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.