Fiscal Equalization of Croatia’s Local Government Finances

An analysis of equalization grant allocations in Croatia

Fiscal decentralization and equalization are important tools to empower local government agencies in terms of financial autonomy and capacity building. The Ministry of Finance of Croatia adopted a fiscal equalization formula in 2018 with the hope of helping local governments achieve higher levels of performance and provide quality services to the public. However, the reality has been less optimal. A recent article by Miličević et al. (2019) “Fiscal Equalization In Croatia: Fine Tuning of The Lorenz Curve” points out a couple of issues that the Croatian administration may have overlooked when designing this allocation formula.

Preferential status in the fiscal equalization is granted to local government units (LGUs) in the areas of special state concern (ASSC) as well as in hill and mountain areas (HMA). According to the Law on Financing of Local and Regional Self-government, those LGUs retain 90% of the PIT collected in their area, while 10% belongs to the county. For other LGUs the PIT revenue sharing scheme significantly differs – LGUs retain only 56.5% of the PIT, 16% belongs to the county, 12% is intended for financing of decentralized functions and 15.5% for equalization fund for decentralized functions (or capital projects – for LGUs on islands with an agreement on joint financing of capital projects for the development of the island).

The devil of the grant equalization process, however, is in the details of how revenue capacity is measured.

The first challenge with the allocation formula is that it redistributes income tax revenue to cities and municipalities using the average values of tax revenue data from jurisdictions in the past five years. A mean value alone does not factor in either the variation of revenue structure or trends of economy growth. The authors suggest that a weighted average with more weight in recent data and/or including a forecast for the current fiscal year would offer a fiscal strength indicator that is closer to reality.

Second, the formula used to calculate the revenue distribution uses a per capita value that is based on the census data back in 2011. Changes in population levels and the demographic structure in Croatia have been rapid and significant since then. Using nearly 10-year-old data for reference undermines the model’s predictability and compromises redistribution fairness. The authors found that, when population was properly adjusted, the inequality in fiscal capacities estimated by the Ministry of Finance decreased significantly.

While fiscal equalization is crucial for the efficient and equitable allocation of resources and for the efficient operation of local governments and is needed in many places in the developing world, the authors suggest that the design of the allocation formula ought to be more sophisticated than is currently the case. The authors suggest that policy makers should consider a spectrum of fiscal, demographic, and political factors to ensure a more efficient and equitable distribution of financial resources.

Read the entire research study below:

Miličević, V., Bubaš, Z., & Jurković Majić, O. (2019). FISCAL EQUALISATION IN CROATIA: FINE TUNING OF THE LORENZ CURVE. Selected Papers (Part of ERAZ Conference Collection).