The decentralization of government in Eastern Europe represents a reaction both from below (to tight central political control) and from above (to privatize the economy and relieve the central government's fiscal stress). In all transitional economies, the developing structure of intergovernmental relations is intimately related to such critical policy issues as privatization, stabilization, and the social safety net. In the fiscal sphere, tax reform, deficit control, and intergovernmental finance are a tripod. Unless each leg is set up properly, the whole structure could collapse. The present strategy of devolving expenditures downward while holding back on revenue flows and transfers to balance the central budget is unlikely to succeed for more than a year or two at best. Net spending reductions at the subnational level may be difficult to achieve. From 10 to 40 percent of outlays go to the subnational sector, and in many countries local governments provide much of the social safety that makes the pain of the economic transition politically tolerable. And, most housing and many enterprises have been shifted to local ownership, with the maintenance and subsidy cost this implies. Since the revenue sources assigned to local governments cannot finance expected levels of local activity, the result of shifting spending downward is likely to be strong demands for increased, rather than decreased, transfers. Alternatively, subnational government may look to coping mechanisms such as holding on to their enterprises (which provide vital social services), developing extrabudgetary revenues, or borrowing. These coping mechanisms threaten privatization, reduce budgetary transparency, and impede stabilization policies. The authors describe the risks to privatization, to macroeconomic stability, and to an adequate social safety net that present policies toward local government may imply. Its themes are that the subnational sector needs to be more realistically factored into national plans - and that subnational expenditures be more clearly assigned and revenue needs more realistically assessed. Such assessments are likely to acknowledge a larger sphere for subnational governments and the need for access to more robust revenue sources. Giving local government a share in the personal income tax is one possible and perhaps desirable approach to meeting these revenues needs. Careful attention needs to be paid to the design and implementation of the intergovernmental fiscal transfers likely to remain prominent features of the intergovernmental landscape for years to come. Caution is also needed on borrowing by subnational government. Consolidating and integrating extrabudgetary funds at the subnational (and national) levels is crucial to enhanced budgetary transparency and macrostability.
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