Improving Intergovernmental Fiscal Relations and Public Health and Education Expenditure Policy:

Selected Issues

Kyiv, February, 2008

Ukraine’s Public Finance Ukraine’s Public Finance Review IIReview II

Why reforms are needed in local government and service delivery financing?

• Because service quality is poor• Because low service quality will hurt future

growth• Because local governments are responsible but

have no means and no incentives to deliver• Because spending pressures will rise (delayed

modernization investments, demographic pressures, EURO 2012, …)

• Because raising additional taxes is not an option• BUT most important: because there is huge

scope to increase efficiency and reallocate resources to achieve higher quality!

What people say: public services are failing!

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Unsatisfied

Source: EBRD-World Bank Life in Transition Survey (LITS) 2007.

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Health services

Education services

Key areas for action• 1. Bring autonomy, incentives and resources to local

level where services are actually delivered• 2. Reform the way public investments are planned,

budgeted and executed• 3. Reform financing arrangements in health and

education to target quality outcomes not quantity inputs. – Optimization of school network is the only responsible way to

improve the quality of education for children in rural areas and across the country.

– Optimization of the network of health facilities is the only way to assure resources to improve the health status and welfare of Ukrainian citizens.

Intergovernmental Fiscal Relations Expenditure Responsibilities

• Some overlapping of functions remains and increasing under-funded mandates • Local governments below rayon level are too small to manage and plan services

such as health and education• Is creating communities with significant responsibilities below rayon level the

answer? We do not believe so (high initial and recurrent costs, scale/inefficiency, weak administrative capacity)

Level of Local Governmen

t

Average Population Size (approximate)

1st tier: Oblasts, ARC and cities of special status

1,730,000

2nd tier: Rayons and cities

61,0003rd tier: Small

rural towns, settlements, villages

1,400

Country

Average population in the second tier of sub-national Government (equivalent to the level of rayon and city)-

CORE LOCAL GOVERNMENT

Indonesia 617,070

Mexico 72,000

Poland 103,619

S..Africa 149,654

Japan 69,291

Selected Recommendations • Strengthen the rayon and city level as the core local

government (right size for Ukraine)• Move up health and education functions to rayons

and city level • Arrange for small town, village, and settlement

councils to keep other current local functions and their current political representation

• Promote the consolidation of third tier local governments through incentives, not by decree

• Avoid creating a new local government below the rayon level with significant expenditure responsibilities

Expenditure Autonomy and sectoral norms: the unfinished reform

• Sectoral (e.g., health and education) “norms” are one of the largest impediment to improve efficiency and financing of the services and local governments in Ukraine

The Inefficient Process of Budgeting Based on Input Norms

Ministry of Finance Ministry of Education

An Average Rayon Budget:

Other 19%

Health40%

Education41%

Ministry of Health

Budget Allocation $$$ Through: (1) Shared Revenues (PIT, Land) (2) Equalization Transfer, (based mostly on demographic /need factors (although problems exist-) (3) Local Taxes

Local Budget Submission complying with Norms (Health and Education)

Mismatch

Input Norms to form school budgets, which constrain budget flexibility (Order No 1/9-234; VR resolution No 2551-III)

Input Norms to form health facility budgets, which constrain budget flexibility (Order No 33)

School Facility Budget: Prepare budgets fulfilling the “norms”-, which lead to high current spending (+ - 95 %)

Health Facility Budget: Prepare budgets fulfilling the “norms”-, which lead to high current spending (+- 96%)

Budget Formation

“Norms” fulfillment + large network of facilities = non-flexible crowded by recurrent spending local budgets; little spending autonomy is left to LG. Only marginal needed investments are possible.

Consequences Recommendations

• Current spending eats most of the budget, leaving capital investments under-financed

• Poorer local governments pay a higher price for the inefficiency by having even less to invest in infrastructure

• The sector lack flexibility to modernize

• Revise and eliminate the norms that have financing implications on local budgets

• Allow rayons and cities more freedom to plan and allocate (and re-allocate) their own resources

Revenue Assignments Issues and Recommendations

• Revenue drops due to tax policy changes do not have a well-established compensation mechanism (changes in rate, base, exemptions, etc) Implement one

• Lack of property tax (core local tax) Legislate and implement a property tax with a proper fiscal cadastre.

• The administrative costs of collecting certain local taxes are likely to be higher than their yield Eliminate low revenue yielding taxes

• Several local taxes have a complicated way to establish tax liability increased administrative and compliance costs (e.g., communal tax marketplace fee) Make the way to calculate tax liability on local taxes simpler.

Equalization transfers are equalizing overall but complicated and inefficient

• The equalization power has not changed since 2001 despite a large number of factors and complexity added to the formula (which also reduced its transparency)

• There is some level of unpredictability in the transfer allocation

• Many factors in the formula encourage existing inefficiency in the network of services and staffing

Recommendations • Streamline the formula, including by eliminating unnecessary/ill-

designed incentives and those that finance specific programs.• On expenditures needs: each component (e.g., health, education,

culture and sports etc) should not contain more than 4-5 factors all demand driven.

• Create an appropriate standard for each service, a unit cost for each service to include in the formula (an improved “H” factor.

• Maintain stable the way in which revenue capacity is calculated• Strengthen the “fiscal effort” mechanism

Capital Transfers are Ad Hoc • There is no stable criteria based system for allocations of capital transfers/subventions • Plagued by political bargaining • Marked inequalities

Public Capital Expenditures by Oblast 2002-2006

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Rayons Capital Investments on Per Capita Basis 2005

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50

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350

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UAH

Per C

apita

Weaknesses in the local capital budgeting mirror those at the national level

• Lack of predictability in subventions/allocation poor planning no multi-year planning.

• New projects take preference over on-going projects

• Weak evaluation and selection of projects• Co-financing requirements exacerbate regional

inequalities in capital spending• Under-execution problems (on top of weak

planning of maintenance — deteriorating asset conditions)

• Targeted programs create inflexibility

Recommendations • Establish in the budget code that a capital transfer/subvention should be

criteria based and criteria should be stable in time, including basic framework

• Consider a two-layered system:– First, a minimum subvention to cover the basic renovation needs of

oblasts and rayons and cities with a simple formula based solely population.

– Second, transfer (potentially larger than the first) to be granted for critical on-going and new projects on a competition basis (concrete criteria for competition and selection should also be established)

– BTW: EURO 2012 a great opportunity to get this started

Local Governments’ borrowing: problems and recommendations

• Refinancing is not recognized as a legitimate borrowing transaction. Amend the legislation to allow it as a way to improve debt structure/maturity to better finance infrastructure.

• There is no bankruptcy framework create one to avoid moral hazard in lending/borrowing

• Borrowing controls are adequate but some holes exist in the regulation (local government bank account may be used to pledge revenues) allow only to pledge local “own” taxes. In time, controls could be revised if the system develops adequately.

• Additionally, inter-budgetary loans harm the development of the sub-national borrowing market, soften budget constraints, and harm transparency

Ukraine devotes a large amount of budget resources to Education….

Public Education Expenditures as % of GDP

1.00

2.00

3.00

4.00

5.00

6.00

7.00

2002 2003 2004 2005 2006

Public Expenditure in Education as % of GDP

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1

2

3

4

5

6

7

Belarus

Bulga

ria

Can

ada

Cze

chRep

ublic

Fran

ce

German

y

Japa

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Korea

Polan

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Rus

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Fed.

UKRAINE

EU-10

OECD

averag

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But in a highly inefficient way. The devastating effects of the education

“norms” are evident

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Bosnia-

Herzegovina Bulgaria

Croatia

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Romania

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Ukraine

Austria

France

Germany

Ireland

Japan

Korea

OECD average

Student Teacher Ratios (primary and secondary education)

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2

4

6

8

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12

14

1999 2000 2001 2002 2003 2004 2005 2006

student/teacher Ratio in GeneralSecondary Education (primary + secondary)

Moreover….. • Teachers workload (in

hours) in Ukraine is low compared internationally (based on inefficient “norms”)

• Ratio of non-teaching staff to teaching staff among the highest in the world (also “norm” driven”)

• This will worsen over time if measures are not taken now

Annual load per teacher in hours (Basic and secondary)--average

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1,400

USA France P hilippines Average OECD Ukraine

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1000000

2000000

3000000

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6000000

2005 2010 2015 2020 2025

5 to 14years

18 to 23

15 to 17

SCHOOL AGED POPULATION

Inefficiencies are also exacerbated by other factors …

• The positive effect of “natural” attrition is offset by re-hiring of retiree teachers

• VR resolution to prohibit closure of facilitiesAs a consequence:

– Low spending on quality enhancing expenditures (investments, IT and connection, laboratory, teaching aids, teachers’ training) poor quality

– Low responsiveness to changing needs in labor market demand

– Lack of flexibility to modernize

Recommendations: Start reforms now….. • Revise and eliminate norms that impose rigidities

in budget formation in facility and local budgets• Optimize school network and give rayons and

cities autonomy to re-allocate staff and resources • Let natural attrition work (Stop re-hiring retired personnel.

Limit hiring to new teaching needs/skills)• If these measures are taken they could save up to

1 % of GDP (see details in the report)• Implement targeting of tuition and stipends in

higher education• Improve controls over out-of pocket payments• Communicate proactively to win support and

mitigate human dimension of restructuring

Ukraine’s health spending level is reasonable BUT performance is concerning

Ukraine

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HEALTH EXPENDITURE VS INCOME

Ukraine

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Pub

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exp

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100 250 1000 2500 1000025000GDP per capita

PUBLIC HEALTH EXPENDITURE VS INCOME

High-Income OECD

EU

EU-10

ECA

Ukraine

Russia

6570

7580

Life

exp

ecta

ncy

at b

irth

1960 1970 1980 1990 2000Year

2004

Inefficiencies are acute

Number of Hospitals per 100,000 people

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6

Ukraine EU-10 EU

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Hospital beds per 100,000 pop Doctors per 100,000 pop Nurses per 100,000 pop

Ukraine EU-10

Moreover…….. • The average length of stay (ALOS) in Ukraine is higher than the

CIS average and almost double of that of the EU members (average)

• Under utilization is more acute below rayon level (e.g., village facilities)

• Ukrainian health delivery system contains a costly and counterproductive drive towards specialization (overabundance of specialists)

As a consequence: – Low level of quality enhancing investments (equipments,

training, modern facilities)=> poor quality for the citizens– The system is irresponsive to current demand– High out of pocket payment which harm substantially the

poor– In this condition not likely to meet successfully the

demographic challenge

Is health insurance a solution in Ukraine?

• NO..– This reform would likely create additional tax

burden. It’s not viable fiscally.– The level of financing is not the problem– Insurance reform will not resolve the underlying

problems of efficiency and inequality– But it could make these problems worse

Recommendations • Revise and eliminate the norms contained in Order 33 of

the Ministry of Health for budget formation at the facility level to allow budget flexibility

• Give rayons and cities the power to rationalize network (through “merging” of facilities) and staffing

Fiscal savings could reach 0.6% of GDP to be spent within the same sector in quality enhancing investments

• Arrange financing incentives to shift doctors toward primary care and integrated family medicine

• Target assistance to the poor by spending more on rayon hospitals and channeling resources for prescription drugs to these hospitals if fiscal saving can be made

• Communicate proactively to win support and mitigate human dimension of restructuring

Finally….• Public service improvements could be a key mechanism

for the government to regain the trust of the people• Optimization should not be viewed as a school or health

facility closure but as a policy to assure a higher quality of educational services for the children with highly skilled teachers, modern information and computer technologies, and improved facilities, and better health status and welfare for all citizens.

• Need to look at education and health professionals as allies => teachers want to teach well, doctors and nurses want to heal

• A top-down approach will fail. Communication is key. Local government accountability is key.