Financing local government

State and local governments play an important shares of total government revenuenot including role in providing public services. Decentralizing intergovernmental grants-also vary widely, rang- both spending and revenue authority can improve ing from 2.2 percent for Tunisia to 72.1 percent for the allocation of resources in the public sector by Yugoslavia. linking the costs and benefits of local public ser- The figures show that subnational governments vices more closely. To the extent possible, subna- tend to be more important as providers of public tional government should charge for services, but, services than as collectors of revenues. Chinanot where such charges are not feasible or desirable, in the sampleis an exception and relies heavily spending must be financed from local general reve- on subnational governments to collect revenue nue, loans, or grants from higher levels of govern- (see Box 7.1). In every sample country the revenue ment. This chapter examines subnational govern- raised by subnational government from its own ment finance and focuses on reforming local sources falls short of its spending. These shortfalls revenue systems to allocate resources efficiently. range from 0.1 percent of GDP in Costa Rica, The Gambia, and Sri Lanka to 4.2 percent of GDP in Patterns of subnational government finance India and are more than 2 percent of GDP in six sample countries. In several countries the com- The role of subnational government varies from bined state and local fiscal imbalance was more country to countryfor political and historical rea- than the total government deficit, which means sons as much as for economic ones. The relative that central governments operated in surplus be- importance of the subnational level of government fore intergovernmental grants were disbursed. is indicated by its share of total government spend- In most countries own-source revenues at the ing. For a sample of eighteen developing countries subnational level fail to cover even current spend- for which comparable data are available, this share ing (see Figure 7.2). When grants are included, ranges from 2.5 percent in The Gambia to 74.9 per- however, subnational government achieves fiscal cent in Yugoslavia (see Figure 7.1). To capture balance or surplus in most sample countries. Ac- longer run patterns, all figures reported in this sec- cordingly, net borrowing, which is equal to the dif- tion are averages of data available for 1974 through ference between total spending and total revenue, 1986. The sample is diverse. India and Yugoslavia is a relatively minor source of funds for subna- conduct more than half of government spending at tional governments. the subnational level, while for seven other coun- Fiscal imbalances do not necessarily indicate in- tries this share is less than one-tenth. India, Yugo- appropriate fiscal policies at the subnational level. slavia, and, to some extent, Brazil have high sub- A grant may really be a shared tax, as in Brazil, or a national spending because they are large countries compensatory grant for the central government's with strong state governments. The subnational repeal of a local tax, as in Bangladesh, or a transfer

154 Figure 7.1 Size of subnational and local governments, averages for 1974 to 1986

U Subnational government spending Local government spending U Subnational government revenue Local government revenue

Percentage of total government spending and revenues 80

60

40

20

0 !

5

Europe, Middle East, Latin America Africa Asia and North Africa

Notes: Only state data are available for Argentina and India. The subnational government data reported here for Indonesia are not separated into state and local data. Sources: IMF, Government Finance Statistics, and World Bank data.

to finance some centrally mandated expenditure tion in the upper right-hand corner indicates a such as teachers' salaries, as in Kenya. Nonethe- highly decentralized government sector. Not only less, the allocation of spending and revenue re- do the state and local governments account for a sponsibilities, and the resultant transfers between large share of total government spending, but they levels of government, may induce an inefficient are largely self-financing. The Gambia is autono- use of resources that contributes to total govern- mous in the financing of subnational government, ment deficits. yet the size of its subnational government is only a Expenditure and financing measures can be com- small fraction of the government sector. Colombia, bined to indicate the degree of fiscal decentraliza- Indonesia, and the Republic of Korea display the tion. The share of state and local governments in opposite pattern: the subnational government has total government spending reveals their impor- a large role in the provision of services, but its tance as providers of public services. The extent to financing comes largely from central government which they are self-financing indicates their fiscal grants and revenue sharing. autonomy, because outside financing may come Expenditure and financing measures, however, with conditions that limit local discretion in the use provide only a partial indication of decentraliza- of funds. Figure 7.3 looks at both aspects for the tion. Central governments that want to exert con- sample of eighteen countries. Yugoslavia's posi- trol over local finance usually have many instru-

155 Box 7.1Local government finance in China The financing of China's local governments presents and "shared-up" to the higher levels. China has no an interesting contrast to local government finance in regular grant program to support capital projects or most market economies. China has three distinct levels current expenditures (all grants are on an ad hoc basis), of government: central, provincial, and local. They there is no mechanism or formal program for lending share a common set of taxes, with policy decisions left to local governments, and there are no guidelines for to the central government and tax assessment and col- local governments to develop beneficiary financing lection to the local government. All tax rates and bases schemes. are set centrally, and there are no truly local taxes at A combination of a backlog in infrastructure needs either the municipal or provincial level. China's reve- and increased urbanization has put great pressure on nue sharing is primarily a division of sales and profit local budgets. The overall elasticity of taxes on profits taxes among the central, provincial, and local govern- and sales may be relatively low, that is, revenues rise ments. Taxes are collected by the local governments less than proportionately with increases in profits and

Figure 7.2 Spending and revenue of subnational governments, averages for 1974 to 1986

El Total spending Current spending' El Total revenue Own-source revenue (including grants, excluding borrowing)

Percentage of subnational government spending 140

120

C

C

Europe, Middle East, Latin America Africa Asia and North Africa

a. Data for current spending are not available for Sri Lanka. Notes:/Sources: See Figure 7.1.

156 Figure 7.3 Fiscal decentralization to the subnational level, averages for 1974 to 1986 sales. This is a structural problem, possibly exacerbated by weaknesses in the tax administration system. The Subnational government spending high tax rates may induce tax avoidance by enterprises (percentage of total government spending) and perhaps even by the local governments that own 80 them. The lack of borrowing and self-financing mecha- Yugoslavia . nisms creates a bias against infrastructure investments because the full cost is shifted onto the general public. Options presently under discussion include reform of 60 the company tax, introduction of autonomous local taxes, and, in particular, the institution of a local gov- India ernment property tax.

40 Brazil Republic of Korea Argentina . Colombia Indonesia Romania The Gambia ments, such as approval of budgets, spending 20 S Mexico. requirements, restrictions on the use of tax bases, S Philippines. Costa Rica Thailand limits on tax rates, and other fiscal constraints. Malawi Chile\ Kenya Many developing countries are actively exploring Tunisia SriLankal S ways to increase local fiscal autonomy to improve 0 public sector efficiency and reduce total govern- 30 50 70 90 ment deficits. Own-source revenue (percentage of gross revenue) Fiscal decentralization and the role of subnational government Notes:/Sources: See Figure 7.1.

State and local governments usually provide a range of public services that contribute substan- tially to raising living standards and growth. These tive capacity to collect revenue and prepare bud- include basic health and education; street lighting gets and investment plans. In Tunisia, because and cleaning; water, sewerage, and power; public municipal staff lacked expertise in project design markets and refuse collection; major transport net- and implementation, municipalities used only a works; and land development for business and portion of the capital resources available to them. residential purposes.Subnational government Second, improving local government's administra- must decide how much to spend for these public tive capacity can unnecessarily duplicate the num- services and how to finance them. Ideally each ber and skills of staff at the central and local levels. subnational government provides both the level Decentralization should not inefficiently expand and mix of public services and the means of financ- public employment. Third, the fact that public ing these services that most closely meet the pref- services provided by one jurisdiction produce ben- erences of individuals in its jurisdiction. In this efits or costs for other jurisdictions calls for in- way decentralization promotes efficiency by allow- volvement by higher levels of government. How- ing a close match between public services and the ever, these problems can be addressed through multiplicity of individual preferences, and it pro- appropriate grant policies and other mechanisms motes accountability and equity by clearly linking for strengthening local administration, as dis- the benefits of services with their costs. This is the cussed below. rationale for establishing state and local govern- Assigning responsibility for services among lev- ments that are responsive to the wishes of their els of government should be as clear and simple as citizens and not simply the instruments of central possible for decentralization to work. Vagueness in government. the division of responsibility can undermine local Decentralization faces certain practical problems. accountability. In Brazil, because of an unclear di- First, local governments often lack the administra- vision of functions between state and municipal

157 government, mayors can garner support for fa- tergovernmental fiscal relations in Colombia was vored municipal projects from state governors in- the basis for comprehensive local fiscal reform and stead of pushing for increased local taxes. This di- showed that such reform is feasible (see Box 7.2). minishes the incentive for generating local The rest of this chapter focuses on reforming local revenue. revenue instruments and overcoming problems in A common feature of government in developing local administration. countries is joint responsibility at different levels for providing the same service in a particular juris- Strengthening local government finance diction. In Turkey, for example, something as ap- parently local in nature as street lighting involves Strengthening local government finance can im- all levels of government. The central government prove the efficiency of the public sector and reduce shares responsibility for funding; a national the need for transfers from central to local govern- agency is mainly responsible for planning, execu- ment, particularly in urban areas. Certain revenue tion, and operation and maintenance; and local sources, such as user charges and property taxes, governments have the main responsibility for are more easily administered by local government. funding and secondary responsibility for plan- Strengthening these revenue sources is important ning. In some caseseducation and health, for for stabilization and structural adjustment in de- examplethe structure of service delivery is un- veloping countries such as Indonesia and Paki- avoidably complex. But for services that are clearly stan, where inadequate reliance on subnational local, such as water and street lighting, it can gen- government finance has caused a heavy financial erally be simple. drain on the central government. Many countries would benefit from periodic re- The principles discussed in previous chapters views of the assignment of functions and finances suggest four criteria for efficiency in raising local to different levels of government. A review of in- revenue:

Box 7.2Fiscal decentralization in Colombia

Concerns about the assignment of fiscal responsibilities cent, compared with the previous fixed rate of 0.4 per- among central, departmental, and municipal govern- cent. This change was important because it introduced ments in Colombia led to the appointment of the Mis- an element of local discretion in rate-setting for the first sion of Intergovernmental Finance in 1980. The mission time. concluded that local resources should be relied on The base and rates of the industry and commerce tax more for local purposes. Subsequent legislation to were also reformed. Before 1983 this taxalthough im- strengthen local government institutions and to de- portant as a revenue source, particularly in the larger centralize both functions and finances marked a his- municipalitieswas levied on a wide variety of bases, toric point in Colombia's fiscal and institutional generally with large variations in rates depending on development. the type and size of the business. The reforms estab- The finances of subnational governments were lished a uniform tax base (based on gross sales) and strengthened by expanding their traditional revenue reduced the variation in rates. sources. The most important changes were those relat- The flow of national transfer payments to the small ing to the property tax, in particular those relating to municipalities has substantially increased. The share of the tax base. First, all cadastral values were updated to the sales tax allocated to the subnational level is to rise a 1983 base by applying an annual increase of 10 per- from 30 percent in 1986 to 50 percent by 1992. More- cent for each year (up to a maximum of fifteen years) over, for the first time in Colombia, the distribution since the last official valuation. Thereafter, in years formula was changed to give a bigger share to small when properties were not revalued, their cadastral val- municipalities that tried to raise their own resources. A ues were to be adjusted automatically each year by a new law provided that the additional funds for munici- price index. Although political considerations have palities above the 1986 share are to be spent solely on kept the rate of adjustment consistently below the rate investment, including maintenance and debt service. of inflation, the adjustment has nonetheless slowed the Finally, the national government was given one year to erosion of this important source of local revenues. transfer functions to the municipal level so as to match Property tax rates were also changed. The basic mu- the transfer of additional revenues by 1992. nicipal rate can now be set between 0.4 and 1.2 per-

158 Table 7.1 Comparison of local public spending and revenue shares by major categories in selected cities (percentage of total spending)

Republic Spending and Brazil, Colombia Kenya of Korea, Ind Pakistan associated São Paulo,Bogotd, Cali, Cartagena, Nairobi, Mombasa,Seoul,Ahmedabad, Bombay, Calcutta, Gujranwala, Karachi, revenue category 1984 19721974 1972 1981 1981 1983 1981 1981-82 1982 1983 1982 Spending on general urban servicesa 30.2 17.322.6 37.2 10.3 7.9 34.0 23.2 12.4 42.2 33.1 16.8 Local tax revenue 68.7 14.016.9 27.1 34.1 75.6 44.2 61.4 47.0 61.3 98.4 85.9 Spending and debt service for public utiitie&' 36.3 69.174.5 61.2 53.0 28.0 29.1 48.9 69.8 46.4 55.4 52.3 User charges and borrowing 30.8 72.080.4 60.1 52.1 -7.8 33.8 30.1 52.2-16.2 -8.7 11.1 Spending on social services' 33.6 13.7 2.9 1.6 36.8 64.0 36.9 27.8 17.8 11.4 11.5 30.8 Grants received 0.4 14.0 2.8 12.8 13.7 32.2 22.0 8.6 0.7 54.9 10.3 3.0 Note: For each city, spending shares (including debt service) add to 100 percent, except for rounding errors; likewise all revenue shares (including borrowing) add to 100 percent. Includes refuse collection, parks and recreation, industries, fire protection, law enforcement, general administration, employee pensions and health care, grants and transfers, and other miscellaneous services. Local taxes include other miscellaneous revenues. Includes water supply, sewerage and drainage, electricity, telephones, housing, markets and abattoirs, highways and roads, and public transport. User charges include revenues from development charges, housing schemes, and so forth. Includes education, health, and social welfare. Source: Bahl and Linn, forthcoming.

The cost of providing local services should be should be financed by local taxes, public utilities recovered, to the extent possible, from charges on should be self-financing, and social services should the beneficiaries. Such charges should be related to be supported by grants. individual consumption or, where this is not possi- In Bogota and Cali spending and revenue have ble, to a measure of individual benefit received. closely matched the efficiency criteria. In Carta- Services whose costs cannot be recovered gena grants from other levels of government have from charges can be financed from general taxes- tended to support the nonsocial services. All the property taxes, business taxes, and sales taxes- other sample cities collected a surplus of local taxes levied within the relevant jurisdictions. to help finance public utilities and social services. If the benefits of local services spill over into Calcutta has received a large share of grants, ap- other jurisdictions or produce nationwide benefits, parently mostly to support public utilities. then grants from higher level governments should Increasing local revenues-especially through finance such services in proportion to their outside user charges-is often desirable, but it is difficult benefits. when local governments do not have revenue au- Borrowing is an appropriate way to finance at thority commensurate with their spending respon- least some local capital investment, provided mac- sibilities. Central government usually lets local roeconomic fiscal balance is maintained. government use only a few revenue sources, and even these are subject to limits. In Thailand, for As these criteria indicate, the appropriate use of example, the proportion of local expenditure fi- local revenue instruments depends on the spend- nanced from local sources declined between 1977 ing responsibilities assigned to local government. and 1982 because of central restrictions on the rate Equity can dictate modifications of these criteria, at which local taxes and charges could be levied. such as avoiding the imposition of user charges on Local authorities could, and should, be encour- low-income households. aged to raise more revenue locally. This might be In the absence of detailed nationwide informa- done through user charges, local taxes, borrowing, tion, public finance data for a sample of cities pro- and grants. vide some insight into the composition of spend- ing by sector, and of revenue by source, for User charges particular local jurisdictions (see Table 7.1). These data make it possible to relate broad categories of User charges can be of two types: consumption spending with revenue sources. The four effi- related and benefit related. They account for about ciency criteria suggest that general urban services one-third of all locally raised revenue in a sample

159 /

Box 7.3Benefit financing: land readjustment in the Republic of Korea and the valorization system in Colombia

In Korea urban land readjustment schemes involve the duce municipal tax burdens. consolidation of numerous small parcels of raw land at The valorization system has been used most exten- the urban periphery. Nothing is paid to the owners. sively in Colombia, and its application in the capital This land is serviced and subdivided for urban use and city, Bogota, has been carefully studied. At the height then returned to the original owners in proportion to of its use in 1968 it contributed 16 percent to the financ- the value of their land contribution. Some of the land is ing of all local public expenditures, including spending retained by the public authority, in part to meet the by local state-owned enterprises. Subsequently its rela- needs of urban infrastructure (especially roads and tive importance has decreased, but it has retained a green spaces) and in part to provide a source of finance role in the financing of urban infrastructure in Bogota. to defray the cost of development. The land retained One of the practical problems encountered in the ap- for this latter purpose is sold at market prices in com- plication of the system has been its dependence on mercial transactions or auctions. large financial transfers from the city's general reve- The scale of Korea's land readjustment program has nue. In practice, valorization charges have not fully been impressive. By 1985 some 43 percent of Seoul's recovered the costs of all projects. An important reason total built-up area was covered by completed or ongo- for this is that some projects have been designed to ing schemes. The system has opened up new land for improve living conditions in low-income areas, and the urban uses and thus has helped to increase the supply beneficiaries have not been expected to pay valoriza- of housing and raise public funds. While it appears to tion charges. If a valorization program is to be main- have conveyed its direct benefits mainly to middle- and tained while pursuing subsidization of low-income high-income landowners, some trickle-down effect neighborhoods, the resulting need for transfers from may have occured. The large scale of the program local general revenues should be recognized, explicitly probably reduced general urban land prices and rents calculated, and met. below the levels that would have occurred in its ab- Arrears in the collection of charges have been an- sence. other reason why valorization charges have failed to Land readjustment programs require fairly sophisti- recover costs. For projects undertaken from 1968 to cated methods of public land management, including 1986, arrears amounted to 16 percent of project costs. effective land registration and cadastral records and The collection problem has arisen mainly from lack of land redistribution formulas. Nevertheless the admin- payment by public agencies and by a few large proper- istrative feasibility of the schemes has been amply ties. The introduction of interest charges on late pay- demonstrated in Korea. ments after 1981 reduced the recovery period for In contrast to land readjustment programs, which project costs. have been used mainly to develop new areas at the Finally, Bogota has demonstrated that the valoriza- fringe of cities and towns, the valorization system often tion system depends heavily on the quality of invest- applied in Latin American countries has principally ment planning and project preparation. In years in been used to finance improvements in infrastructure in which infrastructure planning was weak, the system built-up areas. Street improvements, water supply, receded in importance even though requirements kept and other services have been financed by this system of growing. Projects for which benefits were uncertain or taxation, in which the cost of public works is allocated not clearly concentrated among the properties bearing to affected properties in proportion to the benefits con- the valorization charge often created the greatest col- ferred. Valorization charges are designed to recover lection problems. The participation of beneficiaries in project costs, not to recapture all the benefits the planning and managing the project made the resulting project is expected to confer. The system is intended to charges more acceptable to them. make urban services largely self-financing and thus re- I

of twenty-five cities in developing countries. User frastructure are borne by its beneficiaries. Of charges are especially important at the local level course, when the imposition of such charges is ex- because, being closer to beneficiaries, local public pressly not desired for equity reasons, as in subsi- services are more amenable to such charges than dized improvement of poor neighborhoods, gen- services provided by higher levels of government. eral taxes or grants can provide the necessary User charges reduce the pressure to raise revenue finance. from general local taxes; this can improve effi- A major benefit-related charge is the develop- ciency because the costs of public services and in- ment charge or "betterment tax": a lump sum

160 charge designed to recover the cost of infrastruc- can be either property taxes or other local taxes, ture development from beneficiaries. A develop- such as those on industry, commerce, and the ment charge may cover only a limited projectfor professions. example, a neighborhood paving scheme or the construction of a sewage canalor it may cover the PROPERTY TAX. The property tax has several ad- full development of a new area. It is usually im- vantages as a local revenue source. First, all munic- posed on the owners of property in the areas that ipalities have some taxable real estate within their are improved by public action, and it represents a boundaries. Unlike taxes on business and trade, tax on the increase in land values that results from whose bases are concentrated in major cities, the new local infrastructure. It can be an equitable tax property tax can produce revenue in small outly- because those who benefit from development pay ing local governments as well as in large cities. for its cost. Two particularly successful systems of Second, within small towns the property tax base development chargesland readjustment in East is broad; thus the burden of such a tax can be Asia and the valorization system in Latin distributed across a large segment of the popula- Americaindicate their potential (see Box 7.3). tion, and significant revenue can be raised at low The main difficulty with development charges tax rates. Third, because property values are en- lies in administration and collection. Jakarta's bet- hanced by the provision of local government serv- terment tax suffered from late notification of the ices, property taxation based on accurate property tax department that an area would be improved valuation can recover the cost of services directly and, hence, late notification of landowners; diffi- from the beneficiaries. Relatively little of the tax on culties in tracing landowners because of unregis- residential property will be shifted from property tered land transactions; and a lack of data on land owners to others, whereas the tax on commercial values. A properly functioning property tax (dis- property can be shifted to consumers. Finally, the cussed below) makes administering development burden of the property tax on the poor can be re- charges far more straightforward. duced or eliminated by reducing or exempting User charges are especially well suited to local taxes on properties below a certain value. government finance, but they have often been un- Despite these theoretical advantages, data for ur- derutilized. Colombian cities, such as Bogota, Call, ban local governments in selected developing and Cartagena, were an exception because of their countries indicate that property taxes account for relatively limited dependence on local taxes and only 5 to 25 percent of recurrent receipts of local grants and much heavier reliance on user charges. government, except in Africa, where reliance on Two main factors account for this. First, in the property taxation is generally higher. Moreover, larger Colombian cities local governments provide the performance of the property tax over time has the important public utility services (water, sewer- been mixed. Property tax revenues have declined age, electricity, and telephones), whose cost can be in real terms in more than half of the Asian and recovered through user charges. Second, local Latin American countries. The countries experi- governments in Colombia have placed a relatively encing the greatest revenue erosion were generally heavy emphasis on benefit charges to finance in- those with high rates of inflation, particularly in frastructure. Latin America. In most of Africa, however, prop- When not relying on user charges, local govern- erty tax revenues have grown in real terms. ments often require inefficient transfers from cen- An obvious way to increase property tax yields is tral government that strain central budgets. For to raise the tax rate. This is often a bad approach, example, in Pakistan increasing dependence on however. It exaggerates inequities by increasing federal grants to finance provincial services is at- the burden on taxpayers whose properties are on tributed, in part, to the provinces' low reliance on the tax rolls and who pay their taxes in full. A user charges. In Mexico municipalities have not better approach is to raise more revenue from de- had the incentive to recover the cost of invest- linquent taxpayers by collecting more efficiently. ments made with grants from states or the federal Examining payment records to identify major de- government. linquents, introducing a systematic method of chasing them (such as reminders and warnings), Local taxes and conspicuous enforcement of penalties can to- gether significantly increase collected arrears and As the efficiency criteria indicate, another way to produce longer term improvements in the system. raise revenue locally is through local taxes. These In Delhi,for example, better property tax

161 collectionincluding rebates for timely payments, tax system needs continual updating. General re- penalties for late payments, better facilities for valuation of properties, which can be very expen- making payments, and an improved management sive, can be done at five-year intervals if changes in information systemincreased revenue by 16 per- property characteristics are recorded promptly and cent in 1985-86 and 96 percent in 1986-87. Another price increases are captured by indexing the tax major reason for improved collections was that tax- base or increasing the rate. payers had to pay their assessment before being Experience with fundamental property tax re- able to appeal it in court. form in Brazil and the Phffippines demonstrates Improving collections works best when the tax the need to address all aspects of the problem (see rolls are reasonably complete and valuations are Box 7.4). Brazil, especially, shows that an efficient accurateat least in relative terms. Otherwise, in- property tax can be achieved only if intergovern- creases in the efficiency of collection may exagger- mental fiscal relations provide the right in- ate existing inequities. More basic reforms may centivesan important general rule for all countries. then be necessary. The maintenance of accurate property tax records, usually termed the fiscal ca- OTHER LOCAL TAXES. Taxes on industry, com- dastre, is a particularly important step in basic re- merce, and the professions are usually another im- form, because the tax base is constantly changing portant source of local revenue. These taxes may in developing countries because of rapid urban take several different forms, including a turnover growth and high inflation. An accurate cadastre (gross sales) tax, a tax on the value of gross busi- also aids in planning and providing local services, ness assets, or specific levies tailored to the type of especially infrastructure, and in administering and enterprise. Local taxes on industry, commerce, collecting development charges. and services have accounted for more than 80 per- Valuation is a critical step in basic property tax cent of local revenue in San Salvador and more reform. One approach is to use the annual rental than one-half in La Paz. In the Philippines, busi- value, which in many developing countries is de- ness license taxes are the second largest source of termined by asking renter occupants how much locally raised revenue. The revenue from business they pay in rent and extrapolating from that to taxes can grow substantially, because with urban- owner-occupied property. The method is simple, ization the number and size of business establish- but open to inaccuracy and misrepresentation, es- ments increase and the taxable base grows. A flat pecially for owner-occupied structures. A second charge or exemption eliminates the need to assess approach is based on the capital value, which is small firms. calculated either by estimating the value of the Few local governments in developing countries land and the cost of replacing the structure or by levy broadbased sales taxes partly because central extrapolating from recent sales of comparable governments prohibit it and partly because sales property. (A fundamental policy decision must be taxes are difficult to administer. To avoid adminis- made on whether to tax only land or buildings and trative problems, a higher tier of government improvements as well.) In practice a pragmatic mix might assess and collect a sales tax and then remit of the two approaches will be needed depending part or all of it to the local authority. For example, on the availability of rental and sales data. Valua- the sales tax could be a local surtax on the central tions also require technical expertise and time. To government tax, with the central government act- economize on scarce skills, local governments can ing as collector. The local government could set the draw on a central valuation agency for information rate, determine special exemptions and other de- and technical assistance, as was done in Malaysia. tails, and pay the central government a collection Setting the property tax rate is the next key step charge. Local autonomy would be sacrificed only in basic reform. The rate should be high enough to in choosing the tax base and determining collec- make the property tax worth collecting, and local tion efficiency. One problem with this approach governments should be allowed some flexibility in and the reason it is rarely adoptedis that central setting it, as in Colombia's fiscal reform (see Box governments are generally unwilling to let the lo- 7.2). Flexible rates can ensure that property tax cal authorities share in so lucrative a revenue revenues are maintained between valuations: by source because it may limit the national govern- adjusting rates, local governments can keep prop- ment's ability to raise revenue from the base. An- erty taxes constant in real terms. When property is other is that such a tax might be less visible and revalued, the rate can be reset to where it was at thus make local governments less accountable to the previous valuation. their taxpayers. Once established, a well-functioning property Some local governments use personal income

162 Box 7.4Fundamental property tax reform in the Philippines and Brazil The Philippine Real Property Tax Administration percent on low-value residential property), and fixes (RPTA) Project was designed to address the problems the date on which new general revaluations become of a weak property tax system. The project's approach effective. Interim indexation of values is not permitted. was to change the system of valuation from one based As a result, effective tax rates before and after RPTA on owners' declarations to one based on a government were as low as 0.3 percent. Finally, the RPTA did not inventory. The project aimed to compile in each juris- improve collection. On average revenue collections in- diction a comprehensive inventory of all land parcels, creased by only 1 percent in the year after the project which would incorporate missing parcels, eliminate began. duplicate claims, and include an accurate measurement Brazil's property tax reform (known by the acronym of all land and building characteristics to be used in CIATA) was designed, like the RPTA, to address the valuation. technical defects of a system producing very little reve- The project was successful within its narrowly de- nue. The objectives of the CIATA were to revise the fined objectives. Average valuations increased by 50 fiscal cadastre, in order to incorporate missing parcels percent. This was largely due not to the discovery of and improve the accuracy of valuations, and to devise a missing parcels, but to the revaluation of existing par- better system for monitoring collection and financial cels, based on property characteristics gathered in the reporting. field. Contrary to the government's original diagnosis, The short-run effect of the CIATA on municipal reve- property owners were in the habit of declaring all par- nues was dramatic. Municipalities typically reported cels under their ownership. Owners did, however, un- increases of 100 to 200 percent in revenues in the year derstate the dimensions and quality of each parcel and following implementation. Most of this increase was the improvements they had made to it. due to improvements in the fiscal cadastre: missing The RPTA left several problems, however. First, the parcels were discovered, and values were recalculated calculation of individual valuations remained highly ar- using more accurate data on the physical characteristics bitrary. Although the RPTA yielded more accurate data of individual properties. on the characteristics of individual properties, the Intergovernmental relations in Brazil were an obsta- method used by valuers to convert that data into esti- cle to property tax reform. Unconditional transfers pro- mates of value was not improved. Second, property tax vide 80 percent of the recurrent revenues of local gov- liabilities remained low. The RPTA did not reform rate ernment. Because local governments could draw on setting and related policies. The central government in outside finances to deliver services, they had little in- the Philippines fixes the maximum tax rate on prop- centive to raise property taxes for their constituents. erty, mandates fixed assessment ratios (as low as 15

taxation as an alternative to business taxes. Local rising demand for investment in, and maintenance income taxes have the same characteristics and of, street infrastructure and traffic management. face the same problems as those at the national The case for recouping these costs with a tax is level, as described in Chapter 4: that is, they tend strong. Unfortunately not all urban governments to be narrow in coverage and often quite primitive in developing countries are authorized to tax auto- in administration. Thus most local "income taxes" mobiles. For instance, local authorities in Manila are really poll (head) taxes, wage taxes, or proce- have been told not to levy taxes or fees on motor dures for limited income tax sharing with higher vehicle registration. Furthermore, even where lo- authorities. As with sales taxation, a local surtax cal governments can impose taxes, they generally on the national personal income tax may be the have not made a significant effort to tap this reve- best way for local governments to raise revenue nue source to its full potential. Jakarta and Seoul from the base of individual income. are among the few exceptions. Jakarta proves that Taxing the ownership and use of urban motor automotive taxation, if turned over to local author- vehicles can be an important source of local ities and given sufficient attention, can make a revenueand a reasonably efficient and equitable large contribution to local revenue; it accounted for one. Automobile use is growing rapidly in devel- 37 percent of local current revenue in 1983-84. In oping countries and is concentrated in urban areas Seoul automobile tax revenue more than doubled and among the better off. The increase in use has between 1982 and 1986, while total local tax reve- been accompanied by greater traffic congestion nue increased 64 percent. and air and noise pollution, as well as by rapidly One of the most striking features of local govern- 163 ment taxation in developing countries is the prolif- sisting municipalities with the design and execu- eration of minor revenue sources, including selec- tion of their investment programs (as in Turkey tive excise taxes and a variety of license taxes, fees, and Venezuela), and by improving the operation stamp, and poii taxes. While any one of these adds and maintenance of local infrastructure (as in Jor- little revenue, they may jointly make a significant dan, which is discussed below). contribution. For example, local taxes and fees ac- MDFs are not new. In the past thirty years they count for more than 20 percent of total local reve- have spread rapidly through Africa, Asia, and nue in Indonesia. Often, however, their adminis- Latin America. Historically, few have developed a trative and compliance costs are considerable, and capacity for sustained assistance and funding for they are subject to wide discretion by tax collec- municipal government on the scale needed. They tors. Fewer such taxes would be appropriate in have tended to play a narrow and passive financ- most jurisdictions. ing role by providing little technical or financial appraisal to the investments they have funded and Borrowing offering little assistance to municipalities other than capital finance. Furthermore repayment disci- As mentioned earlier, borrowing is generally a mi- pline has sometimes been weak. MDFs in Hondu- nor source of local government revenue in devel- ras, Kenya, and Morocco, for example, have expe- oping countries. This reflects both the conservative rienced (and tolerated) substantial arrears, and the financial policies of central and local governments latter two made new advances to borrowers in de- and their limited sources of loan finance. In princi- fault. ple, however, there is no reason why local govern- Jordan's MDF has been notably successful. In ments should not borrow to finance at least a por- 1979 the government established an autonomous tion of capital project costs. Debt service payments Cities and Villages Development Bank to provide can be linked to user charges for local services gen- investment finance and assistance to municipal erated by the capital projects for which the debt and village councils, with the aim of extending ac- was incurred. In this manner greater reliance on cess to infrastructure and employment. The bank borrowing favors self-financing projects. This need played a role in financing the spread of urban not imply an increase in aggregate public sector physical and social infrastructure (for example, borrowing. Instead it would usually mean replac- paved roads, schools, clinics, piped water, and ing intergovernmental capital grants with internal electricity) to virtually all settlements, however loans from central to local government. Grant fi- small and remote. It has also been instrumental in nancing places the burden on central governments maintaining and improving the quality of infra- and general taxpayers, rather than on local deci- structure investment through its standards, ap- sionmakers and beneficiaries where it properly praisal, and monitoring. The bank has taken on an belongs. increasingly active role in financial and technical One way to provide local access to loans while advice and in training for municipal authorities. It ensuring some central control to preserve macroec- has introduced new criteria that will allow munici- onomic balance is to create a municipal develop- palities to forecast their debt service capacity more ment fund (MDF). Typically, MDFs have two accurately. broad objectives. The first is to raise additional re- Efforts are under way in many developing coun- sources for public investment. This usually begins tries to strengthen existing MDFs or to set up new with an initial injection of funds from a donor and ones. To succeed the local governments concerned a counterpart contribution, usually larger, from will need a buoyant revenue base to support debt central or state government. In addition domestic service. If MDFs are allowed to recover debt serv- financial markets may be tapped through bond ice from central government transfers to local gov- and debenture issues. But ultimately most of these ernments, they will be tempted to induce local au- programs aim to extract additional resources from thorities to borrow more than they can afford. municipalities themselves through better revenue administration and cost recovery. Intergovernmental grants The second objective is to improve the use of resources. This can be done by developing ap- Central government transfers to subnational gov- praisal criteria and enlarging local capacity for ernments through shared taxes and grants are a sound financial analysis of the projects financed by critical link in distributing expenditure responsibil- MDFs (as proposed in Brazil and Mexico), by as- ity and taxing authority between the two tiers.

164 Box 7.5Effects of intergovernmental grants: the experience of Nigeria in the late 1970s Nigeria embarked on a nationwide reform of its local Furthermore the criteria for distributing transfers government system in 1976. It was intended to reverse placed too great an emphasis on the equality of reve- the deterioration in the treatment of local governments nue across jurisdictions, rather than on the generation by the states after the country achieved independence. of local revenue. The transfers served as a disincentive Specifically, many states had cancelled their grants. to local revenue effort. Local taxes, such as the prop- Under the reform, grants from both the federal and erty tax, remained grossly underdeveloped, and some the state governments were to be substantially in- states decided to suspend or abolish important revenue creased. In the first year local governments received in sources. Various explanations were given to justify ab- grants from the federal government roughly five-and- olition, but they all rested on the supposition that fed- a-half times the amount they had received in the pre- eral transfers made collection of local taxes unneces- vious year. This increase followed from sharp increases sary. So the cumulative effect of Nigeria's dramatic in revenue from oil exports and the reformed grant increase in transfers to local government was to reduce allocation rules. The budgeted revenue of some local local governments' own contribution to local finance in governments increased 1,000 to 2,000 percent. As a relative and absolute terms. For example, the number result local governments greatly expanded their provi- of property tax payers in Ibadan City dropped from sion of social services and economic infrastructure. 27,000 persons in 1975 to 8,650 in 1979. Other cities Some serious problems arose, however. State adminis- experienced similar declines. trations sit between federal and local governments; all The administrative burdens on local government in- but one of them failed to pay its full allocation to the creased as a result of the 1976 reform. The distribution local governments. In many cases federal transfers of increased transfers through states brought local gov- were diverted to other uses without consultation. In ernments under stricter control. Local budgets had to addition virtually all the state governments approved be approved by the states, which often caused severe large salaries for state-appointed local government delays in program execution. In one case the budget officialsincreases, in some cases, of more than two- process had to go through eight stages of approval thirds. with state officials before final approval by the state's Federal grants to states depended in part on the chief executive. The substantial increase in transfers to number of localities under state jurisdiction and thus local governments in Nigeria in the late 1970sin the led to a widespread demand for more local government wake of the steep rise in oil revenuedid not enhance units. The number of local governments increased local governments' autonomy or ability to act. from 301 to 781 between 1979 and 1983, which led to a severe shortage of skilled managerial and technical staff.

Grants are needed because the benefits or costs of in the late 1970s, and this had severely detrimental public services provided by local governments can effects on local government finance and intergov- spill over to other jurisdictions. For example, a ernmental relations (see Box 7.5). Grants can en- highway constructed through one jurisdiction is courage recipients to be less efficient. For example, likely to benefit residents in neighboring jurisdic- grant systems in Indonesia and Sri Lanka have tions, or one jurisdiction's education services con- paid the salaries and allowances of virtually all lo- tribute to a productive labor force that can migrate cal government employees, including primary to other jurisdictions. Some local public services, school teachers. This cost reimbursement grant especially social services, may have national and guarantees a uniform pay scale for local govern- regional benefits as well. ment employees without regard for the financial Another objective of grants is to adjust for dis- health of any single locality; its lack of cost sharing parities in fiscal capacity among local jurisdictions can encourage local governments to employ ineffi- caused by variations in resources, tax bases, and ciently large numbers of people. population. Grants can equalize local fiscal capaci- The experience of several developing countries, ties, although obtaining adequate data to do this including Colombia, Ecuador, and Mexico, reveals by formula can be difficult. that increasing reliance of local governments on Excessive reliance on grants, or unexpected in- grants can decrease the fiscal autonomy of local creases in them, can result in poor use of public jurisdictions. Local governments come to view finances. Nigeria's grant system expanded greatly grants as substitutes for local taxes and user

165 charges. Many intergovernmental grants are sim- ficult to implement effectively, and are open to ply central government subventions of local activi- abuse or ad hoc political bargaining. ties. They have many undesirable qualities: they Local government administration are a drain on central revenue, they encourage in- efficiency and worsen regional and urban-rural Decentralizing spending responsibility and reve- disparities, and they reduce the accountability of nue authority can assist development, provided lo- local government while giving it no assured access cal administrative capacity is adequate to the tasks. to funds. An important reason for past shortcomings was A formula-based grant system addresses these the failure to deal with the difficulties of planning problems by simultaneously meeting central gov- and implementation. ernment objectives and providing local govern- Many of the reforms recommended for public ments with some degree of autonomy. Formula- spending in Chapter 5 apply at the local level also. based allocations require the granting government In particular, local governments should prepare to decide on the factors that are to be used in deter- both a medium-term fiscal plan and a comprehen- mining grant amounts. These may include, for ex- sive annual budget. These force local governments ample, indicators of need, such as population or to evaluate the needs of their jurisdictions and to miles of road, or indicators of local revenue capac- make strong arguments for spending programs, ity, such as local income or taxable economic activ- either current or capital, which then serve as the ity. The grants may be block grants, that is, foundation for strong fiscal efforts. They also help general-purpose, lump-sum transfers that provide central governments to coordinate municipal de- local governments with considerable autonomy, as velopment and provide a clearer picture of re- in the Philippines. Alternatively they may be cate- quired intergovernmental transfers. gorical, that is, restricted to particular uses, some- Effective local administration is hampered by times requiring approval by the central govern- lack of finance and accounting skills because ment. Categorical grants give the central gov- skilled personnel frequently would rather work for ernment more control over the allocation of funds the central government. One approach to local between sectors. staffing is to assign central civil servants temporar- Categorical grants can be designed to cover only ily to local authorities. Also technical agencies at part of the total spent locally in a sector, in which the center can provide direct services to local gov- case grant funds are said to "match" local funds. ernments. Malaysia's. central government lends as- The matching rate can be set to achieve an efficient sistance in public health, sanitation, and food in- level of local spending. If a matching grant is used spection, especially in rural areas, and has to support spending that has spillover benefits, the assigned accountants to state governments. Tech- matching rate should ideally equal the ratio of nical assistance to local governments may be pro- spilover benefit to total benefit, although the in- vided with either loan or grant finance. Municipal formation needed to compute matching rates pre- development funds can enlarge the local capacity cisely is very difficult to obtain. A single grant can- for financial analysis and implementation of in- not accomplish all objectives. For example, if the vestment programs. principal objective is to equalize fiscal capacity Training local officials is essential for better local across jurisdictions, the goals of stimulating local administration. Several Indonesian cities have pi- government tax effort and promoting local fiscal lot programs for local training to improve tax ad- autonomy are not likely to be well served. This ministration and financial management. In Nepal problem can be addressed by including different local officials have attended training workshops on types of grants in the system, for example, pure techniques of financial analysis, current and capital shared taxes to provide adequate revenues for budgeting, and tax collection procedures (includ- large urban areas, formula grants to equalize ing records systems). As a result, at least initially, across jurisdictions, and matching grants to stimu- locally raised revenues have increased. late tax effort. Balancing the merits of shared taxes Another option for local governments with staff- and formula grants is a central issue in designing ing shortages is to buy services from the private grant systems. sector. Many services can be provided this way. Grant systems should be kept as simple as possi- Contracting reduces staff requirements and gives ble. Complex systems lack transparency, are likely local governments the flexibility to provide a to introduce mutually offsetting incentives, are dif- changing mix of services.

166 Toward more efficient local government revenue sources that they are best equipped to use, such as property taxes and user charges. A The structure of government in many developing properly designed system of grants can encourage countries is inefficient. Often fiscal relations are efficient provision of local services. Local govern- opaque because of political expediency rather than ments must be held responsible for their use of lack of knowledge or skifi. This makes reform public resources to those who provide them: for much more difficult. Nonetheless more open and user charges, the beneficiaries; for locally raised transparent systems are urgently needed. Respon- revenue, the general public; for grants, the cen- sibility for many services can be devolved to local tral government; and for borrowed funds, the government. Local government should rely on the creditors.

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