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Economic Aspects of the Annan Plan
for the Solution of the Cyprus Problem

Report
by
Barry Eichengreen
Riccardo Faini
Jürgen von Hagen
Charles Wyplosz
to the Government of the Republic of Cyprus
February 17, 2004


TABLE OF CONTENTS

Executive Summary

1. Introduction
2. Fiscal Policy Aspects of the Annan Plan
2.1. The Federal Design of the United Cyprus Republic
2.1.1 Assignment of Tasks: Principles
2.1.2 Assignment of Revenues: Principles
2.1.3 Assignment of Tasks in the Annan Plan
2.1.4 Assignment of Tasks: Proposed Changes
2.1.5 Assignment of Revenues in the Annan Plan
2.1.6 Assignment of Revenues: Proposed Changes
2.2. The Federal Budget Process
2.2.1 Budgeting Processes and Fiscal Stability: Theory
2.2.2 Federal Budget Governance in the Annan Plan
2.2.3 Proposed Changes
2.3. Vertical Fiscal Relations
2.3.1 Effects of the Annan Plan on Constituent State Budgets
2.3.2 State Budget Governance
2.3.3 Vertical Transfers
2.3.4 Proposed Changes
2.4. Soft Budget Constraints
2.4.1 Principles
2.4.2 Soft Budget Constraints in the Annan Plan
2.4.3 Proposed Changes
3. The Property Problem
3.1. The Solution Proposed by the Annan Plan
3.2. Economic Implications
3.3. Compensation for Loss of Use
3.4. Recommendation: A Close-Ended Property Board
3.4.1 The Risk
3.4.2 Principles for a Closed-Ended Fund
3.4.3 Governance
3.4.4 Intermediate Solutions
3.4.5 Particular Issues
4. Growth Prospects: the Role of Economic Policy
4.1. The Growth Challenge: Principles
4.2. Prospects for the Greek Cypriot constituent state
4.3. Prospects for the T/C constituent state
4.4. The Impact of the Annan Plan on Economic Growth
4.4.1 Factor Mobility
4.4.2 Allocation of Tasks: Specific Growth Enhancing Aspects
4.4.3 Development Policy
4.5. Regional Policy, Labor Market and Migration
4.5.1 Principles and Previous Experiments
4.5.2 The Annan Plan, Convergence and Mobility in the UCR
4.5.3 Proposed Changes
4.6. Reconstruction: Will Foreign Aid Fill the Gap?
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5. Monetary and Financial Issues
5.1. Central Banking
5.1.1 Transition
5.1.2 Governance
5.1.3 The Role of the Supreme Court
5.1.4 Separate Central Bank Branches?
5.2. Currencies
5.2.1 Book-keeping in Euros
5.2.2 Is There a Need to Redenominate Financial Contracts?
5.3. Monetary and Exchange Rate Policies
5.4. Restructuring the Banking System
5.4.1 The Banking System in the Turkish-Controlled Area
5.4.2 Effects of the Annan Plan on Banks in the North
5.4.3 Policy Responses
5.4.4 The Annan Plan Provisions
5.4.5 The need for a permanent blanket deposit guarantee
5.4.6 Agreement on the Clean-Up Operation
5.4.7 Currency Conversion
5.4.8 Refinancing Operations
Appendix A. Econometric Estimates of Growth Potential
Appendix B. Estimates of the Size of the Banking Sector in the T/C Area
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Executive Summary

This report provides an analysis of the economic aspects of the Annan Plan by a
committee of independent experts. The report has been commissioned by the
Government of the Republic of Cyprus under the understanding that the experts are free
to express their own views. The experts’ concern is that the economic agreements
included in the Annan Plan do not adversely affect the UCR and its constituent states,
that they provide a sound and sustainable basis for the unification process and that they
reduce the risks of adverse economic and financial developments at the federal and state
levels. The analysis is intended to serve the common economic interests of both Cypriot
communities.
The report generally takes as given the political constraints built into the Annan Plan.
This includes the intention of limiting the size and authority of the federal government,
a commitment to compensate dispossessed property owners, a commitment to provide
loss-of-use compensation, the imposition of limits to migration of G/C citizens to the
T/C constituent state, and sensitivity to the use of the Cyprus Pound in the T/C
constituent state. This is not to say that these provisions are necessarily desirable; in
fact, in many cases we strongly feel that many of these constraints will adversely affect
the economic development of the United Cyprus Republic. Nonetheless, we take them
as dictated by the political realities.
General assessment
The Annan Plan provides a useful basis for addressing the economic issues arising in
connection with a settlement of the Cyprus question. In a number of important respects,
however, the plan falls short of a complete blueprint and requires revision and additions.
The Annan Plan is in conformity with generally accepted principles of fiscal federalism
when it assigns tasks to the federal government of the United Cyprus Republic (UCR)
and the two constituent states. It correctly identifies the need for the smooth functioning
of markets. It also recognizes the need for the UCR to adopt EU rules in all concerned
areas, including trade, regulation and budgetary matters. Finally, the Plan rightly
emphasizes that a single central bank with the authority to issue a single currency must
exist during the interim period before the UCR joins the European Monetary Union.
We believe that, suitably adjusted and supported by sound economic policies in each
constituent state, the economic aspects of the Annan Plan provide the basis for a
sustained rise of living standards throughout the island, including accelerated growth in
the T/C constituent state leading to the eventual convergence of living standards in the
two constituent states.
However, some economic policy issues are inadequately treated or overlooked. The
most problematic aspects, and our suggested amendments, are presented below.1 The
1 The report considers in detail a large number of additional issues.
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following table distinguishes the issues that must absolutely be addressed to make the
Plan economically viable from those that would lead to serious yet not fatal difficulties.
Essential issues Very important issues Important issues
Property Fund Agreements on pensions
and health benefits
Federal regulation to limit
harmful tax competition
T/C bank restructuring Central bank governance Federal competences vis-à-
vis the constituent states
Taxation of commuting
workers
Clarification of term
“federal economic policy”
Time limit to European
Union’s exemptions from
the Single Market
Unemployment benefits for
commuting workers
Eliminate the goal of
“eradication of economic
inequalities”
Limit the federal
government’s assumption
of external debts to past
commitments
Strengthening of the
financial position of the
federal government
Restrictions to labor
mobility limited in time
Establish procedures to
achieve fiscal discipline at
the federal and constituent
states levels
Establish rules and
procedures for the
implementation of federal
policies in the constituent
states
Apply personnel quotas to
the overall federal
administration
Measures to prevent
harmful tax competition
Property restitution
In general, property restitution and compensation raise delicate political and economic
issues. The process can lead to important economic inefficiencies if it impedes the
establishment of well-defined property rights and the development of property markets.
The process as currently set in the Annan Plan is deeply flawed in these dimensions,
and it threatens the financial viability of the federal government. It must be thoroughly
redesigned. We present a proposal that minimizes the economic efficiencies and
safeguards the federal budget.
The Annan Plan envisages partial restitution – all dispossessed T/C and a minority of
G/C property owners will likely have their previous claims on specific properties
reinstated – and aims at fair compensation for the remainder. However, the basis for
assessing compensation is uncertain. And, crucially, the financing exposes the new
federal government to potentially disastrous open-ended financial liabilities.
We propose that the Property Board be established instead as a closed-ended real estate
fund, created for a limited period, at the end of which it will be liquidated.
The central difference between our proposal and the Annan Plan concerns the treatment
of risk. In both cases, the Property Board will sell all non-restituted properties and pay
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compensation to dispossessed owners.2 But this entails substantial risk insofar as the
price at which properties will be sold is not known ex ante. The question is who bears
this risk. By fully guaranteeing the amounts to be paid to dispossessed property owners,
the Annan Plan shifts the entire burden of this risk onto the federal government.3
Our alternative would link overall compensation to proceeds from property sales. This
would effectively shield the federal government from a very real risk of bankruptcy and
shift some of the risk onto dispossessed property owners.4 Importantly, our proposal
does not imply that total compensation will be lower than those envisaged in the Annan
Plan; it may in fact be significantly higher (which should help to make our proposal
politically attractive).
In practice, instead of issuing government-guaranteed bonds, the Property Board would
issue shares to be distributed to dispossessed property owners. The Board will manage
and sell all properties before a set date and will then pay out the shares. This ensures
that the Property Board will transfer payments from buyers to dispossessed owners
rather than from taxpayers to dispossessed owners. Shares will be tradable, allowing
their holders to cash them in as they wish.
Labor mobility: taxes, unemployment, pensions and health
Restrictions on the mobility of workers from the G/C constituent state to the T/C
constituent state are economically inefficient; fortunately from this point of view, they
will most likely be irrelevant. We expect a large movement of workers in the opposite
direction, from the T/C to the G/C constituent state. This movement, which will lead to
a rapid rise in standards of living in the T/C constituent state and also benefit the G/C
constituent state, will mostly take the form of commuting.
Strikingly, the Annan Plan makes no provision for what may be its most visible and
direct benefit for most of the population. Specifically, commuting will require not only
infrastructure but also agreements on taxation and unemployment, pension and health
benefits.
The risk is that the infrastructure needed for efficient commuting will be under-supplied
and that resources potentially available for its development from the EU will be
inadequately utilized. We therefore recommend that the Federal government establish
adequate infrastructure standards for the two constituent states.
In line with international best practice, we propose that income tax be withheld at a
commonly agreed statutory rate in the constituent state where income is earned by
residents from the other constituent state. The Annan Plan should also establish the
2 Because all dispossessed T/C property owners will be reinstated, the compensation arrangements in
effect mainly provide for transfers from G/C taxpayers to G/C dispossessed owners.
3 The Federal government will have to cover any difference between sales proceeds and ex ante defined
compensation. It can make a profit but it can also face an insurmountable debt.
4 The exact linkage, which determines how risk is allocated between taxpayers and property-owners, can
be set in different ways described in the report.
vii
principle that the two constituent states agree on the sharing of withholding tax
revenues.
Each constituent state should operate its own unemployment, pension and health
systems and subscribe to agreements allowing for labor mobility:
- Unemployment benefits should be provided by the constituent state where a
person has been last employed, irrespective of state of residence.
- Pensions should be made as portable as possible.
- Each constituent state’s health system should cover its residents’ use of the other
system in cases of emergencies and where explicitly requested for medical
reasons.
In each of these areas, the federal government should have the competence to establish
minimum standards that each constituent state is free to improve upon.
Money, central banking and bank restructuring
The Annan Plan correctly emphasizes the principle of one central bank, one money, and
one financial supervisor. However, there is a substantial danger that implementation of
this principle will be undermined by ambiguities and omissions in the current draft. The
importance of proper central banking institutions cannot be overstated since the UCR,
as a EU member state, is obliged to maintain price stability and free capital mobility.
Once the UCR joins the euro area, most central banking functions will be transferred to
the Eurosystem, with the notable exception of bank regulation and supervision.
The Plan envisions a transitory central bank governance structure. This is inconsistent
with the maintenance of confidence. We recommend that the central bank be constituted
with a permanent governance structure as soon as practical. Although it will take time to
fully integrate the two existing central banks, at a minimum the following functions
should be taken over by the new Central Bank of Cyprus from the outset: refinancing of
commercial banks, foreign exchange operations, and supervision of commercial banks
in both constituent states.
The Plan also envisions consolidating central bank management and policy-making
responsibilities within a single body over this transition. This is not in line with
international best practice; it is highly undesirable even for a transitional period. A
Board of Directors with responsibility for setting broad policy guidelines and
supervising the central bank’s administration and a Monetary Policy Committee
responsible for the day-to-day conduct of policy should be set up from the outset.
Separate branches, if they remain in the Plan, should have strictly limited non-policy
functions.
The limited information available to us suggests that many banks in the T/C area are not
likely to be viable in a competitive environment. There is a very real danger of a bank
panic occurring early on, possibly even before the entry into force of the Annan Plan.
This makes it important that bank restructuring and recapitalization be tackled very
early on. If this is done, the necessary bank restructuring need not be costly. As
currently written, the Annan Plan seems to include a blanket bank deposit guarantee to
be extended to the T/C banking system by the Bank of Turkey for a period of three
months. Limiting the guarantee for three months is dangerous, as it invites a run; so is
the ambiguity in wording. The provisions of the guarantee should be expressed in
viii
unambiguous terms, and when the Bank of Turkey’s commitment ends, it must be made
clear that the guarantee will continue to be extended subsequently. This requires an
explicit, unconditional commitment from either the constituent states or the Central
Bank of Cyprus. In addition, as soon as the Plan is agreed upon, both central banks
should cooperate, in particular in the supervision of the two existing banking systems.
All banks must be immediately subject to a thorough auditing process, possibly
conducted by internationally reputable firms.
As the Annan Plan currently reads, the one central bank-one currency principle is
undermined by a number of regrettable ambiguities that may encourage the circulation
of parallel currencies in the T/C constituent state. While parallel currencies do not
represent a threat to price stability, they would reduce the usefulness of the currency as
a medium of exchange until the adoption of the euro. And they may threaten Cyprus’
ability to qualify for adoption of the single European currency if taken too far. For both
reasons the ambiguous language of the Annan Report regarding these matters should be
corrected.
Federal government finances
The Annan Plan envisions a financially-weak federal government. The federal
government’s resources will be strictly limited, which will also in turn constrain its
ability to borrow. Furthermore, the federal government will have to assume some
previously accumulated debts of the constituent states. According to the Annan Plan,
the federal government will have competence over indirect taxation and will be
excluded from direct taxation and social security and insurance contributions. This is
the opposite of usual practice. In addition, the plan makes no provision for budgetary
planning in the Presidential Council. All this means that there is a serious risk of
imbalance between revenues and responsibilities, which could lead not only to
uncontrollable deficits but also to serious political conflicts.
It is vital that the financial position of the federal government be strengthened. To this
end we recommend the following changes:
- An effective framework for controlling the federal budget is necessary. This requires
explicit budgetary planning compatible with EU practice, for providing the Finance
Ministry with more authority in planning and executing the federal budget, for limiting
and possibly prohibiting the Parliament’s ability to increase the budget deficit, and for
reconsidering quotas in the federal administration.
- The Plan must include the possibility of sharing direct taxes between the federal and
constituent state governments. This calls for a commonly agreed definition of taxable
income and rules for setting tax rates.
- The Federal Government cannot be burdened responsibility for distributive policies
nor with significant debt. The Plan must clearly specify that the federal government
only assumes past external debts.
- The federal government should not be assigned the costs of the UN peacekeeping
operation, which would represent more than half of its revenues. At most it could
finance the operating costs of the peacekeeping operation.
- Vertical transfers should be limited to a transitory period.
ix
Federal administration
The Annan plan requires that at least one-third of federal public servants at every level
of administration hail from each constituent state. This may lead to an excessive large
federal administration and represents a major financial risk. This rule should be made
more flexible, for example by applying it to the overall administration rather than at
each level. We also recommend that the Public Service Commission be required to
develop a medium-term personnel plan to be approved by the federal parliament.
Relations between the federal and constituent states governments
The assignment of tasks between the federal government and the constituent states,
while generally consistent with accepted norms and principles, leaves a number of
issues open. The term “federal economic policy,” which is undefined and dangerously
open-ended, must be clarified. It must be made clear that the federal government
possesses the competence to develop and implement a common framework for state
policies in the areas of education, health, social policies, and financial, commercial, and
market regulation.
The federal government will be dependent on the constituent states in the
implementation of its policies. The federal government’s competences vis-à-vis the
constituent states in monitoring and enforcing common regulatory policies and the EU
acquis communautaires therefore need to be clarified.
Relations between the constituent states
The Annan Plan’s assignment of indirect taxes to the federal government and direct
taxes to the constituent states creates a danger of harmful tax competition. To prevent
the constituent states from excessive and harmful tax competition, we recommend that
federal regulations establish floors for tax rates and that tax advantages granted by the
constituent state governments be listed in a publicly accessible federal register.
Growth and convergence within the UCR
The objective of “eradication of economic inequalities between the constituent states
within the shortest possible time,” stated in the Annan Plan, is unrealistic and likely to
be disruptive to economic normalization and growth if interpreted too literally. It may
severely strain the resources of the Federal government and jeopardize macroeconomic
stability.
There should not be an unconditional mandate imposed on the federal government to
eliminate economic differences between the constituent states. Instead, the Annan Plan
should define a general federal competence for a common development policy and leave
it to the federal parliament to fill this with content.
In addition, there is a potential contradiction between the objective of eradicating
economic inequalities between the two constituent states and the Annan Plan’s open
ended safeguard regarding labor mobility and the acquisition of properties in the T/C
constituent state by non-residents. In addition, both measures stand in clear violation of
the Single Market. The Annan Plan requests a blanket exemption from the requirements
of the Single Market from the European Union. We recommend that, if such an
exemption is indeed granted, it be explicitly of limited duration and subject to periodic
appraisal by the European Commission.
1
1. Introduction
The present report was prepared by a team headed by Charles Wyplosz, Professor of
Economics at the Graduate Institute of International Studies in Geneva. The team
includes a public economist, Jürgen von Hagen, Professor at Bonn University, a
monetary economist, Barry Eichengreen, Professor at the University of California at
Berkeley, and a development economist, Riccardo Faini, professor at the University of
Rome.
This report has been commissioned by the Government of the Republic of Cyprus. We
have been entirely free to express our own views whether or not they coincide with the
Government’s positions. In carrying out our work, our exclusive concern has been that
the economic agreements included in the Annan Plan provide a sound and sustainable
basis for unification. Our analysis and proposals are intended to serve the common
interests of both Cypriot communities. Where these interests diverge, the report offers
viable alternatives and indicates how these alternatives affect each community’s
interests.
We have examined the Annan Plan (26 February 2003 version) intended to enable the
creation of a federal United Cyprus Republic (UCR), and we have evaluated its
economic aspects. Our overall assessment is that the economic aspects of the Plan
provide an adequate basis for a lasting settlement to the Cyprus question. At the same
time, we are concerned that important economic issues have not been adequately
addressed. While failing to deal with some of these potential difficulties may jeopardize
the prospects for a solution, we believe that the Plan can be amended to address these
problems. To this end, our report proposes a number of modifications and additions that
aim at improving the Plan. In preparing these proposals, we have taken the basic
approach of the Annan Plan as given, striving for pragmatism and, we hope, political
realism.
Perhaps the most difficult issue is the property restitution process. We are very
concerned that the current version of the Plan may put an unbearable financial burden
on the envisioned Federal government. On the one hand, the ability of the federal
government to raise revenues is strictly limited, essentially for political reasons. On the
other, the Plan’s proposed property restitution process has the potential to create
uncertain and potentially unlimited claims against the federal government. Assuming
that it would be impossible to profoundly modify the principles that underline the
restitution process with a view to making it more manageable, we propose an alternative
scheme. Our scheme rests on one observation and one principle. The observation is that
most of the transfers implied by the restitution process will actually be from Greek
Cypriot (G/C) taxpayers to G/C displaced persons. These amounts will depend on the
evolution of property prices in the two constituent states over several years, which are
unpredictable and would create considerable uncertainty for the Federal budget, should
the plan remain unchanged. We therefore recommend replacing the Federal
government’s open-ended liabilities with a closed fund that will collect income from
property sales and redistribute it to property claimants and then close down. Moving to
this approach would not alter any of the property restitution rules, nor would it
necessarily reduce the amounts of transfers paid out to displaced property owners. But it
would make these transfers dependent on the evolution of property prices, in effect
2
mimicking a market process. Instead of issuing public debt, the Fund would issue
shares. In turn this will limit the financial risks associated by the federal government in
carrying out the restitution process.
Even without the cost of property restitution, we are concerned that the Federal
government’s finances could be strained by normal governmental responsibilities.
Normal governments can, if the need arises, raise taxes or borrow, nationally or
internationally. Under the Annan Plan, as we read it, none of these alternatives will
effectively be available to the Federal government. As a result, there is a serious risk
that the Federal government could become bankrupt. This is why we make a number of
proposals to strengthen its financial position.
The Plan envisions restrictions on the ability of G/C citizens to take up residence in the
T/C constituent state, while allowing T/C citizens to move to the G/C state. In theory,
this limits labor mobility. In practice, given the current difference in income levels, it is
likely that most migration will be from the T/C to the G/C constituent state. Given the
small size of the island, it is also likely that a considerable amount of labor mobility will
take place through commuting. While at one level this is reassuring, this diagnosis
conceals the fact that labor mobility requires agreements on unemployment insurance,
health benefits, retirement plans since, according to the Plan, these schemes will be the
responsibility of each constituent state.
The monetary arrangements foreseen by the Annan Plan are less than transparent. The
Plan foresees a common currency and, consistent with this vision, a single central bank.
Yet, it allows for accounting in euros and provides for central bank branches in the two
constituent with undefined competences. Eventually, the United Republic of Cyprus
(URC) will become a euro area member, which will enshrine the principle of a common
currency once and for all. The transition to the European monetary union, however, will
require that the Maastricht criteria be fulfilled, which in turn requires one currency and
one independent central bank for the UCR. Economic prosperity and financial stability
will benefit from one currency and one independent central bank as well. We therefore
offer a number of proposals to guarantee that these elementary principles will be
respected.
Little is known of the situation of commercial banks in the T/C area. Available
information suggests that these banks’ balance sheets include sizeable non-performing
loans. When the Bank of Turkey terminates its support for the T/C banking system, it
may become apparent that many of its constituent banks are insolvent. There is a risk
that this will trigger a bank panic, quite possibly as soon as the Plan is agreed. The
resulting collapse of the T/C banking system would be a major economic and political
disaster. It must and can be avoided. The report includes a number of measures that
must be taken as soon as possible, ideally immediately, through concerted cooperation
between both existing monetary authorities.
The present report comes in five parts. Section 2 deals with the financial aspects of the
Annan Plan. It includes an overview of the general principles of fiscal federalism, which
are then applied to the specific situation of the UCR, providing detailed suggestions on
how to improve the Plan. Section 0 focuses on the property restitution program. It
emphasizes the budgetary risks of an open-ended commitment, which could bankrupt
the federal government. Instead it proposes the establishment of a close-ended fund that
would be automatically balanced and dismantled when all properties under restitution
3
are disposed of. In a nutshell, instead of issuing federal bonds, as envisaged in the Plan,
the Property Board would issue shares. Section 3.4.1 deals with growth and
convergence in the UCR. Beyond offering an evolution of growth prospects in the two
constituent states, this section examines the importance of factor (labor and capital)
mobility in fostering convergence. This leads to a number of recommendations and a
warning that foreign aid is unlikely to meet the estimated costs. Section 4 is concerned
with monetary issues. It examines critically the Annan Plan’s proposals for the central
bank’s governance and makes alternative suggestions. While reaffirming the principle
that one central bank manages one currency, it considers various possibilities of parallel
currencies; it also studies the question of bank reorganization and recapitalization in the
T/C constituent state.
2. Fiscal Policy Aspects of the Annan Plan
2.1. The Federal Design of the United Cyprus Republic
2.1.1 Assignment of Tasks: Principles
Classical Fiscal Federalism
The assignment of responsibilities (or competencies) to the different levels of
government is a key issue for theories of federalism. The classical economic theory of
fiscal federalism regards it as a static allocation problem and derives answers based on
principles of efficiency. Public choice theory and the new theory of market-preserving
federalism (Weingast, 1995, MacKinnon, 1997) interpret federalism primarily as a way
of imposing discipline on self-interested politicians and governments and a hedge
against the abuse of power and excessive growth of the public sector. From this
perspective, the allocation of responsibilities and resources should create a maximum
degree of competition among governments.
The assignment of responsibilities to different levels of government is the subject of the
traditional theory of fiscal federalism. The main idea here is to achieve an optimal
provision of public goods and public services. The basic assignment rule is the principle
of reciprocity (Musgrave, 1986), or fiscal equivalence (Olson, 1969). It says that the
geographical boundaries of public goods should coincide with those of the government
operating and financing them. Benefit or cost spillovers from one jurisdiction to another
create external effects. The government operating the relevant policy program might
disregard these externalities and fail to implement the best policy for all jurisdictions.5
Similarly, fiscal equivalence rules out “internalities,” i.e., situations in which the policy
area is smaller than the area of the jurisdiction, which leads to similar welfare losses.6
The correspondence of the region benefiting from a policy and the region paying for it
assures Pareto-efficient outcomes in the provision of public goods and services.
5 Defense is a classical example. If the operation of the military were left entirely to city governments, no
city would take into account that strengthening its forces has a positive impact on the security of
neighboring cities, and, therefore, cities would invest too little in defense. Hence, defense policies are
typically allocated at the national level. Macroeconomic stabilization is another classical example.
6 Here, a classical example is regional infrastructure. If regions can obtain infrastructure funding from the
national budget, their representatives will ask for more projects than they would if the funding came
entirely out of the region itself since the cost of each project is spread over all taxpayers in the country.
4
The equivalence principle is an important benchmark for the design of federal entities.
As an organizing principle, it says that public policies characterized by important
spillovers between local jurisdictions should be administered and financed by higherlevel
governments, while policies with no or small spillovers should be administered
and financed by lower-level governments. Pure public goods such as national defense,
whose benefits fall on the entire population of a country, should be provided by the
central government, while local public goods, whose benefits and costs are locally
concentrated – such as street lighting – or which are strongly congestible – such as
parks or schools – should be provided by local governments (e.g., Inman and Rubinfeld,
1997).7
The principle of fiscal equivalence does not rule out redistributive policies within
jurisdictions. To the extent that relatively rich citizens dislike conspicuous poverty in
their immediate neighborhoods, economic support for the poor has the character of a
local public good and, by the principle of fiscal equivalence, should fall under the
competence of local governments for efficiency reasons (Pauly, 1973).8 Nevertheless,
traditional fiscal federalism assigns the responsibility for redistribution to the central
government (Musgrave, 1997). The main argument is that decentralization would lead
to too little income redistribution. When taxpayers are mobile, local governments will
compete for rich taxpayers by offering them low tax rates; meanwhile, poor individuals
will move to jurisdictions offering generous welfare programs. As a result, rich and
poor individuals will tend to cluster in different jurisdictions, which implies that there is
little scope for redistribution at the local level.
The efficiency principle behind fiscal equivalence implies that the level and the quality
of public goods and services should vary across regions according to citizen preferences
and local cost conditions. Traditional fiscal federalism indeed regards the ability of local
governments to tailor the provision of local public goods and services to local demands
and circumstances as the principal justification for decentralized government (Olson,
1969). Oates’ (1972) Decentralization Theorem holds that “in the absence of costsavings
from the centralized provision of a good and of inter-jurisdictional externalities,
the level of welfare will always be at least as high (and typically higher) if Paretoefficient
levels of consumption are provided in each jurisdiction than if any single,
uniform level of consumption is maintained across all jurisdictions.” Decentralization
gives the citizens the opportunity to move to jurisdictions offering packages of taxes
and public goods they like best. This is the essence of Tiebout’s (1956) theory of
decentralized government. Households “vote with their feet” to obtain the best
combination of taxes and public goods. If jurisdictions are small and households are
mobile, decentralized government can achieve the welfare optimum.
When public goods or services have large externalities and there are differences in
regional preferences, the assignment of competencies faces a trade-off between the
efficiency gains from moving the relevant policies to higher levels of government and
internalizes the relevant externality, and the welfare loss from not responding to
7 Inman and Rubinfeld (1997) point out that important public services such as health, water supply,
sewage, and public education can be produced efficiently by relatively small communities.
8 Following this logic, critics of unemployment support in Germany demand a stronger role of city
governments in the administration of these programs. See e.g. Berthold (2002).
5
preference heterogeneity (Alesina et al. 1999, 2001). Large economies of scale in the
production of public services pose similar trade-offs. With homogeneous preferences,
large externalities or economies of scale suggest assigning the production of the relevant
public good to a higher-level jurisdiction. But if preferences differ across regions and
governments are constrained to deliver their services in uniform levels and qualities
throughout their entire jurisdiction, the welfare costs of uniformity can exceed the
efficiency gains from centralization.
Shared Responsibilities
One way of dealing with this dilemma is shared responsibilities, i.e., assigning
competencies over the same policy to different levels of government at the same time.
Indeed, insofar as the geographical design of local and regional jurisdictions is more
often the result of historical developments than of deliberate planning, shared
responsibilities should be the norm rather than the exception. Externalities between
local jurisdictions can be addressed by taxes and subsidies imposed by the central
government. By paying to local governments conditional, per-unit grants subsidizing
public goods generating positive externalities (such as environmental clean-up), or by
imposing financial charges on the production of public services generating negative
externalities (such as dump sites), the central government can change the marginal costs
of the relevant policies for the local governments and induce them to provide the levels
of public goods that maximize social welfare at the national level. The provision of the
relevant public goods then remains a task of the local governments subject to incentives
set by the central government. The advantage over centralized provision is that such
arrangements preserve the responsiveness of public policies to local preferences and
conditions, and yet correct for externalities.
However, the efficient use of taxes and subsidies requires the verifiability of local
preferences and conditions. When local governments can misrepresent costs,
preferences, or the size of the relevant spillovers, taxes and subsidies can distort choices
at the local level and create more inefficiency rather than less.9 In practice,
informational constraints may be too large to use this approach extensively.
An alternative way to implement shared responsibilities is in the form of federal
mandates or through parallel central and local government provision of public goods.
Under a federal mandate, the central government requires local governments to produce
a minimum level of a certain public good, leaving it possible to locally provide more.
With parallel provision, the central government provides a uniform level of a public
good to all local jurisdictions, allowing local governments to provide additional levels
financed out of local taxes if they wish to do so. By requiring a minimum standard or
delivering a lower level of the public good than it would if it were the sole provider, the
central government can achieve a better position in the trade-off between welfare gains
from centralization and losses from uniform central services. While the central
government policy alleviates the externality problem in these cases, the possibility of
additional, local production of the public good reduces the cost of uniformity.
9 For example, in an empirical analysis of federal grants in the US, Inman (1988) concludes that the link
between interjurisdictional spillovers and the size and structure of grants received is very weak at best.
6
It is important to distinguish between shared responsibilities and poorly defined
competencies. If the assignment of competencies is vague or competencies of different
levels of government are overlapping, citizens will find it difficult to hold policymakers
responsible for unsatisfactory performance. The result is poor delivery of public
services and abuse of public funds. In such situations, local governments frequently find
ways to take the central government hostage by abusing funds for essential services
such as schools and hospitals and calling upon the central government to provide more
funds to maintain a reasonable level and quality of these services.10 This happens often
in situations where the federal government provides the financing for programs run by
local governments, or where the local government is responsible for implementing
central government programs. Obviously, shared responsibilities need an even more
carefully designed assignment of tasks to avoid such situations.
Competition to Discipline Governments
The efficiency considerations behind fiscal equivalence rest on the traditional view of
government as a neutral body maximizing public welfare. Public choice theory takes a
different view. It regards politicians as rent-seeking individuals using their positions to
pursue private goals and government as an institution that encroaches on individual
freedoms and seeks to increase its grip on the private economy as much as possible.
This view of government as a “Leviathan” emphasizes the importance of institutional
rules and arrangements forcing politicians to serve the public interest in the pursuit of
their own goals and limiting their discretionary powers (Brennan and Buchanan, 1977).
The Leviathan view leads to a different perspective of the optimal regional structure of
government. Brennan and Buchanan argue that competition among local jurisdictions
constrains the discretionary powers of politicians and leads to lower levels of
government spending and taxation. By creating and promoting such competition,
federalism puts a check on the growth of Leviathan and on the abuse of power by rentseeking
politicians. In Hirschman’s (1970) terms, federal structures give citizens
opportunities for “exit” – moving or taking their assets to jurisdictions whose economic
and fiscal policies they like – in addition to the “voice” of their democratic votes. This
means that decentralization of government is beneficial even in the presence of
homogeneous regional preferences regarding public goods and that externalities and
economies of scale must be large to justify centralization.
The claim that competition among governments improves the efficiency of the public
sector is not uncontroversial. Theory suggests that the effectiveness of competition
depends on the circumstances. Oates and Schwab (1988) show that it can yield efficient
outcomes if consumer preferences are relatively homogeneous and local governments
have access to efficient tax instruments. The efficiency of inter-jurisdictional
competition requires that all jurisdictions be small and act like price takers and
taxpayers do not have market power. This is obviously unrealistic in the Cyprus case,
but the results of imperfect inter-jurisdictional competition are less well understood.
Practical experience suggests that it can lead to inefficient outcomes, e.g., when a large
potential taxpayer such as a multinational company shops around regional governments
for infrastructure investments as a precondition for building a new production site. As
all regional governments deliver such investments but only one obtains the production
10 See Fernandez-Arias, Stein, and von Hagen (forthcoming) for details.
7
site, the others are left with wasteful, unused infrastructure. Under such circumstances,
some collusion among the regional governments assuring that no government invests
resources before locational decisions have been made can improve the outcome.
Another caveat against competition arises from the observation that the most mobile
citizens do not represent the average or the media citizen.
Sinn (1997, 1999) challenges the idea of competition among Leviathans noting that
government interventions in the economy tend to respond to market failures. Sinn calls
this the selection principle. Under such conditions, competition among governments
cannot replace competition among private suppliers without leading to the same
problems of market failure. Sinn (1997: 270) summarizes succinctly: “Competition is
bad when government intervention is good.” This suggests that competition among
Leviathans can be useful to discipline government in areas where their intervention is
not essential from an economic point of view, but the general applicability of the
concept to the design of federal entities is limited to that.
Market-preserving Federalism
The concept of “market-preserving federalism” (Weingast, 1995; McKinnon, 1997)
regards federalism as a solution to the fundamental political dilemma of an economic
system: “A government strong enough to protect property rights and enforce contracts is
also strong enough to confiscate the wealth of its citizens. Thriving markets require not
only the appropriate system of property rights and a law of contracts, but a secure
political foundation that limits the ability of the state to confiscate wealth.” (Weingast,
1995:1) Market-preserving federalism solves this dilemma by combining strong local
government with a federal government enforcing nation-wide free markets and free
mobility of factors, goods, and services.
A federal system is market preserving when (1) primary responsibility for regulatory
and economic development policies remains with the sub-central governments, (2) a
common market is enforced, and (3) sub-central governments have access neither to
money creation nor to central government bailouts for bad local projects or policies or
excessive debts. The first condition limits the central government’s power to confiscate
wealth. Together with the second condition, it establishes competition among the subcentral
governments, assuring that individuals can leave regions with unfavorable
regulatory regimes and that local governments cannot abuse their power by erecting
artificial barriers to trade and mobility. This keeps local governments from
appropriating excessive economic rents. The third condition assures that local
governments are responsible for their actions. Market-preserving federalism demands
the following assignment rule: Local governments should be responsible for all policies
of economic regulation and development, while the central government is responsible
for developing a federal constitution committed to the principles of free and open
markets and for monitoring and enforcing its proper implementation. Rules such as the
interstate commerce clause in the US or the principle of mutual recognition of national
regulation in the EU are essential elements of a constitution promoting competition
among local governments.
2.1.2 Assignment of Revenues: Principles
Classical Fiscal Federalism
The “tax assignment problem” in fiscal federalism (McLure, 1983) asks which taxes are
best assigned to different levels of government. The key issue is to avoid distortions in
8
the locational choices of mobile households and firms, which could arise if tax rates
charged at the local level differ widely across jurisdictions. For example, large
differences in excise taxes between local jurisdictions could induce consumers to
expend resources on inefficient travel to places with low tax rates. Similarly, low
business tax rates may bias investment decisions away from locations where the pre-tax
marginal return on capital is higher.
Inter-jurisdictional tax spillovers are associated with tax exporting, congestion costs
faced by residents of other jurisdictions, tax revenues received in other jurisdictions,
and changes in output and factor prices in other jurisdictions (Gordon, 1983). The first
occurs when residents of other jurisdictions pay part of the tax revenue, e.g., because
they buy a product produced and taxed locally. The other effects are the result of
taxpayer relocations due to changes in local taxes. For example, the congestion of local
schools and parks declines, if taxpayers move away from a community in response to
lower taxes elsewhere.
The basic insight is that local governments should avoid non-benefit taxation of
economic agents, factors, or goods characterized by a high degree of mobility (Oates,
1999). While mobile agents, factors, or goods could be charged benefit taxes by local
governments, i.e., taxes charged for services like sewage or water (Oates and Schwab,
1988), the ideal objects of taxation for local governments are immobile factors such as
land. Non-benefit charges should be left to higher levels of government.
A further implication is that non-benefit charges on mobile individuals, factors or goods
imposed by sub-central governments, if they cannot be avoided, should take the form of
resident-based taxation rather than source-based taxation (Inman and Rubinfeld, 1996).
Since the implementation of residence-based taxation is difficult for taxes on output and
consumption, this strengthens the argument against assigning such taxes to local
governments.
Tax Competition
An important issue in the assignment of taxes arises from the potentially detrimental
effect of tax competition under decentralized taxation. One version of the argument
holds that local governments compete for businesses and new jobs or for rich tax payers
by promising low tax rates or generous tax breaks for firms locating in their region
(Break, 1967).11 When all local governments do this, the equilibrium outcome involves
low tax rates and revenues, which limits the quantity and quality of (non-business
oriented) public services. Each local government finds it optimal to keep its tax rate low
to attract taxpayers, although all governments and citizens collectively would prefer
higher tax rates and higher levels of public goods. Tax competition thus leads to
equilibrium with inefficiently low public services. Although empirical evidence on the
importance and the effects of tax competition is scant (Musgrave, 1997; Krogstrup,
11 Similar arguments pertain to local regulatory policies. For example, Donahue (1997) reports that
Alabama offered Mercedes a subsidy package worth USD 168.000 per job to attract the company’s new
automobile plant.
9
2002), the argument plays an important role among policy makers and in discussions
about tax assignment in practice.12
The response of traditional fiscal federalism is an efficiency-based theory of tax
harmonization among local governments and a theory of vertical grants, i.e., transfers
from higher to lower level governments (Olson, 1969; Break 1980). Limiting regional
differences in tax rates reduces the importance of tax considerations in citizens’
locational choices and thus results in inefficient competition for tax resources. If local
governments are deprived of taxes, the central government can pay vertical transfers to
close the gap between local revenues and spending needs. If such transfers are
permitted, tax assignment can be made entirely on the basis of efficiency criteria
(Spahn, 1988). Economies of scale in the collection and administration of taxes then
suggest vesting the highest level of government with the right to collect the most
important taxes such as taxes on income or value added.
However, centralized tax collection and heavy reliance on vertical grants by local
governments weaken incentives to maintain a sufficiently large tax capacity at the local
level, as the pay-off from doing so accrues to all governments. A solution is to reduce
the vertical grants by tying their size to the taxes collected in the local government’s
jurisdiction, or by allowing local governments to piggy-back on central government
taxes, i.e. to charge a local tax in addition to the federal tax collected by the central
government.
From a public choice perspective, tax harmonization and vertical transfers are harmful
forms of inter-government collusion that limit competition among local governments
and generate more discretionary power for politicians. Similarly, market-preserving
federalism argues against tax harmonization and vertical grants and demands instead
that local governments have sufficient own tax resources to operate, as this promotes
responsibility.
An important issue here is the form of competition under decentralized tax policies. The
potential for harmful competition is probably greater when individual taxpayers like
large corporations enjoy considerable market power. In such cases, it is important to
ensure that local governments do not engage in resource-wasting bidding wars.
Transparency of the process can probably do much to limit the potential damage.
Furthermore, agreements to harmonize tax rates among local governments create
incentives for moving competition to the dimension of local tax administration, e.g. by
promising variable levels of enforcement to potential taxpayers. Such competition is
worse than competing on tax rates, as it promotes “price-discrimination” between
taxpayers. Again, transparency is important in this context. Rather than suppressing tax
competition among local governments, the central government’s role is to design and
enforce rules promoting transparency and efficient competition.
12 Theoretical literature on the issue shows that, tax competition can generate efficient equilibrium and,
indeed, be beneficial for local government when incumbent residents of a jurisdiction ultimately benefit
from efforts to attract capital and business. However, as Oates (1999) points out and Sinn (1999) critically
remarks, this requires assumptions that turn local governments into the equivalent of price-taking firms in
perfectly competitive markets. In an interesting empirical study of tax competition in pre-World War I
Germany, Hallerberg (1997) shows that Prussia enjoyed considerable market power and was able to hold
taxes high.
10
2.1.3 Assignment of Tasks in the Annan Plan
Principles
According to Art 2, the constituent states have the competences for all matters that are
not explicitly assigned to the federal government.
Art. 14 lists the specific competences of the federal government. The federal
government is responsible for external political and economic relations (Art. 14 a, b),
activities with large regional spill-overs (Art 14 c, f, g), certain judicial affairs (Art 14 h,
i, j, k). While this corresponds to conventional arguments, it is not clear why the federal
government should be responsible for antiquities (Art 14 l) and natural resources (Art
14 e). In both areas, economic benefits are locally concentrated and, therefore,
responsibility for relevant policies could be left to the constituent states. An argument
can be made that preserving natural resources and antiquities is a common
responsibility with benefits accruing to future generations, and that local governments
might be too myopic to give proper weight to such considerations. This problem,
however, could be solved through the adoption of a federal regulatory framework rather
than the general assignment of these areas to the federal government. A potential
conflict over competencies could arise from the close connection between federal
policies dealing with “natural resources” (Art. 14.1e) and environmental policies, which
Art. 15.3 puts explicitly under constituent state authority.
A significant weakness of the assignment under the Annan Plan is the lack of federal
competences in areas where lax policies by one constituent state can undermine the
effectiveness of policies aiming at the protection of citizens in the other constituent
state, and where inappropriate policies in one constituent state can distort trade and
competition in the internal markets of the UCR. This mainly concerns education (higher
education in particular), health, social security, and commercial and industrial
regulation including the regulation of safety of the workplace, minimum work
standards, and product safety. Under the assignment rule of the Annan Plan, there is a
significant risk that the less economically developed T/C State would try to compensate
comparative disadvantages due to lower capital equipment and a less educated
workforce by introducing a significantly weaker regulatory regime.13
Another weakness is the lack of federal competences for financial regulation other than
banking regulation. The risk here is that lax policies in one constituent state can
undermine systemic stability in the other constituent state.
While leaving the competencies for these areas to the constituent states might be
regarded as in line with the principle of market-preserving federalism that the states
should run policies determining their economic development, the Annan Plan lacks the
federal regulatory framework necessary to ensure that the negative effects associated
with such decentralization will be avoided. One might argue that the risks emerging
from uncoordinated policies in these areas are mitigated by the fact that the EU imposes
minimum standards in these areas. However, the EU itself has no instruments to enforce
its standards. Art. 19.5 calls upon the federal government to take “necessary measures in
lieu of the defaulting constituent state” if a constituent state fails to fulfill obligations of
13 The strictures of the acquis communautaires may limit its ability to do so, although this leaves open
issues of enforcement – see also below.
11
the UCR vis-à-vis the EU. Violations of the acquis communautaires would fall under
this provision. However, it is entirely unclear what the federal government could do to
force a constituent state to pass and enforce proper regulation in these the areas. Given
its financial and administrative weakness as construed by the Annan Plan, the federal
government will be unable to implement policies for which a constituent state will be
responsible. Nor will the federal government have much financial leverage to penalize
constituent states for laxity in discharging their responsibilities. If, as the Annan Plan
hints, tax collection will be done by the constituent state administration, the latter can
easily withhold their shares of indirect taxes, giving the federal government no leverage
from that end. Short of a genuine federal competence in these areas and the means to
implement federal policies, federal enforcement of EU rules will be weak at best.
Art 14e assigns the federal government competences for the federal finances, including
budgetary policy, indirect taxation, and federal economic and trade policy. Trade policy
will, in effect, be a competence of the EU by virtue of Cyprus’s EU membership. For
federal finances, see below.
The federal government has the competence to maintain a federal administration to
execute its tasks (Art. 14.2). It is called upon by Art 14.3 to delegate the implementation
of its laws to constituent state authorities. This includes the collection of federal taxes.
The principle can serve to keep the federal administration small, which is in line with
the fact that the federal government’s financial resources will be relatively small. It
follows from the model of “cooperative federalism” which is also the principle of
federalism adopted in Germany. An important weakness of this model is that it makes
the federal government dependent on the constituent states in the implementation of its
policies.
To start with, constituent states can undermine the effectiveness of federal policies by
choosing a low level of implementation. This could be a problem in the context of EU
regulatory policies, where the federal government is responsible to the EU for proper
implementation of EU regulations, but may not have the means to fulfill its obligations
if a constituent state refuses to deliver proper implementation. The problem is
aggravated by Art. 14.4, which stipulates that international obligations, which include
EU obligations, will be implemented by the level of government under whose
competence they fall. This is balanced by Art. 19.4 which stipulates that in cases where
the EU requires the existence of a national authority to implement a part of the acquis
communautaires, this authority will be established at the federal level. In all other cases,
however, the establishment of administrative structures will be decided on the basis of
undefined efficiency principles. In view of the economies of scale involved in the
enforcement of the policies of the acquis, economic efficiency would most likely call
for federal administrations in these cases. However, the financial weakness of the
federal government may severely limit the size of the federal administration, with the
consequence that constituent state administrations may still be the more efficient
solution.
In addition, lax implementation of federal policies, in particular of regulatory policy and
indirect tax collection, could become an area of competition among the constituent state
governments for mobile businesses.
12
Grey Areas
The Annan Plan currently has no explicit list of shared responsibilities. Compared to the
norms of fiscal federalism, this is surprising. On the one hand, one would expect that
preferences regarding public goods and services are markedly different between the two
communities, while, on the other hand, the size of either constituent state is too small to
exhaust economies of scale or internalize all local externalities. The coarse assignment
rule of the Annan Plan is likely to produce many inefficiencies.
Shared responsibilities could effectively emerge in the UCR in two ways. The first is
through Constitutional Laws, which stipulate forms of binding cooperation between the
federal government and the constituent states (Art. 16.1), and Cooperation Agreements
(Art. 16.2). Constitutional laws must be approved by the federal and both constituent
state legislatures and have precedence over federal and state laws. Annex II of the
Annan Plan suggests that such laws would be limited to the area of internal security and
citizenship. However, Attachment 1 to this Annex, which regulates the elaboration and
adoption of constitutional laws, is still to be filled with content. Cooperation agreements
must be approved by the federal and the constituent state legislatures and have the same
legal standing as Constitutional Laws. They can create common organizations or
institutions. By giving each constituent state parliament veto power over cooperative
arrangements, the scope for sharing responsibilities under these arrangements seems
rather small.
The alternative route to create shared responsibilities is coordination and harmonization
of constituent state policies (Art. 16.3) not (necessarily) based on Cooperation
Agreements. This is deemed possible “wherever appropriate” and especially in some
specific areas listed in Art. 16.3. Art. 16.4 allows the federal government in particular to
initiate such coordination or harmonization. Art. 16.6 requires the federal government to
financially and logistically support cooperative policies among the constituent states.
This unqualified mandate is a potential weakness, as the constituent states might use it
as a basis to extract funds from the federal government to support local activities.
Furthermore, agreements on cooperation and harmonization can be approved by the
“competent branch of the constituent state governments” and if necessary “the
competent branch of the federal government” (Art. 16.5). This raises two concerns.
First, it takes cooperative agreements outside the realm of parliamentary control.
Governments could undermine parliamentary powers by entering into cooperative
agreements “forcing” them to do things the parliaments did not approve. Second, it
takes the financial control over such agreements away from the finance ministers of the
relevant governments. In particular, heads of federal line ministries might be willing to
accept federal financing of cooperative agreements for political opportunity and create
substantial federal financial obligations in this way.
Art 14d assigns the federal government the competence over “federal economic policy.”
This term is vague and undefined. In the language of EU treaties, “economic policy” is
typically understood as the macroeconomic part of fiscal policy. This would include
macroeconomic stabilization policies and, more importantly, redistribution and social
insurance. The proximity to “federal finances” in Art. 14d might suggest a similar
interpretation. However, by requiring, during the first five years after the entry into
force of the Agreement,

[brother]

So you have pasted info. on annan plan but what have you got to say about it?