GRANT TRANSFERS AND FINANCIAL SUPERVISION IN LITHUANIA

Mark Chandler

January 2002

EuroFaculty Vilnius Centre
Ekonomikos Fakultetas
Vilniaus Universitetas
Sauletekio al. 9, korp. 2-702
LT 2040 Vilnius
Lithuania
Tel.:	+370 2 366291
Fax.:	+370 2 366284
Email:	MARK.CHANDLER@EF.VU.LT

1.  Introduction

	Lithuanian local government operates in a rapidly changing environment. The structure of Lithuanian local government finance is continually being revised also. Through the ten years of transition changes have been made to the number of layers of local government, the number of municipalities, the taxes used to fund local government, and the types of grants paid by the state to municipalities. These changes continue up to the present day, with a fairly radical reorganization of municipal funding in 2002.
Lithuania is a country of 3.5 million people, the approximate size of Ireland.
Its current government is formed from a centre-left coalition of Social Democrats and Social Liberals, with the next parliamentary elections not due until 2004. All main parties in Lithuania are committed to the goals of EU and NATO membership.
Economic growth is a healthy 4-5%, with inflation below 2%. The Social Democrats and Social Liberals also received the highest number of seats in the Spring 2000 municipal elections, totalling 546 from 2026. Mayors of 25 local authorities are affiliated with governing parties. Other centrist parties control 17 mayorships, and the Peasants Party 11 mayorships.
Since reforms in 2000 there are 61 local authorities (LAs), an increase from 56 previously. Twelve municipalities are urban and there are 49 districts. Given an overall Lithuanian population of 3.5 million the average LA has 57 thousand residents. Some urban LAs are geographically submerged within a single district LA, leaving the district without a centre. Each LA is within one of 10 counties used as branch offices of the national government.
	Local government has been seen mainly as performing an administrative role in Lithuania, despite being elected. It is not perceived to have much freedom of manoeuvre on policy but is judged on its capacity to provide value for money. Another traditional role for local government evident in Lithuania is as a training ground for politicians before entering national politics. In 2000, for example, the mayor of Vilnius was appointed prime minister. The main services provided through local government are schools, social security and welfare, higher education, housing and residential services, and recreational and cultural services.  
	Almost all revenue sources for local government are controlled by the state and this weakens local government. The power of municipalities to make policy decisions over expenditure has oscillated since 1990. Overall there is a generally low opinion of local government in the general public according to regular opinion polls. Local government is often perceived to have low capacity to fulfil its responsibilities and this induces resistance to expanding their responsibilities any further. The main body responsible for fiscal and other relations between the LAs and central government is the Association of Local Authorities in Lithuania. The ALAL is also a key source of information on developments in the budget process. The most notable attempt to foster openness from local government is in Vilnius city where the mayor put a live view of his office on the internet 24 hours a day.

2. Local Government Legal Framework

There are two levels of government in Lithuania; national and local. The national government also maintains 10 county level offices with heads it appoints in political bargaining between the coalition partners alongside its ministerial appointments. Similarly some LAs divide their territory into neighbourhoods for administration of some services. Nevertheless the only levels of government elected by the citizenry are the national (president and one-chamber parliament) and the local authorities’ councils.

Main legal acts:
1.	Constitution
2.	Law on Local Self-Government
Constitution: Chapter 10 of the Constitution (articles 199-124) is devoted to “Local Government and Administration”. Article 119 establishes that local administrative units have the right of local self- government and that their governing councils must be elected by the residents of each jurisdiction. The rest of the chapter provides for state support to the independent local authorities, discusses local fiscal policy, establishes the right of local authorities to appeal to court any violations of their rights, and the right of individuals to appeal to court against any infringements by the local authorities.
	The Law on Local Self-Government provided more of the details needed for operation of local government such as the territorial division of the country, the institutional structure and the organizational procedures. It was first passed on 7th July 1994 and has been amended several times since. The main decision-making body of local government is the local council. This is supplemented by the mayor, elected by the council, who is responsible for chairing council meetings, relations with other institutions, making proposals to the council and general supervision of the work of the LA. The structure of LAs also includes an executive board of the council, a head of administration accountable to the mayor, and a controller with legal personality responsible for supervision of funds. The LA’s functions are in three groups by degree of independence from control by the national government; independent, limited independence, and state delegated.
	The key channel for interaction with the national government is the Association of Local Authorities in Lithuania. This body is responsible for conducting budget negotiations with the national government on behalf of the LAs. The ALAL has also been involved in issues such as LA debt and supply of utilities. The ALAL represents Lithuanian LAs at the European Council. Another indirect channel of intergovernmental interaction is the courts. Occasionally LAs are found in contravention of health and safety or other laws and are forced to increase expenditure in a particular area in order to comply with the court decision. The county administrations of the national government employ government representatives whose role according to the Constitution is to evaluate the legality of LA actions.
Much power in local government affairs is vested in the Lithuanian Finance Ministry due to its control of the allocation of budgetary income to the LAs. Income is general, taxes are not assigned to any particular spending categories. This effectively removes one side of the budgetary process from local control. The more controversial question is how much control LAs have over their expenditure. The existence of expenditure norms, used by the Finance Ministry in calculating budget allocation may have considerable influence on LAs. LAs may be heavily politically constrained by these norms since spending less than a norm could be used as strong political ammunition against the ruling party on the local council. If no area receives less than the norm there is no flexibility to increase spending in any areas. Also, however, spending less than the norm could be self-defeating for an LA if the Finance Ministry reacts by reducing the allocation for the LA in that area the following fiscal year. Within the broad spending categories governed by norms LAs may have more flexibility. Even here, though, they are constrained by decisions at the national level such as nationally determined teacher wages. One further constraint on the ability of the mayor or ruling party of a LA to make independent decisions is control from their national party. Although many commentators still argue that political parties are weak in Lithuania LAs that are run by members of the same party as that in national government are less able to push for their own interests and more likely to follow the agenda of the government. Much, however, depends on the political strength of individuals. An illustrative example is the mayor of Vilnius in 2000 who, despite being a member of the party of national government, withheld payment of social security taxes for city employees as a negotiating tactic with the national government.  That the mayor and prime minister were of the same party may even have increased the ferocity of the battle as some commentators would see it as part of the war between these two figures for support within their party.
	Experts of the European Congress of Local and Regional Government conducted a review of deficiencies in the legal structure of Lithuanian local government after a request from the ALAL. This led to 87 recommendations approved by the Congress on 30th May 2001. These included items urging the Lithuanian Government to ensure that financial control is carried out with proportional methods that would not harm local governments’ independence.  Another set of recommendations covered the need to ensure municipalities have recourse to courts to resolve conflicts with the state government. 

3. Intergovernmental Financial Relationship

 	The financial relationship between state and local governments is complex and includes a matrix of impacts on both the revenue and expenditure side. There are formal obligations of one level of government to another, that have financial implications (e.g. grants from the state to local governments), and impacts that arise from political or other non-statutory considerations (e.g. the pressure on local governments to fund spending categories according to state guidelines). Furthermore there are effects from one layer of government to another that may be indirect consequences of their independent decision-making.
	One of the main aims of the 2001 reforms to local government finance, then, was to improve the delimitation of local versus state responsibilities. In order to achieve this functions administered by local governments were divided into three categories; state dependent, partially independent, and fully independent local function. Those functions deemed to be fully state responsibilities were henceforth funded by categorical grants with the municipalities clearly only playing the role of administrators of state policy. Those functions that were fully local responsibilities were to be funded from general revenue and the local councils would have policy control over these.
	Before 2002 local government revenue in Lithuania was dominated by the personal income tax. This tax was used largely for the finance of local authorities although it is controlled by the national government. That dichotomy created problems for the efficient administration of the tax. It may be that part of the reason why revenues were so low from the personal income tax is that the institution in control of collection, the national government, had a significantly weakened incentive to improve collection since local authorities receive the vast majority of the revenues. The LAs could have become a strong interest group for the improvement of efficiency of administration of the personal income tax. The LAs did not, however, take on this role, probably calculating that they would be unable to retain the benefits from such an improvement in collection.
The changes in the funding of state functions for 2002 implied a large increase in the amount of funding from categorical grants. To balance this there was a large fall in funding from general revenue, particularly the personal income tax. In the new system the state budget would take approximately 40% of personal income tax revenue in each town, in addition to the 30% taken by the compulsory health fund. For the first time the state government had a direct and clear interest in personal income tax collection and this may help to improve its efficiency.
The scale of the transformation is shown in the table below. 

	Table of LA Revenue by Source (thsd. Litas).

	2000	2002*	
	Amount	%	Amount	%	
Personal Income Tax	2504272	76.5	1097804
	32.0	
Other Taxes	325556	9.9	295682	8.6	
Non-tax	112521	3.4	69077	2.0	
Grants from the state budget	315405	9.6	1963747	57.3	
Transfers from other budgets	16515	0.5			
Total	3274269	100	3426310	100	

*forecast
Sources: Statistics Lithuania (2001, p. 21-22), Ministry of Finance (2002).

Hence the new revenue structure has grants providing the majority of funding where the personal income tax did before. As shown in the table below for 2000, property taxes are the second most important category.

Tax Revenues in 2000 (thsds. litas and percentage of total revenue)
	Personal income	Land	Land rent	Real estate	Estate, inheritance,
Gift	Stamp	Market place	
	2504272	20849	46019	189804	1831	60031	7022	
%	76.5	0.6	1.4	5.8	0.1	1.8	0.2	
Source: Statistics Lithuania (2001, p. 21).

Municipal revenue is almost totally controlled by the national government, as has been criticised by previous analysts. There is also a healthy debate among specialists within Lithuania on this issue. The ALAL proposed the establishment of local taxation but the national government has not been ready to accept this reform. Giedrius Lingis, ALAL Consultant on Finance and Economics, presented several arguments for the establishment of a local real estate tax [Lingis (2001)].
1. The European Charter of Local Authorities calls for local taxation with rates under the control of LAs.
2. The Law on Local Authorities (2000) provides that a part of LA revenue comes from taxes whose rates can be adjusted by LAs up to maximum levels set by law.
3. Local taxation would ensure healthy competition between LAs.
4. Increase in responsibility of LA councils and reduction in Government responsibility for increasing revenue in specific municipalities.
5. In other countries property taxes provide 30-40% of LA revenue compared to only 8% in Lithuania at present.
6. Real estate tax revenue is more stable and easier to forecast than other forms of taxation.
7. Income tax rates could be reduced, in accordance with the Government’s “Tax System Concept”.
8. It is more difficult to evade real estate tax, and this would enable tax rates to be reduced overall without reducing revenue.
9. Real estate taxes would be paid in the area of residence, where citizens actually use LA services, rather than in the jurisdiction where they work, as at present with the personal income tax.
10. There would be a reduction in the revenue inequality between municipalities.

To this list we might add the improvement in the incentive of LAs to develop the economy of their jurisdiction. The Ministry of Finance has disclosed that it is working on a proposal for local real estate taxation as part of a new Real Estate Tax Law. This may allow municipalities the flexibility to set their own tax rates between limits of ½ and 1%. So far the full proposal has not been presented, however. 
Every year the government must pass a law on the Confirmation of State and Local Authorities’ Budgets’ Financial Indicators. One of the issues that arises repeatedly is the accuracy of the government’s forecast for tax revenue for the following year. An example of this is in the ALAL executive decision “On the Draft Law on the Confirmation of the 2002 State and Local Authorities’ Budgets’ Financial Indicators” (8th October 2001). This decision contains the claim that the 2002 revenue projection for the personal income tax is too high and so, to keep revenue the same in 2002 as it was in 2001, LAs overall would have to receive 45.77% of personal income tax revenue rather than the 44.03% given in the draft law. A more concrete example of failing revenues is in a table of forecast and actual revenue for the first 10 months of 2001 prepared by the Ministry of Finance (2001b). Here we see that overall LAs had received only 79% of their forecast revenue for the year (compared to the 10/12 or 83.3% they should have received). The situation varied significantly across LAs with 11 being on or ahead of schedule. The worst performer, Akmene district, had received only 72% while two municipalities, Palanga city and Neringa, had already received over 100% of their forecast revenue for the year by the end of October.
	One possible explanation of why revenues continue to fall behind projections for most LAs is that governments deliberately overestimate future revenue so that they can better control the distribution of funds. When revenue turns out lower than projected municipalities anyway receive what was projected due to later compensation for the shortfall. If revenue is higher than projected, however, the municipality keeps these extra funds and this implies a loss to the national government. So there is an incentive for the national government, having decided how much money it wants to distrubute to each municipality, to give over optimistic forecasts for revenue that enable it to set tax and grant parameters lower than necessary to ensure that revenue in reality, so that no LAs end up with more revenue than the government intended. This structure ensures that at the margin there is little incentive for most towns to improve revenue since their future compensation for their revenue shortfall will be reduced by exactly the amount that their revenue shortfall decreases by. The only advantage to the municipality would be from the time discount on future compensation.
	The role of tax abatements by the municipalities in the overall state financial system is also fairly controversial. Bronis Rope, President of the ALAL, argues that these abatements are a method to encourage business and therefore ultimately increase revenues and reduce costs across government budgets [Rope (2001)]. He also uses the example of a government decision regarding granting exemptions to disabled persons to argue that such abatements are an integral part of national policy. Hence there is a case against the decision of the Finance Ministry to count revenue lost through abatements as having been received by the municipalities, although on balance it is better to allow municipalities to feel the cost of their decisions, even if prompted by governmental advice. The variety of abatements is quite striking; 5 municipalities gave none in the first 10 months of 2001 while in Neringa they amounted to 722,000 litas [Ministry of Finance]. 
Disagreements over the appropriate revenue for LAs arise from a number of sources. One of the most common is based on the provision of the Constitution that municipalities must be compensated by sufficient revenue to cover any increase in expenditures resulting from decisions of the national government. This gives a legal context for the Lithuanian version of the traditional intergovernmental battles over unfunded mandates. A major financial development stemming from failing tax revenues and disagreements over legal revenue of LAs is the emergence of LA debt. This has an impact on the entire complexion of public finances since the state is implicitly the payer of last resort. The debt also forces LAs to be more assertive in pursuing their claims with the national government. The debt is thus a contributory factor in the initiation of court action against the national government by the ALAL. While allowing municipalities to engage in borrowing the national government has also put maximum limits on the size of LA debt as a proportion of their annual revenue. In the Law on the Confirmation of the 2002 State and Local Authorities’ Budgets’ Financial Indicators the government increased this limit from 25% to 35% for all LAs except Vilnius city whose limit rose from 35% to 50%. There is also a limit of 20% of their annual revenue for the LAs’ borrowing in one year. The part of the debt that is owed to the national government becomes part of the financial negotiation as terms of repayment are traded for agreement on other aspects of the budget. An example of this is the agreement of the Finance Minister on passage of the law on Confirmation of the 2002 State and Local Authorities’ Budgets’ Financial Indicators not to seek repayment of interest free loans to the LAs due to their tax revenue shortfall in 2001.

4. The Grant System

4.1. Roles and Purposes of Grants

The system of grants applied in Lithuania can often seem ad hoc, despite the establishment of formulae and procedures in law. I will disentangle the separate decisions made on the different grants but also show where allocations in one category depend on those in another. The grant system is constantly evolving in Lithuania so I will attempt to give an up to date account of the newest revisions while also providing some context about the systems followed previously.

In Lithuanian legislation grants are divided into compensation grants, specific grants and equalisation aid. Compensation grants are given to towns that received less income than was forecast for them. Grants became a much larger part of municipalities’ incomes in 2002 as part of the general reorganisation of local government finance. The state and local authorities’ budget law lists categorical grants for each municipality. These vary both in number and in size from year to year. The formulae for equalisation grants is established in the Lithuanian Local Authorities’ Budget Income Method of Calculation Law. Prior to 2002 this law was supplemented by the Local Authority Budget Income and Equalisation variables law, which established the size of the formula coefficients that were fixed for three years. For 2002 this law was no longer required and all coefficients were set in the Lithuanian Local Authorities’ Budget Income Method of Calculation Law.

4.2 General Purpose Grants

In the 2002 national budget general-purpose grants to municipalities are only used to compensate for changes to overall projected revenue between 2001 and 2002 and for partial compensation of the revenue shortfall from 1997-2000. This contrasts with the 2001 budget, in which municipalities received general-purpose grants to compensate for the shortfall of tax revenue in the previous year and for functions newly delegated to them by the state government. This latter form of compensation is mandated by the Constitution. The new general-purpose grant in the 2002 budget is the general compensation grant given to ensure that municipalities in 2002 do not receive more than 1% less than they were projected to receive in 2001. In addition, however, there is a general grant from LAs back to the state budget from those municipalities whose projected revenue in 2002 has risen more than 7% from revenue projected for 2001.

(i) Compensation for reduction in revenue.
In previous years the Government has compensated municipalities directly with a grant for the shortfall of income tax revenue compared to that projected. In the 2002 budget, passed in December 2001, there was a provision for continuing compensation for shortfalls from 1997-2000 of 64,555 thsd litas but no compensation for 2001. A shortfall in revenue in 2001, however, is reflected in the revenue forecast for 2002 and so is compensated in LAs where overall revenue is projected lower than in 2001. To illustrates this point consider the example of Birstonas given below.

Birstonas 2001							thsd. litas
Income tax revenue forecast net of Compulsory Health Fund:	2,054
Overall revenue shortfall in Jan-Oct:					268
Birstonas 2002
Income tax revenue forecast net of Compulsory Health Fund:	1,714

Hence there was a downward adjustment of the forecast income tax revenue associated with the overall revenue shortfall the previous year. That reduction in projected income tax revenue is reflected in a lower overall revenue forecast which triggers an increase in the compensation for reduced revenue. Revenue forecasts for the municipalities are thus significant determinants of the size of their general grant. In combination with the inevitable uncertainty associated with any forecast this means that they become controversial numbers in the budget negotiation process. Since the ALAL has complained about the lack of compensation for the shortfall of revenue in 2001 we may anticipate that this will be added to the budget by ammendment during 2002 as the 2001 data becomes available.
An example of the sometimes rather ad hoc nature of the Lithuanian municipal grants system is provided by the phenomenon of interest free loans that the Finance Ministry later does not require to be repaid. This happened in 2001 when interest free loans from the Finance Ministry were kept as grants by municipalities to cover revenue shortfalls from the personal income tax. This dispensation might be labeled grants for needy areas, those that received less than projected from the income tax, although they also form part of the equalization system. The process then forms part of the story on the timing and mechanism of payment of revenue/grants to LAs. It becomes apparent with the operation of this compensation for revenue shortfalls that municipal income does not depend upon income tax collection in a given year, but only on the Finance Ministry’s projection of what that revenue should be.
What is less clear is whether a decline in a municipalities tax revenue that is projected to continue for the following year leads to a decline in the funding of that municipality the following year or if the difference is made up completely by increases in other grants. This is similar to the question of whether any expenditure savings or revenue increases engineered by LAs will result in counterbalancing reductions in grants from the national government. It appears that there is enough flexibility in the municipal funding system for Parliament to adjust the various components of the budget to arrive at whatever final sum it wants to allocate to a municipality. This is an empirical question that could potentially be answered by careful econometric analysis. Unfortunately, in order to do this, we would first need a reliable model of the political decision making in the Parliament regarding municipal budgets. Vote maximizing by members of Parliament may be an inappropriate assumption in a transition country where gains from large-scale privatisations and other similar opportunities for politicians may outweigh re-election as a goal.

(ii) Compensation for newly delegated functions

	Since there is a constitutional requirement to provide increased revenue to municipalities to cover newly delegated functions governments have often felt it necessary to include this allocation as a separate budget item in the budget law. The 2001 budget law contained 3.3 mln litas in grants to the municipalities under this category, while in 2002 there is no such grant. Instead, however, this category of funding is lilely to be partly subsumed under the new special grant to perform state functions. This is part of the effort to clarify municipal activities by dividing them between administration of state functions and independent local functions. The questions of under what circumstances the government is obliged to provide such funds, how it calculates the amounts, and whether there is any mechanism to prevent the Government from removing these funds from another part of the LA budget thus become important.

4.3 Special purpose (categorical) grants

	The number and type of categorical grants has varied through the transition period in Lithuania. They are established not only in the budget law passed before the year begins but also in amendments passed during the year itself. The only consistent grants have been for investment.

	Investment grants have followed the pattern depicted in the table below.

Year	Number of municipalities	Total (thsds. litas)	
1997	16	52,500	
1998	18	61,333	
2000		63,239a	
2002	30	64,731	

Sources:  Budget laws; aStatistics Lithuania (2001, p. 34).

Vilnius city also received special grants to renovate its Old Town of 15 million litas in 1998 and 1999 and 2 million litas in 2000 and 2001. Other grants were less stable as shown in the table below.

Grant	Year	Number of municipalities	Total (thsds litas)	
Pay off debt	1997	7	31,142	
Environment	1997	14	74,862	
Environment	1998	19	81,702	
Housing restitution	1998	44	18,700	
Libraries	1998	56	2,000	
Housing stock	1998	3	10,000	
Children in state care	1999	54	53,053	
National service	2001	59	2,714	
Anti narcotics	2001	2	600	
Source: Budget laws

	In 2002 categorical grants became much more important in the structure due to the radical reorgnisation of local government financing. Functions that are classified as state functions only delegated to local authorities for administration are now funded by categorical grants. They are of the following type and size:

Grant purpose									thsds litas
State functions administered locally:						762,057
Pupil basket:									1,047,378
Special needs pupils:								1,046
Interest on loans for renovation of educational institutions:			5,590
State investment programme:							64,731
Total:										1,945,357

They made up 57% of overall LA revenue. Most notable is the shift of education funding into a categorical grant called the pupil basket. The budget also contained partial compensation of the revenue shortfall from 1997-2000 as a categorical grant, although it is more accurate to consider it a general grant since there is no restriction on what these funds are used for. In practice they are likely to be used to repay debt but, at least at the margin, LAs can decide other uses.

 4.4 Equalisation Grants

	The equalisation system was reformed quite markedly in 2002, by amendment of the Method of Calculation of Local Government Revenue Law. The previous system was based on a state total equalisation grant for local governments, D, given by

D = A - B - C

where A = forecast level of expenditures for all municipalities
B = forecast revenues from tax and nontax sources
C = total specific grants.
Hence the forecast of revenues had a direct impact on the state allocation for equalisation. This total grant was then divided between three sub funds. Revenue shortfall funds went to towns whose revenue was below what had been forecast.  Revenue equalisation funds were for those towns whose per capita revenue was below the average. Expenditure need equalisation went to all towns whose indices of expenditure need were above the lowest. Expenditure need equalisation funds were supplemented by formula determined payments to the fund from LAs with above average tax revenue per capita. 20 municipalties in all paid into this fund. All funds were distributed to municipalities according to formulae that determined their share of funds for revenue shortfall, revenue equalisation, and expenditure need equalisation from their amounts of revenue shortfall, revenue poverty, and expenditure need, respectively, as proportions of the aggregate level. The formulae also contained scaling coefficients that ensured only a part of the relevant gap was considered for equalisation. Some coefficients for the formula were set for three years. Other variables were established annually in the national budget law.

	 Several changes were made to the system in 2002. One of the main criticisms of the system of equalisation in 2001 was that it depended directly on revenue forecasts. Hence the new system was based instead on actual receipts. Another change was the removal of the formula for distributing funds for revenue shortfalls. The new system contains only equalisation for towns with below average revenue and equalisation of expenditure need. The formula for payment into the expenditure need equalisation fund was removed and replaced by payment of a specified proportion of tax revenue by a specified group of 8 municipalities. The structure of equalisation now looks as shown in the flowchart below.

No

Payment into fund by 8 LAs

Calculate funds needed to compensate LAs with below average income tax revenue

Are funds sufficient to fully compensate?

State grants makes up proportion of difference (12/13?).
LAs compensated by a proportion of their shortfall from average revenue.

Yes

All LAs compensated up to average revenue

Remainder of fund distributed by spending equalization formula

State grant for spending equalization equal to 10% of state grant for revenue equalization distributed by spending grant equalization formula

	

The 8 Las that pay into the equalisation fund are the five largest cities and three especially well endowed municipalities. Hence the previous formula for determining payments was abandoned in favour of a simpler approach based on pre-set proportions and fewer payees. Their contributions are as in the table below. In the 2002 budget the proportion of income tax paid to the Compulsory Health Fund is 30% and 57% of the remainder goes to the state budget. Hence only 30% of income tax collected in the municipalities remains to the local level of government and the proportion of overall tax collection that is paid into the equalisation fund is equal to this 30% multiplied by the proportions given in the middle column of the table.	

Municipality	% of income tax (net of Compulsory Health Fund and state budget payments) paid to the equalisation fund	% of overall income tax paid to the equalisation fund in 2002	
Vilnius	60	18	
Kaunas	26	8	
Klaipeda	36	11	
Siauliai	4	1	
Panevezys	16	5	
Ignalina	22	7	
Mazeikai	45	14	
Palanga	30	9	

Since 34% of all income tax in 2002 was projected to be paid in Vilnius, the contribution to the equalisation fund from this municipality alone represents 6% of Lithuanian personal income tax revenue, or 20% of the income tax revenue going to local government. Neringa municipality would appear to be one of the greatest beneficiaries from the new equalisation system; previously it kept only 1% of its income tax revenue.
	The second element of the equalization system is the calculation of revenue equalization grants to municipalities. LAs receive these payments each month that their personal income tax revenue per resident the previous month was less than the national average. The grant makes up 90% of the difference. I.e.

L1i = 0.9 Gi (f  xif )

where L1i = revenue equalization grant to the municipality i
Gi =  population of municipality i
= average personal income tax revenue per resident in Lithuania the previous month
= personal income tax revenue per resident in municipality i the previous month.

This formula decides how much of the month’s equalization fund is paid out to each LA for revenue equalization unless the payments to the fund are not sufficient. In that case an additional state grant for equalization makes up some of the shortfall.

	As long as the payments into the equalization fund are sufficient to cover the grants paid out for revenue equalization according to the above formula, the remainder is used for spending equalization. If the payments to the fund are not sufficient an additional state grant funds the spending equalization. The size of this grant for all municipalities is set at 10% of the total of the state grants for revenue equalization. In either case the total funds for spending equalization are divided among the municipalities according to a set formula. Only the 8 municipalities that pay into the equalization fund are excluded from this process. They receive no grant for revenue equalization and their cost indices are not included in the total index for all towns in the formula.
	The formula for spending equalization determines the share of the total spending equalization funds paid to each municipality throughout the year as follows.

,
where spending equalisation grant to municipality i;
coefficient showing the influence of indicator n ;
proportion of indicator n in municipality i given by the formula , where indicator n for municipality i.

This formula has been simplified by that used prior to 2002 in several respects. The previous formula contained three expenditure groups, each containing several indicators. The n indicators and their coefficients () for the new system were determined on the basis of recommendations by an independent organisation, the Lithuanian Regional Research Institute, as requested by the ALAL [Lionginas (2001)]. The table below gives the coefficients for each indicator.

Indicator	Coefficient	
Length of local roads	0.13	
Area of municipality	0.17	
Number of pension age residents	0.13	
Number of children from 7 to 17 years of age	0.11	
Number of children from 0 to 6 years of age	0.25	
Area of land of educational institutions financed by the municipality	0.13	
Area of mortgaged municipal land	0.04	
Inverse of density for resorts	0.04	

These indicators were found to be objective cost factors, beyond the control of the municipality. They imply that municipal costs depend on physical size factors as well as demographics. The previous system included 11 indicators so this has been reduced to 8.

4.5 Payment of Grants

	Grant payment schedules can have a large impact on local authorities. One of the main reasons is the erosion of the real value of grants over time by inflation. In Lithuania, however, inflation has fallen to below 2% and so this is of minor concern. Perhaps greater concern arises from the rate of interest paid on short-term borrowing to cover waiting periods. Categorical and equalisation grants appear to have been paid according to schedule since this issue has not been raised by the ALAL or individual municipalities. What has been a much larger problem is the receipt of compensation grants for shortfalls in tax revenue and for new mandates.
	In 2001 the Government agreed that local authorities were still owed money to compensate for the shortfall in revenue from 1997-2000. The over optimistic revenue forecasts of these years led to a large delay in payment of compensation. This led to large borrowing by municipalities while they waited to receive funds they were entitled to by law. When municipalities are then paid compensation grants for these shortfalls they grants are added to their budget revenue in the year the grant is paid. These funds, however, cannot really be considered a part of current revenue. They are likely in practice to be used to pay off debt accumulated to cover the expense that was incurred previously. The funds are in fact simply a late payment of a previous year’s revenue. Adding them to the later year’s revenue gives a somewhat distorted picture of the balance between revenue and expenditure since the funds cannot be used to fund expenditure in the year they are received.

4.7. Grants Mechanism Reassessed

	The grants system initiated in 2002 is a radical increase in the importance of grants in Lithuanian local government finance. This is especially true of categorical grants. It is now more evident which are the areas where local governments are administrators of funds received from the state explicitly for spending on certain national policy priorities. Hence categorical grants take a much bigger part of the overall grants picture now. Several simplifications to the equalisation aid formulae have resulted in a clearer system in which towns can more easily predict their contributions to the equalisation fund.
	As with any major change to a fiscal system there are potential winners and losers from the transition. These can been seen from the data provided by Ministry of Finance (2002) used to calculate compensatory grants for and from those towns whose losses or gains exceed the boundaries of 1% and 7%, respectively. Silutes forecast revenue, for example, rose from 50,787 thsd. litas in 2001 to 60,579 thsd. litas in 2002 before capping, a rise of 19%. This was largely thanks to a rise in its categorical grants from 0.1% of its forecast revenue in 2001 to 78.8% of the 2001 revenue in 2002. In Visaginas, however, categorical grants rose by only 39.2% of 2001 revenue and hence this town lost 36% of its revenue in the new system, all of which was recouped by the compensation grant. While the compensation grant system ensures that there are no substantial losers in 2002 this is only provided for three years in the law. Hence if the new financial system survived longer than three years some towns would see substantial loses or gains. Given recent practice, however, it seems unlikely the new system will last that long before being revised.

5. Financial Supervision

Financial supervision of Lithuanian local governments is conducted by a number of different officials. Each municipality has a controller elected by a secret ballot of the council. The parliament ombudsman can investigate citizens complaints. The State Control Office supervises all government institutions. The government representative works at the county level. Finally, the Parliament itself can impose direct rule on a municipality if the courts find it in violation of the law.
The municipality’s controller supervises the execution of the budget and the use of property. They ensure that laws are not broken and also overview the effectiveness of the municipality’s work. The controller is directly accountable to the municipal council, not its executive. Nevertheless Beksta and Petkevicius argue that there is a lack of independence and it would be better to have internal and external audits conducted by independent auditing companies. This has been disputed by Bronis Rope, President of the ALAL, who argues that the principal task of controllers should be to assist LAs with their financial control and therefore they do not need independence from the LAs.
The new Law on Local Authorities requires LAs to establish internal auditing [Vitkauskiene (2001)]. Currently LAs employ financial controllers whose role has not been developed to the point that it is possible to distinguish them completely from auditors. The new law raised many concerns among LA controllers due to the lack of specifics from the central authorities on methods and professional training. It is noteworthy to contrast the reaction from this group of professionals upon being given such leeway with the usual call from LAs for more independence from national government. The following data gives some indication of the workload of controllers.

# of controllers	# of LAs
1			9
2			21
3			16
4			8
>5			6
Total			60

Number of institutions audited:		4167
	# financed in LA budgets		3067
# institutions audited per auditor per year:	20

Algimentas Demenius, Chairman of the Association of Local Authority Controllers of Lithuania (LSKA), contrasted this data with the claim that auditors can only effectively audit 7 institutions per year. EU standards of auditing are far from being reached by Lithuanian municipalities, in part because mayors often do not have the time or will to get involved in what they may perceive as a relatively technical issue. Other controllers present at the LSKA 2001 meeting argued that the Law on Internal Auditing has not been put into practice because it was adopted so hastily, without refinement, and that this is only compounded by absurdly unclear criticism from government institutions.
	Rimas Kalkys, Senior Adviser of the parliamentary Committee on Local Authorities and Government Reform, commented that local government controllers will have to choose between two professions; financial control and internal audit as both of these two separate activities are needed in local government. Kaunas city LA has already made this separation. Darius Matusevicus, Acting Director of the newly formed Department of Financial Control Methodology in the Finance Ministry, pointed out that a Joint Committee coordinating the establishent of the auditing system in the state sector was formed in 2000.
	The Parliament ombudsman can respond to citizen complaints regarding local government employees. These complaints may refer to corruption or to overly bureaucratic behaviour. The ombudsman does have the power to revoke local government decisions that are in conflict with the law. The State Control Office has similar oversight functions to the municipal controllers, and will sometimes control these controllers. Laima Sipkauskiene, chief of the State Control Office’s Budget Control Department reported that state controllers found that audits conducted by LA controllers were superficial, often containing no more than descriptions of annual budget turnover.
	Government representatives are responsible for checking that LAs are in compliance with the law and government decrees. They have had a somewhat tortured existence in that they were abolished in 1997 only to be reinstated in 1998. If the government representative finds a LA to be in contravention of a statute they can require the municipality to make the necessary changes, although this may be challenged in court. There is in practice, however, considerable variety in the role played by these officials [Lazdynas (2001b)]. Sigitas Siupsinskas, ALAL Director, complained that what is required by LAs is an institution that would assist them with effective management of the functions delegated to them but that instead of this the work of government representatives is akin to a bailiff. He postulated that the best controller of the work of a municipality is the community itself. Government representatives claim that citizens, afraid of approaching courts, often turn to them to lodge their complaints about LAs. Petras Papovas, Chair of the Parliamentary Committee on State Administration and Local Authorities, argued that government representatives should leave investigation of the effectiveness of municipalities to LA controllers, and focus instead purely on the legality of LA statutes.

6. Conclusion

	The reforms to local government finance appear to be a move in the right direction. There is now a clearer delimitation of which functions are under the control of municipalities and which are state functions only administered locally. The equalisation system was simplified in several respects. In a country with still limited capacity for public administration, particularly in fiscal areas, that is a significant gain. The sharing of personal income tax revenue with the state budget may also be a positive step if it leads to greater efforts from the state government to improve the efficacy of the tax. The Government has now proclaimed this a main priority.
	The main problem of Lithuanian local government has still not been addressed. This is the issue of giving municipalities some control over their income. Lack of control over income inevitably leads to lack of independence in expenditure and administrative decisions. It also implies the absence of mechanisms to link decision making over services to costs and benefits. The ALAL has called for municipalities to be given a true local tax. If the Government wants to start with a real estate tax with a maximum rate this should be encouraged as a first step. It is then to be hoped that the limit will be raised later to give towns the flexibility to provide extra services if desired by their constituents.
	The equalization system still contains two elements, revenue and expenditure need, that are somewhat contradictory. Some will object to equalization in principle, although this seems less tenable in the Lithuanian system since it involves no distortion of taxing decisions. Equalisation in Lithuania can be seen as a government commitment to provide every municipality with the ability to provide the same level of service. With that objective expenditure needs equalization is rational but revenue equalization more difficult to justify. It seems counter-productive to bring all towns’ per capita revenue to 90% of the national average if some towns have less than 90% of the expenditure need per capita.
	Expenditure need equalization is an imperfect art, however. We can not be sure that the indices used to compute expenditure need give the true picture for all municipalities. This may be part of the justification for the compromise of including revenue equalization. Expenditure need equalization may also create some distorted incentives. While some of the indices, such as area of the municipality, are out of the control of the local council others, such as length of local roads, area of land of educational institutions, and even number of pensioners, may be influenced. Thus it is important not to give the councils too great an incentive to change these variables.

References

Beksta, Arunas and Petkevicius, Algirdas (2000). “Local government in Lithuania” in Horvath, Tamas M. (ed.). Decentralization: Experiments and Reforms (Budapest: OSI/LGI).
Council of Europe (1996). Structure and Operation of Local and Regional Democracy: Lithuania (Strasbourg).
Lazdynas, Rimantas (2001a). “Ministerija nusiteikusi geranoriskai” [The Ministry is benevolently disposed”], Savivaldybiu Zinios 42(164), 29 November: 2 and 8.
Lazdynas, Rimantas (2001b). “Vyriausybes atstovu funkcijos bus perziuretos” [“Government representatives’ functions to be reviewed”], Savivaldybiu Zinios 43(165), 6 December: 4.
Lingis, Giedrius (2001). “Kodel butini vietiniai mokesciai?” [Why are local taxes necessary?”], Savivaldybiu Zinios 43(165), 6 December: 2 and 7.
Lionginas, Jonas (2001). “Aiskinamasis rastas del Lietuvos Respublikos savivaldybiu biudzetu pajamu nustatymo metodikos istatymo pakeitimo istatymas” [Explanation of the bill on a change in the law on the method of determination of revenue of local authorities of the Republic of Lithuania”]. Government document.
Martinez, Jorge (1998). “Municipal finance” in Lithuania: An Opportunity for Economic Success. Volume 2: Analytical Backround (Washington: IBRD).
Ministry of Finance (2001a). “2001 m. savivaldybiu biudzetu prognozuojamos pajamos bei valstybës biudzeto dotacijos pagal priimta 2000.12.19 d. istatyma Nr.IX-89 (tukst. litu)” [“2001 forecast revenue and state budget grants according to legal act Nr. IX-89 passed on 19/12/2000 (thsd. litas)”] <www.finmin.lt> 4 January 2001.
Ministry of Finance (2001b). “25643 tkst. litu paskirstymas (ivertinus Tarybu suteiktas lengvatas) savivaldybiu biudzetu 2001 m. prognozuojamoms negauti pajamoms is dalies kompensuoti” [“The distribution of 25643 thousand litas (evaluating abatements granted by local councils) to partially compensate local auhtorities’ budgets for unreceived revenue”], Savivaldybiu Zinios 42(164), 29 November: 5.
Ministry of Finance (2002). “2002 m. savivaldybių biudžetų prognozuojamos pajamos bei valstybės biudžeto dotacijos pagal priimtą Lietuvos Respublikos 2002 metų valstybės biudžeto ir savivaldybių biudžetų finansinių rodiklių patvirtinimo 2001-12-13 d. įstatymą Nr. IX-643 (tūkst. litų)” [“2002 forecast revenue and state budget grants according to legal act Nr. IX-89 passed on 13/12/2001 (thsd. litas)”] <www.finmin.lt> 4 January 2001.
Rope, Bronis (2001). “Del 2001 m. valsybes biudzeto ir savivaldybiu biudzetu finansiniu rodikliu patvirtinimo istatymo projekto IXP-1194” [On the draft law on the confirmation of the 2001 state budget and local auhorities’ budget’s financial indicators”], Savivaldybiu Zinios 42(164), 29 November: 4.
Statistics Lithuania (2000). Counties of Lithuania (Vilnius).
Statistics Lithuania (2001). Government Finance 2000 (Vilnius).
Vitkauskiene, Irena (2001). “Kontroleriai sprende svarbius klausimus” [“Comptrollers decide important questions”], Savivaldybiu Zinios 45(167), 20 December: 4-5. 

Appendix 1: Revenues 1996-2002 (thsds. litas)

	1996	1999	2000	2001*	2002*	
Total Revenue	2,657,043	3,207,977	3,274,269	3,209,851	3,426,310	
Tax Revenue	1,998,865	2,904,116	2,829,828	2,889,251	1,393,486	
   Personal income	1,514,756	2,576,394	2,504,272	2,623,521	1,097,804	
   Corporate income	216,483					
   Property taxes	177,430	246,606	258,503	258,060	288,082	
      Land		18,795	20,849	19,079		
      Land rent		47,452	46,019	50,457		
      Real estate		178,210	189,804	186,764		
      Estate, inheritance, and gift		2,149	1,831	1,760		
   Other	90,196					
      Stamp duty		73,526	60,031			
      Market place duty		7,590	7,022	7,600	7,600	
Non-Tax Revenue	107,469	175,350	112,272	78,765	69,077	
Grants and Transfers	550,617		331,920	241,835	1,963,747	
*forecast
Sources: Martinez (1998, 96); Statistics Lithuania (2000, 23-38), Statistics Lithuania (2001, 21-22), Ministry of Finance (2001a), Ministry of Finance (2002).

Appendix 2: Expenditures 1996-2000 (thsds. litas)

	1996	1999	2000	
Total Expenditure	2,654,525	3,295,167	3,265,886	
Economy	416,282	453,031	387,941	
   Housing and community affairs	353,950		231,892	
   Fuel and energy affairs	61,715		80,614	
   Agriculture	617		49	
   Transport and communication			74,341	
   Other			1,045	
Social Affairs	2,151,626	2,531,713	2,512,549	
   Education	1,117,107	1,903,867	1,871,815	
   Health care	645,013	17,919	13,266	
   Social security and welfare	290,009	445,124	478,300	
   Culture and recreation	99,497	164,804	149,168	
Other Functions	86,617	310,422	365,396	
   General public services	86,617		155,231	
   Public order and safety			25,852	
   Other			184,313	
Sources: Martinez (1998, 97); Statistics Lithuania (2000, 40); Statistics Lithuania (2001, 28).