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. Nothing herein shall constitute or be considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Rights and Permissions This work is available under the Creative Commons Attribution 3.0 IGO license (CC BY 3.0 IGO) http://creativecommons.org/licenses /by/3.0/igo. Under the Creative Commons Attribution license, you are free to copy, distribute, transmit, and adapt this work, including for commercial purposes, under the following conditions: Attribution—Please cite the work as follows: Farvacque-Vitkovic, Catherine, and Mihaly Kopanyi, eds. Municipal Finances: A Handbook for Local Governments. Washington, DC: World Bank. doi:10.1596/978-0-8213-9830-2. License: Creative Commons Attribution CC BY 3.0 IGO Translations—If you create a translation of this work, please add the following disclaimer along with the attribution: This translation was not created by The World Bank and should not be considered an official World Bank translation. The World Bank shall not be liable for any content or error in this translation. Adaptations—If you create an adaptation of this work, please add the following disclaimer along with the attribution: This is an adaptation of an original work by The World Bank. Responsibility for the views and opinions expressed in the adaptation rests solely with the author or authors of the adaptation and are not endorsed by The World Bank. Third-party content—The World Bank does not necessarily own each component of the content contained within the work. The World Bank therefore does not warrant that the use of any third-party-owned individual component or part contained in the work will not infringe on the rights of those third parties. The risk of claims resulting from such infringement rests solely with you. If you wish to re-use a component of the work, it is your responsibility to determine whether permission is needed for that re-use and to obtain permission from the copyright owner. Examples of components can include, but are not limited to, tables, figures, or images. All queries on rights and licenses should be addressed to the Publishing and Knowledge Division, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. ISBN (paper): 978-0-8213-9830-2 ISBN (electronic): 978-0-8213-9914-9 DOI: 10.1596/978-0-8213-9830-2 Cover art: Joel Mpah Dooh. Other art: Ndoye Douts. Reuse requires permission. Cover design: Debra Naylor, Naylor Design, Inc. 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. Municipal contracts An Assessment.” Ethnic Studies Report 17 (2): focus essentially on capacity building and finan- 253–80. cial and organizational reforms to build munici- Bird, Richard M. 2011a. “Subnational Taxation in palities as key institutions to deliver basic Developing Countries: A Review of the services to the citizens. Literature.” Journal of International Commerce, Economics and Policy 2 (1): 1–23. ———. 2011b. “Are There Trends in Local Finance? References A Cautionary Note on Comparative Studies and Normative Models of Local Government Ahmad, E., and G. Brosio. 2006. Handbook of Finance.” Institute on Municipal Finance and Fiscal Federalism. Cheltenham, U.K.: Edward Governance, Munk School of Global Affairs, Elgar. University of Toronto. Akai, Nobu, and Masayo Sakata. 2002. “Fiscal Bird, Richard M., and Robert D. Ebel. 2007. Fiscal Decentralization Contributes to Economic Fragmentation in Decentralized Countries: Growth: Evidence from State-Level Cross Subsidiarity, Solidarity, and Asymmetry. Section Data for the United States.” Journal of Cheltenham, U.K. and Northampton, MA: Urban Economics 52 (1): 93–108. Edward Elgar. Amin, Khalid, and Robert D. Ebel. 2006. Bird, Richard M., Robert D. Ebel, and Sebastiana “Intergovernmental Relations and Fiscal Gianci. 2007. “Country Studies: Aspects of Decentralization in Egypt.” Egypt Public the Problem.” In Fiscal Fragmentation in Expenditure Review, Policy Note No. 8, World Decentralized Countries: Subsidiarity, Bank, Washington, DC. Solidarity, and Asymmetry, edited by Richard Arzaghi, Mohammad, and J. Vernon Henderson. M. Bird and Robert D. Ebel. Cheltenham, 2005. “Why Countries Are Fiscally U.K. and Northampton, MA: Edward Elgar. Intergovernmental Finances in a Decentralized World 35 Bird, Richard M., Robert D. Ebel, and Christine I. From Theory to Practice.” In Handbook on Wallich. 1995. Decentralization of the Socialist Federalism, edited by Ahmad Ehtisham and State: Intergovernmental Finance in Transition Giorgio Brosio. Cheltenham, U.K.: Edward Economies. Washington, DC: World Bank. Elgar. Bird, Richard M., and François Vaillancourt. 2006. Demszky, Gabor. 2003. “Liberalism in Practice” In “Perspectives on Fiscal Federalism.” WBI The Budapest Model: A Liberal Urban Policy Learning Resources Series 35628, World Bank, Experiment, edited by Katalin Pallai. Budapest: Washington, DC. Open Society Institute. ———. 2010. “Is Decentralization ‘Glue’ or ‘Solvent’ Dillinger, William. 1994. “Decentralization and Its for National Unity?” Working Paper 10-03, implications for Urban Service Delivery.” International Studies Program, Andrew Young Urban Management Program Notes Series 16, School of Policy Studies. Atlanta: Georgia State World Bank, Washington, DC. University. Eaton, Kent, Kai Kaiser, and Paul Smoke. 2011. The Blöchliger, H., and O. Petzold. 2009. Finding the Political Economy of Decentralization Reforms Dividing Line between Tax Sharing and Grants: in Developing Countries: A Development Partner A Statistical Investigation. OECD Working Perspective. Washington, DC: World Bank. Paper on Fiscal Federalism No. 10. Paris: Ebel, Robert D., and Gabor Peteri. 2007. The Organisation for Economic Co-operation and Kosovo Decentralization Briefing Book. Development. Prishtina: Kosovo Foundation for an Open Blöchliger, H., and J. Rabesona. 2009. The Fiscal Society/Soros Foundation. www.lgi.osi. Autonomy of Sub-Central Governments: An Ebel, Robert D., and Robert Taliercio. 2005. Update. OECD Working Paper on Fiscal “Subnational Tax Policy and Administration in Federalism No. 9. Paris: Organisation for Developing Countries.” Tax Notes Economic Co-operation and Development. International 37 (1): 919–36. Boadway, R., and A. Shah, eds. 2009. Fiscal Ebel, Robert D., and Dana Weist. 2007. Sequencing Federalism. Cambridge: Cambridge University Subnational Tax Policy and Administration. Press. World Bank Decentralization Thematic Group. Box, Jamie, and Jorge Martinez-Vazquez. 2004. Washington, DC: World Bank. “Designing Intergovernmental Equalization Ebel, Robert D., and Serdar Yilmaz. 2003. “On the Transfers with Imperfect Data: Concepts, Measurement and Impact of Fiscal Practices and Lessons.” Working Paper 04-12, Decentralization.” In Public Finance in International Studies Program, Andrew Young Developing and Transition Countries: Essays in School of Policy Studies. Atlanta: Georgia State Honor of Richard M. Bird, edited by Jorge University. www.aysps.gsu.edu. Martinez-Vazquez and James Alm. Canuto, Otaviano, and Lili Liu, eds. 2013. Until Cheltenham, U.K.: Edward Elgar. Debt Do Us Part: Subnational Debt, Insolvency Ellis, Peter. 2010. “Indonesia Rising. Policy and Markets. Washington, DC: World Bank. Priorities for 2010 and Beyond: Completing Commins, Stephen, and Robert D. Ebel. 2010. Decentralization.” Policy Note, World Bank, “Participation and Decentralization in Africa: Washington, DC. Revisiting the Arusha Declaration.” Farvacque-Vitkovic, Catherine, and Lucien Godin. Consultation for African Civil Society 1998. The Future of African Cities. Washington, Organizations on Peace Building and State DC: World Bank. Affairs. Addis Ababa: United Nations Farvacque-Vitkovic, Catherine, Lucien Godin and Economic Commission for Africa. Anne Sinet. Municipal Self-Assessments: Dafflon, Bernard. 2006. “The Assignment of A Handbook for Local Governments. Functions to Decentralized Government: Washington, DC: World Bank (forthcoming). 36 Municipal Finances Fox, William, and Christine Wallich. 2007. “Fiscal Kopanyi, Mihaly, Samir El Daher, and Deborah Federalism in Bosnia and Herzegovina: Wetzel. 2004. Intergovernmental Finance in Subsidiarity in a Three-Nation State.” In Fiscal Hungary: A Decade of Experience, 1990–2000, Fragmentation in Decentralized Countries: edited by Mihaly Kopanyi, Deborah Wetzel, and Subsidiarity, Solidarity, and Asymmetry, edited Samir El Daher. Washington, DC: World Bank. by Richard M. Bird and Robert D. Ebel, Kopanyi, Mihaly, Samir El Daher, Deborah Wetzel, 267–94. Cheltenham, U.K.: Edward Elgar. Michel Noel, and Anita Papp. 2000. Gomez-Lobo, Andres. 2001. “Making Water “Modernizing the Subnational Government Affordable.” In Contracting for Public Services, System.” World Bank Discussion Paper No. 417, edited by Penelope Brooke and Suzanne World Bank, Washington, DC. Smith, 23–29. Washington, DC: World Bank. Marcou, Gerard. 2007. “Legal Framework and the Gonzalez, Pablo. 2005. “The Financing of European Charter of Local Self Government.” Education in Chile.” Fund for the Study of In The Kosovo Decentralization Briefing Book, Public Policies, University of Chile, Santiago, edited by Robert D. Ebel and Gabor Peteri, Chile. 50–59. Prishtina: Kosovo Foundation for an Gordon, Nora, and Emiliana Vegas. 2004. Open Society. “Education Finance Equalization, Spending, Martinez-Vazquez, Jorge. 1999. “The Assignment Teacher Quality and Student Outcomes: The of Expenditure Responsibilities.” Paper Case of Brazil’s FUNDEF.” Working paper, prepared for the core course on World Bank, Washington, DC. Intergovernmental Relations and Local Goudriaan, Mirco. 2010. “Effective Aid through Financial Management, World Bank Institute, Municipal Contracts.” Internal working paper, Washington, DC. VNG International, The Hague, Netherlands. ———. 2007. “Challenges in the Design of Griffiths, Ann L., with Karl Nerenberg, eds. 2005. Intergovernmental Transfers.” In Fiscal Handbook of Federal Countries. Montreal and Equalization, edited by Jorge Martinez- Kingston: McGill-Queens University Press. Vazquez and Bob Searle. New York: Springer. Haysom, N., and S. Kane. 2009. “Negotiating Martinez-Vazquez, Jorge, and Robert Martin Natural Resources for Peace. Ownership, McNab. 1997. “Tax Reform in Transition Control and Wealth Sharing.” Briefing paper, Economies: Experience and Lessons.” Center for Humanitarian Dialogue, Geneva, Working Paper No. 97-6, Andrew Young Switzerland. School of Policy Studies, Georgia State Hofman, Bert, and S. C. Guerra. 2007. “Ensuring University, Atlanta. Inter-regional Equity and Poverty Reduction.” Martinez-Vazquez, Jorge, and François In Fiscal Equalization, edited by J. Martinez- Vaillancourt, eds. 2011. Decentralization in Vazquez and B. Searle. New York: Springer. Developing Countries: Global Perspectives on the Imi, A. 2005. “Fiscal Decentralization and Obstacles to Fiscal Devolution. Northampton, Economic Growth Revisited: An Empirical MA: Edward Elgar. Note.” Journal of Urban Economics 57: 449–61. McClure, Charles E., Jr. 1999. “The Tax Jensen, Leif. 2001. Fiscal Design Surveys across Assignment Problem: Conceptual and Levels of Government. Tax Policy Studies No. 7. Administrative Considerations in Achieving Paris: Organisation for Economic Co-operation Subnational Fiscal Autonomy.” Paper prepared and Development. for the core course on Intergovernmental Kalandadze, K., and M. A. Orenstein. 2009. Relations and Local Financial Management, “Electoral Protests and Democratization: World Bank Institute, Washington, DC. Beyond the Color Revolutions.” Comparative McNeil, Mary, and Carmen Malena. 2010. “Social Political Studies 42 (11): 1403–25. Accountability in Africa.” In Demanding Good Intergovernmental Finances in a Decentralized World 37 Governance: Lessons from Social Accountability Rao, M. Govinda. 2007. “Resolving Fiscal Initiatives in Africa, edited by Mary McNeil Imbalances.” In Intergovernmental Fiscal and Carmen Malena, 1–28. Washington, DC: Transfers: Principles and Practice, edited by World Bank. Robin Boadway and Anwar Shah. Washington, Meloche, J. P., F. Vaillancourt, and S. Yilmaz. DC: World Bank. 2004. “Decentralization or Fiscal Autonomy? Regulski, Jerzy. 2010. A Practical Guide to Building What Does Really Matter? Effects on Growth Local Government: The Polish Experience. and Public Sector Size in European Budapest: Local Government and Public Transition Countries.” Policy Research Service Reform Initiative/Open Society Working Paper 3254, World Bank, Institute. www.lgi.osi.hu. Washington, DC. Sen, Amartya. 1999. “Democracy As a Universal Mikesell, John L. 2003. “International Experiences Value.” Journal of Democracy 10 (3): 3–17. with Administration of Local Taxes: A Review http://muse.jhu,demo/jod.10.3sen.html. of Practices and Issues (2003).” Report Shah, A. 2007. “A Practitioner’s Guide to prepared for the World Bank Thematic Group Intergovernmental Fiscal Transfers.” In on Taxation and Tax Policy, World Bank, Intergovernmental Fiscal Transfers: Principles Washington, DC. www.worldbank.org. and Practice, edited by R. Boadway and NALAS (Network of Association of Local A. Shah. Washington, DC: World Bank. Authorities of South-East Europe). 2008. Shah, Anwar. 1998. “Indonesia and Pakistan: Fiscal Skopje, www.nalas.eu. Decentralization—An Elusive Goal?” In Fiscal Ndegwa, Stephen N. 2002. “Decentralization in Decentralization in Developing Countries, Africa: A Stocktaking Survey.” Africa Region edited by Richard M. Bird and François Working Paper Series No. 40, World Bank, Vaillancourt. Cambridge: Cambridge Washington, DC. University Press. Oates, Wallace E. 1972. Fiscal Federalism. Sharma, Y., and A. Muwonge. 2010. “An New York: Harcourt Brace Jovanovich. Opportunity to Improve Service Delivery in Nepal through Local Governance.” Himalayan ———. 1985. “Searching for Leviathan: An Research Papers Archive. Fifth Annual Empirical Study.” American Economic Review Himalayan Policy Research Conference, Nepal 75 (4): 748–57. Study Center, University of New Mexico. ———. 1997. “On the Welfare Gains from Fiscal http://repository.unm.edu/handle/1928/11328. Decentralization.” Journal of Public Finance Slack, Enid, and Rupak Chattopadhyay, eds. 2009. and Public Choice 2 (3): 83–92. Finance and Governance of Capital Cities in Pallai, Katalin. 2003. The Budapest Model. Budapest: Federal Systems. Montreal and Kingston: Open Society Institute. www.lgi.osi.hu. McGill-Queen’s University Press. Peteri, Gabor, and Fikret Sevinc. 2011. “Municipal Smoke, Paul. 2008. “Local Revenues under Fiscal Revenues and Expenditures in Turkey and in Decentralization in Developing Countries: Selected EU Countries.” Local Administration Linking Policy Reform, Governance and Reform Project in Turkey, LAR Phase II. Local Capacity.” In Fiscal Decentralization and Land Administration Reform Project, Policies, edited by Gregory Ingram and Bakanliklar-Ankara. Yu-Hung Hong, 33–69. Cambridge, MA: Rangarajan, C., and Abha Prasad. 2012. Lincoln Institute Press. “Managing State Debt and Ensuring Solvency: ———. 2013. “Why Theory and Practice Are The Indian Experience.” Policy Research Different: The Gap between Principles and Working Paper 6039, World Bank, Reality in Subnational Revenue Systems.” In Washington, DC. Taxation and Development: The Weakest Link. 38 Municipal Finances Essays in Honor of Roy Bahl, edited by Richard In Fiscal Fragmentation in Decentralized M. Bird and Jorge Martinez-Vazquez. Countries: Subsidiarity, Solidarity, and Cheltenham, U.K.: Edward Elgar. Asymmetry, edited by Richard M. Bird and Smoke, Paul, and Robert R. Taliercio, Jr. 2007. Robert D. Ebel, 363–98. Cheltenham, U.K.: “Aid, Public Finance, and Accountability: Edward Elgar. Cambodian Dilemmas.” In Peace and the Wong, Christine. 2007. “Ethnic Minority Public Purse, edited by James K. Boyce and Regions and Fiscal Decentralization in Madalene O’Donnell, 55–84. London: Lynne China: The Promises and Reality of Rienner. Asymmetric Treatment.” In Fiscal Soros, George. 2006. The Age of Fallibility. Fragmentation in Decentralized Countries: Cambridge, MA: Public Affairs Books. Subsidiarity, Solidarity, and Asymmetry, Swianiewicz, Pawel. 2006. “Local Government edited by Richard M. Bird and Robert D. Organization and Finance: Poland.” In Local Ebel, 267–94. Cheltenham, U.K.: Edward Governance in Developing Countries, edited by Elgar. Anwar Shah. Washington, DC: World Bank. ———. 2013. “Paying for Urbanization in China: Thomas, Vinod. 2006. “Linking Individual, Challenges of Municipal Finance in the Organizational, and Institutional Capacity 21st Century.” In Financing Metropolitan Building to Results.” WBI Capacity Governments in Developing Countries, edited Development Brief 19, World Bank, by R. W. Bahl, J. F. Linn, and D. L. Wetzel. Washington, DC. Cambridge, MA: Lincoln Institute for Land Policy. Tosun, Mehmet Serkan. 2010. “Middle East and North Africa.” In Local Government Finance: World Bank. 2000. World Development Report The Challenges of the 21st Century, edited by 1999/2000. Entering the 21st Century. New Jorge Martinez-Vazquez and Paul Smoke. York: Oxford University Press. Barcelona: United Cities and Local ———. 2009. Improving Municipal Management for Governments. Cities to Succeed: An Independent Evaluation Tosun, Mehmet Serkan, and Serdar Yilmaz. 2010. Group (IEG) Special Study. Washington, DC: “Centralization, Decentralization and Conflict World Bank. in the Middle East and North Africa.” Middle Yatta, F., and F. Vaillancourt. 2010. “Africa.” In East Development Journal 2 (1): 1–14. Local Government Finance: The Challenges of Vaillancourt, François. 2002. “Simulating the 21st Century, edited by Jorge Martinez- Intergovernmental Equalization Transfers Vazquez and Paul Smoke. Barcelona: United with Imperfect Data.” Proceedings of the Cities and Local Governments. Annual Conference, 2001, 57–64, National Yilmaz, Serdar, François Vaillancourt, and Bernard Tax Association, Washington, DC. Dafflon. 2012. “State and Local Governments: Wallich, Christine, and Qianqian Zhang. 2013. Why They Matter and How to Finance Them.” “Bosnia and Herzegovina: Subsidiarity As In The Oxford Handbook of State and Local Conflict Avoidance in a Three Nation State.” Government Finance, edited by Robert D. Ebel Paper presented to the Forum on Conflict, and John E. Petersen, 45–82. Oxford and New Security and Development, May, World Bank, York: Oxford University Press. Washington, DC. Zoellick, Robert. 2009. “Securing Development.” Wallich, Christine I., Rosario Manasan, and Saloua Conference on Passing the Baton, United Sehili. 2007. “Subsidiarity and Solidarity: States Institute of Peace, Washington, DC, Fiscal Decentralization in the Philippines.” January 8. Intergovernmental Finances in a Decentralized World 39 CHAPTER 2 Metropolitan Governance and Finance Mats Andersson Urbanization around the world is creating larger This chapter summarizes the main character- cities and economic areas. More than 3.5 billion istics of metropolitan areas. It starts by highlight- people now live in cities and their vicinities. In ing the socioeconomic factors of urbanization, mid-2012, there were 27 megacities with more the  ways that cities grow spatially, and the than 10 million people, and more than 500 metro- opportunities and challenges of megacities. 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 overarching objective is to use subsidies inclusion of capital expenditures in tariffs, fees, fairly to maximize revenues for covering the cost and charges. of operating and maintaining services. That can As we have said, urban services in develop- be achieved by the careful allocation and target- ing countries are often operated with low tariffs ing of the subsidies. The following steps and con- that cover neither the capital investment nor siderations are useful in meeting those objectives: operation and regular maintenance. The first step toward addressing that situation could be achiev- • Scrutinize the operation and maintenance ing the recovery of operation and maintenance expenditures of the service provider to ensure 240 Municipal Finances Box 5.10 Water Subsidies in Delhi, India Huge subsidies are being given to customers the poor are hardly connected to the system through subsidized tariffs. According to the because connection charges are so high. chief minister, who is the chairman of the Thus, the middle-to-high-income customers board of the National Commission of Tariffs enjoy the low tariffs. Further, the poor have to (NCT), as much as 60 percent subsidies are incur coping costs to meet their water needs being factored in the domestic tariffs in Delhi. from tankers. Hence benefits are not reaching These subsidies are meant for the poor, but the target users. Source: TERI 2010, 35. that it is allocating the minimum required still pay less than 5 percent of household income. subsidy. The table summarizes the situations of three groups of customers grouped by household (HH) • Ensure explicit, transparent, measurable, and income, with 5 percent of income serving as a accounted-for subsidies. proxy for ability to pay for water. The detailed • Identify the target groups, their needs, and tariff analysis was carried out because the town their ability and willingness to pay. initially agreed on a flat rate of NPR 100 “because the people can pay only that.” However, the town • Select the appropriate subsidy options. soon discovered that the combined costs of oper- • Select the appropriate method of transfers ation, maintenance, and debt service (O + M + DS) attached to performance. were well above the total revenues that such a flat rate would produce. • Set rules for subsidy implementation and enter The analysis suggests that local policy mak- into a contract with the provider, if possible. ers have a number of options. A flat rate of NPR • Monitor, enforce rules, and evaluate the imple- 300 would result in financial feasibility but would mentation and impact of the subsidies. create an unbearable burden for poor house- holds. The target service would drop the subsidy • Estimate, decide or plan, and budget the vol- if in-house connections paid NPR 300 per month ume of subsidies the government is able and and poor families paid NPR 60 per month for com- willing to cover (an average per customer, per munity taps installed for five-family groups. This service, or per provider). variation seems attractive but not feasible because connections to the houses have already been • Communicate the use of subsidies to key installed. Better-off families could afford to pay stakeholders. NPR 360 per month, which would allow house- Table 5.9 illustrates the various tariff options. hold connections for the poor families for NPR It is based on a real water supply project in 60 per month. Poor families would then receive a  small town in Nepal. The project is running a a large cross-subsidy paid for by the better-off huge deficit of NPR 450,000, or 33 percent. A families. Many more options could be considered. willingness-to-pay survey indicates that most The last two lines of table 5.9 compare two pos- households could easily pay higher tariffs and sible options, including one with differentiated Managing Local Expenditures 241 Table 5.9 Tariff Options for a Small Water Supply Project in Nepal Household Household Household Total Total cost Subsidy income income income Total revenue (O + M + per over NPR NPR 3,000 below number of NPR per DS) NPR month 10,000 to 10,000 NPR 3,000 connections month per month (NPR) Number of 900 2,700 900 4,500 1,350,000 households 5 percent of HH 750 375 100 income (NPR) Current situation: 100 100 100 4,500 450,000 1,350,000 900,000 flat tariff NPR 100 Option 1 300 300 60 3,780 1,134,000 1,350,000 216,000 Option 2 360 360 60 3,780 1,350,000 1,350,000 0.0 Option 3 300 300 300 4,500 1,350,000 1,350,000 0.0 Note: O + M + DS = operations, plus maintenance, plus debt service; HH = household. Option 1: In-house connection for rich and medium-income families for Rs 300 per month and community taps each for five poor families for Rs 60 per month per family fee. Option 2: Target service Rs 360 per HH in house and Rs 60 per HH for community taps. Option 3: Household connections for all and flat rate Rs 300 for each HH regardless of income level. services and differentiated tariffs, each affordable energy and fuel), real property, capital equipment for the particular household groups. (trucks), built assets (hospitals, schools, roads), What lessons can one take away on tariff set- and services (including office accommodation, ting and subsidies? There are many, but let us cleaning, and security, and even banking services). summarize a few of the main ones: (a) finance Procurement is at the heart of delivering public departments have a critical part in analyz- services. It involves large amounts of public ing, monitoring, and controlling expenditures money, and it is the largest single source of allega- incurred under the various tariffs and associated tions of corruption and government inefficiency. subsidies for basic urban services; (b) expendi- Because procurement is central to so much of ture control requires solid information and deep what local governments do, effective procure- understanding of the underlying costs to estimate ment is critical for expenditure management. realistic and justified subsidies; (c) subsidies Generally, all well-designed procurement should be targeted, explicit, and well accounted; systems require high levels of transparency, fair and (d) the total volume of annual subsidies and open competition, and selection of the best- should be estimated and communicated to key qualified supplier. The implementation of those stakeholders, including decision makers such systems is often difficult and time-consuming. as the council, line departments, and the budget As  a result, many local governments tend to committee, as well as the citizens at large and the ignore procurement rules and instruments. They customers of the specific services. purchase goods and services arbitrarily and pay more than they should for inferior goods and Principles of Procurement and Expenditure services. Tracking Because of the importance of procurement, its Procurement takes many forms and encompasses close supervision is essential. Most procurement the acquisition of goods (bulk products such as systems, if implemented as designed, will deliver 242 Municipal Finances similar results. Frequently, however, as we have The Procurement Cycle said, the systems are not implemented for the Although the steps in procuring an item will vary following reasons: somewhat based on the cost of the item being procured (less expensive items usually use less • Lack of well-qualified procurement specialists complicated procedures), in general the steps in • Lack of policy and practice in saving money the procurement cycle are the same (figure 5.6 through good, competitive procurement depicts the competitive bidding process): • A culture of limited transparency • Define the requirements. • Understand the allocation and sharing of risk • Poor definition of specifications (especially for activities involving public- • Pressure on key officials from special interests. private partnerships). Figure 5.6 Competitive Tendering Process Terms of reference Publishing Expression of expression interests of received interest Submitting Technical Short and financial listing requests for proposals proposals deals received Negotiation Opening and proposals contracting 3 weeks 1 week 4 weeks 1 day 2 weeks Managing Local Expenditures 243 • Prepare terms of reference (ToRs) and to the plan must be explained and supported by a detailed specifications, whether for goods or sound project rationale. To ensure that the plan civil works, so that it is clear what is expected reflects the most current thinking, it should be to be provided and by what date. updated regularly, perhaps annually, and made available to all stakeholders. • Advertise the proposed procurement to attract the widest possible interest. Competitive Procurement • Request that companies submit expressions of Local governments often lose money because of interest (EOIs) based on a brief description of inadequate procurement. The fact that fair and the activity to be procured. transparent competition is the foundation of procurement sounds simple and obvious, but it • Evaluate the submissions and select a small is often ignored. The major reason is that it can number of firms, contractors, or suppliers to take up to six months, or more than one year for participate in the final competition. large infrastructure projects. Municipal officers • Send the TORs or detailed specifications and might feel that it is a waste of time if they fail to the applicable commercial terms in a letter of understand the enormous losses that they risk in invitation to the short-listed firms or the pre- a rush for sole-source procurement. Competitive qualified contractors. requesting submission procurement may also be avoided if the project of technical and financial proposals no later has not been properly planned and approved by than a clearly specified date. the council. Sometimes the procurement must be completed quickly so that funds can be spent • Evaluate the proposals and select the lowest before the end of the fiscal year. Other reasons are evaluated bidder, that is, the best price for the vested interests by some officers, council mem- specifications required; invite that firm for bers, and politicians, or simply corruption. Figure contract negotiations. 5.6 depicts the competitive tendering process for • Negotiate and sign the contract. a medium-size project. Competitive procurement has various forms • Begin work. and options; what is adequate depends largely on the size and nature of the procured good or ser- Procurement Plans vice. Very large projects may require international To ensure that only approved items are procured, tendering, if sufficient capacities are not available it is essential to have well-developed and trans- at the national level, as is often the case in small parent procurement plans that specify the goods, or medium-size developing countries. Medium- services, and civil works that the government has size projects might be better tendered nation- decided to procure (table 5.10 is a snapshot from ally. In the modern world, competitive tenders a city’s procurement plan). The plan should indi- are not limited to goods but extend to services, cate the expected time to complete each phase including security, office space, event manage- of the procurement process; it should estimate ment, and banking, which is especially important. when implementation is to start and when it is to Municipalities can gain financially by select- be completed. ing partner banks competitively. Finally,  simple Such a plan will enable management to mon- shopping or single-source selection is still ade- itor the process for delays and inefficiencies and quate for procuring a small quantity of goods or track the expenditures. It will indicate to all hiring specialists (table 5.10 shows various pro- stakeholders what is being planned; any changes curement forms in the local procurement plan). 244 Municipal Finances Managing Local Expenditures Table 5.10 Project Procurement Plan Est. cost Procurement Pre- Domestic Prior Expected bid Ref. no. Contract description ($ millions) method qualification preference review opening Comments Works CW-1 Drainage system 6.770 International No Yes Yes April 16, 2012 competition CW-2 Traffic management 8.94 International No Yes Yes May 25, 2012 competition Goods EQ-1 Computers 0.45 International No No Yes January 16, competition 2012 EQ-2 Stationery 0.05 Shopping No No No June 5, 2012 EQ-3 Advertising 0.045 Direct No No No July 5, 2012 Consultancies TA-1 Management 0.750 International N/A N/A Yes August 7, 2012 information system competition 245 Critical Steps in the Procurement Process include very specific, measurable, time-bound Many local governments follow the procurement outputs; and provide a payment schedule cor- process depicted in figure 5.6, some only because responding to the tasks. A brief and vague ToR it is required by a donor. Most local governments will neither guide the contracting partner nor in the developing world, however, are inexpe- encourage a clear and strong commitment. rienced in critical elements of the procurement Moreover, it will not provide solid ground for process; as a result, they often feel the burdens but the local government to enforce the agreed miss the benefits of good procurement. Box 5.11 actions and demand value for money. summarizes a procurement reform in Uzbekistan. The most critical steps, which make a procure- • Selection of the short-listed companies and the ment effective or failed, are the following: final bidder. Many local governments appear weak in setting up selection committees • Terms of Reference (ToR). It is necessary to with competent and committed members. spend sufficient time, and perhaps money, to They often take the selection as a formal- prepare an adequate ToR document. The ToR ity rather than a critical step, fail to find the should be very specific in defining objectives, best candidate, and then obtain substandard scope of works, and tasks to be completed; results (such as poor products, delays, or weak Box 5.11 Introducing Competitively Tendered Franchises in Uzbekistan Urban public transport services were tradition- each city, chaired by a deputy mayor and oper- ally supplied in Uzbekistan by state-owned ating under precise rules set by a transport enterprises that enjoyed areawide or citywide regulatory agency in the central government. monopolies. Beginning in late 1997 , however, The main selection criteria included bidders’ as part of the transformation of this former discounts, if any, from the passenger fare ceil- socialist economy into one that functions on ing, proposed service frequency, and bus fleet market principles, the Uzbek government characteristics. Franchise duration, initially set implemented radical changes in the organiza- at six months and renewable once for another tion and regulation of urban public bus trans- six months, is progressively being extended (it port services. now lasts for one year). Through a gradual and carefully planned These reforms, completed in two years, process, which included experiments in a few have resulted in impressive changes. Numer- cities, a study tour to London, and progressive ous private operators have entered the public scaling-up to all secondary cities, responsibil- transport market, many new jobs have been ity was given to the city administrations to created in the emerging bus service sector, organize all bus services on the basis of exclu- and a healthy competition has developed, sive route franchises. These franchises were particularly for the rapidly growing minibus allocated through a competitive tendering pro- services. Private operators now supply more cess that was open to private companies and than 50 percent of all urban transport ser- associations of small owner-operators, as well vices. A bus route franchising system is now as state-owned enterprises. Tendering was also being implemented in Tashkent. the responsibility of a special commission in Source: World Bank 2002, 10. 246 Municipal Finances consultant reports). They may fill selection — The suitability of the goods, equipment, or committees with personnel ex officio, who services purchased lack expertise and sometimes have a vested — The useful life and durability of the goods interest in supporting one specific candidate. or equipment • Contracting. Even the best ToR and selection would fail if the contract signed is weak and — Operation, maintenance, and servicing costs does not protect the local government’s inter- — The administrative costs of the selected ests. Sometimes the selected partner provides purchasing method what is alleged to be a standard contract and insists that it is the best, used by many munic- — The delivery period ipalities, and has no room for improvement or — Future transportation costs change. Accepting such a contract is a danger- ous practice. Often just the opposite is true: the — Storage costs “standard contract” is neither standard nor — The time it takes to procure the goods. best. In short, a municipality must prepare its own contract (hiring a good lawyer, if needed), • Transparency. The people have a right to must ensure the best conditions, protect its assurance that correct procedures have been own interest, and negotiate hard. applied, and the primary tool to deliver that assurance is transparency. Not only does trans- Procurement Principles parency in procurement assure the public that Sound principles of public sector procurement the correct procedures are being employed, will contribute to strengthening local govern- but it also encourages suppliers to compete ments’ administration by controlling expen- for the contracts that the government and its ditures and improving the delivery of public agencies award. Transparency in procurement services. Some basic principles of public sector procedures also helps to reduce the risk of procurement include the following: fraud and corrupt practices. • Lowest evaluated bidder. Procuring entities are • Accountability. Accountability is a keystone of under pressure to select the bidder offering any procurement system. It is used to ensure the lowest cost. But most procurement sys- that officials undertaking tasks carry out their tems specify selecting the contractor offering responsibilities with the due diligence that is the best price for the specifications required— owed to both the government and the people. or the lowest evaluated bidder. Governments need to be wary about selecting a contractor • Equity. All eligible suppliers should receive offering an unrealistically low price: expe- notice of all procurement opportunities. The rience suggests that such a contractor will principle behind this is to ensure that all attempt to increase the bid price through a national and international bidders, suppliers, series of change orders or will provide goods contractors, and consultants have a fair basis or services below specified quality. on which to compete for contracts funded by the government. It eventually helps save • Value for money. Value for money is a mea- money too. sure of the efficiency with which the financial resources of the government are used. Value • Effectiveness. The ultimate role of a spe- for money is represented by a number of fac- cific procurement exercise should always be tors, not only price; for example: remembered: Procurement is only a means to Managing Local Expenditures 247 achieve a specific objective. Any procurement much of the country and is comparatively expen- that fails to facilitate the objective of the pro- sive. However, e-auctions and e-procurement for curement is ineffective. public projects have recently begun to emerge. Other e-governance initiatives include some • Efficiency. Government should never overlook in the realm of commerce. To reduce person- the need for speed and efficiency in the pro- to-person interactions between businesses and curement process. The more that nonessential government officials, it is becoming increasingly administration encumbers the procurement common for countries to offer business license process, the more funds are diverted from applications and submissions online. In the meeting the government’s primary objective. developing world, where governance processes The longer the procurement process takes, the are many times dysfunctional, many countries are higher the real cost to the government. simply digitizing dysfunctionality. • Ethical standards. Everyone involved in pro- curement activities must comply with the Contract Management government’s code of ethics. Although the par- Too often, the management of contracts ticular provisions of the code will vary, they made with customers, vendors, partners, or should include a stipulation that no individual employees is delegated to engineering or pro- shall use his authority or office for personal curement units, with little or no involvement gain. That includes accepting or requesting by the financial and legal staff. This is a critical anything of material value from bidders, pro- error. Contract management includes three crit- spective bidders, or suppliers, for the individ- ical areas: (a) contract structuring, negotiation, ual, his or her spouse, parents, children, other and signing; (b) contract monitoring during close relatives, or any other persons through implementation; and (c) releasing payments (or whom the individual might gain direct or indi- collecting dues). Local governments in devel- rect benefit from the gift. The code should also oping countries often fall short in all three address issues such as conflicts of interest, areas. Box 5.12 presents points to remember for disclosure of personal relationships, and con- successful contract management and some rea- fidentiality and accuracy of information. sons why some entities fail to manage contracts successfully. E-procurement Contracting. The contract is critical in pro- “E-procurement” is a nickname for electroni- curement. Contracts are vital in ensuring cally managed procurement processes, in which compliance with terms and conditions, as well as all phases of a procurement are completed on the documenting and agreeing on any changes that Internet or by electronic means. The municipality may arise during project implementation. Many announces the project by calling for expressions local governments often go into contracts with a of interest, then issues a request for proposals limited understanding of the financial and legal through the Internet. Likewise, the bidders are implications. Doing that is particularly dangerous supposed to submit their bids electronically and in public-private partnerships, many of which receive confirmation and results digitally. More have failed because of disproportionate allocation and more governments are experimenting with of risks, responsibilities, and financing between e-governance systems in efforts to reduce cor- the private and public partners. A famous case ruption in government procurement. In the case was the Dar es Salaam water public-private part- of Thailand, progress toward such a system has nership, which failed in three years. Eventually, been limited because Internet access is limited in the private partner walked away, leaving the 248 Municipal Finances Box 5.12 Key Elements for Successful Contract Management • A documented plan for managing the con- budget monitoring procedures, resource tract to ensure a focus across the organiza- management, forward planning, manage- tion on delivering value for money ment reporting systems, and asset • Key performance indicators to measure management and drive the performance of suppliers Why Do Organizations Fail to Manage • Detailed agreement on the required out- Contracts Successfully? puts and the expected performance and quality of service to be delivered • Poorly drafted contracts • Monitoring whether the service is being • Inadequate resources assigned or available delivered according to specifications and to the contract management team to make sure that the costs of the service • The government or customer team does are no higher than expected not match the supplier’s team in skills or • Continual assessment and management experience, or both of risks to service delivery and ensuring • Appointment of the wrong people, leading that business continuity plans are in to personality clashes place, so that critical services continue • Poor understanding of the context, to be delivered through a range of complexities, and dependencies of the contingencies contract • Regular testing and price benchmarking to • Failure to check supplier assumptions pre- ensure achievement of value for money sented in their proposal • Clear legal procedures to implement finan- • Lack of clarity in the authorities and respon- cial penalties in the event of poor supplier sibilities related to commercial decisions performance • Lack of performance measurement or • Administration and change management benchmarking by the customer activities focusing on cost monitoring • Failure to monitor and manage retained and forecasting, ordering, payment and risks (statutory, political, and commercial) Source: Authors, based on World Bank 2005. city with huge costs and a water supply system reports must be scrutinized thoroughly and without an operator. progress verified on-site by a municipal engi- Contract monitoring. Contract monitoring is neer to ensure that payments are released based particularly important in implementing large on verified progress and the completion of work infrastructure projects. It includes monitoring invoiced. Not only do developing countries fall expenses and the stages of physical completion to short of good municipal capacities, but the capac- ensure that the two are moving at the same rel- ities of construction companies and construction ative pace. Municipalities with limited capacity monitoring firms are weak too. An infrastructure often contract out construction monitoring, in investment capacity assessment in Pakistan found which case the one doing the monitoring must that the shortage of construction capacities (engi- be monitored too. In critical phases, progress neers, skilled workers, machinery) was a greater Managing Local Expenditures 249 impediment to infrastructure development than management. These systems play multiple roles lack of funds (World Bank 2007). in the life of local governments. This section Cost control and release of payments. From focuses on their role in expenditure management. the expenditure management perspective, the most critical area of contract management is con- Accounting Systems trolling contract implementation and releasing Budgets are not the product of accounting payments on a timely basis consistent with the systems. After the budget has been approved, contract. More important, payments should be the accounting system will record and report based on verified progress. The World Bank has on the actual results, so that comparisons to the introduced technical audits to complement finan- budgeted amounts can be presented and the cial audits to monitor where and how money is activities of the authority controlled (discussed in used in Bank-funded infrastructure projects. chapter 3). Accounting systems must be designed Variation orders. Some contractors may offer to provide management with timely information a low initial price for services, goods, or work that can be used to control the activities agreed to (perhaps by a narrow margin) and later propose in the budget and which are within the capacity changes or variation orders because of unfore- of the institution and its staff to operate. seen expenses. Some expenses might be truly Figure 5.7 shows a copy of a daily report from unforeseen, such as a drastic change in fuel prices the automated financial management informa- or special situations underground that cannot be tion system (FMIS) of Chiniot City, Pakistan. The detected during planning. But too often, change mayor and the chief financial officer receive a orders are a means for the contractor to increase snapshot every morning; they can also access the the price of the contract (and the profits) to com- reporting system remotely (from home or while pensate for an unrealistic initial proposal. traveling) through the Internet. Change or variation orders are also a common form of corruption. Thus, requests for technical Internal Control Environment variations are not matters only of engineering Among the most important reasons to have a but need close scrutiny by the financial staff, who strong internal control environment is to reduce have the power to reject invoices and delay or exposure to corruption risks. Corruption is deny payments if unjustified expenses or fraud is technically defined as the abuse of entrusted suspected. Change orders are usually associated power for personal gain. Notice that this defini- with the physical work, but financial manage- tion is not limited to the abuse of public office: ment also needs to be involved to determine the corruption can occur in transactions between impact of cost increases on the budget and financ- private parties as well. ing. Finally, if change orders are due to slow pay- A problem encountered by nearly all anticor- ments, that is an administrative issue that needs ruption efforts is that corruption is very difficult to be examined with an eye to efficiency, as well to measure accurately and comprehensively. That as for any indication of kickbacks. makes it difficult to track progress toward com- bating it. So the goal of anticorruption efforts should be to reduce the prevalence of corruption Expenditure Management Systems by making it more difficult and costly to engage Local government entities manage expendi- in such practices. To do that, one must recognize tures through various systems and instruments, that corruption is not a transactional problem but including those for accounting, internal control, rather an institutional problem. In places where cash management, procurement, and contract corruption is rampant, selectively punishing 250 Municipal Finances Figure 5.7 Daily Financial Snapshot: Financial Management Information System of Chiniot City, Pakistan Source: World Bank 2008. people for individual acts will not change the • Increasing transparency of all financial and underlying environment that makes corruption operational information prevalent in the first place. • Use of hotlines for the public to report service But whereas corruption is intrinsically difficult delivery or other concerns to fix, local governments can reduce their expo- sure to corruption risks and make it more difficult • Increased use of technology to increase auto- for such transactions to take place. An effective mated transactions. expenditure management system, with robust internal controls and monitoring and evaluation The situation described in box 5.13 illustrates systems, is critical in a local government (see box the dynamic nature of corruption and the impor- 5.13). Moreover, management must constantly be tance of vigilance by all government officials for aware of “red flags” indicating that weaknesses in signs of weakness in the control environment, the internal control environment have resulted which if not addressed could lead to corrupt in increased vulnerability to corruption. Actions behavior. that management can implement include the following: Cash Management The cash management function is generally • Analysis of variances between planned and found in the finance or treasury office under actual financial and operational performance the management of the finance director.1 The • Trend analysis and comparative trend analysis objectives of cash management are to bring of the movement and variation of transactions funds into the local government’s finance between cities or sections of the same city that office or treasury as quickly as possible, pay cannot be explained the funds out as efficiently as possible, and Managing Local Expenditures 251 Box 5.13 Bypassing an Integrated Financial Management Information System to Embezzle Public Funds The government of an African country that we checks that were used extensively with the have worked with implemented an integrated previous accounting system. In addition, the financial management information system Office of the Auditor General had not required (IFMIS) for the central government and the that its representative permanently working major local governments. Among the local in the capital city offices rotate after the spec- governments to implement the new system ified number of years, in contravention of its was the capital city. The early evaluations of normal procedures. the implementation were positive. A feature After several years it was discovered that of the system strongly supported by the city the city treasurer was, on a regular basis, treasurer was that no disbursements could writing manual checks on the pension fund be made unless the item had been budgeted account to a fictitious company. In collabora- for and all required documentation had been tion with the town clerk, checks were received and approved by the responsible deposited with a colleague working for a official. As the system had been designed by commercial bank, in an account controlled by a major international software company and the town clerk. Because the auditor who had the evaluations from the first round of imple- not been required to rotate from his position mentations had been positive, confidence was also involved with this scam, these peo- was high that the internal control environ- ple were able to steal a substantial amount of ment in the capital city had been improved. money from the city before they were eventu- However, it was later learned that the city ally caught and sentenced to jail. treasurer had never destroyed the manual make effective use of the funds until they are some of the benefits of efficient local government needed for operating expenses. This office may cash management. have one employee responsible for the entire Local governments collect money owed in a function. Depending on the size of the local variety of forms and from a large number of loca- government, the functions may be organized tions. It is one of their main functions. Revenues so that one employee is assigned to collections come from fines, fees, taxes, licenses, permits, and bank deposits, other staff process disburse- and special assessments. It is important that ments, and still others are concerned with internal control procedures be developed and short-term investments. regularly updated to ensure that all funds owed Whether the system is centralized—which are properly collected and reported. All receipts means that one department is responsible for all (revenues) should be received in a timely manner, collections—or decentralized, prudent internal credited to the proper accounts, and deposited in control suggests that the finance official responsi- the correct bank account as quickly as possible. ble should limit the number of offices that collect As discussed in chapter 3, modern, computer- revenue and should implement procedures to ized accounting systems and integrated financial protect the government’s funds and enforce effi- management information systems can greatly cient cash management practices. Box 5.14 lists facilitate bank reconciliations. 252 Municipal Finances Box 5.14 The Benefits of Efficient Cash Management • Efficient cash handling and control sys- • A wide range of financing instruments— tems increase certainty that payments are Treasury bills and other short-term made properly by the due date and that borrowing and lending—gives a govern- receipts are passed without delay to the ment greater flexibility in how best to man- responsible bodies. They also reduce oper- age its financing needs; it is able to avoid ational risk and the scope for mismanage- the risk of high borrowing costs associated ment or fraud. with less flexible arrangements. • By minimizing the volumes of idle cash • Active cash management policies, by off- held by government bodies, most of which setting flows in and out of the ministry of is unlikely to be fully remunerated, and finance account at the central bank, reducing the payment authorities (and remove one of the major influences on checks) in transit or awaiting clearance, short-term changes in money market the government gains direct savings in the liquidity. This in turn reduces one of the ele- form of borrowing that is no longer ments of uncertainty in the central bank’s needed. liquidity forecast and therefore makes • The linkage of government accounts (so monetary policy interventions less prob- that balances are netted through a single lematic. More generally, it can reduce the account at a bank) not only reduces gross volatility of short-term interest rates and balances, but improves visibility of flows— uncertainty in money markets. opening up opportunities for active • Efficient cash management contributes management—and reduces risk, whether to the development of an efficient short- through exposure to the banking system or term securities market, as well as being to financial market movements. facilitated by it. Source: World Bank 1998. As stated earlier, expenditure management Cash flow fluctuation. Accurately predicting systems are intended to increase the efficiency of the peaks and valleys of cash flows is one of the local governments and reduce the overall cost of most difficult aspects of cash management. A providing services. Collecting revenue is one cash flow forecast is a schedule of expected of the major areas where efficient systems can receipts and disbursements for a given period. have a big impact on the cost of doing business. The types of forecasts prepared and their If collection rates are allowed to decline, the frequency will depend on several factors. result is a “tax on the local government.” The Governments with predictable cash flows and uncollected portion of rightfully owed revenues sufficient cash reserves can usually get by will reduce the amount of funds available for with  an annual forecast. An annual forecast providing services. An example of a cash forecast provides an overview of the expected cash is presented in table 5.11; the cash balances can be position by month. Most governments prepare reconciled with the bank deposit balances of the an annual forecast and use it to make longer- municipality. term investment decisions. Managing Local Expenditures 253 Table 5.11 Simple Annual Cash Forecast (thousands of dollars) Opening Cash category balance Jan. Feb. Mar. Apr. May …. Dec. Total 1,000 1,000 Property tax 250 250 300 100 900 Land tax 50 25 75 Other revenue 10 15 10 100 135 Payroll expense –25 –25 –25 –25 –25 –25 –150 Other current expenditures –10 –10 –10 –10 –10 –10 –60 Capital expenditure –150 –100 –575 –825 0 Net change 265 250 115 –120 –600 165 75 End balance 1,265 1,515 1,630 1,510 910 1,075 1,150 Local governments with volatile cash measure the quality of administrative systems in positions, erratic cash flows, or changing demo- public finances and compare them at an interna- graphics may need more frequent and detailed tional level. forecasts. A monthly cash forecast estimates weekly cash positions and helps monitor the Public Expenditure and Financial accuracy of the annual forecast. It is more oper- Accountability Assessments ational than an annual forecast. This type of fore- Public Expenditure and Financial Accountability cast is common because most local governments assessments aim to support reforms in expen- experience fluctuating cash flows and liquid- diture management, as well as other aspects of ity problems. A weekly forecast estimates daily public financial management. The results of each cash positions and can help in monitoring the assessment are reported in concrete and standard accuracy of the monthly forecast. It can be use- terms. PEFA lays down three main requirements ful for governments that need to monitor their for sound financial management: cash positions closely. As presented in chapter 3, • Discipline: Public finances must be dealt with modern computerized accounting systems and in a disciplined manner. integrated financial management information systems can greatly facilitate the preparation and • Strategy: Resources must be allocated in accor- monitoring of cash forecasts. dance with strategic objectives. • Efficiency: Tasks must be performed efficiently. Measuring and Improving Expenditure Management Performance In an attempt to reduce the overlap that One problem for local government officials is existed in measuring countries’ financial man- the lack of opportunities to learn from the expe- agement performance, the Public Financial riences of other governments. That problem is Management Performance Measurement Frame- being addressed through Public Expenditure work was developed through extensive con- and Financial Accountability Assessment (PEFA), sultations between donors and governments. It a program that provides a diagnostic tool to was designed to be an integrated framework to 254 Municipal Finances measure and monitor countries’ public financial for one of the indicators in the PEFA municipal management systems, processes, and institutions assessment2 are shown in table 5.12. over time. It has recently been adapted and used in a small sample of municipalities. The individ- Municipal Audits (Municipal Financial ual items in the framework are scored on a basis Self-Assessment and Urban Audits) and of A (good) to D (not so good), and aggregate Municipal Contracts scores are developed from the scores on the sub- Municipal audits are another monitoring tool items. Since its creation, a large number of assess- for enhancing transparency, accountability, and ments have been conducted, and many more performance in local finances. The World Bank are in various stages of preparation and plan- has introduced municipal audits in a number ning (see http://www.worldbank.org/WBSITE of Bank projects and the MFSA template and /EXTERNAL/PEFA). methodology are increasingly being used by local The municipal assessments prepared by PEFA governments in various regions of the world. The include ones for the canton of Lucerne and the Municipal Finances Self-Assessment (MFSA), city government of Addis Ababa. The reports con- which uses some PEFA indicators, goes into tain rich reviews and discussion of expenditure municipal finances in greater details, includ- management by the two local governments and ing (a) assessment of the financial situation of a also findings developed by the assessors using municipality; (b) review of revenues and expendi- the PEFA methodology that has been developed tures on an annual basis; and (c) identification of for municipalities. The assessments are useful for specific, monitorable measures for improvement finance officers in other local governments both (details are discussed in chapter 8). Municipal to learn more about the methodology at the local audits can be completed as self-assessments or government level and also to learn how other using third-party experts. governments are addressing, or not, issues that Along with the MFSA or independently of it, are generally common to all local governments. the Urban Audit (methodology developed by the The scores achieved by the city of Addis Ababa World bank and customized to local contexts by Table 5.12 Cash Flow Assessment from Addis Ababa Public Expenditure and Financial Accountability (PEFA) Assessment Indicator Score Explanation Predictability of availability of funds for commitment of C+ Single dimensional scoring method expenditure. 1. Degree to which cash flow forecasting and monitoring B A cash flow forecast is prepared for are carried out. the fiscal year and updated quarterly. 2. Reliability and time horizon of the periodic information B Entities of the city government of during the year providing the ministries, departments, or Addis Ababa are provided with a agencies (MDAs) with information about maximum limits reliable indication of actual resource and payment commitments. availability for expenditure commitment a quarter in advance. 3. Frequency and transparency of the adjustments made C Budget adjustments of various to the budgetary allocations available at a level higher amounts are frequent during the than MDA administrations. fiscal year (for last two fiscal years), and they are made transparently. Source: Authors, based on World Bank 2005. Managing Local Expenditures 255 Box 5.15 Summary of Results of Municipal Contracts in Senegal and Mali A World Bank-financed project in Senegal illustrated by the fact that nearly 25 percent (The Urban Development and Decentralization of project costs came through cofunding. Program UDDP/Programme d' Appui aux Municipal contracts have served as a platform Communes - PAC) has reached a large num- for donor harmonization in the country and for ber of municipalities (and citizens) through the channeling bilateral and multilateral interven- signing of municipal contracts and has suc- tions. Greatly contributing to the positive ceeded in funding and supporting a large num- results has been the fact that the project was ber of urban development projects. More implemented in a time when the political envi- important, the project has contributed posi- ronment was supportive of decentralization. tively to long-term capacity building and insti- New legislation on decentralization had tutional reform in local governments in urban recently been introduced, and municipalities finance and organizational management. were willing to cooperate. Financial capacities of the municipalities have In comparison, the municipal contract increased considerably, and positive results approach was less successful in Mali. Despite were achieved in broadening the tax base and the satisfactory implementation of the physi- increasing local tax collection. cal component of the project, in provision of The project changed the behavior of many urban services and investments in infrastruc- municipalities in these areas, with a positive ture, the institutional reform and capacity- impact on the sustainability of the results. -building component did not achieve the Ownership by the Senegalese central govern- expected results in large part due to lack of ment and the municipalities was strong, supervision and monitoring. Source: VNG International 2010, 42. local users themselves) can be a powerful invest- cities to improve their expenditure management ment programming tool. It aims to help local through a municipal contract that manages and governments (1) assess their level of services and regulates relations between the state and the infrastructure, (2) locate and quantify the gaps local government. A municipal contract has as and (3) prioritize and select municipal invest- its foundation a comprehensive analysis of the ments programs. Both audits/self-assessments municipality’s characteristics, its urban features. contribute to enhance transparency, participa- and its organizational and financial capacities tion and accountability in the decision-making (MFSA + Urban Audit). The analysis enables process over what and how priorities should management to establish priorities for invest- be financed, shedding light on the use of public ments, programming, and the funding needed to funds in the municipal space. support the operation of municipal services and Municipal audits can form the basis of any needed adjustments to the municipal staff- municipal contracts. Municipalities may sign ing and organizational structure. contracts with their central governments con- taining performance indicators defined by the Managing Capital Expenditures municipal audits and supported by performance grants. Box 5.15 presents a summary of municipal Managing capital expenditures is somewhat contracts in Senegal and Mali. The audits enable different from managing current expenditures. 256 Municipal Finances All the rules discussed in the context of current but financial feasibility and expenditure control expenditures are valid in managing capital must be the driving forces. Often, after financial expenditures, plus two more: evaluation of capital feasibility is scrutinized, the engineers need to go investment projects and procurement and contract back to work out details of the preferred modality. management. Because of the bulky nature of cap- Capital projects can be evaluated using a vari- ital projects, procurement of development and ety of methods—and in fact should be done that construction services and contract management way—with varying levels of sophistication. We are vital in managing capital expenditures. The introduce the three most common methodolo- opposite is also true—procurement and contract gies. They are net present value, internal rate of management is important in managing some return, and cost-benefit analysis (each relies on current expenditures, such as purchasing fuel, discounting the cost of the benefits of proposed energy, water, or office stationery in bulk. investments to present value). The payback rule Managing capital expenditures is again an and average accounting return are other meth- area in which local governments in developing ods that can be used, but they are not described countries are lagging and thus often experience in detail in this material. These methods will be substantial losses. For example, at the advent of revisited in chapter 7, which discusses external computerization (and perhaps also today) it was sources of financing in assessing viable capital common for each school in a city to receive a investment projects. Other useful methods also small budget, go to the next-door shop, or maybe exist that are not discussed here. a friend’s shop, and buy information technology The need to use these methods in evaluating equipment. Some clever cities moved in a differ- capital projects applies not just to those that gen- ent direction: they combined all the computer erate revenue directly, such as water and sani- needs for schools, offices, and other entities and tation, slaughterhouses, and markets, but also issued a tender to buy, say, 200 computers and 50 to those that are expected to generate increased other pieces of equipment (printers, servers, etc.). economic activity, such as roads. In each case, With competitive tendering, they may have saved the expected financial or fiscal benefits and the 30 percent or more of the costs, or they could increased operating and maintenance costs must have bought 30 percent more equipment from be compared to the initial capital investment the same budget. The same thing could happen to determine the relative financial or economic if a water main needed to be replaced and the merits of a project and evaluate competing invest- next-door entrepreneur is selected, behind closed ments. These issues are discussed in more detail doors, for the construction work. in chapter 6, on asset management. Evaluation of Capital Investment Projects Net Present Value Procurement of capital investment projects is In evaluating any capital project, it is important intertwined with the evaluation of the projects, to determine how much value is added or created before and often during the tendering process, as by undertaking it. The difference between the the companies bidding are often requested to add value added (usually increases in cash flow) and their knowledge and assist in selecting the final the cost of the investment is the net present value form of the project. These decisions require com- (NPV) of the investment. Since the cost of the paring project alternatives in both technical and investment usually occurs in year one (or at least financial terms. The process is iterative; it may the first several years), and the increases in value start with drafting two to three main technical to a government (in the form of increased cash options and discussing them with stakeholders, flows) generally occur in the future, it is essential Managing Local Expenditures 257 to bring this stream of benefits back to their pres- Internal Rate of Return ent value so that they can be accurately compared The internal rate of return (IRR) is the most to the cost of the investment. The future value is important alternative to net present value. As with brought back to present value by applying a dis- the NPV, one must compare investments, usually count rate to those future streams of cash flow. in year one, to benefits in the form of increases in The discount rate (it is also called the “reference” cash flow in future years. However, whereas the or “hurdle” rate) that is used in making this calcu- discount rate in the NPV is a known value (the lation, in the case of a local government, could be cost of capital), with the IRR, the discount rate is the cost of borrowing long-term funds. An invest- what makes the NPV of the net cash flows from ment should be accepted if the net present value an investment equal to zero. Based on the internal is positive and rejected if it is negative. rate of return method, an investment is accept- The concept of present values is discussed in able if the IRR exceeds the required return (hur- detail in chapter 7. Briefly, however, the purpose dle rate) and should be rejected if it does not. of present values is to compare the future of cash Example: Let us again take the example of the flows of alternative investments (positive or neg- two pieces of road grading equipment and calcu- ative) by applying a discount rate to bring them late the internal rate of return for each. The IRRs back to present value. Once the future cash flows confirm the results from the NPV analysis, namely, are discounted back to the present, management that the heavy duty machine is the best option. It can compare alternatives more accurately and has a 15.2 percent internal rate of return, whereas decide which would be better. The discount rate the economy machine has only a 13.8 percent IRR. (or hurdle rate) is generally the entity’s cost of Both IRRs are higher than the hurdle rate (the capital. For a government, the discount rate would cost of long-term borrowing for the city), but the be the rate at which the government can borrow. better machine is financially better too. Table 5.14 To further complicate an already difficult con- summarizes the results and calculations. cept, the discount rate used to calculate the pres- Whereas the net present value is the more reli- ent value of future cash flows should, if possible, able of the two methods and always indicates the correspond to the life of the asset. For example, in correct alternative investment, in practice, the evaluating investments with a 10-year life, the dis- IRR is frequently preferred because it provides a count rate should correspond to the rate at which single rate that can be more easily compared to the government could borrow funds for 10 years. cost of borrowing, rates of inflation, and so forth. Example: The department of public works is comparing two models of road grading equip- Cost-benefit Analysis ment for its maintenance unit. The heavy duty Cost-benefit analysis is a policy analysis tool that model that costs $30,000 will result in estimated uses both NPV and IRR methodology. The objec- net cash flows of $9,000 per year for the next tive of a cost-benefit analysis is to quantify the five years; the economy model costs $20,000 and total costs of a project over its lifetime and com- would raise net estimated cash flows by $5,800 pare them with the value of the total benefits that per year for the next five years. The hurdle rate are expected from it. This is done by discounting is 10 percent. Table 5.13 summarizes the results to present value the estimated stream of benefits and calculations. The calculation shows that the and the stream of costs, and then comparing the heavy duty model is superior because the NPV present value of the costs with the present value is $4,117, versus $1,977 for the economy model. of the benefits. As can be imagined, it is extremely Furthermore, since the NPV exceeds zero, the difficult to calculate accurately the lifetime cost heavy duty model should be purchased. of an investment or its corresponding benefits. 258 Municipal Finances Table 5.13 Net Present Value Analysis of Two Equipment Models (dollars) Hurdle rate 10% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 NPV = ¬ Yi − Y0 Initial investment, heavy duty model 30,000 Revenues (net cash flow) 9,000 9,000 9,000 9,000 9,000 Discount factor d = (1 + 0.1)n 1.10 1.21 1.33 1.46 1.61 Net present value CF/d –30,000 8,182 7,438 6,762 6,147 5,588 4,117 Initial investment, economy model 20,000 Revenues (CF = net cash flow) 5,800 5,800 5,800 5,800 5,800 Net present value CF/d –20,000 5,273 4,793 4,358 3,961 3,601 1,987 Note: NPV = net present value; CF = cash flow; d = discount factor; i = years from 1 to 5. Table 5.14 Internal Rate of Return Calculation Hurdle rate 10% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 NPV = ¬ Yi − Y0 IRR calculation HD 1.152 1.327 1.529 1.761 2.029 PV (IRR HD = 15.2%) –30,000 7,813 6,782 5,887 5,110 4,436 27 IRR calculation economy 1.138 1.295 1.474 1.677 1.909 PV (IRR Economy = 13.8%) –20,000 5,097 4,479 3,936 3,458 3,039 8 Note: IRR = internal rate of return; HD = heavy duty; PV = present value; i = years from 1 to 5. Table 5.15 Sensitivity Analysis (dollars) Sensitivity analysis using data from table 5.14 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 NPV = ΣYi – Y0 12% less net cash flow 7,920 7,920 7,920 7,920 7,920 NPV of the heavy duty model −30,000 7,200 6,545 5,950 5,409 4,918 23 12% cost overrun −33,600 8,182 7,438 6,762 6,147 5,588 517 Therefore, it is essential to apply some judgment or number of other methodologies used in mak- in the form of a sensitivity analysis. ing those calculations. The objective of a sensitivity analysis is to Sensitivity Analysis select those assumptions that are the most criti- While each of these methods, and the others cal to the evaluation, such as a sales price, labor mentioned earlier, will provide a clear indication rate, or collection rate, and assume different val- of the best investment alternative for a particu- ues for them, higher and lower than the base case lar project, capital expenditure analysis is only scenario (see table 5.15). as good as the assumptions used in making the Example: Using the results of the road equip- calculations. What is the probability of correctly ment investment analysis from table 5.13, one estimating the exact stream of benefits from any can test, first, the impact of a possible risk, that capital project? Or what is the probability of cor- the net cash flow gained using the heavy duty rectly estimating the additional operating costs machinery would be 12 percent less than the and the timing of those costs? For that reason, it is base case scenario. Table 5.15 shows net pres- essential to accompany any evaluation with a rig- ent value of $23. Thus, this investment would orous sensitivity analysis, regardless of the type remain feasible as long as the net cash flow does Managing Local Expenditures 259 not drop below $7,900 per year. Second, one budget estimates that reflect existing government can test the impact if the machinery eventu- policies. Local governments do not normally ally costs about 12  percent more than planned, make use of an MTEF; their use of multiyear bud- say, because of a change in  foreign currency gets generally accomplishes the same objective of exchange rates. The results in table 5.15 show linking policies to expenditures over a three- to that the investment would remain feasible, or five-year time frame. even a bit better. One can say, though, that the The PEFA assessment report for the difference between the two sensitivity results is city of Addis Ababa stated that a three-year not significant. medium-term expenditure framework was intro- duced at the city level for the first time for the budget of 2007/08. The assessment indicated that Medium-Term Expenditure the MTEF includes revenues and expenditures Framework—Multiyear Budgets and is rolled out every year. The section on capi- In many cities, budget preparation has become tal expenditures3 is classified by sector and covers highly informal—ad hoc measures are used to road, education, health, water and sewerage, land deal with financing and implementation difficul- development, and other categories. ties; expenditures outside the budget are com- mon; and multiple budgets are produced with Multiyear Budgets to Support a Policy no single comprehensive budget. Cost estimates Environment that the various city departments submit do not As indicated in the discussion of the expendi- attempt to reflect any policy objectives or strate- ture management cycle, policies should lead the gic benchmarks; they simply represent uniform budget process. However, it is difficult to budget increases over the previous year. And because for new programs, whatever they may be, within most of these cities operate with a single-year a one-year budget. A multiyear budget enables budget framework, every year the budgeting pro- local governments to continue with their normal cess starts from scratch. Chapter 3 offers a more budget preparation processes and present in the comprehensive discussion on budgeting. outer years the introduction of new policy initia- tives. The multiyear format enables governments Medium-Term Expenditure Framework to present new revenue policies to support new What is done by the central government’s services (expenditures) that are needed to sup- medium-term expenditure framework (MTEF) port new policies and programs demanded by the needs to be clearly differentiated from what is population. done by local governments. Central govern- A multiyear budget is prepared in the form ments typically rely on a medium-term expen- of a rolling budget, in which the first year has diture framework that is a rolling, three- to the same level of revenue and expenditure five-year budget, which links policies to expen- detail found in a normal budget and the outer ditures. An MTEF has the potential to link the years have more tentative numbers designed to often-competing short-term imperatives of gov- demonstrate commitment toward a particular ernments with the medium- and longer-term set of policies and levels of expenditures. Moving demands of the budget. In technical terms, an outward from year one to year three, the revenue MTEF is a framework for integrating fiscal policy and expenditure estimates become “softer.” As and budget procedures over the medium term by year one is nearing completion, the budget esti- linking a system of aggregate fiscal forecasting to a mates for year two (now the next year) become disciplined process of maintaining medium-term firmer, and an additional year, year four, is added 260 Municipal Finances Table 5.16 A Multiyear Budget • Proper management and sequencing of the Category Year 1 Year 2 Year 3 Year 4 process for assessing policy considerations by the municipal cabinet. Revenue Property tax 100 105 Capacities Necessary to Implement a Land tax 10 12 Multiyear Budget Other 5 A multiyear budget requires program managers Total 115 117 120 and department heads to design and plan their Expenditures activities around established government policies Salaries 45 47 48 and priorities. It forces managers to demonstrate Material 10 11 how proposed activities relate to government and Maintenance 3 3 sector objectives. Because it is a plan to support Total current 58 61 62 prioritized programs over multiple years, the expenditures budget becomes the main vehicle through which Capital 25 26 27 the local government implements agreed-upon expenditures policies and fulfills its mission. To implement a multiyear budget process, a to the planning horizon. A simple example of a local government must be able to do the following: multiyear budget is presented in table 5.16. • Establish clearly defined policy objectives, The chief characteristics of a multiyear budget along with the desired outputs and impacts. are the following: • Design public programs and targeted services • It is a medium-term fiscal framework that to bring about the desired outputs. provides revenue forecasts for a three- to five- • Calculate a realistic estimate of the resources year period and also forecasts the economic needed to properly implement the programs. environment in which it is anticipated that the budget will be operating. • Develop an effective mechanism to coordinate with various departments and special inter- • It contains spending projections that are con- est groups (including harmonization of donor sistent with revenue projections. activities). • It links budget allocations to program impact. • Have budget discipline. • It includes a robust monitoring and evalua- • Have procedures for estimating the forward tion program to develop an impact analysis costs of programs. and provide feedback for the review of policy • Implement an effective monitoring and evalu- objectives. ation system that provides policy makers with Key mechanisms that promote strategic deci- critical information regarding the effective- sion making by core decision-making bodies are ness of the programs. the following: • Generate political leadership committed to improving expenditure management systems • Consultation and debate on policy issues and procedures and increasing the level of • Transparency and accountability transparency in government. • Decision making that is underpinned by A multiyear (program) budget differs from the resource availability traditional line-item budget by focusing on Managing Local Expenditures 261 the expected results of services and activities, What about the public sector? What is the rather than on inputs such as salaries and objective of a government, and how does it supplies. In a program budget, revenues and achieve it? In democratic societies, governments expenditures are linked to multiyear programs exist to provide services that neither the market that meet the municipality’s goals, objectives, nor individual citizens can adequately provide. So and strategies. Significantly, a program budget the outputs of a government are the services that identifies the anticipated results and outputs it provides. of investments. Ideally, a program such as a Chapter 3 reviewed the various types of neighborhood street and sidewalk improve- budgets. Traditional or line-item budgets are the ment program should be clearly delineated, most common, but performance-based budgeting have minimum overlap with other programs, is receiving more attention because it focuses on be results oriented, and lend itself to quan- outputs rather than inputs. As discussed in chap- tifiable measurement. Planning, budgeting, ter 3, budgets can be of several kinds: line-item, administrative control, and reporting will be performance, and program (summarized in tables carried out within the framework of this pro- 5.17 and 5.18). gram structure. Some of the problems that have been encountered with multiyear pro- Traditional to Performance-Based Budgeting gram budgeting relate to having good baseline Budgeting is a way of estimating and allocating data, methods to gather the data, and specific, resources to achieve an objective of a local gov- well-defined targets (see chapter 3 for a more ernment in delivering services. Performance- thorough discussion of program budgeting). based budgeting establishes accountability by linking the commitments of the executive branch, The Shift toward Performance-Based which agrees to achieve stated results in return Budgets for continued funding or other incentives. It also The output of a private sector company is the makes governments more accountable to citizens. product that it sells, and the aim of that company Performance information helps policy makers is to maximize profits through the sale of its prod- put a monetary value on programs. Performance- uct. The company has an incentive to improve the based budgeting forges a link between planned quality of its output, as higher-quality products activities and outcomes. lead to higher sales revenue. The company also In summary, performance budgets use state- has an incentive to minimize the cost of produc- ments of missions, goals, and objectives to ing its output, as cost efficiency and high-quality explain why money is being spent. It is a way to expenditure management lead to lower costs and allocate resources to achieve specific objectives higher profits. The objective of the company is to based on program goals and measured results. make money, and it accomplishes that by produc- Performance budgeting differs from traditional ing and selling its output (Coca Cola sells soda; budgeting because it focuses on results rather Toyota sells cars, etc.). than the money spent and on what the money Table 5.17 Types of Budget Formats Format Character Organization Purpose Line item Commodity/service inputs Items purchased Control Performance Activity/workload Tasks/outputs Management Program Public goals across agencies Outcomes/customer response Planning 262 Municipal Finances buys (results) rather than the amount that is Those negotiations rarely reach issues of effi- made available. ciency and effectiveness. Performance-based bud- The major elements of performance-based geting is not just about performance. It is instead budgeting are defining goals and objectives, a process by which a particular type of budget is developing measures of performance aligned with prepared. Performance-based budgeting should those goals and objectives, linking spending deci- be viewed as having the following six steps: sions to results (outcomes), and accountability • Identify desired outcome. for results. In recent years, the emphasis on out- comes and the importance of delivering the ben- • Define the data necessary to measure perfor- efits of agreed-upon programs to their recipients mance and the systems needed to collect the and participants has made performance-based data on a regular basis. budgeting a hot topic. Table 5.19 illustrates the • Select an outcome performance measure. logic behind the hierarchy of inputs, outputs, and outcomes or performance. • Set a goal. In many ways, the need for and attraction of performance-based budgeting come from the • Report results. shortcomings of the traditional budgeting process, • Implement consequences. which results in a negotiation between managers and funding authorities over relatively small per- It is hard to refute the theory of centage changes from the previous year’s budget. performance-based budgeting. Unfortunately, the process is complex and frequently difficult to implement. Some of the issues that need to be Table 5.18 Flow of Service Provision overcome include the following: Nature of service provision Street repair • Identifying and developing the right perfor- Inputs: Line items: mance measures and indicators Labor, materials, and Tons of gravel; • Developing accounting systems to support equipment contractor payments performance-based budgeting Activity: Performance: Street repair Lanes paved • Creating incentives for decision making based Program result: Program outcome: on performance Increased speed and Reduced commuting • Getting the needed “buy-in” from all branches safety of travel time of government Table 5.19 Performance Budgeting Logic Model Outcomes Inputs Outputs Short term Medium term Long term Staff costs Workshops Awareness Behavior Conditions Materials Outreach Knowledge Decisions Environment Equipment Inspections Attitudes Policies Social Technology Skills Economic Civic Managing Local Expenditures 263 • Overcoming the concern of agencies that too entire entity, such as a local government. However, much attention is focused on a small number many local governments use performance-based of indicators budgeting for certain activities or departments because it is important to link expenditures • The difficulty of measuring outcomes, espe- to agreed-upon policies and programs. The cially intermediate ones U.S. state of North Carolina implemented performance-based budgeting in its local • Incomplete understanding of the relationship governments. between expenditures and outcomes. Example: The city of Sunnyvale, California, Because of its complexity, it is uncommon U.S., has adopted a performance-based budget to see performance-based budgeting used for an for improving child-care services. Box 5.16 Box 5.16 Performance-Based Budget for Child Care Improvement in Sunnyvale, California Service Delivery Plan 52404—Facilitate Child Care Services Facilitate the Child Care Program by:—Staffing the Child Care Advisory Board;—Monitoring child care legislation;—Conducting advocacy/leadership activities; and—Coordinating and monitoring existing child care support services, so that: FY2001/2002 FY2002/2003 FY2003/2004 Service Delivery Plan Measures Adopted Adopted Adopted • Served Child Care Advisory Board 0.00% 85.00% 85.00% Members rate staff support as “good” 85% of the time • 90% of the Child Care Advisory 0.00% 90.00% 90.00% Board work items are completed according to Council’s approved work schedule • Served collaborative agencies rate 0.00% 85.00% 85.00% staff support as “good”85% of the time Costs Products Work hours Product costs Activity 524009—Staff the Child Care Advisory Board Product: A Work Plan Completed FY 2002/2003 Adopted $18,494.14 1.00 338.23 $18,494.14 FY 2003/2004 Adopted $19,181.38 1.00 338.23 $19,181.38 (continued next page) 264 Municipal Finances Box 5.16 (continued) Costs Products Work hours Product costs Activity 524010—Monitor Child Care Legislation Product: A Bill Tracked FY 2002/2003 Adopted $10,461.35 6.00 180.39 $1,743.56 FY 2003/2004 Adopted $10,838.66 6.00 180.39 $1,806.44 Activity 524011—Conduct Advocacy/Leadership Activities Product: An Activity Completed FY 2002/2003 Adopted $15,408.38 1.00 270.58 $15,408.38 FY 2003/2004 Adopted $15,935.43 1.00 270.58 $15,935.43 Activity 524012—Coordinate and Monitor Existing Child Care Support Services Product: An Organization Monitored FY 2002/2003 Adopted $10,789.93 4.00 202.94 $2,697.48 FY 2003/2004 Adopted $11,213.66 4.00 202.94 $2,803.42 Totals for service delivery Costs Work hours plan 52404: FY 2002/2003 Adopted $55,153.80 992.14 FY 2003/2004 Adopted $57,169.13 992.14 Source: www.sunnyvalecity.com. summarizes a portion of that budget. The pro- Variance Analysis gram includes situation analysis, performance Revenue and expenditure levels need to be targets with outputs and outcomes, and specific reviewed regularly—monthly or quarterly—to actions with specific budget allocations. ensure that they conform to the budget and to determine if they are on track to achieve the stated policy objectives. An activity can be ana- Monitoring and Evaluation lyzed in a number of ways, in terms of both finan- Monitoring and evaluation are the next stage of cial and operational performance, but an analysis the expenditure management cycle, although of the variances between planned and budgeted they could be important both during (midterm) amounts and actual results is arguably one of the and after implementation of the annual budget best methods. or specific projects. A number of instruments Given that budgeted levels will generally be and methodologies are used for monitoring and different from actual levels, explanations of the evaluation. This section briefly discusses three, resulting variances should be restricted to those namely, variance analysis, comparative cost anal- that exceed a certain percentage, such as plus or ysis, and benchmarking. minus 10 percent of budget. Table 5.20 shows a Managing Local Expenditures 265 Table 5.20 Variance Analysis Category Budget Actual Variance Variance (%) Explanation Revenues Taxes 10,000 10,500 500 5.0 Grants 15,000 10,500 −4,500 −30.0 Delayed or canceled? Total 25,000 21,000 −4,000 −16.0 Expenditures Labor 4,500 4,600 −100 −2.2 Material 3,000 2,800 +200 6.7 Unpaid bills? Total 7,500 7,400 +100 1.3 case in which four items vary by less than the Example: It is possible to compare costs per 10 percent threshold but the category grants dif- ton of waste removed, costs per child educated fers significantly because of delays; the cost of from kindergarten through ninth grade, costs materials indicates substantial savings that might per kilometer of road maintained, and so on. The be a result of unaccounted bills. comparisons in absolute terms will not mean When the planned level of activity—developed much because each city or part of a city has dif- after extensive review during the budget ferent characteristics, such as being farther from process—is compared with the actual results, the the landfill, for example. But they can indicate variance provides useful information to decision areas of expenditure that need more examination. makers. However, variances, small or large, do Comparisons can also provide interesting lessons not by themselves explain the underlying reasons, regarding procedures to control costs or improve such as whether the budget preparation process services that might be transferred to other areas. was flawed or the environment for the activity has For example, fuel consumption by solid waste changed. Thus, the variance analysis is just a sig- trucks (or any other truck) should be monitored nal that must be followed by specific inquiries and on a daily basis and irregularities investigated. corrective measures; those may include changing If one or two trucks of a 20-truck fleet consume the budget plan by issuing a supplementary bud- much more fuel than the others, say, 30 percent get or warning the respective departments to to  50 percent above average, an inquiry would exercise more stringent expenditure control. establish whether the use of those trucks has changed, whether they need urgent engine main- Comparative Service Delivery Costs tenance, or even the possible theft of fuel. It is difficult to compare two objects and draw firm conclusions, but if the two objects are Benchmarking Service Delivery Standards generally similar, such comparisons are possible. The task of expenditure management is to ensure That would be the case for comparisons of basic that the funds available to local governments are urban services, such as the costs of solid waste spent on improving service delivery and achieving removal, street lighting, and education, provided objectives efficiently and effectively (Helgason in different cities or in different parts of the same 1997). However, what is the level of service that city. Service comparison can provide useful infor- was agreed to? How much solid waste removal or mation, but the contextual differences among street cleaning constitutes an acceptable level of locations must be understood. service? Benchmarking is an instrument that can 266 Municipal Finances be used to improve the performance of the public benchmarking partners. Finance departments sector and the services that are provided. can support such initiatives by helping agen- Benchmarking is becoming a central instru- cies to find benchmarking partners and to ment for improving the performance of the public achieve relevant expertise. sector. Under the right conditions, comparisons Experience has shown that both approaches can be an important driver of performance. The have value; governments should develop pro- basic idea behind benchmarking is simple: cedures to apply both. For example, externally • Find an organization that is best at what your imposed benchmarking may give incentives for own organization does. organizations to initiate more detailed process benchmarking. Benchmarking projects driven • Study how it achieves those results. internally may increase the level of commitment • Make plans for improving your own and ownership of the management and staff in performance. the particular department. In designing departmental benchmarking • Implement the plans. efforts, consideration needs to be given to the fol- • Monitor and evaluate the results. lowing questions: In other words, benchmarking is an attempt to What is benchmarked? identify and implement best practice. Although the idea is simple, putting it into practice may • Processes be more complex and challenging. Knowledge • Results of differences in performance can be an impor- tant incentive for improvement, but achieving Against what is an organization benchmarked? improvements will still require significant effort and leadership. Moreover, it is not sufficient to • Other organizations copy practices from other organizations. Best • Standards practices have to be evaluated and adjusted to the needs of an organization. How is benchmarking used? Benchmarking has been introduced into the • For continuous improvement public sector through two main strategies: • A top-down approach, in which benchmarking • For evaluation is imposed externally, usually by central gov- A close relationship exists between results ernment agencies, such as the finance depart- benchmarking and process benchmarking. Results ment or another agency. Externally imposed benchmarking identifies the processes that need benchmarking can be used by a department to improvement. Process benchmarking improves set targets for one of its subsidiary agencies. In the processes, contributing to better results. this case, benchmarking can be used instead of Organizations can be benchmarked against more direct control by introducing competi- other organizations or against a standard. tive pressures. Benchmarking against other organizations • A bottom-up approach, in which local govern- is an important source of learning, as organi- ment departments or service entities (such zations are constantly challenged by devel- as a water utility) develop their own bench- opments in other organizations. However, marking projects and try to find appropriate benchmarking is not copying. The interaction Managing Local Expenditures 267 between the organizations involved can be an of many organizations. Benchmarking against important source of improvement. a standard can be an interim step toward Box 5.17 explains the growing importance of benchmarking against other organizations, International Organization for Standardization particularly if many organizations bench- (ISO) standards and certificates, also a kind mark themselves against the same standard. of benchmark, in the local government sector. The organizations can then compare their Benchmarks that are identified by an organi- scores against those of other organizations, zation can become a form of “best practice” identify their weak and strong sides (or pro- standard. Benchmarking against standards can cesses), and seek to reduce the weaknesses by be important, as standards or quality models benchmarking their processes against those of are in many cases based on the best practices better-scoring organizations. Box 5.17 International Organization for Standardization Certificates— Improving Municipal Performance and Cost Control ISO is the well-known acronym of the with companies that meet a set of rigorous International Organization for Standardization, standards. a nonprofit organization headquartered in The vast majority of ISO 9001 certificates Geneva, Switzerland, that develops and pub- are issued for private firms as part of their lishes a wide range of standards and issues quality compliance; they are particularly useful ISO certificates, often via partner domestic in international trade and services. However, entities. The ISO 9000 family of standards is municipalities and their utility companies are related to quality management systems and increasingly obtaining ISO certificates in the designed to help organizations ensure that United States, Europe, and the developing they meet the needs of customers and world. For instance, many municipalities in other stakeholders while meeting statutory Eastern Europe have obtained ISO certifica- and regulatory requirements related to the tion, including ones in transition countries product. such as the Czech Republic and Hungary. ISO 9001 deals with the requirements Municipalities in the United States typically that an organization wishing to meet the certify their key service entities, such as those standard has to fulfill. An ISO 9001 certificate for fire protection, water and sanitation, edu- is issued by an independent registrar after it cation, and health, and those overseeing build- has been verified that a company or supplier ing codes or public housing. The ISO helps has implemented the ISO 9001 quality man- streamline services, reducing the cost of agement system and follows all its require- operation, and also lowers the costs of insur- ments in daily operations. Over a million ance and financing. Municipalities in Eastern organizations worldwide are independently Europe start with ISO 9001 certification of the certified. The ISO 9001 certification is recog- entire municipal administration. Some argue nized and appreciated globally because it pro- that it may help them obtain cheaper insur- vides a means for customers to improve the ance or even bank borrowing if a credit rating delivery of quality services by contracting has not yet been obtained. Source: http://www.iso.org/iso/home/about.htm. 268 Municipal Finances By combining the results of the variance anal- Audit and Oversight ysis of expenditures with analysis of the actual service delivery against the benchmarks, manage- Financial and specialized audits are discussed in ment is able to determine its level of efficiency and detail in chapters 3 and 8. Because of the impor- effectiveness in providing services. The example tance of oversight in expenditure management, in table 5.21, which concerns costs of road main- however, it deserves some reference in this chap- tenance activities, provides some useful infor- ter. As stated earlier, expenditure management is mation. The national averages obtained from the shared among different positions in the local gov- road authority can be used as benchmarks: ernment organization. The concept of oversight applies primarily to the members of the local gov- • The cost of resealing was significantly above ernment council and to the central government. the benchmark, probably because of deferred maintenance and bad road conditions (but Role of Oversight in Expenditure that needs verification). Management Oversight is a means of holding the executive • The cost of resurfacing gravel was below the accountable for its actions and ensuring that benchmark, perhaps because of incorrect agreed-on policies and plans are implemented in costing (some costs may be accounted for as an effective and efficient manner. One of the pillars resealing). of a strong internal control framework is a robust • Asphalting was high above the benchmark; system of oversight to monitor the performance this has no logical reason and thus needs of the executive. Normally, the most common inquiry. form of oversight is that provided by the elected officials (the local council, parliament, etc.), but Feedback for Budget Planning realization is growing that communities can also The expenditure management process is driven be significant in monitoring the performance of by evaluations of results, and that is why it is so both contractors and government officials. The important that outputs are specific and measur- role of communities is more prominent in devel- able. They are a critical source of data to begin oped countries that have histories of transparency, developing the next year’s budget. The informa- freedom of speech, and representation. tion developed from the monitoring and evaluation In both long-established and new democra- process, combined with changes and adjustments cies, parliaments have the power to oversee the to the policy framework, enables departments to government through tools and mechanisms that determine more accurately the level of resources typically are outlined in the constitution and that will be needed to deliver the desired level of laws. Legal frameworks vary from one country services and new policy outcomes. to the next, but the oversight functions assigned Table 5.21 Benchmarking Road Maintenance Shillings Kilometers Shillings (millions) (million per kilometer) Activity Plan Actual Variance Plan Actual Variance Actual National average Resealing 25 20 −5 100 105 −5 5.3 4.0 Resurfacing gravel 15 17 2 125 120 5 7.1 8.0 Resurfacing asphalt 5 5 0 150 160 10 32.0 30.0 Managing Local Expenditures 269 to a parliament should also be given to the local annual audits, procurement contracts, and staff government council. It is the responsibility of compensation plans. The site also indicates local elected officials to ensure that their constit- that further work is under way to provide even uencies are receiving value for money. In addi- more financial information to the transaction tion, the principle of subsidiarity applies to the level (for additional information, see http:// oversight provided by the local councils, who are www.fairfaxcounty.gov/finance/transparency). supported by the community, which has a strong Although most local governments may not be vested interest in ensuring that the agreed upon able to provide the level of financial information quantity and quality of services are provided. made available by Fairfax County, they can begin In performing their oversight functions, local to make more information available to increase councils can implement the following practices: the level of transparency as a means to strengthen oversight. • Establish an audit committee to work with independent auditors and review their reports. Expenditure Management and • Meet independently with the auditors to review Political Economy their findings regarding the internal control system and other compliance matters. Local governments operate in a complex envi- ronment influenced by local culture, politics, and • Establish committees to oversee the activities of special interests. Heads of finance departments individuals or a small number of departments. and their staff must be mindful of political pres- • Establish a finance and budget committee to sures while developing and implementing bud- work closely with the finance department to gets, accounting for activities, and monitoring and ensure that the local government is managing evaluating results. One of the best means to mit- its resources and expenditures effectively. igate the risks posed by such special interests is • Meet regularly with constituents to listen to ensure that policies, plans, budgets, and results to their concerns, observations, and possi- are openly provided to all concerned stakeholders ble complaints regarding the performance and community groups. of contractors and the quality of services This expenditure management chapter closes provided. with a brief discussion of the links between expenditure management and the political envi- To ensure that oversight can be implemented ronment. Political influence is intertwined with effectively, information about the workings of most local government activities, in part because government must be available to stakeholders on a local governments always need political support timely basis and in a format that is understandable. and reconfirmation for programs (decision mak- For instance, the financial transparency home ers need political approval). But political influ- page for Fairfax County, Virginia, stipulates that ence also appears without demand for it, and it is the county “is moving forward on providing resi- particularly strong where spending is at stake. dents with more financial transparency. The term financial transparency describes efforts to make Political Pressure from Local Special comprehensive, unfiltered information available Interest Groups to everyone, enabling a clear view of the govern- Expenditure management focuses on ensur- ment’s operations and how tax dollars are spent.” ing that funds are allocated and used to achieve On its financial transparency home page, the agreed-upon priorities and that information is county has provided financial reports, budgets, available to enable governments to plan for and 270 Municipal Finances monitor the performance of their programs and Political Pressure from the Central the impact of their expenditures. Government An effective expenditure management system In many countries, local governments are hin- must include three elements. dered by political and administrative interference from above. The central government can disturb • It is necessary to plan for future expenditures local expenditure management by giving or with- with clear and measurable milestones to mon- holding money, projects, or staff. itor actual performance. Political projects. The most typical problem is • It is necessary to control expenditures so that undertaking projects on purely political bases, the actual spending is consistent with the bud- without consultation with the local stakehold- get and plan. ers. One project proposal sent to a donor for funding literally argued that the “market street • Expenditures need to be monitored and evalu- should be asphalted, because the Governor’s ated to ensure that they are in fact conforming house is located at the end of that street.” to the agreed-on plans. Politically granted projects may create contin- The problem of specials interests is fre- gent liabilities for the local government, which quently not given proper attention in designing must fit their operation and maintenance costs development projects or other investments at into the local budget. the local government level. An example of the Unfunded mandates. Another typical inter- potential impact of special interests is described vention by the central government is to in box 5.18. assign formerly central functions to the local Box 5.18 Potential Impact of Special Interests The U.S. state of New Jersey identified the Macy’s. Thus, the nickname of the project was need to construct a new tunnel linking the “the tunnel to Macy’s basement. ” A new state with New York City. After the required governor of New Jersey stopped work on the environmental studies and technical engineer- tunnel, saying that the risk of cost overruns ing designs were completed, agreement was was placed unfairly on his state. Work was reached that the Trans-Hudson Express Tunnel subsequently restarted because of pressure would be jointly financed by the state of New from numerous sources. Jersey, the Port Authority of New York and Virtually no one questioned the need to New Jersey, and the federal government. expand rail capacity between the two jurisdic- The objective of the tunnel was to increase tions. However, even though the project access for the thousands of people who com- would potentially benefit one company tre- mute daily from New Jersey into New York mendously by requiring that thousands of City. The effectiveness of the tunnel was commuters pass through or near its store questioned by many, however, because it did twice a day, little has been written about that not connect to train stations but ended under impact of this potential special interest in the the basement of a major department store, design and implementation of the project. Source: Based on information from Wikipedia. Managing Local Expenditures 271 governments. This seems to be consistent with both operating and capital expenditures, com- the devolution principle, but the center often fails paring clear and measurable targets to solid to allocate also the corresponding resources or baseline data, and initiating corrective actions taxing power. The result is called an “unfunded as required. mandate.” Similar effects emerge, for example, • Monitoring and evaluation not only measure when a national ordinance increases the salaries and control results but also facilitate cost con- of teachers or other public servants but provides trol and decision making, for example, about no corresponding transfer of funds. The local whether or not to contract out specific services. governments then must cut expenses elsewhere. They often do so by deferring maintenance of • A number of well-tested, effective instruments assets or reducing services. are useful for expenditure analysis, including For example, in Uganda, the Kampala city plan/actual variance analysis, forecasting, and council required privately owned motorcycle benchmarking results to local, national, or inter- taxis (called “boda-boda”) to register their vehi- national indicators. Net present value, internal cles and pay a small registration fee. However, rate of return, and cost-benefit analysis are shortly after this local tax was imposed, the pres- among the most important techniques applied ident abolished it to boost his popularity as he along with a rigorous sensitivity analysis. sought reelection in 2006. Kampala and other local governments were denied a source of locally • Setting, monitoring, and controlling tariffs generated revenue because of political pressure are vital elements of effective expenditure from a politician at center. management. They are useful tools to con- Political interference is not restricted to devel- trol providers, regardless of the institutional oping nations. For example, in the United States, form of service provision, such as department, in 2003, the governor of the state of Virginia legally independent municipal entity, public extended the time that a person must spend in jail utility, public-private partnership, or fully pri- after three drunken driving arrests from five days vate provider. to 15 days. But the local jails are not administered • Cost recovery is a basic principle but by the state government; they are administered by may require subsidizing certain local ser- county governments Thus the directive from the vices, particularly in developing countries. state imposed additional costs on localities that Municipalities in developing countries tend were required to house people in jail for longer to rely on untargeted supply-side subsidies periods. (grants to service entities). In contrast are more explicit, demand-side subsidies that Takeaway Messages target the poor or other communities, while Key messages from this chapter include the requiring full cost coverage by households and following: businesses that can afford to pay. • Expenditure management should be seen and • Modern computerized accounting, budgeting, performed in a cycle of policy setting, plan- and cash and financial management sys- ning, execution analysis, and audit, which tems are key instruments for effective feeds into the next cycle and policy setting. expenditure control. To make these effective, • Effective expenditure management requires a proper internal control environment and close and timely monitoring and analysis of performance-based systems are needed. 272 Municipal Finances • Managing capital expenditures requires Chernyavsky, Andrei, and Karen Vartapetov. long-term planning of both capital investment 2004. “Municipal Finance Reform and Local projects and financing; transparent and com- Self Governance in Russia.” Post-communist petitive procurement; and strong capacities Economies 16 (3), September. for contract management. DANCED (Danish Co-operation for Environment and Development). 2002. • A medium-term expenditure framework is “Solid Waste Tariff Setting—Guidelines a robust instrument for supporting effective for Local Authorities.” Proposal for the expenditure management and for perfor- Department of Environmental Affairs and mance monitoring. It should be combined Tourism, Tanzania, April. with disciplined audits and financial and Ebel, R., and F. Vaillancourt. 2007. regulatory oversight. “Intergovernmental Assignment of Expenditure Responsibility.” In The • Expenditure management is not merely a Kosovo Decentralization Briefing Book. technical process but also a very political Prishtina: Kosovo Foundation for an one. Thus, effective expenditure management Open Society. requires good understanding and manage- Helgason, Sigurdur. 1997. International ment of the political economy implications of Benchmarking Experiences from the plans and decisions. OECD Countries. Paper presented in Paris, February. Notes Kopanyi, M., S. El Daher, and D. Wetzel, eds. 2004. Intergovernmental Finances in Hungary,  1. This section was prepared based on World A Decade of Experience. Washington, DC: Bank 1998, chapter 2. World Bank Institute.  2. More details are available at http://ec.europa .eu/europeaid/what/economic-support Shugart, Chris, and Ian Alexander. 2009. /public-finance/documents/ethiopia “Tariff Setting Guidelines.” Public-Private __addisababa_pefa_report_2010_en.pdf. Infrastructure Advisory Facility (PPIAF), Working Paper No. 8, World Bank,  3. The entire assessment can be found at Washington, DC. http://ec.europa.eu/europeaid/what /economic-support/public-finance Tausz, Katalin. 2004. “Managing Household /documents/ethiopia_ _addisababa_pefa Arrears in Utility Services—Social _report_2010_en.pdf. Policy Challenges and Responses.” In Intergovernmental Finances in Hungary, A Decade of Experience, edited by M. Kopanyi, References S. El Daher, and D. Wetzel. Washington, DC: World Bank Institute. Adrianov, Valentin, Sergei Sivaev, Raymond Struyk, and Emin Askerov. 2003. Russia’s TERI (The Energy and Resource Institute Winter Woes: Tariff Setting for Local Utilities [India]). 2010. Review of Current Practices in a Transition Economy. Moscow: Institute for in Determining User Charges and Incorporation Urban Economics. of Economic Principles of Pricing of Urban Chavez, Carlos. 2002. “Public-Private Partnership Water Supply. New Delhi, India. New Delhi: and Tariff Setting: The Case of Chile.” Paper TERI. for the OECD Global Forum on Sustainable USAID (U.S. Agency for International Development, Paris, April. Development). 2006. Managing Municipal Managing Local Expenditures 273 Services, Assessment and Implementation Select Bibliography Toolkit. Washington, DC: USAID. Farvacque-Vitkovic, Catherine, Lucien Godin, VNG International. 2010. “Effective Aid Roberto Chavez, and Lorence Verdet. 2005. through Municipal Contracts.” The Hague, Street Addressing and the Management Netherlands: VNG International. of Cities. Directions in Development. World Bank. 1997. The State in a Changing World. Washington, DC: World Bank. World Development Report 1997. Washington, Institute of Public Finance. 2008. “Communities DC: World Bank. and Local Government Delivering.” Institute ______. 1998. Public Expenditure Management of Public Finance North West e-Government Handbook. Washington, DC: World Bank. Group, March 2008, Munich. ______. 2002. Cities on the Move, a World Bank Obidegwu, Chukwuma. 2005. The Medium-Term Urban Transport Strategy Review. Washington, Expenditure Framework: The Challenge of DC: World Bank. Budget Integration. East Asia Decentralizes Making Local Governments Work, World Bank ______. 2005. Public Expenditure and Financial paper, Washington, DC. Accountability (PEFA), Performance Measurement Framework. PEFA Secretariat, PEFA (Public Expenditure and Financial World Bank, Washington, DC. Accountability). 2010. Addis Ababa PEFA report, http://ec.europa.eu/europeaid ______. 2007. “Pakistan Infrastructure /what/economic-support/public-finance Implementation Capacity Assessment.” South /documents/ethiopia_addisababa_pefa Asia Region, Report 41630-PK, World Bank, _report_2010_en.pdf. Washington, DC. Shah, Anwar, ed. 2006. Local Public Financial ______. 2008. “Punjab Municipal Service Management. Public Sector Governance Improvement Project.” Staff Progress Report, and Accountability Series. Washington, DC: World Bank, Washington, DC. World Bank. ______. 2011. Guidebook on Capital Investment World Bank. 1991. Urban Financial Management Planning for Local Governments. Urban A Training Manual. By James McMaster, Development Series. Washington, DC: Economic Development Institute. Washington, World Bank. DC: World Bank. 274 Municipal Finances CHAPTER 6 Managing Local Assets Olga Kaganova and Mihaly Kopanyi Local governments own or control large asset many municipalities, particularly in the develop- portfolios, including physical assets such as land, ing world. buildings, infrastructure, vehicles, and equipment This chapter summarizes for practitioners the and financial assets such as investments, owner- main economic attributes of assets; the concept of ship in enterprises, bonds, or bank deposits. Good asset management strategy; and forms, ways, and management of the physical assets is important means of asset management. It underscores that for local well-being for multiple reasons. For asset management should be a defined activity in example, these assets represent the local public a local government and provides a framework wealth; they are the material base for local public and practical tools for good asset management, services. Maintaining and operating assets are the for improving existing practices, and for inter- bulk of local expenses. The assets are important linking asset management with financial manage- resources for local economic development. The ment. The chapter introduces some simple tools financial assets both supplement and support the for financial analysis, indispensable for good asset development and use of the physical assets; management. It also discusses some critical tech- the two main asset clusters can be seen as tran- nical issues, such as how to improve the attrac- sient forms of each other. For example, we can tiveness of municipal land to investors or induce finance a new bus stop from financial savings or competition in land auctions to maximize pro- sell a piece of land to obtain the money; these are ceeds. Some more advanced instruments and typical decisions in asset management. Despite its institutions, such as land-based financing, land importance, systematic asset management is and asset strategy, special purpose corporations, often neglected, with no focal managing entity in and development agencies, are also introduced. Managing Local Assets 275 Municipal Asset Management exchange for money. Large and even midsize urban governments own or control quite large Municipal asset management is a process of and diverse asset portfolios, which typically can making decisions and implementing them regard- include the following: ing operating, maintaining, refurbishing, acquir- ing, or developing physical assets cost-effectively, • Administration buildings and premises (parts with the ultimate objective of providing the best of buildings) possible service to local citizens. In this sense, asset management is among the municipal func- • Public housing tions that have the most direct effect on the lives • Schools and kindergartens of local citizens. Thus, shortcomings in asset management often have visible and painful con- • Medical clinics sequences. For instance, a new water supply sys- • Cultural facilities (libraries, museums, tem is great, but it is painful if, in a few years, theaters) service drops from 24 hours a day to 16, then eight, or even less than two hours a day, as a result • Sport facilities (stadiums, football fields, tennis of poor  maintenance; that is not an uncommon courts, swimming pools) case in Asia. The “asset management framework” • Parking garages denotes a system with rules, procedures, and enti- ties to manage the assets of a local government. • Water, rainwater, and sewerage facilities and networks Classifying Assets • Street lighting Municipal assets exist in many different forms, each of which may require different understand- • Streets, roads, plazas, parks, and forests ing and perhaps a different approach. Thus, classi- • Agricultural land fying assets is the first important step toward good asset management. Several useful ways of classify- • Parking lots ing municipal assets are summarized below. • Vacant land By Material Form • Cemeteries One can distinguish physical (or tangible) and • Farmers markets nonphysical (financial, intangible) assets. The most important physical assets are also known as • Commercial real estate “fixed” or “capital” assets. They include real estate • Production facilities and repair shops (land, buildings), infrastructure, equipment, and vehicles. For the sake of simplicity, this chapter • Storage refers to physical assets simply as “assets,” unless • Landfills reasons exist to use another name or to refer to a specific form of asset. Nonphysical assets include • Cars and specialized vehicle fleets, such as investments, shares of companies, bonds, bills, or ambulances, garbage trucks, and tractors. cash. Physical assets are understood as all kinds of By Ownership resources that the local government can own, Classification by ownership reveals who owns the control, use to produce economic value, or public assets in a municipal jurisdiction. Some 276 Municipal Finances assets are owned by local governments them- law but which reflect the priorities of the local selves; some are owned by the central, state, or citizens (e.g., subsidized housing for low-income provincial government but used by the local gov- families, a sport or cultural center). Service ernment; and some assets have mixed ownership responsibilities are often reinforced by legal (such as state-municipal ownership or public- limitations. private partnerships). The local government may lease some assets from the private sector. By Legal Limitations Classifying assets by legal limitations reveals what By Function local government can do with the asset. In coun- This term stresses what each asset group is used tries that have adopted Roman law principles for. Common categories here may include prop- (e.g., France, Hungary), government-owned prop- erty for administration; for social services (health, erties are divided into two major groups. “Public education, culture); for urban infrastructure domain” implies that the property cannot be (water and sanitation, solid waste management, alienated (sold or mortgaged) and might also transport, communication); vacant land; and carry limitations on its use and management income-generating assets. arrangements (box 6.1 describes a case in Hungary). “Private domain” implies that the By Service Responsibility property can be disposed of and regulated simi- One can distinguish core assets or mandatory larly to a privately owned asset. Although the legal assets important to fulfill local functions pre- rules are particular to a country or region, many of scribed by law. Assets that are not necessary for them aim to distinguish between inherently pub- performing assigned functions are called lic domain property and property that is inher- “non-core assets” and can be considered as ently private domain, which happens to be owned reserved wealth or surplus property (“private by a public entity but can be sold, exchanged, or domain” property). For example, vacant land can altered without a direct impact on services. be used for future urban development or sold to obtain money for funding expansion or renova- Asset Management Approaches tion of core services, such as sanitation networks Asset management appears in two main con- or building a policlinic. Non-core assets can be texts and forms in the life of a municipality. used for services or functions not mandated by Assets can be seen as a group or portfolio or as Box 6.1 Example of Changing the Status of Municipal Property in Hungary An elementary school building is nearly aban- close the school and changes the school doned because of an aging population and zones to ensure school access for all families competition from nearby schools. But it can- affected; (2) it votes to change the legal status not be sold or converted to commercial use of the building to “private domain”; and (3) it because it is a public domain property. then can sell or lease the building for other For its status to be changed requires the purposes. following: (1) the municipal council votes to Source: Kasso and Pergerne-Szabo 2004. Managing Local Assets 277 individual service objects maintained for their sufficient resources to repair three schools may useful life, or “life  cycle.” For example, a road decide to sells some land to generate the money that is maintained and improved can serve to repair the schools. The composition of the people for centuries (or even thousands of asset portfolio will then have slightly changed, years). Both portfolio and life-cycle approaches but the total wealth of the community, espe- are equally important, as they represent differ- cially from the social value viewpoint, ent contexts, times, or situations in the local increased via the reinvestment of the money government’s life. It is also true that various from the land sale in socially significant asset management activities typically belong to property. different local government units. The service or technical units (departments of roads, transport, Life-Cycle Asset Management housing,  etc.) focus on managing assets over The second common understanding of asset their useful life cycle (some might be short; some management implies the strategic management quite long). The finance department, the budget of physical assets during their life cycle. A life committee, and the council need to approach the cycle could be short for a truck, say, 10 years, or entire asset portfolio and making decisions could span centuries. For example, the GT road, a across users, services, and asset forms. 2,500-kilometer (km) major road between Kabul and Kolkata, has existed since the third century. Portfolio Management The term “life cycle” refers to planning, creating In portfolio management, assets are elements of or acquiring, using, managing, and maintaining a the total wealth of the municipality. In portfolio facility and disposing of it when it is no longer management, assets are compared with one required. Managing assets through their entire another and decisions are made to serve the local useful life cycle is particularly important for local community as the material base of the local governments. services and functions. Within this portfolio The cycle suggests perpetual movement. concept, asset management is a process of deci- Referring to the diagram in figure 6.1, logically sions on acquisition, holding, use, refurbishment, the cycle starts at the northwest, with clear or disposition of assets for attaining the goals of a identification of needs, objectives, functions to local government either in financial terms or by fulfill, and the costs and risks associated with expanding or improving local services. Each the selected options (e.g., buying simple, multi- group of assets can be seen as a portfolio within function trucks or special compactor trucks for the total portfolio, and decisions often compare transporting waste). The next section of the alternatives across these portfolios. Physical and cycle includes setting service performance, financial assets are two main portfolios to com- estimating demand, analyzing financial and pare in decisions, such as whether to build water technical options, designing, and procuring. infrastructure or to make a financial investment The next parts of the life cycle include con- in a water company that will build the network struction; commissioning; operation; mainte- and provide water. nance; refurbishment (a road every 15 years), As said, the elements of the portfolio are with continuing performance monitoring; and exchangeable; they can replace or supplement divestiture (as an old truck) or decommission- each other and thus can be seen as transient ing and redevelopment (as the demolition of an forms of money and physical assets. For exam- old school built in the 1920s and its replace- ple, a local government that does not have ment with a new school). 278 Municipal Finances Figure 6.1 Asset Life Cycle Service Identify performance need, standard objective, Demand, risk local forecast Renewal Funding replacement economic modeling Asset Decommission life cycle Procurement Condition performance Construction monitoring Operation service Commissioning delivery Asset Management Functions referring to the list of typical assets shown and Interlinks above, many of them are used for core services No municipality would exist or survive without a that government is responsible for, whether sufficient portfolio of assets, which it needs to they be local public records held in the city fulfill its various vital functions. hall, water service, or schools. The quality of life in a particular jurisdiction and its  attrac- Asset Functions tiveness for people and businesses depend, to a The main reasons why managing assets should be substantial degree, on the quality of public central to local governments are listed below: infrastructure and related services. • Material base. Assets constitute a material • Wealth. Physical (capital) assets normally base for municipal service delivery. Indeed, constitute the biggest share of local public Managing Local Assets 279 wealth, as the example in table 6.1 illustrates. constitute a major expense, especially if they We can see that physical assets are the bulk of are properly maintained and repaired. For the wealth in both of these local govern- example, the cost of operation is the second ments, Los Angeles County and Warsaw, largest after salaries in municipal expenses in Poland. We can also notice big differences in Germany. local circumstances. Warsaw is loaded with land, which is a big reserve, whereas the • Source of revenue. Government property can value of its improvements and infrastructure be a major source of revenues, whether is relatively low. In contrast, Los Angeles one-time, as a sale of surplus property, or owns a much larger share of capital assets in recurrent, including leasing land and com- buildings and infrastructure, and a third of mercial properties or granting concessions the total is in financial assets (including for operating municipal parking lots. equity investments); both play major roles in • Economic development. Local property hold- service delivery. ings are often so large, especially in urban • Liabilities. Assets also can be associated with areas or in countries where land is owned by direct or contingent liabilities. For example, government, that they have a major impact leakage of a main water or sewer line or on spatial and economic development, eruption of an old water main is a liability of including by the private sector. The govern- the owner municipality or its water com- ment can, in fact, have more control over pany. Land that turns out to be contaminated physical assets than over local taxes and may require costly remediation before the fees. government can use or sell it. Real estate • Values beyond the economic value. used as collateral for municipal borrowing Government property can have important has a direct liability risk of being lost if the value other than its “formal” (book or mar- local government fails to repay its loan on ket) value, a factor that needs to be consid- time. ered in decisions regarding some properties. • Operating expenditures. Holding a property For example, an old movie theater in a small incurs costs (electricity, water, cleaning, town that is not functioning and not sustain- repair). Even holding vacant land has some able financially still may have substantial sen- costs, such as protecting it from squatters or timental value for the generation of citizens from illegal dumping. Physical assets owned for whom it was the center of entertainment and controlled by local governments may in their youth. Table 6.1 Assets in the Balance Sheets of Local Governments Asset type Los Angeles County, U.S. (%) Warsaw. Poland (%) Total assets (financial and capital) 100 100 Capital assets, total of which 67 94 Land and easements 28 80 Building, improvements 15 8 Infrastructure 20 8 Equipment 2 NA 280 Municipal Finances • Corruption. Government real estate is histori- Asset and Financial Management cally prone to corruption and conflict of Asset management and financial management interest in many countries. For that reason are  linked in numerous ways. In particular, as managing it requires transparency and good figure  6.3 illustrates, each asset management governance. activity has multiple implications for financial management. For example, if it is decided to Asset Management Interlinked with Other acquire a new property (e.g., to build a school), Areas of Local Governance the project has to be included in the municipali- The idea that local government asset portfolios ty’s capital investment plan; the municipality require special management is just emerging in must identify and secure sources of financing most developing countries. Good asset manage- and process the project through the capital ment requires a multidisciplinary approach. It budget. overlaps with real estate and public financial man- agement and often also involves enterprise man- Framework for Strategic Asset agement (see figure 6.2). Given its nontraditional Management nature, asset management often does not fit well Why do governments need property and infra- into more traditional areas of local government structure at all? The simple and traditional activities, such as budgeting. answer is, to be able to provide services to their Further, as figure 6.2 indicates, good asset citizens according to legal requirements or local management, especially in medium-size and traditions. For example, if primary education or large jurisdictions, requires specific expertise in fire protection is the responsibility of the local both real estate markets and management. Local government, school buildings and fire stations governments need such experts, either on staff or (along with fire trucks) are needed. In practice, under contract for specific tasks. The Guidebook local governments often own properties for many on Packaging and Marketing Municipal Land to reasons. Some property has accumulated histori- Investors, from the Urban Institute, shows an cally by default; some are symbols of power and example of how a real estate company marketed prestige. Some is confiscated because of unpaid municipal land (for more information, see Urban taxes or was abandoned by the owner. Among Institute 2012a). nontraditional reasons for owning property, two stand out: (a) to support local economic develop- ment and (b) to generate additional, nontax reve- Figure 6.2 Interlinks between Asset and Other nues. Another important consideration is that Management Areas the government is a guardian of public property that should be preserved for future generations, such as forests, parks, grazing lands, and Public wetlands. Government financial Strategic asset management of real estate and Real estate asset management management land has four components: inventorying, analyti- cal accounting, portfolio management, and asset strategy and implementation (summarized in table 6.2). If it does not cover these components Enterprise in a satisfactory way, a local government may face management substantial losses either in wealth or in service scope and quality. Managing Local Assets 281 Figure 6.3 Management of Physical Assets and Implications for Local Finance Asset management activities Financial management implications • Capital investment planning Asset acquisition • Capital budgeting • Capital financing • Operation and maintenance expenses Asset holding/use • Income from assets (if any) • Transaction expenses Asset disposition • Capital income For strategic management of municipal engi- asset inventory can be established in various neering infrastructure (e.g., water, wastewater, ways, but it is easiest if there is a reliable land roads), the framework that is conceptually simi- cadastre in the country. Without a cadastre, an lar but adjusted to infrastructure specifics is pre- initial asset inventory can be prepared during a sented in box 6.2. Notice that this framework street addressing survey (Farvacque-Vitkovic et emphasizes that financial planning and life-cycle al. 2006). The survey identifies the general layout management are at the core of good asset of municipal streets, records street length, management. attaches a metric numbering system to the build- ings, and notes the type of use of each plot (resi- Inventorying dential, business, utilities, empty lot, or other Maintaining clear and up-to-date asset records use). If the addressing survey is supplemented and inventories is vital, since we cannot manage with identification of urban fixtures (public something if we do not know it exists. Poor land standpipes, bus shelters, telephone booths, and records encourage corruption, encroachment, the like) or specific surveys of street systems or crime, and health hazards. For instance, hun- utilities, simple use of the address directory will dreds of millions of people live on municipal land provide the basis for an asset inventory. Other without permits (slums discussed in chapter 2), information can be gradually added to the inven- and abandoned land is often used for illegal waste tory, such as the ownership status of the facility disposal, inducing environmental and health or land, property appraisals, and estimated cost of hazards. Protecting municipal property may upkeep. be  costly, but removing people, businesses, or waste  from land is often far more expensive. In Analytical Accounting the  developing world, many municipalities are The analytical accounts on properties are like unaware of the extent of their assets or, at the personal identity cards for the properties (they very least, the property and infrastructure over used to be handwritten on cards). They should which they have domain if not possession. An note key legal and technical information such 282 Municipal Finances Table 6.2 Framework for Strategic Asset Management Inventorying • Develop and maintain comprehensive records of properties owned by the local government (including properties managed and used by various municipal departments and enterprises). Analytical Accounting • Develop and maintain a property management and accounting system on a property-by-property basis (including all revenues, costs, and occupancy/tenant records), specifically for the purpose of asset management (should not be confused with the bookkeeping records). • Include the value of each property in the accounting database and include financial liens against each property. • Formalize in writing the contractual relationships regarding property with all tenants and users of municipal property. • Use private sector property management approaches for improving government property manage- ment. Portfolio Management • Formulate a strategic role for real estate in attaining municipal goals. • Develop classification of real estate by its role in performing governmental functions and apply this classification while conducting an inventory. • Develop and use class-specific financial tools and performance standards. • Monitor property and portfolio financial performance. • Implement a portfolio management approach, including proactive management of social use and surplus portfolios. • Make transparent rules on how municipal property (including land) is allocated to third-party (private, nongovernmental) users. • Develop and implement policies aimed at rationing property demands and consumption by govern- mental departments and social users. • Introduce a transparent process of multiyear capital investment planning. • Make asset managers accountable through regular reporting. Strategy and Implementation • Develop and implement an asset management strategy as a guiding document. • Establish a centralized real estate authority for overseeing or direct control over asset management. • Devise written policies and decision-making roles for the acquisition, holding, and disposition of assets. • Develop in-house real estate expertise and use outside real estate professionals as needed. • Set up incentives for more efficient use and management of municipal property assets. Source: Kaganova 2008. as  size, location, ownership, and use, but also and correspondingly lack strategic manage- any rent contract and revenues; the date, nature, ment. They can only react to negative events, and cost of main refurbishments and replace- for example, having to repair a water main after ments; and even scheduled future renovations it has exploded. Without scheduled cleaning of four to five years ahead. Municipalities in the sewer mains, in many Asian cities from Karachi developing  world often lack analytic records to Dhaka clogged mains cause a mix of storm Managing Local Assets 283 Box 6.2 Essential Elements of the Framework for Infrastructure Asset Management Planning 1. What do you have and where is it 5. When do you need to do it (capital and (inventory)? operating plans)? 2. What is it worth (costs, replacement rates)? 6. How much will it cost, and what is the 3. What is its condition and expected remain- acceptable level of risk(s) (short- and long- ing service life (condition and capability term financial plan)? analysis)? 7. How do you ensure long-term affordabil- 4. What is the level of service expectation, ity (short- and long-term financial plan)? and what needs to be done (capital and operating plans)? Source: Managing Infrastructure Assets, 2005. water and wastewater to back up onto the the direction and nature of development and streets, and people must walk in it for days. Poor expansion of the city, as agricultural land is analytic accounts often mean lack of money set transformed into urban, defining where new aside for proper maintenance. public facilities will be needed. Long-term plans also help the city develop based on citizens’ pri- Portfolio Management orities. A medium-term capital improvement As a basic principle, local governments must aim plan, with specific proposals, signals what to to expand services, and to do that they have to sell for generating money (if needed) and what increase public wealth. The principal rule of port- to build in the next three to five years. Operating folio management is that proceeds from asset with this approach, the local government needs divestitures should be reinvested into another to look at all local assets as portfolios in which form of capital assets. Thus, divestitures should elements are changed, developed, or replaced to be part of a plan to invest for better services or implement the city’s strategy. wealth. Sometimes cities sell properties without The frameworks for strategic asset manage- good marketing and at prices below market ment presented in table 6.2 and box 6.2 are quite because they are in desperate need of cash for ambitious and require time and effort to under- operating expenses. In doing so, they are stand and implement. However, a local govern- consuming public wealth, wealth of the current ment can consider the table and the box menus and future generations. and begin with those items that have the highest priority in local circumstances and are politically Asset Strategy and administratively feasible. Such an approach, Asset strategy has multiple interrelationships tailored to local realities, has worked well in a with other areas of municipal management. It number of transitional countries such as Croatia, is  linked to urban planning, for example, Kyrgyzstan, and Serbia. A subset of activities from through a long-term master plan that indicates the list were implemented, to various degrees, 284 Municipal Finances Box 6.3 Croatian Cities: Initial Asset Management Model 1. Introduction of an information system on the 7. Deregulation of business rentals and improve- property-by-property level ment of rental practices 2. Transitional issues 8. Quantification and monitoring of direct and 3. Property classification indirect property-related subsidies obtained 4. Real estate and business appraisal by tenants and users of local government’s 5. Operating statements for income-generating real estate properties or portfolios 9. Reporting on property 6. Intensive financial analysis of portfolios, prop- 10. Management consolidation erties, and projects 11. Comprehensive asset management plan Source: Kaganova 2008. by several cities in Croatia (Varazdin, Split, Rijeka, council should approve asset strategy for a Karlovac). Box 6.3 summarizes the Initial Asset list of assets above a value threshold that are Management Model, which addressed 11 priority subject to disposition during a coming year, actions from the list in table 6.2. along with a capital investment program. The council may appoint an asset committee of Entities in Charge of Asset Management council and external members to draft strat- Asset management is complex and is usually a egy, policy, and regulations; analyze large, dif- joint activity of units and entities in a local govern- ficult cases; and advise the council on options ment. Even units dedicated to asset management, (see Urban Institute 2012b). such as a property department or a municipal • Regulator. The council issues local regulations company, usually cover just one particular form or that define the rules; for example, a local ordi- segment of assets, such as a municipal land corpo- nance on procedures for leasing and selling ration that manages vacant land. The next section municipal assets or environmental and safety summarizes the work of the main local entities in regulations that affect the use and manage- charge of asset management. ment of assets. The Council The Mayor’s Office The council or local assembly plays two roles in The office of the mayor prepares documents that asset management—it is the highest representa- go to the council for approval and signs major real tive of the local public ownership and chief deci- estate contracts on behalf of the local government. sion maker but is also the highest regulator of The council may also delegate asset transactions asset management in the broad sense. below a certain value threshold to the mayor. • Chief decision maker. The council is the high- est body to approve large-scale, high-value Departments asset transactions, especially those related to Most municipal departments are engaged asset alienation (sales, use as collateral for in  asset  management. A number of them are borrowing) or acquisition. For example, the focused more on portfolio management, such as Managing Local Assets 285 the departments of finance and legal affairs. maintenance, and repair of the physical assets Others deal with individual properties, for exam- used. For example, the department of educa- ple, the departments overseeing works, services, tion is a user of some municipal buildings or and infrastructure. premises and also may share some work with schools that report to it (such as assembling • The finance department (sometimes along with annually the schools’ requests for capital the treasury) defines fiscal targets related to repair funding). asset management for the next budget year, for example, expected revenues from land and • Budgetary units and semibudgetary service property sales or leases or gains from planned units (schools, health centers) are users of reductions in property-related operating properties and often are responsible for their expenses. The finance department or the trea- day-to-day operation and maintenance. sury unit deals specifically with the financial assets, including cash, bonds, shareholdings, Municipal Companies or other securities, for several related reasons. Municipal companies exist in most countries and On the one hand, financial and intangible often hold, use, and manage large portfolios of assets are part of the city’s wealth and assets; municipal land, other real estate, infrastructure on the other hand, they are intertwined with facilities and networks, and movable property the physical assets. Financial assets represent such as equipment, cars, and specialized vehi- reserves that can be used to finance real asset cles. Municipal companies vary widely in pur- investments. Money gained from sale of assets pose and legal (corporate) form. They can be can and should be treated as financial assets, as utilities or specialized companies, such as munic- long as it is not used to fund physical assets ipal land development corporations (discussed again. Investing financial assets is a risky busi- also in chapter 2). ness, and clear prudential rules are required to ensure that the invested money is not lost. In • Municipal companies as independent legal this sense physical, financial, and intangible entities are considered municipal investments. assets are transient forms of one another in Ideally assets donated at the establishment of the asset portfolio. The management of finan- these companies are accounted as divestitures cial assets is discussed further in chapter 7. or invested assets; however, in developing countries the ownership status of many assets, • The legal department often deals with matters such as land parcels or water pipe networks, is related to asset acquisition and disposition; blurred. Thus, most of the physical assets for  example, it will prepare and often sign these companies use are recorded on the bal- lease and sales contracts and keeps all legal ance sheet of the companies, not in local gov- documents related to local government asset ernment folios. Two problems are common in ownership. such cases: (a) local governments do not have • Specialized departments, such as the depart- data on land and buildings held by the compa- ment of works and services, often are respon- nies, whereas the companies may hold more sible for implementing capital investment land than they need; and (b) the property is projects. exposed to business risks if the companies are engaged in commercial activities. • Line departments usually monitor, guide, and represent the users of municipal properties, • Municipal service companies may create with shared responsibility for operation, contingent liabilities for the municipality. 286 Municipal Finances First, the  service responsibility remains on This section addresses the challenges of initiat- the shoulders of the municipality if the com- ing asset management improvement. Four spe- pany defaults; as a result, municipalities often cific steps or groups of tasks are vital in the effort. heavily subsidize their service companies to maintain vital services. Second, the munici- Challenges pality, as the sole owner, has full responsibil- There are four main challenges to improvement ity for the debts and guarantees of its of asset management: The first is the political companies and may default itself as a result of cycle. Good asset management requires long-term a default by its company. Local governments commitment and leadership, which often con- often have partial ownership (some percent- flicts with the election cycle mentality of politi- age of shares) of various corporate entities, cians. A visionary mayor or treasurer is needed to with shared gains and risks. initiate and continue improvement of asset man- agement. The city council also needs to be edu- • Local governments may establish specialized cated on its importance. government agencies that are hybrids of a sort: The second challenge concerns the sequencing they combine a regulatory power of the gov- of actions. There is no obvious or universal ernment with elements of the corporate struc- sequence, and so it has to be defined locally. ture and powers of a company. Examples Intentions should also be tailored to the human include the Urban Renewal Authority of Hong capacity of the local government and its ability to Kong, or the Water Service Authorities in adopt new techniques. Last, better asset manage- India and Pakistan. Such agencies, with mixed ment needs strong ownership of the process; it authority and investor functions, can entail cannot be introduced by consultants. The local intrinsic conflicts of interest and thus are not government needs to internalize the process; recommended for general practice. consultants or providers of technical assistance Public-Private Partnerships can only facilitate or supply approaches, tech- Specific facilities or properties and sometimes niques, and training. Box 6.4 summarizes the case whole portfolios can be managed, during various of Kathmandu, which exemplifies the difficulty stages of the property life cycles, by public-private of correcting previous poor asset management. partnerships (PPPs). Under common good prac- tices, the private partner manages the entity Initial Steps to Improving Asset Management under a contract between a local government and Practical experience shows that initial steps the private partner. Assets either remain in full to  improving asset management include the public ownership (management contract) or following: become part of a joint venture if a separate legal • Identification of problems and areas needing entity is created (more details in chapter 7). improvement. Such an assessment, coupled with recommendations on means to achieve Improving Asset Management in improvement, often requires outside experts Local Government working jointly with knowledgeable people in the local government. For example, energy Asset management is complex and requires efficiency audits are effective new instruments both  professional skill and consistent effort. for asset management improvement. Improving asset management from scratch requires a concerted initial effort and must be • Focal person. Someone in the local government continued as a routine activity over the years. should become responsible for the process. Managing Local Assets 287 Box 6.4 Campaign Asset Management—Road Widening in Kathmandu The recent case of Kathmandu, Nepal, shows enormous volume and value of assets. Road that abandoned assets and inconsistent asset widening is now vital for developing the city, management induce costly corrective actions but it means demolition of structures includ- and severe tensions. The local government of ing all or part of shops, homes, and commer- Kathmandu has not maintained its road assets cial buildings built over decades. or protected its ownership of public roads for The government will provide compensa- decades. The city owns 15- to 20-meter strips tion for only those structures that were built of land along main roads. The roads, however, before the 1977 public notice. As a result, were built decades ago and were narrow, cov- many owners will lose their shops or living ering typically only eight to 10 meters with space without compensation. Huge tensions asphalt road and walkways. The rest remained and demonstrations erupted when the gov- abandoned “no-man’s land, ” with no owner- ernment started bulldozing the illegal struc- ship rights enforced by the city. Encroachment tures, as shown in the accompanying photo on these belts along city roads has grown over (figure B6.4.1). Although as a basic principle time in Nepal. nobody should build structures on public land, The Kathmandu Valley Town Development it would have been better to enforce the own- Enforcement Committee launched a cam- ership rights of the city in a timely manner and paign early in 2011 to widen 400 kilometers of avoid demolishing properties. Because of the city artery roads, based on a notice published desperate need for better roads, the street in Nepal Gazette on July 4, 1977 . The enforce- widening gradually won strong citizen sup- ment followed the ruling 33 years later and port. About half the new roads had been built resulted in the need for demolishing an by the end of 2012. Figure B6.4.1 Demolished Buildings to Enforce Right of Way Source: Himalayan Times, February 4, 2012. 288 Municipal Finances • Task force. If an asset management unit or Grouping Assets department does not already exist, it is not Assets are often grouped in the records by asset advisable to start by creating one. type, by service sector, or by holder or manager Instead,  it  is better to establish an asset (i.e., municipal department). Typical groupings committee in the council or a temporary, might be as follows: cross-department task force on asset man- • Utility and sanitation assets, including sewer agement, under the auspices of the mayor or and water systems, solid waste facilities, and treasurer. municipal electric and lighting systems • Action plan. It is imperative to identify priori- • Highways, roads, and bridges ties and adopt an action plan. The task force  should work according to the specific • Public buildings (in large cities, this portfolio set of priorities established based on the can be further specialized: government use, assessment recommendations. Moreover, the education, sport, culture, public housing, etc.) task force should act strictly according to its action plan (refer to box 6.3 above, on • Land or rights to land Croatia’s experience). • Certain improvements to land other than buildings Inventorying Capital Assets—Step 1 • Certain equipment, vehicles, and furnishings. If inventory records do not exist, inventorying capital assets will be the highest priority for a Table 6.3 shows an example of a basic inven- local government and its task force on improv- tory of buildings. The task force should decide ing asset management. Usually various records what data need to be collected. It is important to exist that can be used as initial sources of data make sure that the data collected and main- for an inventory, such as accounting, land, and tained satisfy practical asset management needs, technical records, though they may be uncoor- and not only formal bookkeeping requirements dinated, inconsistent, and incomplete. The regulated by the central government. For exam- legal department or line departments typically ple, readers will notice that table 6.3 records have some records of existing capital assets such characteristics as building condition and that will be useful to feed into the inventory. occupancy but lacks an important column on Often asset ledgers are maintained by accoun- estimated market value of properties. tants of local governments. Department man- Geographic information systems (GIS) are agers and technical experts can also provide becoming increasingly affordable for local gov- valuable information on the current condition ernments. They help tremendously in the pre- of capital assets. The goal is to identify all cap- cise identification of assets, as well as provide ital assets, arrange them into clusters and logi- interactive maps for strategic planning and daily cal order, and then assemble data for their asset management. However, as summarized in management. If a street addressing program box 6.5, it is better to start simply. Inventorying has been implemented, it will be extremely should be driven by practical asset management helpful for identifying and locating municipal needs and local realities. In places where useful assets. The Urban Audit (discussed in inventory records do not exist, it is wise to start Chapter  5) can be another important tool to the inventory from a simple Excel spreadsheet, help (1) identify/inventory, (2) locate and (3) which later can be imported into a more map existing municipal assets. See box 6.5. advanced database that can be linked to GIS. Managing Local Assets 289 290 Table 6.3 Example of a Basic Building Inventory Building book value, thousands, Current Property Cadastre Total floor Land area, Year of Building local occupancy, NN current function Address number area, sq. m sq. m construction condition currency % Notes 1 2 3 4 5 6 7 8 9 10 11 1 Administrative Chapichi 170,477 7,500 2,600 1985 good 80,670 80 building St, 4 2 Kindergarten local Sevani NA 580 350 1980 satisfac- 3,500 100 government 1 St, 2 tory 3 Kindergarten local River St, NA 990 690 1964 bad NA 33 Repair government 2 57 planned 4 Culture Center Karmin NA 6,500 4,500 1984 bad 61,732 50 St, 39 Municipal Finances Box 6.5 Inventory and Valuation of Built Assets: The Urban Audit Under the Senegal Urban Development and A simple property census and assess- Decentralization Program (PAC), cofinanced by ment of condition can provide an important the World Bank and AFD, urban audits were guideline for scheduling future rehabilitation developed for each local government. The goal and maintenance work. It also complements was to conduct a needs-based evaluation of the infrastructure and services programming the city and use the results to decide on a pri- inventory (IPIE) carried out during urban ority action plan. The audits consisted of a brief audits. IPIE and urban audits were success- evaluation of all properties for which the munic- fully carried out in a large number of coun- ipality has maintenance responsibility, such as tries in West Africa as part of a municipal streets and drainage, administrative and recre- contract model. ational facilities, markets, and the like. Source: Farvacque-Vitkovic et al. 2006. Land and Infrastructure Inventorying • Classification for management, including dis- Land inventorying and inventorying of infra- tinguishing whether properties are core assets structure assets (networks) are usually more used for mandatory functions of the govern- complex than inventorying buildings and prem- ment, are used for noncore activities, or are ises. The basic elements of a land asset inventory surplus property available for future public are as follows: uses (see Step 2 below). • Location of parcel, in address form, and cadas- The land inventory can be compiled as a sepa- tral coordinates with map, if possible rate exercise by the local government, as part of a • Size of parcel in square feet, square meters, national cadastre agency’s systematic registra- acres, or hectares tion that aims to identify and register all private and public land, or as part of a street addressing • Ownership or entity having legal control rights, program. A combination of all could happen; a plus any leasing, right-of-way, deed, mortgage, local government effort to inventory its land, or other legal obligations to third parties coordinated with systematic national registra- tion, can be the most effective approach. • Current use, that is, actual use(s), with the However, experiences show that preparation of a most important distinction being vacant or full land cadastre in urban areas can require a built-up, with further typology for built-up. decade or more. Where a national land cadastre The land use description can be expanded to for public properties does not yet exist, a separate include qualifiers about construction on the inventorying initiated by a local government parcel (legal or illegal; size of building, struc- should be pursued as part of a street addressing ture, condition, and dates of main installation program, regardless of whether some precise and refurbishments). cadastre data might be missing. In either case, • Legal restrictions on development or use, how to organize a realistic and inexpensive pro- including zoning or other limitations on devel- cess will depend on a number of factors, one of opment, use, or sale which is what kind of maps are available for the Managing Local Assets 291 process. The best case is a digital parcel map (according to 5-to-10-year intervals), if known; from the cadastre superimposed on a recent material; and condition. For example, inventory- aerial photo or satellite image. ing of roads by local governments in Ethiopia Developing an asset inventory might be a long included the following categories: and incremental process, and it is important to • Importance: arterial road, subarterial, collec- conduct it by stages and according to priorities: tor, and local (1) list assets, starting from the most important, then (2) gradually add legal, technical, and value • Surface: asphalt, gravel, all-weather (unclassi- data. To continue to be useful, land and building fied), and earth roads inventory records need to be regularly updated to • Size (width): >30-meter reserve; 25–30-meter capture changes in property ownership, land reserve; 20–25-meter reserve; 15–20-meter uses, and legal restrictions. An important issue to reserve; 5–10-meter reserve. address at some moment is to decide in which local department the land inventory database Location of elements can be identified with the should be housed and maintained. help of handheld devices that have become Infrastructure inventorying should start from increasingly available and inexpensive. As with defining key components of the systems to be inventorying land and buildings, it makes sense to inventoried. Typical municipal infrastructure prioritize and stage the inventorying of infrastruc- systems may include the following: ture, and it is important to periodically update the records as a part of asset management. • Water systems: wells, river diversions, dams, transmission lines, water treatment plants, Classify Capital Assets—Step 2 treated water storage facilities, distribution What to do with a particular physical asset pipelines, fire hydrants, pumping stations, and depends on why a city has that asset at all. For water meters example, it may have a school building with a roof • Wastewater systems: collection pipelines, that needs replacement, but by law the local gov- manholes, pumping stations, wastewater treat- ernment is responsible for primary education. ment plants, sewage lagoons, sludge disposal The asset might also be a nonfunctional, decrepit areas old movie theater that is in the municipal portfo- lio for historical reasons, whereas the city has no • Storm drainage systems: canals, ditches, pipe- legal obligations to run movies. These examples lines, manholes, storm water inlets, flood con- illustrate a fundamental principle of good asset trol reservoirs, erosion protection, dikes management, namely, that the asset portfolio • Solid waste collection and disposal facilities: should be aligned with the functions and respon- collection containers, collection vehicles, recy- sibilities of the government. Properties can be cling facilities, landfills usefully sorted into groups according to munici- pal function: • Streets and roads: roadway surfacing, adjoining sidewalks, adjoining lighting, signage, bridges, • Mandatory properties needed for performing traffic control devices, drainage systems. the local government’s functions as stipulated by law Specific basic data will vary for each category of infrastructure elements but in general would • Discretionary properties needed for per- include the length (or quantity) of the elements; forming voluntary functions supported and size (according to some classification); age performed for social, political, or other reasons 292 Municipal Finances • Surplus or income-generating properties not and reasonably minimize their demand for needed for either of the first two but in the space portfolio for historical or business reasons. 2. Minimizing operating costs, without jeopar- Legislation usually defines some functions as dizing property condition and value exclusive or shared responsibilities of local 3. Locating government offices and services in governments. Often, the functions include pro- functional, not prime, areas and in modest, vision of water and sewers, local roads and adequate buildings and facilities parks, cemeteries, preschool and primary education, and local culture and sport. However, 4. Understanding the best use of an asset and very often the law is silent regarding the undertaking cost-benefit analyses to justify quantity or composition of facilities that the governmental use of particular properties government needs to fulfill the functions. For example, exactly which cultural facilities should 5. Investment in the repair and replacement of a government provide? How many sport fields, mandatory properties, as an absolute priority parks, and social (subsidized) apartments? over investment in discretionary and surplus Because the law is silent, those become matters properties. for local government budget and policy to decide. For example, should a local government B. Assets for discretionary functions should be operate and maintain all sports facilities in its optimized by the following: territory? How much of the cost should be 1. Analyzing actual costs and sharing them with shifted to users through fees? stakeholders, to facilitate the best decisions Wise asset management is not just building and maintenance, but also implies adjust- 2. Generating program alternatives to reduce ment  and  remodeling of assets to suit current direct and indirect, property-related subsidies needs and priorities. For example, during recent as much as possible, particularly by means of renovation of a school built in the 1970s, the city the following: of Katowice, Poland, redesigned the internal floor plans, so that usable floor area substantially — Requesting users or their sponsors to main- increased, and new classroom and workshop tain the property themselves spaces were carved from previously unused, — Encouraging users or sponsors to lease empty halls and corridors. unused portions of premises or territory to other commercial or nonprofit entities and Financing Principles and Goals accurately account to the owner for result- For rational responses to uneasy questions ing net revenues, and making appropriate regarding financing assets, it is useful to formu- adjustments to subsidies late financial principles and goals for each group  of properties and follow them in asset — Establishing clear contractual relations management. with the users, which stipulate mutual responsibilities for property maintenance A. Use of properties for mandatory functions and allocation of the costs and revenues should be optimized by the following practices: — Monitoring use and occupancy to ensure 1. Increasing the efficient use of public facilities that unused space is reassigned to more by requiring budget organizations to justify important users Managing Local Assets 293 — Arranging the sharing of facilities by multi- local governments in the developing world have ple groups. no such policies, in part because of the limited discretion of officials and politicians. Lack of C. Use of surplus property should also be optimized: written policies does not imply that there is no policy, however, because existing practices, 1. Leasing property for the most profitable use to whatever they are, always shape some informal, maximize revenues perhaps vague, policy. Table 6.4 suggests key 2. Periodically evaluating the income-generating issues to address and key principles to take into performance of these properties using alterna- account in formulating written asset manage- tive investment benchmarks ment policies (for a detailed discussion, see Peterson and Kaganova 2010). 3. Making selective capital improvements to enhance income generation Ensure Transparency and Inform the 4. Selling underperforming properties to gen- Public—Step 4 erate one-time revenues that can be put to Transparency is a simple, inexpensive, and better use (Such sales need to be timed care- effective way to support good asset management fully, to avoid quick sales in depressed and curb corruption and conflict of interest. In markets.) asset management, many violations of public interests take place at specific moments in the 5. Reducing maintenance costs and liability on property life cycle. The areas prone to violations properties that cannot be leased or sold include (a)  property acquisition or reconstruc- 6. Ruling out investment in acquisition or con- tion; (b)  property disposition (sales); and struction of new surplus properties on princi- (c)  allocation of rights in property to third ple (It is not good policy for local government parties, including rights of use or lease to the to engage in speculative real estate.) and espe- private sector or transfer to municipal enter- cially if capital investment needs of the man- prises. These are the areas where anticorruption datory properties and facilities are not yet mechanisms should be built into the asset man- provided for (A local government should not agement process (Péteri and Schaeffer 2007). invest in building a shopping mall, especially if the local schools or roads are not in perfect Transparency of Information repaired condition.). The simplest form of transparency is transpar- ency of information. Pure facts about municipal Usually, neither the classification nor the property, if properly disclosed, constitute a pow- financial policy principles are required by law. erful instrument to make local governments and However, because this issue is strategically decision makers accountable (box 6.6 summa- important and will have both short- and long- rizes the case of Kyrgyzstan). Hence it is good to term effects on the local citizens, it is recom- introduce at least annual asset reports, presented mended to have the classification approved by the to the local elected body (council, assembly), pub- local elected body. lished, and made available to the public. The report should be factual and specific and should Establish Policy for Good Asset summarize information on property holdings, Management—Step 3 transactions, and investments. Good practice Adopting explicit written policies on key asset reports would contain information and data on management issues is a good practice. Many the following key areas: 294 Municipal Finances Table 6.4 Asset Management Policies Policy issue Key principles to include Valuing and pricing assets for • Market valuation should be required before any transaction, even allocation or disposition among government entities (for example, when municipal land or property is contributed to municipal enterprises or public-private partnerships). • Allocation of surplus property, including vacant land, for private use should take place in exchange for the property’s market value, whether in money or in-kind; any deviation from this rule (giving the property free or for less than its market value) should be preapproved by the elected body. Allocation: Procedures of land • Procedures should be transparent, according to written rules. and property allocation • Allocation should be mainly in the form of competitive procurement, with cases permitting noncompetitive allocation carefully limited by the rules. • Allocations should mainly be for the highest price offered, with other options (such as multiple criteria for choice of winner) limited to special cases only. Rights: Which rights are • Ownership or limited, temporary rights such as leases. allocated • Permitted land uses and mandatory land use parameters (e.g., a flow-to-area ratio) defined clearly before land is allocated. Proceeds: Use of sale proceeds • Revenues from sales of capital assets should be used for capital investment or repayment of long-term debt only, to maintain the wealth of the municipality and share it with next generations. Acquisition: How to acquire land • Acquisitions only according to priorities for capital investment from the private sector preapproved by the local elected body as a part of capital investment planning. • Based on voluntary purchases as much as possible (i.e., minimizing expropriation). • Voluntary purchases should be based on open solicitation of propos- als from private sector sellers. Transparency • Issues of transparency of information on capital assets (see text under Step 4). Source: Peterson and Kaganova 2010. Box 6.6 Power of Information Transparency An inventory of municipal land in one of land, given that land leases made up only Kyrgyzstan’s cities revealed that 86 hect- 11.5 hectares. When this information was ares of municipal land had been allocated to presented to the mayor, he paled, literally, 178 various private land tenants (legal enti- because he immediately recognized nega- ties and physical persons) free of charge, tive legal and public relations implications, which was against the law and also repre- in addition to forgone revenues for the city sented a very large portion of municipal budget. Managing Local Assets 295 Inventory and tenants: Inventory of municipal is  lacking in most countries in general. Hence property assets (buildings, land) directly con- there is a need to educate governments, the pub- trolled by the local government, its budgetary lic, watchdog groups, and mass media. organizations, and municipal enterprises. A directory of public properties (land, build- Financial Implications of Asset ings, premises) used or leased by private and Management nongovernment tenants, with key characteris- tics of tenancy (for how long, at what price or Good asset management has multiple ties with payment).1 financial management and benefits from using Transactions with public property: A directory the tools of financial analysis. Financial manage- of all acquisition and disposition transactions: ment benefits from information generated in from whom acquired, for what price, and through asset management, which can identify forgone what procedure (e.g., public auction, unsolicited revenues as well as financial gains for the munici- bid, debt-equity swap, donation, compensation of pal budget, support service cost reduction, and owners on lost property, confiscation), and file help quantify service efficiency, as well as identify copies of contracts. areas for financial policy intervention. Capital  investments:  Quantitative,  project- by-project information on municipal capital Identifying Potential Gains for the investments. Municipal Budget Let us think for a minute of property-related Transparency of Procedures opportunities for budgetary gains in a city or Another important part of transparency is town. Table 6.5 addresses such opportunities. transparency of procedures and decisions. All rules regarding allocating public property to Financial Analysis of Property or Portfolio nongovernmental users should be in writing Good asset management is not possible without and made available to the public (in an asset financial analysis of properties and portfolios. policy statement). The public should have Some basic analysis tools for improving asset access to key events related to public property, performance are mentioned below (more details such as meetings of city government and in Urban Institute 2012b). This section offers a auctions or opening of sealed bids. brief summary of areas, activities, and tools of financial analysis, including valuation of individ- Mass Media ual properties or portfolios, income statements It is impossible to overestimate the importance on assets, analysis of subsidies, financial analysis of mass media and watchdog groups in build- instruments and methods, financial planning, ing public demand and expectations regarding and life-cycle costing of assets. This chapter transparency. At the same time, ensuring that focuses on how to use these rather than on the public disclosure of information and asset underlying mathematics and financial or statisti- management proceedings are open to the pub- cal theory. lic should not be left to journalists but should be codified in law, or at least local regulations. Valuation Finally, broad awareness and education Knowing an asset’s value is important in many campaigns are needed. Even formulating requests situations: when property is considered for allo- for information or asset management reports cation for a specific use; when its performance is requires some technical knowledge, and that evaluated; when it should be priced for selling or 296 Municipal Finances Table 6.5 Main Asset-Related Revenue and Saving Opportunities from a Budgetary Viewpoint Sources of forgone revenues Potential savings on expenses Operating revenues Operating expenses • Hidden price subsidies to private lessees, • Operation and maintenance of municipal properties users of municipal property (land tenants, and infrastructure is one of cities’ biggest operating retail tenants, NGOs). expenses (in Germany, it is second only to salaries; • Low rent collection rate, below the private in Warsaw, it is about 12 percent to 20 percent of sector benchmarks. the city’s total operating expenses). Optimization of management and operation can save 10 percent to • Self-inflicted limitations on rental revenues 15 percent of this cost without reducing property from municipal land and property, from holdings or outsourcing maintenance and excessive limitations on property use. operations. • Rationalizing property portfolios against need, costs, and benefits (e.g., less floor space per employee, moving two departments or services into a single building, and the like). • Own or lease? Moving to owned buildings instead of leasing space in private ones can be justified in the long term in some cases. Capital revenues Capital expenses • Selling land or property at the bottom of • More efficient capital investment project implemen- the real estate market. tation and replacement of public expenses by • Undisposed surplus properties that could private through PPPs. For example, public land can be sold. be provided to a private developer to build a public parking garage in exchange for the right to use a • Self-imposed limitations on revenues from portion of the site for mixed-use development. municipal land and property sales because of excessive limitations on property use. • Selling a government property that is difficult and costly to maintain (office building, plant) and leasing back sufficient parts of it from the private buyer. Note: NGO = nongovernmental organization; PPP = public-private partnership. leasing out; or when the city needs to estimate The Book Value its wealth, to name a few. Which values do asset The book value of properties functions like a birth managers need to know and why? In this regard, certificate that reflects a one-time, real value there are two groups of government properties. attached to the property; the record remains in For properties that can be alienated (sold), the the accounting ledgers forever. Traditionally, market value (the price a willing buyer would accounting values should by law reflect the offer in fair competition)2 is the key to monitor- historical cost of acquisition or development, ing and controlling performance. As part of the reduced by depreciation calculated by the for- real estate management process, the financial mula defined by central government regulations. performance of each property is evaluated More advanced accrual accounting systems against its market value, often estimated by col- account the depreciation as costs and set funds lecting real transaction prices of comparable aside for future replacement of the given asset. property. They may also incorporate periodic adjustment Managing Local Assets 297 of initial construction costs for inflation or major • Sales comparison. Before putting it on the mar- refurbishment. An important conceptual issue to ket, the potential price of a property can be recognize is that the book value of a property has estimated by collecting price data on similar limited meaning for decision making in asset properties recently sold in fair market transac- management. The book value of a property does tions. If this is the only relevant information not indicate the price a willing buyer would offer, obtainable, there remains the question of how and so it has limited connection to the current similar those sold properties are to the prop- market value unless it was incurred very recently. erty being priced. For local public assets that are not alienable • Income capitalization. This approach esti- under any reasonable assumptions (such as mates the value of the property based on its bridges, roads), the contemporary approach is to revenue stream under its current use. In its estimate the so-called replacement cost, that is, simplest form, this approach uses the formula how much it would cost to rebuild a property or structure of similar quality. One can also estimate the life-cycle cost, which consists of the acquisi- Market value = annual net cash flow divided by a tion cost and the cost of operating, maintaining, rate of return. and repairing the property during its lifetime. The result depends on two main factors: the Estimating Market Value present use and the “hurdle interest rate,” mean- Contemporary property valuation practices rely ing the rate the municipality could realistically on three main appraisal methods or approaches to obtain for a comparable investment. Thus, the estimating market value, each used to the extent estimated market value is adequate to the extent that recent valid and relevant data are available: that the present use reflects the real potential of the building. • Replacement cost. This approach sums the Box 6.7 summarizes the main valuation meth- estimated construction cost to replace the ods used for different kinds of property. building, including architectural and other It is important to remember that the appraisal “soft” costs, and the market value of the land. of a property is only an estimate of its value, Box 6.7 Which Valuation Method to Use? The type of property may influence the selec- • Business rental property. Income capital- tion of an appraisal approach. The following are ization and sales comparison are the most examples: useful. The cost approach may be useful for newer properties. • Apartments and houses not rented. The • Vacant land. Sales comparison is the main sales comparison approach is probably practical approach because there is no best. The cost approach may be helpful, income to capitalize, and there is no con- but for older properties it may require a struction. The approach called “residual large adjustment for depreciation to obtain land value” can be used as well. a helpful result. Source: Urban Institute 2012b. 298 Municipal Finances which  ultimately is determined in the market- mistake. The reference revenue could well be in place. An appraisal based on multiple approaches the range of 400,000 rupees per month. to value is more credible than one based only on a single approach. The projected value strongly Operating Statements for Properties or depends on the appraiser’s perspective. For Portfolios example, if a building generates net revenue of Rational evaluation of the financial performance 20,000 rupees per year, and the hurdle rate of of properties requires information on all revenues return is 9 percent, then it signals a value of about and all expenses associated with each. A standard 222,000 rupees for the municipality. However, a format is an operating statement, which consists willing buyer who feels that the building can pro- of a summary of income and expenses (also called duce 40,000 rupees per year might easily offer an “income statement”). It is important to be flex- 300,000 rupees or more for the property in com- ible in formatting the statement, adding or delet- petitive bidding. This example illustrates that ing classes of income and expenses as appropriate. these valuations are just opinions, and results Box 6.8 presents a template income statement for depend on the reality of the assumptions behind a housing unit, with guiding notes. the valuation. Another lesson is that the munici- It is useful to establish the report so that the pal asset managers should be aware of the ways of actual results can be compared item by item with thinking of willing buyers. the budget and with the results from the previous The most important methodological issue year. For portfolios of homogeneous properties related to valuing local government properties is (such as rental apartments), a portfolio-level to introduce into local government practice the income statement also should be produced. notion of market value, as it is understood in A common problem in many local govern- international practice and in the private sector. ments is that financial performance data are The problem is that some local governments use seldom collected on a property-by-property basis. nonstandard definitions that underestimate the Very often, data are not collected (especially about wealth concentrated in real estate and distort the expenses) or are presented only at an aggregated city’s ability to judge its equity position. level (such as costs of fuel, electricity, or labor). Municipalities often sell a building at a price Therefore, it is essential for the local government that is too low because they do not account for the to introduce and continuously use formats for fact that their present revenue stream is low com- property income statements. Furthermore, all rel- pared to the market. They also have to determine evant revenues and expenses for each property, the hurdle rate to consider—the bank short-term and in particular management and administrative deposit rate, the borrowing rate, the yield of costs, should be included. Sometimes it is difficult bonds? In short, it is wise to compare not only the to attach administrative costs (called “overhead”) market value of a building but also the yield rates to properties. An easy way to overcome the diffi- and revenue streams of comparable assets. For culty is to use one of the measured costs, such as example, what is the revenue base for the planned electricity, or the total measured costs, to distrib- sale of a 5,000-square-meter covered market that ute the overhead costs proportionately. Box 6.9 generates 200,000 rupees per month, when a sheds light on an interesting case of a Nepali comparable market in another part of the city shopping mall. earns 400,000 rupees per month? The discrep- Note that income statements are useful for all ancy might result from poor lease contracts or government real estate properties, not only for corruption, in which case basing the price on rev- income-generating ones. For properties that are enue of 200,000 rupees per month might be a not income generating, such as a city hall or Managing Local Assets 299 Box 6.8 Asset Operating Statement for a Housing Management Unit Operating or income statement for a housing management unit. Notes Thousand 1. Gross potential income includes actual rents and Revenues dollar other income plus amounts that would have been col- Gross Potential 1,000 lected if vacant spaces were leased. This income can Income (1) be further broken down into types of income such as Less Vacancy 50 rents, late payment fees, vending machine revenues, Loss (2) copying charges, etc. If rents are artificially low to pro- Effective Gross 950 vide a subsidy to the tenant, that subsidy may also be Income included as an addition to the amount actually Operating collected. Expenses (3) 2. The amount of rent lost due to vacancy and collection Repairs 100 losses, as well as subsidies in the form of rent reduc- Heat 60 tions. Deducting this from gross potential income Electricity 50 results in effective gross income. Water 20 3. The categories under operating expenses should be Trash Removal 20 modified to include other types of expenses. Some of those listed may be unnecessary and can be deleted. Insurance 30 4. Miscellaneous expenses are those that do not fall into Taxes 50 any of the other expense descriptions but are too Communal Fee 30 small to justify their own line item description. Property 50 5. The category Other may include certain accounting, Management Fee legal, and other charges that are incurred as a result of Miscellaneous (4) 10 the requirements of the owner but that are not neces- Total Operating 420 sary for the successful operation of the property. Expenses 6. Mortgage principal payments require cash but add to Net Operating 530 the wealth of the owner by reducing the outstanding Income debt on the property. Conversely, interest payments, Financing Costs while requiring cash, do not reduce the debt and there- Mortgage Interest 90 fore do not enhance the wealth of the owner. Debt is Overhead Costs a result of the circumstances of the owner. The prop- Appraisal 10 erty itself can operate equally with or without the debt. 7. Cash flow is the amount of cash, positive or nega- Other (5) 5 tive, received by the owner as a result of holding the Total Overhead 15 investment. Net Income 425 Less Mortgage 100 For the purpose of simplicity, depreciation is not consid- Principal Payments ered as an expense in this sample statement, but it (6) should be added as such if a depreciation fund exists in Net Cash Flow (7) 325 which the depreciation is accumulated for future replace- ment of the property. 300 Municipal Finances Box 6.9 Are Local Governments Qualified Owners of Revenue-Generating Properties? Investing in revenue-generating properties is For example, a city in Nepal built a shopping popular among local governments in many complex and quickly leased out the shops in it regions, from Eastern Europe through the for 10 years, at prices below market and below Middle East to South Asia, despite the fact cost recovery level. Then the tenants sublet the that most of the investments generate a min- units at prices 10-fold higher. Now the city may iscule or negative real return. Reasons vary default on its loan because it has no money for and can include inefficient design of a building; debt service. Lesson: financial analysis of a corruption or embezzlement at various stages potential investment should be conducted, and (from construction to lease management); conducted honestly and professionally, well construction cost overruns; below-market before the investment is done; pricing should lease pricing due to confused pricing policies be adequate and enforced rigorously. (for example, is the city holding this property A fundamental issue is that most local gov- to support particular tenants through subsi- ernments are not qualified to be property dized leases or to generate revenue?); poor investors and should not expose public funds enforcement of lease contracts; and simple to the risks intrinsic in investment in commer- lack of expertise in managing commercial real cial property. In other words, it is not good pub- estate. lic policy to invest in commercial real estate. schools, cash flow will always be negative, but it understood; otherwise, inappropriate decisions is still important to know the information for might be made. The asset manager must use judg- comparisons with other properties, especially of ment in interpreting the results of calculations. the same type. Comparing detailed operating costs may make it possible to identify costs that Indicators for Investment Comparison can be reduced. Surplus or income-generating property should be treated as invested property and analyzed against Financial Analysis other feasible investments. The underlying logic A variety of indicators can be used to measure the is very simple and straightforward: the local gov- effectiveness of the management of a portfolio of ernment does not need this property for its core properties and the individual properties in the functions. Property that it retains should produce portfolio. These financial indicators, calculated by returns that are competitive with those of other the asset manager or under his or her direction, available investments, such as bank deposits or provide insights about the performance of the state securities, taking into account the degree of assets and can suggest opportunities for improve- risk. If the property is not generating sufficient ment (for more detail, see Urban Institute 2012b). returns, its performance should be scrutinized to Asset management requires experience, judg- see if and how the performance could be ment, and the ability to analyze and interpret improved. Should the effort fail to produce higher data. Data are useful only if they are properly returns, the owner should consider selling Managing Local Assets 301 the  property and reinvesting the proceeds in R appears more attractive than is justified. Thus, other assets (either financial or infrastructure) or it is important to use realistic value data. using them to repay long-term debt. Before these Net operating income. Net operating income decisions are made, it is useful to consider the real or net cash flow is an absolutely necessary basic estate market cycle. When putting properties up characteristic for any income-generating prop- for sale, it is useful to launch a good marketing erty, because it shows whether the property really campaign. generates net income or in fact generates a net Income capitalization triangle. The income loss. What can be done when an asset manager capitalization triangle is the simplest formula for sees that the income-generating property does analyzing investments: not produce satisfactory returns? First, they should scrutinize the entire chain of property R = I / V, management to find any overlooked opportuni- ties to improve financial results (see table 6.6). where R = capitalization rate, I = income, and Either income needs to increase or expenses need V = (book) value. to decrease, or both. The concept is that each of these three charac- Return on investment. Return on investment teristics can be calculated if the other two can be calculated for each property, or for prop- are  known. In particular, the capitalization rate erty types, or for the entire property portfolio. (rate of return) R can be calculated if annual This analysis is useful because it offers the oppor- income and property value are known (estimated). tunity to compare an individual property with the The capitalization rate can be used as a rough esti- entire portfolio. If a property is producing a mate of investment performance for one year. A return below the average of comparable proper- key for the correct use of this rough estimate is to ties in the portfolio, it should be examined to understand that I (income) should be the net oper- determine if operational aspects of the property ating income, that is, the income left after all could be changed to improve its performance. If expenses are paid out from the revenues gained. no improvements are likely, perhaps the property It must be noted that in the above equation R should be sold and the proceeds invested in other is  dependent on V as well as I. If the estimated assets. value is too high, then R may appear too low. It Likewise, a property performing above the will seem that the cash flow is too low relative to average may be retained as an important compo- value, but it could be perfectly acceptable if a nent of the portfolio. However, it may be perform- lower, more accurate value were to be used. ing in an unsustainable manner and, in its Likewise, if the value is shown to be too low, excellent position, may be a candidate for sale. Table 6.6 How to Increase Net Operating Income Increase income: Decrease expenses: • Increase rent to true market level by auction- • Save on maintenance and repair without ing the lease, upon contract expiration, or compromising property value. renegotiating the current contract. • Reduce utility expenses. • Decrease vacancy time. • Minimize management expenses. • Increase collection rate. • Revise norms for contributions in reserve or replacement funds. 302 Municipal Finances If the property is subject to debt, such as a ranges for different types of properties; for exam- mortgage, then it is important to be careful in ple, residential rental income is usually lower calculating the return on investment. It can be than income from commercial rentals. calculated in two ways. First, we can calculate the return on asset (RoA), meaning the income Discounted Cash Flow Analysis before deducting the interest paid, compared to The discounted cash flow analysis is a more com- the value of the asset, as the performance of the prehensive technique for analyzing income from asset is not changed by financing. The rents and property or investments. It provides an estimate operating costs will be the same with or with- of the market value of a property or project based out debt. Second, we can calculate the return on on estimated future revenues and expenses, equity (RoE), meaning the net income after which are diverse and incurred over time. It is deducting the interest paid, divided by the especially useful when a need exists to make a value of the equity (that is, the value of the asset financially sound choice among two or more minus the amount of the debt). RoA and RoE alternative uses of the same property or among show the performance of the investment differ- alternative investment projects. ently, and it is good to see and analyze both. Figure 6.4 shows a schematic representing For example, a one million dollar property benefits, or revenue inflow, and expenditures, or with a $400,000 debt has equity of $600,000. If money outflow, of a Tanzania landfill over it  produces $100,000 income before interest 20  years and the results of the discounted cash expense, the return on assets is 10 percent flow. The initial investment t0 is negative (blue (100,000/1,000,000). If the interest expense is 8 column). The white field depicts the growing percent of the $400,000 debt, or $32,000, then flow of operating expenses, and the other white the income after interest is $68,000, and thus columns illustrate the periodic refurbishments. the return on equity is 68,000/600,000, or 11.33 The revenue from tipping fees and waste recy- percent. cling starts with zero, during construction of the landfill, and increases gradually as collections Other ratios. The operation statements for each cover a larger part of the city and the number of property allow asset managers to use simple households increases (black field). ratios to compare one property to another within The dark gray column shows the discounted the same category and identify properties that flow of revenues; the light gray shows the dis- perform worse or better than others. Frequently counted flow of expenditures. The investment used ratios are the following: of 1.1  billion shillings is projected to generate 1.2  billion shillings net present value, the dif- Operating expense ratio = total operating ference between the discounted revenues and expense/effective gross income, the discounted expenditures. This investment is projected to have a 21 percent internal rate of or, complementary to that formula, return, against the reference discount rate of net income ratio = net operating income/ 12 percent. Figure 6.4 may help in understand- effective gross income. ing the two important terms used in discounted cash flow analysis, namely, “present value” and Comparisons of line items of income and “internal rate of return.” expense on a per-square-meter basis are also very Present value. Present value is the sum of the useful in comparing rental apartments, offices, or discounted flow of revenue or expenses using a shops. These ratios may be within different reference discount rate (such as inflation, but Managing Local Assets 303 Figure 6.4 Present Value of Costs and Revenues of a Landfill in Tanzania Benefits Discount back to t0 PV benefits 20 years Costs PV costs Discount back to t0 Note: PV = present value; t0 = initial investment. usually higher); the net present value of an invest- Internal rate of return. The net present value ment is the difference between the present values leads to calculation of the internal rate of return, of the revenue and the expenditure flows. A sim- which is an interest rate that would make the dis- ple formula shows how to calculate the net pres- counted flow of revenues equal to the discounted ent value of an asset or investment with a diverse flow of expenditures. In other words, this is the flow of revenues and expenditures, as is typical in highest possible market interest rate that would assets: enable the investment to repay all the expenses without losses, but would not generate net ( R − E )1 ( R − E )2 ( R − E )n revenue. NPV = + ++ , (1 + r )1 (1 + r )2 (1 + r )n Discounted cash flow analysis is based on the premise that money is worth more today than if Where NPV = net present value of the asset one must wait until a later date to receive it. R = revenue flow (all kinds of revenues in each Simply stated, would you rather be given one year 1, 2, … i, …, n) million dinars today or one year from today? E = expenditure flow (all kinds of revenues in Clearly, it is better to receive it today and invest it each year 1, 2, …i, …, n, including cost of for a return during the year. So future revenue is operation, maintenance, and replacements worth less than present revenue. The purchase of or refurbishment) an asset today (or the decision to keep it and r = reference interest rate (such as the rate of receive its value today) entitles its owner to return of similar investments, the borrow- receive the cash flow it produces and eventually ing rate, or yield on state bonds). the proceeds of its sale. The discounted cash flow 304 Municipal Finances is today’s value of the future flow of revenues a  building, usually based on costs (or revenues) from the operation and the eventual sale of the per square meter: asset. The amount of the discount is a percentage • Heating costs per square meter that should reflect returns in the investment mar- ket. A higher discount rate means that future rev- • Water costs per square meter enues are worth less today, while a lower discount rate results in a higher value today. Likewise, rev- • Repair costs per square meter enues further in the future are worth less today • Electricity costs per square meter than revenues received sooner. • Rent per square meter. Occupancy Rate Occupancy is an indicator of the use of prem- The unit cost ratios are useful in comparing ises (usually rental) during a year. It does not properties, provided the properties themselves measure what the tenant does in using the are comparable. Although administrative and space but only that a tenant has the right to use other properties may have no measurable return the space under a lease. It does not measure on investment, their operating costs are subject to whether the tenant pays the agreed rate and on analysis and improvement. This is particularly time. A variation is vacancy, in which vacancy true if the property is comparable to income- % = 100 % of time – occupancy % of time. producing assets in the portfolio. Administrative Occupancy can be measured for each property, offices may be comparable to leased surplus a group of properties, or for the entire offices, for example, and operating costs can be portfolio. compared. Likewise, social housing may not pro- duce market rates of rent, but expenses should Indicators for All Types of Property not exceed those of similar properties that are The above indicators are not relevant for prop- not subsidized. erties that do not produce income, such as The above ratios are useful in energy audits, administrative buildings. It is assumed that which are detailed assessments of energy use by these properties perform a necessary govern- schools, offices, health and sports facilities, and mental or social function rather than generat- so on. They analyze energy use, leaks, and poten- ing revenue. With respect to these properties, tial savings such as insulation of walls, recycling, the asset manager must ensure that they are and so on. As mentioned in chapter 5, International truly needed by the local government and that Organization for Standardization (ISO) analysis they are fully in use (vacancy can be mea- and certification also support energy savings and sured). If not, there may be opportunities to cost reduction, including reduction of building lease portions of them to generate additional insurance fees. income and reduce the burden on the city bud- Deferred maintenance. Underinvestment in get. Likewise, social housing is intended to property and infrastructure maintenance often meet a social need and not to produce a large results in their deterioration and devaluation. cash return, but the income statement is rele- Local governments around the world, but partic- vant for social housing. For social housing and ularly in developing countries, defer maintenance administrative properties, other indicators are to balance budgets and spend the saved money for useful, as shown below. other purposes. Postponing maintenance tempo- Operating analysis. Many indicators can be rarily may be a natural part of life; but it has long created to better understand the operations of and deep negative consequences when it becomes Managing Local Assets 305 a general practice. It is further aggravated when instead of only elders or students. Subsidies are no records are kept on postponed or deferred often not quantified or accounted as a separate items of maintenance. Monitoring deferred main- budget line, remaining hidden among the costs tenance is important. Some rough estimates at of a service provider such as the water company least may be obtained by comparing annual or housing department. That provider then planned and actual expenses on building and requires budget support to cover its annual infrastructure repair. Deferred maintenance losses. remains hidden unless an engineering assess- Rent subsidies are also common, as when local ment and plan spell out maintenance protocols, governments give land or built-up premises to that is, the timing and nature of due maintenance, various private sector or NGO (nongovernmental such as road resurfacing every seven years, truck organization) tenants at below market rents. engine refurbishment after 200,000 kilometers, Under this practice, the local government forgoes or refurbishment of a vegetable market every five potential income (that it could earn by leasing years. The analytical accounts of each property premises at market prices). Such preferential should indicate both the due and the effective rental rates are also, in practical terms, indirect maintenance time and estimated or actual costs. subsidies to the tenants: Quantifying and Managing Property-Related Indirect rental subsidy = (market rent) Subsidies – (actual rent). Subsidies are common in both central and local governments. Ideally a subsidy should be direct Nevertheless, decisions on such indirect and targeted, meaning that the government may rental subsidies are completely political. Decision support a target social group (extremely poor makers should be well informed about the size families, those with disabilities, the aged), a and costs of the subsidies, and the asset managers culture or religion, or a sports event, with a should provide them with that information. transparent, well-defined amount of cash or in- In  particular, for each property, asset managers kind benefits (such as food or the free use of a should know at least the estimated market rent. hall for an event). Subsidies are matters of That allows the size of the subsidy to be policy decision, and they are among the special calculated by estimating the unit subsidy (market functions of local governments. However, sub- minus actual rent per square meter) multiplied sidies can also be hidden, and they can be by the rental area. The template in table 6.7 counterproductive, for example, if everyone is a useful tool to summarize, analyze, and com- benefits from below-cost public transportation municate to decision makers the hidden subsidy Table 6.7 Estimating Indirect Subsidies to Rental Tenants (in shillings) Total indirect Actual rent Market rent Subsidy subsidy to Tenant Address Area (m2) per m2 per m2 per m2 tenants Mr. Smith Main Street 45 50 Shs 90 Shs 40 Shs 1,800 Shs Ms. Brown Post Street 38 50 Shs 70 Shs 20 Shs 760 Shs Clear air NGO Broad Street 120 60 Shs 120 Shs 60 Shs 7,200 Shs Total forgone revenue 9,760 Shs 306 Municipal Finances provided to organizations in the form of dis- Financial Planning counted rent. Asset-associated financial planning has two major It is important to be aware that not only are elements. One is related to the fact that capital such subsidies forgone revenues, but they also cre- assets have a long, useful life. For example, build- ate distortions to the local economy because they ings and infrastructure facilities and networks are provide unfair competitive advantage to tenants useful for 25 to 75 years, or even longer. Therefore, who pay below-market rent. Why, for example, expenses related to these assets need to be planned should a private art gallery be at a serious disad- and executed for their useful lifetime; that is vantage because it must pay higher rent than the called “life-cycle costing.” The second element is gallery registered as a public institution, which is that local governments always have many capital eligible for subsidized space? If reduction of these investment needs, such as repairing and renovat- subsidies is established as a goal, the way to ing existing buildings and networks, acquiring achieve it is obvious: premises with subsidized new equipment, building new roads, and so forth. rent should be those whose market rents are the That implies that those capital expenses need to lowest, in other words, the most modest premises be planned ahead for about three to five years. A in both quality and location. In particular, subsi- useful tool for that is called “capital investment dized premises should not be in prestigious areas. planning” (also discussed in chapters 5 and 7). In sum, policy makers (such as the council) should be well informed about forgone revenues Life-Cycle Costing because revising existing policy and practice can The costs associated with the useful life of a prop- lead to fairer economic conditions for tenants of erty include its acquisition costs (that is, land municipal rentals, more revenues for municipal acquisition and construction), annual costs, and budgets, and greater transparency about who disposition costs. The annual costs, in turn, com- receives public subsidies (direct or indirect) and prise such items as maintenance and repair, oper- how much. The most complicated cases are those ation costs, and expenses for restoration and in which land is given to investors at discounted modernization (or accumulation of funds for prices for the sake of local economic development replacement at the end of the asset’s useful life). and new employment.3 The annual costs depend on the type of facility, materials and equipment used, climate, the cost Incentives for Local Government Employees of labor, and so forth. In practice, they also depend Examples from around the world indicate that on the current condition of the facility—if properly structured incentives for government preventive maintenance and repairs have been employees and government units can result in deferred for the past several years, the current positive outcomes that would be practically operating expenses could be higher than they impossible to obtain otherwise. For example, would otherwise be. Further, annual costs can in  the wake of the municipal financial crisis, differ dramatically within one system. For Montgomery County, Maryland, in the United example, in water systems, the most expensive States, introduced an innovative incentives pro- operations usually are water pumping and water gram for its employees. All employees are encour- treatment. As a result, a water supply service may aged to identify and suggest possible savings spend most of its annual costs on electricity for related to municipal assets. If a suggestion is pumping the water and labor for operating and implemented and the savings materialize, the maintaining the facilities and network. A social employee who made the suggestion receives a rental department pays only repairs and mainte- direct monetary bonus. nance labor and materials, as tenants pay most of Managing Local Assets 307 the operating expenses, such as electricity, tele- 3. The most accurate method requires the prepa- communication, or water. ration of a detailed operating and maintenance Maintenance and repair (M&R) costs are dis- work plan for the facility or system, including a tributed unevenly during a life cycle and depend description of all anticipated operating and on the kind of asset. Figure 6.5 depicts the life- maintenance activities, a description of each cycle costs of various assets over a 50-year life work activity, a detailed staffing plan, power cycle. The small columns signal regular, small costs, materials costs, replacement costs of maintenance instances; the tall columns indicate equipment having a short life expectancy, etc. larger costs or major refurbishments and sub- stantial expenditures. Notice that having and implementing Similarly, annual operation costs, compared operating and maintenance work plans for infra- with  the  initial  construction  cost,  vary  substan- structure and buildings is a core element of good tially by type of asset and constitute a substantial practice in life-cycle management. amount. The total M&R and operation costs over Another component of the annual cost is an asset’s life are often much larger than the ini- restoration and modernization (R&M) expenses, tial construction cost (table 6.8). which are also called “recapitalization” or “depre- Sometimes the total life-cycle cost can be low- ciation.” Municipalities that use accrual account- ered by redistributing the costs along the cycle. ing compute cost and account asset depreciation For example, spending more to build a facility (see also chapter 3). However, for those that use might result in overall savings on M&R and oper- cash accounting, as is typical in the developing ations costs. The same can be true for the costs of world, it is also allowed and is good practice to certain types of repairs, replacement, or renova- budget depreciation costs annually. They are tion. For example, replacing an old air condition- then accumulated in a special depreciation fund, ing system with a modern, energy-efficient one earmarked exclusively for restoration and mod- can lead to substantial savings in annual energy ernization of assets or their replacement at the costs, so that in a few years the investment is end of their useful life. Depreciation funds cover recaptured and life-cycle saving begins. the whole portfolio (for example, all schools in a Three methods are commonly used to plan for city or the water and sewer infrastructure). operating and maintenance costs of both existing Funding for R&M may be seen as sacrificed and planned municipal assets: money when a local budget is constrained. In particular, local politicians might feel that estab- 1. For approximate or preliminary planning, it lishing a reserve fund dedicated to future invest- is common practice to base estimates of annual ment or refurbishment is a poor use of resources, operating and maintenance costs on a percent- when there are always immediate needs for other age of the estimated or original construction expenditures. However, failing to fund M&R or cost. However, this method is the least accurate R&M costs properly results in deferred repairs and cannot be recommended as good practice. and maintenance, which reduce the useful life of 2. Another method uses historical costs. For addi- the assets. tions to or modification of existing facilities, identifying historical costs and adjusting those Capital Investment Planning values, based on required or desired changes A capital investment plan is a rolling, three- to- to  the previous operating and maintenance five-year plan that summarizes the strategic program, is an effective approach for estimat- development program for the upcoming period, ing future operating and maintenance costs. including a detailed list and information on 308 Municipal Finances Figure 6.5 Annual Maintenance, Management, and Repair Costs of Facilities, Washington, D.C. Central plant boiler 600 US$ per square foot 400 200 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 Year of facility life Pump house 150 US$ per square foot 100 50 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 Year of facility life Municipal building US$ per square foot 40 20 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 Year of facility life Source: Authors, based on data from Whitestone Research 2010. planned priority investment projects, the timing expenditure budgets (World Bank 2011). The of their implementation, funding sources identi- rolling capital investment plan is a systematic, fied and approved, and main technical charac- simultaneous evaluation of potential projects; it teristics. Capital investment plans build a bridge should be revised annually by transferring the between the longer-term visions, the master or current year to the capital budget and including development plans, and the annual capital one additional year. The capital investment Managing Local Assets 309 Table 6.8 Examples of the Life-Cycle Costs for Different Facilities, Washington, D.C. M&R and operations Initial or Annual M&R (average) costs, in 50-year life replacement cost and operations costs cycle M&R, % of Operations, % of Facility $ per sq. foot % replacement cost replacement cost % of replacement cost Central plant, boiler 640 100 6.4 4.9 561 Pump house 640 100 3.0 19.4 1,117 Municipal building 264 100 1.7 5.1 340 Public library 230 100 1.7 5.1 338 Source: Whitestone Research 2010. Note: M&R = maintenance and repairs. planning process facilitates coordination among part of an asset’s life cycle, additional investments the local government entities that are responsi- are required a few years after installation. Analysis ble for project implementation (discussed in of asset portfolios focuses on effectiveness, and more detail in chapter 7). investments in securities or commercial proper- ties might show the highest financial return. However, it should be kept in mind that unless Taking a Strategic View of such financial investments are made for the cre- Municipal Assets ation of a strategic reserve, they do not support A strategic view of municipal assets considers the main function of the municipality, which the entire portfolio and draws policy conclusions is  to  provide the citizens with good services. to support decisions to prevent deterioration and Investments in commercial properties bring maximize value. The asset strategy is part of the multiple risks that the government is not suited to broad strategy of the municipality, which uses manage, and they are not recommended. assets to fulfill its functions and goals. From this perspective, analyzing the asset portfolio aims at What Can Be Learned from the Balance identifying how to improve the performance of Sheet? the assets in fulfilling municipal goals and short- A balance sheet can provide a useful perspective and medium-term targets. For instance, in times on the asset portfolio by revealing assets and of financial distress, financial stability might be liabilities (details on the balance sheet are dis- the prime objective. That might require selling cussed in chapter 3). Table 6.9 shows the key cat- assets that induce losses or are too expensive to egories of assets and liabilities that can commonly maintain. When financial conditions are good, be found on a local government asset-liability the question is more how to acquire assets for balance sheet. One of the questions to ask is priority services, to enhance their quality, or to whether it would be beneficial to rebalance and support local economic development. restructure the physical assets, or assets and lia- Analyzing assets’ performance is an important bilities. For example, does it make sense to sell part of capital improvement planning, in which some surplus commercial properties that the main asset acquisitions, renovations, or divesti- government happens to have and invest the pro- tures are taken into consideration and accounted ceeds in needed infrastructure? Should surplus for in the rolling plan. Figure 6.5 illustrates that as land and property be sold to repay debt? 310 Municipal Finances Table 6.9 Asset-Liabilities Balance Sheet Assets Liabilities Fixed assets • Debt, including that secured by municipal property or by a • Land property-generated income stream • Infrastructure • Third-party guarantees • Buildings • Pension obligations • Equipment • Long-term, property-related paying obligations (leases, public-private partnership repayment) Financial assets • Other contingent liabilities (e.g., remediation of land • Investments in enterprises contamination) • Securities, bonds, etc. Obviously, to obtain an undistorted picture of and Hertelendy 2004). Assets transferred to assets requires knowing the market value of land, enterprises are no longer part of the municipal especially that part of it that could be sold. balance sheet, but from a strategic and opera- Similarly, built-up properties that can be classified tional perspective it is wise to improve munici- as surplus should be appraised, at least roughly. pal control over them. The financial analysis tools discussed above, such as the capitalization rate, discounted cash How to Control Municipal Enterprises flow, and net present value analysis, are practi- Very often municipal enterprises hold or own cal  methods for comparing the value of surplus large portfolios of property that originally was land  and property with the total annual capital municipal. Those holdings can be lucrative assets investment budget. Comparison of alternatives is (vacant land, revenue-generating rentals). Usually, necessary in making decisions regarding asset enterprises obtain these assets free from local gov- divestiture or investment, that is, whether it is ernments as in-kind equity donations, and their wise to sell assets that provide little or no cash rev- value is not accounted for on the municipal bal- enue and invest proceeds in shares, bonds, or joint ance sheet or known to the local government. equity ventures that seem to offer higher gains. Revenues from these assets are usually retained by the companies and not shared with the municipal Municipal Enterprises budget. The municipality can and should Municipal enterprises are established because strengthen its control over the enterprises sub- independent and focused management can per- stantially by using governance instruments such form better than municipal line departments, as are applied in the private sector: which often are not suited for daily management • Establish contractual relations with the of most local service delivery. Municipal enter- enterprises regarding their use of assets given prises are independent legal entities, often under to them (e.g., a performance-based service direct municipal ownership. They work  under contract with a water, transport, or solid waste an appointed director. Sometimes they are cor- company). poratized companies governed by a board. Municipalities in the developing world do not • Improve the governance of the enterprises to perform well in controlling their enterprises, protect assets (e.g., hire professionals to rep- despite the fact that the enterprises may rep- resent the municipality on the enterprise resent the bulk of municipal wealth (Kopanyi board or as executives of enterprises solely Managing Local Assets 311 owned or majority-owned by the municipality; the holding might be dangerous for the municipal exercise strong oversight over management, budget, as in the case of the Debrecen Holding in and so forth). Hungary. It started in 2000 with great promise: big investments, big development projects, inde- • Take back assets to the direct control of the pendent borrowing. By 2010, however, its debt local government; transfer back land or prop- became unmanageable, unpaid bills amounted to erty that is surplus to the enterprises’ opera- about 5 million euros, and eventually the munici- tions. That is possible if the municipality is the pality was forced to bail it out. Lessons suggest sole or majority owner of the enterprise. Even that the financial holding is not a suitable tool of so, retransferring assets requires legal action, municipal asset management for developing as it is a divestiture by, and reduction of the countries. equity capital of, the enterprise. The governance and control of municipal • Improve reporting by rigorous scrutiny of the enterprises in developing countries often suf- financial reports and audits of the enterprises. fer from ineffective boards filled with appointed Some municipalities also prepare a consoli- municipal administrators and politicians. Such dated annual report that includes reports on board members lack expertise or motivation the investments and enterprise portfolio, (or both) to work effectively to guide and con- annexed to the closing financial report (budget trol the executives and the operation. The and balance sheet). boards may look similar to those used in the developed countries but be ineffective because After establishing good control and gover- of different corporate cultures and local nance of municipal enterprises, local govern- circumstances. ments may consider the option of creating a financial holding that owns all the municipal Instruments of Land-Based enterprises and shareholdings on behalf of the Financing municipality. This is a German model (stadtwerke) followed in some European countries and is also Land-based financing is a set of instruments similar to development authorities established in that  local governments across the world use to India and Pakistan. Benefits from such a holding, convert their land or land-related regulatory if it is governed well, include robust capital; good powers into funding for infrastructure or security for borrowing; possible pooling of delivery of infrastructure services (Peterson demand for debt to obtain a better interest rate; 2009). There are three distinctive types of and opportunity to rebalance assets to support a instruments, including sale of land or buildings strategy for the entire portfolio. However, this or transferring land to public-private partner- option may discourage direct involvement of the ship ventures; using regulatory instruments local government in outsourcing delivery of ser- for  generating revenue; and taxing or charging vices to the private sector through concessions developments. Cases of these instruments are and similar instruments. discussed briefly below. This model also contains a risk that the holding, which may have a balance sheet larger Converting Government-Owned Land and than the municipality’s, might grow out of control Property into Money or Infrastructure of the municipality and become self-serving Public property can be transformed into money rather than responsive to the municipal needs. or infrastructure by disposition or equity par- Moreover, because of its size (“too large to fail”), ticipation. The simplest way is to dispose of 312 Municipal Finances surplus land or built-up property and use profits from a commercial part of the land the  revenues for capital investment in other development. Such a land-for-infrastructure locations. The term “dispose” may imply sale, scheme is tied to a site, but no public funding is that is, conveyance of full ownership to a buyer, needed. For example, in Kuwait City most of or conveying temporary rights, such as a long- the public infrastructure (public garages, high- term lease. Obviously, for this instrument to way rest stations, markets) has been built work the land or property should be in a through such arrangements. Private developers desirable location within an active real estate sandwiched public garages for the central city market, and the sale should take place at a time into their mixed-use skyscrapers built on gov- when private demand is strong. For example, ernment land, with retail below a garage and impressive sales in Istanbul and Cairo took office floors above. Similarly, in Bethesda, place at the top of the market, before the market Maryland, a public parking garage was built by crash in 2008–2009: a private developer underneath its mixed-use building in exchange for the 99-year lease of • In Istanbul in 2007, the auction of an old bus the site. station and former administrative site pro- duced $1.5 billion, which is equivalent to one- Converting Municipal Power into Money or and-a-half times the city’s municipal capital Infrastructure spending in 2005. Another tool from this group converts municipal • In Cairo in 2007, an auction of desert land for power to define land uses and land use parame- new towns generated $3.14 billion—equivalent ters (land use planning and land use control) to about 10 percent of total national govern- into money or infrastructure through the sale of ment revenues and 117 times greater than the development rights. That is, the local govern- (very low) total urban property tax collection ment sells to developers the right to exceed the in the country. planned parameters of land use (e.g., floor-to- area ratio, maximum number of floors, maxi- However, systematic dependence on revenues mum land coverage) in exchange for money or from government land, especially land sales, is building public infrastructure. This kind of very risky for several reasons. First, land is a arrangement has been broadly employed (e.g., limited resource, and its sale cannot be a sustain- São Paulo, Brazil; Lima, Peru; Stuttgart, able revenue source. Moreover, dependence on Germany; Bethesda, Maryland, U.S.). It is also land sales provides pervasive incentives for spa- used in some Indian states as a form of compen- tial expansion and urban sprawl, which fuel sation to private owners of land when parts of future unsustainability. Land markets are also their parcels are expropriated for public volatile and cyclical, making land sales not a sta- infrastructure. ble revenue source. To mitigate the risks, land sale Similarly, it is possible to capture for the revenues should be placed in a special, multiyear municipal budget a part of the gain in value of budgetary fund that would buffer fluctuations of land (military, railroads) that occurs when it is the land market. rezoned. For example, in the United States and Another instrument from the same group is Serbia, surplus military properties have been contribution of a government site into a PPP, in sold to the private sector, and local governments exchange for obtaining a needed public facility have thus shared in the gain created by rezoning without spending public money. The private of the land from “special use” (military) to partners in such PPPs recoup their spending in “commercial use.” Managing Local Assets 313 Using Government’s Power to Extract a Public Specifics of Strategic Land Share from Private Gains Management and Administration: Finally, the local government can use legislative “The Devil Is in the Details” or regulatory power to extract a public share from Land is often the most valuable asset of local gov- private property gains by taxes, fees, or in-kind ernments if it is valued at its market price (see the contribution. This tool is used in several forms in example of Warsaw in table 6.1). That implies that various countries. the quality of land management is especially A betterment fee can be charged property own- important, and as has been said, inventorying ers whose property value increased as a result of land is the very first step. The next actions in stra- public infrastructure built or improved in the tegic land management have some specifics that vicinity. However, experiments with betterment are useful to know. fees in Australia, Poland, and the United Kingdom were unsuccessful and were abolished, formally or de facto. The lone country with a steady record Strategic Land Classification of success in some cities is Colombia. The basic elements of land classification have Developers’ exactions and land dedication been outlined above. It requires identifying par- (Russia, Serbia, United States) and impact fees cels needed for mandatory and discretionary (Serbia, United States) all require private devel- functions, and surplus land. Figure 6.6 summa- opers to contribute infrastructure or land for pub- rizes the logical frame and specific actions. lic uses in connection with their real estate One of the questions that will unavoidably development projects. Developers’ exactions in emerge is how much vacant land will be needed the United States are related to on-site infrastruc- for future use for public purposes. That depends ture, and impact fees are related to off-site infra- on what kind of urban development is planned. structure. In the Balkans, this kind of fee is called For predominantly residential areas, a general a “land development fee” and is supposed to cover rule is that about 28 percent to 35 percent of the off-site infrastructure, while on-site is paid by territory should be publicly owned for use as developers directly. A good system of impact fees roads and for social infrastructure (schools, hos- requires a strong analytical base and a long-term pitals, etc.). Nonresidential areas may need a investment plan to differentiate accurately the smaller share of public land. If there is insuffi- impact of new development on infrastructure cient land for public uses in areas planned for cost by location, land use, lot, and building size. In new development, the land should be acquired. If, many countries, such as in the Balkans, such fees however, the municipality owns land, but devel- are set up arbitrarily, without any relation to the opment is not planned in the immediate future, a cost of infrastructure, and used practically as a course of action must be determined: Is it better general tax on new development, especially non- to sell the land now, spend the proceeds for cur- residential uses. rent needs, and buy land when development goes Such cases illustrate that the use of land ahead? Or is it better to hold the land? Although financing instruments provides one or both of there is no universal answer, it is useful to remem- two main benefits: direct, immediate revenues for ber that in many growing urban areas, land values funding infrastructure or reducing debt or public generally increase faster than inflation or returns infrastructure facilities’ being obtained without on other investments. Therefore, the land, if it is spending public money. In addition, many of already owned, can be a good investment. these instruments transfer some risks to the pri- A spatial development plan, at least a basic vate sector. one, is necessary to know exactly where the 314 Municipal Finances Figure 6.6 Classification of All Municipally Controlled Land All municipally controlled land Classification required by law or made by local decisions Public use land Other municipally controlled land Policy decision Group A: Group B: Group C: Mandatory Discretionary Surplus land (cemetery, water (public tennis (for private use) station, etc.) court, etc.) Classification needed for good management streets, roads, and public facilities of the future If these powers are used wisely, municipalities are supposed to be. Such a plan allows the sepa- can increase revenues from allocating land and ration of future public use land from other vacant become more attractive than other municipalities land, which would be classified as surplus. The to investors. A number of tools exist for enhanc- latter type of land can be very valuable and also ing land values and prices: needs strategic management. A possible approach to such a land decision is depicted in figure 6.7, • Offer a prepared site, not “raw” land, but a pre- which sorts all vacant sites into four groups (see pared subdivision site with basic infrastructure. Urban Institute 2012b for more details). Providing internal and external roads and off- site hookups to water and sewerage makes the Ways to Enhance the Value of Municipal land ready to use when construction is com- Land pleted and removes a major uncertainty for Local governments, as landowners, have unique investors. However, in preparing land for power over the value of land that they offer to investors, the municipality must take into investors and the prices that investors are willing account environmental and social implications. to pay. Revenues from land sales, PPPs, and sales For example, it should have a resettlement of development rights can increase by two to five action plan that summarizes negative social times if the most profitable uses of land (“highest impacts, such as loss of houses and cropland, and best uses”) are permitted by land use plans and spells out specific actions to compensate and regulations. Moreover, changing land use affected citizens or entities (for more details, parameters may switch land value from negative see English and Brusberg 2002). Fair treatment (meaning that the private sector will not be inter- of people—even if they are encroachers—is ested without subsidies) to positive. fundamental to any good land project. Managing Local Assets 315 Figure 6.7 Classification of Surplus Municipal Land • Golden reserve. “Golden reserve” is the nickname of sites in prime locations, placed under a moratorium from being sold or leased to investors for at least 10 to 15 years. The land can be released from the moratorium when the government needs funding for major infrastructure projects. The local council should approve the list of sites under the moratorium and issue a binding document. Meanwhile, the sites can be used as public spaces or leased for short-term uses like parking lots. • Large construction sites. Sites suitable for capital construction should be released to investors via auctions or other forms of competitive procurement. The release should be planned and preapproved by the local elected body (annual program) and timed to the real estate market (no sales at the bottom of the market). • Small plots. Small holdings that cannot be built up as independent real estate can be offered to owners of neighboring sites. • Other sites. Sites not suitable for capital construction for various reasons (shape, location, slopes) can be leased for temporary light construction uses. Table 6.10 Example of How Permitted Land Uses Influence Land Value Scenario 1 (according to the detailed Scenario 2 (according to a market study conducted by development plan): real estate experts): Greenfield site, 10 hectares; permitted land uses Greenfield site, 10 hectares; permitted land uses are ” defined as production are an “industrial zone, production asset management warehouses; offices; asset management warehouses; auxiliary offices retail asset management–related warehouses (such up to 14% of total floor space. as a showroom, discount retail store, furniture store, or home improvement center). Floor area: Floor area: Production management warehouse: 60,000 m2 Production management warehouse: 40,000 m2 2 Office: 10,000 m Office: 10,000 m2 2 Total: 70,000 m Retail management warehouse: 20,000 m2 Total: 70,000 m2 Prices expected at auction: Prices expected at auction: Euro 14.5/m2, on average Euro 15/m2 (office/warehouse), on average (or 1,448,272 euros for the entire site). Euro 37/m2 (retail/warehouse), on average (or 2,164,077 euros for the entire site). Source: Urban Institute 2012a. • Broaden permitted land uses and land use which a detailed development plan for a parameters. The example in table 6.10 illus- greenfield industrial zone stipulates that only trates how permitted uses influence the value production and warehousing can be devel- and attractiveness of land for potential buy- oped on the site. Under this condition, an ers. In particular, it shows a common case in expected price at auction could be, at best, 316 Municipal Finances 14.5 euros per square meter, on average. If, • Local ordinance. The procurement process however, permissible land uses were should be defined in a formal document, pref- expanded to allow some retail and retail- erably a local ordinance on land allocation and related warehousing, the average expected disposition approved by a local elected body. price could go up to 21.6 euros per square • Competition. The process should be open and meter. That would translate to about 715,805 competitive, with minimal limitations (if any) euros of additional revenues for the munici- on participation. pal budget. • Auctions or sealed bids. For the majority of • Reduce government-related risks and costs for sites, the process should be an open auction or investors. Three main types of risks can be sealed-bid competition, with the winner in removed: either case selected based on the highest price Legal risk—make sure that the city has “clean” or rent offered. Selecting winners based on rights to sites offered to investors. other or multiple criteria should be permitted in special cases only, predefined in the ordi- Financial risks—make all costs related to site nance on land allocation and disposition. acquisition and development known to inves- tors in advance. • Public announcement. A public announcement of the auction or competition should have suf- Timing risk—make the time for obtain- ficient information for potential bidders. ing  permits and infrastructure hookups predictable. • Time. A sufficiently long marketing period should be provided after the public announce- If these risks are not eliminated, investors will ment. For simple and relatively small sites, hedge against them by reducing the price they the time between the announcement and are willing to pay. auction should normally be at least 45 days. For larger or strategic sites, or when demand Good Disposition Procedures and is weak, the period should be at least 90–120 Contracts: Why Do They Matter? days. Good disposition procedures matter because they • Inform the public. The public should be pro- indicate how interested the local government is in vided with information on the results of being a good business partner for private inves- the  procurement, including the identity of tors and how qualified it is to do so. Any uncer- the winner, the purchase price or rent, and tainty in the land procurement process or in land any  conditions or limitations on the site lease or sale contract increases investors’ risks and transaction. Information should be pro- and reduces their trust that the process is not cor- vided by written notice posted in public rupt. In some countries, local residents and busi- places and on websites, and the information nesses still do not have a choice and would accept should be entered in the local public prop- even shaky land rights and unclear contracts. erty inventory. However, relying on that undercuts the munici- pality’s long-term competitiveness both domesti- • Delegate the task. The local governments cally and internationally. Listed below are some should have the right to delegate, by written basic features of a good land procurement and agreement, responsibility for organizing and marketing process (for more information, see conducting land procurement under the estab- Urban Institute 2012a). lished procedures. Managing Local Assets 317 Using Real Estate Brokers for Disposing of least, two things: First, countries without private Surplus Land land ownership, but which are surrounded by Large real estate sales call for a high-quality and countries with ownership, will lose some inves- properly targeted marketing campaign to attract tors, who will go to places they find more secure. good investors. The best solution is to hire a pro- Second, in countries where both options exist, cit- fessional real estate company or agent with a ies granting ownership will have an advantage in good brokerage record. They can distribute the competition with their neighbors for investment. information on your sites through their databases Nevertheless, both options have proponents of clients and organize the marketing to potential and opponents, often based on ideology. On the buyers. The marketing agent should be selected one hand, practically all prosperous societies in through procurement. the contemporary world have grown on funda- If a local government decides to conduct its mental respect for private ownership of land and marketing without the involvement of a private property.4 On the other hand, some believe that real estate broker, it should at least consult infor- land was created by God for everybody’s use and mally with local real estate agents. In any event, cannot be in private ownership. At a more prag- publishing an advertisement in a local newspaper matic level, there are costs and benefits associated is absolutely not enough. The marketing cam- with each option. paign must have other elements, such as a bill- board directing people to websites with asset Arguments for and Benefits of a Long-Term management auction information; brochures; Lease and online postings. Information should be pro- • Under a long-term lease, local government can vided to all local real estate companies, the cham- exercise a level of control over the speed of ber of commerce, and so forth. development, as deadlines for building on the land should be included in the lease contract. Leasing or Privatizing Municipal The contract may also have a provision for ter- Land mination if the investor does not build on time. These provisions create a certain protection Which rights should be given to private economic against land speculators who are buying the actors (citizens, companies) when government land for resale at a profit, not for immediate land is allocated to them for private investment? development. (Conditions requiring that con- There are two major cases in which that question struction be completed in a set time can be is acutely important. The first is the case in which attached to sale contracts as well.) moving land from public to private ownership is not allowed in the country. Investors may only • Local government will get land and improve- obtain term rights, such as leases, but the central ments back after the expiration of a lease. It government may be interested in investigating its must be said that that can be more a curse than options. The second is the case in which private a blessing, as Chicago, Kuwait City, and ownership exists, but local governments may Johannesburg have learned. In those places decide what rights they want to convey to inves- investors stopped maintaining buildings 10 to tors in a specific case. 15 years before expiration of their lease, as they Experience in former socialist countries indi- lacked incentives. At the end of long-term leases, cates that when they have a choice, investors in the cities have found themselves owners of most cases strongly prefer land ownership, not deteriorating commercial properties that have land lease (see below). This signals, at the very nothing to do with governmental functions. 318 Municipal Finances Costs and Risks of a Long-Term Land Lease SAR, China. One can surely assume that small • Investors prefer ownership to land lease. The local lessees are at highest risk under the lease first reason is that owned land can be used as model, as they often do not have good lawyers collateral for borrowing to supply construc- and shrewd negotiators at their disposal. As a tion finance. Second, in many countries, inves- result, the land lease system often uninten- tors trust law and state for protecting their tionally discriminates against them and favors ownership rights more than they trust local experienced foreign interests. This should be governments and lease contracts. The quality recognized as a policy issue. of land lease contracts in most such countries • The land-leasing model is associated with has been inadequate to protect either private higher transaction costs. Trading of land leases or governmental interests. To investors, this incurs higher transaction costs than does trad- implies that they are exposed to high risks, ing of owned land because an investor must among which are the risks of extortion, pres- sell the building and separately transfer the sure by corrupt officials using loopholes, and lease through the local government, which uncertainties in lease contracts. costs additional time and money, compared to • The land-leasing model is also more expensive a single sale of a fully owned property. For the and complicated to administer. First, it implies same reason, properties located on leased land the need to maintain parallel systems for regis- usually have lower liquidity than ones on tering leasehold rights of land tenants and owned land. Altogether these complexities their ownership rights in improvements. make investment in leased land less attractive Second, local governments become holders of to investors. large portfolios of lease contracts, and those If investors sense that municipal leases are must be monitored and managed, adding to too risky or too expensive, given all the time the cost of land management. Third, a single and money required to obtain them, they will property tax is not applicable because taxation just go to private sellers or to other cities or of buildings and payments for land must be countries. administrated separately. • The land-leasing model requires sophisticated Policy Implications legal knowledge on the part of participants What, then, are the key policy implications for and can unintentionally give advantage to for- local governments of decisions whether to sell or eign investors over small domestic lessees. lease? The lease agreement is a binding contract, and • Local governments that would be the first in parties entering into it must be fully aware of their country to start selling land into private their legal obligations under the terms of the ownership most probably will have an advan- lease. That is not something that small land- tage in attracting investors over governments holders in most developing countries, who that prefer land leases. cannot afford to hire qualified lawyers, will understand. The quality of the lease itself is • It is impossible to predict whether an investor crucial. Omission of key provisions—for exam- will buy land for immediate development or ple, who owns what at the date of termination, for speculative investment to resell. However, or provisions for renewal—can lead to multi- a government can consider whether a person ple cases of litigation, as happened in Kuwait, or company has a timebound, quality develop- or mass protests, as happened in Hong Kong ment plan in its selection of a buyer. Managing Local Assets 319 • If doubt exists, a wise local policy could be to discussed, the private sector can bring not only try both options simultaneously, monitor expertise and efficiency but direct funding for outcomes, and correct the policy based on public capital investment as well. These are the evidence. In practical terms, that means main reasons why two advanced asset manage- putting some parcels up for auction sale and ment instruments—public-private partnerships some into long-term leases. In monitoring (PPPs) and land development corporations— outcomes, some core indicators would be the have emerged and become noticeable in asset answers to such basic questions as the management. following: 1. Are higher prices paid for ownership Public-Private Partnerships (everything else being equal)? The prevailing form of PPPs is based on a contrac- 2. Do the intervals between contract signing tual relationship between the government and the and a request for a building permit differ private partner (which can be a consortium of pri- between the two options? vate entities). A less common form (and generally 3. Do the construction completion times not recommended for local governments) is a joint differ? legal entity, established by the government and the 4. Does the amount of investment depend on private partner, usually with shares held by the the land rights? initial partners or publically traded. PPPs vary broadly. On one end of the spectrum are simple Who should decide, and how? Given that the management contracts of three to five years, under decision may have a serious influence on the com- which a private partner operates and maintains petitiveness and prosperity of the municipality, some government facility (such as a public garage) local policy makers—the elected body and the or provides a service that traditionally would be mayor—should have joint responsibility for lease provided by a municipality (such as street clean- or sale decisions. ing). It is important to mention that PPP arrange- ments are very sector specific and require a good combination of technical, financial, and institu- Advanced Asset Management: tional governance expertise. A contract that suits a Public-Private Partnerships and water supply PPP is not appropriate for one that Land Development Corporations operates a bus service or a shopping mall.6 Asset management is a highly technical area, and At the other end are complex, long-term PPP as is shown in figure 6.2, it requires professional arrangements, such as Design-Finance-Build- real estate expertise. When such expertise is not Operate-Transfer (often referred as DFBOT). For involved, many costly mistakes are made, often example, a private partner in a PPP can design, without even being recognized.5 Attracting build, and operate several public schools for a experts qualified to manage large property port- local government (a very common arrangement folios and enabling them to act efficiently are in the U.K.). The partner will also provide financ- often impossible within rigid government ing for the capital investment, and the local administrative structures (i.e., pay levels, government will repay the costs (and a profit) to decision-making processes). Moreover, rational the private partner over the next 30 years through management of capital assets requires actions an agreed annual fee. Private partners in and operations—such as selling surplus land to well-structured, long-term PPPs can do various the private sector—that governments sometimes things, including providing financing and exper- are not allowed to do. Finally, as already tise and taking on specific risks. 320 Municipal Finances Long-term PPPs associated with capital invest- who may be keen to interfere in land transactions ment are the most complex instruments among when they are managed by government directly. all that local governments might use, and for that On the social values side, land corporations reason, only a minority of local governments are can harmonize relationships with local commu- likely to use them. Moreover, as with borrowing, nities concerning what is being developed, as PPPs are usually possible only if the local govern- well as secure the environmental sustainability of ment has a certain level of financial autonomy. buildings and neighborhoods developed. Land It is certainly recommended that any local corporations can also stimulate local economic government engage only gradually in PPPs, start- development and the regeneration of declining ing with simpler, short-term forms, such as out- areas in cities through targeted development sourcing operations and management of selected projects. municipal services or facilities. The government At the same time, experiences with government can enter into long-term PPPs after gaining expe- land development companies raise a number of rience with simple contracts (see also chapter 7). concerns regarding governmental involvement in land and housing development and associated Land Development Corporations risks. Thus, a risk exists that government compa- Local governments sometimes establish land nies might take monopolistic positions in land sup- development corporations as special purpose ply and housing supply. That is potent with market entities. They are quite common in South Asia, distortions, including price hikes (Singapore), or for example, the Delhi Development Authority in the opposite, oversupply (the Republic of Korea), India and the Lahore Development Authority in and may create a direct governmental liability and Pakistan. International experiences with these burden for public finance (Dubai). entities vary widely. Land corporations usually The true costs of such government land corpo- operate under the commercial code, as private rations to taxpayers are often underestimated, companies do, and they have more independence even in full-fledged market economies like than departments or small units of the local gov- Canada. In particular, land is often contributed by ernment. A central idea of this corporate model is various governments into their land corporations that it allows combining private sector efficiency (or purchased from other governmental agencies) with public value goals. On the efficiency side, the at historical cost instead of market value, and this corporate model establishes incentives for the hidden public subsidy to corporation projects is company to make its operations cost-efficient and not accounted anywhere. self-sufficient. It makes it possible to accelerate A very high risk (and a common practice, at all processes, to promote flexibility and entrepre- least in many former socialist countries) is that neurship, and to attract and retain private sector such corporations, like most municipal compa- experts in real estate and finance. nies  historically, may operate without proper The scope and functions of land development governance, accountability, and transparency. corporations vary widely. For example, they may They also tend to become involved in speculative include land acquisition, equipping with infra- real estate development, which should not be a structure, and releasing improved land onto the part of government operations either directly or market; building housing for low-income families; indirectly. It is often unclear whether these corpo- or managing properties used by government func- rations exist primarily to generate revenues for tions. The corporate model can also provide some the government or to serve other purposes. A protection for strategic land management and common case is that such companies consume all long-term planning from the whims of politicians, their revenues, despite the said hidden subsidies Managing Local Assets 321 from central or local government. For instance, improve asset management. It is recommended the Lahore Development Authority has a larger that this document be developed during the budget than the city district government. It has 6-to-18-month period after asset management engaged in huge land transactions and has big improvements have started. This implies that the financial reserves, but it has not paid money into strategy should be a real working document, based the budget of the city district government in the on practical achievements and realistic intentions last decade. related to asset management. These experiences suggest that it is vital to avoid empowering land corporations with regula- Who Should Develop the Strategy? tory authority in tandem with the right to operate In the best case, the temporary asset management as a business in the same jurisdiction. That many task force should be empowered to draft the asset land authorities in South Asia operate that way management strategy as one of its outputs. raises conflicts of interest and makes the land A  mayor or treasurer should lead in drafting it transactions even less measurable and less trans- and in presenting it to the council. parent and more prone to corruption. Such An asset management strategy includes sev- arrangements also may create unfair competitive eral key sections: advantage over private investors. Finally, in considering establishing a munici-  1. Formulation of the mission, goals, and prin- pal company to manage municipal land or other ciples of asset management capital assets, such a company’s activities should  2. Commitment to full inventorying and be seen as part of a bigger picture of strategic and accounting of all properties for asset manage- well-thought-out management of capital assets. ment purposes Before a local government establishes such a company, time, effort, and expertise must be  3. Summaries and reviews of portfolios invested in the critical stage of conceptual design.  4. Classification of all real property items among In particular, the key policy, governance, busi- the three functional groups—mandatory, dis- ness, and organizational contents have to be for- cretionary, and surplus (income generating)— mulated and agreed upon in specific terms, before and formulation of financial goals and a they are codified in legal documents and trans- management strategy for each group lated into company actions.7  5. Formulation of asset policy principles, to the extent that the local government is ready to Asset Management Strategy— commit to them, to maximize revenues and Putting the Puzzle Together ensure proper maintenance How can city managers ensure that the instru-  6. Identification of local regulations that require ments discussed in this chapter become parts of a some changes to improve asset management, complete and coherent program and have a last- and recommendations for specific changes ing  effect on the municipality’s government— (for example, liberalization of the ordinance especially if the mayor and council may change in on business rentals; modification of the ordi- the next election? The asset management strategy nance on land allocation) is a special, important document and a tool that helps. The purpose of this document is to summa-  7. A list of specific actions for each group of rize both the general principles and the specific properties and for separate properties, when tasks of the strategy, including an action plan to necessary (for example, when there is a 322 Municipal Finances change of tenants or managers; to improve asset management, can find in this chapter useful use; or to recommend disposal) ideas, a framework, and practical tools for man- aging its assets better. They include inventorying  8. Suggestions for organizational changes in assets; using transparent procedures for allocat- asset management to ensure effective inter- ing assets for private use; aligning or classifying departmental coordination assets according to their role in delivering ser-  9. Identification of the person in charge of vices that the government has to provide; using implementing the strategy (for example, the the market value of assets for decision making; members of the task force) establishing a depreciation fund for funding asset replacement; monitoring key indicators 10. A realistic mechanism and time schedule for (e.g., asset-related costs and revenues); introduc- implementing the strategy that reflect the ing life-cycle management for infrastructure and local government’s priorities. buildings, starting from planning operating and maintenance expenses for existing and new cap- Who Should Adopt the Strategy? ital assets; using advanced instruments such as The best-case scenario is if the local council or strategic asset management plans; and so forth. assembly adopts the strategy as a guiding and A critical message is that asset management is binding document, like a local ordinance. But a technical area, and so municipal staff members even if it is not a binding document, the strategy must build expertise and pay attention to regula- will be useful, as long as it is used as guidelines in tory, procedural, real estate, and infrastructure practice. The strategy should be periodically operating details. They should also be creative (annually) revisited to measure progress, ensure and inventive and have incentives to adopt those its continued relevance, and update as necessary. attitudes. Hiring experts from outside govern- ment who have specialized knowledge in real estate appraisal, property management, and the Takeaway Messages like, to assist governments on specific issues also For policy makers: Municipal governments across can be justified. the world control large portfolios of physical assets (land, buildings, infrastructure, and vehi- Notes cles and equipment), which usually contain the lion’s share of local public wealth and which these 1. Corruption, favoritism, or conflict of interest governments manage on behalf of local taxpayers often happens through allocating public and citizens. Good management of these assets is property to various users under preferential conditions—free of charge or for a below- critical for public financial well-being and the market price. Disclosure of information on quality and sustainability of local services. It con- conditions substantially reduces corruption. tributes to local economic development and the 2. The market value of land, by definition, is the quality of life. probable price the land should bring in a fair Better asset management produces multiple transaction, after being put on a competitive benefits: very real savings and additional reve- and open market for a reasonable time, with the nues for the local budget; better-quality assets buyer and seller each acting prudently and and services to citizens; and more trust between knowledgeably, and assuming the price is not people and government. affected by undue stimulus. For municipal staff and technical experts: Any 3. No universal formula exists, but see the further government, be it a beginner or a sophisticate in discussions in Urban Institute 2012a; 2012b. Managing Local Assets 323 4. Some rare exceptions exist. In New Zealand, Kasso, Zsuzsa, and Piroska Pergerne-Szabo. 2004. the crown owns the land, and private parties “Asset Management in Secondary Cities.” In hold fully and freely tradable, perpetual land Intergovernmental Finance in Hungary— rights called “fee simple.” Those rights are not A Decade of Experience, edited by M. Kopanyi, different in any respect from private ownership. S. El Daher, and D. Wetzel, 381–403. 5. Fascinating examples of the complexity of Washington, DC: World Bank Institute. “ordinary” real estate decisions that cities can Kopanyi, Mihaly, and Zsofia Hertelendy. 2004. face are explained in Hentschel and Utter 2006. “Municipal Enterprises in Hungary.” 6. The Public-Private Infrastructure Advisory In Intergovernmental Finance in Facility (PPIAF) is a multidonor trust fund Hungary—A Decade of Experience, edited by managed by the World Bank that provides M. Kopanyi, S. El Daher, and D. Wetzel, 337–61. technical assistance on PPP structuring to Washington, DC: World Bank Institute. governments in developing countries. For more Managing Infrastructure Assets. 2005. National details, visit http://www.ppiaf.org. Guide to Sustainable Municipal Infrastructure, 7. For more on land corporations, see http://www Canada, http://www.fcm.ca/Documents .urban.org/UploadedPDF/412299-Government /reports/Infraguide/Managing_Infrastructure -Land-Development-Companies.pdf. _Assets_EN.pdf. Péteri, Gábor, and Michael Schaeffer. 2007. “Property Devolution and Local Government References Asset Management.” In The Kosovo Decentralization Briefing Book, edited by English, Richard, and. Frederick E. Brusberg. Robert D. Ebel and Gábor Péteri. Budapest: 2002. Handbook for Preparing a Resettlement OSI. Action Plan. Washington, DC: International Peterson, George E. 2009. Unlocking Land Values Finance Corporation, World Bank. to Finance Urban Infrastructure. Washington, Farvacque-Vitkovic, Catherine, Lucien Godin, DC: World Bank and PPIAF. Hugues Leroux, Florence Verdet, and Roberto Peterson, George E., and Olga Kaganova. 2010. Chavez. 2006. Street Addressing and the “Integrating Land Financing in Subnational Management of Cities. Washington, DC: Fiscal Management.” Policy Research World Bank. Working Paper 5409, World Bank, Hentschel, John, and Marilee Utter. 2006. “U.S. Washington, DC. Cities—An Entrepreneurial Approach to Municipal Real Estate Asset Management.” Urban Institute. 2012a. Guidebook on Packaging In Managing Government Property Assets: and Marketing Municipal Land to Investors. International Experiences, edited by Olga Washington, DC: Urban Institute. http://www Kaganova and James McKellar. Washington, .urban.org/publications/412532.html. DC: UI Press. ———. 2012b. Guidebook on Real Property Asset Kaganova, Olga. 2008. “Integrating Public Management for Local Governments. Property in the Realm of Fiscal Transparency Washington, DC: Urban Institute. http://www and Anti-Corruption Efforts.” In Finding the .urban.org/publications/412531.html. Money: Public Accountability and Service Whitestone Research. 2010. “Whitestone Facility Efficiency through Fiscal Transparency, edited Operations Cost Reference, 2010–2011.” 15th by Gábor Péteri, 209–22. Budapest: Local annual ed. www.whitestoneresearch.com. Government and Public Service Reform World Bank. 2011. Guidebook on Capital Initiative/Open Society Institute. http://cps Investment Planning for Local Governments. .ceu.hu/publications/joint-publications Washington, DC: World Bank. http://web /finding-the-money. .worldbank.org. 324 Municipal Finances CHAPTER 7 Managing External Resources Maria Emilia Freire In response to rapid urbanization, local govern- central governments about potential overborrow- ments all over the world are facing the challenge ing and reinforced the need for prudent policies of providing new and improved infrastructure and close supervision. and basic services to increasingly demanding This chapter analyzes how local governments constituencies. The problem is compounded by can leverage and manage external resources the irreversible trend toward decentralization, to meet the demand for infrastructure devel- which has delegated to local governments the opment. We define external resources as the execution and financing of large portions of the resources that accrue to the local government city investment program. Within an appropriate other than from its own revenue (taxes, fees, institutional framework and financial controls, and fines), intergovernmental transfers, and many countries have allowed local governments capital revenues (discussed in chapters 1 and 4). to mobilize external finance for infrastructure Thus, external resources include market-based through access to debt markets and private sec- borrowing and private sector participation, pri- tor participation, resulting in better leveraging vate grants and philanthropic aid, and interna- of own resources and savings. Fortunately, the tional aid and development assistance. financial sector of most emerging economies has The chapter starts with a discussion of the developed rapidly, and local authorities now have importance of municipalities’ having a multiyear access to a number of financing alternatives and capital improvement plan (CIP) to guide the use to information on what has worked well in the of external financing. It highlights the difficulties past and what is needed to enter the financing of collaborating across departments and stan- markets. Experiences with local governments’ dardizing feasibility studies. Project selection access to external debt have informed local and techniques such as cost-benefit analysis and net Managing External Resources 325 present value are mentioned as tools for prioritiz- investment takes place at the subnational level ing investments. (Canuto and Liu 2010). Recent estimates indicate The chapter continues with a description of that the available resources from local govern- the characteristics of municipal borrowing and ments are at most 10 percent of the total require- bond issue and discusses instruments that help ments. Thus, leveraging and managing external municipalities access credit markets. Discussion resources are both inevitable and strategic. of subsovereign debt regulations points out that How can local governments finance capital national governments are often concerned that investment? Local governments have several local jurisdictions may borrow above their pay- options. First, they can use current surpluses ment capacity and default on their debt service, and grants from higher government tiers. They forcing the national government to finance these can also tap into local credit and capital markets unfunded debts. and public-private partnerships or even attract After exploring the potential of public-private donations from philanthropic or charitable orga- partnerships in financing local investments, the nizations or international donors. The next sec- chapter presents the types of external assistance tion sheds light on these options before detailed available to municipalities, the emergence of new discussions in the following sections. areas for local investment (including energy effi- ciency loans), and a review of philanthropic aid Investments from Net Operating for municipalities. Surplus Local governments can use their net operating Why Do Local Governments Need surpluses to finance investment on a pay-as- to Mobilize External Resources? you-go basis, which means that the expenditures During the next 20 years, the need for will be financed in line with the generated annual infrastructure to promote growth and service surplus. The net operating surplus is the amount delivery is projected at hundreds of billions of of operating revenues that can be used to finance dollars a year worldwide. A large part of the respon- capital expenditures, left over after paying sala- sibility for raising the necessary funds falls to the ries, operational and maintenance expenses, and cities in developing countries, where much of the debt service (discussed in chapters 3, 4, and 8). expected urban growth will take place. The Asian It implies that investment projects will be built Development Bank estimates that in Asia alone from and at the pace of the available operating nearly US$100 billion worth of new urban infra- surplus. This is different from the pay-as-you-use structure will be needed annually to fill gaps and method (common in project financing), in which keep pace with this unprecedented urban growth. borrowed funds are disbursed and then repaid Financing requirements for water supply, sanita- from the proceeds generated by the project. tion, solid waste management, and slum upgrad- Paying as you go, or relying exclusively on an ing in urban areas are estimated at US$25 billion annual operating surplus, limits the capacity of per year—US$50 billion if urban roads are local governments, given that in most cases the included (Sood 2004)—and an extra US$32 billion operating surplus is small. Because many infra- will be needed for maintenance (ADB 2011). The structure projects are large, limiting capital spend- figures for other regions are similar. In China, ing to the annual revenue stream would make it subnational governments are responsible for very difficult to finance such projects as a landfill 80 percent of government spending; in France, or a major road. Pay-as-you-go financing often Indonesia, and Turkey, more than half of public results in a large number of small, short-lived 326 Municipal Finances projects rather than large strategic investments. municipality could finance the plant out of its Since large investments play a vital role in creating own revenues over, say, three years, it may not be local activity and eventually expanding local gov- fair to do so since the plant will be used by future ernment revenues, depending on pay-as-you-go to generations over 20-some years. Financing long- finance infrastructure leads to missed opportuni- lived infrastructure investments with long-term ties. Moreover, a growing city with good services debt spreads out the payment of the plant over attracts businesses and housing development that time, so that those who benefit from it in the later help generate new own-source revenues. years contribute to the financing as well. The debt financing alternatives depicted in figure 7.1 Capital Grants include a wide range of options, from borrowing Local governments often rely on intergovernmen- from public banks to issuing debt in international tal capital grants in developing countries. Grants capital markets, depending on the circumstances are the principal source of long-term finance for of a given local government. developing basic infrastructure in many small and Using debt financing has other benefits as well. poor municipalities. For growing municipalities It disciplines local governments by forcing them with adequate wealth and self-supporting projects to determine major investment priorities and (for example, urban transport), grants can help lock in the required financing, so that the decision leverage and mobilize additional finances. Grants does not have to be revisited every year. In addi- can also be used as a guarantee for borrowed tion, the ability to finance the construction of an money, resulting in lower risk and better terms. entire facility in a timely fashion saves consider- able money, in some cases more than the cost of Local Credit and Capital Markets interest on the loan. Local governments can access local credit and capital markets. The economic concept behind Public-Private Partnerships such access is that the long-term nature of infra- When local governments partner with the structure projects justifies long-term funding. private sector in financing and building new Let us take the example of a solid waste plant. It infrastructure, they create a public-private part- is likely to cost much more than what a medium- nership (PPP). PPPs have expanded fast in the size municipality could finance in a single year past 30 years, and there are many lessons that can out of its current surplus. Moreover, even if the help local governments select the best type of PPP Figure 7.1 Sources of External Financing for Local Governments Local government borrower Limitations and controls Central Special Domestic Foreign Private government development State banks securities securities banks agency fund market market Managing External Resources 327 for delivering public services in alignment with for effectively acquiring and using external funds. their own technical capacity and responsibilities. A solid capital investment program with well- Experience has shown that the contribution of defined and appraised development projects is PPPs in the municipal realm has been particularly an important instrument for attracting funding important in improving the efficiency of service consistent with the objectives of the municipality. delivery, notably in such sectors as water supply It is also important to demonstrate that the exter- and solid waste management. nal funds are used to finance target projects that are sustainable over a longer term and that have Donations sufficient budget for operation and maintenance. Local governments may also benefit from pri- Finally, timely and good financial reporting, a vate donations and funding from charitable clear and balanced budget, and an operational organizations or international donors. Local surplus are vital to making the case with potential patriots (or expatriates), for example, may donate financiers or donors for the reliability and consis- an educational, cultural, or health facility in tency of the municipal plans. exchange for posting their name on the building. For prudent borrowing, the local government International organizations like the U.S. Agency must have a strong financial position and the for  International Development (USAID) may capacity to pay the principal and the future inter- donate various infrastructure. In some cases these est on the loan on time. It is useful to distinguish funds are free and do not require repayment; between (a) debt or borrowing by the local gov- however, many may require cofinancing from the ernment to finance its own projects, to be paid local budget or fulfilling other policy conditions. off out of the operating surplus, and (b) debt incurred by the municipality on behalf of par- Guarantees ticular utilities or investments that will generate Guarantees have a role to play in using exter- revenues and pay their own debt service. In the nal resources. There are two types: (1) A higher first case, one needs good financial reporting with government tier may provide guarantees as a clear projections showing an operational surplus financial support to the local government, mak- of municipal revenues (that is, creditworthiness) ing borrowing cheaper. In some cases borrowing or a credit rating issued by a rating agency such as can be concluded only with a guarantee by a third Standard & Poor’s. Debt in project finance (such party (government or private bank). (2) Local as a water plant) needs a solid financial analysis governments may also request that independent of the project and its projected revenues. If the entities such as utility companies borrow and new project benefits from an implicit or explicit may issue a municipal guarantee to support the municipal guarantee, the creditworthiness of transaction. In this way, the municipality saves both the municipality and the new project should cash from the budget, although it is assuming a be evaluated. Financial feasibility is vital to bor- contingent liability, that is, the risk that the bor- rowing funds for projects that are expected to rowing entity will fail to pay its debt service and generate enough cash flow to service the new force the local government to step in and pay. debt. Overlooking these aspects and making over- optimistic projections have caused severe finan- Conditions for Obtaining External cial problems in many municipalities. The case of Resources Harrisburg, Pennsylvania (see box 7.1), illustrates The preconditions for obtaining external the importance of making realistic assumptions resources will be discussed in detail below, but when deciding whether to borrow or to guaran- it is worth highlighting a few general conditions tee the borrowing of a public entity. 328 Municipal Finances Box 7.1 Harrisburg, Pennsylvania: A Bankrupt City Harrisburg, the capital city of Pennsylvania, when the incinerator failed to pay for its own filed for bankruptcy protection from creditors debt, Harrisburg was called to honor the debt. in mid-October 2011. Harrisburg is the larg- The second factor was the disagreement est municipality to file for bankruptcy since between the city and the State of Pennsylvania, Vallejo, California, in 2008. The decision was which prohibited Harrisburg from imposing a triggered by two factors that heightened the tax on commuters into the city to address its financial difficulties the city was experiencing financial problems. The state held that, instead in debt service to its bond holders: debt ser- of imposing the commuter tax, the city would vice arrears had reached US$60 million. have to sell off revenue-generating assets The main factor was the US$320 million and eventually raise taxes on its citizens. The guarantee the city had provided for a waste city argued that the poverty rate was about incinerator. The project was supposed to be 29 percent and that taxing citizens would self-financing, but its failure left the city on turn Harrisburg into a “ghost town. ” Claiming the hook for the debt. In many cases, cities bankruptcy protection provided the city with a are too optimistic about the capacity of the better set of tools. project to generate enough revenues; and Source: Tavernise 2011. Feasibility Studies helps ensure that the borrowing is consistent Feasibility studies are vital instruments and with the objectives of the municipality (see chap- preconditions for prudent borrowing. Local gov- ters 5 and 6). To maintain alignment of the local ernments in developing countries often pay insuf- government’s borrowing with these objectives, ficient attention to their importance. They may most countries have specific regulations on how order a feasibility study that includes a few hun- much and for what reasons local authorities can dred pages on the technical design of the project, borrow. Whenever the local government has bor- which is a critical part of a feasibility study, but rowing capacity and the projects are justified, retain only a few pages for discussing the financial using debt to finance investment is economically issues. In reality, these documents are not feasibil- sound. ity studies: feasibility studies should have detailed and thorough financial analysis, including real- Planning Infrastructure: istic assumptions about future revenue flows The Capital Investment Plan and risks, sensitivity analysis, and instruments and commitments for effective collection of the While long-term municipal investments require projected revenues, which are all essential for long-term financing instruments, such invest- assessing the financial feasibility of the project. ments should also be selected and designed in Furthermore, it is vital to involve the customers in the context of a longer (3-, 5-, or 10-year) devel- a timely way and to reach agreement on feasible opment plan. Capital investment planning is both and affordable tariffs at this stage. a procedure and an instrument for selecting, A solid capital investment program with developing, and implementing an investment well-defined and appraised development projects program under a rolling multiyear framework Managing External Resources 329 Figure 7.2 Framework for Drafting Capital Investment Plans 1. Identifying 2. Assessing financing 3. Choosing the best infrastructure needs needs and borrowing combination of and priorities (CIP) capacity funding tools that guides, corresponds to, and is transformed Assessing Financial Need and Borrowing into the annual development plan. The prepa- Capacity ration of a local capital improvement plan usu- The finance department explores main financ- ally includes three phases: (a) identification and ing options and proposes financing alternatives prioritization of the infrastructure needs and for each priority project, ensuring that the whole required capital expenditures; (b) assessment package fits into the overall funding capacity of the of the external resources needed, local priori- city, including borrowing. The capacity of a local ties, and what is feasible (within current legal government to borrow depends on two factors: and financial constraints); and (c) determination the projected local revenues that can be used to pay of the best combination of resources and fund- for or cover future debt service and the size and ing, as depicted in figure 7.2. An approved CIP is structure of the existing debt (that is, the average often a published document that informs both maturity and interest rates, which together deter- the potential financiers and the stakeholders mine the debt service for the upcoming years). (citizens, firms, potential investors, and munic- Future revenues and expenditures are pro- ipal entities). Figure 7.3 shows the front page of jected as a function of internal variables (such as the CIP and annual strategic investment plan the fiscal effort of the municipality and its wage published together for the city of Charlotte, in policies) and external variables (such as economic the United States. growth). Other risks need to be considered, such as the political risk to external variables (for Identifying Infrastructure Needs and example, changes in grants or tax-sharing rates or Selecting Priorities failure of higher-level government to cofinance Local governments decide—in multiple interac- the project as initially promised). Changes in tions within their own administration and in dia- intergovernmental finance arrangements can also logue with their constituency—which investments undermine the capacity of local governments to have priority and how to finance them. During adequately project their stream of revenues and budget preparation (see chapters 3, 5, and 6), line investment capacity. Ongoing projects that have departments or other entities and stakeholders received financing or grants from other levels assess the city’s need for new investments, expan- of government need to be taken into account, sion, or repair of existing infrastructure. This as they may require some budget allocation for initial list of priority projects is often long and counterpart funding. Box 7.2 shows the complex- includes many competing proposals. The depart- ity of issues to be addressed in defining financing ment of planning or a development committee options and limits in a 10-year development plan of the municipal council is assigned to evaluate, in San Francisco. rank, and shortlist the proposals based on socio- Assessing borrowing capacity is a key action for economic and policy priorities as well as on funds local governments. It provides a concrete value for available. how much a local government can borrow while 330 Municipal Finances Figure 7.3 Capital Investment Plan for Charlotte City maintaining fiscal balance over the course of full remains below 15 percent of operating revenues. repayment of the debt. It prevents overborrowing In this way, local governments are able to estimate and reduces the possibility that local governments how much they can borrow in a given year and will default on their debt. National governments how many projects can be included in the final, or local rules aiming to reduce the risk of defaults multiyear capital plan. often limit local borrowing by using simple param- eters such as debt stock or debt service flow (debt Choosing the Best Combination of External as a percentage of net revenues). For example, Financing in Brazil, municipalities can borrow if their debt Once the local government estimates how much stock remains below 60 percent of their operat- it can raise in the credit market (and how much ing revenues or if their debt service (the interest concessionary finance it is likely to receive), it payments on outstanding debt and amortization) will be able to choose the best combination of Managing External Resources 331 Box 7.2 San Francisco: The 10-Year Capital Plan, FY 2012–21 In 2006, after decades of underfunded infra- capital expenditures to be funded by the structure, the mayor and board of supervi- local government (called the general fund): sors approved San Francisco’s first citywide, US$4.8 billion-plus for projects in sectors 10-year capital plan. It was the first time that finance their expenditures out of cost San Francisco had thought comprehen- recovery (transport and utilities) and spe- sively about its infrastructure and developed cial large projects that have financing guar- a plan to address the most pressing defi- anteed and are on a project finance basis. cits. Since then, the city has received voter The US$4.8 billion financed by the local approval for major seismic improvements and government general fund is actually half the for increased funding of its streets program; proposed US$9.8 billion budget that the city for a wide range of new libraries, parks, hos- had to cut because of lack of revenues. The pitals, pipelines, transit lines, and museums; overall package includes US$1.18 billion in and for increased support for the “state of current revenues (pay as you go), US$2.4 good repair” renewal needs. billion in new debt (in the form of general The projects were selected based on the obligation bonds), and US$1.3 billion in previ- availability of funding and the priority of ously authorized but not issued general obli- each project. Departments with their own gation bonds. The city’s borrowing capacity revenues—for example, the San Francisco is determined by two approved restrictions: International Airport and the Public Utilities (a) property taxes will not be raised to cover Commission—finance most of their capital the new debt and (b) the debt service of needs out of user fees. Programs that serve San Francisco’s local government will not the general public (such as fire stations) rely be above 3.5 percent of the city’s own (dis- primarily on funding from the city’s general cretionary) revenues. This restriction implies fund and debt financing. that new debt can be raised only after the old The FY 2012–21 capital plan expects debt is repaid. US$24.8 billion in funding. This plan includes Source: San Francisco Capital Plan 2012–21, http://www.sfgov2.org/ftp/uploadedfiles/cpp/Final_FY09-18_Capital _Plan_All_Sections(1).pdf. external resources that matches the duration of and financed, as well as how the city tries to fit the projects and that will result in lower overall the investment plan into its existing resources debt service. and debt capacity. The mayor and the municipal council review the shortlist before deciding on the priority of the From Capital Investment Plan to projects. The resulting document is a multiyear Financing Plan CIP that includes the priority projects, explains how they fit with the vision of the city, and maps Preparing Capital Investment Plans out how they will be financed. Both the five-year Many local governments prepare rolling, multi- capital plan of Charlotte city (figure 7.3) and the year capital investment plans every year, which San Francisco 10-year plan (table 7.1 and box 7.2) name the priority capital projects for which finan- illustrate how the investment plan is organized cing is guaranteed (see also chapters 5 and  6). 332 Municipal Finances Table 7.1 San Francisco’s 10-Year Capital Plan by Department US$ millions Sectors General fund External and self-financing Total Public safety 1,777 0 1,777 Health and human services 1,129 565 1,694 Infrastructure and streets 1,033 6,550 7,582 Education and culture 678 778 1,456 Neighborhood renovation 92 4,179 4,271 Transportation 0 7,842 7,842 General government 165 0 165 Total 4,873 19,914 24,787 Pay as it goes 1,183 0 0 Debt 3,690 0 0 Source: San Francisco Capital Plan 2012–21, http://www.sfgov2.org/ftp/uploadedfiles/cpp/Final_FY09-18_Capital_Plan_All _Sections(1).pdf. CIP  preparation starts with the identification • Title and description of the proposed project of the infrastructure needs of the city, including include, for example, the size, location, and deficiencies in coverage and the need for expan- cost of a school and how long it will take to be sion or renovation of existing infrastructure. completed. If the city has developed a city development strategy—that is, a medium-term economic vision • Financing includes the proposed financing of what the city wants to be in the future—then over the next five-year period, as well as the most certainly the strategy includes a capital cost of completing each phase of the construc- investment plan identifying the investments tion and its estimated operating and mainte- needed to attain that vision (World Bank 2002). nance costs after completion. However, even if a city has a development • Environmental impact includes how the proj- strategy, it needs more detailed information for ect will affect the environment, both positively the particular projects included in the annual (by reducing greenhouse gas emissions) and development plan. The proposals come from negatively (by generating pollution or traffic). individual departments in the municipality. For example, the education department may propose • Past performance includes municipal spending the construction of two new schools and repairs on infrastructure and in the particular sectors on 13 classrooms, and the transportation depart- (education, roads) in the previous five years.1 ment may propose the pavement of six streets Once the municipal authority defines its invest- totaling 10 miles of road. ment priorities and selects the individual The information provided typically includes projects (possibly in conjunction with key busi- the following elements: ness and civil representatives), the next step • Municipal information includes a city vision is to decide how to finance the plan. This is and strategy and how the project fits into the basically an iterative process, since financing city’s vision of itself, its demography, and its options—project-based financing, budget financ- business or social needs. ing, general obligation bonds, or public-private Managing External Resources 333 Box 7.3 Citizens’ Involvement in City Investment Plans City investment plans are often discussed with the community and with a wide range of stakeholders. Many cities in the United States hold specific “town hall” meetings or public hearings and use electronic means to collect the suggestions of the community on priority investments. Some systems require referendums or a supermajority vote on councils to autho- rize major borrowings. partnerships—influence not only the total funds Table 7.2 Financing the City Investment Plan of available but also the list of priority projects. the City of Charlotte, 2011–15 Thus, after looking into financing options, the Financing sources US$ municipal authority might revise the priority list Financed by general fund 256.7 to avoid unfunded high-priority projects and also Bonds (participation bonds) 203.6 to ensure that funding opportunities are put to Independent utilities 2,131.2 best use. Total 2,591.5 Some cities have developed municipal con- Source: Charlotte 2011–15 Capital Investment Plan, http:// tracts that outline a priority investment plan charmeck.org/city/charlotte/Budget/Documents/FY2011 (based on an urban audit) and a municipal Strategic Operating Plan.pdf. improvement plan (based on a financial audit or on a financial self-assessment of the munic- council. Most likely, the city budget will include ipality). Those cities with municipal contracts its own revenue, transfers from the central and in place carry out the selection of priority state government, local taxes and borrowing, and investments on a very participatory basis, typi- external resources. The revenue-producing util- cally involving citizens and interest groups (see ities are normally included in the CIP, and their box  7.3), and the final selection is based on the revenues and expenditures reported explicitly financial capacity of the local government. Such but outside the municipal budget. a model has been very effective in Africa, among Let us take the case of the Charlotte city other places, where over 200 municipalities have investment plan summarized in table 7.2. The implemented several generations of municipal city spent two years preparing the full plan, based contracts, thereby introducing accountability in on dialogue with the business community. The public spending. The financial self-assessment objectives were to promote economic develop- of the municipality will be further discussed in ment and better living conditions for its citi- chapter 8. zens. The total cost for 2011–15 is US$2.5 billion, Besides funding options and CIP structur- financed by general revenues (10 percent) and by ing, local governments also need to discuss how borrowing and special bonds issued to the general to include the legally independent utilities—for public (8 percent), with the rest financed by large example, the water utility and the solid waste man- municipal enterprises operating in self-financing agement company—into the broad CIP with inde- sectors such as water and sewer, aviation, and pendent financing (possibly using project-based storm water, whose capital plans can be funded financing and user fees) with the approval of the by service charges. 334 Municipal Finances Project Selection Tools useful analytical tools and indicators are available that should be used when possible for selecting or To choose among capital investment projects, prioritizing capital projects: local governments should have a clear sense of priorities and criteria to help them value and • Cost-benefit analysis (CBA) compare projects. Once the list of potential proj- • Internal rate of return (IRR) ects is put together, staff of the local government evaluate them according to criteria established • Net present value (NPV). in advance and rank them in line with those cri- teria (such as costs and benefits) and according These instruments are critical indicators of to their merits or relative profitability as well as feasibility. They indicate how much a project is feasibility and preparedness. The analysis is often worth and help rank technically different projects. carried out by the technical staff of the plan- Chapters 5 and 6 also discuss these instruments. ning department, sometimes in parallel with the A short summary of them from the financing project department of the development bank or perspective is included below. However, most with a central government entity. This is often local governments do not have internal capacity a time-consuming task because departments in to apply these instruments and hire consultants, government have different ways of appraising or especially for conducting a cost-benefit analysis preparing projects, and often project benefits and for projects that may need donor or lender financ- costs are hard to quantify. ing. For projects funded from governments’ own Many times, however, projects are selected on resources, simpler evaluation criteria are used. political grounds (for example, a project for which the mayor has received a special allocation) or Cost-Benefit Analysis because they are financed by the central govern- Cost-benefit analysis is an economic decision- ment and may not be subjected to the prioritiza- making approach used to assess whether a pro- tion exercise. Ideally, the central government’s posed project, program, or policy is worth doing projects should be accounted for and listed in the or to choose between several options. Such an CIP plan to the extent that reasonable informa- analysis compares the total expected costs of a tion is available. The lack of coordination across project with the total expected benefits and estab- government tiers not only is inconvenient to citi- lishes whether the benefits outweigh the costs zens but also creates extra costs (see box 7.4). and by how much. In a CBA, all kinds of direct Although it is widely accepted that politi- and indirect benefits and costs are expressed in cal preferences, preparedness, and feasibility money terms and are adjusted for the time value are important in the choice of priority projects, of money. This process is often very complex and Box 7.4 Lack of Coordinated Plans A city in Pakistan resurfaced its main street under a donor project, but a few weeks later the department of public health commenced replacement of the sewer main on the same street, carved up the new road, and failed to fix the surface properly. A multiyear plan approved and shared with government would have saved both time and money. Managing External Resources 335 Table 7.3 Cost-Benefit Analysis of a Bus project and after, and to attach value to the time Terminal Project over 10 Years based on income estimates. US$ thousands Present Discount Rate Costs and benefits value The first challenge in the cost-benefit analysis is Costs to compare various costs and benefits indepen- dently of the year in which they happen; this cal- Direct project costs culation requires translating the nominal values Cost of design 100 into present values. For calculating the present Civil works 2,000 value of future revenues, we use a discount fac- Financing costs 300 tor d, which is the inverse of a discount interest Operation and 5,000 rate r; thus, di = 1/(1+r)i in any future year (i). The maintenance d discounts the value of money over time rather Other costs Noise 200 than compounding it. For instance, a nominal or Pollution 800 future value of 2 million (in any currency) in reve- Total 8,400 nue over three years would be 2 + 2 + 2 = 6 million. Benefits However, if the discount rate is 5 percent, the Direct revenues for Fees from buses 4,500 earnings of the first year would be the nominal the investor Parking fees 1,500 2 million, but in year 2, the present value of the municipality (cars, motorcycles) earnings would be only 2/(1.05) = or 1.82 million; Lease fees from 500 and in the third year would be only 2/(1.05)2 = cafe, restaurant 1.65 million. Using the R*di formula, 2*1 + 2*0.952 Taxes 1,000 + 2*0.907 = 5.719 million total present value of this Indirect revenues Travel time saving 300 revenue stream.2 Jobs, wages, profit 1,200 The choice of the discount rate reflects the Total 9,000 value we give to time, based on local circum- stances and opportunities. How do we choose a discount rate? We may use the long-term bor- time-consuming, especially as one tries to mon- rowing rate, inflation rate, or capital market yield, etize special benefits and costs. In this way, all since typically these are real opportunities. We flows of benefits and all flows of costs over time may use a rate reflecting the yield typical in sim- (which tend to occur in different magnitudes and ilar projects, similar services, or similar invest- at different points in time) are quantified and ments. But we need to be pragmatic in choosing expressed in present value terms. Future streams the adequate rate, and it is always better to com- of costs and benefits are converted into a pres- pare the various discount rate options: ent value amount using a discount rate. Table 7.3 • A low discount rate implies that we value summarizes the costs and benefits of a bus termi- the future generations on the same basis as nal project, translated into present values, after ourselves. nonfinancial costs (such as noise, pollution) and benefits (time saving) are also estimated in finan- • A high discount rate means that we value the cial terms. For instance, estimating the time sav- present generation more than the future ones ings needs special surveys, such as traffic counts, and that the costs inflicted on future genera- to quantify the number of passengers on various tions are less important than those we bear days, to measure the commuting time before the today. The rate chosen makes a large difference 336 Municipal Finances in the assessment of investments with long- Adjusting for time, we would derive the net pres- term effects such as climate change, and thus ent value as discount rates are a source of controversy. NPV = ∑ Ri/(1+r)i − ∑ Ci/(1+r)i, The net present value is the difference between where r is the interest rate and i would be the the initial investment plus discounted revenues years 0, 1, 2, …, n. and the discounted costs during the active life of When the net present value is greater than the project evaluated at a given discount rate. The zero, the discounted revenues are greater than NPV should be greater than zero for economi- the discounted costs, indicating an economic or cally justified projects. A negative NPV suggests business justification for the project. that we would lose rather than generate real-term The internal rate of return is the discount rate money with the planned investment. that makes the net present value equal to zero, The internal rate of return is the discount rate that is, the largest discount rate at which the total at which total costs, including the initial invest- benefits are equal to the total costs. If the IRR ment, equal the total benefits of the project. is greater than the current market interest rates If  the IRR is greater than the ongoing compa- (or the price of the capital for the government), rable long-term interest rate (for example, the the project is certainly worthwhile implement- bank deposit rate), the project is considered ing. If the IRR is less than the price of money, the economically justified (meaning that we would project should not go ahead. The more profitable gain more than by simply depositing the money the project is, the higher the IRR will be. in a bank). Often, we use cost-benefit analysis to measure To apply the above, consider Ci the cost of a the benefits of alternative interventions or to cal- project in year i and Ri the benefits in year i. The culate an outcome with and without an interven- total cost of the project will be ∑ Ci, the total return tion, as in the example of the proposed covered will be ∑ Ri, and the total net value =  ∑ Ri − ∑ Ci. market in Newville in box 7.5. Box 7.5 Cost-Benefit Analysis, Internal Rate of Return, and Net Present Value: An Example To introduce the concepts of cost-benefit mayor has to decide whether this proposed analysis, internal rate of return, and net pres- business makes sense. ent value, let us start with a simple example. What do you think? The local government in Newville received the following proposal. A group of retail busi- The cost of the project for the municipality is nesses would like to develop a covered mar- US$10 million. The returns are US$12 million ket. They propose that the municipality invest total. At first sight, the project will pay for US$10 million in infrastructure. In return, the itself and yield a net value of US$2 million. business community will pay a US$2 million It seems that the mayor could approve the annual lease fee for the first six years. The project. (continued next page) Managing External Resources 337 Box 7.5 (continued) Is that so? What about the value of time? us choose the 8 percent rate that the bank has Taking the time into account, we see that the offered to the municipality for a time deposit. US$2 million in year 2 or year 3 is not the same What would be the result? By using the for- as the US$10 million spent in the first year. It mula NPV = ∑ Ri / (1+r)i − ∑ Ci / (1+r)i, the r has less value as time passes; and what if a would be 8 percent, and we would need to bank offers 8 percent annual interest for the compute the present values of revenues and six-year time deposit? costs for the six years. Table B7.5.2 shows the To help the mayor make a decision, we results. display the annual costs and annual earnings Lessons in a single worksheet and use a discount rate The present value of the total cost does not to make the values comparable over time (see change, because there was only one cost table B7 .5.1). item; but the present value of the revenue Let us take these values to our mayor. The stream has changed. The present value (PV) cost would be US$10 million; the return would of benefits with the 8 percent discount rate be US$2 million a year and US$12 million in would be only US$9.246 million, which is actu- total. Thus, we would have US$2 million net at ally lower than the cost of the project. The net the end of the period; it looks nice. present value is US$−0.754 million. Therefore, Let us now choose a discount rate to con- it is not a good idea for the city to finance the vert the nominal values into present value. Let project under these conditions, since the city could gain more from depositing that money Table B7.5.1 Current Values in a bank. But also, based on the calculations, US$ millions the local government should request the busi- Year 0 1 2 3 4 5 6 Total ness community to commit or contract to pay a higher annual fee, say, US$2.3 million, which Cost = C 10 10 would ensure a higher rate of return and a Benefits = B 2 2 2 2 2 2 12 positive net present value. Net value −10 2 2 2 2 2 2 2 (∑Bi − C ) Table B7.5.2 Calculation of Net Present Value with an 8 Percent Discount Rate Present Year 0 1 2 3 4 5 6 value (1) Compounded discount rate 1.08 1.166 1.26 1.36 1.469 1.587 (2) Cost = C 10 10 (3) Benefit = B 0 2 2 2 2 2 2 (4) Discount factor di = 1/(1+r)i 0.926 0.858 0.794 0.735 0.681 0.630 (5) Net benefit 1.852 1.715 1.588 1.47 1.361 1.26 9.246 NB = Ri /(1+r)i = di*Bi (6) Net present value (∑NBi−C ) −10 1.852 1.715 1.588 1.47 1.361 1.26 −0.754 338 Municipal Finances Financing Alternatives: Loans or and how the private investors perceive the risk Bonds of the individual local authority. Some countries have had long-standing experience in raising pri- Local governments in developing countries vate debt for urban infrastructure (see box 7.6). rely mainly on grants to finance infrastructure; Local authorities in North America rely mainly however, many have tried to expand and diver- on municipal bonds, while in Western Europe sify their financing by mobilizing market-based municipal banks have been created to help local options as an alternative. Typically, these options authorities. Bond financing is not necessarily an include the following external resources: incremental supplement to other instruments; it • Borrowing from financial institutions or spe- could be quite significant, if the capital market cialized development banks is robust. For example, the market for municipal bonds in Canada and the United States is larger • Accessing capital markets or issuing bonds than the market for corporate bonds. In developing or emerging economies, local • Engaging private sector participation through governments’ access to credit markets is hindered contracts, leases, and concessions. by various factors: The success of local governments in leveraging • Local services such as water supply and solid market-based funds for local investment varies a waste plants are not attractive to private inves- great deal, depending on the depth of the local tors, who fear that the projects have limited credit markets, the quality of local governance, cost recovery and long gestation. Box 7.6 Local Government Borrowing in North America and Western Europe The U.S. municipal bond market was orig- deposits and government contributions to inated in response to the country’s urban establish municipal banks and financial insti- expansion in the 1850s. Municipal investment tutions. Examples of municipal banks include in North America was largely financed by spe- Dexia Credit Local of France, BNG of the cific purpose revenue bonds (issued to finance Netherlands, Banco de Credito of Spain, and a particular project), also called project financ- Credit Communal of Belgium. The 2008–10 ing; others preferred using general obligation financial crisis affected these large banks as bonds (see below for the description of types they launched some nontypical products to of bonds). The central government endorsed compete with other financial institutions. As decentralized financing by conferring tax-free a result, some entities were nationalized and status on municipal bonds and contributing to were totally overhauled, as was the case of state revolving funds and bond banks so that Dexia Credit Local, which was rescued by smaller municipalities could benefit from bond massive public capital and the administra- resources without being penalized for their tion totally changed. But all have continued small size. their role of working with municipalities, Western Europe leveraged the histori- although now restricted to domestic local cal preferential access to long-term saving authorities. Managing External Resources 339 • Local governments often have a weak fis- although bonds are increasingly issued only elec- cal position with a small current surplus and tronically, without a printed paper form, creating unpredictable transfers from higher govern- considerable savings for the issuers. ment tiers. Bonds bear interest at either a fixed or a vari- able rate. The date on which the issuer repays the • Local capital and financial markets are emerg- principal—that is, the bond’s maturity date—may ing and do not offer good products for local be years in the future. Short-term bonds mature governments. in one to three years, while long-term bonds gen- erally will not mature for more than a decade. Capital Markets: Issuing Municipal Bonds Individual investors hold about two-thirds Municipal bonds have been widely used in North of the roughly US$2.8 trillion of U.S. municipal America to finance local government investment bonds outstanding, either directly or indirectly but are much less popular in Europe, especially through mutual funds and other investments. in France and Germany, where local governments Bond investors are typically seeking a steady largely borrow from specialized banks like Dexia. stream of income payments, and compared to stock investors, they may be more risk averse and What Is a Municipal Bond? more focused on preserving than on accumulat- A municipal bond is a debt obligation issued by a ing wealth with more secure but lower yields. local authority with the promise to pay the bond Municipal bonds have been extraordinarily interest (coupon) on a specified payment sched- successful in raising capital for infrastructure ule and the principal at maturity. Thus a bond investments in U.S. cities, in part because the fed- works like a loan: The issuer is the borrower eral government grants tax-free status to munici- (debtor), the holder is the lender (creditor), and pal bonds. The U.S. municipal bond market grew the coupon is the interest. The purpose is similar from US$66 billion in 1960, to US$361 billion in to a bank credit. The issuer (the local government) 1981, to US$2.8 trillion in 2010 (Shapiro 2010). In sells bonds to the general public (often through an 2010, more than 50,000 entities issued a record investment bank) and uses the proceeds from the US$327 billion in municipal bonds (Platz 2009). sale to finance capital projects such as schools, Outside the United States, the market for sub- sewer systems, and the like. (Box  7.7 explains national debt has grown in the past 10 years from underwriting, a process for issuing bonds.) A US$270 billion to US$396 billion, with the aver- bond may be printed and traded like a bank note, age maturity increasing from 7.14 to 9.45  years. Box 7.7 Underwriting The most common process for issuing bonds is through underwriting. In underwriting, one or more banks buy an entire issue of bonds from an issuer and resell them to investors. The secu- rity firm thus takes on the risk of being unable to sell the issue to end-investors. Central and local governments usually issue bonds by auctions, where both the public and banks may bid on them. However, the costs can be too high for a smaller loan, in which case the bond is issued as a private placement bond, which is held by the lender and does not enter the large bond market; this process represents a special form of bank lending. 340 Municipal Finances Municipal bond financing has already been the sum of Mex$90 million. Currently, three other undertaken in many countries; box 7.8 gives exam- Mexican cities have outstanding bond issuances ples of cases in Africa, Latin America, South and totaling US$1.86 billion (Fitch Ratings 2009). East Asia, and Europe. For Latin America, cities in Argentina, Brazil, Colombia, and Mexico have Types of Bonds issued both general revenue and specific purpose There are several types of municipal bonds, bonds. The city of Aguascalientes was the first including general obligation bonds, revenue Mexican city to issue a municipal bond in 2001 for bonds, and structured bonds. Box 7.8 Municipal Bonds in Developing or Middle-Income Countries • Rio de Janeiro was the first city in Latin between US$148,000 and US$500,000 America to successfully issue a bond in with maturities of two to three years. the international capital markets. The city China is revising legislation to allow munic- issued a bond in July 1996 to refinance ipalities to access the bond market, given its existing debt (with an interest rate of the increasing pressure of Chinese cities 10.3 percent for US$125 million over three on bank credit. China has used bonds in an years). The bond was unsecured, despite indirect way. the fact that this was the first time the city • Indian municipalities such as Ahmedabad had issued international debt. Since then, Municipal Corporation have raised about tight fiscal regulations have prevented US$290 million, mainly to finance water municipal bond issuances in Brazil (Platz supply and sewerage systems. To reduce and Schroeder 2007). the risk and increase the marketability of • Bogotá followed Rio’s example and issued these bonds, the India Securities Exchange international bonds in 2001; US$100 million Board is issuing guidelines to increase the were sold at a 9.5 percent interest rate and transparency of issuances and protect a five-year term to raise funds to finance investors’ interests. infrastructure projects. The bonds received • The city of Johannesburg is the only city global ratings by Fitch Ratings of BB+ and in South Africa to have issued municipal Standard & Poor’s of BB. The 2001 Bogotá bonds in recent years, although Kigali, bonds had no sovereign guarantee. Rwanda, is also contemplating this pos- • Zimbabwe issued municipal bonds with sibility. Johannesburg has launched sovereign guarantees, as have Sofia in four institutional bonds totaling US$506 Bulgaria and Moscow and St. Petersburg million. South Africa is the only African in the Russian Federation. country that issues municipal bonds. • Issuers in Asia include Japan, the Republic In 2004, the city of Johannesburg pur- of Korea, Malaysia, and the Philippines chased a partial bond guarantee from (Peterson, G. and P . Annez 2008). Since the Development Bank of Southern 1991, at least 13 local Asian governments Africa (DBSA) and the International have issued bonds totaling US$34.5 million Finance Corporation (IFC), guaranteeing (Platz 2009). The issues have ranged 40 percent of the bond’s proceeds. Source: Ngobeni 2008. Managing External Resources 341 General Obligation Bonds Revenue Bonds General obligation bonds are serviced from Revenue or special purpose bonds are secured by the general revenues of the local govern- the anticipated revenues from the project being ment, such as Rio de Janeiro, Buenos Aires, financed. For example, in a freeway project, the or Johannesburg (see boxes 7.9 and 7.10). The tolls will be used to pay the bonds; in a water proj- municipality uses its full set of revenue sources, ect, the tariffs will do the same. In the case of the including its taxes and fees, intergovernmental Madurai Municipal Corporation, India, the local transfers, and unconditional grants, to service government issued a revenue bond to finance the outstanding debt and interest. If the local 27 kilometers of the Madurai inner-ring road. governments have outstanding debt and the The bond issue generated US$23 million, with a market doubts that they will generate enough 10-year maturity at a 12 percent interest rate. A general revenues to pay the debt service, a special enhancement scheme and guarantee fund portion of those revenues is deposited into an enabled the issue to be rated AA+. The bonds escrow account to ensure the timely servicing were to be repaid by the tolls charged for use of of the bonds. that road. Box 7.9 General Obligation Bond Issue by Novi Sad The city of Novi Sad, Serbia, issued the first municipal bonds in Serbia in 2011, for a total of a35 million. The bonds were issued at an annual rate of 6.25 percent for a 12-year maturity, with a grace period of 2 years. The resources will finance the completion of the Boulevard of Europe and the construction of 100 kilometers of sewerage networks. UniCredit Bank in Serbia was the underwriter. Some economists believe that the desire to put the city on the capital market map was the primary reason for issuing the bond, not economic or financial considerations. Source: Novi Sad 2011. Box 7.10 Long-Term Bond Issue in the City of Johannesburg In 2004, the city of Johannesburg tried to access the bond market with a general obligation bond to lower the general cost of the debt. The bond issue had several objectives: (a) to extend the maturity of existing debt; (b) to finance long-term infrastructure projects; (c) to refinance existing high-cost bank debt; and (d) to diversify funding sources beyond bank lending. The city looked for funding beyond 10 years, but to do so at a reasonable price required credit enhancement. IFC assisted in structuring the operation and provided a partial credit guarantee (for 40 percent of the total) shared with the Development Bank of South Africa. As a result, in June 2004 Johannesburg managed to issue a US$53 million 11.9 percent bond to mature in 12 years. Fitch Ratings gave the city an A−rating. The bond issue was oversubscribed 2.3 times. Sources: IFC 2004; Platz 2009; Amim 2010. 342 Municipal Finances Structured Bonds and pending payments, and the future factors Structured bonds are secured by revenue sources that may affect the creditworthiness of the local that differ from the revenues generated by the governments. A high (investment-grade) rating project itself. For example, the province of by a reliable credit agency is particularly benefi- Mendoza, Argentina, issued international bonds cial. In general, insurance companies and provi- to restructure its domestic debt. The provincial dent funds (funds financed by contributions from government used the province’s expected oil roy- members) are the main purchasers of municipal alties to secure the payment of the bonds, both to bonds, and they need to be sure that the assets are service the bonds and to redeem them at maturity. secure. However, credit ratings are expensive, and In developing countries, investors concerned municipalities may need to assess whether the about the creditworthiness of local governments advantages associated with the rating are less than tend to prefer structured bonds, since the local the expected gain from having their bond rated. government ensures that the bonds will be paid regardless of any internal or external develop- Rating Agencies ment. That is done through the intercept of inter- Rating agencies play a key role in providing the governmental transfers, as well as oil revenues; market with information on the capacity of a that is, before transfers or royalties are deposited given local authority to issue debt and pay it on in the local government account, a sum is taken time. The rated municipalities must share their out (intercepted) to pay the debt service. key financial data with the public and enforce their own fiscal discipline. Risk and Credit Ratings Three major rating agencies for municipal Credit ratings are assessments of the creditwor- bonds account for 95 percent of all international thiness of a given local government or bond issue ratings around the world: made by recognized rating agencies. Basically, the • Moody’s Investors Service rating indicates the risk that a particular govern- ment will not pay the bond’s interest and prin- • Standard & Poor’s cipal on time. Box 7.11 summarizes the evolving • Fitch Ratings. ratings in emerging economies (for more details, see Peterson 1998). Ratings combine quantitative analyses and The assessment of risk is based on the eco- judgment about the capacity of the municipality nomic and financial conditions of local govern- to repay the debt on time; results are published ment, past fiscal indicators, the structure of debt with specific scores (rating grades). In assigning Box 7.11 Ratings in Emerging Economies Ratings are mandatory for local governments in India, when the issue maturity is more than 18 months. Emerging economies that have local government ratings include Argentina, Brazil, Bulgaria, India, Kazakhstan, Malaysia, Mexico, Morocco, Poland, Romania, the Russian Federation, South Africa, Turkey, and Ukraine. Mexico has been particularly active in promoting the preparation of credit ratings for local governments as a base for both bank credit and bond issue. Managing External Resources 343 a rating for general obligation bonds, the rating Comparing Bonds and Bank Credit agencies assess the following factors: Are all local governments able to issue bonds? No. Only local governments with considerable invest- • The local and national economy ment programs, good ratings, and long-term • Debt structure financial needs will be able to do so. Borrowing from commercial banks or bond banks or syndi- • Financial condition cating a loan might be better options for smaller • Demographic factors local governments, given the advantages of issu- ing bonds. How can one compare the loan or bond • Management practices of the local govern- alternatives? Advantages and disadvantages of ment and the legal framework. bonds and loans are explained below and summa- Rating agencies use mathematical ratios to rized in table 7.5 and box 7.12. compare an issuer to others. But a rating is not a scientific evaluation, and subjective judgment Bonds Have Advantages plays a fundamental role in the rating assigned. In Among the benefit of bonds are that local govern- the case of Moody’s rating, for example, the nota- ments receive all the money they need up-front, tion ranges from Aaa (strongest creditworthiness) rather than gradually, as with the typical dis- to Baa (average creditworthiness). Table 7.4 sum- bursement process in banks, and that the funds marizes the different notations of the three rating are usually obtained more cheaply than through agencies. There are grades C and D, too, but clients bank credit, often by two or three percentage are better off avoiding having their performance points. The terms of the funds are also fixed rated if they are likely to receive such a low grade. for the whole period of the issue and cannot be A bond rating performs the function of a credit changed or recalled. risk evaluation. It does not constitute a recom- mendation to invest in a bond and does not take Bonds Have Shortcomings into consideration the risk preference of the Among the shortcomings of bonds are the investor. However, the market follows credit risk following: ratings quite closely, and in the case of bonds, the rating is often the single most important factor • Preparing a bond issue is complex. It requires affecting the interest cost. Although municipali- good data, understanding and disclosure of ties are rated on their merits, the country rating is financial and economic information on the considered a ceiling for subnational entities; thus, local government, and knowledge of the mar- the rating of a city cannot be better than that of ket to ensure that the issue is placed at favor- the host country. able terms. Table 7.4 Investment-Grade Ratings of Three Rating Agencies Rating Moody’s Standard & Poor’s Fitch Ratings Best quality Aaa AAA AAA High quality Aa1, Aa2, Aa3 AA+, AA, AA− AA+, AA, AA− Upper-medium grade A1, A2 A+. A A+, A A3 A− A− Medium grade Baa1, Baa2, Baa3 BBB+, BBB, BBB− BBB+, BBB, BBB− 344 Municipal Finances Table 7.5 Comparison of Bonds and Bank Lending Bonds Bank lending Cost High transaction costs with expensive Simple and fast transaction without costs, preparation except for syndicated loans Maturity Relatively longer term Short term Interest rates Fixed rates Floating rates Repayment Redemption at maturity In installments Merits and demerits Fund raising from extensive investors; The credit rating is not required; banks may high credit rating is required for the offer “relationship lending” based on the issuance. trust built on previous interactions with the bank rather than on specific clear risk indicators (but pros and cons remain). Box 7.12 A Comparison of Bonds and Bank Lending • Long term or short term. Bonds can be local government provides flexibility in loan used for short-term and long-term invest- conditions. Borrowers can pay off the loan ments and cover a variety of needs, includ- partly or totally, at any time, with little or ing infrastructure development. Generally no warning. A downside, however, is that speaking, a bond is meant to finance a lenders can also change the terms of the long-term investment, whereas a bank deal, although borrowers can (in theory) loan is more suitable for short-term needs. move their accounts elsewhere, assum- • Accessibility to the market. The bank loan ing another lender is available. In any case, is open for most municipalities (provided banks are entitled to manipulate lending they have a regular stream of income), terms almost at will. while the bond market implies costly and • Reputation on the bond market. Local cumbersome hurdles for the aspiring governments need to build up a reputa- local authority. Only those that have gone tion. Local government is better protected through the process can operate in the from unilateral change in conditions, since bond market, but once the local govern- the issue of bonds involves standardized ment is accepted in the market, the admin- terms and conditions, depending on the istrative and search costs of borrowing terms on which the capital is borrowed. capital drop significantly. Although standardization strengthens • Flexibility and information. Most local gov- the ability to reach a wider range of ernments use bank credit. Local banks investors, helps lower search costs, and satisfy liquidity needs and provide a set acknowledges liquidity—bond proceeds of banking services on a daily basis. are immediately available to the borrower Eventually, banks engage in a long relation- without any conditions and regardless ship with municipalities that benefits the the timeline of project implementation— latter whenever the need for capital arises. it makes renegotiation in the case of diffi- The relation between the bank and the culties virtually impossible. Source: Platz 2009. Managing External Resources 345 • Bond issuing is expensive. Local governments Several countries have made an effort to develop (issuers) need to pay fees to the rating agency, local rating capacity to help municipalities fees to the bank that sells the bonds to the improve their data and increase their capacity public (underwriter), fees for the operations to borrow from the market. Box 7.13 summarizes in the capital market, and the cost of market- the case of Mexico and the efforts put forward by ing and publicity. For instance, Fitch Rating’s the central government to establish a culture of fee for rating municipal bonds can reach up to local government rating that can be used by the US$750,000 per issue (see www.fitchratings entire banking system when lending to the local .com). The cost depends on the time and effort governments. it takes to evaluate the bond issuer. Given the lack of data on small municipalities, rating can Conditions for a Successful Bond Issue be really expensive for them. Small or medium The success of municipal bond markets depends municipalities can rarely issue bonds because on the size and debt of the domestic financial of the high cost of such issues and because market and the legislation regulating local gov- potential investors are not very interested in ernment borrowing. Domestic capital markets small issues. develop with the growth of domestic pension Box 7.13 National Rating in Mexico Mexico stimulated local government credit ratings with the regulations introduced in 2004 by the national banks and securities commission. The regulations mandate that banks make provi- sions (that is, earmark reserve funds for potential defaults) that increase with the maturity of the outstanding debt and in proportion to the risk level determined by the credit rating assigned by one external rating agency. If the local government entity is not rated, banks assign the highest risk level, and their motivation to lend to such an entity is obviously diminished. Source: Annez and Peterson 2008. Box 7.14 Modernization of Local Investment Finance in Mexico Local Mexican authorities did not have direct access to capital markets. Most of their financing was obtained through the official bank (Banobras) in the form of short-to-medium term bank credit. The adoption of the national rating obligation that was used first for banks had power- ful implications for the development of the local debt markets. Local Mexican governments can now access funds from insurance companies and investment banks. The debt issues are expanding, with reserve funds that require the issuer to deposit three years of debt payment as a guarantee to investors. Source: Annez and Peterson 2008. 346 Municipal Finances funds (as in Chile and Mexico; see box 7.14), the the 1990s—have discredited local governments in decentralization of services and revenues to local the financial markets and explain why commer- governments, and the strengthening of local insti- cial banks are reluctant to lend to local authori- tutions, including improved capacity to produce ties without adequate guarantees from higher financial reports according to standard practice. government tiers. In the United States, famous In countries where pension funds and the insur- local bankruptcies, including Orange County, ance companies are authorized to invest in local California; New York City; and Washington, DC, government debt, the capacity of local govern- occurred in the 1990s. At present, a new surge ment to issue paper is substantially enhanced. of local governments is filing for bankruptcy, as Legislation is also necessary to explicitly the debt issued to finance investments (such as authorize the local governments to issue bonds, sewers and incinerators) has mushroomed and including publication of the information that local governments find themselves in arrears and needs to be made available and how the issue is close to default. Box 7.1 summarizes the situation compatible with the institutional framework in in Harrisburg, Pennsylvania, a city that defaulted place. The debt of the local authorities is always because it had issued a guarantee to the builder of regulated by a law on public debt, followed by a an incinerator. special regulation on local debt. This law regu- lates at least three issues: (a) debt authorization Reasons and Rules for Debt Regulation for each type of local government; (b) types of To restore the confidence of the private sector in authorized debts (short term, long term, loans, the municipal sector and keep local governments’ and bonds); and (c) establishment of a debt limit. debt within their paying capacity, most countries Throughout the history of the United States, have passed legislation establishing the limits and the print media have actively provided criti- conditions for local government borrowing. Some cal information to investors. Rating agencies countries prohibit municipal borrowing (Chile, appeared in 1909 and ever since have played an China, and Pakistan, for example). But in the important role in emerging and established mar- majority of cases, the controls apply to the max- kets. In the past 60 years, ratings have become imum amount local governments can borrow (or a “sine qua non” for most corporate or public the debt ceiling), the type of borrowing allowed issuers seeking to mobilize large sums of capital. (generally, local governments are not allowed to Ratings can be especially important for lesser- borrow abroad), or what types of expenditures known issuers that seek to gain footholds in the can be financed with borrowed funds (in general, domestic market or access to international mar- capital expenditure). kets (Platz 2009). Unfortunately, the financial cri- Brazil has introduced tight debt limits to avoid sis of 2008–09 and the role played by some rating repetition of the debt crisis in the 1990s, when agencies have seriously affected confidence in large municipalities such as Rio de Janeiro and these agencies. São Paulo had to be bailed out repeatedly and the national government absorbed their subnational debt. When national governments allow the local Subsovereign Debt Regulations or state governments to borrow in foreign cur- While many local governments have accessed rency, they implicitly assume a responsibility to long-term financing, some have failed to pay their bail out those governments in case they do not debts on time, leading to increasing costs, embar- pay on time. Indeed, the reputation of a nation rassment for the central government, and even- in the international markets can be seriously tually bankruptcy. Several such cases—mainly in affected when a large local government defaults. Managing External Resources 347 Brazil’s law of fiscal responsibility mandated Most OECD and European Union (EU) member fiscal discipline from local governments, an states allow local borrowing for capital invest- important step that indicated a clean break with ment purposes as well as liquidity (short-term) the overborrowing of the past (see box  7.15). loans but require them to be paid back within Since most of the 5,560 Brazilian municipal- the budget year. Some of the controls used in the ities had approached their debt limits, the OECD member states apply to debt stock, guaran- national government prohibited new munic- tees, revenue to secure debt, purposes, and inter- ipal debt issuance in 2000. At the same time, mediaries (see box 7.16 for a detailed list of rules Mexico promoted the development of domestic in selected countries): markets for local government debt and encour- • Controls on the debt stock or on debt service aged the use of local government credit ratings (that is, amortization plus interest) place (Platz 2009). limits on the amount of debt, generally The regulations on local government borrow- defined as a percentage of annual revenues. ing are typically focused on four rules: In Brazil, debt stock cannot be greater than • The use of the loan proceeds. The loan should 60 percent of current revenues; debt service finance long-term investment projects, not should be lower than 25 percent of current current expenditures. revenues. • The debt limit. The debt stock (total debt out- • Controls on guarantees apply to the issuance standing) or debt service (payment of interest of guarantees and types of collateral a local and amortization on the debt stock) should be government may offer to a lender. Municipal limited to a certain percentage of revenues. guarantees are justifiable in support of essen- tial service projects but should not be used for • Sources of financing. In general, no foreign supporting commercial or revenue-generating loans are allowed. investments. • In case of default. Who pays if default occurs, • Controls on revenue to secure debt apply to the or what revenues can be intercepted to pay the type of revenue that may or may not be used debt, must be specified. for debt servicing. Box 7.15 Brazil’s Fiscal Responsibility Law The Fiscal Responsibility Law of May 2000 governs the expenditures and debt of municipalities. The law includes explicit hard budget constraints: caps on how much a municipality can borrow and caps on particular expenditures. For example, debt service cannot be higher than 25 percent of current revenues, personnel expenditures cannot be less than 60 percent of net current rev- enues, and total debt stock to net revenue can be no more than 100 percent. If a municipality does not respect the spending limits, it is not allowed to make contracts or conduct credit opera- tions. In addition, municipalities produce quarterly reports to the central government. Mayors are not allowed to incur any new expenditures six months before the end of their term. Sources: Platz 2009; Melo 2005; World Bank 2002. 348 Municipal Finances Box 7.16 Municipal Debt Controls in Selected Countries • Austria. Individual criteria; no general rule • Germany. Each local government has for local governments and differing abso- borrowing limits, and explicit approval is lute or relative limits. needed from the state. • Brazil. No foreign debt is allowed; debt ser- • Ireland. Each municipal borrowing must be vice should be at most 15 percent of net approved by the Ministry of Finance. revenues; debt stock should be at most • Italy. Municipalities must have balanced 100 percent of net revenues. Borrowing accounts. Debt service payments may from the central bank and upper levels of not exceed 25 percent of current reve- government is forbidden. nues. Loans must have terms of at least • Czech Republic and Poland. Debt service 10 years. The State Treasury sets the maxi- must be less than 15 percent of revenues. mum legal interest rate. Five-year debt service projections are • Norway. Borrowing is allowed for invest- required. ment only. • Denmark. No municipal borrowing is • Spain. Total municipal debt may not exceed allowed with a few exceptions. Automatic 110 percent of annual revenues. permission is granted for fee-based bor- • United Kingdom. Credit approval ceilings rowing for public utilities. are given each year by the government to • France. Operational surpluses from prior each local government. years must exceed debt service payments. No other restrictions apply. • Controls on the purposes apply to the types of was the usual practice in most municipalities in projects for which a municipality may borrow. Argentina, Bolivia, and Brazil. How could these Most countries allow municipal borrowing for governments get away with bypassing the limits? long-term infrastructure projects only. • First, local governments may decide to ignore • Controls on intermediaries are restrictions on or hide limits. They may accept loans from the types of lending institutions, including local banks and fail to register them in the offi- currency, interest rates, fees, and other loan cial budget documents. When the loans are terms. due, local governments have to produce the payment or ask the state or central govern- ment to bail them out. Informal or Exceptional Borrowing Practices • Second, local governments may take a ven- Despite clear legislation on how much to borrow, dor’s loan in the form of a deferred payment, local governments often circumvent borrowing often with a much higher interest rate than limits. This is especially the case when manage- the market, or just delay paying bills to sup- ment systems are not rigorous and local govern- pliers. This practice is often harmful to the ments may assume that they will not be caught private sector, as vendors may find it difficult for a while. During the 1980s and 1990s, this to survive without being paid. In Greece and Managing External Resources 349 Portugal, the recent financial difficulties have Checklist for Debt Managers forced some vendors out of business, as they To comply with the constraints and legal frame- have been unable to collect local governments’ works imposed by the central government, local payments. officers find it useful to apply some metrics or rules of thumb to ensure that their debt remains Borrowing through Special Entities manageable; that way, the debt can be paid with- Municipalities like to borrow through their out much disruption to the other service provi- enterprises, some of which are called special sions. Table 7.6 provides a simple checklist for purpose vehicles (SPVs), or through the public debt managers. utility companies, which are 100 percent owned Given the uneven size of debt service, the debt by the municipality. This is the typical case in officer will need to carefully analyze the fluctu- China. Local Chinese governments are prohib- ation of interest payments and debt amortiza- ited by law from borrowing from domestic or tion (principal repayment). For that reason, it is foreign banks or issuing debt. To circumvent this important to avoid using simple trends to project restriction, local governments use their special the debt service, as it might be surprisingly large vehicles (or enterprises financed 100 percent by in some years ahead, particularly if a portion of municipal capital) that have authority to borrow. debt stock is in bonds that require repayment of Large metropolitan areas such as Beijing and the principal in bulk at the end of the bond period. Shanghai have used SPVs extensively for borrow- To avoid trouble in debt service and severe liquid- ing to finance huge development projects. This ity crises, local governments might need to build a is a big transparency and budget control issue. debt service reserve fund to ensure their ability to The size of local government debt is unknown, repay debts in a timely way. Figure 7.4 illustrates as local authorities are not obliged to report the volatile debt service fluctuations. In this illustra- debt of their SPVs. As a result, Chinese authori- tion, the municipality needs to budget properly ties are considering whether to relax the previ- to avoid problems in 2014, when the annual debt ous restrictions and allow local governments to service will jump from the range of 90 million (in access capital markets under clear and transpar- any currency) to 190 million; another challenge ent rules. will come in 2017. Table 7.6 A Checklist for Debt Managers Indicator What to do? Debt structure: long vs. short term, Check if it is sustainable and look for unevenness and bunching domestic vs. foreign, flexible interest of payments (balloon payments). rates vs. fixed Debt service: % of net revenues Should be at most 15% over the planning horizon. Total debt: stock as % of net revenues Should be at most 60%; higher than that will lead to high debt service and problems in the future. Total debt per capita Check with cities at the same level of development. Deciding among debt programs • Using net present value of alternative debt profiles to choose the best approach for the intended debt structure. • Modeling and simulating revenue and expenditure flows. • Defining the baseline and alternative scenarios. • Choosing the discount value. 350 Municipal Finances Figure 7.4 Example of a Municipality’s Debt Service Fluctuations, 2012–17 millions in any currency 200 Any currency 150 100 50 0 2012 2013 2014 2015 2016 2017 Year Principal Interest payment projection The financial market turbulence of 2009 seems or an administrator appointed by higher govern- to have contaminated local governments. Bond ment (South Africa) takes over financial control issues became too complicated and embellished of the troubled municipality. The trustee restricts with opaque clauses that eventually backfired on expenditures and manages satisfying creditors the local governments, leaving them little alterna- from the sale of marketable assets and revenue tive to refinance. Overoptimistic projections for savings, with fair sharing of the losses among revenue-producing projects, together with ongo- stakeholders. The overarching objective is to ing discussion between cities and states on what maintain minimum services and functionality of taxes to raise and what assets to sell, have led to the local government, to satisfy creditors to a fair a difficult situation. Eventually both Harrisburg extent, and to implement actions to restore finan- city (see box 7.1) and Jefferson County (box 7.17) cial sustainability (Canuto and Liu 2013). filed for bankruptcy protection.3 Most of the developing countries implement Borrowing not only expands the financing ad hoc interventions, with no rules for manag- capacity of local governments but also entails the ing the insolvency situation. Actions include risk of insolvency. The reasons include overopti- selling some assets, intercepting revenues from mistic revenue projections, economic cycles that higher government, and often bailouts by higher reduce own revenue collection, volatility of trans- government. These actions serve the same main fers, collection inefficiency, and underperfor- purpose—maintaining services—but are often mance of revenue-generating projects. Thus, local ineffective, reduce the accountability of local financial officers and political leaders alike should officers, soften budget constraints, and raise be aware of the insolvency risk and the potential the issue of fairness. The revenue intercept is consequences of failure in debt servicing. Some widely used but often ineffective, as only a por- countries, such as Hungary, South Africa, and tion of revenues can be intercepted, and thus it the United States, follow legislated procedures in cannot eliminate huge debts. The bailout is often which a court-appointed trustee (United States) unfair because well-managed municipalities get Managing External Resources 351 Box 7.17 Jefferson County Files for Bankruptcy Protection Jefferson County, Alabama, followed in the with risky financial swaps that did just the footsteps of Orange County, California, whose opposite of protecting the county from chang- bankruptcy was triggered by the county’s ing interest rates. Bonds sold to investors to investment in risky interest rate derivatives finance the work contained clauses that accel- through the encouragement of an invest- erated payments and interest rates if certain ment bank. In 1994, Orange County filed for bond market conditions came to pass. Those bankruptcy protection, citing US$1.7 billion in conditions were deemed unlikely at the time, liabilities. It was the largest municipal bank- and the clauses were described as money ruptcy in U.S. history until November 2011, savers for the county in the long run. But the when Jefferson County listed US$4.23 billion clauses were triggered by the extraordinary in liabilities, including US$3.14 billion in sewer bond market conditions in 2008, leading to debt, US$800 million in school construction, accelerated payment schedules and penalty and US$305 million in general warrants. interest rates. An initial debt of US$1 billion The problems of Jefferson County are more than tripled. linked to two issues: (a) the investment in The final straw in Jefferson County’s finan- an expensive sewer system for the county cial problems came when its occupational and (b) the financial structure of the bond tax was ruled unconstitutional in 2011, slicing that financed that investment. Like Orange US$66 million from its annual income. The County, Jefferson County allegedly owes part decision to file for bankruptcy was based on of the debacle to the financial adviser who the belief that it would be easier to have a structured and sold most of the US$3.1 billion debt reduction ordered by the courts than to sewer bonds that led to the bankruptcy, along negotiate with individual bondholders. Source: Church, Selway, and McCarty 2011. nothing, whereas reckless spenders may receive debt interest and amortization when they come a huge ad hoc grant from the central government due. That failure may happen because of the local based on their need to pay for salaries, water, or government’s limited resources, because of poor energy. In sum, rule-based insolvency procedures revenue collection, because of some extraordi- are more effective, are in harmony with the mar- nary and unforeseen event like a natural disaster, ket, and better support market-based external or even because of changes in central government financing. regulations. In countries where municipal borrowing is undeveloped, banks insist on a variety of secu- Credit Enhancement and Loan rity arrangements, such as mortgages, claims on Guarantees municipal real estate, or revenue intercepts. Debt Credit enhancements are devices that mitigate or may be influenced by what properties the munic- reduce the risks in debt transactions. The main ipalities may legally offer as security. If only a few risk in lending money to local governments is the properties are available for security, then banks risk of default, that is, the risk that the local gov- and municipalities will need to develop other loan ernment does not have enough money to pay the structures that rely on cash flow from general or 352 Municipal Finances Figure 7.5 Log Frame for Credit Guarantees Guarantee or credit enhancement Lo may ca en ee l g pay ym nt t ov a pa ara er fee u nm G en t Commercial bank Local government credit to local obtain better government credit dedicated revenues. To reduce the perceived risk have several potentially negative impacts: the of municipal borrowing, local governments can lenders may neglect due diligence, the intercept access several types of credit enhancement or may transfer all business risk to the borrower loan guarantee instruments. Figure 7.5 summa- municipality or central government, and the rizes the logical frame and the positive impact intercept may raise equity issues because some of guarantee instruments. For example, the local municipalities benefit from intercepts while oth- government may buy a guarantee for a fee and ers meet their fiscal responsibilities. Revenue obtain better debt conditions. Or the guarantor intercepts became unmanageable in Argentina may step in and continue debt service on behalf and Brazil in the 1990s, leading to severe legal of the local government in case of its inability restrictions. to service the debt. The guarantor may pay just a portion (for example, half ) of the interest due, Guarantees and Credit Enhancement and the debtor may absorb the loss (called a Guarantees and credit enhancement offer com- “credit guarantee”) or pay the entire debt service fort to lenders who may be reluctant to lend to until the local government restores its financial local governments when there is not enough position (called a “full financial guarantee”). information and financial transparency. A good example is the Unit Guarantee Corporation in the Revenue Intercepts Philippines, which provides credit guarantees for The revenue intercept provision means that pay- municipalities that seek to finance infrastructure ments from higher levels of government (trans- projects through debt issuances (see box  7.18). fers) can be pledged to the repayment of debt. The However, local governments need to take into intercept provision is widely used as a good guar- account that when they provide a guarantee to antee mechanism, especially when local govern- a project or public enterprise, they should be ments borrow from the private sector. It is worth sure that the project can generate enough reve- mentioning, however, that revenue intercepts nue to pay its own debt. The cases of Harrisburg, Managing External Resources 353 Box 7.18 Loans to a Local Government without Sovereign Guarantee The Local Government Unit Guarantee will improve the capacity of local authorities Corporation, Philippines (UGC), was created to submit infrastructure projects to the capital in 1998 as a private financial credit guaran- markets and to receive commercial banking tee institution. It is owned by the Bankers loans. UGC guarantees cover up to 85 percent Association of the Philippines (38 percent), the of principal and interest; bonds are guaranteed Development Bank of Philippines (37 percent), 100 percent of principal and interest subject to and the Asian Development Bank (25 percent). an interest rate cap. The guarantee fee ranges The UGC has a co-guarantee agreement with from 1 percent to 2 percent a year. For borrow- USAID to cover infrastructure projects for ers who do not have an identified stream of local government units. UGC aims to make revenues, there is a reserve fund created from private financial resources available to cred- the monthly gross revenues of the borrower. itworthy local governments; these resources Source: Alam 2010. Pennsylvania (box 7.1), and Johnsville, Jefferson .gov/our_work/economic_growth_and_trade County, Alabama (box 7.17), have shown the nega- /development_credit). tive impact of guaranteeing projects of uncertain profitability. Special Purpose Vehicles and The Infrastructure Guarantee Fund in Korea, Pooled Finance Arrangements and FINDETER in Colombia have the same function of protecting the municipal lenders and Although large municipalities can access either ensuring that local governments pay their debts. bank or capital market resources, small local gov- At the multinational level, USAID has established ernments may not have the expertise or resources a facility—the Development Credit Authority to finance the transaction costs involved in issu- (DCA)—to encourage the development of credit ing bonds. Pooling municipalities’ debt and their markets in emerging economies. Today, the DCA projects can reduce the costs and risks of the has a presence in most developing countries. operation. Special arrangements can work for Since the DCA was established in late 1999, emerging markets that have large needs for infra- more than 267 partial credit guarantees have structure finance. Municipal bond banks and facilitated more than US$2.3 billion of private special purpose vehicles are well developed in capital debt financing in more than 64 countries. North America, notably in Canada and the United Through the DCA guarantee mechanism, USAID States. Special purpose vehicles have been used in is able to leverage an average of 28 dollars in pri- Asia too. Box 7.19 describes the case of the Tamil vate sector funds for every dollar spent by the Nadu Water Fund. U.S. government. Claims on the DCA portfo- lio are approximately 1 percent, demonstrating Special Purpose Vehicles that the targeted borrowers are both a cred- A special purpose vehicle is a legal entity created itworthy and a profitable source of business to fulfill narrow, specific, or temporary objec- (for more information, see http://www.usaid tives. SPVs are used by the private sector when a 354 Municipal Finances Box 7.19 The Water and Sanitation Fund in Tamil Nadu The Water and Sanitation Pooled Fund (WSPF) in India. The bond relied on multiple credit in the state of Tamil Nadu, in India, was the enhancements, including a guarantee for first pooled-financing bond in South Asia. 50 percent of the principal amount from the It was installed in August 2002 as a special USAID Credit Authority. The bond issuances purpose vehicle. It pooled the water and by WSPF are contingent on the prior approval sanitation requirements of 13 municipali- of the state government. The state has mobi- ties and towns and raised Re 301 million lized nearly Re 3,000 million within five years by issuing an unsecured municipal bond in through India’s first bond by a joint public- December 2002. With a 15-year tenor, it is private investment with the Tamil Nadu Urban the only true long-term financing instrument Development Fund. Source: OECD 2010. firm wants to make an investment but does not used SPVs and local government–owned compa- want to risk its unrelated assets. Similarly, a local nies to issue municipal bonds, as they are banned government transfers assets to an SPV (such as a from doing so themselves. There is little market “Housing Development Ltd.”) for management scrutiny of the underlying financial conditions or may use an SPV to finance a large project, risk- and little information available about the size ing only the invested assets, achieving a narrow of outstanding debt of this kind. The Shanghai set of goals without putting its entire wealth at Urban Development Investment Corporation has risk. SPVs established as joint ventures of local issued bonds to help finance transport invest- government and private partners to finance ment, and many other localities in China have projects are an integral part of the public-private issued bonds through SPVs and their companies, partnerships common throughout Europe. using the corporate bond model. SPVs are also used in the public sector to sep- arate the public nature of the municipality from Hybrid Forms of Loans profitable endeavors. A special purpose vehicle In poor countries, the hybrid loan, a combination is like a specific firm with a very clear mandate of a market loan and grants, is an important tool to perform a certain function. It can be owned for accessing resources. The hybrid reduces the by a private company, by a municipality, or by a debt service of the loan and makes it affordable public-private partnership. The characteristic of to the local authority. A good example of this is an SPV is that it does not put in danger the cap- the hybrid financing of Ouagadougou (box 7.20). ital of its main shareholders. In this sense, the Chinese municipalities have created and used Debt Management and SPVs to borrow to finance infrastructure and Institutional Framework bypassed the prohibition on borrowing directly. In such cases, the expenditures and revenues Managing the debts of a local government is a of the SPV are not included in the local govern- challenging task. It requires perpetual attention ments’ budget and are not an object of public and the use of sophisticated tools to measure scrutiny. Chinese municipalities have widely borrowing capacity in light of projected future Managing External Resources 355 Box 7.20 The Hybrid Financing of Ouagadougou The capital of Burkina Faso has more than could be allocated to debt service. Because 1.2 million inhabitants. The local government many communities would not be able to afford wanted to invest in upgrading the local mar- the debt payment, the available grant was allo- ket, which accommodates 2,900 traders. Its cated by priority to the poorest communities. objective was to strengthen and improve the On average, the loan was a2 million and a central covered market, as well as market- grant was a3.15 million. The variable rate loan places in secondary towns. Economic and is at a very concessionary rate (euribor less financial analysis determined the amount of 1.86 percent), with a maturity of 20 years plus revenue to be expected from the shoppers, as 5 years of grace. well as the amount of municipal savings that Source: Paulais 2013. revenues and liabilities and must also comply government can borrow or how much debt it can with national regulation. Because municipalities issue is fundamental to ensuring that a planned seem to have difficulty controlling their indebt- investment will be implemented without hurt- edness, many national governments impose rules ing the long-term fiscal stability of the local and limits aiming to restrict municipal debt. government. Furthermore, lenders often fail to do their own Local government borrowing capacity depends due diligence because they assume that munic- on four factors: ipalities cannot go bankrupt, or that there is an implicit sovereign guarantee, or because they do • The municipality’s economic and financial pros- not understand the difference between public pects. When the municipality’s prospects for finance and market operations. economic activity and tax receipts are good, borrowing capacity is greater than in a time of How Much Can a Local Government economic crisis and scarce revenues. In a sys- Borrow? tem of intergovernmental transfers, the risk Borrowing capacity is the maximum amount of associated with the central government’s trans- new debt that a local government can issue with- fer policy should also be taken into account. out hurting its capacity to deliver services and • The characteristics of the new loans or bonds, serve existing and new debt. It depends on how interest rates, and maturities. If the city can much money it has to repay and service the new issue debt with long maturities and low or debt today, reduced by its commitments payable concessionary interest rates, the borrowing in the future, but increased by its likely future capacity will be greater than if the municipal- revenues. ity has no alternative but to borrow on com- Often, legal constraints and debt caps impose mercial terms. additional limits, but the most important is whether the local government will have the • The structure and size of debt stock. If a local capacity to pay the outstanding and new debt on government has an outstanding debt with time. Having a good sense of how much a local low maturities and high interest rates, and if 356 Municipal Finances various debts coincide and induce a cluster Debt Management Strategies of payments at the same time, it is likely that A debt management strategy is a plan that the debt service absorbs an important portion local government intends to implement over the of the local government’s current revenues. medium term to achieve a desired composition of Sometimes, a local government obtains new the debt portfolio (World Bank 2009). It ensures debt to restructure the stock of debt, stretch that the government’s financing needs and pay- the average terms, and lower the annual bur- ment obligations are met at the lowest possible den of debt service. cost consistent with a prudent degree of risk. Debt management strategies help local governments • The institutional framework and the limits decide how much to borrow, what the best combi- imposed by the national or higher-level govern- nation of debt instruments is, and what actions to ment or by the local constituency itself. take to ensure that debt stock and debt service do not become too large to be properly paid. When Balloon Payment Risk we speak of debt management strategy, we often Borrowing capacity is a serious matter that can refer to the following objectives and processes: be tested by simplified mandatory indicators such as debt stock or new debt as a percentage • Choosing debt instruments and terms for new of net operating revenues. But for larger bor- debt, taking into account the existing stock. rowing, a more detailed cash-flow analysis is • Ensuring that the local government debt is in required that covers the entire repayment period line with the repayment capacity estimated by of the new debt. Local governments in the devel- a detailed cash-flow analysis. oping world often calculate the historical trend of their debt service and net revenues and the • Creating debt service reserve funds to ensure said mandatory indicators to justify debt capac- that the borrower can meet several months ity. These projections may ignore or hide poten- of debt service payments, as creditors often tial balloon payments, which may occur because require. the grace periods of the various loans or the final • Selecting debt alternatives using net present payment of bond principals coincide and cause value approaches to compare various medium- an extraordinary expenditure a few years ahead. and long-term debts. These are often honest mistakes, but many local governments hide the balloon payments inten- Choosing debt instruments may look simple tionally because they want a particular project. for most local governments, but for large cit- Good feasibility studies with thorough financial ies, the treasurer or finance chief faces difficult analysis and cash-flow analysis for the entire trade-offs between alternative instruments. For loan period are vital to avoiding or mitigating instance, if foreign interest rates are lower than balloon payments. Creditors can also mitigate domestic interest rates, foreign currency debt may these risks by requiring the borrower to set aside seem attractive. However, the trade-off becomes a debt service reserve fund that gradually depos- less clear once we take into account the exchange its funds for 6 to 12 months of debt service. In rate risk, which will determine the eventual cost the case of revenue-generating projects as well, of foreign currency debt after possible devalu- creditors may request that the borrower set up ations of the local currency. Since local govern- an escrow account and deposit in it all revenue ments do not have revenues in foreign currency, collected from the project, disbursing the debt their exposure to exchange rate risk is very high. service first before other payments are due. For that reason, most countries do not authorize Managing External Resources 357 local governments to borrow in foreign currency. begins with refinancing the short-term debt and Box 7.21 describes the crisis that triggered regula- obtaining federal government guarantees to allow tory change in Argentina. longer maturities and lower rates, if possible. The choice between debt instruments (bonds and Aligning Local Debt with Capacity bank credits) is also fundamental. The interest Ensuring that local debt is in line with repay- rates of bonds are lower in general, but costs are ment capacity is part of the analysis of borrowing associated with them, including the cost of finan- capacity discussed above. However, managing cial transparency and disclosure. Loans could also the risk exposure embedded in the debt port- be renegotiated, however, whereas renegotiating folio and making sure that the city is paying the bonds is virtually impossible, in part because of least possible for a given debt stock are important the large number of bondholders. parts of debt management strategy. For example, St. Petersburg is a good example of a city that, short-term loans and flexible interest rate loans after passing through some rough times during are more risky, more volatile, and usually more the transition to a market economy, managed to expensive than longer-term loans. Restructuring reduce the average maturity of its loans, its out- debt portfolios of cities in fiscal distress often standing debt, and its debt service (box 7.22). Box 7.21 Challenge in Foreign Currency Borrowing In the late 1990s, the Argentine cities of learned lessons, and both Argentina and Brazil Mendoza, Rio de Janeiro, and São Paulo bor- have forbidden subnational governments to rowed in foreign currency to refinance their borrow in foreign currency. domestic debt because the foreign inter- History tends to repeat itself: Hungarian est rates were substantially lower than the municipalities enthusiastically borrowed in domestic interest rates. While the cities bene- Swiss francs with low interest in the early fited at first from substantial reductions in debt 2000s; then many became bankrupt after service, the exposure to currency devaluation 2010. The crisis fueled a debate over whether became too risky. The central governments the lenders shared responsibility. Box 7.22 St. Petersburg’s Experience with Debt Management To deal with its debt problems, St. Petersburg • Reducing exposure to foreign currency risk has centralized the management of its debt • Lessening the burden of domestic borrow- and adopted a strategy focused on four goals: ing by extending maturities • Ensuring the effective use of guarantees • Minimizing the cost of borrowing by to promote capital investments. improving the city’s credit rating Source: Platz 2009. 358 Municipal Finances St. Petersburg has grown faster than the national Figure 7.6 Log Frame for Debt Instruments average, accounting for more than 15 percent of Revenue-producing projects the foreign direct investment into the country. The city has borrowed extensively in both domes- producing tic and external markets and then suffered several Revenue- projects Loans and Loans and setbacks. After some serious restructuring, it cen- grants bonds tralized management of its debt, which is now in the hands of the Committee on Finance. The debt unit issues periodic reports and monitors and actively manages risk. Loans and purpose projects Social Grants only grants Comparing Debt Alternatives Net present value is a useful instrument for assessing how loans with different maturities and Poor Wealthy municipality conditions compare, taking into account current market rates or other relevant discount rates. Social purpose projects Banks are often better informed and more sophis- ticated than municipalities and offer complex alternative proposals with various interest rates, repayment schedules, and conditions. Net pres- the Philippines government uses the log frame ent value analysis helps in comparing competing presented in figure 7.6. For local governments offers by showing their true cost. (Maturity pro- that are poor and finance social purpose projects, files are also important factors in identifying the the best financing is a grant from government or cost of debt.) Comparing loans and bonds is par- donors. If the investment generates revenues, ticularly interesting, as loans often disburse grad- loans can be used, regardless of the wealth of the ually and are also paid back over time, whereas community. Bond issuance, however, should be bonds can be disbursed all at once and payment reserved for wealthy local governments that are can be delayed to the end of the bond period financing revenue-generating projects. (bullet-type bond). Bonds can also be issued in Institutions that help local governments access tranches and paid back at regular intervals, with- the credit market include the following: out a bullet final repayment. Organizing data so • Investment development banks that the debt servicing and debt maturity profile • Specialized institutions, such as municipal can be readily determined is an important func- development funds (MDFs), that channel tion of the debt management officer.4 borrowed and grant funds to local governments (for example, the Municipal Development Creating Institutions That Reduce Market Fund Office, the Philippines; the Town Failures in Municipal Borrowing Development Fund, Nepal; the Tamil Nadu Financial Intermediaries Urban Development Fund, India; and the To ease impediments in local borrowing, cen- Municipal Development Fund, Georgia) tral governments, often helped by international organizations, have created financial interme- • Credit enhancement mechanisms such as diaries to enhance the capacity of local govern- the Local Government Units Guarantee ments to access debt markets. To help identify Corporation in the Philippines and the Infra- the best option for different local governments, structure Credit Guarantee Fund in Korea Managing External Resources 359 • Special purpose vehicles, such as the Water to manage their responsibilities for recurrent and Sanitation Pooled Funds in Tamil Nadu expenditures. However, borrowing large sums and Karnataka, in India, that raise finance for of money to finance long-gestation, long-lived small municipalities; the Investment Fund capital investment projects is not as frequent. for Urban Development in Vietnam; and the There are several reasons for this. First, bank Urban Development Investment Corporations regulations in general limit their capacity in China. to lend for long-term projects because their deposit liabilities are mostly short term and Resuming Bank Lending to Local Governments volatile. Second, commercial banks in general The initial reluctance of the banks to lend to do not have the expertise to assess munic- municipal governments has been reduced over ipal projects or their risks. In this context, time as banks have had some successes. For commercial banks either refuse to finance example, in South Africa, some commercial municipal investment or charge high interest banks are ready to contribute to the investment rates or require significant collateral to secure programs in large cities. In Morocco, commer- themselves against the perceived local govern- cial banks have provided substantial refinancing ment risk. of the public investment programs in some years. To take into account these constraints, many In Cape Verde (as in many other countries), an countries have established specialized finan- international donor uses the commercial banks cial institutions to provide long-term credit for to allocate its resources to local authorities, using municipal infrastructure projects: clear guidelines on risk and repayment condi- tions. A similar example is FINDETER—a two- • The Infrastructure Development Finance tier financial institution in Colombia—which was Company, in India, was established in 1997 established to coach the market and encourage to offer long-term private finance for infra- market-based finance in municipalities. structure projects as well as to provide tech- nical assistance. The institution was initially New Instruments sponsored by the government of India but New instruments have been developed accord- over time has been purchased by the private ing to the needs and characteristics of the local sector. authorities. For example, the United States has very successfully used state revolving funds, • The Development Bank of Southern Africa which are funded partially by the federal govern- established a development fund in 2001 to ment, to leverage state funds in financing priority provide grants and technical assistance to sectors such as water and sanitation. In addition, municipalities for implementing infrastruc- the so-called green financing instruments were ture projects. The bank raises funds from developed to encourage emerging economies to domestic and international capital markets, invest in activities that will diminish greenhouse institutional investors, and bilateral and mul- gas and carbon dioxide emissions. tilateral development finance institutions. It provides loans for municipal infrastructure, Borrowing from Development Banks and urban renewal, water, sanitation, health care, Financial Institutions transportation, and education, for example. In developing economies, municipalities often work first with commercial banks to manage • The Caixa Economic Federal Brazil man- their cash flows, and they occasionally borrow ages several programs and extends technical 360 Municipal Finances assistance to the municipalities eligible for and the Infrastructure Finance Corporation in financing at subsidized rates. South Africa. Bond Banks Specialized Institutions: Municipal Because many local government loans are small, Development Funds pooling individual credits or bonds is beneficial, Municipal development funds (MDFs) have been especially for large lenders. Bond banks, estab- instrumental in building domestic municipal lished by the federal governments, collect all the credit markets, while strengthening local govern- borrowing needs of municipalities and issue a ments’ capacity to prepare and appraise projects single class of bond backed by a diversified port- and channeling finance to subnational entities on folio of borrowers. This arrangement reduces behalf of donors (Clark et al. 2008). This makes investor risk and lowers the borrowing costs of it feasible to reach and fund small subprojects the local governments; an example is the Water suited to the needs of smaller cities. Central gov- and Sanitation Pooled Fund, in India, described ernments have created MDFs as a way to offer in box 7.23. municipalities longer-term credit at interest rates Bond banks have been used extensively in lower than those offered in the domestic market. Canada and the United States since the 1970s. At the same time, they often provide technical Special-sector bond banks established by the assistance in project design and structuring and Federal Clean Water Act 1984 helped munic- training to municipal staff on project finance and ipalities issue bonds backed by federal grants implementation. and by matching contributions from the states. Municipal development funds are pooled Outside the North American continent, examples financial arrangements combining capital grants of bond banks include the Kommunalbanken in from state and central governments and loans Denmark, the Kommunivest in the Netherlands, from donors. Subsidized credit is then made Box 7.23 Syndication and Access to Market: The Water and Sanitation Pooled Fund The Water and Sanitation Pooled Fund is a fund • Reserve fund: This fund carries 1.5 times common to small cities in the state of Tamil the annual debt service. Nadu set up to finance water and sanitation • Partial credit guarantee: A guarantee projects. In 2003, this common fund issued (provided by USAID DCA) covers 50 a bond for US$6 million to be repaid from the percent of the loan. water tariffs of a group of municipalities. The final rate was 3 percent below the To be successful, the issue required three market rate charged by the Tamil Nadu Urban levels of guarantees: Development Fund. In addition to funding, the • Escrow account: The municipalities deposit pooled fund also provides advice to member their payments in an escrow account. municipalities. Source: USAID 2003. Managing External Resources 361 available to local governments to finance infra- • Tamil Nadu (India), Tamil Nadu Urban structure projects. Local authorities are evaluated Development Authority on their capacity to repay the loans. MDFs have worked as revolving funds most of the time. More • Tunisia, Caisse des Prets et de Soutien des recently, some MDFs have accessed debt markets Collectivités Local and issued bonds to increase their financial base • Vietnam, Local Development Investment for helping local governments. Funds MDFs can act as a first-tier bank and lend directly to local governments, or they can serve Experience with MDFs has been mixed, with as a second-tier bank by lending to commercial good and some not-so-good results. It is critical banks and encouraging them to on-lend to local to ask whether (a) the MDFs are supposed to be governments. Lending to local governments is temporary intermediaries that help municipali- often accompanied by technical assistance and ties gain experience in debt financing, including support in project design and selection. Beyond preconditions, selection of instruments, and the lending, MDFs provide municipalities with tech- design and implementation of large projects, or nical capacity, project appraisal, and oversight (b) they are supposed to help municipalities move of local project preparation and construction gradually toward the local financial and capital (World Bank-IEG 2009). markets to eventually gain direct access to funds. More than 60 countries have established MDFs seem to be quite successful in fulfilling the MDFs, generally with the backing of interna- first function but less so in leading municipalities tional agencies. Examples of MDFs include the to the markets. Some successful MDFs are briefly following: discussed in box 7.24. The World Bank and the Inter-American • Bolivia, Servicio Nacional de Desarollo Urbano Development Bank have been particularly com- mitted to the establishment of municipal devel- • Colombia, Findeter opment funds. Between 1998 and 2008, the World • Czech Republic, Municipal Finance Co. Bank Group financed 190 municipal development projects. One-fourth of the projects helped cre- • Georgia, Municipal Development Fund ate municipal development funds. The projects • Jordan, Cities Villages Development Bank focused on four main priorities: (a) financial management improvement, such as integration • Latvia, Municipal Development Fund Latvia of municipal accounts and training of financial staff; (b) improvement of tax records; (c) access • Morocco, Fonds d’Équipement Communal to credit markets; and (d) support to the develop- • Nepal, Town Development Fund ment of credit ratings and supervision capacities. Not all experiences have been successful. In • Panama, Fondo de Desarollo Municipal Africa, five MDPs were unsuccessful, as munic- • Parana State (Brazil), Paranacidade ipal revenues were overestimated and the loans were not repaid (e.g., Zimbabwe and Nigeria), • Philippines, Municipal Development Fund or the commercial banks that were supposed to Office participate declined, fearing the lack of financial • Senegal, Fund of Local Communities capacity of the municipal sector. In Asia, MDFs had a good start with Tamil Nadu, but later on, the • Sri Lanka, Local Government Loans Fund financial market had developed in India, interest 362 Municipal Finances Box 7.24 Successful Municipal Development Funds Bangladesh. The Bangladesh Municipal Deve- municipalities in Tamil Nadu. Building on that lopment Fund started operations in 2002 as a success, the MUDF has been converted into government-owned company to provide finan- an autonomous financial intermediary, with cial support to local governments for financing participation of private capital and manage- urban infrastructure. It was supported by a line ment and renamed TNUDF . An asset manage- of credit from the World Bank for US$78 million. ment company—a joint venture between the All types of urban projects are eligible; the inter- Tamil Nadu government and private invest- est rate was established at 9 percent. The proj- ment companies—now manages the TNUDF . ect has been very successful: 113 municipalities The new arrangement has brought private have used credit from the fund. Because all of sector management expertise to the selection them have to deposit 10 percent of their loans and financing of subprojects sponsored by into an escrow account (to guarantee adequate either public or private agencies and has facili- and timely repayment), the secondary impact tated the access of creditworthy municipalities of the fund has been a generalized increase in to the private capital market. A separate grant own-source revenues. Local governments have window has been created for poverty-oriented also improved their asset management sys- investments, such as slum upgrading and tems and accounting procedures. the cost of resettlement. This grant window Brazil. The Parana State Urban Development is managed by an asset management com- Fund (FDU) was created in the state of Parana, pany that also provides technical assistance Brazil, in 1998. It was financed by the state to municipalities in preparing investments and budget and a loan from the World Bank and improving their financial management. later on by the Inter-American Development Senegal. Senegal’s Fund of Local Communities, Bank and retained earnings. FDU’s assets are created under the Urban Development and projected to grow from US$311 million in 2001 Decentralization Program, played a major role in to US$1 billion by 2015. FDU lends to munic- strengthening the capacity of the local author- ipalities in Parana as well as to urban utilities. ities to manage investment resources, raise Interest rates vary according to the program, revenues, abide by borrowing constraints, and but they have been highly subsidized. Loans prioritize expenditures. With the help of munic- are 100 percent guaranteed by state transfers ipal contracts (introduced at the same time), to municipalities or by the revenues accruing the fund was a key piece in consolidating the to public utilities. FDU was the first of many decentralization process in Senegal. urban development funds in Brazil. Their major South Africa. The Infrastructure Finance role was educating Brazilian municipalities to Corporation has a structure similar to that of enter the credit market and to improve project the Parana urban development fund. It lends selection and supervision. to municipalities—especially large metropoli- India. The Tamil Nadu Urban Development tan areas—to finance infrastructure and water Fund (TNUDF) was established within the supply. The sources of funds include domes- World Bank–financed Tamil Nadu Urban tic and international markets, raised through Development Project and initially named the bond issues and long-term loans extended by Municipal Urban Development Fund (MUDF). international financial institutions. The loans By 1996, the government-owned MUDF had granted to municipalities are in general at a financed over 500 subprojects in 90 out of 110 fixed rate with up to 20-year maturities. Source: Sood 2009; Alam 2010; Freire and Petersen 2004. Managing External Resources 363 rates went down, and the attractiveness of these Group, the Asian Development Bank, the African funds was substantially eroded. In Pakistan, the Development Bank, and the European Bank for MDF focused mostly on grant financing. Reconstruction and Development, or EBRD) or MDFs continue to operate and help municipal use the information issued regularly by the minis- governments improve their capacity to borrow try of planning or ministry of development when directly from the market. When municipalities so-called wholesale projects are being prepared or the credit markets are ready to work directly to help local governments. In general, the inter- with each other, MDFs may become suddenly national financial institutions and the national uninteresting. They may lack the tools to com- governments use some entry criteria in selecting pete with aggressive commercial banks, which by the local governments that will benefit from the now have understood the characteristics of local loan. The criteria include fiscal indicators (as a governments, know the legal framework, and are proxy for the capacity of the local government to ready to lend at competitive rates. In these con- pay the debt and finance the counterpart fund- ditions, MDFs may have sufficient funds to lend ing), past performance in project implementa- but lack potential clients (Tunisia and Morocco). tion, and budgetary and accounting practices. In Then the need is for sufficient flexibility to allow addition, local governments may need to show those funds to be used to strengthen smaller or that their strategies are consistent with the main less-competitive projects or local governments. objective of the wholesale program, such as pov- erty alleviation, competitiveness, or extension of basic services. External Assistance Available to Local Authorities The World Bank: IBRD and IDA Assistance Multilateral and bilateral institutions have long for Municipal Development been involved in financing local governments and Multilateral support can be grants or loans. The improving their capacity to go to the market to large part of the multilateral assistance is in the raise funds for their projects. As noted above, the form of subsidized loans, especially for poor coun- World Bank and USAID have encouraged MDFs tries eligible for credit from the International and municipal bonds. In India, for example, the Development Association (IDA) with highly promotion of the municipal bond market was part concessionary assistance. Box 7.25 shows the of USAID’s Financial Institutions Reform and loan terms from the International Bank for Expansion Project. Reconstruction and Development (IBRD), or the To gain official external support, local gov- World Bank, and IDA credits. In either case, local ernments either contact the representatives of governments face substantial transaction costs those institutions directly (for example, the Inter- associated with these grants or subsidized loans. American Development Bank, the World Bank Before a city or central government receives the Box 7.25 IDA and IBRD Lending Terms • IBRD terms include 20 years maturity and a six-month Libor, plus a 0.5 percent spread. • IDA terms include 40 years maturity, 10 years grace, and 0.75 percent commission. 364 Municipal Finances assistance, substantial improvements have to take financially sound infrastructure investments suit- place at the institutional, operational, and report- able for credit financing. ing levels. EBRD provided up to €75 million in long- Rarely do local governments receive direct term lines of credit from 10 and 15 years to part- loans from international organizations. In the ner banks for on-lending to local governments most common case, a project is prepared and in euros or local currency. Partner banks make negotiated with the local government, but the loans of up to €5 million, each with a maturity central or the state government assumes the role of 5–15 years, available to local governments for of borrower and on-lends the funds to the local investment in infrastructure. EBRD provides for government, with or without an add-on disburse- risk sharing for up to 35 percent of the partner ment fee. The funding is disbursed through a cen- bank’s risk on a portfolio of loans to local gov- tral facility or MDF or second-tier facility and then ernments. EBRD’s support acts like a guarantee, allocated to specific local governments according and the bank will step in with risk funding only to prior agreement or some allocation formula. in the event that a municipal loan defaults. For The exception is loans to large cities, such as municipalities, EU funds provide support for Cairo, Mexico City, Mumbai, Rio de Janeiro, São project preparation, loan application, and project Paulo, and Shanghai, where the World Bank has implementation. financed projects directly, although often with a sovereign guarantee. Criteria Participating municipalities should serve a pop- EU-EBRD Municipal Finance Facility ulation of less than 100,000 people. They should The Municipal Finance Facility was an initia- have sound financial management and a good tive of EBRD and the European Commission, to cash flow. Investments can be in infrastructure develop and stimulate commercial bank lend- such as local transport, district heating, water ing to small and medium municipalities and supply, sewerage, solid waste management, pub- their public utility companies in countries that lic roads, and parking. joined the EU in 2004. They included the Czech The Inter-American Development Bank  and Republic, Estonia, Hungary, Latvia, Lithuania, the World Bank have developed their own Poland, the Slovak Republic, and Slovenia, fol- subsovereign municipal financing facilities that lowed by Bulgaria and Romania. The facility com- provide infrastructure finance to creditworthy bines EBRD financing, in the form of long-term municipalities without the central government loans or risk sharing, with EU Phare grant sup- guarantee. port in the form of a maturity enhancement fee and technical cooperation for partner banks or Environmental and Energy- public utilities. Efficiency Loans and Credits Objectives Energy efficiency and climate change have gained The facility aims at encouraging the commercial special prominence in the past 10 years, leading to banks to lend to small and medium municipali- the development of specific programs to help local ties, to enhance the banks’ ability to assess risks governments and national entities. International of municipalities and to manage their loans in financial institutions, bilateral donors, and pri- the sector, to provide local governments access vate institutions have developed specific prod- to medium- and long-term financing, and to ucts to educate the local authorities and prepare help them prepare and implement feasible and projects that are self-financing. A typical project Managing External Resources 365 is retrofitting a public building to make it more The World Bank and IFC have put together a energy efficient. For example, Los Angeles was wide range of programs that lead to sustainable able to finance the retrofitting of the city’s cen- financing for Russian cities. tral offices, with the cost financed by three years Climate change is leading to global warming of savings on energy bills. Russia is moving fast on and consequent serious economic disruption and this front as well. In November 2009, Federal Law dislocation of millions of people. Policies devised 261-FZ (“On Energy Efficiency Improvement to control emissions and pollution include reg- and  Energy Saving”) was adopted to help the ulations and standards, as well as economic country reduce its energy intensity by 40 per- instruments such as taxes and charges, tradable cent by 2020. These regulatory changes have permits, voluntary agreements, subsidies, and important implications for local governments financial incentives. and cities, including the development of new A growing number of cities have obtained energy-efficiency competencies and responsibili- substantial financing of vital local services ties, including sustaining achieved results in local through the Clean Development Mechanism. public buildings and utilities; supervising installa- The mechanism provides a link between reduc- tion of metering devices; maintaining local infor- ing a city’s carbon footprint and the changes mation systems on energy efficiency in buildings in behavior needed to effect that reduction (such as energy audit results, energy  passports, (see box 7.26 for the example of Lahore City, energy-efficiency measures, and savings reports). Pakistan). Those changes come about through Box 7.26 The Lahore Composting Carbon Finance Project The Saif Group, through Lahore Compost aerobic process with open windrow technol- (Pvt.) Ltd., has set up its first composting ogy to achieve the maximum level of mature plant at Mahmood Booti, Pakistan, under an product and a safe environment and to agreement with the city district government reduce waste disposal by half. The compost- of Lahore. The project was set up on a build- ing process normally takes around 60 days operate- transfer basis, whereby the project to complete with regular processing (see will be transferred to the city after 25 years. figures B7 .26.1 and B7.26.2). This is the first public- private partnership in The project was verified in 2011 by the Pakistan on such a large scale in the area of United Nations Carbon Authority, and since municipal solid waste recycling. then the volume of carbon reduction is The project was validated and registered validated every year. Thus, the project has as a Clean Development Mechanism been benefiting from the carbon credits that project with the United Nations Framework are expected to generate about US$6 mil- Convention on Climate Change in April 2010. lion in total revenues over five years and that It produces up to 150 tons of compost daily support the financial viability of the project. from 1,000 tons of municipal solid waste Besides its financial and environmental ben- supplied by the city. Lahore Compost uses an efits, the project generated about 50 jobs, (continued next page) 366 Municipal Finances Box 7.26 (continued) including more than 20 for unskilled workers, the project requires plan management to pro- most of whom are former scavengers. vide laboratory-quality evidence and checks The carbon credit is free money, but the and balances to prove emission reduction, transaction cost is paramount. Verification of which will eventually be good for the public too. Figure B7.26.1 Turning the Windrows Figure B7.26.2 Validation incentives in the form of carbon credits pro- carbon credit financing. The Asian Development vided to cities for reducing their greenhouse gas Bank financed the project through the certi- emissions. In 2007, the Municipal Corporation fied emissions reduction (CER) carbon credits of Mumbai financed a landfill closure and gas fund. One CER amounts to a saving of one ton of capture project at the Gorai landfill, drawing on carbon dioxide. Managing External Resources 367 Jordan Bolivia The greater Amman municipality handles Santa Cruz, Bolivia, has about 1.3 million half the solid waste generated in Jordan. With people and is growing 6 percent each year. US$25 million in World Bank financing, the city Sanitation services are well provided by 10 of Amman has expanded existing transfer sites cooperatives, but coverage is limited to 32 and its existing landfill site (World Bank 2010). percent of the population. Among the projects The design of the landfill site includes provi- for improving the situation are four waste- sions for recycling recoverable materials and water treatment plants whose methane gas landfill gas recovery. The latter is captured to is being transported to a flare by a system of generate “green” electricity and will amount to tubes. This project is funded by an emission 160,000 megawatt hours that will be channeled reduction purchase of US$2.09 million by the to the national electricity grid. In addition, the Community Development Carbon Fund and certified emissions reductions resulting from the Bio Carbon Fund. The local cooperative the project are estimated at 950,000 tons of CO2, SAGUAPAC receives the proceeds from this which will generate a further US$15 million in purchase and is responsible for implementing CER revenue by 2014, while the electricity sale the project, which is estimated to cost US$1.48 will generate revenues estimated to reach US$25 million to install and US$24,000 a year to oper- million by 2019. ate and maintain (Jaguari 2007). Morocco India In 2006, Morocco enacted its first law on solid The 18 million urban dwellers in Karataka, India, waste management. In 2007, it launched a have water coverage for less than four hours a day. 15-year municipal solid waste program in urban To improve the efficiency of water provision, the areas. The goals included 90 percent coverage government has launched a program to improve by 2021, sanitary landfills in all urban areas, energy efficiency and reduce greenhouse gas the closure and rehabilitation of 300 existing emissions. The program has been implemented open dumps, and the promotion of solid waste in six cities, with energy savings of 16 million reduction and recovery. The program aims to kilowatt hours and reduction in total emissions improve solid waste management practices of 13,620 tons of CO2. The resulting emissions in Morocco, which were among the worst in reductions—about 60,000 emissions reduction North African countries at 0.05 percent of gross units—will be purchased by the Community domestic product spending per year, compared Development Carbon Fund. The gross reve- to 0.2 percent in the Arab Republic of Egypt and nue will amount to between US$600,000 and 0.1 percent in Lebanon, Syria, and Tunisia. Gas US$900,000, which will be shared among the capture projects will capture and flare methane participating municipalities. from landfill sites, reducing emissions by 0.7 to 1.0 million tons of CO2 equivalent per year and Private Sector Participation earning Morocco revenue from carbon emission reductions sold under the Clean Development Public-private partnerships have gained impor- Mechanism. Generating revenues to the sector tance as an alternative way for local governments through carbon trading is an added incentive to finance infrastructure and deliver efficient for municipalities to tackle solid waste problems public services. The private sector brings not while also mitigating climate change (World only  capital and knowledge but also access to Bank 2010). technology and management practices that result 368 Municipal Finances in greater efficiency. PPPs are characterized by would ensure that the services are provided at the sharing of investment, risk, responsibility, and the lowest possible cost. In some cases, how- reward among partners. That shared responsibil- ever, competition does not work. One example is ity also makes the project more responsive to con- public goods such as city street lighting, police, sumer needs. In the context of this chapter, the and security, for which cities cannot charge main issue is that many PPP arrangements offer the user because people cannot be excluded financing alternatives to municipalities. Cities from receiving the service. A second example is can save public funds by engaging in a PPP with a those instances in which large investments are private investor and may use their public money at stake, leading to a de facto natural monopoly, instead for additional public projects that would for example, the local water service. In this case, not attract private investors. By handing over private sector operation by itself (in a monopo- public assets to private operators, the municipali- list situation) may not aim at the lowest possible ties can save on costs of operations, provided that price. Table 7.7 summarizes how the public and the private firm is more efficient and runs the ser- the private sectors can operate in several urban vice with same quality at less cost. services. Private or Public Delivery of Services Forms of Public-Private Partnerships In principle, it should be normal for the pri- The contractual form of a PPP varies depending vate sector to deliver the local services, such as on the type of service, who owns the assets (the water, energy, and so forth, that are considered local government or the private partner), who private goods. Competition among private firms bears the risk, and the duration of the contract. Table 7.7 A Typology for Delivery of Urban Services Urban service Type of good Role of public sector Role of private sector Urban transport Private (with positive Ensure efficient solutions Operate and construct externalities), merit and serving low-income systems. good. people. Piped sewerage systems Public good; Direct public provision. Can be contracted for monopolistic; specific works. positive externalities. Water supply Quasi-public good; has Regulation required to Can deliver but is positive externalities. ensure public health. regulated. Land service, All goods are private and Regulations to address Deliver infrastructure, infrastructure, and can be delivered by the environment and safety finance development, household connections private sector. considerations; zoning. charge consumer. Slum upgrading Large component of Finances public good: Community can deliver public good. water and sanitation. and build large part of the services. Solid waste collection Private good (positive Public sector ensures Private sector delivers externalities). provision and coverage. the service. Waste disposal Quasi-public good. Public direct provision. Deliver under contract. Source: Batley 2001. Managing External Resources 369 Table 7.8 Types of Public-Private Partnerships Type of PPP What they do Characteristics Management Transfer responsibility for operation Local government retains ownership and contracts and BOT and maintenance of a local funding of the project. It offers some government–owned business to the performance objectives by which to judge private sector for generally up to five the effectiveness of the firm in charge of the years. maintenance and operation. Examples: Lahore composting plant BOT; the bus transport service in Hanoi. Leases Local authority owns the assets, Risks are shared; leases can go 5–20 years. but the private sector leases the asset and takes care of the maintenance and operation. Concessions Private sector takes responsibility Concessions are for 25–30 years. Contracts for the maintenance and operation are very detailed, outlining performance and for the investment in the facility. standards, required investment, and mechanisms for adjusting prices and tariffs. The Transmillenio bus system; the Senegal urban water concession. Joint ventures Private sector holds shares in this The local authority may give daily structure. Over time, the local management to the private partner. government may sell the other shares to the private sector. Full or partial Private sector owns full or part of With complete divestiture, the private sector ownership the service or structure. takes full responsibility for operations, maintenance, and investments. All assets become private as well. Source: Delmond 2009. Note: BOT = build, operate, transfer. Table 7.8 illustrates the main types of PPPs. In PPPs Have Significant and Measurable their simplest form, we have management con- Benefits tracts for service delivery that last for one to three The main benefits of PPPs include the following: years, with assets belonging to the public sector. • Cost savings. Local governments will realize In the case of build-operate-transfer arrange- cost savings in both the construction of capital ments, leases, and concessions, the assets are pub- projects and the operation and maintenance of lic, but the risk is now private or shared and so is service. the investment to be made. Concessions can go for up to 25 years. Divestiture is the most extreme • Risk sharing. Local government can share case of privatization. It happens when all assets the risks with the private partner. Such risks are bought by the private sector and there is no include cost overruns, difficulty complying intervention of the public sector any longer (the with environmental regulations, and the risk rail system in the United Kingdom in the 1980s, that revenues may not be sufficient to pay for example). operating and capital costs. 370 Municipal Finances • Improved service. PPPs can introduce innova- the private sector partner are comfortable with tion in the company that organizes and carries the agreement. The most contentious features out the service delivery. They can also intro- of the renegotiated contracts seem to be the level duce new technologies and economies of scale of lowest tariff, the investment requirements, that often reduce costs. and weak regulatory bodies. Sometimes the ini- tial contracts suffer from lack of communication Several decades of PPPs have provided empir- with the public at large, the absence of social pro- ical evidence that confirms the positive impacts grams, contract violations, and ineffective and of engaging private partners in service delivery. unpredictable conflict resolution mechanisms. Private sector involvement in most infrastructure The main risks in PPPs include the following: sectors brings greater efficiency and satisfaction to the consumer. Prices go down significantly, • The main risk is the loss of control. PPPs that the quality of service improves, and service is entail significant investments by the private extended to the target community. This result partner often allow the partner to become very is especially evident in the case of telephones, involved in making decisions on how services energy, and water service. Labor productivity are to be delivered and priced, against the best increases substantially, sometimes by 50 percent. interests of customers. In the electricity sector, the number of connec- • Political risks are also common. An incom- tions per worker has jumped from less than 500 plete regulatory environment and corruption per employee before privatization to 750 after can transform the public-private partnerships privatization. Distributional losses have also into an opportunity for abuses and political fallen substantially, in some cases from 20  per- turmoil. cent and 40 percent in electricity and water, respectively, to 10 percent and 20 percent, after Despite some concerns about the lack of local privatization (Andres et al. 2008). technical expertise, PPPs are being used through- out the developing countries. For example, in PPPs Also Have Risks Uganda, local governments can contract out the Privatization tends to be associated with some provision of services and are encouraged to do negative images. The first contracts were based so. Contracts are in place for solid waste manage- on unjustified optimism and show some careless- ment, road maintenance, retail markets, car parks, ness in design and performance criteria. The local and even property tax collection. For land devel- government did not have enough information on opment, property is leased to private contractors the sector in question or enough leverage over the for 15 years. private partner, which made it difficult to moni- tor the performance of the partnership and take Successful PPP Cases corrective measures. One effect of poor contracts The number of successful PPPs in municipalities is the high rate of renegotiation and cancellation continues to go up. Four are especially interest- of PPPs. In Latin America in the 1990s, PPP con- ing: the Bogotá Transmillenio bus system conces- tracts in the water sector were renegotiated in sion contract, the bus transport service in Hanoi, 74 percent of cases in the first 18 months (Batley Lahore’s composting plant BOT, and the Senegal 2001). urban water sector concession. In all cases, the Nevertheless, the rate of cancellations is now contracts were very clear, the clauses that deal particularly low, suggesting that once the techni- with problems were well defined, and the private cal details are solved, the local government and sector contributions of investment, tariffs, and Managing External Resources 371 rate of return were wisely negotiated. Moreover, private sector bidding. Good PPPs follow that the preparation process was rigorous and took rule, and failed partnerships may have bypassed into account the demand for the services being the prefeasibility study. Boxes 7.27 and 7.28 shed provided, the earnings streams, the costs of the light on these issues. investment, the likelihood of private sector inter- Although the advantages of PPPs for cities are est, and an adequate PPP format for the project. well established, local governments should care- As a basic principle, a prefeasibility study should fully examine the need for technical and financial be prepared before submitting the project for expertise, so that they can negotiate the contracts Box 7.27 Feasibility Analysis for a Sanitary Landfill Increasingly, Asian cities are looking to the pri- review of capital requirements and projections vate sector for capital investment in the solid of the operations and maintenance costs and waste sector. In the assessment phase, a full amortization of each. The land to be allo- number of different types of analysis and data cated to new facilities would also need to be would be needed for a potential PPP project in appraised and valued. this sector. Because of significant economies The demand analysis would require a study of scale for sanitary landfills (costs per ton of the willingness and capacity of residents decrease as the size of the facility increases), to pay for improved services. The potential the private sector will be looking to ensure a recipients of services would be asked about certain flow of waste into the facility to guar- their opinions on service options, costs, and antee revenues for recycling and disposal methods of payment. operations. Thus, part of the feasibility stage The feasibility of undertaking waste recy- will entail collecting data on existing and pro- cling as a source of revenue should also be jected waste quantities and waste densities explored, together with on-site recycling and from different sources. composting activities, which minimize waste To determine which service options could generation, as a voluntary alternative to be viable, cost analyses would be performed on payment of the full service charge. different disposal options. This would include a Source: CIDA 2011. Box 7.28 Water PPP in Argentina In the case of Aguas de Tucuman, Argentina, when water tariffs went up overnight and the qual- ity did not improve as expected, the public sector tried to activate some of the contract clauses with little impact. The international water company ended up suing the state government for breaching the contract. Source: Andres et al. 2008. 372 Municipal Finances with full control. Renegotiations of PPPs, as men- reflect the uncertainties of the sector, and provide tioned above, have been the norm in the water measures to bring the contract back in line when sector in Latin America. Troubled PPPs also necessary. occur in Africa; box 7.29 describes a situation in Dar es Salaam, Tanzania. These experiences do PPPs and the Poor not invalidate the benefits of PPPs but show the A good opportunity for the private sector to need for good preparation and improved tech- engage profitably in city projects, while also ben- nical skills. Fortunately, international financial efiting the poor, is through innovative products institutions and bilateral aid agencies provide a specifically designed to meet the needs of the great assortment of technical assistance to ensure poor at prices they can afford and delivered in that the partnerships are designed with rigor, ways that fit their lifestyles (box 7.30 illustrates Box 7.29 Dar es Salaam: A Failed Water PPP Many cities have struggled through first PPPs were failure to extend the agreed coverage, to but learned from them. That was the case follow the procurement rules, and to pay the with water and sanitation in Dar es Salaam. agreed return to the city. The sector was constrained for 30 years Ten years later, the city is revisiting its by lack of investment. In 2002, a British- strategy and is welcoming PPPs; it plans to German-Tanzanian joint venture—City Water invite private investors to participate in pub- Services—was awarded the tender for a lic transportation projects and in real estate 10-year lease to manage the technical and development. A decade of learning by doing commercial operations of the water and san- has provided excellent guidelines on how to itation system of the city. Three years later, engage in a public-private partnership that in May 2005, the government accused the respects and abides by the principles of the operator of failure and terminated its con- local government. tractual arrangement. The apparent reasons Source: Sway 2011. Box 7.30 “Urban Concessions” PPP in Brazil In São Paulo, Brazil, new public-private partnerships—called “urban concessions”—are being developed in which impoverished parts of the city will be converted to private operation in exchange for the execution of an infrastructure plan. The concessionaires will recoup their investment and obtain profit from the redevelopment of expropriated properties during the con- cession period. It is envisioned that the property owners will receive compensation according to predefined criteria, while sitting tenants may either be relocated to low-income housing or obtain a rental grant. Managing External Resources 373 the challenges of meeting those requirements). forward, local governments need to pay attention Potential areas include financial services, such as to the design of contracts, methods for resolving the Kuyasa Fund in Cape Town. Another example disputes, and the technical details both before is the SKS Microfinance in India, in the area of and after signing a PPP contract. housing. In the area of solid waste management Clear norms for supervising the delivery of the and recycling are the Quezon City Materials service need to be included in the contract and be Recovery Facilities, in the Philippines, and the subject to good supervision. If local governments New Delhi Municipal Council in India. The lat- do not possess the requisite knowledge and skills ter officially subsidized waste pickers—usually to pursue a PPP on their own, they should not the poor—who pick up waste from residents’ hesitate to seek outside assistance, as long as they doorsteps and contribute to the 33 percent waste understand the overall vision and guiding prin- recovery rate by private, independent recyclers. ciples of the PPP arrangement. Local decision Increasingly, output-based aid (OBA) has been makers must also have a firm understanding of used to structure subsidies to the private sector the risks they will assume under a PPP, as well as to ensure that performance targets—particularly their contingent liabilities should things not go as those related to service provision to the poor—are expected. adequately met. OBA basically links the payment of subsidies to the demonstration of specific ser- Philanthropic and Individual vice delivery or outputs: for example, the con- Contributions nection of a specified number of customers to the electrical grid or to the water distribution In addition to other financing options, municipal- network. Private providers must therefore carry ities should seek philanthropic aid. Since the end their own risks of nonperformance and pro- of the 1990s, philanthropic aid has increased dra- vide their own finance up-front (in most cases) matically. The total amount comes to about US$5 to meet the performance targets and obtain the billion a year worldwide, of which 75 percent OBA grant. OBA has been found to be especially comes from U.S. foundations. These foundations effective in extending water connections to slum have more than tripled their contributions over areas through one-time fee subsidies for network the past 10 years, with contributions over the extension and connections, as in cities in Ethiopia, period totaling US$44 billion in 2007 (Paulais Indonesia, Mozambique, and the Philippines 2013; Foundation Center 2009). The Bill and (GPOBA 2008; World Bank 2005). Melinda Gates Foundation is the most important world foundation Most of the funds are channeled Some Lessons Learned through nongovernmental organizations, often Public-private partnerships have great potential European ones (for example, Switzerland is the for enabling local governments to expand ser- headquarters of many foundations, such as the vices at reduced cost and with greater efficiency. World Global Fund to Fight AIDS, Tuberculosis, But for the best use of PPPs, local governments and Malaria; the Red Cross; and others). need to know more about the specific sectors in Local authorities rarely have direct access which they are working and the legal covenants to philanthropic aid, unless through state or that they may need in case of disagreements national government. In 1995, the Soros founda- with their private partners. Success depends on tion (the Open Society Institute) helped establish a locality’s long-term vision, its capacity to regu- the National Urban Reconstruction and Housing late service providers and service quality, and its Agency, in South Africa, and has extended further ability to enforce regulatory controls. In moving help to subsidize low-income mortgages. In 2007, 374 Municipal Finances a Gates Foundation contribution reinforced the the Philippines, PRODEL in Nicaragua, and the capacity of local governments in the water and Jamii Bora Trust Low-Cost Housing Scheme in sanitation sector. Kenya. Local governments do, however, engage the The Jamii Bora has created a successful low- general public in making specific contributions cost housing program of about US$12.5 million to fund development projects. For example, in (commercial and residential). The organization the city of Uzgen in the Kyrgyz Republic, the local purchased 293 acres of privately owned land government engaged the population in raising and has constructed houses with a combination funds for improving the water system. The city of members’ savings, market finance, and dona- has grown very fast, and the water system had not tions from well-wishers. Members finance the kept pace. The city could not afford a World Bank housing units (about US$3,000 each) with loans loan because it did not have the necessary coun- from the trust, about $45 per month per house- terpart funds (3 percent of the total cost). The hold. Maintenance costs are covered through city administration designed and implemented a monthly fees of approximately US$7 charged to successful public relations campaign to convince households (UN-HABITAT 2005). Community residents to make a one-time contribution to raise funds in India and Thailand have grown substan- the funds. To solicit funds for the first stage, the tially with the help of the central government and local administration mobilized students to raise foreign donors. awareness of the importance of potable water Capitalized by donors, Community-Led and to convince their parents to contribute. Later, Infrastructure Financing is a fund for the a similar process took place in which the city was urban poor that supports community-initiated able to expand its water coverage from 35 percent housing and infrastructure projects with the to 65 percent of the residents (Kaganova 2011). potential for scaling up. It works with the Community funds are growing in impor- National Dwellers Federation and other large tance, especially to help low-income families community organizations to provide consistent address shelter needs. These funds establish and approaches and maximum leverage. The goal is strengthen local savings groups that provide col- to increase the access of poor urban commu- lective finance for shelter improvement, leverage nities to commercial and public sector finance resources from the national government and for- for medium- to- large-scale infrastructure and eign donors, and can be important in promoting housing initiatives. The organization provides community development. bridging loans, guarantees, and technical assis- They can also contribute to infrastructure tance; undertakes rehabilitation projects; and at significant savings (Mitlin and Muller 2004). attracts commercial, local, and public sec- One example is the Slum Dwellers International, tor finance for further schemes (http://www a network that incorporates savings and lend- .homeless-international.org). ing activities for shelter improvement. Over the past 15 years, the organization has evolved Takeaway Messages into an international movement with affiliates Many local governments have substantial needs to in more than 12 countries. It has helped mil- expand infrastructure and provide basic services. lions of households access land and improved Given the long-term nature of municipal infra- housing with small grants. Other examples structure, it is possible and efficient to use long- include the Cambodia Urban Poor Development term funds to finance these projects. This ensures Fund, the Bann Mankong (secure housing) in that the generations that will enjoy the benefits of Thailand, the Community Mortgage Program in the project are also those who pay for them. Managing External Resources 375 However, it takes time and experience for case revenues are less than expected, the costs local governments and financial institutions each are higher than planned, or some other factor to know and understand how the other operates. has turned for the worse (as when the borrowing Until they do, central governments step in to reg- is in a foreign currency and a devaluation of the ulate how much local governments can borrow, national currency occurs). what they can borrow for, and which revenues they can pledge as guarantees. In many countries Notes (such as Chile), local governments are not autho-  1. Most capital improvement plan processes rized to borrow. In others, the central govern- require that submitters of proposals identify not ment borrows on their behalf. just benefits and cost (broken down by phases Local governments that are interested in and of execution) but also a list of all necessary per- can access external financing should follow some mits, licenses, and ownership or right-of-way key steps: documents required for approval of a project, to obtain finances, and to start construction. • Select projects that are worthwhile to finance  2. Computing Present Value—An Illustration with market (expensive) resources. • Make sure they have a good financial position Discount interest Base Y1 Y2 Y3 (measured by a net operating surplus). rate r = 5% year Compounded 1.000 1.050 1.103 1.158 • Project their balance sheets and find out interest rate (1 + r)i whether new borrowing is in line with the con- Discount factor in 1.000 0.952 0.907 0.864 straints imposed by the national legislation. year i di = 1 / (1 + r)i • Compare alternative forms of borrowing, Present value of cash 2.000 1.905 1.814 5.719 including banks and capital markets. flow PV = CFi*di • Understand when public-private partnerships  3. Municipalities can file for bankruptcy in are efficient ways to finance expensive infra- a few countries, for example, in Hungary and the United States. Unlike the corporate structure and what enforcement provisions bankruptcy that may end up with liquidation, are needed to be sure that the public sector municipal bankruptcy is a protective proce- gets its fair share. dure in which the basic services are aimed to • For municipalities that are not used to borrow- be maintained, while noncore assets and com- mercial investments are sold and services and ing in the market, institutions such as public staff perhaps reduced, to satisfy the creditors, investment banks and municipal development who also share the risk of being compensated funds can assist in introducing them to the only partially. rigor of market-based finance.  4. For more details and guidance on munici- Enhancement instruments such as guarantees pal borrowing structure, see Petersen and are also used to make municipal projects less risky Crihfield 2000. for creditors and to attract potential investors. Sometimes a local government will face finan- References cial stress and eventually bankruptcy. It is always ADB (Asian Development Bank). 2011. Urban useful to understand what can go wrong when Infrastructure Financing. http://www.adb.org you borrow to finance a project and how the /documents/periodicals/intersections/2011 local government can remedy or take action in /Urban_Infrastructure_Financing.asp. 376 Municipal Finances Amim, Munawwar. 2010. “Municipal IFC (International Finance Corporation). 2004. Infrastructure Financing: Innovative Practices Structured Finance: The City of Johannesburg. from Developing Countries.” Commonwealth Washington, DC: IFC. Secretariat Local Government Reform Series, Jaguari, Sergio. 2007. Contribution of CDM Projects No. 2, Marlborough House, London. to Sustainable Development Case Study: Bolivia. Andres, Luis A., L. Guasch, T. Haven, and Vivian Washington, DC: World Bank. Foster. 2008. The Impact of Private Sector Kaganova, Olga. 2011. Guidebook on Capital Participation in Infrastructure: Lights, Shadows Investment Planning for Local Governments. and the Road Ahead. Washington, DC: World Washington, DC: World Bank. Bank. Melo, Luis. 2005. “Financial Decentralization and Annez, P., and G. Peterson. 2008. Lessons for the the Law of Fiscal Responsibility in Brazil.” In Urban Century: Decentralized Infrastructure City Finance, edited by George Peterson and Finance in the World Bank. Directions in Patricia Clarke Annez. Washington, DC: World Development Series. Washington, DC: World Bank. Bank Institute. Mitlin, Diana, and Anna Muller. 2004. “Windhoek, Batley, Richard. 2001. “Public-Private Namibia: Towards Progressive Urban Land Partnerships for Urban Services.” In The Policies in Southern Africa.” International Challenge of Urban Government, edited by Development Planning Review 26 (2):167–86. Mila Freire and Richard Stren. Washington, Ngobeni, Jason. 2008. “Asking the Right DC: World Bank. Questions: Johannesburg Completes a Canuto, Otaviano, and Lili Liu. 2013. Until Debt Groundbreaking Municipal Bond Issue.” Do Us Part: Subnational Debt, Insolvency, and PPIAF Gridlines 22 (Public-Private Markets. Washington DC: The World Bank. Infrastructure Advisory Facility). World Bank, Church, Steven, William Selway, and Dawn Washington, DC. McCarty. 2011. “Jefferson County Files for Novi Sad. 2011. “Information Memorandum for Bankruptcy.” Bloomberg News, November 9. the Issue of the City of Novi Sad Long-Term http://www.bloomberg.com/news/2011-11-10 Debt Securities.” Novi Sad, Serbia. /alabama-s-jefferson-county-declares-biggest -municipal-bankruptcy.html. OECD (Organisation for Economic Co-operation and Development). 2010. Innovative Financing CIDA (Canadian International Development Mechanisms for the Water Sector. Paris: OECD. Agency). 2011. “PPP Guide for Municipalities: Cities Development Initiative for Asia.” CIDA. Paulais, Thierry. 2013. “Financing African Cities— http://www.cdia.asia/wp-content/uploads The Imperative of Local Investments.” AfD /PPP-Guide-for-Municipalities2.pdf. and World Bank, Washington, DC. Delmond, Jeff. 2009. Private Sector Investment in Petersen, John, with John Crihfield. 2000. Infrastructure–Project Finance, PPP Projects “Linkages between Local Governments and and Risks. 2nd ed. Alphen aan den Rijn, Financial Markets: A Tool Kit to Developing Netherlands: Wolters Kluver. Sub-Sovereign Credit Markets in Emerging Foundation Center. 2009. Philanthropy Annual: Economies.” Working paper, World Bank, 2009 Review. http://foundationcenter.org Washington, DC. /philanthropyannual. Peterson, George. 1998. “Measuring Local Freire, Mila, and John Petersen. 2004. Access to Government Credit Risk and Improving Sub-National Credit. Oxford: Oxford Press; Creditworthiness.” World Bank Working Paper Washington, DC: World Bank. 37855, World Bank, Washington, DC. GPOBA (Global Partnership on Output-Based Aid). Peterson George and Annez P. 2007. Financing 2008. “GPOBA Activities.” Global Partnership Cities. Fiscal Responsibility and Urban on Output-Based Aid. www.gpoba.org. Infrastructure in Brazil, China, India, Poland Managing External Resources 377 and South Africa. World Bank and Sage Tavernise, Sabrina. 2011. “City Council in Publications, Delhi. Harrisburg Files Petition on Bankruptcy.” Platz, Daniel. 2009. “Infrastructure Finance in New York Times. October 21. Developing Countries: The Potential of Sub- UN-HABITAT. 2005. Financing Urban Shelter: Sovereign Bonds.” United Nations Department Global Report on Human Settlements. London: of Economic and Social Affairs, Working Paper Earthscan and UN-HABITAT. 76, New York. http://www.un.org/esa/desa USAID (U.S. Agency for International /papers/2009/wp76_2009. Development). 2003. “Pooled Finance Platz, Daniel, and Frank Schroeder. 2007. Model for Water and Sanitation Projects: Moving beyond the Privatization Debate: The Tamil Nadu Water and Sanitation Different Approaches to Financing Water and Pooled Fund (WSPF).” USAID Note, USAID, Electricity in Developing Countries: Dialogue Washington, DC. on Globalization. New York: Friedrich- World Bank. 2002. Cali: A City Development Ebert Stiftung. http://library.fes.de/pdf-files Strategy. Washington, DC: World Bank. /iez/04877.pdf. ———. 2005. “Output-Based Aid: Supporting Shapiro, Mary. 2010. Speech of Mary L. Schapiro, Infrastructure Delivery through Explicit Chairman of the Securities and Exchange and Performance-Based Subsidies.” Commission, at the SEC Open Meeting on OBA Approaches Note 5, World Bank, Municipal Securities Disclosure. Washington, Washington, DC. DC. May 26. http://www.sec.gov/news ———. 2009. Improving Municipal Management /speech/2011/spch012011mls.htm. for Cities to Succeed. Washington, DC: Sood, Pryanka. 2004. “India: Experiments in World Bank. Local Governments Accessing the Private ———. 2010: The Cost of Environmental Capital Markets Provide Promising Results.” Degradation: Case Studies from the Middle In Subnational Capital Markets in Developing East and North Africa. Washington, DC: Countries: From Theory to Practice, edited World Bank. by Mila Freire and John Petersen, 413–42. World Bank–IEG. 2009. “Improving Municipal Washington, DC: Oxford University Press and Management for Cities to Succeed.” Internal the World Bank. Evaluation Group Special Study, World Bank, Sway, Idda L. 2011. The Failure of Public Private Washington, DC. Partnerships in Water Delivery Services: World Bank and IMF (International Monetary A Case of Dar-es Salaam City, Tanzania. Fund). 2009. Developing a Medium-Term Saarbrücken, Germany: LAP Lambert Debt Management Strategy: Guidance Academic Publishing. http://www.cdia Note for Country Authorities.Washington, .asia/wp-content/uploads/PPP-Guide-for DC: World Bank and IMF. http://www.idfc -Municipalities2.pdf. .com/. 378 Municipal Finances CHAPTER 8 Achieving Greater Transparency and Accountability: Measuring Municipal Finances Performance and Paving a Path for Reforms Catherine Farvacque-Vitkovic and Anne Sinet Given the rapid urbanization occurring in coun- national or state administrations for exertion of tries all over the world, local governments control over local entities or by banks for analysis everywhere face the challenge of providing of financial risk. infrastructure and basic services to increasingly Performance measurement should be  desig- demanding constituencies. This situation is com- ned to assess not only the efficiency and effective- pounded by the irreversible trend toward decen- ness of the municipal services specifically but also tralization in which central governments have the productivity of the municipal departments. delegated to local governments the execution and Performance can be measured along several financing of large portions of local investment dimensions: efficiency, which is the relationship programs. Most municipalities face heightened between services or products and the resources fiscal stress and often have to do more with less required to produce them; effectiveness, which to meet residents’ needs; how well local govern- indicates the quality of municipal performance ments meet those constituent needs is often mea- or the extent to which a department’s objectives sured by using methods initially developed by are achieved; and productivity, which combines Achieving Greater Transparency and Accountability 379 the components of efficiency and effectiveness developing countries, where local revenues are in a single indicator that refers generally to the often insufficient to meet basic needs and where municipal staff and internal performance of the the effectiveness of public expenditures is even organization. more crucial. In summary, performance measurement is a Finally, the world economic crisis and its broad concept which tries to get better answers impact on public finances have greatly contrib- to two major questions: uted to promoting the measurement of municipal financial performance (Paulais 2009). The over- 1. Are we doing the right things ? arching objective is to increase accountability 2. Are we doing things right ? and transparency in a context of skewed financial resources. Why Is Municipal Finances From Analysis of Municipal Finances to Self-Assessment Imperative? Performance Assessment Municipal Finances performance measurement The analysis of a municipality’s financial situ- is important because it provides an opportunity ation is the first step in performance measure- to obtain a clear picture of the financial situa- ment. The calculation of the financial situation tion of the municipality and support dialogue depends on country-specific accounting data and with key stakeholders (Central government, procedures and on the generic systems of reve- financial partners, citizens). It also provides nues and expenditures customized at the local an opportunity for benchmarking (ratios) and government level (including municipal agencies helps evaluate how effectively and efficiently dedicated to water, solid waste  etc.) The  key public funds are being used. ratios and indicators are directly inspired by The Anglo-Saxon world has been pushing the methods developed by external entities such as envelop on developing methodologies for deal- the central or state administrations for control ing with these questions. Municipalities have and supervision and also by the banking sys- used performance measurement for sometime tem and rating agencies for risk analysis and do in Canada, the United Kingdom, and the United not contain any home-grown inputs from local States. In these countries, the culture of perfor- governments. mance measurement has been widespread for The assessment of the effectiveness, effi- several decades. However, the effectiveness of ciency, and quality of budget planning and imple- those methods is regularly subject to debate, and mentation (performance measurement) is more the picture is mixed: in most countries, public challenging. These assessments focus on the administrations are not accustomed to thinking effectiveness of the expenditures or resources in terms of results but more in terms of volume. used, specifically, what the municipality did with Moreover, the performance measurement also its budget that was visible or useful for the popu- needs to evaluate how local governments’ efforts lation and whether services performed gave the are perceived and to help determine a course of optimum value for money. Does the population’s action. This is a complex, demanding, and costly perception of value for money coincide with the process. municipality’s effort? Despite the obstacles mentioned above, the The central governments have had to scale culture of financial performance measurement is back their benchmarking initiatives in view of spreading beyond the English-speaking countries. the highly complex decentralized systems now in Moreover, the concept takes on a new meaning in place, local investment financing (public-private 380 Municipal Finances partnerships and cross-financing arrangements), • Third, it presents the Municipal Finances and the distribution of responsibility among the Self-Assessment (MFSA) and guides the municipality and its departments and agencies. reader through its use and application. In addition, the diversity of local governments’ situations (size of the municipalities, economic Section 1: Measurement of potential, existing intercommunal arrangements, Municipal Finances Performance: and the like) has made it more and more difficult Lessons Learned to establish comparable financial benchmarks for municipalities, even for local governments in the Three main systems can be considered as repre- same country. sentative of a typology of generic situations: All these reasons have contributed to devel- • The system for measuring municipal perfor- oping the Municipal Finances Self-Assessment mance in Canada and the United States. This (MFSA) as a reliable way to monitor internal system has introduced the culture of perfor- investment planning and budget processes mance measurement in local governments and to convince external partners of the sus- and in the broader public sector. However, tainability of a city’s finances and financial even if performance measurement is wide- management. spread in the United States and a few other countries, most municipalities have only a limited ability to measure their performance Toward Municipal Finances Self-Assessment because of workload issues, and it is often not The MFSA templates are presented at the end clear whether the quality and efficiency of ser- of this chapter. It focuses on five main topics: vices correspond to the resources required to (a)  how to calculate a municipality’s financial achieve them. position; (b) which financial ratios to select; • The European approach to measuring munic- (c)  how to make financial projections; (d) how ipal financial performance. The European to appraise financial management; and (e) how approach is illustrated through the French to summarize lessons learned from the previ- model, which focuses on a sound analysis of ous steps and incorporate them into a municipal the financial condition of the municipality and finance improvement plan. on whether the amount of revenue allows a Subsequently, the chapter is structured around sufficient degree of flexibility in decision mak- three main sections: ing. The culture of performance evaluation as applied to finance began with the debate on • First, the chapter focuses on lessons learned how well basic municipal responsibilities like from performance measurement practices water supply and environmental services were and experiences in developed countries and being managed, as well as what municipalities’ assesses how to adapt performance measure- “social responsibilities” are. ment in the context of developing cities. • Performance measurement in nonmarket econ- • Second, it reviews the four key reporting omies. Countries that do not have market mechanisms commonly used for measuring economies have also developed integrated municipal finances performance: (a) State municipal finances evaluation, but their sys- supervision, (b) risk analysis by financial tems are oriented toward the achievement partners, (c) internal financial follow-up by of strategic national goals to which all local municipal staff and (d) reporting to citizens. governments have to contribute. The financial Achieving Greater Transparency and Accountability 381 resources of the municipalities are allocated Since the 1980s, there has been a renewed through complex equalization mechanisms in interest in measuring municipal performance, line with the quantitative objectives assigned. in particular with the generalization of munic- This system generates specific audits and ipal bonds as the main mechanism for local supervision to verify whether the quantitative governments to finance investment projects performance targets are reached and, if nec- (also discussed in chapter 7). In addition to the essary, to adjust the financial resources pro- traditional ratios for calculating the capacity of vided to the local governments by the central the municipality to repay its debts, the munici- administration. Most of these countries have pality has to prove that it is well managed. The embarked on a transition, but because changes ratios and indicators focus on investment and in intergovernmental systems are slightly less operating costs and on the quality and quantity rapid than in other components of the national of services provided. economy, cumbersome procedures are still By most counts, more than half of all U.S. visible. cities were applying performance measures of some type in the late 1990s (GASB 1997; Poister The above classification is, by no means, exhaus- and Streib 1999). Local performance mea- tive: it is a general overview of the main systems sures were instigated by the Governmental and is helpful in determining the key lessons Accounting Standards Board established in 1984 and best practices that could help foster better with the agreement of the Financial Accounting financial management processes and improve the Foundation and the ten national associations financial position of municipalities. of state and local government officials; the pur- pose was to establish and improve standards of Lessons from Canada and the accounting and financial reporting for U.S. state United States: The Need for Advanced and local governments. Performance Measures Financial conditions and management prac- In the United States, municipalities have used tices of local governments have become key regular financial self-assessments for a long components of the rating analysis conducted by time. One could say that municipal performance specific agencies and, consequently, of the capac- measurement was born in the United States at ity of the municipality to get its bonds subscribed the beginning of the 1930s. This early develop- at the lowest cost. ment is linked to the substantial responsibility Therefore, most U.S. municipalities now historically assumed by local officials for fiscal show a strong commitment to the effective use decisions and services to their population and of performance measures, at least to get ready to the earlier appropriation of results-oriented to reply specifically to the state auditor and to management by the public sector (box 8.1 sheds the rating agencies involved in the process of light on this evolutionary process). bond issuance. But they also want to improve The law traditionally required local officials to their internal management (results-oriented periodically provide upper levels of government systems), budgeting practices, and strategic with statistics on service delivery performance planning processes over the medium and long and cost accounting. This obligation was justified terms. by the number of state grants in local budgets1 and The entire scheme is supported by popula- by the need for the state administration to have tion surveys and communication policies tar- control over the disbursement of those grants. geted to citizen communities and customers. 382 Municipal Finances Box 8.1 U.S. Experience in Municipal Performance Measurement Public performance measurement can be a long tradition and extensive experiences in traced back at least to the 1930s, when the public sector with performance measure- Herbert Simon elaborated the concept of effi- ment, mainly in the United States and other ciency and studied performance measures in Anglo-Saxon countries. U.S. municipalities (Simon 1947/1997) (see Performance measurement in the public Ridley and Simon 1938). sector means the measurement of perfor- A significant milestone in the early days of mance indicators for efficiency (minimiz- performance measurement was the rise of ing input for given output), effectiveness, government research at the New York Bureau and equity, which are intended to be used of Municipal Research. It was focused mainly in administrative and political processes to on performance budgeting or cost account- improve rational decision making. ing, based on the question, How can the However, results of a survey of municipal executive act with broad discretion and still governments in Canada and the United States be subject to legislative oversight? show that there is limited use of the balanced In more modern times, concern for mea- scorecard. Most municipal governments, suring the performance of public entities however, have developed measures to assess arose with the interest in program budget- their organizations’ financial performance, ing in the 1960s and program evaluation in customer satisfaction, operating efficiency, the 1970s. Studies have promoted the use innovation and change, and employee per- of performance measures and provided formance. Respondent administrators, in instruction on how to develop and use them general, have confidence in the quality of (Hatry and Fisk 1971; Hatry et al. 1988), while the performance measures, and about half other authors focused on how to incorporate reported that these measures were used to them into larger management processes support various management functions. The (Epstein 1984). respondent administrators also have a good Even though many assume that public understanding of the balanced scorecard, management relies mainly on importing ideas and the implementers are positive about their and models from the private sector, there are experience. Source: Williams 2004. Box  8.2  illustrates the role of performance infrastructure and services and their imple- measurement in communicating with citizens. mentation costs. Each municipality develops Early  on, these policies became part of the its own presentation with no compulsory for- municipal performance self-assessment imple- mat, and today there are many examples and mentation, contributing to the development of applications that illustrate the efforts made by a real culture of performance measurement in Canadian and U.S. municipalities on perfor- local public administration.2 mance measurement.3 The format for performance measurement The reports, generated locally, are comple- requires a combination of budgetary and phys- mented by regular independent audits  reg- ical aspects, related mostly to development of ulated by law and focused mainly on the Achieving Greater Transparency and Accountability 383 Box 8.2 Vancouver: Communicating Municipal Priorities and Performance The images are examples of communica- public services and their priorities. Results tion tools created by the city of Vancouver, help city officials determine what issues are to illustrate budgeting and spending. Every most important to residents and how the city two years, the city conducts a two-step com- is performing and provide information for the munity survey to gauge citizens’ opinions on budget planning process. generally accepted accounting principles. For External comparisons (that is, comparisons several decades, municipal performance mea- among municipalities), however, are still poorly surement has been integrated tightly into the developed for various technical and political rea- broader municipal management system and sons. Two examples of performance measure- procedures. ment are provided in box 8.3: the Ontario, Canada, But performance compared to what? A per- Municipal Performance Measurement Program formance measure is virtually valueless without and the New York City Citywide Performance comparison with relevant baseline data. The first Reporting. step developed by U.S. municipalities has been Figure 8.1 illustrates specific performance putting in place an internal gauge and to compare measurement indicators by main municipal ser- results from one year to the next or from one ser- vices and assessment of the operating costs of vice or department to another and to point out roads. The figure shows that the indicators are main trends. simple, practical, and sector specific. 384 Municipal Finances Table 8.1 Perspectives on Performance Service delivery Financial management Human resource management Core performance indicators Level indicators relating to resource Indicators that provide information related to government goals focus management. These are aimed at on strategic human resource issues, on issues such as infrastructure tracking the effective and efficient such as reductions in staff, the extent capacity, literacy and numeracy use of financial resources in such of diversity in the workplace, and staff levels, crime rates, and water areas as local taxation and invoice turnover. Some municipalities introduce quality. The aim is to develop payment. Indicators are spending extensive surveys of employees to outcome-based indicators to per capita (population) for the main measure their satisfaction and identify provide information on progress services provided to the population: emerging issues. The objective is to toward long-term targets. The police, environmental services, fire, develop business planning processes needs and the progress are transportation, etc. The change over and create results-oriented job published in community status 1, 5, or 10 years is given. Operating descriptions to enable all employees to reports. They are presented as and investment expenditures can understand how their work contributes percentages of achievement. be distinguished from each other. to citywide goals. Source: Boyle 2004. Box 8.3 Municipal Performance Measurement in Ontario and New York Service efficiency measures in Ontario, • Operating costs and total costs for police Canada, municipalities. The Ontario govern- services per capita. ment’s Municipal Performance Measurement • Operating costs and total costs for paved Program requires municipalities to submit roads per lane kilometer storm water and financial and related service performance operating costs and total costs for collec- data to the province and public on a range of tion and conveyance of wastewater per services provided by municipalities (including kilometer. general government, fire, police, roadways, New York City performance reporting. The New transit, wastewater, storm water, drinking York City website http://www.nyc.gov offers a water, solid waste, parks and recreation, library good and innovative example of the perfor- services, and land use planning). The program mance measurement policy implemented by has several objectives: U.S. municipalities and of the communication • To promote better local services and con- policy as a component of its interactive system tinuous improvement in service delivery (flexible, easy to use). Oriented mainly toward and government accountability citizens and users, the performance scheme • To improve taxpayer awareness of munici- provides regular information on spending and pal service delivery funds allocated to the primary expenditures • To compare costs and level of performance items: critical performance indicators are of municipal services both internally (year to provided for all city agencies, with monthly year) and externally among municipalities. updates and automatic evaluation of trends within specified program areas. The list of indicators includes: It relies on a formal internal framework of • General government operating costs and data collection and treatment (citywide perfor- total costs for governance and corporate mance reporting), with integrated operational management as a percentage of total data residing in disparate databases devel- municipal operating costs. oped and maintained by separate agencies. Achieving Greater Transparency and Accountability 385 Figure 8.1 Performance-Based Measurement Examples from Two Jurisdictions in Canada (a) Measuring road performance, in Durham, Ontario OPERATING COSTS/TOTAL COSTS FOR PAVED (HARD TOP) ROADS PER LANE KILOMETER Durham 2009 result Durham 2010 result Operating costs for paved (hard top) $6,053.91 per paved $7,034.05 per paved lane roads per lane kilometer lane kilometer kilometer Total costs* for paved (hard top) roads $19,019.01 per paved $23,876.73 per paved per lane kilometer lane kilometer lane kilometer The following narrative is an integral component of the above noted performance measurement results. These results should not be used to compare data from one municipality to another unless the influencing factors discussed in the narrative are also taken into consideration. * Total costs means operating costs as defined by MPMP plus interest on long term debt and amortization on tangible capital assets as reported in the Financial Information Return. General comments The costs for paved roads can be influenced by: Frequency of freezes and thaws Frequency and severity of rainfall events Age and condition of the network The proportion of heavy trucks in the traffic stream The municipality’s pavement standards The volume and type of traffic using the roads Detailed comments The Region of Durham road system is composed entirely of arterial roads. Compared to local roads or residential streets, arterial roads face enhanced impacts of higher volumes of traffic (particularly truck traffic) and consequently experience a more rapid rate of deterioration and, in addition, demand a higher level of service than non-arterial roads. (b) Performance-measuring indicators for municipalities in Ontario Service area Measure General Operating costs for governance and corporate management Government as a percentage of total municipal operating costs Fire protection Operating costs for fire services per $1,000 of assessment Police protection Operating costs for police services per person Violent crime rate per 1,000 persons Property crime rate per 1,000 persons Total crime rate per 1,000 persons Youth crime rate per 1,000 youths Roads Operating costs for paved (hard top) roads per lane kilometer Operating costs for unpaved (loose top) roads per lane kilometer Operating costs for winter maintenance of roadways per lane kilometer maintained in winter Percentage of paved lane kilometers where the condition is rated as good to very good Percentage of winter events where the response met or exceeded locally determined municipal service levels for road maintenance Transit Operating costs for conventional transit per regular service passenger trip Number of conventional transit passenger trips per person in the service area in a year Wastewater Operating costs for the collection of wastewater per kilometer of wastewater main Operating costs for the treatment and disposal of wastewater per megaliter Operating costs for the collection, treatment and disposal of wastewater per megaliter (Integrated System) Number of wastewater main backups per 100 kilometers of wastewater main in a year Percentage of wastewater estimated to have by-passed treatment Storm water Operating costs for urban strom water management (collection, treatment, disposal) per kilometer of drainage system Operating costs for rural storm water management (collection, treatment, disposal) per kilometer of drainage system 386 Municipal Finances Main Lessons Learned from Canada and other countries and illustrates the limits of the United States a too-ambitious performance measurement The municipal finance assessment applied system. in Canada and the United States focuses on Consequently, it is important to design a sys- the level of service provided to the popula- tem for measuring financial performance in tion through workload or outcome ratios and harmony with the objective and capacity of the service indicators. The main objective of the municipality itself. measure is to help determine expenditures through a results-based budgeting approach The European Experience that connects resource allocation to spe- Except in the United Kingdom, Europe has no cific, measurable results that reflect agreed tradition of internal performance measure- priorities. ment. To measure the performance of munic- One impressive lesson learned from U.S. ipal finances through the service delivery municipal performance measurement is the effort and cost efficiency is not part of the cul- importance given to communication of per- ture. However, financial ratios and the general formance indicators to communities and cit- financial position of municipalities are usually izens, with the clear objective of increasing under tight control of the mayor and his staff, public confidence in government. Confidence the central government administration, and begins with the ability to spend money wisely. now even the European Commission:4 the vol- Yet, budgets are often full of administrative ume of finance, its year-over-year increase, the details seemingly disconnected from the vision balance between the current and the capital and the strategic direction of the municipal- investment budget and debt ratios are com- ity. The  objective is to connect resources with mon concepts shared by most local officials. results so that budgeting is a strategic manage- Municipal finance assessment is widespread ment and communication tool for legislators but focuses mainly on balancing ratios and and city managers. trends. However, in actuality, the performance Financial ratios are published annually by measurement applied in most U.S. municipal- state agencies (the ministry of finance or min- ities is limited to workload or output measures istry of the interior) or even by national associ- and does not inform the public about the effi- ations of  local governments (figure 8.2). A fair ciency, effectiveness, or productivity of the amount of information on local finances is avail- municipality (see Ammons 2001). Despite the able in most European countries but, again, pri- general expansion of the performance mea- marily on financial position and revenues. Only surement systems among local U.S. govern- partners involved in the local development sec- ments, it is difficult to get comparable data, tor and experts or consulting firms make use of even today. The administrations are very cau- this information. tious about publishing benchmarks and per- Service budgeting is not commonly assessed, formance scores, because of the many external as it is the prerogative of municipal councils factors that influence the results (see above) or to decide on priorities, generally on the basis the inconsistent accounting practices across of the program or agenda on which they were municipalities for overhead costs, employee elected.5 Consequently, performance measures benefits, capital acquisition, depreciation, and focus more on financial sustainability than on the like. This situation is common to numerous efficiency and budgeting policy. Achieving Greater Transparency and Accountability 387 Figure 8.2 Municipal Debt per Citizen and Total Debt in 10 French Cities Source: Agence Française de Notation 2010. However, under the constraints of the finan- the scope of their financial assessment and cial crisis, more aggressive attempts to renew include evaluation of the quantity and quality the assessment of the municipalities and, in of services provided by the municipal bud- particular, of their financial situation have get or in partnership with the private sector been initiated. The objective is generally to (figure  8.3). These rankings have had a visi- reclaim budgetary leeway while maintaining ble influence on improving city management, a high commitment to social welfare. People at least for the largest cities (those with more are increasingly aware that the best way to than 100,000  inhabitants). Figure 8.3 shows achieve this objective is to modernize the state the population’s degree of satisfaction with administration and make it more effective. As municipal budget expenditures on sectors with the decentralization process, most of the such as urban services, economic develop- services are now provided by local govern- ment, police and security, schools, culture, and ments, so that municipalities are directly con- sports. cerned with the need for modernization and City satisfaction indexes provide compar- professionalization. ative benchmarks on living conditions, local Citizens and taxpayers are also very keenly taxation, level of services, business incen- involved in how state and local government tives, and private investment attractiveness; decisions affect the environment, the overall they gradually become targets toward which quality of services, and, ultimately, the quality the local elected officials and their staff work. of life. Even if their mandate does not encompass all This trend is confirmed through various the functions of public service delivery, munic- rankings that force local authorities to enlarge ipal governments have included population 388 Municipal Finances Figure 8.3 Municipal Expenditures on Selected Sectors and Citizen Satisfaction Source: Agence Française de Notation 2010. mobility and globalization in their policies and the control of the municipality; and (c)  the know they have to compete with other cities to performance results can vary significantly ensure their development. Among the top pri- from one year to another, making it difficult orities for most large and medium-size cities to appraise a situation fairly,  particularly for in Europe are the quality of services provided small and medium-size municipalities that do to the population, social welfare, housing, not have the same amount of investments each environmental protection, and the investment year. climate. Traditional financial analysis does not This evolution in municipal financial address those issues properly. The citizen sat- assessment, however, has to overcome var- isfaction surveys are among the most powerful ious technical issues: (a) the accounting instruments for filling these gaps. Since all basic classification is often an ineffective way to services are well provided in these countries, estimate the cost of a service or an investment the surveys give more importance to tariffs and project; (b)  service delivery involves a lot of policies and to environmental and sustainability partners or providers only partially under aspects. Achieving Greater Transparency and Accountability 389 Adapting Performance Measurement in The extent of decentralization can be the Context of Developing Cities: Key roughly estimated by how much leeway local Conditions for Success governments have in making financial deci- In most developing countries, measurement of sions and how much municipalities contribute municipal financial performance is new and part to national public finance. On this basis, the of the change management process. Experiences contributions of municipalities to the national with performance measurement and practices public capital investment effort through taxes are few in these countries, and the challenge and other revenue streams and to the living is to promote its development as an integrated conditions of their population often appear as component of good governance and skilled city prerequisites to instituting measures of munic- management. ipal financial performance. In most developing Municipalities can adapt existing methods countries, local governments’ contribution to and prove they are able to both assess their own the national public investment effort is weak situation by themselves and act on key findings. (less than 10 percent of total public invest- Self-assessment will not preclude the institu- ment), or it falls under the direct control of tionalized auditing process carried out by state the central government with little connec- auditors and will not substitute for financial tion to considerations of municipal financial assessments carried out by financial partners performance. like banks, which will also intervene for their own purposes in their own way. However, it is very clear that the municipalities that are able Condition 2: The Involvement of Financial to carry out self-assessment will be far better Partners positioned to report to their central govern- The involvement of financial partners ment and to their citizens and prepare bankable (banks,  specialized financing institutions, or projects, thereby gaining confidence and trust the financial market) in the financing of local from both their internal and external partners. government investment programs generally Some conditions might help in the dis- provides an effective incentive for improving semination and scaling up of performance municipal finances: to gain access to credit measurement. Among them are: (a) the  level and become creditworthy for medium- and of  decentralization or the importance given long-term commitments, municipalities  need to the decentralization reform process even if to present satisfactory financial ratios to all the issues are not solved; (b)  the pressure secure  the confidence of their financial to increase local investment and to mobilize partners. resources for it; and (c) the transparency of com- In most developing countries, the contribu- municating financial data and the effort to sup- tion of the banking sector to the financing of the port municipal capacity building. local government sector is limited (at least in the absence of state guarantees). Measurement of financial performance will help stimulate Condition 1: The Extent of Decentralization local investment financing from the banks, the Increased decentralization and emphasis on specialized institutions, or the financial mar- reform are expected to exert pressure on national kets and thereby contribute to a virtuous circle and local governments to disseminate informa- of improved performance. tion on their financial situation and financial A substantial source of external funding management efficiency. comes from donors and development agencies. 390 Municipal Finances However, either local governments are ill faced in instituting performance measurement equipped to prepare financially sound invest- in developing countries. ments programs, or donors lack the tools that Even if those conditions are challenging, evo- would give them the confidence to go ahead lution is already visible in some developing coun- with project or program funding. This is a tries, especially when cities are ranked according recurrent problem everywhere. In the Balkan to living conditions and competiveness that countries, for example, the need for investments clearly reflect the policies implemented by the is great, but the EU complains that it cannot dis- municipalities on basic  services, housing and burse in the absence of good project proposals social policies, quality of urban space, employ- from municipalities. The World Bank has been ment, and the like. implementing municipal development projects All such policies refer to municipal finance for the past 30 years, and yet it seems to rein- and management in various degrees: even if cen- vent the wheel and the rules of the game every tral agencies or concessions to the private sec- time a new project comes along and, in many tor are mostly responsible for providing these cases, the performance-based grants, which are facilities, municipalities have their role and often recommended or implemented, fall short contribute more or less to the image of the cit- of major transformational reforms in municipal ies. Their capacity to program the priorities, to finances and practices. The financing of munic- implement and coordinate the projects, and to ipal infrastructure subprojects is the opportu- pay for maintenance are crucial to improving nity to stimulate a common understanding of urban living conditions. Municipal finance is municipal finances assessment and its path to thus located at a strategic crossroad. reforms. Figure 8.4 summarizes Morocco’s effort to link improvements in municipal finance to the urban development process. Both examples give Condition 3: Data Collection and greater responsibility to local governments for Dissemination increasing the performance of public services, Anyone who has ever worked in develop- under tight control from the state government. ing cities will confirm that, in most cases, the In both cases, the municipal financial situation is availability of data is an issue, and yet every considered essential to improving the effective- time a donor-funded project is prepared, a huge ness, efficiency, and productivity of the contribu- data collection effort gets under way. There are tion of the municipality to urban development. several problems with data collection: What The city rankings in Morocco include data and for what purpose? Are the data reli- selected  dimensions for assessing the quality of able and pertinent? Who should be using and life and the competitiveness of those services maintaining the data? Why do the data get lost which are directly under the responsibility of the and go unused after external project fund- municipalities and Wilayas such as health, edu- ing expires? How do we make data open and cation, housing and basic services, infrastructure, available to the public and other stakeholders? real estate, and civil services. The borrowing eli- In the case of municipal financial data, the gibility guide of the Morocco Municipal Credit key starting point is the definition of terms. Institution (Fonds d’Equipement Communal) In many cases, poor accounting classification prescribes eligibility criteria for the municipal- can be a constraint. The abuse of the data and ities: (a)  an  indebtedness rate that is less than misinterpretation that could send wrong policy 40  percent (of total annual repayment to global signals are other reasons for the difficulties resources); (b) a net operating surplus that enables Achieving Greater Transparency and Accountability 391 Figure 8.4 Example of Performance Measurement and City-Ranking Criteria in Morocco Source: La Vie Eco 2011 (Moroccan newspaper). 392 Municipal Finances the municipality to pay its total debt (loans con- Section 2: Measurement of tracted previously plus new loans); (c) a cash Municipal Financial Performance: contribution to the project of at least 20 percent Key Traditional Reporting of project cost; and (d) adequate human, material, Mechanisms and organizational means to complete the project. Four different methodologies for measuring Performance measurement is included in sev- municipal financial performance are illustrated eral World Bank projects in Africa. The Senegal below: (a) state supervision; (b)  risk analy- Urban Development and Decentralization sis by financial partners; (c) internal financial Program (UDDP) developed in 1990’s opened follow-up by municipal staff and officials; and the path to many other similar projects in Africa (d) democratic dissemination. The first two where the model was cloned and implemented. methodologies are driven by municipalities’ The Senegal UDDP introduced for the first time external partners. Their objective is to exercise the concept of municipal audits and municipal judgment on the financial condition of the contracts in Africa. The Municipal Development municipality. The two others are generally Agency (ADM) supported 67 municipalities implemented and used internally to improve the in implementing a sustainable priority invest- management of the financial condition and to ment program and provided them with a communicate with the outside world (citizens financing plan that combined soft loans, grants, and partners). The objective of this section and savings. The plan included: (a)  physical is to present these different methodologies and investment and financial performance improve- to show how they can guide municipal perfor- ment plans as part of the municipal contracts mance measurement. signed by the municipalities and the ADM; (b) physical investment financing, an incentive to improve municipal financial performance, in From State Supervision to Democratic which loan reimbursement is a driving force for Dissemination: Overview increasing revenue; and (c)  strictly monitored The tools and procedures used by central trends in line with the Financial Ratios Guide governments to carry out their supervisory (figure 8.5) published by the ADM. role are numerous but quite similar all around the world. State government administration Figure 8.5 Ratios Guide Senegal applies a matrix of monitoring indicators that aim to determine whether the munic- ipal budget or accounts conform to public accounting rules and to the objectives set by national policies  governing volume and allocation. The risk analysis of municipal finance carried out by the financial partners (bankers and rating agencies, for example) follows international standards, allowing for the specific require- ments of the country. These requirements can be more or less detailed, depending on the nature and magnitude of the project or program to be Source: Agence de Développement Municipal (ADM). funded. Achieving Greater Transparency and Accountability 393 Internal financial monitoring focuses on The state auditor or treasurer prepares state- municipal financial management and comple- ments of position based largely on accounts ments financial analysis and assessment. In the and cash balance. The objective is to confirm case of municipalities, the methodology does not whether the budget of the municipality con- follow international standards but is generally forms to public accounting rules and to national influenced by methodologies used by the corpo- policy objectives as they  apply to volume and rate sector. allocation, for example. Democratic dissemination covers various With the progress of decentralization, initiatives that help municipalities better com- central government administrations have devel- municate their financial performance to their oped a set of ratios to introduce targets and constituents. The key objective is to show to cit- benchmarking in local government financial izens how the municipality is keeping its prom- management and to anticipate possible ises and how it is striving to do its best to improve overspending or overborrowing that would service delivery and its citizens’ quality of life. likely destabilize public finances. Typically, ratios focus on the following items  and Reporting and Accountability to the Central objectives (see also table 8.2): Government and State Oversight and Monitoring • Is the budget well balanced? Around the globe, central governments super- • Is the appropriation of mandatory expen- vise and monitor local government finances. ditures such as salaries and debt service In most cases, local government finances sufficient? account for less than 5–10 percent of total pub- lic finances, and the performance measurement • Are capital investments (the development focuses mainly on administrative supervision budget) greater than 40 percent of the total or control of local budgets and decision making budget? (see the section on budgetary control below). • Is the fiscal autonomy of the local government When the percentage of local government enough? Are the intergovernmental transfers finances is higher than the usual 5–10 percent, state less than a certain percentage of the current oversight and monitoring become an economic revenue? issue. The measurement changes and focuses more on enhancing the transparency of local gov- • Are budget preparation and approval on ernment finances to stimulate economic growth, schedule? to develop municipal credit, and to enhance Key indicators used in west and central regional competitiveness. Tools and  methods Africa provide a useful example of targets and are necessarily more sophisticated  and directly benchmarking: involve local governments in tandem with the central government through vertical subnational • Date of budget approval. performance monitoring systems. • Is the budget well balanced and sincere? Budgetary Control • Are mandatory expenditures listed? There are as many budgetary indicator grids as countries. They are usually completed by the • Is the Y-1 budget deficit less than 5 percent of ministry of finance or the ministry of interior. operating revenue? 394 Municipal Finances Table 8.2 Key Mandatory Municipal Finances Ratios Information on local taxation Tax potential Tax pressure Per capita Average (strata) Three taxes (Property tax, Land tax, Housing tax or local residence tax) Business tax All four taxes Compulsory key ratios Amount Average (strata) 1 Actual operating expenditure per capita 2 Local Tax receipts per capita 3 Actual current revenue per capita 4 Total capital investment expenditure per capita 5 Debt outstanding per capita 6 Intergovernmental operating transfer per capita (DGF) 7 Salaries/total operating expenditure 8 Tax pressure (actual or potential) 9 Operating expenditure + debt repayment/actual current revenue 10 Capital investment expenditure/actual operating revenue 11 Debt outstanding/actual operating revenue • Are salaries and wages less than 20 percent of • Capacity of the local government to handle current revenue? the technical challenges of providing data and to act on implementing recommendations. • Is the capital investment budget greater than This ability is particularly relevant in coun- 40 percent of total expenditures? tries where local governments are imple- • Is debt service less than 12 percent of current menting part of the national budget through revenue? delegated functions with revenue coming mainly from intergovernmental transfers. The effectiveness of monitoring depends on In France, Finance Law 1999 stipulates that even several factors: if there is no longer prior control over municipal • The availability of data and the quality of the budgets, municipalities have to calculate 11 key accounting management, often limited to cash ratios every year and communicate them to the management. central government. These ratios are published by the Ministry of Interior and provide a clear • Capacity of the central government to man- vision of the trends in local finances. Table 8.2 age the information and react appropriately in lists the typical compulsory ratios based on case of difficulties. French and international practices. Achieving Greater Transparency and Accountability 395 Local Government Collection and budgetary issues. In parallel, the National Dissemination of Financial Data Associations of Local Governments publish its When local government finances contrib- own statistics. ute a higher share of gross domestic product Figure 8.6 shows two pages from a white (GDP) and public finances, central govern- paper, which is published every year by ments want to have better knowledge of what Japan’s Ministry of Internal Affairs and is happening in the municipalities and to be Communications. It assesses the status of rev- able to share that information with other local enues, expenditures, flexibility of the finan- governments to increase their contributions cial structure (ordinary balance ratio, real debt to the improvement of national public finance service ratio. and debt service payment ratio), goals. outstanding local government borrowing, data Central administrations publish more and on local public enterprises, and information on more sophisticated statistical yearbooks or ratio efforts to promote of the soundness of local pub- handbooks that profile the financial performance lic finance. of local governments and include local budget data in state accounting. Reporting and Accountability to Financial This type of monitoring of subnational finan- Partners cial performance requires accuracy and is often In addition to state supervision and monitor- produced by specialized departments in the ing, guidance provided by the financial partners central government. For example, in France, at of the local governments is crucial to improv- least two ministries (the Ministry of Finance ing the measurement of municipal financial and the Ministry of Interior) and the National performance. Institute of Statistics publish detailed statis- It is generally acknowledged that public funds tics every year on subnational finance and will not be enough to bridge the financing gap Figure 8.6 Illustrations from Japan’s White Paper on Local Public Finance, 2011 Source: MIAC (Japan). 396 Municipal Finances for much-needed investments and that external Many cities around the globe are very dependent funding from national banks or capital markets on such transfers, which remain a large share of will be required. The financial partners need a their revenues. higher degree of information on financial perfor- The fiscal equalization grant is frequently used mance measures: in developed as well as in developing countries. However, it may have negative effects on the • Conditions for getting intergovernmental trans- financial performance of the municipalities and fers from the central state. These conditions has to be carefully implemented. In general, the depend on allocation criteria (operating or perverse effects of this very common category of current transfers, subsidies to specific invest- intergovernmental transfers are, first, that the ment projects, and the like) and rules. Central costs of serving numerous small and medium- administrations are demanding that local size local governments are very high; second, governments meet increasingly challenging that these grants can discourage municipalities standards of financial performance, including from making their own efforts to mobilize local those for receiving the automatic allocations resources better; and, third, that they serve the of grants. disadvantaged cities at the expense of the richest. • Conditions for obtaining bank credit (commer- Performance grants encourage efficient local cial or donor). These conditions will highlight financial management practices through spe- mainly those ratios that demonstrate the cred- cific criteria such as “fiscal effort,” that is, the itworthiness of the local government through amount of revenue collected by the local gov- what is generally named risk analysis. If a guar- ernment as a percentage of its fiscal poten- antee from the state is required by the bank tial, for example, or the percentage of revenue or donor, the state government will follow its allocated in the budget to social and priority own procedures to assess the creditworthiness investments. of the local government. However, incentive-based intergovernmental transfers and performance grants are generally • Conditions for launching municipal bonds. demanding and not easy to set up: they require These conditions require rating and bench- a complete and detailed national database and marking the client (local government) reliable information on the financial perfor- and analysis of the project’s financial mance of local governments to allow national sustainability. comparisons, city classifications, and indexing. Financial partners have a crucial responsibility to Local authorities are often critical of the way promote the measurement of municipal financial calculations are made by central governments performance in addition to the monitoring by the and of the lack of transparency in the process. state and to the requests for accountability from In the case of the French experience on the citizens. intergovernmental transfers, the calculation of the dotation globale de fonctionnement (annual Intergovernmental Transfers as Incentives for allocations) requires 65 numbers and data on Increasing Measurement of Municipal each municipality, including different categories Financial Performance of population data, and also many data on taxa- Transfers are the primary means by which cen- tion policy implemented by the local government tral governments direct and affect the volume (gross and net fiscal basis, exemptions, fiscal of resources channeled to municipal budgets. rates, and so forth). Achieving Greater Transparency and Accountability 397 Criteria for transfer allocations often empha- it includes financial projections based on size optimal distribution of funds and correc- the duration of the loan amortization (the tion of structural or long-term fiscal imbalances financial and physical depreciation of the assets among a large number of local governments being financed), an unusual exercise in most (sometimes several levels of subnational gov- municipalities in developing countries. It can ernments), and devote little attention to munic- include broader risk analysis such as country ipal financial performance. There is a huge risk analysis, features of the local government literature on these issues with positive exam- system, degree of decentralization, fiduciary ples such as Brazil, Mexico, and South Africa environment, and rules: Who is responsible? but also with more questionable experiences Who sets the tariffs? Who sets the tax policy? Is in places such as Tunisia or Vietnam (see annual repayment a compulsory  expenditure chapter 1). in the accounting procedure? Table  8.3 pro- vides guidance for financial risk analysis issued by the Network of Associations of Local Measurement of Municipal Financial Authorities of South-East Europe (NALAS) to Performance and Bank Risk Analysis partner municipalities. The development of subsovereign credit without The international donor organizations are the guarantee of the state government has put strong financial and professional supporters of pressure on local governments to improve helping municipalities build creditworthiness financial information and implement measure- and risk analysis capacity. ments of internal financial performance. Bank risk analysis focuses on the financial sustainability of the borrower and on its capacity Measurement of Municipal Financial to pay back the loan, with the key ratios below Performance and Access to Capital Markets recognized as valid in most situations: and Public-Private Partnerships Rating procedures focus on financial and non- • Existing and future debt as a percentage of financial performance criteria of local gov- current revenue ernments and can include assessment of the • Operating surplus as a percentage of current feasibility and sustainability of specific projects revenue to be financed (that is, project risk). The three main international rating agencies—Moody’s, • Cash balance at the beginning and end of the Standard & Poor’s, and Fitch Ratings (see year chapter 7) publish their main assessment areas • Resource projections (growth potential) but do not disclose detailed procedures and internal scores. National rating agencies (often The criteria vary in accordance with the amount partners of the big three) are becoming increas- of the loan, the category of the financing (project ingly instrumental in supporting municipal rat- financing or budget financing), and the insti- ings and financial assessments. More and more tutional and economic context of the country municipal self-assessments are also completed and city. and generally use the same or similar interna- The main characteristic of risk analy- tional standards as the big international rating sis compared to previous approaches is that agencies. 398 Municipal Finances Table 8.3 Guidance on Risk Analysis and Ratios Financial risk analysis Surplus Generation and Liquidity and financial debt servicing ability Cash flow adequacy Capital structure flexibility • Analytical distinctions • Focus on debt service • Leverage • Sources of liquidity with profitability capability • Type and structure of • Analytical distinctions • Type and structure of • Potential calls on debt with profitability debt liquidity • Analysis of cash flow • Type and structure of • Hedging arrangements • Short-term debt coverage and cash debt maturity generation ability • Analysis of cash flow • Off-balance sheet • Bank credit facilities coverage and cash obligations generation ability • Asset values • Unencumbered assets and debt capacity Ratios Definitions Interpretation Ratio of recurrent revenues Measures the degree to which A ratio of 100% or close to 100% may be to total revenues a local government relies on inappropriate for a local government that recurrent revenues. is funding the acquisition of significant nonfinancial assets. Recurrent revenues per Measures the relative burden of A higher level of operating revenues per capita taxes and user charges on local capita indicates a relatively high burden of taxpayers and service users. taxes and charges. Ratio of own-source Measures a local government’s A relatively high percentage of own-source revenues to total revenues own-source revenues compared revenues (maximum indicator 100%) to its total revenues. indicate that the local government is more reliant on recurrent, predictable revenues to fund its activities. Source: Josifov, Pamfil, and Comsa 2008. The six most significant analytical areas • Managerial assessment are listed below; each of them refers to several criteria: • Project-specific issues The rating agencies often carry out baseline • Legal and economic framework credit assessments; box 8.4 explains the four • Economic base of the services area main factors. Many central governments do not allow • Municipal finances their subnational governments to tap into the • The municipality’s existing operations capital market through municipal bonds. In Achieving Greater Transparency and Accountability 399 Box 8.4 Baseline Credit Assessment As of late 2006, Moody’s had rated 249 local • The baseline credit assessment of the and regional governments in 30 countries local government around the world, outside the United States. • The supporting government’s rating The number of local government ratings had • An estimate of the default dependence more than doubled since 1998. between the two entities Moody’s uses two explicit factors to establish • An estimate of the likelihood that the the rate: (a) the local government’s intrinsic other entity would provide extraordinary credit strength; and (b) the likelihood of extra- support to prevent the local government’s ordinary support from another entity to pre- default vent a default. The four analytical inputs are: Source: Rubinoff, Bellefleur, and Crisafelli 2008. Africa, only Johannesburg and Lagos have (a)  transparency, that is, providing the public launched municipal bonds. In Morocco, the with essential information about what the gov- Municipal Credit Institution has a long experi- ernment is doing; (b) civic engagement that ence with pooling municipal bonds through the allows members of the public to contribute ideas Caisse des Dépôts et de Gestion. and expertise so that their government can make policies with the benefit of information from Reporting and Accountability to Citizens widely dispersed constituents of the society; and (Social Accountability) (c) accountability that ensures that governments What is Social Accountability? In practice, are responsible to the public for their decisions Social Accountability is an evolving umbrella and actions. covering several components and a menu of options such as: (1) Citizen monitoring/ Communicating and Sharing Information: oversight/feedback on public sector perfor- Open Data, Open Government mance; (2)  User-centered public information A vast menu of tools and methods has been access/dissemination; (3) Public complaint and developed to address the open government grievance redress mechanisms; (4) Citizen agenda in the recent past. Most of these have participation in resource allocation decisions targeted central governments, but few have such as participatory budgeting. How do we attempted to work with local governments. define open government? The Transparency and Those efforts that have focused on local gov- Accountability Initiative (which includes a num- ernments include expenditure tracking, third- ber of partners such as the Ford Foundation, party monitoring, beneficiary feedback, and the  Open Society Foundation, and the U.K. participatory budgeting. Department for International Development) Expenditure tracking (BOOST). Boost is proposes the following definition: Three key a tool that helps monitor public spending principles form the basis of an open government: using disaggregated data from the financial 400 Municipal Finances management  information/treasury systems, Participatory budgeting. Perhaps, the  best including information on spending at the sub- example of citizen participation comes from the -national level. Boost has been introduced in participatory budgeting experience. Participatory Kenya, Moldova, and Togo, where central gov- budgeting started in 1989 in the municipality of ernments have been willing to  put their trea- Porto Alegre, the capital of Brazil’s southernmost sury data online. BOOST platforms are under state, Rio Grande do Sul, and was intended to development in a number of countries. In some help poorer citizens and neighborhoods receive instances, geo-mapping techniques can be used a larger share of public spending (see box 8.5). within BOOST to track the use of public funds. Throughout the 1990s, participatory budget- Another tool is Public Expenditure and Financial ing spread to other municipalities in Brazil and Accountability  (PEFA), a program supported by to other countries in South America, including the World Bank. The PEFA program is a multi-do- Bolivia, Guatemala, Nicaragua, and Peru, and nor partnership between seven donor agencies various forms of participatory budgeting have and international financial institutions—including taken root in other parts of the world. Such pro- the World Bank—to assess the condition of a grams offer citizens from poor and historically country’s public  expenditure, procurement and excluded groups access to the decision-making financial accountability systems and develop process. However, most of the time only a small a practical sequence for reform and capacity build- share of the total budget focusing on small ing actions  (http://www.pefa.org/en/content/ neighborhood investments is actually open for resources). It can be applied at both the national citizen ‘s participation. The lion’s share of the and the municipal level; yet very few cities have budget with the key capital investments is not, applied it—only Dakar in 2009 and Ouagadougou drawing criticism that, in many cases, real par- in 2010, as well as some experimental work car- ticipation is only given lip service. ried out in Kosovo. Third-party monitoring. Increasing attention Social Accountability: Magic Bullet or is being placed on equipping civil society organi- Just Hype? zations (CSOs) with the proper tools to provide What does the evidence of Social Accountability a third-party perspective on public affairs. One impact tell us? There has been a number of key issue is that, often, these organizations are excellent literature reviews and the evidence not independent entities and may not provide the for many, so far, seems inconclusive. The “What best unbiased perspective. Next” question is key to successfully address Beneficiaries’ feedback. Citizen report cards the next generation challenges. There is both and scorecards, E-petitions, and reporting a need to (a) bring rigor to the process and to based on information and communication the tools; (b) to move away from confronta- technology are tools designed to enable cit- tion and (c) to better understand the fine line izens to speak up and report their discontent between demand and supply. Social account- with the quality and coverage of municipal ser- ability mechanisms, in many ways, raise a lot vices. Many cities around the world are con- of expectations on the demand side  but fail ducting beneficiary surveys and providing a to provide the answers on the supply side. space either on an E-platform or through more Local governments are not necessarily the bad structured face-to-face community meetings guys, drenched in corruption and faulted with for citizens to raise their concerns and be part poor  governance. The reality is that many of the decision-making process. local governments would like to provide better Achieving Greater Transparency and Accountability 401 Box 8.5 Citizen Involvement: Participatory Budgeting in Porto Alegre, Brazil • The first city to engage in participatory • Regular decision-making forums of elected budgeting was Porto Alegre, Brazil, representatives have been created at a which introduced the practice in 1989. number of levels: sixteen regional forums Participatory budgeting was introduced, bring people together from different parts in part, as a way to address severe of the city; five thematic forums (such as inequalities in services (especially water health, education, housing, and sanitation) and sanitation) and the quality of life bring together people from throughout the around the city. city; and a municipal budget council com- • Participatory budgeting gives residents prises representatives of the regional and some control over the annual allocation thematic forums. of capital expenditures. Residents can • The process covers all capital expendi- decide on local matters, such as the tures that range from 5 to 15 percent of location of street improvements or a the total budget of Brazilian municipali- park, as well as citywide issues such as ties. In Porto Alegre, the number of par- programs for helping the homeless ticipants in the budgeting process is now population. more than 14,000 people per year. Source: Goldsmith and Vainer 2002. services but are faced with many competing Section 3: Toward a Generic demands in a context of very limited financial Framework for Measuring resources and low capacity. It is very important Municipal Finances Performance: to understand the constraints of the supply The Municipal Finances side. This is why audits/self-assessments are Self-Assessment so important and combining complementary The World Bank has developed over the years audits is so crucial because they help provide a framework for local government assessments a full picture and create a coallition among (municipal audits) that has been tested, imple- key stakeholders. Interestingly enough, Social mented, and customized in a growing number of Accountability tools seem to have predomi- municipalities. The Municipal Finances  Self- nantly been applied in social development/ Assessment (MFSA, also called financial audits) is community driven projects (CDD) on essen- part of it. It has proved to be a powerful instrument tially small scale projects. Their application in for improving governance and accountability, cities on larger scale projects has been limited. modernizing management practices, and paving There is great opportunity for merging social the path toward change and reforms (box 8.6). audits with urban and financial audits, giving The objective of the MFSA is to assess a city’s more in-depth meaning to the accountability financial health and to identify specific actions and transparency agenda. 402 Municipal Finances Box 8.6 Improving Local Governments Capacity: The Experience of Municipal Finances Self-Assessment (MFSA) in South East Europe The MFSA methodology was developed by these revenues are highly volatile and the World Bank and has been customized for subject to global financial stress, that South-East Europe by the World Bank with the there is a pressure to sell and develop support of international and local experts. This land, and that urban planning functions adaptation required a common understanding and issuance of building permits have of terminology and a clear definition of bud- been quickly devolved to largely unpre- get items (categories) on both the revenue pared local governments. It is essential and the expenditure sides. The template or that the region start a conversation on framework of analysis was validated by all these important issues—a conversation stakeholders. that should include all levels of govern- ment, the citizens, the service provid- 1. One important lesson from the MFSA pro- ers, the private sector, and the donor cess is the recognition by participating mu- community. The C2C series has helped nicipalities of the need for municipal de- launch this conversation in a forum partments and staff to share information where these issues could be discussed and data among theTechnical Departments, safely, problems could be unbundled, the Public Utility Companies (PUCs) in and solutions could be identified. The charge of service delivery, Tax Services, MFSA process clarified the need for a State Treasury, and so forth. This has typi- more global and integrated approach cally not been the case. Creditworthiness that combines MFSA with Urban Audits assessments, municipal finance projec- (Land, Infrastructure and Services Self- tions, and financing strategies require data Assessment), which a number of munic- inputs from various sources that are not ipalities have begun to pursue. reported in any of the typical mandatory 3. The debates launched as part of the MFSA- accounting reports. The MFSA provides a Urban Audit, as well as the findings of platform for consolidating and reconciling the NALAS Fiscal Decentralization Study these information sources. and the World Bank Municipal Finances 2. The C2C dialogues and the embedded Review underlined the need to assess the MFSA process helped make a vital connec- progress of fiscal decentralization in the tion between financing, urban planning, region. land management, and ultimately invest- 4. The municipal staff from some 25 cities ment programming and service delivery. and municipalities in the region (including The series of seven City to City Dialogues capital cities) took part in this experience was structured in a way that helped close and more municipalities have expressed that loop. Several factors have a funda- a desire to join in. Scaling up and institu- mental impact on the way cities urbanize tionalizing these tools are the next steps and on the future of urban investments: to be taken in collaboration with regional, the fact that a large share of local reve- national, and local stakeholders. nues come from land development, that Source: C. Farvacque-Vitkovic, S. Palmreuther, T.Nikolic, A.Sinet. Achieving Greater Transparency and Accountability 403 to improve mobilization of local resources, Third, it encourages city officials to share their public spending, public assets management and findings with other municipalities from the maintenance, investment programming, and region. Fourth, it helps assess the extent to access to external financing (borrowing plus which such a monitoring tool or dashboard donor funding). can be integrated into city management oper- The MFSA performs several functions: (a) it ations. This task is typically outsourced to reviews municipal budgets (revenues and expen- external auditors so that local governments are ditures), financial management practices, sav- not direct owners of the process. In addition, ings capacity, investment efforts, and financial assessments are typically carried out on an projections for the next five years; (b) it provides ad hoc basis rather than being used as a reg- some benchmarking through a set of simple and ular monitoring tool. The MFSA is therefore a comparable key indicators and ratios; and (c) it radical departure from normal practice; and it defines key actions to be included in a municipal promotes the following mutually reinforcing finance improvement plan with a clear defini- objectives: tion of what concrete actions will be included, how these actions will be implemented and by • To promote financial self-assessment at the whom, the timeline for implementation, and the municipal level as part of the management implementation cost (if applicable). change process in local public administra- The MFSA is sometimes carried out in tions: Accountability. parallel with an urban audit that provides a • To encourage local governments to share snapshot of the city’s quantity and quality of information with other municipalities, and to services and infrastructure and identifies a inform central government, local government municipal investment program (box 8.7). The associations, and citizens about their cur- World Bank has also developed a framework rent situation: Visibility in the use of public for the urban audit that, like the financial audit, funds. has been tested, implemented, and customized in a growing number of municipalities. The • To encourage financial and other relevant urban audit has for its main objective the gath- municipal departments—asset management, ering of baseline information on the existing urban and strategic planning, and the mayor’s condition of infrastructure and services, the cabinet—to work together on capital invest- identification of patterns of urbanization and ment plans and municipal programs securely pockets of poverty, and the spatial location and anchored in financial feasibility: Prioritization. quantification of the gaps, leading to the identi- • To monitor the financial situation and act fication of a priority investments program and on a set of key initiatives to improve the a priority maintenance program. mobilization of local resources, rationalize public expenditures, and improve finan- MFSA Innovations cial management practices: Efficiency and The MFSA has introduced some innovative transparency. features. First, it relies on municipal staff them- selves, using an integrated approach, to assess • To agree on a common set of concepts, meth- the financial situation in their municipalities. odologies, and internationally accepted indi- Second, it puts city officials in the driver’s cators, and to improve communications and seat in determining the best and most realistic negotiations with banking institutions and actions to include in their improvement plans. donors: Access to external funding. 404 Municipal Finances Box 8.7 Urban and Financial Audits: A Potentially Powerful Combination Integrated urban and financial audits in city of Tunis, were facing financial problems Senegal. In the middle of the 90’s. the World serious enough to delay repayments of the Bank initiated in Senegal an interesting and loans to the National Municipal Development innovative municipal development program Fund. The situation was critical for the 71 (Urban Development and Decentralization municipalities with no savings capacity and Program-UDDP/PAC). This program is based for the 61 municipalities that had insuffi- on the concept of municipal audits and cient savings to service debt or to mobilize municpal contracts and aims to encourage Municipal Investment Program funds. local governments to take greater respon- The principal objective of the project, sibility in investment planning and financing which was financed by the World Bank and and to provide them with the tools needed the Agence Francaise de Developpement to better assess their needs and manage (AFD), was to restructure the 132 most finan- their day-to- day functions. Municipal audits, cially strapped municipalities. The means set including a Financial Audit and an Urban up to achieve this objective were: Audit, led to the identificaton of a Municipal • Adjustment plans specific to each munici- Program/Municipal Contract. All municipal- pality to enable them to return to normal ities in Senegal have, by now, signed and financial status. implemented several generations of munic- • “City contracts” with objectives, terms, ipal contracts. Since its inception in Senegal, and methods for implementing and mon- the model has been cloned in many coun- itoring the Municipal Investment Plan, as tries in Africa and today over 200 municipal- well as the respective obligations of the ities distributed in 10 countries have signed local and central governments. one or several municipal/city contracts (Burkina Faso, Cameroon, Cote d’ Ivoire, The adjustment plans were designed Guinea, Madagascar, Mali, Mauritania, Niger, on the basis of audits of the financial and Senegal, Rwanda). Figure B8.7 .1 illustrates organizational circumstances and of the the critical steps in implementing financial management practices (objectives, adjust- and urban audits/self-assessments. ment activities, resources and timetables, Risk analysis and innovative financial performance indicators, and monitoring pro- analysis solution in Tunisia. Tunisia has cedures). “Structural adjustment program also been a precursor in municipal audits contracts” were signed by the Ministry of and municipal contracts. The Third Tunisian Interior, city authorities, and the National Municipal Development Project, supported Municipal Development Fund. This started by the World Bank, began in 2002. Out of several generations of municipal improve- 260 municipalities, about 132, including the ment plans for Tunisian municipalities. (continued next page) Achieving Greater Transparency and Accountability 405 Box 8.7 (continued) Figure B8.7.1 Critical Steps in Implementing an Integrated Urban and Financial Audit Urban audit Financial audit Priority Priority Municipal investment maintenance adjustment program program program Signing of municipal contract Selection for detailed design Participation and studies citizens’ involvement Selection of companies for PIP, PMP, MAP Tracking and execution of PIP, PMP and MAP Note: PIP = priority investments program; PMP = priority maintenance program; MAP = Municipal Adjustment Program. (Municipal Finances Improvement Plan). The Municipal Finances management issues (city profile) (steps 1 Self-Assessment (MFSA): and 2). Template Description • Module 2. Perform a historical analysis and The template of the Municipal Finances Self- create summary tables (revenue, expendi- Assessment is detailed in the following pages. It tures, and financial situation) (steps 3–5). provides a framework for analysis and decision- • Module 3. Perform financial projections making which local governments can use and (step 6). adapt to their specific situation. An Excel format of the template is provided at http://siteresources. • Module 4. Evaluate financial management worldbank.org/EXTURBANDEVELOPMENT/ tools and processes and prepare a Municipal Resources/MFSA-Template.xlsx which potential Finances Improvement Action Plan (steps 7 users can download and use directly. and 8). The main modules of the MFSA are the Key findings from the MFSA will shed a light on following (see figure 8.7): several aspects of municipal finances: • Module 1. Collect and organize relevant • Financial sustainability of the local govern- information on city finances and urban ment, based on operating surplus, capacity 406 Municipal Finances Figure 8.7 Modules of the Municipal Finances Self-Assessment Steps Objectives 1. Summarize through key data the institutional position of the city 2. Complete with urban profile 1 City profile and preliminary data of urban audit methodology 3. Mention key issues Basic 1. Put together basic data to database for perform self-evaluation 2 financial self- 2. To involve the different assessment municipal departments Generic 1. Ability to generate growth financial and savings and operating surplus 3 accounting 2. Capital investment effort framework 3. Creditworthiness 1. Detailed revenue and expenditure structure and trends 4 Historical analysis 2. Dependency on grants and external financing 3. Level of service provided 1. Review of economic and financial Ratio performance through main 5 analysis indicators 2. Comparison with other LGU 1. Which vision of development Financial 2. Impacts of political choices on 6 projections future accounts 3. Financial needs (loans) 1. Level of municipal autonomy Financial 2. Budget credibility 7 management 3. Reporting: comprehensiveness, assessment transparency, predictability Financial 1. Key measures to improve 8 improvement financial management and action plan financial performance Note: LGU = Local Government Unit. to borrow money, and ability to increase its best tool for an actual exercise. These illustra- capital investment. tive template tables can be adjusted according to specific local context. • Financial governance and manage- ment quality, based on credibility of the budget and its comprehensiveness and Step 1: City Profile transparency. The City Profile is made of three components: • Efficiency of service delivery, based on cost 1. Institutional and territorial organization/ and tariff analysis, in addition to other ratios Demography/Economy of the City measuring physical performance. 2. Municipal organization Each step is explained in detail below with template tables to illustrate the process of filling 3. Main urban issues and challenges facing the out a MFSA with real data. Excel sheets are the city over the next three to five years. Achieving Greater Transparency and Accountability 407 1. Institutional Organization/City Map/ affected by the financial situation. For exam- Demography/Economy ple, how the territorial organization has a direct Objective: To provide a general overview of the effect on the distribution of the budget and the municipality’s demographic and economic situ- performance of public functions; how population ation through a few summary indicators; and to increases, decreases, or composition affect the clarify the make-up of the entity’s territorial orga- budget; or how the local tax system affects the nization which can sometimes be quite complex local economy and vice versa. (City, Municipality, Metropolitan area). Insert a map of the city (A4) showing the munic- 2. Local finances and management ipality’s administrative boundaries. For existing Objective: To provide a preliminary set of sum- subdivisions (sub-city) or metropolitan entities, mary data describing the volume of local finance, show the different levels of administration. utility management, numbers and composition of Insert short summaries on the three municipal staff, and so forth. items—Territorial Organization, Demography, Insert a short descriptive summary on the Economy—describing how they affect or are different items. Table 1 Summary Indicators of the Municipalities Demographic and Economic Situation City with One city City with sub- inter-communal level municipalities upper level I Territorial organization Number/Name of subnational/metropolitan entities Sub-municipalities or metropolitan financed by Yes/No Yes/No the city level City level financed by sub-municipality level Yes/No Yes/No and/or the metropolitan level Area of the municipality and agglomeration in square kilometers Year N-3 Year N-2 Year N-1 Year N II Demography Country population Total resident population Annual growth Rank in the country (in population) III Economy GDP per head (country level) - in USD or Euro City GDP per head (if available) - in USD or Euro Median disposable annual household income - in USD or Euro Activity rate Unemployment rate (% active population) 408 Municipal Finances Year N-3 Year N-2 Year N-1 Year N IV Total Municipal budget revenue Total revenue Revenue per capita Annual city capital investment Debt outstanding V Utilities management Denomination Annex to M Tariff budget (Yes/No) (current) Water supply Wastewater Electricity Urban heating Other VI Tax policy Rate Last increase Fixed locally Property tax Local business tax Tax 3 Tax 4 VII Municipal staff (regular staff) Number % Total 100% General administration Education Social services Technical service units Environment (including solid waste) Contractual workers total VIII Financial reporting (Yes/No) Year N-3 Year N-2 Year N-1 Year N Long-term investment program Annual budget Annual financial statement Audited accounts Timeframe: The timeframe for analysis could Taxes: Fill in data for the property tax and go back as far as three or four years to provide a local business tax line items and list the two better picture of trends. other most important local taxes. Utilities: State if utility company budgets are reported on and annexed to the municipal budget reports. Achieving Greater Transparency and Accountability 409 3. Urban issues and challenges We suggest setting up a database (Excel sheets) Objective and content: To explain and illustrate with five main tables: the municipality’s development policy, using the • Municipal/city budget + annex Public Utility following framework: Company (PUC) budgets • Is there a strategic vision for the development of • Cash balance and arrears the city? If yes, outline the main components such as the City Development Strategy and the • Indebtedness long-term Development Plan, and identify the • Capital investment levels of approval required such as the City Assembly or the central government. • Tax potential and performance • Present the main components of the Local These five tables will each include three years Economic Development Plan needed to of historical (actual data) and one year of planned achieve the vision, including capital invest- data. Sources should be clearly identified, includ- ments, institutional development, and so forth. ing document title and issuing entity, such as, for example: budget department, taxation depart- • If one exists, outline the Capital Investment ment, economic department, entity other than the Plan using the following rubric: municipality, Ministry of Finance, and so forth. General budget database: IX Capital Investment Plan Project name Timeframe Total Source of • Because the accounting systems and classifica- costs financing tions used are all different (functional classifi- cation, classification by category, and so forth), the budget database will have to be adjusted for consistency. Expenditures and revenues should be listed by type (tax revenue, grants, fees, loans, etc.) as well as how they will be used Provide a short summary of the multiyear (payroll, operation and maintenance, debt ser- development program approved by the city coun- vice). Avoid simply making a long unorganized cil. List all priority projects; add more lines if list of revenues and expenditures. needed. • Actual data are preferable to planned bud- get numbers. These can be cash accounting Step 2: Basic accounting and transactions (payment and receipt) or com- financial database mitment accounting transactions (contract signed and receipts validated through an Objective and content: To collect the data and invoice or the equivalent). information on which to base historical analy- ses and projections and to calculate performance • Current and capital expenditures should be ratios and gaps. It consists of organizing data not clearly differentiated, even if the accounting in the usual accounting formats, which can vary format does not do so. Expenditures are nor- from country to country or even among munici- mally considered to be capital expenditures palities in the same country, but in a more generic when they contribute to expanding the munic- financial format. ipality’s public assets. 410 Municipal Finances • State-mandated expenditures should be sepa- Companies’ budgets. Consider only finan- rated from the municipality’s own expenditures. cial transactions between the city budget Similarly, revenues coming from the central and the other budgets accounted for in the State Government and earmarked for specific city budget. For example, subsidies from the expenditures should be identified as such. general budget to the PUC’s budget should be accounted for as expenditures in the city • The different types of subsidies or intergov- budget and as revenues in the PUC’s budget; ernmental transfers should be included, and similarly for dividends or cash coming distinguishing between transfers that can and from PUC budgets to the city budget. If pos- cannot be reallocated by the municipality. sible, a consolidated budget should be set up • The general budget should be analyzed sep- subsequently. arately from the independent Public Utility Table 2 Step 2: Financial self-evaluation basic database 1. GENERAL BUDGET (simplified table) Year Year Year Year Year in millions of … N-3 N-2 N-1 N N+1 A A A E P TOTAL REVENUES I STATE REVENUES (INTERGOVERNMENTAL) 1 Shared taxes City share - VAT and sales taxes …% - Personal income tax …% - Corporate Income Tax (tax on company profit) …% - Tax on the transfer of property rights …% - Motor vehicle tax …% - Others …% 2 Unconditional transfers - Operating transfer - Investment grant Road rehabilitation Education … 3 Conditional transfers (path through) - for wages from Ministry … - for social policy (poor households) from Ministry … - …. from Ministry … (continued next page) Achieving Greater Transparency and Accountability 411 II LOCAL REVENUES 1 Local taxes and levies - Property tax (regardless if centrally collected) - Business taxes 2 Local fees - Licenses - Permits - Local development fee - Authorizations and issuance - Others (fines …) 3 Local asset proceeds - Rents - Sales - Charges - Levies on exploitation of natural resources (forest, mineral, water, etc.) …other 4 Dividends, funds, or assets from PUCs Utility 1 Utility 2 Utility 3 5 Donations 6 Loan proceeds 7 Municipal bond proceeds Note: A = Actual; E = Estimated; P = Projection. When filling in dividends, funds, or assets from the PUCs, please add the combined value of all wealth transferred from the PUCs to the municipality, if any occurred in the given year. This could include cash, land, or equipment. Table 3 Total Expenditures Year Year Year Year Year in million local currency… N-3 N-2 N-1 N N+1 A A A E P I EXPENSES ON DELEGATED FUNCTIONS 1 Preschool education Wages Operating Maintenance (Construction) Capital investment 412 Municipal Finances 2 Primary and secondary school Wages Operating Maintenance Capital investment 3 Healthcare 4 Social assistance and poverty alleviation 5 Public order and civil protection Wages Operating Maintenance Capital investment 6 Environment protection Wastewater Solid waste 7 Other II OWN EXPENDITURES 1 Infrastructure and public services - Current expenditures Direct expenditures Subcontracts - Capital expenditures Direct expenditures Subcontracts 2 Social, cultural, recreational expenditures 3 Local economic development 4 Social housing 5 Urban development 6 Civil security 7 Transfer to local government entities 8 Support to PUC (subsidies, grants, or in-kind) Utility 1 Utility 2 Utility 3 9 Loan repayment 10 Interest charges 11 Guarantees called (paid by the municipality) For Support to PUC (subsidies, grants, or in- whether cash (grant, subsidy), equity, or in-kind kind), enter the total combined value of all sup- asset (land, structures, or equipment) transferred port provided to PUCs (by sectors or service) by the municipality. Achieving Greater Transparency and Accountability 413 Cash balance and arrears: • The objective is to complete the budgetary • Identify the volume of arrears (expenses and accounting data picture by providing incurred but not paid) differentiating between information on cash transactions. Provide a public and private providers. monthly summary. Table 4 2. Cash Balance, and Arrears I Cash Balance Cash Cash Cumulative Cumulative Net change in receipts payments inflow outflow the stock of cash January February March April May June July August September October November December II Arrears (overdue liabilities by the city or by its entities) Year N-3 Year N-2 Year N-1 Year N Public stakeholders - Water supply PUC - Electricity PUC - Social welfare - … City dues to private contractors Labor arrears (wages, salaries) Indebtedness database: • Complete the table with amortization figures for each loan, which can be used for further • Put together useful data on loans and bonds analysis and financial projections. launched and subscribed but not fully reimbursed. • Differentiate between Medium Long Term (MLT) debt and Short Term (overdraft credit facility) debt. 414 Municipal Finances Table 5 3. Indebtedness Database Interest Year of the Bank or Initial Grace Rate loan Duration Currency Maturity Rate (%) institution amount period (fixed, subscription variable) MLT DEBT Achieving Greater Transparency and Accountability I 1 On-lending loan (from Central State) 2 Direct loan - Commercial bank - State development bank 3 Municipal bond II SHORT TERM DEBT 1 Treasury facility from State 2 Facility from commercial bank + amortization figure for each MLT loan 415 Capital investment database: by  sector (sectors can be adjusted to reflect specific policy). • Provide a figure for capital investment expen- diture by year (historical and projected) and • Provide a simplified tentative financing plan. Table 6 4. Capital Investment Database Year Year Year Year Year Year Year Year N-3 N-2 N-1 N N+1 N+2 N+3 N+4 A A A E P P P P Population Inflation rate (annual) I TOTAL INVESTMENT 100% % growth Delegated investments …% (from earmarked grants) - Education - Healthcare - Housing -… Municipal investment …% - Roads rehabilitation - Street lighting - Solid waste equipment purchase - Urban renewal -… Investment into PUC (assets, … % grants, or equity provided for PUC in cash or in-kind) - Water supply - Wastewater - Transport - Urban heating - Other II TOTAL FINANCING - Earmarked grants …% - Own budgetary revenue …% - Loans or municipal bond …% - Equity from PUC …% 416 Municipal Finances Tax potential and Tax Performance: provisions: for example, the name of the tax and the related tax regulations. • The objective is to put together relevant infor- mation from the tax administration about the • It is important to obtain information on city’s tax potential. the number of taxpayers and to distinguish between households and businesses, espe- • The items (property tax, business tax, …) can cially in the case of property taxes. be adjusted according to the local taxation Table 7 Tax potential & Performance Year N-3 Year N-2 Year N-1 Year N Number Number Number Number tax- Amount tax- Amount tax- Amount tax- Amount payers payers payers payers I PROPERTY TAX Tax base (taxable) Households Business Others Tax rate Households Business Others Exemption Households Business Others Tax collected Households Business Others II BUSINESS TAX Tax basis Rate Exemption Tax proceeds collected III Development fees (quasi taxes)… Achieving Greater Transparency and Accountability 417 Step 3: Generic financial ability, at the end of the year, to self-finance framework part of its capital investment budget, directly or through additional debt (borrowing). Objective and content: Even if the database is different from one municipality to another, the • Creditworthiness: the level of debt service generic financial framework should be the same. relative to the strength of the municipality’s The purpose is to be able to evaluate the munici- financial position. pality’s financial position at a glance and to assess • The level of capital investment compared with the following: the operating budget. • The ability to generate growth savings and oper- • The degree of dependence on grants from the ating surplus as a means of financing the capital State Government. investment budget: evaluate the operating mar- gin or surplus and see how it contributes to the • The general surplus at the end of the year: tak- self-financing of the capital investment bud- ing account of the general surplus or deficit get. This will show the municipality’s financial from year N-1 in the actual budget of year N. Figure 8.8 Structure of Current and Capital Budget Revenue Expenditure 1. Taxation revenue 1. Payroll Current budget 2. Grants 2. Operation & Maintenance 3. Others {income from 3. Debt service services and assets} 4. Year N-1 loss (only current) 4. Year N-1 margin (only current) Operating surplus Capital investment Self-financing budget 1. Property sales 1. Civil works 2. Subsidies 2. Land and equipment 3. Loans purchase 3. Loan repayment The figure should be complemented by a with the current revenue and capital investment graph comparing the operating surplus or margin expenditures. Box 8.8 Main Definitions • Current or operating budget should often considered mandatory and are rela- include the expenses and receipts used tively predictable. to provide for daily operation. They are (continued next page) 418 Municipal Finances Box 8.8 (continued) • Current revenues include tax receipts, grants These are administrative accounting sys- from the State or other levels of government, tems. Consequently, the capital revenues and resources recovered by the local author- and expenditures will be yearly operations. ity in the form of prices, rates, fees, tariffs, • Usually, capital expenditures are implemented and so forth, generated by the local assets over more than one year (12 months) and owned by the municipality (land lease, public have to be split over several fiscal years. The utilities and facilities, and so on). amounts can vary from one year to the next. • Current expenditures include mainly salaries • Debt service should be split between the (payroll including social insurance and other current budget–for loan interest, and the cap- charges connected to staff management), ital budget–for loan repayment. In a more running costs, operation and maintenance prudential approach, all the debt service (often difficult to identify because subsidies (including loan principal repayment) should paid by the local authority to assist other be covered by the operating surplus, as a structures (associations, related budgets, proof of debt servicing ability. and so on), and debt service incumbent on • Total budget or annual account can be bal- the local authority. anced, positive, or in deficit (negative): net • Capital revenues and expenditures are oper- position. ations that increase or reduce the assets of • More precise budget analysis requires taking the local authority (acquisitions or sales, civil into account (including in or annexing to the works). Most of the local public accounting budget report) expenditures that are not paid systems are cash-based and thus do not and that affect apparent surplus at the end of include depreciation or physical amortization the year; likewise for revenues that are billed of the assets owned by the municipality. or levied but not recovered during the year. Step 4: Historical analysis and to see its resources used to finance an operat- summary table ing deficit. After self-financing, the analysis turns to the Objective and content : To review the previous characteristics of debt already incurred by the year’s budget and identify trends and perfor- local authority: mance in the level of public services provided, taxation efficiency, and so forth. • Is the level of debt acceptable? The objective is to understand how the bud- • Who are the lenders? get is structured and to identify the major trends and how they occur. The analysis is mainly • What is the cost of the debt? based on gross self-financing (or savings) cal- • How much time will be needed to pay it back, culated as the positive difference between and so forth? operating receipts and expenses. Self-financing makes it possible to pay for a portion of invest- The capacity of the local authority to develop ments; it is a crucial indicator of the quality of a summary table, such as the one recommended management on the part of the local authority here, based on a transparent and easy-to-control and features prominently in dialogues with methodology, reinforces the credibility of the financial partners: no financial partner wants municipality’s financial management. Achieving Greater Transparency and Accountability 419 Main outputs: Ten tables should be produced: • Table 7: Indebtedness situation • Table 1: Financial position • Table 8: Capital investment budget financing • Table 2: Main revenue sources • Table 9: Cash balance • Table 3: Tax potential and tax performance • Table 10: Arrears • Table 4: Transfers Predictability and City Dependence These tables and figures have to be set up from  the  database ( five tables) prepared in • Table 5: Main operating expenses line items Step 2. At this stage, links between both files have by category not been introduced because of the differences • Table 6: Municipal assets and maintenance in accounting presentation among the various expenditures countries. Table 1 1. Financial Position Year Year Year Average N-3 N-2 N-1 Year N annual % Items Calculation actual actual actual est. growth structure 1 Total current revenues 2 Balance N-1 (if surplus) 3 Current revenues year N (1 − 2) 4 Operating expenditures 5 Operating margin (1 − 4) 6 Debt repayment 7 Net margin (5 − 6) 8 Capital expenditures 9 Financing requirements (8 − 7) 10 - Own capital revenues 11 - Investment grants 12 - Loan (9 − (10+11)) 13 Investment balance (8 − (7+10+11+12)) 14 Overall closing balance (1+10+11+12) − (4+6+8) Insert a short summary and comment on the data (on the basis of ratios) included in ratio main lessons learned from the financial position analysis—Step 5. 420 Municipal Finances Table 2 2. Main Revenue Sources Year Year Year Year N-3 N-2 N-1 N Average % annual structure Items Calculation actual actual actual est. growth (total) TOTAL CURRENT REVENUES 1 State Transfers - Shared taxes - Unconditional transfers/grants Refer to database - Conditional operating transfers 2 Own revenues - Local taxes & levies - Local fees - Local asset proceeds 3 Other revenues - Surplus Y-1 - Revenues received from PUC TOTAL NON-RECURRENT REVENUES 1 State transfers and grants - Unconditional development transfers Refer to database - Conditional development grants 2 Own revenues - Property sales - Long-term leases 3 External revenues - Loans proceeds - Municipal bonds - Donations TOTAL REVENUES database Refer to 1 State Transfers 2 Own revenues 3 External revenues Insert a short summary and comment on the evaluate revenues and the potential of the local main lessons drawn from the revenue source taxation system; and estimate revenues from data: analyze the principal sources of municipal commercial facilities. financing (taxation, grants, local taxes, and so on); Achieving Greater Transparency and Accountability 421 Table 3 3. Tax Potential and Performance Analysis Year Year N-3 to N-2 to Year Year Year N-3 Year N-2 Year N-1 Year N N-2 N-1 Items Source actual actual actual est. growth growth 1 Property tax (housing) - Number of items - Number of taxpayers - Amount taxable - Amount collected - Collection rate 2 Property tax (commercial and business) - Number of items - Number of taxpayers - Amount taxable - Amount collected - Collection rate 3 Business tax - Number of items - Number of taxpayers - Amount taxable - Amount collected - Collection rate Main tax payers List of the 10 to 50 major taxpayers Insert a short summary and comment on the and tax potential: tax potential of the modern main lessons learned from the above data, analyz- and informal sectors; (b) assessment rate; (c) col- ing the tax potential and pressure for land, prop- lection rate overall and by category of tax paid erty, and business taxes: (a) economic activity (concentration). 422 Municipal Finances Table 4 4. Transfers Predictability and City Dependence Average % Allocation Year N-3 Year N-2 Year N-1 Year N annual structure Items Criteria actual actual actual plan growth (total rev.) 1 Unconditional transfers - Transfer 1 - Transfer 2 -… 2 Conditional transfers - Transfer 1 - Transfer 2 -… Insert a short summary and comment on the Provide information on allocation criteria for main lessons learned from the above data on pre- grants, and assess the degree to which local gov- dictability of transfers and the level of city depen- ernments can affect the volume allocated to them dence: percent of transfers compared to total (performance criteria, if any). revenues. Table 5 5. Main Operating Expenses Line Items by Category (better than functional) Year Year YearYear Average N-3 N-2 N-1 N annual % structure Items actual actual actual plan growth (total rev.) CURRENT EXPENDITURES 1 Payroll (including employees benefits and misc.) - Administrative staff - Technical department staff - Other staff (contractual workers) 2 Operating costs - Office supplies - Electricity - Communication (telephone, etc.) - Fuel and gas -… 3 Maintenance costs … 4 Of which maintain state assets Total Achieving Greater Transparency and Accountability 423 Insert a short summary about the princi- specific expenditures such as maintenance of pal operating expenditure line items. Evaluate infrastructure and facilities, and so forth. Table 6 6. Municipal Assets and Maintenance Expenditures Tentative Year Year Year Year Average Dominant Items assets N-3 N-2 N-1 N annual implementation Inventory actual actual actual plan growth arrangement (1) Roads, streets Artery roads km Residential streets km Paved roads total km Public lighting (number of lighting posts) Water, networks (km) Water treatment plants (number) Sewer network (km) Wastewater treatment plants (number) Solid waste management facilities trucks Solid waste (transfer stations, landfill total capacity ton per day) Other public infrastructure and equipment (parks, cemeteries, parking and garage, etc.) (m2) Educational facilities (number of classrooms or m2) Healthcare facilities (m2) Administrative facilities (m2) Cultural facilities (m2) Sport facilities (m2) Commercial facilities (m2) Environmental facilities Public housing (number of apartments and other units, m2) Cultural heritage Vacant municipal land (hectare) (1) direct by municipal staff, by contractors, by residents … 424 Municipal Finances Insert a short summary on the asset by private contractors, and by the residents composition and management, particularly themselves. if there is public housing and land property. No information is required on asset valuation Provide a short description of how mainte- because of the complexity of the calculation. If the nance activities are carried out: directly by municipality has already conducted an evaluation municipal staff, by municipal enterprises, of its assets, provide the main results and analysis. Table 7 7. Indebtedness Situation Donor/bank & Year N-3 Year N-2 Year N-1 Year N Items conditions actual actual actual plan Loan 1 - Outstanding loans - Loan repayment - Interest charge Loan 2 - Outstanding loans - Loan repayment - Interest charge Loan 3 - Outstanding loans - Loan repayment - Interest charge Municipal bond - Outstanding loans - Loan repayment - Interest charge Cash facility (short term) …Loan Overdraft Suppliers’ credit Insert a short summary on the municipali- and (c) contribution to annual debt service. The ty’s existing debt: (a) number of loans or other amortization tables will be useful for making external financing, (b) profile of these loans, projections for the next 5 to 10 years. Achieving Greater Transparency and Accountability 425 Table 8 8. Capital Investment Financing Year Year Year Year Average N-3 N-2 N-1 N annual % structure Items actual actual actual plan growth (total rev.) Total capital investment costs - Civil works - Equipment purchase - Others Financing - Grants from state - Investment revenues (sales of assets, etc.) - Self-financing (Y1 or -1) - Loan Insert a short summary about the structure of the municipality’s capital budget and its financing. Table 9 9. Cash Balance Inflows Cumulative Outflows Cumulative Balance January February March April May June Graph July August September October November December Insert a short summary on both the cash bal- rates (for example, the grants payment rate or the ance at the end of the year and the monthly cash tax collection rate) and outflow rates. If applica- flow. Include possible difficulties faced during the ble, mention any specific arrangements with the year with fluctuations between monthly inflow Treasury or the banks (cash facility). 426 Municipal Finances Table 10 10. Arrears Year Year Year Year Average % outflows N-3 N-2 N-1 N annual current and Items Calculation actual actual actual plan growth capital inv. CURRENT BUDGET Energy - Material - Salaries or other labor - costs Social security dues CAPITAL BUDGET Public institutions - Private entities - TOTAL Insert a short summary regarding the munic- and will also highlight its potentials and key ipality’s unpaid invoices and commitment gaps. The ratio analysis tables can be filled out amounts, distinguishing between current and by linking the relevant cells the historical anal- capital expenditures. The analysis can also differ- ysis tables. entiate between institutional debt or arrears and It is important to work closely with the private contractors’, arrears. Ministry of Finance to publish these ratios annu- ally at the national level for all municipalities as a tool for comparison and self-improvement. Step 5: Ratio analysis It is recommended that reference be made to Objective and content: The objective of the ratio ratios already used by the Ministry of Finance analysis is to create municipal finance bench- or the Ministry of Interior, or even to ratios marks for internal purposes (financial man- calculated by regional associations of local agement dashboard) as well as for purposes of governments. regional comparison. Finally, ratios comparing local finance perfor- The following ratios and benchmarks are mance and GDP are not suggested at this stage based on international standards used in Western but could be usefully added if data on local GDP European countries and in the U.S. were available. The following comparison is com- Participating in the MFSA will help each mon at the national level: weight of local expendi- municipality better understand its position rel- tures and local taxation/GDP. ative to others in the region and in the world, Achieving Greater Transparency and Accountability 427 Step 5. Ratio Analysis (Municipal Finance Dashboard) 428 Graph with Comparative mention of the index City index benchmark if Criteria Indicator (definition) Objective (benchmark) YN-3 YN-2 YN-1 possible STOCK RATIO Creditworthiness Operating savings before The LG has the > 0,3 Graph with mention interests/Current actual capacity to borrow of the benchmark if revenues and to invest possible Net operating surplus (after The LG has the > 0,2 Graph with mention debt service including capital capacity to borrow of the benchmark if repayment)/Current actual more possible revenues Cash (end of the year)/ The LG ability to 90 days Graph with mention current liabilities (divided by meet its short-term of the benchmark if 365 days) obligations possible Indebtedness Debt outstanding/Operating The LG capacity to < 10 years Graph with mention surplus (capacity to clear its clear its debt with of the benchmark if debt) operating surplus possible Debt service/Total current The annual debt < 10 % Graph with mention revenues burden is correct of the benchmark if regarding current possible revenue Fiscal autonomy Own tax receipts + The LG has the > 80 % Graph with mention unconditional grants/Current ability to increase its of the benchmark if actual revenues revenue possible Tax pressure (Tax receipts/ < 70 % Tax potential) Municipal Finances Capital investment effort Capital investment The LG favors > 40 % Graph with mention expenditures/Current actual development of the benchmark if revenues expenditures possible Capital investment The LG functions are > 50 % Graph with mention expenditures delegated still weak of the benchmark if by state/Total investment possible expenditures Level of service Maintenance works The LG has > 30 % Graph with mention expenditures/Operating important non- of the benchmark if expenditures current assets to possible Achieving Greater Transparency and Accountability maintain and make it a priority Others Total number of municipal The LG has limited > 25 Graph with mention employees/population room for financing employees of the benchmark if maintenance and for 1,000 possible capital investment inhabitants Salaries and wages/ > 40 % Operating actual expenses Actual revenues/Estimated The LG has a good > 95 % Graph with mention revenues visibility and budget of the benchmark if is reliable possible Arrears amount/Net cash The LG accumulates > 1 Graph with mention (end of the year) short-term debt of the benchmark if and reduces its possible credibility toward contractors (continued next page) 429 430 Graph with Comparative mention of the index City index benchmark if Criteria Indicator (definition) Objective (benchmark) YN-3 YN-2 YN-1 possible FLOW RATIO 1 Margin ratio: Total The city is living 1,02 Graph with mention financial resources (cash)/ or not within its of the benchmark if total financial obligations financial means possible (payment + arrears) COMPARISON RATIO Total revenues/capita Comparison with LG Graph with mention Total expenditures/capita of same size in the of the benchmark if country or abroad possible Current actual revenues/ (EU): list to establish capita Debt outstanding/capita Capital investment expenditures/capita Insert a short summary about the lessons learned from the ratio analysis. Municipal Finances Step 6: Financial projections projections based on past trends and also taking significant changes into account. The methodol- Objective and content: The five-year finan- ogy should be adjusted according to the size of cial projections serve to provide a review of the the municipality and the issues it currently faces, municipality’s financial position with a focus such as specific future investment programs, on creditworthiness. The main objective is to specific indebtedness situations that need to be demonstrate the impact of policy decisions addressed, and so forth. (expenses, borrowing, tax pressure, and so on) The following tables provide a preliminary and their underlying assumptions on the finan- and simplified framework for projections. Insert cial position of the municipality. Usually, several a short summary about the lessons learned from sets of assumptions and scenarios are tested: the preliminary results obtained. Achieving Greater Transparency and Accountability 431 432 Step 6. Five years of financial projections In current currency Trends Main Specific for Year Items assump- Index calcula- Year N Year N+1 Year N+2 Year N+3 Year N+4 Year N+5 previous N-1 tions tion 3 years Actual Estimated Projection Projection Projection Projection Projection A TOTAL CURRENT REVENUES Own tax revenues - Property tax - Business tax - Others (development fee) State transfers - Shared tax - Unconditional grants - Conditional grants Other revenues - Asset rent, interest Municipal Finances B TOTAL OPERATING EXPENDITURES Payroll (including employees’ benefits and misc.) - Administrative staff - Technical department staff - Other staff (specific …) Operating costs - Office supplies Achieving Greater Transparency and Accountability - Electricity - Communication (telephone, etc.) - Fuel and gas - Maintenance costs - Other (continued next page) 433 434 Trends Main Specific for Items assump- Index calcula- Year N-1 Year N Year N+1 Year N+2 Year N+3 Year N+4 Year N+5 previous tions tion 3 years Actual Estimated Projection Projection Projection Projection Projection C GROSS OPERATING SAVINGS (A - B) D DEBT SERVICE Existing debt - Interest charge - Loan repayment New debt (loans > YN-1) - Interest charge - Loan repayment Total debt service - Interest charge - Loan repayment E NET SAVINGS (C - D) F CAPITAL EXPENDITURES G INVESTMENT FINANCING (F - E) Investment grants Own capital revenues excl. operation surplus Loans H OVERALL CLOSING BALANCE (CASHFLOW) (A+G) - (B+D+F) Municipal Finances Step 7: Financial management This section draws on the Public Expenditure assessment and Financial Accountability (PEFA) methodol- ogy, also developed by the World Bank, and pro- Objective and content: The objective is to vides a checklist of six key indicators of sound assess the strength of the municipality’s financial financial management. management. Insert comments on the different items and A municipality may have a good financial sit- propose specific actions for improvement. uation but weak financial management; likewise, a municipality may have poor financial capacity but a fair financial management system. Financial Management Assessment Aggregate fiscal Strategic allocation Efficient service discipline of resources delivery 1. Credibility of the Overoptimistic Revenue shortfalls/ Efficiency of resources Budget revenue forecasts/ Underestimation of used at the service Underbudgeting of the costs of the policy delivery level/A shift across nondiscretionary/ priorities/Noncompliance expenditure categories, Noncompliance in in the use of resources. reflecting personal budget. preferences rather than efficiency of service delivery. 2. Comprehensiveness Activities not managed Extrabudgetary funds/ Lack of comprehensiveness / and Transparency and reported through earmarking of some increase waste of resources/ adequate budget revenues to certain decrease the provision of processes are unlikely programs …/Limits services/limits competition in to be subject to the the capacity of the the review of the efficiency same kind of scrutiny legislature, civil society, and effectiveness of the and controls (included and media to assess different programs and their from financial markets) the extent to which inputs/ May facilitate the as are operations the government is development of patronage or included in the budget. implementing its policy corrupt practices. priorities. 3. Policy-Based Weak planning Process of allocation The lack of a multiyear Budgeting process /no respect of the global resource perspective may contribute for the fiscal and envelop in line with LG to inadequate planning macroeconomic priorities/annual budget of the recurrent costs of framework/lead to too short to introduce investment decisions and unsustainable policies. significant changes in of the funding for multiyear expenditure/ costs of procurement. new policy systematically under-estimated. 4. Predictability and Impact on fiscal Planned reallocations/ Plan and use resources in a Control in Budget management/ Authorized expenditures/ timely and efficient manner/ Execution inadequate debt policy/ fraudulent payments. Competitive tendering excess of expenditures. process practices/control of payrolls. (continued next page) Achieving Greater Transparency and Accountability 435 5. Accounting, Allows for long-term Regular information on Inadequate information and Recording, fiscal sustainability budget execution allows records would reduce the Reporting and affordability of monitoring the use of availability of evidence that policies: timely and resources, but also is required for effective audit adequate information facilitates identification and oversight of the use of on revenue forecasting of bottlenecks and funds and could provide the and collection/existing problems that may lead opportunity for leakages, liquidity levels and to significant changes in corrupt procurement expenditure flows/debt the executed budget. practices, or use of levels, guarantees/ resources in an unintended contingent liability manner. and forward costs of investment programs. 6. External Scrutiny and Consider long-term Pressure on LG to LG is held accountable for Audit fiscal sustainability allocate and execute the efficient and rule-based issues and respect its budget in line with its management of resources, targets. stated policies. without which the value of services is likely to be diminished. The accounting and use of funds are subject to detailed review and verification. Step 7. Financial Management Assessment Criteria Indicator Indicator A. Credibility of the Budget Aggregate expenditure out-turn compared to original approved budget Composition of expenditure out-turn compared to original approved budget Aggregate revenue out-turn compared to original approved budget Stock and monitoring of expenditure payment arrears B. Comprehensiveness and Transparency Classification of the budget Comprehensiveness of information included in budget documentation Extent of unreported government operations Transparency of Inter-Governmental Fiscal Relations Oversight of aggregate fiscal risk from other public sector entities Public Access to key fiscal information 436 Municipal Finances C. Budget Cycle Policy-Based Budgeting Orderliness and participation in the annual budget process Multiyear perspective in fiscal planning, expenditure policy, and budgeting Predictability and Control in Budget Execution Transparency of taxpayer obligations and liabilities Effectiveness of measures for taxpayer registration and tax assessment Effectiveness in collection of tax payments Predictability in the availability of funds for commitment of expenditures Recording and management of cash balances, debt, and guarantees Effectiveness of payroll controls Competition, value for money, and controls in procurement Effectiveness of internal controls for non-salary expenditures Effectiveness of internal audit Accounting, Recording, and Reporting Timeliness and regularity of accounts reconciliation Availability of information on resources received by service delivery units Quality and timeliness of in-year budget reports Quality and timeliness of annual financial statements External Scrutiny and Audit Scope, nature, and follow-up of external audit Scrutiny of the annual budget law by the City Council Scrutiny of external audit reports by the City Council D. Donor Practices Predictability of direct budget support Financial information provided by donors for budgeting and reporting on project and program aid Proportion of aid that is managed by use of national procedures Predictability of transfers from higher level of government Achieving Greater Transparency and Accountability 437 Step 8: Municipal Finances current agenda of National Associations of Improvement Plan Local Governments. That is, they need to have some traction for actual implementation, and Objective and content: The objective is to should include precisely what is expected from translate the lessons learned from the differ- central government. ent steps of the MFSA into a limited number of The Municipal Finances Improvement Plan actions to improve the municipality’s financial can be divided into situation and financial management. The tem- plate below is a very preliminary and incom- – Short-term actions: 1 year plete indication of what could be included – Medium-term actions (1 to 3 years). and should be further developed based on the findings of the MFSA. The municipality is All of them should include a specific descrip- free to list any action it considers to be a pri- tion of what needs to be done and why, quanti- ority. Actions that are not under the full con- fied targets if appropriate, a timeline, and how trol of the municipality can also be mentioned and by whom the actions will be implemented. if they are part of State reforms currently It should also indicate whether or not there is under discussion or if they are included in the a cost. Objective 1: Improve Financial Situation of the Municipality Schedule Short- Cost Responsible Specific Priority Expected term/ Items estimate if entity/ objective action result Long-term any person ST/LT Actions under the control of State Increase fiscal Replace conditional autonomy grants with unconditional grants or shared taxes Give more flexibility on local tax policy … Actions to be implemented at the LG level Increase fiscal Increase local tax autonomy collection Reconsider the rate of property tax for households … 438 Municipal Finances Objective 2: Improve Financial Management of the Municipality Schedule Short- Cost Responsible Specific Priority Expected term/ Items estimate if entity/ objective action result Long-term any person ST/LT Credibility of Improve forecast the budget reliability Policy-based Improve cost analysis budgeting of main expenditure Improve budget Improve expenditure e.g., execution control Competitive bidding, performance contacts Notes  4. The first measure taken by the decentraliza- tion reforms adopted in France, for example,  1. Except for the property tax, most of the was the repeal of the a priori control over the revenues of the local budgets come from tax decisions taken by the municipal councils. proceeds distributed by the state or even by However, the public finance accounts are con- the national government as shared taxes or solidated (central and local governments) and grants. contribute all together to the calculation of the  2. To get more information on the effective- economic performance ratios of the countries. ness of the performance measurement in the Consequently, particular importance is given municipalities and counties in the United to the accounts balance and to the level of States, see the models of performance- debt as the main risk indicators. In France, the measurement use in local governments. calculation is supported both by the national See also Melker and Willoughby 2005. treasury system and the principle of unity of  3. However, we note state and provincial initia- cash transactions. Tax pressure is also gener- tive to fix some standards through a mandated ally determined on the basis of a consolidated municipal performance measurement program analysis that brings together national and local with the objective to standardize data collection taxation. and generate benchmarks and, potentially, com-  5. Municipal councils are free to decide on the parisons. On this last development, there is a use of the resources provided by the budget. real caution because of the many outside factors This basic principle of municipal autonomy that influence the results, including geography, is reinforced by the financing system when population, community priorities, organiza- more than 50 percent of the municipality’s tional forms, accounting and reporting prac- revenues are recovered locally through local tices, the age of the infrastructure, and so on. taxes. Achieving Greater Transparency and Accountability 439 References GASB (Governmental Accounting Standards Board). 1997. “Analysis of State and Local Abers, R. 2001. “Learning Democratic Practice: Government Performance Measurement Distributing Government Resources through Applications.” http://www.seagov.org. Popular Participation in Porto Alegre, Brazil.” Goldsmith, W.W., and C. B. Vainer. 2001. In The Challenge of Urban Government: “Participatory Budgeting and Power Politics in Policies and Practices, edited by M. Freire and Porto Alegre.” Land Lines 13 (1): R. Stren, 129–43. Washington, DC: World Bank Institute. Hatry, H., and D. Fisk. 1971. “Improving ADM (l’Agence de Développement Municipal). Productivity and Productivity Measurement.” 2008. Guide de Ratios 2008–2011. Senegal: In Local Governments. Washington, DC: Urban l’Agence de Développement Municipal. Institute Press and National Commission on Productivity. Agence Française de Notation. 2010. Rapport de l’Observatoire des Finances Locales. Paris: Hatry H., D. Fisk, M. D. Kimmel, and H. Blair. Agence Française de Notation. 1988. Program Analysis for State and Local Ammons, D. N. 2001. Municipal Benchmarks: Governments. 2nd ed. Lanham, MD: University Assessing Local Performances and Establishing Press of America. Community Standards. Thousand Oaks, CA: International Centre for Local Credit. 2008. Sage Publications Inc. International Survey on the Impact of the Boyle R. 2004. “Assessment of Performance Financial Crisis on the Public Finances Reports: A Comparative Perspective.” (conducted October 2008–July 2009). In Quality Matters: Seeking Confidence Josifov G., C. Pamfil, and R. Comsa. 2011. in Evaluation, Auditing and Performance Guidelines on Local Government Borrowing Reporting, edited by R. Schwartz and J. Mayne,. and Recent Developments in South East Europe. New Brunswick, N.J.: Transaction Publishers. Skopje, Macedonia: Network of Associations Epstein, P. D. 1984. Using Performance of Local Authorities of South-East Europe Measurement in Local Government: A (NALAS). Guide to Improving Decisions, Performance Melker, S. J., and K. Willoughby. 2005. “Models and Accountability, with Case Examples of Performance-Measurement Use in Local Contributed by 23 Government Officials from Governments: Understanding Budgeting across the Country. Council on Municipal Communication and Lasting Effects.” Public Performance Series. New York: Van Nostrand Administration Review 65 (2). Reinhold. MIAC (Ministry of Internal Affairs and Farvacque-Vitkovic C., A. Sinet, and L. Godin. Communication). 2011. “White Paper on Local Municipal Self-Assessments, A Handbook for Public Finance.” Tokyo: Ministry of Internal Local Governments. World Bank publication Affairs and Communication. (forthcoming). NALAS. 2011. Report on Fiscal Decentralization Farvacque-Vitkovic C., A. Sinet, and S. Palmeuther, Indicators in South East Europe. T. Nikolic, 2014. Improving Local Governments Capacity, The Experience of Municipal Finances Paulais T. 2009. Local Governments and the Self-Assessment (MFSA) in South East Europe. Financial Crisis: An Analysis. Washington, World Bank publication. DC: Cities Alliance and Agence Française de Farvacque-Vitkovic C. and S. Palmeuther. 2014: Développement. Improving Local Governments Capacity, City to Poister, H. T., and C. Streib. 1999. “Performance City Dialogues on Municipal Finances, Urban Measurement in Municipal Government: Planning and Land Management in South East Assessing the State of the Practice.” Public Europe. World Bank publication (forthcoming). Administration Review 59: 325–35. 440 Municipal Finances Ridley, Clarence E., and Simon A. Herbert. 1938. Serageldin, M., D. Jones, F. Vigier, and E. Solloso. Measuring Municipal Activities: A Survey 2008. Municipal Financing and Urban of Suggested Criteria and Reporting Forms Development. Human Settlements Global for Appraising Administration. Chicago: Dialogue Series 3. New York: UN-Habitat. International City Managers’ Association. Williams, Daniel W. 2004. “Evolution of Rubinoff D., A. Bellefleur, and M. Crisafulli. 2008. Performance Measurement until 1930.” “Regional and Local Governments outside the Administration and Society 36 (2): 131–65. US.” Moody’s International Public Finance. http://www.moodys.com. Achieving Greater Transparency and Accountability 441 Additional Readings: Chapter 8 On Performance Measurement All American City: History. 2004. http://www.ncl.org/aac/information/history .html Allecian, S., and Foucher, D. 1994. Guide du Management dans le Service Public. Paris: Editions d’Organisations. Allegre, H., and Mouterde, F. 1989. Le Contrôle de Gestion dans les Collectivités Locales: Méthodes, Outils, Tableaux de Bord. Paris: Editions du Moniteur. Ammons, D. N., C. Coe, and M. Lombardo. 2000. “Performance Comparison Projects in Local Governments: Participants’ Perspective.” Public Administration Review 61: 89–99. Ammons, D. N. 1994. “The Role of Professional Associations in Establishing and Promoting Performance Standards for Local Government.” Public Productivity and Management Review 17: 281–98. Anthony, R. N. 1965. Planning and Control System, A Framework for Analysis. Division or Research, Harvard Business School (180 p). Arrow, K. J. 1997. Choix collectifs et Préférences Individuelles (traduction française de Social Choice and Individual Value, 1951). Diderot Editeur, Paris. Bessire, D. 1999. “Définir la Performance.” Comptabilité Contrôle Audit 5 (1): 416–24. Bouquin, H. 1991. Le Contrôle de Gestion. Paris: PUF. Bourguignon, A. 2000. “Performance et contrôle de gestion.” In Encyclopédie comptabilité contrôle Audit. 931–41. Paris: Economica. Bruder, K. A., and Gray, E. M. 1994. “Public Sector Benchmarking: A Practical Approach.” Public Management 76: S9–S14. Brule, J. 1997. “Contribution à l’Elaboration d’un Contrôle de Gestion dans les Collectivités Locales.” Thèse de Doctorat en Sciences de Gestion, CENAM, Paris (344 p). Carles, J. 1999. Management Stratégique et Renouveau du Projet Politique. La lettre du cadre territorial (400 p). Coe, C. 1999. “Local Government Benchmarking: Lessons from Two Major Multi- Government Efforts.” Public Administration Review 59: 110–23. Crowel, A., and S. Sokol. 1993. “Playing in the Gray: Quality of Life and the Municipal Bond Rating Game.” Public Management 75: 2–6. Demeestere, R. 2002. Le Contrôle de Gestion dans le Secteur Public. Paris LGDJ (196 p). Downs, A. 1957. An Economic Theory of democracy. New York: Harper. Victor, D. A., and K. Kaiser. Sub-National Performance Monitoring Systems – Issues and options for higher levels of Government. Additional Readings: Chapter 8 443 Dupuis, F., and Thoening, J. C. 1985. L’Administration en Miettes. Paris Ed. Fayard (316 p). Gibert, P. 1980. Le Contrôle de Gestion dans les Organisations Publiques. Editions d’organisations, Paris. Grizzle, G. A. 1987. “Linking Performance to Funding Decisions: What is the Budgeter’s Role.” Public Productivity Review 10: 33–44. Guenguant, A. 1995. “Equilibre Budgétaire et Diagnostic Financier Global.” In Analyse Financière des Collectivités Locales. Paris: PUF. Hofstede, G. 1981. “Management Control of Public and Not-For-Profit Activities.” Accounting, Organizations and society 6(3): 193–211. ICMA (International City/County Management Association). www.icma.org. Jensen, M. C., and W. H. Meckling. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 3 (October): 305–60. Joncour, Y. 1993. “Moderniser la gestion et les financements publics: des priorités à contresens.” Pol et Management 2 (June). Morin, E. M., A. Savoie, and G. Beaudin. 1994. L’Efficacité Organisationnelle: Théories, Représentations et Mesures. Gaétan Morin Editeur, Québec. Kaplan, R., and Norton, D. 1998. Le tableau de bord prospectif. Paris: les éditions d’organisations. Kaplan, R., and Norton, D. 2004. Strategy Maps: Converting Intangible Assets into Tangible Outcomes. Harvard Business School Press. Duff, R. L., and J.-C. Papillon. 1988. Gestion Publique. Editions d’organisations, Vuibert, Paris. Lorino, P. 2003. Méthodes et Pratiques de la Performance. Le Pilotage par les Processus et les Compétences. Les Editions d’Organisations, Paris. Meyssonier, F. 1992. Stratégie et Style de Contrôle de Gestion dans les Communes. 13ème Congrès de l’AFC Bordeaux mai (31 p). Morin, E., M. Guindon, E. Boulianne. 1996. Les Indicateurs de Performance. Editeur Guérin Montréal. Performance des Services Publics Locaux. 1989. Colloque Paris IX 24 avril 1989. Litec, Paris. Poincelot, E., and Wegmann, G. 2007. “What Are the Motives of the Managers Using Non-Financial Indicators: An Empirical Study.” Working Papers, FARGO (Research Center in Finance, Organizational Architecture and Network). Poister, H. T. 2003. Measuring Performance in Public and Nonprofit Organizations. John Wiley & Sons–Jossey-Bass. Rey, J. P. 1991. Le Contrôle de Gestion des Services Publics Communaux. Editions Dunod. Roussarie, O. 1994. “Les Outils de Contrôle de Gestion Utilisés dans les Services Publics Urbains.” Thèse de Doctorat Sciences de Gestion, Université de Poitiers. Schmitt, D. 1988. “Le Contrôle Budgétaire Interne.” Politiques et Management 3 (September). 444 Municipal Finances Thiebout, C. M. 1956. “A Pure Theory of Local Expenditures.” Journal of political Economy 64 (October): 416–24. UN-Habitat. 2009. Guide To Municipal Finance. UN-Habitat. Self-Evaluation Handbooks Almy, R. R., R. J. Gloudemans, and G. E. Thimgan. 1991. Assessment Practices: Self-Evaluation Guide. Chicago: International Association of Assessing Officers. Shah, A. 2007. Local Budgeting, Public Sector Governance and Accountability Series. The World Bank. http://www.worldbankinfoshop.org/ecommerce/catalog /product?item_id=6355058 Fund for Moroccan Township Facilities and Infrastructure. (Fonds d’Equipement Communal du Maroc). 2008. Handbook for Participatory Planning in Local Development. DGCL, Ministry of Interior. www.fec.org.ma Groupe de Travail Financement des Investissements des Collectivités Locales. 2005. Financer les Investissements des Villes en Développement—Notes & Douments n°23—Agence Française de Développement. http://www.afd.fr /jahia/webdav/site/myjahiasite/users/administrateur/public/publications /notesetdocuments/ND-24.pdf Groves, S. M., and M. G. Valente. 2003. Evaluating Financial Condition: A Handbook for Local Government. Washington, DC: International City/County Management Association. Hatry, H. P., D. Fisk, E. R. Winnie. 1973. Practical Program Evaluation for State and Local Government Officials. Urban Institute Press. Partenariat Pour le Développement Municipal, L’Emprunt des Collectivités Locales D’Afrique Sub-Saharienne (PDM). 2008. Revue Africaine des Finances Locales. juin. http://www.pdm-net.org/PDM_final_130608_web.pdf SNV Mali (Organisation Néerlandaise de Développement). 2004. Outil d’Auto-évaluation des Performances des Collectivités Territoriales. MATCL SNV Helvetas. http://www.snvmali.org/publications /outilautoeval.pdf Southwestern Pennsylvania Regional Planning Commission. 1990. Standards for Effective Local Governments: A Workbook for Performance Assessment. Pittsburgh, PA. Additional Readings: Chapter 8 445 The Way Forward Catherine Farvacque-Vitkovic The task of getting municipal finances right is daunting, but reachable. There is no doubt that the world is getting more complex. Municipal officials are not only dealing with the day-to-day business that comes with running a city, but they also increasingly have to address issues of social inclusion, local economic development, job creation, crime and violence, climate change, floods, droughts, and natural and man made disasters. They are also expected to welcome increasing numbers of urban dwellers, deal with an increasing number of informal settlements, and cover the costs of providing infrastructure and services in increasingly sprawling cities. There are no quick solutions; no one size fits all. From the eight chapters of this book, however, readers can take away a greater understanding of what works and what does not: Good Intergovernmental Relations Matter. A wave of decentraliza- tion policies has swept many parts of the world. That happened in part because of the recognition that local governments are closer to their con- stituents and thereby more responsive to their needs. The trend has not always been accompanied by good practices. Fiscal policies and transfer formulas have not always been as equitable as required. Thus, measuring the positive impacts of the devolution of functions and resources to the local level remained a challenge for policy makers and academia. This book helps share experiences on intergovernmental transfers. It promotes The Way Forward 447 formula-based, as opposed to ad hoc, allocation of central government trans- fers and advocates incentive mechanisms to ensure that transfers do  not crowd out, but rather stimulate, collection of local own-source revenues. Intergovernmental finance relations generate the governance framework, the playing field, and the underlying incentive mechanisms for the functioning of the systems to manage revenues, expenditures, assets, and external resources and for measuring performance. Metropolitan finance matters. With continued urbanization  around the world, cities become more and more economically interdependent with their surrounding settlements and hinterlands; thus, metropolitan areas compose a single economy and labor market, a community with common interests and joint actions. Such an area needs some areawide management, formed either from the bottom up by the local governments or as a top-down deci- sion by a higher government. There is a great variety of metropolitan gover- nance models and modalities, each with its merits and demerits. The range includes simple cooperation by local governments; regional authorities (or special purpose districts) organized voluntarily; metropolitan-level governments; and amalgamated local governments. The main areas of finan- cial cooperation and benefits in metro regions include tax sharing to prevent tax competition and harmonize revenues; cost sharing or a common budget for metropolitan-level initiatives and services; coordinated revenue mobili- zation through user charges, property taxes, and earmarked taxes; and joint mobilization of funding sources for large infrastructure with areawide bene- fits. The main reasons for forming metropolitan governance include efficiency gains, economies of scale, addressing spillover effects and disparities, and improving services. However, often politics rather than efficiency and equity determines the formation of metropolitan governance and finance systems. Financial management practices matter. Financial management concepts and techniques help local governments use their limited financial resources in an efficient and transparent manner and thereby enable them to function accountably. Budgeting, accounting, and financial reporting are the pillars of good financial management. Modern information technology, the introduction of computerized financial management systems, and use of other ICT instru- ments have accelerated information flows and data security. More importantly, they have shifted the functions of the three pillars from mere recording of data to daily strategic management of cities and timely informing of long-term stra- tegic decisions. Financial management has myriad tools and techniques, but it is important to recognize that they are relevant only if local governments use them to fulfill their core mandate of providing services in an efficient, effective, and sustainable manner. Though all financial management concepts and tools are important, local government managers do better to adopt simple but fun- damental tools and techniques first and gain proficiency in their practice before moving on to more sophisticated and complex tools and systems. 448 Municipal Finances Revenues matter. Local governments have to learn to do more with less. In many countries, local revenues amount to less than 10 percent of public reve- nues, and many central governments are not inclined to empower the locals with additional sources of revenues or to pay much attention to the administra- tion and collection of municipal fiscal revenues. Regardless of central policies, in many developing countries, local governments would be able to collect sig- nificantly larger revenues by improving revenue policies on taxes, fees, and charges and by focusing their efforts on a few key potential sources of revenues while paying attention to tax administration, revenue collection and tax base. A main message to take away is that improving local revenues depends on the local circumstances. But revenue opportunities always exist: expanding the basis of taxes and fees, rigorously collecting of market services fees, establishing a culture of taxing or charging beneficiaries of new infrastructure develop- ment, collecting land-based revenues, or using assets for strategic revenue gen- eration and development. Introducing new revenue instruments or higher rates will be ineffective without establishing reliable databases and boosting revenue administration capacity. Collecting more revenues requires good com- munication with the citizens and informing them about how and where the revenues will be spent; it also requires instituting fair enforcement and reme- dies mechanisms. Expenditures matter. Expenditure management should be seen as a cycle driven by the policies that the local government aims to achieve. After an agree- ment on the final policy agenda and strategies, it is essential to mobilize and allocate adequate resources and then proceed to implement the planned activi- ties. The final steps in the cycle are monitoring and objectively evaluating the results to see whether the agreed-on outputs and outcomes are being achieved. The results of these evaluations will provide critical information to the next annual policy and program. There are a number of ways to analyze an activity in terms of both financial and operational performance, but an analysis of the vari- ances between what was planned or budgeted and the actual result is arguably one of the best methods. Saving expenditures requires tight and daily control of operating expenditures (salaries and hiring staff ), competitive procurement of bulk products and services (fuel, energy, maintenance, banking), competitive procurement in designing and implementing capital investment projects, and forceful contract management. Local governments in the developing world often try to avoid using competitive procurement because it is often a long and painful process. But with better expertise and human capacity, managing com- petitive procurement becomes faster and less complicated. Alignment between financial planning, expenditures planning and investments programming is key for expenditures management to be improved. This requires that a number of municipal departments which traditionally do not talk to each other start work- ing together towards a same goal. It also implies that there should be more open debates to discuss key priorities and selection of investments. The Way Forward 449 Public asset management matters. Municipal governments everywhere control large portfolios of physical assets (land, buildings, infrastructure, and vehicles and equipment), which make up the lion’s share of local public wealth. Good management of those assets is critical for quality and sustain- ability of local services (e.g., roads, water, schools); for local economic devel- opment (e.g., land for private production and business); and for citizens’ quality of life. Good asset management generates multiple benefits: savings or additional revenues for the local budget, better quality of assets and services, and better trust between people and the government. The primary asset man- agement tools and procedures include the following: inventorying assets; using transparent procedures for allocating assets for private use; aligning or classifying assets according to their role in delivering services; using the market value of assets for decision making; establishing a depreciation fund for financing asset replacement; monitoring key performance indicators such as costs and revenues; and planning ahead for operating and maintenance expenses when acquiring new capital assets. Finally, municipal staff need to gain expertise and pay attention to the regulatory framework, procedures and analytic tools, and real estate markets. External funding matters. Local governments’ investment needs are often much greater than their annual operating surplus can finance. Thus, they need external funding, which can be raised through borrowing, issuing bonds, private-public partnerships, and grants or philanthropic aid. Municipalities borrow funds directly from banks or indirectly through issuing bonds. The capacity of the municipality to borrow is a function of its creditworthiness, which depends on the economic and financial situation and guarantees or other enhancement tools. Creditworthiness analysis and credit ratings are valuable tools to demonstrate that the municipality has the capacity to repay a loan or bond on time. Prudent use of external resources is crucial because without it, the fiscal situation of a city may be jeopardized in the years ahead. External resources should be used to finance the priority projects identified in the city’s capital improvement plan, and liabilities should never exceed the level of the expected revenue flows. Although project selection is always a political process, participatory dialogue and good feasibility studies supported by analytical techniques play an important role in ranking projects and sup- porting informed decisions. Municipal finances performance measurement matters. Measuring municipal financial performance is important because it provides an opportu- nity to obtain a clear picture of the financial situation and supports dialogue with stakeholders (central government, financial partners, or citizens). It provides data and ratios that are useful in prioritizing investments. Finally it helps in evaluating how efficiently and effectively public funds are being used. In a democratic society where open government and open data have become 450 Municipal Finances accepted norms, an abundance of social media tools and instruments are ready to capture citizens’ voices demanding accountability and transparency from their government. It is essential that local governments be prepared to present and articulate, as genuinely as possible, their current situation, their bottlenecks, and their perspectives for the future (projections). That will also help municipalities make their case to central governments regarding trans- fer allocation and guarantees; prepare well-packaged bankable projects; and be accountable to their constituents for the use of public funds. With these objectives in mind, the Municipal Finances Self-Assessment (MFSA) presents a unique opportunity to equip local governments with a tool that makes it easy for them to connect the dots among responsible fiscal and financial dis- cipline, sound financial management, and capacity to finance recurrent and capital expenditures, as well as to attract private financing with a clear view of a path to reform. Getting cities’ finances in order should become our collective mantra. In an ever urbanizing world, cities and towns weigh heavily on national economies and on social prosperity and stability. The stakes are too high to leave room for compla- cency. What do we want the cities of tomorrow to look like? What is the legacy we want to pass on to the next generation and beyond? Municipal finance is at the core of the problems and at the crossroad of the solutions. The Way Forward 451 INDEX Boxes and notes are indicated by b and n following the page numbers. A cash-based, 110, 117, 127 ABC. See activity-based costing comprehensiveness in, 119–20 Abidjan, Côte d’Ivoire concepts and terms in, 109–12 business tax in, 173b cost, 110, 132–35, 145, 209 metropolitan governance in, 77, 78b, 88 cost principle in, 113 accountability in developing countries, 110, 126–32 in capital investment planning, 334 double-entry, 110, 114–16, 119, 127, 144–45 in expenditure management, 224–25, 232–33, expenditure management in, 222, 250, 251 254–55, 400–401 financial, 110 in financial reporting, 138b, 139 financial statements in, 123–26. See also financial in intergovernmental transfers, 25 statements in municipal finance self-assessment, 404 fund, 126, 128–29b, 130–31, 139, 145, 207 in open government, 400–401 going concern principle in, 113 in performance-based budgeting, 262 good practices in, 119–20 in performance measurement, 380, historical perspective on, 112b 394–402, 447 information from, for decision-making, 132–35 in procurement, 247 as information system, 120 in property taxation, 158 management, 110 in revenue collection, 158, 182–83, 194 manual vs. computerized, 118–19, 118–19b, 145 in sales of public land, 182–83 objectivity principles in, 113 small-scale vs. large-scale, 402 operations and maintenance costs of fixed assets in subsidy allocation, 241 in, 129–32 account balance, 114 practices in, 113–19 accounting, 93–94, 109–35, 144–45 principles of, 112–13 accrual-based, 110, 117, 127, 144–45 public sector appropriation, 111 commercial accounting vs., 110 auditing and, 112, 120 key terms in, 110–11, 111b bases of, 116–18 responsibility, 133–34 bookkeeping vs., 109–10 role in managing organizations, 109 budgetary, 111 single-entry, 110, 114, 127 business entity principle in, 112 standards and standard setters in, 111–12 Index 453 timeliness in, 119, 120 Alameda County, California, utility surcharges in, training and capacity development in, 120 177, 178b types of, 110 Alaska, politics and expenditures in, 225b weaknesses in standards and practices, 132 allocation, 110–11, 111b, 220 accounting equation, 114, 125 allotments, from budget, 101 accrual-based accounting, 110, 117, 127, 144–45 amalgamation of local governments, 51, 56, 82–86 action plan, in asset management, 289, 323 Amman City, Jordan activity-based costing (ABC), 133 fines and penalties in, revenue from, 179 Addis Ababa, Ethiopia, financial accountability tax authority in, 154–55 assessment in, 255, 260 waste management in, 368 addresses, street amortization, 350, 414 and asset inventory, 282 Amsterdam, Netherlands, metropolitan governance and tax systems, 184–85, 190–91, 191b, 208, 208b, in, 82, 90 212n6 analytical accounts, of assets, 282–84 and user charge collection, 237, 238b Anchorage, Alaska, amalgamation of, 83 ad hoc scale economies, 58 annexation, 51, 56, 82–86 ad hoc transfer mechanisms, 29 annual account, 419b ADM. See Municipal Development Agency annual rental value, for property taxation, 165–67 administrative budgets, 95 apportionment, in budget process, 101 administrative costs, 233 appropriation, 110–11, 111b administrative decentralization, 5–6 appropriation accounting, 111 adverse audit opinion, 142, 145 Aquino, Benigno, 11–12 aerial photography, for property tax area-based assessment, 164–65 information, 184 Argentina Afghanistan, informal settlements in, 91n1 foreign currency borrowing in, 358, 358b Africa. See also specific countries informal or exceptional borrowing practices in, 349 centralization in, 9, 10 local business taxes in, 173b local business taxes in, 173b, 174 metropolitan governance in, 50 metropolitan governance in, 51, 88–89 municipal bonds in, 341, 342, 343 municipal bonds in, 341, 341b, 399–400 public-private partnership in, 372b municipal contracts in, 30, 334 revenue intercepts in, 353 municipal development funds in, 362 arithmetic mean growth rate, 198b performance measurement in, 394–95 ARPEGIO, 59 property taxes in, 167, 190–91 Arusha Declaration (1990), 9 public-private partnerships in, 372b, 373 Asia. See also specific countries revenue collection enforcement in, 186 financing needs in, 326 urbanization in, 48 land development corporations in, 321–22 African Charter for Popular Participation manual accounting in, 118–19b in Development and Transformation metropolitan governance in, 50, 89–91 (Arusha Declaration, 1990), 9 municipal bonds in, 341, 341b African Development Bank, 364 municipal development funds in, 362–64 agency funds, 129b property tax assessment in, 167 agglomeration, urban, 42, 42b, 43–46 public-private partnership in, 372b aggregate fiscal discipline, 220 special purpose vehicles in, 354–55, 355b Aguascalientes, Mexico, municipal bonds in, 341 Asian Development Bank, 326, 364, 367 Aguas de Tucuman, Argentina, public-private assessment partnership in, 372b for local revenues, 183, 185 Ahmedabad Municipal Corporation (India), 341b for property taxes, 155, 164–69 454 Municipal Finances asset(s) indicators for all types of properties in, 305–7 in accounting equation, 114, 125 indicators for investment comparison in, 301–5 capital, 276 Initial Asset Management Model of, 285, 285b classification of, 276–77, 277b, 292–94, 314–15 inventorying of, 282, 283, 289–92 current revenue from, 179–80 land, 312–22. See also land assets designated, 126 life-cycle, 278, 279 as economic development resource, 280 multidisciplinary approach in, 281 fixed, 129–32, 276 municipal enterprises and, 286–87, 311–12 functions of, 279–81 operating statements in, 299–301, 300b, 303 grouping of, 289 operation and maintenance costs in, 129–32, 280, liabilities associated with, 280 299–301, 307–10, 420, 424–25 life cycle of, 278 ownership of process in, 287 management of. See asset management policy for, establishing, 294, 295 as material base, 279 political cycle and, 287 net, 125–26, 127, 139 portfolio management in, 277–78, 283, 284 nonphysical, 276 public-private partnerships and, 287, 320–21 permanently restricted (PR), 125–26 recommendations, 323 physical, 276 reform of, 287, 288b portfolio of, 274, 276 sequencing of actions in, 287 as revenue source, 280, 296, 297. See also shortcomings in, consequences of, 276 income-generating properties strategic, framework for, 281–85, 284b self-assessment (MFSA) of, 420, 424–25 strategic view in, 310–12 temporarily restricted (TR), 125–26 strategy and implementation in, 283, 284–85, 322–23 undesignated, 126 subsidies in, 306–7 unrestricted (UR), 125–26 task force on, 289, 322 valuation of, 296–99 transparency in, 294–96, 295b values beyond economic value, 280 asset management strategy (document), 322–23 as wealth, 279–80 auctions, for land disposition, 317 asset management, 274–325 audit(s) action plan for, 289, 323 compliance, 141, 143 advanced, 320–22 definition of, 101 analytical accounting in, 282–84 delayed, 143 approaches in, 277–78 energy, 305 balance sheet as tool in, 310–11 financial, 141, 402. See also municipal finance challenges of, 287–89 self-assessment corruption potential in, 281 management or performance, 141–42 in developing countries, 283–84 municipal, 255–56 employee incentives for improvements in, 307 types of, 141–42 entities in charge of, 285–87, 287–89 urban. See urban audit expertise in, 320, 324n5 audit committee, 270 financial analysis in, 296, 301–7 audit conferences, 143–44 financial implications of, 296–310 auditing, 93–94, 141–44, 145 financial management and, 281, 282, 296 accounting and, 112, 120 financial planning in, 307–10 basic concepts and practices in, 141–42 financial principles and goals in, 293–94 budget, 98, 101 human (local) capacity for, 287 capacity shortage for, 143 importance of, 274–75, 446 in expenditure management, 222–23, 225, 255–56, improvement of, 287–96 269–70 Index 455 follow-up in, 143–44 metropolitan governance in, 68, 90 municipal practices in, 142–43 municipal development fund in, 363b objectives of, 141 performance-based grants in, 26 private sector or external, for municipalities, bank(s) 143, 144b bond, 354, 361, 361b audit opinions, 141–42, 145 development, 359–61 audit report, 141–42, 145 municipal, 339, 339b, 340 audit strategy, 144b bank credit (loans), 339–40 Australia bonds vs., 344–46, 345b, 359 betterment fees in, 314 guarantees for, 328, 347, 348, 352–54, 354b, 359 intergovernmental transfers in, 22 institutional resumption of, 360 local revenue in, 152, 153 local markets for, 327 metropolitan governance in, 51, 89 performance conditions for, 397 property taxes in, 152, 157, 159, 169 risk analysis for, 398, 399 Austria bankruptcy, 328, 329b, 347–48, 351, 376n3 debt regulation in, 349b Bann Mankong (Thailand), 375 local business taxes in, 172 baseline credit assessment, 399, 400b revenue sharing in, 18 bases, of accounting, 116–18 sales taxes in, 171 Beijing, China, special purpose vehicles in, 350 authority, revenue or tax, 153–55 Belgium autonomy local government borrowing in, 339b intergovernmental transfers and, 24, 25 local income tax in, 172 ratio analysis of, 428 municipal contracts in, 30 average accounting return, 257 belt, metropolitan, 42, 43, 45–46b average cost pricing, 177 benchmarking, 205b, 266–69 average growth rate, 198b basic idea of, 267 average incremental pricing, 177 bottom-up approach in, 267 budgetary, 394–95 B city satisfaction, 388–89 balanced budget, 216–18 decentralization and, 380–81, 394–95 balance sheet, 114–15, 123, 125–26, 145 difficulties in, 380–81 in fund accounting, 126, 130–31 finance self-assessment, 404, 427–30 logical frame of net assets in, 126, 127 municipal bond, 397 self-assessment of, 420 questions to address in, 267 as tool in asset management, 310–11 ratio analysis, 427–30 balance total, 217 top-down approach in, 267 Balkan countries. See also specific countries benefit principle, 150, 151, 211 performance measurement in, 391 benefit taxation, 147, 158, 173, 212n1, 212n3 balloon payment, 357 Benin Banco de Credito (Spain), 339b municipal contracts in, 30, 32, 32b Bangalore, India revenue mobilization strategy in, 208, 208b financial reporting in, 138b, 139 best practices, 266–69. See also benchmarking line-item budget of, 96 betterment levies, 148, 181–82, 314 property taxes in, 170 bidding, competitive Bangladesh in land disposition, 317 asset management in, 283–84 in procurement process, 243–48, 246b, 257, 445 auditing in, 143, 144b Bill and Melinda Gates Foundation, 374–75 456 Municipal Finances billing and collection performance-based grants in, 398 for local revenues, 183, 185–86, 189, 212n7 revenue intercepts in, 353 for property taxes, 169–71 sales taxes in, 171 Bio Carbon Fund, 368 targeted subsidies in, 210 blanket balance sheet subsidies, 237 tax authority in, 154 block grants, 14 urban concessions in, 373b BNG (Netherlands), 339b break-even analysis, 134–35 Bobo-Dioulasso, Burkina-Faso, street addressing “bridge to nowhere” (Alaska), 225b initiative in, 190 Budapest, Hungary Bogotá, Colombia local capacity of, 9 metropolitan governance in, 51, 74 metropolitan governance in, 72, 89 municipal bonds in, 341b budget(s) property taxes in, 159, 160–61b, 167, 169, 170 administrative, 95 public-private partnership in, 371–72 audits of, 98, 101 Bolivia balanced, 216–18 informal or exceptional borrowing practices capital, 97–98, 105–6, 229–32 in, 349 current or operating, 97, 418, 418b local expenditures in, 148 definition of, 94 local revenue in, 152, 153 economic, 95 municipal development fund in, 362 execution of, 98, 101, 107–8, 194–95, 204 participatory budgeting in, 401 expenditure side of, 105 waste management in, 368 fixed, 96 Bologna, Italy, metropolitan governance in, 65, 89 flexible, 96 bond banks, 354, 361, 361b formulation of, 98–99 bond financing. See municipal bonds functional, 96 bookkeeping, accounting vs., 109–10 good, principles of, 95b books of final entry, 113 as instruments of financial control, 95 books of original entry, 113 as instruments of planning, 94–95 book value, 297–98 legislative approval of, 100–101, 194–95, 203–4 Boost (expenditure-tracking tool), 400–401 line-item, 95, 96, 262–63 borrowing. See debt; external resources monitoring of, 108–9, 194–95, 204, 205b borrowing capacity, 330–31, 356–59 multiyear, 229–32, 260–62 Bosnia–Herzegovina, confederalism of, 8, 8b operating, 97 BOT. See build-operate-transfer (BOT) arrangements performance-based, 262–65, 394–95 Botswana, local revenue in, 151–52, 153 preparation of, 98–101, 104–6, 194–95 bottom-up approach, in benchmarking, 267 program, 96–97 Brazil. See also specific cities responsibility accounting, 134 budgeting in, 102, 103b revenue side of, 104–5 debt regulation in, 331, 347–48, 348b, 349b self-assessment of, 404, 406, 410–17. See also development bank/institution in, 360–61 municipal finance self-assessment informal or exceptional borrowing practices in, 349 standard structure of, 104 local business taxes in, 174 supplementary or revised, 100–101, 107, 233 local revenue in, 151–52, 153, 154, 155 total, 419b metropolitan governance in, 50, 64, 66b, 90 types of, 95–98 municipal bonds in, 341, 341b, 342 budget-actual variance analysis, 108–9 municipal development fund in, 362, 363b budgetary accounting, 111 participatory budgeting in, 102, 103b, 401, 402b budgetary reporting, 138–39 Index 457 budgetary units, 286 CAGR. See compound annual growth rate budget calendar, 99, 100 Cairo, Egypt budget circular, 99 sales of public land in, 182, 313 budget cycle, 98–101, 194–95 World Bank financing in, 365 budget database, 410–13 Caixa Economic Federal Brazil, 360–61 budgeting, 93–109, 144 California. See also specific cities and counties comprehensiveness of, 106–7 local insolvency in, 347, 352b concepts and practices in, 94–95 metropolitan governance in, 61, 62b, 88 definition of, 94 performance-based budgeting in, 264–65, entities in charge of, 99–100 264–65b expenditure planning in, 226–32, 227–28b, 260–65 revenue enhancement in, 192b feedback for, 269 utility surcharges in, 177, 178b financial information for, 93 CAM. See Comunidad Autonoma de Madrid improving process of, 99 Cambodia Urban Poor Development Fund, 375 incremental, 107 Cameroon, municipal contracts in, 30 issues, practices, and challenges in, 106–8 Canada. See also specific cities nonfinancial information for, 93 bond financing in, 339, 354, 361 participatory, 94–95, 101–4, 225, 401, 402b intergovernmental transfers in, 20, 22, 30 politicized, 107 land development corporations in, 321 process of, 98–101 local business taxes in, 174 purpose of, 98 local revenue in, 152, 153 realism in, 107 metropolitan governance in, 53, 58b, 65–69, 74–76, revenue, 194–204 75b, 88 weaknesses in execution, 107–8 municipal contracts in, 30 Buenos Aires, Argentina performance measurement in, 380, 381, 382–87, metropolitan governance in, 50 384b, 385b municipal bonds in, 342 property taxes in, 152, 157, 159, 169, 170 building inventory, 289, 290 water tariff in, 176b building licenses, 178–79 Cape Town, South Africa build-operate-transfer (BOT) arrangements, 320, 370 amalgamation of, 83, 89 Bulgaria budget of, 83, 85 EU-EBRD financing in, 365 local revenue in, 153 local revenue in, 153 metropolitan governance in, 83, 84, 84b, 89 municipal bonds in, 341b private services benefiting poor in, 371 Burkina Faso property tax assessment in, 168 expenditure management in, 401 sales of public land in, 182 hybrid financing in, 355, 356b Cape Verde, bank lending in, 360 municipal contracts in, 30 capital assets, 276. See also asset(s) street addressing initiatives in, 190 capital balance, 217 business entity principle, 112 capital budgets, 97–98, 105–6 business licenses, 178 logical flow of process, 106 business tax, local, 154b, 172–74, 173b ranking project proposals in, 106 capital expenditures, 97–98, 226, 410, 419b C management of, 229–32, 256–60 cadastre and tariff setting, 235–36 for asset inventory, 282, 291–92 capital grants, 327 for revenue collection (taxation), 160–61b, capital investment database, 410, 416 162–64, 191 capital investment financing, 180–83 458 Municipal Finances external resources for, 325–78, 446. See also bank Caracas, Venezuela, metropolitan governance in, credit (loans); debt; municipal bonds 51, 74 land-based revenues for, 181–83, 184 carbon credits/funds, 360, 365–68 metropolitan, 58–59, 60b cash balance and arrears, 410, 414, 420, 426–27 mobilization of, 326 cash-based accounting, 110, 117, 127 pay-as-you-go, 326–28 cash book, 121–22 pay-as-you-use, 326 cash flow, 300b ratio analysis of, 429 cash flow analysis. See also internal rate of return; self-assessment (MFSA) of, 410, 416, 420, 426 present value capital investment plan (CIP), 105–6, 229–32, 307–10, discounted, 303–5, 335–38 329–35 cash flow statement, 123, 145 assessing financial need and capacity in, 330–31 cash forecast, 253–54 bridging long-term vision to annual budget in, 309 cash management, 251–54, 253b citizen participation in, 334, 334b cash payments, 234 identification of needs and priorities in, 330, 333 cash transactions, 414 inclusion in city profile, 410 CBA. See cost-benefit analysis information required for, 333, 376n CCB. See citizens community board local complications from central planning in, 230 Central Asia. See also specific countries local financial capacity for, 230–32 centralization in, 9 preparation of, 330, 332–34 central city, in metropolitan area, 42 problems common in, 231–32 centralization public-private partnerships in, 230 arguments supporting, 8–10, 33 published document of, 330, 331 clawback to, 10 capital projects fulfillment of central functions in, 9 average accounting return of, 257 lack of local capacity and, 8–9, 33 cost-benefit analysis of, 257–59, 335–38, 337–38b legacy of, 9–10, 33 database and assessment of, 410, 416, 420, 426 macroeconomic record of, 12, 34 environmental impact of, 333 certified emissions reduction (CER), 367–68 evaluation of, 257–58 CFO. See chief financial officer internal rate of return in, 257–59, 335, 337–38b Chad, municipal contracts in, 30 lack of coordination on, 335, 335b change orders, 250 net present value of, 257–59, 335, 337–38b charitable donations, 181, 328, 374–75 payback rule for, 257 Charlotte, North Carolina, capital investment plan of, planning for. See capital investment plan (CIP) 330, 331, 332, 334 politics and, 335 chart of accounts, 113, 116 selection of, tools for, 335–38 Chicago, Illinois, leasing of municipal land in, 318 sensitivity analysis of, 259–60 chief financial officer (CFO), 99–100 capital projects funds, 126, 129b Chile capital revenue, 155–56, 180–83, 419b local borrowing prohibited in, 347 current revenue vs., 180 local business taxes in, 173b donations and public contributions, 181, 328, metropolitan governance in, 90 374–75 output-based transfers in, 20 external, 181 tariffs and subsidies in, 236 own-source, 180 tax authority in, 155 planning for, 196 China. See also specific cities public-private partnerships, 181 development promotion in, 182 transfers and grants, 180–81, 327 financing needs in, 326 capital subsidies, 239–40 fiscal data in, 26 Index 459 fiscal equalization in, 23, 24, 26 output-based transfers in, 20 land tax in, history of, 159b property taxes in, 159, 160–61b, 167, 169, 170 local borrowing prohibited in, 347 public-private partnership in, 371–72 metropolitan governance in, 48, 50, 61, 62, 64b, tax authority in, 154 85–87, 91 colonialism and centralization, 9 municipal bonds in, 341b commitments, financial, 110–11, 111b special purpose vehicles in, 350, 355, 360 communauté urbaine (UC), in France, 69–70 unitary system and decentralization in, 7 Communauté Urbaine of Marseille (CUM), 70 Chiniot City, Pakistan, management information communes system in, 250, 251 in Côte d’Ivoire, 77 CIP. See capital investment plan in France, 69 Circonscription Urbaine (Benin), 208b Community Development Carbon Fund, 368 citizens community funds, 375 accountability to, 400–402 Community-Led Infrastructure Financing, 375 financial reporting for/by, 138b, 139 Community Mortgage Program (Philippines), 375 information for. See transparency comparability, of financial reporting, 137 participation in budgeting process, 94–95, 101–4, comparison ratio, 430 401, 402b compensating errors, in accounting, 118 participation in capital investment planning, competitiveness of service provision, 388–89, 391–93 334, 334b competitive tendering (bidding) participation in performance measurement, in land disposition, 317 382–87, 384b, 388–89, 393–94, 400–402 in procurement process, 243–48, 246b, 257, 445 as users of financial reports, 136 completeness, of financial reporting, 137 citizens community board (CCB, Pakistan), 102 compliance audit, 141, 143 city council compound annual growth rate (CAGR), 198b asset responsibilities of, 285, 323 computer-aided, mass valuation systems (CAMA), budget approval by, 100–101, 194–95, 203–4 159–62, 162b, 168–69, 168b budget responsibilities of, 99, 285, 323 computerized accounting systems, 118–19, 145 capital planning responsibilities of, 332 Comunidad Autonoma de Madrid (CAM, Spain), 59, expenditure responsibilities of, 216 91n2 oversight by, 269–70 Conakry, Guinea, waste management in, 237, 238b city profile, 406–10 concessions, in public-private partnerships, city-region. See metropolitan areas 370, 373b city satisfaction indexes, 388–89 conditional nonmatching transfers, 15–16, 17 City to City (C2C) Dialogues, 403b conditional transfers, 14–17, 19–20, 26–32, 34–35 civic engagement, 400 confederations, 8, 8b Clean Development Mechanism, 366–67, 366–67b confirmatory value, of financial reporting, 136 closed-ended, matching transfers, 15–16 congestion (vehicle) taxes, 175, 211–12 COG. See council of governments construction permits, 178–79 Colombia contingent liability, 328 bank lending in, 360 contracting betterment fees in, 314 among local governments, 54, 60–61, 62b credit guarantees in, 354 in land disposition, 317 land-based revenues in, 182 in municipal enterprises, 311 local business taxes in, 173b in procurement process, 247, 248–50, 249b metropolitan governance in, 51, 74 in public-private partnerships, 248–49, 369–70 municipal bonds in, 341, 341b contract management, 248–50, 249b, 257 municipal development fund in, 362 contracts, municipal. See municipal contracts 460 Municipal Finances contributions, philanthropic and public, 325, 368–74 national initiatives on, 346, 346b, 348 conurbation, 42b performance measurement and, 382 Copenhagen, Denmark, water tariff in, 176b credit side (Cr), of T-account, 114 corridor, metropolitan, 42, 43, 45–46b creditworthiness, 328, 343–44, 398, 418, 428, 446 corruption Croatia asset management and, 281, 294–96, 323n1 asset management in, 284–85, 285b contract changes and, 250 balanced budgets vs. fiscal deficits in, 217–18 internal control environment and, 250–51, 252b local revenue in, 152, 153 public-private partnerships and, 371 subsidies in, 234, 235b cost(s) cross-subsidies, 210, 236, 237 break-even analysis of, 134–35 Cuba, water tariff in, 176b controllable, 133–34 CUM. See Communauté Urbaine of Marseille fixed, 134 current balance, 217 life-cycle, 307–8, 309, 310 current budget, 97, 418, 418b uncontrollable, 133 current deficits, 217–18 variable, 134 current expenditures, 97–98, 226–29, 410, 419b cost accounting, 110, 132–35, 145 current revenue, 155–56, 179–80, 419b activity-based, 133 Czech Republic basic techniques of, 133 debt regulation in, 349b for service delivery, 132–33, 209 EU-EBRD financing in, 365 cost-benefit analysis, 257–59, 335–38, 337–38b intergovernmental transfers in, 152 cost centers, 207 local revenue in, 152, 153 cost efficiency, monitoring of, 204, 205b metropolitan governance in, 89 cost management, 132–35 municipal development fund in, 362 cost-plus pricing, 234–35 property taxes in, 164 cost pools, 133 cost principle, 113 D cost recovery, user charges for, 175–77, 231, 236 Dakar, Senegal, expenditure management in, 401 cost sharing, in metropolitan finance, 49, 52b, 53–57 Dana Alokasi Khusus (DAK, Indonesia), 23–24 Côte d’Ivoire Dana Alokasi Ummum (DAU, Indonesia), 23 local business tax (patente) in, 173b Dar es Salaam, Tanzania metropolitan governance in, 77, 78b, 88 growth of, 48 municipal contracts in, 30 informal settlements in, 91n1 council. See city council metropolitan governance in, 72, 73–74b, 89 council of governments (COG), 51, 55, 63–67 public-private partnerships in, 248–49, 373, 373b coupon, bond, 340 data, fiscal credit(s), 114 actual, in budget database, 410 Credit Communal (Belgium), 339b central government collection and dissemination credit enhancement, 352–54, 359 of, 396 creditor in fiscal equalization transfers, 25–26 in accounting, 114–15 open, for open government, 400–402 in bond issue, 340 in performance-based programs, 28–29, as user of financial reports, 135–36 391–93, 396 credit ratings, 343–44, 343b, 398–400, 446 databases agencies determining, 343–44, 347, 398–99, 400b for municipal finance self-assessment, 410–17 baseline assessments for, 399, 400b for revenue collection, 207 cost of obtaining, 343, 346 for user charge assessment, 185 in emerging economies, 343, 343b DAU. See Dana Alokasi Ummum Index 461 Dayton–Paris Agreement of 1995, 8b accounting effects of, 127 DCA. See Development Credit Authority budgeting impact of, 106–8 debit(s), 114 centralization arguments vs., 8–10 debit side (Dr), of T-account, 114 cycles and reversals in, 10 Debrecen Holding (Hungary), 312 deconcentration in, 5–6, 6b, 33 debt. See also bank credit (loans); municipal bonds delegation in, 5, 6–7, 33 amortization of, 350 devolution in, 5, 6, 33 in capital investment financing, 58–59, 181 economic efficiency in, 6, 10–11, 12, 33 conditions for incurring, 328–29 economic growth in, 12, 34 default on and bankruptcy, 328, 329b, 347–48, fiscal, 2–7, 33. See also fiscal decentralization 351–54, 352b, 376n3 fulfillment of central functions in, 9 deferred payments on, 349–50 globalization link to, 1, 10, 33 existing, 330 and infrastructure financing, 325 financial feasibility and, 328, 329 and intergovernmental relations, 443–44 in fiscal decentralization, 2, 5, 12 intergovernmental transfers in, 2, 5, 12, 13–32, 34. foreign currency, 357–58, 358b See also intergovernmental transfers guarantees for, 328, 347–48, 352–54, 354b, 359 legacy of centralization vs., 9–10 institutional aid and support for, 359–65 lessons and results of, 12–13, 34 local capacity for, 330–31, 356–57 local capacity for, 8–9, 25, 33 log frame for, 359 local expenditure impact of, 218–19 management of. See debt management local revenue impact of, 148–49 medium long term (MLT) vs. short term, 414–15 macroeconomic stability in, 12 in metropolitan finance, 58–59 matching principle in, 11 need for, assessing, 330–31 nation building in, 11–12, 11b, 33, 34 new instruments for, 360 in Nepal, 3b pooling of, 354, 361–64, 361b performance measurement in, 380–81, 390, 394–95 ratio analysis of, 428 in Poland, 4b regulation of. See debt regulation political, 1, 33 self-assessment (MFSA) of, 410, 414–15, 420, 425 public sector size in, 12 special purpose vehicles for, 350, 354–55, “reaction from below” and, 2, 10, 33 355b, 360 revenue mobilization efforts in, 208, 208b debt crises, 347–52 subsidiary principle in, 2–4, 11 debt limit, 348 three D’s of, 5–7, 33 debt management, 355–64 top-down process of, 2 borrowing capacity in, 330–31, 355–59 trend to, factors in, 10–12, 33 comparing alternatives in, 357, 359 in unitary systems, 7 objective and processes in, 357 welfare gains in, 6, 10–11, 33 strategies for, 357–59 Decentralization Act of 1981–82 (Nepal), 3b debt managers, checklist for, 350–52 Decentralized City Management Program (Benin), debtor 208b in accounting, 114–15 decision-making, management, 132–35 in bond issue, 340 deconcentration, 5–6, 6b, 33 debt regulation, 331, 347–52, 348b, 349b deferred maintenance, 305–6 debt service, 348, 350, 351, 419b deferred payment, 349–50 debt service flow, 331 deficit(s) debt service fund, 126, 128b, 350, 357 balanced budget vs., 216–18 debt stock, 331, 348, 350, 356–57 budgetary weaknesses and, 107–8 decentralization, 1–39 deficit grants, 25 462 Municipal Finances delayed audits, 143 development plan, 314–15 delegated expenditures, 411 development revenue. See capital revenue delegation, 5, 6–7, 33 development rights, 313 Delhi, India devolution, 5, 6, 33 Delhi Development Authority in, 68, 69, 90, 321 Dexia Credit Local (France), 339b, 340 metropolitan area of, 68, 90 DFBOT. See Design-Finance-Build-Operate-Transfer municipal council of New Delhi in, 371 Dhaka, Bangladesh, asset management in, 283–84 tariffs and subsidies in, 236, 241b Dhaka Capital Development Authority (Bangladesh), Deltametropool (Netherlands), 82 68, 90 demand-side subsidies, 240 directory of public properties, 323 democratic dissemination, 393–94 discipline, fiscal, 215–16, 220, 254. See also demography, in city profile, 407–9 expenditure management Demszky, Gabor, 9 disclaimer, for audit opinion, 142 Denmark discounted cash flow analysis, 303–5 bond bank in, 361 discount rate, 258, 299, 336–38, 337–38b, 376n2 debt regulation in, 349b discretionary properties (assets), 292–93, 314–15 local expenditures in, 148, 218 District Development Committee Act of 1991 local income tax in, 172 (Nepal), 3b local revenue in, 153 divestiture, 370 water tariff in, 176b donations, 181, 328, 374–75 departments. See also specific departments donor-funded projects, expenditure management asset management in, 285–86 for, 229 capital planning in, 333 double-entry accounting, 110, 114–16, 127, 144–45 dependency syndrome, 25 Dubai, land development corporations in, 321 depreciation, 308 Dulles Corridor Metrorail project, 59, 60b derivation principle, in revenue sharing, 18–19 Durham, Canada, performance measurement in, 386 designated assets, 126 Design-Finance-Build-Operate-Transfer (DFBOT), 320 E developing countries. See also specific countries earmarked transfers, 14–17, 34. See also conditional accounting in, 110, 126–32 transfers asset management in, 283–84 East Asia. See also specific countries expenditure management in, 232 bond financing in, 341, 341b local expenditures in, 218 fiscal equalization in, 23 local government borrowing in, 339–40 metropolitan governance in, 50, 90 local insolvency in, 351–52 Eastern Europe. See also specific countries local revenue in, 151–52 ISO certification in, 268b municipal bonds in, 341, 341b macroeconomic record in, 12 performance measurement in, 380, 390–93 revenue sharing in, 19b property taxes in, 159–62, 160–61b, 164–65 school consolidations in, 223 user charges (tariffs) in, 234, 236–37, 237b EBRD. See European Bank for Reconstruction and Development Bank of Southern Africa, 360 Development development banks, 359–61 economic budgets, 95 development charges, 148, 179, 314 economic densities, urbanization and, 47–48 Development Credit Authority (DCA), 354 economic development development exactions, 314 assets as resource for, 280 development funds, 59, 359, 361–64, 363b. See also charges or fees on, 148, 179, 314 municipal development funds municipal or metropolitan fund for, 59, 359, development impact fees, 179, 314 361–64, 363b Index 463 public-private partnerships for, 182. See also enterprise funds, 129b, 139 public-private partnerships entries, accounting, 113 spatial plans for, 314–15 environmental impact, of projects, 333 economic efficiency environmental loans and credits, 365–68 in decentralization, 6, 10–11, 12, 33 EOIs. See expressions of interest in metropolitan governance, 49 e-procurement, 248 economic growth equalization, fiscal, 22–24, 25–26, 397 decentralization and, 12, 34 equity urbanization/megacities and, 47–48 in accounting equation, 114, 125 economies of scale, in metropolitan finance, 49, 53, in procurement, 247 58, 62, 87 Essen, Germany, water tariff in, 176b economy, in city profile, 407–9 Estonia, EU-EBRD financing in, 365 Ecuador ethics. See also accountability; transparency local business taxes in, 173b and procurement, 248 metropolitan governance in, 50–51, 74, 90 Ethiopia education financial accountability assessment in, 255, 260 expenditure management in, 223, 224 inventorying of assets in, 292 output-based transfers for, 20 public-private partnerships in, 374 as private vs. public good, 150 Europe. See also specific countries property taxes for, 170 citizen satisfaction surveys in, 388–89 effective gross income, 300b debt regulation in, 348 effectiveness, as performance dimension, 379–80 EU-EBRD financing in, 364–65 efficiency financial holding in, 312 in municipal finance self-assessment, 404 local expenditures in, 218 in performance measurement, 379–80 local government borrowing in, 339, 339b, 340 Egypt. See also Cairo, Egypt metropolitan governance in, 50, 89 deconcentration in, 6b municipal bonds in, 341, 341b electronic databases, for revenue collection, 207 municipal contracts in, 30 emerging economies performance measurement in, 381, 387–89, 439n4 credit guarantees in, 354 priority-setting by municipal councils in, 387, credit ratings in, 343, 343b 439n5 external resources for, 325 property tax assessment in, 167 green financing in, 360 European Bank for Reconstruction and Development local government borrowing in, 339–40 (EBRD), 364, 365 employees existing debt, 330 incentives for, 307 expenditure(s) as users of financial reports, 136 administrative, 233 encumbrances (commitments), financial, 110–11, 111b authority to incur, 233 energy audits, 305 capital. See capital expenditures energy-efficiency loans and credits, 360, 365–68, control of, 222 366–67b current, 97–98, 226–29, 410, 419b enforcement decentralization and, 218–19 good practices in, 187–88 management of. See expenditure management in local revenue collection, 183, 185–88, 209 mandatory (delegated), 411 in property tax collection, 169–71, 212n4 miscellaneous, 226–29 enhancement programs, for local revenue, 191–94, mismatch with policy, 225, 226b 192b, 193b, 202 own, 226 enhancements, credit, 352–54, 359 projections of, 431–34 464 Municipal Finances as share of total public expenditures, 148 expenditure side, of municipal budget, 105, 404, expenditure assignment, 2–4, 12, 13–14. See also inter- 410–13 governmental transfers expressions of interest (EOIs), 244 expenditure management, 215–74, 445 extended urban region. See metropolitan areas accountability in, 224–25, 232–33, 254–55, external resources, 325–78, 446. See also bank credit 400–401 (loans); municipal bonds accounting in, 222, 250, 251 combination of, choosing, 331–32 auditing in, 222–23, 225, 255–56, 269–70 conditions for obtaining, 328–29 balanced budget vs. fiscal deficit in, 216–18 credit enhancement for, 352–54, 359 battle between finance and line departments in, definition of, 325 219–20 energy-efficiency (green), 360, 366–67b benchmarking in, 266–69 feasibility studies on, 329 big picture issues and challenges in, 216–17 guarantees for, 328, 347–48, 352–54, 354b, 359 budgetary controls in, 232–34 institutional aid and support for, 359–65 budget plans for, 226–32, 227–28b, 260–65 intermediaries for, 349, 359–60 capital, 229–32, 256–60 key steps in securing, 376 cash management in, 251–54 local credit and capital markets for, 327 concept and principles of, 215–16 local government success and experience with, cycle of, 221–24, 445 339–40, 339b definition of, 216 mobilization of, need for, 326 in developing countries, 232 municipal development funds of, 59, 359, donor-funded projects in, 229 361–64, 363b effective system of, 220–21 need and capacity for, assessing, 330–31 entities involved in, 216 new instruments for, 360 feedback from, 269 philanthropic and public contributions for, 181, financial constraints and alternatives in, 224–25 328, 374–75 improvement or reform of, 222b pooling arrangements for, 354, 361–64, 361b internal control environment for, 250–51, 252b private sector, 325, 327–28, 368–74. See also medium-term or multiyear, 229–32, 260–62 public-private partnerships monitoring and evaluation in, 220, 222–23, 225, special purpose vehicles for, 350, 354–55, 265–69 355b, 360 oversight in, 269–70 types of, 325 payment systems in, 233–34 performance-based budgets in, 262–65 F performance measurement in, 254–56, 380 Fairfax County, Virginia planning in, 221–22 education funding in, 170 policy setting in, 221, 223–24 expenditure management in, 225–26 politics and, 224, 225b, 270–72 transparency in, 233, 270 pressure from central government and, 271–72 utility surcharges in, 177, 178b procurement and expenditure tracking in, 242–50 faithful representation, in financial reporting, 136–37 resource allocation in, 222, 223b FASB. See Financial Accounting Standards Board self-assessment in, 404, 410–13, 420, 423–25 feasibility studies, 329, 372, 372b service cost comparisons in, 266, 269 federal systems, 7–8 systems for, 250–56 fee(s), 157, 178–79. See also user charges tools in, 216 feedback, in performance measurement, 401 transparency in, 224–25, 232–33, 251, 269–70 fee simple, 324n4 user charges (tariffs) and subsidies in, 231, 234–42 fiduciary funds, 129b, 139 variance analysis in, 265–66, 269 Fifth Urban Project (Ghana), 207b Index 465 final accounts, 113, 115, 119–20 potential users of reports, 135–36 finance department relevance of, 136 battle with line departments, 219–20 timeliness of, 136 political pressures on, 270–72 transparency and accountability in, 138b, 139 role in asset management, 285–86 understandability of, 137 role in capital planning, 330 verifiability of, 137 role in expenditure management, 216 financial statements, 123–26. See also specific types role in tariff analysis and setting, 235, 242 financing. See also specific debt and financing “finance follows function,” 4, 17, 148 instruments finance ratios, in performance measurement, 394 energy-efficiency (green), 360, 366–67b financial accounting, 110 external resources for, 325–78 Financial Accounting Foundation, 382 guarantees for, 328, 347, 348, 352–54, 359 Financial Accounting Standards Board (FASB), 112, hybrid, 355, 356b 136–38 institutional aid and support for, 359–65 financial assets, 276 intermediaries in, 349, 359–60 financial audit, 141. See also municipal finance key steps in securing, 376 self-assessment land-based revenues for, 181–83, 184, 312–14 financial crisis/stress, coping with, 192b, 212 local credit and capital markets for, 327 Financial Institutions Reform and Expansion Project metropolitan, 58–59, 60b (USAID), 364 mobilization of, need for, 326 financial management, 444–45. See also expenditure municipal development funds for, 59, 359, management; municipal financial management 361–64, 363b checklist for, 438–39 new instruments for, 360 performance measurement of, 385 pay-as-you-go, 326–28 self-assessment (MFSA) of, 435–37 pay-as-you-use, 326 financial performance measures. See performance philanthropic and public contributions for, 181, measurement 328, 374–75 financial position, 420. See also balance sheet pooling arrangements for, 354, 361–64, 361b financial projections, 330, 404, 406, 431–34 private sector participation in, 325, 327–28, Financial Recovery Action Plan (FRAP, Kampala), 368–74. See also public-private 192b, 193 partnerships financial reporting, 93–94, 135–41, 145. See also special purpose vehicles for, 350, 354–55, 355b, financial statements 360 benefits and costs of, 137–38 FINDETER (Colombia), 354, 360 budgetary, 138–39 fines, revenue from, 179 to central government, 394–96 Finland comparability of, 137 local income tax in, 172 completeness of, 137 local revenue in, 153 concepts and practice of, 135–36 fiscal decentralization, 2–7, 33 faithful representation in, 136–37 borrowing and debt in, 2, 5, 12 formats for, 139–41 deconcentration in, 5–6, 6b, 33 GASB requirements for, 139–40 definition of, 2 good, characteristics of, 136–38 delegation in, 5, 6–7, 33 good practice examples of, 139–40, 140b devolution in, 5, 6, 33 management/internal, 138 economic efficiency in, 6, 10–11, 12, 33 materiality of, 137 economic growth in, 12, 34 neutrality of, 137 expenditure assignment in, 2–4, 12, 13–14 performance reporting and, 139, 140–41 horizontal imbalance in, 5, 13 466 Municipal Finances intergovernmental transfers in, 2, 5, 12, 13–32, 34. fund(s) See also intergovernmental transfers agency, 129b, 139 lessons and results of, 12–13 capital projects, 126, 129b macroeconomic stability in, 12 debt service, 126, 128b, 350, 357 matching principle in, 11 definition of, 126 public sector size in, 12 enterprise, 129b, 139 questions to address in, 2–5, 33 fiduciary, 129b, 139 revenue assignment in, 2, 4–5, 12, 13–14 general, 126, 128b subsidiary principle in, 2–4, 11 internal service, 129b three D’s of, 5–7, 33 pension, 139 vertical imbalance in, 5, 13 permanent, 129b welfare gains in, 6, 10–11, 33 proprietary, 129b fiscal discipline, 215–16, 220, 254. See also expendi- special revenue, 126, 128b, 139 ture management trust, 129b, 139 fiscal equalization, 22–24, 25–26, 397 fund accounting, 126, 128–29b, 130–31, 145, 207 Fiscal Responsibility Law of 2000 (Brazil), 348, 348b balance sheet in, 126, 130–31 Fitch Ratings, 343–44, 346, 398–99 financial statements in, 139 fixed assets, 129–32, 276 future directions, in municipal finance, 443–47 fixed budgets, 96 fixed costs, 134 G flexible budgets, 96 GAAP. See Generally Accepted Accounting flow-based business tax, 172–73 Principles flow ratio, 430 GASB. See Governmental Accounting Standards Ford Foundation, 400 Board forecasts GDP. See gross domestic product cash, 253–54 general benefit principle, 150, 151 revenue, 196–202 general consumption taxes, 171–72. See also sales foreign currency borrowing, 357–58, 358b taxes foreign loans, prohibition of, 348 general fund, 126, 128b formulas, for intergovernmental transfers, 20–22, 21b general ledgers, 120–21 France. See also specific cities Generally Accepted Accounting Principles (GAAP), debt regulation in, 349b 125–26 financing needs in, 326 general obligation bonds, 339b, 342, 342b local business taxes in, 172 general purpose (unconditional) transfers, 14, 15–16, local government borrowing in, 339b, 340 34 local revenue in, 153 geographic information systems (GIS), 289 metropolitan governance in, 48, 50, 57b, 69–70, 89 Georgia (country) municipal contracts in, 30 development fund in, 59 performance measurement in, 381, 387–89, 395, municipal development fund in, 362 397, 439n4 Tbilisi metropolitan area in, 43, 45–46b, 90 property taxes in, 164 Germany tax authority in, 154 debt regulation in, 349b FRAP. See Financial Recovery Action Plan development rights in, 313 free ridership, 49b, 185, 185b financial holding (stadtwerke) in, 312 Fremont, California, revenue enhancement program intergovernmental transfers in, 14, 18, 22, 30 in, 192b local business taxes in, 172, 174 fuel taxes, 174 local government borrowing in, 340 functional budgets, 96 local revenue in, 153 Index 467 metropolitan governance in, 79, 90 street addressing and waste management in, 237, municipal contracts in, 30 238b revenue sharing in, 18 GVRD. See Greater Vancouver Regional District tax authority in, 154 water tariff in, 176b H Ghana The Hague, Netherlands, metropolitan governance citizen reporting in, 139 in, 82, 90 municipal contracts in, 32b Hanoi, Vietnam, public-private partnership in, 371–72 property tax reform in, 207b Harrisburg, Pennsylvania, bankruptcy of, 328, 329b, GIS. See geographic information systems 347, 351, 353–54 GLA. See Greater London Authority Havana, Cuba, water tariff in, 176b Glasgow, Scotland, water tariff in, 176b hay (district), in Egypt, 6b globalization, 1, 10, 33 hedonic price, 168 gmina (municipality), in Poland, 4b historical analysis, in municipal finance self-assess- going concern principle, 113 ment, 406, 419–27 golden reserve, of land, 316 holding, for municipal enterprises, 312 good disposition procedures, 317 Hong Kong, China governance systems, 7–8 land leasing in, 319 Governmental Accounting Standards Board (GASB), municipal company in, 287 112, 139–41, 382 Honolulu, Hawaii, water tariff in, 176b governorate, in Egypt, 6b horizontal imbalance, 5, 13, 33 Grand Lyon, France, 69–70 housing assistance, 375 grants. See also intergovernmental transfers human resource management, performance measures capital revenue from, 180–81, 327 in, 385 general purpose (unconditional), 14, 15–16 Hungary performance-based, 19–20, 26–32, 34–35, 382, bankruptcy in, 376n3 397–98, 439n1 centralization in, 9 specific purpose (conditional), 14–17 EU-EBRD financing in, 365 Greater London Authority (GLA), 67–68, 76, 76b, 82 expenditure assignment in, 14 Greater Vancouver Regional District (GVRD), 68–69, financial holding in, 312 88 local business taxes in, 172, 173b, 174 Greece, debt crisis in, 349–50 local capacity in, 9 green financing, 360, 365–68, 366–67b metropolitan governance in, 72, 89 gross domestic product (GDP) municipal insolvency in, 351, 376n3 per capita, decentralization and, 12 public vs. private domain in, 277b property tax as percentage of, 159 revenue sharing in, 18–19 ratios of local financial performance to, 427 targeted subsidies in, 238 gross potential income, 300b hurdle rate. See discount rate gross receipts tax, 171 hybrid financing, 355, 356b gross self-financing or savings. See operating surplus growth rates, for revenue forecasting, 197, 198b I guarantees, 328, 347–48, 352–54, 354b, 359 IASB. See International Accounting Standards Board Guatemala IBRD. See International Bank for Reconstruction and local revenue in, 157 Development participatory budgeting in, 401 IBT. See increasing block tariff Guinea IDA. See International Development Association municipal contracts in, 30 IEG. See Internal Evaluation Group policy–expenditure mismatch in, 226b IFAC. See International Federation of Accountants 468 Municipal Finances IFMIS. See integrated financial information systems state finance commissions (SFCs) in, 22 impact analysis tariffs and subsidies in, 236, 241b of multiyear budgets, 261 Indonesia of municipal revenue policy, 209–11 financing needs in, 326 impact fees, 179, 314 fiscal data in, 26 imposto sobre servicos (ISS, Brazil), 171 fiscal equalization in, 23–24, 26 incentives public-private partnerships in, 374 employee, for savings ideas, 307 revenue sharing in, 19 in intergovernmental transfers, 25 unitary system and decentralization in, 7 in local revenue collection, 189 infrastructure. See also capital projects in metropolitan governance, 50 asset inventory of, 291–92 income, net operating, 302 external resources for, 325–78. See also bank credit income capitalization, 298, 298b (loans); debt; municipal bonds income capitalization triangle, 302 identifying needs and priorities in, 330, 333 income distribution, municipal revenue policy and, infrastructure and services programming inventory 209 (IPIE), 291b income-generating properties, 293–94 infrastructure (development) charges and fees, 148, indicators for investment comparison of, 301–5 179, 314 operating statements for, 299–301, 300b, 303 Infrastructure Development Finance Company qualifications of local governments to own, 301b (India), 360 income statement. See operating statements; Infrastructure Finance Corporation (South Africa), statement of receipts and payments 361, 363b income tax, corporate, 172–74 Infrastructure Guarantee Fund (Republic of Korea), income tax, personal, 154b, 172 354, 359 increasing block tariff (IBT), 176b Initial Asset Management Model, 285, 285b incremental budgeting, 107 input-based transfers, 14 indebtedness database, 410, 414–15 institutional organization, in city profile, 407–8 India. See also specific cities intangible assets, 276 budgeting in, 96, 98, 102b integrated financial information systems development bank/company in, 360 (IFMIS), 113 development fund in, 59 Inter-American Development Bank, 362, 364, 365 development rights in, 313 interest, bond, 340 energy/environmental programs in, 367, 368 interest groups, pressure from, 270–71, 271b financial holding in, 312 intergovernmental finance financial reporting in, 138b, 139 decentralization and, 1–39. See also fiscal data in, 29 decentralization intergovernmental transfers in, 22, 26, 29 globalization and, 1, 10, 33 land development corporations in, 321 macroeconomic stability in, 12 local revenue in, 153 overview of, 1–13 metropolitan governance in, 50, 68, 69, 90 summary table of, 420 municipal bonds in, 341b, 342, 361, 361b, 364 transfers in, 2, 5, 12, 13–32. See also municipal companies in, 287 intergovernmental transfers municipal development funds in, 362–64, 363b unfunded mandate in, 7, 271–72 performance-based grants in, 26, 29 intergovernmental relations, 443–44 pooled financial resources in, 361, 361b intergovernmental transfers, 2, 5, 12, 13–32, 34 private services benefiting poor in, 371 accountability in, 25 property taxes in, 169, 170 ad hoc, 29 special purpose vehicles in, 354, 355b, 360 budgetary impact of, 106–8 Index 469 capital revenue from, 180–81 International Public Sector Accounting Standards commissions, committees, or forums for, 22 (IPSAS), 112 data considerations in, 25–26, 28–29 inventory of assets, 282, 283, 289–92 design of, 20–22, 24–26, 34 investment(s) detrimental or ill-designed, 25 capital. See capital investment financing; capital fiscal equalization in, 22–24, 25–26, 397 investment plan; capital projects forecasting revenue from, 201–2 indicators for comparison of, 301–5 formulas for, 20–22, 21b investment development banks, 359 general purpose (unconditional), 14, 15–16, 34 investment trusts, 129b good practices in, 443–44 investors, as users of financial reports, 135–36 guidelines for, 24–25 IPIE. See infrastructure and services programming input-based, 14 inventory institutional settings of, 20–22 IPSAS. See International Public Sector Accounting local reliance on, 150–53, 423 Standards macroeconomic stability from, 12 Ireland matching provisions in, 14–17, 34 debt regulation in, 349b municipal contracts for, 29–32, 35 property taxes in, 159 natural resource sharing and, 29 water tariff in, 176b output-based (performance-based), 14, 19–20, IRR. See internal rate of return 26–32, 34–35 ISO. See International Organization for performance-based, 396–98 Standardization persistent inequalities in, 24 Istanbul, Turkey results-based chain in, 19–20 amalgamation of, 83, 91 self-assessment of, 420, 423 sales of public property in, 182, 313 source of (transfer pool), 14 Italy specific purpose (conditional), 14–17, 34 congestion (vehicle) taxes in, 175, 211–12 subnational autonomy in, 24, 25 debt regulation in, 349b tax sharing in, 17–19, 34 local business taxes in, 172 transparency in, 24 metropolitan governance in, 50, 65, 89 types of, 14–20, 17b unforeseen events and, 29 J intermediaries, financial, 349, 359–60 Jamii Bora Trust Low-Cost Housing Scheme (Kenya), internal control environment, 250–51, 252b 375 Internal Evaluation Group (IEG), 32, 32b Japan internal rate of return (IRR), 257–59, 304–5, 335, data on local public finance in, 396 337, 337b local business taxes in, 174 internal reporting, 138 metropolitan governance in, 50 internal service funds, 129b municipal bonds in, 341b International Accounting Standards Board Jefferson County, Alabama, bankruptcy of, 351, (IASB), 112 352b, 354 International Bank for Reconstruction and Jhelum, Pakistan, budget of, 217 Development (IBRD), 364–65, 364b job order cost accounting, 133 International Development Association (IDA), Johannesburg, South Africa 364–65, 364b leasing of municipal land in, 318 International Federation of Accountants (IFAC), 112 metropolitan governance of, 84, 86b, 89 International Financial Reporting Standards, 112 multiyear budget of, 229, 230 International Organization for Standardization (ISO), municipal bonds in, 341b, 342, 342b, 400 268, 268b, 305 transparency in, 233 470 Municipal Finances joint ventures, 370. See also public-private partnerships Kosovo Jordan expenditure management in, 401 expenditure assignment in, 13–14 property tax assessment in, 168–69 fines and penalties in, revenue from, 179 Kummunivest (Netherlands), 361 intergovernmental transfers in, 22 Kuwait City, Kuwait, management of land assets of, land-based revenues in, 181 313, 318, 319 local expenditures in, 218 Kyrgyzstan municipal development fund in, 362 asset management in, 284, 295b tax authority in, 154–55 public contributions in, 375 waste management in, 368 journals, 113, 115, 120–21 L judgmental forecasting, 203b labor market, of metropolitan areas, 41–42 Lagos, Nigeria K growth of, 48 Kabul, Afghanistan, informal settlements in, 91n1 municipal bonds in, 400 Kampala, Uganda Lahore, Pakistan Financial Recovery Action Plan in, 192b, 193 environmental (composting) project in, 366–67, informal settlements in, 91n1 366–67b political pressure and expenditures in, 272 expenditure budget of, 226 tax authority in, 155 informal settlements of, 46 Karachi, Pakistan land corporation in, 321–22 asset management in, 283–84 public-private partnership in, 371–72 water tariff in, 176b tariffs and subsidies in, 237 Karnataka, India Lahore Development Authority, 321–22 energy-efficiency efforts in, 368 land assets, 312–22 special purpose vehicle in, 360 classification of, 314–15, 316 Kathmandu, Nepal, asset management in, 287, 288b enhancing value of, 315–17 Katowice, Poland, asset management in, 293 funding from. See land-based revenues Kenya golden reserve of, 316 community fund in, 375 good disposition procedures and contracts expenditure management in, 401 for, 317 local business taxes in, 173b, 174 inventory of, 291–92 local revenue in, 153 leasing or privatizing, 318–20 metropolitan governance in, 81–82, 89 management and administration of, 314–18 property taxes in, 170 percent needed for public use, 314 revenue mobilization strategy in, 205, 206b prepared site vs. “raw” land, 315 tax authority in, 154 real estate brokers for disposition of, 318 Kerala, India risks and costs associated with, reducing, 317 fiscal data in, 29 sale of, 181–83, 211, 312–13, 319–20 intergovernmental transfers in, 22, 26, 29 valuation of, 296–99, 323n2 participatory budgeting in, 102b land-based revenues, 181–83, 211 Kigali, Rwanda, municipal bonds in, 341b instruments for, 184, 312–14 Kommunalbanken (Denmark), 361 speculation reduction via, 183b Korea, Republic of valorization for, 181–82, 182b guarantee fund in, 354, 359 land-based taxes. See property taxes land development corporations in, 321 land cadastre. See cadastre metropolitan governance in, 50 land dedication, 314 municipal bonds in, 341b land development corporations, 321–22 Index 471 land development fees, 179, 314 role in asset management, 286 land speculation, 183b, 321 role in expenditure management, 216 land use planning and control, 313, 315, 316–17 line-item budgets, 95, 96, 262–63 land value-capture tax, 148, 181, 183b Lithuania, EU-EBRD financing in, 365 land value increment tax, 182 Ljubljana, Slovenia, water tariff in, 176b Latin America. See also specific countries loans. See bank credit (loans) land-based revenues in, 181–82 local assets. See asset(s); asset management local business taxes in, 173b local capacity metropolitan governance in, 50–51 borrowing, 330–31, 356–59 municipal bonds in, 341, 341b for capital investment planning, 230–32 participatory budgeting in, 102, 103b, 401, 402b development of, 9, 25 property tax assessment in, 167 lack of, and centralization, 8–9, 33 public-private partnerships in, 371, 372b, 373 for own-source revenue, 162, 188–89, 189b Latvia local credit markets, 327 EU-EBRD financing in, 365 local expenditures. See expenditure(s); expenditure municipal development fund in, 362 management LDA. See London Development Agency Local Governance Law of 1990 (Poland), 4b leapfrog development, 183b Local Government Development Project (Ghana), leases, in public-private partnerships, 370 207b leasing, of municipal land, 318–20 localization, 1. See also decentralization arguments for and benefits of, 318 local revenue. See revenue, local costs and risks of, 319 Local Self-Governance Act of 1999 (LSGA, Nepal), 3b policy implication of, 319–20 Lomé, Togo, street addressing initiative in, 190 ledgers, 113, 115, 120–22 London, United Kingdom cash book, 121–22 congestion (vehicle) taxes in, 175, 211–12 trial balance and, 124, 125 cost-efficiency program in, 204, 205b legal department, role in asset management, 286 metropolitan governance in, 48, 53, 67–68, 76, 76b, legislature 82, 89 asset responsibilities of, 285, 323 London Development Agency (LDA), 67–68, 76b budget approval by, 100–101, 194–95, 203–4 Los Angeles, California budget responsibilities of, 99, 285, 323 assets as wealth of, 280 capital planning responsibilities of, 332 energy-efficiency efforts in, 366 expenditure responsibilities of, 216 metropolitan governance in, 61, 62b, 88 oversight by, 269–70 lowest evaluated bidder, 244, 247 liabilities LSGA. See Local Self-Governance Act of 1999 in accounting equation, 114, 125 Lucerne, Switzerland, financial accountability assess- associated with assets, 280 ment in, 255 license fees, 178–79 Luxembourg, local business taxes in, 172 life-cycle asset management, 278, 279 Lyon, France life-cycle costing, 307–8, 309, 310 metropolitan finance in, 57b Lilongwe, Malawi, growth of, 48 metropolitan governance in, 69–70, 89 Lima, Peru development rights in, 313 M revenue sharing in, 18 Madagascar, municipal contracts in, 30 linear trend growth rate, 198b Madrid, Spain line departments local revenue in, 153 battle with finance department, 219–20 metropolitan finance in, 59, 91n2 budgetary responsibilities of, 99 Madurai Municipal Corporation (India), 342 472 Municipal Finances maintenance, deferred, 305–6 Mauritania, municipal contracts in, 30 maintenance and operations plan (MAP), 31b Mauritius, local revenue in, 153 maintenance and repair (M&R) costs, 308–10 mayor maintenance costs, 129–32, 420, 424–25 asset responsibilities of, 285, 322 maintenance pool fund, 133 budgetary responsibilities of, 99 Malawi, urbanization and economic growth in, 48 capital planning responsibilities of, 332 Malaysia, municipal bonds in, 341b expenditure responsibilities of, 216 Mali MCPM. See Minimum Conditions Performance municipal contracts in, 30, 256, 256b Measurement property taxes in, 190 MD&A. See management discussion and analysis management accounting, 110 MDFs. See municipal development funds management audit, 141–42 MDQ. See Metropolitan District of Quito management discussion and analysis (MD&A), Mechinagar, Nepal, expenditure budget of, 226–29, 139–40 227–28b management information system (MIS), 108, 189, 250, medium-term expenditure framework, 260–62 251 megacities, 46–49 management letter, from auditor, 143 Melbourne, Australia, metropolitan governance in, 89 Managing Municipal Services (USAID), 234 Mendoza, Argentina mandatory expenditures, 411 debt management in, 358b mandatory properties (assets), 292–93, 314–15 municipal bonds in, 343 Manila, Philippines, metropolitan governance in, 79, Metro Manila (Philippines), 79, 81b, 90 81b, 90 metropolis, 42b manual accounting systems, 118–19, 118–19b, 145 metropolitan areas manual cashbook, 234 corridor or belt, 42, 43, 45–46b MAP. See maintenance and operations plan definition of, 42 map, city, 408 economy and labor market of, 41–42 Maputo, Mozambique, own-source revenues in, 189, emergence of, 41–48, 86 189b finance of. See metropolitan finance marginal cost pricing, 176 governance of. See metropolitan governance markaz, in Egypt, 6b informal settlements in, 43–46, 91n1 market value megacities in, 46–49 of assets, 298–99, 323n2 monocentric structure of, 43 methods for estimating, 298, 298b multipolar structure of, 43, 45 of property, for taxation, 155, 164, 165, 166 one large municipality covering, 84–86 Marseille, France polycentric structure of, 43, 44 metropolitan finance in, 57b population of, 42 metropolitan governance in, 70, 89 radius of, 42 Maryland socioeconomic cohesion of, 42 development promotion in, 182 spatial growth of, patterns of, 42–47 education funding in, 170 sprawl of, 43, 44, 183b employee incentives in, 307 terms related to, 42b land-based financing in, 313 metropolitan councils of government, 51, 55, 63–67, mass media, disclosure of information via, 296 91n3 matching principle, 11 metropolitan development fund, 59 matching provisions, of conditional transfers, 14–17, 34 Metropolitan District of Quito (MDQ), 74, 90 material base, assets as, 279 metropolitan finance, 53–59, 87, 444 materiality, of financial reporting, 137 amalgamation and, 83–84 maturity date, bond, 340 budget for metropolitan-level initiative in, 57b Index 473 cost sharing in, 49, 52b, 53–57 Metropolitan Washington Council of Governments, development funds in, 59 63–64, 65, 65b, 88 financing services and operations in, 53–58 Metropolitan Zone of the Valley of Mexico (ZMVM), funding of large infrastructure projects in, 82, 88 58–59, 60b Metro Vancouver/Greater Vancouver Regional funding of metropolitan-level entity in, 58 Service District (GVRD), 68–69, 88 investment financing in, 58 Mexico. See also Mexico City pooling of resources in, 49 credit ratings in, 346, 346b, 348 public-private partnerships in, 59 municipal bonds in, 341, 341b revenue mobilization in, 58b performance-based grants in, 398 scale economies in, 49, 53, 58, 62, 87 tax authority in, 154 tax or fee policies in, 57–58b water tariff in, 176b metropolitan governance, 48–53, 60–87, 444 Mexico City, Mexico annexation or amalgamation for, 51, 56, 82–86 metropolitan governance in, 50, 82, 88 authority coinciding with representation in, 51 World Bank financing in, 365 case-by-case joint initiatives by local governments MFSA. See municipal finance self-assessment for, 54, 60, 61 Middle East. See also specific countries citizen accessibility in, 52b centralization in, 9–10 committees and working groups for, 54, 61 Milan, Italy, congestion (vehicle) taxes in, 175, 211–12 contracting among local governments for, 54, MILF. See Moro Islamic Liberation Front 60–61, 62b Minimum Conditions Performance Measurement definition of, 48 (MCPM), 26–27, 27b disparities addressed in, 50 Ministère des Finances et de l’Economie (Benin), 208b examples of, cities used as, 88–91. See also specific Ministry of Nairobi Metropolitan Development cities (Kenya), 81–82, 89 financial reasons for, 57–58b Minneapolis–St. Paul, Minnesota functions of, 48–49 metropolitan finance in, 57–58b good, examples of, 49–50 metropolitan governance in, 70–71, 77, 80b, 88 horizontal coordination among local governments MIPs. See Municipal Investment Plans for, 51, 54, 60–61 MIS. See management information system lack of, consequences of, 49, 49b miscellaneous expenditures, 226–29, 300b local context for, 50, 87 MMC. See Metropolitan Montreal Community local government commitment to, 87 modified accrual-based accounting, 117, 127 models of, 50–56 Moldova national context for, 50, 87 expenditure management in, 401 politics and choice of, 53, 87 property valuation/taxation in, 159–62 questions for analyzing, 51–53, 52b monocentric structure, 43 regional authorities for, 51, 55, 61–71 Montgomery County, Maryland, education funding smaller (local) government units in, benefits of, 53 in, 170 specialized services in, 49–50 monthly cash forecast, 254 spillovers (externalities) in, 49 Montreal, Canada, metropolitan governance in, 65–67 stakeholders in selection or change of, 51–53 Moody’s Investors Service, 343–44, 398–99, 400b metropolitan-level government, 51, 56, 71–82 Morocco Metropolitan Montreal Community (MMC), 65–67 bank lending in, 360 metropolitan planning and development agencies, local business taxes in, 173b 67–68 municipal bonds in, 400 Metropolitan Washington Airports Authority municipal contracts in, 30 (MWAA), 59, 60b municipal development fund in, 362 474 Municipal Finances performance measurement in, 391–93 tax-free status in U.S., 340 tax authority in, 154 underwriting of, 340b urban tax in, 190 municipal contracts, 29–32, 30b, 31b, 35, 256, 256b, 334 waste management in, 368 Municipal Demarcation Board (South Africa), Morocco Municipal Credit Institution, 391–93, 393 83, 91n6 Moro Islamic Liberation Front (MILF), 11–12 Municipal Development Agency (ADM, Senegal), 393 mortgage principal payments, 300b municipal development funds (MDFs), 59, 359, Moscow, Russia, municipal bonds in, 341b 361–64 motor vehicle taxes, 174–75, 211–12 municipal enterprises (companies), 286–87, 311–12 motor vehicle violations, revenue from, 179 municipal finance improvement plan, 404, 406, Mozambique 438–39 own-source revenues in, 189, 189b Municipal Finance Management Act No. 56 of 2003 public-private partnerships in, 374 (South Africa), 140b Multan, Pakistan, budget of, 217–18 municipal finance self-assessment (MFSA), 29, 31b, multipart tariffs, 177 255–56, 381, 402–39, 447 multipolar structure, 43, 45 access to external funding in, 404 multiyear budgets, 229–32, 260–62 accountability in, 404 Mumbai, India of assets and maintenance, 420, 424–25 energy/environmental program in, 367 benchmarking in, 404 local revenue in, 153 of capital investment, 410, 416, 420, 426 sales of public land in, 182 of cash balance and arrears, 410, 414, 420, 426–27 World Bank financing in, 365 city profile in, 406–10 municipal audits, 255–56 databases for, 410–17 municipal banks, 339, 339b, 340 definitions in, 418–19b municipal bonds, 339–47 efficiency and transparency in, 404 advantages of, 344 of expenditures, 404, 410–13, 423–25 bank credit vs., 344–46, 345b, 359 of financial management, 435–37 cost of issue, 346 of financial position, 420 definition of, 340 financial projections in, 404, 406, 431–34 in developing and middle-income countries, 341, functions of, 404 341b generic financial framework for, 418, 418–19b electronic issue of, 340 historical analysis and summary tables in, 406, general obligation, 339b, 342, 342b 419–27 interest (coupon) of, 340 improvement plan in, 438–39 investors in, characteristics of, 340 of indebtedness, 410, 414–15, 420, 425 legislation authorizing, 347 innovations of, 404–5 maturity date of, 340 of intergovernmental transfers, 420, 423 performance measures for, 382, 397 key findings from, 406–7 pooling of resources for, 354, 361, 361b modules of, 406–7 reputation on bond market, 345b for municipal contracts, 31b revenue or specific purpose, 339b, 342 objective of, 402–4 risks and credit ratings of, 343–44, 343b, 346, prioritization in, 404 346b, 382, 398–400 ratio analysis in, 427–30 shortcomings of, 344–46 of revenue, 404, 410–13, 421 short-term vs. long-term, 340 South-East Europe experience with, 403b standardization of, 345b of tax potential and performance, 410, 417, structured, 343 420, 422 successful issue of, conditions for, 346–47 template for, 406–39 Index 475 urban audit with, 403b, 404, 405b–406b metropolitan governance in, 82, 90 of utility budgets (subsidies), 411–13 municipal contracts in, 30 visibility of public fund use in, 404 net income ratio, 303 municipal financial management, 93–145 net operating income, 302 accounting in, 93–94, 109–35, 144–45 net operating surplus, 326–28 accounting information for decision-making in, net present value (NPV), 257–59, 304, 335, 337–38b, 359 132–35 Network of Associations of Local Authorities of asset management and, 281, 282, 296 South-East Europe (NALAS), 398, 403b auditing in, 93–94, 141–44, 145 neutrality, of financial reporting, 137 budgeting in, 93–109, 144 New Delhi, India financial reporting in, 93–94, 135–41, 145 municipal council in, 371 pillars of, 93–94 tariffs and subsidies in, 236 scope of, 94 New Jersey, politics and expenditures in, 271b municipal improvement plan, 334 New York Bureau of Municipal Research, 383b Municipal Investment Plans (MIPs), 405b New York City, New York Municipality Act of 1953 (Nepal), 3b bankruptcy of, 347 Municipality Act of 1991 (Nepal), 3b performance measurement in, 385b municipal revenue policy, 208–11, 210b New York City area, metropolitan governance in, 67 MWAA. See Metropolitan Washington Airports New Zealand Authority land ownership in, 324n4 water tariff in, 176b N Niamey, Niger, street addressing initiative in, 191b Nairobi, Kenya, metropolitan governance in, 81–82, 89 Nicaragua National Advisory Council on State and Local community fund in, 375 Budgeting (NACSLB), 99 participatory budgeting in, 401 National Associations of Local Governments, 430 Niger National Capital Territory of Delhi (NCT, India), 68, municipal contracts in, 30 90. See also Delhi, India street addressing initiative in, 191b National Dwellers Foundation, 375 Nigeria National Urban Reconstruction and Housing Agency, municipal bonds in, 400 374 municipal development funds in, 362 nation building, decentralization and, 11–12, 11b, 33, 34 urbanization and economic growth in, 48 natural resource sharing, 29 nondevelopment revenue. See current revenue Nepal nongovernmental organizations, aid from, 374 asset management in, 287, 288b nonmarket economies, performance measurement in, budgeting in, 102, 226–29, 227–28b 381–82 citizen reporting in, 139 nonphysical assets, 276 development fund in, 59 nonrecurrent revenue. See capital revenue local revenue in, 155 Nordic countries. See also specific countries municipal development fund in, 362 decentralization and expenditures in, 218 performance-based grants, 26–27, 27b local income tax in, 157, 172 political economy of decentralization in, 3b local revenue in, 212n2 revenue-generating properties in, 299, 302b North Africa. See also specific countries tariffs and subsidies in, 241–42, 241b municipal contracts in, 30 net assets, 125–26, 127, 139 North America. See also specific countries Netherlands local government borrowing in, 339, 339b, 340, bond bank in, 361 354, 361 local government borrowing in, 339b metropolitan governance in, 50, 62, 88 476 Municipal Finances performance measurement in, 380, 381, 382–87, Orange County, California, bankruptcy of, 347, 352b 383b, 385b orcamento participativo (OP), in Brazil, 102, 103b North Carolina Organisation for Economic Co-operation and capital plan in Charlotte, 330, 331, 332, 334 Development. See OECD countries performance-based budgeting in, 264 OSR. See own-source revenue Norway “other recurrent revenues,” 180 debt regulation in, 349b Ouagadougou, Burkina Faso local income tax in, 172 expenditure management in, 401 water tariff in, 176b hybrid financing in, 355, 356b Novi Sad, Serbia, municipal bonds in, 342b street addressing initiative in, 190 NPV. See net present value output-based aid (OBA), 371 Nyiregyhaza, Hungary, targeted subsidies in, 238 output-based transfers, 14, 19–20, 26–32, 34–35 overhead costs, 299 O oversight, 269–70 OBA. See output-based aid own expenditures, 226 objectivity principle, 113 own-source revenue (OSR), 4–5, 13, 105, 156–80 object-of-expenditure (line-item) budgets, 95, 96 capital, 180 obligations (commitments), financial, 110–11, 111b categories of, 157, 157b obligations accounting, 111 definition of, 105, 148, 156 observations, auditor’s, 142 development level and, 151–52 occupancy rate, 305 local institutional capacity for, 162, 188–89, 189b OECD countries nontax sources of, 105, 157, 175–80. See also specific debt regulation in, 348 user charges and fees decentralization in, 34 shared revenue vs., 18, 155–56 local revenue in, 152, 159, 212n2 as share of total revenue, 152, 157–58 water tariffs in, 176b size of municipality and, 151, 152 “old ways” approach, 9–10, 33 tax sources of, 105, 147–50, 155–71. See also one-stop shops, 207–8 specific taxes Ontario, Canada. See also Toronto, Canada performance measurement in, 385b, 386 P OP. See orcamento participativo Pacioli, Luca, 112b open-ended, matching transfers, 15–16 Pakistan. See also specific cities open government, 400–401. See also accountability; balanced budgets vs. fiscal deficits in, 217–18 transparency construction capacities in, 249–50 Open Society Institute, 374, 400 financial holding in, 312 operating analysis, 305 informal settlements in, 46 operating (current) budget, 97, 418, 418b intergovernmental transfers in, 22, 29 operating expense(s), 300b, 420, 423–24 lack of coordinated planning in, 335b operating expense ratio, 303 land development corporations in, 321 operating income, net, 302 local borrowing prohibited in, 347 operating statements, 299–301, 300b, 303 local revenue in, 151 operating surplus, 326–28, 420 management information system in, 250, 251 operational efficiency, 215–16, 220. See also expendi- manual accounting in, 118–19b ture management manual cashbook in, 234 operation costs, 307–10 municipal companies in, 287 operation expenditures, and tariff setting, 235–36 natural resource sharing in, 29 operations of fixed assets, accounting for, 129–32 participatory budgeting in, 102 operation subsidies, 238–39, 240 property taxes, 165–67, 169 Index 477 public-private partnership in, 371–72 decentralization and, 390 tariffs and subsidies in, 237 in developing countries, 380, 390–93 user charges in, 175 dimensions of, 379–80 vertical imbalances in, 13 distortions in, 29 water tariff in, 176b European approach to, 381, 387–89 Panama, municipal development fund in, 362 in expenditure management, 254–56, 380 Parana State Urban Development Fund (FDU, Brazil), feedback in, 401 362, 363b financial analysis in, 380–81 Paris, France, metropolitan governance in, 48 financial crisis and, 380, 388 participatory budgeting, 94–95, 101–4, 225, 401, 402b financial partners and, 390–91, 396–400 benefits of, 103–4 formats for, 383–84 examples of, 102, 102b, 103b in grant process. See performance-based grants process of, 101–2 in human resource management, 385 partners importance of, 446–47 financial, accountability to, 396–400 indicators in, 384–87 public–private. See public–private partnerships internal financial monitoring in, 393, 394 pay-as-you-go financing, 326–28 lessons learned in, 381–93 pay-as-you-use financing, 326 methods and tools for, 393–402 payback rule, 257 in nonmarket economies, 381–82 payment systems, 233–34 objective of, 380 PEFA. See Public Expenditure and Financial in public-private partnerships, 371 Accountability Assessment ratio analysis in, 394, 427–30 penalties, revenue from, 179 in revenue management, 204 Pennsylvania risk analysis in, 393, 398, 399 annexation by Pittsburgh in, 83 self-assessment for. See municipal finance bankruptcy by Harrisburg in, 328, 329b, 347, 351, self-assessment 353–54 in service delivery, 385 pension funds, 129b, 139 standards for, caution on, 439n3 People’s Plan Campaign for the Ninth Plan (PPC, state (central government) supervision in, 393–98 India), 102b third-party monitoring in, 401 percent change, 198b too-ambitious system of, 387 performance audit, 141–42 U.S/Canadian system of, 380, 381, 382–87, 383b, performance-based budgets, 262–65, 264–65b, 384b, 385b 394–95 performance reporting, 139, 140–41 performance-based grants, 19–20, 26–32, 34–35, 382, periphery, of metropolitan area, 42 397–98, 439n1 permanent funds, 129b performance-based transfers, 396–98 permanently restricted (PR) assets, 125–26 performance measurement, 379–441 permit fees, 178–79 accountability in, 380, 394–402, 447 Peru benchmarking in. See benchmarking development rights in, 313 budgetary, 380, 394–95. See also performance- participatory budgeting in, 401 based budgets revenue sharing in, 18 citizen information and participation in, 393–94, philanthropic contributions, 181, 328, 374–75 400–402 Philippines citizen participation in, 382–87, 384b, 388–89 community fund in, 375 comparisons in, 384 credit guarantees in, 353, 354b, 359 culture of, 380, 381 decentralization and nation building in, 11–12, 11b data for, 28–29, 391–93, 396 fiscal equalization in, 23 478 Municipal Finances log frame for debt instruments in, 359 PPPs. See public-private partnerships metropolitan governance in, 79, 81b, 90 Prague, Czech Republic, metropolitan governance municipal bonds in, 341b in, 89 performance-based grants in, 398 predictive value, of financial reporting, 136 property taxes in, 170 preliminary audit report, 142 public-private partnerships in, 371, 374 present value, 257–59, 303–4, 335, 336–38, physical assets, 276. See also asset(s) 337–38b, 359 piggybacking, tax, 17, 154b, 171, 172 price regulation, of user charges, 209 PIPs. See priority investment programs principal–agent relationship, in delegation, 6–7 Pittsburgh, Pennsylvania, annexation by, 83 principal payments, 300b, 350 Poland. See also specific cities prioritization, in municipal finance betterment fees in, 314 self-assessment, 404 debt regulation in, 349b priority directions, in budgeting, 99 decentralization in, 4b priority investment programs (PIPs), 31b EU-EBRD financing in, 365 private domain, 277, 277b metropolitan governance in, 50 private goods, 150 property taxes in, 164 private ownership of land, 318, 324n4 political decentralization, 2, 3b, 4b, 33 private purpose trusts, 129b political projects, 271 private sector, financing from, 325, 327–28, 368–74. politicized budgeting, 107 See also public-private partnerships politics privatization, 318–20, 370. See also public-private and asset management, 287 partnerships and capital projects, 335 process benchmarking, 267 and expenditure management, 224, 225b, 270–72 process costing, 133 and metropolitan governance, 53, 87 procurement, 242–50, 257 and public-private partnerships, 371 accountability in, 247 and user charges, 175 competitive tendering or bidding in, 243–48, 246b, polycentric structure, 43, 44 257, 445 pooled financial arrangements, 354, 361–64, 361b. See contracting in, 247, 248–50, 249b also municipal development funds critical steps in, 246–47 poor cycle of, 243–44 philanthropic aid for, 374–75 effectiveness of, 247–48 public-private partnerships and, 373–74, 373b efficiency of, 248 targeted subsidies for, 209–11, 238–42, 306 electronically managed, 248 portfolio, of assets, 274, 276 equity in, 247 portfolio management, 277–78, 283, 284 ethical standards in, 248 Portland, Oregon, metropolitan governance in, 67, 77, implementation challenges in, 242–43 79b, 88 plans for, 244, 245 Portland Metropolitan Service District, 77 principles of, 247–48 Porto Alegre, Brazil, participatory budgeting in, 102, terms of reference in, 244, 246 103b, 401, 402b transparency in, 242, 247 Portugal value for money in, 247 debt crisis in, 350 PRODEL (Nicaragua), 375 land cadastre in, 163 productivity, 379–80 powiat (county), in Poland, 4b professional licenses, fees for, 179 PPC. See People’s Plan Campaign for the Ninth Plan program budgets, 96–97, 262–63 PPIAF. See Public-Private Infrastructure Advisory program reporting, 139 Facility projections, financial, 330, 404, 406, 431–34 Index 479 property-related subsidies, 306–7 characteristics of, 369 property taxes, 154b, 157–71 concessions in, 370, 373b appropriateness and usefulness of, 158–59 contracting in, 248–49, 369–70 assessment of tax base for, 155, 164–69, 185 cost savings in, 370 as benefit tax, 158, 212n3 failed or troubled, 371, 372–73 billing, delivery, collection, and enforcement of, feasibility studies for, 372, 372b 169–71, 212n4 forms of, 320, 369–70 cadastre for, 160–61b, 162–64, 191 land-for-infrastructure approach in, 182, 211, 313 computer-aided, mass valuation systems (CAMA) lessons learned in, 371 for, 159–62, 162b, 168–69, 168b performance monitoring of, 371 debate over, 170–71 renegotiation or cancellation of, 371, 373 in developing countries, 159–62, 160–61b, 164–65 risk sharing in, 370 development level and, 152 risks of, 371 disadvantages of, 159 service delivery in, 209, 369, 371 exemptions from, 210 successful cases of, 371–72 forecasting revenue from, 199–200 tariff (user charge) setting in, 235 as good local tax, 170, 211 Public Record of Operations and Finance (PROOF, history of, 158, 159b India), 138b, 139 local capacity for, 162 public sector accounting. See also accounting as percentage of GDP, 159 commercial accounting vs., 110 property identification for, 162–64, 184, 185, key terms in, 110–11, 111b 190–91, 191b public sector size, decentralization and, 12 property rights and, 159 rates of, establishing, 169 Q revenue enhancement programs and, 191–94 qariya (village), in Egypt, 6b revenue mobilization strategies for, 207, 207b qualified audit opinion, 142, 145 split-rate, 183b qualitative revenue forecasts, 197, 202 street addressing system for, 184–85, 190–91, 191b, quality-of-life measures, 391–93 208, 208b, 212n6 quantitative revenue forecasts, 197, 198b proprietary funds, 129b Quezon City Materials Recovery Facilities public contributions (donations), 181, 325, 368–74 (Philippines), 371 public domain, 277, 277b Quito, Ecuador, metropolitan governance in, 50–51, Public Expenditure and Financial Accountability 74, 90 Assessment (PEFA), 254–55, 260, 401, 435–37 public goods R budget planning for, 94 RAJUK. See Dhaka Capital Development Authority financing of, 147, 150 Randstad (Netherlands), 82, 90 public land, sales of, 181–83 ratio analysis, 394, 427–30 Public-Private Infrastructure Advisory Facility “reaction from below,” 2, 10, 33 (PPIAF), 235, 324n6 reallocations, 233 public-private partnerships (PPPs), 59, 181, 327–28, recapitalization, 308 368–74 receipts and payment account, 123 access to, performance measures and, 398–400 recurrent revenue. See current revenue asset management in, 287, 320–21 reference rate. See discount rate benefits for the poor in, 373–74, 373b regional authorities, 51, 55, 61–71 benefits of, 370–71 regional development agency, 52b build-operate-transfer arrangements in, 320, 370 regional (metropolitan-level) government, 51, 56, capital investment planning in, 230 71–82 480 Municipal Finances regional planning and service delivery authorities, 55, vs. central government revenue, 154b 63, 69–71 classification of, 155–56 Regional Planning Association (RPA, New York City current, 155–56, 419b area), 67 decentralization and, 148–49 regional planning authorities, 50, 51, 55, 63, 67 development level and, 151–52 regional service delivery authorities, 55, 63, 68–69 enhancement of, programs for, 191–94, 192b, 193b, registration, for local revenue collection, 183–84 202, 445 registration fees, vehicle, 174 estimation of, 155, 188b, 196–202. See also revenue regressive tax, 171 forecasts relevance, of financial reports, 136 incentives for collection, 189 reliability, of revenue forecasts, 197–98 land-based, 181–84, 312–14 rent, as current revenue from assets, 179–80 management of, principles of, 150 rental value, for property taxation, 165–67 mobilization of. See revenue mobilization rent subsidies, 306–7 monitoring and evaluation of, 204, 205b replacement cost, 298 municipal policy on, 208–11 residual land value, 298b nontax sources of, 105, 154, 157, 175–80. See also resource allocation, 222, 223b. See also expenditure specific user charges and fees management outsourcing collection of, 209 responsibility accounting budgets, 134 projected, 330, 431–34 responsibility accounting system, 133–34 role of, 148–50 restoration and modernization (R&M) costs, 308 self-assessment (MFSA) of, 404, 410–13, 421 results-based chain, 19–20 as share of total public revenue, 149, 445 results benchmarking, 267 size of municipality and, 151, 152 return on asset (RoA), 303 sources of, 147–48, 154b, 155–80 return on equity (RoE), 303 structure of, 150–53, 155–56 return on investment, 302–3 summary table of, 420, 421 revenue, local, 147–214, 445 tax sources of, 105, 147–50, 155–71, 211–12. accountability in collection, 158, 182–83, 194 See also specific taxes administration for, 183–94 from transfers. See intergovernmental transfers assessment functions in, 155, 164–69, 183, 185 revenue assignment, 2, 4–5, 12, 13–14. See also billing and collection functions in, 169–71, 183, intergovernmental transfers 185–86, 189, 212n7 revenue bonds, 339b, 342 enforcement functions in, 169–71, 183, revenue budget cycle, 194–204 185–88, 209 revenue collection sharing, 17–19 identification and registration functions in, revenue forecasts, 196–202, 203b 162–64, 183–84, 190–91, 190b, 191b revenue intercepts, 353 local institutional capacity for, 162, 188–89, 189b revenue mobilization street addressing systems in, 184–85, 190–91, decentralization and, 208, 208b 191b, 208, 208b, 212n6 improving collection efficiency for, 207–8 assets as source of, 280, 296, 297. See also linking revenue collection to service provision for, income-generating properties 205–7, 206b authority to raise or collect, 153–55 metropolitan, 58b benefit principle and, 150, 151, 211 strategies for, 204–8 budget approval of, 203–4 revenue planning, 196 budget debate over, 202–3 revenue sharing, 17–19, 34, 148 budget execution of, 204 derivation principle in, 18–19 budgeting of, 194–204 listing in financial documents, 18 capital, 155–56, 180–83, 419b local reliance on, 152 Index 481 in metropolitan finance, 57–58b Santiago, Chile, metropolitan governance in, 90 in municipal budgeting, 105 São Paulo ABC Region, 64, 66b, 90, 91n4 own-source revenue vs., 18, 155–56 São Paulo, Brazil in transition economies, 18–19 debt crisis in, 347 revenue side, of municipal budget, 104–5, 410–13 debt management in, 358b revised budget, 100–101, 107, 233 development rights in, 313 Rijeka, Croatia, budget of, 218 metropolitan governance in, 50, 64, 66b, 90, 91n4 Rio de Janeiro, Brazil public-private partnership in, 211 debt crisis in, 347 urban concessions in, 373b debt management in, 358b World Bank financing in, 365 metropolitan governance in, 50 satellite images, for property tax information, 184 municipal bonds in, 341b, 342 satisfaction indexes, 388–89 World Bank financing in, 365 Saudi Arabia risk analysis, 393, 398, 399 formula-based intergovernmental transfers in, RoA. See return on asset 21, 21b Roanoke, Virginia, audit report for, 142 water tariff in, 176b RoE. See return on equity scale economies, in metropolitan finance, 49, 53, 58, rolling budget, 260 62, 87 Romania, EU-EBRD financing in, 365 Scotland, water tariff in, 176b Rotterdam, Netherlands, metropolitan governance Second Land Administration Project (Ghana), 207b in, 82, 90 Second Urban Project (Ghana), 207b RPA. See Regional Planning Association selective sales taxes, 171–72 Russian Federation self-assessment. See municipal finance energy-efficiency efforts in, 366 self-assessment local expenditures in, 218–19 self-financing, 419 local revenue in, 153 Sen, Amartya, 9 municipal bonds in, 341b Senegal revenue sharing in, 18 expenditure management in, 401 tariffs and subsidies in, 236, 237b municipal contracts in, 30, 32, 32b, 256, 256b Rwanda municipal development funding in, 362, 363b, 393 municipal bonds in, 341b municipal finance self-assessment in, 405b–406b municipal contracts in, 30 performance measurement in, 393, 401 tax system in, 190, 190b S urban audit in, 291b, 405b–406b St. Petersburg, Russia Senegal Urban Development and Decentralization debt management in, 358–59, 359b Program, 291b, 363b municipal bonds in, 341b sensitivity analysis SAIs. See supreme audit institutions of capital projects, 259–60 sales comparison, 298, 298b of revenue forecasts, 198 sales taxes, 154b, 171–72 separation modeling, 10 advantages and disadvantages of, 171 Serbia forecasting revenue from, 199–201 asset management in, 284 piggyback, 171 municipal bonds in, 342b regressive nature of, 171 revenue enhancement program in, 194 selective, 171–72 surplus military properties in, 313 San Francisco, California, capital investment plan in, service delivery 330, 332, 332b, 333 benchmarking standards for, 266–69 Santa Cruz, Bolivia, waste management in, 368 comparative costs of, 266, 269 482 Municipal Finances competitiveness of, 388–89, 391–93 natural resource sharing in, 29 performance measurement of, 385 performance-based grants in, 398 public-private partnership for, 209, 369, 371 philanthropic aid in, 374 ratio analysis of, 429 property taxes in, 159, 168 Service Efforts and Accomplishments reporting water tariff in, 176b (GASB), 140–41 South Asia settlements, informal, in metropolitan areas, 43–46, budget approval in, 90 91n1 land development corporations in, 321–22 SFCs. See state finance commissions metropolitan governance in, 50, 90 Shanghai, China pooled-financing bonds in, 355b development promotion in, 182, 211 South-East Europe metropolitan governance in, 48, 61, 62, 64b, financial risk analysis in, 398, 399 85–86, 91 municipal finance self-assessment in, 403b municipality and metropolitan area of, 85–86, 87 revenue sharing in, 19 solid waste disposal system in, 62, 64b South Sudan, decentralization and nation building in, special purpose vehicles in, 350, 355 11, 11b World Bank financing in, 365 Spain shared taxes. See tax sharing debt regulation in, 349b Simon, Herbert, 383b local business taxes in, 172 Singapore local government borrowing in, 339b congestion (vehicle) taxes in, 175, 211–12 local revenue in, 153 land development corporations in, 321 metropolitan finance in, 59, 91n2 single-entry accounting, 110, 114, 127 sales taxes in, 171 SKS Microfinance (India), 371 water tariff in, 176b Slack, Enid, 91n5, 164 spatial development plan, 314–15 Slovak Republic, EU-EBRD financing in, 365 special interest groups, 270–71, 271b Slovenia special purpose districts. See regional authorities EU-EBRD financing in, 365 special purpose vehicles (SPVs), 350, 354–55, water tariff in, 176b 355b, 360 Slum Dwellers International, 375 special revenue funds, 126, 128b, 139 slums, 46 specifications (terms of reference), 244, 246 social accountability, 400–402 specific purpose bonds, 339b, 342 social audits, 205–6, 212n9 specific purpose transfers, 14–17, 34. See also condi- Sofia, Bulgaria, municipal bonds in, 341b tional transfers solid waste. See waste management speculation, land, 183b, 321 Soros Foundation, 374 spillovers, in metropolitan governance, 49 South Africa. See also specific cities spillovers, tax, 57 bank lending in, 360 split-rate property tax, 183b fiscal data in, 26 sprawl, 43, 44, 183b intergovernmental transfers in, 14, 20–22, 21b, 26, SPVs. See special purpose vehicles 29, 398 Sri Lanka, municipal development fund in, 362 local revenue in, 153 Standard & Poor’s, 343–44, 398–99 metropolitan governance in, 51, 53, 83, 84, 84b, state finance commissions (SFCs, India), 22 86b, 89, 91n6 statement of activities, 139, 145 municipal bonds in, 341b, 342, 342b, 361, 400 statement of financial position. See balance sheet municipal development fund in, 361, 363b statement of net assets, 139 municipal financial management in, 139, 140b statement of receipts and payments, 115, 123, municipal insolvency in, 351 124–25, 126 Index 483 state revolving funds, 360 Sutton (London borough), United Kingdom, cost-effi- state supervision, in performance measurement, ciency program in, 204, 205b 393–98 Sweden stock-based business tax, 172–73 local income tax in, 172 Stockholm, Sweden, congestion (vehicle) taxes in, 175 local revenue in, 153 street addressing municipal contracts in, 30 for collection of revenue (taxes), 184–85, 190–91, Switzerland 191b, 208, 208b, 212n6 financial accountability assessment in, 255 for collection of user charges, 237, 238b philanthropic organizations in, 374 for inventory of assets, 282 syndicats intercommunaux, in France, 69 structured bonds, 343 Stuttgart, Germany T development rights in, 313 T-accounts, 113–14, 121 metropolitan governance in, 79, 90 Tamil Nadu, India Sub-Saharan Africa. See also specific countries municipal development fund in, 362, 363b metropolitan governance in, 51 special purpose vehicle in, 354, 355b, 360 municipal contracts in, 30 tangible (physical) assets, 276. See also asset(s) subsidiary principle, 2–3, 11 Tanzania subsidies, 234–42 development fund in, 59 allocation of, 240–42 failure to pay taxes in, 187b blanket balance sheet, 237 informal settlements in, 91n1 capital, 239–40 metropolitan governance in, 72, 73–74b, 89 demand-side, 240 property valuation/taxation in, 159 in developing countries, 236–37, 237b public-private partnerships in, 248–49, 373, 373b fairness issues in, 234 urbanization and economic growth in, 48 forms and implications of, 238–40 targeted subsidies, 209–11, 238–42, 306 management of, 237–42 tariffs. See user charges operation, 238–39, 240 task force, on asset management, 289, 322 property-related (rent), 306–7 tax(es) self-assessment of, 411–13 authority of local governments, 153–55 service delivery, to private sector, 371 billing and collection of, 169–71, 183, 185–86, supply-side, 240 189, 212n7 targeted, 209–11, 238–42, 306 in city profile, 409 Sudan, decentralization and nation building in, 11, 11b criteria for choosing best, 210b summary tables, in municipal finance self- easy and convenient payments of, 186 assessment, 406, 419–27 enforcement of, 169–71, 183, 186–88, 212n4 Sunnyvale, California, performance-based budgeting failure to pay, reasons for, 186–87, 187b in, 264–65, 264–65b good, features of, 149–50, 150b, 155 supplementary budget, 100–101, 107, 233 identifying payers of, 162–64, 183–85, 190–91, suppliers, as users of financial reports, 136 190b, 208, 208b supply-side subsidies, 240 impact analysis of, 209–11 supreme audit institutions (SAIs), 120, 142–43 incentives for compliance, 189 surcharges on utilities, 177–78, 178b, 212n5 linking service provision to collection of, 205–7, surplus properties, 293–94, 314–16 206b surtax, 17 local, 147–50, 155–75, 211–12. See also specific types sustainability potential and performance, self-assessment of, in intergovernmental transfers, 25 410, 417, 420, 422 in municipal finance self-assessment, 406 revenue enhancement programs and, 191–94 484 Municipal Finances revenue mobilization strategies for, 204–8 Trans-Hudson Express Tunnel, 271b shared. See tax sharing transition economies subsidies for or exemptions from, 210–11 local expenditures in, 218–19 tax amnesty, 186 revenue sharing in, 18–19 tax base, 17, 155, 164–69, 185 transparency tax cascading or pyramiding, 171 in asset management, 294–96, 295b tax piggybacking, 17, 154b, 171, 172 in expenditure management, 224–25, 232–33, 251, tax rates 269–70 authority to set, 153, 154 in financial reporting, 138b, 139 property tax, establishing, 169 in intergovernmental transfers, 24 tax sharing, 17–19, 34, 148 in municipal finance self-assessment, 404 derivation principle in, 18–19 in open government, 400–401 listing in financial documents, 18 in performance measurement, 380, 447 local reliance on, 152 in procurement, 242, 247 in metropolitan finance, 57–58b in sales of public land, 182–83 in municipal budgeting, 105 in subsidy allocation, 241 own-source revenue vs., 18, 155–56 Transparency and Accountability Initiative, 400 in transition economies, 18–19 trend analysis, for revenues, 196–202 tax spillovers, 57 trial balance, 113, 115, 117–18, 123–25 Tbilisi, Georgia, metropolitan area of, 43, 45–46b, 90 trust funds, 129b, 139 tehsils, in India, 68 Tunisia temporarily restricted (TR) assets, 125–26 local business taxes in, 173b terms of reference (ToRs), 244, 246 municipal contracts in, 30, 405b territorial organization, in city profile, 407–8 municipal development fund in, 362, 405b Thailand performance-based grants in, 398 community fund in, 375 rent tax in, 190 e-procurement in, 248 urban and financial audits in, 405b–406b fiscal equalization in, 23 Turkey local revenue in, 153 amalgamation in, 83, 91 three D’s, of decentralization, 5–7, 33 financing needs in, 326 time-series forecasting, 203b intergovernmental transfers in, 14 Togo local business taxes in, 174 expenditure management in, 401 local expenditures in, 218 property taxes in, 190 property taxes in, 162 top-down approach sales of public property in, 313 in benchmarking, 267 Twin Cities Metropolitan Government, 57–58b, 70–71, in decentralization, 2 77, 80b, 88 Toronto, Canada amalgamation of, 82–83 U local revenue in, 153 UC. See communauté urbaine metropolitan governance in, 53, 74–76, 75b, 88 Uganda ToRs. See terms of reference development fund in, 59 total budget, 419b local revenue in, 152, 153 Town Panchayat Act of 1962 (Nepal), 3b local tax authority in, 155 traffic violations, revenue from, 179 performance-based grants in, 26 transfer pool, 14 political pressure and expenditures in, 272 transfers, intergovernmental. See intergovernmental public-private partnerships in, 371 transfers revenue enhancement program in, 192b, 193 Index 485 Ukraine urbanization, 41–49, 86. See also metropolitan areas local business taxes in, 173b, 174 Urban Renewal Authority of Hong Kong, 287 local revenue in, 153 USAID. See U.S. Agency for International unconditional (general purpose) transfers, 14, 15–16, 34 Development understandability, of financial reporting, 137 user charges, 154b, 175–79, 176b, 234–42 underwriting, 340b capital investment funds from, 231 undesignated assets, 126 computing or setting of, 176–77 unforeseen events, intergovernmental transfers for, 29 average cost pricing for, 177 unfunded mandate, 7, 271–72 average incremental pricing for, 177 union parishads, in Bangladesh, 144b capital expenditures and, 235–36 unitary systems, 7 cost-plus pricing for, 234–35 United Kingdom. See also specific cities expenditure control in, 231, 234–37 betterment fees in, 314 main steps in, 231b debt regulation in, 349b marginal cost pricing for, 176 Department for International Development, 400 operation expenditures and, 235–36 metropolitan governance in, 48, 53, 67–68, 76, 76b, principles of, 236 82, 89 in public-private partnerships, 235 municipal contracts in, 30 cost recovery through, 175–77, 231, 236 performance measurement in, 380, 386 database assessment for, 185 property taxes in, 152, 157, 159 designing, 175 public-private partnerships in, 320 in developing countries, 234, 236–37, 237b water tariff in, 176b difficulties with, 177 United Nations Carbon Authority, 366b economic rationale for, 175 United States. See also specific cities and states free ridership vs., 185, 185b accounting standards in, 112 impact analysis of, 209–11 bond financing in, 339, 340, 354, 361 linking to service cost, 206–7, 209 financial reporting in, 139–41 multipart, 177 local business taxes in, 174 politics of, 175 local insolvency in, 328, 329b, 347, 351, 352b, 376n3 price regulation of, 209 performance measurement in, 380, 381, 382–87, revenue mobilization strategy for, 206–7 383b, 385b street addressing system for collecting, 237, 238b philanthropic aid from, 374 subsidies for, 209, 210–11, 234–42 property taxes in, 152, 164, 169, 170 utility budgets, 409, 411–13 sales taxes in, 171 utility surcharges, 177–78, 178b, 212n5 surplus military properties in, 313 Utrecht, Netherlands, metropolitan governance in, utility surcharges in, 177, 178b 82, 90 U.S. Agency for International Development (USAID), Uzbekistan, procurement reform in, 246b 328, 354, 364 Uzgen, Kyrgyzstan, public contributions in, 375 U.S. Association of Contract Cities, 62b Unit Guarantee Corporation (Philippines), 353, V 354b, 359 validity, of revenue forecasts, 197–98 unqualified audit opinion, 142, 145 Vallejo, California, bankruptcy of, 329b unrestricted (UR) assets, 125–26 valorization, 181–82, 182b urban agglomeration, 42, 42b, 43–46 valuation urban audit, 31b, 255–56, 289, 291b of assets, 296–99, 323n2 municipal finance self-assessment with, 403b, of property, for taxation, 155, 164–69 404, 405b–406b value added tax (VAT), 154b, 171 urban concessions, 373b value-based assessment, 164–69 486 Municipal Finances value-capture technique, 148, 181, 183b Washington Metropolitan Area Transit Authority value for money (VfM), 204, 205b, 246, 247, 380 (WMATA), 59 Vancouver, Canada waste management citizens and performance measurement in, 384b comparative costs of, 266 metropolitan finance in, 58b environmental loans and credits for, 366–67b, metropolitan governance in, 68–69, 88 366–68, 371 variable costs, 134 inventorying assets for, 292 variance analysis, 108–9, 265–66, 269 metropolitan governance and, 62, 64b variation orders, 250 street addressing for, 237, 238b VAT. See value added tax Water and Sanitation Pooled Fund (India), 361, 361b VDCs. See village development committees water tariffs and subsidies, 175, 176b, 236, vehicle taxes, 174–75, 211–12 241–42, 241b vehicle violations, revenue from, 179 wealth, assets as, 279–80 Venezuela, metropolitan governance in, 51, 74 weekly cash forecast, 254 Verband Stuttgart Region (Germany), 79 welfare gains, in decentralization, 6, 10–11, 33 verifiability, of financial reporting, 137 West Bank vertical fiscal gap, 13 property tax in, 170b vertical imbalance, 5, 13, 18, 22, 33 utility surcharges in, 177–78 VfM. See value for money WMATA. See Washington Metropolitan Area Transit Vietnam Authority municipal development fund in, 362 World Bank performance-based grants in, 398 auditing initiatives of, 255–56 public-private partnership in, 371–72 energy-efficiency programs of, 366 special purpose vehicle in, 360 financial assessment tool of, 402–4. See also Village Act of 1956 (Nepal), 3b municipal finance self-assessment Village Development Committee Act of 1991 financial assistance from, 364–65, 364b (Nepal), 3b general purpose (unconditional) transfers from, 14 village development committees (VDCs), in municipal contracts supported/evaluated by, 30, Nepal, 3b 32, 32b Village Panchayat Act of 1962 (Nepal), 3b municipal development fund program of, 362 virements, 233 performance-based programs of, 26, 391 Virginia. See also Fairfax County, Virginia property tax programs of, 159–62, 167, political pressure and expenditures in, 272 190–91, 207b visibility, of public fund use, 404 revenue enhancement programs of, 191–94, 192b voivodship (region), in Poland, 4b street addressing initiatives of, 190–91 volumetric tariff, 176b urban audit framework of, 404 Wyoming, revenue authority in, 155 W Warsaw, Poland, assets as wealth of, 280 Z Washington, D.C. Zimbabwe bankruptcy of, 347 municipal bonds in, 341b development promotion in, 182 municipal development funds in, 362 metropolitan finance in, 59, 60b ZMVM. See Metropolitan Zone of the Valley of metropolitan governance in, 63–64, 65, 65b, 88 Mexico Index 487 ECO-AUDIT Environmental Benefits Statement The World Bank is committed to preserving Saved: endangered forests and natural resources. The • 25 trees Office of the Publisher has chosen to print • 11 million BTUs of Municipal Finances on recycled paper with total energy 50 percent postconsumer fiber in accordance • 2,095 pounds of net with the recommended standards for paper greenhouse gases usage set by the Green Press Initiative, a non- • 11,362 gallons of waste profit program supporting publishers in using water fiber that is not sourced from endangered • 761 pounds of solid forests. For more information, visit www waste .greenpressinitiative.org.