Тhe war in Ukraine and the EU’s rush to shore up its neighbourhood from authoritarian encroachment have focused the spotlight on the unfinished business of enlargement and integration in Southeast Europe.1 And once again, the critical issues of contention, which have stalled EU’s efforts in this respect are the outstanding rule of law and state capture problems in the region. Local incumbents have pushed hard to overlook those issues for the sake of geopolitical stability, yet EU leaders have been wary this is the right trade off to make, given the experience with previous enlargements.2 In addition, Russia’s continuing global effort to discredit the European idea has forced European institutions to upgrade their domestic democratic resilience defences, including the adoption of a broad, new anti-corruption package, which would further raise governance standards for accession.3 Hence, SEE countries need to continue their efforts on fighting back high- level corruption and state capture elements, in parallel to building up their institutions of democratic resilience on a daily basis through painstaking work on legal, institutional and practical checks and balances. At the same time, their leaders would have to fend off mounting pressure from Russia and China on embracing their authoritarian, state capture-based model  of development, supported by seemingly no-strings attached transfers for infrastructure (such as for example from the Belt and Road Initiative).4 In this respect, the governance of EU and national fiscal policies and transfers5 will play an increasingly critical role in sustaining democratic resilience and showing democracy can deliver through spurring the continuous inflow of constructive capital.6

Public spending always incites intense controversies among analysts and practitioners. However, its significance rises even further in times of transition.

As technological, social and geopolitical shifts accelerate,  the  purpose  and effectiveness of public expenditure warrant additional scrutiny. The management of public finances is intertwined with public administration reform, and even more importantly it needs to be considered within the more general framework of public governance. Public financial management cannot be optimised when its governance is compromised. When, as is the case in the countries of Southeast Europe (albeit to a varying degree), the government structures in charge of public finances have become geared into or incapacitated by state capture networks, any general considerations about the optimal management design need to be modulated through knowledge about the mechanisms of state capture.

State capture is a form of corruption which programmes public institutions  for a systematic delivery of private benefits to their captors.7 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. In its mature form, it goes beyond a simple deviation in the functioning of a given public institution into a stable pattern of institutional behaviour resistant to the application of standard, generalised anticorruption policies; it becomes a virtual long-term privatisation of government functions.

This paper analyses the risks entailed by the misuse of fiscal transfers from central to local governments in countries with significant state capture risks. Within nations, such transfers are a commonly used tool of equalisation policies seeking to offset disparities in the economic development of territorial units. They are, however, no less commonly subject  to partisan bias,  and not only in Southeast Europe. Malpractice in central-local government fiscal relations can take various forms. At one end are favouritism and political particularism of the “pork barrelling” variety – not illegal but often highly unfair and ineffective appropriations for the benefit of single constituencies. In many countries, the distributive  choices  of  sub-national  governments are often related to their electoral incentives; politicians seek to reward constituents or sway opponents. At the other, however, political cronyism can degenerate into outright embezzlement. 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.8

Since public investment often represents a significant part of discretionary spending, its overall integrity largely depends on the fairness of procurement procedures. However, when local government purchasing is affected by various corrupt practices, equalisation policies might achieve the opposite of their official intention. In this case, 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. Such accruing of risks requires an integrative approach to the design of oversight policies, whereby the compliance with fiscal and procurement rules is supervised in a coordinated manner with the enforcement of anti-corruption regulations.

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 by far the largest financial donor to SEE 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, it is the same state capture clique which exploits both intranational and EU transfers for the benefit of special interests.

The risks and damages inflicted by capture is all the more significant given that EU funds are the bulk of discretionary spending channelled towards local level development in the SEE countries. SEE public budgets are relatively small, and regional development policies tend to be delivered by way of EU funds. In the SEE countries sub-national territories are eligible for some form of EU funding under cohesion objectives, though SEE EU member states receive a much higher appropriation compared to candidate countries. As mandatory national spending (such as pensions) is bound by strict rules, it is difficult to appropriate corruptively for the benefit of political cronies. Hence, it is likely that EU funds would be a special focus of pork barrelling and state capture networks. Ultimately, political distortions in EU spending programmes erode the capacity of the Community to act as the promoter and guardian of good governance and economic development among its current and prospective members.

Corrupt fiscal relations between central and local government – in both  the literal and broader senses – have even larger implications. Fiscal policy is centralised in most SEE countries and a high degree of administrative and fiscal centralisation is a considerable risk factor for state capture; the latter, in turn, further institutionalises this centralisation. Corruption is crucial in this process. In order to support increasing concentration of power in central government, junior government officials are often given some licence to extract rents from households and businesses. Thus, the retail market   of corrupt administrative services becomes closely linked to the wholesale purchase of government policies. The resulting authoritarian drift makes government vulnerable not only to domestic but also to foreign capture, which, in times of intensifying geopolitical rivalry, poses structural dangers to countries. In a closely integrated Europe this ultimately affects the whole continent. Given that Southeast Europe has been among the areas most vulnerable to Russian and Chinese influence, how the support structures of democratic resilience are built from the ground up should be better understood.

It is small leaks that sink great ships, as the saying goes. It is imperative, therefore, that the integrity of the whole machinery of governance be maintained by inspecting and strengthening the integrity of its every detail.

The findings presented in the current report are far from conclusive and ultimate, given the lack and disparity in the quality of the available data. Yet, it makes a first attempt at an integrated data-based look at the corruption and state capture risks at this critical juncture of good governance of central to local government fiscal transfers. And it attempts to at least outline the clash between two interpretations of the existing data – one broadly democratic, including examples of positive developments, and one broadly clientelist, showcasing the existing governance gaps and risks. The data in of and of itself cannot determine which kind of political favouritism is at play in SEE countries. Hence, policy interpretations and recommendations should be interpreted more as a warning call for action, rather than a verdict and finger pointing. The report also provides a unique empirical contribution in terms of systematized data on local level institutional rules, decentralisation trends, fiscal transfers and public procurement. It should therefore prompt further inquiries into the involvement of electoral or clientelistic considerations influencing the local allocation of national and European funds. It is at this level that all the governance risks converge and consequences are experienced by individuals and business. The report also builds upon R2G4P’s wider efforts on finding public-private solutions to governance problems in SEE, by consulting and showcasing examples of success stories in local governance. It further makes the call for continuing such public-private cooperation in prevention policies through regular risk monitoring and assessment by using the evidence-gathering mechanisms implemented in the development of this analysis.9