Local Finance

Outline of Presentation• Revenues:

– Theory of revenue assignment – Which financing tools for which services?

• Expenditures:– Theory of expenditure assignment– Main Municipal roles and responsibilities in

different countries

Introduction

• The main elements of local finance are the system of revenues, the system of expenditures, local budgets and local financial administration.

Expenditure Assignment

• Revenue assignment requires a clear description of task to be performed by each tier of LG.

• Resource gap could not me measured until the expenditure needs can be ascertained. This exercise requires a very clear delineation of task to be performed by each tier of LG.

Cont.,

• Expenditure assignment refers to specifying the functions and expenditure responsibilities for each level of government, central as well as local. In other words, what are the functions and expenditure responsibilities of each level of government in the decentralized system of governance; who will do what and who will pay for what?

Theory of Expenditure Assignment

• Guidelines to divide government expenditure responsibilities among federal, provincial, and local governments:1. Federal government should have primary

responsibility for stabilization policy and income distribution policies; local governments should focus on the allocation function – delivering goods and services and determining how funds will be raised

2. Services should be delivered at the level of government closest to the individual citizen for economic efficiency (“subsidiarity” principle). Exceptions occur where there are:

– economies of scale – externalities

3. Finance follows function – assign expenditure responsibilities first and then revenue raising powers

4. Balance expenditure assignment and revenue assignment

General government services10%

Protection of persons and property

Transportation and communication

20%Health3%

Social services9%

Education0%

Resource conservation and industrial development

Environment17%

Recreation and culture12%

Housing3%

Regional planning and development

2%Debt charges

Other expenditures1%

Composition of Total Expenditure by Local General Government, Canada (2005)

Approaches

• Expenditure- led approach , is regarded as the best approach in identifying expenditure assignments to central and sub-national government. It minimizes the confusion emerging from the duplication and overlapping of function.

• The revenue-led approach, where public revenue resources are first allocated in a general way between levels of government.

Principles, Conditions for Successful Implementation and Common Problems in Expenditure Assignment

• Theoretically, expenditure assignment should adopt the principles of allocative efficiency, redistributive justice, subsidiarity, economic stability and growth.

Suggested Revenue Sources of Central Government and Local Bodies

ESTIMATING FISCAL GAP ANDINTERGOVERNMENTAL FISCAL

TRANSFER

Types of grants

• There are broadly two types of grants: conditional and unconditional. Conditional grants are given in two broad forms. They are matching and non-matching. Again the matching grant is divided into open-ended or closed-ended.

Cont.,

• Conditional grants are sometimes called specific purpose grants or categorical grants, wherein the central government specifies the purpose for which the recipient local body can use the funds.

• Conditional grants can be matching or non-matching. In the case of conditional matching grant the central government asks local bodies to match certain portion of the expenses on specific programs as a condition to receive the grant.

Cont.,

• Open-ended conditional matching grant is a type of grant in which the central government does not impose a limit on the matching funds. Closed ended conditional matching grant is such a grant fund for which the central government puts a maximum ceiling on the cost it will borne to finance a service.

Design of a grant system

• It has to address the following – what is the amount that is to be distributed (vertical balance); what is the purpose of the grant transfer to local bodies; how the grant amount be distributed among local bodies (horizontal distribution); and how is the system being administered, monitored and managed.

Size of the grant pool

• Determination of the size of the grant pool is essential to ensure vertical balance. There are three common approaches to determining the size of the grant pool.

a. The ad-hoc approachb.The systematic approach

Distribution of the conditional grant among eligible local bodies

• Various approaches are followed by different countries for distribution of conditional grants horizontally to LBs.

• One is to distribute the funds based on calculation of actual cost to provide the identified services with predetermined standards.

• Another approach is to estimate expenditure needs based on critical factor(s) as predictor that represent the needs most (for example, for calculating the education expenses the population of the school going age can be taken as predictor).

• A further different approach is to calculate the unit cost of the establishment to provide the services (such as unit cost of a health post) and factor it with the number of such establishments required.

Distribution of unconditional grant eligible local bodies

• Distribution of unconditional grants can also be made by calculating the actual expenditure needs and assessing revenue gaps, which is an elaborate exercise that demands huge MIS system, and is also not congenial from the standpoint of local autonomy.

Design of grant formula for intergovernmental fiscal transfer

• Bahl suggests that design of a formula based grant system should give serious considerations on the elements of the formula, the data necessary to implement the formula, and the costs associated with administering the grant program.

Cont.,

• Design of a formula requires selection of factors to be included the formula and their relative weights.

• A good factor is one that fairly reflects the characteristics of the LB jurisdiction (e.g., revenue situation, expenditure needs, services and level of development) and for which reliable data can be found from respected sources. The data should be free from manipulation, statistically sound and regularly updated.

1 Main steps to evaluate borrowing capacities of LG

2 Main issues: LG still an “unknown” entity

3 A comprehensive and long term financial approach

Institutional context: decentralisation process in the institutional framework, legal capacity to borrow (domestic and external borrowing), indebtedness limits, financial autonomy of LGs, possible guarantees (debt repayment),

Organizational context of LG: administrative capacities (skilled and experienced staff), financial information system, accountability system, certified accounts,

Political context: Master Plan (urban planning) Financial capacities: classic financial

assessment, risk analysis (including currency risk) => rating (rating agency or internal rating)

1 Main steps Evaluation of borrowing capacities of LG

Financial assessment: LG often considered as “Central government services” => Inappropriate financial tools (calculation of fiscal balances, debt ratios, cash on hands…)

Donors are cautious: implementation of Municipal Funds as a preliminary step => Way to reinforce decentralisation process but no direct dialogue with LG leaders and no real transfer of responsibilities

Donors favour most populated cities (State or regional capitals), which exacerbates financial inequities within a country of a region: direct loan with Central Government guarantee and / or credit line to local banks to finance LG

2 Main issues LG: still an “unknown” entity

Municipal Fund

LG &municipal companies

Central government

Donors

Specialized financial

institutionLocalbanks

Support of a reliable fiscal decentralization

Support of LG direct access to financial markets

Loans / Subsidies

Loans Loans

LoansLoans

Classic types of financial support for LG

Donors

PEFA methodology as a comprehensive approach: PEFA first used to evaluate financial performances of States (Ex: European Commission => PEFA & budgetary support for EDF project implementation)

PEFA studies for LG can provide: a global evaluation of local public finances

system, an evaluation on a long term (every 3-4 years)

to identify progress (better rating for weak component),

an objective diagnostic to implement an coordinated Action Plan (stakeholders: Central government, LG, national audit office)

approachA comprehensive and long term financial

approach based on PEFA methodology1/4

approachPEFA study’s place in a reform cycle of

Local Public Financial Management (LPFM)2/4

Implementation of LPFM reforms

LPFM reforms (short & long term

Objectives)

Recommendations& measures to be

Analysis of causes

Financial & riskassessment

Identification of main weaknesses

Credibility of the budget: the budget shall be realistic and executed as planned,

Comprehensiveness and transparency: complete follow-up of financial risks, communication of budget and financial information to public,

Policy-based budgeting: according to local public policies voted by local assemblies,

Predictability and control in budget execution: existing of mechanisms and procedures,

Accounting recording and reporting: adapted accounting system, perfect recording (paper – numeric)

External scrutiny and audit: certification and / or national public office

methodologySix dimensions taken into account 3/4

Outputs of financial management system: immediate outputs (to be compared with expected expenditures and revenues), amount of arrears and “debts”,

Cross-cutting issues of financial management system: capacity to produce full information at every step of budget cycle (budget, execution, final account),

Budget cycle: performance of each system, process and entities participating in the budget cycle of the LG.

methodologyThree categories for indicators 4/4

Fiscal Relationship between Central and Local Bodies

• In general three broad aspects of governance should guide the design of fiscal relationship between levels of governments. They are authority, resource and accountability.

• Besides, the crosscutting principles guiding the fiscal relationship are transparency, predictability, inclusiveness (participation of wide cross section of population) responsiveness, and reliability.

Authority

• Authority aspect of institutional relationship should address who does what, who controls what resources, how different functions (fixing rate, defining base, collection, distribution) are undertaken.

• How the authority is bestowed (through act, rules, policy or directives), the conditionality of the funds that are transferred are important to establish authority. The division of responsibilities among levels of government, the checks and balances system, the system of cooperation and coordination would make the authority more effective.

Resources

• In a decentralized system the degree of financial autonomy exercised by Local Bodies is a measure of fiscal power. The more financial autonomy the LBs achieve the higher the degree of control over financing of local services leading to exercise of higher fiscal power.

• LB revenue can be categorized as own-source revenue and revenue transferred by another level of government. Own-source revenue is revenue raised and spent by the agency levying the tax, fee or assessment.

Accountability• The functions related to accountability aspect of

managing intergovernmental relations are carrying out financial and performance audit to attest LB incomes and expenditures, to see if the procedures and processes are in compliance with the set norms and standards, and to judge to what extent the principle of value for money is applied by LBs.

• Accountability should also be evaluated on the part of the CG operations in relation to managing intergovernmental fiscal relations.

Distribution of Local Government Expenditures, Selected Countries (%)

US UK Fra. Spain Neth. Den. Swe. Italy Bel.

General admin.Public safetyEducationHealthSocial sec./welfareHousingRec. and cultureFuel and energyAgricultureMining, mfg., const.TransportationOther economicOtherTotal

387333

1100507

53000518

8400408

603173

600070

131657

13000050

87000000007

681102162

1300006

Fiscal Design across Levels of Government:

EU Applicant States and EU Member States

GDP per head

Mean 1

Czech R

epublic

Hungary

epublic

GDP per head

Key IndicatorsPopulation

(in 1000)Size (km2)

Growth Inflation rate

Public deficit

(% GDP)

Public debt (% GDP)

Bulgaria* 8,170 110,971 4.00 10.3 -0.7 76.9Cyprus 757 9,251 4.00 4.9 -3.2 63Czech Republic 10,273 78,866 3.30 3.9 -4.2 17.3Estonia 1,436 45,227 5.00 3.9 -0.7 5.3Hungary 10,024 93,030 3.80 10 -3.1 55.7Latvia 2,373 64,589 5.90 2.6 -2.7 14.1Lithuania 3,696 65,300 7.70 0.9 -3.3 23.7Malta 391 316 -0.80 2.4 -6.6 60.6Poland 38,646 312,685 1.10 10.1 -3.5 40.9Romania* 22,435 238,391 5.30 45.7 -3.8 22.9Slovak Republic 5,401 49,035 3.30 12.1 -6.7 32.4Slovenia 1,990 20,273 3.00 8.9 -2.3 25.8Turkey* 65,293 769,604 -7.40 54.9 -11 57.8

Weighted average 10 Applicant States 2.54 8.45 -3.67 36.58Weighted average 15 Member States 1.50 2.30 -0.60 63.00

II Main findings

• Current approaches to sub-national government within the EU– Federal approach (Austria, Germany, Belgium)– Tradition of relatively strong sub-national

government (Denmark, Finland, Sweden)– Tradition of relatively weak sub-national

government (Greece, Ireland, Portugal)– Intermediate approach (France, Italy,

Luxembourg, Netherlands, Spain, UK)

Current approaches to sub-national government in 10 Applicant Countries

• Unitary approach• Four countries with genuine regional level

(Czech Republic, Latvia, Poland, Slovak Republic)

• Only two countries with two tiers of local government (Latvia, Poland)

Czech R

epublic

Hungary

epublic

Under 10001000-2000

2000-50005000-10000

10000-5000050000-100000

Over 100000

Population ofauthority

Czech R

epublic

Hungary

epublic

Under 10001000-2000

2000-50005000-10000

10000-5000050000-100000

Over 100000

Population ofauthority

Distribution of municipalities by size range

Decentralisation profiles Sub-national expenditure levels (% of GDP)

0.05.0

10.015.020.025.030.035.0

Decentralisation profiles Sub-national revenue levels

%GDP % total revenue

The allocation of responsibilities (sub-national spending by function as a percentage of total sub-national

spending. Mean values)

ApplicantStates

SelectedmemberStates

ApplicantStates

SelectedmemberStates

Composition of sub-national revenues

Grants

Non-tax revenues

Tax revenues

Grants

Non-tax revenues

Tax revenues

Income and profits Property Goods and services Others

The choice of sub-national taxes

Local tax autonomy

Revenue sharing where the CG:SNG revenue split…Level Sub-nationalgovernment taxesas % of total tax

revenue

SNG setstaxrate

and base

SNG setstax rate

SNGsetstax

baseonly

…is setby SNG

…can bechanged only if

SNG agree

…is set in legis-lationand may be changed

uni-laterally by CG

…is set annuallyby CG as part of

the budget

CG setsboth rateand taxbase ofSNG tax

(a) (b) (c) (d1) (d2) (d3) (d4) (e)

Bulgaria (2000) Local 10.0 - - - - - 39.0 61.0 -100.0

Czech Republic (1999) Local 11.1 2.7 5.6 - - - 91.7 - - 100.0Estonia (1999) Local 16.2 - 9.2 - - - 90.8 - - 100.0

Hungary (1999) Local 10.4 49.2 - - - - - 50.8 100.0Latvia (1999) Local 17.1 - - - - - - - 100.0 100.0

Lithuania (1999) Local 22.0 - - - - - - - 100.0 100.0Poland (1999) Local 8.3 - 41.9 0.6 - - 57.6 - - 100.0

Romania (2000) Local 10.5 - 6.0 0.6 - - - 75.0 18.4 100.0Slovak Republic (2000) Local 4.0 7.0 28.2 - - - - 64.8 - 100.0

Slovenia (2000) Local 7.9 16.7 0.6 0.4 - - 82.3 - - 100.0Mean (by country) - 11.8 7.6 9.2 0.2 0.0 0.0 36.1 25.2 21.8 100.0

Belgium (1995) Local 6.0 13.0 84.0 - - - 2.0 1.0 - 100.0Communities 13.0 - 3.0 - - 97.0 - - - 100.0Regional 10.0 8.0 92.0 - - - - - - 100.0

Denmark (1995) Municipalities 22.0 - 96.0 - - - 4.0 - - 100.0Counties 9.0 - 93.0 - - - - - 7.0 100.0

Netherlands (1995) Municipalities 1.0 - 100.0 - - - - - - 100.0Polder boards 1.0 - 100.0 - - - - - - 100.0

Spain (1995) Local 9.0 33.0 51.0 - - 16.0 - - - 100.0Regions 5.0 15.0 7.0 - - 78.0 - - - 100.0

Sweden (1995) Municipalities 22.0 4.0 96.0 - - - - - - 100.0Counties 11.0 - 100.0 - - - - - - 100.0

United Kingdom (1995) Local 4.0 - 100.0 - - - - - - 100.0Mean (by tier) - 9.4 6.1 76.8 0.0 0.0 15.9 0.5 0.1 0.6 100.0