Tax Policies at the Local Level (2013)

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In 2007, amendments were adopted to the Constitution of the Republic of Bulgaria which introduced Article 141 empowering municipal councils to determine rates of local taxes under conditions, by a procedure and within the frames established by the law. Through these amendments, municipalities in practice received taxation powers for the first time. At the end of 2007, the relevant changes were also made in the Local Taxes and Charges Act, providing such powers to municipal administrations.

The following years were extremely turbulent for municipal budgets and the country's fiscal policy in general. The serious revenue growth in 2007 and in 2008 was followed by a decline after the onset of the crisis in 2009. It was the crisis that put to the test the new powers of municipalities and revealed the lack of adequate tools for the implementation of an appropriate fiscal policy at the local level. Municipal budgets inevitably shrank during the hard years, and remain heavily dependent on government transfers. At the same time, within their limited powers, municipalities have begun conducting their own fiscal policy and are competing regarding the level of local taxes.

State of Municipal Budgets

The developments of municipal budgets have created an interesting picture in recent years, which is dominated by the impact of the crisis after 2008. In the pre-crisis years, there was a persistent and synchronous increase in municipal revenue and expenditure; the relatively good condition of the municipal budgets was fuelled both by the increase in own revenues and the sustainable growth of transfers from the central budget. In 2008, driven by record-high revenues in the state and municipal budgets, municipal expenditures increased significantly, and in practice municipalities reported a deficit even before the onset of the crisis.

In 2009-2010, revenues in municipal budgets shrank, leading to deficits and debts at the municipal level. The consolidation of municipal budgets occurred relatively rapidly, spending also shrank significantly in 2009-2010. This scenario is very different from developments in the state budget where fiscal consolidation takes longer and occurs mainly on the revenue side - expenditures at the consolidated level increased nominally in any one year. With municipal budgets, there are objective factors that make consolidation more painful, that is, relatively fast, and to hit the expenditure side even in nominal terms.

One reason is the lack of buffers at the municipal level. The gap that appeared in the central budget for instance was mostly covered by the fiscal reserve, which serves precisely as such a buffer. The resources accumulated in the fiscal reserve in good years (especially 2007-2008) helped to finance the expenditures even during the crisis, without necessarily generating new debt. Municipalities, in practice, have no "buffer" to rely on: at the end of each year, municipal budgets close their accounts with certain budget allowances (for 2012 amounting to BGN 430 million), but most of this money (about BGN 300 million) constitutes unspent target funds and can be spent only as intended.

Another reason is the lack of adequate own revenues which does not provide many opportunities for a fiscal policy at the local level. Municipal budgets are so arranged as powers of local authorities and fiscal rules that, in the medium term, it is normal for income and expenses to move together. The lack of "buffers" and the limited capacity to finance the gaps opened in the municipal budgets have resulted in spending policies which promptly take into account any problems on the revenue side. Figures also reveal that in 2012, municipalities already reported a small surplus, although their own revenues continue to be below 2008 levels.

Graph 1: Municipal budgets (excluding European funds), mln BGN

Source: Ministry of Finance, IME

The consolidation on the expenditure side is mostly in terms of capital expenses, with expenses for salaries increasing each year. In practice, the shrinking municipal budgets almost entirely affected municipalities' investments, and this could not help but reflect on the potential for growth. At the same time, the role of EU funds allocated for capital expenditure has increased; these are already double the capital expenditure from municipal budgets. In other words, in recent years the investment activity of municipalities has been largely dominated by the absorption of EU funds, which is both good news and bad news. It is good news because EU funds play an increasingly significant role, are aimed at achieving concrete results, and have softened the blows dealt by the crisis. It is bad news, because municipalities are becoming extremely dependent on EU money at the expense of their own resources. Leaving aside the municipal charges that are "earmarked" funds (municipal waste charges, kindergarten fees, etc.), the local budgets are dependent firstly on the fiscal policy of the central government, secondly, on funds from European institutions and only then on the tax policy at the local level.

It should be noted that funds under EU programmes are accounted for in municipal extrabudgetary accounts and funds, i.e. they are not part of the figure above (Figure 1), which is based on municipal budgets. In 2012, with funds accounted for under various operational programmes, municipalities have made total expenditures of approximately BGN 860 million, most of which for capital expenditures. If these extrabudgetary funds were added to the accounts, that is, we take into consideration the so-called "local budgets" (municipal budgets, municipal extrabudgetary accounts and funds), the local expenditure in 2012 almost reached the levels of 2008-2009. In practice, EU funds are already ahead of municipal tax revenues. This resource is mainly invested, which makes it an even more important for local development.

Deficit and Municipal Debt

During the "hard years", municipalities also started accumulating larger deficits; in 2009 and 2010 deficit exceeded 15% of municipalities' own revenues: a total of over BGN 500 million in deficit for the two years for all municipalities. In recent years, the deficit at the municipal level gradually declined and in 2012 a small surplus was reported. If the recovery in own revenues continues, supported by better absorption of EU funds, we can expect a reversal of the trend of indebtedness, and a breath of fresh air for local finances in the coming years.

Municipalities' smaller revenues and budget deficits in recent years understandably led to an increase in municipal debts and problems in some municipalities; there were extreme cases of freezing of accounts and temporary closure of municipal services. In early 2009, municipal debt was less than BGN 500 million, most of it being domestic debt. At the end of 2012, the amount of debts already doubled, reaching nearly BGN 1 billion, with external debt slightly larger than the domestic one. Also in 2008, the annual tax revenues of municipalities solidly exceeded the municipal debt, but then the picture changed considerably: within just one year, municipal debt got seriously ahead of municipal tax revenues.

Graph 2: Municipal debt (mln BGN)

Source: Ministry of Finance, IME

It is important to note that almost half of municipal debt is that of the Sofia (Stolichna) Municipality. Its debt is entirely external, undertaken through municipal loan agreements, and represents almost the entire external municipal debt in the country. Practically all other municipalities only have domestic debt.

Currently, the amount of municipal debt is about 60% of the municipalities' so-called "own revenues" which may seem stable, but there are two factors that should not be overlooked. One is that tax revenues no longer cover municipal debt, and ultimately these are the actual own revenues of municipalities, because municipal charges are expected to be used only for their intended purpose. The other factor is that the distribution of municipal debt is not even. Although the cumulative municipal debt is an important and interesting indicator, the actual indebtedness and debt payments are divided among 264 municipalities. There are quite a few municipalities with no accumulated debt at all and this issue is simply not on their agenda: as of end-2011 for instance, 75 municipalities in the country had no municipal debt. Other municipalities have accumulated debt that even exceeds their own revenues (from taxes and fees) for the year, f.e. the Municipality of Kyustendil.

Revenues in Municipal Budgets (excluding EU funds)

The new powers did indeed provide municipal authorities with the powers to set the rates of local taxes, but within a certain range, which in the early years was very restrictive and did not allow any major differences in taxation. At the beginning, municipalities were given an opportunity to increase certain tax rates, with the minimum levels being actually the 2007 baselines. In other words, the lack of confidence in tax policies at local level was more focused on the possibility of taxes being cut to an excessively low level rather than on the risk of overtaxation.

The legal thresholds of taxation adopted by local authorities have widened somewhat in the following years, allowing also for a reduction in tax rates. This helped establish a more proactive tax policy and even created incentives for tax competition between municipalities, but the effect on the level and breakdown of revenues was not great. Naturally, the crisis has also had an impact on local revenues and it's possible that some of the potential positive effects of tax policy at local level have remained hidden. As a whole, however, the general picture over the past years did not change dramatically: municipalities continue to rely heavily on government transfers, then on non-tax revenues (charges and income from real property), with tax revenues coming last on the list.

Graph 3: Revenues and transfers in the municipal budgets (excluding European funds), mln BGN

Source: Ministry of Finance, IME

Basically, municipalities' own revenues (tax, non-tax and state aid) continue to be less than the transfers from the central budget, and it means that their fiscal autonomy is still only a wish. This trend is preserved despite the transfer of the patent tax to municipalities (2008) and the introduction of the new tourist tax (2011), as these were only small steps with negligible impact on municipal revenues.

The graph also shows the decline in revenue in the municipal budgets after 2008; the recovery is still very fragile. The slight uplift in 2011-2012 was achieved precisely due to own revenues while the size of transfers remained unchanged. In this case, the condition of public finances and the high dependence of municipal budgets on central transfers predetermine the freeze of municipal revenues. Only the increased EU funds gave a breath of air to the local authorities (not shown on the graph). In practice, if municipalities had been financially independent to a large extent and had been spending mostly their own revenue, their current condition would have probably been better.

Own Municipal Revenues

Own municipal revenues are dominated by several budget items. In terms of taxes, these are the real estate tax, the vehicle tax, and the tax on acquisition of property. Non-tax revenues are dominated by the waste collection charge. Interestingly, despite of the social tension related to the municipal waste collection charge, in recent years revenue from the so-called "garbage charge" remained relatively stable. At the same time, the revenues from property taxes have increased. Compared to the record-high 2008, only the revenues from the tax on acquisition of property are still depressed, which is to be expected given the slump in the real estate market.

Source: Ministry of Finance, IME

The overview of municipal budgets shows serious differences among municipalities with respect to fiscal independence or their dependence on state transfers. In Stolichna Municipality, for instance, own revenues exceed transfers, reaching 60% of the budget. Varna is also close to 60%, while in Plovdiv and Bourgas the rate is about 50%, i.e. half the proceeds are from own revenues and the other half is from transfers.

In Gabrovo Municipality, own revenues are about 35% of the total revenues while tax revenues account for only 10% of the municipal budget. In smaller settlements like Kotel, own revenues account for just 15% of the budget, while tax revenues have negligible contribution. The picture in most municipalities in Bulgaria resembles the one in Gabrovo and Kotel. Municipal own revenues in the 28 largest cities account for 30-40% of the budget, while for municipalities in smaller towns they are in the 15-20% range. Resort municipalities along the Black Sea coast and in the mountains are an interesting case in point: the proportion of own revenues is significant and sometimes exceeds the figures for the capital city. In Bansko Municipality for instance, own municipal revenues are more than 60% of the budget, and in the municipality of Sozopol they reach 75% of the budget. This is largely determined by the profile of municipal revenues, primarily tied to the value of the real property (property tax and waste collection charge) and the transactions concluded (real estate sales tax). In places with active construction developments and high demand, respectively high value of real estate properties, municipal own revenues are larger and ensure greater fiscal independence.

Graph 4: Budgets of selected municipalities (revenue, transfers, loans), mln BGN (2012)

Source: Municipal budgets, IME

In general, some degree of financial independence has been achieved by those municipalities, within the boundaries of which fall of the largest cities and resorts where the value of real estate is highest. Even there, tax revenues account for no more than 20-30% of municipal budgets, which is illustrative of the serious challenges the financial autonomy of Bulgarian local government faces.

In the great majority of municipalities, i.e. outside the largest cities and resorts, the situation is obvious: about one out of each 10 BGN in the budget comes from local taxes. Even where own revenues account for a larger portion of the budget, if these are mostly generated from charges and fees, we can hardly speak of financial independence. Local policies and the competition between municipalities can be achieved in the fullest extent if local authorities rely on their own tax policy, respectively on the revenue from taxes.

Local Taxes and Charges

The new powers of municipalities obviously did not automatically result in financial independence, but nevertheless municipalities already carry out their own tax policies. Let us look at the developments concerning the main sources of revenue in municipal budgets: property tax on company-owned real estate; tax on the acquisition of real estate properties; tax on vehicles and waste collection charge for non-residential company properties.

Property Tax on Company-Owned Real Estate

The tax on real estate owned by companies attracts the greatest amount of interest from the point of view of local taxation. Municipalities’ policy-making in this regard has been relatively active since 2007, which means that tax competition is in place at local level. The chart below shows the tax rates in 227 municipalities across the country - both for the current year 2013 and the baseline 2007. The year 2007 was taken as a baseline as it was the last year in which the tax rate was the same for all municipalities under the Local Taxes and Charges Act.

It is worth noting that, given the limits set by law (from 0.1 to 4.5 per mils, as of 2013), the tax rate is usually within the range of 1 to 2 per mils. There are isolated examples of higher rates, the highest rate being in the municipalities of Avren and Zlatitsa (4.5 per mils, which is the maximum allowed by law). The only rate below one per mil continues to be in Hissarya - 0.6, which a record-low level for the country.

Interestingly, local tax policy is relatively sustainable, with no significant changes during the years. For example, last year saw only 1/20^th of municipalities making changes in real property taxation, which could be due to the ongoing financial problems for both businesses and municipalities.

Graph 5: Immovable property tax for legal entities (‰)

Source: IME 2013

* Data covers 227 municipalities

In the case of real estate, the "tax base" is very important, i.e. the value of the property the tax rate is charged on. Years ago, the local tax on real estate was determined on the basis of the "tax assessment" for natural persons (residential property) and the book value for companies (non-residential property). The difference is that in the first case the rate is fixed by the tax authorities – „depending on the type of property, its location, area, structure and physical amortisation”, while in the other, the property's book value (or historical price) is being taken. The difference between the two tax bases can be quite significant both for old buildings whose book value is often lower than the possible tax evaluation, and for newly built property, where the tax assessment could be much lower than the book value.

New provisions which came into force in early 2011 state that for real estate owned by companies, the higher value will be taken into account when choosing whether to use the carrying value or the tax assessment. This change caused much debate because it is entirely in favour of the taxation authority: it does not define which evaluation is right (correct) but simply which one is higher. To some extent, this was taken into account by municipalities; over the past two years there were almost no cases of increasing property tax rates for businesses because the higher base was offset by the unchanged rate. Revenues from local property tax increased in recent years.

Property Transfer Tax

Taxing the acquisition of property was, until recently, the largest source of tax revenues to municipalities. In this case, we are taking the tax rate on the transfer of immovable property for consideration, which by law is in the range of 0.1 to 3 per mils (as of 2013). Below are the rates for the „base” year 2007 and the current year 2013.

Graph 6: Tax on property acquisition against payment (‰)

Source: IME 2013

* Data covers 225 municipalities

It should be noted that the majority of municipalities have put the tax rate up compared to the 2007 baseline, and many municipalities have set the maximum rate of three per mils. One reason for this may be sought in the huge drop in revenue from this type of tax after the crisis (in 2009 revenues nearly halved compared to the previous year), which was caused by the bursting of the property bubble and the much smaller number and size of transactions. Examples of reduction in the tax rate are very few.

Tax on Vehicles

Tax on vehicles is another key source of revenue for municipalities. In this case, we will focus on cars with a capacity between 74 kW and 110 kW. The law is quite strict on this count: BGN 1.10 to 3.30 per 1 kW. Actually the lower limit is equal to the base level from 2007, i.e. no option was provided to cut this type of tax. Below are the rates for the „base” year 2007 and the current year 2013.

Graph 7: Vehicle tax (commercial and passenger vehicles, 74 kW to 110 kW)

Source: IME 2013

* Data covers 226 municipalities

Most rates do not exceed BGN 1.50 per 1 kW, with many municipalities keeping down to the minimum. These figures and the experience with property taxation shows that the lack of opportunities to reduce the tax to the "base" 2007 levels certainly stops some municipalities from reducing that rate. The question remains why the legislature keeps the minimum at the base levels when experience with other types of tax has identified no problems.

Waste Collection Charge for Non-Residential Property Owned by Companies

The municipal waste collection charge is a key revenue source for municipalities forming a significant part of so-called "non-tax revenue". In this case, we are looking into the waste collection charge for non-residential property owned by companies as it is most relevant to the economic processes in municipalities.

Graph 8: Annual waste collection charge for properties of legal entities (‰)

Source: IME 2013

* Data covers 225 municipalities

In this type of charge, there are no minimum and maximum rates set – a fact that predetermines large discrepancies. The so-called "garbage charge" is the highest in the municipality of Kocherinovo (22 per mils), followed by Godech and Stamboliyski (20 per mils). Among municipalities in the district centres, the garbage charge is the highest in Pazardzhik (13.5 per mils) while the lowest rate is in Sliven (1.2 per mils), followed by Gabrovo (3.1 per mils) and Varna – (3.9 per mils).

The garbage charge, similarly to property tax, is determined in proportion to the property evaluation when the quantity of household waste cannot be determined. Here, municipalities are free to determine the base themselves: either book value or tax evaluation. In some municipalities, the property tax model was adopted. For instance in Razgrad the garbage charge is levied either on tax value or on the book value, whichever is higher. The figures show that changes in the tax base had an impact on the rate for this charge in many municipalities: district centres saw a decrease in the garbage charge rate over the past couple of years. In Razgrad, the parts-per-thousand rate was changed from 11.5 to 6.5 because of the changed base.

Conclusions and Recommendations

Changes in recent years have shown that municipalities are already implementing a more active taxation policy, but this has led neither to changes in the structure of revenues, nor to a greater degree of autonomy. Municipal own revenues do not have much in common with the economic developments in the respective area: real property is being taxed while profits and incomes barely affect local budgets. In practice, the arrival of a major investor does not automatically generate benefits for the local budget; instead it even takes away incentives of local authorities to work for a better business environment. It is precisely the lack of incentives for development that is the leading argument for more powers and responsibilities at local level.

Strategic documents and programmes over the years have contained many plans for decentralisation and specific measures which, for the most part, have been implemented without yielding real results: new local taxes (license and tourism tax), more power to determine tax rates (wider discretion in setting local taxes), expanded tax base (changes related to the choice of the higher value between the tax value and book value). The above shows that most measures have already been implemented but no major impact in terms of real financial autonomy is evident. It takes us to the concept of restructuring the taxation system as key aspect of achieving financial independence.

“Restructuring” should be understood as transferring over to municipalities some of the existing taxes (or portions of these taxes) currently collected by the central government. This may include direct taxes – personal income and corporate tax, or for instance a portion of VAT. The topic has been discussed actively in recent years, and the changes proposed have been extremely diverse. The most feasible option at the moment seems to be the transfer of a portion of the personal income tax to local taxes. Putting this idea to practice in the short term is highly unlikely because there will be both political and administrative obstacles and issues hindering this process.

Municipalities will find it difficult to win greater fiscal decentralisation if they fail to improve their budget effectiveness and transparency and the way municipal companies and property are currently funded and managed. If good results are shown, any demands for more powers and resources will be more successful and convincing.

This means changes in at least two aspects:

• Transition to an effective programme-based budgeting at local level: it results in greater effectiveness and transparency.
• Improved transparency of municipal budgets and the budgeting process, to increase cost-effectiveness. Without achieving minimum standards for budget transparency, it would be difficult to persuade citizens and politicians that greater fiscal autonomy is indeed justified.

Such steps could open the way towards fiscal decentralisation and greater financial autonomy, with some possible changes in this direction being:

• Parliament would no longer set limits to local taxes; the decision and the responsibility would entirely fall with local government.
• At least one direct tax would become local – for instance, personal income tax. Direct taxes are not at all the central government's main source of revenue, so transferring them to the government that stands closest to the citizens would not be an illogical step.
• Municipalities would receive a "share" of economic growth – i.e. a proportion of the revenue from as many types of taxes as possible, particularly those associated with local economic activities (f.e. a percentage of the revenue from profit tax, VAT, excise duties).
• Municipal revenue collection and spending powers would be balanced so they are no longer dependent on the state budget, creating a fiscal asymmetry.
• Open and transparent management of municipal property.
• The powers of municipalities in the area of economic and social policy would increase.

The financial autonomy of municipalities is an important factor for local development and allows for competition between local authorities in respect of taxes. The presence of tax competition protects citizens from overtaxation while at the same time it compels even those who levy high taxes to spend the money collected in a more efficient manner.