THESISFISCAL DECENTRALIZATION: CASE STUDY OF VIETNAM

LIST OF FIGURES AND DIAGRAMSPage Number Figure 3.1: The ratio local expenditure to total expenditure 26Figure 3.2: The ratio capital expenditure to local expenditure balancing expenditur

UNIVERSITE LIBRE DE BRUXELLES NATIONAL ECONOMICS UNIVERSITY

Vietnam – French Community of Belgium Master Programmes

MASTERS IN PUBLIC MANAGEMENT AND ECONOMICS

THESIS

FISCAL DECENTRALIZATION: CASE STUDY OF VIETNAM

Prepared by: Dinh Duy Dong Instructed by: Dr Le Thanh Tam

Hanoi 2010

I am thankful to everyone who has helped me along the way I reallyappreciate the constant support and encouragement I received from many peoplethroughout the process

I would like to first thank my advisor, Dr Le Thanh Tam, for hertremendous help and support I do not think that I would have been able tocomplete this thesis without her belief in me, and her enormous support

My gratitude is extended to my colleagues and coworkers, who helped mewith the collection of data for the research I am also very grateful for the time andinformation shared with me by all the employers involved in the survey

I very much appreciate the encouragement and support provided by all theprofessors and staff at the Vietnam - French Community of Belgium MasterProgrammes and the Faculty of International Education I also truly value thefriendship and assistance by the classmates of MPM5 Discussions and exchangeswith them have really helped improve my scientific thinking and researchmethodology

Last but not the least, I would like to thank my family and friends whoalways believed in me, and have been there for me throughout this process

LIST OF TABLES

Page Number

Table 3.1: Assignment of Expenditure Responsibilities in Vietnam 24Table 3.2: The number of sub-nations having low growth rate of

education and training, science and technologies expenditures

LIST OF FIGURES AND DIAGRAMS

Page Number

Figure 3.1: The ratio local expenditure to total expenditure 26Figure 3.2: The ratio capital expenditure to local expenditure

(balancing expenditure)

27

Figure 3.4: Share of local revenue in total revenue 36Figure 3.5: Share of intergovernmental fiscal transfers in total local

revenues

40

Diagram 2.1: Four pillars of fiscal decentralization system 8Diagram 3.1: Levels of territorial administration and budget 22

LIST OF ABBREVIATIONS

TABLE OF CONTENT

EXECUTIVE SUMMARY iii

CHAPTER ONE: INTRODUCTION 1

Rationale of the thesis 1

Objective of the thesis 2

Thesis questions 2

Scope of research 2

Methodology 2

Thesis Structure 3

CHAPTER II: LITERATURE REVIEW ON FISCAL DECANTRALIZATION 4

2.1 Definition of Fiscal Decentralization 4

2 2 Rationale for fiscal decentralization 5

2.3 Content of fiscal decentralization 8

2.3.1 Expenditure assignments 8

2.3.2 Revenue Assignments to Local Governments 12

2.3.3 Intergovernmental transfers 14

2.3.4 Sub-national Borrowing/Debt 16

2.4 Measuring level of fiscal decentralization 18

CHAPTER III: THE FACT OF FISCAL DECENTRALIZATION IN VIETNAM 21

3.1 Current territorial administrative structure 21

3.2 Assignment of expenditure responsibilities 23

3.2.1 Current assignments 23

3.2.2 Significant issues 29

3.3 Revenue assignments 30

3.3.1 Current revenue assignments 30

3.3.2 Significant issues 37

3.4 The system of transfers 38

3.4.1 Current transfers system 38

3.4.2 Significant issues 41

3.5 Sub-national government borrowing 41

CHAPTER IV: RECOMMENDATIONS FOR IMPROVING FISCAL

DECENTRALIZATION IN VIETNAM 46

4.1 Orientation on fiscal decentralization 46

4.2 Recommendations 47

4.2.1 To enhance the budget expenditure assignments 47

4.2.2 To enhance the revenue assignments for local authorities 49

4.3 Improving transfers system 51

CONCLUSION 53

REFERENCES 55

APPENDIX TABLES 57

EXECUTIVE SUMMARY

The issue of fiscal decentralization has begun to feature significantly in manycountries around the globe Fiscal Decentralization may be defined in many ways,but typically involves increased autonomy and responsibilities for lower-levelentities in one dimension or another

Fiscal decentralization covers two interrelated issues The first is the division

of spending responsibilities and revenue sources between levels of government(national, regional, local etc) The second is the amount of discretion given toregional and local governments to determine their expenditures and revenues (both

in aggregate and detail)

A design of fiscal decentralization systems is based on four pillars:expenditure assignment, revenue assignment, intergovernmental transfers/grants,and sub-national debt/borrowing

Most studies empirically examining fiscal decentralization describe the extent

of fiscal decentralization as the local share of total government expenditure Thisindicator measures the degree of local expenditure responsibility in the publicsector By the same taken, the local share of total government revenue is alsoapplied to measure the degree of fiscal decentralization A vertical fiscal gap isdefined as the local revenue deficiency cause by the difference between localgovernment revenue capacity and its expenditure responsibility Following somefiscal decentralization indicators are focused to measuring level of fiscaldecentralization: (i) Local share of total fiscal expenditure; (ii) Local share of totalfiscal revenue; (iii) Local dependency on fiscal transfer; (iv) Local fiscalautonomy; (v) Local expenditure discretion Base on these indicators, fiscaldecentralization is classified into the following three types First, theintergovernmental fiscal relationship can be considered as highly decentralized.Another type is that although local fiscal autonomy is limited, the discretion overexpenditure is relatively high The third type is both local fiscal autonomy andexpenditure discretion are limited

Over the past decade, Vietnam has been implementing decentralizationprogram A cornerstone of this program was the approval of the 1996 State BudgetLaw, the result has been a substantial and growing level of decentralization, withthe share of sub-national government in total expenditure increasing from 26percent in 1992 to 43 percent in 1998 ; and to 48 percent in 2002 (SocialistRepublic of Vietnam and the World Bank, 2005).

The 1996 State Budget law was the first legal document in Vietnam toprovide explicit regulation for public financial management The law defined therole and powers of each level of government in the budget process, reflecting theincipient decentralization of public finance The law created framework financialrelations between the national government and lower tier of government

A revised State Budget law was approved by NA in December 2002 andcame into force in January 2004 This Law builds on the achievements of itspredecessor, strengthening the legal platform of budget management in fourimportant regards: (1) Clarifying powers and responsibilities; (2) Strengtheningdecentralization; (3) Promoting administrative reform; (4) Strengtheningtransparency and accountability

Although Vietnam has reached some achievements through current fiscaldecentralization system as of January 2004, some weaknesses of Vietnam currentsystem of decentralization are necessarily improved in coming time:

(i) Assignment of expenditure responsibilities:

One main problem with expenditure assignment in Vietnam is deal with thecapital expenditure needs of sub-national government Most sub-nationalgovernments lack of capital funds to rehabilitate, replace or construct newinfrastructures

Another significant issue is the lack of regulation of concrete explicitexpenditure assignments for the lower levels of governments of districts andcommunes

One of the toughest issues is the overlap of power of deciding education andtraining, sciences and technologies expenditures between NA and People’sCouncils.

(ii) Revenue assignments:

- The localities did not have significant autonomy of revenue sources

- According to the State Budget Law, the commune budgets are entitled toenjoy at least 70% of five items of revenue (included: land use right transfer tax,agricultural land use tax collected from family households, house and landregistration fees) In fact, some communes achieved excess resources afterensuring all spending tasks while others’ revenues can not cover their spendingtasks The inability to reconcile these revenues caused difficulties in managingbudget

- The VAT and special consumption tax raise the unfairness betweenprovinces and the growing gap in budget revenues, expenditures between localitiesand encourage local government to get further involved in market activities, offerspecial advantages to business

- The 2002 State Budget Law does not contain regulation on remittingrevenue to the high-level budgets in the case of suddenly increased revenue items

of low-level budget Therefore, in implementing process, some localities hadunexpected increase in revenue over the target in the first year of the budgetstability period, while some others had to face with the situation when there were

an increase in district budget and a decrease in province budget but they could notregulate the budget from district to province level

(iii) By using stability periods, the current methodology provides morepredictability in local budgets but, this approach also carries some risks especially

if, as announced, the stability periods are to be expanded to larger number of years.Since the balancing transfers are fixed in nominal terms at the beginning of eachstability period, sub-national government may fall short of adequate funding inhigh inflation scenarios or if their ability to raise revenues falls and theirexpenditure needs rise sharply during the stability periods

To improve fiscal decentralization is an indispensable way to increase theactiveness, self-control and flexibility in budget management of governmentauthorities at all level to effectively meet the requirements of socio-economicdevelopment of Vietnam

The local budget self control should be strengthen and enhanced step by step

to actively and efficiently assist the performance of the functions and tasks of thelocal authorities, basing on the on-going improvement of management capability,transparency and financial explanation responsibility of local authorities

On the basis of specific factors and disciplines to enhance the assignment ofstate budget, from my point of view, the orientation to improve the fiscaldecentralization in the coming time should focus on the following contents:

Firstly, to better separate state budget in to specific levels, heading to a moreadequate budget assignment system in which local authorities at each levelpossesses bigger decision making power of budget and be independent fromsuperior authorities

Secondly, to grant local authorities with higher decision making powerregarding revenue sources management In order to be self-control in budgetmanagement, local authorities should be granted with the decision making powerand management of revenue sources so that they can adjust the size of local budgetthrough using their own revenue sources, including taxes The increase in self-control power is an objective requirement for hierarchy of state budget and in themean time, creates adequate revenue sources for the local budget expendituretasks

Thirdly, to increase the decision making power of local authorities regardingexpenditures Local authorities should be granted a reasonable power overexpenditures in their intended order

Fourthly, to increase the financial transparency and explanation responsibility

at local levels The desired target of budget assignment shall only be achieved if it

is attached with the enhancement of financial transparency and explanationresponsibility at local levels Suitable regime should be applied in order to increase

the transparency and accessibility in budget management at local levels Moreover,the control and supervision activities of authorized agencies should be taken toensure the effectiveness of budget management, the roles of people agencies andState audit body should be appreciated Budget explanation responsibility of eachlevels should be intensified not only before superior level but also before thePeople council and people of respective levels

CHAPTER ONE: INTRODUCTION

Rationale of the thesis

The budget is increasingly being seen as a tool to promote governmentaccountability and effectiveness, rather than simply as a vehicle for allocatingresources and controlling expenditure Therefore, the management of fiscaldecentralization is a challenge in many countries around the world It relates to notonly the budget management but also the organization of the State apparatus andsocio- economic issues of each country Based on the specific conditions, eachcountry decides the way to decentralize its state budget Decentralization of fiscalauthority presents some major opportunities: local government of the budget canresult in better mobilization and allocation of resources, and in delivery of serviceswhich are more appropriate and responsive to the needs and wishes of local peopleand more efficient given local conditions and circumstances (Socialist Republic ofVietnam and the World Bank, 2005)

Over the past decade, Vietnam has been implementing decentralizationprogram A cornerstone of this program was the approval of the 1996 State BudgetLaw, the result has been a substantial and growing level of decentralization, withthe share of sub-national government in total expenditure increasing from 26percent in 1992 to 43 percent in 1998 ; and to 48 percent in 2002 (SocialistRepublic of Vietnam and the World Bank, 2005)

After five years of implementation, Vietnam NA approved a new StateBudget Law in 2002, which allowed significant continuity in fiscaldecentralization Nevertheless, there are still limitations and difficulties during theimplementation of decentralization process I believe that it is indispensable tohave solutions to improve the prevailing regime of fiscal decentralization in order

to increase further both the efficiency and equity of the system This explains why

“Fiscal Decentralization: Case study of Vietnam” issue is chosen to my researchtopic

Objective of the thesis

- This thesis, thus, attempts to review the theoretical concepts as a basis toanalyze the practical of fiscal decentralization in Vietnam to provide a description

of the strengths and weaknesses of the system

- Base on significant issues of fiscal decentralization in Vietnam, to propose

to improve the prevailing regime of fiscal decentralization in order to increasefurther both the efficiency and equity of the system

Thesis questions

Within this context, the thesis has an attempt to address the following majorquestions:

- What are the theoretical and rationales behind fiscal decentralization?

- What are the strengths and weaknesses of Vietnam’s current system offiscal decentralization?

- What is needed to be done to further improve Vietnam’s system of fiscaldecentralization?

Scope of research

The issues examined in this research rest inside the following boundary:

- Scale: Vietnam Government Sector

- Focusing on analyzing and clarifying the mechanism of fiscaldecentralization to local governments as of the effect of the 2002 State BudgetLaw (implemented from 01/01/2004)

Methodology

This thesis substantially builds on the theories of fiscal decentralization andvarious other available official publications and case studies to bring qualitativeand quantitative analysis, logics and analytical review methods to the examination

of practice of fiscal decentralization in Vietnam Most data used for this study isderived from the MOF

Thesis Structure

The thesis is structured in four main parts

The first part, Chapter two: Literature review on Fiscal Decentralization is

dedicated to all the theories related to the research theme

Chapter three: The fact of fiscal decentralization in Vietnam, provides a

description of strengths and weaknesses of Vietnam’s current system of fiscaldecentralization

Chapter four: Recommendations for improving fiscal decentralization in Vietnam, recommendations are offered to improve Vietnam’s system of fiscal

decentralization

The final part, Conclusion, recaps the thesis.

CHAPTER II: LITERATURE REVIEW ON FISCAL

DECANTRALIZATION

2.1 Definition of Fiscal Decentralization

The issue of fiscal decentralization has begun to feature significantly in manycountries around the globe Members of the Executive Board of the IMF asked theFiscal Affairs Department to organize a conference to inform them about the latestmethodological developments, and to draw lessons from experiences of differentcountries and regions A conference was held in Washington in November 2000,bringing together leading academics and “practitioners” from various countries(Ehtisham Ahmad and Vito Tanzi, 2002)

Decentralization may be defined in many ways, but typically involvesincreased autonomy and responsibilities for lower-level entities in one dimension

or another (Jonathan Rodden, Gunnar S Eskeland, and Jennie Litvack, 2003).Fiscal decentralization generally refers to the devolution of taxing andspending powers from the control of central government authorities to governmentauthorities at sub-national levels (regional, provincial, municipal, etc) In a muchdecentralized system, local governments have considerable power to mobilizeresources, through taxing authorities accompanied by strong tax bases (NiñaBoschmann, 2009)

Therefore, Fiscal decentralization covers two interrelated issues The first isthe division of spending responsibilities and revenue sources between levels ofgovernment (national, regional, local etc) The second is the amount of discretiongiven to regional and local governments to determine their expenditures andrevenues (both in aggregate and detail)

These combined dimensions have a significant impact on the reality ofdecentralization in its broader political and administrative sense How much powerand responsibility regional and local governments actually exercise dependsubstantially on

(1) What range of public services they finance;

(2) Whether their revenues are commensurate with these responsibilities;(3) How much real choice they have in allocating their budget to individualservices;

(4) Whether they can determine the rates of their taxes and charges (bothallowing them to vary their level of spending and making them answerable to thepayers)

The term "local government" will be used to describe both upper (regional,county, and district) and lower (city, municipal, settlement) tiers of self-government (Kenneth Davey, 2003)

The varieties of fiscal decentralization may exist, corresponding to the degree

of independent decision making exercised at the sub-national level, the generaldescription of the term fiscal decentralization encompasses the political, economic,and institutional underpinnings of intergovernmental fiscal relations, and rangesfrom examining the efficiency of public institutions and developing sustainableinfrastructure finance, to rationalizing fiscal transfer mechanisms and supportingthe social safety net

Therefore, a carefully designed fiscal decentralization policy should not onlyenhance local autonomy where sub-national governments are allowed to actindependently within their own sphere of competence in designing revenue andexpenditure policies but also promote political accountability, economic efficiencyand transparency (Robert D Ebel and Serdar Yilmaz, 2001)

2 2 Rationale for fiscal decentralization

Fiscal decentralization has many proponents, in particular as a strategy toimprove service delivery at local level Commonly accepted objectives for fiscaldecentralization include those of an efficient allocation of resources via aresponsive and accountable government, an equitable provision of services tocitizens in different jurisdictions, and preservation of macroeconomic stability andpromotion of economic growth (Niña Boschmann, 2009)

Decentralization is believed having a potential to increase efficiency withregard to the use of public funds mainly through improved governance as a result

of (i) increased ownership, (ii) better fine-tuning to local circumstances, and (iii)increased and more direct mechanisms of accountability First, decentralization isassociated with increased efficiency, as lower spheres of government are morelikely to assess demand and to know peoples’ priorities Second, decentralizationmay lead to stronger democracy, as it makes local government more accountablefor its actions

Arguments related to efficiency advantages through decentralization inparticular refer to higher consumer efficiency, competition, lower transaction costsand more efficient revenue rising Consumer efficiency relates to the assumptionthat consumers’ preferences differ within a country; and, therefore uniform levels

of services in all municipalities are inefficient In this sense, decentralized servicedelivery increases efficiency, as services can be provided according to localpreferences (Niña Boschmann, 2009)

Oates (1972) formulated the decentralization theorem as "each public serviceshould be provided by the jurisdiction having control over the minimumgeographic area that would internalize benefits and costs of such provision"

The decentralization theorem is based on the assumption that centralgovernment can only provide goods and services uniformly across jurisdictions.Therefore, according to the argument, there are potential efficiency gains fromfiscal decentralization Efficiency gains from decentralization can be allocative andmanagerial:

(1) Efficient Allocation of Resources

Decentralization will increase efficiency because local governments havebetter information about their residents’ needs than the central government.Decisions about public expenditure that are made by a level of government that iscloser and more responsive to a local constituency are more likely to reflectpeople’s choices than decisions made by a remote central government (RobertD.Ebel and Serdar Yilmaz, 2001)

(2) Competition among Local Governments

An interesting argument asserts that a primary economic rationale fordecentralization is to improve the competitiveness of governments that is,decentralization will make local governments try to satisfy the wishes of citizens(Breton, 1996) Vertical and horizontal competition between different governmentsunits can work as an incentive for cost-efficient service delivery, as competitionrestricts the possibility to endlessly increase taxes Moreover, transaction costsmay be significantly lower when services are provided locally, since localknowledge can be used and decisions can be implemented faster Lastly, especially

in developing countries a large portion of the economy falls outside the tax net.Since sub-national governments are more likely to have reliable information aboutthe tax base, they might be able to capture more individuals for tax-paying (NiñaBoschmann, 2009)

Another rationale for decentralization is that good governments are thosecloser to the people (Roy Bahl, Decentralization Policies in Asian Development,2009) This line of argument comprises several related strands of discussion,including accountability, participation, checks and balances and a greater variety

of choices First, local government is more likely to be accountable to itsconstituency, since information flows are better in a geographically confined area,and people can more easily control whether local authorities consider their needs.Second, decentralization can increase participation of the local population whenimmediate beneficiaries (either directly or through representation) are involved inplanning for allocation of public resources, it is assumed that interventions werelikely to better suit local needs and priorities as compared to a situation where theCentral Government plans and delivers on their behalf – hence increasingeffectiveness The presumed positive effects of dispersing responsibility to lowerspheres of government may be foiled, however, if inappropriate forms ofdecentralization are implemented Within a democratic system, we generallyextend this model to include devolution of power to “the people,” which they canthen exercise via locally elected government Decentralization may, at the least, be

important for political reasons, and it may also improve the welfare of thepopulace (Niña Boschmann, 2009)

2.3 Content of fiscal decentralization

The design of a decentralized system requires "sorting-out" of public sectorresponsibilities among different types of governments and the process of sortingout entails transfer of some decision-making powers from central to sub-nationalgovernments (Ebel, Varfalavi and Varga, 2000) Ideally, to achieve the relevantpolicy objectives, intergovernmental fiscal system should be designed based oneach country’s specific circumstances The policy objectives should include notonly the public finance goals of efficiency, transparency, and accountability butalso should aim at maintaining national integrity and political stability and beingequitable to different people and places Such a design is based on four pillars:expenditure assignments, revenue assignments, intergovernmental transfers/grants,and sub-national debt/borrowing (Bird, 2000)

Diagram 2.1: Four pillars of fiscal decentralization system

2.3.1 Expenditure assignments

Expenditure assignment is the first step in designing an intergovernmentalfiscal system Designing revenue and transfer components of a decentralizedintergovernmental fiscal system in the absence of concrete expenditureresponsibilities would weaken decentralization process (Martinez-Vazquez, 1998)

FISCAL DECENTRALIZATION

EXPENDITURE ASSIGNMENTS

REVENUE ASSIGNEMTS

INTERGOVERNMENT TRANSFERS

SUB-NATIONAL DEBT

The lack of clarity in the definition of sub-national responsibilities has anegative impact on three important respects First, if the responsibilities areimprecise, the necessary corresponding revenues will remain poorly defined.Second, without clear responsibilities, sub-national government officials mightprefer to invest in populist projects which benefit them in the short run rather than

in projects with long term impact on the region’s economy (such as infrastructure,education, etc.) Third, there will be confusion whether sub-national expendituresrepresent local priorities or centrally determined programs (Robert D Ebel andSerdar Yilmaz, 2001)

A report prepared by the US Advisory Commission on IntergovernmentalRelations (ACIR) on Governmental Functions and Processes (1974) lists fourprinciples in regards to setting the right incentives for efficient and equitabledelivery of public services These principles are economic efficiency, fiscalequity, political accountability, and administrative effectiveness They suggest thatexpenditure assignments should be made to governmental units that can: (1)supply a service at the lowest possible cost; (2) finance a function with the greatestpossible fiscal equalization; (3) provide a service with adequate popular politicalcontrol; and (4) administer a function in an authoritative, technically proficient,and cooperative fashion

The principles of expenditure assignment provide a framework to determinewhether each function could be best performed by central government or any otherlevel of governmental unit In more specific terms they relate economic, political,and administrative considerations to the geographic and population sizeconsiderations: 1

(1) Economic Efficiency: Functions should be assigned to jurisdictions(a) That is large enough to realize economies of scale and small enough not

to incur diseconomies of scale; [economies of scale]

1 ACIR (1974)

(b) That is willing to provide alternative service offerings to their citizens andspecific services within a price range and level of effectiveness acceptable to localcitizenry; [public sector competition]

(c) That adopts pricing policies for their functions whenever possible [publicsector pricing]

(2) Fiscal Equity: Appropriate functions should be assigned to jurisdictions(a) That is large enough to encompass the cost and benefits of a function orthat are willing to compensate other jurisdictions for the service costs imposed orfor benefits received by them; [economic externalities]

(b) That has adequate fiscal capacity to finance their public serviceresponsibilities and that are willing to implement measures that insureinterpersonal inter-jurisdictional fiscal equity in the performance of a function.[fiscal equalization]

(3) Political Accountability: Functions should be assigned to jurisdictions(a) That is controllable by, accessible to, and accountable to their residents inthe performance of their public service responsibilities; [access and control]

(b) That maximizes the conditions and opportunities for active andproductive citizen participation in the performance of a function [citizenparticipation]

(4) Administrative Effectiveness: Functions should be assigned tojurisdictions

(a) that is responsible for a wide variety of functions and that can balancecompeting functional interests; [general-purpose character]

(b) That encompass a geographic area adequate for effective performance of

a function; [geographic adequacy];

(c) That explicitly determines the goals of and means of discharging publicservice responsibilities and that periodically reassess program goals in light ofperformance standards; [management capability]

(d) That are willing to pursue intergovernmental policies for promoting local functional cooperation and reducing inter-local functional conflict;[intergovernmental flexibility] and

inter-(e) That has adequate legal authority to perform a function and rely on it inadministering the function [legal adequacy]

There is wide diversity between individual states in the scale of the tasksdevolved to local government In most countries local government is responsiblefor what are often called "communal services": local roads and lighting, watersupply and sanitation, waste management, parks and sports facilities, cemeteries,social housing What varies greatly is the extent of local responsibility for thesocial sector, chiefly comprising education, health and social assistance In somecases the whole service is funded by the State Budget, in some costs are splitbetween levels of government, in some local budgets meet all costs except centralsupervision Cost splitting may be by function (e.g the State paying for secondaryeducation, hospitals, social benefits and local government for basic education,primary health care and social services) or by cost factor (e.g the State providingprofessional salaries while local government pays all other operating costs)(Kenneth Davey, 2003)

Other functions usually can be provided better at the central governmentlevel, such as: National defense, Border controls, International affairs, andEducation standards Expenditures undertaken for the stabilization of the economysuch as massive investment or unemployment compensation are by their scalenaturally ascribed to the central government Expenditures undertaken bygovernment for equity or income equalization reasons, such as social welfare orlow income housing should fall under the domain of the central government Onthe other hand, implementation of social programs can very well be left to localgovernments, which may have informational and other comparative advantages(Niña Boschmann, 2009)

It is normal to distinguish between current and capital expenditure Currentexpenditure covers such operating costs as salaries, repairs, energy and other

utilities, travel, materials and debt service Capital expenditure covers investment

in new construction, major renovations, and purchase of land and substantial anddurable equipment It is also normal to distinguish between the financial sourcesfor these two types of expenditure Operating costs are normally covered by acombination of local taxes, user fees, intergovernmental transfers comprisingeither grants/subventions or shares of State taxes These will be described in turn(Kenneth Davey, 2003)

2.3.2 Revenue Assignments to Local Governments

The essence of decentralization is that sub-national governments have theauthority and responsibility to own-finance local services at the margin Completefiscal autonomy over revenues requires that in principle local governments canchange tax rates and set tax bases The general principles of revenue assignment todifferent levels of government are listed in fiscal federalism and local governmentfinance literature as (Oates, 1972; Bird, 2000):

1 The tax base assigned to sub-national governments should be immobile inorder to allow local authorities some freedom to vary rates without the basevanishing Inter-jurisdictional mobility of tax base makes taxation of mobilefactors difficult to sub-national governments

2 Redistributive taxes should be assigned to the central government Taxesimposed on mobile factors for redistribution purposes might result in inefficientjurisdictional allocation of the factors of production Uniform redistributive taxesminimize locational distortions of economic activities

3 Services provided by sub-national governments should to the extentpossible be financed through user charges and other local fees and taxes that arerelated to benefits Efficient allocation of resources requires sub-nationalgovernments recover their expenses from the beneficiaries of their services.Examples of benefit related revenues include taxes levied on motor vehicles andfuels and construction fees

4 Taxes that are subject to important economies of scale in collectionefforts should be centralized.

5 Taxes subject to cyclical fluctuations need to be protected by a system ofcounter-cyclical rate adjustments in order to avoid sub-national governments’exploitation of fiscal power

6 Taxes levied on tax bases that are unevenly distributed should becentralized Uneven distribution of tax bases among sub-national governmentsforces the residents of one sub-national area bear the economic burden of taxesimposed by another jurisdiction Taxation of natural resource is the best example

of this type of taxation practice

7 The revenue yield should be stable and predictable over time

Each level of government should be assigned taxes that are related to thebenefits of its spending Thus, the proper assignment of taxes that are related tobenefits depends on the assignment of expenditure functions In general terms, thecentral government should be responsible for expenditures having benefits thatextend across sub-national boundaries or that are characterized by economies ofscale not realized at the sub-national level The following taxes are usuallyreserved for the central government2:

• Import duties,

• Value-added taxes, and

• Corporate income taxes

Certain taxes are usually, and for good reason, collected mainly by localgovernments, including:

• Property taxes,

• Commercial or business licenses,

• Industrial cess, and

• Local retail sales tax

2Niña Boschmann, 2009

To the extent possible, services provided by government should be financed

by user charges and fees This is both fair and efficient, in the sense of encouragingresponsible use of the nation's economic resources A fee-based approach allowsbeneficiaries to pay for identifiable public services that might otherwise not beprovided Among the best examples of benefit-related taxes are those levied onmotor vehicles and motor fuels and used for the construction and maintenance ofroads and highways

Related to the local-government revenues or tax code is the issue of revenuesharing Revenue sharing (same as shared responsibilities) has a number ofadvantages and disadvantages One of the major concerns, however, is how asystem of revenue sharing would fit in with the style of the desired system ofintergovernmental relations

2.3.3 Intergovernmental transfers

Transfers are a compromise solution in the debate over the division ofrevenue-raising authority and expenditure responsibility They permit nationalgovernments to retain the authority to tax productive resources bases, butguarantee state and local governments a flow of revenues A system of grants is astep toward fiscal decentralization in that it finances local government services, butthe degree of autonomy it gives local governments in making their budgetdecisions depends on the structure of the grant system

No policy instrument of fiscal decentralization is more discussed, or moreoften reformed, than inter-governmental transfers On the one hand, transfers arepreferred to local taxation in most developing and transition countries because theyrecognize the superior tax administration capabilities of the central governmentand because they allow a greater measure of central control On the other hand,transfers are an object of criticism precisely because of the central control, and insome countries because they discourage local revenue mobilization, are notadequately equalizing, and are not transparent Reform in most countries hasconcentrated on finding a middle ground between central control and the goals of

decentralization (Roy Bahl, Decentralization Policies in Asian Development,2009).

Intergovernmental transfers take a number of forms (Kenneth Davey, 2003):(1) Shares of national taxes distributed either

a) By formula (e.g per capita), or

b) By origin (i.e to the local government where they are collected)

(2) grants/subventions which are either

a) Targeted to support specific expenditures (e.g social benefits, education),or

b) Untargeted and used at the discretion of local government (often known aslock grants)

There are many ways to design a grant system The grant could be distributedbased on a formula (population, land area, etc.); based on derivation (where themoney is collected); based on cost reimbursement (how much was spent for roads,etc.); or even on a political basis There is also the question of how the totalamount of the grant pool is determined, for example as a share of a national tax, or

as a share of total cost incurred for some services, or on a political basis Thissuggests that grant systems can have many faces, and that some can be equalizingwhile others can benefit rich provinces and cities; some can place the money whereproductivity can be greatest and where tax effort can be stimulated; some can forcethe local government to provide services at national standards, and so on

Tax sharing and block grants usually have two main purposes, vertical andhorizontal equalization Vertical equalization means closing the gap between thecosts of the services devolved on local governments and the yield of their directrevenue sources Horizontal equalization adjusts differences between individuallocal governments in their per capita revenues or spending needs Equalizationformulae should be based on objective measurements of local spending need andrevenue capacity They should not be open to influence by the decisions andperformance of the recipient local government For example, calculations of

revenue capacity should assume that all local governments levy the same rate oftax, and should not change because a particular authority chooses to increase orreduce it (Kenneth Davey, 2003)

In fact, there is no optimal grant structure What is a good feature of aparticular type of grant depends on whether one takes a local or a nationalgovernment view, and on which objectives the government most wants to achieve.Most reviews suggest that governments have quite different objectives By addingconditional grant as a third dimension to be considered in the design of a system ofintergovernmental transfers, in addition to the dimensions of the vertical andhorizontal allocation, this yields three policy dimensions along which governmenthave the opportunity to make policy choices

2.3.4 Sub-national Borrowing/Debt

There are three primary reasons why sub-national borrowing can beconsidered as an appropriate tool for sub-national public finance:

1 Intergenerational equity: The benefits of certain investment projects, such

as infrastructure and education, are spread over time, which means that not onlypresent residents of a locality, but also future residents will consume the servicesprovided by the projects Therefore, the benefit principle of taxation suggests thatfuture residents should also contribute the cost of investment For this purposeborrowing is an appropriate tool that offers a means through which payments forcapital projects can be spread over the life of the project so as to coincide moreclosely with the stream of future benefits (Oates, 1972)

2 Economic Development: Delaying infrastructure investments might have anegative impact on sub-national economic performance Such a negative impactwill have a direct effect on resident’s life in terms of less employmentopportunities and decline of earning levels Therefore, borrowing is an appropriatetool for sub-national governments in investing on infrastructure projects tostimulate regional economy

3 Synchronization of Expenditure and Revenue Flows: Access to financialtools offers an opportunity to sub-national governments to synchronizeexpenditures incurred and revenue collection For a variety of reasons expenditureincurred and tax intake may not be fully synchronized for a particular year In such

a situation, borrowing provides sub-national governments to smooth out themismatch and provide services without disruption

There are at least two different channels through which sub-nationalgovernments can borrow: through a public intermediary such as infrastructurebank or direct borrowing from private capital markets The internationalexperience suggests that lending through a public entity; either central governmentlending or public financial intermediary suffers from political favoritism Directaccess to private markets entails development of market-based relationshipbetween lenders and sub-national governments, which requires the use of privatecredit rating and bond insurance agencies to monitor sub-national borrowing.Establishing these institutions offers a potential for improving transparency andpolitical accountability in local government management As capital marketsemerge, residents of local governments would learn more about the financialhealth of their governments Sub-national borrowing is an important component ofthe devolution of fiscal powers to local authorities However, a well-designedregulatory framework for sub-national borrowing is necessary to ensure that sub-national borrowing does not provide perverse incentives to lending institutions andsub-national governments for excessive lending and borrowing Such a frameworkincludes standardized accounting procedures for sub-national governments,disclosure of sub-national governments, liabilities and repayment capacity.However, these measures by themselves will not be sufficient to curb moral hazardproblem The macro concern of moral hazard occurs when sub-nationalgovernments are backed by the central government by providing guarantees totheir borrowing In these circumstances, the incentive structure is set for excessiveborrowing of sub-national governments, which would ultimately lead sub-nationalgovernments to default on loans (Commission on Fiscal Imbalance, 2002)

2.4 Measuring level of fiscal decentralization 3

Most studies empirically examining fiscal decentralization describe theextent of fiscal decentralization as the local share of total government expenditure.This indicator measures the degree of local expenditure responsibility in the publicsector By the same taken, the local share of total government revenue is alsoapplied to measure the degree of fiscal decentralization A vertical fiscal gap isdefined as the local revenue deficiency cause by the difference between localgovernment revenue capacity and its expenditure responsibility

Following some fiscal decentralization indicators are focused to measuringlevel of fiscal decentralization:

(1) Local share of total fiscal expenditure

RLE = ∑iLEi/(∑iLEi+CR)

Where I denotes a local government, LEI is the expenditure of localgovernment (i), and CE is the expenditure of the central government Accordingly,RLE measures the ratio of local expenditure to total fiscal expenditure includinglocal and central expenditure This indicator hence quantifies the degree of localexpenditure responsibility with the central government

(2) Local share of total fiscal revenue

RLR = ∑iLRi/(∑iLRi+CR)

Where LRi denotes the revenue of local government (i), and CR is therevenue of the central government LR does not include fiscal transfers fromcentral to local government Therefore, the denominator captures the total fiscalrevenues without redundancy

(3) Local dependency on fiscal transfer

DFT = ∑iFTi/∑iLTRi

3 Hiroko Uchimura andYurika Suzuki, 2009.

Where FTi d denotes the fiscal transfer from the central government to localgovernment (i), and LTRi is total revenue of local government (i) Accordingly,DFT measures the ratio of the fiscal transfer to local total revenue.

(4) Local fiscal autonomy

FA = ∑iLORi/∑iLTRi

Where LORi denotes the own revenue of local government (i) Thus, FAmeasures the ratio of local own revenue to local total revenue Local revenue isgenerally classified into three categories, i.e., tax revenues, non-tax revenues, andfiscal transfers from the central government In addition, the tax revenues of localgovernments are classified into eight categories based on the degree of localcontrol over the rate and base of a tax (a) A tax: local governments set its rate andbase (b) A tax: local government only set its rate (c) A tax: local government onlyset its base (d) Tax sharing revenues: local governments set revenues- splitbetween central and local governments (e) Tax sharing revenues: revenue-splitcan only be changed with the consent of local governments (f) Tax sharingrevenues: revenues-split is fixed in legislation and may be changed unilaterally bethe consent of the central government (g) Tax sharing revenues: revenue-split isset by the central government as a part of the annual budget process (h) A tax: thecentral government set both its rate and base Local governments have total orsignificant control over the taxes in the first three categories (a-c) as well ascategories (d) and (e); whereas local fiscal autonomy is limited or none exist in thelast three categories (f-h) Based on this classification, taxes included in LOR arethose of categories (a) to (e) Non-tax revenues are included in local own revenues,while fiscal transfers from the central government are not included in local ownrevenues (LOR)

(5) Local expenditure discretion

FD=∑iGRi/∑iLTRi

Where GRi denotes general revenues of local government (i) FD measuresthe ratio of general revenues to local total revenues, which captures the degree of

expenditure discretion of local governments In addition to LOR, the mentioned tax sharing revenues of (f) and (g) are also included in GR In general,fiscal transfers are classified into two categories: general-purpose transfers andspecific-purpose transfers In this case, general-purpose transfers are included in

above-GR, but specific-purpose transfers are not

Base on these indicators, fiscal decentralization is classified into thefollowing three types First, when the local share of total fiscal expenditure as well

as that of revenue is relatively high, the intergovernmental fiscal relationship can

be considered as highly decentralized Another type is where the local share oftotal fiscal expenditure is high, while that of total fiscal revenue is relatively low

In this case, the fiscal gaps between local expenditure responsibilities and revenuemeans are bridged mostly by intergovernmental fiscal transfers in decentralizeddeveloping countries Therefore, this type of fiscal decentralization is furtherclassified into two categories depending on the types of fiscal transfers Asmention above, there are two types of transfer: general-purpose (unconditional)transfers and specific-purpose (conditional) transfers Accordingly, the second type

of fiscal decentralization is where local expenditure responsibility is high and thefiscal gap, i.e , the difference between local expenditure responsibility and localown revenue, is filled by unconditional transfers In this case, although local fiscalautonomy is limited, the discretion over expenditure is relatively high The thirdtype is where local expenditure responsibility is high and fiscal gaps are bridgedmainly by conditional transfers, in which case both local fiscal autonomy andexpenditure discretion are limited

CHAPTER III: THE FACT OF FISCAL DECENTRALIZATION IN VIETNAM

The 1996 State Budget law was the first legal document in Vietnam toprovide explicit regulation for public financial management The law defined therole and powers of each level of government in the budget process, reflecting theincipient decentralization of public finance The law created framework financialrelations between the national government and lower tier of government

A revised State Budget law was approved by NA in December 2002 andcame into force in January 2004 This Law builds on the achievements of itspredecessor, strengthening the legal platform of budget management in fourimportant regards: (1) Clarifying powers and responsibilities; (2) Strengtheningdecentralization; (3) Promoting administrative reform; (4) Strengtheningtransparency and accountability

This chapter focuses on assessing the strengths and weaknesses of Vietnamcurrent system of decentralization

3.1 Current territorial administrative structure

Vietnam’s territorial administrative structure is organized into four levels ofgovernment The country is divided into 63 provinces, ranging in populationbetween approximately 0,299 million and 7,66 million The provinces aresubdivided in to 698 districts, which, in turn, are subdivided into 11.113communes

At the central level, the legislative power resides in the NA, which according

to Article 84 of the constitution approves the state budget, which includes not onlythe central government budget but also the consolidated provincial – district -commune budgets On the executive side, the Prime Minister is the head of thegovernment and he and the rest of the governments are appointed by the NA TheCommunist Party operates in parallel to the government structure at all levels ofgovernment The Party exercises considerable authority and control but does notmicromanage governance issues At each lower level of government there is a

legislative authority, the People’s Council, and an executive authority, thePeople’s Committee.

Levels of territorial administration Levels of buget

Diagram 3.1: Levels of territorial administration and budget

According to article 4 of the State Budget Law, the state budget shallcomprise the central budget and local budgets Local budgets shall comprisebudgets of the local administration at various levels that have People’s Councilsand People’s Committees This means the state budget includes 4 budget levels:the central budget, the provincial budget, the district budget and the communebudget, which is conformity with four levels of territorial administrative structure(Diagram 3.1)

The budget structure is hierarchical: the budget at each level has to beapproved not only by the People’s Council at that level but also by the upper levelgovernment Each administrative level operates under a system of dualsubordination and accountability: at the same level of government, the People’sCommittee is accountable to the People’s Council and ultimately to localresidents The same officials are also accountable to the upper level and ultimately

to the central authorities Whatever authority sub-national governments exercisethrough the People’s Council and the People’s Committee, including its approved

Central level Central budget

Provincial level Provincial budget

District level District budget

Commune level Commune budget

budgets, is always under the supervision of the NA, which has the power tosuspend inappropriate decisions of the People’s Councils.

3.2 Assignment of expenditure responsibilities

to be granted a wide scope of expenditure responsibilities

In case of de-concentrated responsibilities4, sub-national government act asimplementers of central government’s programs These programs comprise sectorprograms and national targeted program In this case, the central government canregulate and design programs, but it also has responsibilities to ensure funding forthese responsibilities is available to local government; local authorities are only incharge of implementation

4 De-concentrated responsibilities or delegated responsibilities from central to local government.

Table 3.1: Assignment of Expenditure Responsibilities in Vietnam

Health - Central Facilities

- Research

- National Health Programs

- Provincial Services - District services as

assigned by the provincialgovernment

- Commune health activities

as assigned by the provincialgovernment

Education - Post-secondary

- National Programs

- Provincial Services - Districts services as

assigned by the provincialgovernment

- Commune services asassigned by the provincialgovernment

Economic

activities

- Economic services,managed centrally

- Provincial Services - Districts activities as

assigned by the provincialgovernment

- Commune activities asassigned by the provincialgovernment

Culture and Sports National Programs - Provincial activities,

supporting individuals

- Districts activities asassigned by the provincialgovernment

- Commune activities a asassigned by the provincialgovernment

- Social Security

- Provincial activities - Districts activities as

assigned by the provincialgovernment

- Commune activities a asassigned by the provincialgovernment

- Other DefenseActivities

- Districts activities asassigned by the provincialgovernment

as assigned by the provincialgovernment

Police and Security - Nation Police - Local security and

political and socialorganizations

…

Capital Investment Programs in infrastructure

Support of state enterpriseand join companies

National investment anddevelopment programs

Construction of basiceconomic infrastructureSupport of stateenterprises according tothe law

Public SchoolsPower

Water supplySanitationTransport

Health enters, schools, localroads, water supply system

Transfers Transfers to sub-national

government

Transfers to districtbudget

Transfer to communebudget

…

Source: Jorge Matinez-Vazquez, 2005, Making Fiscal Decentralization Work in Vietnam

A significant change in the 2002 State Budget Law is the requirement offunded expenditure mandates from higher to lower level of government5 The newprovision in the new State Budget Law should protect lower level governmentfrom facing new responsibilities without corresponding finance source withinstable period In fact, within stable period, central government only ensures theentire funding for the provinces which get balancing supplement from centralgovernment to implement new responsibilities for the provinces, while the othershave to fund for expenditure mandates from central government, such as: Hanoi,

Ho Chi Minh, Dong Nai, Vung Tau, Binh Duong…

Figure 3.1: The ratio local expenditure to total expenditure

Source: Author’s calculations basing on MOF’s data.

As can be seen in Figure 3.1, the share of local expenditure in totalexpenditure increased significantly in stable period In the stable period 2004 -

2006, the share rose from 43,28% in 2004 to 44,49% in 2006 And in the stableperiod 2007 – 2010, it increased from 42,12% in 2007 to 45,56% in 2010 Thisshare in total expenditure, to judge along this single dimension, positions Vietnam

5 Unfunded mandates are reassignments or new assignment of responsibilities to lower level of government where there is no financial source to the balance capability to implement new responsibilities This issue has plagued many transitional countries from socialism as central governments have tried to shift their deficits down to local government ((Jorge Matinez – Vazquez, 2005).

among highly decentralized countries6 (Jorge Matinez – Vazquez, Making FiscalDecentralization Work in Vietnam, 2005).

Source: Author’s calculations basing on MOF’s data.

However, in terms of economic expenditure, the share of capitalexpenditure in local expenditure increased from 30,62 percent in 2004 to the peak35,69 percent in 2005 and decreased gradually to 26,54 percent in 2010 (Figure3.2) This share illustrates that expenditure tasks assigned to provincial levelmainly are recurrent expenditure, almost capital expenditure in provincialterritories are supplemented by central government through targeted transfers tolocal governments, expect some large provinces which have high growth rate ofcapital expenditure year by year, such as: Ho Chi Minh, Ha Noi, Quang Ninh, DaNang, Khanh Hoa, Binh Duong, Dong Nai, Vung Tau,… Capital expenditures ofalmost sub-national in northern midland and mountain areas do not grow in stableperiod even decrease gradually year by year (Appendix Table A-1)

It is caused by revenue assignments and transfers systems, which is discussbelow It leads to inefficient decisions with poor matching of needs and also to

6 Decentralization is a multidimensional concept and the share of sub-national governments in total

expenditures is only one of those dimensions Whether a country is decentralized also depends, among other things, on the level autonomy exercised by sub-national governments on the composition of

expenditures and their ability to raise their own revenues.

lack of maintenance and interest by local governments on the centrally builtinfrastructure.

Realizing the resolution of central committee of Vietnamese communistparty on orientation of education and training, sciences and technologiesdevelopment aiming to increase share of education and training expenditure,sciences and technologies expenditure in total expendiure to 20 percent and 2percent, respectively, the 2002 State Budget Law approved by NA regulates that

NA decides the total State budget expenditure, including central budgetexpenditure and local budget expenditures detailed according to the fields ofdevelopment investment expenditure, regular expenditure, debt repayment and aidexpenditure, expenditure on addition to financial reserve and budget reserve funds.The development investment expenditure and regular expenditure include thespecific spending levels for education and training, sciences and technologies(article 15)

Table 3.2: The number of sub-nations having low growth rate of education and training, science and technologies expenditures

Year

The number of sub-nations which have

the ratio education and training expenditure decided by People's Council to by NA (%)

The number of sub-nations which have the ratio science and technologies expenditure decided by People's Council