Fiscal Federalism: Elusive Concept Far from Reality

It was in 1995 that Ethiopia adopted federalism. The constitution also gives ultimate power to regions which formed the country. Although regions seem autonomous and independent, they have been losing economic power and have been surviving on subsidies from the central government. This makes Ethiopia’s fiscal federalism to be based on solidarity finance allocation from the center. This confusion is causing friction among regions and the federal government. EBR’s Ashenafi Endale explores.

Ethiopia adopted Federalism in the 1990s; after the Ethiopian People Revolutionary Democratic Front (EPRDF) came to power in Ethiopia. It was the 1995 constitution that gave power to regions which formed the country. For over the last two decades, however, regional states have been losing economic power and have been surviving on subsidies from the central government.

Although economic power is political power, as put by Solomon Nigussie (PhD), a renowned fiscal federalism intellectual at Addis Ababa University, they were not able to do so.
Particularly since last year, the regional states are trying to compete with each other and the federal government economically by establishing their own business entities including banks, transport, media and other key industries.  Regions are also contacting foreign investors directly, showcasing the fermenting extreme regionalism.

Article 98 of the constitution states that the federal government and regional states levy and collect profit, sales, excise and income taxes on enterprises they jointly establish, incomes derived from large scale mining, petroleum and gas operations as well as royalties on such operations.

In order to soothe the ever increasing regional complains over unfair resource allocation, a few months back, the parliament passed a new revenue sharing law which divides collected profit tax between the central government and the regions. The law granted 40Pct of royalty income and 30Pct of VAT for the regions while the rest goes to the central government.

The House of Federation also finalized revising the formula it has been using to ration budget for the nine regional states in Ethiopia, which it should have done by 2016, according to Keria Ibrahim, the house speaker. The new formula which will be used starting from the 2020/21 fiscal year, replaces the old one that has been in place for the last two decades.

Yet, the central government is not pleased with the new slice going to regions.  “The new budget allocation formula gave too much for regions. It is too much,” says Eyob Tekalign (PhD), State Minister for Finance.

At the presence of the Deputy Prime Minister on August 28, 2019, the government launched the ‘Homegrown Economic Reform’, which necessitates more resource containment for the federal government. Admitting all the problems that the government has been denying for the last decade, the reform calls for urgent adjustments at macroeconomic, structural and sectoral levels. However, dozens of opposition party leaders at the launching ceremony strongly argued that the reform will face the fate of all previous reform efforts, unless the government reached a new consensus with regional governments, none of whom were present at the grand meeting.

One of the biggest disadvantages for regions is that enterprises in Ethiopia pay tax where their headquarters are based even though they operate across the country. Addis Ababa and Dire Dawa, have their own administration and their revenue is not to be shared among the regional states. This makes revenues generated from the two cities to directly go to the federal government coffer.  Though these big companies generate high revenue, regions cannot demand for a fair share of the revenue, even though those companies operate on their land.

“It is good 30Pct of the income in form of VAT is going to regions. The question is to which region. For instance if a cement company is headquartered in Addis Ababa and its factory is in one of the regional states, all revenue collected first goes to the federal government. Later, the central government allocates the 30Pct of the revenue for all regions,” Solomon explains.
In this context, the regional state in which the factory is located will be put in a difficult position because the revenue sharing formula doesn’t include such factors, according to Solomon. This is why experts recommend the revenue sharing formula to consider factors such as where the company is located and in which regional states it sold most of its products,” argues Solomon.

According to Solomon, the way the central government is taking land from regions and putting it in the national land bank also shows the gap in the law. “The community sees investment around, but does not know how much it is benefiting from the tax or royalty. This is what happened to the Midroc Gold in Legedembi. The company pays tax to the federal government but there is no way to guarantee that the money is going to the area the gold mine is located. In the same manner, the central government took land from regions and gave it to commercial farmers.”

Large enterprises prefer to license at the federal level and base in the capital city, because the central government controls investment, land, foreign currency, credit supply, and have power over incentives.

Regional states are only allowed to collect income tax from employees in the region, land lease from farmers, tax from house renters and profit and sales tax from businesses in their territory, which are usually small businesses.

As a result, revenue from all the regions usually constitutes less than a quarter of the country’s tax revenue, on average. For instance, the state of Oromia, which is the largest region and one of the areas with rich resources, collected ETB18.5 billion in 2018/19, which is 9.3Pct of ETB 198 billion total tax revenue of the country. 

“Regions have vast land still laying vacant besides the investment lands they gave to the central government. Nobody stopped them from investing on the vacant land. I also do not think there is central government pressure on the regions,” says Eyob.

“There are multiple potentials in all regions which can foster competition among them,” argues John Snow, general manager of J&S Metal, who is also a long-time investor in Ethiopia. “This is critical as unemployment and low productivity are the major problems now.”

Since their tax base and economic opportunities are taken by the central government, regional governments have no option but to stay dependent on subsidies rationed from the central government in order to cover their expenditures.  Although expenditures have been growing faster, they cover 80Pct of their expenditure from the subsidy provided by the central government.

Ethiopia’s fiscal federalism is based on solidarity finance allocation from the center. The center collects all the revenue, and rations it to regions. In this system, the center has the finance and resource, while the regions have the expenditure demand. Even though the constitution states regions gave the power to the central government, it is as if they lost it.
The other fiscal federalism modality is based on competition. Under this system, regions are economically autonomous and compete with each other under a free market economy. Regions have the power to directly attract FDI, access to banks’ loans, levy tax and rollout their own economic roadmaps. They collect tax, cover their expenditure, and pass over the excess to the central government. This system is common in USA, China and other economies.

“In China, provinces and mayors of provincial towns have autonomous economic power. The central government evaluates them only based on their contribution to the national economy,” says John. “States in Ethiopia are similar to provinces in China. The difference is in Ethiopia, everything comes from the central government.”
Based on the 1995 constitution, Ethiopia should adopt a competition based fiscal decentralization. However, Solomon strongly argues the preamble. “This was more applicable for states in the USA, which had autonomous political and economic experiences before they came together and formed the country. To the contrary, regions in Ethiopia never exercised such a practice before. Historically, the central government dominates everything in Ethiopia.”

Solomon argues the incumbent cannot give autonomy for regions because the constitution states what was not on the ground. “In Ethiopia before the constitution, there was indigenous knowledge but not statehood. The main problem in Ethiopia is the constitution is not implemented according to what the regions agreed upon and the way they wanted it.”
As a result, many argue that practically, the existing system is similar to previous unitary regimes, based on the sustaining mentality of perceiving regions as aid takers rather than economically active participants. On top of that, the ruling party adopted the developmental state ideology, which contradicts the federal system. The federal system is expected to give autonomy to regions, while power lies in the center under the developmental state economic growth model.

The government has been applying a solidarity fiscal federalism for the nine regions, while applying a competitive mechanism for the two city administrations, who cover their expenditure from their own revenues. But experts argue that the regional governments could have been economically successful, if the central government had adopted a competitive fiscal federalism.
Mushe Semu, a seasoned financial expert and opposition party leader, is cautious of both sides. “If regions are given more autonomy, the political system will be like a confederation. Given the current ethnic politics, regions might also use their revenues and economic autonomy to purchase weapons and destroy each other. The damage done because regions were allowed to establish their own police force is enough example,” he stresses. 

Regional governments have been grieving for longer years over the unfair distribution of resource from the central government. They argued that the system left no room for the growth of the regions, which finally led to waves of political unrest. However, heads at regional states argue rationing from the central state is never enough.
“For instance, all major investments come through the federal government. Even though there is huge investment demand in the region, we cannot facilitate that by ourselves. Investment land is in the hands of the federal government. We cannot even pay the compensation for farmers who leave their land for development purposes, among others,” says Assegid Alemu, head of Oromia Regional Administration Office.

An official from the State of Amhara, who spoke to EBR on the condition of anonymity, says the relationship between the regional governments and the central government is usually volatile. There is no principle or constitutionally binding mechanism. Everything is based on the political rule of the day at the central government and the regions are just subordinates. Hence stating that the federal government does not rule based on the constitution.

Mushie agrees, but with different perspectives. “When you are an observer from outside, Ethiopia’s federal system is the best. The problems only become visible from a close distance. The federal law is good but regions have no close watch on what is going on in the center. They also do not have firsthand information on the resource allocation mechanism.”
According to Mushe the central government achieved tremendously, in terms of building infrastructure for the regions. “You cannot see such rapid infrastructure growth in any other African country, whether federal or unitary. However, building infrastructure is not enough, unless it is changed to productivity as well as social and economic progress.”
On the other hand, according to Solomon, giving autonomy poses two main challenges. “The first is it results in absence of information symmetry. It will be difficult for the central government to manage information related with investment, finance flow and trade in all regions. The second is it creates a huge gap for tax evasion, if a product has to pass various tax systems in the same country.”


8th Year • Sep.16 - Oct.15 2019 • No. 78


 

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