88878 Municipal Finances Municipal Finances A Handbook for Local Governments Catherine Farvacque-Vitkovic and Mihaly Kopanyi, Editors © 2014 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 17 16 15 14 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Library of Congress Cataloging-in-Publication Data has been requested. CONTENTS Foreword xvii Acknowledgments xix About the Editors xxi Key Contributors xxiii Introduction xxvii Chapter 1. Intergovernmental Finances in a Decentralized World 1 Abdu Muwonge and Robert D. Ebel Chapter 2. Metropolitan Governance and Finance 41 Mats Andersson Chapter 3. Municipal Financial Management 93 Rama Krishnan Venkateswaran Chapter 4. Managing Local Revenues 147 Maria Emilia Freire and Hernando Garzón Chapter 5. Managing Local Expenditures 215 Lance Morrell and Mihaly Kopanyi Chapter 6. Managing Local Assets 275 Olga Kaganova and Mihaly Kopanyi Chapter 7. Managing External Resources 325 Maria Emilia Freire Contents v Chapter 8. Achieving Greater Transparency and Accountability: Measuring Municipal Finances Performance and Paving a Path for Reforms 379 Catherine Farvacque-Vitkovic and Anne Sinet Additional Readings 443 The Way Forward 447 Index 453 Boxes 1.1 Political Economy of Decentralization Reform: Nepal 3 1.2 Poland: Political Decentralization in a Multitier System 4 1.3 Egypt: Deconcentration with Limited Authority 6 1.4 Bosnia-Herzegovina Confederalism 8 1.5 Nation Building by Means of Decentralization in Sudan and South Sudan 11 1.6 Intergovernmental Transfers 17 1.7 Formulas for Fiscal Transfers—South Africa and Saudi Arabia 21 1.8 Minimum Conditions Performance Measurement 27 1.9 Objectives of Municipal Contracts 30 1.10 The Process of Municipal Contracts 31 1.11 Municipal Contracts: Some Examples of Best Practice 32 2.1 Terms Related to Metropolitan Areas 42 2.2 The Emergence of the Tbilisi Corridor 45 2.3 Risks and Missed Opportunities Due to Lack of Metropolitan Governance 49 2.4 Questions to Ask When Reviewing the Governance Structure of a Metropolitan Area 52 2.5 Common Financial Reasons for Regional Cooperation or Establishing Regional Service Entities 57 2.6 The Dulles Corridor Metrorail Project 60 2.7 The U.S. Association of Contract Cities 62 2.8 Solid Waste Management in Shanghai Municipality 64 2.9 The Metropolitan Washington Council of Governments 65 2.10 São Paulo ABC Region 66 2.11 Metropolitan Governance System in Dar es Salaam 73 2.12 Toronto: Evolution from a One-Level System to Two Levels, and Back to a One-Level System 75 2.13 London: Evolution from a Two-Level System to a Single Level and Back to a Two-Level System 76 vi Municipal Finances 2.14 Abidjan: Evolution from a Two-Level Local Government to a Regional Government 78 2.15 Formation of the Portland Metro Government 79 2.16 The Twin Cities Metro (Minneapolis–St. Paul), Minnesota, U.S. 80 2.17 Stages of Emerging Metro Manila, the Philippines 81 2.18 Changing Metropolitan Governance Models in Cape Town, South Africa 84 2.19 The Change of Governance Structure of Johannesburg, South Africa 86 3.1 Principles of a Good Budget 95 3.2 Participatory Planning in Kerala, India 102 3.3 Participatory Budgeting in Porto Alegre 103 3.4 Examples of Appropriation, Allocation, and Commitments 111 3.5 Accounting in Historical Perspective 112 3.6 Manual Bookkeeping in Pakistan 118 3.7 The Fund Structure of State and Local Governments in the United States 128 3.8 PROOF–A Campaign for Transparency and Accountability in Bangalore 138 3.9 Municipal Finance Management Act, South Africa 140 3.10 Use of Private Sector Auditors to Audit Local Governments in Bangladesh 144 4.1 A Good Local Tax 150 4.2 Which Revenue Sources Should Be Defined Centrally Rather Than Locally? 154 4.3 Principal Revenue Sources for Local Governments 157 4.4 Land Tax in Old China 159 4.5 Updating the Cadastre to Increase Tax Revenues—The Case of Colombia 160 4.6 Computing the Tax Base of a Building in Village X 162 4.7 Developing a Computer-Assisted Mass Appraisal Model 168 4.8 Property Tax in the West Bank 170 4.9 Local Business Taxes around the World 173 4.10 Water Tariffs—An Example of User Charges 176 4.11 Charging Willing Buyers 178 4.12 Surcharge for Energy Saving 178 4.13 Computing Land Value Valuation 182 4.14 Land-Based Revenues, Speculation, and Leapfrog Development 183 4.15 The Free Rider Paradigm and the Need for Local Taxes 185 Contents vii 4.16 Reasons Why People Do Not Pay Taxes—Survey in Tanzania 187 4.17 How to Estimate Potential Revenues 188 4.18 Success in Increasing Own-Source Revenues in Maputo 189 4.19 Development of Tax Registers in Senegal 190 4.20 Tax Department Involvement in Street Addressing Surveys in Niger 191 4.21 What to Do When in Financial Stress 192 4.22 Financial Recovery Action Plan in Kampala, Uganda 192 4.23 Main Steps in Revenue Enhancement Programs 193 4.24 Methods for Calculating Growth Rates and Projecting Revenues Years Forward 198 4.25 Revenue Forecasting Techniques 203 4.26 Value for Money Strategy—London Borough of Sutton 205 4.27 Citizens’ Information Leaflet, Kenya 206 4.28 Improving the Property Tax in Ghana 207 4.29 Benin Increases Its Revenue Capacity 208 4.30 Criteria for Tax Choice 210 5.1 Reforming Expenditure Management 222 5.2 Weaknesses in Resource Allocation and Use 223 5.3 Alaska’s Bridge to Nowhere 225 5.4 Mismatch between Policy Goals and Expenditure Allocations in Guinea 226 5.5 Snapshots of Expenditure Budgets 227 5.6 Main Steps in Setting New Tariffs 231 5.7 Supporting Public Utility Companies in a Croatian City 235 5.8 Tariff-Setting Experiences in the Russian Federation 237 5.9 Street Addressing to Support Household Waste Management in Conakry, Guinea 238 5.10 Water Subsidies in Delhi, India 241 5.11 Introducing Competitively Tendered Franchises in Uzbekistan 246 5.12 Key Elements for Successful Contract Management 249 5.13 Bypassing an Integrated Financial Management Information System to Embezzle Public Funds 252 5.14 The Benefits of Efficient Cash Management 253 5.15 Summary of Results of Municipal Contracts in Senegal and Mali 256 5.16 Performance-Based Budget for Child Care Improvement in Sunnyvale, California 264 viii Municipal Finances 5.17 International Organization for Standardization Certificates— Improving Municipal Performance and Cost Control 268 5.18 Potential Impact of Special Interests 271 6.1 Example of Changing the Status of Municipal Property in Hungary 277 6.2 Essential Elements of the Framework for Infrastructure Asset Management Planning 284 6.3 Croatian Cities: Initial Asset Management Model 285 6.4 Campaign Asset Management—Road Widening in Kathmandu 288 6.5 Inventory and Valuation of Built Assets: The Urban Audit 291 6.6 Power of Information Transparency 295 6.7 Which Valuation Method to Use? 298 6.8 Asset Operating Statement for a Housing Management Unit 300 6.9 Are Local Governments Qualified Owners of Revenue- Generating Properties? 301 7.1 Harrisburg, Pennsylvania: A Bankrupt City 329 7.2 San Francisco: The 10-Year Capital Plan, FY 2012–21 332 7.3 Citizens’ Involvement in City Investment Plans 334 7.4 Lack of Coordinated Plans 335 7.5 Cost-Benefit Analysis, Internal Rate of Return, and Net Present Value: An Example 337 7.6 Local Government Borrowing in North America and Western Europe 339 7.7 Underwriting 340 7.8 Municipal Bonds in Developing or Middle-Income Countries 341 7.9 General Obligation Bond Issue by Novi Sad 342 7.10 Long-Term Bond Issue in the City of Johannesburg 342 7.11 Ratings in Emerging Economies 343 7.12 A Comparison of Bonds and Bank Lending 345 7.13 National Rating in Mexico 346 7.14 Modernization of Local Investment Finance in Mexico 346 7.15 Brazil’s Fiscal Responsibility Law 348 7.16 Municipal Debt Controls in Selected Countries 349 7.17 Jefferson County Files for Bankruptcy Protection 352 7.18 Loans to a Local Government without Sovereign Guarantee 354 7.19 The Water and Sanitation Fund in Tamil Nadu 355 7.20 The Hybrid Financing of Ouagadougou 356 7.21 Challenge in Foreign Currency Borrowing 358 7.22 St. Petersburg’s Experience with Debt Management 358 Contents ix 7.23 Syndication and Access to Market: The Water and Sanitation Pooled Fund 361 7.24 Successful Municipal Development Funds 363 7.25 IDA and IBRD Lending Terms 364 7.26 The Lahore Composting Carbon Finance Project 366 7.27 Feasibility Analysis for a Sanitary Landfill 372 7.28 Water PPP in Argentina 372 7.29 Dar es Salaam: A Failed Water PPP 373 7.30 “Urban Concessions” PPP in Brazil 373 8.1 U.S. Experience in Municipal Performance Measurement 383 8.2 Vancouver: Communicating Municipal Priorities and Performance 384 8.3 Municipal Performance Measurement in Ontario and New York 385 8.4 Baseline Credit Assessment 400 8.5 Citizen Involvement: Participatory Budgeting in Porto Alegre, Brazil 402 8.6 Improving Local Governments Capacity: The experience of Municipal Finances Self-Assessment (MFSA) in South East Europe 403 8.7 Urban and Financial Audits: A Potentially Powerful Combination 405 8.8 Main Definitions 418 Figures 1.1 Results Chain in Education 20 2.1 Monocentric Structure 43 2.2 Sprawl 44 2.3 Polycentric Structure 44 2.4 Multipolar Structure 45 3.1 The Pillars of Financial Management 94 3.2 The Budget Cycle 98 3.3 Standard Budget Structure 104 3.4 Example of a T-Account 114 3.5 Logical Frame of Net Assets 127 3.6 Break-Even Analysis 135 4.1 Local Share in Public Expenditures and Revenues (2011) 149 4.2 The Benefit Principle of Municipal Finance 151 4.3 Brazil—Sources of Revenues by Size of Municipality, 2003 152 x Municipal Finances 4.4 Revenues in Budget Context 156 B4.5.1 Property Tax Potential Revenue 2004–10 161 4.5 Cadastre Information (personal files) 163 4.6 Information Flow to Assess the Property Tax Base 164 4.7 The Revenue Budget Cycle 195 4.8 Local Revenues and Price Indexes in New York City, 1993–2009 (percent) 196 4.9 Property Tax and Revenue Forecasting Scenarios 200 4.10 Sales Tax Collections, Year-over-year, 1991–2009 201 5.1 Revenues in Budget Context 217 5.2 Expenditures by Function and Decentralization 219 5.3 The Iterative Budgeting Process 220 5.4 The Expenditure Management Cycle 221 5.5 Manual Cashbook 234 5.6 Competitive Tendering Process 243 5.7 Daily Financial Snapshot: Financial Management Information System of Chiniot City, Pakistan 251 6.1 Asset Life Cycle 279 6.2 Interlinks between Asset and Other Management Areas 281 6.3 Management of Physical Assets and Implications for Local Finance 282 B6.4.1 Demolished Buildings to Enforce Right of Way 288 6.4 Present Value of Costs and Revenues of a Landfill in Tanzania 304 6.5 Annual Maintenance, Management, and Repair Costs of Facilities, Washington, D.C. 309 6.6 Classification of All Municipally Controlled Land 315 6.7 Classification of Surplus Municipal Land 316 7.1 Sources of External Financing for Local Governments 327 7.2 Framework for Drafting Capital Investment Plans 330 7.3 Capital Investment Plan for Charlotte City 331 7.4 Example of a Municipality’s Debt Service Fluctuations, 2012–17 351 7.5 Log Frame for Credit Guarantees 353 7.6 Log Frame for Debt Instruments 359 B7 .26.1 Turning the Windrows 367 B7 .26.2 Validation 367 8.1 Performance-Based Measurement Examples from Two Jurisdictions in Canada 386 8.2 Municipal Debt per Citizen and Total Debt in 10 French Cities 388 Contents xi 8.3 Municipal Expenditures on Selected Sectors and Citizen Satisfaction 389 8.4 Example of Performance Measurement and City-Ranking Criteria in Morocco 392 8.5 Ratios Guide Senegal 393 8.6 Illustrations from Japan’s White Paper on Local Public Finance, 2011 396 B8.7.1 Critical Steps in Implementing an Integrated Urban and Financial Audit 406 8.7 Modules of the Municipal Finances Self-Assessment 407 8.8 Structure of Current and Capital Budget 418 Maps B2.2.1 Tbilisi Metropolitan Area 46 2.1 Economic Densities (“Economic Mountains”) in Parts of the World 47 2.2 East Africa with Population Density 48 B2.10.1 São Paulo Metropolitan Region 66 2.3 Grand Lyon, with Lyon City in the Center, Surrounded by 57 Suburbs 70 B2.11.1 Dar es Salaam Metro Region 73 B2.14.1 The 10 Communes of Abidjan 78 2.4 Metropolitan Nairobi 82 B2.18.1 Population Density in Cape Town, South Africa 84 B2.19.1 Johannesburg within Gauteng Province 86 2.5 Shanghai Core City and Suburban Districts/County 87 Tables 1.1 Vertical Imbalances in Pakistan 13 1.2 Classification of Forms of Intergovernmental Transfers 15 1.3 Shared Revenues (Taxes) in South East Europe Countries 19 1.4 Selected Output Indicators Applied to Performance-Based Grants 28 2.1 Advantages and Disadvantages of the Various Metropolitan Governance Models 54 2.2 Horizontal Coordination among Local Governments 61 2.3 Types of Regional Authorities 63 2.4 Characteristics of Regional (Metropolitan) Authorities 64 2.5 Metropolitan Washington Council of Governments Financial Snapshot 2010 65 xii Municipal Finances 2.6 London Development Agency Financial Snapshot 2010–11 68 2.7 Financial Snapshot of Delhi Development Authority 69 2.8 Metropolitan-Level Government 71 B2.11.1 Transfers to Local Governments in Dar es Salaam Metro Region 2009/10 74 2.9 Annexation of Territory or Amalgamation of Local Governments 83 2.10 Budget of City of Cape Town 2011/12 85 3.1 Line-Item Expenditure Budget of Bangalore, India 96 3.2 Attributes of Current and Capital Expenditures 97 3.3 Budget Calendar for Budget Fiscal Year January–December 2010 100 3.4 Logical Flow of the Capital Budgeting Process 106 3.5 Example of Variances between Budgeted and Actual Expenses for a Water Utility 109 3.6 Sample of a Journal 113 3.7 Balance Sheet of a Housing Management Unit of a Municipality 115 3.8 Purchase of Machinery 116 3.9 Borrowing 116 3.10 Paying a Utility Bill 116 3.11 Sales of Goods 116 3.12 Equity Received 116 3.13 Chart of Accounts 116 3.14 General Journal 121 3.15 Posting Transactions in Three T-Accounts 121 3.16 Sample Ledger Accounts 122 3.17 Sample Cash Book 122 3.18 Consolidated Receipts and Payments Account for the Year Ended December 31, 2010 123 3.19 Trial Balance of City XYZ 124 3.20 City XYZ—T-Accounts and Cash Account 125 3.21 Statement of Receipts and Payments 126 3.22 Government Funds Balance Sheet 128 3.23 Example of a Government Funds Balance Sheet 130 4.1 Brazilian Municipalities—Composition of Current Revenues by Size of City, 2003 151 4.2 Structure of Local Revenues, Selected Countries, 2006 153 4.3 Structure of Revenue 156 4.4 Selected Local Government Taxes by Country, 2010 158 Contents xiii 4.5 Assessing the Property Tax Base—Alternative Approaches 166 4.6 Annual Rental Value Tables—Punjab, Pakistan 166 4.7 Methods Used to Assess the Property Tax Base 167 4.8 Updating the Property Tax Database in Bogotá 167 4.9 Main Local Business Taxes in the European Union 172 4.10 Main Capital Revenue Categories 179 4.11 Land Financing Instruments 184 4.12 Collection Improvement Results of Property Tax Reform in Serbia 194 4.13 Revenue Data and Growth Factors for Forecasting 197 4.14 Predictability of Main Local Revenues 202 4.15 Revenue Performance: Monitoring and Evaluation Indicators 204 5.1 Jhelum City Budget 217 5.2 Budgets of a Big City in Pakistan and a Medium-Size City in Croatia 218 5.3 Municipal Expenditures by Function in the Russian Federation 219 5.4 Expenditure Plan Submitted by a School to the Finance Department 220 5.5 Multiyear Budget for the City of Johannesburg 230 5.6 Managing and Financing the Water Supply in New Delhi 236 5.7 Options for Poor Customers 239 5.8 Forms and Means of Operation Subsidies 240 5.9 Tariff Options for a Small Water Supply Project in Nepal 242 5.10 Project Procurement Plan 245 5.11 Simple Annual Cash Forecast 254 5.12 Cash Flow Assessment from Addis Ababa Public Expenditure and Financial Accountability (PEFA) Assessment 255 5.13 Net Present Value Analysis of Two Equipment Models 259 5.14 Internal Rate of Return Calculation 259 5.15 Sensitivity Analysis 259 5.16 A Multiyear Budget 261 5.17 Types of Budget Formats 262 5.18 Flow of Service Provision 263 5.19 Performance Budgeting Logic Model 263 5.20 Variance Analysis 266 5.21 Benchmarking Road Maintenance 269 6.1 Assets in the Balance Sheets of Local Governments 280 6.2 Framework for Strategic Asset Management 283 6.3 Example of a Basic Building Inventory 290 xiv Municipal Finances 6.4 Asset Management Policies 295 6.5 Main Asset-Related Revenue and Saving Opportunities from a Budgetary Viewpoint 297 6.6 How to Increase Net Operating Income 302 6.7 Estimating Indirect Subsidies to Rental Tenants 306 6.8 Examples of the Life-Cycle Costs for Different Facilities, Washington, D.C. 310 6.9 Asset-Liabilities Balance Sheet 311 6.10 Example of How Permitted Land Uses Influence Land Value 316 7.1 San Francisco’s 10-Year Capital Plan by Department 333 7.2 Financing the City Investment Plan of the City of Charlotte, 2011–15 334 7.3 Cost-Benefit Analysis of a Bus Terminal Project over 10 Years 336 B7 .5.1 Current Values 338 B7 .5.2 Calculation of Net Present Value with an 8 Percent Discount Rate 338 7.4 Investment-Grade Ratings of Three Rating Agencies 344 7.5 Comparison of Bonds and Bank Lending 345 7.6 A Checklist for Debt Managers 350 7.7 A Typology for Delivery of Urban Services 369 7.8 Types of Public-Private Partnerships 370 8.1 Perspectives on Performance 385 8.2 Key Mandatory Municipal Finances Ratios 395 8.3 Guidance on Risk Analysis and Ratios 399 Contents xv FOREWORD Municipal Finances, A Handbook for Local Governments takes sides. It takes the side of mayors and municipal managers. Few publications on municipal finance target local-level decision makers and financial staff in such a direct and prag- matic way. This book’s content and key messages are geared to respond to daily concerns and issues that cities and municipalities face in the management of their finances. Municipalities have made it clear that they need access to global knowledge and that they are seeking to be part of a larger community of practice. A companion e-learning program (“Municipal Finances—A Learning Program for Local Governments”) has also been developed by the same World  Bank team. Its online delivery by the World Bank and its partners will help reach out to an even greater number of interested audiences and help create a platform for a larger community of practice. Municipal Finances, A Handbook for Local Governments takes a position. Much has been learned about what works and what does not, and yet every time we talk about finances or engage in policy discussions or project prepa- ration we tend to reinvent the wheel. Structured around eight chapters, this book reviews lessons learned about intergovernmental relations, metropolitan finance, financial management, revenues management, expenditures manage- ment, public assets management, external funding, and municipal finances per- formance measurement. It spans the arc from decentralization to transparency and accountability and travels the less-charted waters of assets management, creditworthiness, response to financial crisis, reporting mechanisms to various levels of government and civil representation. Municipal Finances, A Handbook for Local Governments calls for action. Not only does it provide cutting-edge knowledge on many technical issues, it also guides local governments through the maze of existing instruments. In partic- ular, it provides a framework for municipal finances self-assessment to  help municipalities evaluate their situations honestly and pragmatically, draw conclusions, and move forward on the path of reforms. In democratic societ- ies, where open government and open data have become accepted norms, an Foreword xvii abundance of social media tools is ready to capture citizen voices demanding accountability and transparency from their governments. It is essential that local governments be prepared to present, and articulate as genuinely as possible, their current financial and economic situation, their bottlenecks, and their perspectives for the future. The world of today will shape the cities of tomorrow, and the cities of today will shape the world of tomorrow. The task of getting municipal finances right is an immediate and urgent goal. We hope that the lessons and propositions outlined in this handbook will be a step in the right direction. Ede Jorge Ijjasz-Vasquez Abha Joshi-Ghani Senior Director for Urban, Director, Knowledge Exchange and Rural and Social Development Learning Global Practice The World Bank The World Bank xviii Municipal Finances ACKNOWLEDGMENTS First, we would like to thank all the contributing authors of this book, who devoted immeasurable time and energy to this effort. Their diligence and patience toward the editors’ numerous requests, queries and revisions and their professional expertise were vital to the success of this endeavor. We are especially thankful to Christine F. Kessides, Manager, World Bank Institute, and to Abha Joshi-Ghani, Director, World Bank Institute, for their support and guidance. We would like to thank our formal reviewers for their valuable advice and constructive comments, especially Jonas Frank, Matthew Glasser, Tony Levitas, Lili Liu, Gabor Peteri, Hiroaki Suzuki, and Victor Vergara, as well as Stephen Hammer and Sameh Naguib Wahba, World Bank. We also have greatly benefited from numerous conversations with colleagues, peers, regional experts within the World Bank and outside the World Bank. Our engagement with many municipalities and local government practitioners around the globe has provided the fertile ground for learning “from the trenches.” There are too many to mention by name. We have benefited from the professional and technical support of Sabine Palmreuther, Sheila Jaganathan, Maya Brahmam and Chisako Fukuda, World Bank Institute, and of Jeffrey N. Lecksell, Cartographer, World Bank. Sawdatou Wane and Brett Beasley have provided important support. We also are grateful to the World Bank department of publishing and knowledge, especially Patricia Katayama, Rick Ludwick, and Nora Ridolfi for their professional guidance. Last but not least, we are grateful to the Austrian government which helped finance some parts of this work under the World Bank-Austria Urban Partnership. Catherine Farvacque-Vitkovic and Mihaly Kopanyi Editors Dedicated to Patrick Farvacque, whose love of mathematics and contribution to municipal finances were an inspiration. Acknowledgments xix ABOUT THE EDITORS Catherine Farvacque-Vitkovic has more than 25 years of World Bank expe- rience in many regions of the world and has worked in about 30 countries. As a Lead Urban Development Specialist, she has led the preparation and imple- mentation of a large number of urban development and municipal management projects around the world and has been the recipient of numerous awards for excellence. She is the author or coauthor of several sector studies as well as sev- eral books, such as Crest 1650–1789: La Ville et Son Evolution; Reforming Urban Land Policies and Institutions in Developing Cities/Politiques Foncières des Villes en Développement; The Future of African Cities, Challenges and Opportunities for Urban Development/ L’Avenir Des Villes Africaines, Enjeux et Priorités; Street Addressing and the Management of Cities; Building Local Governments’ Capacity; Municipal Self-Assessments, A Handbook for Local Governments (forth coming). She has a keen interest in translating lessons from experience and cutting-edge know-how into practical knowledge products and is currently leading the development and worldwide delivery of an e-learning curriculum on land man- agement, urban planning and municipal finances. Mihaly Kopanyi is a municipal finance consultant. Before he retired from the World Bank in 2011, he was a municipal finance adviser and cochair of the Municipal Finance Thematic Group and worked in 30 countries. His core com- petency areas include intergovernmental finance and financial intermediar- ies. He has written or edited a dozen books and numerous articles, the latest of which is “Financing Municipalities in Turkey,” and the municipal finances e-learning program of the World Bank Institute. He holds a PhD in price policy and a doctor of university degree in logistics. He was a professor and chair of the Microeconomics Department, Budapest University. His postgraduate stud- ies include training at the Wharton School and Stanford University. About the Editors xxi KEY CONTRIBUTORS Mats Andersson specializes in urban development and metropolitan man- agement, municipal finance, project management, institutional development, and related training. His clients include multilateral and bilateral development agencies, financial institutions, governments, and research institutes. From 1994 through 2007 he was an urban management and municipal finance specialist at the World Bank, responsible for project development, lending, and advisory programs in China and Eastern and Central Europe. He has also advised clients in Sweden, Canada, East Africa, and Latin America. Mats holds MBA degrees from Sweden and the United States, and is a Certified Management Consultant (CMC) of the Canadian Association of Management Consultants. Robert D. Ebel is an international consultant and former Lead Economist with the World Bank Institute (WBI). While at the WBI, he served as the World Bank’s technical representative to the Sudan Peace Consultations (2002–05), and for the African Union, a technical resource person at the Inter-Sudanese Peace Consultations on Darfur (2006). From 2006 to 2009, he was Deputy Chief  Financial Officer for Revenue Analysis and Chief Economist for the government of Washington, D.C. Maria E. (Mila) Freire is an international consultant on urban economics and public finance. While at the World Bank, she held several positions, including Senior Advisor to the Sustainable Development Network, Manager of the Urban Program for Latin America, and core member of the World Development Report 2009, Reshaping Economic Geography. Her recent publications include Urban Land Markets (2009), Cities and Climate Change—An Urgent Agenda (2011), and Financing Slum Upgrading (2013, Lincoln Institute of Land Reform). Mila holds a PhD in economics from the University of California, Berkeley. She teaches urban economics at The Johns Hopkins University in Baltimore, Md. Hernando GarzÓn is an economist. He earned his doctorate at the Maxwell School at Syracuse University (1988) and joined the World Bank as an Inter- Governmental Finance Specialist in 1989. Dr. GarzÓn is a former staff member Key Contributors xxiii of the Bank and currently works as an international consultant. He has worked extensively in fiscal decentralization, intergovernmental finance, urban finance, and municipal development funds. His broad international experience in devel- oping and emerging economies covers 36 countries across all regions. His most recent World Bank publications include “Municipal Finance and Service Provision in West Bank and Gaza” (2010) and “City Finances of Ulaanbaatar” (2013). Olga Kaganova is Principal Research Scientist at NORC at the university of Chicago and is an internationally recognized expert on government land and asset management, consulting for donor organizations and governments on a wide range of reforms, from national policies to improving the performance of municipal property. She has worked in 30 countries and advised the governments of Chile, the Arab Republic of Egypt, Ethiopia, Kosovo, and Kuwait; the U.S. state of California; and the cities of Bishkek, Cape Town, Moscow, Mecca, Ulaanbaatar, Warsaw, and Laibin. She has published two books and numerous papers and is an adviser for the Canadian National Executive Forum on Public Property and an adjunct professor at Clemson University. Lance Morrell has more than 35 years of professional experience in financial management in the public and private sectors. After he retired from the World Bank with more than 22 years of project experience in East Asia and Africa, Mr. Morrell founded FEI Consulting, LLC, and continued to work on financial management and institutional strengthening projects throughout the world. Before joining the World Bank, Mr. Morrell served as treasurer and as division controller for major corporations. He is a Certified Public Accountant and a Chartered Global Management Accountant. Abdu Muwonge is a Senior Economist in the Urban and Water Unit, in the Sustainable Department in the South Asia Region at the World Bank. Before joining the World Bank, he worked at the Economic Policy Research Center (EPRC) in Uganda. He has previously taught undergraduate economics and statis- tics at Makerere University and Mbarara University of Science and Technology in Uganda. Mr. Muwonge holds a master of arts degree in economics from the University of Dar es Salaam and a master’s degree and PhD in public finance from Andrew Young School of Policy Studies, Georgia State University. Anne Sinet is a lead international specialist in local and municipal government finance and institutional organization in France and developing countries. Her work includes a senior managerial position in the DGCL (French Ministry of the Interior); she was a Senior Associate in three private French consulting firms and has undertaken many consulting assignments for the World Bank, European Union, EIB, ADB, and French Cooperation Agencies. She has been extensively involved in financial and fiscal analyses for local governments in more than 50 countries and is author or coauthor of several handbooks and research-based books. xxiv Municipal Finances Rama Krishnan Venkateswaran is a Lead Financial Management Specialist at the World Bank. His extensive experience in municipal finance includes work in Sri Lanka, Bhutan, Nepal, India, Ghana, Uganda, and Swaziland. He has worked with the Cities Alliance Secretariat in the Municipal Finance Task Force. Before the World Bank, Rama worked with the government of India and held senior positions in local governments, including chief administrative officer of a  dis- trict. Rama has a master’s degree in economic policy management, Columbia University, and a master’s in accounting, George Washington University. He is a Certified Public Accountant and a Certified Government Financial Manager. Key Contributors xxv Introduction Catherine Farvacque-Vitkovic From Detroit to Lahore, most cities around the to manage. At the same time, municipalities are world are facing financing challenges. Bankruptcy, becoming increasingly dependent on intergovern- budget deficits, financial debacles, unmaintained mental transfers, which have been shrinking over infrastructure, declining quality of services, entire time, in part because of the fiscal pressure created neighborhoods closing down, increasing urban by the global economic slowdown. poverty, and mounting social exclusion are com- Today, in most countries, municipal budgets mon headlines and are the unfortunate fate of are sufficient to cover cities’ operating costs but many local governments. Most countries have not to finance much needed capital investments. embarked on a decentralization process, with var- That will require that cities make more effective ious degrees of progress and success. It is fair to use of their own revenues as well as access credit say that, in most cases, the transfer of responsibil- markets. A key issue is how local governments ities from the central government to local govern- can expand their resource base beyond transfers. ments has not been accompanied by the adequate Municipal practitioners are keen to use and inte- transfer of resources. Among the most important grate new financial management ideas and tools to pending issues are the needs to (a) clarify the dis- control their costs, identify new revenue sources, tribution of responsibilities among the levels of and improve local tax collection. In addition, government and (b) strengthen the resource base local governments have potential access to large of local governments. Some reforms attempt to sources of external funding, though they often do clarify responsibilities without addressing finan- not know how to tap them (EU funding for south- cial issues. Others assign municipal governments eastern Europe, for example). Municipalities new responsibilities that they are ill equipped seek support on how to plan and execute priority Introduction xxvii investments and prepare fundable projects. For city officials improve their financial management those local governments that are in better financial even in the toughest of economic environments. shape, enhancing their creditworthiness and pru- dently accessing capital markets offer opportuni- What to Expect? A Quick Overview ties for profound change. In all cases, improved of Handbook Objectives and Content governance practices and enhanced accountabil- ity mechanisms have become central to sound city Objective: This handbook is a component of government and municipal management. a larger program promoted by the World Bank The World Bank has been involved in a large “Municipal Finances—A Learning Program for number of urban and municipal development Local Governments”. It is a companion publi- projects. The 2009 Internal Evaluation (IEG) cation to an e-learning product delivered by the Report noted that over 190 such projects were World Bank and other partners. It aims to enhance implemented since 1998 and found that “among the knowledge and capacity of local governments. the three dimensions of municipal management – The program adopts local governments’ perspec- planning, finance, and service provision – finance tive and provides tools and how-to instruments yielded successful results”. It also pointed to improve the management and transparency of out that the highest performance was among local finances. municipal development projects implemented Chapter 1: Intergovernmental Finances in by the World Bank in Africa and we will review a Decentralized World. Written for municipal in this book how the introduction of specific finance practitioners and policy makers alike, tools helped achieve this result. Lessons from chapter 1 provides the basic foundation for work- the ground show that, although reforms at the ing through the next seven chapters. It begins with macro-level are difficult to achieve, a lot can a discussion of why “getting municipal finance be done at the local government level when there right” is key to achieving a nation’s broader goals is political will for greater accountability in the of economic growth, macroeconomic stabiliza- use of public funds and when reforms on reve- tion, and, for some countries, national cohesion nue generation are clearly connected to visible among diverse populations. It then summarizes expenditures/investments in infrastructure and the key considerations of alternative governance service delivery. This is grounded in the under- structures, as well as fundamental questions standing that (a) the strategic management of related to what role municipalities should play in municipal finances is critical in ensuring long- a country’s revenue and expenditure systems. The term sustainability of local services and infra- chapter concludes with an examination of the structure and (b) increased fiscal constraints and role of government-to-government grants policy pressure from the global financial and economic and the tools for ensuring accountability between downturn require increasingly sophisticated the various levels of government and between the responses from local governments in mobilizing municipality and its citizens. and using financial resources. Chapter 2: Metropolitan Governance and Against this backdrop, there is both a sense Finances. This chapter describes how cities tend of urgency and a huge opportunity for capacity to grow and the challenges that interdependent building programs directed at local governments. local governments in larger metropolitan areas Despite the financial pressures weighing on local have to deal with. Readers will find an overview governments across the globe, there are many good of governance models and municipal finance practices which need to be shared and many fail- issues in metropolitan cities around the world. On ures which need to be learned from. This handbook municipal finance, the chapter focuses on those builds on these practices and is designed to help aspects that are unique to municipalities that are xxviii Municipal Finances part of larger, interdependent agglomerations. administrators, local government council mem- The chapter includes several case descriptions. bers, department heads, and finance staff to Chapter 3: Municipal Financial Manage- manage and control expenditures so that local ment. This chapter introduces the basic building services can be provided efficiently and effec- blocks of municipal financial management and tively and the tax burden on citizens can be provides the conceptual foundation for the sub- minimized. By managing and controlling expen- sequent chapters on improving expenditure ditures and developing procedures to monitor management and performance assessment. The and evaluate the results, government officials chapter discusses the fundamental concepts of will be better able to minimize the tax burden budgeting, accounting, financial reporting, and on the population while providing desired levels auditing and their applications in a local gov- of services. ernment context through case studies and sim- Chapter 6: Managing Local Assets.  This ple problem sets. The objective of the chapter chapter demonstrates why physical assets  (land, is to enable the reader to develop a good under- buildings, infrastructure, etc.) and enterprises standing of those critical processes in municipal are important for local well-being. It provides a financial management and link them in a prac- framework and a set of practical tools for improv- tical way to larger goals of improving local gov- ing asset management and for linking asset man- ernment financial transparency, efficiency, and agement with financial management. The chapter effectiveness. guides local governments on who should do what Chapter 4: Managing Local Revenues. This and how to begin a long-term improvement pro- chapter reviews the main revenue sources avail- gram. It suggests ways to find additional savings able to local governments, the issues typically and generate additional revenues from assets associated with such sources, and the key chal- and provides tools for the financial analysis of lenges facing city financial officers. It provides a assets. It elaborates on a number of technical position on what are the most promising sources issues because such technical details are critical of revenues. It supports the enhancement of local for successful asset management (e.g., how to institutional capacity by highlighting the differ- improve the attractiveness of municipal land to ent roles and responsibilities of a revenue author- investors or induce competition in land auctions). ity, including a description of the main functions Finally, the chapter discusses more advanced of a revenue administration. It discusses the instruments of asset management, such as land main issues and challenges associated with rev- policies, land-based financing, land asset strategy, enue management functions and offers guidance public-private  partnerships, and special purpose to practitioners on how to achieve more effec- corporations. tive and efficient revenue administration and Chapter 7: Managing External Resources. collection. It illustrates how to conduct revenue This chapter discusses how local governments trend analysis, including a discussion of differ- can access external resources to finance ent approaches to revenue forecasting. Finally, it local development programs. It reviews the addresses the main challenges that the political types of external resources available to local economy poses for revenue management, governments—from grants to borrowing and describes how to implement revenue mobiliza- private sector partnerships—discusses how to tion strategies, and examines the impacts of rev- ensure prudent borrowing, and illustrates the enue policy. importance of a participatory capital invest- Chapter 5: Managing Local Expenditures. ment program to guide the choice of pri- This chapter introduces concepts designed ority programs and ensure their financing. to strengthen the ability of local government Case studies are used to illustrate experiences Introduction xxix and strategies. By the end of the book, readers partners, (c)  internal financial follow-up by will be able to assess which financing alter- municipal staff, (d) reporting to citizens. Third, it natives will be more suitable for their local also provides step-by-step guidance to complete government. a Municipal Finances Self-Assessment (MFSA) to Chapter 8: Achieving Greater Transpar- (a) assess a city’s financial health and (b) identify ency  and Accountability: Measuring Munici- specific actions to improve financial management pal Finances Performance and Paving a Path practices, mobilization of local revenues, public for Reforms. This chapter attempts to define what spending, public assets management and main- performance measurement really means. Are we tenance, investment programming, and access doing the right things? Are we doing things right? to external funding. By  the end of the book, First, the chapter focuses on lessons learned from readers will be able to use the MFSA template performance measurement practices and experi- for their city and apply the findings  of  assess- ences in developed countries and assesses how ment in their day-to-day business and in their to adapt performance measurement in the con- medium-term reform agenda. For users’ conve- text of developing cities. Second, it reviews the nience, the Excel template can be downloaded at four key reporting mechanisms commonly used http://siteresources.worldbank.org/EXTURBAN for measuring municipal finances performance: DEVELOPMENT/Resources/MFSA-Template (a) state supervision, (b) risk analysis by financial .xlsx. xxx Municipal Finances CHAPTER 1 Intergovernmental Finances in a Decentralized World Abdu Muwonge and Robert D. Ebel The World Development Report, Entering the communications technology are facilitating the Twenty-First Century, reaches the dramatic spread of global knowledge that allows local conclusion that two forces are shaping the world groups to bypass central authorities in their in which development policy will be defined and search for improved government effectiveness. implemented. The first is globalization, the con- Also influential is the emergence of local, tinuing integration of the countries of the world. national, and supranational organizations and The second is localization, political self- institutions, such as civil society and other citi- determination and the devolution of finances zen networks, free trade regimes, Millennium (World Bank 2000). What is labeled “localiza- Development Goal partnerships, and, in some tion” is often cited as “decentralization”—the cases, a common currency. sorting out of intergovernmental public sector This chapter is organized in three sections. functions among multiple types of government, The first develops the “big picture” of intergov- central and subnational. Moreover, whereas at ernmental finance by drawing the distinction first glance the two trends seem countervailing, between political and fiscal decentralization and they are in fact complementary, as they often then proceeds to identify alternative models or stem from the same set of external factors. variants of decentralized governance. It con- The underpinnings of the complementarity cludes with a review of what has been learned of globalization and localization are several. from recent empirical literature regarding the For example, advances in information and economic and fiscal results of decentralizing. Intergovernmental Finances in a Decentralized World 1 The  second section takes on the key topic of at least by law, allowed a high degree of political transfers from central to local governments, their and fiscal authority (boxes 1.1 and 1.2). design, uses, and intended outcomes. The chapter concludes with a list of takeaway lessons. Fiscal Decentralization Whereas the decision to decentralize is political, the economic and financial payoff flows from a Overview of Intergovernmental well-designed system of fiscal decentralization— Finance that is, the intergovernmental sorting out of Wherever one looks around the globe, some kind responsibilities for expenditures and financing of decentralization is taking place or being dis- among the various types, tiers, or levels of govern- cussed. A variety of definitions, rationales, and ment, in a manner that is in harmony with the arrangements are, and can be, encompassed political framework. under the very imprecise and awkward term “decentralization.” Thus, it is useful to begin by Questions for Any Intergovernmental Setting laying out some terminology. Four fundamental questions must be addressed with respect to fiscal decentralization: Political Decentralization Political decentralization refers to arrangements 1. Which type or tier of government does what whereby the legal legitimacy of local government (expenditure assignment)? is recognized either explicitly in the national con- 2. Which type of government is responsi- stitution or by statutory and administrative deci- ble for obtaining which revenues (revenue sions. In most countries it involves providing for assignment)? (a) local  elections; (b) a division of spending responsibilities or competencies among types of 3. How can fiscal imbalances between the cen- governments; (c) subnational (e.g., municipal) ter and subnational units and across subna- own-taxing authority; (d) rules and regulations tional jurisdictions be resolved, when the case relating to local borrowing and debt manage- for decentralizing spending is almost always ment; and (e) a special status for capital cities greater than that for decentralizing reve- (Slack and Chattopadhyay 2009). In much of the nue generation (a role for intergovernmental postsocialist and developing worlds, this process transfers)? is centrally led and legislated; that is, it is 4. How shall the timing of receipts and payment “top-down.” Even though the political impetus for capital spending be addressed (borrowing for decentralizing the central state may reflect a and debt)? reaction “from below” to long years of extensive central control (Bird, Ebel, and Wallich 1995; This chapter addresses only the third of those Swianiewicz 2006; Regulski 2010), and in some four questions, the topic of intergovernmental cases even a “reaction from above,” as in order to transfers. The first two questions and the fourth generate trust in a new system of governance, and are addressed in subsequent chapters of this even though the center has started decentralizing book. A brief summary is useful before proceed- with lower levels (Smoke and Taliercio 2007), it is ing to the details of intergovernmental transfers. nevertheless the general case that the central Expenditure assignment. The fundamental authority manages the decentralization process. guideline for which type of government has the This is true even in cases where the political out- responsibility for which spending functions is come is such that subnational governments are, the  subsidiarity principle, that is, that public 2 Municipal Finances Box 1.1 Political Economy of Decentralization Reform: Nepal A country’s structure of local governments is a were not explicitly brought into the local function of several complex factors, including governance structure. history, politics, economic potential, constitu- In 1999 Parliament passed the Local tions, and legislation, among others. Nepal is Self-Governance Act (LSGA). The LSGA was an example of the complexity of establishing, considered a landmark in Nepal. It laid down transitioning to, and managing decentraliza- the foundations of local self-governance by tion processes. Throughout its modern his- increasing the devolution of administrative, tory, Nepal was defined by a unitary system of fiscal, and judicial powers to local bodies. The government. Before 1951, little or no consider- current assignment of expenditure responsi- ation was given to empowering the local gov- bilities in Nepal is largely based on the LSGA. ernments. But even after a series of political As of 2011, Nepal’s local government reforms in the 1950s, it was not until the structure was divided into 75 districts, 58 1980s that some efforts were made to decen- municipalities, and 3,913 village development tralize power. Underlying the present local committees (VDCs). These jurisdictions fall government system are several pieces of leg- into 5 development regions and 14 adminis- islation. In the 1950s, two acts had been pro- trative zones. A VDC consists of 9 wards, and mulgated establishing local government units: the municipalities consist of from nine to 35 the Municipality Act of 1953 and the Village wards. Municipalities and VDCs are directly Act of 1956. Following the country’s return to elected. Officially, all three local bodies are autocratic rule in 1960, those acts were autonomous, so there is no legally mandated replaced by the Town Panchayat Act of 1962 hierarchical relationship between them. In and the Village Panchayat Act of 1962. practice, district-level governments have In 1981–82 the Decentralization Act was some supervisory role over both municipali- introduced, and local bodies were given ties and villages, and some resources that some responsibilities in local-level planning fund municipal and village programs are and resource allocation. By 1990, multiparty channeled through the districts. democracy was restored, and the country’s Although the LSGA was intended to be the fifth constitution was ratified, which enshrined blueprint for fiscal decentralization, most of decentralization as a fundamental element the major elements of the act were not actu- of democracy. In 1991, three acts were ally implemented. Most public services in passed creating elected local bodies, namely, local areas are provided by line agencies of the District Development Committee Act, the central government ministries. In some cases, Village Development Committee Act, and the these are deconcentrated to the local area. Municipality Act. These laws were criticized Local governments provide services, but only as not having provided local governments in limited amounts. In general, Nepal remains enough autonomy; local bodies lacked suffi- largely centralized, with only about 6 percent cient expenditure and taxing power, and civil of total government expenditures made by society, nongovernmental organizations, dis- local governments. advantaged groups, and the private sector Source: Sharma and Muwonge 2010. Intergovernmental Finances in a Decentralized World 3 Box 1.2 Poland: Political Decentralization in a Multitier System The local government structure in Poland is tional governments in 1999: powiat (county) a result of two waves of decentralization and voivodship (region). reform. The first wave took place in 1990, At present there are three tiers of territorial when the local government system was intro- governments: almost 2,500 municipalities; duced on a gmina level. Local government 315 counties, plus 65 cities with county reform was one of the main priorities for the status; and 16 regions. On both a municipal first postcommunist government, which was and a county level, local self-governments are formed in September 1989. Quick but inten- the only form of public administration. Central sive preparations allowed the passage of the state functions, such as registration of births new Local Government Law in March 1990, and marriages, are delivered by local govern- which was followed by local elections in May ment as delegated functions financed by 1990 and a radical decentralization of financial specific grants. On a regional level, there is a regulations in January 1991. The 1990 reform dual structure—elected self-government and introduced elected local government on the a governor, appointed by the prime minister, gmina level only; upper tiers of territorial divi- with his or her own administrative apparatus. sions continued to be managed by the state However, functions of self-government and administration. The second stage of the reform state regional administrations are clearly sepa- introduced two new tiers of elected subna- rated, and there is no hierarchical subordina- tion between them. Source: Swianiewicz 2006. responsibilities should generally be exercised by fiscal decentralization is that “finance follows the authorities that are closest to the citizens, and function” (Bahl 1999a; Bahl and Martinez- that assigning a responsibility to another author- Vazquez 2006; Smoke and Taliercio 2007). After ity should be based on considerations of the the assignment of expenditure responsibility, the extent of the task and requirements of efficiency next question is: Which government unit shall (Oates 1972; Yilmaz, Vaillancourt, and Dafflon levy which revenues? This question of finance is 2012; Marcou 2007). Further considerations just as important and complex as the spending include the presence of externalities (the spill- function. Indeed, a good argument can be made over of spending activities across legal jurisdic- that one does not have a system of fiscal decentral- tional boundaries), economies of scale (unit cost ization unless subnational (e.g., local) govern- of production), and capacity to administer and ments have the autonomy to levy (and, in many implement the function (among the several good cases, collect) their own revenues. To realize expositions of the expenditure assignment the  efficiency benefits that will flow from a question are Martinez-Vazquez 1999 and Dafflon well-designed system of decentralization, local 2006). In chapter 5 of this book, Morrell and governments must be able to generate own-source Kopanyi explore expenditure practices for revenues (Jensen 2001; Ebel and Weist 2007). municipalities in detail. The assignment of revenues to different types of Revenue assignment. One of the guidelines for government should not be interpreted to imply the implementation of a well-designed system of that the proceeds from each type of tax should be 4 Municipal Finances designated to only one type of government. There must be allowed to borrow and take on debt that is no reason to assign revenues of a given tax or fee is financed over time, if their financial situation is to one government, as long as the overlapping use in good standing. of the tax or fee does not cause unacceptable ineq- There are principles and rules to sort through uities, economic distortions, or complexities of it all—a process that is studied under the topic of taxpayer compliance and revenue administration. subnational debt management (Canuto and Liu Such problems can often be avoided by assigning a 2013). An important intergovernmental issue given tax to more than one type of government arises when local governments that are part of a (McClure 1999). The robust literature in this unitary intergovernmental hierarchy become a regard is discussed and applied to municipalities source of contingent liabilities. Under these by GarzÓn and Freire in chapter 4 (see also Ebel (typical) circumstances, it may become necessary and Taliercio 2005; Bird 2011a; and Smoke 2008). for the central government to impose limits or Intergovernmental transfers. Once one has other controls on local borrowing activity. This sorted out the expenditure and revenue assign- and other topics of debt management are ments among different types of government, it discussed by Kaganova and Kopanyi in chapter 6 becomes very clear that there is no a priori reason and by Freire in chapter 7 (for additional material, why, for subnational (e.g., municipal) govern- see Rangarajan and Prasad 2012; Wong 2013; ments, the expenditure sum will equal the poten- Peteri and Sevinc 2011; and Canuto and Liu 2013; tial revenue flow. In almost every case, there will also helpful is the World Bank Thematic Group be a financial imbalance between the central and website on subnational borrowing and debt, subnational governments (vertical imbalance), as www.worldbank.org/subnational). well as among municipal governments (horizontal imbalance). That is the reason why decentralized The Three Ds—Deconcentration, Delegation, systems must also establish a system of intergov- and Devolution ernmental transfers, almost always from the The term “fiscal decentralization” encompasses central to the local authority. The problem of three distinct arrangements or variants, each of imbalances and how to address them is discussed which has a place in a country’s intergovernmen- below. tal financial system. The three are deconcentra- Borrowing and debt. What about the timing of tion, devolution, and delegation. An important receipts to pay for capital spending? How is infra- policy question is which of the three variants can structure such as schools, roads and highways, be said to dominate a nation’s public finances. and water and transportation systems financed? Deconcentration. Deconcentration is some- Thus, the fourth issue facing a decentralized soci- times referred to as administrative decentraliza- ety arises—the role of local borrowing and debt tion. It denotes a process whereby regional offices management. How can the timing of receipts to of central ministries are established in local juris- local government to pay for capital spending be dictions for the purpose of deciding the level and structured? The Golden Rule of capital finance is composition of the local goods and services to be that, on both efficiency and equity grounds, the provided. Deconcentration with authority means payment for capital goods should be spread over that the regional branches of ministries have some their useful life. It therefore follows that a financ- ability to make independent decisions, albeit usu- ing mechanism be established so that the future ally within central guidelines. Deconcentration generations that benefit from today’s capital without authority occurs when regional offices are spending for infrastructure will pay for the bene- created with no independent decision-making fits they derive from using it. Local governments authority. In either case, when deconcentrated Intergovernmental Finances in a Decentralized World 5 offices provide services (such as education, health efficient) utilization of limited resources than services, water, or transportation), local residents would occur if the decisions on local tax and are likely to have little to say regarding the scope spending policies were made in some distant cap- or quality of the services and the manner in which ital. When each locality makes local decisions, the they are provided (box 1.3). entire society gains financially. In technical jar- Devolution. Devolution is at the other end of gon, there has been an increase in social welfare. the “three-D” line. In devolution, independent Efficiency or welfare gains from decentralization local self-governments are established, with can be particularly significant in countries with a responsibility for the delivery of a set of public high degree of economic, demographic, and geo- services and the authority to impose taxes and graphic diversity. fees to finance them. Devolved governments have Delegation. The third variant, delegation, is considerable flexibility to select the mix and level often thought of as an intermediate arrangement of services and in some cases plenary authority to between devolution and deconcentration. It can generate their own revenues. With devolution, be characterized as a principal-agent relationship citizens have the ability to use their local govern- between a higher-level government (principal) ment to express their preferences regarding the that assigns a local government (agent) responsi- mix and level of public services they want bility for supplying certain local functions (e.g., (demand), while taking into account their cost education, water distribution, health clinics), (supply). The result of devolution that provides which may or may not be financed by transfers for such local decision making is “better” (more from the principal to the agent. The failure of Box 1.3 Egypt: Deconcentration with Limited Authority The Urab Republic of Egypt has five types governorate has at least one city. Cities may of local governments: governorate, markaz, be divided into districts. A district (hay) is the city, district, and village. It has 26 gover- smallest local government unit in urban gover- norates, headed by governors who are norates. Districts are divided into sections appointed by the president. A governorate is (subdistricts) or neighborhoods (sheyakha). the main service delivery unit in Egypt. It can City and district chiefs are appointed by the be simple and completely urban (with no minister of local development. The village markaz or village) or complex, consisting of (qariya) is the smallest local government unit urban and rural communities. Governorates in rural governorates. The service responsibili- are deconcentrated local governments, with- ties of villages vary according to their size. out policy-making power; they simply follow Larger villages are part of the local govern- instructions from the center. ment system and have service responsibili- The markaz is the second-tier local govern- ties. Smaller ones, called “satellite” villages, ment unit in complex governorates. A markaz are not considered local government units and consists of a capital city, as well as other cit- have no service delivery responsibilities. They ies and villages, and functions as the center are part of either a village or a markaz. The for the jurisdiction. It is headed by a markaz village chief is appointed by the governor. chief, appointed by the prime minister. Each Source: Amin and Ebel 2006. 6 Municipal Finances the  higher, principal authority to pay for the jurisdictions. In such cases, various types of delegated responsibilities—that is, the creation of subnational governments, such as municipalities, an unfunded mandate—can establish a potentially may exist, but they are not sovereign; rather, they contentious central-local relationship and may are creatures of the central state. lead to legal battles (if the locality has the legal Examples abound around the world. In Africa, right to go to court), incentives for local budget- Burkina Faso, Egypt, Ghana, and Uganda are such ing sleight-of-hand, and even conflict. unitary systems. East Asia and Pacific examples When funded, however, delegation may include Thailand, Japan, and the Republic of improve efficiency if it allows subnational govern- South Korea. In Europe and Central Asia, the ment units to administer programs of national pri- United Kingdom, Ukraine, and all the Central ority in ways that better reflect local economic, Asian republics are examples. Such systems in social, and financial circumstances. Under such Latin America include Colombia and Peru. arrangements the center may—indeed, is likely Examples in the Middle East and North Africa to—set minimum or standard levels of services. are  Egypt, Jordan, Saudi Arabia, and Tunisia. If  the detailed, day-to-day decisions on service Examples in South Asia include Bangladesh, delivery remain local, however, an opportunity Sri Lanka, and Bhutan. But to be unitary may not exists for finding new, creative, and perhaps be the same as being centralized. For example, cost-reducing ways to deliver those services. As China has been characterized as both federal and will be discussed in the following section, the decentralized (Wong 2007; Bahl 1999b). Indonesia design of intergovernmental fiscal transfers and is a case of a unitary state that has decentralized the degree and nature of central monitoring its fiscal system such that now subnational gov- will  influence the balance between central and ernments are major deliverers of services, account local  decision making in the delegated areas of for one-third of public spending, and manage half responsibility. of all public investments (Ellis 2010). Federal systems. Under a federal system, public Unitary, Federal, and Confederal versus sector decisions are made by different types or Federal Systems tiers of governments that are independent of one To add to the complexity of just what decentral- another (Griffiths with Nerenberg 2005; Ahmad ization entails, there is wide variation in how and Brosio 2006; Boadway and Shah 2009). intergovernmental systems are structured around Though not nearly as numerous as that list of uni- the world. Three systems of governance can be tary states, there are plenty of examples: in Africa, distinguished: unitary, federal, and confederal Ethiopia, Nigeria, and South Sudan; in East Asia systems. What adds to the complexity is that in and the Pacific, Australia, Malaysia, and the practice each of these systems may be character- Federated States of Micronesia; in Europe, ized as having various degrees of the three Ds. Austria, Belgium, and Germany; in Latin America, Unitary systems. A unitary system is one in Brazil, Mexico, and Saint Kitts and Nevis; in the which the central government has the constitu- Middle East and North Africa, Iraq and the tionally bestowed authority (in some cases the United Arab Emirates; and in South Asia, India, authority is bestowed by an absolute monarchy or Pakistan, and Nepal. In a federation, some a theocracy) not only to determine what political constitutions are quite explicit that there is no powers are assigned to its constituent units hierarchy among certain types of governments (subnational governments, including, of course, (e.g., Pakistan’s center vis-à-vis the four prov- municipalities), but also whether to create, abol- inces; the central government of the United States ish, or change the boundaries of the subnational and the 50 state governments). Others are Intergovernmental Finances in a Decentralized World 7 constitutionally federal but nevertheless more both politically and fiscally, whereas others move central than decentralized (Ethiopia, Malaysia, ahead with decentralization. The first is to look Sudan). at the reasons why so many countries continue Confederation. A confederation is typically a holding on to centralized public sectors. The sec- treaty-based system of states in which a weak ond is to examine the arguments, both theoreti- central government serves as the agent of the cal and practical, that are conventionally made in member units, usually without significant inde- support of decentralizing and how the theory of pendent spending and taxing powers (Wallich public finance treats the question. The third is to and Zhang 2013). A few such arrangements have explore the impact of decentralization—that is, existed over the years (such as Switzerland as the empirical evidence. Confederation Helvetia, 1815–48). Today’s best example is Bosnia and Herzegovina (box 1.4 sheds Why Tilt to Centralization? light on the Bosnia situation). Even in that case, The World Development Report 1999/2000 however, the center is gaining more of a fiscal (World Bank 2000) observed that many devel- foothold, having been authorized to levy a national oping countries are still centralized, notwith- value added tax (VAT) as of January 2006. standing the identified trend toward localization. Three arguments are offered in support of To Decentralize, or Not? centralization: Three steps help us get at the question of why Lack of local capacity. An argument often set some states tend to remain centrally controlled, forth  in developing countries is that local Box 1.4 Bosnia-Herzegovina Confederalism Under the Dayton-Paris Agreement (1995), affecting municipalities in the federation either the former Yugoslav Republic of Bosnia and are delegated to the cantons or are shared by Herzegovina now contains two entities: the several departments in the federal ministries. Federation of Bosnia and Herzegovina and the The constitution of the Federation of Bosnia Republika Srpska. These are de facto sepa- and Herzegovina defines the functions of each rate governments and administrative organs level of government, including granting to the with substantial powers to pass legislation, cantons all powers not expressly granted to impose taxes, and otherwise govern. Sarajevo the federation, such as land use planning, local is both the capital of Bosnia and the capital of business development, and local economic the federation. Banja-Luka is the capital of development. The Republika Srpska has a cen- Republika Srpska. tralized administrative structure and its own The federation contains 10 intermediate- ministry of local government to regulate and tier units (cantons) and approximately 80 conduct dialogue with its municipalities municipalities. The cantons have their own (approximately 60, including one independent legislatures, their own basic laws and city, Brcko); the federation does not have such constitutions, and their own governors and a ministry. ministries. Financial and budgetary matters Source: Fox and Wallich 2007. 8 Municipal Finances governments do not have the capacity for can assert its precedence vis-à-vis subnational self-government. This argument is most often government because the priorities of the nation- heard when discussion arises as to the merits of state must come first. Those include providing for granting localities such as municipal govern- the national defense, conducting foreign policy, ments authority to generate their own revenues protecting national borders, and managing mac- or the authority to borrow. In a country with a roeconomic stabilization. Such an argument long tradition of centralization, that local gov- against extensive decentralization is particularly ernments lack the capacity to be self-governing is common in low- and middle-income countries an observation that is likely to be both true that tend not to be economically diversified and and  tautology. As local governments in several that are therefore more exposed to fluctuations in newly decentralizing countries have demon- international commodity prices, to natural disas- strated, developing capacity to govern is a ters, and to debt burden costs. The result is that learning-by-doing process (Thomas 2006). To the central government holds tight control of the broadly paraphrase Amartya Sen’s essay main tax and borrowing instruments (Tosun and “Democracy as a Universal Value,” a country Yilmaz 2010). does not have to be deemed “fit” to be decentral- Legacy. The argument for the concentration ized, but rather governments become capable by of political and fiscal power in the center is often being decentralized (Sen 1999). about the persistence of old methods—“old ways Thus, for example, in the early 1990s under are good ways.” This is seen particularly across Mayor Gabor Demszky, the Budapest munici- much of the African continent, where decades of pality borrowed in the Eurobond market, not colonialism led to a deeply ingrained tradition because it could not borrow from Hungarian of  top-down authoritarianism. (Ndegwa 2002; sources but rather to demonstrate that the city Commins and Ebel 2010). Reflecting on the was sufficiently creditworthy to do so. As legacy of  colonialism, the African Charter for Demszky writes, in 1991 the “sad state of Popular Participation in Development and Budapest was a true reflection of forty years of Transformation (the Arusha Declaration, 1990) dictatorship,” and thus, its “citizens chose to fol- characterized Africa as having an “over- low another path” (Demszky 2003). centralization of power and impediments to the Here it is important to stress two lessons effective participation of the overwhelming concerning a country’s becoming capable of majority … regarding social, political and eco- being decentralized. First, to “decentralize nomic development.” the  central state” is not about dismantling it. Of course, Africa is not alone in the “old Successful decentralization is just as much about ways are our ways” approach. Despite a tradi- building the capacity of the center to become tion of local self-government in much of intergovernmental (Kopanyi et al. 2000; Pallai Europe, the governance of command and con- 2003). Second, successful public sector reform trol still characterizes many former Soviet requires much more than focusing on individual republics, particularly those of Central Asia. (e.g., bureaucratic) capacity; it also requires link- The past couple of years have also witnessed a ing organizational, institutional, and individual clawback of power by the central government capacity to intended development outcomes in Hungary (Barati-Stec 2012). In the Middle (Thomas 2006). East, authoritarian control has been main- Ensuring that central functions are fulfilled. tained by a long-established system of political The second argument is that in an established oligarchy, resulting in what Tosun labels unitary or federal system, the central government “excessive centralization,” a legacy model that Intergovernmental Finances in a Decentralized World 9 is being challenged all over the region. The gradually improving since the early 2000s, fol- world waits to see whether the endgame of this lowing four decades of stagnation, the outlook is challenge will be more of the same or more plu- not bright” (Yatta and Vaillancourt 2010). A sim- ralist and self-governing societies (Tosun 2010; ilar warning has been made with respect to Tosun and Yilmaz 2010). some recent European decentralizing actions because of “the suddenness and severity” of the Why Decentralize? fiscal crisis that has interrupted a prolonged That much of the world is undergoing some form period of steady growth in local budget of decentralization attests to the importance of resources (Regulski 2010). such a development. At least four factors help Politics and the “reaction from below.” The explain the trend to decentralization: second explanation goes back to the point The globalization link. The conclusion of the above, that although the decision to decentralize World Development Report 1999–2000 that the is political, once that decision is made it is the early 21st century trends toward globalization economic and fiscal reforms that lead to a and localization are reinforcing is supported by change in intergovernmental fiscal arrangements. more recent research. It includes “separation” Focusing on Africa, Latin America, and post- modeling that finds a “demand by the hinter- communist Eurasia, Kalandadze and Orenstein lands regions for local autonomy, which (2009) cite 17 cases—not all successful, as yet—of increases with national income growth, greater popular, soft electoral revolutions “from below” relative hinterland population, and increasing since 1991. national population” (Arzaghi and Henderson The economic efficiency argument. For the 2005), as well as case studies of a growth of citi- economist, the chief argument for decentraliza- zen organizations that “no longer rely on top- tion concerns improvements in efficiency—that down measures to improve governance” (McNeil is, the payoff in general “welfare gains” that and Malena 2010). results from well-designed intergovernmen- That said, not only trends but also cycles tal  arrangements (Oates 1972, 1997; Yilmaz, apply to countries, regardless of the degree of Vaillancourt, and Dafflon 2012). The efficiency their economic development (Bird 2011b). Thus, argument for decentralized government goes as a period of intergovernmental reform may be follows: Due to different preferences for level followed by a political clawback by central and mix of local public goods and services authorities of reforms gained in earlier years. across jurisdictions and differences in the local Such reversals are likely to happen more quickly costs of producing and distributing goods and and deeply in unitary states than in federal services, the general welfare of the whole soci- states, the latter of which, if well established, ety will be enhanced if decisions about which give subnational governments the constitutional bundle of local goods and services should be powers to raise their own revenue. provided from locality to locality are made Indeed, a cyclical central clawback in unitary locally (presumably by freely chosen local offi- states is now occurring. Thus, the 2011 United cials), rather than by a central official (who may Cities and Local Governments (UCLG) report make decisions based some set of centrally on local government in Africa concludes that determined standards or to satisfy bureaucratic “fiscal decentralization is suffering from the incentives). difficult financial situation in most African Consider, for example, a set of local goods countries today” and that “although reve- and services, such as primary health care and nue  generation by African countries has been education. Now assume that the costs of 10 Municipal Finances producing those services are the same across the principle of subsidiarity has led to greater the country. Communities have different pref- national cohesion and helped to deflate seces- erences and needs for the mix of the services to sionist tendencies in a particular region. be provided. Thus, in apportioning a public Historical cases  include ones in Belgium, budget of a given size, Community Y, with a Canada, India, Indonesia, Germany, the Russia large young population, can be expected to Federation, Spain, Sudan, and Switzerland. Box express a strong preference for schooling, 1.5 sheds light on Sudan (see also Bird and Ebel whereas Community E, which has a predomi- 2007; Bird and Vaillancourt 2010). nantly aging population, sees a greater need for In October 2012, the Benigno Aquino–led health clinics. For a given budget, decentralized central government of the Philippines signed a matching of costs and preferences leads to effi- peace agreement with the Moro Islamic cient use of public resources. By not having Liberation Front (MILF) that is to serve as a underutilized health clinics in Y and empty framework to end a four-decade-long conflict in classrooms in E, the society as a whole has a the southern Mindanao region. The agreement “welfare gain.” This “matching principle”—that envisions that by 2015 a new, autonomous local the provision of public services should be car- government in the region will have worked with ried out to the extent possible by the type of the central government to sort out issues sur- government that is closest to the people—is rounding the sharing of wealth generated from reflected in the “subsidiarity principle” of the petroleum and mineral mining, with the center European Charter of Local Governments still managing matters such as currency, cus- (Marcou 2007). toms, national defense, and foreign policy. As the Nation building. In some countries decen- Sudan peace consultations (2002–05) have tralization has been a strategy to promote demonstrated, it will take time, goodwill, and national cohesion and to defuse tensions if the good politics to make this work. How any oppo- society is  fragmented by ethnicity, religion, sition to the peace agreement from a rival rebel language,  endowment of natural resources, or group, the Moro National Liberation Front other conditions. Several cases have been docu- (MNLF), will play out remains to be seen, but if mented in which a nation-state’s practical use of the agreement works, it will be because Box 1.5 Nation Building by Means of Decentralization in Sudan and South Sudan Following the signing of the 2005 Compre- to improve access to basic public services. hensive Peace Agreement, the government Decentralization can also help in building of South Sudan has registered important national cohesion to hold the state together. progress in infrastructure and basic services. In addition, if implemented well, it can enable However, improving local communities’ empowered citizens to hold the local authori- access to these services is a huge task. ties accountable. Decentralization of authority can be adopted Source: Zoellick 2009. Intergovernmental Finances in a Decentralized World 11 decentralization worked (Bauzon 1999; Wallich, per capita output. A similar finding with Manasan, and Sehili 2007). respect to revenue autonomy concludes that “decentralization of expenditures coming with Decentralization—Emerging Lessons and centrally controlled revenues seems to be an Results obstruction to economic growth” (Meloche, The argument presented above is the answer to Vaillancourt, and Yilmaz 2004). Imi (2005) the question “Why decentralize?” But does it concluded that in a mixed pool of developed work? Does decentralization deliver on its theo- and transition countries, decentralization “par- retical promises? Although measuring decentral- ticularly on the expenditure side is instrumen- ization is difficult (Ebel and Yilmaz 2003), the tal to economic growth.” following summarizes what is known empirically • On the matter of macroeconomic stability, about the relationship between decentralized there  is evidence that subnational revenue fiscal autonomy and the accomplishment of a autonomy improves the fiscal position of nation’s broader economic and fiscal objectives: subnational governments but that reliance • A strong correlation between decentralization on intergovernmental transfers may worsen and growth in gross domestic product (GDP) that fiscal position (Ebel and Yilmaz 2003). per capita supports the argument that as • The findings relating to the relationship people become more educated, better between fiscal decentralization and public informed about their government, and more sector size are decidedly mixed, with a study aware of problems that affect their lives, their on the United States, which is a mature feder- desire to bring the control of government ation, finding no evidence of a relationship functions closer to themselves grows. (Oates 1985), and others suggesting that in the • The dismal macroeconomic record of central- postsocialist transition countries, the public ized command and control in Central and sector’s expenditure share of national GDP Eastern Europe has been well documented decreases with increased subnational tax (Bird, Ebel, and Wallich 1995). Conversely, autonomy (Ebel and Yilmaz 2003). developed countries are associated with Once the definition, the rationale, and the mature systems of decentralization and scholarly findings on decentralization results degrees of fiscal autonomy (e.g., Akai and have been presented, one must turn to the Sakata 2002). hard  work of implementing intergovernmen- • If, as the theory argues, decentralization tal  reforms (Kopanyi, El Daher, and Wetzel enhances efficiency in the allocation of public 2004;  Barati-Stec 2012; Martinez-Vazquez and services, that should show up as economic Vaillancourt 2011). A first step entails getting right growth. And, indeed, the evidence is support- the responses to the four fundamental ques- ive. Martinez-Vazquez and McNab (1997) tions,  set out above, of (1) revenue assignment, found such a relationship with respect to the (2)  expenditure assignment, (3) the design of revenue side of the budget. Ebel and Yilmaz intergovernmental transfers, and (4) borrowing (2003) reached a similar conclusion, whether and debt assignment. The tasks associated with the decentralization variable is defined in the four fundamentals fall to central finance and terms of a narrow or a broad definition of reve- planning officials, civil society organizations, and nues (a broad definition includes unrestricted municipal finance practitioners, cooperation grants), with respect to the growth rate of real among whom is to be desired. Tensions will surely 12 Municipal Finances arise among the implementers, but in an open, a “vertical fiscal gap.” A national government may pluralistic society such tensions can be healthy have more revenues than warranted by its direct for the system as a whole (Soros 2006; Eaton, and indirect spending responsibilities, whereas Kaiser, and Smoke 2011; Smoke, 2013). regional and local governments may have reve- nues that fall short of their expenditure responsi- Intergovernmental Transfers bilities. A vertical fiscal imbalance occurs when such a vertical fiscal gap is not adequately The next section of this chapter addresses addressed by the reassignment of responsibilities, selected issues on the topic of intergovernmental by fiscal transfers, or by other means. Often cen- transfers, including the rationale of transfers, tral governments in developing countries are their classification among government tiers, the assigned the power to collect the most robust rev- elements of a good and bad transfer design, the enue streams—such as customs taxes, the value institutional setting in that design, fiscal equaliza- added tax, and personal and corporate income tion, and practical examples of performance tax. Table 1.1 illustrates a vertical imbalance in grants and municipal contracts. Pakistan, where the federal state collects Such transfers are a necessary element of any 90  percent of public revenues but spends only well-decentralized system, as two types of finan- 67  percent. In contrast, the subnational levels cial imbalances—vertical and horizontal—will collect about 10 percent of revenues but account occur and will need to be resolved. “Vertical for 33 percent of public expenditures. imbalance” refers to the differences between Very often the expenditure and revenue expenditures and own revenues for different assignments in a fiscally decentralized nation types or levels of government. That difference produce horizontal fiscal imbalances because of across governments of the same type or level— the different fiscal capacities and expenditure municipalities, for example—is referred to as needs of subnational governments. As a result, “horizontal imbalance” (Bird, Ebel, and Gianci intergovernmental transfers play a crucial role, 2007; Boadway and Shah 2009). both vertically (in enabling local governments to This section addresses the financial aspects of perform their assigned responsibilities) and hori- intergovernmental relations that strongly influ- zontally (in holding interregional disparities to ence the nature, scope, and depth of decentraliza- acceptable levels). tion. The financial aspects are often measured by Expenditure needs depend on the assignment (a) the distribution of revenues and expenditures of functions. Thus, in countries where municipal- among government tiers: the central government; ities have few responsibilities, their expenditure the middle tier, that is, the state or province; and needs are relatively small. For instance, munici- the local governments (e.g., municipalities); palities in Jordan provide mainly solid waste, (b)  the assignment of public service delivery road, and some administrative services; the functions among the tiers; and (c) the “own- source” revenues of the subnational government Table 1.1 Vertical Imbalances in Pakistan tiers, meaning the revenues that they may collect Revenues (%) Expenditures (%) or obtain independently and use at their own discretion (Jensen, 2001; Blöchliger and Petzold National 90.2 67.1 2009; Blöchliger and Rabesona 2009). Provincial 4.9 28.8 At lower tiers of government, a revenue defi- Local 4.8 4.1 ciency often arises from a mismatch between rev- All levels 100 100 enue means and expenditure needs, referred to as Source: Shah 1998. Intergovernmental Finances in a Decentralized World 13 municipal sector’s share of public expenditures is have supported local government operations with small by international comparison, at less than unconditional transfers in Bangladesh, Ghana, 5 percent (Dillinger 1994). At the other extreme, India, Tanzania, Uganda, and other developing when local governments provide most local countries. services, including basic health care, primary education, the social safety net, infrastructure, Specific Purpose Transfers water, and solid waste disposal, their expenditure Specific purpose—also called “conditional” or needs and share in public expenses are much “earmarked”—transfers finance, or provide incen- larger. In Hungary, the local share of public tives for governments to undertake, specific expenditures was about 12 percent in 2012. programs or activities. These grants may be regu- lar or mandatory in nature, or they may be discre- Types of Transfers among Government Tiers tionary or ad hoc. Conditional transfers typically Intergovernmental transfers can be broadly clas- specify the type of expenditures that can be used sified into two main categories: general purpose to finance (“input-based conditionality”). These (also called “unconditional”) transfers and may be capital expenditures, specific operating specific  purpose (also called “conditional” or expenditures, or both. Conditional transfers may “earmarked”) transfers (table 1.2). The source of also require attainment of certain results in ser- the transfers, or the “transfer pool,” could be the vice delivery (“output-based conditionality”). general budget of the central government and Input-based conditionality is often intrusive and may include a share of specific taxes. For instance, unproductive, whereas output-based condition- in Turkey 11.5 percent of the revenue from the ality can advance grantors’ objectives while pre- value added tax and from personal and corporate serving local autonomy. income taxes is channeled to the transfer pool for Conditional transfers may incorporate local governments (Peteri and Sevinc 2011). matching provisions; that is, they may require Box 1.6 shows an example of the various transfers municipalities to finance a specified percentage a local government may receive and how they are of the expenditure using their own resources reported in a typical financial statement. (table 1.2). Matching requirements can be either  open-ended, meaning that the central General Purpose Transfers or  other higher-level government matches General purpose transfers have no conditions whatever level of resources the municipality attached to the nature of the recipient’s spending. provides, or closed-ended, meaning that the Municipalities thus have the freedom to exercise grantor matches municipal funds only up to a policy discretion on the use of this type of transfer prespecified limit.  Matching requirements (table 1.2). Sector block grants are one form of encourage greater scrutiny and local ownership general purpose transfer. They provide budget of grant-financed expenditures. Closed-ended support with no terms attached in a broad but matching ensures that the grantor has some con- specific area of subnational expenditure. In many trol over the costs of the transfer program. countries, general purpose transfers are formula The central government enforces matching based, meaning that they are allocated based on payments as a signal of commitment by the specific factors, such as population and area of municipalities to contribute to the maintenance jurisdiction as a proxy for service coverage. of established assets. Municipalities may be Examples of countries with unconditional trans- required to finance a specific expenditure up to a fers are Germany and South Africa. Recently, certain level, above which the central or the state international agencies such as the World Bank government supplies the additional resources 14 Municipal Finances Table 1.2 Classification of Forms of Intergovernmental Transfers Conditional Open-ended, matching Closed-ended, matching Nonmatching Unconditional Description Matching: For every Euro (or other currency unit) the subna- The donor gives a fixed Provided for equalization tional government (SNG) receives from the granting (e.g., sum of money with the purposes or basic central) government, the recipient must spend some own stipulation that it be functional areas. Funds funds on the activity to receive the grant. This “match” is spent on a public good. may be used at the typically expressed as a % of the size of the donor grant. There is no percentage recipient’s discretion. With an “open-ended” grant, If the grant is “closed-ended, ” share (“match”) re- there is no “cap” on the the donor government sets a quired of the recipient. amount of grant funds. The ceiling on the amount of cost of the grant depends on funds being transferred. the amount of funds matched by the recipient. Purpose of grant Encourage spending on production of good or service having Encourage spending on Increases overall capacity Intergovernmental Finances in a Decentralized World positive social and/or interjurisdictional externalities. a national priority sector. to spend. May have Restriction on its use specific equalization goal differentiates it from an (horizontal imbalance) unconditional grant. and/or be a way to correct vertical imbalance. Illustration There is no ceiling or cap on Most categorical grants Community develop- An equalization grant is the amount of the funds as (environmental management, ment, job training, designed to address the long as the recipient group housing, substance abuse transportation. capital horizontal imbalance of a (which may be an SNG or a treatment) have some limit on grants. recipient. Sector “block” defined group of individuals) donor cost (closed-ended). grants have a designated meets the conditions (e.g., Another example is perfor- purpose, broadly defined. measure of need) for qualify- mance grants (these may be “Sector” refers to a ing to receive the transfer. nonmatching). category such as health, Thus, the grant becomes an education, transportation, “entitlement.” Grants to give water. people access to safety net, housing, or education services are often structured in this manner. (continued next page) 15 16 Table 1.2 (continued) Conditional Open-ended, matching Closed-ended, matching Nonmatching Unconditional Effect on govern- The donor government (e.g., The determination of total The donor gives recipient The donor will cap the mental spending center) sets the terms of the amount spent is determined a fixed amount of a grant amount of the grant. As match, but the recipient may jointly by donor and recipient. with stipulation on its long as the community or may not agree to accept But this all ends when the use. If the community wants to consume at least the match. Thus, even donor-determined cap is wanted to consume less an amount of the public though the center greatly reached. The cap is a way that of the public good than good equal to the amount influences the potential the center can control its own the grant condition, then of the grant, then the fact amount of spending, the budget, That is, at some point the grant affects SNG that the grant is condi- actual amount is jointly the recipient is no longer behavior. Otherwise this tional or unconditional is determined. entitled to the grant. looks like an uncondi- irrelevant. tional grant. Fungibility Fungibility means that money can be used for more than the designated purpose. Thus, the new money that flows from donor government grants may replace own-recipient spending that would have been spent on the designated activity in the absence of the grant. That is, the grant “frees up” the SNG’s other funds that would have been used for the grant-designated purpose in the absence of the grant. One strategy for donor governments to reduce the degree of fungibility is to require a maintenance-of-effort pre-donor grant. Recognizing that all grant funds have some degree of fungibility (this is especially true for the unconditional and matching grant), the donor stipulates that the SNG must maintain own-SNG support for a given program equal to that in some previous year. This previous year may be expressed as an absolute funding amount or a percentage of total revenues available to the SNG. Other comments Relative price of public goods Relative price of public goods No change in relative No change in relative declines. declines. prices of public goods in prices of public versus excess of the grant. private goods. Source: Authors, adapted from Ebel and Peteri 2007. Municipal Finances Box 1.6 Intergovernmental Transfers Shared taxes – Investment grants (general) – VAT and sales taxes Conditional transfers (earmarked) – Personal income tax – Road rehabilitation grant – Corporate income tax – Education subsidy Unconditional transfers – Social welfare subsidy (poor households) – Operating transfers (equalization grants) – Special grant for salaries (ad hoc) Source: Shah 2007. required. This kind of matching raises an equity to finance its expenditures from its own sources. issue in that municipalities with ample resources However, as noted above, except for the most of their own can afford to meet matching require- revenue-rich local governments, gaps between ments and may thus acquire substantial central expenditures and revenue assignments are likely government transfers. In contrast, poorer munic- to occur for many reasons. This gives rise to yet ipalities will find it difficult to meet matching another form of central-to-local transfer, revenue requirements to finance certain expenditures, sharing. particularly in developing countries. Shared tax base. Revenue sharing arrange- As is evident from table 1.2, some conditional ments can be of two types. In the first type, the transfers do not require local matching, but only revenue-generating government (e.g., the center require that the funds be spent for a particular or middle-tier governmental unit) determines the purpose. These are referred to as “conditional tax base, and the recipient (e.g., municipal) nonmatching transfers.” For a given level of assis- government adds to that its own “surtax,” which is tance, municipalities may prefer unconditional an extra local tax applied on the revenue base, nonmatching transfers, which provide them with using a rate determined by the municipality. In maximum flexibility to pursue their own objec- such an arrangement either the local government tives. Because such grants augment resources or, typically, the central authority administers and without influencing spending patterns, they collects the revenue for all tax base sharing gov- allow municipalities to maximize their own wel- ernments. Tax base sharing, in which the central fare (Shah 2007). government “vacates” some of the total tax base so as to allow a subnational government the option Shared Taxes to  determine its own tax rate—often referred to A number of policy questions are relevant to the as “tax piggybacking”—is particularly common in topic of tax sharing between higher levels of North America. The merit of piggybacking is that government and municipalities. it preserves local fiscal autonomy while minimiz- A basic intergovernmental finance guideline ing the cost of local tax administration. says that finance (revenue assignment and inter- Revenue collection sharing. The second type governmental transfers) should follow function of arrangement specifies that a proportion of (expenditure responsibilities). Ideally, from the centrally generated revenues be shared between viewpoint of accountability, each government central and subnational governments. The unit should be able to raise the revenues it needs central-subnational tax split may be determined Intergovernmental Finances in a Decentralized World 17 by a constitutional commission, decided on the the case of Lima, Peru, even a well-established basis of an agreement between the central and local government may collect certain taxes on subnational governments, or, more commonly, behalf of other governments and return the pro- established by direct parliamentary, statutory ceeds to that government after deducting a fee for action that allows the central government con- the cost of collection (Mikesell 2003). trol over the central budget. The structure of Revenue sharing is a feature in a number of such revenue (or, as listed in some statistical federations, both developed and developing reports, “tax” rather than “revenue” sharing) (Rao  2007). Among Organisation for Economic arrangements varies among countries with Co-operation and development countries, exam- respect to type of revenue shared, procedures for ples include Austria (where the shares of the per- setting the central-local split, frequency of for- sonal and corporate income, property, and value mula changes, and whether the sharing is based added taxes are determined by the national par- on origin (derivation) or the geographic location liament every four years) and Germany, where or builds in some degree of horizontal equaliza- the revenue split of the central personal and cor- tion (Blöchliger and Rabesona 2009). porate taxes and value added tax is set by the Regardless of matters such as the structure and national parliament (the Bundestag representing process of sharing centrally levied revenues, as a the central government) with the consent of the matter of classification, shared revenue is clearly state and local governments (Blöchliger and not “own-local” revenue. For a receipt to be classi- Rabesona 2009). Australia assigns the entire rev- fied as “own source” revenue requires at a mini- enue received from the goods and services tax to mum, some degree of authority to establish the the states on the basis of an equalization or “rela- tax rate or the level of a nontax charge or fee tivities” formula. States’ equalization payments (Jensen 2001). Even with this understanding, are reduced by an amount proportional to the readers should be alert to complications in how share of the goods and services tax they receive. revenue sharing policies are listed in financial In effect, this arrangement simply ensures a documents. For reporting purposes, “what counts source of equalization payments. as tax sharing in one country may count as an The growing revenue requirements of local intergovernmental grant in another,” thereby mak- governments in newly decentralizing “transition” ing “the two sub-central funding arrangements of economies have led to revenue sharing in several tax sharing and intergovernmental grants difficult postsocialist countries in addition to the case to disentangle” (Blöchliger and Petzold 2009). already cited of Hungary (table 1.3). Thus, in the As with grants, shared revenues signify a com- Russian Federation, the central government now mitment by the central government to address shares all of its personal income tax, a portion vertical imbalance. Even so, however, the of  the VAT, and a portion of corporate income commitment may change over time. In Hungary tax  with the oblasts. And in Romania local the personal income tax (PIT) is a centrally governments have a claim on both profit and collected tax that is partially redistributed to the dividend taxes levied by the central government local level. In 1990, 100 percent of the PIT was on locally owned enterprises. In these economies redistributed to its origin; by 2006, only 8 per- the central government may reduce its deficit by cent  was redistributed by origin, with another cutting shares to the local governments when 20 percent to 25 percent distributed by formula to fiscal pressure at the central level increases, as other municipalities. As of 2011, that 8 percent occurred in Hungary. derivation share had been eliminated (Barati-Stec Another feature of transition economies is that 2012). Sometimes a central, provincial, or, as in taxes are often shared based on where they are 18 Municipal Finances Table 1.3 Shared Revenues (Taxes) in the groundwater extraction and use tax South East Europe Countries (70 percent). Their contributions to overall local Local share revenues are relatively small, however. As of Country Tax percentage 2009, 84.5 percent of oil revenue accrues to the Bulgaria Personal income 50 central government and 15.5 percent to subna- Croatia Personal income 52 tional governments. For gas revenue, 69.5 per- Real estate 60 cent  goes to the center and 30.5 percent to the Macedonia Personal income 3 regions. Subnational governments receive an Montenegro Personal income 10 extra 0.5 percent of both oil and gas revenues, which is earmarked for increasing local spend- Real estate 50 ing on primary education. The sharing of oil Natural resource 30 and  gas revenues was introduced to redress Romania Personal income 77 complaints by the resource-rich provinces that Slovenia Personal income 50 although they face the development costs Serbia Personal income 40 and  environmental consequences of resource Inheritance 100 exploitation, the benefits were accruing only to Property transfer 100 the central government. Turkey All national 5 collected taxes Output-Based Transfers Source: NALAS 2008. Conditional, nonmatching, output-based trans- fers may be used if the purpose of the grant is to derived, in part because of the subnational allow the recipient government to address central governments’ strong notions of source entitle- spending priorities (e.g., when the center deter- ment and primary claim on tax revenues gener- mines that there are net “external” or “spillover” ated in their jurisdictions. Problems may arise benefits to a multijurisdictional region or the when local governments collect revenues and are country as a whole) or when accountability for required to pass them on to the central results is an aim. Output-based transfers respect government, retaining their shares according to local autonomy and budgetary flexibility, while contracted or predetermined ratios. providing incentives and accountability mecha- In Indonesia, although most tax sharing is nisms to improve service delivery. Output-based based primarily on the derivation principle, grants may also empower citizens by increasing fishery and property-related taxes use “equal their knowledge regarding a link between grant shares” as an added criterion. The 9 percent financing and service delivery performance (as in national share of the property tax is actually a fee Canada and Chile, described below). These trans- to compensate the national tax administration fers impose conditions based on the results to be for collecting and administering the tax. It is achieved, while providing flexibility in the design noteworthy that in apportioning personal of programs and spending levels to achieve those income taxes, place of work, rather than the objectives. Such transfers help restore cities’ almost universally used place of residence, is the focus on the results-based chain and the most basis. In addition to the sharing arrangements effective service delivery framework. for national revenues, local governments receive To achieve grant objectives, a municipal shares of the four provincial taxes: the motor official examines the results-based chain to vehicle tax (30 percent), the vehicle transfer tax determine whether or not program activities (30 percent), the fuel excise tax (70 percent), and are  expected to yield the desired results Intergovernmental Finances in a Decentralized World 19 Figure 1.1 Results Chain in Education Program objectives Inputs Intermediate inputs Education spending by Improve quantity, quality, age, gender, urban/rural; Enrollment, and access to education spending by grade level student/teacher ratio, services and number of teachers, class size staff, facilities, books Outputs Outcomes Impacts Research Informed citizens, Achievement Winners and Literacy rates; civic engagement, scores, graduation losers from supply of skilled enhanced rates, dropout government professionals international rates programs competitiveness Source: Shah 2007. (see  figure  1.1). To do that requires monitoring additional grant as a salary bonus for teachers in program activities and inputs, including interme- the best-performing schools (Gonzalez 2005); a diate inputs (resources used to produce outputs); central grant to municipal governments to subsi- outputs (quantity and quality of public goods and dize water and sewer use by the poor in Chile services produced and access to them); and out- (Gomez-Lobo 2001); central per capita transfers comes (intermediate- to long-run consequences for education in Colombia and South Africa; and for consumers and taxpayers of public service federal per pupil grants to states for secondary provision or progress in achieving program objec- education and to municipalities for primary edu- tives); impact (program goals or long-term conse- cation in Brazil (Gordon and Vegas 2004). quences of public service provision); and reach (the numbers of people who benefit from, or are Institutional Settings in the Design of hurt by, a program). Such a managerial focus rein- Transfers forces joint ownership and accountability by the Designing intergovernmental transfers is not a principal and the agent in achieving shared goals simple task. The central government may choose by highlighting terms of mutual trust. Thus, inter- to take up the transfer design or may delegate it to nal and external reporting shifts from the tradi- an independent entity. A separate body may be tional focus on inputs to a focus on outputs and involved in the design and enforcement of the fis- outcomes, especially outputs that lead to results. cal arrangements. Such a body may have true An example of an output-based grant system is decision-making authority or be purely advisory. the Canadian health transfer program (Shah The fiscal resources of a central budget come 2007). The program has enabled the Canadian from different sources, partly from the taxes on provinces to ensure access to high-quality health incomes generated in the municipalities. A key care for all, regardless of income or place of resi- question is how to allocate the portion going to dence. Other examples include Chile’s per pupil the municipalities. It is good practice to transfer grants to all schools, which include a 25 percent resources to municipalities based on a clear 20 Municipal Finances formula, as in the examples shown in box 1.7, factor for fiscal capacity differences. The Saudi which summarizes the transfer formulas in South formula allocates only development grants, while Africa and Saudi Arabia. The South Africa for- taking into account general needs (measured by mula is complex and includes general revenue population and area) and infrastructure needs grants, development grants, and an equalization (measured by cost of and gap in infrastructure). Box 1.7 Formulas for Fiscal Transfers—South Africa and Saudi Arabia South Africa uses an equitable share formula administrative and governance costs. It is to provide transfers from the central govern- important for poor municipalities, which are ment to local governments. The size of the often unable to raise sufficient revenue to grant is determined as follows: fund the basic costs of administration and governance. Grant = (BS + D + I − R) ± C, The revenue-raising capacity correction raises additional resources to fund the cost of where BS is the basic services component, basic services and administrative infrastruc- D is the development component, I is the ture. The approach uses the relationship institutional support component, R is the between demonstrated revenue-raising revenue-raising capacity correction, and C is a capacity by municipalities that report informa- correction and stabilization factor. tion and objective municipal information from The basic services component is to enable Statistics South Africa to proxy revenue- municipalities to provide basic services (water, raising capacity for all municipalities. sanitation, electricity, refuse removal, and oth- The government of Saudi Arabia intro- ers), including free basic services to house- duced a transfer formula for distributing devel- holds earning less than R800 (about US$111) opment grants in 2009, as local governments a month. (As of April 1, 2006, environmental are supposed to cover their operation health care services have been included as a expenses from own-source revenues. The basic service.) Since by its nature environmen- adopted formula allocates funds from the tal health is delivered to everyone in a munici- development pool such that the grant is based pality, this subcomponent is calculated on all 35 percent on population, 20 percent on area, households, not only poor ones. For each sub- 10 percent on the Index of Construction Costs, sidized basic service, there are two levels of and 35 percent on infrastructure deficit (gap). support: a full subsidy for households that The formula is more precisely stated as actually receive services from the municipality follows: and a partial subsidy for unserviced house- holds, currently set at one-third of the cost of 0.35*(Popi / ∑Popi) + 0.20*(Areai / ∑Areai) the subsidy to serviced households. + 0.10*ICCi+ 0.35*Infgapi. The development component was set at zero when the current formula was introduced on April 1, 2005. The formula is clear and simple but requires The institutional support component detailed data to estimate the cost of the con- supplements the funding of a municipality for struction index and the infrastructure gap. Sources: Shah 2007; and authors. Intergovernmental Finances in a Decentralized World 21 Transfer formulas are subjects of both science which followed a recommendation by the 10th and politics, as the results of analytic studies are Finance Commission (1995–2000), a certain often overruled by political considerations. Thus, percentage of all union taxes has been distributed some formulas change year by year and end up to the states. Many SFCs have also adopted this including a dozen variables (as in Jordan) that system because it allows the local governments often are redundant, inconsistent, and conflicting automatically to share in the buoyancy of state and undermine the effectiveness of the transfer taxes and levies. Such a system also has built-in system. transparency, objectivity, and certainty. Local gov- Common in the design of transfers is the ernments can anticipate, at the beginning of each designation of an independent grants commis- fiscal year, their share in the divisible pool. The sion, an intergovernmental forum, or an system enables local governments to consider the intergovernmental-cum-civil-society forum. The entire economy in creating their own annual bud- grants commission can be permanent, as in gets, giving them incentives to generate their own Australia or South Africa, or can convene period- revenues and mobilize additional resources. ically, as in India, where independent grants com- missions in the states provide fiscal advice on Fiscal Equalization state-local government relations. Because Indian As noted above, allocation of expenditure and fiscal commissions are advisory, their recommen- revenue assignments in a fiscally decentralized dations may not always be adopted. In one case, nation typically leads to horizontal imbal- in Kerala, nearly all fiscal commission recom- ances because of the different revenue capacities mendations have been embraced by the state and expenditure needs among subnational gov- government (see Shah 2007). ernments. Decentralization design also often Other countries, such as Canada and Germany, leads to vertical imbalances in favor of the central have intergovernmental forums or federal- government because tax revenue sources are provincial committees that negotiate the design seldom as decentralized as expenditure responsi- of the fiscal transfer system. Another option is bilities. To overcome these imbalances, as well as the  use of intergovernmental-cum-civil-society to achieve other policy objectives, equalization committees, with equal representation from all grants and other intergovernmental transfers constituent units, chaired by the federal govern- have become key elements of intergovernmental ment, to negotiate changes in federal-provincial finance reform around the world (Martinez- and local fiscal relations. In Pakistan, for example, Vasquez 2007). provincial-level finance commissions design and Equalization can be undertaken to guarantee allocate provincial-local fiscal transfers. The pro- some basic (minimum) level of local service vincial finance commission awards in Pakistan provision, in conjunction with the broader goal are based on a revenue sharing rule between the of equalizing fiscal capacity among subnational federal government and the provincial govern- governments. A key issue is whether a grant ments. Each province then has the authority to actually does equalize across municipalities with devise a formula for distributing its allocation to different economic and financial endowments the local governments. (fiscal disparities). The central government may In India, the most critical function of the state not commit to full equalization for several rea- finance commissions (SFCs) is to determine sons: First, central resources to do so may be the fiscal transfer from the state to local bodies in inadequate. Second, full equalization might the form of revenue sharing and grants-in-aid. penalize better performers and create incentives Since the 80th amendment to the constitution, for backward local governments toward grant 22 Municipal Finances seeking. Third, it may be difficult to develop distributed based on a formula as well. In some a  formula that truly equalizes across countries, the equalization system takes into municipalities. account both revenue capacity and expenditure Policy makers in both developed and develop- needs, whereas in others (Thailand and the ing countries face significant challenges with the Philippines) only expenditure needs are consid- introduction and reform of equalization grants ered. The size of the distribution pool differs and other intergovernmental transfers. One of the greatly from country to country. Whereas in challenges is a lack of any clear framework, in Indonesia and the Philippines equalization grants either the decentralization literature or the make up the largest share of central-local grants, recorded details of international practice, in in Thailand and China earmarked grants domi- which to consider numerous hard issues. For nate. In addition to the equalization grant, the example, should the capital expenditure needs of distribution of earmarked grants sometimes subnational governments be considered part of includes equalizing elements. In other cases, equalization grants? Are independent grants however, those grants are not targeted to poor commissions a preferred institutional setup for regions and may even have a counter-equalizing implementing equalization grants? What is the effect. appropriate relationship between the conditional In Indonesia the equalization grant, called and unconditional grant elements of the system? Dana Alokasi Umum or DAU, has become a key Should efforts be made to equalize differences in part of the intergovernmental fiscal system. The fiscal capacity, or expenditure needs, or both? funding for the DAU consists of 25 percent of And how can those differences be measured with central government revenues after tax sharing limited data (Vaillancourt 2002; Box and with the regions. Ten percent of the DAU goes to Martinez-Vazquez 2004; Hofman and Guerra the provincial level, which plays a relatively 2007). Fiscal capacity equalization, when not minor role in public services, and 90 percent to done correctly, can create an incentive for regions the local governments. In the aggregate, this to act strategically to influence the size of their grant finances some 70 percent of local grants, leading to inefficiencies in the provision of government spending and 50 percent of provin- local public goods. cial government spending. The DAU is distrib- Most East Asian governments care about equi- uted according to a formula that takes both table services to their people and consequently revenue capacity and expenditure needs into take an interest in the distribution of fiscal account. Revenue capacity is defined as potential resources among the subnational governments own-source revenues, plus shared tax revenues, that deliver the services. Countries such as plus 75 percent of shared natural resource reve- Indonesia have included subnational fiscal equity nues. Expenditure needs are defined as a func- as an explicit goal in the constitution. The consti- tion of population, poverty rate, land area, and tutions of other countries, such as the Philippines construction cost index as an indicator of or China, include strong commitments to equal geographical circumstances. In addition to the access to services, and the delivery of many of the formula allocation, part of the DAU is distributed services is devolved to subnational governments based on past spending patterns, by and large to (Hofman and Guerra 2007). accommodate transitory effects that occurred in Many of the equalization grant systems in East the 2001 decentralization. Finally, a lump sum Asian countries contain desirable features. All per region is included. The new earmarked base distribution of resources on a formula, and grants system, the Dana Alokasi Khusus (DAK), is most determine the pool of resources to be still small compared to the general grants system Intergovernmental Finances in a Decentralized World 23 (about 3 percent of total grants), but it also • Rich regions are also powerful regions, and includes an element of equalization through they do not like to lose out against the poorer required counterpart funding: Regions with low regions. It is hard for the center to tax away fiscal capacity pay the minimum of 10 percent and redistribute resources from the rich counterpart (matching) funds, whereas those regions (Hofman and Guerra 2007). with high fiscal capacity pay up to 50 percent in counterpart funds. Designing Transfers In China, an ad hoc amount is dedicated to Local government financial management is transfers to the 16 poorest provinces and distrib- made easier if transfers are designed and imple- uted on an equalizing basis. Although the 1994 tax mented effectively and simply, using a basic sharing reform introduced a formula-based formula for which data can easily be accessed. equalization scheme, it is still in a “transitional” The following guidelines will be helpful in status with limited funds. The formula-based designing transfers: scheme relies on variables such as provincial • Clarity in grant objectives. Grant objectives GDP, student-teacher ratios, number of civil should be clear and precise. servants, and population density. The scheme remains small, and each beneficiary province • Autonomy. Subnational governments should receives only a fraction of its fiscal needs as deter- have complete independence and flexibility in mined by the transfer allocation formula. In 2001, setting priorities. the equalization scheme accounted for only • Revenue adequacy. Subnational governments 3 percent of total central transfers. should have adequate revenues to discharge Equalization mechanisms diminish subna- designated responsibilities. tional fiscal disparities, but even with such • Responsiveness. The grant program should be mechanisms, disparities remain. Inequalities may flexible enough to accommodate unforeseen persist for numerous reasons: changes in the fiscal situations of the cities. • Expenditure needs may vary significantly, for • Equity ( fairness). Allocated funds should vary example, because of wide variations in costs directly with fiscal need factors and inversely among the subnational governments or with the tax capacity of each jurisdiction. asymmetry in decentralization; in other words, some regions do better than others. • Predictability. The grant mechanism should ensure predictability of the total size of • Central government emphasis on revenue the  pool and of subnational governments’ mobilization. Too much or poorly designed allocation shares by enabling publication of equalization could reduce the incentive for five-year projections of funds availability. own revenue mobilization, to the detriment of general government’s tax take in the economy. • Transparency. Both the formula and the alloca- tions should be disseminated widely, to • Inequalities among regions could induce achieve as broad a consensus as possible on migration to regions with better economic the objectives and operation of the program. prospects. • Efficiency. The grant design should be neutral • Poor regions may be less capable of handling with respect to subnational governments’ money than rich ones, or less concerned with choices of resource allocation to different poverty alleviation than the center. sectors or types of activity. 24 Municipal Finances • Simplicity. Grant allocation should be based transfers are conditional in nature or driven by on  objective factors over which individual political patronage. units have little control. The formula should • Sustainability may be lacking when there are be easy  to understand, so as not to reward no built-in sustainability mechanisms, so that grantsmanship. transfers serve short-term purposes and do not • Incentive. The design should provide incen- contribute to strengthening an intergovern- tives for sound fiscal management and dis- mental fiscal transfer system. That typically is courage inefficient practices. the case with ad hoc transfers that are based on • Reach. All grant-financed programs create win- political patronage (e.g., special allocations for ners and losers. Consideration must be given to each member of the provincial assembly in identifying beneficiaries and those who will be Pakistan). A related problem occurs when no adversely affected to determine the overall use- mechanism is put in place to sustain the opera- fulness and sustainability of the program. tion and maintenance of established invest- ments using such ad hoc transfers. • Safeguarding of the grantor’s objectives. The grantor’s objectives are best safeguarded by • Capacity development is undermined when having grant conditions that specify the transfers are built around top-down systems results  to be achieved (output-based grants) that do not stimulate local governments to and by giving cities flexibility in the use of develop compliance systems that they own. funds. Sometimes compliance and administrative requirements are too laborious, and the • Affordability. The grant program must recog- required data may not be available, contribut- nize donors’ budget constraints. ing to high transaction costs of using the trans- • Single focus. Each grant program should focus fers. The problem is compounded when only on a single objective. limited human resources are available to man- age huge demands from the top for reporting. • Accountability for results. The grantor or higher-level government must be accountable • “Deficit grants”—specific transfers to finance for the design and operation of the program. municipal government deficits—are very nega- The municipality must be accountable to the tive and create perverse incentives unless hard grantor and to its citizens for financial integrity conditions are attached. and results, that is, improvements in service • Accountability is thwarted when transfers are delivery performance. not accompanied by monitoring to ensure that local officials are able to honorably account for Bad or Detrimental Design of Transfers the use of transfer funds. Transfers can be perceived as being ill designed or detrimental based on the following: Data Concerns Regarding Fiscal Equalization Transfers • A dependency syndrome can be generated The policy debate on fiscal inequalities, and on when local governments always know that intergovernmental fiscal relations more generally, someone else will pick up their tab. requires more data. Without more sound informa- • Autonomy in revenue and expenditure deci- tion on how large inequalities are and how they sion making can be lost, especially when have evolved over time, a policy debate on what Intergovernmental Finances in a Decentralized World 25 inequalities are acceptable or desirable may be some embody the features of earmarked grants. A based on soft ground and political will. Most more comprehensive objective would be to aim for developing countries lack much subnational fiscal each local government to be able to deliver at least data. For levels of government below the first sub- a minimum level of public goods and services. national tier, data are even scarcer. Data on differ- entials for service delivery are also critical for Performance Grants Systems in the assessing interregional disparities in access to ser- Developing World vices. To obtain better data requires setting up Local governments receive transfers either as for- monitoring systems in government, an undertak- mula-based general purpose grants, or based on ing that requires significant resources. Indonesia, criteria such as population, poverty, or remote- for example, has managed to maintain a database ness or some form of performance conditions. of subnational fiscal information at the center As  discussed above in the section on types of that—supported by laws requiring the regions to transfers, performance-based transfer systems report—has information on most of its 410 local are used to promote governance and institu- governments. In  China, the needed data exist at tional  development reforms, including financial the originating level, but the aggregation of infor- management, transparency, and citizen involve- mation at each level of government implies that ment and participation. This section summa- the central government has little relevant infor- rizes conditions for obtaining intergovernmental mation on the fiscal situation at subnational levels. transfers based on various performance criteria. For some countries, obtaining better data requires adjustments in accounting systems and budget Access to Performance-Based Grants classifications. Moreover, more policy analysis of Access to some transfers from a higher government the data is needed to inform the policy debate. tier (central, state, or provincial government) is Ultimately countries should aim to regularly conditioned on overall performance in areas such review the results and progress of their intergov- as budget execution, revenue  mobilization, and ernmental fiscal systems, including fiscal dispari- service delivery. Such performance-based grants ties and service delivery disparities. For example, often supplement basic transfers that are allo- following the highly successful example of South cated to local governments regardless of their Africa, Indonesia has embarked on preparation of effort or improvements. Box  1.8 presents the intergovernmental fiscal reviews; such reports example of Nepal’s Minimum Conditions would allow policy makers to evaluate their inter- Performance Measurement (MCPM) system, governmental fiscal system on a regular basis. which provides incentives for improved basic In summary, irrespective of whether more or local services. Other similar programs incorporat- less fiscal equalization is desirable, significant ing performance measures financed by the World scope exists for improvement in the design of Bank include the Uganda Local Government intergovernmental systems. Most countries need Development Program, Kerala Local Government to identify a more comprehensive objective and Service Delivery Project, West  Bengal for  their equalization system as a whole. The Institutional Strengthening Project, and  the center must determine its equalization objec- Bangladesh Local Governance Support Project. tives  and priorities (that is, income levels, Transfers that are allocated conditional upon fiscal capacity, expenditure needs, per person rev- a municipality’s performance are underpinned enues available) within a viable assessment of the by a logical formula that takes into account political environment. The objectives pursued by factors such as population and area. Typically, equalization grants are frequently unclear, so that the grants are allocated based either on historical 26 Municipal Finances Box 1.8 Minimum Conditions Performance Measurement The purpose of the Minimum Conditions (MC) and performance measures (PM) are Performance Measurement system (MCPM) linked to the development grants to bring is to augment grant support to local govern- about better performance in core areas such ments nationwide and to introduce incentives as planning, financial management, good gov- for better local performance and compliance ernance, and transparency. with governance standards, based on 35 mea- The MCs serve as safeguards to ensure sured parameters. that critical functions (e.g., approval of annual These general, unconditional grant funds budget and program on time) of the local are to help local self-governments to deliver bodies are discharged. The Ministry of Local more public goods and services and respond Development annually adjusts the grants to more effectively to citizens’ needs and priori- local bodies based on their scoring in the ties. Increased block grant transfers are also MCPM assessment. Local bodies that meet expected to act as incentives for empower- the minimum conditions and score high in the ment, enhancing local citizens’ participation in performance measures receive additional cap- local governance. The minimum conditions ital grants, and those that fail the MCs do not. Source: Government of Nepal. figures or on some simple formula. For exam- and toward the notion that city authorities are ple,  Nepal’s formula is based on population (50 accountable for improvements in outputs, pro- percent), area (10 percent), poverty (25 percent), cesses, and outcomes. Municipalities are likely to and tax effort (15 percent). Municipalities still respond to the central government goals by seek- must comply with basic or minimum conditions ing to ensure that they can demonstrate program (MCs) to access their grants. Compliance means results, so as to be rewarded with higher access to the transfers, and noncompliance subsequent transfers. Hence, well-designed means no access. The MCs include safeguards to performance-based grants can generate benefits bring down fiduciary risks to acceptable levels. for both the central government and the For example, a local government may be deemed municipalities. However, several challenges— to qualify for transfers based on clean audits, including data constraints, inadequate capacity at preparation of regular quarterly financial reports, the municipal level, elite capture, corruption, and and evidence of participatory planning. lack of commitment—can impede the realization A major premise of performance-based grants of well-intentioned performance-based grants. is that they will generate desired behavior on the part of city authorities, who will care about the Performance Improvement Targets and results. It is important to note that the academic Indicators debate as to whether transfers induce improved Local governments are often required to demon- revenue mobilization remains unsettled. From an strate improvements in public finance manage- operational perspective, however, the process ment to access performance grants. In some cases aims to make it plain to city authorities that “there other indicators, such as gender, poverty, and is no free lunch.” As noted above, performance environment issues, are also taken into account. grants shift consideration away from only inputs The process involves assigning weights and scores Intergovernmental Finances in a Decentralized World 27 to a cluster of indicators that are being considered which would provide a summary of annual reve- in a particular environment. For example, in some nue and expenditure patterns. Additional data cases, greater weight may be put on planning and requirements (quantitative or qualitative) may budgeting, and in other cases emphasis may be come into play, such that municipalities would placed on revenue mobilization. The decision is a have to demonstrate  to the central government conscious one based on the desire to provide achievement of a certain score to obtain the grant. incentives to local governments for behavioral An example is a minimum condition requirement change on a particular indicator. The scoring is that municipalities hold a participatory planning carried out by a team of professionals (ideally with process, with well-documented minutes of partic- an independent view), and scores are communi- ipation, and have a good-quality annual plan that is cated to the local and central governments in time linked to the five-year development plan. to allow for decision making for the next cycle of Municipalities would then be scored on this crite- grant allocation. Table 1.4 provides examples of rion as part of the assessment of whether they indicators and their corresponding objectives. qualify for the grant, for example, from a low grade of 1 to a maximum of 10. Data Considerations Such a combination of qualitative and quan- Conceiving and establishing a good transfer system titative data can be used to analyze a variety depends on having the necessary fiscal data. A key of public policy matters in the municipality and source of data is typically the municipal budget, make informed decisions on revenue and Table 1.4 Selected Output Indicators Applied to Performance-Based Grants Area of municipal finance Objectives Example of indicators Planning • Extending time horizon • 5-year development plan • Project selection • 3-year rolling capital investment plan Budgeting • Timeliness • Submission by agreed date • Credibility • Variance between midterm budget and actual Expenditure management • Efficiency • Percentage of expenditures done • Timeliness of contract timely management • Procurement plans in place by specified • Sustainability of operations date and maintenance • Created or updated asset registry • Control (asset, expenditure • Compliance with procurement authorities) procedures Revenue management • Fiscal effort • Percentage improvement in revenue collection year on year Reporting • Timeliness and accuracy • Annual financial statement Oversight and monitoring • Audit • Public display of audit opinion • Disclosures • Resolution of audit queries • Citizen satisfaction • Public display of annual financial statement • Evidence that consultative meetings have been held 28 Municipal Finances expenditure management and guide local gov- good transfer system, the entire system may ernments in their investments programming. be  subject to distortions and foul play among The discussion by Farvacque-Vitkovic and Sinet municipalities. An example is the special alloca- in chapter 8 provides advice for local practition- tions that members of the provincial assembly ers in collecting and structuring municipal data, have in Pakistan, the “personal grant envelope.” financial reports, and performance ratios to ful- These are funds given to the elected members of fill performance criteria (Municipal Finances provincial and national assemblies to distribute, Self-Assessment—MFSA) and guide local gov- largely at their own discretion, for projects in ernments in their day to day business and their political constituency. Another problem medium-term reform agenda. with this type of funding is that it tends to Thus, an outcome of performance-based undermine the autonomy of local governments. grants—direct or indirect—may be the emergence Unforeseen events can also cause the central of a new set of fiscal data at the local government government to release transfers (usually condi- level. Better organizational capabilities are tional) for a specific purpose. For example, earth- gained along the way, as city officials prepare to quakes, hurricanes, and severe flooding can access available grants and develop simple for- destroy infrastructure and property and cause mats of fiscal data. Sometimes, local governments deaths in many localities. Today, many local gov- do not even recognize that they are building a ernments are expected to formulate and imple- good, simple fiscal database. In other cases, sup- ment a disaster risk reduction strategy. They have port may be required to design simple and easy- a significant role in providing emergency relief to-use financial statements, asset registry and damage assessment. When a natural disaster checklists, and service delivery updates. If those occurs, the central government may release trans- things are done well and captured electronically, fers in response. local governments will be able to develop a his- In natural resource sharing, a transfer program tory of records on office and information man- may be created to compensate some regions and agement (see also chapters 3 and 8). In India (for local governments based on resource wealth (or example, in Kerala, West Bengal, Tamil Nadu, and lack thereof ). Such a transfer system may be Karnataka), a series of e-governance initiatives advocated to try to promote equity among the have transformed the way municipalities are cap- local authorities in a country. A major political turing key fiscal and service delivery data, thanks debate is going on in this regard in Pakistan in part to the information communication tech- because less-urbanized provinces such as nology revolution in the country. Baluchistan, that are blessed with abundant natu- ral resources, receive unfairly small shares of Distortions in Measuring Performances transfers allocated based on population or urban- Various events and practices can distort efforts to ized area. They argue for a fairer share based on improve local government performance. the revenues that originate in their natural Ad hoc transfer mechanisms, which the resources, but which are often realized by the authors would classify as transfer mechanisms industrialized provinces that sell the processed and practices to avoid, are transfers to munici- products. South Africa has a similar debate with palities that are allocated without a clear central multinational investors (Haysom and Kane 2009). government objective and are not driven by a formula or a clear decision-making process. Municipal Contracts Often, such transfers are driven by political Municipal contracts are another key performance- patronage, and if they coexist with a reasonably based instrument. In a context of increased Intergovernmental Finances in a Decentralized World 29 decentralization and greater involvement of local currently expanding the use of city contracts governments and of communities, the Municipal beyond the initial urban renewal objective. Contract has emerged as a useful tool to facilitate Sweden, Belgium, Germany and Canada have also the selection, implementation and financing  of experimented with various forms of municipal urban services and infrastructure and push the contracts. A municipal contract is usually a con- envelope on municipal management reforms. sensual and binding, performance-based agree- Many countries in Europe have adopted the ment between a municipality and the central Municipal Contract approach. In France, munici- government for a four- or five-year period. It pal contracts were initially introduced on an typically includes a priority investment plan, a experimental basis in the 80’s. During the 2000’s, municipal maintenance plan, and a municipal 247 municipal contracts involving 2,000 munici- adjustment or reform program. In North Africa, palities were signed to benefit inter-municipal municipal contracts have also been used in Tunisia projects (2 billion euros in investments). The and Morocco. In Sub-Sahara Africa, municipal Netherlands adopted the contract formula in its contracts have been widely implemented with the “large city” policy. The UK adopted an original support of the World Bank and AFD in countries form of partnership policy based on a “strategic such as Senegal, Guinea, Mali, Burkina Faso, local partnership” which brought together local Mauritania, Cote d’ Ivoire, Niger, Cameroon, stakeholders (civil society, the private sector, local Madagascar, Benin, Rwanda, Chad. (Farvacque- governments) for the purpose of identifying and Vitkovic and Godin). Box 1.9 summarizes the key financing neighborhood projects. The UK is objectives and attributes of municipal contracts. Box 1.9 Objectives of Municipal Contracts The following are some of the key objectives the central government and the municipal of municipal contracts: government, based on the provisions of the contract and publicly acknowledged • To support integrated urban and local de- obligations. velopment through an increase in urban • To enhance citizen participation in investments in infrastructure and service developing the strategic vision of the delivery and by focusing on improving mu- municipality for its future growth and nicipal governance and management. development and develop stronger • To give the municipality greater responsi- accountability between the municipality bility in the selection and financing of and its citizens. municipal investments by putting its role • To define and monitor the implementation on a contractual footing. of the key components of the Municipal • To ensure prioritization of investments and Contract (Municipal Investments Program greater visibility and transparency on the and Municipal Adjustment Program -- use of public funds. including the Municipal Finances • To ensure strong commitment, through Improvement Plan). signing of a municipal contract between Sources: Farvacque-Vitkovic and Godin 1998; Farvacque-Vitkovic, Godin and Sinet 2013; Goudrian 2010. 30 Municipal Finances Box 1.10 The Process of Municipal Contracts A municipal contract is developed based on an 3. The third stage consists of drafting the assessment of the municipality’s characteris- municipal contract, itself, with a clear set tics, particularly urban features and organiza- of commitments from the local and central tional and financial capacities and weak- governments in order to close the deal on nesses. The assessment leads to a municipal a financing and technical program. It will program which includes clear investments specify the content of the priority invest- priorities (Priority Investments Program) as ment programs (PIPs) and of the Municipal well as clear capacity development measures Adjustment/Improvement Program (MAP). (Municipal Adjustment program). 4. The implementation and monitoring Development of municipal contracts can stage requires a coordinated effort to be divided into four stages: align the financing with the technical and human resources, as well as the 1. The diagnostic/audit/self-assessment stage: political commitment to implement the This stage includes (1) the completion of a contract. financial and organizational audit/self- assessment which aims to assess a city’s Evidence suggests that municipal con- financial health and to identify specific tracts have been very effective in supporting actions to improve mobilization of local local governments, even where decentraliza- resources, public spending, public assets tion reform has been a difficult process (World management and maintenance, investment Bank 2009). They have enhanced municipali- programming and access to external financ- ties’ financial capacity and contributed to ing. The MFSA leads to a very concrete investments in infrastructure and service Municipal Finances Improvement Plan; and delivery. (2) an Urban Audit which aims to locate, The success or failure of a municipal con- identify and quantify existing gaps in service tract depends on two main factors: the qual- delivery and infrastructure and which leads ity of the municipal contract process itself to (a) a Priority Investment program and (b) a and the political and institutional environment Municipal Maintenance Program. in which it is developed and implemented. 2. The validation/consultation stage examines The quality of the municipal contract depends the key findings of these assessments/ on the capacity-building efforts that munici- audits. It is a very important stage because palities engage in to enable better prepara- it involves a set of consultations with the tion, implementation, monitoring, auditing, key stakeholders in order to reach a con- and strategic development. The level of polit- sensus on a “municipal program” which ical commitment and ownership at the would consist of (1) a set of very concrete central and local levels, the degree of partici- and monitorable capacity development pation by stakeholders and citizens, and and revenue enhancement measures and the extent of harmonization and align- (2) a program of investments based on the ment among various donors working in the financial capacity and the priorities of the local government sector are also important citizens. influences. Source: Farvacque-Vitkovic, Godin, Sinet, 2013. Intergovernmental Finances in a Decentralized World 31 Box 1.11 Municipal Contracts: Some Examples of Best Practice A recent Independent Evaluation Group (IEG) two largest cities, Cotonou (population review points out that by the late 2000s, more 690,584) and Porto Novo (population 234,168). than 200 municipalities across French-speaking Confirmed by beneficiary assessments at West Africa were implementing municipal completion, the success was helped by the contracts. In the short term, they resulted in introduction of delegated contract manage- increased municipal capacity to invest. ment practices. Those practices enabled rapid Municipal capital investment as a share of processing and execution of service contracts current revenues rose from 10 percent to with local small and medium-size enterprises, 17 percent over the period 2001–03 (World which provided higher-quality, lower-cost urban Bank 2009). infrastructure services and left municipal Among the examples of successful munic- administrations more time to concentrate on ipal contract projects are Senegal I (Urban their planning and programming tasks. Development and Decentralization Program), Ghana also had a string of successful which helped 67 municipalities throughout municipal development programs (MDPs). Senegal strengthen their financial and organi- Ghana I brought significant service improve- zational management and improve implemen- ments, notably in solid waste management, to tation of investments in urban infrastructure six municipalities. This success was extended and services. The project used municipal to 11 more municipalities by Ghana II. Ghana IV contracts in which central and local govern- took the model further by investing intensely ments agreed to certain benchmarks for in financial and technical training for the staffs municipal reform. of 23 municipalities through the national A highly satisfactory project was Benin I Institute of Local Government Studies, which (Urban Rehabilitation and Management), which itself came out of the project considerably helped improve urban services in the country’s strengthened (World Bank 2009). The Internal Evaluation Group (IEG) of the pros  and cons of decentralized government. World Bank found that among the most successful This  is true in unitary, federal, and confederal are Benin’s First Urban Rehabilitation and states alike. The character of a “decentralized” Management, Second Decentralized City system of public sector reform varies from Management, and the Third Second Decentralized country to country, but there is general agree- City Management; and Senegal’s First Urban ment that by “decentralization” one is referring Development and Decentralization Program and to the structure of the relations among differ- Second Local Authorities Development Program, ent  types of government—that is, the sorting under various World Bank projects (World Bank out  of governmental roles and responsibilities 2009). among central and subnational (e.g., municipal) governments. There is also agreement that to be  “intergovernmental” requires a financially Takeaway Messages strong, but reorganized and refocused, central Wherever one looks around the globe, a new government along with a well-designed and generation of public policy makers, academics, capable system of subnational governments. At and civil society activists are discussing the present, the public finance literature typically 32 Municipal Finances distinguishes two primary forms of a decentral- regional offices and officers have no power to ized system: political and fiscal. “Political decen- modify centrally mandated rules and regula- tralization” refers to arrangements whereby the tions. Delegation can be characterized as a legal legitimacy of local government is recog- principal-agent relationship in which  higher- nized explicitly in the national constitution or by level governments (principals) assign local statutory and administrative decisions. “Fiscal governments (agents) the responsibility for decentralization” is the intergovernmental sort- supplying certain local functions. With devolu- ing out of expenditure and financing roles and tion, independent local self-governments are responsibilities among the various types of gov- established with the full responsibility for the ernments in a manner that is in harmony with delivery of a set of public services, along the political framework. For a nation to realize with the authority to impose taxes and fees to the theory-promised social and economic bene- finance the services. fits of an intergovernmental society requires Why do some states tend to remain heavily both political and fiscal decentralization. politically and fiscally centrally controlled There are four fundamental questions to be while others move ahead with decentraliza- addressed in fiscal decentralization: (1) Which tion? Three arguments are offered to explain a type or tier of government does what (expendi- continuing tilt to centralization. They are ture assignment)? (2) Which type levies which (1)  the argument that there is a lack of local revenues (revenue assignment)? (3) How can capacity to govern; (2) ensuring that central “vertical” fiscal imbalances between the center functions such as national defense, foreign pol- and subnational units and “horizontal” icy, protecting national borders, and managing imbalances across subnational jurisdictions macroeconomic stabilization are fulfilled; and be resolved? (4) How shall the timing of receipts (3) legacy—the persistence of old methods— be addressed (borrowing and debt)? and “old ways are good ways.” “Fiscal decentralization” is also a term That much of the world is undergoing some encompassing three variants: deconcentration, form of decentralization attests to its impor- delegation, and devolution. An important pol- tance. There are at least four explanations icy question is which of these three variants for  this trend: (1) the complementary, indeed can  be said to dominate a nation’s public reinforcing, nature of the 21st-century trends of finances. Deconcentration denotes a process globalization and localization; (2) the politics whereby regional offices of central ministries of the “reaction from below” for systems of and/or of centrally appointed administrative citizen control over their local government; officials are established in local jurisdictions (3)  the economic efficiency and political for the purpose of determining the level and accountability arguments that there is payoff in composition of the provision of local goods terms of general welfare gains that result from and  services. The central authority retains well-designed intergovernmental arrange- control of the rules for the financing side of ments; and (4) for some nations, decentraliza- the  budget equation. Deconcentration “with tion can serve as a strategy for promoting authority” means that the regional offices are national cohesion to defuse tensions that arise given some flexibility to make “own” local where the society is fragmented by history, service and tax decisions, but again, subject to ethnicity, religion, language, endowment of central guidelines. Under a system of decon- natural resources, or other aspect of geography centration “without authority” the nonelected and place. Intergovernmental Finances in a Decentralized World 33 What are practitioners learning? What does authority, an independent grants commission, one know about the relationship between an intergovernmental forum, and an intergov- decentralized fiscal autonomy and the accom- ernmental-cum-civil-society forum. plishment of a nation’s broader economic and Intergovernmental transfers can be broadly fiscal objectives? Four lessons are being learned: classified into two main categories: general (1) There is a proven dismal macroeconomic purpose (also called “unconditional”) transfers record of centralized command and control; and specific purpose (also called “conditional” the advanced (e.g., OECD) countries of the or “earmarked”) transfers. General purpose world tend to be those that have adopted  a transfers have no conditions (“strings”) system with some degree of local political self- attached and may be either mandated by the determination and devolution of finances. law (e.g., the constitution) or made at central (2) Consistent with the theory of public finance legislative discretion. Unconditional grants that argues that decentralization enhances may be designed to simultaneously address efficiency in the allocation of public services, both vertical (central versus local capacity to there is an emerging body of empirical evidence generate revenues) and horizontal imbalances that reveals a positive relationship between (equalization of fiscal capacity disparities a  well-designed and implemented system of among subnational governments). Specific decentralized government and national eco- purpose or conditional or earmarked transfers nomic growth. (3) Case study work attests to are financing, or intended to provide incen- the national cohesion outcome for several tives, for governments to undertake specific nation states. (4) Some evidence exists that programs or activities. Such transfers may subnational revenue autonomy improves the incorporate matching provisions by requiring macroeconomic stability of the nation state. municipalities to finance a specified percent- Intergovernmental transfers play a key role age of expenditures using their own resources. in the finances of municipalities. How they are Another important type of transfer is centrally designed and implemented is very important shared revenue, an arrangement in which a in understanding their impacts in a decentral- portion of the monies (receipts) derived ized framework. Designing intergovernmen- from  a  national tax, or other, nontax revenue, tal  transfers is not a simple task. The fiscal is  transferred to subnational governments. life  of a local government financial manager However, depending on the formula for the in  a typical working day can be made more central-subnational division of receipts, reve- effective if transfers are designed and imple- nue sharing may exacerbate or reduce the mented in a formula-driven, transparent, and horizontal fiscal disparities among subnational accountable manner that relies on data that governments. can be readily accessed and understood by Performance-based transfer systems are donor and recipient alike. The central govern- intended to promote and create incentives for ment may choose to take up the transfer design governance and institutional development or may delegate it to an independent entity, reforms, including financial management, which may have the final decision-making transparency, and citizen involvement and par- authority or be advisory. The four commonly ticipation. Under a system of performance- practiced options in the design of transfers based transfers, local governments access include a central legislative or executive grants based on some criteria (e.g., population, 34 Municipal Finances poverty, remoteness) or some form of perfor- Decentralizing.” Journal of Public Economics mance conditions. However, various events and 89: 1157–89. practices can distort the efforts made toward Bahl, Roy W. 1999a. “Implementation Rules for improving performance-based grants systems Fiscal Decentralization.” Georgia State of local governments. These include transfers University, Andrew Young School of Public that (a) are arbitrarily allocated without a clear Policy, Atlanta, Georgia, U.S.A., www: asyps objective or transparent formula; (b) serve as .gsu.edu/publications. “gap filling” to cover subnational government ———. 1999b. Fiscal Policy in China: Taxation and fund deficits; (c) are intended to address events Intergovernmental Fiscal Relations. Ann Arbor: (e.g., earthquakes, hurricanes, and severe flood- 1990 Institute Press/University of Michigan Press. ing) but which may be conditional for a specific purpose granted for a limited time; and (d) take Bahl, R., and J. Martinez-Vazquez. 2006. into account the sharing of natural resource “Sequencing Fiscal Decentralization.” World Bank Policy Research Working Paper 3914, revenues to compensate specific regions and World Bank, Washington, DC. thus local governments for resource wealth (or Barati-Stec, Izabella. 2012. Hungary: An Unfinished deficiencies), without paying attention to the Decentralization? IMFG Papers on Municipal performance of local governments. Finance and Governance. Toronto: Munk Municipal contracts are another key School of Global Affairs. performance-based-instrument through which Bauzon, Kenneth E. 1999. “The Philippines: The municipalities have been supported to address 1996 Peace Agreement Southern Philippines: urbanization challenges. 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It politan areas with over a million (Brinkoff 2012). summarizes the metropolitan-level governance Cities are growing particularly rapidly in devel- models applied internationally and describes oping countries, some at rates of 3 percent to their municipal finance implications, with exam- 5 percent annually. People move to cities for bet- ples. A great diversity of metropolitan governance ter jobs, better services, or a better business envi- models and modalities and many effective and ronment; for family reasons; or because of natural equitable arrangements exist. Often political cir- disasters or social unrest in their places of origin. cumstances and decisions influence the formation With improved transportation, people are also or evolution of governance and finance systems. able to commute over longer distances from villages or small towns to larger urban areas. As a Emergence of Metropolitan Areas result, cities have become economically interde- pendent with their surrounding settlements and Cities have been emerging and growing since hinterlands, constituting metropolitan areas— known historic times. But also, many large cities each a single economy and labor market, a com- have over time become more economically inter- munity with common interests, benefiting from dependent with their surrounding urban settle- some joint actions. ments and hinterlands, constituting a single Metropolitan Governance and Finance 41 economy and labor market that is called a city- area. Although the jurisdictional boundaries of region, a metropolitan area, or an extended urban local governments tend to have a long history, region. The economic links between the core and years of urban growth often change an area’s the periphery may become so close that one part character. Therefore, a metropolitan area usually cannot succeed without the other, and thus they includes a number of independent local govern- behave as a single entity. The term “metropolitan ment jurisdictions. Metropolitan areas are often area” is often a loose definition with no clear supported with some institutions or arrange- boundaries. It may be based on labor market ments to coordinate their development or some (people live in one part of the area and work in joint functions for more efficient and equitable another part), a catchment area for amenities and service provision and cost sharing, in addition to education institutions, or access to key infrastruc- efforts by each individual local government. ture, or it may be an area based on a firm’s local Agglomerations of this kind host a quarter of economic environment. Some definitions of the world’s population. Around the world, there related concepts are shown in box 2.1 for general are more than 500 metropolitan areas with popu- reference. This chapter defines a metropolitan lations of a million or more (Brinkoff 2012), a total area as follows: population estimated to be more than 1.6 billion in mid-2012. These agglomerations include a cen- An area constituting a single economy and tral city and neighboring communities linked to labor market, a community with common interests and joint actions; often including a the core by continuous built-up areas or through number of local government jurisdictions. commuting patterns. An agglomeration is typi- cally named after its central city. Some have more The radius of such an area is often on the than one central city (such as “the Ruhr” area in order  of 20 to 40 kilometers (km), but is some- Germany). times larger,  or the area may be shaped as an urban corridor or  “belt” (one jurisdiction after How Do Cities Grow Spatially? another). Socioeconomic cohesion characterizes Cities grow spatially in different ways. Figures 2.1 the formation and emergence of a metropolitan through 2.4 illustrate four types of spatial growth Box 2.1 Terms Related to Metropolitan Areas Urban agglomeration is an extended city or at the border between France and Belgium). town area comprising the built-up area of a Each city or town in a conurbation may never- central place (a municipality) and suburbs theless continue to act as an independent linked by a continuous urban area. focus for a substantial part of the area. Conurbation is a more specific term for Metropolis is a very large city or urban large urban clusters, where the built-up zones area which is a significant economic, politi- of influence of distinct cities or towns are cal, and cultural center for a country or region connected by continuous built-up develop- and an important hub for regional or interna- ment (e.g., Essen–Dortmund in the Rhine- tional connections and communications. Ruhr district in Germany), even in different New York City is often cited as the quintes- regions, states, or countries (e.g., Lille–Kortrijk sential metropolis. Source: Wikipedia. 42 Municipal Finances of a city or area. In a monocentric structure settlements. Thus, a metropolitan area may (figure 2.1), a core city is growing outward from a emerge or be formed either through outbound central core, in more or less concentric circles growth of a city or through a gradual expansion over time, with decreasing population densities and integration of various settlements that at the farther one gets from the center. Sometimes some point form an interdependent, agglomer- the spatial extension has instead the character ated metropolitan area. of  sprawl (figure 2.2), with low-density areas A metropolitan area sometimes forms a expanding in various directions. corridor or a “belt” (one jurisdiction after A polycentric structure (figure 2.3) results another), for example, because of the topography from growth that is more a matter of integration or the location of key infrastructure (such as an of various areas than an outward expansion of a international airport) or a tourist attraction. The core area. Often a number of urban subcenters metropolitan area of Tbilisi, Georgia, provides a exist and grow, and over time they become good example (see map B2.2.1). It is a 60-km sufficiently close to a main city, from a transport corridor of four local governments along a valley, perspective, to allow significant business with Tbilisi the dominant city. The emergence of interaction and daily commuting. A polycentric this corridor is summarized in box 2.2 and illus- structure tends to evolve toward a multipolar trated in the accompanying map. structure (figure 2.4), which is characterized by a core city and various secondary subcenters, with Informal Settlements the areas in between them having become Agglomerations are mixtures of towns, villages, denser in population, forming contiguous urban urban and rural areas, forests, riverbeds, and Figure 2.1 Monocentric Structure 50-km radius 25 km Metropolitan core Outer core Major Inter-city Secondary metropolitan road sub-center High density Medium density Low density suburban suburban suburban Source: Chreod Ltd. Metropolitan Governance and Finance 43 Figure 2.2 Sprawl 50-km radius 25 km Metropolitan Outer core Major inter-city Metropolitan core road sub-center High density Medium density Low density suburban suburban suburban Source: Chreod Ltd. Figure 2.3 Polycentric Structure 50-km radius 25 km Metropolitan core Outer core Major inter-city road Principal metropolitan Secondary metropolitan High density suburban sub-center sub-center Medium density suburban Source: Chreod Ltd. 44 Municipal Finances Figure 2.4 Multipolar Structure 50-km radius 25 km Metropolitan core Outer core Major inter-city road Principal metropolitan Secondary metropolitan High density suburban sub-center sub-center Medium density suburban Low density suburban Source: Chreod Ltd. Box 2.2 The Emergence of the Tbilisi Corridor The Tbilisi area has grown into an agglomera- Tbilisi is the dominant city, but the metro- tion, with the local economy and labor market politan area is more than an extension of Tbilisi. spanning Rustavi city and the Gardabani dis- It is a small cluster of jurisdictions with comple- trict and municipality in one direction, and the mentary strengths and characteristics. Rustavi district and municipality of Mtskheta in and Mtskheta can draw economic strength the other. These four local governments form from their proximity to the much larger city of the Tbilisi Metropolitan Area (TMA), an area of Tbilisi, and Tbilisi may, over time, benefit from about 2,600 square kilometers with a popula- developments in Rustavi, Mtskheta, and tion of 1.5 million. Gardabani through reduced congestion. The To realize the full potential of the TMA, the proximity of the urban areas, with a good road Tbilisi city government established the Tbilisi network connecting them, has created a fairly Metropolitan Development Agency (TMDA) in integrated labor market. It is estimated that 2009. For some functions, all four municipali- about 20 percent to 30 percent of Rustavi resi- ties may benefit by joint or coordinated efforts, dents, and more than 40 percent of Mtskheta rather than acting individually or competing residents, work in Tbilisi; and that some with one another. 10 percent of the residents of Gardabani town (continued next page) Metropolitan Governance and Finance 45 Box 2.2 (continued) commute to Tbilisi. Certain entities and facili- covering Tbilisi, Rustavi, and Mtskheta, and a ties serve a great part of the area, such as a new landfill under construction to serve private water and waste-water company, Rustavi and Gardabani. Map B2.2.1 Tbilisi Metropolitan Area Source: World Bank. Source: Tbilisi Local Authority. state and private lands. That mixture creates (road,  water, electricity, health and education opportunities for rural people to move into the services),  and where most dwellings have urban area for agglomeration benefits, and they no  land  ownership  or formal use permits. often create large informal settlements, mostly Informal settlements are common side effects of on public land. These settlements either are agglomeration development that is positive scattered in parts of the city (as in Lahore, overall, and they create major legal, social, and Pakistan) or may contain a substantial part of the economic challenges in the developing world. city’s population.1 Many form in wetlands, riverbeds, or zones exposed to flooding. The Megacities term  “slums” denotes settlements with over- As already stated, in 2012 the world had 27 mega- crowded  housing that lack basic infrastructure cities with populations of 10 million or more 46 Municipal Finances (Brinkoff 2012). Large urban areas offer large Responding to Urbanization local markets (because of lower transport costs) Those challenges produce needs for action by and facilitate economies of scale and industrial local and national governments; for example, diversity (providing innovation incentives). All • Increased need for supporting infrastructure contribute to job creation and economic develop- (to reduce distances, mitigate congestion, ment. Agglomeration facilitates economic growth prevent slums, etc.) through the sharing of information, labor, and other inputs; specialization and intraindustry • Increased demand for basic services trade; and competition. However, megacities also • Need to mitigate higher costs for firms and face challenges, including the following: residents for land, labor, housing, etc. • Infrastructure and housing shortages (creating • Need to mitigate environmental stress large unplanned settlements) • Need for a more effective governance struc- • Severe traffic and housing congestion ture, with institutions to facilitate the mobility of goods and people, enforce regulations, etc. • Large informal (household enterprise) sectors in need of support • Need for subsidies to reduce social and economic divisions. • Megacity governance and management challenges Economic densities are very concentrated around the world (map 2.1). Megacity  manage- • Insufficient access to investment capital. ment needs to be somewhat differentiated from Map 2.1 Economic Densities (“Economic Mountains”) in Parts of the World Source: World Bank 2010. Metropolitan Governance and Finance 47 management of other cities. Large urban centers urban population will overtake the rural popula- and their development need to be placed in the tion in this large continent by 2030. context of their national economies. Megacities and the productivity of urban centers are Metropolitan Governance increasingly determining national economic growth, as well as the economics of subregions Metropolitan areas strongly benefit from coordi- (World Bank 2010). For example, Dar es Salaam’s nating or integrating service provision, joint efficiency as a port city has effects on Tanzania and development, and cost sharing, instead of separate on neighboring countries (Democratic Republic of individual efforts by each adjacent local govern- Congo, Uganda, and Zambia). The connections ment. International experience has shown that in of  cities across countries mean that productivity successful metro areas, significant economies of of each city influences others, forming a cross- scale have been accomplished in certain service border growth pole at a subregional level. The functions. For example, in Paris, London, and map of East Africa (map 2.2) well illustrates the Shanghai, the metro administrations address significance of the large cities in the region. areas that have twice the population of their core Although Africa has to date been lagging in city. The concept of metropolitan area governance terms of urbanization, it is well on its way to can be defined as follows: becoming a predominantly urban continent. a set of institutions, rules, and actions that Africa’s annual urban population growth averages delineate policies and conditions for the life 4 percent, the fastest in the world. Three of the and economy of a metropolitan region. ten fastest-growing cities in the world are in Africa (Lagos, Nigeria; Dar es Salaam, Tanzania; Metro areas are often characterized by rapid and Lilongwe, Malawi). It is expected that the change in density and landscape, evolving mixed land use, speculative real estate markets, a lack of spatial integration of the local economy and infra- Map 2.2 East Africa with Population Density structure, and disparities in service provision and administrative capacities. Whereas activities to retain existing businesses should normally be left to the lowest level of government serving the business community, attracting new firms for job creation and related efforts for economic devel- opment are normally best pursued at a broader regional level. The same applies to solid waste disposal or to addressing various environmental challenges, such as air and water quality, whose impacts transcend jurisdictional boundaries. For  example, inadequate maintenance of storm drains  in one area can cause flooding in other communities (spillover effects). As for police services, crime does not respect jurisdictional boundaries, so coordination is needed. Strong interdependencies also exist in tourism promo- tion and management. Such spillover effects Source: World Bank 2010. tend to provide incentives for intergovernmental 48 Municipal Finances dialogue and special arrangements among local procurement, sharing emergency equipment, governments. and so forth A lack of any (formal or informal) governance • Cost sharing. When the local governments in arrangement at a metropolitan scale tends to cre- the area would achieve efficiency (economies ate serious problems and missed opportunities of scale) by sharing the costs of delivering a (summarized in box 2.3). service; for example, a waste disposal facility or coordinated drainage system for the whole Good Metropolitan Governance area, or a single police force. As metropolitan areas emerge and grow, the need  for metropolitan-level management—for • Spillovers. When spillovers (also called coordination and joint decisions—increases. The “externalities”) across jurisdictional borders following are examples of cases in which metro- need to be addressed for fairness; for exam- level management is particularly beneficial for the ple, in cases of air or water pollution caused residents and their local governments. Many are by neighboring industrial areas (negative driven by financing concerns or opportunities: spillover), or when all the tourism attrac- tions are in one area, but visitors stay  and • Pooling financial resources. When synergy spend in another area (positive spillover). would be achieved through a joint effort by the local governments in the area, by pooling their • Specialized services. When local governments financial or human resources for a particular in the area have a need for specialized  ser- purpose, such as promotion of the area, joint vices (for example, hazardous waste Box 2.3 Risks and Missed Opportunities Due to Lack of Metropolitan Governance Some rules are always in place in metropolitan increasing air pollution, the troubled city regions, but one can distinguish adequate may need to fix what is a joint or regional from inadequate governance. The negative problem from its own resources, without consequences of poor governance, which is fair contribution by the neighbors, who characterized by a lack of dialogue and coordi- benefit from the positive effects of the nation (possibly due to political diversity), agglomeration but spend their money include these: elsewhere and may even aggravate the troubles of the inner city. • Fragmentation. Provision of some public • Underutilization. Some land may have services (particularly those of common limited value locally but potentially a interest, such as bus or other pub- higher value from a regional perspective. lic transport services) may be frag- • Disparities. Different parts of the metro mented, resulting in higher costs and area may experience differences in the financing challenges for each local quality and level of amenities and services government. because income inequality among resi- • Free ridership. For example, if some areas, dents affects the tax base of the various usually the inner city, are congested, with local governments. Metropolitan Governance and Finance 49 disposal) or equipment that would be most The local governments in some areas cooper- effectively met jointly, or by one of the local ate with one another only when they are required governments with all others paying for the to do so by a higher-tier government or in matters service of joint convenience (e.g., to be eligible for some funding). That may or may not create true and • Disparity. When the metropolitan area has sig- lasting metropolitan governance. Cooperation nificant inequalities (income disparities) among local governments has sometimes been among its residents, by subarea or jurisdic- encouraged by incentives from a provincial or tion,  and that is considered a priority to be national government. For example, in the United addressed. States, it was for many years a prerequisite It is important to recognize, however, that the for  obtaining grant funding from the federal needs and potential for action for a particular city government—particularly for road and transit area depend on a number of local factors, for infrastructure and wastewater management— example: that the local governments show approval of the needs and solutions in a regional plan by a • National context: regional entity. Many regional planning councils — The constitution and other laws and regu- were created following the availability of EU lations of the country regional economic development grants (OECD 2006). Other incentives for regional coordination — The division of responsibilities (functions) have been created through intergovernmental among various government levels systems (e.g., in India), through legal frameworks — Relations with higher-level governments, (e.g., Brazil, France, Italy, and Poland), or through the intergovernmental system financial incentives and political influence (e.g., in the Netherlands). • Local context: — The history and culture of the area (e.g., a Metropolitan Governance Models strong tradition of local autonomy or no International experience demonstrates a great such tradition) diversity of metropolitan models, particularly across North America (Dodge 1996) and Europe — The importance of easy access by the resi- (OECD 2006). In East Asia, China, Japan, and the dents to their local government and ensur- Republic of Korea have consolidated metropoli- ing their corresponding accountability tan governments for their megacities (Yang 2009). Many megacities are in South Asia, but few — Revenue sources available to the local well-established and functioning approaches governments. exist. While many metropolitan development Fragmented local government structures in authorities exist, they tend to focus mostly on metropolitan areas are usually highly dependent investment planning and land development. on intergovernmental transfers or on spending Although Latin America is also home to many by  higher-tier governments. Metropolitan-wide megacities, the frameworks for metropolitan governance arrangements, on the other hand, governance in São Paulo, Mexico City, Buenos allow externalities for many public services to be Aires, and Rio de Janeiro are lacking or weak. An internalized and a broader range of services to be exception is the metropolitan district of Quito, in assigned to the metro-level agencies (Bahl, Linn, Ecuador, which has an elected metropolitan and Wetzel 2013). council with broad responsibilities, presided over 50 Municipal Finances by an elected metropolitan mayor. Somewhat — A regional service delivery authority similar systems exist in Bogotá and Caracas, but — A regional planning and service delivery they are weaker in practice (Rojas, Cuadrado- authority Roura, and Fernández Güell 2007). Sub-Saharan Africa is rapidly urbanizing, but most cities lack • Metropolitan-level government effective institutions to address subjects at a — Metropolitan-level local government metropolitan scale. South Africa is an exception, having through amalgamations established eight — A regional government established by a municipalities, each essentially covering its higher tier of government (federal, state, or metropolitan area. provincial) Where institutional arrangements at local • Annexation of territory or amalgamation of levels are lacking or weak, coordination tends to local governments. be exercised by national or provincial or state governments (e.g., Lagos state). In Australia public transport and other local functions are managed How Do Stakeholders Select or Change by the provincial governments (Abbott 2011). a Model? International practices underscore that some The system of local administration has a signifi- formalized governance framework is needed to cant impact on the efficiency and equity of a coordinate local governments across a metropoli- regional economy. Although there is no single tan area. Various models have been applied inter- perfect arrangement for local governance—each nationally to address that need. Several models has advantages and disadvantages—the system of may coexist in a single metropolitan area. The political accountability and responsibility ideally approaches listed below will be described further, coincides with authority and the revenue base. and variations illustrated through city examples. The emergence of larger metro areas indicates a Subsequent sections will show how cities have need for governing fairly large jurisdictional addressed finance challenges and how their insti- areas, establishing an authority that coincides tutional and financial arrangements have evolved with  representation. That means that any entity over time. established to coordinate subordinate localities The main models and approaches to metro- or service delivery functions should ideally be politan governance are the following: representative of, and accountable to, the entire jurisdiction and should receive corresponding • Cooperation among local governments resources and authority. — Case-by-case joint initiatives The governance structure affects its acces- sibility to citizens, the degree of public — Contracting among local governments participation in decision making, and the — Committees, commissions, working groups, accountability and responsiveness of the gov- partnerships, consultative platforms, etc. ernments. The evolving size of an urban area, its economic potential, economies of scale, • Regional authorities (sometimes called financing power, accessibility, and easy move- “special purpose districts”) ment of labor are among the main factors that determine a specific metropolitan governance — A metropolitan council of governments design. The most appropriate model for a par- (COG) ticular area depends on both the national and — A regional planning authority local contexts. Box 2.4 includes a simple list of Metropolitan Governance and Finance 51 Box 2.4 Questions to Ask When Reviewing the Governance Structure of a Metropolitan Area The following questions can be used to mandate be expanded to address some of advance the evolution of the governance the items mentioned or not? What would structure of a metropolitan area: be the pros and cons? • Would the various problems and opportu- • What problems of a similar nature exist nities be better addressed through a among the local jurisdictions in the area higher-level metropolitan government for that need to be, or might most effectively some functions? If so, could the functions be, addressed jointly? Examples include of any existing regional agency be incorpo- public transport, the local road network, rated into it or not? Would amalgamation of solid waste disposal, road maintenance, some local authorities be an option to and drainage. consider? • What opportunities exist for the local • How could it be ensured that citizen authorities in the metropolitan area to be accessibility to the government, and gov- stronger and more effective by acting ernment responsiveness and accountabil- jointly? Examples of such opportunities ity, would not be weakened in any revised include city branding, attracting foreign structure? direct investment (FDI), tourism promo- • If a metropolitan agency exists, what addi- tion, and some procurements. tional functions that are currently managed • Could the local authorities save public by a higher-tier government could be resources (gain efficiency) by managing assigned to it? some service delivery jointly rather than • Should inequality among the local govern- individually, for example, through econo- ment areas (in income and service mies of scale, coordination potential, and provision) be addressed by the national so forth? government via the local governments in • Could the problems and opportunities be the area, or as a metropolitan issue, by the addressed by a metropolitan agency or not? local governments acting jointly? Why not? What constraints would exist? If • Is the cost sharing within the metropoli- not, how would the problems and opportu- tan area fair with regard to spillovers and nities most effectively be addressed? If yes, externalities across the jurisdictions (e.g., would such an agency be established and air pollution, people living and paying directed by local governments or by a taxes in one jurisdiction but working in higher-tier government? Would creating it another, etc.)? If not, should it be require a lengthy legislative or regulatory addressed by the national government process? If so, is it worth it? through the transfer system or as a met- • If a regional development agency already ropolitan issue, through action by the local exists for certain functions, could its governments themselves? 52 Municipal Finances questions to help one analyze metropolitan intergovernmental relations are structured. It governance arrangements. depends in particular on whether metropolitan cities will be treated the same as other local gov- Benefits of Smaller Government Units ernments in the country or be treated differently— Experience in metropolitan areas underscores for example, a special status for national capital that good metropolitan governance systems insti- cities or cities with “provincial city” status; tutionalize an adequate division of labor between whether they have special expenditure assign- the metropolitan-level institutions and the local ment and taxing arrangements because of their governments. With few exceptions, local size; or whether other special arrangements exist governments remain key governing bodies for under the intergovernmental transfer system. most functions, while agreeing to allow a joint The degree to which the actions of local govern- metropolitan governing body to perform other ments in a metropolitan area will be regulated by functions. Local governments remain critical higher-tier government ministries is also impor- to  ensuring accessibility, responsiveness, and tant, as is the coordination of service delivery in accountability and close and clear links between the area by the local governments and higher-tier expenditures and revenues; to allocating resources governments (Bahl, Linn, and Wetzel 2013). efficiently; and, last but not least, to ensuring par- Financial considerations are often among the ticipation by citizens in local decisions. Many prime incentives to form special metropolitan believe that even some level of competition among arrangements, either through a bottom-up pro- local governments may be healthy in specific cess by the incumbent local governments or as a areas, as it provides incentives for them to be more top-down decision by a higher-level government efficient. (provincial or national). The main economic or Metropolitan experiences also suggest that financial factors include potentials for cost sav- politics, rather than efficiency and equity, often ings by joint initiatives (scale economies); cost determines the choice of governance structure. sharing in areawide service provision or capital Case studies discussed in later sections show that investments; and desire to address fiscal inequal- changes in metropolitan governance in London, ity, when significant tax base differences exist Toronto, and South Africa were driven substan- among the jurisdictions of a metro area. This sec- tially by political factors, although economics, tion summarizes generic financial aspects appli- finance, and efficiency were also taken into con- cable to any of the governance models; various sideration. International experiences suggest that financial implications and related solutions in flexibility of governance arrangements over time individual cities are included in the case study and across jurisdictions is desirable. As shown in descriptions below. some of the cases described below, some metro areas have applied different models over time. Financing Services and Operation Table 2.1 summarizes the pros and cons of var- To a large extent it is operational financial factors ious governance models, which are discussed in (operational revenues and expenditures) that detail in the following sections. motivate metropolitan cooperation and influence its form, depth, and instruments. Financing Metropolitan Areas or Service Cost Sharing Functions When a public service is managed across a met- The success of metropolitan-area public finances ropolitan area, an equitable cost-sharing arrange- depends to a large extent on how the vertical ment is needed among the local governments—for Metropolitan Governance and Finance 53 54 Table 2.1 Advantages and Disadvantages of the Various Metropolitan Governance Models Conceptual model Pros (advantages) Cons (disadvantages) HORIZONTAL COOPERATION AMONG LOCAL GOVERNMENTS Case-by-case joint initiatives Useful for areas where limited interdependencies Usually limited in scope. (agreements among local among local governments exist (or a small area No commitment to addressing a need on a authorities). with, for example, only two local governments). permanent, ongoing basis. Can be an initial phase to gain experience and build trust regarding coordinated joint efforts among the local governments. Possible approach when more permanent and formal arrangements are constrained by politics or prohibited by legal frameworks. Contracting among local One local government can specialize in a particular The contracting local government still must monitor governments. service or function, for the benefit of all local the quality and coverage of the service provision governments in the area. (contracting out does not mean abdicating Sometimes useful when one of the local responsibility for the service or function). governments dominates in terms of human and Risks: Access by residents to the service provider financial capacity. may be affected; accountability may be weakened or unclear to residents. Committees, commissions, Temporary or permanent bodies for coordination. Usually advisory role only. working groups, partnerships, Often character of networks rather than consultative platforms, etc. institutions.a Municipal Finances Flexible approaches. REGIONAL AUTHORITYb Metropolitan council of A forum for the member local governments to Impact depends on (a) the financial and human governments (COG) and similar address items of common and regional interest, resources mobilized or allocated to the COG, and arrangements. while maintaining their authority over any (b) the general coherence among the member local decisions through the requirement for government councils regarding views on metro endorsement by their respective councils. issues. Can provide flexibility if local governments are allowed to join and exit at any time. Regional planning authority Permanent focal point for metropolitan (regional) Risk of limited impact if their power is advisory only, (with or without authority to planning. without ability to enforce or implement plans. Ability enforce or implement the Specialized, metropolitan-level analytical resources requires significant institutional capacity and Metropolitan Governance and Finance plans). (highlighting spillovers, opportunities for scale resources to be effective. economies, inequalities, etc.). Regional service delivery Achieving economies of scale (efficiencies) for Effectiveness depends on authority to levy user fees, authority (as public entity or certain services. collect contributions from local governments, apply corporation or a regional utility Engagement by local governments as “owners” of precept powers, or have earmarked transfers or tax company). the authority or company because its service authority. provision responsibility is “delegated” to the Risks: Access by residents may be affected; authority or utility company. accountability may be weakened or unclear. If corporatized (utility company), facilitates a transition to private sector service provision or a public-private partnership (PPP) arrangement (as required). Regional planning and service Combination of those for regional planning Combination of those for regional planning delivery authority (as public authorities and regional service delivery authorities and regional service delivery authorities, entity or corporation, regional authorities, noted above. noted above. utility company). (continued next page) 55 56 Table 2.1 (continued) Conceptual model Pros (advantages) Cons (disadvantages) METROPOLITAN-LEVEL GOVERNMENT A higher-level metropolitan A permanent government structure (directly Effectiveness tends to depend on (a) the degree of local government. elected or through lower-level local governments) authority over the lower-level local governments and for certain metro functions. (b) whether it has mainly planning functions or some Specialized metropolitan-level resources. service delivery functions as well. A regional government A permanent government structure (directly Risk of limited connection with, and engagement by, established by higher-tier elected or appointed by a higher-tier government) the local governments in the area (can sometimes be government (for a particular for certain metro functions. mitigated with strong local government metropolitan area). Specialized metropolitan-level resources. representation). Resourcing directly from the higher-level Access by residents may be affected; accountability government. may be weakened or unclear. ANNEXATION OF TERRITORY OR AMALGAMATION OF LOCAL GOVERNMENTS Creates a jurisdiction that covers a larger portion With a larger jurisdiction, access by residents to the (or all) of the metropolitan area, which tends to local government may be affected, and local facilitate metropolitan-level coordination, although accountability may be weakened. local administrative offices or sector arrangements may still be needed. Facilitates addressing equalization within the area (one tax base). a. OECD 2006. b. Also called a special purpose district; bottom-up, voluntary organizations. Municipal Finances example, for solid waste disposal, drainage to what is a reasonably fair cost-sharing arrange- network maintenance, sewerage networks and ment. That often becomes a politically charged wastewater discharge, and road maintenance. subject. Costs that can be charged based on usage, such as the volume of garbage disposed of from a settle- Tax Spillovers ment, should ideally be charged on that basis In some countries, value added tax (VAT) reve- (such as a tipping fee paid at the landfill). In the nues are shared between the national and the case of maintenance of areawide networks, (such local governments. Cases in which the revenues as roads, drains, and sewers) however, charges due local governments are transferred to the based on network size and use in different local jurisdiction where a business enterprise has its government areas may not always be appropriate headquarters may distort the allocation among or equitable. All transport users in the area bene- local governments. This may particularly affect fit from a well-integrated and well-maintained a metropolitan area if, for example, headquar- road network, for example. Well-maintained ters are located in the core city but production storm drains and sewers have sanitary benefits plants or businesses operate in the suburban across the area. Nevertheless, some sections of a areas. In such cases, it is necessary that tax rev- network may cost more to maintain than others enues be adjusted either by a higher govern- because of geography (some people live on hills; ment (at the transferring level) or locally at the some on flat land), the locations of pumping metropolitan level. Box 2.5 summarizes finan- stations, and so forth. Agreements need to be cial considerations for regional cooperation reached among the various local constituents as and the establishment of regional entities. Box 2.5 Common Financial Reasons for Regional Cooperation or Establishing Regional Service Entities • Coordinated tax or fee policy agreements an agreed, formula-based contribution by (e.g., harmonized tax base, rate, and each local government from its general administration) between the local govern- revenues. ments in the area can prevent tax and fee Example: Lyon, France, shares the tax base competition. The area can, for example, of its metro area. Part of the local tax reve- have a common business tax, property tax nues of each commune is allocated to a formula, and automobile tax and common common budget for joint initiatives and fees for various types of permits. (Joint expenditures. tax policies may or may not support the • A tax-sharing system, to harmonize reve- overall revenue mobilization, however.) nues and expenditures across a region, can Example: Marseille, France, uses a joint address a significant mismatch between system for the collection of a business tax, social needs and the tax base (for example, with a common tax rate to avoid some tax the local property tax) in different local competition in the area. government areas. • A common budget for metropolitan-level Example: In the Twin Cities (Minneapolis and initiatives and services can be based on St. Paul, Minnesota), in the United States, (continued next page) Metropolitan Governance and Finance 57 Box 2.5 (continued) a metro council has expanded access to for transportation), or agreed compensa- property taxes in the region to finance its tion from local governments (direct sup- service provision and targeted transporta- port subsidies), or authority to capture a tion subsidies. revenue stream to local governments. • Revenue mobilization through user Example: Vancouver, Canada, applies a charges, property taxes, earmarked taxes variety of revenue instruments to finance (for example, road, payroll, and gas taxes its service delivery. Ad Hoc Scale Economies Contracting out certain services may some- Local governments may act together for a specific times be an option for more integration. A private purpose to benefit from economies of scale, for service organization may establish larger, coordi- example, to purchase equipment at a better price nated entities through contracts with each local or to contract for a service. Acting jointly can government in the metropolitan area. reduce transaction costs and potentially yield a Financing Large Infrastructure Projects in price benefit in such activities as engaging a con- a Metropolitan Area sulting firm to prepare a metropolitan-level land Mobilizing funds for large infrastructure projects use plan, promoting an international event, or try- that affect (or benefit) several jurisdictions ing to attract firms to locate in the area. These requires special arrangements. Sometimes stake- actions usually require specific negotiations holders establish a separate entity to implement among the local governments to reach a cost- the project and possibly also to own and operate sharing agreement. it, maintaining the created assets over time (e.g., a bridge, a wastewater treatment plant, or a land- Funding a Metropolitan-Level Entity fill). Alternatively, they might contract with an Any metropolitan-level entity (such as a metro- existing metropolitan (regional) utility company politan planning or service delivery authority) has to plan, implement, and manage the project. In to be funded on a sustainable basis. Operating either case, the project entity or utility company expenditures are usually financed from a combi- often borrows (issues debt) to finance the project. nation of sources, such as the following: Another option is for the respective local govern- (a)  predefined, agreed-upon contributions from ments to borrow individually to contribute to the concerned local governments; (b) to the extent capital cost of the joint infrastructure investment. possible, user charges for the services that the The participants must agree on an equitable con- metropolitan entity is in charge of providing; tribution scheme, proportional to the expected (c)  transfers from higher tiers of government; benefits that each will receive, or perhaps using a (d)  earmarked taxes; (e) authority to capture a formula that takes into account numbers of citi- revenue stream to the local governments (“precept zens who will benefit. power”); (f ) direct taxing power (such as a road tax); (g) donations; and (h) other sources, such as Examples of Investment Financing fees and direct subsidies, depending on the func- Due to the large size of metropolitan-level invest- tions of the entity. ments, frequently a higher-tier government is 58 Municipal Finances actively involved, and funding from various stake- Area  Transit Authority (WMATA), the state of holders is needed. Two such examples are Virginia, and two counties. When completed, the described below. In the first, a company named line will be turned over to WMATA to own and ARPEGIO was established to plan and contract operate. Box 2.6 details the governance and on behalf of regional and metropolitan area local financial arrangements for this metropolitan rail governments in Spain. The second describes a project, highlighting the eagerness of the partners metrowide rail investment with the cooperation to maximize benefits from joint financing and a of the federal government, a state authority, and clear management arrangement. None of the enti- two county governments in the United States. ties involved would have been able to finance and implement this project as a sole investor and ARPEGIO and the Comunidad Autonoma de operator. Madrid. ARPEGIO, operating under private company law, is owned by the Comunidad Leveraging Finance through Public-Private Autonoma de Madrid (CAM) in Spain, a regional Partnerships government which covers more or less the func- For some local governments, borrowing may not tional area of the Madrid metropolis of 5.2 million be an option, whether because of national regula- people.2 The responsibilities of CAM include tions or because they are not creditworthy in the transport and infrastructure, education, health, eyes of banks and capital markets. In those cases, planning, economic development, environment, public-private partnerships (PPP) offer opportu- culture, and research. The purpose of ARPEGIO nities to access external financing. The local is to supply and manage land for all classes of use: governments may join forces with private part- industrial, residential, offices, commercial, and ners for jointly funding and operating service public. It is a means for responsive planning and assets, based on agreements to share costs, risks, contracting, with capacity to undertake medium- and the benefits of investment. PPP agreements and long-term strategic projects that are not very usually include arrangements for asset ownership, attractive to the private sector. ARPEGIO puts operations, and maintenance. Various approaches development land on the market at affordable to them are explained in chapter 7. prices; invests in infrastructure, properties, and amenities; and subsequently manages urban public services in the areas. ARPEGIO is financed Municipal or Metropolitan Development Fund by obtaining public lands from the governments Establishing a municipal, metropolitan, or regional at low prices, restructuring and selling them for development fund for capital investments may development, and providing marketing and also be an option, with contributions from various management services within a framework set by levels of government, international agencies, and the CAM government (www.arpegio.com). the private sector. About 60 countries (such as Georgia, India, Nepal, Tanzania, and Uganda) The Dulles Corridor Metrorail Project. The have created national funds as part of their inter- Dulles Corridor Metrorail line is a 37-km exten- governmental system specifically to finance local sion of the existing commuter rail system in the government development projects. Such financ- greater Washington, D.C., area to Dulles ing vehicles usually do not apply exclusively to International Airport and important employment metropolitan areas but to all urban areas or local centers. The Metropolitan Washington Airports governments in the country. However, govern- Authority (MWAA) manages the project. Project ments in metropolitan areas are often prime recip- partners include the Washington Metropolitan ients of such funds as loans or grants. Metropolitan Governance and Finance 59 Box 2.6 The Dulles Corridor Metrorail Project The Dulles Metrorail project is funded by many density and development, and higher property interested parties, including voluntary taxes by values. local businesses and landowners, county gov- Phase 2 of the project, with an estimated ernments, a state government, and grant cost of US$2.7 billion, will be financed by the funds from the U.S. federal government. MWAA, the state of Virginia, and two coun- Owners of land and commercial property in ties, with loan guarantees but no cash funding the area agreed to pay a special tax for the proj- by the U.S. government. The parties have ect’s first phase (three years before its comple- signed a cooperation agreement for financing tion), in the hope that this extension of rail and managing the project. service would bring opportunities for increased Funding Breakdown Phase 1 (US$2.6 billion) Funding entity Source 41% MWAA Revenues from existing toll road (with toll increases) 10% State of Virginia State bonds and other budget sources 15% County Special tax on businesses/landowners in the area 34% U.S. federal government From fuel tax revenues and economic stimulus funds Source: www.dullesmetro.com. Metropolitan Governance Cases constituents, compared with acting indepen- dently. They typically agree to solve a particular The following sections discuss various metropol- temporary problem, such as managing a flood or itan governance and financing models and cases. coordinating traffic related to a large event. Less common, but equally possible, is pooling their Horizontal Coordination among Local assets to make the area more attractive to a firm Governments considering locating a plant or office, to be a When special efforts need to be made for local stronger competitor for a regional or interna- coordination, but the autonomy of the local gov- tional event, to obtain a bank loan on slightly bet- ernments must be preserved, coordination can be ter terms, or to promote tourism and attract achieved through various ad hoc arrangements visitors to the area. without any broader or long-term commitment. Models, characteristics, and examples of such horizontal coordination approaches are summa- Contracting among Local Governments rized in table 2.2. That it has the responsibility to provide a public service does not necessarily mean that a local Case-by-Case Joint Initiatives by government has to deliver that service itself. A Local Governments government can engage with another government The local governments in an area may join forces in various ways for delivery of a service: (a) a con- when it clearly benefits all of them and their tract between two governments of the same level 60 Municipal Finances Table 2.2 Horizontal Coordination among Local Governments Models Characteristics Examples Case-by-case joint Joint action puts the local governments in a position to achieve City candidates for initiatives economies of scale (e.g., bulk purchasing, firefighting, road the Olympic Games maintenance, tourism promotion) or in a stronger position, for or other big events example, for attracting a firm or event or promoting tourism. tend to apply on Common financial considerations: behalf of their metro area. • Agreements are usually based on each participating local government’s assessment of the cost and benefit to them of the joint activity. • When significant costs are involved, a reasonable cost- sharing formula needs to be agreed on. Contracting A local government engages another local (or higher-level) Los Angeles among local government for the delivery of a service that it is County, United governments responsible for. States; Common financial considerations: U.S. Association of Contract Cities; • The local government contracting out the service or function would determine the cost and benefit of this Shanghai, China. option, compared to providing the service itself. This is particularly important if significant capital investments are needed, whether in the short or longer term. Committees, Temporary or permanent bodies for coordination. Ruhr, Germany; working groups, Turin, Milan, Italy; consultative Paris, France; greater platforms, etc. Toronto, Canada. (one local government performs another local areas, but rather to any local government, it is government’s service responsibility for a fee or mentioned here because it is a way in which other compensation, or another service); (b) local governments in a metropolitan area can performance by a local government of another engage in a limited but still beneficial way. It is level local government’s service responsibility particularly applicable where an area has one for  a fee; or (c) performance by a higher-tier dominating local government, possibly with government of the responsibility of a local govern- more human and financial capacity. Positive ment for a fee. Box 2.7 describes contracting by a results of an initial contractual arrangement number of local governments in the Los Angeles may pave the way for more advanced and area. In Shanghai, some district and county local broader models of cooperation such as will be governments have contracted a specialized unit at discussed below. the higher, municipal local government level to arrange funding and manage the implementation Regional Authorities of some of their infrastructure projects, benefiting A regional authority is an independent legal entity, from the higher capacities at the municipal conceptually a voluntary association or organiza- government level. tion established by the member local governments Although the service contracting approach for planning, service delivery, or to make better does not apply specifically to metropolitan use of their public resources. Such city-to-city Metropolitan Governance and Finance 61 Box 2.7 The U.S. Association of Contract Cities Service delivery contracts between two or the savings from such a contract or coopera- more local governments can be organized indi- tive provision of services must be balanced vidually or be facilitated by an association of against the costs of coordinating the actions local governments. The U.S. Association of (transaction costs), the program provides Contract Cities—whose members are mostly organizational flexibility in providing local in the state of California—promotes and services, particularly for small local govern- facilitates a market-based approach for ments that may not have the capacity to carry particularly small local governments. These out certain functions themselves. The governments perform few of their mandated Los Angeles, California, area has numerous functions themselves. Instead they buy and small local governments. The Los Angeles sell services among partner cities based on County government, by far the largest, specialization. They often involve private firms provides a variety of services to the smaller in a highly competitive environment. Although governments on a contract basis. Source: www.contractcities.org. arrangements are sometimes called “special pur- commissions, health boards, utility commissions pose associations” or “special purpose districts” (e.g., for a lake or a river basin or watershed), and in the United States. The concepts of various such transit authorities. For services with more spill- models are summarized in table 2.3. overs (externalities), such as roads, for which Two or more local governments may create user charges are not feasible or efficient, the an association to achieve economies of scale. For metropolitan authorities sometimes have taxing example, for waste management they may jointly powers. Such service consolidation mechanisms operate a garbage disposal facility, a landfill, or can generate efficiency gains, particularly for public transport. Some countries (e.g., Brazil, smaller local governments in a metro area, allow- France, Italy, and Poland) have established a ing them to remain independent. separate legal framework for such arrange- Box 2.8 summarizes the solid waste disposal ments. This approach represents an administra- system in Shanghai municipality. It is a coordi- tive or political integration, with the member nated operation among nine district govern- governments represented on the governing ments, which collect about 9 million tons of waste board or council of the association. Regional daily and transport it to a large landfill operated authorities or utility companies can collect con- through a public-private partnership. tributions from member local governments or Service delivery contracts are agreed to levy user fees to pay for the services provided. between the metropolitan authority (utility Some are even authorized to levy taxes. company) and the participating member govern- The local governments in metropolitan areas ments. In some cases national governments have in North America frequently establish such “spe- encouraged establishment of regional authorities cial purpose” bodies for particular services. They through incentives and special legislation. In the include school boards, police boards, library United States, it was for many years a prerequisite boards, conservation authorities, recreation for obtaining grant funding from the federal 62 Municipal Finances Table 2.3 Types of Regional Authorities Models Characteristics City examples Metropolitan Forum for coordinated efforts by the member local São Paulo, Brazil; Bologna, Italy; Council of governments. numerous examples across the Governments Decisions need endorsement of the respective local United States. (COG) government board or council. Regional Responsibility for planning or solving a specific Many examples of advisory Planning problem, for broad regional planning, or for specific entities exist, but few with Authority functions; with or without authority to enforce or decision-making or implementing implement plans. powers. Portland, United States (in the past, with decision-making power); New York City (operated by an NGO). Regional Service Responsible for delivery of one or more services; Greater Vancouver Regional Delivery maybe called a “special purpose district”; operates Service District (GVRSD), Canada, Authority as a public entity, a service agency (corporation or is a multiservice public cooperative) owned by the member local corporation; it has significant governments (shareholders or members). planning functions but focuses on Can usually levy user fees and taxes or collect funds extensive service delivery from the local governments to pay for the services. responsibilities. Regional Combination forum that plans and delivers one or In France, the cities of Lyon and Planning and more services (e.g., a regional transportation or Marseille, some “municipal Service Delivery water authority); operates as a public entity, public development agencies” (e.g., in Authority corporation, regional utility company, or cooperative. Delhi and Dhaka), and the Lagos Mega-City Development Authority in Nigeria. government—particularly for roads and transit national associations of councils of governments and wastewater treatment infrastructure—that (COGs) also exist.3 The COG is a variation of the local governments show approval of the needs and regional authority approach, with limited inde- solutions in a regional plan by a regional entity. pendent decision-making authority so as not to Many variations on regional authorities exist. undermine the accountability of each individual An important common element, in contrast to local government. elected or appointed metropolitan governments, is that member local governments direct the The Metropolitan Washington Council of operations through representation on councils or Governments boards. Table 2.4 shows various dimensions char- The Metropolitan Washington Council of acterizing a regional authority. Governments, in the United States, was formed in 1957. It is composed of 21 local governments sur- Metropolitan Councils of Governments rounding Washington, D.C., covering an area of Metropolitan councils of governments represent 7,733 square kilometers (km2), with a population a bottom-up approach to regionalization that is of about 4.5 million. It is an independent, non- common in the United States for various pur- profit association financed by contributions from poses. It is so frequently applied that a few the participating local governments, federal and Metropolitan Governance and Finance 63 Box 2.8 Solid Waste Management in Shanghai Municipality Shanghai offers an example of how solid waste the landfill (they collect a limited flat fee from management can be arranged in a diverse households). Food waste is collected from way, seeking the most cost-effective solution restaurants separately and charged by volume. for all involved, including using a public-private The municipal government also operates a partnership arrangement. Shanghai municipal- centralized hazardous waste facility, serving all ity is composed of nine core city district the district and county governments, and two governments, seven suburban district govern- incinerator facilities. In addition, a few private ments, and one rural county government. In recycling facilities exist. 2004, a municipal investment and holding The municipal investment and holding company formed a joint venture with an company mobilizes its financing from various international firm for the construction, opera- sources, including domestic bond issues, and tion, and maintenance of a sanitary landfill (for also supports the investment programs of the 25 years) to serve the core city districts. suburban districts and county if requested. Collection and transportation of waste to the This is an example of how a large metropolitan- landfill are the responsibility of the district gov- level entity can use its financial and human ernments, some of which contract them out to resource strengths to support local govern- private firms. The district governments pay a ments with less capacity. charge based on the volumes disposed of at Table 2.4 Characteristics of Regional (Metropolitan) Authorities Dimension Simple Advanced Function Planning Planning and service delivery Scope Single function Multiple functions Degree of authority Advising or guiding the function(s) Managing the function(s) Legal status Public sector agency Public sector corporation or utility company Operational Nonprofit For profit (although rare) Accountability of the Appointed or elected by the local Elected by residents of the area council or board governments in the area state grants, service contracts, and donations São Paulo ABC Region from foundations or the private sector (see The São Paulo ABC Region4 is one of only a box 2.9 and table 2.5). few  examples of intermunicipal cooperation in COG policies are set by the local governments Brazil (see box 2.10). A political body made up of through a board of directors. Most COG decisions representatives from the state government, require endorsement by the respective local gov- seven local governments, and civil society has ernment councils. For intermunicipal transport played important roles in economic develop- infrastructure (such as the main road network), ment for at least part of the area. In addition to the Washington COG has some independent deci- the area’s local governments, it has the active sion-making authority based on one vote per engagement of civil society and the local private member. sector. 64 Municipal Finances Box 2.9 The Metropolitan Washington Council of Governments The Metropolitan Washington Council of for Regional Planning and Measuring Progress Governments (COG) provides a focus for action in the 21st Century, ” which is a new planning and develops responses to issues of regional guide for environment, housing, transportation, significance in the greater Washington, D.C., and other regional priorities. It is a voluntary area. Its mission is to enhance the quality of agreement that requests area governments to life and competitive advantages of the region pledge to advance the goals articulated in the by providing a forum for consensus building document to their best effort. It accepts the and policy making; implementing intergovern- differences among the cities and counties but mental policies, plans, and programs; and also interconnections across the region. The supporting the region as a source of expert targets and indicators set to measure progress information. COG has committees on trans- judge the region as a whole, rather than mea- portation, the environment, health and human suring individual jurisdictions. Measuring such services, housing and planning, cooperative things as regional green space, affordable purchasing, and publications, reflecting its scope housing units, school graduation rates, and and the common goals of its 21 members. financial performance, using targets and indica- COG recently produced a document titled tors, will help to determine if the region as a “Region Forward—A Comprehensive Guide whole is heading in the right direction. Source: www.mwcog.org. Table 2.5 Metropolitan Washington Council of Governments Financial Snapshot 2010 Revenues US$000 Expenses US$000 Building rents/interest 1,000.0 Community planning and services 1,095.1 Membership dues 3,223.5 Member services 1,105.7 State grants 4,323.6 Public safety and health 1,883.0 Other grants and fees for services 4,427.4 Environmental programs 5,649.4 Federal grants 14,526.7 Transportation planning and projects 17,768.0 Total 27,501.2 Total 27 ,501.2 Bologna, Italy Metropolitan Montreal Community (MMC) Bologna, Italy, is another city where metro In 2000, the provincial government of Quebec governance has been established on a voluntary created the Metropolitan Montreal Community basis. In 1994, 48 local governments and the (MMC), a metropolitan coordinating body for the province of Bologna signed a “metropolitan city greater Montreal area. The MMC board is accord” creating a metro council composed of composed of representatives of the member the mayors in the area and presided over by the municipalities. MMC is in charge of planning, provincial president. Each local government is funding, and coordinating public transport, waste free to withdraw at any time and may participate management, economic development, and social in all or only some of the council’s activities. This housing. It is headed by an appointed president is a  flexible, low-risk approach for the local (currently the mayor of Montreal) and covers an governments. area of 3,838 km2, with a population of about Metropolitan Governance and Finance 65 Box 2.10 São Paulo ABC Region Brazil’s 1988 constitution increased the auton- labor unions). One of the most important omy of local governments and delegated results of the regional planning process articu- responsibility for designing metropolitan lated through the chamber was the creation in structures to the state (provincial) legislatures. October 1998 of the Regional Development The São Paulo metropolitan region includes Agency (RDA), with a board of directors com- the City of São Paulo and 38 surrounding posed of private sector members (a control- municipalities, with a total population of 18 ling 51 percent) and the Intermunicipal million. Consortium (49 percent). The RDA is now con- Although there is no institution of metro- sidered the legal branch of the consortium and politan governance per se for the area, there is can sign agreements with external agencies an Intermunicipal Consortium of the Greater and receive financial resources. Since 1997 , ABC Region, which comprises seven cities many agreements on economic, social, and with 2.5 million people (map B2.10.1). These territorial development have been signed. The municipalities created the consortium in 1990 RDA is an example of a flexible and pragmatic to focus primarily on coordinating policies that approach in solving metro problems. Pilot proj- had spillover effects across municipal bound- ects have built trust among the participants aries. Issues that the local governments faced over time. forged a regional identity to help local leaders and politicians address economic decline Map B2.10.1 São Paulo Metropolitan through a number of initiatives. Region The purpose of the consortium, made up of representatives from the state govern- ment, seven local governments, and civil soci- ety, is to promote economic development of the region through consensus and to imple- ment innovative public policies. Although the engagement of concerned mayors weakened in the mid-1990s, the local community under- took several initiatives, including creating a Forum for Issues of Citizenship, an umbrella nongovernmental organization (NGO) with more than 100 NGOs as members, with an emphasis on regional issues. In 1997 a Chamber of the Greater ABC Region was cre- ated as a forum for strategic planning, with participation from civil society, the public sec- tor, and the local economy (businesses and Source: World Bank. Sources: See www.agenciagabc.com.br; additional information is available at www.unhabitat.org/downloads /docs/SantoAndredetailedsummary.pdf. 66 Municipal Finances 3.5 million. Its budget is mainly funded by contri- presence for the organization in New Jersey and butions from the member municipalities  and Connecticut and on Long Island. They have a crit- some grants from the provincial government. ical part in research, planning, and advocacy for projects in their respective areas. Projects include Regional Planning Authorities environmental protection (watershed and green A regional planning authority is a formal entity area development); public transport concepts, whose purpose is to design regional (metropoli- including reviews of functionality and develop- tan) strategies or exercise planning and policy ment of light rail and other systems; highways; development authority on an ongoing basis. Some and the comprehensive plan for coordinated air- regional planning authorities have been estab- port development (more information is available lished with very broad mandates, whereas others at www.rpa.org). have a narrow focus, such as a river basin or watershed commission. Numerous examples of Metropolitan Planning and Development advisory, guiding, and planning entities exist (e.g., Agencies for land use), although some are weak because Metropolitan planning and development agencies they lack clear authority for decision making or are legal forms of regional authorities, often com- implementation of plans. bining governing authority and development and Council of Governments, Portland, Oregon service functions. Many larger cities around the Initially, the COG in Portland, Oregon, was mainly world have established a separate agency for plan- a metropolitan authority for land use manage- ning and development, some with a narrow man- ment. With that authority, it introduced the con- date such as land use planning only, and others with cept of a growth boundary for the metro area. broader development mandates covering the entire Over time it has taken on other functions as well, metropolitan region. These agencies are founded and eventually it was elevated by the government by local or national governments as self-financing of the state of Oregon to a higher-level, elected entities and often receive state or municipal land to metropolitan government. be developed and sold for housing or business pur- poses. The following are several examples. Regional Plan Association, New York City Area New York City is part of a metropolitan area London Development Agency, U.K. for  which most regional planning is done by a In 1999, the Greater London Authority (GLA) was nongovernmental organization (NGO), the created, comprising 32 local governments and the Regional Plan Association (RPA). Serving the Corporation of London. GLA is led by an elected New  York–New Jersey–Connecticut metropoli- assembly and chaired by the directly elected lord tan region, the Regional Plan Association (RPA) mayor of London. He has the power to direct a covers the largest urban region in the United “subordinated” local government to reject, but States, comprising 31 counties. The RPA performs may not direct it to approve, a large development most regional planning functions. It is an indepen- initiative. dent metropolitan policy, research, and advocacy Until 2012 the London Development Agency group supported and partly funded by the munic- (LDA) was accountable to the GLA assembly, ipalities. RPA has three state committees, com- through the lord mayor, for coordinating posed of  business leaders, experts, and opinion economic development. It worked in partnership makers who provide strategic advice to the asso- with industry and the public and voluntary sec- ciation’s state offices. Guided by the state com- tors. The mayor appointed a 17-member board mittees, these offices ensure an on-the-ground and the chief executive of the LDA. Table 2.6 Metropolitan Governance and Finance 67 Table 2.6 London Development Agency governments. Delhi has been under the effective Financial Snapshot 2010–11 (£ millions) control of the national government since 1953. Project delivery 142 Because it is a “Union Territory,” the financial Land for 2012 Olympic Games 214 transfers provided to the states in India are not Assembly administration 56 available to Delhi. Delhi receives only discretion- Total net expenditure 412 ary grants rather than a share in central taxes. Government grant 275 Delhi’s major sources of tax revenue are the value Borrowing 111 added tax or VAT, state excise, stamp and registra- Capital receipts 44 tion fees, and taxes on vehicles. Delhi collected Rs Total financing 430 121.9 billion (about  US$ 2.2 billion) in its own Surplus/(deficit) 18 taxes in 2008–09 (more information is available at www.delhi.gov.in). Source: www.lda.gov.uk. The Delhi Development Authority (DDA) was shows a financial snapshot of the LDA for 2010/11. formed in 1957 to provide and secure the develop- Effective March 2012, the LDA was abolished by ment of Delhi according to an approved plan. The the government of the United Kingdom and its responsibilities of the DDA include preparing mas- functions were incorporated into the GLA. ter plans, designing and investing in housing, land acquisition and development, greening, sports, Dhaka Capital Development Authority, biodiversity, urban heritage, constructing high- Bangladesh way overpasses, sports facilities, and biodiversity The greater Dhaka area currently consists of a parks. DDA played a major role in developing Dhaka City Corporation and five municipalities sport, housing, and transport facilities for the (including Dhaka itself ), with an estimated popu- Commonwealth Games in 2011. Its budget at a lation of 15 million people. Its population is antici- glance is shown in table 2.7. The DDA is a small pated to grow by 3 percent to 4 percent annually. entity compared to the overall Delhi budget, but it The authority (local name, Rajdhani Unnayan plays a substantial role in land development and Kartripakkha, or RAJUK) was established in 1987 construction of public infrastructure. to develop, improve, extend, and manage the city and the peripheral areas through a process of Regional Service Delivery Authorities proper development planning and development A regional service delivery authority is an entity control. RAJUK addresses issues related to devel- established with clear operational authority opment policies, projects, and controls and also to  deliver certain services to meet regional engages in land acquisitions and disposals. The (metropolitan) needs, based on agreements among government of Bangladesh appoints the chairman the participating local governments. It may be and five  other full-time members to govern the focused on a single service (such as public trans- RAJUK  (more information is available at www port, water supply, or solid waste management) or .rajukdhaka.gov.bd). be a multiservice authority. Its regional planning Delhi Metropolitan Area and Delhi responsibility (if any) is usually limited to planning Development Authority, India for the services for whose delivery it is responsible. The National Capital Territory of Delhi (NCT) is the metropolitan agglomeration around Delhi, Metro Vancouver/Greater Vancouver Regional home  to more than 22  million people. NCT is Service District, Canada divided into nine revenue districts, which are fur- The Vancouver metropolitan administration is a ther subdivided into 27 tehsils, lower-level local flexible and demand-driven example of  an 68 Municipal Finances Table 2.7 Financial Snapshot of Delhi Development Authority (2010–11 revised estimates) Revenues Rs millions Expenditures Rs millions Disposal of land for residential and commercial use 1,036.2 Acquisition of land 246.0 Receipts from shops 93.0 Development of land 1,272.6 Disposal of houses 226.6 Houses and shops 449.3 Government housing services or institutional 10.7 Estate expenditure 250.4 Interest from investments 1,605.0 Development scheme 226.8 maintenance Deposit works (earmarked transfers) 525.6 Deposit works 525.6 Miscellaneous revenue 260.9 Miscellaneous expenditure 255.4 Total 3,232.4 3,226.0 Source: http://dda.org.in. organization providing different services to mem- and so they combine the two previously described ber municipalities through individual agreements. approaches. This is a particularly popular The Metro Vancouver/Greater Vancouver approach in France. The areas and average popu- Regional Service District (GVRD) was established lations of French local governments (called com- in 1965. At first it was a service organization to munes) are small by international standards. assume responsibility for regional planning and They therefore make extensive use of coopera- take over the functions of separate agencies for tive arrangements for service provision. There is sewerage service, water supply, health and hospi- a particular legal framework for intermunicipal tals, and business development. Functions of cooperation called syndicats intercommunaux in managing affordable housing, regional parks, air France. The syndicats are similar to cooperatives quality, and emergency response were added or federations of local governments formed to later. The organization now also provides various carry out single or multiple functions. One human resource management services to the local  government may be involved in several municipalities on a contract basis. It does not syndicats. have particularly strong land use planning pow- ers. The GVRD is now a public corporation with a Grand Lyon, France board composed of representatives of the 18 The Grand Lyon metropolitan government is a member local governments. It was initially estab- communauté urbaine (“urban community,” or UC) lished by the provincial government but has established in 1969, three years after approval of a evolved into a corporation governed by the mem- related national law (see map 2.3). It was estab- ber municipalities. It finances most of its services lished bottom-up, derived from the needs and through user charges, cost recovery, a share of interests of the participating municipalities. The the property tax, and annual contributions from governments not only coordinate economic the member local governments (more informa- development, land use, and some service provi- tion is available at www.metrovancouver.org). sion, but also (since 1999) share the tax base. Part of the local tax revenues of each respective com- Regional Planning and Service Delivery mune (town) is allocated to a common budget for Authorities metropolitan-level initiatives and expenditures. Some regional authorities serve substantial The business tax is governed by Grand Lyon; the functions in both planning and service delivery, property and housing tax by the municipal level. Metropolitan Governance and Finance 69 Map 2.3 Grand Lyon, with Lyon City in the The municipalities of Marseille, Marignane, and Center, Surrounded by 57 Suburbs Saint Victoire created a public corporation in 1992 that focused on a few road and traffic proj- ects. In 2000, 17 cities joined the consortium, and they established the Communauté Urbaine of Marseille (CUM). The area had a total population of 980,000 in 2000. CUM is a metropolitan orga- nization governed by the mayors and councillors of the municipalities. CUM now is responsible for regional economic development, transportation, land use and housing, crime prevention, waste disposal, and environmental policies. It collects a common tax on business and thereby eliminates tax competition among the municipalities. It also achieves more cost-effective tax collection than Source: World Bank. if each local government collected the tax in its jurisdiction. As this example shows, a local gov- The UC council is made up of representatives ernment may be responsible for a service, or in from the member cities in proportion to their this case, collecting a tax, without necessarily population. Since 2002, after the creation of con- having to execute the task itself. Discussions are ferences of mayors, the member towns have ongoing to extend the borders of CUM to neigh- opportunities to discuss in smaller groups their boring urban communities where there is signifi- problems and expectations for submission to the cant industrial and economic activity and UC. (Grand Lyon established an innovative zon- potential (more information is available at www ing of its territory into nine subzones by means of .marseille-provence.com). this consultative power.) Urban transportation services are managed by a separate authority, Twin Cities Metropolitan Government, partly financed by a grant from Grand Lyon, Minneapolis–St. Paul, Minnesota, U.S. whose main sources of revenues are tariffs and an The Twin Cities Metropolitan Government is an earmarked tax on enterprises. Since 2000, the example of a regional planning and service deliv- area of Grand Lyon has been gradually expanding ery authority that evolved into a regional govern- through annexation of adjacent towns. Although ment. The Minneapolis–St. Paul metro area had the city of Lyon has only about half a million to respond to increasing polarization between inhabitants, Grand Lyon contains 58 municipali- two neighboring, decaying inner cities and their ties with 1.4 million people. The total metropoli- rapidly growing suburbs (urban sprawl). The tan area (Grand Lyon plus three nearby areas) main challenges included a spatial mismatch consists of 139 municipalities with a total popula- between affordable housing and available jobs, tion of 2 million (more information is available at causing serious traffic congestion; two low- www.grandlyon.com). income central cities that provided daytime ser- vices to a large working population who did Communauté Urbaine of Marseille, France not pay taxes to the core city because they lived Marseille is an example of a transition from vol- in the richer suburbs; and the need for suburban untary cooperation among local governments to a local governments to respond to a continu- regional planning and service delivery authority. ous  need for expensive infrastructure in new 70 Municipal Finances residential areas (more information is available at quality differences among the jurisdictions. It has www.metrocouncil.org). since evolved into a regional government autho- In sum, significant mismatches existed between rized by the state of Minnesota and subsequently the social needs and the property tax bases in rich into a public sector corporation. and poor local jurisdictions in different areas. The need to harmonize revenues and expenditures Metropolitan-Level Government across the region was strong enough to drive the The responsibilities for regional coordination and creation of a tax sharing system. This initial volun- sometimes selective service delivery functions tary organization of the local governments, in the may be vested with a separate local government or early 1970s, later grew into a regional planning and council (table 2.8). Although they have separate service delivery authority to minimize service functions, sometimes such local governments Table 2.8 Metropolitan-Level Government Model Characteristics City examples Metropolitan local A separate, metro-level local government, directly elected Toronto, Canada government or appointed by the partner local governments. (1954–98); London, Responsible for coordination and selective functions, U.K.; Quito, Ecuador; which may or may not include service delivery. Cape Town, South Africa (until 2000); Dar Its authority over the partner local governments varies; es Salaam, Tanzania; it can have (a) no substantial authority over them (e.g., in Budapest, Hungary; Dar es Salaam); (b) limited authority (e.g., Budapest); or (c) Abidjan, Côte d’Ivoire substantial authority over the area’s lower-level local (until 2001); Shanghai governments (London; cities in China). (and other large The metropolitan-level local government is in some cases Chinese cities). the only local government for the area, with local administrative offices under it (e.g., the metropolitan municipalities in South Africa). Common financial considerations: • A higher-level local government tends to be funded through transfers from a higher government tier and/or through tax sharing among local governments in the area. Regional government A higher-level metropolitan (regional) government is Twin Cities and established by established by a provincial or national government for a Portland, U.S.; Abidjan, higher-tier metropolitan area. Côte d’Ivoire (from government Numerous approaches to structures established by 2001); Madrid, Spain; higher-tier governments are possible, including (a) a mayor of London, U.K. directly elected institution (Stuttgart, mayor of London); (directly elected); (b) an appointed body (as in the Twin Cities, U.S., and the Stuttgart, Germany; Ministry of Nairobi Metropolitan Development); and (c) an Manila, Philippines; entity with strong local government representation in Nairobi, Kenya. which only the chair is indirectly elected or appointed by higher-level government (as in metro Manila). Common financial considerations: • Funding would normally be part of the provincial or national government budget. Metropolitan Governance and Finance 71 would not be above the other local governments in question the general plan. In 1997, the city the metropolitan area in terms of reporting rela- received additional authority over the develop- tionships, but rather would be separate entities of ment and protection of the built environment. A equal rank and legal status. Budapest, Hungary, specific system of urban master plans has since and Dar es Salaam, Tanzania, illustrate such been established, reflecting the strengthened, structures. unified management of the city. Metropolitan Local Government Dar es Salaam, Tanzania–Metropolitan Local City Government, Budapest, Hungary Government Budapest offers a case of a metropolitan local gov- Dar es Salaam is Tanzania’s largest and most ernment with broad functions. The city covers an important industrial and commercial center, with area of 525 km2 and has a population of 1.7 million a population of about 4 million (approximately 10 (2011), close to 20 percent of the country’s popula- percent of the country’s population). Its popula- tion. The local government system of Budapest is tion grows by about 4.3 percent per year. It is one unique in Hungary, comprising the municipality of the fastest-growing cities in the world, expected of Budapest (called “the city”) and its 23 district to reach 5 million by 2030. governments, all equal in rank and legal status Dar es Salaam is legally an administrative (Horváth and Peteri 2003). Both the city and the region of the country. The regional administration districts are local governments, not clearly subor- is an arm of the national government, with an dinated to one another, and each has specific appointed regional commissioner coexisting with duties and powers, specified by the Act on Local the three Dar es Salaam municipalities and a Governments and the Act on the Capital City. Dar  es Salaam City Council (DCC), which is Although the city was handled as a special case, another administrative entity for the same area. the district governments received broad man- Box 2.11 provides more information about the dates. The municipality of Budapest, with an governance system of Dar es Salaam. elected mayor and a 33-member general assembly, provides the following public services: mainte- Two-Level Local Government System with nance and supervision of hospitals and polyclin- Separate Rank and Legal Status ics, art and public culture institutions, children’s A two-level system sometimes has a separate, and youth homes, secondary schools and dormito- usually elected, level of local government with ries, social homes providing specialized care, and coordination authority over the lower levels and markets and market halls. The public utilities of responsibility for some planning and service deliv- the municipality of Budapest now operate as ery functions.5 We first describe the governance municipal companies. structure in Quito, Ecuador. The following exam- A legal amendment in 1994, however, gave the ples also illustrate the influence that a higher-tier general assembly of the city supremacy in impor- (national or state or provincial) government can tant matters of regulation and in revenue sharing have and the not uncommon evolutionary nature and city planning. Regarding the sharing of cer- of institutional arrangements for metropolitan tain revenues from the national budget and local governance. Some cities have used a two-level revenues, the influence of the districts was structure in the past but returned to a one-level reduced to voicing their opinions, whereas previ- local government system (Toronto and Abidjan), ously consent of the district mayors was required. and some have returned to a two-level structure In city planning, the city became the primary reg- after operating in a one-level system for some time ulatory authority; previously the districts could (London). 72 Municipal Finances Box 2.11 Metropolitan Governance System in Dar es Salaam The metropolitan local government system As in many other developing countries, the was established in 2000. It is composed of a local governments in Dar es Salaam are highly coordinating Dar es Salaam City Council (DCC) dependent on intergovernmental transfers, and three municipalities of fairly similar popula- particularly for their capital investments. tion size, with their respective mayors and Transfers in Tanzania include recurrent sector councils (shown in different colors on block grants, sector basket funds, and minis- map B2.11.1). As a separate local government, terial subsidies, as well as development grants the DCC is made up of six councillors from (see table B2.11.1). Recurrent block grants each of the three municipalities, plus a few rep- account for about two-thirds of all intergovern- resentatives of the national government, who mental transfers. Until 2004, Tanzania had a elect a mayor from among the members. discretionary system of intergovernmental The DCC is responsible for coordination grants. Among its many shortcomings was a among the three municipalities and for a few tendency toward inequality, allocating a rela- specific functions, such as management of tively high share to wealthier and urban juris- the city’s landfill, its main market, and a main dictions. Starting in FY 2004/05, a new transfer bus terminal. However, it does not have juris- system was introduced. Both recurrent block diction over any land or any authority or direct grants and development grants are now dis- decision-making power over the other three bursed to local governments based on local governments in the city, which has formulas. limited its ability to influence the city’s deve- lopment. Despite strong socioeconomic cohe- sion and physical integration across the three Map B2.11.1 Dar es Salaam Metro Region municipalities, the administrative integration and coordination among them have not yet advanced very far. The DCC’s funding comes from limited transfers from the national government and from facilities that it manages. The three municipalities collect own-source revenues through development levies, agricultural leases, city service levies, land rent, licenses, and fees. Property tax is also part of local governments’ revenue in Tanzania, but a national tax authority collects and redistrib- utes the revenues. Revenue collection from property taxes has started to increase substantially after efforts to obtain better identification and valuation of properties, cur- rently being completed by the local govern- ments in the city. Source: World Bank. (continued next page) Metropolitan Governance and Finance 73 Box 2.11 (continued) Table B2.11.1 Transfers to Local Governments in Dar es Salaam Metro Region 2009/10 (T Sh millions) Municipal Council (MC) Kinondoni Temeke Dar es Metro and City Council (CC) Ilala MC MC MC Salaam CC region Education grant 20,852 31,062 19,733 6 71,654 Health grant 10,859 7,106 5,998 273 24,237 Other sector grants 740 618 299 241 1,898 General purpose grants 6,621 2,923 2,483 2,157 14,184 Total recurrent grants 39,073 41,709 28,514 2,677 111,973 Subventions 1,506 2,838 4,196 0 8,540 Recurrent transfers 40,578 44,547 32,710 2,677 120,512 Development grant 6,514 5,368 8,513 10,075 30,471 Total transfers 47,092 49,916 41,223 12,753 150,983 Source: www.logintanzania.net/report4b.asp. Source: www.logintanzania.net. The Metropolitan District of Quito an  elected metro Toronto government and six The Metropolitan District of Quito (MDQ) was additional independent local municipalities, was created by law in 1993 as a second-level local gov- established. After operating under that two-level ernment, covering an area of 4,230 km2 with a system for more than 40 years, during a period of current population of about 2.5 million. At the exploding population and economic growth, the lower level are 61 zones and parishes. MDQ has a seven municipalities were merged in 1995 into one special status as the national capital, with a single-level local government, the City of Toronto, directly elected mayor and council (15 members) an area of 632 km2, with a current population of with strategic responsibilities for economic about 2.5  million. With its surrounding urban development, land use, environmental planning, municipalities, the metropolitan area has about and transportation. It also oversees metropolitan 5 million people. The evolution of Toronto’s insti- companies for water supply, solid waste manage- tutional arrangements is described in box 2.12. It ment, health, and education services. Financially illustrates how institutional arrangements may MDQ depends on transfers from the national change as a city’s circumstances change. government, but it also has its own resource base The transformations in Toronto were driven (taxes and special contributions). Somewhat to a great extent by the desire to increase the similar systems exist in Bogotá, Colombia, and effectiveness of urban development and service Caracas, Venezuela, although they are weaker in delivery, including harmonization of service lev- practice (Rojas 2007). els across the area. Each time a regional authority was disbanded, something else soon took its Toronto City, Canada place. The provincial government played an Toronto operated as 13 independent municipali- important role in the evolution. On metropolitan ties until 1953, when a two-level system, with matters, it is quite common that a higher-tier 74 Municipal Finances Box 2.12 Toronto: Evolution from a One-Level System to Two Levels, and Back to a One-Level System Stage 1. In the early 1950s, with growing ser- justice became provincial responsibilities in vice demands on suburban local governments 1970. with limited resources, but with a core City of Stage 3. The structure was successful in Toronto that had a solid financial base (a strong meeting its objectives of providing infrastruc- property, commercial, and industrial tax base), ture in the suburbs, maintaining a vibrant core the political boundaries no longer reflected the city, and pooling revenues over the whole socioeconomic realities. At the time, each metropolitan area. However, in the 1970s municipality acted independently with respect needs changed as a result of growth outside to transportation, land use, and housing. of the Metro area. Between 1971 and 1975, Stage 2. In 1954, Metropolitan Toronto the provincial government created four (Metro) was formed by provincial legislation, regional governments around Metro, and in as a metropolitan-level government for the 1988 it established the Office of the Greater City of Toronto and 12 suburban local govern- Toronto Area (OGTA) to encourage Metro and ments. The purpose was to (a) redistribute the the four regions around it to coordinate their wealth of the city to the suburbs, so that they waste disposal, regional transport, land use, could provide infrastructure; (b) coordinate and infrastructure planning. A forum of the land use and transportation; and (c) maintain greater Toronto area mayors and the chairs of local governments’ responsiveness to local the regional governments focused on eco- needs. The Metro’s initial responsibilities were nomic development and the marketing of the planning, borrowing, property assessment, area. public transit, roads, and administration of Stage 4. The current City of Toronto was justice. The suburban local governments were formed in 1998 through provincial legislation, responsible for fire protection, garbage collec- amalgamating the Metro government and six tion and disposal, licensing and inspection, lower-level local governments to create a local power distribution, policing, public single-level government. A Greater Toronto health, general welfare, recreation and com- Services Board (GTSB) was created shortly munity services, and the collection of taxes. thereafter to oversee regional transit as a sep- Responsibilities were shared for parks, plan- arate level of governance for this function. The ning, roads and traffic control, water supply, GTSB was governed by elected representa- and sewage disposal. Costs were shared tives from each local government, with limited based on the property tax base. powers to coordinate decision making Over time, responsibilities changed. Metro among the member local governments. It was took over police, social assistance, traffic con- abolished in 2001. In 2006, the provincial trol, licensing, conservation, waste disposal, government created the Greater Toronto and ambulance services. In 1967 , the number Transportation Authority (GTTA) to coordinate of municipalities was reduced from 13 to 6. transportation, the most critical function in Property assessment and administration of need of coordination. Source: Slack 2007. Metropolitan Governance and Finance 75 government plays a significant role, not only from services, and responsibility as local planning a fiscal transfer perspective but to ensure that authorities. The GLA is a higher-level strategic arrangements exist for reasonable coordination authority to promote sustainable development of public services and areawide development. and define strategy. Its main responsibilities are transport, police, economic development plan- Greater London Authority, U.K. ning, fire and emergency planning, land use plan- London, with a current population of more than 7 ning, culture, and environment and health; it also million, has since 2000 elected members of the coordinates London-wide events. However, the Greater London Authority (GLA), which is a city- GLA has very little fiscal autonomy. More than 80 wide government with a mayor and assembly. It percent of the revenues of both the GLA and the covers an area of 32 local authorities (“bor- local governments come from central govern- oughs”), which have independent mayors and ment grants. Other revenues include a local prop- councils. Functions assigned to the boroughs erty tax and user charges. Box 2.13 describes how include housing, education, social and health London arrived at this current structure. Box 2.13 London: Evolution from a Two-Level System to a Single Level and Back to a Two-Level System Stage 1. London was governed by a two-level but accountable to it through the lord mayor structure from 1964 to 1986, comprising the of London: Greater London Council and 32 local govern- ments, each with its own mayor and council. • Transport for London is responsible for roads, Stage 2. In 1986, the Greater London buses, trains, the subway system, traffic Council was abolished and London’s gover- lights, and the regulation of taxis. The mayor nance instead became a direct responsibility appoints a commissioner, chairs the board, of central government ministers, coordinated and appoints 15 nonexecutive members. by a subcommittee headed by a junior minis- • The London Development Agency (abol- ter for London, using agreements and ad hoc ished in 2012; its functions are now part of arrangements for regional planning. In 1994, GLA) coordinated economic development the Government Office for London (GOL) was and worked in partnership with industry established to allow the central government and the public and voluntary sectors. to act as a strategic authority, coordinating all • The Metropolitan Police Authority has 23 entities related to London. members, of which 12 are assembly mem- Stage 3. In 1999 the new Greater London bers, and six are independent Londoners. Authority (GLA) was created, comprising 32 • The London Fire and Emergency Planning local governments and the Corporation of Authority is responsible for fire and emer- London. The lord mayor of London was directly gency services. The mayor appoints its elected in 2002; he can direct a local chair. There are 17 members, of whom nine government to reject (but not to approve) are from the GLA and eight are nominated large development applications. Four func- by the association of London local tions are separate from the GLA Assembly governments. Source: www.london.gov.uk. 76 Municipal Finances City of Abidjan, Côte d’Ivoire Ministry of Nairobi Metropolitan Development, Abidjan is the former capital and the largest city Kenya) in Côte d’Ivoire. A polycentric structure, it was • Strong local government representation originally made up of 10 towns (communes), with (the higher-tier government only appoints the no large, predominant city center. The current chair, as, for example, in Metro Manila, the metropolitan area consists of 13 municipalities Philippines). with a population on the order of 6 million. It is an economic and cultural hub in West Africa and has Three city examples below illustrate different a high level of industrialization. Abidjan became a approaches, as well as how higher-tier govern- municipality in 1956, divided into administrative ments have initiated coordinated governance in areas by lagoons (see map B2.14.1 in box 2.14), and metropolitan areas. has gone through a number of institutional changes since then. The current name of the met- Portland Metro Service District, U.S. ropolitan structure is the Abidjan District (in Portland has an elected regional authority called 2001 it replaced the former name, City of Abidjan). the Portland Metropolitan Service District Box 2.14 describes the emergence of the current (“Portland Metro”), created by the Oregon state system through three stages. legislature in 1977. It is an authority that gained the support and respect of the local govern- ments in the area based on one function—land Regional Government Established by use regulation and management. It was origi- Higher-Tier Government nally a consolidation of a regional planning Metropolitan governance reforms have rarely council, a metro service council responsible for emerged purely from local government initia- solid waste disposal, and the administration of a tives; rather, a national or provincial government regional zoo. In 1990 it was given added respon- has usually initiated change by either imposing or sibilities for various facilities (the stadium and encouraging it (OECD 2006). For example, some- the exhibition center) and soon after, several times the higher-tier government has proposed regional parks, cemeteries, and marine facilities. that municipalities agree to work together to Box 2.15 sheds light on the gradual formation of improve coordination of services such as water, the Portland metropolitan system by higher waste management, or public transit. Although government. many metropolitan governments have been estab- lished by a higher-tier government, experience The Twin Cities Metro (Minneapolis–St. Paul), shows that such an institution will often be weak U.S. unless it is supported by the local governments The Twin Cities Metro is an example of a regional with which it must work. planning and service delivery authority that Numerous models or approaches exist to evolved into a regional government appointed by establish regional governments or councils for the U.S. state of Minnesota. Cooperation among governing, regional planning, and service deliv- the Twin Cities area’s many local governments ery, including the following: was initially motivated by a need for tax sharing because of significant differences between rich • Direct election (e.g., Stuttgart, Germany; and poor jurisdictions. The initial voluntary orga- London, U.K.; and Portland, Oregon, U.S.) nization of local governments evolved into the • Appointment by a higher-tier government (e.g., current Twin Cities Metropolitan Council, whose the Twin Cities, Minnesota, U.S.; and the extensive functions are described in box 2.16. Metropolitan Governance and Finance 77 Box 2.14 Abidjan: Evolution from a Two-Level Local Government to a Regional Government Stage 1. Reforms in 1978 restored commune, companies managed solid waste removal, or local government, status to the major cities electricity, and water. This system functioned in Côte d’Ivoire. At the time, Abidjan had 10 for more than 20 years, but the national gov- local governments, differing in size and ability ernment interfered in the local governments’ to raise their own funds, each with an elected carrying out some functions, such as inspec- mayor and set of councillors (see map tion of construction sites and issuance of driv- B2.14.1). At the same time, a higher-level, ers’ licenses. The city had little influence over metropolitan local government, the City of its finances. National government collected Abidjan, was established, with a council com- property taxes and remitted them to the local posed of the City mayor and four councillors governments, which then paid (often delayed) from each local government. The mayor of the a fixed portion to the higher-level local govern- city was indirectly elected by the 10 mayors. ment, the City of Abidjan (Stren 2007). The major functions of this metropolitan gov- Stage 2. In 2001, the City of Abidjan was ernment were waste disposal; public lighting; replaced by a regional (“district”) government sanitation; traffic regulation; maintenance of of Abidjan. The post of mayor of Abidjan was roads, parks, and cemeteries; and town plan- replaced by that of district governor; this person ning. The local governments in the area were was appointed by the president of the country responsible for markets, allocation of plots for and assisted by a district council. This became a public purposes, maintenance of primary higher-tier regional government, above the schools and clinics (but not school or health original 10 local governments, to which three policy, or the supervision and payment of large suburban jurisdictions (local govern- staff), and operating social centers; they were ments) and some rural areas were added. This to share responsibility with other government metropolitan area now has a population of levels for pollution and hygiene. Private sector approximately 6 million. Urban planning is a key district-level function. Service delivery is Map B2.14.1 The 10 Communes of Abidjan constrained by limited local resources. After an attempted military coup in 2002, security has increasingly become a priority. Stage 3. In September 2012 (after the presidential election) the District of Abidjan was dissolved by a presidential ordinance and replaced by a governorate (an executive body) under the direct control of the national govern- ment. A decision had been taken to separate the finances of the District of Abidjan from the contributions of the municipalities by having local revenues collected in the area shared by the two levels (municipalities and district) according to percentages fixed by law. By early 2013 the reallocation of the previous dis- trict revenues was still pending, with several Source: World Bank. options being contemplated. 78 Municipal Finances Box 2.15 Formation of the Portland Metro Government The Portland Metro is governed by a directly that the council operates (a solid waste dis- elected Metro Council with seven councillors posal facility, a zoo, and convention, arts, and and an executive officer. It has a strong land expo centers). use statute, as a tool for regional development, In 1973 a state law established an urban which has included establishing a longer-term growth boundary limiting large-scale devel- urban growth boundary to create a certain opment in Portland to prevent excessive degree of predictability for private sector land sprawl. It limits access to utilities such as developers in their business planning. An sewerage, water, and telecommunications, important feature of the law is that Portland as well as coverage by the fire and police Metro may levy property, sales, and income departments and schools. Originally this law taxes and issue Metro bonds to finance its mandated that the city must maintain enough investment programs. Complementing the land within its boundary to provide for an regional Metro authority, the local govern- estimated 20 years of growth. However, in ments in the area (three counties and 25 cities 2007 the law was altered to require planning and townships) have created a coordinating for an estimated 50 years of growth within group (called “FOCUS”) to develop joint rec- the boundary, as well as protection of nearby ommendations to the Metro Council. Local farms and rural land. The growth boundary, governments are also represented on a along with efforts by the city to create regional planning advisory committee. economic development zones, has led to the The Metro Council of Portland gets about development of a large downtown area, a 15 percent of its revenues from property large number of mid- and high-rise develop- taxes. More than 50 percent of its revenues ments, and an overall increase in housing and come from fees and user charges for facilities business density. Source: www.oregonmetro.gov. Metro Manila, the Philippines Baden-Württemberg state government by Metro Manila has about 11 million people and law in 1993. The Verband is a directly elected, includes 17 municipalities. The extended urban higher-level metropolitan entity composed area includes another 4 million people in 18 of 179 local governments including the City more local governments. The country has a long of Stuttgart. Its  main responsibility is now history of autonomous local governments resist- serving as a public transport authority for ing control from higher tiers, and people have the area, but it is also engaged in tourism strong loyalties to their local government units. and regional planning. This governance Nevertheless, most of the various metropoli- structure became fairly weak, in large part tan-level entities that have existed in Manila were because it had no authority to tax or levy user established and appointed by the national govern- charges. Its funding is derived about equally ment (see box 2.17). from local governments’ contributions and intergovernmental grants from the state of Verband Stuttgart, Germany Baden-Württemberg (information from www The Verband Stuttgart Region (Stuttgart .region-stuttgart.org; www.region-stuttgart regional association) was created by the .de/en). Metropolitan Governance and Finance 79 Box 2.16 The Twin Cities Metro (Minneapolis–St. Paul), Minnesota, U.S. The local governments in the Minneapolis–St. In 1994, the Metro Council was made a Paul region had particular incentives for institu- public corporation, owned by the state of tional change. Over time they had grown Minnesota. It received operating responsibili- closer, but they needed to respond to increas- ties for metropolitan transport and sewerage ing polarization between decaying inner cities service, and its previous functions were and rapidly growing suburban areas (“urban strengthened. It also received expanded sprawl”). A spatial mismatch between afford- access to regional property taxes to finance able housing and available jobs caused traffic its administration and transport subsidies. This congestion and a continuous need for expen- reform changed the council from a regional sive infrastructure in new suburban areas. planning agency with only loose supervisory With two low-income core cities and richer control over a number of regional agencies suburban communities, the two core city gov- into a new regional government with an ernments had to provide services for a large annual budget allocation from the state gov- working population in the city center during ernment 15 times the size of its previous the day, who mainly contributed to the tax budget. base of the many suburban areas where they A directly elected metro council has been lived. proposed and debated on several occasions The Twin Cities case is an example of a but has not yet obtained sufficient support in regional planning and service delivery author- the state legislature. Currently the council ity that evolved into a regional government, comprises a chairperson and 16 members rep- and subsequently into a public sector corpo- resenting geographic districts, all appointed by ration. The current metropolitan area covers the governor of Minnesota and confirmed by seven counties, with about 200 small munic- the state legislature. The council has the fol- ipalities, about 100 special service district lowing responsibilities: operation of an exten- organizations, and a population of about sive bus system; collection and treatment of 3 million. A Twin Cities Metro Council was wastewater; engagement of communities established by the Minnesota state govern- and the public in planning for future growth; ment in 1974 to adopt development plans forecasting the region’s population and house- and policies and to coordinate the activities hold growth; ensuring affordable housing for of existing regional service delivery agen- low- and moderate-income individuals and cies. The agency would also appoint their families; and planning, acquisition, and fund- boards and review their annual budgets. The ing for parks and trails. It also provides a Metro Council was also given the authority to framework for decisions and the implementa- review all projects of “metropolitan signifi- tion of regional systems including aviation, cance” proposed by the local governments in transportation, parks and open space, water the area. quality, and water management. Source: www.metrocouncil.org. 80 Municipal Finances Box 2.17 Stages of Emerging Metro Manila, the Philippines Stage 1. In the 1960s, the mayors of Manila the 17 local governments in the area and and the neighboring municipalities created a headed by a chair indirectly elected by the league to address pressing growth issues in members every six months. It continued to col- the region. However, since membership in the lect revenues from the local government units, league was voluntary, it was unable to coordi- but the amount was reduced to 15 percent of nate long-term development effectively. In local governments’ annual revenues. 1975, the Metro Manila Commission (MMC) Stage 3. In 1995, the MMA was replaced was formed, following a referendum, to cre- by the Metropolitan Manila Development ate a single metropolitan area by integrating Authority (MMDA). The MMDA is a develop- four cities and 13 municipalities. Under the ment and administrative unit under the direct MMC, all metropolitan legislative and execu- supervision of the president of the country. It tive authority was vested in a small governing performs planning, monitoring, and coordina- body appointed by the president of the coun- tion functions but can do so only if it does not try. The role of the MMC was executive and diminish the autonomy of local governments policy making, and to provide services com- on local matters. Its council is still domi- mon to the metropolitan area. The local gov- nated by the 17 mayors of the area local ernments contributed 20 percent of their governments, but the chair and a number of annual revenues to the MMC. the managers are appointed by the president. Stage 2. Popular support for the MMC The MMDA is responsible for almost all declined, and in 1990 a new president replaced traditionally local public services. It derives it with the Metro Manila Authority (MMA). The resources from the central government, a MMA was responsible for basic urban ser- 5 percent contribution from the local govern- vices, including land use planning, traffic man- ments, and revenues from metro service fees agement, public safety, urban renewal, and and fines. The MMDA has been criticized for waste management. It was governed by a met- being more of a national corporation than a ropolitan council composed of the mayors of fully local institution. Source: www.mmda.gov.ph. The Ministry of Nairobi Metropolitan the defined “metropolitan area” is much larger Development than it would be if defined based on socioeco- Metropolitan Nairobi was established in 2008 nomic cohesion factors, such as the existence by presidential decree to facilitate implemen- of a single economy and labor market. The tation of a growth and development strategy defined area is 32,000 km2. It encompasses for the Nairobi metropolitan area of 15 local four counties with a total of 15 local govern- governments (see map 2.4). Initially it was ments. The population is about 11 million, intended to cover most local government func- growing at 3.4 percent per annum. The area is tions, plus promotion and development of a so large because the Kenyan government deter- funding framework. To date, the ministry has mined that if a small part of a county was part functioned mostly as an additional channel for of the integrated economy and labor market, national government funding for minor invest- then the entire county should be included in ments in the metro area. This is a case in which the area governed by the ministry. Metropolitan Governance and Finance 81 Map 2.4 Metropolitan Nairobi 1990s unintentionally made worse the fiscal dis- parities of the Metropolitan Zone of the Valley of Mexico (ZMVM) (Raich 2008). Despite state inter- vention through a system of redistributive trans- fers, the increased fiscal disparities occurred for three primary reasons: (a) an indirect negative effect of the transfers on local fiscal efforts, includ- ing the collection of property taxes; (b) uneven dis- tribution of services and infrastructure in the metropolitan area; and (c) the existence of differing governance structures in the various jurisdictions within the zone. Legal and political complexities made it difficult to mitigate the problems, although the situation has since improved somewhat. Annexation or Amalgamation of Source: World Bank. Local Governments Although the boundaries of an economic region The Randstad, The Netherlands grow incrementally over time, government bound- The Randstad is a conurbation in the Netherlands aries tend to change only occasionally, through that consists of the four largest Dutch cities— legal actions. Annexation and amalgamation are Amsterdam, Rotterdam, The Hague, and sometimes the most effective approach to achieve Utrecht—and the surrounding areas. With a pop- needed scale, cost sharing, efficiency, and equity in ulation of 7.1 million, it is one of the largest conur- public service delivery (table 2.9). Yet amalgama- bations in Europe. It covers an area of about 8,287 tion tends to be politically controversial, usually km2. The area figure is the sum of the areas of the requiring the active involvement of a national or a four member provinces, although the Randstad is provincial government. Few amalgamations have normally not considered to cover the whole of achieved coverage of an entire metropolitan area, any of them. The Randstad has had a history of usually because of the local political dynamics. strong competition among cities, particularly the The following are some examples: two main cities of Rotterdam and Amsterdam. • London, U.K. The Greater London Authority The national government has been instrumental covers 7.5 million people, but the functional in promoting collaboration, rather than competi- economic area, the greater southeast, has a tion, on certain priority subjects for the area population of 20 million. through financial incentives and political influ- ence. Recently, local planners have started to refer • Toronto, Canada. The amalgamation of the to the Randstad as the “Deltametropool,” consist- City of Toronto (2.5 million people) is some- ing of two large metropolitan areas (source: www times considered both too small and too large. .randstadregion.eu). It is too small to cover the metropolitan eco- nomic region referred to as “the greater Mexico City Metropolitan Area, Mexico Toronto area” (5 million people) or to address The Mexico City metropolitan area illustrates a regionwide spillovers related to transport and case in which fiscal decentralization policies in the planning. It is too large to be fully locally 82 Municipal Finances Table 2.9 Annexation of Territory or Amalgamation of Local Governments Characteristics Examples Creates a jurisdiction that covers a larger portion (or all) of the metropolitan area, Toronto, Cape Town, facilitating equalization within the area (one tax base). Istanbul, Pittsburgh, With a larger jurisdiction, residents’ access to local government may be affected Madrid, Anchorage and local accountability weakened. Common financial considerations: • Cost savings usually occur through scale economies. • Harmonization of service and salary levels across the new local government may be standardized to the local government with highest levels, resulting in higher costs. • One-time transition costs need to be taken into consideration. responsive and accessible compared with its (2,455 km2) now the largest city in South Africa. earlier six separate municipalities. Table 2.10 is a snapshot of the Cape Town budget for the 2011/12 fiscal year with indications of Some local governments, however, do indeed changes of budget lines from previous years. essentially cover their entire metropolitan eco- Anchorage, Alaska, U.S. is another example, a nomic region (their functional area). Examples municipality which has grown from 20 km2 to are the following: more than 5,000 km2 during the last 50 years. • Cape Town, South Africa. Cape Town’s boundaries were drawn by the Municipal Financial Implications of Amalgamations Demarcation Board of South Africa6 in 1998 Particular financial adjustments are needed when and now encompass 95 percent of the people an amalgamation of local governments is consid- who live and work there. ered. For example, how are salaries to be har- monized or duplicate assets to be divested? • Istanbul, Turkey. Istanbul’s administrative Amalgamation does not necessarily reduce costs. boundaries were expanded in 2004 to include When Toronto amalgamated six municipalities areas previously governed by the central gov- into one City of Toronto, for example, it unified ernment, increasing its area from 1,830 km2 to salaries and services across the six former local 5,340 km2 (Turan 2011). government areas, and overall costs went up. Pittsburgh, Pennsylvania, U.S., is a classic Harmonization of service levels often means con- example of annexation. In the early 20th century, forming all to the levels of the local government Pittsburgh successfully undertook the annexation with the highest expenditure, resulting in higher of 12 neighboring municipalities. More recently, overall costs for the amalgamated entity. That may new suburban local governments have been incor- outweigh other cost savings that can usually be porated within the jurisdiction of the City of achieved. One-time transition costs must also be Pittsburgh, in gradual adjustments as the area has taken into consideration in moving to a new gov- changed. ernance structure. For example, Cape Town went Cape Town, with a population of about through various local governance reforms in a 3.5  million, had a two-level metropolitan struc- short time and in recent years has seen further ture in the 1990s and became one amalgamated structural reforms, territorial changes, new man- municipality in 1998 by consolidating a number of agement structures, and new forms of service local governments (see box  2.18). It is by area delivery. Such frequent reorganization may run Metropolitan Governance and Finance 83 Box 2.18 Changing Metropolitan Governance Models in Cape Town, South Africa The 1996 interim constitution in South Africa Map B2.18.1 Population Density in allowed for three types of local governments: Cape Town, South Africa metropolitan, urban, and rural. The Cape Town Metropolitan Council is a metropolitan govern- ment. The constitution also provided for three categories of municipalities. Category A munic- ipalities had exclusive municipal executive and legislative authority in their areas. Category B municipalities shared authority in their areas with a Category C municipality within whose area they fell. Category C had authority in an area with more than one municipality. A subsequent study recommended a single-level metropolitan government sys- tem, with each municipality to cover its metropolitan area, to redress inequalities, promote strategic land use planning, coordi- nate infrastructure investment, and develop a citywide framework for economic and social development. It was thought that the change would prevent the local governments from Source: World Bank. competing for investment in an uncoordi- nated way. In 1998, all Category C municipali- became one-level (amalgamated) municipali- ties in South Africa, like Cape town (see map), ties like Cape Town shown in the map above. Source: www.capetown.gov.za. the risk of disrupting local service delivery because Johannesburg City, South Africa of the time and resources that the changes require. South Africa has eight large, one-level, metro- politan municipalities, including Cape Town One Large Municipality Covering the and Johannesburg. The city of Johannesburg is Metropolitan Area the provincial capital of Gauteng province and Where the geographical area of a municipality the largest city in South Africa, with a popula- essentially coincides with the economy of a met- tion close to 4 million. The municipal city’s ropolitan area, financial management coordina- land area of 1,645 km2 is large, with a moderate tion is somewhat less challenging because of less population density of 2,364/km2. It is the institutional complexity. In other cases alloca- world’s largest city not situated on a river, lake, tion of resources across a broad area for service or coastline. Box 2.19 summarizes the way delivery and investments, often with the active Johannesburg has become a single, amalga- involvement of municipal suboffices, presents mated municipality. particular difficulties for a municipal council. 84 Municipal Finances Table 2.10 Budget of City of Cape Town 2011/12 Rand Change Rand Change Expenditures millions % Revenues millions % Employee-related costs 7,091.6 9.1 Property rates 4,582.0 8.9 Remuneration of councillors 108.8 17.9 Penalties and other charges 85.8 6.6 Debt impairment 1,040.0 7.5 Service charges 8,125.7 22.4 –electricity Depreciation 1,392.8 17.0 –water 1,828.1 10.1 Finance charges 766.4 3.6 –sanitation 991.1 10.2 Bulk purchases 5,785.9 22.1 –refuse 820.4 7.6 Contracted services 2,320.2 31.6 –other service charges 625.4 −4.0 Transfers and grants 96.4 10.1 Rental (facilities, equipment) 264.0 8.0 Other expenditure 3,539.8 4.4 Interest from external 192.4 −10.0 investments Total expenditure 22,141.9 100.0 –outstanding debtors 218.3 3.6 Capital Budget Fines 186.9 3.5 Rand Change Licenses and permits 30.0 4.5 Sources millions % Capital grants and donations 2,715.4 940.2 Agency services 116.0 Capital replacement reserve 970.9 272.0 –Operational transfers 1,897.8 28.4 External financing fund 1,357.4 85.4 Other revenue 1,912.3 8.6 Revenue 46.3 32.7 Gains on disposal of 105.0 −66.2 personal protection equipment Total 5,089.9 100 Total revenue 21,981.2 100.0 Source: www.capetown.gov.za/en/Budget/Pages/Budget2011-2012.aspx. Shanghai Municipality, China have corresponding powers. The overall metro- Shanghai is another example in which one munic- politan area is 6,340.5 km2. Despite the fact that a ipal government covers its entire metropolitan Chinese municipal government covers its entire area. Chinese cities have a two-level local govern- metropolitan area with a two-level local govern- ment structure, a municipal government with a ment system, coordination and financial alloca- number of subordinated districts and county gov- tions can still be challenging. Although the core ernments. All large cities in China operate under city urban districts tend to have well-coordinated the same governance model, in which the munici- services (transport, water and sewerage net- pal jurisdiction includes both urban and large works, etc.), coordination with subordinated sub- rural areas. District governments tend to be the urban local governments, county governments in more urban ones, and counties the more rural ones. particular, is often difficult because they are inde- Shanghai Municipality currently has nine dis- pendently governed. tricts, defined as its core city, seven semiurban Shanghai is an example in which political suburban districts, and one rural county (the economy legacy and culture may influence how large island; see map 2.5). Shanghai is one of four an area is practically managed. In this case, the municipalities which are treated as provinces and higher-level municipal government tends not to Metropolitan Governance and Finance 85 Box 2.19 The Change of Governance Structure of Johannesburg, South Africa The population of the greater Johannesburg formation, the one-level city government has metropolitan area was about 7 .2 million in substantially improved governance and effi- 2007 . An even broader definition of this metro- ciency. It has, for example, issued management politan area gave it a population of about contracts for water and sanitation services; 10.3 million at the time. Gauteng province is corporatized roads department and solid waste growing rapidly and experiencing heavy functions; sold information technology assets urbanization (more information is available at and leased them back; and moved to private www.gautengonline.gov.za). management of its properties. The urban portion of Gauteng is a polycen- tric region (as depicted in the map below) with Map B2.19.1 Johannesburg within a projected population of close to 15 million by Gauteng Province 2015 (see map). The city of Johannesburg evolved from a segregated city (with seven white councils and four black councils), through a fragmented stage with one metro council plus four subordinated local councils. The cur- rent, integrated stage is a one-level city gov- ernment, with one tax base that covers the main part of the metropolitan area. In the ear- lier two-level arrangement, the higher-level local government was responsible for borrow- ing and debt repayment, and the lower-level government collected most revenues. When finances were tight at the lower level, how- ever, transfers of funds to the higher level tended to be delayed or stopped. Since its Source: World Bank. interfere with the details of how the subordinated functions. Cooperation among local governments lower governments run their affairs. may be encouraged by incentives from a provin- cial or national government through intergovern- mental systems, legal frameworks, or specific Takeaway Messages financial incentives. Metropolitan areas are becoming “the new normal.” But many governance approaches exist, each With continued urbanization around the world, with its pros and cons. The main models and cities become more economically interdependent approaches are cooperation among local govern- with their surrounding settlements and hinter- ments; regional authorities or special purpose lands, creating metropolitan areas with a single districts (as bottom-up, voluntary organiza- economy and labor market, a community with tions); metropolitan-level governments (either common interests and joint actions. Such areas as a second-level local government or as a need some areawide management for selective regional government established by a higher-tier 86 Municipal Finances Map 2.5 Shanghai Core City and Suburban through user charges, property taxes, earmarked Districts/County taxes, and so forth; and mobilization of multiple funding sources for large infrastructure with are- awide benefits. A municipal development fund at the national level, with multiple funding sources, is sometimes used to support local capital invest- ments in metro areas. Cooperate, don’t compete. This is the essence of a metropolitan approach: to cooperate on certain initiatives or services (while possibly competing on others in terms of service quality and cost- effectiveness). Cooperative agreements may include joint revenue mobilization, funding of investments, and service expenditures. Choosing a structure. In choosing a governance structure one needs to weigh (a) the potentials for economies of scale and service coordination effi- Source: World Bank. ciency and the need to address area spillovers and disparities, versus (b) the impact on residents’ government); and consolidating local govern- access to their government and its responsiveness ment through amalgamation or annexation of and accountability. territory. Division of functions. In any metropolitan gov- No one size fits all. The most appropriate gov- ernance arrangement, ensure that functions and ernance structure depends on the national as well responsibilities are clear (not overlapping, diffi- as local context (legal framework, local govern- cult to misunderstand, etc.) among the involved ment responsibilities, issues and opportunities in entities, particularly if specialized authorities or the area, institutional capacity and tradition, etc.). different levels of local government are applied. It may be formed through a bottom-up process by In addition, be aware of the risk of limited effec- the local governments in the area or as a top- tiveness with a metropolitan agency with no down decision by a provincial or national govern- independent authority (i.e., advisory only). ment. Institutional and financial arrangements Clear and reliable sources of funding. For a may need to evolve over time, as needs and cir- regional authority or metropolitan-level govern- cumstances change. Politics, rather than effi- ment to fulfill its functions, it is critical that it be ciency and equity, often determines the formation assigned sufficient revenue sources to fulfill its or evolution of metro area governance and finance mandates on a sustainable basis. systems. Local government commitment. To be effective, Tailored financing arrangements are needed. the metropolitan-level structure must have the Examples of financial considerations in regional support and commitment of all local governments cooperation include tax sharing agreements to involved, independently if it is formed bottom-up prevent tax and fee competition and to harmo- by themselves or top-down by a higher-tier gov- nize revenues and expenditures across a metro ernment. Depending on the circumstances, con- region; cost sharing or a common budget for sider allowing individual local governments the metropolitan-level initiatives and services (and flexibility to participate in some or all metro-level entities); coordinated revenue mobilization functions. Metropolitan Governance and Finance 87 Annex Cities Used as Examples in This Chapter Metropolitan Area Key Metropolitan Features North America Los Angeles County, U.S. • Providing services for a fee to many smaller local govern- ments in the area under individual contracts; cost-effective for all involved. Mexico City, Mexico • Large area as a conglomerate of municipal and state Zona Metropolitana del Valle de jurisdictions, governed by forming collective bodies Mexico (ZMVM) (commissions) and bilateral agreements. Characterized by legal, political, and fiscal complexities causing unintended inequalities through the transfer system in the past. Twin Cities, U.S. • The initial coordination initiative and authority were moti- vated by fiscal inequality in the region. • Regional planning and service delivery authority evolved into a regional government of the state; now a state-owned corporation, receiving a portion of property taxes from the region to cover its costs for service provision. Portland, U.S. • An elected metro council formed for land use management, Metro Council with significant power; now has broader functions and an  advisory committee formed by a number of local governments. Toronto, Canada • Evolution from a one-level to a two-level system, and back to a one-level system, with amalgamated local governments (and common tax base) after extensive involvement of pro- vincial government. Vancouver, Canada • Public corporation owned by the member local govern- Greater Vancouver Regional District ments, providing them a number of services (but all local (GVRD) governments do not provide all services through GVRD). • Has access to a variety of funding sources, including user charges; share of property tax; and annual contributions from member local governments. Washington, D.C., U.S. • Council of 21 local governments with coordination func- Metropolitan Washington Council of tions but without own decision-making authority (the local Governments government councils must ratify any decisions), except for some transport items. Africa Abidjan, Côte d’Ivoire • Evolution from a one-level to a two-level regional govern- ment system; initiatives by local governments as well as national government. 88 Municipal Finances Cape Town, South Africa • Many changes in the 1990s, including amalgamation in 2000 into one large municipality, corresponding to the functional economic area and the regional labor market. (Eight such metropolitan municipalities exist across the country.) Dar es Salaam, Tanzania • Three local governments plus a Dar city council (at the same level and having no authority over the three local govern- ments) for general coordination and a few specific func- tions, without any land and with very limited own-source revenues; growing property tax revenues for the local gov- ernments but still heavily dependent on transfers from the national government. Johannesburg, South Africa • Evolution from seven local governments to a two-level system, to one local government with sector entities. Nairobi, Kenya • Ministry from 2009 for development of the Nairobi metro Ministry of Nairobi Metropolitan area; a new window of national funds for 15 local govern- Development ments in the area. Australia Melbourne • State (provincial) government provides (and funds) a number of traditionally local services such as public transportation. Europe and Cental Asia Bologna, Italy • A flexible approach created by 48 local governments, the metropolitan city council is presided over by the provincial president; local governments may participate in some or all activities of the council. Budapest, Hungary • City local government and many district local governments, all equal in rank and legal status; the metropolitan area and the commuter area are being distinguished as two separate planning contexts. London, U.K. • Evolution from a two-level to a one-level and back to a two- level system. Greater London Authority (GLA) with little fiscal autonomy; more than 80 percent of both GLA and local government revenues come from central government grants. Authorities for transport, police and fire services, and emergency planning. Lyon, France • Planning and service authority with metro tax sharing sys- tem; small local governments with cooperative arrange- ments for service provision. Marseille, France • Common business tax to prevent tax competition among Communauté Urbaine de Marseille local governments in the area. Prague, Czech Republic • One elected local government with subordinated district offices. Metropolitan Governance and Finance 89 Randstad, The Netherland • One of Europe’s largest conurbations with the four largest Dutch cities (Amsterdam, Rotterdam, The Hague, Utrecht) and surrounding areas; joint efforts mainly ad hoc or through national government pressure. Stuttgart, Germany • A directly elected, higher-level metropolitan entity, mainly for public transport; also engaged in tourism and regional planning. No authority to levy taxes or user charges (funded by the state and local governments). Tbilisi, Georgia • One dominating city (the capital) and a few smaller, less- affluent local governments, with informal, case-by-case coordination efforts to date. Latin America Bogotá, Colombia • The city is divided into 20 localities, each governed by an administrative board of no fewer than seven members, elected by popular vote; the principal mayor designates local mayors from candidates nominated by the respective administrative boards. Santiago, Chile • Greater Santiago has 37 local governments but no metro- politan government; functions distributed among various authorities. An “intendant” of the Santiago Metropolitan Region is appointed by the president. São Paulo, Brazil • ABC Council, a political body of the state, local govern- Intermunicipal Consortium of ments, and civil society; active engagement by civil soci- Greater ABC Region ety and private sector, particularly for economic development of the metro area; a flexible, pragmatic approach to regional problem solving but not a govern- ment structure. Quito, Ecuador • The Metropolitan District of Quito (MDQ) is an elected metropolitan council with broad responsibilities, presided over by an elected metro mayor. MDQ depends on transfers from the national government but also has its own resource base (taxes and special contributions). East and South Asia Dhaka, Bangladesh • A regional planning and development agency for land matters. Manila, the Philippines • Strong tradition of local government autonomy, but most metropolitan entities established and controlled by the national government. New Delhi, India • The metropolitan area of Delhi is nine districts of the  National Capital Territory of Delhi (NCT) and four major satellite cities outside the NCT (in two differ- ent states), with various development and service authorities. 90 Municipal Finances Shanghai, China • One municipal government for a large area, with a number of subordinated district governments (for the highly urban areas) and subordinated but more independent counties (with large rural areas). Middle East Istanbul, Turkey • Annexation of territory earlier governed by the national government. Notes other parts of the country through the Municipal Demarcation Board, initially 1. Dar es Salaam, Tanzania, is an example creating six (now eight) such large metropoli- where more than 70 percent of the popula- tan municipalities. tion lives in unplanned settlements. In terms of city area, more than 50 percent of Kampala, Uganda, and more than 70 percent References of Kabul, Afghanistan, are informal settlements. Abbott, J. 2011. “Regions of Cities: Metropolitan 2. This is an example of a two-level system with Governance and Planning in Australia.” 179 lower-level municipalities. CAM was In Governance and Planning of Mega-City created in 1983 and is administered by a Regions—An International Comparative directly elected council (which elects a Perspective, edited by J. Xu and A. Yeh, president). CAM took over the previous 172–90. New York: Routledge. powers of the province of Madrid. When it Bahl, Roy W., Johannes F. Linn, and Deborah L. was established, the lower-level local govern- Wetzel, eds. 2013. Financing Metropolitan ments’ powers and responsibilities were Governments in Developing Countries. significantly reduced. Cambridge, MA: Lincoln Institute of Land 3. For example, the National Association of Policy. Regional Councils and the Association of Brinkhoff, Thomas. 2012. “City Population.” The Metropolitan Planning Organizations. Principal Agglomerations of the World, www Additional information is available at www .citypopulation.de/world/Agglomerations .abag.ca.gov/abag/other_gov/rcg.html, .html. including links to all COGs in the United States. Dodge, William R. 1996. “Regional Excellence—  4. The name of ABC region refers to three Governing Together to Compete Globally and smaller cities bordering on São Paulo—Santo Flourish Locally.” Washington, DC: National André, São Bernardo do Campo, and São League of Cities. Caetano do Sul. Horváth, Tamás M., and Gábor Péteri. 2003.  5. The source for parts of this section is Enid “General Conditions of a Decade’s Operation.” Slack, “Managing the Coordination of Service In The Budapest Model—A Liberal Urban Delivery in Metropolitan Cities: The Role of Policy Experiment, edited by Katalin Pallai, Metropolitan Governance,” Policy Research 359–405. Budapest: Open Society Institute. Working Paper, August 2007, World Bank, OECD (Organization for Economic Co-operation Washington, DC. and Development). 2006. “The Governance of 6. Similar consolidations of jurisdictions aimed Metro-Regions.” In Competitive Cities in the at covering the “functional area” were done in Global Economy. Paris: OECD Publishing. Metropolitan Governance and Finance 91 Raich, Uri. 2008. Unequal Development— Turan, Neyran. 2011. “Towards an Ecological Decentralization and Metropolitan Finance in Urbanism for Istanbul.” In Megacities–Urban Mexico City. Saarbrucken: VDM Verlag Form, Governance and Sustainability, edited by Dr. Muller. A. Sorensen and J. Okata, 245–87. Heidelberg: Rojas, Eduardo, Juan R. Cuadrado-Roura, and José Springer. Miguel Fernández Güell, eds. 2007. Governing World Bank. 2010. World Development Report the Metropolis—Principles and Experiences. 2009: Reshaping Economic Geography. Washington, DC: Inter-American Washington, DC: World Bank. Development Bank. Yang, J. 2009. “Spatial Planning in Asia— Slack, Enid. 2007. “Managing the Coordination of Planning and Developing Megacities Service Delivery in Metropolitan Cities—The and Megaregions.” In Megaregions: Role of Metropolitan Governance.” Policy Planning for Global Competitiveness, Research Working Paper, World Bank, edited by C. L. Ross, 35–52. Washington, Washington, DC. DC: Island Press. 92 Municipal Finances CHAPTER 3 Municipal Financial Management Rama Krishnan Venkateswaran Financial management is a crucial element of financial resources—both what is available and municipal management. It enables the local what is required—to achieve identified priorities. government to plan, mobilize, and use financial Nonfinancial information includes community resources in an efficient and effective manner, priorities, policy, and political considerations. as well as fulfill its obligation to be accountable Accounting involves classification and doc- to its citizens. This chapter covers the basics of umentation of various financial transactions the municipal financial management process. It of the local government; it provides the basic discusses the four fundamental components of financial information required for preparation public sector financial management: budgeting, of the budget and financial reports and data to accounting, reporting, and auditing, and their communicate with clients and partners such as applications in local government. Each process is lenders or higher-level governments. Accounting discussed separately, and the chapter also brings information includes specific figures on reve- out their linkages and synergies. nues earned and expenditures incurred within Figure 3.1 depicts the pillars of public finan- a specific period (usually a financial year) and cial management. Let us look at them briefly information on assets and liabilities of the entity. before we delve into more detailed discus- Financial reports provide aggregate figures on the sions. Budgets provide operational and financial government’s revenues and expenditures, which plans for the attainment of the local govern- help readers to understand the “big picture” of ment’s goals. Budgets are developed based on the government’s financial position and the effi- both financial and nonfinancial information. ciency of its financial management. Auditing is Financial information includes the estimates of the process of independent verification of the Municipal Financial Management 93 Figure 3.1 The Pillars of Financial Management operations, but budgeting practices are not uni- form across countries. “The budgeting process provides the medium for determining what gov- Budgeting ernment services will be provided and how they will be financed” (Mikesell 2011). Budgeting is the process of allocating scarce resources across unlimited demands; it is a financial and operat- ing plan for a fiscal year (12 months). The budget contains information about the types and amounts Public Auditing financial Accounting of proposed expenditures, the purposes for which management money will be spent, and the proposed means of financing. Although budgets are usually prepared for one financial year at a time, the recent trend has been to plan for three to five years as the basis for the annual budgets. That results in the annual Financial budgeting process becoming part of a medium- reporting term planning and program implementation process, helping the entity to achieve continuity in the planning and execution of its development program. financial information contained in the accounting records and financial reports. It provides assur- Budgets as Planning Instruments ance to external persons or entities about the The adoption of a budget implies that deci- credibility of the information. sions have been made—on the basis of a plan- ning process—as to how the organization plans Budgeting to reach its objectives. The planning function in any government is of critical importance for the A budget is the annual financial plan of a local following reasons: government, which defines its operational and development priorities for the ensuing financial • Public goods. The type, quantity, and quality of year and describes how the plans will be financed. goods and services that the public sector pro- The budgeting process is vital in laying out the duces are not evaluated and adjusted through city’s choice of expenditure priorities and identi- the market mechanism. fying the resources necessary for the realization • Public interest. The goods and services pro- of planned expenditures. This section explains vided by the public sector are often among the the role of budgeting in municipal financial man- most critical to the public interest. agement and helps the reader to understand the objectives of the budget process, the components • Immense scope. The immense scope and diver- of a good budget, the steps in the budget process, sity of modern government activities make and the relationship of the budget to other aspects comprehensive, thoughtful, and systematic of the financial management process. planning a prerequisite to orderly decision making. Budgeting: Concepts and Practices Budgeting and budgets are vital in the plan- • Participation. Government planning and deci- ning, control, and evaluation of government sion making generally take place in a joint 94 Municipal Finances process involving citizens, their elected repre- and preserves audit trails after budget execution. sentatives, and the executive branch. Box 3.1 presents four principles of a good budget. Thus, budgets help ensure that govern- ments  deliver the services that citizens have Types of Budgets demanded, through choices made in a demo- Budgets have been used for centuries, but the cratic process, and that available resources are forms, types, and scope of budgets have con- used efficiently. tinued to change. This section discusses the various budget types and their merits and Budgets as Instruments of Fiscal Discipline shortcomings, including the challenges of and Control implementing them in  practice (adapted from Budgets are instruments of financial control used Mikesell 2011). by both the executive and the legislative branches of a local government. For example, the mayor, Administrative the chief financial officer, or the city manager can Budgets can be classified according to the admin- use the budget to monitor actual expenses, com- istrative entity that is responsible for manage- pare them to plans made at the start of the year, ment of the particular public service or function. and improve operational efficiency. At the same Thus, the budget can be organized according to time, the city council can use the budget to keep the agency or department that will implement track of whether the executive branch is using the work for which the funds are provided, such resources efficiently to address the development as the health or water department, the education priorities that the council has established. authority, the waste management department, The control function in budgeting involves and so forth. restraining expenditures to the limits imposed by available financing, ensuring that enacted Economic budgets are executed and financial reports are Budgets can be classified by economic function, accurate, and preserving the legality of the gov- that is, by the type of revenues and expenditures, ernment’s expenditures. The control function such as taxes, salaries, supplies, and so forth. This permits development of information for the cost kind of classification is also called “line-item” or estimates used in the preparation of new budgets “object of expenditure” classification. Box 3.1 Principles of a Good Budget Those preparing a local government budget Principle 3. Equip the local government should keep the following principles in mind: with a budget that is consistent with the Principle 1. Establish broad goals to guide goals and the approaches that have been government decision making. decided on. Principle 2. Establish credible approaches Principle 4. Enable the local government to for achieving the goals that have been set by monitor and evaluate its performance and to developing appropriate policies, programs, make adjustments to meet contingencies and and strategies. changing circumstances. Source: Adapted from NACSLB 1998. Municipal Financial Management 95 Functional Line-Item Budgets The functional classification identifies spending Line-item budgets provide for budget allocations according to the intended purpose or objective, in a very detailed manner, by specific allocation for example, education, health, social services, for each expenditure item. These budgets are without specifying the (often several) administra- input oriented and describe minute details; as tive departments that will receive the resources a result the budget documents are voluminous. or the expenditure category for which the bud- Although line-item budgets help governments geted funds will be used. to exercise financial control over each item of expenditure, they do not provide flexibility to Fixed or Flexible Budgets adjust spending in accordance with changes in Fixed budgets are those specifying appropriations needs and circumstances and do not provide a of fixed amounts. The appropriated amounts may “big picture” view of what resources are being not be exceeded, regardless of changes in demand used for. Table 3.1 is a copy of the budget snapshot for government services. Earmarked grants of the city of Bangalore, India. from a higher government tier are typical fixed budgets, which can be spent exclusively for the Program Budgets target purposes (e.g., education, health, or roads); Program budgets provide budget allocations for unspent amounts may be returned to the grantor. a whole program and expect the budget holder Flexible budgets permit the local government to to make allocations for the various expenditure adjust the budget  allocations during the course categories within it. In this method, local gov- of the year, in accordance with program require- ernment control is exercised over expenditures ments, and thus enable it to adapt to contingen- for the overall program and not over individual cies and unexpected events. expenditure items. Program budgets are output Table 3.1 Line-Item Expenditure Budget of Bangalore, India Source: http://bbmp.gov.in. 96 Municipal Finances oriented. Although program budgets provide Capital Budgets the budget holder with flexibility to manage Capital budgets include revenues from capital resources efficiently, they also require efficient transactions (such as the sale or lease of assets, accounting and control procedures to prevent land, or other property) and provide expenditures waste or misuse of resources. Hence govern- for goods and services whose benefits extend ments often start with an efficient line-item beyond one year. That includes allocations for the budgeting process and then move into preparing construction of buildings and acquisition of assets program budgets. such as plant, machinery, and vehicles. Capital budgets are also called “development budgets” Operating Budgets (in some Asian countries). They are nonexistent Local budgets typically consolidate two budgets, in many developing countries because they are an operating budget and a capital budget. An oper- not legislated by the central government. ating budget (also called a “current budget”) is Table 3.2 summarizes the main attributes of typically larger and more detailed than a capital current and capital expenditures. It is impor- budget. Operating budgets include revenues from tant  to distinguish current (also called “operat- current year transactions (tax collections, rents ing”)  and capital (also called “nonrecurrent” or received) and provide for expenditures that are “development”) expenditures and to segregate the necessary for day-to-day operations during the current and capital budgets. The table supports year (wages and salaries, office expenses, mainte- the view that segregation is possible and very use- nance expenditures, etc.). ful for analyzing the financial position of a local Table 3.2 Attributes of Current and Capital Expenditures Current expenditures Capital expenditures It is an amount spent to acquire goods or services It is an amount spent to acquire or improve a long- essential for daily operations and is expensed term asset, such as equipment or buildings. immediately. Its effect is temporary—its benefit is received withinIts effect is long term—its benefit is received for a the accounting year. number of years in the future. No asset is acquired, nor is the value of an asset An asset is acquired or the value of an existing asset increased. is increased. Except for some intangible assets, it generally has It has no physical existence because it is incurred for items that are used by the organization. physical existence. It is recurring and regular; it occurs repeatedly. It does not occur again and again; it is nonrecurring and irregular. It helps to maintain the business. It improves the position of the business. It is normally charged against revenue in the income A portion of the expenditure (depreciation on assets) statement in the year it is expensed. is shown in the income statement as an expense, and the balance is shown in the balance sheet on the asset side. It does not appear in the balance sheet. It appears in the balance sheet until its benefit is fully exhausted. It reduces the revenue (profit) of the organization. It does not reduce revenue; the purchase of a fixed asset does not affect revenue. Municipal Financial Management 97 government, regardless of whether or not national approve their budgets prior to the start of the fis- regulation stipulates the two separate budgets. cal year, the preparation stage of the cycle takes place prior to the budget year. Similarly, the audit Budget Preparation and evaluation stage takes place mostly after the This section describes the steps in the bud- close of the fiscal year. The overall purpose of the get process, including the budget cycle, the budget process is to help decision makers make budget  manual or circular, the budget calen- informed decisions about the provision of ser- dar, budget formulation practices, budget esti- vices and the development of capital assets, but mates,  budget approval, and supplementary or it also helps promote stakeholder participation in revised budgets. It addresses budget processes the budgeting process. and how they help local governments maintain financial discipline and accountability. Budget formulation. Budget formulation has The Budget Cycle both policy and procedural aspects. The exec- Public sector budgeting is organized around utive leadership (usually the mayor’s office in a cycle within a fiscal year, which allows the a city) sets out the detailed policy and program system to absorb and respond to new information goals that it wants to implement in its jurisdiction. and thereby allows the government to be held These are usually assembled through a develop- accountable for its actions. The budget cycle con- ment planning process in which cities prepare sists of four phases: (1) preparation and submis- medium- and long-term development plans. For sion, (2) approval, (3) execution, and (4) audit and example, in India five-year plans are prepared at evaluation. The first three phases are discussed in both the national and provincial levels that lay out detail here, and auditing is discussed in chapter 8. the broad development priorities and programs. Figure 3.2 depicts a budget cycle, a contin- Based on these five-year plans, provinces and uous process with interlinked phases that do cities prepare annual plans, which in turn form not necessarily occur during the same budget the basis for annual budgets that describe the pri- year. Because local governments are required to orities and programs for a particular fiscal year. Figure 3.2 The Budget Cycle 1. Stakeholder input 8. Adjust as necessary Po on pt ati lic pha do ent y/ s st e 7. Monitor A ra em 2. Vision/mission te results pl g goal setting y im Budget cycle t en de Re 6. Adopt ve vie sm 3. Needs budget lo w ses assessment pm as en ds t ee N 5. Operating/budget 4. Direction to impacts staff Source: NACSLB 2000. 98 Municipal Finances The National Advisory Council on State and is necessary to plan ahead and set up a calendar Local Budgeting (NACSLB) in the United States with specific dates for each unit, specifying the has recommended the following steps to improve deadline for submission of their financial data to the quality of the budget process (Freeman and the accounting department. Table 3.3 provides an Shoulders 2000): example of a typical budget calendar that would be issued during the middle of the year before the • The budget process should consist of activi- fiscal year being considered. ties that encompass the development, imple- mentation, and evaluation of a plan for the Entities in Charge of Budget Preparation or provision of services and capital assets. Approval • A good budget process incorporates a long- Local governments usually follow specific guide- term perspective, establishes links to broad lines for budget preparation that are provided by organizational goals, focuses budget deci- higher authorities. Many other players are also sions on results and outcomes, involves and involved in the process of preparing the budget. promotes effective communication with stake- In municipalities in Western countries, the main holders, and provides incentives to government players are the following: management and employees. City council. The city council is responsible for adopting the current and capital budgets for • The budget process should be strategic in the upcoming fiscal year. Its approval is often nature, encompassing a multiyear financial issued as a local bylaw or ordinance. The coun- and operating plan that allocates resources on cil thus is also responsible for approving mod- the basis of identified goals. ifications to the budget under implementation • A good budget process moves beyond the throughout the fiscal year. traditional concept of line-item expenditure The mayor. The mayor is primarily responsi- control, providing incentives and flexibility to ble for the presentation of the city budget to the managers that can lead to improved program city council. She or he may delegate the respon- efficiency and effectiveness. sibility to a subcommittee of the council, such as a budget committee or standing committee for Budget circular and budget calendar. The pro- finance. cedural aspect of budgeting relates to translating Heads of departments. The head of each policies and plans into budget estimates. Around department, agency, or other independent unit the first quarter of a fiscal year, the finance must submit departmental budget plans to department of the local government sends a the finance officer or the budget committee. The budget circular for the following fiscal year to plans should include detailed estimates of  the all local government departments, agencies, or budget needs of the entity for the coming fiscal entities. The circular includes (a) the budget year (some municipalities require estimates for planning calendar; (b) instructions for prepar- the next three years as well) and estimates of any ing budget plans; (c) an indication of what funds revenue anticipated to be collected by the entity. are likely to be available; and (d) overall priority Chief financial officer. The chief financial directions from the executive leadership. Large officer (CFO) usually leads the day-to-day pro- municipalities have to create complex budgets cess of budget preparation and works under the that require the harvest of enormous amounts of direction of the mayor and the budget committee. data and information from every single unit or The CFO is responsible for reviewing and com- department. To manage this lengthy process, it menting on the city’s budget and its multiyear Municipal Financial Management 99 Table 3.3 Budget Calendar for Budget Fiscal Year January–December 2010 June 4, 2009 Open budgeting process at division level for budget input. July 7, 2009 Personnel budget estimates for 2010 to departments for review. July 2009 Begin citizen survey to help set budget priorities. July 14, 2009 Close division-level budget plans; open department-level budgeting. July 20, 2009 Personnel budget for 2010 returned to Finance Department. July 28, 2009 City council meeting on budget. August 3, 2009 Finalize fees and service charges. August 10, 2009 Department budget requests and revenue estimates completed for all funds. August 20, 2009 Revenue and expenditure summaries due to CFO for review. September 8–10, 2009 Internal budget review with CFO, department heads, and finance committee. September 21–25, 2009 Final internal reviews with CFO, department heads, and finance committee. September 29, 2009 Special meeting with council to present the 2010 Preliminary Budget. October 7 , 2009 Present proposed utility fee adjustments to city council. October 20, 2009 City clerk publishes notice of public hearing on revenue sources. November 1, 2009 Preliminary budget filed with city clerk and made available to the public. City clerk publishes notice of filing of preliminary budget and notice of public hear- ing on budget. November 2, 2009 Status reports and preliminary budget amendment estimates for 2010 budget to council; public hearing on city’s revenue sources and property taxes. November 14, 2009 Continuation of public hearing on revenue sources and public hearing on proposed budget and levy of property taxes. December 8, 2009 Second public hearing on budget and council adoption of the budget. January 1, 2010 Start implementing the new budget. Source: Adapted by author from a U.S. city government budget calendar. Note: CFO = chief financial officer. financial plans. He or she is required to submit prepared by committees of the city council with periodic reports to the council and mayor on the the help of city executives (such as the standing budget execution progress and the state of the committee on finance found commonly in local city’s economy and finances. The CFO’s report governments in South Asia). As part of its scru- should include analysis and evaluation of the tiny, the city council may hold hearings to obtain city’s various operations, fiscal policies, financial the advice and opinions of key stakeholders. After transactions, and recommendations. completing its examinations, the city council adopts the budget by passing a local appropria- Legislative Approval of the Budget tions act or council resolution. Local governments’ budgets are prepared by the The budget thus becomes a local bylaw that mayor (or the mayor’s designated or delegated cannot be changed by any entity below the coun- representative) and presented before the local cil. Should it be deemed necessary, the council government council. After receiving the draft may adopt a modified budget, which is called a budget document, the council usually turns it over “supplementary” or “revised” budget. In some to a committee of the council for scrutiny. The countries, regulations require issuing a revised committee will advise the council concerning the budget if either revenues or expenditures devi- budget proposals. In some countries, budgets are ate from plans substantially (say, by more than 100 Municipal Finances 20  percent). Local governments in many devel- Participatory Budgeting—Engaging oping countries revise the budget just before Stakeholders in Budget Formulation closing the fiscal year, a practice that undermines Participatory budgeting is a democratic pro- the fiscal discipline and control functions of cess in  which citizens or community members budgeting. are directly involved in decisions about how to spend all or a part of a local budget (www.par- Budget Execution ticipatorybudgeting.org). Citizens’ involvement The budget execution process includes the vari- varies in form, depth, and breadth. Many local ous operations involved in translating the bud- governments have opened up decisions in entire get statement into decisions and transactions municipal budgets, involving citizen assemblies using the budgetary resources. Budget execution in setting overall priorities and choosing new commences with the apportionment (fund allo- investments. States, cities, counties, schools, uni- cation) process, to ensure that the departments versities, housing authorities, and coalitions of or other units receive allotted funds in a system- community groups have used participatory bud- atic manner, so that planned activities are imple- geting to open spending decisions to democratic mented smoothly and without causing cash participation. In some cases the local govern- flow constraints to the city. The apportionment ment sets aside a small portion of the budget and process enables managers to plan and execute entrusts communities to decide priority projects spending and projects in accordance with the for their neighborhood. Common forms of citizen availability of resources. Once funds are appor- participation in the budget process are discussed tioned, departments make allotments to their below, along with some challenges to its imple- operating units on a monthly or quarterly basis, mentation. Box  3.2 summarizes an example of to control spending during the fiscal year. participatory planning from Kerala, India. During budget execution, multiple subsys- tems of the city operate in cooperation. Local Participatory Budgeting: How Does It Work? taxes and  other revenues are collected. Cash is In participatory budgeting, community members managed such that funds temporarily not needed make budget decisions through an annual series are invested. Supplies, materials, and equip- of local assemblies and meetings. Although there ment are procured and paid for. Expenditures are many models of participatory budgeting, most incurred are recorded in accounting records and follow a basic process: diagnosis, discussion, deci- consolidated into financial reports. sion making, implementation, and monitoring: • Residents identify the most important local Audit needs, generate ideas to respond to those Audits are the final phases in the budget cycle. needs, and choose budget representatives for An audit is an “examination of records, facilities, each community. systems, and other evidences to discover or verify • The representatives discuss the local priorities desired information” (Mikesell 2011). The audit and together with experts develop concrete seeks to discover deviations from accepted rules projects that address them. and practices and bring out instances of any ille- gal or irregular transactions or decisions. Audits • Residents vote for which of the projects to aim at holding management accountable and pre- fund. venting repetition of inappropriate actions in the • The local government includes them in its future. The goals of the audit process may vary budget and allocates funds to implement the depending on the purpose of the audit. chosen projects. Municipal Financial Management 101 Box 3.2 Participatory Planning in Kerala, India In 1996 India’s Kerala State embarked on discussed and prioritized the various devel- a remarkable experiment in local planning opment needs of the community and and budgeting known as the “People’s Plan presented them to the local government Campaign for the Ninth Plan” (PPC). The objec- council, which consolidated them into a tive of the PPC was to devolve 35 percent of “Development Report. ” Based on these the state development budget from a central- development priorities, the local govern- ized bureaucracy to local communities, where ment council prepared the annual plan and local people could determine and implement budget and presented them to the citizens. their own priorities. The PPC developed from The plans were then sent to the District a series of local-level planning experiments led Planning Committee, which scrutinized by the left-of-center parties in the state, led by them to iron out inconsistencies, fill in gaps, the Communist Party (Marxist), which exper- and thus enable the local plans to be more imented with various forms of community comprehensive. mobilization. The PPC unfolded as a sequence The PPC radically improved the delivery of assemblies, seminars, task forces, local of public services, brought about greater council meetings, implementation and mon- caste and ethnic equality, facilitated the itoring committees, and the like. The meet- increased entry of women into public life, ings were held at the lowest tier of the local and enhanced democratic practice. The government structure, known as the grama PPC brought about such a radical new sabha, in rural localities and the ward commit- model of engaging citizens in community tee in urban areas. development and decision making that even These meetings, often facilitated by a change of government in 2001 could not resource persons from a popular NGO, overturn the model. Source: Franke 2007. • Residents monitor the implementation of the http://internationalbudget.org). Box 3.3 contains budget projects. more information on the Porto Allegre experience. The Pakistan budget law mandates that local Where Has It Worked? governments set aside 25 percent of their local The Brazilian city of Porto Allegre started the development budgets for “citizens community first full participatory budgeting process in 1989 boards” (CCB). Communities apply to use funds for its municipal budget. As many as 50,000 from the CCB budget for small road, drainage, and people have participated each year in the orca- water improvement projects and commit to pay a mento participativo (the Portuguese term for portion of project cost (say, 15 percent to 30 per- “participatory budget”) that started in Porto cent) as their cash contribution. In Nepal, many Allegre, to decide as much as 20 percent of water supply projects are initiated, financed, and the city budget. Since 1989, participatory bud- implemented by water user communities, which geting has spread to more than 1,200 cities in receive 50  percent grants from the government, Latin America, North  America, Asia, Africa, and pay 20 percent cash, and borrow about 30 percent Europe (for more details about participation, visit of total project cost. 102 Municipal Finances Box 3.3 Participatory Budgeting in Porto Alegre Participatory planning and management pro- detriment of other projects; that investments cesses in local governance are a precondition required for local economic development do to the success of social inclusion strategies not receive as high a priority as they should in where poverty alleviation is a key component. a developing country; and that the longer-term In this perspective, the experience of Brazil’s perspective is sometimes obscured by the participatory budgeting (OP) is interesting and attention to urgent needs. instructive. The OP has proved to be a more In addition, the significant commitments of versatile and flexible instrument than orig- staff time and resources required for effective inally envisaged. It has offered the poor and outreach, organization, and smooth imple- the marginalized an unprecedented opportu- mentation are costs that must be considered. nity to participate in local governance without Despite these concerns, however, there is preempting the statutory powers of elected no doubt that the OP helped trigger a change representatives or the executive authority of in the relations between citizens and their municipal officials. Officials and community municipality, as each side developed a better leaders attest to the OP’s impact in promoting understanding of the needs, constraints, and a better understanding of the role and func- roles and responsibilities of the other. The tions of local government, a precondition to opportunity to participate in decisions regard- constructive dialogue, cooperation, and part- ing the allocation of public funds for projects nership. At the same time there have also fostered a shift in the local political culture been some concerns regarding the outcomes from confrontational tactics and corrupt politi- of the OP process, including concerns that cal bargaining to constructive debate and civic funds are allocated to social projects to the engagement in governance. Source: Serageldin et al. 2005. What Are the Benefits? • It develops active and democratic citizens. Elected officials, community organizations, aca- Community members, staff, and officials learn demics, and international institutions such as democracy by practicing it. They gain more the United Nations and the World Bank have understanding of complex political issues and declared participatory budgeting a model for community needs. democratic government. Why? Their endorse- ments are based on the following: • It builds communities and strengthens commu- nity organizations. People get to know their • It gives community members a say. Ordinary neighbors and feel more connected to their people have more voice, and they get to city. Local organizations are able to spend make real decisions. less time lobbying, and more time decid- ing policies themselves. Budget assemblies • It produces better and more equitable decisions. connect groups and attract new members. Local residents know best what they need, and budget dollars are redistributed to communi- • It connects politicians and constituents. ties with the greatest needs. Politicians build closer relationships with Municipal Financial Management 103 their constituents. Community members inform management decisions, for reporting, or get to know their elected officials and local for communicating with stakeholders, especially governments. citizens. • It makes government more accountable and The Revenue Side of the Municipal Budget efficient. Local officers are more accountable Budget preparation is an iterative process in which when community members decide on spend- draft budget plans and cost or revenue estimates ing in public assemblies. There are fewer are exchanged vertically between lower-level opportunities for corruption, waste, or costly and higher-level entities, such as departments public backlash. and their units, or between departments and the city council or its budget committee. Horizontal Budget Preparation Techniques exchange and coordination across departments, Budget preparation techniques and practices such as service or functional departments and apply the general budget concepts and principles the finance department, are also intensive. to the formulation of a typical municipal budget. Nevertheless, it is the revenue side of the budget This section identifies and discusses the main that is the logical starting point for three reasons components of a municipal budget from both (Lee and Johnson 1998): revenue and expenditure sides. • Preparing entities. Ascertaining the possible The section will bring together the various revenues available for appropriation helps the concepts through a hands-on exercise in bud- budget preparer to fix the boundaries, in terms get formulation. It then turns to the concepts of available resources, of the expenditures and techniques relating to capital budgeting, that the organization can plan. including various techniques for appraising • Citizens. Citizens are usually concerned about investment projects and their applicability in the taxes and worry at budget time about tax hikes. municipal context. Figure 3.3 is a visual impres- sion of a standard budget; it depicts the form fol- • Politicians. Political leaders are always con- lowed throughout this handbook. In contrast to scious that program initiatives leading to the detailed and lengthy line-item budgets, such higher expenditures, and therefore higher short, summary or snapshot budgets are used to taxes, may have negative effects politically. Figure 3.3 Standard Budget Structure Revenues Expenditures Current revenues Current expenditures Payroll budget Current Own revenues: taxes, fees Operation and maintenance transfers from government Interest payments other revenues (rents) Deficit carried forward (if any) surplus carried forward Operating surplus Self-financing Capital expenses budget Capital revenues Capital Civil works Sale of property, land purchase of property, land grants repayment of loan principal loans 104 Municipal Finances The revenue side of a municipal budget usually based on historical and current spending trends. has four components: (1) own-source revenues, The budget office also takes into consideration (2) fiscal transfers from higher governments, expected changes in general economic indica- (3) shared taxes, and (4) debt or borrowing. tors, such as the rate of inflation, in preparing its “Own-source revenue” refers to the various spending estimates. The plans and information tax and nontax sources of revenue that munici- generated and exchanged at this stage also help palities can collect. They may include property the units themselves and the budget office to taxes, income taxes, retail sales taxes, and oth- prioritize programs, projects, and expenditures. ers, depending on national revenue assignment Usually the budget office gives certain guidelines (see chapter 1). Nontax sources include user fees in advance (through the budget circular) with and charges, such as the fee that a vegetable ven- respect to the various assumptions, trends, and dor pays to use the municipal market, but also priorities, and that helps the departments and proceeds from the lease or sale of assets. Fiscal other units prepare their expenditure proposals. transfers are the various grants that higher levels The budget office scrutinizes the proposals and of government provide to municipalities, whether finalizes them, often based on bargaining discus- unconditional or conditional. Shared taxes include sions with the respective departments. Those those that are collected by higher levels of govern- discussions also help the budget office to plan for ment but whose proceeds are shared with local expenditure management (see also chapter 5). governments based on a formula. Borrowings are As mentioned, in the process of preparing the the loans and other forms of debt that munici- budget, it is essential to collect data on actual palities can take on to finance their expenditures revenues and expenses for the last year or two, (chapter 5 and chapter 7 discuss more details). as well as to propose an estimate of the next At the start of the budget preparation pro- year’s revenues and expenditures that takes into cess, the budget office (or the finance or revenue account changes in policies and events adopted department) surveys the historical trend of rev- by the governing body. The budget needs to show enue collection figures to estimate the resources how much money will be available, where it that can be raised. In addition, the budget office comes from, and how it will be used. tries to estimate the possibility of increasing tax or other rates or expanding the existing tax base. Capital Budgeting in Municipal Governments The budget office will also explore the possibil- Capital budgeting is a tool for expenditure plan- ity of new sources of revenue. These efforts are ning that often includes a multiyear capital essentially of a technical nature, carried out with improvement plan (CIP) and preparation of an a view to presenting options to city management. annual capital budget. The capital improvement The city management makes the final call on rev- plan is important because purchasing, develop- enue options, considering their technical, eco- ment, expansion, or rehabilitation of physical nomic, administrative, and political feasibility. assets requires large money outlays, often beyond the limits of the annual budget. Hence separate, The Expenditure Side of the Municipal Budget long-term planning is necessary to ensure that Simultaneously, the budget office informs the projects are evaluated in a systematic manner, departments (or leaders of projects and programs) from both technical and financial perspectives, to about the extent of financial support to be expected help the city management select a list of projects in the budget and invites their  expenditure pro- that are feasible and within the city’s operating posals. The various operating expenditure items, and financial capabilities. Table 3.4 briefly sum- such as salaries and office expenses, are estimated marizes the logical flow of a capital planning and Municipal Financial Management 105 Table 3.4 Logical Flow of the Capital Budgeting Process Phases Steps Results Planning Update inventory and An inventory of infrastructure with analysis of condition and assess asset condition. adequacy of maintenance spending. Identify projects. A project list with rough cost estimates (capital improvement plan). Project evaluation Detailed costing of both construction costs and subsequent operating costs, estimation of any revenue, comparison with strategic plans, and cost-benefit analysis to identify priorities. Project ranking Ranking of projects using capital budgeting techniques. Budgeting Financing Financing arrangements for projects to be included in the budget. Budget Expenditures included in budget proposals of the appropriate departments, their placement in resource envelope available to gov- ernment, inclusion of project operating costs in the long-term budget forecasts for period when project is completed and running. Execution Procurement Process for selection of contractors for projects. Monitoring Review of physical and financial progress of project; coordination of spending with revenue flow. Auditing External audit Ex-post review of financial records upon project completion. budgeting process. Capital improvement plan- look at a few common issues that affect the bud- ning and capital budgeting are different in scope geting practices of local governments everywhere. and time frame, but both largely follow the same This section discusses some practical difficulties logic, processes, and techniques. that municipal finance officers face, particularly The capital budget may be a section of the in developing countries, focusing on problems overall budget (as in figure 3.3) or issued as a that prevent the preparation of realistic and com- separate document. The capital budget should prehensive budgets and ways to address them. have cost estimates for all infrastructure projects that are proposed, including both the investment Comprehensiveness cost  and implications for the operating bud- As a basic principle, the municipal budget should get (Mikesell 2011). Capital budget preparation be comprehensive, covering all areas (each service requires ranking project proposals using capital or function) and aspects (revenue, expenditure, budgeting techniques such as payback period, the short- and long-term impacts) of functioning. net present value method, internal rate of return, Against this principle, municipal budgets in most or profitability index. They are discussed in detail developing countries deal only with the revenues in chapters 4, 5, and 6. and expenditures of core governmental functions and do not include ancillary activities carried out Issues, Practices, and Challenges in by the city. For example, the municipal budget Municipal Budgeting often does not include the expected revenues and Though the principles of budgeting are uniform expenditures of municipal enterprises such as a globally, the reality is not. The rules and practices water supply company that is organized and man- of budget formulation differ from country to coun- aged as an independent company. try, and even within a country the basic principles, The other concern regarding budget compre- issues, and challenges may vary. Here we put the hensiveness relates to the extent of decentral- differences in the rules and procedures aside and ization and the transfer of powers and functions 106 Municipal Finances to local governments (see chapter 1). Even in Service or line departments and budget officers decentralized settings, where local governments often project revenues or expenses by simply are expected to take the lead in local development increasing the actual results of the current year, activities, budget allocations from central minis- adding, say, 5 percent or 10 percent to every line. tries are often made to line departments and not This is not a bad way to start, since it at least might routed through local governments’ plans and bud- factor in inflation, but a major trouble is that infla- gets. This often creates fragmentation in planning tion may have different impacts on revenues and and execution, as well as tensions between local expenses and on different revenue and expen- governments and the line departments. diture items. Realistic estimates should reflect good understanding of future events, along with Realism natural uncertainties. For instance, a 20  percent Budgets are useful to the extent that they are real- increase in tax revenues could be realistic if the istic. The four main shortcomings in this regard city council has approved a rate increase or if are political distortions, information shortage, the tax base is expanding because of the dynamic incremental budgeting, and balloon budgeting. growth of housing. Politicized budgeting. Often in developing countries, budget presentation is an opportunity Weaknesses in Budget Execution for political grandstanding by the mayor and city The most common weakness in budget execu- council. As a result, the municipal budget docu- tion is a disconnect between the budget doc- ment reads more like a wish list of programs and ument and daily expenditure decisions. The projects divorced from financial reality. Such signs include (a)  huge overspending in some a situation arises from weak accountability of line items without any discussion or higher-level city management to its citizens and stakehold- approval; (b) delays in budget execution due to ers and  also from soft budget constraint by the delayed transfers from the central government; higher-level government. In other words, where (c) unclear distinction between revenue and there is a strong accountability framework and expenditure items; (d) a revised budget issued at the national government exerts hard budget con- the very end of the fiscal year with huge changes straint, city managements hesitate to announce from the initial budget plan; and (e) a huge deficit grand plans and projects without ascertaining at year-end, when a balanced or surplus budget that they have adequate financial resources. was planned. All are results of weak fiscal control Shortage of timely information. Another hur- and discipline in the municipality. dle to local budgeting arises when local govern- The central governments in developing coun- ments do not know beforehand the fiscal transfers tries often approve development grants very early that they will receive from the national govern- in the fiscal year, rather than the year before. ment. That occurs because of a weak intergov- Development projects thus often start at midyear ernmental fiscal relationship, or where central or in the third quarter of the fiscal year. As a result, governments do not feel obliged to announce in development funds remain unspent at the end of advance the transfers and entitlement payments the fiscal year, causing a large but artificial surplus due. It weakens the ability of local governments in the closing budget. It is particularly confusing to forecast revenues or forces them to make esti- if there is no clear distinction between current mates in their budget documents based on guesses. and development expenses. Quite often weak pro- Incremental budgeting. Local governments curement and cash management systems result sometimes fail to use proper techniques and in overspending or in delayed budget execution, instruments in preparing budget estimates. eventually constraining local governments from Municipal Financial Management 107 implementing their budgets efficiently and timely. very simple ways to support efficient and effective Councils are often forced to alter their budgets decision making. For example, a city government and approve a supplementary budget during the can use an MIS to track the patterns of its reve- fiscal year, undermining the authority of the bud- nues and expenditures. Analysis of revenue col- get process, as well as its planning and control lections may show that property tax collections functions. are higher in certain wards of the city, compared to others. That could prompt the city manage- Budget Monitoring ment to investigate the reasons for the varia- Successful budget execution depends to a large tion and redistribute resources to help the areas extent on robust budget monitoring by top execu- that are not performing well. There are simple tives (such as the mayor or city manager) and the techniques, easy to implement, that can provide city council. Especially in large cities, however, useful insights into the efficiency of budget exe- budgets involve hundreds of millions in financial cution. (Chapter 8 includes a detailed discussion resources and plans and projects in a variety of of performance measurement.) sectors. The magnitude often reduces the ability of the council and executives to monitor budget Budget-Actual Variances execution and exercise control. Management Budget-actual variance analysis is an old and information systems, discussed in this section, are simple tool for budget monitoring. It is often useful tools to track budget execution, identify not possible to create a perfect budget because weaknesses promptly, and take remedial action. some future events are unpredictable. But a well- developed and realistic one that is based on the Management Information Systems actual financial situation, current and past, can be A management information system (MIS) the best road map to efficient financial manage- involves three primary resources: people, tech- ment. For example, uncertainties or unexpected nology, and information. Management informa- financial developments, such as an increase in tion systems are different from other systems, unemployment because of an economic down- such as an accounting or procurement system, turn, or major damage to a water treatment plant because they are used to analyze activities from due to severe weather, can result in revenue short- the perspective of management decision mak- ages and a parallel increase on the expenses side. ing. MISs help city governments to realize the Such occurrences will cause differences between maximum benefit from their investments in per- the budgeted and actual amounts that need spe- sonnel, equipment, and business processes. All cial attention when the budget is revisited and local governments use information systems at all refined. But variances that are not generated by levels of operation to collect, process, and store such unforeseen events should be minimized. data; an MIS does those things in a timely, sys- Two types of variances occur, favorable or tematic, and comprehensive fashion. MIS data unfavorable: are aggregated and disseminated in the form that • Favorable variance occurs when actual results city managers need to carry out their functions. are better than budgeted or planned (F). Costs The term “MIS” may conjure up the image are lower, or revenue is higher, than expected. of sophisticated computers and highly qualified analysts crunching reams of data and producing • Unfavorable variance occurs when actual complicated spreadsheets and charts. Although results are worse than budgeted or planned management information systems can be very (U). Costs are higher, or revenue is lower, than sophisticated, they can also be implemented in expected. 108 Municipal Finances Variance analysis is a tool to evaluate variances Accounting in revenues and expenses. It reveals whether the This section discusses the basic concepts and government is operating within its authorized principles of accounting, with an overview of its resources. A variance, positive or negative, often subject matter. The objective of the section is to calls for explanations. Thus, it is important to ana- introduce the reader to the role of accounting as lyze and understand the causes of variances and the basis for documenting, classifying, and orga- take corrective action. Not all variances are worth nizing financial information in a systematic man- investigation, however. For example, a variance ner. The section also provides a brief overview of of only 1 percent of spending is well within the the types of accounting and their relationship to normal range. A variance of 10 percent or more auditing and the various accounting standards. in spending is likely to signal that something is wrong and warrants attention. Proper variance analysis requires some thought to (a) analyze Accounting Concepts and Terms the variances, (b) identify the causes, and (c) take The role of accounting in managing organizations. appropriate action. Accounting systems are used to provide com- Variances can occur for many reasons, such plete, timely, and accurate information concern- as changes in funding levels due to inflation, ing revenues, expenditures, assets, and liabilities. population change, or government funding deci- Within a local government, accounting records sions and policies. Changes in the cost of ser- provide information on billing taxpayers and vices, labor, or material can also cause variances receiving tax payments, paying employees, and in budgets. paying vendors and contractors for goods, work, Table 3.5 presents an example of a variance cal- and services. Accounting systems also inform culation for expense items of a water utility. The management and external stakeholders about the table shows a huge total variance of 35  percent financial resources, the efficiency of the organi- that deserves attention and remedies. First, each zation’s financial management, and its financial cost item needs close scrutiny. For example, we position during and at the end of the financial might find that the increased cost of water pro- year (Lee and Johnson 1998). vision is due to an increased energy tariff, which Difference between accounting and book- would be beyond the control of management. keeping. People often mistakenly use the terms Meanwhile, the cost of fee collection has jumped “bookkeeping” and “accounting” to mean the by $11,000, which could be acceptable only if same thing. Accounting is concerned with iden- fees collected had experienced an even greater tifying how transactions and events should be increase. described in financial reports. It is also concerned Table 3.5 Example of Variances between Budgeted and Actual Expenses for a Water Utility Expense item Budget ($) Actual ($) Variance ($) Variance (%) Cost of water provision 140,000 $190,000 50,000 U 36 Cost of fee collection 28,000 39,000 11,000 U 39 Administrative expense 60,000 85,000 25,000 U 42 Other expenses 12,000 10,500 −1,500 F −13 Total 240,000 $324,500 84,500 U 35 Note: U = unfavorable variance; F = favorable variance. Municipal Financial Management 109 with designing bookkeeping systems that make • Public sector accounting and commercial it easy to produce useful reports and to control accounting, in their basic principles, are the an organization’s operations. Thus, accounting same. Certain specific accounting practices is broader than bookkeeping, and accounting that suit accounting in government orga- requires more  professional expertise and judg- nizations create the differences between ment. Bookkeeping is the process of recording the two. One of the most visible differences transactions and other events, either manually is that  local governments in the develop- or with computers. Bookkeeping is critical to ing countries use single-entry cash basis accounting, but it is only the clerical part of the accounting. In contrast, the vast majority of accounting process. commercial entities use double-entry accrual basis accounting. Furthermore, government Types of Accounting accounting is based on the annual budget Although accounting may seem to be a single term process, and therefore budget allocations, and subject, in fact various types of accounting appropriations, and commitments become exist, and each plays a specific role in the financial very significant. management of organizations. The most impor- tant accounting types include financial account- Key Terms in Public Sector Accounting ing, cost accounting, management accounting, Public sector accounting has three building and public sector or commercial accounting. blocks: allocation, appropriation, and commit- ment. We briefly introduce these three terms • Financial accounting provides information to because they keep popping up during discussions management and external stakeholders, such on municipal financial management; a detailed as a city council, shareholders, or citizens, on discussion is beyond the scope of this chapter. It the receipts, expenditures, assets, and liabili- is important, however, to be familiar with their ties of a municipality. In other words, financial definitions and implications in the budgeting accounting is concerned with the reporting of process. Box 3.4 provides some concrete exam- financial transactions and the financial posi- ples for applying these terms. tion of the municipality, monthly, quarterly, Appropriation. An appropriation is the and at the close of the financial year. total amount of resources a local government department can spend for the entire fiscal year. • Cost accounting provides information to man- Spending authorizations granted by the legisla- agement on the cost of operations and helps ture (e.g., the city council) depend on both the with measuring and controlling the costs of budget system and the nature of the expendi- specific services or functions. Cost accounting ture. Authorizations that permit government is an internal function and generates informa- departments or units to incur obligations and tion relating to historical costs of operations to make payments out of public funds are usu- and efficiency. Although cost accounting uses ally granted through appropriation, a financing information from the financial records, its source against which expenses must be matched methods and processes are different. and reported on the statement of operations. • Management accounting is a later development The receipt of an appropriation is recorded at of cost accounting in which the data and infor- the departmental level only. mation from cost accounting are converted Allocation. Allocation is a budget execution into decision reports for management, using process to allocate funds to the program level; various analytical and presentation techniques. it is a percentage of an appropriation that is 110 Municipal Finances Box 3.4 Examples of Appropriation, Allocation, and Commitments Appropriation example. The federal Environ- programs, after-school or summer programs, ment Protection Agency approved a grant and the like. The district determines the per of $200,000 to a city’s Division of Debris pupil expenditure (PPE) as a measuring tool, Removal. This grant is an appropriation or and then schools are sorted by poverty level. funding for a specific purpose, to enable For example, if school A has 75 percent poor the division to assist the city in an emer- children, it receives 1.4 times the PPE in allo- gency cleanup of its hazardous yard trash cation funds; school B, with 35 percent of its disposal site. students in poverty, receives 1.25 times the Allocation example. Usually in the edu- PPE, and so forth. cational system, funds may not be provided Commitment example. In the United to schools based solely on academic need, States, central government or federal agencies but rather poverty must be considered as commit funds for large projects. For example, the determiner. The purpose of the “alloca- the U.S. Department of Transportation agreed tions” funds is to help disadvantaged children to commit resources to fund a bridge project in meet high academic standards through food the District of Columbia. earmarked for a specific agency or staff office. Commitments or obligations accounting. This The receipt of an allocation is usually recorded kind of accounting is essential in keeping budget at the intermediate and activity levels. implementation under control. Most developed Commitments. Commitments or obligations, countries keep registers of their transactions at also known as “encumbrances,” are legal pledges each stage of the expenditure cycle, or at least to provide finance. Broadly, a commitment arises at the obligation stage and the payment stage. when a purchase order is made or a contract is Commitments or obligations accounting pro- signed, implying that goods will be delivered or vides the basis for budget revisions. Decisions to services rendered and that a bill will have to be increase or decrease appropriations and the prep- paid later on. The commitment is recorded for aration of cash plans must take into account com- the amount of the obligation for one fiscal year. mitments already made. Budgetary or appropriation accounting. Bud- getary or appropriation accounting consists of Accounting Standards and Standard Setters tracking and registering operations concerning Accounting standards enable accountants to appropriations and their uses. It should cover apply a common approach to their treatment appropriations, apportionment, any increase of financial transactions, thereby ensuring or decrease in appropriations, commitments or comparability of financial reports. Although obligations, expenditures at the verification or the basic principles of accounting are uni- delivery stage, and payments. Budgetary account- versal, their application in public and private ing is only one element of a government account- sector organizations and specific business sit- ing system, but it is the most crucial both for uations is determined by accounting standards. formulating policy and for supervising budget Accounting standards are usually set by national- implementation. level, standard-setting bodies, the ministry Municipal Financial Management 111 of finance, or the office of the auditor general prepares annual financial statements based on in developing countries. In the United States, the information in its accounting records. The the Government Accounting Standards Board external audit is an independent verification of (GASB) sets standards for government account- them. The auditor expresses an opinion concern- ing, and the Financial Accounting Standards ing whether the financial statements present a Board (FASB) sets standards for the private true and fair view of the organization’s financial sector. At the global level, the International affairs. Accounting Standards Board (IASB) sets the International Financial Reporting Standards. Accounting Principles and Practices Similarly, the International Public Sector This section elaborates the basic principles of Accounting Standards (IPSAS) are issued by the accounting and forms the foundation for the IPSAS board, which is a part of the International remaining discussions on accounting. It strives Federation of Accountants (IFAC) (www.ifac to help the reader understand the building blocks .org). Box 3.5 offers a glimpse of the historical of accounting for financial transactions. Simple emergence of accounting. numerical examples illustrate the theory, and The relationship between accounting and audit- exercises help to test one’s grasp of the principles ing. Auditing is a process of independent verifica- discussed. tion of financial processes and statements. Thus, Accounting is based on a few basic principles: auditing commences after the accounts have been prepared and finalized. The audit can be internal • Business entity principle. This principle or external; the verifier can be an internal per- requires that every organization be accounted son (independent of the entities that complete for separately and distinctly from its owners. financial reports) or an external entity, typically It also requires a local government to account a private or central public auditing office. The separately each entity it may control. The rea- purpose of an audit is primarily to provide assur- son behind this is that separate information ance to stakeholders of the credibility of an orga- for each entity is relevant to decisions that the nization’s financial statements. The organization entity would make. Box 3.5 Accounting in Historical Perspective The first known accountants worked for the The man who first wrote down the method, religious authorities in ancient Mesopotamia Luca Pacioli, was a Franciscan friar. Double- (now Iraq), making sure that people paid their entry bookkeeping recognizes that all trans- taxes (of sheep and other agricultural produce) actions have two aspects—a credit and to the temples. In trying to keep track of who a debit—and in a properly constituted set owed what, they had to issue receipts and of books, the two sets of figures always IOUs (“I owe you”—a promise to pay) and balance. For those of a particular turn of accidentally invented writing. mind, the balance has a beauty, maybe even Thousands of years later, in late medieval divinely inspired. Italy, double-entry bookkeeping emerged. Source: http://news.bbc.co.uk/go/pr/fr/-/1/hi/magazine/8552220.stm. 112 Municipal Finances • Objectivity principle. It requires the informa- through the Chart of Accounts, and consolidation tion in financial statements to be supported financial records through the Trial Balance and by evidences (invoice, receipt, etc.) other than Final Accounts. Finally, a brief discussion sheds someone’s imagination or personal opinion. light on the role of information technology in the The reason for it is to make financial state- recording and compilation of accounting infor- ments useful by ensuring that they present mation, with a reference to standard accounting reliable information. software packages and integrated financial infor- mation systems (IFMIS). • Cost principle. This principle requires the Entries. Regardless of the type of organiza- information in financial statements to be based tion or the type of financial transaction, accounts on costs incurred in transactions, consistent are maintained within sets of books called with the objectivity principle. “journals” and “ledgers.” Journals are the books • Going concern principle. This principle requires of original entry, and ledgers are called books of accountants to prepare financial statements final entry. Transactions are initially recorded in under the assumption that the business will journals when they occur and are later posted continue operating. It is not especially relevant to the relevant accounts in the ledgers. Table 3.6 for local governments, as they are expected is a snapshot of a journal in which transactions to exist ad infinitum. However, some of the are entered in chronological order from original enterprises that local governments may estab- vouchers. lish (for example, a local water company) are Accountants using manual systems may still susceptible to failure and closure. write the same entry several times—first in the journal and then into various ledgers. Computer- Accounting Practices ized systems do this by one keyboard entry that This section introduces the reader to the prac- immediately generates all of the required subse- tice of basic bookkeeping, the chart of accounts quent entries automatically. and the various books of accounts, computerized T-accounts. In the simplest form, an account accounting, and the preparation of trial balances. looks like the letter T. When a T-account is used, It discusses the standard formats or templates increases are placed on one side of the account for basic accounting records such as the jour- and the decreases on the other side. That makes nal, ledger, and cash book and summarizes good it easy to determine the balance of the account. principles of maintaining accounting records. The balance of an asset account is the amount This section will help the reader to understand of the asset owned by the entity on the date the the organization of accounting information balance is calculated. The balance of a liability Table 3.6 Sample of a Journal (any currency) # Date Voucher no. Description Debit amount Credit amount 1 8/3/2012 1529 Mr. Brown, property tax payment 400 2 8/5/2012 37245 Mr. Green, water bill payment 125 3 5/6/2012 525 Electricity (street lighting) bill 1,325 4 8/5/2012 6473 Ms. Watt, rental bill payment 250 5 8/7/2012 1530 Mr. Moron, property tax payment 820 Municipal Financial Management 113 account is the amount owed by the entity on the is not a preferred method of accounting. Recall date of the balance. that we have said that any financial transaction In the T-account, the left side is called the debit essentially has two aspects—the debit aspect and side, abbreviated Dr, and the right side is called the credit aspect. Modern systems of accounting the credit side, abbreviated Cr. When amounts recognize both the debit and credit aspects, as in are entered on the left side of an account, they are the example in table 3.6, and record each trans- called debits, and the account is said to be debited. action as an entry into two (or more) separate When amounts are entered on the right side, they ledger accounts. This is called the double-entry are called credits, and the account is said to be accounting system. credited. The difference between the total debits and the total credits recorded in an account is the Principles and Procedures of Double-Entry account balance. In other words, there is a debit Accounting balance when the sum of the debits exceeds the Double-entry accounting, also known as the sum of the credits and a credit balance when the double-entry system of bookkeeping, is a system sum of the credits exceeds the sum of the debits. in which each transaction has two fundamental Figure 3.4 shows the accounts after Mr. Moron aspects, the receiving of a benefit and the giving paid half of his annual property tax dues. of a benefit. Both aspects are recorded in the same set of books. In accounting, the one who receives is a debtor, and the transaction is recorded as a Single-Entry versus Double-Entry Accounting debit on a particular account (dr). The one who Single-entry accounting systems record transac- gives is a creditor, and the transaction is recorded tions line by line, in the order of occurrence, to a as a credit on another account (cr). Under the simple journal or cash book. Small organizations double-entry system, every debit must have a and some local governments follow single-entry corresponding credit and vice versa, and the total accounting. Rather than use modern accounting of the debit entries and the credit entries must systems, they record only one aspect of a transac- be equal. In deciding which account has to be tion in the account books. They may also maintain debited and which account has to be credited, the separate records for some transactions, such as accounting equation below should be used: lists of arrears or receivables, or payables, or asset records (discussed in chapter 6). Those records, assets = liabilities + equity. however, are not integrated into the financial The components of the accounting equation statements and at best are attached as memo items can be summarized in the balance sheet. Table to financial reports. Thus, the single-entry system 3.7 shows a simple balance sheet of an indepen- does not provide a comprehensive picture of the dent housing management unit of a municipality. financial affairs of the entity and for that reason In practice, however, local government organiza- tions tend to have more complex balance sheets Figure 3.4 Example of a T-Account than that one. The fundamental principle of the double- Dr Property tax Cr entry system lies in analyzing the two changes involved in a business transaction and properly $1,640 recording both of the changes in the books of accounts. For the accounts to remain in balance, a debit (dr) change in one or several accounts $820 must be matched with a credit (cr) change in 114 Municipal Finances Table 3.7 Balance Sheet of a Housing Management Unit of a Municipality Assets Liabilities and owners’ equity Cash $5,600 Liabilities Accounts receivable $4,200 Notes payable $10,000 Inventory $9,000 Accounts payable $20,000 Total liabilities $30,000 Fixed assets Owners’ equity Buildings and equipment $7,000 Capital stock $7,000 Land $12,000 Retained earnings $800 Total owners’ equity $7,800 Total $37,800 Total $37,800 one or several other accounts. Therefore, after a Examples of Double-Entry Bookkeeping series of transactions, the sum of all the accounts Let us look at some examples that illustrate the with a debit balance will equal the sum of all the double-entry system of recording business trans- accounts with a credit balance. actions into debit and credit accounts (see tables The main terms used in double-entry account- 3.8 through 3.12). ing are the following: Example 1: The Municipal Company purchased Journal. This is the book in which all transac- $7,000 worth of machinery and paid in cash. tions are recorded at first, using the double-entry Analysis of transaction: Increase in assets format of debit and credit. (equipment) by $7,000, and decrease in assets Ledger. This is the second process, in which (cash) by $7,000. the journal entries are posted to another book Example 2: The company borrowed $15,000 known as a ledger. In the ledger, all the accounts from a bank. are classified and individually maintained. Each Analysis of transaction: Increase in assets ledger (account) has two identical sides—a left (cash) by $15,000, and increase in liabilities (pay- side (debit) and a right side (credit), and all the ables, that is, borrowings) by $15,000. transactions relating to that account are recorded Example 3: The company paid a utility bill of chronologically. $1,000 by check. Trial balance. This is the third process, in Analysis of transaction: Increase in expenses which the arithmetical accuracy of the books of by $1,000 and decrease in assets (cash) by account, at a point in time, is tested by means of a $1,000. trial balance. It is an informal accounting sched- Example 4: The company generated sales rev- ule or statement that lists the ledger account bal- enue the amount of $12,000; 60 percent of sales ances and compares the total debit balance with was received in cash, and 40 percent on credit. the total credit balance. Analysis of transaction: Increase in revenue Final accounts. In the final process, the result (sales) by $12,000, increase in assets (cash) by of the full year’s operational activities is deter- $7,200 ($12,000*60 percent), and increase in mined through final accounts—the “statement assets (receivables) by $4,800. of receipts and payments” (called an “income Example 5: A partner invested $20,000 in the statement” in business accounting) and a balance company. sheet; these are described in detail in the section Analysis of transaction: Increase in assets (cash) on financial reporting. of $20,000; increase in owner’s equity of $20,000. Municipal Financial Management 115 Table 3.8 Purchase of Machinery The Chart of Accounts Ledger entry Debit Credit The chart of accounts is basically a structure of identifying numbers assigned to each account to Equipment $7,000 identify various functional areas or segments of Cash $7,000 the local government. The charts of accounts for local governments are often regulated by higher Table 3.9 Borrowing government entities and issued in laws or ordi- Ledger entry Debit Credit nances, for example, by the ministry of finance or the office of the auditor general. Because the Cash $15,000 numbers are assigned in order, local governments Borrowing $15,000 are allowed, and even encouraged, to add more detailed subaccount numbers into the regulated Table 3.10 Paying a Utility Bill chart of accounts. Ledger entry Debit Credit The chart of accounts in a small municipal- ity may be very simple. The left side of table 3.13 Expenses (utilities) $1,000 shows a general structure of main accounts; the Cash $1,000 right side indicates the structure of the number- ing of various accounts and subaccounts. A lon- Table 3.11 Sales of Goods ger number indicates a lower rank of subaccount. Ledger entry Debit Credit Thus, users such as local governments can add more numbers to the end of some account num- Cash $7,200 bers to enable more specific segregation of var- Receivables $4,800 ious transactions, such as the cost of energy use Revenues (sales) $12,000 by office buildings (account 1501) or by schools (account 1502). Table 3.12 Equity Received Bases of Accounting Ledger entry Debit Credit Accounting systems could be quite different in Cash $20,000 scope and methodology. Accounting of finan- Owner’s equity $20,000 cial transactions can be different depending on the basis of accounting. The “basis” refers to the Table 3.13 Chart of Accounts Accounts Numbers Sample asset accounts { 101 Cash (cash in hand) 105 Bank accounts 150 Buildings 1501 Office buildings Assets 100–199 1502 School buildings 151 Accumulated depreciation Liabilities 200–299 160 Vehicles and equipment Revenues 300–399 170 Investments and stocks Operating expenses 400–499 190 Other assets 116 Municipal Finances timing of recording a financial transaction, that and expenses are deducted in the period when is, whether it is recorded at the time of its occur- they are incurred, whether they are paid or not. rence or at the time of the exchange of cash. Using accrual-basis accounting, an organization The former is called accrual-based accounting, records both revenues and expenses when the and the latter is called cash-based accounting. transactions occur. Accrual accounting is the These are the two main systems, but there are most common method used by businesses and is others that are somewhere in between, which increasingly used by local governments as well. may be called “modified accrual” or “modified For example, if a municipality sells an old truck cash basis.” for $5,000, under the cash method, that amount is not recorded in the books until the buyer pays Cash-based accounting. In cash-based accounting, the money to the municipal cashier or the cashier record keeping works on a strictly cash-in, cash-out receives a check from the buyer. In contrast, under basis. That is, financial transactions are recorded the accrual method, the $5,000 is recorded as rev- only when money actually changes hands: enue immediately, when the sale is complete (the contract is signed, and the buyer takes the truck), • Income is recorded only when money (cash even if the money is only received a few days or or a check) or revenue is actually received. months later. The same applies to  expenses. If Therefore, a tax bill issued is not recorded the water department receives an  electric bill as revenue, only the tax actually paid in and for $1,700, under the cash method, the amount is appearing in cash or in the bank account of the added to the books only after the department has municipality. actually paid the bill. Under the accrual method, • Expenses are recorded only when they the $1,700 is recorded as an expense the day the are actually paid. Thus, an electricity bill bill is received. received is not recorded as an expense until and unless it is actually paid to the electricity Modified accrual-based accounting. Although company. most local governments in developing countries use cash-based accounting, several developed Accrual-based accounting. In the accrual-based countries have been moving toward the use of an accounting system, transactions are accounted as accrual basis. However, a strict accrual basis is revenues or expenses independent of the move- not feasible for many local governments, and thus ment of cash: most of them have been using modified accrual accounting. That generally means that they • Income is recorded when it is earned, even if account all expenditures, regardless of whether the money has not yet been received. cash is paid out, but recognize revenue only when it becomes both available and measurable, rather • Expenses are recorded when they are than when it is earned. The reason for this choice incurred—not necessarily when they are actu- is their limited ability or capacity to collect billed ally paid. and due revenues, such as taxes, water or solid In accrual-based accounting, total revenues waste fees, and so on. and expenses are shown in the financial state- ments whether or not cash was received or paid Trial balance. As discussed, in a double-entry out in a particular accounting period. In other accounting system, every transaction is recorded words, income is reported in the period when with equal debits and credits. As a result, one it is earned, regardless of when it is received, knows that an error has been made if the total of Municipal Financial Management 117 the debits in the ledger does not equal the total part of the work that accountants do in preparing of the credits. Also, when the balances of the the final accounts and are not dealt with in detail accounts are determined, the sum of the debit here. balances must equal the sum of the credit bal- ances. This equality is tested by preparing a trial Manual versus Computerized Accounting balance. When a trial balance does not balance, it Systems indicates an error in the account balances. The The increasing use of computers in accounting error(s) may have been in journalizing the trans- is a significant trend that changed accounting actions, in posting to the ledgers, in determining practices beginning in the latter half of the twen- the account balances, in copying the balances to tieth century. Some Asian countries still rely on the trial balance, or in adding the columns of the manual accounting, often with computer assis- trial balance. tance, such that simple Excel tables are cre- However, a trial balance is not by itself a proof ated to generate reports, but the legally binding of complete accuracy. Some compensating errors records are manual. Box 3.6 shows the manual do not affect the equality of the trial balance ledger of a municipality in Pakistan, with hand- because they affect the debit and credit sides written entries and the fingerprints of illiterate equally. Locating errors and rectifying them are customers. Computerization has changed the Box 3.6 Manual Bookkeeping in Pakistan Photo by Mihaly Kopanyi 2010. 118 Municipal Finances defining characteristic of accounting from a focus aspects of transactions. Often this is mis- on recording financial transactions to serving understood as implementing accrual-based structured information to management and accounting, but that is a completely different stakeholders. approach and more difficult to implement. This interface of accounting with infor- It is better, first, to gain experience working mation systems includes people, procedures, with a cash-based double-entry system and equipment, and their interactions. Modern then enhance the municipal accounting sys- accounting systems are designed to capture tem in a stable and systematic manner. data relating to financial transactions and to generate from these data a variety of financial, • Computerize after strengthening business pro- managerial, and tax accounting reports and cesses. Although computerization of account- visual summaries. These can take different ing procedures improves efficiency, if local forms, from low-cost accounting software pack- governments computerize without changing ages in small organizations to very expensive their underlying processes, the effectiveness and complicated enterprise resource planning of the whole system is reduced, since the inef- software in big ones. These systems computer- ficiencies of the old system persist (“Garbage ize activities such as recording transactions in in garbage out”). Therefore, local govern- the journal and ledger, generating the trial bal- ments embarking on computerization should ance, and preparing the financial statements. In start with a detailed analysis of their financial addition, most accounting software packages procedures and systems and identify ways come  with modules on budgeting, inventory, to improve them before computerizing the billing, and the like, increasing their usefulness process. for municipalities. • Revenues and expenses are recorded at the time they are earned and due. This principle is Good Practices in Maintaining Books of critical in accounting and should be the cor- Accounts nerstone of an organization’s accounting for In this section we summarize practical approaches, transactions. Often financial officers and city experiences, and good practices in local govern- managements are under pressure to paint a ment accounting. rosy picture of their finances. That pressure causes them to recognize revenues much • Basics first. It is important for municipalities before they are actually collected, or not to to make sure that they are able to fulfill basic pay or record expenses when they are due. If accounting functions such as preparing jour- payments due are delayed because of a short- nals and ledgers, posting transactions on a age of cash, or if contractors are paid without daily basis, tallying cash balances at the close delivery of services to prevent budget alloca- of a business day, and the like, which will make tions from being turned back to the ministry of them better prepared to move into advanced finance at the end of the fiscal year, it is equally accounting practices such as accrual-based problematic. These practices distort the true accounting or integrated financial manage- financial position of the local government and ment systems. should be avoided. • Double-entry accounting system first. Local • Final accounts should be comprehensive. The governments should start with cash-based annual financial statements of any entity are double-entry accounting, recording both intended to provide a comprehensive picture Municipal Financial Management 119 of the entity’s financial performance for the • Invest in capacity building and training. Staff stated period. Local governments may have skills and capacities are very important for subsidiaries or related enterprises whose the effective and efficient performance of any finances are not reported in or along with the system. As municipal governments improve financial statements. Again, such practices dis- their accounting systems and processes, it tort the financial picture of the local govern- is important to strengthen the technical and ment. For example, if a municipality owns a managerial skills and capacities of the staff water distribution company, even though the who manage the systems. Junior staff should company is a separate entity, because it is fully be trained in the technical processes of book- owned and controlled by the municipality, its keeping and accounting, and higher-level staff financials should be included and reported as should be trained in financial management part of the municipality’s off-budget financial concepts and practices to equip them to use reports. accounting data to improve the organization’s efficiency and effectiveness. • Final accounts should be prepared in a timely manner. Final accounts should be prepared • Treat accounts as an information system. within a reasonable time after the close of the Accounting forms the backbone of the finan- financial year. Although companies are usually cial record system of any organization. At the required by law to prepare their annual finan- same time, the value of accounting is in man- cial statements within a reasonable period agement’s use of accounting information for (usually three to six months after the close of decision making. In municipal governments, the financial year), local governments often accounting records should not be seen just do not conform to such stringent standards. as historical records of financial transactions. Timely annual financial statements let stake- They should be seen as the organization’s holders know the financial performance for financial information system, providing valu- the past year. If statements are delayed, their able information regarding operational and informational value is eroded. financial efficiencies and conveying the finan- cial performance of the organization to citi- • Accounts should be audited by independent zens and stakeholders. external auditors. An annual audit by indepen- dent external auditors enhances the credibility of financial statements. The auditors’ manage- Detailed Discussion of Accounting Books ment letter or opinion also provides valuable and Financial Statements feedback that should be acted on. Where no This section further addresses the details of definite arrangement exists for annual exter- accounting and bookkeeping practices. In a busi- nal audits, local governments should voluntar- ness, it is normal to encounter a significant vol- ily initiate audits of their financial statements, ume of transactions of various kinds that have in consultation with the Supreme Audit an impact on the entity’s financial position. Institution or with the professional organiza- Recording all of the transactions to the general tion of auditors in their country. To enhance ledger directly may cause mistakes; that is the transparency and accountability, the munic- reason why the process of recording transactions ipality should also publish the audit report is divided into two steps. First, transactions are and opinion in a forum or location where the recorded in the general journal, which is one of community and other stakeholders can access the accounting prime entry books. Second, entries them. from the general journal are posted to the general 120 Municipal Finances ledger, which is composed of the corresponding the T-accounts to help minimize errors in post- accounts (or categories) that constitute the bal- ing corresponding transactions. The second step ance sheet and income statement. To illustrate, let thus is to post the journal entries to the general us assume that a city with double-entry account- ledger using the T-accounts, as shown in table ing collected property taxes of $20,000 and paid 3.15. Notice that every transaction is posted both employee benefits of $5,000 on November 20. as a debit and as a credit, for example, cash debit $20,000 and property tax credit $20,000. Journal General ledger accounts classify accounting All the business transactions are recorded in the data into categories, the chief ones being assets, general journal daily and in chronological order. liabilities, equity, revenues, and expenses. Although the structure and form of a general Table 3.16 is a sample of a general ledger tem- journal vary depending on business needs, the plate that includes columns for the date and recording of some data in a journal is mandatory. explanation of transaction and debit and credit Table 3.14 shows an example of a general journal columns, and shows the balance of the account template with columns for the mandatory data. after the transactions have been posted. The table They are (a) date of transaction; (b) names or ref- shows that at the end of the day on November 20, erence numbers of the accounts that are debited there was a $15,000 cash balance. It is important and credited; (c) a description of the transaction; to notice that “Payroll and employee benefits” is and (d) columns for debits and credits to record a debit account, and thus the positive balance is a the exact amounts of each business transaction. debit, whereas the property tax ledger is a credit account, in which the positive balance is a credit. General Ledger Finally, the sums of balances are equal: $5,000 + The next step after recording all the business $15,000 = $20,000. transactions in the general journal and using the T-accounts is to post the transactions to the gen- Cash Book eral ledger accounts. The cash book is a ledger in which all cash trans- T-accounts also form part of the year-end actions (whether cash received or paid) are posting. During the posting process, one can use primarily recorded according to date. It is both Table 3.14 General Journal Date Description Posting reference Debit Credit Nov. 20 Cash $20,000 Property tax revenue $20,000 Nov. 20 Cash $5,000 Payroll and employee benefits $5,000 Table 3.15 Posting Transactions in Three T-Accounts Cash account Payroll and employee benefit expenses Property tax revenue Nov. 20 $20,000 $5,000 Nov. 20 $5,000 Nov. 20 $20,000 $15,000 Balance $5,000 Balance Balance $20,000 Municipal Financial Management 121 Table 3.16 Sample Ledger Accounts Dr Cash account Cr Date Particulars J/F Amount Date Particulars J/F Amount Nov. 20 Property tax $20,000 Nov. 20 Employee benefits $5,000 Balance $15,000 Dr Payroll and employee benefits (debit account) Cr Date Particulars J/F Amount Date Particulars J/F Amount Nov. 20 Cash $5,000 Balance $5,000 Dr Property tax revenue (credit account) Cr Date Particulars J/F Amount Date Particulars J/F Amount Nov. 20 Cash $20,000 Balance $20,000 Note: J/F denotes Journal or Folio reference (if any). Table 3.17 Sample Cash Book Debit Credit Date Particulars V. No. L. F. Amount $ Date Particulars V. No. L. F. Amount $ Nov. 20 Property xx 20,000 Nov. 20 Employment xx 5,000 tax—cash benefits Balance 15,000 a book of original entry, in which all cash trans- should be written in this column, below the actions are recorded as soon as they take place name. (similar to a journal), and a book of final entry, in V. No. (Voucher Number): The voucher which the cash aspect of all cash transactions is number of each item of receipt and pay- finally recorded, without posting in the ledger as ment is also written (cash memo num- a cash account. The cash book is one of the most ber, payment voucher number, or receipt important accounting records for local govern- voucher number). ments using manual accounting systems. If we were to take the same transactions given L.F. (Ledger Folio): This is the page number above and record them in a cash book, it would of the ledger where the opposite account look like table 3.17. The columns of the cash book has been opened. This will make it possible to locate the account from the ledger. are as follows: Date: The date of the transaction. Amount: The amount of the transaction. When cash is received, the amount is Particulars: The name of the opposite recorded on the debit side, and when cash account against which a cash transaction is paid, the amount is recorded on the credit occurred. A  narration of the transaction side. 122 Municipal Finances Receipts and Payments Account shown on the debit side, and payments are shown The receipts and payments account statement on the credit side. Cash receipts and cash pay- shows a summary of inflows and outflows under ments of both a capital and a revenue nature are the various account heads. It includes head- also recorded here. However, this statement does ings that begin with the cash in hand (opening not include any unpaid expenditures or any unre- balance) at the commencement of the year and alized income related to the period. end with the closing balance at the end of the year. The Financial Statements Local governments prepare a receipt and Local governments with double-entry account- payment account at the end of the year for the ing systems typically prepare four financial purpose of disclosing the results of their financial statements at the end of the fiscal year: Trial transactions. Table 3.18 summarizes the consol- Balance, Statement of Receipts and Expenditures, idated payments and receipts account of a small Statement of Financial Position (balance sheet), municipality. This is a very simple, easy-to-follow and Cash Flow Statement. Local governments snapshot, with sufficiently detailed, specific reve- publish or submit to higher government tiers nue and expenditure items. the Statement of Receipts and Expenditures, Cash Similarly to the cash account, receipts in a Flow Statement, and the Statement of Financial receipts and payments account statement are Position. Table 3.18 Consolidated Receipts and Payments Account for the Year Ended December 31, 2010 (dollars) Receipts Amount Payments Amount Opening Balance: Program Expenses: - Cash 500 Salaries: Program staff 18,300 - Bank 25,500 26,000 Salaries: Admin. staff 11,000 Local contribution 10,250 Road develop. works 27,000 Grants from: Education centers 13,000 - Local agencies 15,500 Health program 9,700 - Foreign agencies 55,700 Other Expenses: - Govt. dept. 22,000 Stationery 2,400 Interest from: Traveling expenses 15,000 - Bank 150 Fuel & maintenance 7,200 - Investment 1,400 Rent 4,200 Loans and Advances: Loans and Advances: Loans taken 45,000 Loans to staff 15,600 Loan refund from staff 10,000 Loans returned 14,800 Advances for administration 5,300 Purchase of land 35,000 expenses Sale of furniture 3,400 Closing Balance: - Cash 1,600 - Bank 19,900 21,500 Total 194,700 Total 194,700 Municipal Financial Management 123 Trial Balance Relation between Ledger Accounts and the Trial The previous section described how transactions Balance are first entered in journals and the cash book Table 3.20 summarizes the City XYZ example. and then posted in the ledger in their respec- The T-accounts shown resulted from entering tive accounts. At the end of the accounting year, the city’s transactions, which were then posted these accounts are balanced. To check the accu- to ledger accounts. From the balances of ledger racy of postings in the ledger, a statement is pre- accounts summarized in table 3.20, the city’s pared containing balances of all ledger accounts trial balance can easily be prepared. Readers on a particular date. A trial balance consists of a should take the time to follow the T-account debit column with all debit balances of accounts balances to reconcile how the trial balance is and a credit column with all credit balances of prepared. accounts. Table 3.19 is a trial balance of City XYZ, Financial Statements prepared for the 2009 fiscal year by February The Statement of Receipts and Expenditures 28, 2010. The balance of the statement tells lit- is a key part of a comprehensive annual finan- tle about the financial position of the city, but cial report, which presents the financial state- it indicates that the credit and debit entries ments of the local government. Each year, every are correct because they are balanced. The governmental organization prepares a Statement next section explains how the trial balance is of Receipts and Expenditures and supports it by developed, based on the balances of the various important analysis (such as the management ledger accounts, using a sample of T-accounts discussion and analysis, or MD&A, in munici- and the balance of the cash account. This exam- pal governments in the United States) and in the ple signifies the importance of checking the notes to the financial statements. accuracy of the posting of transactions and the The Statement of Receipts and Expenditures relationship between the ledgers and the trial reports on total revenues and total expenses. balance sheet. Governmental organizations issue it with a focus on the entire organization, including all kinds of activities and all kinds of revenues and Table 3.19 Trial Balance of City XYZ (dollars) expenditures during the fiscal year. In short, Account title Debits Credits the statement shows how much money they Cash 42,260 have earned (revenue) and how much they Accounts receivable - have  spent (expenses). Table 3.21 is a sample Office supplies 840 income statement prepared in part from the Insurance 2,000 data presented in table 3.20. Added data show opening balance, transfers, and expenses not Payroll & employee benefits 20,500 shown in table 3.20. Consultant fees 350 The statement of activities first establishes Rent 1,000 the change in fund balance as a result of reve- Utilities 250 nue and expenditure balances, then adds the Contributions 50,000 fund balance at the beginning of the report- Property tax 12,000 ing period (fiscal year). The sum of these Business licenses 5,200 two yields the end-of-period fund balance of Totals 67,200 67,200 $40,500. 124 Municipal Finances Table 3.20 City XYZ—T-Accounts and Cash Account Contributions revenue Office supplies expenses Cash account Jan. 10 $50,000 Jan. 20 $240 Jan. 3 $5,200 Jan. 31 $600 Jan. 10 $50,000 Balance $50,000 Balance $840 Jan. 15 $350 Payroll and employee benefits Jan. 20 $240 expenses Insurance expense Jan. 30 $10,000 Jan. 30 $10,000 Feb. 1 $2,000 Jan. 31 $1,000 Feb. 15 $10,500 Feb. 1 $2,000 Balance $20,500 Balance $2,000 Feb. 3 $12,000 Property tax revenue Business licenses revenue Feb. 15 $10,500 Feb. 3 $12,000 Jan. 3 $5,200 Feb. 25 $600 Total $67,200 $24,940 Balance $12,000 Balance $5,200 Balance $42,260 $24,690 Consultant fees Occupancy/rental expenses Jan. 15 $350 Jan. 31 $1,000 Balance $350 Balance $1,000 Utilities expense Accounts payable Feb. 8 $250 Jan. 31 $600 Feb. 25 $600 Balance $250 Balance $0 The Statement of Revenues and Expenditures The Statement of Financial Position (Balance thus gives a sense of how well the local govern- Sheet) ment entity, as a whole, is operating and reports The Statement of Financial Position or bal- the following items: ance sheet reflects the structure of an organi- zation’s assets and the financing sources used • Revenues such as contributions, program fees, to finance those assets, as of a particular date. membership dues, grants, investment income, And as the name indicates, there should be bal- and amounts released from restrictions. ance between its parts because this financial • Expenses such as expenditures, encum- statement reflects the essence of the accounting brances, other financing uses, and all expenses equation, which is of a business type, such as salaries, utilities, and so forth. Expenses can also be reported in assets = liabilities + equity. categories such as major programs, fundrais- The net assets of a government organization are ing, management, and general. equivalent to the net worth (equity) of  a com- • The bottom line resulting from all the revenue mercial organization. The Generally Accepted and expenditure items would be the change in Accounting Principles (GAAP) suggest that the fund balance—the surplus or deficit. net assets be classified as unrestricted (UR), Municipal Financial Management 125 Table 3.21 Statement of Receipts and Table 3.22 shows a sample of a small local Payments (dollars) government entity’s Statement of Financial Revenues Unrestricted Position (balance sheet), with restricted and Earned revenue 17,200 unrestricted, and designated and undesignated Contributions 10,250 assets; it also shows the total assets and the net Program revenues assets. From the table one can make a number of Other sources 3,400 observations. The table includes current assets Interest and dividend income 1,550 (50,000), of which total 40,000 is unrestricted Grants 93,200 and designated for operations (25,000) and for Loans and advances 60,300 Board (15,000). There are 10,000 restricted assets, Released from restricted funds grants from the central government earmarked Total unrestricted revenue 185,900 for specific expenditures. Expenses Program expense 22,700 A Brief Introduction to the Fund Accounting Development expense 27,000 Model in the United States In the United States, municipalities follow an Management and general 29,300 accounting model called “fund accounting,” in Loans and advances 65,400 which revenues and expenditures are reported Other expenses or fund uses 27,000 under different funds (box 3.7). A fund is a fiscal Total operating expenses 171,400 and accounting entity with a self-balancing set Change in fund balance 14,500 of accounts recording cash and other financial Fund balance, beginning of period 26,000 resources. Thus, a local government should have Fund balance, end of period (surplus or deficit) 40,500 only one general fund, but it may have many other types of funds. For example, a city may maintain a separate, special revenue fund for each restricted temporarily restricted (TR), or permanently revenue source, a separate capital projects fund restricted (PR). Local governments in many for each major capital project, and a separate countries must classify their assets according to debt service fund for each issue of outstanding GAAP (as is discussed in more detail in chapter 6). bonds. Figure 3.5 illustrates the components of net assets Table 3.23 shows a balance sheet in fund- and highlights their meanings. based accounting of a U.S. city. The general fund The term “Statement of Financial Position, or in a local government embraces most major gov- balance sheet” is one used by nonprofit organiza- ernment functions, such as police, street mainte- tions. The statement’s purpose is to report assets, nance, sanitation, and so on. The balance sheet liabilities, and net assets as of a specified date. displays financial assets and liabilities, with The Statement of Receipts and Payments depicts memo items on other assets, and it provides deci- the overall status of the organization’s surplus sion makers with very specific information on the (or deficit) by looking at revenues and expenses sources and uses of funds and accrued liabilities. over a period of time (fiscal year). The Statement of Financial Position depicts the overall status of Municipal Accounting in Developing the organization’s finances at a fixed point in time Countries (the end of the fiscal year). It totals all the assets This section discusses problems that local and subtracts all the liabilities to compute overall governments are facing in developing coun- net assets and surplus or deficit. tries in applying modern accounting principles 126 Municipal Finances Figure 3.5 Logical Frame of Net Assets Net Assets - Diagram Undesignated surplus (deficit) Board designated For project Purpose restrictions For cash reserve Unrestricted For acquisition For project For quasi-endowment For function For capital purchases Property and equipment Temporarily restricted Fixed assets net of Time restriction long-term debt For future fiscal year (Restriction imposed Permanently by donors) restricted Purpose restriction Endowment (Restriction imposed by donors) Source: GASB 1999. and practices. Although the discussion briefly double-entry accrual-based accounting for local touches upon current debates on these issues, it governments. focuses on how to address them from a munic- Although it is true that double-entry ipal management perspective rather than on accrual-based accounting is the state-of-the-art policy. method, whether such accounting is feasible in a  local government context also must be con- Cash or Accrual Basis sidered. Just to name a few main impediments: Finding a suitable accounting method is a estimating the value of municipal assets and common issue for municipal governments in establishing opening balance sheets are hard developing countries. Local governments have to do quickly. Therefore, instead of rushing to traditionally applied single-entry cash-based implement sophisticated forms of accounting accounting, as that is the method that central such as full-accrual accounting, it is advisable governments follow. As decentralization pro- to build up the capacities of the accounting gressed and local governments started acquiring system and the staff by first transitioning to a their own identity, the need to adopt account- double-entry cash basis and then perhaps to a ing systems and procedures more suited to modified accrual basis. The experience of the their business requirements became important. local government in preparing accounts using Advisers and consultants often think of local double-entry cash-based accounting will enable governments as being similar to private enter- it to move comfortably to more sophisticated prises and for that  reason have recommended methods. Municipal Financial Management 127 Table 3.22 Government Funds Balance Sheet Current year Total to Unrestricted Prior Municipality date of issue date Operations Board designated Restricted Note year Assets a Current assets 50,000 25,000 15,000 10,000 42,000 Fixed assets 20,000 20,000 20,750 Long-term assets Total assets 70,000 25,000 35,000 10,000 62,750 Liabilities Current liabilities 3,000 3,000 3,500 Long-term liabilities Total liabilities 3,000 3,000 3,500 Net Assets Unrestricted Undesignated 22,000 22,000 26,500 b Board designated 15,000 15,000 Property, plant equip. 20,000 20,000 20,750 Temporary restricted 10,000 10,000 12,000 Permanently restricted Total net assets 67,000 22,000 35,000 10,000 59,250 Total liabilities and net assets 70,000 25,000 35,000 10,000 62,750 a. Restricted for sole use for school health screening program. b. Amount designated for the School Board discretion on teachers training. Box 3.7 The Fund Structure of State and Local Governments in the United States Governmental Funds • Special revenue funds—to account for Purpose: To account for and report govern- and report the proceeds of specific rev- ments’ operating and financing activities enue sources that are restricted or com- financed predominantly through taxes and mitted for specified purposes other than intergovernmental grants. debt service or capital projects (e.g., gas Basis of accounting/measurement focus: tax revenues required to be used for road Modified accrual/current financial resources repairs) There are five kinds of governmental funds: • Debt service funds—to account for and report financial resources that are • General fund—to account for and report all restricted, committed, or assigned to financial resources not accounted for and expenditure for principal and interest reported in another fund (continued next page) 128 Municipal Finances Box 3.7 (continued) • Capital projects funds—to account for Fiduciary Funds and report financial resources that are Purpose: To account for and report resources restricted, committed, or assigned to held by governments as trustees or agents for expenditure for capital outlays, including another party or parties. the acquisition or construction of capital Basis of accounting/measurement focus: facilities, such as buildings and highways, Full accrual/economic resources. and other capital assets There are two kinds of fiduciary funds: • Permanent funds—to account for and report resources restricted in that only • Trust funds, including the earnings on investments, not the — Pension (and other employee bene- principal, may be used to support fit) trusts—to account for and report the reporting government’s programs for resources accumulated to pay pen- the benefit of the government or its sion, health care, and other benefits citizenry (e.g., maintenance of a public to the government’s retired or disabled cemetery or park). employees (e.g., a local government’s pension plan for its employees) Proprietary Funds — Investment trusts—to account for and Purpose: To account for and report govern- report investment pools in which other ments’ activities that are similar to those governments participate (e.g., a state carried out in the private sector and financed government pool open to local govern- predominantly through user charges. ments within the state) Basis of accounting/measurement focus: — Private purpose trusts—to account Full accrual/economic resources for and report resources held for indi- There are two kinds of proprietary funds: viduals or external organizations (e.g., a scholarship fund for employees’ • Enterprise funds—to account for and re- children, funded by a donation from a port business-type activities that serve citizen) the public at large (e.g., an electric • Agency funds—to account for and report utility) resources held on a short-term basis on • Internal service funds—to account for behalf of individuals, organizations, or and report goods and services provided other governments (e.g., taxes collected to departments of the same government on behalf of another government). These (e.g., a centralized purchasing function or funds have only assets and liabilities—no motor pool). revenues or expenses. Source: http://media.wiley.com/product_data/excerpt/01/EHEP0015/EHEP001501-2.pdf. Accounting for Operations and Maintenance management. Just as asset creation is critical to Costs of Fixed Assets building up the local government’s capacities Most local governments pay a great deal of atten- for delivering services, asset maintenance and tion to their capital budgets and to asset cre- replacement are necessary for sustaining the ation; often very little attention is paid to asset service delivery capacities created. Therefore, Municipal Financial Management 129 130 Table 3.23 Example of a Government Funds Balance Sheet (USD thousands) Health and Other Total urban dev. Community Route 7 government government General programs redevelopment construction funds funds Assets Cash and cash equivalents 3,418.5 1,236.5 5,606.8 10,261.8 Investments 13,262.7 10,467.0 3,485.3 27,215.0 Receivables (net) 3,644.6 2,953.4 353.3 11.0 10.2 6,972.5 Due from other funds 1,370.8 1,370.8 Receivables from other governments 119.1 1,596.0 1,715.1 Liens receivables 791.9 3,195.7 3,987.6 Inventories 182.8 182.8 Total assets 9,408.6 7,504.7 13,616.0 10,478.0 10,698.3 51,705.6 Liabilities and Fund Balances Liabilities: Accounts payable 3,408.7 130.0 190.5 1,104.6 1,074.8 5,908.6 Due to other funds 25.4 25.4 Payable to other governments 94.1 94.1 Deferred revenue 4,250.4 6,273.0 250.0 11.0 10,784.4 Total liabilities 7,753.2 6,428.4 440.5 1,115.6 1,074.8 16,812.5 Fund balances: Reserved for: Inventories 182.8 182.8 Liens receivables 791.9 791.9 Encumbrances 40.3 41.0 119.3 5,792.6 1,814.1 7,807.3 Debt service 3,832.1 3,832.1 Municipal Finances Other purposes 1,405.3 1,405.3 Unreserved, reported in: - General fund 640.3 640.3 Special reserve funds 1,035.3 1,330.7 2,366.0 Capital project funds 13,056.2 3,569.8 1,241.3 17,867.3 Total fund balances 1,655.3 1,076.3 13,175.5 9,362.4 9,623.5 34,893.0 Total liab & fund balance 9,408.5 7,504.7 13,616.0 10,478.0 10,698.3 51,705.5 Amounts reported for government activities are different, because: Capital assets used in governmental activities are not financial resources and therefore are not reported in the funds. 161,082.7 Municipal Financial Management Other long-term assets are not available to pay for current period expenditures and therefore are deferred in the funds. 9,348.9 Internal service funds are used by management to charge the cost of certain activities such as insurance and telecom to 2,994.7 individual funds; the assets and liabilities of the internal service funds are included in governmental activities in the statement of net assets. Long-term liabilities, including bonds payable, are not due and payable in the current period and therefore are not reported (84,760.5) in the funds. Net assets of governmental activities 123,558.8 Source: Authors, adapted from Freeman and Shoulders 2000. 131 local government financial management should analytic tools. The section introduces some of the include adequate provision for the operation, basic concepts in cost accounting, such as stan- maintenance, and replacement of the assets they dard costs, cost centers, direct and indirect costs, have created. From an accounting perspective, costing of overhead, and activity-based costing. this would require that the municipality make Some advanced management accounting tech- adequate provision for operating costs (based niques, such as break-even analysis, are briefly on the data generated through its cost control outlined. systems) and for the depreciation of fixed assets. Chapter 6 discusses asset management in detail. Cost Accounting and Cost Management Cost accounting provides key information for Weaknesses in Accounting Standards and managers, helping them both in operation deci- Practices sions and in analyzing operational efficiency. In While there is no disagreement that reforms a cost accounting system, the costs of providing are necessary to improve the quality of munici- services are managed by measuring each service pal accounting, a common impediment to such separately, enabling the manager to moni- reforms is the absence of well-defined accounting tor the cost of delivering particular services standards and procedures for local governments such as water, solid waste management, hous- in most developing countries. Usually account- ing, education, or health care. Cost accounting ing standards and procedures are designed for gives the decision maker analytical information national governments, with local governments that can be used to increase the efficiency of expected to follow along. In such cases the util- operations. ity of the standards for local governments is often reduced because they are not fully responsive Role and importance of cost accounting to local government requirements, especially in of service delivery. While financial account- areas such as cost accounting by service and local ing such as this chapter has discussed helps function, accounting of billing for and collection an organization prepare financial statements of fees and charges, local pension funds, and the that give an aggregate view of its revenues and like. Hence, wherever no specific standards and expenses and the resultant surplus or deficit, procedures exist for local government account- cost accounting helps an organization obtain ing, special efforts should be made to define them a detailed view of the underlying costs that by taking into consideration the requirements of flow into the aggregate financial reports. Such local governments. Fixing such weaknesses by detailed cost information can be used to control reforming the accounting system is full of chal- costs and to determine appropriate pricing for lenges, in particular when a computerized, auto- products and services. In a local government, mated accounting system is replacing a manual cost accounting information provides valuable system. insights to the finance officer, the city manage- ment, and the managers of specific service enti- Using Accounting Information for ties on the true costs of providing services. It Management Decision Making helps the city government to estimate the extent This section discusses using accounting infor- of cost recovery and sustainability of a service by mation to support management decisions. Some comparing the cost of operating it with the fees of the material will be revisited in subsequent and charges received for it. chapters (including chapters 5, 6, and 8). Here Cost accounting information helps the finance we focus only on cost accounting and on some officer control costs and make operations more 132 Municipal Finances efficient, reducing pressure on the city’s bud- cost objects, such as products and services, on the get and avoiding the politically difficult steps basis of the activities undertaken to produce each of raising user fees and taxes. Cost accounting one. For this purpose, the cost accounting systems systems are forward looking and therefore help group activities into cost pools and use them as the finance officers model future costs and prices and basis for assigning costs. analyze the financial position of the entity in dif- For example, a city government may use the ferent scenarios. However, cost accounting sys- same trucks, loaders, labor, and equipment for tems are still in their infancy in local governments maintaining parks and sports, health, and school in most developing countries. They need the facilities. Hence it may set up a maintenance attention of policy makers. For instance, munici- pool fund and allocate the cost of trucks (fuel, pal accounting systems derived from central gov- labor, repair) by distance in kilometers of trans- ernment accounting do not support accounting of port used. It may allocate the cost of loaders and the specific costs of basic services such as water, other equipment based on the time of use for each solid waste management, or public transport. The maintenance project in the areas covered. The discussions below give a broad overview of some logic of ABC systems is that the basis for the allo- of the relevant cost concepts. cation of costs is usually the key cost driver, and so the allocation leads to more accurate costing of Basic cost accounting techniques. Cost activities. Though an elaborate discussion about accounting systems can differ based on the nature advanced cost accounting is beyond the scope of an entity’s operations. In an entity that carries of this chapter, it is useful for local government out mass production with common work (such executives to understand that such sophisticated as most municipal services, from solid waste techniques exist and make accounting of service disposal to water and sanitation), the system of delivery costs more accurate. In that way they can process costing is adequate. In contrast, if an orga- help improve the quality of municipal financial nization carries out specific services designed for management. individual customers (such as information tech- nology or construction work), a job order cost Cost centers and responsibility accounting. accounting method is often used. Although these As discussed above, one objective of a cost cost accounting systems are useful by themselves, accounting system is to break down the cost details they have deficiencies, especially when shared of a product or service, so that management can costs are involved (i.e., various departments or identify costs that can be controlled. An uncon- processes share a service), making it difficult to trollable cost is one the manager cannot influence. apportion the costs of jobs and processes accu- For example, in a municipal government, office rately. Such deficiencies have led to the introduc- expenses are a controllable cost, but insurance tion of activity-based costing. premiums on the city’s trucks are not controllable because they are not set by the city government. Activity-based costing. Activity-based costing Even then, the manager might save costs by com- (ABC) systems refine costing systems by focusing petitive selection of insurance companies. on individual activities as the fundamental cost The concept of controllable costs and expenses objects. An activity is an event, task, or unit of work provides the basis for a responsibility accounting with a specified purpose, for example, removal of system, in which managers are responsible for the wastes from a part of a city, registration of births costs and expenses that fall under their control. and deaths, and so forth. ABC systems calculate Prior to each reporting period, the organization the costs of individual activities and assign costs to develops plans that specify the expected costs Municipal Financial Management 133 or expenses under the control of each manager. or production at which total variable and fixed Those plans are called responsibility accounting costs are equal and the business makes neither budgets. The responsibility accounting system a profit nor a loss. That is the break-even point. accumulates costs and expenses to include in The calculation depends on carefully distinguish- timely reports to managers about the costs for ing costs that are variable (that change when the which they are responsible. The reports are per- output changes) and costs that are fixed (that are formance reports and compare actual costs and not directly related to the volume of output). The expenses to the budgeted amounts. Managers simplest computation of the break-even point is use performance reports to focus their attention break-even point = total fixed costs / on specific, actual costs that differ from budgeted (sales − variable costs). amounts and decide corrective actions to bring the costs down. In local governments, financial planning is of major importance. Breakeven analysis reveals Techniques for Efficient Management Decision how revenue and costs vary with a change in Making service level, that is, what effect a change in a Accounting is the language of any business, but service or the mix of services will have on reve- increasingly accounting is also assuming greater nues. Ideally, the goal is to find a level of output importance in the management of local govern- at which the government will reach breakeven— ments because they are providing services to their that is, total revenues are equal to or exceed total citizens from limited resources. Setting up basic costs. accounting systems allows the efficient recording Municipal services should approach cost and compilation of financial data; the data need recovery rather than produce extra revenues. to be analyzed, structured, and presented to make However, moving around breakeven may risk them useful for management decision making. generating a deficit, raising a demand for subsi- Several financial analysis techniques help man- dies, or undermining the sustainability of services. agements to draw meaningful conclusions. The Thus, break even analysis is also a useful tool to techniques include ratio analysis, trend analysis, measure which programs are self-supporting and financial modeling, and ranking investment proj- which are subsidized or need to be. By studying ects using capital budgeting techniques, break- the relationships among costs, service volume, even analysis, and other methods. We will discuss and revenue, municipal management can better break-even analysis, one of the simplest tech- approach many planning decisions. Break-even niques, which can be used in almost any orga- analysis can also be useful when city managers nization. Other techniques will be discussed in are making lease-or-buy decisions or are deal- chapters 5 through 8. ing with other common issues of day-to-day city management. Break-even analysis. Break-even analysis is a Figure 3.6 shows a break-even chart, a graph- technique widely used in business settings, espe- ical representation of costs C at various levels of cially by production management and manage- output, together with the variation of income A ment accountants. It is a helpful tool in deciding from sales or fees. The intersection of the two whether or not to purchase equipment, for exam- lines represents the break-even point, at which ple, a compactor truck, because it computes how neither profit nor loss is made. Thus, the entity is close the operation would be to its break-even facing with losses as long as the volume of out- level with and without the truck. Break-even put or sale is less than Q0 and begins to realize analysis simply calculates the level of service net revenues when output or sales exceed Q0. 134 Municipal Finances Figure 3.6 Break-Even Analysis A e € om c In C P Variable costs B Fixed costs 0 Loss Profit Output Q Q0 The reason is that services always have an initial require information about an entity. Financial investment, which generates a fixed cost even if reports are means of communicating to the users there is no production. of financial information material that they use to make choices among alternative uses of scarce resources. The objective stems largely from the Financial Reporting needs and interests of those users, who lack the This section builds on previous discussions of ability to gather the information they need and accounting to take it to the next level, using therefore must rely, at least partly, on the entity’s accounting information to compile financial financial reports. Financial reports are also means reports. Before the content and techniques of pre- of performance monitoring (the subject of paring financial reports, the importance of finan- chapter 8). The potential users of financial reports cial reporting for transparency and accountability and their information needs include the following: in the public sector is addressed. Also touched • Investors. For companies, investors are inter- on are the roles of participants in the reporting ested in the entity’s ability to generate net cash regime, including higher-level governments, line inflows because their investment decisions ministries, the parliament and other legislative relate to the amounts, timing, and uncertain- bodies, oversight institutions such as the auditor ties of those cash flows. general, and the citizens themselves, as well as financial reporting as a tool to communicate with • Creditors. Creditors provide financial capital to stakeholders. a local government by lending it cash (or other assets). Like investors, creditors are interested Financial Reporting: Concepts and Practice in the amounts, timing, and uncertainty of a Financial reporting provides a consolidated set of municipality’s future cash flows. To a creditor, information to a wide range of stakeholders that a borrower is a source of cash in the form of Municipal Financial Management 135 interest, repayments of borrowings, and price financial reports also need to consider pertinent premium of debt securities. information from other sources, such as informa- tion about general economic conditions or expec- • Suppliers. Suppliers provide goods or services tations, political events and the political climate, rather than financial capital. They are inter- and the industry outlook. ested in assessing the likelihood that what a Users of financial reports also need to be municipality owes them will be paid when due. aware of the characteristics and limitations of • Employees. Employees provide services to the information in them. To a significant extent, a municipality, and so they are interested in financial reporting is based on estimates, rather information to assess its continuing ability to than exact measurements, of the financial effects pay salaries and wages and provide incentive on entities of transactions and other events and payments, retirement, or other benefits. circumstances. Hence users of financial report- ing have to read the financial statements as a • Citizens. To citizens, a municipality is a source whole, especially the notes and annexes in which of services. Citizens are interested in assessing the bases and assumptions for the estimates are the ability of the local government to continue described. providing those services, as they have a long- term involvement with the municipality and Characteristics of Good Financial Reporting depend on it for services. According to the Financial Accounting Standards • Governments, their agencies, and regulatory Board (FASB), the following are the qualitative bodies. Governments and their agencies and characteristics required in good financial report- regulatory bodies are interested in municipal ing (FASB 2000; Skousen et al. 2000): activities because they are responsible in vari- • Relevance. To be useful in making investment, ous ways for ensuring that economic resources credit, and similar resource allocation deci- are allocated efficiently. They also need sions, information must be relevant to those information to help in regulating activities, decisions. Relevant information can make a determining and applying taxation policies, difference in the decisions of users by help- and preparing national income and similar ing them evaluate the potential effects of statistics. past, present, or future transactions or other The above categories of information users events on future cash flows (predictive value) and their requirements are applicable in both or confirm or correct their previous eval- the private and public sectors, although the kind uations (confirmatory value). Timeliness— of information required of a municipal govern- making information available to decision ment may be different than what is required makers before it loses its capacity to influence from a business enterprise. For example, the decisions—is another aspect of relevance. national government would be interested in how efficiently the municipality has used inter- • Faithful representation. To be useful in making governmental transfers to meet development investment, credit, and similar resource allo- requirements, whereas the citizens may be more cation decisions, information must be a faith- interested in knowing about the money spent on ful representation of the real-world economic local development works. phenomena that it purports to represent. The Financial reporting is but one source of infor- phenomena represented in financial reports mation to permit decision making. Users of are economic resources and obligations and 136 Municipal Finances the transactions and other events and circum- economic phenomena. Consistency refers to stances that change them. To be a faithful rep- use of the same accounting policies and pro- resentation of those economic phenomena, cedures, either from period to period within information must be verifiable, neutral, and an entity or in a single period across entities. complete. Comparability is the goal; consistency is a Verifiability implies that different knowl- means to achieving that goal. edgeable and independent observers would reach general consensus, although not neces- • Understandability. Understandability is the sarily complete agreement, either quality of information that enables users (a) that the information represents the eco- who have a reasonable knowledge of busi- nomic phenomena that it purports to rep- ness and economic activities and financial resent without material error or bias (by accounting, and who study the information direct verification); or with reasonable diligence, to comprehend its (b) that the chosen recognition or measure- meaning. Relevant information should not be ment method has been applied with- excluded solely because it may be too com- out material error or bias (by indirect plex or difficult for some users to understand. verification). Understandability is enhanced when informa- To be verifiable, information need not be tion is classified, characterized, and presented a single-point estimate. A range of possible clearly and concisely. amounts and the related probabilities can also • Materiality. Information is material if its be verified. omission or misstatement could influence Neutrality is the absence of bias intended the resource allocation decisions that users to attain a predetermined result or to induce make on the basis of an entity’s financial a particular behavior. Neutrality is an report. Materiality depends on the nature and essential aspect of faithful representation amount of the item, judged in the particular because biased financial reporting informa- circumstances of its omission or misstatement. tion cannot faithfully represent economic A financial report should include all informa- phenomena. tion that is material in relation to a particular Completeness means including in financial entity—information that is not material may, reporting all information that is necessary for and probably should, be omitted. To clutter a faithful representation of the economic phe- financial report with immaterial information nomena that the information purports to rep- risks obscuring more important information, resent. Therefore, completeness, within the thus making the report less useful in decisions. bounds of what is material and feasible, con- sidering the cost, is an essential component of • Benefits and costs. The benefits of financial faithful representation. reporting information should justify the costs of providing and using it. The benefits of • Comparability. Comparability, including con- financial reporting information include bet- sistency, enhances the usefulness of financial ter investment, credit, and similar resource reporting information in making investment, allocation decisions, which in turn result in credit, and similar resource allocation more efficient functioning of the capital mar- decisions. Comparability is the quality of kets and lower costs of capital for the economy information that enables users to identify sim- as a whole. However, financial reporting and ilarities in and differences between two sets of financial reporting standards impose direct Municipal Financial Management 137 and indirect costs on both preparers and users for reporting to the municipality’s external stake- of financial reports, as well as on others such as holders are several forms of internal reporting. auditors and regulators. Thus, standard setters Various departments prepare periodic financial seek information from preparers, users, and reports and submit them to the financial officer other constituents about what they expect the and the mayor for their internal review (weekly, nature and quantity of the benefits and costs of monthly, and quarterly). The local government proposed standards to be, and consider in their also prepares and submits reports to higher levels deliberations the information that they obtain. of government reporting on the use of fiscal trans- fers and other resources received. These reports Financial Statements in Action—Policy serve the purposes of monitoring bodies and are Perspective not usually shared with other external stake- The financial statements of any organization are holders. Box 3.8 summarizes a case in Bangalore, the income statement, the balance sheet, and the India. cash flow statement. We have introduced them Budgetary reporting. The executive reports in the context of accounting, and we now discuss to the city council regarding progress in budget them from a policy perspective. execution during the course of a financial year in Local governments prepare various reports monthly budgeted/actual reports and variance for different purposes and target audiences: analyses. These reports are also internal, help- Management/internal reporting. In addition ing the city council know whether the approved to the annual financial statements that are used budget is being executed in accordance with Box 3.8 PROOF–A Campaign for Transparency and Accountability in Bangalore The Public Record of Operations and to assess municipal undertakings across the Finance (PROOF) campaign was launched city, and public discussions. These include in Bangalore, India, in July 2002, by four comparing the city’s Revenue and Expenditure NGOs—Public Affairs Centre, Janaagraha, Statement to original budget figures and Centre for Budget and Policy Studies, and the balance sheet, with detailed information Voices. PROOF is a campaign for transpar- about current and long-term assets and short- ency in municipal governance, conducted in and long-term liabilities. close partnership with the local government Performance indicators were initially devel- to enable government and citizens to work oped for two sectors: education, to assess together and ensure that public money is the performance of Bangalore schools, being used for public goods. and health, to assess the performance of PROOF requires that municipal finances the city’s government hospitals. The aims related to public services are published and of the reviews are to improve public finan- scrutinized by organized groups and the public cial accountability and performance, bring at large. It focuses on three areas: obtaining government and the public closer together, quarterly financial statements from the gov- and provide benchmarks to develop and ernment, developing performance indicators reshape public expenditure priorities. Source: http://ww2.unhabitat.org/cdrom/TRANSPARENCY/html/2_6.html. 138 Municipal Finances plans and whether revenues and expenditures Formats and Standards in Municipal Financial are being realized in accordance with budget Reporting—Good Practice Examples projections. Variants of budget reporting include In the United States, the Government Accounting program reporting and performance reporting. Standards Board (GASB) sets the financial report- Program reporting describes the execution of a ing standards for municipal governments. In June specific program (for example, school rehabili- 1999, GASB issued Statement 34 “Basic Financial tation). Performance reporting records progress Statements—and Management Discussion and against plans or measured performance targets Analysis—for State and Local Governments” (such as collection of arrears). These reports are (GASB 1999). GASB 34 brought about a signifi- discussed in detail in chapter 8. cant change in the format and content of local Citizen reporting. Citizens are among the most government financial reporting. It was the result important stakeholder groups and have a key of a continuous effort by standard setters in the interest in knowing the state of affairs of their country to fully meet the needs of financial state- local government. For example, how well does ment users. the city government deliver services, and how Box 3.9 describes how the government of South efficiently does it use resources (including the Africa has achieved significant progress toward taxes collected) for the development of the com- standardized municipal financial reporting. munity? Quite often, however, citizens find it dif- Each local government prepares two govern- ficult to understand formal financial statements mentwide financial statements, statement of net and audit reports prepared for professionals. To assets and statement of activities, that integrate bridge the gap, proponents of social accountabil- the revenues and expenses of governmental ity, such as some civic organizations, have started activities, as explained previously. These state- to encourage municipalities to simplify compli- ments provide an aggregate picture of the reve- cated financial statements. Box 3.8 summarizes nues and expenditures of the local government the example of the PROOF transparency initia- as a whole. tive in India. The organization disseminates bro- Fund financial statements provide detailed chures, briefs, and leaflets that use nontechnical reporting on specific economic activities car- language and easy-to-understand formats such ried out by a local government, as explained as charts, pictograms, and simple tables with key above and shown in table 3.23. These activities numbers. Similar initiatives are taking place in are grouped together and reported in eight dif- such countries as Nepal and Ghana. ferent fund financial statements. For example, the enterprise fund accounts for revenues and Municipal Financial Reporting Formats expenditures relating to any commercial-type This section summarizes financial reporting operations (such as water and sewer service or in the context of municipal government pol- local bus service) run by a city government with icy. It focuses on content such as the reporting user charges or fees. Similarly, there are fiduciary of receipts, payments, assets, and liabilities and funds, agency funds, special revenue funds, and the the formats and standards used. It discusses pension fund, which is a trust fund outside the good practices in municipal financial reporting, municipal budget. including linking it with performance reporting Management discussion and analysis (usu- (discussed more in chapter 8). Some problems ally referred to as “MD&A”) is a unique aspect of that local governments in developing coun- the reporting requirements introduced by GASB tries face in the preparation of comprehensive 34. MD&A provides an analytical overview of a financial statements are also addressed. government’s activities through the year and an Municipal Financial Management 139 Box 3.9 Municipal Finance Management Act, South Africa The National Treasury of the Government of conditional grants, subsidies, technical guide- South Africa has played a pivotal role in the lines, policy advice, and the placement of inter- introduction of financial management reforms national advisers with some municipalities. across government since 1994 and in local The strategy takes into account the differing government since 1996. The reform initiative capacities of municipalities to implement the has been implemented through the Municipal reforms, as well as the need for institutional Finance Management Act No. 56 of 2003 strengthening, building municipal capacity, (MFMA), which is supported by the annual and improving municipal consultation, report- Division of Revenue Act. These pieces of ing, transparency, and accountability. legislation have been aligned with other local The MFMA aims to modernize budget, government legislation, such as the Structures accounting, and financial management prac- Act, Systems Act, and Property Rates Act and tices, placing local government finances on a their regulations, to form a coherent package. sustainable footing to maximize the municipal- The national treasury’s primary objective ities’ capacity to deliver services. It also aims was to secure sound and sustainable manage- to put in place a sound financial governance ment of the financial affairs of government— framework by clarifying and separating the national, provincial, and local. That includes roles and responsibilities of the council, mayor, regulatory interventions, manuals, guidance, and other officials. The MFMA is required by circulars, workshops, seminars, training, the country’s constitution, which obliges all internship programs, and hands-on support three tiers of government to be transparent to municipalities. The national treasury has about their financial affairs. It also forms an developed a phased implementation strat- integral part of the broader reform package for egy of financial and technical support for local local government outlined in the 1998 White governments, based on the MFMA, including Paper on Local Government. Source: http://mfma.treasury.gov.za/Pages/Default.aspx. introduction to the figures and results reported in include its performance in the achievement of the financial statements. It provides an analysis its development goals and programs. The impor- of the government’s financial activities based on tance of such a results-based approach to govern- currently known facts, decisions, or conditions ment activities is now being recognized all over and helps users assess whether the government’s the world, and several initiatives on performance financial position has improved or deteriorated reporting are being introduced. For example, the during the year. Service Efforts and Accomplishments reporting initiative of GASB in the United States attempts Links between Performance Reporting and to introduce standards for performance reporting Financial Reporting along with the standards for financial reporting It is important to remember that finance con- for local governments. The goal is to assist users stitutes only one aspect of a local government’s of the information (including citizen groups, state responsibilities and performance. Hence report- legislators, city council members, and other inter- ing of a government’s activities should also ested persons) to evaluate the efficiency of the 140 Municipal Finances services that governments provide and to assess Types of Audits governments’ effectiveness in achieving their A financial audit is a historically oriented, inde- goals and objectives. Chapter 8 discusses perfor- pendent evaluation performed for the purpose mance measurement in more detail. of certifying the fairness, accuracy, and reliabil- ity of the financial data. Financial audits focus on whether financial statements prepared by Auditing an entity reflect the financial position of the Auditing helps to ensure that funds are not subject organization. Auditors examine the accounting to fraud, waste, and abuse or to error in reporting. treatment of various transactions in the entity’s Auditing in the public sector also helps to ensure financial statements and whether the informa- that the entity carries on its business in compli- tion disclosed in the financial statements reflects ance with the established rules and procedures of the underlying transaction. This is the most com- public financial management. Without going into mon form of audit. the technical details of the auditing process, the A compliance audit focuses on whether the discussion in this section focuses on the use of entity complied with certain rules and proce- audit reports as tools of accountability, the differ- dures regarding the spending of money. This ences between various types of audits and their kind of audit is usually done in the public sector, relationships, and the audit models in the public so that the auditor verifies the compliance of the sector. It also addresses the meaning and signifi- entity with the government’s established rules cance of audit opinions, the various types of audit and procedures for financial management. opinions, and audit standards. A management audit is a future-oriented, independent, and systematic evaluation of the Auditing—Basic Concepts and Practices activities of the organization prepared to help Auditing is a systematic process of objectively it attain its objectives. A management audit is obtaining and evaluating evidence regarding asser- also called a “performance audit.” It evaluates tions about economic actions and events. It consists the organization’s performance against its stated of a series of sequential steps, including evaluation plans and analyzes the reasons for any variance of internal controls and testing the substance of in performance, with the aim of drawing lessons transactions and balances. The auditor communi- for the future. cates the results of his or her audit work to inter- The auditor’s findings are communicated ested users through the audit report. The findings through the audit report. The audit report is the of the auditor are expressed in the form of an opin- culminating step in the audit process, and express- ion concerning the fairness with which the finan- ing an audit opinion is the auditor’s overriding cial statements present the organization’s financial goal. The audit report concisely describes the position, operating results, and cash flows. auditor’s responsibility, the nature of the exami- Auditing in the private sector is used largely nation, and the auditor’s findings. The form of the to ensure that the financial statements issued by audit report is standardized in many countries. a firm fairly reflect its financial position. In the The introductory paragraph identifies the public sector, other objectives are equally impor- financial statements covered by the audit report tant, such as compliance with the rules and pro- and clearly differentiates management’s respon- cedures for public expenditures, and are included sibility for preparing the financial statements in the scope of the audit. Another purpose of from the auditor’s responsibility for expressing auditing in the public sector is ensuring that pub- an opinion on them. The scope paragraph states lic funds are not misused or misappropriated. whether the audit was conducted in accordance Municipal Financial Management 141 with accepted auditing principles. The opinion contain material differences from accepted paragraph conveys the auditor’s findings. accounting standards and practices. Materiality For instance, an audit report issued by the is judged according to whether the differences company KPMG to the City of Roanoke, Virginia, might affect the conclusions drawn by users of in the United States, illustrates the structure, the financial statement. details, and depth of an audit report and the mes- Adverse opinion. An adverse opinion is sages and issues discussed with management. expressed when the financial statements contain One interesting finding was the following: serious differences from accepted accounting standards. In rendering an adverse opinion, the The City calculates its allowance for uncol- auditor states that the financial statements do not lectible receivables based on historic data fairly present the entity’s financial position and and specific account analysis. We evalu- results of operations, in accordance with account- ated the key factors and assumptions used ing standards and principles. to develop the allowance, including pos- sible management bias in developing the The standards and practices of audit reports estimate, in determining that the allowance and opinions described above are not found for uncollectible receivables as of June 30, in many developing-countries’ public sectors. 2011 is reasonable in relation to the financial The audits are not risk based, and the auditor’s statements of the city. (Roanoke City findings do not make any distinctions between Department of Finance reports 2011, http:// material findings and nonmaterial findings. The www.roanokeva.gov/85256A8D0062AF37 auditor simply lists his observations in the form / C u r r e n t B a s e L i n k / N 2 7 W 8 P B L 2 94 of audit paragraphs or audit queries and gives LGONEN) them to the audited entity at the conclusion of the fieldwork. That is considered a preliminary We can draw two lessons from this statement: audit report, and the audited entity is expected First, the city carries out a careful analysis and to provide suitable replies to the audit queries makes some assumptions in estimating the uncol- raised within a specified time period. If the lectible receivables (arrears). Second, the source auditor is satisfied with the replies received, the data, the analysis procedure, and the assumptions audit paragraphs or audit queries are dropped, are evaluated by the auditor as adequate. and a final audit report is prepared and submit- ted to the audited entity. In that system, the audi- Types of Audit Opinions and Their Significance tor does not express an opinion on the financial Upon completion of the audit fieldwork, the audi- statements of the entity but instead carries out tor must decide whether or not an opinion can be a “100 percent” check on all financial transac- rendered. If an opinion cannot be rendered, the tions from both financial and compliance points auditor must clearly disclaim an opinion and give of view. the reasons for the disclaimer. If an opinion is ren- dered, the auditor must decide whether to issue Municipal Audit Practices an unqualified, a qualified, or an adverse opinion. This section discusses the role of audits in local Unqualified opinion. An unqualified audit governments with specific reference to the issues opinion expresses the auditor’s belief that the developing countries face. It centers on the weak- financial statements present a true and fair view nesses in public sector audit systems in devel- of the entity’s financial position. oping countries, the impediments to regular and Qualified opinion. The auditor expresses timely audits, and the role of the supreme audit a qualified opinion if the financial statements institutions (SAIs) in public sector auditing. 142 Municipal Finances External audits play a significant role in audit agencies more often than not carry out com- enhancing the accountability of municipal gov- pliance audits, undertaking financial audits often ernments, in addition to providing valuable feed- poses a challenge to their knowledge and skills. back to city management on the quality of the Because the agencies frequently have the respon- city’s financial management. However, the expe- sibility to audit numerous agencies of higher-level riences in most developing countries indicate governments, they often find it difficult to program that audits do not always play the critical part that municipal audits within a reasonable period after they are expected to play for a variety of reasons. the close of the financial year. A possible solution to this issue is to involve private sector auditors in Delayed audits carrying out the external audits of municipalities, In most developing countries, government enti- as in the case in Bangladesh summarized in box ties such as supreme audit institutions or the 3.10. The practice has been successful in several office of the auditor general audit municipalities. countries but is not widespread. Governments These agencies often are responsible to audit a and supreme audit institutions should establish large number of ministries, departments, central policies and frameworks (including audit stan- government agencies, and provincial govern- dards for municipalities) to facilitate the engage- ments. As a result, municipal audits often have ment of private sector auditors. a lower priority than others and are often con- ducted well after the close of the financial year. In Audit Follow-Up fact, in quite a number of cases, audits have been Audit follow-up is a critical part of the audit pro- delayed by years. cess. In the management letter, the auditor points out specific issues that the city management needs Compliance audits to rectify to improve the quality of its financial man- External audits carried out by public sector audi- agement and reports. City executives must respond tors are often compliance audits in which the to the audit observations diligently and have them auditors verify whether the entity’s expenditures rectified by the time of the subsequent audit. In the are in accordance with the government’s rules public sector, it often does not happen as expedi- and procedures. Although verifying that is impor- tiously as desired. The reason is that executives tant, municipal governments also require audits to often take audits as a criticism of their actions provide assurances on their financial statements, and do not want to admit that they were wrong. particularly if they plan borrowing or issuing debt. Without well-specified public sector audit stan- Local citizens and other stakeholders, such as dards in many developing countries, auditors can lenders, are interested in knowing about the qual- make audit observations without understanding ity of the municipality’s financial management. the nature and context of an administrative action. They expect the annual external audit to provide That makes it difficult for executives to address the the necessary assurances. Hence municipal gov- auditor’s queries satisfactorily, and some audit que- ernments should undergo both financial and com- ries are left pending for months or years. pliance audits, done together or separately. Some developing countries have introduced the practice of audit conferences, in which the Capacity shortage auditor, the audited city, and the supervising line Public sector audit agencies often are short on ministry sit together to go over the audit observa- capacity, another factor that causes weak munic- tions and resolve issues through discussions. Such ipal audits. Weak capacities appear in both skills a process expedites, and reinforces the impor- and numbers of auditors. Because public sector tance of, a prompt response to audit observations Municipal Financial Management 143 Box 3.10 Use of Private Sector Auditors to Audit Local Governments in Bangladesh Bangladesh has approximately 4,500 rural An audit strategy has helped to address local governments (called “union parishads”). this issue by forming a public-private part- As part of its policy to empower local govern- nership among the C&AG, the ministry of ments, the government of Bangladesh, with local governments, and the institute of char- World Bank support, introduced a system of tered accountants of Bangladesh, which block grants to union parishads in 2006. With was contracted to carry out the annual increased financial resources flowing to local external audits, with the C&AG providing governments, the central government was quality assurance for the audit process. keen that financial audits be conducted on a The outcome of this innovative approach regular and timely basis. However, the comp- was that the annual external audits of the troller and auditor general (C&AG), who has the union parishads are completed within a rea- constitutional mandate for the external audit sonable time after the close of the financial of public sector institutions in Bangladesh, year, and the audit reports are made avail- lacked the capacity to complete annual exter- able to the local governments and their nal audits of 4,500 union parishads in a regular stakeholders, enhancing the framework for and timely manner. local accountability. Source: World Bank 2011. by city executives. In many local governments, tool that allocates funds and responsibilities and audits are handled by the executives, with little induces actions by local entities and persons to involvement by the municipal council. That needs achieve the set goals. to change; the council should be fully abreast of Budgeting weaknesses in developing countries the audit observations and make it a priority to include unrealistic plans and estimates, a short- ensure that the executives take prompt correc- age of timely information, politicized targets, and tive actions. As a good practice for strengthening balloon revenue targets. Implementation weak- social accountability, audit observations and the nesses include overspending, delayed execution, corrective measures taken could be shared with unclear items, and persistent deficits. citizens and other stakeholders, published on the The primary role of the accounting system city’s website or on public notice boards. is to provide and record timely and accurate information on revenues, expenditures, assets, and liabilities to inform stakeholders about the Takeaway Messages sources and uses of financial resources. The main Budgets are developed based on both financial types of accounting include financial accounting, and nonfinancial information and determine cost accounting, managerial accounting, and tax how local services will be provided and financed accounting. Accounting systems include sin- in a fiscal year. The budget is often a local ordi- gle-entry and double-entry accounting and cash- nance or bylaw approved by the council or equiv- based or accrual-based systems, or combinations. alent body of a local government. It is a guiding, The most advanced system is double-entry financing, executive, monitoring, and evaluation accrual-based accounting, but double-entry 144 Municipal Finances cash-based accounting is a more realistic option state auditors who focus on verifying compliance for the local governments in developing coun- with public sector rules rather than the qual- tries. Cost accounting and fund accounting are ity of finances, hence the need for simple self- more sophisticated systems that provide more assessments in order to ensure the accountability specific information on key activity areas and of public funds. functions and eventually on local government effectiveness overall. Computerized accounting (and management References information) systems offer convenient solutions in FASB (Financial Accounting Standards Board). which each transaction is entered only once and 2000. Statement of Financial Accounting automatically posted in various accounts, journals, Concepts. Norwalk, CT: FASB; www.fasb.org. and ledgers. Computerized systems are generally Franke, Richard W. 2007. “Local Planning: more accurate than manual systems. Moreover, The Kerala Experiment.” In Real Utopia: they shift the focus of accounting from registering Participatory Society for the 21st Century, transactions to providing timely and structured edited by Chris Spannos, 130–35. Oakland, CA: information to those who need it, such as the AK Press. mayor and executives, the council, and citizens. Freeman, Robert J., and Craig D. Shoulders. 2000. Financial reports are key communication and Governmental and Non-Profit Accounting. control tools for local governments. The three Saddle River, NJ: Prentice Hall. main external financial reports are the Statement GASB (Government Accounting Standards of Activities, the Statement of Financial Position, Board). 1999. “Statement #34. Basic Financial and the Cash Flow Statement. Many other reports Statements and Management Discussion and are used internally, including budget/actual, trial Analysis for State and Local Governments.” balance, asset register and maintenance, or cost www.gasb.org. center reports. Accounting and financial report- Lee, Robert E., and Ronald D. Johnson. 1998. ing are often regulated by national institutions Public Budgeting Systems. Gaithersburg, MD: that prescribe standard formats and procedures. Aspen Publishers. The financial reports are the subjects of audit- Mikesell, John. 2011. Fiscal Administration. ing, which is a process of systematic collection Boston: Wadsworth. and evaluation of information on the financial NACSLB (National Advisory Council on State transactions and the financial reports. The three and Local Budgeting). 2000. “Recommended Budget Practices: A Framework for Improved main types of audits include the financial audit, State and Local Government Budgeting, the compliance audit, and the management audit. NACSLB.” Government Finance Officers The results are presented in an audit report, Association, www.gfoa.org. which may include an unqualified, qualified, or Serageldin, Mona, et al. 2005. Assessment of adverse opinion by the auditor. Participatory Budgeting in Brazil. Washington, The audit report provides valuable feedback DC: Inter-American Development Bank. to  management and calls for corrective actions. Skousen, Fred, Earl K. Stice, and James D. Stice. For external stakeholders, an audit report with 2000. Intermediate Accounting, 14th ed. positive statements is an assurance that the finan- Cincinnati, OH: South-Western College cial reports fairly represent the financial position Publishing. of the local government. That is a vital message World Bank. 2011. “Progress Report on Bangladesh for investors and creditors. Local governments Local Government Support Project.” in developing countries are often audited by World Bank, Washington, DC. Municipal Financial Management 145 CHAPTER 4 Managing Local Revenues Maria Emilia Freire and Hernando Garzón In some important respects, a local government firefighting, street cleaning, street lighting, free is analogous to a business. It provides services to parking, and even shelters for the poor and pris- its customers—residents. In turn, residents must ons for lawbreakers. These are so-called public pay for the services they receive (Bird 2011). goods because not only do they benefit the whole However, the ways residents pay for services vary community, but individuals cannot reasonably be substantially. Fees and user charges for water or excluded from their use, and their consumption energy would seem the most obvious ways, but by one individual would not interfere with con- there are many more. For example, if you need a sumption by another (e.g., national defense, park place to sell fruit, you use a stand in a vegetable services, public lighting). Thus, they need to be market; you pay your municipality for the space paid for by means of taxes that reflect the willing- and for the infrastructure you get. You use the ness of the community to finance these services walkway to store construction materials for your and (in principle) the benefits that individuals house, and you pay a fee for the inconvenience of extract from them. In this case—of goods whose your neighbors or other pedestrians. Those fees use cannot be regulated through normal pricing are called “benefit taxation,” that is, people pay mechanisms—local (benefit) taxes are the most for the benefits or the utility they receive. They appropriate vehicle of financing. hope that what they pay is in line with the cost The sources of revenue for local governments of the service that is being provided.1 vary across countries but generally include However, most municipal services are not sold taxes, user fees and charges, and intergovern- and billed like water or energy. Local govern- mental transfers. Other revenues may include ments provide services such as police protection, investment income, property sales, and licenses Managing Local Revenues 147 and  permits. In terms of taxes, property and should be collected at the local level remains business taxes are probably the most often levied a difficult question. The responsibility of local by local governments around the world. Other governments to provide services to their constit- local  taxes can include income taxes, general uencies and their authority to raise revenues are sales taxes, and selective sales taxes (for example, intertwined functions and should be in harmony. taxes on fuel, liquor, tobacco, hotel occupancy, As discussed in chapter 1, an important rule of and vehicle registration) and land transfer taxes sound fiscal decentralization is that finances (or stamp duties). Often, these taxes are collected should follow functions (Bahl 2002); that is, at the state level and shared with local levels local governments should be able to access the according to predetermined formulas. They are resources to finance the public services that they called “shared taxes.” To meet capital expendi- are mandated to provide. However, in reality, ture requirements, some municipalities charge spending is much easier to decentralize than rev- developers for growth-related capital costs, using enues, and local governments often need financ- so-called development charges or “betterment ing from upper levels of governments or the levies.” A land value capture tax is sometimes lev- private sector to fill the gap. ied to finance infrastructure. This chapter discusses the various aspects of managing local government revenues. It relates The Role of Local Revenues—Big Picture to the questions addressed in the first chapters, How cities finance their public expenditures is an notably how local governments should finance the important issue in urban development. Because responsibilities assigned to them and what instru- every city is different, no single approach will suit ments are best suited to be used at the local level. all. The appropriate strategy for any city depends In a time when demands on local governments on factors such as size, economic conditions, are increasing, the capacity to raise local revenues demographic composition, and level of urbaniza- as a complement to other resources is crucial for tion (Slack 2009). local governments to ensure adequate provision While there is a consensus that cities’ resour- of services and maintain fiscal balance. ces should be in line with their responsibilities— This chapter focuses on local taxes, user charges, for example, larger cities need to spend more and and other local revenues, commonly referred as therefore need to mobilize more local revenues— “own-source revenues” (OSRs). Capacity for col- fiscal theory recognizes that local governments lecting own revenues is among the most impor- have a limited tax base (Bird 2009). Fiscal decen- tant evidences and factors of local autonomy, tralization has delegated to local governments accountability, and self-reliance. Transfers, grants, many functions, from water supply and solid waste and borrowing play a vital part in financing most management to investment in infrastructure such municipalities, as discussed in chapter 1. Borrowing as streets and roads, flood control, and the like, and other forms of debt financing are reviewed in as well as social services. Regardless of how well chapter  7, in conjunction with the modalities for these functions are executed, the municipal man- financing capital improvement plans. dates are clear and can be justified by the fact that local governments are closer to their constituen- cies and in principle capable of responding more Financing the City and the Quest efficiently to their demands. Around the world, for the Good Local Tax local (municipal) expenditures as a share of total Cities collect revenues to provide services and public expenditures vary between 45  percent in fulfill public functions. But how much revenue Denmark and 11 percent in Bolivia. 148 Municipal Finances The rationale for which sort of revenues It is also true that revenues are often cen- should be decentralized is much less clear. Local tralized for political rather than merely tech- governments have generally lower tax poten- nical or administrative reasons. Furthermore, tial than central governments, mainly because local governments often miss the tax potential some taxes can be collected more efficiently by of their jurisdictions because of lack of informa- the central government than local governments. tion, low institutional capacity, and weak political That is the case for customs levies, personal and commitment. corporate income taxes, value added taxes, and taxes on royalties. What Is a Good Local Tax? This largely explains why the local revenue Fiscal theory suggests that good local taxes have share of all public sector revenues is consistently three features: they are easy to administer locally; lower than the share of local spending in total are imposed on local residents; and do not raise public sector spending (see figure 4.1); it under- competition with other local governments or scores the need for intergovernmental grants the central government (box 4.1). These princi- to bridge the gap between municipal responsi- ples impose serious limits on what can be con- bilities and municipal revenues, as discussed in sidered a  good local tax. For example, although chapter 1. user charges and property taxes are clearly local Figure 4.1 Local Share in Public Expenditures and Revenues (2011) Norway Denmark Hungary France Canada (2010) Germany United Kingdom Spain Mexico (2010) Netherlands 0 5 10 15 20 25 30 35 40 Share in revenues Share in public expenditures Source: OECD 2011. Managing Local Revenues 149 Box 4.1 A Good Local Tax • Tax base should be immobile, so that local governments can vary the tax rate without the taxable base moving somewhere else. • The tax yield should be adequate to meet local needs, be stable, and be predictable. • Tax base should not be easy to export to nonresidents. • Tax base should be visible to ensure accountability. • Taxpayers should perceive the tax as fair. • The tax should be easy to administer. Source: Bird 2001. taxes (they are paid by the people who receive such as electricity, water, urban transport, waste the services), other taxes may be collected by the management, and parking) can be successfully central government and shared with local gov- financed by fees or user charges. In contrast, ernments, depending on the governments’ fiscal public goods, such as parks, street cleaning, architecture. That is the reason for the existence and lighting, should be financed by local taxes. of so many combinations of local and central Moreover, other factors such as externalities government taxes. and redistributive spillovers need to be taken To fulfill all mandated and desirable functions, into account (see  figure 4.2). Redistributive pol- local governments need access to several taxes. icies and spillovers or externalities exceed the Such an arrangement will increase their flexibil- responsibility of the local government and thus ity to respond to changes in the economy, evolving should be funded (at least partially) by the cen- demographics, changes in the political climate, tral government. Other services, such as educa- and other factors. For example, property taxes tion and cultural services, do not fit clearly into provide a stable and predictable source of reve- any particular category. If seen as a private good nues but do not increase with economic growth (excludable), education should be financed by as fast as income and sales taxes do. the beneficiaries, with the possible contribu- tion of local taxes (at least partially and comple- Principles of Local Revenue Management mented by grants). If seen as a public good and There are two key principles of local revenue an essential ingredient to improve the country’s management: human capital, central government grants are 1. The services that municipalities provide largely justified (Slack 2009). should be clearly linked to the revenue sources needed to finance them. The Structure of Revenues in Local Governments 2. Services should be financed by their Studying the structure of local government rev- beneficiaries—“the general benefit principle”— enues requires distinguishing between sources directly or indirectly. of revenues and the factors that affect the level In this context, private goods (in the sense of those revenues, such as the size of municipal- that they are excludable, i.e., people who do not ities, the wealth of the local economy, and who pay can be prevented from getting the service, provides public services. 150 Municipal Finances Figure 4.2 The Benefit Principle of Municipal Finance Redistributive Spillover Private goods Public goods effect effects Water Police Roads/transit Sewers Firefighting Social assistance Culture Garbage Local parks Social housing Social assistance Transit/tolls Street lights Transfers User fees Property tax Transfers (Income tax) Source: Slack 2009. Table 4.1 Brazilian Municipalities—Composition of Current Revenues by Size of City, 2003 (percentages) 5,000 to 20,000 to 50,000 to Above Population 0 to 5,000 10,000 50,000 1 million 1 million Brazil Tax revenues 3.5 5.6 12.1 21.7 36.6 19.6 Intergovernmental transfers 91.1 87.3 73.8 62.3 45.3 66.1 Other revenues 5.3 7.1 13.9 16.1 18.1 14.3 Current revenues 100 100 100 100 100 100 Source: World Bank 2006a. The structure of local revenues varies among Brazilian pattern reflects a general tendency, both countries and cities, but some general namely, the positive correlation between the size of tendencies are noticeable. For example, as shown the city and the role of own-source revenues. in table 4.1 and figure 4.3, the size of the munici- Unlike Brazil, some developing countries must pality affects the role of local taxes, compared to deal with rapid urbanization and megacities with transfers from the central government, in total very low own-source revenues, such as large revenues. Smaller municipalities have smaller cities in Pakistan that collect only about 7 percent tax bases and therefore are more dependent on of their spending as own revenues. That is a typ- the central government. For small cities of 5,000 ical pattern in many Asian and African countries. or fewer, grants are 91 percent of revenues; taxes Comparing several countries (table 4.2) sug- and other sources account for only 9 percent. In gests that the revenue structure of local govern- the case of large cities of more than 1 million, ments also varies with the development level of grants account for 45 percent and taxes and other the country. Cities in less-developed countries revenues for 55 percent. The figures might be seem  to rely more on grants and transfers. For somewhat different in other countries, but the example, grants represent 83 percent of local Managing Local Revenues 151 Figure 4.3 Brazil—Sources of Revenues by Size of Municipality, 2003 (a) Small municipalities (b) Large municipalities Other Tax revenues Tax revenues revenues 37% 4% 5% Other revenues 18% Intergovernmental Intergovernmental transfers transfers 91% 45% Source: Authors based on World Bank 2006a. revenues in Botswana, 65 percent in Brazil, and personal income tax, and business tax and trans- 91  percent in Uganda. OECD (Organization for fer the agreed share to the local level. Shared taxes Economic Cooperation and Development) cities are particularly important in formerly centralized rely more on own revenues, either property governments such as the Czech Republic (46 per- taxes or income taxes.2 Property taxes seem to cent of local revenues are in the form of shared be especially important in Australia, Canada, the income and business tax). United Kingdom, and the United States, reflect- The share of own revenues in total revenues also ing the availability of support in the form of varies, ranging from 61 percent in Croatia (31 per- administrative and information processes, as well cent if shared personal income tax is excluded) as traditional and customary factors. to 9 percent in Uganda. Developed countries In many other countries, various obstacles generally  show a higher share of own revenues make it difficult to use property taxes to finance and a greater reliance on local taxes. A great vari- local governments: weak cadastre systems, ety of local taxes exist, although most countries confused property rights, no tradition of mar- rely on property taxes, motor vehicle taxes, and ket valuation, and difficulty in bringing people sales and income taxes. In addition, a large part to recognize a tax on something that they rarely of own-source revenue is accrued through sur- consider selling. charges and special revenues. These sources will The role of shared taxes varies. Many coun- be discussed in detail in the following sections. tries prefer to have higher levels of government Hybrid types of shared taxes are used by many collect and administer such taxes as property tax, countries, at least in the postcommunist  world. 152 Municipal Finances Table 4.2 Structure of Local Revenues, Selected Countries, 2006 (percentage) Local taxes Other revenues Property Income and Total local taxes (including fees tax business tax (includes shared taxes) Grants and sale of assets) Total Australia 39 0 39 14 47 100 Bolivia 19 8 72 18 10 100 Botswana 8 10 83 7 100 Brazil 4 13 63 24 100 Bulgaria 20 0 20 70 10 100 Canada 38 0 40 42 18 100 Croatia 3 46 61 12 27 100 Czech Republic 6 4 56 28 16 100 Denmark 3 48 51 39 10 100 Finland 2 44 47 29 24 100 France 34 18 45 29 26 100 Germany 5 16 42 34 24 100 Kenya 16 0 21 33 46 100 Mauritius 12 26 67 7 100 Russian Federation 4 23 31 58 11 100 South Africa 17 0 20 25 55 100 Spain 16 10 52 36 12 100 Sweden 58 59 22 19 100 Thailand 8 55 31 14 100 Uganda 3 1 5 91 4 100 Ukraine 2 34 42 38 10 100 Cities: Cape Town 25 25 25 50 100 Toronto 42 42 21 37 100 Madrid 12 47 39 14 100 Mumbai 19 65 4 31 100 Sources: DEXIA 2008; Slack 2009; IMF Government Finance Statistics 2007. Sometimes they are accounted as grants, some- adjust user charge schedules? The situation var- times as own revenues (see chapter 1). They bring a ies across taxes and countries. Tax responsibility sense of stability to local revenues because they are can be seen in four ways: authority to establish defined and collected by the central government. taxes, to set tax rates, to collect the tax revenue, and to allocate the proceeds (see box  4.2 and chapter 1). Revenue Authority How much tax authority local governments have • Authority to establish local revenue sources. to respond to increasing urban needs is a key fac- Local governments’ revenues are defined in tor of revenue management. Can local govern- the constitution or in the law that governs the ments adjust tax rates, impose new taxes, and country’s finances. The assignment of tax bases Managing Local Revenues 153 Box 4.2 Which Revenue Sources Should Be Defined Centrally Rather Than Locally? User chargers and fees. A general rule in public be used locally, even by small units of govern- finance is to charge for services whenever the ment, especially in the form of piggybacking direct beneficiaries can be identified. When the on the centrally defined system. consumption of a public service benefits both Real property tax. The real property tax is by the direct users and the community at large (for nature a local tax, given that it has an immobile example, consuming clean water reduces con- tax base. It is hard to administer, especially in tagious diseases; that is, it has positive external- developing countries where information and ities), the central government may intervene to valuation are often weak. subsidize larger population groups and encour- Sales tax. Excise and single-state retail taxes age a greater level of service than if the good are prime candidates for local use, especially were produced and sold by the private market. if a taxing region is large enough to avoid rev- Broad-based business levies. Business tax enue loss from customers’ crossing borders rates are not well suited to be established by into lower-tax regions. Over time, sales taxes subnational governments, but these taxes are have been replaced by the VAT, a national tax increasingly used by local and state authori- that avoids the cascading effect of the usual ties. To minimize potential distortions in the sales tax. Although it is a better tax in gen- flow of factors and goods within a nation, a eral, the wide use of the VAT has resulted in high degree of national uniformity is desirable a shrinking number of good local taxes. for levies such as the corporate income tax Business, personal, and corporate income and the value added tax (VAT). taxes are often shared taxes–they are col- Personal income tax. Although the personal lected by states or the central government income tax is often a national tax, it can also and shared with local governments. Sources: Bird 2001; 2006. (local tax sources) is part of countries’ fiscal set either by the central government or by the framework. In countries with a unitary sys- state government, often within a range of val- tem (such as France, Kenya, or Morocco), the ues from which local governments can choose tax base is defined by the central government. (as in Colombia). City governments have grad- In federal countries (such as Brazil, Germany, ually gained greater authority (autonomy) to and Mexico), revenue assignment authority is set their own tax rates and user charges, often shared between the federal and the state govern- with the approval of the sector authority ments. In general, city managers have authority (ministry). Tax exemptions or abatements are to establish nontax sources (e.g., user charges, usually limited by law and are also under city fees, licenses, permits) and to set to some extent authority. their local taxes (e.g., the property tax and, in some cases, the valuation of the tax base). • Revenue collection authority. Local taxes are collected directly by the local government, or • Setting of tax rates. The authority over tax collection is outsourced to higher government rates varies among countries. Tax rates are entities, peer cities (for example, Amman 154 Municipal Finances collects property tax on behalf of four cit- than overestimate expected revenues. Local gov- ies), or even the private sector (for example, ernment revenues fall into different groups that the case of property tax in Kampala). Central are important for both planning and analysis pur- governments may collect local taxes on behalf poses. Finance officers need to be aware of the of local governments and transfer the pro- characteristics of a good local tax: predictability, ceeds to each local government (as for Chile’s buoyancy, equity, and local control. Ideally, local property tax). Federal taxes shared with local revenues are controlled locally and proceeds are governments are collected by the upper level stable, predictable, buoyant, equitable, and usable of government and transferred back based on without constraints. However, very few revenues the origin of tax collections. Many of these pass this test; property taxes and fees may be the processes are determined by political, cul- closest ones. tural, or historical practices. Some local government revenues are very sta- ble and predictable (property taxes); others show • Revenue allocation authority. Generally local wide variations (sales tax). Some are restricted for governments have autonomy to allocate or specific uses (road charges), and others have no spend their revenues freely, but sometimes restrictions. Depending on the country, some local tax proceeds are earmarked for specific pur- revenue sources are established by the local coun- poses. For instance, in Brazil, 25 percent of cil, but many others may be beyond local control. net local revenues must be allocated to edu- For example, in the United States the constitution cation. In Nepal, 75 percent of general shared of the state of Wyoming (Wyoming 2011) gives tax revenues ought to be spent in development local officials very little decision-making author- expenditures. Revenues from vehicle taxes ity with respect to taxes and fees. The same is true are allocated to street and road maintenance for Mexico and many developing countries. in many countries. Revenues from asset sales, Municipal revenues can be classified in dif- fiscal charges on land development, and con- ferent ways, notably own revenues, intergovern- struction permits are ideally earmarked for mental transfers, and external revenues. Good specific capital purposes. revenue management also requires distinguish- • Valuation. Particularly in the case of the prop- ing between current (or recurrent) and capital erty tax, valuation is frequently carried out by (or nonrecurrent) revenues, although that is not the higher-level authority to ensure a uniform mandated in many developing countries. definition of “market value” (as in Canada). Table 4.3 and figure 4.4 show the classification Alternatively, a higher level authority may of local revenues used in this chapter. Revenues establish a methodology to determine “market are classified into current and capital. Within values”. current revenues are own revenues, transfers, and other revenues. Shared taxes (collected by the central government and shared with subna- Main Revenue Sources of Local tional entities) sit at the border of own revenues Governments and transfers. Because they often provide a large Estimating how much money will be available portion of local revenues (as in Argentina, Serbia, to a city can be the most challenging as well as and Turkey), this category has a big influence the  most important part of preparing a local on own-revenue capacity projections. Shared budget. Estimates that are too high can cause real taxes are commonly considered transfers, even headaches as the fiscal year progresses. It is better though many argue that they are own revenues if to err on the safe side and underestimate rather the share is returned to the local government of Managing Local Revenues 155 the  jurisdiction where they were collected. The financing capital investments directly or by Council of Europe has issued a clarification state- leveraging debt. Failure to generate sufficient ment on the matter: “Shared taxes are financial current revenues suggests that the municipal- transfers; if they are not in direct relation to the ity is financially unsustainable. Such a munic- amounts collected locally, they are also consid- ipality will generate arrears (unpaid bills), sell ered as grants” (Council of Europe 2006). assets and use up its wealth (as some cities in Recurrent revenues should be sufficient to the United States have done temporarily, in finance current (or operational) expenditures; response to the fall in tax revenues after 2008), that is, they should be sufficient to finance reg- or be bailed out by the central government ular operation and even to generate an oper- through discretionary grants (as occurred in ational surplus, which then can be used for Jordan). Table 4.3 Structure of Revenue Own-Source Revenues Current Capital Own-source revenues (OSRs) are funds that local Categories revenues revenues governments raise directly, as opposed to trans- Own-source Taxes Asset sale fers and grants received from higher govern- revenues Fees/charges Dividends ment tiers. Distinguishing and measuring them Asset fees Betterment fees is important to assess municipal fiscal creditwor- Other Contributions thiness, autonomy, and capacity to raise revenues. Revenues Shared taxes General capital They are also important with respect to revenue from higher incentives: own-source revenues are the funds General transfers grant government that local governments control, can project, and Earmarked Earmarked tiers can increase through local decisions, procedures, grants grants and actions. Central government transfers and External Liquidity Loans, bonds revenues borrowing donations could be very significant, but the local Bond (debt, equity) government does not control them—there is little Equity or nothing it can do to increase them. Figure 4.4 Revenues in Budget Context Revenues Expenditures Current revenues Current expenditures Own revenues: taxes, fees Payroll Current budget Transfers from government Operation and maintenance Other revenues (rents) Interest payments surplus carried forward Deficit carried forward (if any) Operating surplus Self-financing Capital expenses budget Capital Capital revenues Civil works Sales of property, land Purchase of property, land Grants Repayment of loan principal Loans 156 Municipal Finances Box 4.3 shows a typical list of OSRs; the 24 Most local governments have a long list of OSRs can be grouped into the following catego- OSRs assigned by law, a handful of which pro- ries: taxes, charges, fees, asset and investment pro- vide the bulk of their revenues. Table 4.4 shows a ceeds, and other small revenues. Taxes are levied list of countries in various levels of development. to finance general expenses; charges finance the The data suggest that local taxes provide a sub- costs of services; fees are supposed to cover the stantial share of local revenues (37  percent, in direct costs of specific services or functions such this group) and that the property and the income as issuing marriage, birth, or death certificates; taxes are the most significant (44  percent and licenses; or permits. These distinctions are less 41 percent, respectively). In contrast, Guatemala clear in practice. Some taxes and charges may collects only a sales tax and a small amount of be called “fees” (as a “water fee”). Some fees are property tax. The table also reflects a great vari- set far above the direct cost of the respective ser- ety of revenue sources across countries. Property vices; for example, business licenses, vocational tax is the sole local tax source for municipalities fees, or building permits, which in fact are taxes, in Australia, Canada, and the United Kingdom, may be called fees to make them politically more whereas local income tax is the main tax revenue acceptable. in the Nordic countries. One can conclude that Box 4.3 Principal Revenue Sources for Local Governments 1. Property tax (rates) on land and/or 14. Fees for fairs, agricultural shows, cattle buildings fairs, industrial exhibitions, tournaments, 2. Tax on the transfer of immovable property and other public events 3. Tax on motor vehicles 15. Fees for licensing of businesses, profes- 4. Local sales tax and/or tax on the sale of sions, and vocations local products (or surcharge) 16. Fees for other licenses or permits and 5. Tax on local businesses and services penalties or fines for violations 6. Tax on electricity consumption (surcharge) 17. Fees for advertisement 7. Tax on nonmotorized vehicles 18. Fees on sales of animals in cattle 8. Tax on tourism, hotels, restaurants, and markets entertainment 19. Fees for registration and certification of 9. Tolls on roads, bridges, etc., within the births, marriages, and deaths limits of the local government 20. Fees for education and health facilities 10. Charges for public works and public utili- established or maintained by the local ties such as waste collection, drainage, government sewerage, and water supply 21. Fees for other specific services rendered 11. Charges for markets and rents for market by the local government stalls 22. Rent from land, buildings, equipment, 12. Charges for the use of bus stations and machinery, and vehicles taxi parks 23. Surpluses from local commercial 13. Fees for approval of building plans and enterprises erection and reerection of buildings 24. Interest on bank deposits or other funds Source: Devas, Munawwar, and Simon 2008. Managing Local Revenues 157 Table 4.4 Selected Local Government Taxes by Country, 2010 Local taxes As percentage of local taxes Countries % Local revenue Income tax Sales tax Property tax Australia 40.1 0.0 0.0 100.0 Austria 66.5 44.3 37.7 8.7 Belgium 33.4 79.8 14.4 0.0 Canada 37.0 0.0 2.0 98.0 Denmark 44.0 93.6 0.1 6.3 Germany 34.9 85.8 0.8 13.4 Ireland 5.7 0.0 0.0 100.0 Japan 57.9 17.2 23.6 13.5 Norway 49.8 90.2 0.5 6.5 Spain 47.0 38.4 50.5 10.9 Switzerland 52.8 87 .0 0.0 12.2 United Kingdom 30.9 0.0 0.0 100.0 United States 38.8 5.9 19.8 74.2 Guatemala 26.2 8.6 Average 37.1 41.6 11.5 44.2 Source: IMF Government Finance Statistics. every country needs to find its own most suitable • Being visible, the property tax increases local tax system. accountability, although it may be more diffi- The next sections will discuss the following cult for local governments to increase tax rates. sources of local own-source revenues: prop- • Residential property taxes are particularly erty tax, sales tax, automobile tax, local personal appropriate to fund local governments because income tax, local business tax, user charges, utili- they are borne by local residents. In addition, ties surcharges, fees and fines, and other revenues. local governments have a comparative advan- tage in identifying and valuing properties The Property Tax because they are familiar with the local base. The property tax can be appropriate for financing Land-based taxes have been used for centuries local services for many reasons: (see box 4.4). • Real property is immovable: it cannot move Property tax can fund those local services away when taxed or when taxes are increased. that cannot be charged directly to the users • To the extent that there is a clear link between through user fees and are not covered by grants. the services funded at the local level and prop- The property tax can also be viewed as a form erty values, the accountability of local govern- of benefit tax or land-based tax that captures ments to local residents can be substantially part of  the value accrued by a piece of land as improved. a result of public investment in that land or in • It can be seen as a benefit tax, if the services the vicinity. This assumes that adequate valua- taxpayers receive (roads, garbage collection, tions are able to measure the impact of the new or police services) approximate the value that investment on land prices (Brzeski 2012). In they pay in property tax.3 addition, property taxes can be extremely useful 158 Municipal Finances Box 4.4 Land Tax in Old China One of the oldest land taxes was used in China for more than 2,000 years. It was established at one-tenth of the product of land and was used to finance infrastructure and security. The taxes were paid in produce. The farther the land was from the capital, the bulkier was the produce used to pay the land tax. Source: Wikipedia. for land  management, as they discourage land for everyone. In countries where property rights speculation and promote the productive use of are not clear, where property boundaries are sub- urban land. ject to litigation, where there are multiple claims Property taxes have also some drawbacks, the on land, where land registration is not function- most important being: ing well, and where the judicial system is absent, then the property work does not work. It is fair to • The high cost of accurate valuation of property say that in those contexts, fiscal cadastres should values not be promoted and that street addressing and • The political difficulty of enforcement the connection between the street addressing data base and the local fiscal registers, focusing • The apparent inelasticity of property values on occupancy and street level instead of property with respect to GDP or national income (prop- rights and plot boundaries should be favored. erty values respond less quickly to changes in Despite the theoretical arguments in favor GDP than incomes or sales) of the property tax as the best local tax, the dif- • The fact that few jurisdictions update property ficulties that most countries encounter in try- values on an annual basis. That means that to ing to use it well have led some tax experts to maintain property tax revenues in real terms believe that “governments in developing coun- local jurisdictions would have to increase the tries are not able to administer a well-func- tax rate regularly and this leads to taxpayer tioning property tax” (Bahl, Martinez-Vazquez, resistance and discontent. and Youngman 2008) because of the drawbacks listed above. More recently, however, programs These shortcomings explain the relatively have been introduced, as in Colombia, that may smaller role that property taxation plays in devel- indicate how property taxes can be better man- oping countries and the small share of revenues aged. In Colombia, property tax now accounts that property tax yields in most developing cities. for 40  percent of city revenue (see box 4.5). In OECD member countries, the property tax In addition, some developing countries have represents 2 percent of GDP; in developing coun- started to use  computer-aided, mass valuation tries it is between 0.3 percent and 0.7 percent of systems (CAMA), which enable annual updat- GDP (Slack 2009; Bahl, Martinez-Vasquez, and ing of the tax base (see box 4.6). This modeling Youngman 2008). In Australia, Canada, Ireland, process is being introduced in six large cities of South Africa, and the United Kingdom, prop- Tanzania under a joint World Bank–GIZ proj- erty taxes provide most of the local revenues ect (TSCP). A  well-functioning CAMA system, (DEXIA 2008). In summary, property tax is not established in Moldova under a World Bank Managing Local Revenues 159 Box 4.5 Updating the Cadastre to Increase Tax Revenues—The Case of Colombia Despite general skepticism, the case of taxpayers, Bogotá’s city council adopted an Bogotá has proved that political will, tech- increased ceiling, to change the property tax nical expertise, and investment can signifi- proportionally to the logarithm of the proper- cantly increase property tax proceeds. To ty’s value. This had two benefits: (a) it sepa- raise finances for a planned first subway line, rated the technical updating of the cadastre in 2008 the mayor of Bogotá initiated a major from the political implications of increasing updating of the physical records and taxation the property tax; and (b) property owners no values of 2.1 million properties. As a result, longer observe jumps in their property tax, property tax revenues increased by US$171 which creates predictability and certainty over million and reached 40 percent of own reve- the medium term and lessens resistance. The nues by 2010. The cost of improvement was ceiling cut about 20 percent of the additional less than US$15 million. revenues for 2009 and 2010. These results Colombia has four cadastre agencies under are in line with the idea of Bahl, Martinez- the National Geographic Institute Agustin Vazquez, and Youngman (2010) that “revalua- Codazzi, that are in charge of establishing the tion is not inexpensive, but the consequences property tax base for its large cities, which are of failure to revalue, at least periodically, can responsible for setting their own rates and col- be even more costly” (4). lecting the property taxes. The reassessment work included three For quite a while, the property tax base of components: the physical revision of changes Bogotá had not been updated, and the city was in parcels’ physical configuration; legal forgoing important revenues during a boom in changes, through the verification of owner- the real estate market. To capture those gains, ship; and economic changes through assess- the city refurbished tax administration and ment of property values by researching the real revaluated the properties. The cadastral value estate market. All these components required increased by 47 percent, from US$ 66.5 billion human and technical resources proportional in 2008, to US$98 billion in 2010. The key ele- to the number of plots and inversely so to the ments behind this success included improved time available for the process. The cadastre human resource management, introduction update of 1,212,000 urban plots costs the city of information technology, engagement of about US$7 .8 million, or US$6.50 per prop- stakeholders and career civil servants, open- erty. Hundreds of temporary workers carried ness to review the project’s results, massive out the physical updating, representing about improvement in assessment techniques with 35 percent of the total cost. The economic and econometric modeling, and mitigation of the market analysis represented about 23 percent project’s impact on the property tax through of the total cost. The rest was spent for tech- a ceiling on the tax increase. The accompa- nology and administration. nying chart, figure B4.5.1, shows the gradual Next steps. Bogotá is trying to imple- increase of tax dues (white) and the revenue ment two strategies: annual updating of the forgone through the ceiling on tax increases. cadastral database and improving the struc- The reassessment exercise led to dra- ture of the property tax rate. The city is look- matic increases in cadastral values and prop- ing for methods that would allow updating erty tax bills. To minimize the resistance of the physical and economic information on (continued next page) 160 Municipal Finances Box 4.5 (continued) Figure B4.5.1 Property Tax Potential Revenue 2004–10 550 500 US$ 2009 millions 450 400 350 300 2004 2005 2006 2007 2008 2009 2010 Potential revenue forgone due to increased ceilings Estimated loss due to lag in cadastral database Property tax revenue assuming zero evasion Additional revenue due to cadastral updating Cadastral base without cadastral updating properties without the massive amount of with individual assessments of a sample of fieldwork and number of assessors. The phys- properties sold in a neighborhood. The rate ical information will be updated by focusing policy will be changed by introducing rates on new construction activities, using informa- differentiated by land use and higher rates for tion from the urban curators who issue con- vacant land. struction permits, the registry office about The secrets of success. Among the changes in ownership, the department of factors leading to the effort’s success were urban planning to monitor changes in land use strong political support; the technical capacity regulations, and aerial photographs to guide of the cadastre agencies to revalue properties; the cadastre staff. The economic information and a clear policy to avoid sudden increases will be obtained by using market samples, in tax bills. Source: Ruiz and Valejos 2010. Managing Local Revenues 161 Box 4.6 Computing the Tax Base of a Building in Village X A house is included in the national cadas- constructed; the building is 60 years old. The tre as item # 407 in the ward 080604 (Mt. following table shows the value assessed for Michael) with the following elements: the use purposes of land assessment. The tax base is is for single-family residence; has one floor; assessed as follows: total area = 434 m2, of which 358.4 m2 are Vt* = * Vcx * Ax * Cax * Cix * Cq x * Cv 109,122 609 358.4 1.00 0.9 1.01 0.55 Assessed Unit value Area of Coefficient Coefficient Coefficient Coefficient value of buildings construction of use of location of quality of age and comfort project with the support of SIDA (Swedish To tax real property, local governments need Development Association), has been in use for to follow at least three steps: over a decade. 1. Identify the properties that are being taxed. Performance of the property tax depends on the city’s administrative capacity and efforts, 2. Assess the property value and tax base. which can make or break the system. The operating costs can be upstream (identifying 3. Set the tax rate. the property and the payer) and downstream (billing and collecting). To make it worthwhile, Property Identification and Fiscal Cadastre the property tax administration and operating The first step in levying a property tax in one city is costs should range from 2 percent to 5 percent to identify the existing real estate properties, their of  mobilized revenues. A recent survey found size, use, location, and owners. This is best done that in Turkey, large municipalities collect with the preparation of a fiscal cadastre, which substantial property tax revenues, whereas includes information on each property, including hundreds of small municipalities collect less physical description, a notation of ownership, and property tax than their costs of administra- the assessed value of land and improvements. A tion and collection (Peteri and Sevinc 2011). complete inventory of all parcels and assigning a The potential of property tax is, however, unique tax identification number to each prop- very important, and cities should invest in the erty allows a quick tracking of the parcels. capacity required to make it the good instru- Some countries have a well-developed land ment that it is meant to be (Brzeski 2012). cadastre that has been maintained for decades. Ultimately, if the property tax is really going It identifies the plot boundaries, improvements, to be made operational, the central govern- ownership, deeds, and other legal requisites. ment has to make significant efforts to increase The land cadastre is the basis of ownership capacity and improve cadastres and take on a transactions and focuses on the legality, the good deal of at least the initial political costs. precise boundaries, and zoning regulations. If 162 Municipal Finances Figure 4.5 Cadastre Information (personal files) it exists, the land cadastre is the best source in can use simplified procedures in establishing establishing a fiscal cadastre. Figure 4.5 shows fiscal cadastres (discussed below). the land cadastre of a rural property within a set Fiscal cadastres can be prepared without of plots identified in South Portugal in 2006. The such precise, legally binding identification of the identification reference—for example, 0084-R- boundaries, deeds, subdivisions, and so forth. L10—means that the plot is located in the city They require only good identification, some of Porches (0084), is a rural parcel (R), and is technical details on land and improvements, located in grid L10. ownership or user information, the tax value Establishing and updating land cadastres is assessment, and billing records. Property iden- a time- and money-consuming exercise usu- tification may be difficult in developing coun- ally carried out by central government enti- tries and transition economies. Land cadastres ties under the supervision of the national or maps may not exist or may be outdated, own- geographic department to ensure consistency ership information may be incomplete, and data and lower unit costs. Municipalities can use on land records may be kept in separate depart- information available in the land cadastre as a ments. Figure 4.6 depicts the relationship and basis to design and establish an integrated sys- sequence among the cadastre, the identification tem for managing the property tax. When land of plots, the assessment of the areas and value, cadastres are not available, local governments and the billing of the taxes. Managing Local Revenues 163 Figure 4.6 Information Flow to Assess the Property Tax Base Updated lists of property values are issued Fiscal Cadastre every year for owners Contains identification prior to billing. number. Description of property (use). Tax bills are issued Value of property. Land (Geographical) Cadastre annually, displaying ID number, property value, Based on GIS and field tax rate, and tax to be paid. identifaction. A unique code is assigned reflecting the exact location. Ownership Register Done by national government. Contains history of Registers are updated only ownership change. when there is change in Confirms current owner ownership or who is responsible for subdivision of property. tax payment. Assessment of the Tax Base register value. This method is used in France Authorities always emphasize that property is and the United States. The market value of assessed for taxation purposes. In theory, that the property can be based on the capital land would mean that the property value is a good esti- value, the capital value of land and buildings, mate of the market value. In reality, property tax is or annual rental value. often levied without reference to estimated mar- ket value. The general principles of assessing the Fiscal experts such as Enid Slack (2009) favor property tax base and how it can be estimated and the market value approach, as it is closer to the updated by applying various models are discussed right cash flow value, captures any improvement below. in the area, and is more transparent. Developed Tax base models have different typologies, countries tend to use the market value assess- depending on how the property is assessed or val- ment. Developing countries use a mixture of the ued (Brzeski 2012). Although  multiple methods two, beginning with area assessment and captur- exist, area-based and value-based assessments are ing some market value elements in the unit tax for the two main method categories: buildings and land. Area-based models have the advantage of being simple and incurring lower • Area-based assessment uses the area (or usable costs. Once the cadastre is prepared, the design area) of the real property assets (for example, is registered, and basic values are given to land square meters of land and improvements) and and buildings using a unit price system, annual the characteristics of the plot—urban, rural, updating requires much less data. It typically close to main centers—to compute its taxa- requires the area’s measurements and type of use tion value. This method is used in the Czech (urban, rural). No market data or valuation work Republic and Poland. is required, which leaves little room for disputes • Value-based assessment estimates the prop- and appeals. Furthermore, area-based models do erty value through its market value or the land not require frequent reassessments, which plague 164 Municipal Finances value-based systems. However, its revenues are factors in an area-based assessment is impor- not buoyant and do not increase with market tant to ensure the fairness of the assessment. booms. It is, however, recession-proof in that it is That is especially true because citizens see vis- independent of market recessions. ible differences among properties, and they do so mostly by looking at factors that the market Area-Based Assessment would recognize, such as proximity of infra- Under an area-based assessment system, the structure, access to energy, and the like. tax jurisdiction estimates the value of a unit (in general, a square meter) of land area, a square Value-Based Assessments meter of building, or some combination of the Value-based assessments follow two main two. Where both measures of area are included, approaches: market value or rental value. Market the assessment of the property is the sum of an value is defined as the price that a willing seller assessment rate per square meter multiplied by and a willing buyer would agree to on a given the size, for example, Ls , ti , bi , property. It can apply to capital land value, or Ls = land size (m2) capital land value plus buildings, or buildings Bs = building size (m2) separately, or annual rental value. Under the pli, = assessed price of m2 land (function of use, rental value (or annual value) approach, prop- and characteristics) erty is assessed according to an estimate of its pbi, = assessed price of m2 building (function of rental value or net rent. Table 4.5 summarizes the conservation, quality, and use). various value-based assessment approaches and The value assessed will be indicates the countries applying them. Value-based assessments are supposed to be V = Ls pl + Bs pb. close to the market value, but market value can be observed only when a property is sold. Because The unit value of land and buildings reflects only a minority of properties are sold in a year, (a) the location—in general, properties in the cen- taxable values are just good estimates. Assessing ter of town command higher prices than those in or reassessing market values needs strong sup- the periphery; (b) the level of conservation of the port in the form of reliable and up-to-date prop- building; (c) the profitability of rural land; and erty data, with building details, and equally (d) the use of structures. The example depicted reliable and market-based evidence of unbiased in box 4.6 suggests that area-based models rarely sales transactions. These methods require reg- use area solely; they estimate a value that captures ular reassessment and revaluation, which pose the factors that substantially influence market not only technical but also political challenges value, such as location, quality, comfort, and age. even in the highly developed countries. In short, most area-based models are intercon- Annual rental value. The annual rental value nected with market values, but the relationship is models use the rental value of the property as the more distant and perhaps less systematic than in tax base. A net value or a gross value can be used the value-based models discussed below. depending on whether the maintenance expenses One of the problems with area-based models are borne by the owner or the tenant. The annual is that they are slower in including increments in rental value models capture a number of market land value associated with public investments, factors in estimating fair rental value. However, although some calibration is possible by using policy considerations are also involved, such as coefficients of additional value-influencing preferential rates for owner-occupied proper- factors (Brzeski 2012). Capturing some market ties (as are customary in Pakistan; see table 4.6). Managing Local Revenues 165 Table 4.5 Assessing the Property Tax Base—Alternative Approaches Measure Tax rates established by local governments Tax base Definition used Where used (LG) and the range of tax rates Assessed unit Size of M2 of land Armenia, Portugal: LGs set the tax rate, within value, or area property and building Belgium, 0.7 percent and 1.3 percent. based adjusted to area, Bulgaria, Denmark: LGs within 1.6 percent and account for adjusted Denmark, 3.4 percent. quality and Germany, Israel, structures Spain, Poland, and Italy: LGs within a cap set Italy, Poland, up by central government. Portugal, Spain Germany: set up by local governments. Bulgaria: 0.15 percent of value of property. Market value Price of Comparable Australia, In Hungary, set by local government. potential sales Canada, Hungary, sale or Japan, purchase Netherlands, South Africa, United States Rental value Value in Net rental France, India, In United Kingdom, as function of a cap. current use Income Ireland, Morocco, In France, local governments with a cap. Pakistan, United Kingdom Self- Sales price Determined Peru, Turkey assessment by owner of property Sources: Slack 2009; DEXIA 2008. Table 4.6 Annual Rental Value Tables—Punjab, Pakistan Residential Property—ARV Valuation Table Self-occupied Rented Building Land rental value Building rental Land rental value rental value Category (Rs/sq yd) value (Rs/sq ft) (Rs/sq yd) (Rs/sq ft) Property situated Up to Over Up to Up to Over Main/Off Up to 500 Over 500 3,000 3,000 500 Over 500 3,000 3,000 Class roads sq yds sq yds sq ft sq ft sq yds sq yds sq ft sq ft A Main roads 0.4 0.3 0.4 0.3 4 3 4 3 Off roads 0.3 0.25 0.3 0.25 3 2.5 3 2.5 B Main roads 0.3 0.25 0.3 0.25 3 2.5 3 2.5 Off roads 0.25 0.2 0.25 0.2 2.5 2 2.5 2 C Main roads 0.25 0.2 0.25 0.2 2.5 2 2.5 2 Off roads 0.2 0.15 0.2 0.15 2 1.5 2 1.5 Source: Ellis, Kopanyi, and Lee 2007. 166 Municipal Finances Annual rental value systems may not yield good an expression of the premium for long-term res- revenue if areas have rent controls. The Pakistan idence (because the initial value does not change annual rental value table may look like an area- over time, the tax base is highly inequitable); and based system, but the unit taxes (e.g., 0.4 rupee (c) banding of values; that is, properties are clas- per square yard) were estimated from market sified as belonging to a certain established “band” samples of actual rental transactions. of values. Other simplified tax base variants. Table  4.7 Updating the property tax base and improv- shows the prevalence of property taxation ing tax administration represented a signifi- around the world. Other tax base variants include cant investment for Bogotá city; the total cost (a) a unitary flat tax, for cities that need cash was nearly US$17 million (over 2009 and 2010), and decide to use the same tax for all properties which was repaid by the additional tax proceeds (Ireland); (b) and initial acquisition value, by well within one year. Table 4.8 summarizes the which cities use historical acquisition values as direct cost of updating the database. Table 4.7 Methods Used to Assess the Property Tax Base Capital Capital value Capital Capital value land land and value Annual land and buildings buildings rental Area Unitary Region Countries value buildings separate only value based flat tax Africa 25 1 8 3 4 7 11 6 Asia 24 2 6 2 0 11 11 0 W. Europe 13 0 9 0 0 6 0 0 E. Europe 20 1 6 0 0 0 15 0 Latin America 16 2 14 1 0 1 0 0 Total 98 6 43 6 4 25 37 6 Source: Muccluskey, Bell, and Lim 2010. Table 4.8 Updating the Property Tax Database in Bogotá Cost US$ Item thousands 2009 Percent Observations Administrative support 557.8 7.1 Management and administrative staff including selection of personnel to be hired. Support staff and material 954.8 12.2 Project headquarters, vehicles, attire, secretaries, and assistants. Mapping 392.2 5.0 Digitizing staff, carrier officers to supervise. Communications 79.1 1.0 Staff and contractors, managing relations with communities and media. Economic component 958.1 12.2 Assessors, carrier civil servants, econometric modeling team. IT support 560.5 7.2 Hardware and program assistants, IT support staff. Temporary employees 4,330.3 55.3 Over 460 technicians and professionals. Total 7,832.8 100.0 Source: Ruiz and Valejos 2010. Managing Local Revenues 167 CAMA. Computer-aided mass appraisal has has revolutionized the administration of prop- become widely used in the United States, Canada, erty taxes (see box 4.7). The traditional valuation and Western Europe in the last two decades. methods require a great deal of data on sales and It  has been introduced to developing countries rents and are therefore expensive to use in transi- with great success, as it enables the assessment of tional and developing countries. Recent improve- a property tax base with much less data and cost ments in spatial analyses of location, using GIS (Eckert 2008). and low-level technology, have reduced the CAMA is a process to estimate a hedonic amount and type of data needed for CAMA. price index for a class of real estate, such as res- In countries in transition where there is an idential properties, from a representative sam- existing property tax, CAMA can be very use- ple of sold properties from the entire population ful in recalibrating models to achieve more (Eckert  2008). The index relates sales prices market-oriented results. In countries without a to the physical and location features of the sold tax, CAMA, with some low-level technology and properties. The weights (or the coefficients external ground data, can establish a working of the estimated regressions) are then used to property  tax at a reasonable cost in a relatively value unsold properties. In this way, local gov- short time. In Kosovo, a property tax was estab- ernments can have a valuation of the universe of lished in 30 cities in 18 months. In Cape Town, a unsold properties. CAMA brings an easier way general revaluation was done in two years using to assess the property tax base, and in a way, it CAMA. Further updates can be done in months Box 4.7 Developing a Computer-Assisted Mass Appraisal Model The development of a CAMA method follows modification of existing or accepted models. several steps: A linear model is the easiest and can be esti- Data collection. Data are gathered con- mated as follows: cerning both sold and unsold properties, P = A0 + A1X1 + AsX2 + … + An Xn, including and inventory of property characteris- tics, location, and other factors that may affect where P is the sale price of the property; value. Data can be qualitative or quantitative Xi is the attribute of the property—location, and categorical (good, fair, poor) or continuous quality, size, and use. (e.g., number of beds). Data are then analyzed Ai is the estimated weight that will be used in terms of distribution and to identify outliers. later to assess the value of the unsold property. Data are fitted into multiple regression analy- A key part of the modeling process involves sis to identify the strongest predictors of the continual testing of the model to determine if value of the property in analysis. it is accurately predicting the value of proper- CAMA modeling. The appraiser developing ties. Once a CAMA model is developed by the the model uses various techniques to develop appraiser for a class or subclass of property, an appraisal model that replicates the market it is then applied to all properties, sold and in assigning value to the various features of a unsold, in that class or subclass. This ensures property. Such techniques may include linear that all properties in the class or subclass are or multiple regression statistical analysis, or treated equitably. Source: Eckert 2008. 168 Municipal Finances (Eckert 2008). The problem is that collection rates rates vary from 3 percent in the rural areas to and valuation efforts often do not keep up with the 30 percent for vacant urban land taxed on a rental speed of the new systems. In Kosovo, collections value basis. The last reform in 2007 focused on are less than half the amount billed annually, and updating the basic cadastre and keeping it cur- local governments are not valuing properties, so rent on an annual basis. The results have been the base is eroding almost as fast as it was created. impressive, although the city has established tax increase ceilings to avoid upsetting the taxpay- ers with sudden hikes in their property tax bills Establishing Tax Rates (described above in box 4.5). Assessed tax val- Once the tax base is chosen, the next element is ues have increased several times, and collection to set the tax rate, which usually is a local govern- results have also improved. ment function. Local governments set property By contrast, in many transition and developing tax rates in different ways: economies, the national government may set the • They can choose one rate for all assessed rates for property taxes, in the form of either a cap properties (the simplest way) or use differ- or a range of rates. Local governments may vary ent rates according to whether the govern- rates by class of property, for example, residen- ment is  taxing land or buildings or urban or tial, commercial, and industrial (India, Pakistan). rural land;  according to location and type of This is justified because needs and consumption infrastructure available; or according to use of public goods vary, and when local governments (residential, commercial, industrial). want to attract businesses, these taxes may come into play. Often local governments can establish • The central government may put a cap on the their own tax rate, within a range of values agreed local tax rate, as well as a limit on abatements with the central government. and exemptions. • Property tax rates may be updated annually Billing, Delivery, Collection, and Enforcement using an inflation index that maintains the Billing, delivery, collection, and enforcement real value of the tax proceeds and minimizes (“downstream activities”) have a substantial political controversies. impact on the performance of the property tax. • In some cases, as in Australia, Canada, and Many local governments understand their impor- the United States, local governments deter- tance and have a keen interest in maximizing the mine their expenditure requirements, subtract results. Some of these activities can be outsourced the amount they expect to receive from other to the private sector, provided there are good revenues such as grants and other taxes, and incentives for effective collection and enforce- divide the residual amount by the assessed ment (Brzeski 2012). Billing and delivery may be property value to get the property tax rate. a challenge in countries without good property This process undergoes several iterations addressing systems (box 4.8). before the increase in tax is announced, for Although voluntary compliance is always pre- a sudden increase in tax rate would have to ferred, enforcement is unavoidable and requires be justified and supported by similar market procedures for dealing with tax arrears and non- value increases rather than merely by the wish compliance. Public awareness of simple, swift, of the local government to spend more. and effective procedures, including judicial sale or arrest, usually induces voluntary compli- Changing rates or adjusting the base is sub- ance. Additional encouragement to compliance ject to policy decisions. In Bogotá, property tax can be achieved when payment is easy to make Managing Local Revenues 169 Box 4.8 Property Tax in the West Bank Local taxation in the West Bank is fairly difficult considering the particular circumstances. However, despite the constraints, the property tax is collected in 29 towns, and property tax revenue represents about one-fifth (19.16 percent) of the total current budget. Source: World Bank 2010. (electronic payment via the Internet, or payment than the provision of public goods. For expendi- at the local post office) and tax bills provide infor- tures such as education and health, transfers from mation about how the money is spent, rather the central government are the best direct source than about the penalties for noncompliance. Tax of revenue. Ironically, it is in those countries arrears are relatively small in developed coun- where the property tax is used to fund teacher tries (4 percent or 5 percent in Canada and the wages that the yields and systems are the most sig- United States), but they can reach 40 percent to nificant (e.g., Montgomery County, Maryland, and 50 percent, as they have in the Balkans, Kenya, Fairfax County, Virginia, in the Washington, D.C., and the Philippines.4 metropolitan area). Simplified procedures, such as Disputes and complaints are dealt by the com- area-based assessments (as are used in Bangalore) pliance office of the property tax authority, as they and self-assessments (introduced in such cities as may be based on incorrect information. When Bogotá), have led to significant increases. the taxpayer is not satisfied, the issue may follow In many countries, the property tax is under the administrative process of arbitrage and tax attack (Ingram 2008). Its unpopularity comes tribunals. from its visibility—taxpayers are faced with large In sum, the property tax is a good tax for local tax bills once or twice a year. Many taxpayer governments—the tax base is fixed, and when the revolts can be traced to rapid increases in prop- proceeds are used to pay for local services they erty tax bills, and many recent reforms involve approximate a user fee (Ingram 2008). In addition, limiting increases in property tax bills from year property tax revenue is predictable and stable, a to year. The visibility of the tax is also a virtue in clear advantage for local governments that do not that it provides an incentive for citizens to scru- have much diversity in revenues. In developing tinize the expenditures of the local government, countries, however, the property tax may be dif- promoting fiscal discipline and citizen involve- ficult to implement. First, administration may be ment. For many local governments with limited costly, especially the initial investment in property technical capacity, the biggest difficulty in imple- identification and staff training. New techniques, menting a property tax is obtaining accurate such as computer-assisted mass appraisal, can information on the properties to be taxed and significantly reduce the cost of valuation. Second, their value. Without this basic information, local local governments may tax more nonresidential authorities will have a hard time designing and property because it is easier to obtain revenue implementing an efficient and fair real estate tax. from a deeper pocket. However, that might be The debate over whether the property tax is counterproductive, since businesses are mobile the best local tax is still very much alive and, as and may leave town. Third,  local governments indicated earlier, property tax is not for every- cannot rely on property tax for purposes other body. But a larger number of experiences around 170 Municipal Finances the world provide information on how local a small surtax attached to the central or provincial governments have dealt with their particular or state tax system. Sometimes cities introduce an circumstances and have succeeded in using prop- additional, “piggyback” tax or surcharge of 1 per- erty taxation to finance their functions (Bahl, cent or 2 percent. That could be a good way to go, Martinez-Vazquez, and Youngman 2008; 2010). since it is easy both technically and politically and would avoid high compliance costs. General Consumption or Sales Taxes Value added tax (VAT). In most countries, the Local sales taxes are general consumption taxes general sales tax (or gross receipts tax) is levied charged at the point of purchase for certain goods as  a value added tax at the central government and services. The tax is set as a percentage of the level, although there is some experience with price of the purchased product. A sales tax is a state or provincial VATs as well, as in Brazil. Many regressive tax, meaning that its impact decreases analysts believe that the sales tax is not a good tax as a payer’s income increases. Ideally, a sales tax and suggest that it should be abolished and incor- is fair, has a high compliance rate, is difficult to porated into a comprehensive value added tax avoid, and is simple to calculate and collect. A con- (Werneck 2008). Turnover sales taxes have been ventional or retail sales tax attempts to achieve gradually replaced by national VATs in many that ideal by charging only the final or end user. countries, leaving local governments without an It is unlike a gross receipts tax, which is levied on important local tax. In such cases, tax revenue the intermediate business that purchases materi- sharing arrangements have been devised to dis- als for production or ordinary operating expenses tribute part of the tax proceeds among local gov- prior to delivering a service or product to the ernments. Such sharing ought to be in the nature marketplace. The sales tax prevents so-called of a grant and not based on origin. However, the tax cascading, or pyramiding, in which an item infrastructure needed for an effective VAT is is taxed more than once as it makes its way from fairly big, including proper accounting practices, production to final retail sale. which may be lacking in developing economies, General consumption taxes include retail sales where sales without receipts or electronic regis- taxes and value added taxes (VATs). Local retail ters are common and so is the informal sector. sales tax rates are in general about 2 percent to Local governments outside the United States 5 percent and are collected by the cash counters seldom levy general sales taxes. The exception of stores and from other final sales transactions. is Brazil, where they are a major form of munic- They are very important for local governments. ipal taxation (the imposto sobre servicos, or ISS), In Spain, they account for half of local revenues; imposed on all services except communications in Austria, 30 percent; and in the United States, and interstate and intercity public transporta- 25 percent. tion, which are taxed by the states. The ISS is Local sales taxes have two main benefits: imposed on retail sales at the minimum rate of (a) they provide an elastic source of revenue—that 2  percent; maximum rates differ by the type is, when the economy grows, so do retail sales, of  service, with the maximum being 5 percent providing more revenue for the local government; of gross revenue. The main problem with gross and (b) they are transparent and easy to collect. receipts taxes is  that they tax business inputs They also have shortcomings: evasion problems and cause tax cascading effects, with consequent can sometimes be serious, and large rate differ- distortions to the organization of production, as entials between neighboring local governments businesses attempt to reduce tax liabilities. lead to people crossing the border to make pur- Selective sales taxes on automobiles (such as chases in the lower-rate city. Local sales tax can be fuel taxes and vehicle registration) are another Managing Local Revenues 171 type of sales taxes. They have a double benefit 15  percent of GDP. Municipalities in Denmark, in that they discourage road use and at the same Finland, and Sweden impose local income taxes time produce revenues that are often earmarked on their own, parallel to the national income for road maintenance. tax, because they are directly responsible for social services and health. They use the tax Local Personal Income Tax base assessed for national income tax purposes Income taxes are used at the local level but to a (a similar system is used by the state governments much lesser degree than property or retail sales of the United States). In these countries, the taxes. Local personal income taxes can be of two local personal income tax constitutes the main types: a surtax on the central or state income tax source of local revenues (85 percent in Finland (a piggyback tax) or a separate, locally admin- and Denmark; almost 100 percent in Sweden; istered tax. The second type is less common 16  percent in Belgium). To prevent the local gov- because it is more difficult to implement and very ernment from overtaxing, the public tax ceiling expensive to administer. has become a formal agreement in Denmark, Local income taxes are not common in devel- Norway, and Sweden (Slack 2009). oping countries. Rather, local governments in less developed countries (e.g., in Pakistan, Serbia, Local Business Tax Turkey) receive a substantial share of income tax Local business taxes, or taxes on economic revenues through tax sharing systems such as those activity, take various forms. The tax can be a outlined in chapter 1 (Bird 2001). Nevertheless, corporate income tax, a tax on capital or labor; income taxes can be justified at the local level on a nonresidential property tax; or it can be a license the grounds that local governments are increas- fee or other charge to commerce or industry. In ingly being called upon to address issues of pov- the European Union, 10 countries use a business erty, crime, regional transportation, and other tax, which contributes between 15  percent and regionwide needs. To the extent that local gov- 30  percent of local governments’ revenue. The ernments are required to provide social services, local business tax is more important than any a small tax on incomes is probably more appropri- other local tax in Germany, Hungary, Italy, and ate than a property tax because the local income Luxembourg (see table 4.9 and box 4.9). tax is more closely related to ability to pay. The local business tax is calculated on The local income tax is a big revenue raiser different bases, depending on the country. The in Nordic countries, yielding revenues of up to two main approaches are stock base or flow base. Table 4.9 Main Local Business Taxes in the European Union Percentage of Percentage of Country Name of tax Base tax revenues total revenues Austria Municipal business Value of salaries 20 10 France Professional tax Rental value of capital assets 43 19 Germany Local business tax Company profit 43 19 Hungary Local business tax Net turnover tax: difference between 38 12 revenues and cost of production Italy Regional tax Net value added 54 24 Spain Economic activity tax Profit on economic activity 9 3 Source: DEXIA 2008. 172 Municipal Finances Box 4.9 Local Business Taxes around the World In Côte d’Ivoire, the main local tax is a local businesses’ average number of employees. business tax (patente). It is a set of fixed In Ukraine, a simplified system was intro- taxes that vary according to the type, size, duced consisting of fixed rates on gross sales and location of a business. This tax pro- by sole owners, plus a 10 percent sales tax on duces one-third of total revenues in Abidjan. gross sales by enterprises. A similar tax exists in Morocco, where six In Latin America, local business taxes are tax rates are applied to several hundred cat- quite common. Argentina has a local tax on egories of businesses, classified by rental gross receipts at rates between 1 percent and value and type of business. In Tunisia, the 12 percent. Colombia’s business tax ranges business tax is levied at a rate of one-fifth of from 0.2 percent to 1 percent of gross receipts. 1 percent of gross business income. Sometimes a tax is levied on the firm’s wealth. Hungarian local governments collected 86 Chile imposes a tax of 2.5 percent to 5 percent percent of their own-source revenues from on firms’ net wealth; Ecuador imposes a simi- local businesses, with a maximum rate of lar tax at 3 percent. In Kenya, the business tax only 0.3 percent but on a base of gross sales. is in the form of a license fee, a flat contribu- In addition, a small communal tax, at a fixed tion that is not related to the income or assets amount per employee, is levied based on of the business. Source: Bird 2001. Using stocks (e.g., payroll, the number of employ- to nonresidents. One good economic argument ees, value of property assets, capital goods) to in favor of local business taxation is that it can be determine the tax base enables local govern- seen as a proxy for a benefit tax. However, public ments to have relatively stable tax revenue from services benefiting specific businesses would be one year to the next. Many view it as unfair, since better paid by appropriate user charges, as well as it ignores businesses’ ability to pay and discrim- a property tax. When these charges are not fea- inates among stocks or specific assets. That is sible, some form of broadly based business tax is not the case when the tax assessment is based on justified. flows (e.g., profit, added value, or net turnover); Local business taxes have several shortcom- that is more equitable for businesses but is sensi- ings. First, local business taxes are generally not tive to change in the economic environment and equitable and may accentuate disparities among provides less-predictable tax revenue. Box 4.9 cities; they lend themselves to being exploited. provides a summary of how business taxes are Second, from a policy viewpoint, a high business used in different countries. tax can hurt employment and investment, espe- Local business taxes are often popular with cially in economic downturns. That is the reason residents and elected officials because (a) they are that the local business tax in the European Union more responsive to economic growth than prop- has been revised in many countries to exempt erty taxes; (b) cities have more discretion over the small firms. Third, corporate income taxes are level of the business tax than any other tax rate; difficult to administer because the payers have and (c) no one is sure about the incidence of the to determine how much income is attributable to tax, so it is easy to claim that it is partly exported the local jurisdiction imposing the tax; especially Managing Local Revenues 173 when firms have businesses in several jurisdic- may result in a fine, removal of plates, or vehicle tions, that process is technically complex. For impoundment. Just as with all other local taxes, instance, in Turkey, the large cities gain excep- effective and efficient management of the vehicle tionally high local taxes from corporate income tax requires a complete database on vehicle own- because they host the headquarters of large firms ers and a credible enforcement system. In many that operate around the country. For transitional countries, this is typically a shared tax with local economies, a local business tax is one of the eas- governments receiving 50 to 100 percent of the iest taxes to levy, whereas their limited admin- yield. National governments are usually reluctant istrative capacity often makes the use of other to give taxing power over cars to local jurisdic- taxes, such as the property tax, more difficult. tions. Doing so can create tax competition between It is odd to notice that although economists jurisdictions if the registry rules are leaky. agree that local business taxes are inefficient and Vehicle registration fees are also better for distort economic decisions, most governments at reducing local pollution and congestion because all levels ignore such advice and impose them any- these negative externalities are largely localized way (Bird 2006). They do so on the basis that if by owners’ registration and vary by engine size, the proceeds are used to provide services to local vehicle age, axle, and weight. These factors affect businesses, the use of a business tax at the local the amount of pollution, congestion, and road level is totally compatible with the benefit princi- damage more than would fuel consumption. ple. In addition, local governments often have very Fuel taxes are typically national and aim at few tax alternatives. Being able to tax local busi- financing intercity roads and externalities. Fuel nesses,  without arousing the opposition of their purchase is also less localized, so that a fuel tax is entire constituency, can be a powerful argument less efficient in reducing local externalities than in its favor. Countries with long experience of congestion charges or tolls, which can vary by time using local business taxes include Brazil, Canada, of day and location (Slack 2009). Cities that levy a Germany, Hungary, Japan, Kenya, Ukraine, the fuel tax often piggyback on state fuel taxes because United States, and most West African countries. the administrative costs of levying their own tax would be too high. The earnings from this tax are Motor Vehicle Taxes generally earmarked for local roads  and transit The motor vehicle tax is becoming more common services or environmental remediation. in urban areas in both developed and developing Administration remains the core and main economies. Vehicle taxes are consistent with the challenge for an effective vehicle taxation system. criteria of equity, ability to pay, and the benefit Adequate updating of a motor vehicle database principle. Generally there is a positive correlation should be automatic. That means that the vehicles between the market price of vehicles and the level database is updated as part of the transfer of own- of income of their owners. Vehicle taxes are easier ership when the sale of a vehicle is completed. For to manage in comparison to other local revenue instance, the plate of a sold car remains with the sources. The characteristics of vehicles are well seller, and the new owner must obtain a new plate. known, and so are the average market prices, This provides strong support to timely ownership based on mileage and physical condition. Tax records, since driving without a plate or registra- enforcement is relatively easy and effective, con- tion is a criminal charge. Tax rates for the purpose sidering that for this particular tax, enforcement of tax assessment need to be transparent, and is usually done directly by the police. tax payment obligations and deadlines need to For instance, not having an up-to-date vehi- be communicated to all owners on a yearly basis. cle registration (i.e., proof of tax compliance) A stamp on the plate or windshield is a simple, 174 Municipal Finances cheap, and transparent instrument. Enforcement of consumption that is reached when the price needs to be credible, and impounding vehicles equals the cost of providing an additional unit of should be considered an enforcement option. the service (see box 4.10). Congestion taxes are a recent type of tax User charges are subject to local politics and designed and implemented in large cities with the often are set below costs, particularly in devel- objective of discouraging the use of private cars oping countries, with multiple negative conse- and reducing congestion and pollution in the city quences, such as the following: (a) The service center. The tax has been successfully implemented provider owned by the municipality may reduce in London, Milan, Singapore, and Stockholm. the quality, time of availability, or coverage of ser- Congestion and pollution have been substantially vices (for instance, water is provided only three or reduced, and the proceeds of the congestion tax four hours per day in most Pakistani cities). (b) The have been used to finance the renovation of major provider requires subsidies from the municipal public transit systems, notably the subway in budget, so that the costs are eventually paid by the London. The methods to compute and levy the same customers or taxpayers. (c) Underpricing a tax vary; for example, an average tax charged dur- service (by not charging enough for it) can result ing particular hours (London, between 7 a.m. and in overconsumption. In contrast, user fees for 6 p.m.) or as a function of the congestion in the water that are based on marginal cost encourage city and the hour of the day (Singapore). The con- water conservation, discourage water consump- gestion tax is an example of a win-win situation tion for low-value uses (e.g., watering the lawn in which a fiscal tool generates revenues for the or washing the car), and postpone the time when local government and also leads to less carbon new investment is needed (Devas 2001). emission. It promotes the use of the mass trans- User charges are also an important way to port system, contributes to improving air quality, provide economic signals, both to consumers, and generates time savings in commuting, hence concerning the scarcity of services, and to pro- increasing urban productivity. viders, about the demand for services that needs to be met. User fees also ration the use of exist- User Charges ing facilities and give appropriate capital invest- User charges are paid by consumers to the local ment signals. In other words, they can reduce the government for private goods and services, such demand for infrastructure: “Whenever possible, as water, electricity, waste collection, or public local public services should be charged for rather transport. A user charge is a charge per unit of than given away” (Bird 2001). Cost recovery is output, for example, the water tariff per cubic a basic economic principle but may be in con- meter of consumed water, the electricity bill for flict with social justice in that some low-income a given consumption of kilowatt hours, and the groups may not be able to afford cost-recovery- fee per trash bin or per kilogram to collect solid level tariffs. Thus, appropriate tariffs may require waste. User charges or user fees have an inter- targeted subsidies to ensure access to public esting economic rationale. Well-designed user services for the poor. fees allow residents and businesses to know how much they are paying for services. When proper Designing User Charges prices are charged, governments can make effi- Determining the proper domain and design cient decisions about how much to provide, of user charges is quite challenging. In theory, and citizens can make efficient decisions about municipalities should charge for private good how much to consume. In theory, user charges services the same price as would be charged in a affect behavior and promote an optimal level competitive market. Managing Local Revenues 175 Box 4.10 Water Tariffs—An Example of User Charges A water tariff is a price charged for water costs go up with the level of consumption— supplied by a service provider. It is supposed increasing-block tariff systems—are used by to recover the costs of water treatment, about half of the water utilities in OECD coun- storage, transportation, and delivery. Water tries, such as Spain. Flat rates are still reported tariffs vary widely among cities. Tariffs (often in Canada, Mexico, New Zealand, Norway, and average cost pricing) can be set below costs the United Kingdom. As for developing coun- (which leads to overconsumption), at the level tries, a recent sampling of 94 utilities indicated of cost recovery, or above the level of cost that one-third used increasing-block tariffs and recovery to include a predetermined return the remainder used flat fees. The highest on capital. water tariff in the world is found in Scotland, Water tariffs are set based on (a) finan- equivalent to US$9.45 per cubic meter (m3) in cial criteria (cost recovery); (b) economic cri- 2007 . The lowest is in Ireland, where residen- teria (efficiency pricing based on marginal tial water is provided free. The lowest residen- cost); and sometimes (c) environmental cri- tial water and wastewater tariffs were found teria (incentives for water conservation). In in Ljubljana, Slovenia (equivalent to US$0.01 addition, social considerations play a role, per m3); Saudi Arabia (equivalent to US$0.03 such as a desire to avoid too great a burden per m3); Havana, Cuba; and Karachi, Pakistan on poor users. Water tariffs include at least (equivalent to US$0.04 per m3).The highest one of the following components: a volumet- water and wastewater tariffs were found in ric tariff, in which metering is applied, or a flat Copenhagen (US$8.00 per m3), Honolulu rate, with no metering. The tariff for a first (US$7 .61 per m3), and Glasgow (US$5.89 block on an increasing block tariff (IBT) is usu- per m3). An even higher combined water ally set very low to protect poor households. and wastewater tariff can be found in Essen, The size of a first block can vary from five to Germany, a city that was not included in the 50 cubic meters per household per month. In OECD survey. The tariff in Essen is equivalent South Africa, the first block of six cubic meters to US$8.41 (€5.61) per m3, according to a sur- per household per month is provided free vey carried out for the weekly magazine Der (free basic water). Spiegel. Many utilities charge higher tariffs for International comparisons. Linear volumet- commercial and industrial customers than for ric tariffs are the most common form of water residential users as a way to subsidize resi- tariff in OECD countries. Tariffs whose unit dential customers. Source: Easter and Liu 2005. Four Methods of Computing User Charges the cost of the product, as well as the oppor- tunity cost, that is, the value of the alterna- • Marginal cost pricing is the ideal way to tive use of resources if they were not used compute a user charge, as it approximates the for the good or service being offered. Other market price in perfect competitive market, concepts are important, including the long- that is, the cost of producing an additional unit term marginal cost; that is, the cost of expand- of the good. This principle is difficult to apply ing the  facility, including infrastructure and because it requires complete information on capital costs. 176 Municipal Finances • Average cost pricing is a more practical method municipalities lack the necessary expertise to that guarantees that all costs will be recov- price correctly. ered. The prices are easier to calculate: all the Some practical issues regarding the imple- financial costs required for providing a certain mentation of user charges include the lack of service are divided by the number of consum- technical knowledge on how to set an adequate ers or the volume sold, which produces the user charge structure; the lack of a cost account- appropriate user charge. ing system to determine the actual cost of service provision that would need to be recovered to • Average incremental pricing uses the average ensure service sustainability; and a fairly weak cost price but asks how much it would cost to enforcement system due, in some cases, to short- serve an additional consumer. sighted interest in short-term political gains at • Multipart tariffs unbundle the service and the expense of the financial sustainability and charge for each component according to its quality of municipal services. However, even if price elasticity. Multipart tariffs make it possi- average cost is the adopted method, local enti- ble to set a fixed charge for basic consumption, ties and their public facilities would do well to with progressively higher charges for greater employ user charges. They discourage overcon- consumption, to help low-income customers sumption and provide a steady stream of revenue through built-in subsidies in the tariff struc- to local governments. ture. Some of these pricing techniques may also consider higher unit-prices during peak Surcharges on Utilities hours of consumption (e.g., electricity supply), Utility surcharges are levied on household as well as separate fees for new connections to services, such as water, electricity, telephones the existing network. These one-time fees usu- (landlines and mobile phones), and cable tele- ally cover part of the capital cost of the invest- vision (box 4.11 is a summary of the surcharges ments in the services’ main infrastructure. in Fairfax County, Virginia). They are widely used because recovery tariffs are well accepted Difficulties with User Charges and the surcharge is typically a small addition to The biggest difficulty with user charges is the sug- the generally acceptable bills. Surcharges5 con- gestion that they harm low-income families, who stitute an emerging form of taxation for devel- cannot afford to pay them. Many studies have oping countries. They act as increases in utility shown that this is not true, as the poor tend to pay tariffs, and they may discourage the consump- higher prices for privately sold water. A consen- tion of services. In general, however, people sus exists that relatively simple pricing systems, believe that they meet the criteria of a broad tax such as a low initial charge for the first block of base and fairly low tax rate, making these taxes service use, can deal with most inequity concerns. more affordable and politically acceptable. A second problem is the cost of metering or In practice, these surcharges should be used implementing the price system. Charging the for specific purposes, notably to increase the effi- marginal cost of water requires metering, and ciency of the services being taxed. An example is the installation of meters has a cost. Costs are the energy fund in Alameda County, in California, also associated with obtaining the informa- established in 1995 to finance energy-saving proj- tion that municipalities need to price services ects to make electricity cheaper for consumers in correctly. For example, they need to know the longer run (see box 4.12). long-term capital costs, infrastructure invest- Municipalities in the West Bank offer another ments that will be needed, and so forth. Many unique case, where surcharges are the largest Managing Local Revenues 177 Box 4.11 Charging Willing Buyers There are 11 various taxes and surcharges imposed on cable TV, Internet, and phone services in Fairfax County, Virginia, in the United States. The charges increase the direct service fee by 11.9 percent. The largest items include a communications sales tax of 6.43 percent and a federal subscriber lines charge of 6.07 percent. The smallest are nearly invisible: a federal regulatory recovery fee of 0.08 percent, a cost recovery surcharge of 0.06 percent, and a federal excise tax of 0.18 percent. Box 4.12 Surcharge for Energy Saving Alameda County, California, in the United States, collects utility surcharges to finance energy saving investments. All proceeds are deposited in a Designated Energy Fund. The money is used to increase the efficiency of planned projects, help pay for projects with long payback periods, and cover gaps in project financing. Source: http://californiaseec.org/documents/best-practices/best-practices-alameda-county-ac-fund. local revenue source. Municipalities impose sur- revenues, but they have substantial implications charges on both electricity and water, which that policy makers need to be aware of. In some provide substantial general local revenues. countries business licenses constitute an impor- These two surcharges generated half of all tant revenue source. Businesses are relatively easy local revenues—36.0  percent and 14.3 percent, to identify, and enforcement is based on the need respectively—in 2008 (World Bank 2010). for a license to operate legally. Business licenses also serve other purposes, such as compliance Fees, Permits, and Licenses with public safety ordinances and regulations on User fees include license fees, such as those for hygiene, for example, in restaurants, schools, and registering marriages and births, fees for pro- sport facilities. However, excessive license fees viding a copy of a marriage or birth certificate, may discourage business development and even- or pet registration. These fees aim to reimburse tually be transferred to customers. the cost the local administration incurred to Construction permits or building licenses in provide that service or document. However, a rapidly growing cities may generate significant number of license fees are in fact taxes, set high revenues. (Teheran offers an extreme case, in above actual costs. These typically include busi- which building permits provide two-thirds of ness or professional license fees, building per- the  city’s revenues.) They offer easy identifi- mits, and others. cation, ability to pay, and practically automatic Taxing by charging high fees. Charging exces- enforcement—no payment, no license. Cons- sive fees has become a popular practice in devel- truction permits serve other purposes, such as oping countries. These seem to be cheap and easy public safety and compliance with zoning rules 178 Municipal Finances and regulations and minimum construction speci- or replacement of existing capital facilities and fications. However, high building permit fees may cannot just be added to general revenue. They have negative effects on willingness to pay user are essentially user fees levied in anticipation of charges over time; some developers argue that use, expanding the capacity of existing services to they have paid the fee for water, road, and waste handle additional demand. The amount of the fee removal by paying a high license fee in advance. may not be arbitrary but must be clearly linked to Land development fees and construction the added service cost. permits are by far the most important local gov- ernment revenues in many developing countries, Fines and Penalties including most of the post-Yugoslav countries. In The category of fines and penalties primarily some of the Balkan countries, land development includes motor vehicle traffic violations and pen- fees constitute a large share of local governments alties for late payment of taxes and user charges. revenues (50%). This has a number of implications Their use varies from one city to another. Fines on the level of vulnerability of the municipal rev- and penalties can be a significant revenue source enues structure as well as the way municipal land for urban traffic management in medium-size is dispensed of and the way cities of the region and large cities. Amman City, Jordan, has intro- urbanize. The 2008 financial cricis has shown duced a computerized system for recording and the need to diversify the sources of revenues. penalizing traffic violations. Because half of the Abolishing these fees would curtail new invest- country’s population lives in, and the other half ments, but allowing local governments to set them often travels into, Amman, it has improved traf- at any level hurts business and encourages illegal fic rule compliance and generated substantial construction. One alternative is for the central revenue for the city. government to impose rate ceilings, as in Albania. The tax base could be set per square meter, by Current Revenue from Assets zones, or on estimated construction costs. Current revenue from assets is mainly rent from Professional licenses are sometimes used leases of municipal land and buildings. Table 4.10 in developing countries, typically for specific summarizes the main capital revenue categories. high-revenue professions such as lawyers, doc- This category of revenues applies to municipal tors, and real estate agents. In some countries, real estate used in retail and wholesale activities; however, the costs of collection and enforcement for example, municipal food markets and munic- may be greater than the revenue they generate. ipal urban land and buildings. Asset revenues The use of electronic forms has reduced the cost often have great potential. Potential revenue of administering these taxes. Development impact fees are one-time charges Table 4.10 Main Capital Revenue Categories applied to offset the additional public ser- Categories Capital revenues vice costs associated with new development. Own-source revenues Asset sales Development impact fees are usually applied at Betterment fees the time a building permit is issued and are ded- Contributions icated to provision of the additional services— such as water and sewer systems, roads, schools, Current surplus libraries, and parks and recreation facilities— Revenues from higher General capital grant government levels Earmarked grants made necessary by the presence of new residents in the area. The funds collected cannot be used External revenues Loans, bonds, and for operation, maintenance, repair, alteration, equity Managing Local Revenues 179 from assets is sometimes underutilized because development expenditures; and (c) that the sale inventories of municipal fixed assets are gener- or long-term lease of assets (either land or prop- ally incomplete and outdated, or they may never erty) reduces the wealth of the municipality, and have been developed. To improve revenues from thus the proceeds should be accounted for in the land assets, cities can benefit from (a) more capital budget and reinvested to finance local transparent management of fixed assets; (b) a public infrastructure to ensure that the wealth of legal requirement that city governments submit the community remains the same or grows. Many yearly balance sheets to the overseeing authori- developing countries do not require the prepa- ties explicitly reporting on fixed assets; (c) a com- ration of separate current and capital budgets. petitive system to set rents and award leases; and However, this distinction is essential for local (d) good contract management and enforcement, governments to secure proper revenue manage- supported by a transparent, reliable, and up-to- ment and to pursue development. Some impor- date asset revenue database. Further details and tant capital revenues are discussed in detail in discussion on the management of local govern- chapters 6 and 7, but they are briefly summarized ment assets are included in chapter 6. here for the sake of a comprehensive description of the capital budget. Other Recurrent Revenues • Own-source capital revenues. This category “Other recurrent revenues” is a residual category includes (a) proceeds from the sale or lease of that indicates possible misclassification if it is too assets (land or building); (b) betterment fees or large. A figure greater than 5 percent may mean other development levies, including quasi-tax that the revenue manager does not have an accu- construction permits and land development rate account of the items included as revenue. fees; (c) contributions from beneficiaries of It also signals a lack of transparency that hurts local public goods; and (d) sometimes opera- accountability. A large “other revenues” segment tion surpluses from the previous fiscal year, also could be a result of balloon budgeting, as which may be allocated to the capital budget when the local finance department puts a large or set aside as reserves. Municipalities should sum in the category to ensure a formally balanced put great or major emphasis on their own budget. This is a highly inappropriate budget- capital revenues because they are under the ing practice that violates basic disciplines and most direct control of the municipality. Using distorts budget execution. asset sales, betterment levies, and contribu- tions requires a clear strategy interlinked with Capital Revenues and Main the urban planning, zoning, and development Sources of Capital Investment plans (discussed in chapter 6). Financing • Capital transfers and grants. Transfers and In many countries revenue accounting requires grants are allocated by many central gov- segregating current (also called “recurrent” or ernments not only as general block grants or “nondevelopment”) revenues and capital (also current grants, but also as separate transfers called “nonrecurrent” or “development”) rev- for general capital investments. They may also enues. The reasons behind this distinction are be earmarked grants for specific investments, (a) the basic principle that a municipality should such as water and sanitation, roads, health, finance its regular operations from recurrent culture, or education. Earmarked or target revenue flows; (b) that nonrecurrent revenues grants may require copayment by the munic- are better accounted in, and used for, capital or ipality and perhaps also by the beneficiaries. 180 Municipal Finances Some of these grants may be competitive, and several ways in which local  governments can accessing them may require application and tap their land assets to mobilize revenue. The local policy decisions. Some capital transfers most important include betterment levies (or aim to fund delegated services and develop land value capture), sale or lease of public land, infrastructure in services for which the local public-private partnerships, and impact fees governments are not responsible. Proceeds (Peterson 2009). from earmarked grants are best spent precisely Land value capture taxes are levied to capture for the set purpose and in the exact amount. the increment in land value attributable to public • External revenues. Borrowing by local govern- investment. These taxes are also known as “land ments is justified, especially to finance long- value increment taxes,” “betterment levies,” or term investment plans, provided that debt “valorization taxes” (Slack 2009). Betterment service is ensured and does not jeopardize levies are directly levied on the owners of prop- the fiscal stability of either the local or the erty whose value has improved because of the higher levels of government. Operational sur- government’s investment in nearby public infra- pluses and own-capital revenues can be used structure, such as street paving; water, sewer, and for cofinancing or repaying debt; they play drainage systems; bridges; public lighting; or rail an important role in estimating and ensuring or bus rapid transit. To contribute to the financing municipal borrowing capacity and creditwor- of these types of projects, part of the project cost thiness (discussed in more detail in chapter 7). is typically distributed across the beneficiaries. In Jordan, beneficiaries pay 50 percent of the cost of • Donations and public contributions. Local or road development and pavement, in cash advance foreign donors or philanthropists may donate or installments. a capital item or money to be used for the pur- For example, a subway increases demand chase of a capital item in their homeland or in for housing and offices on properties located a disadvantaged area. They may want public- nearby, which in turn will result in higher prices ity for their donation, which the municipality being charged for those properties. In addition, can arrange to acknowledge their sponsorship zoning changes that accompany investments in (such as naming the library). infrastructure—for example, increased densities • Public-private partnerships. Capital costs can along the subway line—will boost land values. be paid by means of partnerships between the A  land value capture tax is a way for the public private sector and the municipality. In most sector to tax some or all of the private windfall cases the private sector partner will have a gain created by the infrastructure. Box 4.13 sum- profit motive, so the terms and conditions marizes the main steps in valorization. must be carefully defined to protect the com- Some Latin American cities finance street munity’s interests. improvements, water supply, and other local pub- lic services through a system of taxation known Land-Based Revenues to Finance Local as valorization whereby the cost of public works Investment is allocated to property owners in proportion to Land is a good instrument to finance local invest- the benefits conferred by the works (Bird 2001). ment. Investment in infrastructure increases the The benefits are estimated on the basis of the market value of land, and it is a good practice to market value of the benefited plot. The valoriza- have the public sector recover some of that addi- tion charge is a lump-sum levy, although it can be tional value so that more infrastructure can be paid in installments (box 4.14 provides examples financed. As mentioned in chapter 5, there are of land-based revenues that reduce speculation). Managing Local Revenues 181 Box 4.13 Computing Land Value Valuation 1. Calculate the cost of the project. 2. Divide by the number of the beneficiaries. 3. Determine the zone of the influence of the project. That is, where will property values increase as a result of the project? Rail stations will have larger zones of influence than a school or a theater. 4. Distribute the tax within the zone. Closer properties will pay a higher portion. The distribution of valorization charges involves a considerable amount of administrative discretion. 5. Collect the tax before construction. Often the tax will not cover the total costs of the project, and project costs are often underestimated. Source: Slack 2009. In addition to valorization contributions, contributed to sprawling and land sales on the Colombia has been levying a plus valia or land periphery of cities. value increment tax (also called a betterment Improvements in land-based instruments and tax) since 1980. This tax is designed to recoup the use of public land assets to promote local the benefits that are a consequence of “urban development have also become more common, actions,” including changes in the classification including the revival of downtown Washington, of land from rural to urban and specific public D.C., and the private-public partnerships now works typically related to the expansion of the common in the financing of large urban proj- urban road network. Valorization revenues can ects, including subways (Shanghai), waterfronts be substantial, depending on the actual construc- (Baltimore and Washington, D.C.), and Olympiad tion of such projects. In Cali, they accounted for Villages (Barcelona). 31 percent of city revenues in 1980. Betterment Other issues concerning land-based financing levies are more common in developed than in relate to the volatility of land markets. Although developing economies. Usually they operate as a using one-time land sales to finance one-time surcharge (i.e., additional levy) on the property infrastructure projects is adequate, including tax bill. expected revenues from the sale of land assets in a Land sales have been used by cities such multiyear budget may pose some financial risk, as as Cairo, Cape Town, Istanbul, and Mumbai the revenues may not materialize at the expected (Peterson 2009). These sales have generated rev- values. enues of US$1 billion to more than US$3 billion, Land sales often lack transparency and dedicated primarily to infrastructure investment. accountability. The majority of land sales are The value of these transactions is large in relation conducted off-budget, and the large sums to the investment they will be financing. In addi- involved may invite corruption and institutional tion, some countries may have become too reliant capture by the selling agency. Special legisla- on land sales (e.g., China and the Balkans). Local tion that earmarks the revenues from land for governments have become dependent on land capital investment can protect receipts from sales to finance capital expenditures, which have being diverted to operating budgets. Table 4.11 182 Municipal Finances Box 4.14 Land-Based Revenues, Speculation, and Leapfrog Development Public transportation investments often Several local governments in the United increase nearby land values. All too often, States use a value-capture technique that is however, land near public transportation embedded in their property tax. This split-rate (such as bus, tramway, and rail stations) property tax creates an incentive for landhold- remains vacant because landowners, spec- ers to develop high-value sites or sell to those ulating on future land price increases, tend who will. It reduces the tax rate on assessed to hold out for prices in excess of what building values and increases the tax rate on buyers and renters will pay today. This assessed land values. It thus motivates afford- drives developers to seek cheaper sites able compact development by making more farther away from public transportation land available for development close to public and other urban infrastructure amenities. transportation and reducing building costs. Once this cheaper land is partially devel- The split-rate property tax can also help local oped and inhabited, its occupants create governments raise revenues to finance infra- political pressure to extend transport ser- structure. This technique’s ability to foster vices to their area. Once the infrastructure affordable compact development might help is extended, land prices in the remote area bridge the gap between those who advocate begin to rise, choking off new development making city development compact by setting there (even though land is available within growth boundaries, and those who fear the the existing urbanized area) and driving impact of growth boundaries on affordable developers and users even farther away. housing. An econometric study, published This cycle is partially responsible for “leap- in the National Tax Journal, found that trans- frog” development, also known as “sprawl. ” forming the traditional property tax into a Transportation infrastructure, intended to value-capture, split-rate tax would shrink an facilitate development, thus chases it away. urbanized area. In reality, an urban area would The resulting sprawl strains the transporta- not shrink, but new development would tend tion, fiscal, and environmental systems on to occur within the existing urbanized area, which communities rely. rather than outside it. Source: Rybeck 2004. summarizes the potential and issues concerning are also expected to assist the units in charge of land-based taxes. budgeting, financing, and appraisal of real estate and any other local tax bases. Revenue adminis- Revenue Administration Issues tration capacity is a function of four key elements: and Challenges • Identification and registration of local resi- In any local government, the department of rev- dents liable for payments (tax, fees, charges) enue has the main responsibility for determining • Assessment of payment obligations (for both and collecting taxes due, at the least cost to taxpay- taxes and other charges) ers, and fostering the highest degree of public con- • Billing and collection fidence in the integrity, efficiency, and fairness of the process. Revenue administration departments • Enforcement of payments. Managing Local Revenues 183 Table 4.11 Land Financing Instruments Instrument Description Requirements Problems Sale of public land Public land assets are Inventory of land Needs competency for sold, with proceeds assets, market inventory and sale. used to finance valuation, and It may result in sprawl infrastructure strategic decisions (China). investment. about best use, open auctions for disposing Difficult to implement if of land that is sold. the agency does not benefit directly from the sale. Betterment levies Public sector taxes away Difficult to implement Needs experience with a portion of land value on a parcel-by-parcel the instrument, as in gain coming from basis; simplified South America. infrastructure projects. approach adopted by Bogotá is better. Impact fees Developers pay the cost Strong analytical Need to develop of systemwide capacity to estimate simplified approaches infrastructure expansion the infrastructure cost that capture the concept needed to implications of of recovering the off-site accommodate growth. development at cost of growth without different locations. overwhelming technical demands. Acquisition and sale Public sector acquires Social contract is It is difficult to reach of excess land land surrounding the needed on who agreement on the proper infrastructure project should benefit from exercise of eminent and sells land at a profit land value gains domain. when project is resulting from public completed and land infrastructure, the value has increased. original landowner, public sector, displaced occupants, etc. Source: Peterson 2009. Identification and Registration Functions identification of taxpayers. Another method is to In principle, taxpayers and beneficiaries of cross-check consistency between the number of municipal services must register with the local beneficiaries of household services (for exam- revenue administration. However, they do not ple, solid waste collection and water) and the always do so. The degree of compliance varies number of households actually served. Finally, with the particular tax or user charge. To identify Street Addressing is often a very important tool the missing taxpayers, local governments can use to increase the accuracy of taxpayer lists.  Many different methods. One method used for prop- street addressing programs have had great impact erty taxations is aerial photography or satellite on capturing the local tax base by reconciling the images, to obtain accurate information on prop- street addressing data base with the fiscal regis- erty size and location and check consistency with ters of the tax department. 184 Municipal Finances Assessment Functions register so as to receive the service. Illegal Assessing the tax base is the first step in deter- connections for water, sewers, and electricity mining the tax obligations, particularly in the are common in some developing countries. case of property and business taxes. In practice, Detecting and registering, or disconnecting, however, information on both taxpayers (the illegal connections is difficult for both techni- tax roll) and the value of the tax base is some- cal and sometimes political reasons. The effect times incomplete and outdated. For instance, is free riding, since the volume of water pro- new subdivisions or transfers of property are vided is much higher than the consumption not recorded on time, and the people who of those who pay (see box   4.15). Bulk meter- bought or inherited the property do not show ing and comparing metered and unaccounted up in the tax records. The same problem may volumes of services help the identification of occur with the establishment of a new indus- areas, and eventually customers, with illegal try or business, which may not be recorded or connections. registered in a timely manner. These are partic- ularly acute problems if the data are maintained Billing and Collection Functions only in paper records and updated manually. Once the tax bases are assessed, the next step Comprehensive, computerized tax records are is to bill and collect payment. Unfortunately, in important to ensure that changes in ownership many situations the names and addresses are cannot take place without being recorded in all unknown. Street addressing6 and resident iden- relevant fiscal systems. tification have become important programs to Similarly, for user charges, the consumption improve tax collection in both formal and infor- of water or electricity by individual users needs mal urban areas. The main point is that under to be established, but sometimes the databases most legal enforcement systems, a taxpayer or of beneficiaries may be outdated. The prob- subscriber is not legally responsible for pay- ability of underregistering is smaller than for ments of which he or she has not been formally property taxes, as users have the incentive to notified. Therefore, a basic condition for an Box 4.15 The Free Rider Paradigm and the Need for Local Taxes The free rider paradigm describes the situa- hate free riders because they fear that free tion in which everyone benefits from a good riding will prevent necessary services from program (for example, firefighting or green being provided. If paying for defense or fire- spaces), but some people do not pay because fighting is voluntary, many people might free they know other people will. In sum, a free ride, making the service uneconomic. The rider is a person who receives the benefit of a popular solutions to free riding are coercion so-called public good without paying for it. In and taxation. To prevent the free rider prob- the case of firefighting or defense, free riders lem, payments for public goods are made will have their lives and property protected compulsory, usually in the form of a tax or without contributing to the cost. Economists compulsory levy. Source: http://www.kingwatch.co.nz/Christian_Political_Economy/free_riders.htm. Managing Local Revenues 185 effective collection system is a working billing Easy and convenient payments are vital (and mailing) system. elements of effective collection. People are Unfortunately, although 100 percent of tax- less willing to pay if they must walk to a far- payers are obliged to comply with tax obli- away office, or wait in line for hours, or pay- gations, only a portion of them are actually ment is restricted to cash or check. Internet and registered (in some countries as few as 50 electronic banking payments reduce transaction percent or 60  percent). In addition, not all reg- costs for taxpayers and collection hurdles for the istered taxpayers pay their taxes. Collection administration staff. efficiency in normal circumstances reaches Poor revenue enforcement may be due to 95 percent in developed countries but is just a combination of various factors: (a) lack of 70 percent, or even less under poor practices, accountability of the local government; (b) lack in developing countries.7 In this context, it of political will; (c) weak institutional and admin- does not make sense to increase tax rates as a istrative capacity; (d) lack of incentives for both means to increase tax revenues. That would revenue collection and enforcement; (e) lack of only penalize the taxpayers already registered a policy of publicizing good use of tax proceeds; and paying taxes but do nothing about those and (f ) payment informality and corruption. who are unregistered. The challenge to rev- Indeed, surveys in many developing countries enue managers is to broaden the base; that is, have shown very clearly that taxpayers (even to get more taxpayers registered and interested poorer people) would be ready to pay more taxes in paying. Actually, one could argue that broad- if services improved and if government was more ening the tax base could make it possible to transparent. Sometimes corruption is so common reduce tax rates, which in turn would improve that taxpayers refuse to pay because they believe tax compliance. that resources will never be used to improve the living conditions of the population. A study Revenue Collection Enforcement of six African countries found that 30 percent Another critical step in revenue administration to 70  percent more revenue could be collected is the enforcement of payments. Weak enforce- at the local level if people paid what they were ment can be caused by lack of penalties for non- supposed to (Action Aid 2011). Improvement compliance. Furthermore, clear and unbiased in this regard would make more money avail- records and timely reminders about unpaid able to be invested in services for the poor and bills and accumulated arrears are vital parts of marginalized. the enforcement system. If taxpayers know that What can local governments do? the tax records are weak, they are less willing to Ask people why they refuse to pay taxes, and pay. In the course of implementing tax reforms, the answers might surprise you. You may think governments sometimes grant partial amnes- that people prefer to keep their money, but it ties on tax debts that have accumulated over may be that people think that the tax collectors many years. Tax amnesties (that is, a one-time keep the collected money for themselves. People discount, forgiveness of penalties, or deduction refuse to pay because they do not think the local of tax arrears) are usually granted to encour- government will spend the tax money properly. age improved compliance on current payments. When you know the reasons, you will be able Conversely, denial of service, such as car regis- to address the most pressing problems facing tration, could be used to encourage payment of tax collection and at the same time make tax other taxes. collection more just. 186 Municipal Finances One way to find out why people refuse to Revenue collection often remains poor because pay tax is to do a survey in your local area. Ask the local government does not know how much it people how they experience the tax collection could collect under good conditions. For example, system and what it would take for people to pay although revenues may be increasing 4 percent to their taxes. Interviews with as few as five people 5 percent a year, the potential could well be a dou- can give you a good idea of where there might be bling of the annual collection amount. Box 4.17 problems (see  box 4.16). Using personal stories, illustrates simple methods to estimate potential for example, about the abuse of power by tax revenues. collectors, can be a very effective way of inform- Good practices in enforcement can be as easy ing people about the problems in your local tax as following up with a phone call to taxpayers system. when there is a delay in payment. An incen- Failure to comply is a less severe prob- tive is offered to waive the penalty if payment lem among beneficiaries of municipal services is made immediately or no later than a specific because it may be easier to cut their water or date. If needed, a reminder notice is sent to the electricity if they do not pay their bills. A big taxpayer’s street address or e-mail address. A challenge for municipal revenue administrators visit is made to the taxpayer to obtain a signed is creating an up-to-date database on taxpayers notification. Alternatively, the bill is given to a and subscribers to municipal services and imple- collection agency. As a last resort, the case is menting an enforcement system. sent to a municipal tax court if the taxpayer Box 4.16 Reasons Why People Do Not Pay Taxes—Survey in Tanzania Opinions on tax in Tanzania A big surprise was that 73% of the people In Tanzania a survey among taxpayers showed interviewed said that they would be willing to interesting results on why the local govern- pay more tax if public services improved. This ment was not able to collect much tax: shows that the biggest problem in low tax collection is not necessarily that people prefer • 58% answered that tax collection was low to keep their own money. If the budget is fair because people did not feel that their tax and just, more people will also be willing to money would be spent well by the local pay taxes. government. It also shows that how taxes are col- • 48% answered that they thought tax col- lected can be very important. If tax collec- lection was low because the tax rates tion involves corruption, intimidation, or even were too high. violence, tax collection will also be low. Civil • 46% answered that the problem was that society can play a key role in addressing these tax collectors were dishonest. problems by uncovering them and demanding • 38% answered that the problem was that that they be changed. tax collectors harassed the local population. Source: http://www.actionaid.org/sites/files/actionaid/budgets._-._elbag_handbook_series.pdf. Managing Local Revenues 187 Box 4.17 How to Estimate Potential Revenues There are several ways to estimate local particular tax. This is especially useful in government potential revenues. The three the case of the property tax. most commonly used are described below. PNRpt = (ENP * ARpt) – CCpt), 1. Average per capita revenue: national vs. city. The method compares the per capita revenue of a given tax (e.g., sales tax) at where PNRpt is potential additional net the national level (NApc) with per capita revenue from the property tax, ENP is revenue obtained at the city level (CApc). estimated number of taxable properties, If the city average is below the national ARpt is average yearly revenue per prop- average, and there is no apparent justifica- erty, and CC is current yearly collection tion—for example, the city is small or less from property taxes. affluent—then the difference between the 3. Estimated vs. actual revenue per sub- two is the potential revenue (PRs) for that scribers. Given the actual number of sub- particular tax multiplied by the number of scribers (e.g., water consumers) and given inhabitants (Pi). the average annual payment per sub- scriber, one can estimate the potential PRs = (NApcs – CApcs) * Pi, income and the difference between that potential and the actual tax collection. where PRs is potential revenues by source, NApcs is national average per capita by PNRsi = (ENP * APsi) – TPsi), source, CApcs is the national average per capita by source, and Pi is the population where PNRsi is potential net revenue from of city i. service i, ENP is estimated number of 2. Estimated vs. actual revenue from properties (beneficiaries) in the city, APsi is taxpayers. This method compares the average yearly payment per subscriber to total revenue that would be obtained if all service i, and TPsi is total yearly payments taxpayers pay the average obligations and from current subscribers to service i. the actual income received on that refuses to pay. Taxpayers are informed of all Developing Local Institutional Capacity these legal actions, as well as future steps Lack of institutional capacity hampers local to expect if they fail to make payment. The revenue managers in estimating how many tax- challenge to the city’s tax administration is payers are missing from their tax rolls, how many to implement and enforce these procedures of those who are registered are inactive, and how legally through a tax court. Typically, just a few much is actually being evaded in tax payments. cases need to be enforced; if they are broadly In addition, even when taxpayers are registered publicized, it usually generates an immediate and active, sometimes there is no complete and rise in tax compliance. reliable information on their tax liabilities, tax 188 Municipal Finances Box 4.18 Success in Increasing Own-Source Revenues in Maputo The city of Maputo, in Mozambique, has management have created institutional shifts increased its own-source revenues by almost for revenue enhancement. The use of rigor- 30 percent since 1998 through revenue man- ous analysis, initiated through tariff studies, agement reforms supported by World Bank has identified the ratio of expenditures that projects. These have enabled Maputo to can be financed with own-source revenue, increase its tax base, taxing more properties the relative proportions of fiscal and nonfiscal and initiating adjustments in user fees for cer- revenues, and measures to increase revenue tain services (notably a new, incremental solid collection efficiency. It has provided an empir- waste fee). Legislative reform, tariff studies to ical basis for decisions to expand the property inform policy and management decisions, and tax base and improve tariff setting and collec- prioritization of both revenue and expenditure tion of user fees. Source: World Bank 2007. payments made, and their balances (taxes in find out what they owe and make payments. arrears are practically unknown). Furthermore, There are no online payments, nor are there for many taxpayers that are actually registered, contracts with banks to receive tax payments. their addresses and information on their cur- rent economic activities are incomplete or • A substantial part of taxpayers’ records are outdated, making billing and tax enforcement still  kept manually, and electronic records fairly difficult. Introduction of modern comput- between  the treasury and accounting are not erized management information systems helps integrated. resolve many of these everyday matters (box 4.18 • Mail payments are unreliable because of poor describes measures undertaken in Maputo, service and can also be costly. Mozambique). The challenge to tax administrators, and Various solutions for these problems exist: revenue managers in general, is therefore to gradually overcome current weaknesses by using • Implementation of a taxpayer address system management information systems to upgrade for billing tax liabilities, to reduce transaction their institutional capacities to identify taxpay- costs in tax compliance ers (and subscribers to services), assess their • Integrated electronic systems to manage tax- payment obligations, ensure accurate and timely payers’ current tax accounts billing, and enforce collection. • Unified billing systems Incentives to Improve Revenue Collection • Provision for taxpayers to pay by mail, through Many local governments lack the appropriate banks, or through e-mail incentives to encourage tax compliance. Typical problems with incentives include the following: • Setting up “tax help desks” to help taxpayers comply with their obligations • Tax payment is not comfortable. Taxpayers may have to stand in line for long periods to • Separate systems for large and small taxpayers. Managing Local Revenues 189 Street Addressing and Tax Systems addressing component provide an opportunity A major source of improvement in revenue col- to reexamine the municipal taxation system, lection and management is adoption of a mod- and in particular the property tax system, so ern street addressing system that can provide that it can be adapted to the local context in a the tax authorities with reliable information on cost-efficient way. the location of taxpayers and taxable businesses. Rather than struggle under a cumbersome Examples around the world confirm the utility of and complex taxation system based on anti- street addressing projects in improving the per- quated, largely unenforceable tax laws, munici- formance of tax systems. palities are moving toward simplification of tax laws and adopting a property taxation approach Improving the performance of the existing more closely aligned with existing capacities tax system and resources. For example, in Burkina Faso, One of the main benefits of the address directory Mali, and Togo, property taxation reform has is the ability to obtain information on economic been coupled with street addressing projects activities and the population not listed on the conducted under the auspices of World Bank– tax rolls. It improves the efficiency of the prop- financed urban development projects. The cit- erty tax by supplementing incomplete property ies of Ouagadougou, Bobo-Dioulasso, and Lomé records. Box 4.19 explains a project implemented carried out street addressing initiatives in con- in Senegal. The process, managed by the tax junction with the implementation of a local tax department, involved reconciling the address on all types of residences, using a simplified basis directory with the taxpayer rolls to create a tax more in accordance with household capacity to register that includes both. pay. This type of residence tax was inspired in part by the urban tax in Morocco and the old Street addressing and property tax reform Tunisian rent tax. On the whole, the assess- A  number of urban development projects ment of taxes on a simplified basis and the use in francophone Africa that include a street of an address directory have reduced procedural Box 4.19 Development of Tax Registers in Senegal The Senegal program aimed at determining 2. Close the information gap between the the number of people not listed on the tax address directory and the existing tax rolls. rolls by comparing the rolls with address direc- 3. Include address information on tax rolls tories and incorporating address information and assessment notices. on the tax rolls. The project included several 4. Locate addresses not surveyed (busi- steps: nesses, dwellings, mixed-use properties). 5. Conduct additional field surveys. 1. Assess the performance of tax enrollment 6. Create a register of all potential taxpayers. and collection operations for business 7. Determine tax amounts and create rolls taxes and license fees and for the prop- or registers for collection of advance erty tax (names of taxpayers surveyed, payment. amounts assessed, and so forth). Source: Farvacque-Vitkovic 2005. 190 Municipal Finances Box 4.20 Tax Department Involvement in Street Addressing Surveys in Niger The city of Niamey spearheaded a street plot. In this way, the two directories were rec- addressing initiative using funding from the onciled with one another in real time. When International Association of Francophone an area being assigned addresses has not yet Mayors (AIMF). It established several mixed been surveyed and entered in the cadastre, teams consisting of municipal agents, a the subdivision plan also held by the cadastral representative of the water company (SEEN), and municipal agents is often used. This type a representative of the electric company of dual codification system, for street address- (NIGELEC), and a cadastral agent. Each street ing and cadastral purposes, makes it possible and door number was penciled onto the to reconcile the address directory with the cadastral map on paper. The team leaders other directories kept by the government and filled in each door number on survey forms, utility concessionaires. according to the cadastral reference for the Source: Farvacque-Vitkovic 2005. complications (box 4.20 summarizes experi- in which street addressing initiatives can play ences in Niger). a fundamental role. The innovation lies partly in requiring citizens to participate in the costs Supplement the cadastre with street address of the city (rather than taxing property that is data often unregistered) and partly in seeking simple In the event that such a cadastral reform proves solutions. to be overambitious, a less sweeping program can be adopted by using street addressing data Revenue Enhancement Programs to supplement the information in the cadastral Developed countries initiate gradual, annual, unit. If fieldworkers experienced with maps incremental changes in their well-established have no problem identifying individual prop- revenue systems. In contrast, developing erties, the same will hold true for tax or trea- countries require comprehensive reforms sury agents responsible for tax auditing and for improving their local revenue adminis- collection, as mentioned above in regard to the tration, establishing databases, and substan- tax registers. This type of intervention would tially enhancing institutional capacity on most take a two-pronged approach: (a) incorporate fronts, from assessment, billing, and collection the addresses into the cadastral data and (b) to enforcement and remedies (see box 4.21 and establish a correspondence between addresses box  4.23). Donor agencies, such as the World and cadastral references for plots that are so Bank, or bilateral donors, such as the French, identified. German, U.S., or Swiss agencies, often provide The fact that a cadastral documentation is substantial financial and technical support for inadequate or nearly nonexistent and often these reforms, which can be seen as lifetime out of date does not preclude the implementa- investments for the participating cities, often tion of innovative property taxation systems, with good and short recovery of invested costs. Managing Local Revenues 191 Box 4.21 What to Do When in Financial Stress The financial crisis of 2008 led many local cutting costs; that is the only way the public authorities into financial stress, mainly will accept new taxes. Strengthen long-term because expected revenues did not materi- financing planning. (f) Keep morale of per- alize and expenditures could not be cut to sonnel high. accommodate the fall in revenues. Without Fremont, California, used a four-point plan the ability to borrow to finance short-term to survive recession. In July 2003 the mayor deficits, many local governments faced explained the situation: Sales tax revenues tough decisions. The road map followed by had dropped by 25 percent, business tax many local governments includes common- by 30 percent. No growth was projected. sense steps. (a) Figure out what is going on: In addition, hotel and motel tax receipts if the source of the problem is a decline in had declined by more than 50 percent dur- sales tax, is it a short-term or a structural ing the preceding two years. Property taxes problem? (b) Communicate what is going had slowed down. In view of this situation, on: the public should be told the origin of the council decided on a plan to raise reve- the problems and why services are being nues and consolidate long-term revenues. reduced or taxes increased. (c) Rethink pri- It included (a) cutting spending and reduc- orities and reallocate resources to the most ing services; (b) increasing local activity and important programs. (d) Avoid short-term promoting consumption from local sellers; remedies such as using one-time revenues and (c) thinking creatively about sources of or carryovers from previous years or defer- new growth (for example, Sterling, Illinois, ring infrastructure maintenance. (e) Use invested in brownfields redevelopment to new revenues after doing the homework of spur economic growth). Source: International City Management Association 2003. Box 4.22 Financial Recovery Action Plan in Kampala, Uganda The city of Kampala became bankrupt in assigned. The city managed to stabilize its bud- the mid-2000s, with enormous overdue get, increased property tax collection three- liabilities (about 30 percent of annual bud- fold, and worked out its overdue liabilities get) and poor revenue collection. The coun- over five years. Property tax collection was cil adopted a detailed Financial Recovery improved by a computerized database, timely Action Plan (FRAP) and implemented it in billing, reminders, and good communication, the following years under a World Bank proj- including a leaflet attached to each bill that ect (KIIDP). explained the use of property tax revenues, The plan was based on a 31-page FRAP noting that two-thirds of property tax revenue action matrix, with specific assumptions, fore- is used for improving services in the same casts, actions, responsibilities, and budgets collection zone. Source: World Bank 2006b. 192 Municipal Finances Box 4.23 Main Steps in Revenue Enhancement Programs 1. Develop baseline indicators on both 8. Develop baseline indicators for actual and current subscribers and current taxpayers. potential user charge collection by service, Estimate the actual number of beneficia- and actual and potential tax collections by ries and the potential number of taxpayers tax source, to measure performance in to compare performance before and after local revenue collection efficiency. the implementation of any proposed reve- 9. Establish minimum standards in the provi- nue management plan of action. sion of the different municipal services, 2. Update databases (registers) of service determine actual standards, and evaluate subscribers and taxpayers, through third- performance in adherence to standards. party information, direct field surveys, and 10. Determine the number of units of ser- self-reporting requirements. vices supplied and establish the unit cost 3. Expand street nomenclature to update per service. addresses, which are needed for billing, 11. Compute expected cost based on collection, and enforcement of user minimum standards; determine actual charges, local taxes, and other revenue cost, and measure expenditure efficiency sources. performance. 4. Upgrade the current billing and collection 12. Compute the user fees (user charges) that system for both user charges and local reflect the actual cost of providing each taxes (including hardware, software, office service. This information constitutes basic equipment, and staff training). input for monitoring and assessing 5. Update the property tax information on performance in expenditure efficiency by property owners, physical characteristics municipal service. of the properties, valuations, and their 13. Develop benchmarks, indicators regarding corresponding tax assessments (i.e., the unit cost for main municipal services. The municipal cadastres), and make the unit cost indicators should differentiate updating automatic and electronic. between construction costs (i.e., capital 6. Implement a transparent system of incen- outlays per unit of public works) and tives to reward early compliance with tax associated operations and maintenance payments and user charges. (O&M) costs. 7. Implement a transparent system of disin- 14. Develop a system for the legal enforce- centives (penalties) for late payment of ment of user fees and local taxes, together user fees and local taxes. with a system of appeals. These  reforms  are often parts of, or to some the case of Bogotá; boxes 4.18 and 4.20 show West extent conditions of, large infrastructure invest- African cases. Box 4.22 summarizes the Kampala ment programs aiming to ensure financial sus- Financial Recovery Action Plan (FRAP), showing tainability of the built assets and long-term the complexity and demanding nature of a reve- sustainability of the improved services. nue enhancement program (see also chapter  5). The World Bank supports dozens of such pro- The impact of infrastructure investments on grams or program components annually in all land and real estate prices and the expected continents. The case study in box 4.5 summarizes revenue from betterment taxes need careful Managing Local Revenues 193 projection and realistic timing. Street addressing in three years). Despite Serbia’s progress, tax bills programs take time, and their revenue impact are still very low, the tax base is poorly registered, will be strong and visible after two or three years, and total collection averages less than 1 percent rather than just a few months. Guiding, monitor- of GDP. ing, and managing revenue enhancement pro- grams and projecting revenues require an expert Internal Accountability in Revenue team and a good combination of qualitative and Collection quantitative analysis. In many developing countries, the system of local Serbia has gone through a comprehensive accountability in revenue collection by municipal reform of local taxation. An important reform internal controllers and the city council is fairly included the transfer of the property tax rev- weak. The little time that is generally allocated in enue policy and administration from the cen- the budget process to debate the revenue budget tral to the local governments. After legislative (in contrast to the much longer time devoted to changes in 2006, the cities started reforming reviewing and disputing the expenditure bud- their own systems and achieved remarkable get) is a good indicator of the fairly weak internal results—40 percent to 90 percent increases in tax accountability in revenue collection. Similarly, revenues by 2009. municipal external and internal audits focus The typical difficulties experienced before and more on the expenditure side than on revenue during the reforms included the following: performance. Thus, revenues forgiven, missed, • Small human capacity and inadequately or lost often remain hidden from the council or trained staff policy makers. • Lack of technical equipment and software The Revenue Budget Cycle • Outdated, vague databases inadequate for billing and enforcement Typically a local government budget process consists of at least seven steps: revenue forecast, • Unwillingness of other government agencies setting expenditure limits, budget preparation, to hand over basic data. budget negotiation, budget approval, budget The case of Serbia provides a good example execution, and budget evaluation. The circu- of the importance of incentives and points to the lar nature of the budget is known as the budget fact that cities collect more taxes when the tax cycle, as each step uses the output of the previous authority is devolved to the local level (table 4.12 one and helps the step ahead. Figure 4.7 depicts shows the remarkable results achieved in Serbia the revenue budget cycle (see chapter 3 for more Table 4.12 Collection Improvement Results of Property Tax Reform in Serbia 2006 2007 2008 2009 2006/2009 Cities SRD millions Percent Belgrade 2,439 2,625 3,694 4,792 196 Kragujevac 110 138 184 180 164 Vranje 37 37 44 54 146 Vrnjacka Banja 20 18 23 28 139 Source: City to City Dialogue Program, WBI, 2012. 194 Municipal Finances Figure 4.7 The Revenue Budget Cycle 1. The formulation phase: Political priorities are identified and plans formulated. 2. The approval phase: 4. The monitoring phase: Local government Authorities follow the approves the draft revenue generation plan budget. and spending commitments. 3. The implementation phase: Revenue is generated and spent according to the budget. details on budgeting). The cycle spans one year across all its administrative units. Such ceilings and is repeated every fiscal year. In countries generally are the maximum a local government where the budget year starts with the calendar can spend in a fiscal year. The sum of  all these year (i.e., from January to December), budget departmental ceilings is the budget ceiling for preparation starts as early as April of the pre- the whole local government. These expenditure ceding year to give the technical team enough ceilings are determined based on the revenue time to assemble facts, past realization rates, forecast and the municipal development plan. and trends to be used in the projections, and to The municipal budget director receives and prepare the basic revenue projections around reviews with each department or administrative which the overall budget unfolds. Budget prep- unit that unit’s expenditure proposals. He or she aration requires the projection of the locality’s reaches agreement within the local government revenues (all the categories discussed previ- and prepares a budget proposal. Then, as the ously), plus projections of the intergovernmen- third step, the mayor submits the budget pro- tal transfers and special taxes or revenues posal to the municipal council for its discussion collected for special purposes (e.g., land-based and approval. The following sections review five revenues). phases of the revenue budget process: revenue The second step in the budget cycle is the set- planning, revenue forecasting, discussion and ting of expenditure limits or budget ceilings. The approval, implementation, and monitoring and local government tentatively sets budget ceilings auditing. Managing Local Revenues 195 Revenue Planning to plan expenditures.8 As discussed before, Revenue planning is crucial for local govern- the local government revenues come from ments, as it provide the means to assess whether taxes, fees,  licenses, user charges, and they will be able to meet expenses; that is, the intergovernmental transfers. To forecast the operating budget and the provision of services. revenues accruing from each source, local gov- Capital expenditure planning (included in the ernments can use  simple projections (looking capital budget) is carried out in response to the at past trends) or can try to understand what needs for expansion and rehabilitation of infra- factors influenced the past behavior of tax rev- structure and service coverage. The planning of enues to enhance the quality of the forecasts other capital revenue for the financing of multi- (figure 4.8 depicts New York revenues from year development plans depends on (a) any bal- 1993 to 2009). ance surplus in the operating budget, (b) capital For example, most taxes will fluctuate with grants, and (c) long-term credit for local public changes in income and economic activity, as well investment (chapter 7 further develops the con- as tax rates. If forecasters know how different cepts of capital improvement planning and its taxes are linked with economic variables (e.g., financing). GDP and employment), they can use macroeco- nomic projections prepared at the national level Revenue Forecasting and Trend Analysis and their knowledge of their city to make accu- Local governments need to forecast the rate projections for the city’s own revenues. That revenues they will be collecting in order is, the analyst tries to find the link between the Figure 4.8 Local Revenues and Price Indexes in New York City, 1993–2009 (percent) 160 140 120 100 80 60 40 20 0 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 –9 –9 –9 –9 –9 –9 –0 –0 –0 –0 –0 –0 –0 –0 –0 –0 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 Council tax PPI Average earnings Source: www.osc.state.ny.us/localgov/training/chapters/myfp/two/rev_aid.htm. 196 Municipal Finances factors that drive revenues (income, production, 2. Examine the data to determine any patterns, tax rates, building permits issued, retail sales, rates of change, or trends that may be evident. etc.) and the revenues that government collects Patterns may suggest that the rates of change (property taxes, user fees, sales taxes). The abil- are relatively stable or changing exponentially. ity to project future resources is critical to avoid Table 4.13 shows the behavior of key taxes in budgetary shortfalls. the last five years in both nominal and real Revenue forecasts can be made for aggregate terms; that is, taking into account changes in total revenue or for individual revenue sources, prices. such as sales tax revenues or property tax reve- nues. There is no single method for projecting 3. Consider to what degree economic condi- revenues. Different methods tend to work better tions, changing citizen demand, and changes for different types of revenue. Similarly, there is in government policies affect the revenue. no standard time frame over which to attempt a These assumptions determine which fore- forecast. The local government might look ahead casting method is most appropriate. to the next year’s budget, while managers of a city 4. Project revenue collection in future years. The water system may be concerned about a 20-year method selected depends on the nature and time horizon. Finally, revenue forecasting is inti- type of revenue. Revenue sources with a high mately tied to the public policy process and is degree of uncertainty, such as new revenues thus subject to considerable scrutiny and even and grants or asset sales, may require some political pressure. sort of qualitative forecasting method, such as Guajardo and Miranda (2000) suggest a consensus or expert forecasting. Revenues seven-step process to include economic and that are generally predictable will typically be political factors in projecting local revenues: forecast using a quantitative method, such as a 1. Select a time period over which revenue data trend analysis or regression analysis (see are examined. The length of time depends box 4.24). on the availability and quality of data, the 5. After the projections have been made, the type of revenue, and the degree of accuracy estimates are checked for reliability and sought. Table 4.13 Revenue Data and Growth Factors for Forecasting Projection Historical series (revenue collected in US$ millions) Growth in percent alternatives Local taxes 2008 2009 2010 2011 Nominal Real Function of Sales tax 45 48 50 52 4.9 2.4 GDP Property tax 15 16 18 17 4.2 1.7 Price index Business tax 7 7 9 10 12.6 8.9 GDP User charges 9 9 10 12 10.1 6.6 GDP Surcharges 0.9 0.9 1 1.2 10.1 6.6 GDP Total 76.9 80.9 88 92.2 6.2 2.5 Price increase 3 percent 4 percent 2 percent 5 percent 3.66 Managing Local Revenues 197 validity. Conducting a sensitivity analysis 6. Monitor and compare revenue collection with assesses reliability. The key parameters used to the estimates. Monitoring serves both to assess create the estimates are varied, and if this leads the accuracy of the projections and to deter- to large changes in the results, the projection is mine whether there is likely to be any budget assumed to have a low degree of reliability. shortfall or surplus. Box 4.24 Methods for Calculating Growth Rates and Projecting Revenues Years Forward Percent Change: The first option compares Vtn = last value, and 1/(tn−to) = number of consecutive time periods using the following years or using the basic formula of formula: VTn = VTo (1 + r)n−1 Percent change = [(CR – PR)/PR]*100, (Eq.1) and solving for r: where CR = Current Revenue and PR = Past r = {exp[ln(VTn /VTo)/N]−1}*100. Revenue. Average Growth Rate: For a longer period, Arithmetic Mean Growth Rate: the same change formula can be used, but the Alternatively, if the time series is character- total percent would be divided by the number ized by volatility in yearly revenues, the first of years (N): and the last year might not be representative; in such cases, it may be better to use the arith- Average growth rate = {[(CR−PR)/PR] /N}*100 metic mean growth rate (also known as the (Eq. 2); for (tn−to). Arithmetic Mean Return—AMR). The formula of the AMR is as follows: However, for such longer periods, the AMR = 1/n(X1 + … + Xn), (Eq. 4) use of the first and last year may be suit- able only when the revenue changes are where n = number of time periods of one rather uniform. A more accurate growth rate year, and Xi = percent revenue change for would be obtained using compound growth period i.; computed as [(CR – PR)/PR]*100 rates. (Eq. 1) i = 1…to… n. Compound Annual Growth Rate Linear Trend Growth Rate: Another option (CAGR): CAGR takes into account the first and is to compute the CAGR of the trend line, the last value of the particular time period but calculated by the least squares method. This includes the effect of the annual compound- would provide the growth rate of the trend ing periods in the final growth rate. The results in revenues for the particular time period. For are fairly reliable if the changes from one year example, Excel automatically draws the trend to the next are rather smooth. The CAGR can line, calculates the trend equation, and R2, be computed as CAGR (tn−to) = ([(Vtn/Vto)*1/ which indicates the quality of the forecasting (tn−to)] – 1)*100 (Eq. 3), Vto = initial value, trend. 198 Municipal Finances 7. Update and adjust the revenue forecast as developed countries. The tax base is normally conditions affecting revenue generation fairly stable, at least in the short term, and local change. Fluctuations in collections may be policy makers determine both assessment and caused by unexpected changes in economic tax rates. There are two methods to project real conditions, policy and administrative adjust- property taxes: ments, or changing patterns of consumer demand. • Assume it is kept constant at the current price level. • Assume a conservative adjustment for pro- Projecting Individual Sources of Local jected changes in total assessed value. Revenues The first step in projecting local government In the United States and other countries revenues is to classify the revenues according to where property tax is the main fiscal instru- a given methodology and identify the economic ment of municipalities, local authorities try to and other factors that affect each of them. Some establish property taxes so as to cover the local revenues are very sensitive to economic changes government expenses. This often leads to big (e.g.,  sales and business taxes), while others increases in tax rates and opposition from the depend far more on policy decisions or long- taxpayers. The  charts in figure 4.9 show two term development trends (property tax). Some possible policy scenarios used in New York City. are fairly predictable (automobile tax), whereas In the first, a dynamic increase of property tax others are erratic (fines). Some are controllable, eliminates the deficit; in the second scenario, and others are completely out of the control a constant property tax rate would yield an of municipal executives. Some represent large increasing deficit. sources of revenue, whereas others do not make a Sales tax and other non-property taxes: discernible difference to the bottom line (parking • Sensitive to economic change? Yes violations). In projecting local revenues, it is useful to • Predictable? No ask four questions: How sensitive is the tax to • Controllable? No economic change? How predictable is it? How much control can local governments exert over • Large source of revenues? Yes the proceeds? How important is the impact of the tax on the local government budget? Sales tax and other non-property taxes such Property taxes and other property-related tax as utility, restaurant, or hotel occupancy taxes items (transfer tax): are major revenue sources for counties, cities, or towns. It is useful to track the sales tax sepa- • Sensitive to economic change? Not rately from other non-property taxes because it is significantly affected by different factors. • Predictable? Yes In some U.S. cities, local sales taxes are col- lected by the state and distributed to counties • Controllable? Yes and certain cities that preempt the county tax. Many counties share sales tax revenues with • Large source of revenue? Yes other local governments according to formulas Real property taxes usually represent the based on factors such as population and property largest portion of local government revenues in values. Managing Local Revenues 199 Figure 4.9 Property Tax and Revenue Forecasting Scenarios (a) Tax increased to eliminate deficit 25 20 15 US$ millions 10 5 0 –5 2005 2006 2007 2008 2009 2010 2011 2012 2013 (b) Constant rate after 2009 with deficit 20 15 10 US$ millions 5 0 –5 –10 2005 2006 2007 2008 2009 2010 2011 2012 2013 Surplus/deficit Property tax Source: Office of State Controller 2010, http//www.osc.state.ny.us/localgov/training/chapters/myfp/two/rev. Sales and most other non-property taxes are is shared with the government doing the pro- more volatile than the property tax because they jection), changes to the base (such as sales tax are affected by changes in the economy with very free weeks), or even municipal preemption of a little lag. They are also subject to policy changes portion of the rate by a city. at the state, county, and sometimes municipal Recent history will help local governments level, including changes to the rate (if the revenue determine the starting point for their sales tax 200 Municipal Finances Figure 4.10 Sales Tax Collections, Year-over-year, 1991–2009 Percent increase year-over-year 15 10 5 0 –5 –10 91 93 00 03 92 01 02 09 98 99 08 94 04 96 05 97 06 07 95 19 19 20 20 19 20 20 20 19 19 20 19 20 19 20 19 20 20 19 Source: Office of State Controller 2010. http//www.osc.state.ny.us/localgov/training/chapters/myfp/two/rev.http//www.osc.state .ny.us/localgov/training/chapters/myfp/two/rev.http://www.osc.state.ny.us/localgov/pnbs/research/snapshot/080919snapshot.pdf projections, and information about the local Other local revenues: economy (up or down) will provide impor- • Sensitive to economic change? No tant factors to take into account. Many central government departments (e.g., ministry of econ- • Predictable? Depends omy, central bank, or department of planning) • Controllable? Depends publish forecasts for the factors that influence non-property tax revenues, including national • Large source of revenues? No gross domestic product (GDP), employ- Other local revenues include fines, licenses, ment trends, retail trade, and wage growth. sale of property, interest earnings, and other Figure  4.10 shows that sales tax revenues are small sources of revenue. If a locality aggregates sensitive to economic cycles and dropped from some or all of these into a single category, it is best 2008 onward. to project based on steady recent trends or by In the United States, local data (but not projec- holding them constant, adjusting if necessary for tions) can be obtained from the Bureau of Labor major known changes to large revenue sources. Statistics and the U.S. Census Bureau. Local gov- If a locality is doing a line-item projection, these ernments should be particularly conservative in should be projected according to the most rea- projecting this revenue source because it is large sonable trend, such as inflation or known fee and can be volatile. Several questions should be increases, or held constant. considered: State and federal transfers and grants are • Has there been a change to the sales tax rate? generally beyond a locality’s control. Timing and the relative health of the state budget • Has there been substantial economic change, affect most of its aid categories. It is a gener- such as in unemployment or retail growth? ally accepted practice to hold state aid revenues • Has there been a change in interest rates that constant, unless there is a reasonable possibil- may affect spending and therefore the sales tax ity of a decrease or the solid expectation of a collected? specific increase. Table 4.14 summarizes the Managing Local Revenues 201 Table 4.14 Predictability of Main Local Revenues Property tax Sales tax Other local taxes Transfers Sensitive to economic change Not significantly Yes Yes No Predictable Yes No Mixed Mixed Controllable Yes No Yes Large source of revenue Yes Yes No Yes Forecast methods 1. Remain Function of GDP, Indexed to Remain constant employment inflation constant 2. Cover deficit Source: Prepared by authors using information from New York Office of State Controller, http://www.osc.state.ny.us/localgov /training/chapters/myfp/two/rev_aid.htm. characteristics of the main revenue sources for particularly important when a substantial rev- forecasting purposes. enue reform is planned and taking place. These There are some exceptions, however. Certain reforms can be seen as long-term investments state aid programs are reimbursed based on local (computerization of the various databases, costs or participation (many school aid grants fall expansion of databases by identifying new cus- into this category). Localities may contact the tomers, legalizing illegal connections, etc.). state agency administering the program for assis- They require not only substantial amounts of tance with these types of aid projections. Federal money and time, but often firm political support. grants are generally specific to certain programs, Forecasting revenues under these circumstances some of which can be start-up grants, meaning requires a team of experts, who must set specific that the local government must continue to fund actions and calculate the expected one to five the program after the federal aid ends. Generally, years ahead, using a combination of qualitative therefore, federal aid is a small but variable and quantitative techniques. revenue source. Forecasting methods range from relatively The Revenue Budget Debate informal qualitative techniques to highly sophis- Budget debates at the local government level ticated quantitative techniques. In revenue focus more on how to use the resources available forecasting, more sophisticated does not nec- than on how to obtain them. Exceptionally, local essarily mean more accurate. In fact, an expe- administrations are required by city councils or rienced finance officer can often guess what is the ministry on local governments to explain the likely to happen with a great deal of accuracy. In assumptions made in forecasting the revenues. In general, forecasters use a variety of techniques, this context, the main task of the revenue man- recognizing that some perform better than others ager is to present to the city council proposals for depending on the nature of the revenue source. how to (a) encourage tax payments through facil- Box 4.25 summarizes the nature of two main fore- ities and incentives; (b) upgrade revenue billing casting methods. and collection through expanding the city’s street Forecasting in revenue enhancement pro- address system; (c) upgrade and integrate taxpay- grams is quite different from regular forecast- ers’ current accounts through electronic man- ing. Forecasting with qualitative techniques is agement information systems; and (d) mobilize 202 Municipal Finances Box 4.25 Revenue Forecasting Techniques Revenue forecasting projects future revenue the market to judge the growth of real estate. streams, including business sales projections Their opinions and knowledge will help pro- or estimations of revenue collected in taxes ject how much tax revenue the municipality for a government entity. The ability to estimate might expect in taxes on new housing sales, revenue accurately is vital to successfully for example. building an annual budget. Time-series forecasting uses trends based Judgmental forecasting relies less on data on historical data compiled over the course of and more on judgment, using the assess- several years or instances. Forecasters rely- ment of a person or committee based on ing on this basic method look at data evolving past experience or perhaps past trends. over time. Such issues as cyclicality and sea- Such forecasting does best when the condi- sonality might influence the forecast results. tions are unpredictable or rapidly changing. Four methods are usually mentioned: Sometimes it uses the experience of a small (a) naïve–constant increase, (b) using time group of experts familiar with the nature of series such as moving average models, government activity. For example, a small (c) causal models, and (d) judgmental municipality may gather together a group of forecasting. local real estate professionals experienced in Source: Garrett and Leatherman 2010. potential revenue, either with currently available of a budget resolution. Sometimes the local bud- revenue sources or with new revenue sources gets require the approval of the state or central such as betterment levies. ministry in charge of local governments. More As we have said, analysis of the local budget common is the need to have state governments focuses more on expenditure levels and composi- approve the municipal budget, as in Mexico. In tion than on the revenue side. Often revenues are general, budgets need to be balanced for approval, overestimated, leading to higher spending than is but the meaning of “balanced” varies. In many justified. For instance, the revenue forecast may cases it includes the use of external resources to assume an unrealistic collection of tax arrears finance planned and approved investment expen- or may include revenue from the expected sale ditures (see also chapter 7). of municipal land at a much higher price than Given the usual bias in favor of revenue overes- is realistic. These odd practices usually result in timation, prudent fiscal policies would require a municipal fiscal deficits or unfinished local infra- rigorous analysis of the methods and assumptions structure projects. used to project the components of municipal revenue. This function is usually the responsi- Revenue Budget Approval bility of an internal control unit in the municipal Once proposed expenditures and revenue are administration. The economic commission of the agreed upon, the annual municipal budgets is city council, the city councilors in general, and in approved. Budget approval requires voting on the some countries the ministry of local governments budget bill in the municipal council and issuance or its equivalent may be involved. The challenge Managing Local Revenues 203 to a city council (including the economic com- Typically, monitoring of revenue collection is mission) and to a municipal internal controller is done on a monthly basis by revenue source, as to ensure that the revenue forecast is realistic, in well as for the aggregate of all sources. If substan- order to prevent fiscal deficits or unfinished pub- tial differences are observed, remedial action is lic works, among other possible outcomes. taken for the cases that depend on factors under the control of the revenue administration depart- Revenue Budget Execution ment, such as weak billing or limited enforce- The challenge in revenue execution is to ensure ment. Several objective indicators may be used to the collection of an amount equal to or greater monitor performance in each of the main func- than the forecast. In practice, the actual collection tions in revenue administration. These issues are of a given tax often turns out to be less than pre- further discussed in chapter 8 in the context of dicted. For some taxes the actual collection may municipal financial performance monitoring. be higher, eventually canceling the collection that An example of the use of cost-efficiency per- was less than predicted. This is the normal situa- formance indicators is the case of the Borough of tion in most budget executions that occur within Sutton in London. The borough has implemented fiscal discipline, avoiding excessive and repeated a program on cost savings or cost efficiency in overprojections (and underprojections) of reve- service provision (called “value for money,” or nues. In contrast, in the absence of rigorous dis- VfM), as illustrated in box 4.26. cipline local governments are characterized by low revenue collection efficiency and significant Revenue Mobilization Strategies budget deficits. Therefore, the challenge in reve- nue execution, particularly in those municipalities An overall strategy in revenue management, and with soft budget constraints, is to take advantage in municipal financial management in general, of and learn to use their own resources (i.e., their consists of linking key municipal functions, such revenue base) and live within their means, rather as (a) revenue collection to service provision, than rely on distorting cross-subsidies from the (b) cost of service provision to beneficiaries, and central government. Table 4.15 describes relevant (c) user charges to expenditures by service. Each indicators to monitor revenue performance. of these strategies is explained below. Table 4.15 Revenue Performance: Monitoring and Evaluation Indicators Main functions Effectiveness (%) Accuracy (%) Cost efficiency Retrieval time 1. Taxpayer Registered tax Registries with TCR/RT Electronic identification and payers/total residents errors/total Average cost per registry H, hours registration registries D, days 2. Tax billing Number of taxpayers/ Bills with errors/ Total cost of billing/TT E, H, D taxpayers billed total bills 3. Tax collection Revenues collected/ Total value of Total collection costs/ E, H, D total accounts accounts received/ total accounts total accounts Average cost per account 4. Tax enforcement Arrears recovered/ Delinquent Total cost of recovery/ E, H, H total arrears accounts/total total delinquent accounts accounts 204 Municipal Finances Box 4.26 Value for Money Strategy—London Borough of Sutton The London Borough of Sutton has estab- that service managers are involved at an early lished a “value for money” strategy and stage. The workshops involve councilors, used benchmarking to drive the council’s relevant service managers, other council staff, efficiency program. A key objective of the and external consultants. Ideas that the work- strategy was to balance flexibility with a shops identify are then consolidated into an systematic and objective assessment. The efficiency program that informs the financial process also required the support of ser- and corporate planning process. vice managers and appropriate member Efficiency projects are categorized into involvement. four areas: A benchmarking system provides a guide • Customer services—transferring process to comparative performance across all ser- from back-office to front-facing customer vice areas, taking into account particular local service staff pressures. Potential areas of efficiency savings • Invest-to-save projects are identified using an assessment tool known • Procurement projects as a “VfM quotient, ” which uses data from the • Transitional services—combining similar Audit Commission and the Chartered Institute functions of the council or with other of Public Finance to provide automatic assess- partner organizations. ments of each service’s value for money. Automated production of these reports frees These areas are supported with specialist officers’ time for more intensive research into staff and funds. Members play an active role performance and results. Service areas are by taking personal responsibility for provid- then charged with selecting one or two sig- ing ideas and oversight of selected projects. nificant areas of potential efficiency savings Regular reports are produced to ensure that to be subjected to particular focus through senior officers and members can monitor efficiency challenge workshops. This ensures progress. Source: Audit Commission U.K. 2009. Linking Tax Revenue Collection to Service and maintenance) of basic economic and social Provision infrastructure, such as streets, public lighting, Local taxpayers are often reluctant to pay taxes sidewalks, or roads. (Box 4.27 shows the leaf- because they do not know whether those rev- let used in Kenya to inform taxpayers about the enues are well and in accord with their pref- sources and uses of the taxes they pay.) This is erences and priorities. The primary concern is similar to the idea that fuel taxes are used to that local taxes may be used mainly to pay for fund road maintenance or that water tariffs municipal workers and municipal bureaucracy, pay for the maintenance of the water infra- or even worse to benefit the local administra- structure. This type of revenue allocation and tion. One of the strategies to regain trust in use (which accords with the principle of ben- the local government is to open the accounts efit taxation) should be transparent, be made and display the direct link between local taxes known to all local residents, and be supported and the provision (or expansion, rehabilitation, by social audits to encourage tax compliance Managing Local Revenues 205 Box 4.27 Citizens’ Information Leaflet, Kenya Kenya’s citizen’s budget much money each sector will receive and In 2011 the Kenyan Ministry of Finance how much has been earmarked for the poor, published a six-page citizen’s guide to the as well as a lot of other information. The cit- national budget. The document presents izen’s budget also explains briefly what the some of the key figures from the budget in government intends to do about important diagrams and bullet points. For example, this areas, such as creating youth employment pie chart is from the document. The citizen’s and cushioning the poor from rising food budget provides information about how prices. Investment income, Other, 2% 7% Value added tax, 28% Excise duty, 13% Income tax, 42% Import duty (net), 13% Source: Action Aid 2011, 14. and local revenue mobilization efforts in gen- subsequently using water user charges to main- eral.9 Two ways of doing that are linking costs tain the quality of service are consistent and make to beneficiaries and linking expenditures to sense in the eyes of the taxpayer. user charges. Linking user charges to expenditures by ser- Linking the cost of service provision to benefi- vice. User charges should be set at a level that ciaries. Linking the cost of service provision to will enable financing of the actual cost (O&M) of its beneficiaries improves transparency and the providing the service, as mentioned before, mak- efficiency of resource allocation (discussed fur- ing service provision financially sustainable. In ther in chapter 5). For instance, using property practice, the local government needs to have good taxes to upgrade a water distribution system and knowledge of the cost of providing each service; 206 Municipal Finances that requires good accounting and budgeting to the local government, payments, and arrears. systems by service. Therefore, one of the main hur- Identification of taxpayers can benefit from cross- dles to setting adequate service fees is the estab- ing different databases. For instance, the names of lishment of accounting and budgeting by service, water subscribers could be electronically crossed accounting by cost centers, or fund accounting. with the addresses and names of property taxpay- User charges can then be set at a level that recov- ers to broaden the tax base (box 4.28 summarizes ers the actual cost of service provision and is con- the case of Ghana). sistent with the best consumption. Benchmarking One-stop shops. To improve revenue collection can also enhance expenditure efficiency and user efficiency, one-stop shops have been established charge collection performance. in many cities in developing countries. They are meant to have up-to-date information on the Improving Revenue Collection Efficiency clients’ (i.e., taxpayers’ and service subscribers’) Electronic databases. All information on taxpayers current accounts. All information is accessible in and subscribers to services should be managed one office, so that clients do not have to visit sev- in electronic databases. Centralized databases eral different, perhaps remote, offices for their keep track of outstanding financial obligations complaints or inquiries to receive attention. Box 4.28 Improving the Property Tax in Ghana In Ghana, the World Bank has supported with customary law on land ownership. property tax reform through both urban and The reform increased revenue genera- land administration projects, such as the Local tion capacity in five cities. The percentage Government Development Project; Second increase in property tax revenue collected Urban Project (SEC Cities); Fifth Urban Project; by the five assemblies from 1988 to 1997 and Second Land Administration Project. ranged in nominal terms from 2,713 percent Project support has built capacity for district in Accra to 62 percent in Tamale. The street assemblies to overcome the constraints to addressing initiatives made it possible to property tax collection, most notably the dual locate and compile a register of taxable system of land delivery (traditional and pub- individuals and businesses. Still being lic) that has created a complicated system of rolled out in secondary cities, the street property rights. Revenue mobilization from registration system in Accra and Tamale has property taxes has also been constrained by enabled district assemblies to accurately failed attempts to create accurate official land determine their tax base, and it presents registries and the limited base of landowners opportunities for augmenting revenue per- with official titles. formance in both primary and secondary The Second Urban Project, for instance, municipalities in Ghana. The new legal has improved registration systems by link- framework has made taxation a viable land ing an updated street addressing system management instrument by standardizing with land cadastres and by harmonizing the land ownership criteria and creating a basis legislative framework on land administration for land valuation. Source: Farvacque-Vitkovic et al. 2008. Managing Local Revenues 207 Box 4.29 Benin Increases Its Revenue Capacity Benin’s two-phase Decentralized City Mana- have reduced recovery costs for locally and gement Program (DCM I and DCM II) has centrally administered urban taxes. On the enhanced revenue mobilization capacity in policy side, the program supported develop- three primary cities (Cotonou, Porto-Novo, ment of clear tax recovery procedures and and Parakou) and three secondary cities implementation guidelines for finance depart- (Abomey-Calavi, Lokossa, and Kandi). During ment staff. DCM I, the three primary municipalities The alignment of central and local gov- increased their total revenues by 82 percent, ernment revenue management systems 148 percent, and 131 percent, respectively. has reduced tax administration costs and The second phase of the program established improved coordinated management of rev- municipal structures for improving tax billing enues and expenditures. The Ministère des and collection. Tax collection efficiency has Finances et de l’Economie established a also improved through a significant decrease central unit for each municipality to control in administrative expenses. revenues and expenses, in line with cen- The program introduced computerized tral government accounting procedures. budget management systems. The integrated Capacity building for the Circonscription taxpayer and user database has enabled Urbaine and line ministry staff has improved municipalities to track compliance by taxpay- their efficiency in property and profes- ers and identify potential taxpayers. The auto- sional urban tax collection, budgeting, and mation and computerization of tax collection accounting. Source: Farvacque-Vitkovic et al. 2008. A decentralized city management program to At the local level, revenue issues deal with enhance revenue mobilization is illustrated by deficiencies in the coverage of those liable for the experience of Benin in revenue collection taxes and nontax payments. Examples include efficiency (box 4.29). the adequacy of identification and registration of taxpayers; the currency of the tax assessments, such as valuations of property; and the accuracy Municipal Revenue Policy and currency of cadastral records. What are the Municipal revenue policy starts with identi- deficiencies in the billing and collection of taxes fication of the issues affecting municipal rev- and fees? The enforcement and remedy systems enue performance. Some of those issues may are also important to making sure that taxes are require actions at the national policy level, such paid equitably. as the size of and formula for intergovernmental transfers, the assignment of local taxes, and the Policy Tools establishment of tax rates (and ceilings for user What are the tools that local governments can charges). Others may be solvable at the local level. use to make sure revenues are enhanced, identi- The system of intergovernmental fiscal transfers fied, and collected in the most efficient and equi- discussed in chapter 1 is out of local control, and table fashion and that problems identified can be thus it is better to focus on local actions. promptly addressed? In general, sound revenue 208 Municipal Finances policy needs to look for means to enhance reve- • Public-private partnerships. Services financed nues, broadening the efficiency of the coverage of by user charges, such as water and solid waste local tax bases, so that tax rates can be the low- collection, in principle have the potential to be est possible. Similarly, covering all the subscrib- provided in partnership with the private sec- ers of services allows for the lowest user charges, tor; that typically ensures revenue collection which in turn enhances affordability and access efficiency, sustainability, and good standards to services. in service provision. Most local governments need the following for successful revenue management: Revenue Policy Impact Analysis Any tax revenue policy will affect people’s income • A credible enforcement system. Political resis- and savings. The following are some items that tance may be attenuated if resources are allo- need to be considered when setting prices or cated to improving the quality and quantity of tariff rates: public goods and services. Efficiency. Any municipal revenue policy • User charge set at a level to recover the oper- should aim to finance local public goods and ation and maintenance costs of service provi- municipal services efficiently and equitably. sion. Local revenue policy needs to ensure the Efficiency considerations are important to avoid financial sustainability of municipal services. unnecessary over- or underconsumption of ser- vices. In the case of water tariffs, if tariffs are • Cost accounting systems by service. To be able too low, people will overconsume, and revenue to set user charges at a level that ensures cost will be insufficient to cover operation and main- recovery for each service, the municipality tenance. If the tariff is too high, people will not must track the cost of each. It is practically be able to afford a social optimum of the service impossible to set adequate charges without being supplied. knowing the operation and maintenance costs Impact on the distribution of income. Taxes of municipal services. and user charges affect local income distribu- tion. Local inequities produced by fiscal policy • Affordable user charges. Local governments may worsen poverty levels, or they may reduce need to adopt a policy regarding user charges the concentration of wealth. In this respect, that addresses issues of ability to pay. Two revenue policies may be neutral, regressive, or approaches are generally applied: (a) price progressive with respect to their effects on local regulation, which often implies a general income redistribution. Progressive revenue subsidy, or (b) targeted subsidies to house- sources (e.g., income taxes) generally stream- holds. Price regulation usually distorts the lines aggregate local demand for public goods true cost of service provision, leading to and services, which ultimately improves local excess demand requiring overproduction and economic growth. to unsustainability. Failing to solve the prob- Impact on the absorption capacity of new tax- lem of cost recovery is not the best way to payers. Improvement in the management of local approach inability to pay. revenue often results in increases in the taxes • Outsourcing revenue collection. Outsourcing that residents should pay. This is particularly may be viable for user charges, including the true when new land valuations are made for administration of services. Ultimately the purposes of the property tax. In this case, local objective is sustainable service provision revenue administrators ought to offer a plan for according to set standards. a gradual increase in tax obligations to facilitate Managing Local Revenues 209 Box 4.30 Criteria for Tax Choice Local governments need to make choices on Let’s take four major taxes: property tax, sales where to put emphasis across available instru- tax, income tax, and vehicle taxes. One can ments. In many cases, the options are limited model how much each tax would need to and described in the constitution or regula- be increased for a given amount of revenue tory framework, and the degrees of freedom needed and simulate how the municipal left to the local government may be limited. council would vote. Would administrative ease However, it is useful to share a framework for and political feasibility be the most important cases where such potential exists. criteria? Or would yield and buoyancy be more There are several criteria to evaluate the important (maybe in a situation of financial best local taxes to be used by the local gov- stress)? What about equity (or progressivity)? ernment. Bahl (1996) suggests five criteria: Would the municipal council consider that administrative ease, yield, equity or incidence, property taxes are more progressive than neutrality, and political feasibility. Taxes can be sales tax, although the latter is much easier to easily classified according to these criteria. implement or increase? tax compliance. For  instance, if revaluations are workers in the formal market. The federal gov- made every five years, then the corresponding ernment and employers finance it. It is a great increases in the tax could be divided into propor- policy to help poor workers commute to the tional increases over the next five years. An alter- labor market. native is to use an annual price index to adjust the In the absence of direct subsidies, cross- value of the tax base gradually, without big jumps, subsidies can help the poor access a service by as has been done in Colombia. having the richer pay a higher tariff and allow- Box 4.30 summarizes the criteria local ing the poor to pay less. These cross-subsidies governments can use to help in choosing the are often implicit in the user fee structure; for best taxes that are adapted to their particular example, charging a smaller unit price for low circumstances. consumption. Cross-subsidies are particularly used in water and energy services. Another way The Role of Target Subsidies that the poor are helped through tax policies is Regardless of how well the revenue structure is exemptions from taxes. For example, in some planned and administered, some residents will countries owner-occupied property of widows be unable to pay user charges. Typically they and senior citizens without the ability to pay is are the poor, the unemployed, and the disabled. exempt from the property tax. Additionally, spe- In theory, such groups should be protected by cific programs to subsidize only basic, minimum the safety net of regional or central govern- consumption of some household services, such as ments, which should provide target subsidies to electricity and water, may assist people unable to those who need them, perhaps using the local afford their monthly payments. government as a conduit. The subsidy can be Many developing countries fail to follow these targeted to a specific use, as is the transporta- simple practices; instead, they often keep tariffs tion voucher in Brazil, which is available to all generally low under the argument of protecting 210 Municipal Finances the poor. As said, that is the least efficient way to starts with the premise that the main role of the protect the poor and has multiple adverse effects, local government is to deliver goods and services such as overconsumption by the rich, loss of rev- to local residents. Wherever possible, local gov- enue that must eventually be covered by the gen- ernment services should be paid for on the basis eral budget, and low quantity and poor quality of of the benefits received. Where the beneficiaries services (e.g., unclear water available one hour can be identified and where the services are not per day). primarily redistributive in nature (e.g., social The main question, however, is who should security), user fees are recommended. This is pay for the subsidies? In practice, the local gov- the case of water, sewers, recreation, and transit. ernment pays in revenue forgone. Subsidies on Revenue sources are combined in different basic consumption of services, such as water ways by local governments, in line with the cul- and electricity, should be financed from at least ture and the legislative framework. There are, three sources: (a) other consumers, or those however, some common features: who pay the higher fees because of the cross- • Most local own-source revenue comes from subsidies implicit in the fee structure; (b) local the property tax and from sales and busi- taxes; and (c) state transfers from the central ness taxes. Income taxes are used mostly in government to deal with poverty and social Northern Europe countries. issues (safety net). However, local governments are not expected • Property tax is a good local tax because the base to take care of inequality concerns, which are is immobile and the tax is visible. However, it the responsibility of the central government. requires technical capacity and political com- If local governments were to increase taxes to mitment. Often politicians avoid the property improve the living conditions of their poor, local tax because it is too visible. If taxes and valu- residents might resent the policy and decide to ations are kept updated and transparent, tax- leave the community for another jurisdiction, payers are likely to accept the advantages of where tax revenues are reinvested in the phys- the property tax. Much progress is still needed ical infrastructure of the city. Unfortunately, in developing countries, where the property taxpayers are often selfish, and they prefer that tax represents a very small proportion of tax the central government be the one to address revenue and where the infrastructure for set- poverty. ting up a property tax is often not in place. • Land-based revenues have been used recently Takeaway Messages to finance infrastructure in developing coun- tries, and they are likely to be important reve- A solid financial structure is essential to the nue for the future. Land sales and leases (Cairo, success of cities in meeting the challenges of Mumbai), betterment levies, and improvement urbanization. The financial structure affects the fees are ways to capture the value of public quantity and quality of services, the efficiency land. They can also be used as the contribution with which those services are provided, whether of the public sector in private-public partner- the costs are shared across the city in a fair and ships, notably in large projects. Examples are efficient way, and both citizen access to govern- the Shanghai Metro project and the São Paulo ment and local government accountability to Metro 4 Station. citizens. The choice of revenue tools is also important. • Another recently used source of local reve- The benefit model of local government finance nues is the congestion pricing or congestion Managing Local Revenues 211 tax used in London, Singapore, Milan, and liabilities (arrears, fines, and penalties) from Stockholm with the aim of reducing traffic, collection of current annual tax dues. congestion, and pollution. The benefits of 5. Some consider that utility surcharges are these taxes have been visible: carbon emis- essentially benefit taxes illegitimately sions have dropped and the revenues raised charged on excludable goods because it is were used to expand and improve the public easier to collect these than general taxes on transport infrastructure. pure, nonrival, public goods. However, sur- charges could be good instruments to finance In time of financial stress, many local gov- new development, for example, supporting ernments are living in the moment. Cities need green development, when imposed on energy. to reflect about the factors that have led them 6. Street addressing is the system that generally into fiscal distress and take the actions that will assigns a specific nomenclature (or address) improve their situation in the medium and long to each location (i.e., plot of land, dwelling, term. Quick fixes (such as selling a physical asset) building, etc.), making identification possible. Under the most modern system, this informa- will not work. Reconsidering the allocation of tion is supported by GIS maps. resources and identifying potential increases in 7. This difference could be exaggerated, given existing tax rates (even if temporary) are the best the difficulty in separating the potential num- ways to deal with any financial crisis in an open ber of taxpayers (whether registered or not), and transparent way. the registered taxpayers, and those actually receiving a tax bill. Notes 8. Derived from Garrett and Leatherman 2010. 9. The term “social audits” refers to the role of 1. The difficulty of measuring the individual civil society organizations in formally over- utility that a given person extracts from using seeing the operations of the local government, a public service justifies the use of proxies particularly the implementation of local devel- in financing the service, notably progressive opment projects. income taxes or proportional property taxes (Musgrave and Musgrave 1976). 2. Particularly in the Nordic countries; References for more information, see OECD Fiscal Decentralization Database, http://www.oecd Action Aid, International Governance Team. 2011. .org/tax/federalism/oecdfiscaldecentralisation “Budgets, Revenues and Financing in Public database.htm#C_4. Service Provision.” http://www.actionaidusa 3. This principle is often at odds with the prin- .org/sites/files/actionaid/budgets_revenues ciple that the rate of the property tax should _and_financing_public_service_provision be set so that when applied to a given base it _hrba_governance_resources.pdf. yields the amount of money the local govern- Audit Commission U.K. 2009. London Borough ment needs to provide basic services. This of Sutton. http://www.auditcommission. means that everybody is paying a different cov.uk/SiteCollectionDocuments amount for the consumption of the same /AuditCommissionReports/National public services on the assumption that the Studies/23042009summingupREP.pdf. “utility” of these services is proportionate to Bahl, Roy. 1996. “Fiscal Decentralization: Lessons one’s wealth. for South Africa.” In Restructuring the State 4. In many countries, collection rates look much and Intergovernmental Fiscal Relations, edited better than they are because local property tax by Bert Helmsing, Thomas Mogale, and systems do distinguish collection of old unpaid Roland Hunter. Freidrich-Ebert-Stiftung. 212 Municipal Finances ———. 2002. “Implementable Rules of Fiscal Ellis, P., M. Kopanyi, and G. Lee. 2007. “Property Decentralization.” In Development, Poverty Taxation in the Large Cities of Punjab and Fiscal Policy, edited by M. G. Rao, 253–77. Province, Pakistan.” Journal of Property Tax New Delhi: Oxford University Press. Assessment and Administration 4 (2): 31–52. Bahl, Roy, J. Martinez-Vazquez, and J. Youngman. Eckert, Joseph. 2008. “Computer-Assisted Mass 2008. Making the Property Tax Work: Appraisal Options for Transitional and Experiences in Developing and Transitional Developing Countries.” In Making the Property Countries. Boston: Lincoln Institute of Land Tax Work, edited by R. Bahl, J. Martinez- Policy. Vasquez, and J. Youngman. Cambridge, MA: ———. 2010. Challenging the Conventional Wisdom Lincoln Institute of Land Policy. of the Property Tax. Boston: Lincoln Institute Farvacque-Vitkovic, C. 2005. Street Addressing and of Land Policy. the Management of Cities. Washington DC: Bird, Richard. 2001. “Setting the Stage—Municipal World Bank. and Intergovernmental Finance.” In Challenges Farvacque-Vitkovic, C., M. Raghunath, C. Eghoff, of Urban Governments, edited by M. Freire and C. Boakye. 2008. “Development of Cities and R. Stren. Washington, DC: World Bank of Ghana—Challenges, Priorities and Tools.” Institute. Africa Region Working Paper 110, World Bank, ———. 2006. “Local Business Taxes. In Perspectives Washington, DC. in Fiscal Federalism, edited by Richard Bird Garrett, T. A., and John C. Leatherman. 2010. An and François Vaillancourt. Washington DC: Introduction to State and Local Public Finance. World Bank Institute. http://www.rri.wvu.edu/WebBook/Garrett ———. 2009. “Tax Assignment Revisited.” In Tax /chapterfour.htm. Reform in the 21st Century, edited by J. Head and Guajardo, S. A., and R. Miranda. 2000. An Elected R. Krever, 441–70. New York: Wolters Kluwer. Official’s Guide to Revenue Forecasting. Chicago: ———.2011 “Subnational Taxation in Developing Government Finance Officers Association. Countries: A Review of the Literature.” Policy Ingram, Gregory. 2008. “Foreword.” In Making the Research Working Paper 5450, World Bank, Property Tax Work: Experiences in Developing Washington, DC. and Transitional Countries, edited by Roy Bahl, Brzeski, W. Jan. 2012. “Global Position Paper on Jorge Martinez-Vazquez, and Joan Youngman. Property Tax Reforms.” International Property Boston: Lincoln Institute of Land Policy. Tax Institute, Toronto, Canada. International City Management Association. 2003. Devas, Nick. 2001. “Financing Cities,” Insights IQ Report, vol. 35, no. 8, August. #38, November, http://www.id21.org/insights Muccluskey, W. J., Michael E. Bell, and Lay C. /insights38/ insights-iss38-art01.html. Lim. 2010. “Rental Value versus Capital Value. Devas, Nick, A. Munawwar, and D. Simon. 2008. Alternative Bases for the Property Tax.” In Financing Local Government. Commonwealth Challenging the Conventional Wisdom on Secretariat Local Government Reform Series, the Property Tax, edited by Roy Bahl, Jorge London. Martinez-Vasquez, and Joan Youngman, DEXIA. 2008. Sub-National Governments 119–57. Cambridge MA: Lincoln Institute of in the European Union. Organization, Land Policy. Responsibilities and Finance, Paris. Musgrave, Richard A., and Peggy B. Musgrave. Easter, K. W., and Y. Liu. 2005. “Cost Recovery 1976. Public Finance in Theory and Practice, and Water Pricing for Irrigation and 2nd ed. Tokyo: McGraw-Hill Kogakusha Ltd. Drainage Projects.” Agriculture and Rural Peteri, G., and F. Sevinc. 2011. “Municipal Development Discussion Paper 26, World Revenues and Expenditures in Turkey.” Bank, Washington, DC. UNDP–LAR Project, UNDP, Ankara, Turkey. Managing Local Revenues 213 Peterson, George E. 2009: Unlocking Land Values Cities and Municipalities.” Report No. 35749- to Finance Urban Infrastructure; World Bank BR. World Bank, Washington, DC. PPIAF, Washington DC. ———. 2006b. “Uganda at a Glance.” World Bank, Ruiz, Francisco, and Gabriel Valejos. 2010. “Using Washington DC. Land Registration as a Tool to Generate ———. 2007. “Implementation Completion Municipal Revenue: Lessons from Bogota.” Reports for Maputo Municipal Development World Bank, Washington, DC. Program (MMDP) I.” World Bank, Rybeck, Rick. 2004. “Using Value Capture to Washington, DC. Finance Infrastructure and Encourage ———. 2010. “West Bank and Gaza, Municipal Compact Development.” Washington, Finance and Service Provision.” Sustainable DC: District of Columbia Department of Development Department, Middle East and Transportation. North Africa Region Report. World Bank, Slack, Enid. 2009. Guide to Municipal Finance. The Washington, DC. Human Settlements Financing Tools and Best Wyoming. 2011. “Guidelines for Preparing Practices Series, UN HABITAT, Nairobi, Kenya. the Municipal Budget—A Handbook for Werneck, R. 2008. “Tax Reform in Brazil: An Municipal Elected Officials. Available at Evaluation at the Crossroads.” PUC Texto par http://www.wyomuni.org/vertical/Sites Discussao, N 558. Rio de Janeiro: Pontificia /percent7BAA188EFF-AB49-49A3-ACFE Universidade Catolica. -6BC586C039AD percent7D/uploads World Bank. 2006a. “Brazil: Inputs for a Strategy /percent7BD4C29F11-6798-4AE1-AD5C for Cities. A Contribution with a Focus on -0E67ABFAF498 percent7D.PDF. 214 Municipal Finances CHAPTER 5 Managing Local Expenditures Lance Morrell and Mihaly Kopanyi Local governments throughout the world are the efficiency and cost-effectiveness of municipal under increasing financial pressure to do more services and functions. Even though the nature of with less. Although not all local governments the services that municipalities provide varies by have the same level of responsibility for provid- size and local situation, the concepts presented in ing services, most of them face a rapidly grow- this chapter, together with those in chapters 3 and ing demand for urban services as a result of the 4, apply to most local governments. continuing fast growth of the urban population. The objectives of this chapter are to introduce However, the capacity of those local governments concepts designed to strengthen the abilities of to supply urban services and to undertake the local government administrators, members of necessary infrastructure development is severely local councils, department heads, and finance constrained by a shortage of fiscal resources. staff to manage and control the level of expen- Although the situation is the result of many fac- ditures, so that local services can be provided tors, the problem has become more extreme efficiently and effectively and the tax burden on following the financial crisis of 2008, which inten- citizens minimized. sified the general need to increase efficiency and to manage financial resources more effectively. Expenditure Management Concept Although the demand on local governments for and Principles more services at a lower total cost will continue, the ideas and tools that this chapter presents will Throughout the world, legislatures and special- provide local government officials, and in partic- ists are discussing the importance of fiscal dis- ular finance officers, with the means to increase cipline and operational efficiency. The concept Managing Local Expenditures 215 of expenditure management is to ensure that are being followed. The council sets rules, the funds available to local governments are provides guidance, discusses expenditure spent on improving service delivery and achiev- performance analysis and decides on correc- ing government objectives efficiently and effec- tive actions, and communicates expenditure tively. Shortcomings in expenditure management performance to external entities, such as the result in the arbitrary allocation of resources central government and the citizens. and inefficient operations, which are common in • Finance department. The treasurer or the head many developing countries. Expenditure man- of the finance department focuses on ensuring agement systems are the tools that enable local that each line department receives a budget governments to ensure that revenue budgets are sufficient to provide the agreed services; the realistic and expenditures are consistent with funds allocated to the various departments are the revenue forecasts. These systems also help to used for their intended purposes; and systems ensure that strategic priorities receive the needed and procedures are in place to monitor and budgets and that the various public services are evaluate recurrent and capital expenditures. provided at reasonable cost. • Line departments. The heads of the line or What Is Expenditure Management? functional departments focus largely on man- Expenditure management focuses on ensur- aging and controlling their specific costs, for ing that funds are allocated and used to achieve example, in a solid waste services department, agreed priorities and that information is available investing in and maintaining machinery and to enable governments to plan and monitor the the costs of fuel and wages. performance of their programs and the impact of their expenditures. Its tools include planning Expenditure Management—Big Picture Issues resources and expenditures; allocating or appro- and Challenges priating resources and transferring funds to The scheme in figure 5.1, introduced in chapter 3, entities and functions; controlling and executing illustrates the perspective and roles of the mayor, expenditures and the release of funds; and mon- the council, and the finance department in itoring expenditure performance. They will be expenditure management. Among other func- discussed in more detail in the following sections. tions, they need to focus on the big picture of municipal finances, as they are responsible for ensuring that total revenues are sufficient to Expenditure Management Entities cover the total expenditures of the municipality Several entities are involved in expenditure or, in other words, that the budget is balanced management, each fulfilling specific aspects and (see also chapter 8). functions of the overall expenditure manage- ment of a local government; and the allocation of The balanced budget. The local situation and functions depends on (local) legal and political challenges to a large extent depend on a country’s circumstances: fiscal architecture and specifically the level and • Council and mayor. Members of the local depth of decentralization (explained in more government council focus on ensuring that the detail in chapter 1; see also Ebel and Vaillancourt services demanded by the taxpayers are pro- 2007). As a result, comparing structures and vided efficiently, that the funds collected are revenue and expenditure balances requires used appropriately, and that the government’s careful understanding of the country’s situation. policies and internal control procedures Nevertheless, some general principles and basic 216 Municipal Finances Figure 5.1 Revenues in Budget Context Revenues Expenditures Current revenues Current expenditures budget Current Own revenues: taxes, fees Payroll transfers from government Operation and maintenance other revenues (rents) Interest payments surplus carried forward Deficit carried forward (if any) Self-financing Operating surplus Capital revenues Capital expenses budget Capital Sale of property, land Civil works grants purchase of property, land loans repayment of loan principal Table 5.1 Jhelum City Budget (PRs millions) triple balances, as does Jhelum city (population 2004–05 2005–06 2007–08 200,000), in Pakistan, as shown in table 5.1. The 2007/08 budget suggests that although municipal Current revenues 91.9 130.9 115.5 borrowing is prohibited in Pakistan, delayed pay- Current expenditures 30.0 42.8 47.5 ment to developers (forced credit) is apparently Current balance 61.8 130.1 117.8 an option. Development revenues 14.8 25.1 15.5 Hundreds of municipalities in developing Development and transition economies face persistent current expenses 36.1 144.1 188.3 deficits—in part because of the global financial Development crisis. That means that they fail to finance regu- balance (21.3) (119.0) (172.9) lar operations from current revenues, and either Closing balance 40.6 11.2 (55.0) accumulate deficits over years or finance opera- tions from capital receipts; that is, they are using structures provide a useful basis for analysis up the wealth of the community. Table 5.2 shows and comparisons, including the balanced budget the budgets of a big (over 3 million) Pakistani city principle and the division of functions among and a medium-size city in Croatia. government tiers, for example. Although the two budgets look similar, the cur- Municipalities should plan for and maintain rent deficit is more persistent in Pakistan, while balanced budgets for both legal and pragmatic it is temporary in Croatia and due largely to the reasons. Figure 5.1 depicts an ideal situation global economic downturn. Despite their current that is realistic in developed countries, namely, deficits, both of these cities finance development, current revenues exceed current expenditures largely with state grants, and in Croatia, with loans. and provide a substantial operating surplus that Needless to say, a current deficit is an unhealthy is available for self-financing a portion of capital situation that should be fixed. A persistent current expenditures. Thus, a balanced budget includes deficit may indicate either soft budget constraints, three balances: current balance (with surplus), meaning weak expenditure control, or a vertical capital balance, and balance total. Well-managed imbalance, meaning a mismatch between expen- municipalities, even in developing countries, diture and revenue assignments, which should be plan and execute their budgets with these corrected by the central government. Managing Local Expenditures 217 Table 5.2 Budgets of a Big City in Pakistan and a Medium-Size City in Croatia Multan budget Rijeka budget (PRs thousands) 2008–09 2009–10 2010–11 (€ thousands) 2008 2009 2010 Current revenues 5,318.7 4,719.5 5,850.5 Total current revenues 128.4 120.7 119.5 Current expenditures 4,054.0 4,761.8 6,138.7 w balances forward Current balance 1,264.7 −42.3 −288.2 Current expenditure 124.2 122.4 127.6 Net operating balance 4.2 −1.6 −8.1 Capital or dev. receipts 1,018.0 1,403.0 0.0 Capital revenues/financing 32.2 17.2 33.6 Capital expenditures 1,420.0 868.0 965.0 Capital expenditures 36.4 15.5 25.5 Capital balance −402.0 535.0 −965.0 Capital balance (surplus/ −0.2 8.6 8.5 Total balance 862.7 492.7 −1,253.2 deficit) Overall closing balance 4.0 7.0 0.4 Expenditures by functions or sectors. The level services; and a large portion of their small budgets of fiscal decentralization largely determines covering administrative expenditures. the structure of expenditures by function or Municipalities in the developing countries tend service sector. The Nordic countries of Europe to be similar to the more centralized European are deeply decentralized, with a broad scope of countries, with small shares of total public expen- functions devolved to the local governments. ditures, minor functions in the provision of social Other European countries remain more cen- and urban services, and a large share of their tralized, with few functions assigned to the budgets going for administrative expenditures. local level. Like them, most of the municipali- Some even argue that local employment is their ties in the developing world have limited func- prime function. The citizens, however, may not tions. For example, municipalities in Jordan feel that the local government serves them and are largely responsible for local roads, street thus may not be willing to pay higher taxes if the lighting, and solid waste management; other bulk of the budget is spent for administration functions are performed by central government rather than services. Lessons can be drawn from entities. the assignment of functions, as well as national Figure 5.2 shows a very clear relationship traditions, to determine the structure of expendi- between decentralization and the size and struc- tures, and expenditure control should be assessed ture of expenditures by function. Municipalities against those characteristics. in decentralized countries cover a large share of Table 5.3 shows the emerging situation of the public expenditures (in Denmark, 35 percent of Russian Federation following the political tran- GDP); spend the bulk of their budgets on social sition. Russian municipalities are substantially services; pay in part for some urban services, responsible for the provision of social services most of which are provided by private entities; (low-income housing, health, and education). and spend only a small portion of their budgets The  table  suggests that over time they have on administration. The opposite side of the pic- rationalized expenditures by, among other ture shows cities in centralized countries paying things, privatizing part of the housing stock. a small share of municipal expenses (in Turkey, They increased expenditures on urban services, 5 percent of GDP), with minor responsibilities education, and health. They are also speci- for social services; substantial spending on urban fying expenses more precisely, reducing the 218 Municipal Finances Figure 5.2 Expenditures by Function and Decentralization 100 40 90 35 80 30 70 Percentage Percentage 60 25 50 20 40 15 30 10 20 10 5 0 0 N E FIN LIT GB T AUR SK T R L HU T N A EU P EU27 15 L R RO O M E T FR L LUA X R L E TU P R LT PO BE BU IR SW ES LA ES CZ NE GR CY GE PO IT DE SL M Administration Urban services Social services Local expenditures in % of GDP Source: http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database. Table 5.3 Municipal Expenditures by Function council (explained in more detail in chapter 3). in the Russian Federation (%) The finance department sets the budget calendar Function 1996 2002 and communicates policy decisions and guide- lines. Against these the line departments draft Local administration 3.3 6.7 their budgets and submit proposals to the finance Infrastructure and economic services 8.3 9.9 department for review and negotiation (see Housing and communal services 26.6 19.5 figure 5.3). The finance department is responsible Culture 2.1 3.0 to enforce key policy targets (including the bal- Education 25.6 33.2 anced budget), to consolidate the departmental Public health 14.5 15.5 budgets into the municipal budget, and to submit Social policy 7.2 7.6 it for approval by the mayor and council. It is a Other 12.4 4.6 lengthy process, with competitions, battles, and Total 100.0 100.0 sometimes harsh discussions between the finance Source: Chernyavsky and Vartapetov 2004. and other departments. The functional or line departments are pri- undefined “other expenditures” line item from marily responsible for fulfilling their tasks from 12.4 percent to 4.6 percent. the budget allotted to them, thus controlling their expenditures. Therefore, during the planning Expenditure Management—A Battlefield process they have a vested interest in increasing between the Finance and Line Departments their budgets over the previous year’s amount. Budget planning is an iterative process driven Sometimes battles occur between the finance and controlled by the treasury or finance depart- department and other entities in discussions of ment and usually by a finance committee of the expenditure plans. Table 5.4 shows how a school Managing Local Expenditures 219 Figure 5.3 The Iterative Budgeting Process required to achieve revenue increases and, more important, expenditure cuts, including reducing the number of police and spending on park main- Policy tenance. Finance departments should identify, Rules BUDGET and offer to decision makers, alternative solu- tions to achieve needed budget restructuring. An Effective Expenditure Management System An effective expenditure management system must include three elements: 1. Milestones. It is necessary to plan for future Unit level draft expenditures with clear and measurable mile- plans stones to monitor actual performance. 2. Spending control. It is necessary to control expenditures so that actual spending is consis- Table 5.4 Expenditure Plan Submitted by tent with the budget and plan. a School to the Finance Department Revised 3. Evaluation. Expenditures must be monitored Estimates and evaluated to ensure that they are in fact 2011 (Rs) Plan 2012 (Rs) conforming to agreed-on plans. Gross 32,500,000 36,125,000 The overarching objective of expenditure expenditurea management, as said, is to improve the use of Revenues from 8,000,000 10,120,000 resources. To fulfill that objective, local govern- tuitionb ments must promote achievement of three inter- Net financing 24,500,000 26,005,000 related outcomes: need a. The costs of energy and utilities will increase total expenses 1. Aggregate fiscal discipline—ensuring that by 5 percent, and four part-time professors will be hired, based actual expenditures are consistent with actual on approval by the school board. total revenues, to keep government spending b. Applications suggest that the number of students will increase by 10 percent, and tuition will be increased by within sustainable limits 15 percent. 2. Allocative efficiency—consistency between budgets allocated to programs and activities supports its expenditure plan with specific infor- that promote the strategic priorities of the mation about changes from the previous (base) communities year. 3. Operational efficiency—the provision of public The negotiations between the finance and line services at a reasonable quality and cost. departments are particularly difficult when the departments are requested to cut expenditures, Although those three outcomes are reasonable, a challenge that municipalities have been facing they must be achieved by local governments that all over the world, including in the United States, are by their nature complex organizations, with because of the economic downturn after 2008. numerous and often conflicting political agen- In such cases detailed and specific measures are das and competing special interests.  One  group 220 Municipal Finances within  the local government may want a tax the key requirements for improving expenditure increase to improve a specific local service; management. another group may lobby to increase pension pay- ments to employees; the interests of community Policy Setting groups may differ from those of developers or The cycle begins with, and is driven by, the poli- local businesses, and so on. cies that the local government is trying to achieve. To begin the process, government officials must review current policies to determine if they are The Expenditure Management still valid and, together with the various stake- Cycle holders, identify new or modified policies that are Expenditure management should be seen as a important to the communities. An example might continuous cycle that includes reviewing and be introducing a development fee that requires setting policies, developing and approving plans, local property developers to finance upgrades of mobilizing and allocating resources, implement- trunk infrastructure when developing adjacent ing plans and controlling expenditures, moni- properties. Another example could be requiring toring accounting expenditures, and evaluating that housing developers ensure that 15 percent and auditing expenditure performance. Figure 5.4 of  all new housing units are affordable for low- depicts the expenditure cycle, and box 5.1 illus- income groups. trates some actions that can be taken to improve expenditure management. We begin by briefly Planning explaining the elements of the expenditure man- After a transparent review of, and agreement on, agement cycle; more details will be discussed the local government’s policies and strategies, in the subsequent sections. Box 5.1 summarizes plans need to be finalized for each department Figure 5.4 The Expenditure Management Cycle Review policy Evaluate and audit Develop plans Mobilize and Monitor and allocate account resources Implement plan, control expenditures Source: World Bank 1998, 32. Managing Local Expenditures 221 Box 5.1 Reforming Expenditure Management To improve expenditure management requires • Well-functioning accounting and financial the following: management systems. These are among the basics that underpin governmental • Greater focus on performance—the results capacity to allocate and use resources effi- achieved with expenditures. This focus has ciently and effectively. the potential to engage all stakeholders in • Attention to the links between budgeting pursuit of budgetary and financial manage- and financial management systems and ment reform. other servicewide systems and processes • Adequate links among policy making, of government—for decision making, for planning, and budgeting. Such links organizing government, and for personnel are essential for sustainable improve- management. A well-performing public ments in all dimensions of budgetary sector requires that all component parts outcomes. work well and, where appropriate, together. Source: World Bank 1998, 3. and unit. In developing effective plans, it is essen- frequently affect resource allocation are listed tial that measurable milestones are identified to in box 5.2. enable performance to be monitored. The imple- mentation plans should enable government offi- Expenditure Control cials to make midcourse corrections or to expand Once plans have been developed and fully funded or contract some programs if actual levels of reve- to address the agreed-on strategic policies, the nues or expenditures alter the initial plans. local government will proceed to implement the plans and to properly account for and control Resource Allocation both revenues and expenditures. Various tools The next step of the cycle is to mobilize and allo- and procedures can be used to perform adequate cate the resources needed to achieve the policies expenditure control at every level of the local gov- and then implement the planned activities. At ernment and in each department and unit autho- this point, the sources of revenue (discussed in rized to spend funds. chapter 4) must be reviewed, and realistic rev- enue budgets must be developed and compared Accounting and Monitoring with the estimated expenditures (procedure dis- The next step in the expenditure management cussed in chapter 3). This budgeting or planning cycle is to account for each expenditure, ade- process is iterative, as estimated expenditures quately ensuring that costs are applied to the spe- may be greater than realistic revenue projec- cific activities (cost centers), and then to monitor tions. Thus, the process will need to continue the results through financial and technical means. to the point where the estimated expenditures for the agreed plans and programs are adjusted Evaluation and Audit to be consistent with the revenues that realisti- The final step in the expenditure management cally can be generated. Some weaknesses that cycle is to review and audit the results of the 222 Municipal Finances Box 5.2 Weaknesses in Resource Allocation and Use Weaknesses that undermine expenditure • Little relationship between budget as for- management, and public financial manage- mulated and budget as executed ment in general at the local government level, • Inadequate accounting systems include the following: • Unreliability in the flow of budgeted funds to agencies and to lower levels of • Poor planning government • Lack of links among policy making, plan- • Poor cash management ning, and budgeting • Inadequate reporting of financial • Poor expenditure control performance • Inadequate funding of operations and • Poorly motivated staff maintenance Source: World Bank 1998, 5. programs to evaluate objectively whether or not recommend solutions, and to conduct or facilitate the agreed-on outputs and outcomes are being stakeholder consultations. Once the proposed achieved. The results of these evaluations will plan has been fully developed and its cost deter- provide critical information to all stakeholders mined, it is presented to the communities for dis- during the review of government policies that will cussion. After a number of stakeholder meetings be part of the next annual policy review program. and revisions to the plan, stakeholders agree that Each of these items is discussed in more detail the local government should organize a referen- in the following sections, but the question may dum for the citizens of the zones affected and be raised as to where the cycle should begin. The decide which school to close based on popular objective of a local government is to deliver those vote With this strategic policy decision in place, services that the population demands and is will- the finance and education departments will pre- ing to pay for in the form of taxes and fees. Thus, pare revenue and expenditure plans to support the policy framework should be the place where eventual implementation. Those plans would the planning and expenditure management cycle contain measurable outputs and outcomes, as begins and ends. well as intermediate targets to enable officials to Example: The economic and demographic monitor and evaluate the results. changes in many East European cities require consolidating schools by closing some and moving Review and Develop Policies and Plans students from unsustainable schools to grow- What is an expenditure management policy? In a ing areas nearby. Closing a school is among the broad sense, it is a way of making choices about hardest of decisions, charged with both interests planned expenditures in the years ahead (next and politics. Ideally the decision on which of five year, or the next three to five years). Many play- schools would be closed should be made based on ers are involved in the policy-setting process. detailed analysis, since the answer to this simple The elected officials (mayor, council, etc.) and question is not straightforward. Thus, the local their respective constituents are critical in defin- government contracts a consultant to analyze ing the new policy agenda (e.g., spending more the situation based on clear and hard numbers, to on education, and maybe less on roads, because Managing Local Expenditures 223 education is a high priority). Policy options and Example: Local elected officials may use their plans are also frequently developed internally by influence with a department to gain its support service and line departments. As with the exam- for certain projects which would benefit the offi- ple above on a school rationalizing program, once cials and their constituents. The projects may policy options have been agreed on, the service be high priorities for the local communities but and line departments are essential in developing may not have the impact of others are supported cost estimates and implementation plans, and the by the department or government because of the finance department must identify ways to finance influence of a few elected officials (the “bridge to the costs. nowhere” in Alaska is an example; see box 5.3). Arguably the most difficult part of the expendi- ture management cycle is to review policy options Incorporating Financial Constraints and decide on those policies that are most appro- and Examining Alternatives priate for a specific local government. A major reason why this step is so difficult is that it is not The policies and projects that elected officials merely technical but largely depends on the polit- and their staff support must recognize the hard ical process and is thus subject to the involvement budget constraints imposed by realistic revenue of special interests. It is crucial that the elected forecasts and the recurrent costs of proper oper- officials in the government provide legitimacy to ation and maintenance of assets. Analyses must policy decisions and the resource implications be based on realistic revenue and expenditure over the life of the policy by being at the center assumptions and include, as much as possible, of the process of reconciling what is affordable, alternatives for decision makers to consider, as given the level of revenues that can reasonably well as clear and verifiable indicators that can be be expected, and what is being demanded of the used to monitor and evaluate progress in develop- various sectors. ing and implementing each alternative. What is the right package of policies depends For good functioning, government officials on (a) the priorities of the society, (b) the costs must coordinate the drafting and analyses of of programs and activities needed to meet those options by the departments, and the data and priorities, and (c) the objectives of special interest underlying assumptions used must be made avail- groups. A program may be relatively inexpensive able to all to ensure transparency and encourage a but not fall in a priority area. Or a program may high degree of realism in the process. Neither the be in a priority area but be much more expen- analyses nor the conclusions will satisfy all con- sive than another program in some other priority stituents, and that is why transparency is essential. area. In either case, the program is not right. To In some cases, for example, a department may establish priorities, one needs to know the pref- withhold information regarding its best estimate erences of the citizens and have a participatory of the full cost of a program to get the program process in place. Functional and service depart- approved. Once a budget has been provided and ments and municipal agencies or enterprises are work started, perhaps based on half of the actual responsible for and active in estimating and artic- estimate of its cost, future budget allocations will ulating customers’ needs and priorities in their normally be easier to obtain. competency area. Often they have a vested inter- Neither transparency nor large-scale  policy est too. Therefore, the policy formulation process dialogue is common in many developing induces competition among departments, agen- countries. Rather, proposals are drafted by cies, politicians, and interest groups, as well as department experts behind closed doors, among project proposals. or by consultants, and not communicated 224 Municipal Finances Box 5.3 Alaska’s Bridge to Nowhere The U.S. state of Alaska received a federal After heated debate, this Alaska project grant of $398 million to build the Gravina was canceled; the grant was revoked and the Island Bridge to connect the town of money diverted to finance another Alaska Ketchikan, Alaska, with Gravina Island, which project. has about 50 residents and is the location of One lesson learned is that even though the the Ketchikan Airport, which receives about local government and its 50 residents included 200,000 passengers a year. The bridge was this bridge in its capital plans, it is also essen- planned to be nearly as long as the Golden tial that costs be reasonable and that the local Gate Bridge in San Francisco. For comparison, government be able to operate and maintain the Golden Gate Bridge carried about 118,000 its capital projects from its operating budget. vehicles per day, for a total of 43 million vehi- cles a year, in 2006. Source: http://askville.amazon.com/bridge-Alaska-literally. to stakeholders because consultations are a development) use municipal audits to control time-consuming and sometimes painful polit- and measure the performance of municipal ical process. Indeed, sector departments have entities. Performance management can also be the professional expertise to draft proposals or supported by specific performance contracts discuss alternatives, but they may have vested between a municipality and service entities, interests, too. In addition, in some cases mis- whether public, private, or mixed ownership. matches occur between government policy The central government may also set perfor- and the actual expenditures, as shown in box mance targets, condition grants on the munic- 5.4, either for political reasons or because of ipality’s meeting them, and enforce such an resource constraints issues. arrangement by a municipal contract (see Well-organized analyses and participatory chapter 8 for more details). budgeting (explained in chapters 3 and 8) are Example: Fairfax County, Virginia, U.S., increasingly used to support informed deci- decided that it wanted to extend the mass rapid sions that reflect citizens’ priorities. Chapter 8 transit system out to the international airport. discusses an effective data collection, analysis, Elected officials from a number of jurisdictions and decision process that is used increasingly, and many of their constituents supported the including in developing countries. Municipal and extension, and the relevant staff and consultants financial audits start with developing structured began developing various technical alternatives databases and proceed to completing analyses, and cost estimates. Among the options under comparing results with benchmarks, and eventu- consideration was whether to locate the station ally preparing a specific action plan for improving at the airport on ground level or underground. local services and financial performance, includ- The technical analysis indicated that the above- ing time frames. ground option was substantially less expensive. Higher bodies such as the council or central But the underground option would not change government (financier of operations and the landscape, and thus it was more appealing Managing Local Expenditures 225 Box 5.4 Mismatch between Policy Goals and Expenditure Allocations in Guinea A 1996 public expenditure review (PER) in the recurrent costs of investment projects fell Guinea revealed a complete mismatch far short of what would be required for between the government’s stated policy adequate operation and maintenance. priorities and its actual priorities, based on Based on the findings and recommenda- expenditure allocation. Although the govern- tions of the PER, the government of Guinea ment designated primary education, public launched an initiative to define affordable poli- health, and road maintenance as priorities, cies. Four line ministries began revising their funds often were allocated to other areas medium-term policies and costing out their instead. No system existed for costing out implementation. The government also began policy proposals or subjecting them to rigorous preparing a medium-term expenditure frame- scrutiny. An exercise to cost out the policy mix work for the four ministries (initially), in the that would be needed to meet the govern- context of its economic reform program, ment’s stated priorities revealed that the and central ministries began preparing a share of priority programs in total spending macroeconomic policy document to help the would need to triple over the succeeding four cabinet make intersectoral allocation deci- years, implying drastic cuts in other expendi- sions. The ministry of planning took steps to tures to remain within the budget. The report improve the predictability of the macroeco- also showed that actual allocations to meet nomic framework. Source: World Bank 1997. to many. After numerous public hearings, revi- for easy communication (see chapters 3 and 8). sions, and reviews of the cost and financing Strategic discussions and decisions on the budget assumptions, the decision was made in favor of require such short budget snapshots. the lower-cost, ground-level option because it Box 5.5 shows a general budget template and was more consistent with the estimated revenue a real budget snapshot from a Nepali city. The stream. two templates, albeit in different order, follow the same logic, namely, they separate (a) own Budget Plans expenditures, (b) delegated expenditures that are No good expenditure control system can operate financed by earmarked grants from higher gov- without adequate budget plans. The expenditure ernment tiers, and (c) capital expenditures. Own budget is the result of the planning process dis- expenditures are those activities that have been cussed above. Expenditure budgets are often very devolved to the local level; what activities are del- detailed. For example, the expenditure budget egated depends on the local circumstances. of Lahore, a city of 7 million, is about 400 pages The Mechinagar budget shown in box 5.5 long, with detailed line items for each and every offers further information, including (a) that unit, function, and action. The council discusses “current expenditures” are fully assigned, which these very detailed budget plans, but the expen- means that there is no “other” category that is diture managers in finance departments use, and not attached to specific functions, and (b) that submit to the council, short budget summaries unassigned “miscellaneous” expenditures are the 226 Municipal Finances Box 5.5 Snapshots of Expenditure Budgets Sample expenditure plan 2008 2009 2010 2011 Total expenditures Actual Actual Actual Plan EXPENSES ON DELEGATED FUNCTIONS 1. Preschool education Wages Operating Repair and maintenance Capital investment 2. Primary and secondary school 3. Health care 4. Social assistance and poverty alleviation 5. Public order and civil protection 6. Other OWN EXPENDITURES 1. Infrastructure and public services -Current expenditures Direct expenditures -Capital expenditures Direct expenditures Subcontracts 2. Environment protection Wastewater Solid waste 3. Social, cultural, recreational expenditures 4. Local economic development 5. Social housing 6. Urban development 7. Civil security 8. Transfer to sublocal government entities Support to public utility companies 9. (subsidies, grants, equity, in-kind) Utility 1 10. Loan repayment 11. Interest charges 12. Guarantees called (paid by the municipality) (continued next page) Managing Local Expenditures 227 Box 5.5 (continued) Expenditure Budgeted vs. Actual Mechinagar City, Nepal Actual 2007/08 % Budget Variance 2007/08 share 2007/08 100-A/B% 52 Salaries 10,661 14.96 11,035 3.39 53 Allowances 252 0.35 385 34.45 54 Travel and per diem 692 0.97 705 1.83 55 Services 384 0.54 480 19.98 56 Rent 178 0.25 180 1.21 57 Repair and maintenance 544 0.76 550 1.09 58 Office supplies 905 1.27 915 1.07 59 Newspapers 49 0.07 50 1.94 60 Fuel 567 0.80 600 5.53 61 Clothes/food allowance 351 0.49 355 1.18 64 Food (prisoners/animals) 295 0.41 310 4.8 65 Financial asst./donations 41 0.06 50 17.29 66 Contingencies 4,772 6.70 5,282 9.66 68 CURRENT EXPENDITURES 19,692 27.64 20,897 5.77 69 DEBT PAYMENT 4,000 5.61 4,000 0.00 71 Health 668 0.94 700 4.58 75 Fin. assistance 1,144 1.61 1,159 1.25 76 Miscellaneous 3,140 4.41 3,850 18.44 77 DELEGATED PROGRAMS 4,952 6.95 5,709 13.25 78 Furnitures 22 0.03 50 56.47 79 Vehicle 99 0.14 150 34.17 80 Machinery equipment 305 0.43 11,210 97 .28 81 ORDINARY CAPITAL 425 0.60 11,410 96.27 82 Land/building purchase 365 0.51 365 0.14 83 Building construction 250 0.00 1,300 80.80 85 Other dev./construction 41,815 58.69 58,136 28.07 86 CAPITAL INVESTMENT 42,180 59.20 59,801 29.47 87 TOTAL EXPENDITURE 71,249 100.00 101,817 30.02 Note: Template from Municipal Finances Self-Assessment (MFSA-see chapter 8) and budget of Mechinagar, Nepal. largest item in the delegated programs, which urban construction (e.g., roads, drainage) in one signals improper budgeting and uncertainty of line that represents over half the total budget; it control. As for development expenditures, one would be better to separate that line into the main can also notice (c) that the city singles out expen- investment categories. The Actual/Budget (A/B) ditures on land and buildings but reports all other column shows (d) that by end of the fiscal year, 228 Municipal Finances large differences appear between planned and or a road) will not be in place after construction actual investments, a common situation in devel- is complete. oping countries because of delays in allocation of Example: Some donor projects are managed grant funds, delays in construction, or both. externally by a project unit hired by the donor. Thus, the local government may not be properly Donor-Funded Projects informed about the details concerning costs, imple- Many developing countries receive support from mentation schedules, and, more important, about development partners, bilateral or multilateral the timing and amount of recurrent costs. In such donors. Receiving a project free makes local cases direct budgeting of these projects in advance governments happy but often makes them myo- or detailed and timely accounting of actual costs is pic too, in that they tend to ignore or hide the not possible. Possibly some agreed-on amount of longer-term implications of operating and main- total support can be made note of as an off-budget taining the assets received. For proper expen- memo item. In the case of an in-kind donation, diture management, it is important that local such as a school building, the local government governments ensure that the recurrent costs that must operate it by hiring teachers, paying elec- these donor-funded projects entail are properly tricity and water bills, and making repairs. It must captured in future budgets. This is not always easy budget for and perform those operation and main- or even possible since many projects are imple- tenance functions immediately upon taking over mented outside of the normal budget process. the building from the donor. However, local governments must actively ana- lyze all government and donor-funded projects Multiyear Budgets and Capital to understand the implications of operating and Investment Plans maintaining them and should account them on-budget instead of off-budget. Policies generally take more than one year to Many projects are structured by, paid for, and implement, and when a government is prepar- implemented by external agencies, with no money ing only a single-year budget, implementation transferred to the local budget. There is nothing becomes more difficult. To ensure that the true wrong with that; from an accounting perspec- cost of a program is recognized and the desired tive these are in-kind contributions. However, outputs and outcomes are realized, it is best to two challenges must be considered: First, these budget over a longer term, such as three to five projects need to be integrated in the longer-term years. This section discusses the use of multiyear plans of the municipality, be included in a medi- budgets or investment plans. um-term budget, and be part of the category of Table 5.5 presents the three-year, rolling, highest-priority projects. Second, the financial medium-term budget for the city of Johannesburg, implications need to be planned for and bud- South Africa. It compares the adjusted actual geted. Even if it is not possible to incorporate the results for the current year with the budgets for projects into the normal budgeting process, nota- the next three fiscal years. The budget, along tions about them must be shown in the budget to with a great deal of other financial information, is ensure that provision for the recurrent costs they posted on the city’s website. entail will be in place when they have been com- pleted. Unless provisions are made in the budgets What Is a Capital Investment Plan? for the outer years, the risk increases that the staff, A capital investment plan (CIP) is a multiyear equipment, and supplies needed to make use of (usually three to six years) program of cap- the assets (for example, a school, a health clinic, ital investment projects, prioritized by year, Managing Local Expenditures 229 Table 5.5 Multiyear Budget for the City of Johannesburg Actual Budget Estimate Estimate 2010/11 2011/12 Change 2012/13 2013/14 (R millions) (R millions) (%) (R millions) (R millions) Revenue 26,430 29,371 11.1 32,843 36,875 Expenditure 25,960 28,266 8.9 31,348 34,217 Surplus (deficit) before tax 469 1,104 135.4 1,495 2,657 Tax paid 59 295 286 303 Surplus for the year after tax 410 809 97.3 1,208 2,354 Capital gains and contributions 1,976 2,701 36.7 3,315 3,427 Surplus with capital gains and contributions 2,386 3,510 47.1 4,524 5,782 Source: http://www.joburg.org.za. with anticipated start and completion dates, represent the majority of local public investments. annual estimated costs, and proposed financing The imposition of centrally planned projects methods. The plan is usually approved by an reduces the incentives of local policy makers to elected body, such as a city council, and after engage in the time-consuming CIP process. Such approval, it can be used to secure financing projects create a number of complications for from donor institutions or banks. The approved local governments: CIP connects midrange plans with the annual • The projects are often selected without ade- budgetary process. The plan is reviewed and quate consultation or coordination with local revised annually, and an additional year is governments or their stakeholders and as a added. When the process is fully established, result may not reflect local priorities. the CIP becomes a rolling plan linked to the annual budgeting process. Each year, the previ- • Project schedules may conflict with capital ous year is removed from the CIP period, a new projects of the local governments themselves. year is added, and current-year capital bud- • Once completed, such projects often have a get expenditures become part of the approved major impact on local budgets because the annual budget. local government is expected to pay their Capital investment planning by local govern- operations and maintenance costs, frequently ments often includes investments (assets) by creating a substantial budgetary liability. the local government itself and by its entities, including enterprises established and owned by the government for the provision of municipal Financial Capacity of Local Governments services (such as utility companies). The plan A critical input in the capital investment planning may also include investments by the private sec- process is knowledge of the local government’s tor through public-private partnerships (PPPs). capacity to fund capital investments. Its capac- The Guidebook on Capital Investment Planning ity includes the feasibility of incurring debt and for  Local Governments (World Bank 2011) con- attitude toward borrowing (chapter 7 discusses tains more details (chapters 4 and 7 of this book external sources of financing). Knowledge of also discuss specifics of the CIP). financial capacity should include the govern- In many developing countries, projects ment’s recurrent obligations and the annual funded by central or regional governments often revenue stream that will be available to ensure 230 Municipal Finances effective operations and maintenance or finance restoration, and recapitalization. Establishing the debt. Unless the local government has the ability levels of such tariffs or fees is of critical impor- to fund and implement a capital investment pro- tance (box 5.6 provides an example of the steps gram, the list of projects prioritized through the involved). It is good practice to base such tariffs CIP process is nothing more than a “wish list” on full cost recovery, a rare case in developing of local needs and preferences. Considering that countries. It usually would imply that the tariffs most local governments can finance only a few would cover M&R costs, operations costs, debt priority projects in any one year and only a small service (that is, payment of loan interest), and percentage of their total capital needs, the realistic depreciation. assessment of financial capacity is essential. Problems common in the CIP process include Few would argue with the idea that bad the following: planning leads to unsatisfactory results. With capital projects, bad planning and weak expen- • Capital investment plans do not include diture management generally lead to too many realistic assumptions about funding and projects being started (too wide an investment) financing, resulting in a series of wish lists. but not completed on time, or at all, because of a • Capital investment decisions are made without lack of financial resources (too shallow a pool of reference to life cycle costs and management. financing). The impacts of bad capital planning are also evident in extended construction sched- • Capital investments require that the local ules and poor quality of construction due to lack government assume an unrealistic and unsus- of money. Such wide but shallow investments tainable level of debt. result in poorly constructed capital projects and • Local governments plan for or establish also deny citizens the improved services that public-private partnerships without clear jus- would have resulted from the government’s actu- tification and without the capacity to manage ally completing critical, high-priority capital them effectively. projects. When municipalities have infrastructure sys- • Capital investment priorities are distorted by tems that provide fee-based services (for exam- the availability of funding, or the lack of it, ple, water, sewerage, etc.), some part of the user for specific activities. For example, funding fees should be dedicated for capital investment, or grants may be available to local govern- including maintenance and repair (M&R) costs, ments for specific types of investments (such Box 5.6 Main Steps in Setting New Tariffs 1. Calculate the existing cost of service. 6. Recalculate tariffs. 2. Develop alternative scenarios. 7. Discuss results with stakeholders. 3. Calculate the cost of each. 8. Select the preferred scenario. 4. Calculate tariffs by scenario. 9. Build public support. 5. Compare tariffs to willingness to pay. 10. Present to the tariff-setting body and secure a tariff change. Source: USAID 2006, 46. Managing Local Expenditures 231 as roads or health clinics), regardless of locally • Monitor and evaluate expenditures to ensure identified priorities. Funds may be provided that they are in fact conforming to agreed-on by the central government to support line plans. ministry programs or by donor agencies that Local governments in developing countries are committed to supporting specific types of face numerous entrenched obstacles in control- investments. ling expenditures, some of which are inherent in • The capital investment program may the budget process: include too many projects (too wide) with • A disconnect between the budget and govern- too little funding (too shallow). It may over- ment policies emphasize roads, versus everything else, because roads are politically popular and • Lack of clarity of objectives in budget prepa- their planning and financing are the easiest ration to control. • Emphasis on fighting for resources rather than The process of capital investment planning results and budgeting is a dynamic and iterative one that • Difficulties in planning in the single-year generally involves four stages: framework, complicated by the unpredictabil- 1. Financial planning ity of budgetary resources 2. Project identification and prioritization • Accountability undermined by a lack of clear objectives and anticipated results 3. Program and project management • Fragmentation of the budget, with lack of 4. Monitoring and evaluation. coherence among the parts. Expenditure Management—Budgetary When reviewing ways to improve their bud- Controls geting and expenditure controls, it is important To this point, the chapter has defined the concept to keep in mind that local governments are in of expenditure management and reviewed the the business of delivering services. When bud- steps in the expenditure management cycle. get processes are plagued by challenges such as The  previous two sections discussed reviewing those listed above, it is difficult for local author- and developing policies and plans for recurrent ities to prioritize spending strategically because and capital expenditures. The next element in the they may be unable to learn what the spending is expenditure management process concerns actually accomplishing. the procedures to control actual expenditures One very effective means to control expendi- to ensure that services are being provided in a tures is to ensure that the budget and other critical cost-effective manner. documents are readily available for all to see. It As stated earlier, an effective expenditure man- has been well documented that such increased agement system must include three elements: transparency can increase the efficiency of gov- ernments, and it also makes the misuse of public • Plan for future expenditures, with clear and funds less likely. With the increased use of the measurable milestones to monitor actual Internet, local governments are able to provide performance. their stakeholders and potential investors with • Control expenditures so that actual spending easy access to relevant information about their is consistent with the budget and plan. finances, the services they are providing, and 232 Municipal Finances much more. Two examples of local governments’ close relatives of the top personnel, and paying making effective use of the Internet to make their generous compensation frequently signal weak operations more open and transparent are the expenditure management. They make citizens websites of the city of Johannesburg, South Africa unhappy and reluctant to pay taxes that appear (http://www.joburg.org.za), and Fairfax County, to be mainly used for the benefit of the local Virginia, U.S. (http://www.fairfaxcounty.gov). administration. Getting away from these kinds of practices requires clear policy and strong political Budgetary Control Is Essential support for expenditure control procedures. After a budget has been approved, it is normal to Budget adjustments are inevitable during issue a warrant (or similar document) to those the year for a number of reasons. An absolute authorized to incur expenditures, specifying the increase in a department’s budget (supplemen- items of expenditure under their control and the tary estimate) would normally require approval approved provision for each. To provide effective by the authority’s chief financial officer, and control, it must be clear who is responsible for often by the council, since it affects the overall authorizing each expenditure item (accounting budget. Reallocations within a department’s officer). The same applies to each revenue item, budget (virements, or the transfer of items from in that one person needs to be responsible for its one financial account to another) are normally collection (also discussed in chapter 3). within the power of that particular department to The degree of delegation of authority to incur authorize. expenditures varies among local government Control of expenditures requires active man- systems and individual authorities. No one sys- agement of each item and regular, up-to-date tem is necessarily better or worse than another, information. That means that transactions must but adequate systems depend on the size of the be entered promptly in the authority’s accounting authority and the ability and capacity of the system (chapter 3 discusses accounting, as well as staff. Generally speaking, it is better to delegate the importance of good record-keeping systems). authority to incur expenditures to the operating Progress on each item must be monitored con- departments to which the budgets have been pro- tinuously, and variations from budgeted amounts vided. Centralized control can lead to operating identified and understood. Depending on the rea- departments’ feeling without power and thus sons for the variation, appropriate action must be perhaps not as responsible. Regardless of which taken either to correct the problem or, if the cur- unit has authorization to incur expenditures, a rent situation is different from what was expected system of monitoring and oversight is essential. during budget preparation, to adjust the overall Areas where monitoring and oversight are crit- and departmental budgets. ical include the hiring of staff and the level of wages paid them (although that is often compro- Controlling Payments Is Essential mised by the highest council or mayor level) and Payment systems should incorporate internal con- contracting with private firms for services that trol procedures, such as requiring multiple sig- should have been done in-house. natures for payment authorizations and  checks, Weak control over administrative costs is typi- preparation of all checks from the accounting cal in local governments, particularly in develop- system, and so on. However, care must be taken to ing countries. It is a critical shortcoming because not include so many checks and balances that pay- administrative expenditures, particularly wages, ments are unnecessarily delayed. In some govern- salaries, and benefits, are among the costliest line ments, authorization procedures can  require as items. But also, reckless hiring of staff, hiring of many as 25 steps before a payment can be released. Managing Local Expenditures 233 While the logic behind such complex and time- section summarizes the critical areas to manage, consuming procedures is to strengthen internal the basic principles, and common practices. The control, in reality the reverse is normally the case. guide Managing Municipal Services summarizes Payment systems must be related to budgets basic principles and practices (USAID 2006). to ensure that no payment is processed unless a As this publication makes clear, cost analysis is prior commitment was approved and tied to a spe- the first step, and among the most important, in cific budget line item. Before payments are made, tariff setting or approving tariff changes (see also they should be reviewed to ensure that no errors box 5.6). were made and that all necessary approvals and These issues are particularly important in supporting documentation have been received. developing countries, where most tariffs for Payments for goods need to be compared to services are below the level required to recover contractual prices and conditions, and payments their cost and thus induce budget expenditures. for salaries and wages should be verified by the Another argument to mention is that politicians, physical presence of the labor force. Cases have especially before elections, are often enthusiastic been known of municipalities having deceased and very generous in “protecting the customers” staff still on their payroll. The picture in figure 5.5 by fighting against tariff increases, while also is a nice example of a manual cashbook with fin- promising to expand basic urban services. These gerprints of illiterate people who received cash unfunded promises often create headaches for support in Pakistan. financial departments because it is a hard fact that the budget—and eventually the same citizens— will cover the subsidies. Furthermore, uncon- Managing Tariffs and Subsidies trolled subsidies raise fairness issues because Expenditure management officers and units they support all customers, including those who are crucial in managing tariffs, or fee schedules, could afford to pay full costs. In some cases they which require particular attention to controlling are regressive, conferring greater benefit on the and/or reducing associated formal or hidden rich because they consume more of the subsi- subsidies. These tasks are important both in dized services (e.g., water, gas, electricity). Finally, planning and in implementing the budget. This subsidies create particular difficulties when the local government gives them to private providers under service contracts. Subsidies can be a rather Figure 5.5 Manual Cashbook substantial share of the budget. Box 5.7 shows the case of a Croatian city that spends more than 12 percent of its annual budget on subsidies to the operations of local public utility companies. Expenditure Control in Tariff Setting Tariff setting may seem to be the domain of the revenue managers. The fact is that revenue and expenditure managers should work on it hand in hand. Expenditure control is a real challenge because tariffs are generally sluggish and often determined by tradition, constrained by cus- tomers’ willingness and ability to pay or by tariff Source: Photo Mihaly Kopanyi. agreements. A tariff based on cost-plus pricing is 234 Municipal Finances Box 5.7 Supporting Public Utility Companies in a Croatian City Euro % Public transport 4,640.0 4.1 Waste management 2,077.8 1.8 Maintenance of roads and public spaces 1,087.4 1.6 Producing and distributing heating energy 501.2 0.4 Water supply and wastewater treatment 2,904.0 2.6 Others 2,506.8 1.6 Total 13,717.2 12.1 not advisable without good understanding of the The finance department plays a critical role costs, nor is it politically feasible. in tariff analysis, negotiation, and approval; the There might seem to be a big difference department should scrutinize tariff proposals and between setting tariffs for and subsidizing ser- the underlying expenditures, efficiencies, and vices being directly provided by local government– subsidies. A very simplified form of a tariff, mea- owned entities, on the one hand, and working sured in unit costs, is the following: with private providers, on the other. From the Tariff = capital expenditures + operation expenditure control perspective, however, the real expenditures + allowed revenue, difference is that private provision requires mak- ing the tariffs, costs, and subsidies more explicit. or in a more popular form: A municipal department can get financial sup- Tariff = CAPEX + OPEX + allowed revenue. port by simply changing its budget appropriation or can hide a subsidy in various ways. However, What constitutes capital expenditures when a municipality works with a private com- (CAPEX) is a difficult question. In general, it is pany, the private partner wants to ensure that all the cost of amortization of service-related assets terms and conditions are in the contract, includ- and debt service. However, the finance depart- ing the agreed tariff, rules for changing tariffs, sub- ment should carefully assess what relevant sidies from the municipality, if any, and so forth. assets should be included in the capital base. In short, most tariff-setting and subsidy issues are Should obsolete assets be included? Is it better very much the same, regardless of who owns the to compare the city’s utility to a well-organized service entity, since eventually the customers and entity (benchmark company) or to the national the municipality will pay the costs. Tariff setting average? The utility might own excess capital in public-private partnerships is discussed in the in the form of vacant land, unused or aban- Public-Private Infrastructure Advisory Facility doned assets, or a luxury leisure compound in (PPIAF) guidelines (Shugart and Alexander the mountains. Are all of these included in the 2009). Regulated tariff setting in PPP arrange- asset base for tariff setting, or only the assets ments has been very successful in the Chilean directly related to the specific service? The water sector (Chavez 2002). cost of certain capital expenditures should be Managing Local Expenditures 235 recovered separately and not included in the Current practices in transition and developing overall tariff rate, for example, connections countries tend not to meet these criteria. One of for water supply and sewage services. Because the reasons why municipalities fail to meet these these costs directly benefit a specific user or principles is pressure from the elected officials facility, the cost of that connection should be to provide services to their constituents at rates recovered directly from the beneficiary in the that are below cost. One of the direct impacts of form of a fee and not included in the overall such political pressure is that municipalities have tariff rate, which applies to all the users of the insufficient revenues to properly operate and entire system. maintain their systems, resulting in poor levels of Similarly, in the case of operations expendi- service and premature deterioration of the assets. tures, excess labor, inefficient operation (such Interesting examples include the water sectors in as huge water losses), oversized marketing, India (TERI 2010) and Chile (Chavez 2002) and training expenditures, or donations for sports district heating in Russia (Adrianov et al. 2003). or charities should not be part of the calculation As shown in table 5.6, many water companies in of the fair and true operation expenses of the India are heavily subsidized, including two of the service-providing entity. The operation of large three in New Delhi. The companies cover some utilities might be so complex that answering operation and maintenance costs themselves, those questions requires an analysis in depth of but rather than collect tariffs from customers, CAPEX and OPEX, and that might justify hiring they receive subsidized payments from the local an external specialist to support informed deci- governments—disconnecting service provision sions about tariff levels. costs from revenues. The basic tariff-setting principles are well The typical challenges in developing countries recognized and obeyed in developed countries include the following (see also box 5.8): but are often overlooked, compromised, or • Initial investments or network expansions are unknown in developing countries. Good tariffs often financed by central government grants should pass three tests. They should and not accounted for in tariffs; historical tariff • Ensure cost recovery, financial feasibility, levels often fail to cover the costs of operation and a good price signal for providers; and fair maintenance. As a result, services are often intermittent, with low quality and low • Ensure affordability and a good price signal coverage. The providers have no incentives for for customers; and either cost savings or service improvement. • Avoid cross-subsidies, or preferably, any sub- The situation often is unsatisfactory to both sidies at all. providers and users. Table 5.6 Managing and Financing the Water Supply in New Delhi Water supply functions of service companies Capital Operation and Geographic areas works maintenance Revenue function Municipal Corporation Delhi (MDC) Yes Yes Yes New Delhi Municipal Corporation (NDMC) Yes Bulk supply only Bulk payment from NDMC Delhi Cantonment Board Yes Bulk supply only Bulk payment from Cantonment Source: TERI 2010, 38. 236 Municipal Finances Box 5.8 Tariff-Setting Experiences in the Russian Federation • Utility enterprises do not understand • Municipalities lack formal tariff regulations. tariffs. • Tariffs are instruments of officers’ political • Tariff regulation accounts only for inflation objectives. or an increase in the cost of electricity and • Tariff approval is unrelated to the budget ignores other factors. process. • The tariff rule is operation cost, plus profit, without provision for investment needs. Source: Adrianov et al. 2003. • Price signals are distorted by low tariffs for all provided becomes much easier. Box 5.9 describes customers, which may create perverse incen- an application of street addressing in waste col- tives to overuse resources, ignore losses, and lection for the city of Conakry, Guinea. Through accept excessive tariffs to cope. For example, a World Bank–financed urban project, the city the poor may purchase water from tankers, designed a street addressing system to enable it to which costs 10 times more than piped water address poor collection of solid waste. would cost. Low tariffs and lack of cost controls may result in blanket subsidies of various kinds to • Cross-subsidies are frequent. Commercial and municipal enterprises, including agreed annual industrial customers often pay excessive tar- block grants, discretionary grants at the end of iffs (“because they can afford to pay”). A cross- the fiscal year (often justified as a need to pay subsidy also occurs between those who pay salaries), or payment of their unpaid utility bills. fees and charges and those who do not. For example, the Water Company of Lahore has The billing and collection systems are often paid about half of its electricity bills in recent defunct, in part because of a lack of reliable prop- years; the remainder was paid by the finance erty data. Developing a computerized land and department when the electricity company real estate cadastre offers a solution but is both complained. Blanket balance sheet subsidies are time-consuming and expensive. Cities in devel- among the worst in supporting services because oping countries that fail to obtain resources for they discourage enterprises from improving a cadastre project could benefit from alternative services and reducing costs. In addition, bal- instruments such as street addressing. They may ance sheet subsidies are often ad hoc and based establish a fiscal database by attaching a code on political connections rather than measured to each property for tax and fee collection pur- needs; they work like entitlements when neither poses. The code does not provide full legal ref- the company nor its customers account them as erence to the property but is used for revenue subsidies. collection purposes (discussed in more detail in chapter 4). Managing Subsidies Once the provider has a robust set of house and Sustainable services require stable cost recov- business addresses, preparing bills for services ery, which in turn often results in tariffs’ being Managing Local Expenditures 237 Box 5.9 Street Addressing to Support Household Waste Management in Conakry, Guinea Household waste management in Conakry in World Bank, had just completed its first street the late 1990s was initially the sole responsi- addressing project and published a street map, bility of municipal authorities. Unsanitary which at the time was one of the few such conditions in that city led to efforts to clarify documents that were up-to-date. The street and assign the tasks of solid waste collection, map, data dase, and street index developed as transfer, and treatment. The responsibility for part of the street addressing program served waste collection was turned over to small as a guide to delineate collection zones for the and medium-scale enterprises (SMEs), which various SMEs. The installation of street signs could bill the users directly. This system called simplified this process and made it easier to fix for a precise delineation of each entity’s cover- collection zone boundaries and routes and to age area and the establishment of waste set up transfer points. The street addressing transfer points. system thus played a highly positive role in The task of transferring waste to the exist- launching an operation that indisputably owed ing landfill was handled by the city’s Public its success to the concentrated efforts of sev- Solid Waste Transfer Department (SPTD). The eral authorities, operators, and donors focused Second Urban Project (UDP 2), financed by the on a radical transformation of the city’s image. Source: World Bank 2005, 26. unaffordable for some in the society. Although, as implications to advise the council in reaching a matter of principle, subsidies should be avoided informed decisions. The table also shows that or reduced to a minimum, fair and broad pro- well-targeted subsidies can produce substantial vision of services often requires some form of savings, along with fairer provision of services to subsidy, particularly in developing countries. A the poor. In Nyiregyhaza city, Hungary, the pri- simple cost recovery tariff would exclude poor vate providers together with the municipality citizens entirely or partially. However, it is equally established a support fund (RÉS, or gap founda- important to limit the use of subsidies and avoid tion) to subsidize the poorest of the poor, paying unnecessary use of public resources. The section two-thirds of a household’s bills if the household below discusses options for accommodating the paid one-third (Tausz 2004). poor, various forms of subsidies, and finally the allocation and targeting of subsidies. Forms of Subsidies and Implications From the expenditure management perspec- Targeting the Poor tive, it is important to distinguish the forms of Various means and instruments are available to subsidies—capital versus operation. It is impor- support access by the poor to a fair share of public tant for management to understand the differ- urban services, whether water, electricity, public ences between the two, what types of subsidies transport, social housing, district heating, educa- are being  provided, and who are the primary tion, or health. Table  5.7 summarizes them and beneficiaries. their implications. Expenditure managers need Operation subsidies support the costs of to be aware of these options and their specific operation and regular maintenance of the various 238 Municipal Finances Table 5.7 Options for Poor Customers Targeting option Description Application examples Service-level Provision of lower quality or • A public tap instead of house connection to targeting reduced scope of services water. (applicable for segregated zones; • Community containers for waste collection self-selection of this service is instead of door-to-door collection of waste bins. advisable if possible). • Building smaller housing units with simpler amenities. These services might still require a subsidy but much less than the full services. Income-based Household income or proxy • The target group pays a portion of the tariff, and subsidies indicators, such as salary or the municipality pays the rest to the provider electricity consumption, determine based on actual fee collection. subsidy. • Volume-based tariffs: a low tariff for basic volume and a high tariff above basic level. • Electricity consumption is the basis of “communal charges” for solid waste or a basket of basic services. • Elderly people pay half-fare for public transport. Other measures Property value as proxy of • Property value is the basis of a “communal tax” of poverty poverty—an official poverty list that covers a basket of basic services. (sensitive politically and socially). • Households on the poverty list pay a third of their bills. Geographic Households in a specific geographic • Slums or other areas defined as poor may pay targeting area pay lower tariffs, fees, charges. smaller tariffs for selected services. Sources: Prepared by authors using DANCED 2002; Chavez 2002; and Kopanyi, El Daher, and Wetzel 2004. services. Operation subsidies appear in various have a number of major implications: (a) the cost forms, including explicit and implicit; and of the donated capital is often not accounted demand-side and supply-side. It is important to fairly in the entity’s balance sheet; (b) capital sub- stress that the central and/or the local government sidies distort tariff setting because capital costs will eventually pay for the subsidies, whether the (i.e., amortization) are not built into the tariff; service entity is public or private. Table 5.8 sum- (c) the investments may not be sustainable, so marizes the various forms and means of providing that another grant or subsidy may be required for operation subsidies and sheds some light on their major refurbishment, replacement, or expansion possible impact. of an asset in time; (d) the donor of an asset may Capital subsidies are common throughout the not provide a subsidy for its operation and main- world but are more prevalent in developing coun- tenance, and the municipality may fail to budget tries. The central or the local government may the expense; and (e) old capital subsidies create provide a grant to cover a portion of a service difficulties in forming public-private partner- entity’s investment, or all of it. The central or local ships because their value is often unknown. government, or international donors, may pro- Finally, and most important, capital subsidies vide assets as in-kind donations. These practices are not targeted. Because they benefit all users, Managing Local Expenditures 239 Table 5.8 Forms and Means of Operation Subsidies Form of subsidy Means of subsidies Effects Supply-side subsidies Explicit Performance grant to provider. Guaranteed revenue amount paid based on fulfilled agreed minimum performance (e.g., volume of service). Target grant to provider to The municipality pays or subsidizes a portion of the tariff pass through to target groups. or fee. Implicit Annual block grant to provider. Entitlement; no incentive for improvements. Discretionary, ad hoc grant Filling the income gap, the subsidy bails out the entity, also called balance sheet often end of the year. subsidy. Forced subsidy, payment of The entity elicits the subsidy by failing to pay its bills. providers’ arrears to suppliers. Demand-side subsidies Explicit Cross-subsidy. Differentiated tariffs for various groups, such as commercial and industrial versus residential; could be adverse. Volume-based banded tariffs provide incentives to saving scarce resources (water, electricity); fair; good price signal. Tariff based on capacity (diameter of water connection pipe, electricity meter capacity). Subsidy forced by nonpayers. When fee collection is poor, those who pay in fact subsidize those who avoid payment. A tariff increase to cover the missing income would further charge those who are already paying. Credit to the poor. Creates incentives with respect to both demand and supply. Implicit Low tariff forced by the Subsidy to the demand-side, but not accounted for as a subsidy council. subsidy; distorts price signals to customers. Undermines financial sustainability and induces supply-side subsidy or deterioration of assets and services. they waste public resources as those who can costs, gradually reducing operation subsidies, afford to pay the full costs enjoy the subsidies. which require clear measurement, effective allo- Thus, the finance department should calculate cation, and targeting (box 5.10 illustrates water and communicate to stakeholders (such as subsidies in India). the council) the true costs of services, including Subsidy Allocation and Targeting capital expenditures, and may aim for the gradual The overar