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Your Three Minutes In Polish Cities: Income Reform Should Help Restore Financial Capacity

This report does not constitute a rating action.

The recent reform on the income structure of Poland's local and regional governments (LRGs) should bolster their revenue and improve cash flow predictability.   In our view, the reform, adopted on Sept. 3, 2024, may also help restore the prudent financial framework, which has been temporarily altered over the last few years. The key measure is a change in the calculation of personal income taxes (PITs) and corporate income taxes (CITs) that are allocated to LRGs. This should increase their overall revenue, while replacing the ad hoc one-off transfers from central government. These one-off payments were implemented in 2022 under the previous Law and Justice (PiS)-led central government that introduced the so-called Polish Deal tax reform. We note that the 2022 changes weakened the financial performance of larger cities in Poland, including those that we rate: Lodz (BBB+/Stable/--) and Krakow (A-/Stable/--).

Chart 1

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What's Happening

One of the main benefits of the new reform is that it will stabilize the share of PIT and CIT that LRGs receive. These tax revenues (contributing about 65%-70% of tax revenue for rated cities) will be calculated based on the actual taxable income of residents and companies located within the jurisdiction of the city. These revenues will also include additional smaller flat-tax revenues, which were previously excluded. In contrast, the existing calculation is more prone to exemptions, which reduces the amount that LRGs receive. The new reform will also bring spending autonomy that merges various past subsidies into one, with full spending discretion.

Why It Matters

Polish LRGs, particularly the larger ones, saw their financial performance deteriorate from 2022 until 2024 (see chart). The tax reform of 2022 slashed their revenues and only partly compensated them with central government transfers. This weakened Lodz's and, to an even greater extent, Krakow's operating performance considerably. Debt rules have also been softened--specifically the rules for balanced budgets and debt servicing (e.g. excluding refugee expenditure among others)--until 2025. Polish public finance law limits an LRG's debt servicing to the average net surplus over the past three- or seven-years (depending on the period initially chosen by the LRG) of operating revenue and privatization proceeds, less operating expenditures. Under the new framework, debt rule softening has been prolonged until 2029. The sudden centralization of budget revenue automatically constrained LRGs' borrowing capacity and ability to finance development projects on the balance sheet, while clouding the medium-term predictability of their finances.

What Comes Next

The final budget will be approved at central government level in 2024, which will provide input for LRG budgets. Although the reform should strengthen Polish cities' finances, it will take time and further reforms to restore sound financial performance and a solid borrowing framework, and achieve higher decentralization.

Related Research

Primary Credit Analysts:Michelle Keferstein, Frankfurt (49) 69-33-999-104;
michelle.keferstein@spglobal.com
Felix Ejgel, London + 44 20 7176 6780;
felix.ejgel@spglobal.com
Secondary Contacts:Maxim Rybnikov, London + 44 7824 478 225;
maxim.rybnikov@spglobal.com
Carl Sacklen, London;
carl.sacklen@spglobal.com

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