Making Fiscal Decentralization Work in Vietnam (PER 2004)

Jorge Martinez-Vazquez

May 2004

Professor of Economics and Director, International Studies Program, Andrew Young School of Policy Studies, Georgia State University.

1. INTRODUCTION
Vietnam is a poor country with large and increasing needs in infrastructure, education, health, and other areas of the public sector. The current policy of the Government of Vietnam (GOV) is not to increase tax effort, but actually to reduce it. Recently, the GOV has cut the rates of several taxes with the goal of making Vietnams exports more competitive internationally and to attract more foreign direct investment. Tax revenues will be further cut in the near future as the GOV prepares for accession to the WTO by reducing the level and dispersion of customs tariff rates. The large current needs for additional public funds and the plans not to increase taxes, or actually to decrease them, present the GOV with a significant policy dilemma. Possibly the only non-inflationary solution to this dilemma is to increase the efficiency and effectiveness of the entire public sector. Because Vietnam has significantly decentralized expenditure responsibilities to the provincial and local governments (the share of subnational governments in total expenditures is around 40 percent; see Table 1), the GOV decentralization policy takes special importance in the overall drive for greater efficiency and overall fiscal balance of the public sector. The ability of the GOV to increase the quantity and quality of public services lies largely in a more efficient and equitable system of decentralized finance. This is the fundamental reason for assessing in this chapter of the Public Expenditure Review (PER) the ongoing decentralization process in Vietnam. During the past eight years the GOV has embarked on an extensive decentralization program. A fundamental cornerstone of the decentralization process was the approval of the Budget Process Law in 1996.1 Despite the advances represented by this law, after five years of implementation it became apparent that some parts of the system had worked less well. In 2002 a new State Budget Law was approved, which in some ways represented a significant departure from the decentralization principles imbedded in the 1996 Law, such as granting provincial governments complete flexibility to arrange the finances of lower level government (districts and communes), but in some others it also allowed for significant continuity in the decentralization system. Besides the important steps toward a more decentralized system of intergovernmental relations represented by the 2002 State Budget Law, the GOV has opened up another important avenue for decentralization in Decree no.10 and Decision 192, which respectively grant revenue-making governmental units and purely administrative units at all levels of government significant discretion to manage their funds and make decisions concerning staffing levels and remuneration above the minimum levels mandated by the central government. These measures will have overall important consequences in the efficiency and equity of decentralized government operations. Although some of the implications of these two other pieces of legislation will be cited in this chapter of the PER, the focus of the chapter will be on intergovernmental fiscal relations as framed by the 2002 State Budget Law. The full implication of Decree no.10 and Decision 192 are covered in a separate chapter of the PER.
1

For a discussion of the history of decentralization processes in Vietnam prior to 1996 see Pham Dinh Cuong, State Budget Fiscal Management Decentralization in Vietnam, Ministry of Finance, April 2004.

The goal of this chapter is to provide a description of the strengths and weaknesses of Vietnams current system of decentralization and to propose alternative measures to increase both the efficiency and equity with which the system may be able to operate in the future.2 Further reforms will be needed to make decentralization policy work more effectively toward the GOV goal of increasing the overall efficiency of public expenditures and facilitating economic growth. The report is organized as follows. Section 2 discusses the vertical structure of government and examines several reform issues in this area. Section 3 reviews some of the current deficiencies in the assignment of expenditure responsibilities among the different levels of government and offers suggestions for their clarification. Section 4 appraises several important issues in the side of revenue assignments and offers recommendations for providing provincial and local governments with a higher degree of revenue autonomy. Section 5 describes the current system of transfers and presents options for their reform in an integrated fashion with the potential reforms in revenue assignments. Section 6 discusses several important issues in fiscal management and budgeting, including the role of transparency and accountability. Section 7 concludes by reviewing several issues on subnational borrowing.

2. VERTICAL STRUCTURE OF GOVERNMENT

CURRENT TERRITORIAL ADMINISTRATIVE STRUCTURE Vietnams territorial administrative structure is organized into four levels. The country is divided into 64 provinces, ranging in population between approximately 5.5 million and 0.3 million. Three large cities are granted provincial status: Hanoi, Ho Chi Minh City, and Hai Phong. The provinces are subdivided into approximately 611 districts, which, in turn, are subdivided into 10,602 communes. 3
2

This study builds on several past studies on intergovernmental fiscal relation in Vietnam, including Jorge Martinez-Vazquez , Improving the Design of Fiscal Decentralization in Vietnam, a report to the Ministry of Finance, December 2002; David Husband, Public Finance Developments in Vietnam, a report to the Asian Development Bank, February 1996; Richard M. Bird, Jennie I. Litvack, and M. Govinda Rao, Intergovernmental Fiscal Relations and Poverty Alleviation in Viet Nam, Policy Research Working Paper 1430, The World Bank, March 1995; and Charles E. McLure, Jr and Jorge Martinez-Vazquez, Intergovernmental Fiscal Relations in Vietnam, a report to the Asian Development Bank, Working Paper 98-2 International Studies Program, Andrew Young School of Policy Studies, Georgia State University, February 1998. 3 Some new districts and communes have been created in recent times by splitting older units. Note also that many towns have district status. Finally, in urban areas there are wards or urban districts. But unlike the rural districts, the urban districts do not have separate budgets. In addition, wards or districts in urban areas do not have the same functions as districts in rural areas. For example, health services are more centralized in urban areas.

At the central level, the legislative power resides in the National Assembly, which according to Article 38 of the Constitution, approves the state budget.4 The state budget includes not only the central government budget but also the consolidated provincialdistrict-commune budgets. On the executive side, the Prime Minister is the head of the government and he and the rest of the governments are appointed by the National Assembly. The Communist Party operates in parallel to the government structure at all levels of government. The Party exercises considerable authority and control but does not micromanage governance issues.5 At each lower level of government there is a legislative authority, the Peoples Council, and an executive authority, the Peoples Committee, which is appointed by the legislative authority. The budget structure is highly hierarchical and follows a nested or Matruska doll model, which was common in the former Soviet Union. The budget at each level has to be approved not only by the Peoples Council at that level but also by the upper level government. Eventually all subnational budgets get consolidated into the state budget and this gets approved by the National Assembly at the central level.6 The public administration at all levels operates under a system of dual subordination and accountability. At the same level of government, administrators are accountable to the Peoples Council and ultimately to the residents of the jurisdiction (the Peoples Councils at the local level are elected by universal suffrage).7 The same officials are also accountable to the upper level government and ultimately to the central authorities. Whatever authority local governments exercise through the Peoples Council and the Peoples Committee, including its approved budgets, is always under the supervision of the Standing Committee of the National Assembly. This latter institution has the power to suspend decisions of the Peoples Councils and, in extreme cases, dissolve the Council. The same powers can be exercised in the vertical line of the executive government. The Prime Minister can dismiss the Chairman and Vice Chairman of the Peoples Committees and can annul their decisions.

The National Assembly is elected for a period of five years and meets twice per year in sessions lasting 4 to 8 weeks. Between sessions of the National Assembly a Standing Committee acts as the legislature, issuing ordinances with the power of law. Laws enacted by the National Assembly and ordinances issued by the Standing Committee are often broadly worded, and thus vague. The government, therefore, has the important power to issue decrees, decisions, and circulars interpreting them. These legal instruments are sometimes used by the executive to introduce significant policy changes, as has been recently the case with Decree no.10 and Decision 192 concerning payroll and use of funds flexibility by budget implementation units. 5 For example, occasionally the party issues resolutions concerning particular policies where the government desires most strict observance. According to Article 4 of the Constitution, the Communist Party provides guidance to the National Assembly and the government (but does not exert explicit control) through the issuance of resolutions. 6 The 2002 State Budget Law gives the Prime Minister or Chairman of the Peoples Committee at the next higher level of government the right to request adjustments in the budget of the lower level of government. 7 The effectiveness or meaning of this horizontal accountability is compromised by the fact that opposition parties are not allowed in Vietnam. In recent years, independent candidates have been allowed to run side by side with the Communist Party candidates.

SIGNIFICANT POLICY ISSUES An important issue with the vertical structure of government is whether four levels of government are actually needed in Vietnam, given that other countries of the same size, or even larger, appear to be able to function with only three levels. A higher number of layers of government can lead to duplication of administrative services and higher administration costs than is warranted. More layers of government can also work to dilute policy directions and even reverse policy goals of higher levels of government. On the other hand, given the remoteness and at times the backwardness of some areas of the country, it may not be possible to administratively function with just two levels of subnational governments. For example, suggestions in the past for the elimination of the district level altogether and the inclusion of a province representative in each commune run into the problem that many communes have very low levels of administrative capacity.8 One possible solution to the issue of too many layers of government is to allow flexibility and asymmetries at the sub-provincial level. More geographically compact provinces with better prepared officials at the commune level may decide to do without the intermediate level of districts. A second issue is the highly hierarchical relations among the different levels of government, following the Matruska doll model of budget structure. This model detracts from budgetary autonomy. Although there is interest, at least in the Ministry of Finance (MOF), in exploring ways to dismantle the Matruska doll model and provide for more autonomy and independence of budgets at all levels of government, the reforms brought in this area by the 2002 State Budget Law actually moved to create a stronger budget dependence of districts and communes from provincial budgets. The Law gave provincial governments almost complete freedom to organize the budgets of local governments. This measure in the State Budget Law responded to a perceived necessity to adapt to the different needs and circumstances in which provincial governments find themselves vis-vis their districts (and communes). In particular, there are significantly different levels of administrative capacity across districts and communes. The system of vertical government in Vietnam has been strongly hierarchical and the new State Budget law makes it more so. The 1996 Budget Law specified the revenue and expenditure assignments at each level of government. After five years of implementation the government decided to eliminate most of these central rules for the provinces vis--vis the local governments. Provinces have now practical freedom to organize the affairs of the immediate lower-level governments, including expenditure and revenue assignments, and transfers. 9 Even though Vietnam is a unitary country; the 2002 State Budget Law provided the system of intergovernmental fiscal relations with strong federalist features. Flexibility at the sub-provincial level can be a positive feature enhancing the efficiency of local
This low capacity at the commune level was compounded by the fact that government officials at this level were, most of the time, part-time volunteers. Recently, the GOV has extended full-time civil service status to commune officials. 9 The restrictions for the provinces, on deciding revenue and expenditure assignments for local governments in Article 34 of the 2002 State Budget Law are discussed below.
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budgets, especially given Vietnams diversity and the differences between more urban areas and rural areas in the mountain and plain regions. However, this approach is not without significant risks. By leaving it up to the provinces to arrange fiscal relations, there are fewer guarantees that central government policies will be implemented as desired. It could be argued that the new arrangements will make it more difficult for the central government to set in motion coordinated policy actions since central directives are more likely to be re-interpreted and diluted. It is quite early to determine the impact of the practically complete freedom granted to the provinces vis--vis their local governments. A lot of this information should be provided in the future from provincial expenditure reviews. But early informal reports and some information directly obtained in field trips point out some (otherwise to be expected) trouble spots. For example, the central government objectives of territorial equalization and the war on poverty may be compromised by the decisions of provincial governments to retain (or centralize) many of the revenue sources over which they have discretion and shift down expenditure responsibilities in many important areas to districts and communes. Similarly, central government efforts to increase efficiency and equity in the allocation of scarce public resources, for example by using per capita expenditure norms for the health sector are being undone by the fact that the provincial governments continue to use physical norms such as hospital beds, with all the inefficiencies and unfairness they represent. 10 It is notable that, with the most recent reforms in administrative structure, Vietnam is moving in a direction opposite to international trends. The recent international experience in unitary, and also some federal countries, has been one in which central authorities struggle to find ways to strengthen their control and extend their arms over what happens beyond the provincial (intermediate) level of government. This does not always imply greater centralization in policy objectives but, yes, more centralization in operation from the viewpoint of the control exerted by the central authorities over what happens at lower levels of government. This control (telling intermediate levels of government how they should behave vis--vis lower levels of government) is common policy in unitary countries, but much less common in federal regimes. In recent years a considerable number of unitary countries (for example, Indonesia, Poland, South Africa, and Ukraine) have abandoned the hierarchical model of vertical government structure and adopt a bi-furcated system whereby the central government authorities deal separately with provinces and local governments, and there is no direct authority between provincial governments and local governments. The main reasons for adopting this model have been political and can be summarized as a need to weaken the grip of the provinces on the local governments, either because of mismanagement in the past (e.g., Ukraine) or purer political reasons, such as the desire to contain separatist threats (e.g., Indonesia). Of course, given the typically large number of local governments, the adoption of a bifurcated system requites the adoption of automatic rules and formulas so that the central authorities can deal directly with the numerous local governments.

10

The provinces argue that they still need to use physical norms to adapt the peculiarities of their territories. Obviously, there may be a need to adapt the central-provincial per capita norms but the provinces have lacked the capacity to do so in a manner that preserves the right incentives and fairness introduced at the center.

With a combined effort to significantly strengthen local governments administrative capacity in the future, the GOV should revisit the fundamental question on the vertical structure of government. The most important question is whether the new model in the State Budget Law, which provides provincial governments with considerable discretion vis--vis local governments is yielding the desired results of a more efficient allocation of public resources because of the added flexibility, or instead, the new model is getting in the way of important central government objectives such as added efficiency, more fairness in the territorial distribution of public resources, or the achievement of objectives in central government programs such as poverty reduction. This evaluation should become a systematic part of the provincial expenditure reviews. Without trying to anticipate results, there are some reflections that need to be taken into account. First, the international average experience may get repeated in Vietnam. Intermediate level governments with a lot of discretionary power toward local governments generally have a hard time not behaving as centralized mini-states themselves by retaining the lion share of revenue sources while shifting down responsibilities for service provision and not providing adequate infrastructure outside the city capital. Second, even if most provinces in Vietnam are behaving responsibly and fairly with their local government finances, it must be noted that the effectiveness of decentralization, i.e., the gains in efficiency in public expenditures, does not arise unless decentralization is completed to the lower levels of government or even to the implementation units themselves.11 This second consideration should be weighted heavily, given the key importance of increasing the efficiency of expenditures in the entire public sector for the sustainability of the GOVs fiscal strategy. A second question on the vertical structure of government is whether a country the size of Vietnam needs four levels of government. Many countries, including large federations, seem to manage with three levels of government. Reducing the number of levels of government can save public resources by eliminating duplicate administrative services and taking advantage of economies of scale in the public sector. Thus the question is whether, by strengthening the commune governments, it will be possible some time in the future to eliminate rural districts as separate jurisdictions with their own separate budgets. Another possibility is to consider the adoption of an asymmetrical vertical structure below the provincial level and allow some provinces to eliminate the districts as budget making units. More rural provinces with very dispersed communes and low capacity would be allowed to keep the districts as budgetary units. Whether all communes have adequate administrative capacity or not, a third related issue is if some communes may be too small to efficiently deliver public services due to their inability to take advantage of economies of scale. The problems arising from small scale can be addressed through amalgamation or consolidation (voluntary or forced) of smaller communes, by promoting the associations of communes to deliver certain services, or even by outsourcing public service delivery to the private sector. The

11

The parallel decentralization process structured around Decree 10 and Decision 192 should help considerably in bringing some level of decentralization to budget implementation units. The pros and cons of this process are discussed in a separate chapter of the PER.

other possibility is to reassign certain responsibilities subject to economies of scale to the higher level governments, the districts (where kept) or even the province. Getting the territorial administrative structure right in Vietnam is important because this structure forms the underpinnings of the institutional set up under which fiscal decentralization policies take place. The basic objective underlying an efficient and sustainable design for decentralization should be to provide all levels of subnational governments with adequate autonomy to make financial and expenditure decisions and with the right incentives to operate maximizing allocative and technical efficiencies. OPTIONS FOR REFORM Study the effects on public service delivery of granting provincial governments the large degree of discretion over the public finances of districts and communes. The centralization of decentralized power at the provincial level may be having undesirable effects on the GOV objectives of greater overall efficiency of public expenditures and a fair distribution of public resources. If the provincial governments continue to follow obsolete expenditure allocation rules and norms, the advances in fiscal management represented by the State Budget Laws of 1996 and its update in 2002 are unlikely to yield the desired efficiency gains. It is also important to know: (a) whether the equalization objectives of the GOV vis--vis the provinces are being maintained within the provinces in terms of districts and communes, and (b) whether or not the quantity and quality of service delivery at the lowest levels of government are being compromised by deficient funding levels from the provincial budgets. Consider the introduction of a legislated fiscal structure for provincial governments to follow in their fiscal relation with local governments, and develop political and fiduciary accountability for local governments. Depending on the outcomes of the performance of provincial governments vis--vis local governments, the GOV may want to reconsider the policy decision made in 2002 of significantly increasing the discretionary power of provincial governments (or re-centralizing the decentralization process at the province level). The need for flexibility across a diverse territory could still be accommodated in the legislated framework by allowing different modalities of organizing sub-provincial fiscal relations. At the present time districts and communes lack any degree of budgetary autonomy. However, the benefits of decentralization can only be realized when local authorities and managers are provided with enough autonomy to perform and at the same time are made fully accountable for their decisions. Promote administrative capacity at the local level. The delivery of public services and effectiveness of decentralization policy in Vietnam continues to experience problems due to the limited technical and administrative capacity of many local governments. Local authorities need to be trained on the different aspects of fiscal management and decentralization reform, and to take the initiative and be in charge. The central and provincial governments should considerably strengthen their programs to upgrade and maintain critical levels of technical and administrative capacities at the district and commune levels.

Reconsider the optimality of four levels of government. Reducing the number of levels of government can save public resources by eliminating duplicate administrative services and taking advantage of economies of scale in the public sector. The issue is whether, by strengthening the commune governments, it will be possible some time in the future to eliminate rural districts as separate jurisdictions with their own separate budgets. The GOV could also consider the adoption of an asymmetrical vertical structure below the provincial level and allow some provinces to eliminate the districts as budget making units. Review the suboptimal size of some local governments; promote flexible cooperation/association among local governments and the contracting with the private sector. Because of the small size of some communes (and even districts) for some types of public services, the government needs to consider ways to promote the realization of economies of scale through the amalgamation of some local governments and the creation of associations and cooperation mechanisms. The goal should be to increase efficiency in the consumption and in the production and delivery of public services. Associations of local governments can be helpful in the delivery of utility services (energy, water treatment) but also for other services such as transportation and garbage collection. In addition, specialized health care is another area where economies of scale can be significant. The promotion of associative behavior by local government can take different forms, such as monetary incentives in the transfer system. The government should also promote an orderly outsourcing of local public services to be provided in the private sector, when this can reduce production costs without diminishing the quality of and access to the public services.

3. ASSIGNMENT OF EXPENDITURE RESPONSIBILITIES

CURRENT ASSIGNMENTS The 2002 State Budget Law radically changed expenditure assignments in Vietnam in one way, and in another way it left them basically unchanged. The previous assignment of public expenditure responsibilities had been approved in the Law on State Budget of 1996.12 The big change in expenditure assignments is that the new State Budget Law only lists expenditure assignments for the central governments and the provincial governments. On the other hand, the new Law on State Budget basically left expenditure assignments unchanged because the formal division of responsibilities between the central and subnational governments continues to be the same as specified in 1996. The current expenditure assignments are shown in Table 1. The 2002 State Budget Law basically leaves it to the provinces to organize expenditure assignments for the districts and communes inside the provinces. This follows the principle of granting a
12

The actual text for expenditure assignments in articles 31 and 33 of the 2002 State Budget Law is reproduced in Table A-1 in the Appendix.

great deal of flexibility to provincial governments to adapt to their diverse specific conditions. The only exception is contained in article 34 of the new Law on State Budget, which requires that townships and cities under a province must be assigned responsibilities for the construction of public schools, lighting, water supply and sewerage, urban traffic, and other public infrastructure. (Table 1 about here) Inspired in the necessity for self-sufficiency during the struggle for independence in the 1950s and later conflicts, Vietnam has kept over the years a significantly decentralized system of public service delivery. The assignment of expenditure responsibilities, which has evolved in practice over the years, is in general terms consistent with the theoretical principles of expenditure assignments. Services are assigned at levels of government commensurate with the geographical area of benefits, and broadly speaking these assignments take into account economies of scale in the production and delivery of public services. Thus, Vietnams expenditure assignments are generally consistent with the subsidiarity principle (decision-making power is given to the lowest possible level of government feasible). All this does not mean, as we discuss immediately below, that there are no important problems and issues with the assignment of responsibilities in Vietnam. Furthermore, there is a need for more information. In particular, with the new regime of broad flexibility given to the provinces to arrange by the 2002 State Budget Law there is a need to gather information on how the provinces are actually assigning expenditure responsibilities to their districts and communes.13 In terms of what subnational governments actually do in Vietnam it is important to differentiate between de-concentrated and decentralized responsibilities.14 In the case of de-concentrated responsibilities, subnational governments act as implementers of a variety of central government programs that pursue national objectives. Lacking its own de-concentrated offices in the provinces, districts and communes, the central government ministries and other central agencies need to rely on the different levels of local authorities for the implementation of these programs. These programs comprise Sectoral Programs, such as the School Rebuilding Program, and National Targeted Programs, such as the Poverty Eradication Program. The latter programs cut across several sectors. Most often in the case of delegated responsibilities, central government agencies design and fund the programs and the local authorities are in charge of implementation.
See Tables A-11 and A-12 in the Appendix for the expenditure assignments to districts and communes in Binh Duong province for 2004. 14 We should note that Vietnam does not follow the practice in expenditure assignments of some other countries which for decentralized responsibilities to local governments differentiate between own responsibilities of local governments and delegated responsibilities from the central to local governments. In the case of the former type, local governments are free to implement, regulate and they must finance them out of their general funds. In the case of the latter, the central government can regulate (for example introducing minimum standards) but it also has a responsibility to ensure funding for these responsibilities is available to local governments. Whether this approach is relevant depends on the nature of the expenditure norms adopted. As we will discus below, Vietnam uses expenditure norms just for notional budgeting purposes and they are not mandatory for local governments.
13

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A significant positive development in the 2002 State Budget Law is the prohibition of unfunded expenditure mandates from higher to lower levels of government.15 This is, in general, an important measure to improve fiscal management and orderly intergovernmental fiscal relations, but it is especially important for the current context in Vietnam with the provincial governments having practically complete freedom to assign expenditure responsibilities to the lower level governments.16 Although there have not been generalized occurrences of unfunded mandates in the past, the new provision in the State Budget law should protect lower level governments from facing new responsibilities without corresponding funding within any stability period. The share of subnational government expenditures in total (state budget) expenditures was an average 38 percent in the period 1996-2000 and rose to over 43 percent in 200102 to fall again to 37 percent in 2003 (see Table 2).17 This share in total expenditures, to judge along this single dimension, positions Vietnam among highly decentralized countries.18 From 1997 to 2004, capital expenditures at the subnational level have represented anywhere between 75 percent and 100 percent of recurrent expenditures (Table 2). In terms of expenditure composition, subnational governments have a higher presence in the State budget (central plus subantional governments), in both recurrent and capital expenditures, for public utilities (water and electricity), education and health (Table 3).19 For example, in the case of education, practically all expenditure in preprimary, primary, and lower and upper secondary education is at the subnational level. (See Table 4 for 2002 figures.) The economic composition of subantional expenditures in 2002 is, by international standards, lean on wages and salaries (28 percent of total subnational expenditures) and robust in capital expenditures (44 percent). Even for those service categories that are traditionally labor intensive, such as education and health, wages and salaries represent a modest 51 percent and 32 percent, respectively of subnational expenditures in those sectors. (See Table 5). Data are available for expenditures by province for 2002 on education, health, agriculture and transport (See
15

Unfunded mandates are reassignments or new assignments of responsibilities to subnational governments where there is no associated increase in funding to local governments to implement the new responsibilities. This issue has plagued many transitional countries from socialism as central governments have tried to shift their deficits down to local governments. This issue has not played an important role in Vietnams transition. 16 Of course, this measure does not guarantee, as discussed below, that local governments will always have assigned adequate sources of revenue for whatever expenditure functions they are made responsible for. 17 For 2004 this share is expected to fall further to 35.8 percent. The break on subnational government expenditures is apparent in Table 2. While the overall growth rate in State budget expenditures in 2003 was 19.5 percent, for subnational governments it was only 2.6 percent. For 2004, the growth rate was lower for all categories but much more so for subnational governments. The main reason for this appears to be a significant reduction in the overall equalization (supplementary) transfer. 18 Decentralization is a multidimensional concept and the share of subnational governments in total expenditures is only one of those dimensions. Whether a country is decentralized also depends, among other things, on the level of autonomy exercised by subnational governments on the composition of expenditures and their ability to raise their own revenues. As discussed below, along some of these other dimensions, Vietnam is less decentralized. 19 Subnational governments expenditures by functional and economic classification for 2002 are presented in Table A-2 in the Appendix.

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Tables A-3 to A-10 in the Appendix.)20 For education, 41 percent of expenditure is dedicated to primary education, 41 percent to lower and upper secondary, and 9 percent to preprimary. For health, most of the expenditures (81 percent) are dedicated to curative services, while in the case of transportation, 95 percent is spent on roads, and in the case of agricultures 60 percent is spent on irrigation and 8.5 percent on forestry. (Tables 2, 3, 4, and 5 about here)

SIGNIFICANT POLICY ISSUES One main problem with expenditure assignments in Vietnam is lack of clarity. The statement of expenditure assignments in the 2002 Law on State Budget is too broad and vague. A reading of Articles 31 and 33 of the State Budget Law reveals the use of the same unclear general language used to describe the expenditure responsibilities of the central and provincial governments. For example, Article 31 describes as responsibility of the central government ..regular spending on non-productive activities in the fields of education, training, health-care..and other operations managed by the central agencies. Next, Article 33 describes as responsibility of provincial governments ..regular spending on locally managed non-productive activities in the fields of ...education and training, health care .and other locally managed non-productive activities. Most other assignments in those two articles are equally unclear. One way to increase clarity and certainty in expenditure assignments is to assign exclusive responsibilities to each level of government. For example, national defense issues may be fully assigned to the central government and street lighting to local governments. However, the assignment of exclusive responsibilities is not always feasible. Some responsibilities need to be shared by two or more levels of government, as may be the case in general education or primary health. But, in general, the greater the number of co-shared responsibilities, the greater the potential for confusion in expenditure assignments. Vietnam has currently a considerable number of co-shared responsibilities, often involving the four levels of government. A way to introduce clarity in the case of co-responsibility is to be explicit in the law about the attribution of competences for the regulation, the financing, and the implementation of the responsibility. For example, in the case of general basic education this will demand a clear statement of the level (s) of government with competence to regulate (introduce standards and so on), which may be the Ministry of Education or the Peoples Councils, the level (s) obligated to finance the service, and the level in charge of actually implementing or delivering the service. This type of information is not available in Vietnam. Even in practice, it is not clear what role line ministries at the central level play to set policies, regulate or monitor services. While responsibility for the implementation of many public services has been assigned at the subnational level, the competence for regulation and financing are less clear. It would appear that policy
20

These tables show the expenditures by province in millions of VND and as percent of total expenditure in the sector by subtype of expenditure category (e.g. primary education, lower secondary, etc.).

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formulation and setting standards for services has been retained by the central government, but in many instances these are not obeyed at the local level and the central authorities lack the means for monitoring and enforcing these regulations. The financing of shared responsibilities varies the most. Another significant issue is the lack of concrete explicit expenditure assignments for the lower levels of government districts and communes. As indicated above, the 2002 State Budget Law leaves it, with very minor exceptions, to provincial governments to arrange all expenditure assignments with districts and communes within their territories. The objective pursued by this measure has been to provide provincial governments with flexibility to adapt expenditure assignments to the diverse conditions prevalent in their territories. Although the diversity argument has some merit, it is not fully convincing. In fact there are many countries as diverse as Vietnam that have managed to work with defined assignments for all levels of government.21 Overall, these recent changes have moved intergovernmental fiscal relations in Vietnam in the wrong direction. What the system of expenditure assignments in Vietnam needs is more structure, more detail, and more clarity at all levels of government. Without denying the importance of the issue of diversity of conditions within the provinces, it would be desirable to consider alternative ways to deal with this issue. But first it is important to explain why it is worthwhile to look for alternatives. Without explicitly defined and stable expenditure assignments at the district and commune levels, these governments actually are not able to exercise the most minimum degree of autonomy and independence in their budgets. It would mean next to nothing that these local governments may have assigned revenues and even stable transfers if the provincial governments can change expenditure assignments each stability period and claw back any additional resources local government may have been able to generate through the collection of local taxes and fees or even more efficient management of their expenditures. The new approach to expenditure assignments makes districts and commune governments mere appendices of provincial governments. This fact severely limits the ability of Vietnams decentralization system to pursue the GOV objective of increasing the overall efficiency of public expenditures. It is a well established fact that the most important efficiency gains from decentralization take place at those levels of decision that are closer to the citizens, such as in the case of districts and communes or even the implementation units themselves, like schools and hospitals. Thus, if it is the right thing to provide explicit clear expenditure assignments to districts and communes, how can we address the need for flexibility given not only the diversity of local governments but also their different levels of administrative capacity? One response in the international practice is to provide explicit but asymmetric assignments. Those local governments that are more developed and have greater capabilities are granted a wider scope or package of expenditure responsibilities, with
21

In fact, if Vietnams provinces are so diverse that would call for different assignments of responsibilities to the provinces themselves. However, the assignments to the provinces in the State Budget Law are uniform.

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the intermediate level of government (the province or the district as the case may be) taking the slack. But, of course, the central government would need to invest in training and capacity building at the local level so that eventually expenditures assignments at any level can be made symmetric or uniform. One of the toughest issues in expenditure assignments is how to deal with capital expenditure needs of subnational governments. One approach followed in some countries is to reserve all capital expenditure responsibilities at the central level. This is fundamentally wrong because it leads to inefficient decisions with poor matching of needs and also to lack of maintenance and interest by local governments on the centrally built infrastructure. In general, subnational governments should be responsible for the infrastructure they need to deliver the services for which they are responsible. This principle seems to be accepted in the 2002 State Budget Law. In fact, the only specific expenditure assignments to local governments are for infrastructure investments in public schools, lighting, water supply and sewerage, urban traffic, and other public infrastructure (Article 34.) However, most local governments lack the capital funds or the financial ability and sophistication to borrow for their needs for rehabilitation, replacement and new construction of infrastructure. As we discuss below, the general funding formula from the central government to the provinces (and local governments) includes funds for capital investment purposes but those appear not to be enough for the large infrastructure needs of local governments. Thus one important question that should be considered is how to mobilize the resources needed to start filling the gap for these infrastructure needs. At least part of the solution will have to be that subnational governments borrow for capital investment purposes. The new Budget Law allows subnational governments to do just that. Although for the time being there has been minimal borrowing at the subnational level in Vietnam, careful monitoring and strict rules will be needed to control this borrowing in the future.22 It is not clear either that current arrangements have taken care of the lack of maintenance problem. Infrastructure facilities, including clinics, schools, roads and irrigation schemes, are reported to be in severe disrepair across the country. It is not possible to establish how much of this problem arises from expenditure assignment issues (for example, a good deal of investment is still directly financed by the center, often compensating those where maintenance has been poor) and how much is due to the lack or resources. As in many other countries, budgetary constraints in the past often have translated into significantly reduced funding for maintenance operations.

OPTIONS FOR REFORM Clarify the expenditure responsibilities in the State Budget Law. The new expenditure assignment should strive for exclusive assignments to different levels of
22

For example, in 1994 the Government allowed Ho Chi Minh City to issue bonds to finance a road.

14

government where feasible. Otherwise, for each shared responsibility it should clearly specify the competences for: (i) regulating and establishing norms for provision; (ii) financing the service; and (iii) actual delivering the service for each level of governments that shares the responsibility. Consider the re- introduction of an explicit assignment of expenditure responsibilities for districts and communes in the State Budget Law. In order to address the diversity in each of the provinces, the new expenditure assignment could allow for asymmetric assignments below the province level to adjust for different levels of administrative capacity among districts and communes. In this way there may be two or more standard packages of services for districts and communes. The provincial governments could retain some of the functions when the implementation capacity at the local level is not present. If the principle that provinces should be able to decide expenditure assignments for local governments is retained, it will be important to retain also the practice that expenditure assignment be kept fixed during a stability period of 3 to 5 years for districts and communes. In addition, these temporary assignments should be made explicit (written.) The Ministry of Finance should conduct a periodic survey of expenditure assignment practices in the provinces. Complement the clarified expenditure assignments with the strengthening of institutions for intergovernmental dialog and coordination. Even with an explicit and clear statement of expenditure responsibilities along the lines recommended here, it must be recognized that it is generally impossible to anticipate in the law all situations encountered in delivery of services. Rather than including more and more detail and complexity in the law, one effective way to deal with these additional uncertainties is to create or strengthen institutions of coordination among agencies at different levels of government that share a particular expenditure responsibility. Holding regular meetings and providing information at all levels facilitates coordination for clarifying an effective assignment of expenditure responsibilities. Delimit the role of governments in private sector activities. The most fundamental step in expenditure assignment is to clearly delimit the role of government vis--vis private sector activities. Defining and implementing the proper role of the public sector in Vietnam still remains a challenge. Ideally, all levels of government should concentrate exclusively in the delivery of public services. At the present time, all levels of government in Vietnam are deeply involved in private sector activities. This poses risks for the misuse and waste of public resources. Public officials everywhere are notorious for their minimal understanding of business matters. As the private sector of the economy grows, the central authorities must promote the concentration of subnational governments exclusively in public sector activities. In theory, government intervention could only be justified where the private sector cannot do a better job because of market failure or overriding social equity objectives.

15

4.

REVENUE ASSIGNMENTS

CURRENT REVENUE ASSIGNMENTS The revenue assignments in the 2002 State Budget Law distinguish three types of revenue sources: taxes assigned 100 percent at the central level, taxes assigned 100 percent at the local level, and shared taxes between the central and subnational governments. 23 The lists of taxes under each category areas follows.24 The tax revenues assigned 100 percent to the central government include export tax and import taxes, VAT and excises on imports; taxes and other revenues from the petroleum industry, and corporate income tax on enterprises with uniform accounting. Shared taxes between the central and provincial governments include all VAT receipts with the exception of VAT on import goods, corporate income tax with the exception of receipts from enterprises under the whole-unit accounting system, personal income tax, tax on profits remitted abroad excluding tax on overseas remittances of the petroleum industry, excise taxes on domestic goods and services; and gasoline and oil fees. The State Budget Law does not specify the sharing rates. These sharing rates are uniform for all shared taxes for each province and they can differ by province and are calculated as part of the budget process at the start of each stability period of at least three years. The calculation of the sharing rates is discussed below. Before the 2002 State Budget Law the shared taxes were VAT, enterprise income tax, personal income tax, remittance tax.25 The 2002 Law added two additional taxes, special consumption taxes and gasoline and oil fees, to the list of sharable taxes. The tax revenues assigned 100 percent to the local government level include land and housing taxes, natural resource taxes excluding those on petroleum activities, license tax, tax on transfer of land use rights, fees on land use, land rent, revenues from the leasing and sale of dwellings publicly owned, and registration fees and other fees and charges.26 As in the case of expenditure assignments, the most significant innovation in revenue assignments introduced by the 2002 State Budget Law with respect to the revenue
What in Vietnam is called taxes assigned 100 percent at the local level in other transition countries is called local or subnational own taxes. The advantage of Vietnams approach is that it does not create the illusion, as is the case in other transition countries, that subnational governments may have control over those taxes simply because they are assigned 100 percent to them. When there is no autonomy at the local level and all decisions on policy are made at the central level, it is more correct to talk about taxes assigned 100 percent at the local level than about local taxes. 24 For the complete listing in articles 30 and 32 of the 2002 State Budget Law, see Table A-1 in the Appendix. 25 Note that revenue sharing arrangements between the provinces and local governments (districts and communes) for these taxes was left to the discretion of the provincial governments even prior to the amendment of the Law on State Budget. 26 Until recently local governments also had assigned to them the tax on agricultural land use. This tax has been abolished mostly to help poor rural families.
23

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assignments in force since 1996 is that revenue assignments are now stated only for the central governments and the provinces. In the 1996 Law, there were also explicit revenue assignments (100 percent assigned revenues) at the district and commune levels. But even though the Law gives the provinces discretion to set the revenue assignments for the districts and communes, article 34 of the 2002 Law provides some general principles and minimum standards the provinces need to follow in designing revenue assignments for local governments:27 the budgets of communes and townships should receive at least 70 percent of revenues from the tax on transfers of land use rights, land and housing taxes, license tax on individuals and individual households, and registration fees for land and housing. 28 the budgets of townships and cities under a province should get at least 50 percent of revenues from registration fees, excluding registration fees for land and housing. Vietnam has an unusual revenue sharing system. As indicated above, the revenue sharing rate is the same for all shared taxes but it differs by province. In addition, the revenue sharing rate is determined by formula. The formula estimates the gap between expenditure needs (estimated on the basis of norms) and revenue capacity (estimated on the basis of past revenues).29 In the stability period ending in 2004, the sharing rate (which again applies to all sharable taxes) for the group of 56 poorest provinces was 100 percent. For the other 5 provinces the sharing rate changed once between 1996 and 2004. From 1997 to 2000 the provinces sharing rates were: HMC 15%, Hanoi 23%, Van Toa 27%, Dinh Siung 16% and Dong Nai 33%. These rates were increased across the board in 2001, under a new stability period that lasted until 2004, with the rates being HMC 24%, Hanoi 30%, Van Toa 48%, Dinh Siung 52%, and Dong Nai 53%. This generalized increase in the sharing rates for 2001-2004 was to compensate the provinces for the increase in public employee salaries.30 The two additional taxes (special consumption taxes and gasoline and oil fees) added to the list of shared taxes in the 2002 State Budget law and effective in fiscal 2004 increased the number of surplus provinces from 5 to 15. The current revenue sharing system in Vietnam represents a significant improvement over the regulation system that prevailed prior to 1996.31 However, it is notable that the
See Tables A-11 and A-12 in the Appendix for the revenue assignments to districts and communes in Binh Duong province for 2004. 28 The tax on the use of agricultural land collected from households originally in this list has been abolished. 29 The transfer system is discussed in the next section. 30 As we discuss in the next section the compensation to the 56 poorest provinces for the salary increases was in the form of an increase in the general equalization transfer. 31 The system of regulation was a form of revenue sharing quite prevalent in transitional countries from planned socialism, whereby central governments negotiated different sharing rates for a number of taxes with the provincial governments. The results were different sharing rates by tax by province, instability, and negative incentives to collect taxes at the subnational level since any additional revenues collected were likely to be clawed back by the center by the annual downward adjustment of some sharing rates.
27

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Vietnamese system contrasts with the revenue sharing system used in many other countries. Typically, in the international practice, sharing systems have sharing rates that are standard and uniform across all provinces, while equalization is achieved through a system of equalization grants. In Vietnam, the different sharing rates across provinces are used for equalization purposes. The two systems are quite comparable. One may argue that a system like Vietnams that leaves 100 percent of revenues of all shared taxes in the poorer provinces gives a greater incentive to mobilize revenues by subnational governments than a system with standard sharing rates. However, using standard rates and equalization grants based on tax capacity and expenditure needs should also promote incentives for revenue mobilization in an adequate way. On the other hand, when there is considerable unevenness in the distribution of the tax bases it can be extremely hard to arrive at satisfactory uniform sharing rates for certain large taxes such as the VAT and the enterprise profit tax. The advantage of Vietnams approach is that it allows for lower sharing rates for those jurisdictions with higher revenue potential. In Vietnam, all tax collections are centralized. The General Taxation Department collects all domestic taxes with offices that extend through the provinces and the districts, and the Customs Department collects all taxes falling on imports. One problem with centralized tax collections is the potential lack of incentives that central government bureaucrats may have to mobilize and collect local revenues. But in Vietnam, like in other countries in transition to a market economy, tax collection and revenue mobilization issues are quite complex due to de facto dual subordination of tax administrators to the central administration and the local authorities. This latter means that provincial and local officials can have a recognizable influence on the decisions and activities of tax administrators.32 The important role played by local incentives to collect taxes is captured by the practice of letting local authorities retain a share of the collections above the targeted amount for taxes. The surplus collections retained at the local level include not only local and shared taxes but also those assigned 100 percent to the central government.33 The retention rate is 100 percent for Hanoi and HCM City and 30 percent for all other provinces.34 The actual collections from the different revenue sources of subnational governments for 2002, the most recent year available, are shown in Table 6. The data are
32

For example, it is not unusual for the provincial authorities to provide bonuses to the tax administrators with a better performance in collections. Provincial authorities also usually provide office facilities, housing and other amenities to tax inspectors and other officials of the central government tax administration agency. 33 This system of incentives is a realistic measure that has contributed to more revenue mobilization at the subnational level and obviated the need to create subnational tax administration agencies, as has been done in China. But the system of incentives has not been without its own problems. There is considerable evidence since the incentive system was introduced that local governments tend to underestimate their revenues in the proposed budgets and that this problem has gotten worse since 1996. See Vietnam: Managing Public Resources Better. Public Expenditure Review 2000 Volume 2. A Joint Report of the government of Vietnam-Donor Working Group on Public Expenditure Review, Hanoi.) 34 There is no good justification for the preferential treatment given to the two largest and richest areas of the country in this respect. By all appearances this was not a minor concession of the National Assembly to the lobbying power of Hanoi and HCM City. Not surprisingly, a common ongoing demand from other provinces is to have their retention rates raised to 100 percent.

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presented by province, total revenues and per capita revenues, for 100% assigned taxes, shared taxes and transfers. The figures show considerable differences across provinces in their abilities to raise taxes. For the case of 100% assigned taxes, the best of province raises 761,000 VND per capita (HCM City) and the worst off 37,000 VND (Ha Nam), or a multiple of 20. In the case of shared taxes the difference is even more pronounced with Ba ria Vung Tau raising 1.378 million VND per capita and Bac Giang 29,000 VND per capita, or a multiple difference of 47. It must be noticed that in the latter case of shared revenues the disparities across regions get dampened by the choice of lower sharing rates for richer regions through the formula applied by the Ministry of Finance.35 (Table 6 about here) Not surprisingly, there are also large variations in the composition of revenues. On total, for 2002, subnational governments received 23 percent o total revenues from 100% assigned taxes, 23 percent also from shared taxes, and 54 percent from transfers (Table 7). The balance is from fees and other miscellaneous sources. The average figures are a bit more slanted toward transfers (18 percent for 100% assigned taxes, 18 percent for shared taxes, and 63 percent for transfers). However, these figures hide quite more pronounced extremes in revenue composition. The lowest contribution of 100% assigned taxes to an individual provinces total revenues is 3.3 percent, and for shared taxes is 2.3 percent (Table 7). At the other end, the largest contribution of transfers to total provincial revenues is 94 percent. This is practically the profile of Bac Can province. This compares to HCM City where less than 9 percent of total revenues comes from central government transfers. (Table 7 about here) In terms of (consolidated) state budget revenues (central and provincial governments combined), the provincial governments share for 2002 was 25 percent.36 This share has oscillated mildly up and down 25 percent in the 1997-2002 period (see Table 2). The expectation is that provincial revenues will grow faster than central revenues and that by the end of 2004 about 30 percent of state revenues will correspond to provincial governments.37 SIGNIFICANT POLICY ISSUES The first issue is that the change in approach in the 2002 State Budget, which basically eliminated explicit revenue assignments at the district and commune levels, is moving the system of intergovernmental fiscal relations toward more unpredictable financing. There are some advantages to this approach to revenue assignments between provincial and local governments. It may provide provincial governments with budget
35

But even then, there is more variability across provinces in terms of shared tax revenues per capita (coefficient of variation 1.21 in Table 6) than in revenues per capita from 100% assigned taxes (coefficient of variation 0.86). 36 Of course, this figure excludes central government transfers to provincial governments. 37 This will be helped no doubt by the two additional taxes, special consumption taxes and gasoline and oil fees, added to the list of sharable taxes starting in 2004.

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flexibility, the ability to adapt to the particular circumstances in the province, and it may allow for high levels of equalization, which may be hard to reach when there is a concretely specified revenue assignment. But clearly, the lack of concrete revenue assignments also imposes costs on subnational governments. First, the approach deprives subnational governments of revenue autonomy, which in turn diminishes the efficiency and fiscal accountability gains associated with fiscal decentralization. The approach may also deprive subnational governments of revenue certainty and predictability, which makes budgeting and planning over time much less efficient. The negative impact on certainty and predictability is partially controlled by the practice of stability periods, by which the provinces fix revenue assignments for local governments for periods of three years or longer. The lack of written specific assignments may lead to unfair outcomes since richer and larger jurisdictions may be able to cut better deals with the upper level government authorities. The lack of concrete assignments at the sub-provincial level also can create negative incentives for the subnational governments for revenue mobilization and for increased tax collections. Note that this effort may come through their own taxes and fees or by contributing to the better administration and enforcement of shared taxes with the central government. The fundamental reason is that the practical lack of rules for revenue assignments leaves it open to upper level governments to claw back any increased revenues or even enhanced expenditure efficiency by local governments. The experience of other countries is that the lack of formal assignments may also lead to institutional friction and dissatisfaction between provincial and local governments. There is some evidence in field trips that provincial governments do claw back revenue gains by districts and communes in the reassignment of revenues at the beginning of each new stability period. But for the time being, there is no information on the incentive effects of this practice. It is also interesting to note that, by reverting to a system of revenue assignments with unspecified assignments at the sub-provincial level, Vietnam is going against the trend in many other countries in transition where it has become more common policy to establish explicit, stable and uniform assignments including sharing rates between the different levels of government including local governments. The second issue of importance with current revenue assignments in Vietnam is the lack of any meaningful degree of revenue autonomy (in the sense of being able to increase revenues at the margin) by subnational governments. In Vietnam, the authority to introduce taxes, change the structure of existing taxes as well as to fix their rates has been retained fully by the central authorities. The only form of tax autonomy for local governments that currently exists is the ability to introduce tolls for roads, as well as certain fees, for example, for schools and hospitals. The issue of tax autonomy is a difficult one for many governments, especially those in unitary political systems. There is often political resistance to devolve taxing powers below the center and there may be even the perception that the equal treatment of citizens requires a completely uniform tax system in the entire country. However, the

20

benefits of fiscal decentralization in terms of greater expenditure efficiency can only arise if local governments become accountable and able to responsive to the needs and preferences of citizens of taxpayers. The most effective way to provide budgetary accountability and responsiveness is by granting local governments a meaningful degree of tax autonomy. Through local tax autonomy taxpayers become more aware of the costs of services and local officials actions are subject to closer scrutiny by taxpayers. Not all forms of tax autonomy are desirable. For example, it may be counterproductive for the development of the market economy to allow subnational governments to introduce their own taxes or be able to modify the structure off existing taxes. The former can lead to highly inefficient or distortionary choices of taxation and the latter may increase compliance and administration costs and make domestic commerce more difficult. The simplest best form of revenue autonomy is to let local governments select tax rates for at least one significant source of revenue, probably between minimum and maximum rates stated by the National Assembly or parliament. In this way taxing powers are merely delegated in a controlled manner and the lack of uniformity in taxation can be a voluntary democratic decision of local residents and be linked to local needs and preferences. The exercise of some degree of tax autonomy at the local level has some other benefits besides promoting accountability and efficiency. In particular, providing a meaningful degree of tax autonomy at the local level is the simplest and most effective way to address the issue of vertical imbalances (the mismatch between expenditure responsibilities and funding made available to different levels of government, an issue that is discussed in the next section). It is important to note that greater tax autonomy at the local level may also bring some side problems, such as an increase in horizontal (local government to local government) disparities. But there are tools, for example, equalization transfers, that can be employed to deal adequately with these issues (these issues are also discussed in the next section). A third set of important issues with revenue assignments in Vietnam is related to the selection of the type of tax and the mechanisms currently used for tax sharing. As we saw above, all important taxes are shared between the central government and the provinces. These include the VAT, the corporate profit tax, the personal income tax, and starting in 2004 two new taxes, special consumption (excise) taxes and gasoline and oil fees, to the list of sharable taxes. Shared taxes represent one of the most important sources of revenue at the subnational level. Tax sharing (as opposed to own revenues, that is assigned 100% and with some discretion on rates) tends to break the link between the benefits and costs of public spending. Therefore, some view revenue sharing as a factor promoting general fiscal irresponsibility and discouraging tax effort at the local level. But a more important issue in the short run is that the mechanism used for tax sharing, the derivation principle (splitting revenues between the central government and the subnational jurisdiction where revenues are actually collected), introduces several serious problems. These are particularly acute for some taxes, such as the VAT and the enterprise or corporate profit tax. In the case of the VAT, the general use of the derivation principle leads to an unfair distribution of resources since the VAT can be credited and debited in different

21

and far-flung local jurisdictions.38 For example, if the enterprise has production facilities (not independent units) in other jurisdictions, VAT is paid exclusively in the jurisdiction where the headquarters of the enterprise is located. In more concrete terms, these problems tend to help large official cities (Hanoi or HCM City) and more industrially developed provinces (for example, Binh Duong and Hai Phong) where it is more likely that the headquarters of enterprises will be located.39 The use of the derivation principle for sharing VAT revenues also can lead to market protectionism by subnational governments with negative implications for national economic development. Revenue sharing of this type encourages local governments to get further involved in market activities, offer special advantages to business and try to create artificial barriers to internal domestic trade. In order to make the VAT neutral with respect to the spatial allocation of production inputs as well as consumption, it is generally agreed that the VAT should operate according to the destination principle. This means that VAT should be levied and received by the local government where consumption takes place (destination basis), as opposed to where the goods are produced (origin basis). But, this would require the very undesirable introduction of internal borders to tax commodities being imported into the jurisdiction and to zero-rate those that are being exported. These difficulties have led other countries to centralize VAT revenues, as most recently has been the case in Russia, Ukraine and Kazakhstan. These countries now distribute VAT and other central government revenues through a formula-based system of equalization transfers and other grants. Other countries have used instead a direct formulary approach to the sharing of VAT with local governments, as in Germany, on a per capita basis, and in Canada with the Maritime Provinces, on the basis of statistical estimates of the final consumption of taxed items in each jurisdiction.40 In the case of the corporate income tax, sharing on a derivation basis also presents some problems. The sharing of this tax with local governments is further complicated by how apportionment of the revenues is carried out in practice. In Vietnam it appears that the effective sharing of the CIT by the central government with the provinces is by the place of registration or the headquarters of the enterprise. This can be a source of unfairness since enterprise activities, and consequently the consumption of local public services, many times take place in jurisdictions other than the one where the enterprise is registered. Thus, the current system would benefit the richest and most industrialized
38

Note that the potential problem of collecting and crediting VAT for exports is solved in the State Budget Law by assigning these revenues 100% to the central government. 39 It could be argued that the unfair sharing of tax revenues may not matter much in a system like Vietnams because whatever additional revenues the more industrialized jurisdictions get, these may be taken away by the formula used to determine tax sharing rates and then these funds may be given to the poorer provinces through increased transfers. In a sense, the current system of finance works that way, but the redistribution is always incomplete and tax sharing tends to be seen by local governments as a more stable and predictable source of revenue. 40 A third alternative is the creation of regional VATs. Long thought to be unworkable, several approaches have now been suggested in the public finance literature which, in theory, would allow for the functioning of subnational VATs. Introducing regional VATs in Vietnam would not be advisable because of the still developing tax administration and the need to strengthen the administration and enforcement of the central VAT.

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cities and provinces. 41 However, this problem is mitigated in Vietnam because the corporate income tax on enterprises with uniform accounting is centralized.42 Finding a remedy to this unfairness is not an easy task. A first solution to the problem is simply the centralization of all revenues from the corporate profit tax. The recentralization of the corporate income tax (as 100% assigned to the central government) may not be feasible from either a political or a budget perspective. Another solution, less preferable but nevertheless workable, is to share the revenues from the CIT proportionally across local governments where the business operates using an apportionment formula. The types of formulas used in other countries typically approximate the share of the enterprise income in a locality by a weighted average of several factors, which include the enterprises share of labor, sales, and even assets in that locality vis--vis the entire country. There is no exact way to arrive at an apportionment formula and basically all apportionment formulas present problems; practically, the final choice on the formula is the result of a political compromise. But even though apportionment formulas are far from perfect, the final sharing of tax revenues is fairer. Although the personal income tax is a much more appropriate tax to be shared with local governments, the apportionment of the personal income tax at the local level may also present problems in urban areas where workers live in one jurisdiction and work in a different one, as may be the case for example between HCM City and Bing Duong Province. The main issue here is that personal income tax withheld by enterprises on wage income is paid at the place of work rather than at the place of residence. However, in general, the personal income tax should be paid in the place of residence because that is where taxpayers consume most local public services. Achieving the switch of revenue sharing from the place of work to the place of residence requires that workers report to their employers in a verifiable way their place of residence and that employers and the administration authorities, perhaps through the treasury system, apportion the funds to local jurisdictions according to the residence principle. The two new taxes added to the list of sharable taxes starting 2004, special consumption (excise) taxes and gasoline and oil fees, may also lead to problems with unfair apportionment is these taxes are paid at origin by the factory or importer rather
There are, in addition, several other reasons why the corporate income tax is not a good tax to share with local governments. This tax represents one of the most unstable sources of revenue and for that reason is much less suitable for local governments. Central governments can address sudden budget deficits by issuing debt, while most local governments cannot. Therefore sudden downfalls in tax revenues tend to be much more damaging for subnational budgets. Also the corporate income tax is likely to be exported to (paid by) individuals in other local jurisdictions, which may induce collective fiscal irresponsibility by local government officials. The tax base of the corporate income tax is also less evenly distributed than are most other taxes, which tends to increase horizontal fiscal disparities at the local level and make the design of a fair system of intergovernmental fiscal relations more difficult. 42 Uniform accounting means that for enterprises with branches, the entire accounting is carried out at headquarters and that taxes are paid at headquarters. However, this is not of general application since in practice the list of enterprises with uniform accounting (for the effects of the State Budget Law) is decided by the Ministry of Finance. The current list includes only eight electric companies, six official banks, Vietnam Airlines, Vietnam Railways, Vietnam Post and Telecom, and Vietnam Insurance Corporation.
41

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than at destination where those commodities are purchased and consumed. In addition, the problem of market protectionism and distortions of industrial policy will arise when excise taxes are shared using the origin principle. It becomes clear why, in the case of excises on tobacco and alcohol, every province would like to build its own cigarette factory as well as brewery and distillery. A last set of issues has to do with the use of fees and charges at the subnational level. Fees and charges have become a more relevant issue because of the significant role given to these sources of revenues in Decree 10 and Decision 192 toward the administrative decentralization of service implementation units.43 Local fees and charges are important from a revenue assignment viewpoint because in effect they provide local governments (or their implementation units) with some degree of revenue autonomy. However, in the overall context of revenue assignments, this source of revenue continues to be rather small. For education, parents now contribute to the costs of schooling by paying for textbooks and by paying a school fee which increases with the education cycle. Fees and charges are also common in health services and most patients have to pay for their medicines. Revenues collected by fees are typically retained by the facilities concerned such as hospitals and schools, but reporting is deficient and the revenues are not always used for the maintenance and operation of schools and clinics. Subnational governments have discretion to set fees for water, sewerage, and solid disposal services.44 Fees are also charged for irrigation and transport. At the commune level, local residents contributions in cash and in kind contribute to the maintenance and improvement of rural roads. Often, fees and charges are insufficient to cover the cost of service delivery for basic services. In the case of water services, wastage due to lack of maintenance has made full cost recovery measures more difficult. Lack of metering makes cost recovery more difficult. It also preempts the selective disconnection of services as a credible threat to enforce payment by individual users. The judicious use of charges and fees can increase efficiency and reduce wastage in government operations. However, there is also a down side to this policy, especially for social services when user charges are not based on ability to pay. The otherwise desirable use of user charges requires that government policies pay more attention to service coverage of the poor, in particular what implications this may have for access by the poor to basic services in education and health. Since these issues are discussed elsewhere in the PER, they will not be discussed any further here.

43

As indicated previously, these two important norms are discussed in an accompanying chapter of the PER so the main issues they raise are not addressed here. 44 Electricity tariffs are set by the central government.

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OPTIONS FOR REFORM Here we review some of the options that can be considered by the GOV to improve revenue assignments. However, the reform of revenue assignments in general will require seeking a balance and coordination within other elements of the system of intergovernmental fiscal relations, especially transfers. In the case of Vietnam, the reform of revenue assignments will also require coordination with tax policy and tax administration reform. For example, it may be desirable to keep overall tax effort at the same level at the same time local governments are granted a meaningful degree of tax autonomy. Provide explicit revenue assignments to local governments: Even though there may be some advantages to a flexible unwritten approach to revenue assignments for local government, the disadvantages (from uncertainty, instability, negative incentives, potential arbitrariness, and so on,) clearly outweigh any potential advantages. Ultimately, the reasons one can use for an explicit assignment between central and provincial governments, something the GOV does in the 2002 State Budget Law, are identical to those that justify an explicit assignment between provinces and local governments. Increase revenue autonomy at the provincial and local levels: Reforming revenue assignments and tax laws to give local governments a higher degree of tax autonomy should be a priority in the medium term. Increased revenue autonomy will be a good way to address existing vertical imbalances and more importantly to increase the efficiency and accountability of local budgets. As argued above, the least costly way to provide revenue autonomy, in terms of compliance and administration costs and interference with the central governments ability to maintain macroeconomic stability, is to confine local tax autonomy to choosing the tax rate levels of a closed list of local taxes with common tax bases throughout the national territory. In this regard the taxes assigned to the local level should exhibit several properties. First, local taxes should encourage the link between payment and benefits received in order to improve political accountability and help match the demand and supply for public services at the local level. Second, local taxes should tend to be more equally distributed geographically to avoid creating large horizontal disparities. Third, they should not be exportable, in order to encourage responsible fiscal behavior. They should have immobile bases in order to minimize the distortions created by their impact on factor location. Finally, local taxes should be quite stable over time and in particular exhibit low sensitivity to the business cycle because of the lower ability of local governments to finance deficits. There are probably no taxes that can completely exhibit this list of desirable characteristics and at the same time provide adequate revenue for local governments. But it needs to be clear that not all taxes are created equal for their assignment to local governments. There are better and worse choices that can be made in the assignment of local taxes in the face of these desirable features. In the actual international experience, the PIT and property taxes are the two most frequently used taxes to provide revenue autonomy to local governments. Some countries also rely, but much less so, on the
25

taxation of consumption at the local level in the form of sales and excise taxes. The most obvious choice to provide subnational governments with some degree of tax autonomy is to develop a piggyback flat rate personal income tax for provincial governments, and potentially also for local governments. This option would be more meaningful for larger local governments only. Provincial governments will be free to adjust the flat rates between a minimum and a maximum fixed by the National Assembly. Local governments could be given the option of introducing or not their piggyback flat rates also up to a nationally legislated maximum rate. Another form of bringing some degree of revenue autonomy at the provincial level is the use piggyback taxes or surcharges on the special consumption (excise) taxes on alcohol and tobacco. This will definitely require the adoption of a destination principle (which would be needed anyway for the fair apportionment of shared collections for this tax.) A common way to accomplish the introduction of a destination principle for these taxes is to require the use of stamps at the factory or point of importation for each consumer unit of the product to be sold in each jurisdiction. Provincial governments would be free to introduce up to a maximum rate their own piggyback excises. To avoid serious incentives to inter-provincial contraband the maximum rate should be kept within limits. Note that piggyback taxes on the VAT and corporate income tax should be avoided because of the administrative complications, exportation of the taxes, and other reasons The best choice to develop tax autonomy at the local level (districts and communes) is to start preparing for the introduction of a modern real estate property tax. However, any property tax will take time to yield significant revenues. The key to the successful introduction of the new real estate property tax is a fiscal cadastre, fair and efficient valuation or appraisal methods, and a fair and transparent administration of the tax, including efficient appeals procedures. Some local governments have asked for more tax autonomy to administer these taxes. In field visits, local authorities expressed the opinion that there would be a comparative advantage for local governments to collect these types of taxes. Another way to enhance local tax autonomy associated with the real estate tax is to regulate the voluntary introduction by municipalities of betterment or improvement levies. These are surcharges to the property tax that local governments may approve within their jurisdictions, as one time or multi-year charges, for improvement directly benefiting certain homeowners, such as improvements in street lighting, sidewalks and so on. These levies have become common in many developing countries and in some cases represent a significant source of revenue for local governments. A final possibility for promoting local tax autonomy is the introduction of taxes on motor vehicles. This source of revenue, of course, would be for some time be only relevant to local governments in richer urban areas of the country. Address the current problems with the apportionment of shared taxes: Possibly

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the most serious problems with the apportionment of shared taxes are those associated with the VAT. There are two possible solutions here. The first is to completely centralize revenues from the VAT. This is the solution adopted in recent years by many other transition countries, including Russia, Ukraine and Kazakhstan. The centralized revenues could be used by the central government to finance an increase in the pool funds available for equalization, perhaps under a new formula-driven approach as discussed in the next section, or to strengthen the system of conditional grants to ensure minimum standards in critical social services (education and health) or to increase the funds available to all subnational governments for capital infrastructure.45 The second solution is to apportion the VAT revenues, now shared with provincial governments on a derivation basis, by using one of several fairer and more transparent alternatives. These include the sharing on an equal per capita basis or the sharing in proportion to estimates of final consumption in each jurisdiction. In response to the problem of an unfair apportionment of the corporate income tax, the GOV could also consider the complete centralization of these revenues, or at least significantly expand the current list of units that carry out uniform accounting, which in effect would also centralize those revenues according to the 2002 State Budget Law.46 An alternative solution is the introduction of a formula for a fairer apportionment of corporate profit tax revenues. Following international practices, this formula could originally be based on the geographical distribution of the enterprises payroll. Later on the formula could include information on the geographical distribution of assets and/or sales. We must note that there is no ideal formula to distribute corporate profit tax revenues fairly. The use of a formula is a second best approach once it has been decided that this tax will continued to be shared with the provinces. Because revenues from the personal income tax should and will continued to be shared with the provinces, the GOV should consider adopting the principle of sharing these revenues with local government according to the place of residence of workers, where most local services get consumed. Rationalize the current system of fees: There will be a need to normalize user charges at the local level. Further attention must be given to the fact that the use of fees and user charges, much enhanced by the introduction of Decree 10 and Decision 192, may de facto deny access and exclude from service consumption the poorest groups of
The possible centralization of VAT revenues is a good example of a policy measure that may require coordinated policy action beyond the issue of revenue assignments. Besides the use of funds for strengthening the transfers system, this type of measure may also require to consider changes in expenditure assignments. However, note that changes in expenditure assignments may not be at all necessary if, for example, the re-centralized revenues from the VAT channeled back to subnational governments through different transfers. 46 Centralizing VAT and corporate income tax revenues may be considered excessive because of the perception that revenue sharing with some problems is preferable to a much bigger importance of transfers as a subnational government revenue source. However, it should be remembered that revenue sharing is just another form of transfers, which in this case apply a particular formula, the principle of derivation basis, for distribution. But, as we noted the results obtained from the application can be considered unfair to many provinces and distorting to economic activity.
45

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citizens. This would be counter-productive and could severely undermine the government objectives for redistributing income and for fighting poverty. One solution is to use, where feasible, lower fees for the poor. A more general and preferable solution is to rely on income support programs for the poor that include need arising from higher services fees. The solution the GOV had devised recently to help the poor in the health area is also a good alternative.47 In general, user charges need to be further rationalized, brought into the open, be made official, regulated, and controlled.48 Actions in the area of tax administration: At this stage, there is no need for the creation of subnational tax administrations in Vietnam. The first priority in the area of tax enforcement and collections should continue to be the modernization and strengthening of the national tax administration and customs service. However, the de facto dual subordination of tax administrators to local authorities may create conflicts of interest now or in the future, especially in the richest provinces and cities that get less than 100 percent of shared revenues or if some taxes like the VAT are completely centralized. To regain control of tax administrators the central government needs to fund adequately the budget needs of the state tax administration and avoid having the provinces and local governments contribute in any way to the operations of the central government tax administration agency. Other measures, such as the regular geographical rotation of the agencys personnel would also help in regaining full control of the agency by the central authorities. As provincial and local authorities lose control over tax administrators, the GOV should consider ways to introduce other institutional arrangements for keeping central tax administrator incentives in collecting provincial and local taxes or those 100% assigned to subnational governments. In a more distant future when tax autonomy is introduced at the provincial and local levels, the GOV should also start thinking about the creation of separate provincial and local tax administrations. The objective should be to develop the role played now by the tax collectors into full fledged local tax administrations in charge of collections of all local taxes and fees, with the exception of those that would piggyback on national taxes. This could be done on a pilot basis.

5. THE SYSTEM OF TRANSFERS

FISCAL IMBALANCES No design of a decentralized system of finance does ever reach a perfect balance between expenditure assignments and revenue assignments. Like most other countries where decentralization is taking place, Vietnam suffers from fiscal imbalances. Horizontal imbalances can be caused by differences in local economic activity, wealth or
47

Decision 139 and Decree 30 develop provincial funds to provide free medical services for the poor and those close to the poverty line with a substantial budget. 48 See the accompanying report on Decree 10 and Decision 192 for a detailed discussion of these issues and recommendations.

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resource endowments. For example, HCM City and Hanoi have larger tax bases per capita than other provinces in Vietnam. Horizontal fiscal imbalances also may appear because of differences in expenditure needs. The differences in needs may arise from either different prices or costs of service provision due to geographical or climatic conditions or from adverse demographic profiles because of groups of population with special needs. For example, it is likely that the unit costs of provision for most public services are higher in the mountain regions than in the coastal regions of Vietnam. Horizontal imbalances can be enlarged from physical and institutional impediments to population migration or the mobility of capital across provinces, and from government policies that implicitly or explicitly favor some areas of the country over others.49 The typical measure of horizontal fiscal imbalance involves the comparison between fiscal capacity measures and expenditure need measures. The typical remedy for horizontal fiscal imbalances is a system of equalization grants. As described below, Vietnam has a system of equalization grants (the balancing transfer), which is able to reduce otherwise significantly larger horizontal disparities. However, significant disparities still remain after transfers. As shown in Table 6 the large disparities in public funds arising from the assignments of shared taxes (coefficient of variation in per capita revenues of 1.21 and a difference between maximum and minimum per capita values of 47 fold) and from taxes assigned 100% (coefficient of variation in per capita revenues of 0.86 and a difference between maximum and minimum per capita values of 20 fold) are significantly reduced after transfers. Total revenues per capita (also in Table 6), which include revenues from transfers, show a coefficient of variation of 0.42 and a difference between maximum and minimum per capita values of less than 5 fold.50 Thus, significant equalization takes place but substantial disparities remain. Vietnam, also like most decentralized countries, suffers from vertical fiscal imbalances. Vertical imbalances arise when the revenue sources assigned to each level of government do not broadly correspond to their assigned expenditure responsibilities. These include not only central-provincial relations but also provincial-local relations. Vietnam is not different from many other developing and transitional countries undergoing decentralization in which, at first sight it would appear that all levels of government have expenditure responsibilities and needs that exceed their revenue sources. However, measuring the lack of correspondence between expenditure responsibilities and available sources of revenue is made difficult by the ambiguity surrounding measures of expenditure needs. These measures differ depending on the

Internal migration and regional industrialization policies have played more significant roles in countries like China and the former Soviet Union than in Vietnam. 50 We should note that fiscal horizontal disparities across provinces actually could be much more pronounced than those shown for shared taxes in Table 6 since it must be remembered that while poorer provinces can keep 100 percent of those revenues, richer provinces are allowed to keep just a portion. If data on total collections per capita (for all taxes) were available across provinces they would show a much higher coefficient of variation and dispersion of values between maximum and minimum values.

49

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quantity and quality of services, and those responsible for the public services naturally most of the time would like to improve both dimensions.51
Vertical imbalances have been sometimes associated with the existence of structural budget deficits at a particular level of government; for example, whether budget deficits have been persistent at the central level and not at the local level. But this is an imperfect measure because, by law and practice, in most countries budget deficits have been consistently higher at the central than at the subnational level. Local governments in many countries are not allowed to run deficits and in some cases they are not allowed either to borrow for capital spending. A more accepted and sound approach to measuring vertical imbalance is to identify the ability of different levels of government to finance expenditures from their own sources of revenues. The attraction of this type of measure lies in the fact that the most effective way to address vertical imbalance is to provide each level of government with their own taxes and enough autonomy on the tax rates (if not the base) so that they can make their own decisions regarding overall revenues and therefore what services to cover and at what level. In short, it would make it so much harder to talk or protest about a mismatch between expenditure obligations and available revenues if every level of government has its own autonomous way to raise revenues.52 In practice, this approach to measuring vertical fiscal imbalance is to compute the share of local government expenditures that cannot be financed with sources of revenues over which local governments have discretion or autonomy. By construction, this coefficient of vertical imbalance takes values between zero and one, with values closer to zero indicating a smaller vertical imbalance, and values closer to one indicating larger vertical fiscal imbalance.53 Ordinarily, there is no agreement on the definition of sources of revenues over which local governments have discretion or autonomy. If we take it to mean at least the ability to change the rates of a tax, then we can conclude that there is a substantial vertical imbalance in Vietnam against subnational governments. As we have seen, the provinces, districts and communes have extremely low levels of tax autonomy. In a less strict sense of the definition for vertical imbalances, in particular if we include 100% assigned taxes and shared taxes as forming part of the sources of revenue over which subnational governments have discretion, then vertical fiscal imbalances are less serious in Vietnam. In practice, most central governments, Vietnams included, attempt to close vertical imbalances by increasing transfers, including revenue sharing measures.

51

Several approaches can be used to reduce that ambiguity. One approach is to prepare a listing of standards (or norms) for the provision of public services at all levels. The norms can be quite general or exhaustive and detailed. A more complex approach is to measure the expenditures required for explicitly stated and agreed upon levels and quality of public services and, finally, compare them to available resources for each level of government. 52 This argument implies that there is also an adequate level of equalization to allow poorer governments to afford standard levels of service provision. 53 It must be noted that this measure of vertical imbalance is not without problems. There is disagreement on the concepts applied to the formula, including the type of expenditures and revenues. It is at times difficult to clearly establish what is not controlled by subnational governments.

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CURRENT SYSTEM OF TRANSFERS

Horizontal and vertical imbalances are generally addressed through a system of transfers. However, transfers are also used by central governments in the pursuit of other objectives, including for example, national priorities in particularly targeted sectors or to address spillovers or externalities across subnational boundaries. Vietnams system of transfers is not very conventional but nevertheless plays a key role in the final outcomes from decentralization. Here are its main elements. Equalization transfers: The so named Balancing Transfers from the central government to the provinces in Vietnam are designed to increase the financing viability of poor provinces. The balancing transfers are unconditional grants, determined using some sort of formula, and which remain fixed in nominal terms for the usual stability period of three years. In essence, the methodology used for the determination of the equalization transfer still follows that used for the subventions given in the old Soviet budgeting system to those jurisdictions where approved expenditure budgets exceeded the sum of own revenues and the 100 percent retention of all shared revenues. However, the current system of equalization transfers in Vietnam has improved in some significant ways from the gap filling ad hoc negotiated transfers used in the past. An important improvement is in the explicit methodology or formula used to arrive at the amount of the transfers, which cuts down the role of bargaining and makes outcomes more objective.54 The formula uses the difference between estimated expenditure needs and revenue capacity or potential. The estimation of the revenue potential used in the formula has not evolved much. With the exception of the important concept of the stability period, the derivation of revenue potential for the local government follows the traditional steps in the old Soviet budgeting system. Expected revenues for the local government are determined by the local branch of the tax administration on the bases of the actual revenue collections of the previous years, taking into account any tax policy changes applicable in that year and the expected economic growth during the year. Often direct estimates of revenue forecasts for large enterprises in the jurisdiction are added to these three elements. The overall revenue estimates are presented to the Peoples Committee of the corresponding level of government. The minimum expenditure needs of the local government are derived of the basis of the prevailing system of expenditure norms, 55 and are supposed to cover all current expenditures (salaries, operation and maintenance, and so on) and (some minimum amount of) capital expenditures.56 The norms are adjusted for different regions depending on geography and remoteness. The significant improvement vis--vis past practices is in the nature of these norms. As we discuss below, prior to 1996 these norms reflected physical standards and basically they were unaffordable and therefore inapplicable. Currently, norms
54

Note that this formula used for the determination of equalization transfers to the poor provinces is also the same formula used, in theory at least, to derive the customized tax sharing rate for the rich provinces, which we discussed under revenue assignments above. In a way, Vietnams equalization transfer formula has some of the features of a Robin Hood or fraternal system where the rich contribute to the equalization pool by forgoing revenues from shared taxes. 55 The expenditure norms are discussed in the last section of the paper. 56 Capital grants are discussed below in this section.

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are primarily specified as money amounts per capita and they are affordable for current budgets. Although these norms could be improved in a number of ways, their application helps produce an overall acceptable measure of expenditure needs in the equalization formula for equalization grants in Vietnam. Another improvement over the ad hoc negotiated equalization grants of the past is the use of a stability period of three years. The approach of using stability periods helps most with the control or reduction of the negative incentives provided to provincial governments by the equalization transfer methodology currently used. As noted above, the current formula states that the higher the revenues raised by the provincial government, the lower the equalization transfer (or tax sharing rate for the surplus provinces). Because the transfer is computed once only at the beginning of the stability period, local governments may feel freer to exercise higher tax effort in the years within the stability period. The stability period also avoids, at least in intervals of three years, the constant coming and going of provincial officials trying to negotiate with the Ministry of Finance a better deal for their jurisdictions. The use of the stability period has the additional benefit of providing provincial governments with more stable and predictable sources of revenues. These potential benefits of the stability period have led the Ministry of Finance to consider the extension of the stability period to four years and even to five or more years after the introduction of a Medium Term Expenditure Framework at the central level. Provinces appear to implement a system of balancing or equalization transfers that is similar to that of the central government with the provinces. However, at the provincial-local level there are no explicitly written rules or methodology. This keeps with the 2002 State Budget Law principle of providing the provincial governments with flexibility to address the local finances of their districts and communes. To arrive at the equalization transfers for districts and communes,57Provincial governments also compare local government forecast revenues from 100% assigned taxes and tax sharing with estimated expenditure needs. National norms, modified by the provincial governments, are used to estimate expenditure needs. From the field visits, it would appear that provincial governments are still using physical norms that were long ago abandoned by the central government. Provincial governments also implement stability periods of three years with their local governments, which means that the equalization transfers are set the first year and remain at the same level for the other two years. Although there is information on the level of equalization achieved at the centralprovincial level, there is no information on how much equalization takes place within the provinces. The rhetoric from the provincial finance departments in the provinces visited did put emphasis on equalization but this could not be verified with actual data.58

57

One of the consequences of the flexibility (and preeminence) given to the provincial governments in the 2002 State Budget Law is that the hierarchical role of the district government toward the commune government has been diminished, if not entirely suppressed. It appears that, at least in the provinces visited, the provincial budget finance department sets fiscal rules not only for districts but also for the fiscal relations (including balancing transfers) between districts and communes. 58 The field visits to districts and communes showed in some cases local budgets that were quite short of revenues for their assigned functions and with little or no revenue sharing of any significant taxes by the provincial government.

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Conditional or targeted transfers: There are two types of conditional grants in Vietnam. In the first group there are transfers for the implementation of national programs, such as those for the poorest communes, reforestation, or the national health program. There are also conditional transfers in this group that are specifically designed for a particular province. For example, Hue holds a festival every four years and for this motive it receives a targeted transfer for the beautification of its historical sites. Another example is the targeted transferr to Hanoi to provide housing for retired national leaders.59 The amounts for all these types of transfers appear explicitly in the annual budget. These targeted grants work pretty much in the same way as conditional transfers in international practice. The provinces need to qualify for the program according to some explicit rules but, in general, there no formulas for the distribution of funds. The transferred amounts are not constant within the stability period. Subnational governments have the obligation to use the funds for the stated functions in the targeted transfer program. Often, the transfers are passed through the provincial budgets to their final recipients (either lower levels of governments or implementation units, such as hospitals and clinics.) In this sense, there are no separate conditional transfers or targeted grants between the provincial and local governments. The practice of matching grants, whereby the central government leverages its resources by covering only a share of the project costs with the rest to be covered by the subnational government, is not common in Vietnam. But, in recent times the government has started to make use of this tool.60 The second type of conditional grants is essentially some form of emergency grants from the central government to the provinces to cover unplanned or unexpected expenditure needs. A recent example was the funds provided to some provinces to palliate the economic effects of the aviary flu. By the nature of these transfers, obviously they cannot appear itemized in the annual budgets. The funds come from the central governments Contingency Fund. Capital transfers: Vietnam does not have an explicit separate system of capital transfers. The bulk of the funds that can be used by subnational governments for investment in capital infrastructure is supposed to come from the balancing or equalization transfer, although some of the conditional grants funds (for example, the school construction program) are also for investment in infrastructure. Here is how funds for capital investment are factored in the equalization transfer. The National Assembly in the consolidated budget states the overall capital expenditure needs, which for 2004 were fixed at 28 percent of the budget. This is the factor the Ministry of Finance uses to gross up the expenditure needs factor in the calculation of the equalization grant. In particular, the Ministry adds up all the recurrent expenditure needs from the application of the expenditure norms and any other adjustment factor and then it divides the total by 0.72 (= 1 - 0.28). The result is the total expenditure needs of subnational governments, which now include the estimate of capital expenditure needs.61 It must be noted that these funds (notionally for capital investment) are
59

In contrast to national targeted programs, the special targeted program is typically solicited by proposal of the beneficiary province and, after consultations with the Ministry of Finance and National Planning Agency, it needs to be approved by the National Assembly as part of the annual budget. 60 For example, the central government has recently agreed to finance 50 percent of a provincial road in Hai Phong. 61 Since the richer provinces do not get an equalization grant, they do not either get funds explicitly for their capital expenditure needs. However, it must be remembered that the computation of the tax sharing rates for the richer provinces (those getting less than 100 percent sharing rates) involves the same formula and procedure as the computation of equalization grants for the poorer provinces. Therefore, the sharing rate so

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unconditional, as the rest of the equalization grants, and the provincial governments can use them for any purpose besides capital infrastructure.

SIGNIFICANT POLICY ISSUES

The system of transfers in Vietnam is quite unique in international practice, especially how equalization is performed in integration with the tax sharing system and in the determination of capital transfers. Despite its peculiarities, the system of transfers has performed satisfactorily. There are a number of features, however, that could be improved.

Let us start with the equalization transfers. On the side of the determination of expenditure needs, although there is the appearance of objectivity in the derivation of transfers, there is a still a good deal of negotiation and ad hoc adjustment. The adjustments are generally done to achieve greater equalization, such as the priority given to the highlands, or they may be in response to particular needs, but the system would be more transparent if it were to use an explicit formula and only the formula for the calculation of needs. The role of negotiations appears to be more important when it involves the donor city-provinces; i.e. those that do not receive any transfers and which contribute to funding the system by receiving revenue sharing rates below 100 percent. Again the system would be more transparent, and possibly fairer, if the negotiations were ruled out by using an explicit formula. There is much more negotiation still involved at the sub-provincial level, with uncertain results in fairness and equalization. Another issue in the estimation of expenditure needs is that, although considerable progress has been made by the introduction of per capita expenditure norms to approximate the expenditure needs at the central-provincial level, many provinces still use the old physical standards or norms, such as number of staff in the measurement of expenditure needs for districts and communes. This type of norm leads to negative incentives in expenditure decisions, such as hoarding excess capacity. On the revenue side of the equalization methodology, negative incentives to revenue collections and expenditure efficiency remain. Although the methodology currently used is an improvement over past practices, it still sends signals to subnational governments that greater revenue mobilization will be met with reduced equalization transfers (or lower tax sharing rates, for the richer provinces.) It must be emphasized again that the revenue estimates that enter the calculation for equalization transfers are actual revenues, and even though these estimates are frozen in time for a stability period of three years, the message to local governments is that the more you collect over a period of this stability period, the less you will get in transfers in the next period. It could be argued that the negative incentives toward revenue mobilization are minimized because all provinces but fifteen share all the major taxes at 100 percent. However, this argument ignores that if the territorial unit collects more in shared or own taxes, then it may get less than the 100 percent of revenue sharing (and of transfers) in the future. As we argue in the recommendations below, the revenue estimates used in the formula
determined is supposed to leave equivalent funds for the capital expenditure needs of these richer provinces.

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preferably should be based on some form of revenue capacity (i.e., the potential to collect revenues on the bases of the actual economic bases and current legislation). Using a tax capacity measure means that local governments do not get penalized for exercising a greater tax collection effort. The determination of the overall level of funding for equalization purposes is still non transparent. The Ministry of Finance indirectly limits the level of transfers by fixing in nominal terms the expenditure norms used in the computation of expenditure needs. Budget affordability is further ensured because the expenditure norms are fixed in nominal terms for a number of years. However, it would be more desirable for the entire process to rest on rules, both for the determination of the overall pool of funds to be distributed and for how the funds will be distributed, at the provincial and sub-provincial levels. However, macroeconomic and overall budget balance conditions may demand continued flexibility in the determination of the overall level of funding.
By using stability periods, the current methodology provides more predictability in local budgets but, this approach also carries some risks especially if, as announced, the stability periods are to be expanded to four, five, or even a larger number of years. Since the equalization transfers are fixed in nominal terms at the beginning of each stability period, subnational governments may fall short of adequate funding in high inflation scenarios or if their ability to raise revenues falls and their expenditure needs rise sharply during the stability periods. It is true that the central government does have the ability (and it does in practice as discussed above) to come to the rescue with emergency or unplanned targeted grants out of its contingency fund but, this type of action may not be feasible for the nearly 50 provinces that receive equalization grants. Thus, if the problem with incentives on the revenue side is addressed by making use of fiscal capacity measures, the GOV should reconsider abandoning the concept of stability periods, and its extensions to a larger number of years.

One last word in equalization transfers should be dedicated to the need to structure transfers at the sub-provincial level. A more objective, transparent and formuladriven system of transfers at the sub-provincial level, should promote increased revenue mobilization and greater expenditure efficiency at the local level. As discussed in more detail in the next section, there are two possible approaches for addressing this issue. One approach would be to bypass the intermediate level government from any type of fiscal authority over local governments, and put in place direct revenue sharing rules and formula driven transfers from the central government to the local governments as well. Of course, this could be an option for the districts but definitely not one for the communes. A second approach would keep the current hierarchical relationship between the intermediate level and local governments, but this relationship would be fully structured or mandated in the law with explicit revenue sharing rules and formula driven transfers. In summary, although the current equalization system represents a significant improvement over past practices and provides some advantages (e.g., more revenue certainty for local government) it still does have some important flaws. A new improved system of equalization transfers in Vietnam, besides allowing for central government

35

policy flexibility and macroeconomic stability, should at the same time perform better in terms of incentives, transparency and objectivity. Let us now turn to conditional grants. As reviewed above, Vietnam has a budding conditional grant program based on the special budget allocations for the national targeted programs. An important task ahead is to fully build a conditional matching and non-matching grants program for both recurrent and capital expenditures, that is based on well defined explicit sectoral policies with assigned roles for design and supervision of the line ministries.62 In particular, the introduction of a selective system of conditional matching grants can be effective in promoting national priorities at the local level, leveraging local funds and effort. Funding for the additional conditional grants could come from the re-centralization of some taxes, such as the VAT, but it could also come from funds now allocated to line ministries. Last, a few comments on capital transfers. The current methodology for capital transfers, using the 0.28 factor in the equalization grant, is attractive in its simplicity. The methodology has the advantage of avoiding endless negotiations and discussions on the valid merits of a large number of provincial projects and it may be fairly equalizing (given that the base, the recurrent expenditure norms, are primarily per capita norms.) However, it is a rough approximation of any one provinces capital expenditure needs, and in particular does not take into account any measure of capital infrastructure deprivation across provinces. Clearly, given the different levels of economic development across provinces, the per capita expenditure needs are unlikely to be proportional. The fact that the funds for capital investment are actually unconditional provides flexibility to subnational governments but it can also make it more difficult to develop much needed social and economic infrastructure and other national priorities. OPTIONS FOR REFORM The GOV should consider in the medium term the reform of the system of transfers in Vietnam along two sets of activities: First, the upgrading of the current balancing transfer methodology to a full formula-driven system of equalization grants, including a stable and explicit formula used to distribute the funds and possibly an explicit and stable rule to establish the pool of funds. The formula should equalize fiscal disparities among local governments on the bases of expenditure needs and fiscal capacity. The second activity will consist of the strengthening of the conditional grant system for pursuing national objectives through well defined sectoral policies in sectors such as education and heath, with and without matching provisions. These conditional grants can also be used to fund capital infrastructure programs.

If the GOV decides to introduce minimum expenditure requirements for some delegated responsibilities, conditional grants may also be an effective way to guarantee adequate funding.

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Upgrading the equalization grant system.63 The essence of an equalization transfer system is to compensate for fiscal disparities that arise from differences in fiscal capacity and/or expenditure needs. On the one hand, tax capacity should ideally be measured by the size of the tax bases available to subnational governments or the revenue that these tax bases would yield under standard tax rates. A variety of methods is used around the world to measure fiscal capacity of subnational governments. These include per capita income, gross regional product, and statistical methods to calculate the amount of revenue that a local government would collect if it were to exert average fiscal effort by applying the average tax rate for the entire country to the respective standard tax base of the local government (a methodology known as the representative revenue system. The latter more sophisticated methods would be certainly needed if Vietnam were to proceed to give the provinces and local governments some measure of tax autonomy or discretion. It could be argued that, since at the present time there is no tax autonomy at the local level, there is no need for calculating tax capacity. However, even if provincial governments do not have discretion over policy, they have, as we have seen, discretion over tax administration effort, through the dual subordination of tax officials. The expenditure needs of a local government can be defined as the funding necessary to cover all expenditure responsibilities assigned to the them at a standard level of service provision. In practice, this can be measured from the bottom up with norms or by using some type of index of relative expenditure need as the weighted sum of demographic factors as proxies for expenditure needs (e.g., population, the young and the elderly, the level of poverty and unemployment, and so on) and differences in the price level or cost of living. As pointed out above, the per capita norm approach currently in use does a reasonable job of measuring expenditure needs, and given the familiarity in Vietnam with this approach, there would be little to be gained by switching to a relative index methodology.
The use of an explicit rule for the determination of the pool of funds to be used for equalization purposes would increase the transparency and predictability of the system of equalization transfers. A common rule used in many countries is to fixed the pool as a share of central government revenues, where some types of revenues may be excluded. This measure would be more important if the reforms were to discontinue the use of stability periods. If an explicit rule for the determination of the pool of funds were adopted, the norms used to estimate expenditure needs would have to be redefined to be affordable within that pool.64

Strengthen the system of conditional grants. The GOV should explore the further development of conditional grants to pursue their national policy objectives and to induce local governments to spend more on particular sectors through the use of conditional matching grants, which, in effect, lower the effective price for local governments for these services. These approaches may be preferable to the introduction of obligatory
Space limitations impede any detailed presentation of potential reform alternatives. For a discussion of possible alternatives, see Jorge Martinez-Vazquez (2002) Improving the Design of Fiscal Decentralization in Vietnam. A Report Prepared for the Ministry of Finance, Hanoi. 64 Note that, in a way, the current use of norms by force implies a particular pool of funds used for equalization, but the size and derivation of this pool is now done in a non transparent way.
63

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minimum expenditure standards because they allow the central government to impose their preferences while subnational governments are able to exercise their rights to make their own budget decisions. Conditional grants are best implemented (when feasible) on a capitation basis (i.e., per student and per inhabitant).65 The per capita basis could be modified, if needed, by some adjustment coefficient to reflect different costs of provision or needs, but only as long as these adjustments can be made by formula and do not involve negotiation among central and local authorities. The needs arising from different levels and/or quality of infrastructure can be addressed also through conditional grants disbursed, when feasible, using a formula or objective criteria.66 Phasing in and managing a new system of transfers. An important decision in the reform of the system of transfers is whether to introduce reforms cold turkey or whether to phase-in the reforms over a period of years to smooth out the transition to the new regime. A more gradual approach would typically make the changes in regional funding more politically acceptable, since it would give time for local governments to adjust. Drastic changes in the system of transfers and the overall level of funding can hurt local governments ability to carry out longer term plans, may create uncertainty, and may increase political friction, destabilizing the reforms. A final consideration is the need to formalize the management and upkeep of a new system of transfers. There is from the start a need to collect better statistics and improve the existing ones. There is also a need to update, from time to time, the equalization formula, introducing changes in the mechanism to keep it within its objectives, and to maintain a dialogue with the subnational governments and other stakeholders in order to guarantee the required political support for the sustainability of the system. This task may require exclusive attention and dedication within the Ministry of Finance.67

6. BUDGET PROCESS: AUTONOMY, THE USE OF NORMS, AND TRANSPARENCY AND ACCOUNTABILITY
The different aspects of the budget process (at all levels of government) are regulated in the 2002 State Budget Law. By constitutional mandate, the National Assembly needs to approve the entire state budget, which includes the central government budget and the consolidated budgets of all subnational governments (provinces, districts and communes). This section focuses on several aspects of the budget process particularly relevant to the well functioning of Vietnams decentralized system of finance: the exercise of budgetary autonomy by subnational governments, the use of norms in the budget formulation process, and transparency and accountability.

65

The use of conditional grants on a per client basis will not actually be a radical departure from current budgetary practices, given the role that per capita budgetary norms play now in the actual budget process. 66 Care should be exercised not to fund more local governments with better and more modern facilities. This would be adding the inequity of providing less operating funds to those jurisdictions with already more inadequate physical facilities. 67 Some countries, such as Australia, India, and Nigeria, have also used, in some cases very successfully, the institution of a Grants Commission. The Commission is a semi-autonomous institution at the central government level, which is exclusively charged with the administration and upkeep of the transfer system. But this type of approach would not appear to be needed in Vietnam.

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BUDGETARY AUTONOMY As in the case of other unitary countries, all subnational budgetary authority in Vietnam is delegated by the central government. However, the delegation of authority can be performed with quite different degrees of autonomy. The important point is that the benefits of decentralization will not accrue unless a minimum degree of budgetary autonomy is achieved. Budgetary autonomy is a multidimensional issue, which requires a great deal of institutional development and which may take some time to accomplish. Therefore, it is important to develop a medium or long-term strategy for reform in this area. Some of the most important dimensions are as follows Separation of budgets. In a decentralized system, efficiency requires that local governments are able to plan and approve their own budgets separately from those of the central government or any other upper-level government. This is far from being achieved in Vietnam because, as just pointed out above, the Constitution still mandates that the National Assembly must approve the entire State Budget, which includes the budgets of the provinces, as well as districts and communes.68 Constitutions are difficult to change, and indeed they should not be changed frequently, but on the other hand, it will continue to become increasingly obvious in Vietnam that the National Assembly has very little to say or add to the budgets of communes and districts and in most cases to the budgets of the provinces. There is also a timing inconsistency in the entire budget process. Lowerlevel governments depend heavily on the decisions, such as transfers, from the upperlevel governments, but the lower-level government budgets need to be approved before the upper-level budgets get approved. One clear advantage of the separation of budgets is that local governments could approve their own budgets even if the upper-level government fails to approve its budget in a timely fashion. The separation of budgets also empowers subnational councils and promotes fiscal responsibility and horizontal accountability. The limitations associated with the lack of separation between budgets at different government levels were aggravated by some changes in the budget process introduced in the 2002 State Budget Law. In particular, the provisions that give provincial governments practically a free hand to arrange the budgets of districts and communes goes in the opposite direction of separating the budgets of different levels of government. Clearly, the need to respect the constitutional mandate - that the National Assembly must approve the consolidated State Budget - does not require the current level of budget interdependence, which practically eliminates any notion of budgetary autonomy at the district and commune levels. At some point in the medium term, the GOV should think about jettisoning the Matruska doll model of budget organization. This will eventually require amending the
Each level of government has its own budget, but the budget for each level of government has to be approved not only by its Peoples Council but also by the Peoples Council of the upper-level government. Thus, the budgets for the communes are approved by the districts, those of the districts by the provinces, and the provincial budgets by the National Assembly. In this way the budgets of the communes are approved four times. This methodology still follows the nested Matrushka doll model of the former Soviet Union.
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Constitution by eliminating the requirement that National Assembly approve the consolidated State Budget, inclusive of provincial government budgets. Local governments (districts and communes) should also have their own separate budgets without previous approval by the provincial governments. Revenue autonomy at the margin. Local budget autonomy requires that local governments be able to increase and decrease the size of their budgets by using their own revenue sources, including taxes.69 The issues of revenue assignments and tax autonomy were discussed above, but it is important to make clear here that local budgetary autonomy is not possible without some meaningful level of discretion granted to subnational governments to change the rates of some taxes. Predictability of revenues. To enjoy budget autonomy, local governments need a sufficient degree of stability and predictability of revenues and expenditures. The introduction of stable rules and formulas, with explicit and stable revenue assignments at the sub-national level, are critical to increase budget predictability and certainty. However, by providing the provinces with complete freedom to arrange assignments of revenues and expenditures, the intergovernmental finance system has moved toward more negotiation and uncertainty. Sufficient discretion in expenditure decisions. Local budget autonomy also requires that local governments have discretion in making expenditure decisions according to their own priorities and in deciding what is the most cost efficient combination of inputs to deliver public services. Subnational governments in Vietnam are subject to some minimum expenditure requirements in the areas of education and science, but these requirements are not exceedingly constraining and therefore do not impinge significantly on local expenditure decisions. The most serious limitation on expenditure authority came until recently from the lack of employment and pay scale flexibility. Salaries can represent over 80 percent of total expenditures for many local governments, and formally the central authorities control pay scales and the number of job positions at the local level. Pending a full reform of the civil service at the subnational level, the recent changes introduced by Decree 10 and Decision 192 provide decision units with subnational governments with more discretion over jobs and even overall compensation.70 First, the elimination of the soft budget constraint for local governments, so that the central government budget does not get saddled with expenditure liabilities incurred at the local level. Subnational government budget constraints have hardened quite considerably in recent years but there are still elements of discretion and negotiation in the formulation of transfers and revenue sharing. Second, the introduction of strong horizontal accountability systems of local authorities to their constituents, so that subnational officials are more inclined to make fiscally responsible payroll decisions

69

Note that autonomy does not require that local governments be able to finance 100 percent of their expenditures from their own sources. Revenue autonomy only requires that local governments be able to increase or decrease their revenues at the margin. 70 See the accompanying PER report by Christine Won for a discussion of these two measures.

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Detrimental role for dual-subordination. For local budgetary authority to be effective, local budget or finance officials need to respond exclusively to local authorities. So far, Vietnam has kept the traditional Soviet system of dual subordination of local finance officials to the local government and to the Ministry of Finance. But if there is to be budgetary autonomy, finance and other officials at the local level need to be exclusively subordinated to the local authorities for whom they work. Note that this change in policy may eventually require that the interests of the central government in the provinces and districts may be carried out by central government de-concentrated offices, separate from the decentralized governments. This latter is now the case with the deconcentrated offices of the central tax administration agency.71 Providing incentives for the right local choices. In a workable decentralized system of finance, the central government needs to find ways to induce local governments to pursue national objectives which are not invasive of subnational budgetary autonomy. The worry typically is that in voluntary systems the decentralization of public services with national significance may not be taken as seriously by local governments and, therefore, that they may spend less than is (nationally) desirable. A non-invasive way to address this type of concern is to use conditional matching grants, whereby the central government induces subnational governments to spend more on particular items of national importance. Some central governments also choose, as is the case of Vietnam, to impose minimum expenditure requirements on local governments in those areas of national importance. Currently, there are only two types of minimum expenditure requirements imposed on local governments in Vietnam: (i) local governments will need to spend 18 percent of their budgets on education by 2005 and 20 percent in 2010; (ii) local governments need to spend 2 percent of their budgets on science and technology. These levels are enforced at budget approval time by the National Assembly. It is less clear how well the actual performance is monitored. These minimum expenditure requirements are not particularly invasive given the special importance of education. The extension in the use of expenditure requirements (as opposed to conditional grants) would be detrimental to local governments discretion and autonomy to make their own expenditure decisions.

71

Although, as noted before in the case of the tax administration agency , there is practice of dual subordination in reverse, by which the control of central government tax administrators is weakened by their responsiveness to the priorities of local governments.

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THE ROLE OF NORMS Expenditure norms figure pre-eminently in the formulation of subnational budgets. In particular, these norms are used to determine expenditure needs of local governments, and therefore whether local governments get an equalization transfer and, if not, how certain taxes will be shared with the central government. An interesting feature of budgetary norms in Vietnam is that they are used only for budget formulation purposes and are not to be obeyed in the budget execution of local governments. That is, budgetary norms are not used as minimum expenditure requirements for subnational governments. Until recently, subnational government budgets were formulated on the basis of a set of norms for seven types of expenditures covering seven types of expenditures: education, health, culture and information, sports, radio broadcasting and general administration (Ministry of Finance Circular 38). The recent budget reforms have expanded the set of norms from 7 to 11. The four new norms cover expenditures in social safety net, defense and security, and economic services. The norms allow for different costs of service provision in budget formulation by using coefficients that adjust the basic norm up or down according to four groupings of regions.72 The existing norms for the most part are efficiently defined in per capita or per client basis and they seem to have been affordable. However, there are still some problems, such as, for example, the use of population, as opposed to number of students, as the basis for education needs. Clearly, the age distribution of population can change significantly among local jurisdictions, thus using a population criterion will punish those jurisdictions with a proportionally higher share of children of school age. In addition, the education norm adds salary as an additional criterion for determining expenditure needs in education.73 This complicates the norm unnecessarily since any differences in salaries across regions should be already incorporated in the regional cost multipliers that are used to modify the basic norm. The current budgetary norm for administration expenditures based on the number of staff is also problematic. This sets negative incentives to add to the payroll, or more importantly not to downsize it, where it could be more efficient. The budgetary norms for economic expenditures (sanitation, road repair, irrigation and so on) should also be re-examined. For example, using the norm length of roads as the basis for the transport budget tends to favor richer more developed provinces. Besides the budgetary norms, there are first many physical and staffing norms that are regularly issued by the line ministries in education, health and so on. Often these regulatory norms are ignored at the subnational level due to the lack of resources to implement them and because the line ministries lack monitoring capacity. Second, in addition to the budget norms used at the center by the Ministry of Finance vis--vis the provincial budgets, the actual allocation of funds by the provincial governments to their units and for the formulation of budgets for districts and communes are actually based on a set of separate budget allocation norms, which can be quite different from those used
72

The basic principles set by the Ministry of Finance for budgetary norms are that the norms need to be affordable and that they must provide a reasonable level of equity among local governments in order to ensure a minimum level of public services to citizens regardless of where they live in the country. 73 Salary has a minimum weight of 0.2 and population a maximum weight of 0.8.

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by the Ministry of Finance. The use of different identification criteria can sometimes have important consequences. For example in the case of health, the budget norms for transfer and revenue sharing is on a per capita basis, while the budget allocation norm in most provinces seems to be on a per-hospital-bed basis. The number of beds is an inferior choice because it is unfair (it pays more to those jurisdictions with built-in capacity) and because it creates perverse incentives (by paying jurisdictions to increase the number of beds or keep them even when there is clearly excess capacity.) This approach discourages the closing down and consolidation of inferior and inefficient institutions. However, the differences between the two sets of norms do not always have negative consequences. Similarly, for education, the budget transfer norms use the criterion of population, the budget allocation norms may use the criterion of number of students, which is more appropriate. The important question here is whether Vietnam should keep explicit budget norms for the formulation of local budgets. On the whole, the answer is yes because the particular way in which Vietnam has been using budgetary norms offers clear advantages and just a few disadvantages. Furthermore the latter could be avoided with just some effort. Budgetary norms have facilitated budget formulation and provided a useful quantification of expenditure needs. In addition, the Ministry of Finance has been successful in avoiding the worst possible trap in the use of norms, that they become unaffordable. What needs to be avoided is using criteria that can lead to inefficiencies in expenditure policy. Thus at some point soon, the GOV should review again the criteria used at the central-provincial level and seek to introduce a per-student norm in education and other per-client based norms. This review should include the norms used at the subprovincial level to try to avoid the use of physical norms and the adoption of client based norms there too. If there is no need any longer for the stability periods, the GOV should consider the revision of the budgetary norms every year making sure that they are affordable and also consistent with the new budget priorities.

TRANSPARENCY AND ACCOUNTABILITY For decentralization to work it is required that systems of vertical accountability (to central government authorities), which are predominant in centralized systems, be substituted for systems of horizontal accountability to subnational government councils and to local residents themselves. For this accountability to exist, government budgets need to be transparent and fully accessible to citizens, and budget decisions need to be subject to public scrutiny and influence. Proper scrutiny of subnational budgets paired with voice institutions help ensure that government officials are accountable and eventually more responsive to the needs and preferences of residents, which represents the essential advantage of a decentralized system of governance over centralized models. There is an ongoing effort in Vietnam to enhance the transparency of government budgets and policies, thereby increasing accountability. This trend has been apparent

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since the approval of the 1996 State Budget Law and has been enhanced with the new 2002 State Budget Law. The 2002 State Budget Law states that the budget plans, budget final accounts, and auditing results of the central budget, the local budget, budget planners, and organizations financed by state budget, must be made public.74 It has become common practice to publicly announce budgetary policies, such as expenditure and allocation norms, budget processes, budget figures, data, and materials related to annual budget planning.75 The final accounts for executed budgets at all levels of government are also made public. In addition the powers of the National Assembly and the Peoples Councils have been enhanced concerning approval of budget and monitoring of their execution. Another important component of government accountability is proper internal control and external audit of the public accounts. Here also there have been improvements. The Treasury is now solely in charge of internal control and audit of public accounts at different levels of government through the district level. The role of the State Audit Agency has been strengthened to conduct external audits covering all state budget revenues and expenditures. The audit results are reported to the National Assembly and the auditing reports must be made public in accordance with the Governments regulations. Despite the significant advances in budget transparency and publicity, Vietnams subnational governments have some way to go to achieve the desirable level of transparency and accountability. The discretion provided by Decree 10 and Decision 192 to budget implementation units raise additional challenges in this area. The development of a comprehensive national accounting system in close line with international practices to be used by all budget spending units would represent a significant step forward. There is also a need to issue regulations on procedures for the publicity of auditing reports prepared by the State Auditing Agency. It must be noted that much of the work done so far has concentrated on the publicity of budgets (preparation, approval, implementation and audit), and most of it as it applies to the central government. So far, there has been insufficient attention given to how to increase participation and accountability to local residents, and how to increase monitoring of provincial, district and commune budgets. Ultimately, budget accountability will require political accountability and fully contested elections of local government officials. Sound local self-governance and governments accountability

To implement this stipulation, the Ministry of Finance has been preparing the draft of the (amended) Rules on Finance Publicity to be submitted to the Prime Minister for his decision. The planned amended Rules shall require the publication of most of the targets determined by the NA and Peoples Councils and targets that are assigned by the Prime Minister and sub-national Peoples Committees to budget planners, including targets that have never been made public before. 75 In 1998, for the first time the budget revenue and expenditure figures were published on the Annual Statistics Book issued by the General Statistics Office. Decision 182 of 2001 stipulates the content, timing and format of the publication of the state budget. The Ministry of Finance prepares annually a comprehensive report on the budget publicity implemented by budget planners of the central and provincial budgets. For 2002, 58 provinces sent their publicity reports to Ministry of Finance.

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require citizen voice regarding quantity and quality of services and the representation of their preferences in budget decisions and priority setting. Finally, external audit has been a weak aspect of the budget process at the national and subnational levels in Vietnam. However, important reforms were initiated in 2003, when authority over the external ex-post audit function carried by the State Audit Agency was transferred to the National Assembly. Until then, the State Audit Agency had not been independent of the executive authority. The external audit office at the provincial level should similarly respond to the provincial Peoples Council. Parallel arrangements should be used at the district and commune levels. A less frequent, but equally important function for budget oversight, is the evaluation of budget performance. This function is complementary and needs to be performed side-by-side with ex-post audits which focus on financial aspects and compliance with established budget rules. Budget evaluation, which focuses on budget performance and outcomes, can be carried out by the legislative and executive branches of government. Performance measurement or ex-post evaluation of expenditures as compared with budget program targets and outcomes exist neither at the central nor at local levels. It must be recognized that the evaluation function requires skills and practice and will take time to be introduced. Budget evaluation practices should start first at the central, and perhaps provincial, level. A first step in this direction is to change the general budget formulation philosophy in Vietnam from the current input-oriented approach, which builds incrementally on the resource allocations of past years to an approach that is driven by goals, outcomes and performance.

7.

SUBNATIONAL GOVERNMENT BORROWING

Disciplined access to credit can be an appropriate source for financing subnational government capital investments for those expenditure responsibilities that have been assigned to them. The use of borrowing to finance this type of activity is justified because of the bulkiness of some projects and the lack of liquidity of subnational governments, and because the repayment of credit over time represents a fairer distribution of infrastructure costs among the different cohorts of users during the useful life of the infrastructure. However, borrowing at the subnational level is risky because local officials can be easily tempted to overspend and to try to shift the repayment of debts to future governments and taxpayers. Therefore, there is a need for balance between access to borrowing by subnational governments with institutional mechanisms that preserve fiscal discipline. Internationally there are two types of control mechanisms that are relied on: first, a set of rules and regulations for subnational borrowing established and enforced by central government authorities; second, private credit markets discipline. Because the second mechanism requires developed private financial markets, most developing countries, including Vietnam, rely on rules and regulation set by the central authorities. The current rules for subnational government borrowing are set out in Article 8 of the 2002 State Budget Law:

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Only provincial governments can borrow; districts and communes cannot. Provincial governments can only borrow in domestic markets.76 Borrowed funds can only be used to finance capital expenditures. The projects to be financed by credit need to be included in the provincial fiveyear public investment plan approved by the Provincial People council. For a given year, a provinces stock of outstanding debt cannot exceed 30 percent of its capital budget for that year.

The Ministry of Finance monitors and enforces these rules on subnational borrowing at several steps. The debt limits are monitored through the Treasury report for the province. This is quite effective because all subnational government transactions, including those involving borrowed funds and disbursements, have to go through the Treasury. In addition, provinces have to provide a report on their debts to the Ministry of Finance during their meeting on budget estimates, with the following information: (i) total debt outstanding, (ii) maximum limit for provincial debt, (iii) debt service with interest and principal payments during the reporting period, and (iv) the borrowing plan by type of instruments. Provincial governments have borrowed domestically from two sources, bond issues and institutional loans. Through 2003, only Ho Chi Minh City has made use of bond issues, selling around VND 2 trillion.77 The second source of funds has been loans from the Development Assistant Fund (DAF). Table 8 shows the outstanding debt of provinces with the DAF. Overall, the stock of outstanding debt from subnational governments in Vietnam is low in terms of GDP or equivalent perspectives. Thus, there is no threat of domestic financial instability caused by subnational government borrowing. But, given the serious deficiencies and needs for infrastructure investment at the subnational level across the entire country, it is to be expected that this level of debt will increase substantially in the future. If this increase can be done orderly and preserving basic fiscal discipline, it will lead to improved basic public services and generalized increases in welfare. Several reforms could be considered by the GOV in the near future. First, many of the current borrowing rules to be followed by subnational governments are sound and should be kept, but several of them could be updated. The debt limit rule that for a given year, a provinces stock of outstanding debt cannot exceed 30 percent of its capital budget for that year could be substituted for rules that use more stable benchmarks. Some of the rules used in international practice to limit borrowing at the subnational level
There are plans to allow the two largest cities , Hanoi and Ho Chi Minh City, to borrow in international markets with central government guarantee upon approval by the Prime Minister. 77 In 2003, the GOV approved a sizable plan of the City to issue urban bonds to finance infrastructure projects. In September and October, the City sold VND1.75 trillion worth of two-year and five-year bonds at annual interest rates of 8.52% and 9% via retailing and underwriting with VND1.5 trillion sold to credit institutions. In December, Ho Chi Minh City sold VND250 billion of five-year urban bonds at an interest rate of 8.5% to Hochiminh Securities Trading Center, of which, Industrial and Commercial Bank of Vietnam (ICB) bought VND50 billion, the Bank for Investment and Development of Vietnam bought VND145.2 billion, the Sacombank VND50 billion, and Ho Chi Minh City Securities Co. VND4.8 billion.
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include: borrowing in any year cannot exceed some percent of subnational revenues in that year total debt cannot exceed some percent of subnational revenues in any year expenditures on debt service must not exceed some percent of subnational government revenues in any year all subnational debt must be registered with the Ministry of Finance who shall control and monitor compliance subnational debt cannot be guaranteed by the central government except as approved by the National Assembly all borrowing by local governments is subject to approval by the Ministry of Finance. total local borrowing will be limited annually in the State Budget.78

There is probably no need for all these instruments to impose debt limits since, depending on the percentages chosen, not all constraints will be binding but, several combinations of these rules could provide a better control for subnational debt levels than the current rule as a percent of the capital budget. It is quite likely that capital budgets are more unstable. Furthermore, if capital budgets are too small, the current rule may be excessively conservative. The second issue that the GOV could consider has to do with the fact subnational government borrowing may be too low, given the expenditure responsibilities of subnational governments for infrastructure and given also the low levels and high needs for capital infrastructure. Since borrowing is an efficient and equitable way for subnational governments to finance their needs for capital infrastructure, there is a need to study how a subnational credit market can be developed. At the present time, most subnational governments lack credit-worthiness and therefore lack the ability to issue bonds or borrow from financial institutions. Credit-worthiness can be improved through more transparent budgeting and accounting, and development of autonomous sources of revenue for subnational governments. These types of reforms have already been discussed in previous sections. On the other hand, the countrys financial system and capital markets remain underdeveloped. Even if local government revenues and credit worthiness are significantly improved, the necessary level of local borrowing and capital expenditure and maintenance may not take place because of market failure on the supply side. Ideally, in the future, private financial markets will provide credit-worthy local governments with all their needs for long-term financing and help create fiscal discipline among local governments. In the shorter term, the lack of development of financial and capital markets leaves the government with very few options to support subnational government borrowing and capital expenditures. Lending from the Ministry of Finance is not a good option because the possibility of generating a soft budget constraint and moral

The National Assembly could determine the total subnational limit and the Ministry of Finance could administer or apportion this limit among local governments.
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hazard. The GOV could support the creation of a local credit facility or bank. But this move is also full of dangers. Such an institution would need to operate using strict banking criteria and with independence from political pressures and politically motivated project selection and lending criteria.

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