Executive Summary

Public finances in SEE are vulnerable to capture

The rising global geopolitical tensions have put the European Union (EU) and its neighbourhoods under additional stress, as evidenced by the brutal wars in Ukraine, Nagorno-Karabakh, Israel and Africa. Corruption and state capture vulnerabilities have turned into serious (economic) security concerns, while simultaneously making them more difficult to tackle, in particular in non- established democracies, as entrenched elites turn to geopolitical leverage games. Addressing these vulnerabilities in Southeast Europe (SEE), is critical for the further integration of the region into the EU, and the survival of the democratic tradition in Europe.

The ongoing overlapping transitions in the technological, economic and geopolitical realms raise the significance of the proper governance of public finances in SEE. However,  when government structures in charge  of public finances have become geared into state capture networks, as has been evidenced in many cases in SEE, any general considerations about  the optimal management design need to be modulated through knowledge about the mechanisms of state capture. The building blocks of state capture include a variety of tools, such as power over the design and enforcement of regulations, privileged access to public resources, control over the media and the financial sector, influence over domestic and foreign policy, etc. When the machinery of state has been captured by special interests, the real decision- making power over the allocation of public resources resides in the leaders of patronage and clientelist networks which shadow official government institutions, and which typically are party-political leaders with long-term access to public resources.

This report analyses the risks entailed by the misuse of fiscal transfers from central to local governments in nine SEE countries. Such transfers are typically a tool of equalisation policies seeking to offset disparities in the economic development of territorial units and ensure equitable delivery of public services across the whole country/society. When general rule of law  is compromised, however, intergovernmental transfers can be susceptible to corruption risks which can undermine the effectiveness of these transfers and lead to misallocation  or  diversion  of  funds.  The  distortions  created by clientelistic transfers are at risk of being further exacerbated by rigged local government procurement. When local purchasing and investment is compromised, the inequity of preferential intergovernmental transfers to local allies of the central government is compounded by the channelling of public money to local business cronies.

The impact of the cumulative distortions created by the misallocation of public finances at the intergovernmental and local levels goes beyond the national borders. Since the European Union is a major financial donor to these countries, their domestic policies and the way they procure services and assets
at local level have an impact on whether and to what extent EU aid is effective in promoting balanced economic development. In fact, typically it is the same state capture cliques which exploit both intranational and EU transfers for the benefit of special interests. Uneven data availability prevents definite conclusions about specific cases and patterns of state capture vulnerabilities in SEE, in particular as concerns EU candidates. Yet, the findings presented here should prompt further inquiries into the involvement of electoral or clientelistic considerations influencing the local allocation of European funds. It is at this level that all the governance risks converge and consequences are experienced by individuals and businesses. Regular risk monitoring and assessment through evidence-gathering mechanisms is therefore required to inform prevention policies.

Fiscal decentralisation needs a strong revenue base

Given that intergovernmental transfers are used in SEE as an instrument which enables political influence on local governments, the level of fiscal decentralisation is a key underlying factor. Although most of the SEE countries have made substantial progress during the last 10 years, in one way or another the fiscal decentralisation remains a challenge for all of them. Most local governments remain highly dependent on the central government with a significant share of transfers compared to tax revenue. Their own revenues represent insignificant part of their countries’ GDP, ranking below the EU and OECD averages. The same goes for local expenditure levels as a share of total government (public) expenditure and GDP.

Subnational government expenditure as share of public expenditure and GDP in SEE

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Consequently, governments in the region might experience resource allocation challenges where municipalities have limited financial resources to address local needs, leading to disparities in service delivery and development across regions. The result are fiscal imbalances, limited local self-financing power and strong central government leverage. With the exception of Montenegro, in all other SEE countries the distribution of transfers from central government is the main instrument of keeping the local services functioning. This and the common lack of transparency and predictable intergovernmental system make the SEE local authorities vulnerable to clientelist or electorally motivated interventions.

Central funding through transfers, however, can undermine local fiscal autonomy. This is understood as the ability of subnational governments to raise tax locally to finance expenditures but also decrease local leaders’ motivation to increase the tax burden in their jurisdictions due to the provided transfers from central government.

Corruption risks in central-local government fiscal relations

A high degree of administrative and fiscal centralisation could be a considerable risk factor for state capture; the latter, in turn, further institutionalises this centralisation. Risk evaluation should start with an examination of the design of the transfer system employed in SEE.

Conditional transfers allow central governments more latitude how and for what to spend the money than unconditional transfers. However, because they are allocated through intergovernmental negotiations, they provide local level leaders with a manoeuvring margin to extract additional resources from the central administration. Conditional intergovernmental transfers render local officials subordinate to the priorities of the centre, with the associated rent-seeking effects.

The room for manoeuvre of central governments with unconditional transfers is more limited since the amount which each municipality is receiving is determined by a formula. However, there are risks related to the political manipulation of the formula by the incumbent government or discrepancies between the determined by formula transfers’ value and the actually distributed amounts. Reducing formula complexity and increasing its transparency during and after implementation is a logical step for the SEE countries to avoid or moderate governance risks and political capture. The simpler the transfer formula is to apply, the easier is the oversight of its implementation.

Risk mitigation policies require an understanding of the incentives  driving clientelism in intergovernmental fiscal relations. Central and local governments, as well as the incumbent political parties, benefit by building central and local leaders’ reputations, securing votes and re-election. Intergovernmental transfers in SEE have been used to secure and/or change the political allegiance of mayors. Similarly, the previous allocation of funds has served to re-confirm the political loyalty of mayors. However, the promise of future funding tends to sway some mayors to change their allegiance toward the political party, which is most likely to win the upcoming elections. When the territory (municipality) is politically aligned with the incumbent party(s) of the central government it can benefit by higher allocations from central budget funding or from foreign donor (including EU) funding compared to similar in size and needs municipalities run by the opposition. Local companies, usually large employers, as well as in particular SOEs, benefit by non-competitive award of municipal budget funding.

The intergovernmental spending channels exposed to corruption and state capture risks (clientelist transfer channels)

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Source: Center for the Study of Democracy

Oversight and transparency of central-local government relations in SEE are wanting

Most municipalities in SEE comply with transparency requirements only partially. Information on local government finances is public in name only without actually being accessible,  easy  to  understand,  or  even  relevant to citizens’ concerns. In the nine analysed countries citizens and non- governmental organisations are rarely involved in the decision-making related to local government finances. The associations of municipalities are sometimes involved, however not all their recommendations are taken into account.

In terms of oversight, the SEE governments mostly rely on existing  generic control mechanisms to prevent all corruption-related and fiscal mismanagement risks – budget planning oversight, inspections by audit authorities, financial police and inspectorates,  local  level  anticorruption  and ethical committees, councils, codes, integrity and action plans, etc. However, the specific issue of the abuse of discretion in transfers for partisan purposes and the related corruption and state capture risks remain unacknowledged. This leads to the lack of targeted prevention and deterrence measures, as well as sanctions.

National legislation and strategies in SEE do not specifically identify any corruption risks related to the misuse of national and foreign donors’ funds from the central to the local level; when they are mentioned in the national integrity strategies it is in a very general way.

Integrity provisions at the municipal level in SEE are often very general, target low-level civil servants rather than decision-makers, lack clear deadlines for their implementation and are not tailored to local circumstances. Municipal integrity plans focus on managing risks related to budget planning, public procurement planning and implementation, contract drafting and conclusion, financial management and controls, etc., but are often very general.

Compromised local procurement further exacerbates the distortions of biased fiscal transfers

Public procurement is the government activity with one of the highest corruption risks in SEE, due to the large amounts distributed through procurement procedures. The types of public procurement irregularities identified in the region include favouritism and clientelism, overpricing of contracts, tailored tender specifications, conflict of interest in the tendering process, high share of non-open procedures, short advertisement periods, contract modification and delivering sub-standard service in the implementation phase.

The lack of public procurement integrity systems at the municipal level and mechanisms not tailored to local needs render the existing national ones ineffective.

The transparency of procurement contracts is usually ensured through the launch of dedicated online procurement portals. Still, the quality and extent of information provided by the local authorities in these portals differs across SEE countries. Transparency requirements are rather optional, and there is no follow up sanction in the case the local administration does not comply.

The evaluation and assessment of the public procurement procedures and the effectiveness of prevention measures usually rely on self-assessment using descriptive and qualitative methods. There is a lack of clear indicators and quantitative evidence-based instruments which can evaluate results. Procurement oversight and anticorruption authorities mostly look into input indicators (regulations, procedures, resources), rather than outputs, i.e., actual impact.

Evidence of political favouritism in local public procurement

In order to find out whether – and if so how – local procurement follows partisan interests, leading to contract allocation according to political loyalty and electoral considerations, this report has examined the presence of politically motivated factors in the distribution of public procurement contracts. The statistical analysis of the relationship between public procurement contract values, political party affiliation of local leadership and election results in nine countries in the SEE region, allows for a number of conclusions.

Political alignment with the central government means larger contracts. In most of the countries studied, data suggests that there is a politically motivated distribution of public procurement spending rather than one based on impartial allocation, reflecting public needs. When municipalities are politically aligned with the ruling party of the national level, they tend to receive larger public procurement contracts.

Winning margins in elections pay off. Higher winning margins in local elections, which are used as indication of less political competition, are generally associated with a greater chance of winning larger contracts. This suggests that municipalities with predictable electoral outcomes tend to allocate more public procurement spending. This is possibly due to a higher likelihood of corruption, capture, or abuse. Case studies from Hungary and Romania provide concrete examples of how political networks can lead to abuse of public procurement processes, including favouring certain firms with political connections and inflating contract prices. These cases highlight the potential for corruption and conflict of interest in local government in these countries.

Combined effects of political alignment and  electoral  competition.  The directions of the relationships between these two factors vary across countries. Positive coefficients in some countries (e.g., Bulgaria, Hungary, and Romania) may indicate that politically aligned municipalities receive larger contracts, which could be due to political motivations or administrative efficiency. In contrast, negative coefficients in other countries (e.g., North Macedonia, Croatia, and Serbia) suggest that politically aligned municipalities receive smaller contracts, possibly as a strategy to obtain loyalty or support.

Importance of local networks and context. Corruption in public procurement is often facilitated by well-established local networks. The predictability of election results may affect these networks, and a disruption of such networks may reduce opportunities for corrupt cooperation. It is also important to consider the specific context of each country, including the share of public procurement at the local versus national level and the degree of fiscal and administrative decentralisation.

The way forward: reducing the risks from clientelistic intergovernmental transfers

There are a number of policy measures, that could reduce the risks from discriminatory and biased funding from the central towards the local level, as well as the misuse or mismanagement of national and foreign donors’ funds.

Improve strategic planning and evidence-based decision-making

The first step involves the recognition of the problem in government policies. Once the problem is recognised, the process could move towards the establishment of clear and transparent criteria for funding allocation. Further, the evaluation of risks of preferential and politically biased decisions should be mainstreamed into fiscal oversight. The latter should involve collaboration among multiple public bodies in order to ensure transparency, accountability, and equitable distribution of resources between central and local governments.

Officials responsible for making funding decisions need to be trained to recognise and react to cases of preferential treatment and bias, while municipal officials should be equipped to detect public procurement irregularities and use electronic tendering procedures. Civil society could help with the organisation of such capacity building, as well as the introduction of electronic procurement.

Establish a regular public-private mechanism for monitoring funding decisions for a combination of corruption and fiscal risks

Anticorruption agencies, audit offices, financial inspectorates, the associations of municipalities and civil society and the media should review decisions related to budget transfers and assess any potential bias, discrimination, or conflict of interest. The audit offices and financial inspection institutions should establish procedures for random and regular inspections in cooperation with anti-corruption authorities, in addition to the ad hoc checks performed based on requests, referrals and complaints. The review of the budget transfer decisions should:

  • Consider the choice between unconditional transfers and conditional transfers;
  • Detect the corruption risks associated with  formula-based  transfers  such as manipulation of the formula criteria, data falsification, formula complexity and political interference in formula design;
  • Check the accuracy of data inputs for the formula and the fairness of the allocation process;
  • Recommend steps towards the reduction of formula complexity and the increase of transparency during and after its implementation to avoid and reduce policy indiscretion and political capture;
  • Assess the links between political affiliation and fiscal transfers in historical perspective, including at least the last two local election cycles, as part of the annual budget procedure.

Apply regular corruption risk assessment methods

In addition to the financial audits and the self-evaluation reports of local government authorities, it is also recommended for the governments at central and local level to use a wider range of corruption risk assessment mechanisms, in order to develop a comprehensive approach towards tackling all corruption and conflict of interest threats. These could include the following state of the art tools developed by R2G4P partners:

  • The Monitoring Anticorruption Policy Implementation (MACPI) tool, which assesses, monitors and facilitates the enforcement of anticorruption measures and policies at the level of individual public bodies, including municipalities;
  • The State Capture Assessment Diagnostics (SCAD), which is based on anonymous online survey among a large pool of experts, as well as the State Capture Assessment Diagnostics at Sectoral Level Integrated Tool (SCAD-SLIT);
  • The Corruption Risk Indicators (CRIs), which measure the corruption risks of public procurements;
  • The Corruption Monitoring System (CMS), which provides victimisation and perception data in the corruptness of municipal councillors and municipal officials;
  • The corruption proofing of legislation (CPL) and anti-corruption tools related to asset declarations on local level.

Increase the integrity of public procurement at local level

National and EU oversight of local level public procurement should be prioritised and increased in both fiscal and anti-corruption control systems.  In particular, the European Commission should seek to establish a more coherent framework of monitoring the effects of its interventions through its different funding instruments at the local level, in combination with national transfers. In addition, the following measures could help improve the integrity of local level public procurement:

  • State clear commitments and set deadlines for public procurement reforms in strategic documents (e.g., National Recovery and Resilience Plans).
  • Establish regular and systematic monitoring of political favouritism between the national and local governments in public procurement building on the tools developed in this study.
  • Improve e-procurement data collection and publication, collecting more comprehensive data by, for example, lowering reporting thresholds and making public data more readily accessible for societal actors (e.g., data download options).
  • Further strengthen the policies for transparent and fair allocation of public procurement contracts by increasing publication of calls for tender, making tendering terms more pro-competitive, diminishing the use of non-open procedure types, and breaking up dominant market position of incumbent firms often having strong political connections.

Improve oversight of public procurement at the local level, including review of anti-competitive tendering terms, to constrain the strategic use of public procurement for rewarding political actors for their loyalty.