FISCAL RELATIONS BETWEEN CENTRAL AND LOCAL GOVERNMENTS: GOVERNANCE RISKS AND MITIGATION POLICIES

Conditional transfers adjust the expenditure priorities of local authorities   to national policies. The process contains in itself a natural governance conflict, as it implies that the central government has to convince subnational authorities to pursue certain policies or goals, which do not necessarily reflect local priorities, and which might also be under-financed, leaving the local governments to bear the wrath of disgruntled voters. When spending decentralisation is funded through intergovernmental transfers this renders local officials subordinate to the priorities of the centre, with the associated rent-seeking effects and related risks of growing political bribery.²⁸

Unconditional transfers, on the other hand, are primarily meant to provide equalisation of public financing across the country, and 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 the formula transfers’ value and the  actually  distributed  amounts.²⁹  Although the formula is a mechanism designed to limit the power of the central government in the distribution of funds³⁰, when there is no transparency the risks of manipulating or overruling the formula are high.³¹ In addition, the complexity of formulas might make it less comprehensible to the public and more prone to manipulation.

The SEE countries use different formulas to try to achieve equity and efficiency based on social (e.g., population and poverty), geographical (e.g., marginalisation and size) or economic (e.g., tax collection and economic dynamism) criteria for distribution of transfers.³² However, their formula- based allocation of transfers in and of itself alone does not always assure transparency, which is a common issue for emerging and developing countries.³³ The formula could be public, but the data used to calculate     the exact amount that should be allocated to municipalities might not be transparent and comprehensible for the general public. In other cases, the central government may decide to apply some elements of the formula, leaving at the same time space for discretion. Therefore, formula-based transfers are not fully immune from manipulation. Further, they sometimes may create loopholes which allow substantial and systematic circumvention. Loopholes which make formula-based transfers in SEE countries vulnerable to systematic circumvention, misuse and corruption include:

• possible manipulation of the formula criteria, e.g., adjusting population figures, economic indicators, or other criteria to artificially increase the allocation for political or personal gain, data falsification;
• formula complexity (designing a formula that is difficult for oversight bodies or the public to understand, making it easier to manipulate);
• political interference in formula design (pressuring officials to adjust the formula to benefit specific areas or politically influential groups), insufficient oversight mechanism (e.g., auditing processes or weak enforcement of rules);
• inadequate monitoring and evaluation (failing to conduct regular reviews and audits to assess the accuracy of data inputs and the fairness of the allocation process);
• limited  public  participation  (not  involving  citizens  or  stakeholders  in the development of the formula, reducing the likelihood of detecting manipulation).

Therefore, it is crucial that countries within the SEE region not only focus their efforts on implementing correctly formulas but also increase their transparency in terms of political objectives. Reducing formula complexity and increasing its transparency during and after implementation is a logical step for the SEE countries to avoid or reduce political capture. The simpler the transfer formula is to apply, the easier is the oversight of its implementation.

Both transparency and accountability rules are equally important to the formula structure, including the source of data and the methodology of calculation   of the indexes used in the formula. For instance, the highest weight in the formula should not rely on inaccurate or outdated data sets. Criteria used by the SEE central governments should be clearly articulated to the public. Responsible institutions controlling the formula should be pressed to make public the data used for running the formula and the results obtained. Further, formulas should be kept protected from frequent changes, unless no clear rational is provided to the public.

At the same time, both conditional and unconditional transfers can be discretionary or non-discretionary. Though the division is not clear cut, discretionary transfers are typically such that are decided by the central government on an annual basis, whereas non-discretionary are decided on  a longer-term basis. As such, discretionary (unconditional) transfers in the SEE countries are the most vulnerable to corruption and state capture risks, as they are the subject of negotiation between central and sub-national authorities in which central authorities may be more or less disposed to favour the particular municipalities to which the transfers apply. The discretionary transfers are especially prone to undue sub-national influence.³⁴ While they provide flexibility, they are more susceptible to corruption risks due to potential abuse of power and lack of transparency.

Common risks for the SEE countries, making the discretionary transfers vulnerable to corruption are political favouritism, clientelism and patronage (allocating funds to politically important areas during elections), inadequate oversight (lack of regular audits or independent reviews to monitor how discretionary funds are allocated and spent), arbitrary decision-making (decision-makers allocating funds without a clear rationale or justification), misallocation of resources (allocating funds to projects without contribution  to the overall community well-being), limited competitive process (allocating funds without open competition or bidding process), lack of transparent decision-making (without disclosing the criteria or considerations used). Although they are necessary in the case of unique or temporary projects, such as the construction of infrastructure or the improvement of the regional or local economic structure, it is important that the central level choose the procedures of project selection and design and the role of negotiations and contracts with sub-national authorities. In this respect, the progress in the process of EU integration, with its capacity building for planning and oversight of discretionary project spending is particularly important for the region.

Risks associated with municipal or regional development funds

Risks of political bias in intergovernmental transfers are particularly present when the funding for municipalities is distributed by various national funds, by the ministries of local/regional development and/or by government-controlled foundations. By design, these funds are tasked to allocate the financial support on a competitive basis (applications received by individual municipalities),   or based on the needs of the municipalities according to fixed criteria. Yet, evidence suggests that the distribution of such funding in SEE might often  be based on political alignment and misuse of the received funds for election campaigns.

In Albania, the Regional Development Fund distributes conditional transfers upon application by local government units. The distribution of transfers and management of the Fund is carried out by the Committee for the Development of Regions, consisting of the prime minister, the deputy prime minister and relevant ministries³⁵. However, there are indications that the funding is allocated based on political ties, which do not reflect local development goals. For example, 26 municipalities controlled by right-wing parties³⁶ from the opposition have managed approximately 20% of the Fund in the period 2016 – 2018, while 34 majority-run municipalities were awarded the remaining 80% of the Fund.³⁷ Moreover, the size of the Regional Development Fund has increased significantly, leading to concern that it collects the funds that should have been allocated through unconditional transfers (budget transfers). Municipalities with low project application capacity and small populations often face difficulties benefiting from this Fund. The Fund’s reports are not published online.

Hungarian organisations (mostly CSOs) with ties to the Fidesz party have been recipients of substantial financial support through the state’s civic fund, particularly under the auspices of the Municipal Civil Fund.³⁸ Notably, Fidesz-affiliated groups have secured the largest disbursements of funds for election campaigns and the development of pre-election media resources within the framework of this Fund. Of the 83 grant recipients receiving HUF 11 million (EUR 29,657) each, almost half (38 organizations) are associated with Fidesz politicians.³⁹  An additional 12 entities maintain indirect connections  to the ruling parties. These indirect links manifest through initiatives such as arranging campaign functions for local politicians or disseminating government messages via printed publications.

The objectives of state funding to independent civic organisations have evolved over time. While media infrastructure took precedence in the allocation of funds in 2022, the primary focus has shifted in 2023 towards orchestrating events designed to promptly engage and mobilise voters.⁴⁰ Some of these organisations claim to be politically independent. However, their active involvement in local elections and collaborative  candidacy with Fidesz in electoral coalitions exposes  their  close association with the ruling party. There have been multiple instances of presence of local Fidesz candidates at these events. Moreover, the upper limit for funding across both application rounds was set at  HUF 26  million (EUR  70,100), a threshold solely attained by organisations affiliated with the governing party.⁴¹

In Romania, the National Programme for Local Development (PNDL)  is the main source of financing for local infrastructure in areas such as healthcare, education, water and sewage, heat and electricity, including public lighting, transport, roads, sanitation, culture, worship, housing and sports. Funding comes from the central government, which retains ample discretion regarding allocation and oversight of spending. In the period 2007-2022 funding from PNDL and its predecessors, the Reserve Fund and other emergency funds, have been allocated based on political criteria, with mayors in power receiving even up  to  three  times  more  than those in opposition. The calculations also  show  that  mayors  from the funded counties have changed their political allegiance.⁴² Experts monitoring the funds conclude that there is a lack of administrative capacity within the Ministry of Local Development, Works and Administration (MDLPA) to implement PNDL, Projects are managed on paper only, project implementation data are missing or are obtained long after completion, there are no effective controls and no performance audit to show whether or not PNDL is successful.⁴³,⁴⁴

Understanding governance risks in intergovernmental transfers: who wins what?

In order to correctly identify the risks of transfers made for purposes other than equitable local development and in order to design efficient counter- measures, policy makers should first understand the “incentives”, the “benefits” and the “payment” expected for these benefits for each of the involved parties.

Central and local governments, as well as the incumbent political parties, benefit by:

• Building central and local leaders’  reputations,  securing  votes  and re-election. The process is often associated with promises and announcements made during election campaigns. It is not, however, necessarily limited to campaigning and can arise in any part of the electoral cycle. The idea behind the practice is that the money allocated to the representative’s district, canton or municipality will benefit the lives of the local constituents, thereby securing their support and votes. Support in this context can also mean contributions to that politician’s next election campaign.⁴⁵
• Securing and/or changing the political allegiance of mayors. The previous allocation of funds could 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.⁴⁶
• Decision-making power over local level  contracts,  investments  and projects. Non-transparent and discriminatory allocation of public procurement contracts, state aid, concessions, and investments projects based on political connections or pressure become an extension of privileged intergovernmental transfers thereby further exacerbating the misuse of public finances.
• Decision-making power over political  appointments.  In  exchange for the national or foreign donor funds, the central level and/or local level leaders could ensure the political appointment of close to them persons  in the municipalities, state-owned enterprises (SOEs) and/or companies (usually large employers).

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 compared to similar in size and needs municipalities run by the opposition;
• higher share of foreign donor (including EU) funding;
• debt annulment or low-interest loans provided by the central government, which further discourages the strict financial management of the municipality/canton and compromises the oversight over investment decisions;
• decision-making power over political appointments of close to the mayor / municipal council members in local companies, SOEs, and other recipients of the national or foreign donor funds.

Local companies, usually large employers, as well as sometimes SOEs, non- governmental, academic and media entities, benefit by:

• non-competitive award of municipal budget funding, foreign donor (including EU) funding, procurement contracts, concessions, permits and state aid;
• debt annulment or low-interest loans provided by the state or the municipality;
• the opportunity to purchase underpriced municipal property;
• securing political appointments in the municipal or central-level public bodies.