Advancing fiscal decentralization reform in North Macedonia

For over two decades, the United Nations Development Programme (UNDP) has collaborated closely with North Macedonia's government to boost local governance. This partnership encompasses strengthening core capacities, improving transparency, refining financial management, accelerating digital transformation, and creating revenue generation frameworks. As part of these efforts, two innovative approaches are being introduced to enhance municipal performance and ensure fair inter-governmental transfers. One focuses on equitable intergovernmental transfer distribution, while the other incentivizes increased local revenue collection. These measures are pivotal in advancing sustainable local governance in North Macedonia.

Local governments in North Macedonia currently struggle with low revenue and expenditures compared to European Union (EU) and OECD averages. The local government revenue here stands at around 5%-5.5% of the country's GDP, well below the EU-27 average of 11.2% (source: Eurostat, 2023). Furthermore, local governments have traditionally relied on sizeable inter-governmental transfers to complement the low and surprisingly volatile own-source revenue. The COVID-19 pandemic further exacerbated the situation. In 2020, a UNDP report highlighted how local governments were affected, offering recommendations to manage the challenges arising from increased expenditures and reduced revenues. To address this, reforms in inter-governmental fiscal relations are being put forth.

These reforms aim to not only increase funding but also improve the equity and stability of these financial transfers.

Key objectives of the reform

The reform objectives are threefold:

1. Fairer Funding: The first objective is to make sure that general-purpose transfers are distributed more equitably based not just on the needs of communities (reflected by measures like population, area, number of settlements), but also on their ability to generate revenue. Poorer municipalities will be given more funds through a new component added to the existing general-purpose transfer which is disbursed from a Fund based on the net Value Added Tax revenue collected by the central government.

2. Stimulating Local Fiscal Efforts: The second objective focuses on motivating municipalities to increase their fiscal effort, resulting in higher own revenue collection. This can be done by providing a higher general-purpose transfer to those municipalities with above-average fiscal effort. Alternatively, the reward could be offered based on the increase in net revenue collection compared to the previous three years.

3. Diverse Funding: The third objective suggests creating a more stable General-Purpose Transfer Fund by diversifying the tax sources allocated to the Fund. Currently, the Value Added Tax (VAT) is the main source, but the proposal includes other taxes like personal income tax (PIT) and corporate income tax (CIT) to create a fund that is more balanced and stable through time.

Results. What has been done so far?

The implementation of these reforms is underway. UNDP, in collaboration with the government, has proposed policy options to both enhance the equalization grant and to introduce a performance-based grant. 

Several models were suggested for enhancing the equalization grant, either through adjustments to the existing formula or by introducing additional components to it. The Ministry of Finance opted for an approach that involves adding a new component to the formula. Under this method, funds are allocated to local governments whose fiscal capacity, as measured by their ability to generate local own revenues, falls below a threshold established in relation to the national average fiscal capacity. Local governments with fiscal capacity exceeding the national average will not receive such transfers. In this context, per capita personal income tax (PIT) serves as a proxy for measuring fiscal capacity.

For the performance-based grant two important alternatives were considered. The first one links the amount transferred to the fiscal effort exercised by the local authorities, rewarding a consistent high level of fiscal effort. The second one provides additional transfers to those municipalities which collect increased amounts compared to the three-year moving average. This model stimulates primarily those local governments who previously exercised the lowest level of fiscal effort. The government opted for the second model.

Finally, the revised system maintains the existing and long-standing mechanism for distribution of the general-purpose (VAT-based grant) and includes two additional components for enhanced equalization grants and performance-based grants. While striking a balance between simplicity and effectiveness, the new system includes additional components to the existing general-purpose grant, expressed as percentages of collected net VAT revenue from the previous fiscal year. 

Table 1. Percentage of collected VAT revenue in the previous fiscal year

As a part of this overhaul, the shared taxes allocated to local governments will also increase from 3% to 6% by 2024. While these changes might not seem massive, they're significant steps towards making local governments in North Macedonia more financially resilient, especially in times of various crises.