Economic Policy Review ISSN 1313 - 0544

Municipalities Are Entitled to a Share of the Income Tax

Author: Petar Ganev / 09.10.2014
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It is clear that municipalities need fresh capital for investment. The current structure of Bulgaria’s fiscal policy suggests and inevitable  lack of resources in municipal budgets for investment[1]. Not surprisingly, almost all cases of public investment at local level, which can be given as examples of projects that lead to improvement in quality of life, have been are carried out with EU funds. If you go to any major city in the country, the first thing you will notice is that either a park was completely renovated or the tiles and gardens in the city center have finally been fixed. Some may even boast of a new water treatment plant. All of this is usually financed via European funds.

Why were the park and the city center (which had barely unchanged since the beginning of the transition) suddenly refreshed after joining the EU? Most people would say that this is because, being a poor country, Bulgaria does not have money, while in recent years rich Europeans allocate funds for such projects. However, this is not true - there have always been money for the center and the park. It is our fiscal policy that concentrates all available resources on the Yellow Brick Road. In recent years we have repeatedly showed evidence that there is simply no free resources (own funds) in the municipal budgets  to be spent on capital investment (see "Tax Policies at the Local Level 2013"). Redistribution of public funds in the country serves entirely national policies, sucks out resources from the regions to the center and kills the small town and village (see "Regional Profiles 2013").

Even though this is generally clear to everybody, the political establishment[2] is not taking any steps. On the contrary, last year just the opposite happened - they came up with the Fund for regional development. Although it sounds quite ambitions, there is no actual fund - it’s just that some money from the budget are being spent in another form of subsidized development. Instead of taking steps to create means for municipalities to ensure their own financing, the politicians decided to spend 500 million BGN on some regions. The final decision as to which regions will receive the money and which projects will be approved was once again made on the “yellow bricks.” Of course, as expected, the money was redistributed politically and thus local authorities were made even more dependent on the central government.

Real change at the local level will occur when municipalities receive the means to raise and keep their own resources - not with the absorption of more European funds, or via government-created regional funds. Studies and research in recent years have shown that the best way to tackle this issue could be the redirection of 2 percentage points of the personal income tax (one fifth of the entire tax) to municipal budgets. Here some clarification is needed as well, regarding the proposal of the CEDB for up to 2% additional income tax being imposed by and going entirely to municipalities as an option on the 10 percent national flat tax on income.

In every case, the work of tax authorities should continue the same way as it is at the moment. In other words, there cannot be separate procedures or payments to the state budget and to the municipal budget. People will continue to pay taxes as before, but the resource will be transferred internally and automatically to the municipal budget. The principle can be only one and it is extremely simple – the reallocation of tax revenue is made according to the permanent address on a person’s identity card. There were all sorts of opinions that such redirection of part of the income tax to municipalities is almost impossible because we do not know whether to pay by a residence, working place, etc. It is clear that many people don’t actually study or work in the municipality of their permanent residence, but this issue is absolutely solvable. The general idea that the payment should be made where your ID says you live, respectively, where you vote and where you often pay other local taxes (for example the car tax). Let us note that although you can vote in different places (with request) on parliamentary elections, you can vote for mayor in only one municipality. i.e. the tax payment should be made where you vote for mayor.

Is it fair? Some will say that many people work in the capital city, but they will have to pay their taxes in other municipalities. Yes, indeed, there will be such group of taxpayers, but income taxes payment being made according to the ID address is still the best possible alternative. The problem with residence cannot become a barrier to an adequate fiscal policy. Moreover, it is the taxpayer’s responsibility and choice where to pay taxes. If a person feels a resident of his native village, though working in the city for a long time, why should he be unable to direct part of his taxes to their municipality? If not, this tax feature could become a strong argument for him to change his residence, so that the money can go where the person currently lives – an actual incentive for solving the problem with the permanent addresses will appear.

So far we have described that part of the revenue from the income tax can be transferred to the municipalities, and that it should rely on the principle "money follows the ID card." The question is can the administration deal with it right now. Even though it sounds strange the tax administration is not quite ready. Recently the IME asked for a division of income tax revenues by municipalities and it turned out that such could not be provided. In other words, the realization of this idea requires some changes in the tax administration.

The principle "money follows the ID card," however, is simple enough to solve this problem. The solution is not in tax declaration changes, as most people anyway do not fill it themselves – most people sign employment agreement and income tax is paid directly by the employer and tax declaration is not filed at all. Who pays the tax and how does not really matter. The important thing is that the tax field across each ID is marked as paid – that kind of information should exist. The connection between the tax paid and the permanent address obviously can easily be done through ID numbers, as long as the administrations are communicating.

The administrative redistribution of the income tax to municipalities is feasible. The questions that remain are what the tax rate should be and whether the municipal tax should be included, or above the 10 percent tax for the central budget. An additional two percent tax rate practically would provide resources which will exceed the 500 million of the 2013 regional fund. Maintaining the 10 percent national flat tax and allowing municipalities to impose their own on top of that hides both political and administrative risks. First, it means there is no redirection (the state retains its own) but only an opportunity for municipalities to raise the tax burden. Meanwhile, administratively now we need a third variable in the data array – the tax rate enacted in the local budget. It's not impossible, but it can serve as an argument for politicians to delay the changes with couple more years. While fiscal freedom really requires not just redirection of revenues but real legal rights in taxation, a change which is only in the direction of increasing taxes is very controversial. The choice should be between likewise automatic redirection of tax revenues or dividing the flat 10% in two for example one part is directed to the central budget, and the other – to the city. The first can happen as early as next year, replacing this year’s regional “fund”.

It is a matter of debate whether municipalities are to be given complete freedom of disposing the remised income or in the beginning for example to accept the rule that the money can be spent only for capital investments and to meet old obligations. This means having something like a transitional healing period for municipal budgets. In both cases, not only the dependence on the central government is eliminated, but also the basic point of democracy is brought back at the local level as the municipal council will be more responsible for the finances of the municipality. Currently, for example, "free" money in municipalities comes from EU funds and in the last year – from the so called regional "fund". Both are within the mayor power and his administration and actually have no relation to the councilors. However own tax revenues what a transferred resources from income tax would be are not laid out by the administration in a project and depend entirely on the decisions of the municipal council. This in the long run may be a good rehabilitation solution for the deformations of local democracy in the country.


More on this topic can be found in the upcoming edition of "Regional Profiles 2014."

[1] Completely different debate is that these "public" local investments (parks, sports facilities, infrastructure, etc.) can often find a private solution. Realities in the country, however, are such that the front door is closed for private solutions both politically and administratively. Along with the debate on the municipalities own funds there should be a debate also on "public" investments on a free-market basis.

[2] This term is not used by chance. Democratic deformations in the country, both on national and on local level, benefit from the centralization of resources and putting their fate in dependence on the political situation.