Central state’s fiscal control stunts Ethiopian federalism

This article is part of the Analytical Reporting to Improve the Federation (ARIF) project.

Before a diverse federation can really move forward, regional states’ tax takes need to increase.

A palpable air of tension hangs over the southern Ethiopian city of Hawassa, which is perhaps unsurprising considering the rocky few years its residents have lived through.

Hawassa has been the epicenter of a drawn-out regional state formation process as Sidama extricated itself from the Southern Nations, Nationalities, and Peoples’ Region (Southern Nations).

Southern Nations is a melting pot renowned for the diversity of its residents in terms of language, culture, and religion, with more than half of the country’s 80-plus ethno-linguistic groups found in the region. This heterogeneity gives the region its lengthy name and identity—but also has its drawbacks.

Since 2018, Southern Nations has contended with rising autonomy demands from its constituent parts. Ten of its thirteen identity-based zones have petitioned for referendums on whether to become a regional state themselves.

Sidama, in 2020, and South West Ethiopia Peoples’ Region (South West), the year after, have thus far managed to become separate regions through constitutionally prescribed self-determination procedures. A third referendum on regional statehood was held in a central part of Southern Nations on 6 February.

But the two new regional administrations are struggling to provide services for their citizens, reflecting the fact that the federal system overall has dwindling resources due to reduced growth amid the civil war and Covid-19 pandemic.

“The budget we have received cannot sustain [the regional government’s] expenses and also allow us to answer piled up development needs of the people,” said Desta Ledamo, Sidama’s president, during a 2021 fundraiser. The Southern Nations finance bureau reported severe budgetary constraints early that year, to the extent that some regional employees were not paid their salaries.

So, while in theory the new structures should deliver better public services due to their greater proximity to the people, the enhanced budgets to pay for improved governance are missing. This reflects the reality that, despite the federal system’s decentralization, regional administrators look upwards for revenues, which mostly accrue at the center.

Arguably, to improve public administration, regional officials need to be more democratically accountable to citizens, thus providing them an incentive to deliver better services.

This can be done in part by increasing their responsibility for raising revenues from the citizens that they provide services for. Greater fiscal autonomy would also reduce the regions’ reliance on the federal government and strengthen their constitutionally granted autonomy in policy making, which has in the past been constrained by the ruling party controlling policy from the center.

This could partly be addressed by increasing the amount of revenue collected locally, which is already occurring in some instances. While that will inevitably be a contested, convoluted process, a good place to start is by adjusting the approach to fiscal federalism to ensure that more revenue is collected at the regional rather than federal level.

Encouragingly, and to the Prosperity Party government’s credit, this process is already underway—though there is a long way to go to rebalance Ethiopia’s federation so that its devolutionary principles contribute more to material improvements in citizens’ lives.

For example, Ethiopia’s government plans to introduce property taxes to broaden the revenue base. After the proposal, a debate arose among pundits and in the House of Federation—the upper chamber of parliament tasked with matters such as inter-regional disputes and autonomy claims—over whether or not these taxes should be levied and collected by the regional or federal governments. Some representatives argued that regional administrations need the new taxes to meet their expenditure needs.

Still, regardless of such discussions, developments toward more genuine and equitable federalism are hampered by the country’s dire economic and political situation. This has led to spiraling costs to address the country’s multiple security crises, which are exacerbated by decreasing government revenue. All of this negatively impacts effective tax collection and the development of more equitable distribution mechanisms.

Current System

Sidama’s long quest for regional statehood was realized three years ago following a referendum in which more than two million people voted in favor of separating from Southern Nations. The financial aspect of the separation sheds light on Ethiopia’s fiscal management system, which is decentralized in terms of both spending and revenue generation.

Running a regional administration is not cheap, and included huge costs for payroll and office rentals during the transition.

With this in mind, the administrators wasted no time in requesting the federal government to allocate it grants, which come in the form of block grants for general spending and also for specific purposes.

Those subsidies are critical as regional administrations generally collect a relatively small amount of tax compared to the federal government, partly because the constitution assigns the most profitable revenue streams to the center.

The Ethiopian constitution devotes seven articles towards tax affairs. Under these provisions, the federal government is responsible for collecting certain levies, such as import and export duties, as well as profit and sales taxes for federal enterprises.

Regional governments are assigned their own slate of revenues, including profit taxes for businesses operating within their jurisdiction and income taxes on those private firms’ employees.

Meanwhile, profit, sales, excise, and personal income taxes on state-owned enterprises established jointly by regional and federal authorities, taxes and royalties on large-scale mining projects, and hydrocarbon operations are classified as concurrent taxes to be shared between the regional and federal governments.

In practice, beginning in 1997, the federal government has been in charge of levying and collecting these concurrent revenues and redistributing them to the regions based on a distribution formula set by the House of the Federation that has only been revised once since 1995 when the constitution came into effect.

The constitutional distribution of taxation powers has created a large fiscal imbalance between the federal government and the regional states since the taxing powers allocated to the regional states are far from sufficient to cover their expenditure.

Some regions, such as Afar and Somali, have not been able to fund more than fifteen percent of their expenditure from their own revenue. In more developed regions, like Amhara and Oromia, it has been between twenty and 40 percent. In any case, federal grants fund between 60 and 80 percent of regional budgets and make up around 40 percent of total federal expenditure.   Arguably, to help the fortunes of Ethiopia’s federation to reverse, these shares need to be reversed.

Funding Sidama

Following the formation of Sidama region, the House of Federation announced that it did not have adequate census data to revise the budget distribution formula and decided Sidama would take twenty percent of the subsidy allocated for Southern Nations.

“It’s a good thing we are at a juncture where the revision of the budget subsidy formula is being reconsidered, said President Desta during the region’s council’s session in 2020, where its first budget was approved. “Whether it’s less or more for us, it is essential that there is equitable distribution.”

The initial 2020/21 budget was determined to be 10.7 billion birr in the 2020/21 fiscal year, half of which was earmarked for capital spending. Since, costs associated with setting up the regional government and other capital investments have soared.

As a result, the budget for Sidama in the 2022/23 fiscal year is nearly double its maiden allocation. Some of that growth seems to have come from increases in local taxes, as Sidama’s federal subsidies grew by only two percentage points over the same period.

A little less than half of this year’s total budget (8.9 billion birr) will cascade down to wereda administrations, which are responsible for delivery of basic services such as health, education, and agricultural services. Setting up the zonal administrations is expected to cost 150 million birr, while over half a billion is set aside for capital projects. The rest will be spent on regional government institutions.

However, according to sources in the public sector, the region has been struggling with budgetary issues from the outset. They say the situation has gotten worse over time, which has forced the region to cut capital outlays—though it’s been able to maintain salary payments with only “minor delays,” a government worker told Ethiopia Insight.

Another change that came with Sidama’s formation is fiscal procedure at the Hawassa City Administration. According to a city official, all budgetary support received from Southern Nations has stopped since Sidama was formed, and the city is now meeting its financial needs on its own.

In the current fiscal year, the entirety of the three billion birr budgeted for Hawassa will comprise revenue collected by the city’s authorities, which makes up fifteen percent of Sidama’s total twenty billion birr budget.

The shift to relying solely on local revenue has been detrimental in light of ever-increasing costs, such as those stemming from rural-to-urban migration and the accompanying increases in demand for public services. Another challenge is the cost of resettling people displaced by infrastructure projects.

Concurrent Taxes

Another way to help regions like Sidama raise more revenue has been by increasing the share of concurrent revenues that go to regional governments.

The House of Federation has the constitutional mandate to determine the distribution formula along with overseeing the distribution of concurrent tax revenues. It must also ensure equitable distribution and delivery of the budget.

Despite being granted a share of concurrent taxes under the 1995 constitution, these revenues have historically been relatively insignificant for regional governments. But after regional lobbying, a new concurrent revenue distribution formula was introduced three years ago.

According to Wakitole Dadi, director of Regional States Fiscal Equalization at the House of Federation, the formula was revised due to the need to factor in various, and rapidly changing, economic conditions. Implementation, too, was an issue, as there were administrative changes such as the deployment of a new system for regional shares to be tracked.

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“Regions have been disgruntled with this for years,” Wakitole said. “Our study found that 90 percent of the concurrent tax revenue was going to the federal government.”

This was the result of vagaries with the formula and implementation. For decades, regions have not received revenue from profit taxes on companies headquartered elsewhere but operating in their jurisdictions. This meant that regions providing infrastructure, services, and labor to companies operating locally were not benefiting from it.

According to Wakitole, the regions had stopped following up on concurrent taxes owing to their small shares. This problem was, at long last, addressed in the revision, with an agreement that regions would collect profit taxes from private businesses operating in their region even if they are registered in another jurisdiction.

Percentage Shares

The formulas were also significantly modified. Personal income tax from public enterprises jointly established by regional administrations and the federal government was previously divided equally. The new formula dedicates this revenue source fully to the regions.

Similarly, value-added taxes (VAT) and excise taxes earned from these businesses are now apportioned evenly, as opposed to the old model which assigned 70 percent to the federal government.

The other major change has to do with large-scale mining and petroleum and gas operations. The previous practice saw the federal government retain 60 percent of revenues from royalty payments, while a profit tax from these activities was equally distributed. Under the new formula, regional states as well as lower administrative echelons where mining activity is being conducted are the main beneficiaries.

While only a quarter of the revenue goes to the federal government, 50 and 25 percent goes to the region of origin and other regions, respectively. Of that 50 percent, regions are required to distribute ten percent to the specific area of origin.

This revision has resulted in a tremendous increase in regional revenues. Regions collectively received six billion birr under the old formula, a figure that soared to 22 billion birr the following year, and over 32 billion birr the year after that.

Some regions saw larger increases than others, including Somali, which saw its revenues shoot up by nearly 2,500 percent to two billion birr. As for Southern Nations, its earnings soared by 370 percent in the first year to 3.6 billion birr, presumably in part due to increased revenues from Legedembi gold mine.

“We can’t even say we used to earn anything significant. Now we’re getting billions,” said Abate Teferi, finance head of Southern Nations. “This has been tremendous for us.”

According to an Ethiopian taxation expert, the revisions are a step in the right direction, but more tinkering is needed. They point to the distribution of VAT as an area that needs attention. As it’s a consumption-based tax, the regions that produce the goods or services will often miss out compared to where the final transaction occurs. One suggested remedy is applying an equalization principle to ensure that areas with lower levels of economic activity are not left behind with regards to VAT.

Economic Woes

Despite these positive developments, major economic and political constraints have hampered meaningful change.

Annual inflation in Ethiopia has been hovering around 20 percent for the past two and a half years. Things got worse at the beginning of March 2022, as inflation soared to over 30 percent, accordingly increasing the cost of government projects and stretching budgets.

Rampant price increases are partly the result of productivity and supply chain constraints. Rising global prices for basic necessities such as cereals and petroleum products are mostly responsible for the ballooning cost of living.

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The Tigray and Oromia wars were also no small part of the problem. Budgets that would have otherwise gone into productive infrastructure projects were scrapped to cover defense costs. In response, the federal government got back into the habit of borrowing large sums from the central bank.

The conflict had other negative economic consequences. Ethiopia went through one of the lowest net income periods in its recent history, as development partners cut loans and grants because of the war.

The damage to people and infrastructure, and the resulting need for reconstruction financing, now looms over the country’s budgetary future. A rehabilitation and recovery plan published by the federal government states that six regions require $3.6 billion dollars in budget support.

Delayed Benefits

War in the north, Oromia, and elsewhere, inflationary pressure, and other disadvantageous global trends have prohibited regional administrations from reaping the benefits of increased revenues following the revision of tax distribution practices.

Although the revised revenue distribution represents a positive move towards fiscal autonomy, the federal government was not ready to compensate for its losses. A report published by the Ministry of Finance indicates the federal government faced an 18 billion birr deficit as a result of the new distribution formula in the first year alone.

While the regions’ share of revenue from joint taxation has increased, the budget subsidy the government extends has not declined. Still, it has only increased by seventeen percent over the last three years, which is lower than the inflation rate.

“Either the government has to cut the budget subsidy budget or use deficit financing measures, but how the government plans to address the problem was never clear,” said the taxation expert.

The federal government has also shown a commitment to revise the distribution formula for the general-purpose regional grants. Proclamation 1250 legislated in 2021 outlining the system for determining the division of the federal subsidy and joint revenues says that the subsidy allocation formula “may” be revised every five years. However, this has yet to be put into practice.

The formula currently in use was supposed to be revised in the 2019/20 fiscal year. According to Wakitole, the House of Federation has been working to revise the formula, but the lack of a recent population census and socio-economic research has hindered this.

New Beneficiaries

Another problem that has complicated regional fiscal administration is the formation of new states. South West followed in the footsteps of Sidama in late 2021, when voters chose to create the country’s eleventh region, which comprises five zonal administrations and two special districts. Though these structures might eventually improve the efficiency of government, initially they mean increased administrative costs.

The South West administration operates this year with an 11.3 billion birr budget, 6.4 billion birr of which was to be covered by a federal subsidy, 435 million birr earmarked for implementation of sustainable development goal projects, and 39 million from foreign assistance. Zonal administrative costs over the seven months between the referendum and the beginning of a new fiscal year came directly from Southern Nations.

Negash Wagesho, South West President, says the region is struggling with its finances. “As the subsidy budget we are receiving is a portion of the existing region [Southern Nations] and does not factor in infrastructure needs, population size, and distribution, we are facing a serious budget deficit,” he said during an event celebrating the first anniversary of his state’s formation.

Discussions between the administrators of Southern Nations and South West ended with an agreement that the newly formed regions would retain a portion of Southern Nations’ budget that would have gone to the zones under their jurisdictions. South West walked away with 19.4 percent of the Southern Nations’ budget, which it received in the form of direct deposits from the federal government.

Officials say budgetary constraints in South West are worsened by widespread underdevelopment, as most of the region’s residents lack access to basic infrastructure. This translates into a pressing need for financing, which President Negash addressed during his speech by calling on the House of Federation to provide a solution.

Additionally, extra financing would require an increase in the ability of weaker regional and sub-regional governments to efficiently spend it, which in turn would require investment in building their capacity.

Tracking Spending

Members of the House of Federation say their reservations about changing the distribution formula stem from the absence of an up-to-date national census, which needs to be conducted before a new formula can be determined.

In addition to population data, experts must account for tax potential, nineteen types of revenue sources, urbanization rates, and pastoral population sizes when devising the formula.

The House of Federation official said that it’s preparing to conduct other major parts of the revision study, including economic activity and expenditure needs. “It is necessary to design the subsidy formula carefully because it could lead to self-inefficiency if regions are subsidized beyond their budgetary needs,” said Wakitole.

There has not been a national census conducted since 2007, which was Ethiopia’s third since 1984. Statisticians estimated the population at 73.5 million fifteen years ago, but projections are that the figure has since grown to over 125 million.

Ethiopia’s House of Peoples’ Representatives.

The fourth national census was to take place in 2017 but was postponed due to security concerns. Although experts at the federal agency in charge of taking the census had plans to conduct one before the sixth national elections, the onset of COVID-19 resulted in the further postponement of both the census and the elections.

While the national elections were eventually held in 2021, except in Tigray, the costly war in the north put an end to plans to conduct the census during the fiscal year that ended in July 2022.

The availability of up-to-date census data would ensure that regions are fairly represented in federal decision-making if electoral constituencies are redrawn so they have a comparable population size. Accurate demographic data would also help facilitate a more equitable distribution of fiscal resources to regions and sub-regional levels.

Most importantly, it would assist policymakers and the House of Federation determining an equitable distribution method whereby they would factor in the infrastructural needs and economic potential of regions based on their demography.

Without a proper census it would be infeasible to conduct a needs assessment to serve as the basis of the program budget. “Ultimately population is the biggest factor for these calculations” says the taxation expert.

The problem is that, as with fiscal reform more generally, the census is highly sensitive in Ethiopia due to a widespread belief that the outcome would decide who gets money and power.

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Main photo: House of Federation voting to delay the census; 29 April 2018.

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