Kyiv, February, 2008

1. Ukraine’s Public Finance Review II Improving Intergovernmental Fiscal Relations and Public Health and Education Expenditure Policy: Selected Issues Kyiv, February, 2008

2. 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!

3. What people say: public services are failing! Health services Education services Source: EBRD-World Bank Life in Transition Survey (LITS) 2007.

4. 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.

5. 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)

6. 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

7. 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

8. 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 Consequences Recommendations

9. 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.

10. 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

11. 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

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

13. 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

14. 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

15. 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

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

17. But in a highly inefficient way. The devastating effects of the education “norms” are evident

18. 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

19. 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 facilities As 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

20. 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

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

22. Inefficiencies are acute

23. 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

24. 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

25. 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

26. 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.