative – in practice, the zone is managed by a private operator, - in most other regions the recent development of zones is promoted by the “Industrial Zones National Company”.

In most cases the municipality gives away the terrain on which it plans to establish the industrial zone, while the state company finances the necessary infrastructure. This is not because the municipalities cannot find alternative means to develop these zones, such as partnerships with private actors, but is rather due to the attractiveness of the easy access to finance that the National Company provides. The latter already has six operating zones, five are being developed and quite a few memorandums for cooperation have been signed with various municipalities.

If it is true that 7 to 10 more zones are to be built in the country, the majority of which will most likely be financed be the National Company, the dominance of a large state operator in the country is becoming more and more significant. Certain recent announcements indicate that a regulatory mechanism for the industrial zones’ operators will be established in the following months. It is yet to be seen what the role of municipalities in the management of zones would be and whether the operational centralization is the right move.

Regardless of the legal frame regulating the management of zones, it is important that the municipalities continue to collaborate, where this is justified, and to present themselves as investment centers beyond the scope of the concrete industrial zones. For this reason the merging of Sliven and Yambol is to be welcomed since this is the first case of two regional centers, rather than just a city and its periphery, that promote themselves together. But there are plenty other opportunities, such as the eventual new zone between Gabrovo and Sevlievo or a potential merging between Stara Zagora and Kazanlak which at the moment work independently with the National Company. A good starting point for the possible collaborations is the IME’s analysis of the economics centers in Bulgaria.

Fiscal decentralization is based on two fundamental principles – ‘local self-governance’ and ‘subsidiarity’. Decentralization is a necessary condition so that local authorities could independently and responsibly manage public funds. We are convinced that common problems are most quickly and efficiently dealt with at the most basic possible level.

Given the contextual substantial transformations of the Bulgarian economy, decentralization is particularly important. In the decade following the 2009 financial crisis and the Bulgarian accession to the EU the transformation’s dimensions are generally two – an increasingly active integration of the private sector into international value added chains through growing exports and a gradual disappearance of low-productivity manufacturing based on manual labor which is being replaced by production with higher value added.

These processes are well illustrated by the shift of labor force amongst the sectors of the economy. For less than a decade the workers employed in construction have decreased with nearly 50%, while those in clothing and shoes manufacturing with a third. The employed in the food and furniture industries have also been diminishing despite the increased value of production. Simultaneously, more and more people are working in the automotive, pharmaceutical, electronics and power tools industries. Generally, manufacturing produces and exports significantly more than it did 10 years ago but with 100 000 fewer employees.

Chart 1: Change in the employed in selected sectors, 2017 to 2008

Source: NSI

The structure of exports has also changed notably – the share of the automotive industry has tripled, that of power tools has doubled, while the portion of the machine, chemical and pharmaceutical, metal and plastic manufacturing is also expanding. On the other hand, the importance for the export of fuel, basic metals, textile and clothing has been gradually dropping.

 Chart 2: Share of total exports of goods of main products, 2008 and 2018

Source: INTRACEN

Some of the main export goods are products completely new to the Bulgarian industry. This is the consequence of a lot of new greenfield investments and of the recovery and substantial increase of the capacity of factories which, until recently, were exporting minimal quantities. These novel export goods are various: lighting, resistors, electric installations’ components, rubber hoses, electric bicycles and mopeds, etc. If we look at the dynamics of bicycles and sports equipment manufacturing we register production increases of 3.5 and 2.5 times respectively for the last 8 years and a nearly double rise in the employed in these sectors. The last observation is just another confirmation of the continuously improving labor productivity.

Chart 3: Turnover and number of employed in the production of Bicycles and Mopeds and Sports Equipment

Source: Yearly financial reports

The perceived shift is not only in the structure of products but also in the geographic allocation of jobs creation. In the period following the 2010 ‘bottom’ levels of manufacturing there is a minimal but unequal increase in the number of the employed. Sofia (capital) loses manufacturing jobs, as well as Burgas, Blagoevgrad and Dobrich. At the same time, new investment centers for export-oriented production appear – Plovdiv, Sofia, Stara Zagora, Sliven, Gabrovo. The relatively high unemployment rate also attracts investors to Lovech and Vratsa and we expect the latest data to show the same trends in Pleven and Montana. It is not an accident that some of the successful bicycles and sports equipment factories are also located in the Northwestern region of the country.

Despite the rapid increase in consumption and resurgence of bank crediting in the last years, the number of the employed in trade and finance remain below the 2008 levels. Contrariwise, employment in the outsourcing of supportive business services is gradually growing as the sector is turning into a key employer of workers with relatively good education and mastery of foreign languages. Nonetheless, the uncontested leader in employment growth over the last decade is the IT sector. Software engineering and information services are on average the best paying jobs in the country – already even above the maximum insurance threshold. However, this phenomenon is limited to Sofia (capital) – more than 30 000 new jobs – and, albeit to a lesser extent, to Plovdiv and Varna. Even though recently there has been good news from other regions too (e.g. Burgas), these economic zones still fail to attract a sufficient number of IT companies.

Chart 4: Change in the number of employed in manufacturing, 2010-2017

Source: NSI

Having in mind the anticipated decline in the working-age population, the serious work force competition within the open and increasingly mobile common European labor market, as well as the achieved record-breaking employment levels, the challenge is to increase investment in those goods and services that create greater value added. These are activities that produce globally highly valuend goods and services created with contemporary technologies and highly qualified and productive laborers. Employers of this kind can offer sustained, long-term wage increases and can contribute to the general income growth of Bulgarian households.

Yet, the described transformation of the Bulgarian economic structure is a process encompassing hundreds, even thousands of separate investment plans. The initial step is the choice of Bulgaria as a country to invest in, which is then followed by the decision to build a factory or establish a service in a specific city or region. Municipalities must be especially active in this process, since they determine the conditions for the choice of location of a potential investor. Precisely this, together with the regional quality of living, should be at the center of local elections’ debates and, even more, it should be at the basis of the following four years of local self-governance