Chapter 1: Principles of Municipal Finance

Nic
Nic Cheeseman is associate professor of African politics at Oxford University, the former editor of African Affairs, and the author of Democracy in Africa (Cambridge University Press, 2015).
Dominic Burbidge
Dominic Burbidge is departmental lecturer in the School of Interdisciplinary Area Studies, Oxford University, and researcher at the Department of Politics & International Relations.

Introduction

The world’s population is becoming increasingly urbanized, with estimates suggesting that by 2050, two-thirds of humanity will live in cities and towns.1 This shift will require governmental reforms—particularly on the part of local governments, which will be responsible for managing many of the socioeconomic consequences of large-scale urbanization. The scope and complexity of this transformation precludes a fully accurate prediction of the changes it will require of a particular local government. Nonetheless, by comparing experiences and discussing strategies, it is possible to establish principles that can serve as general guides for reform. It is crucial that this reform process remain grounded in formulating and implementing policy changes that benefit citizens.

  • 1. UN-Habitat, Guide to Municipal Finance (Nairobi, United Nations Settlements Programme, 2009), p. vii.

The world’s population is becoming increasingly urbanized, with estimates suggesting that by 2050, two-thirds of humanity will live in cities and towns.

What is municipal finance?

Municipal finance consists of the revenue and expenditure of local government in urban areas. Although the remit and capacities of local governments to engage in financial decisions vary enormously, across countries municipal nance generally aims to generate the resources needed to fund local services to the satisfaction of citizens through fair taxation and use of external resources. This is, of course, a difficult task, but it is a goal shared by the administrative structures and institutions that comprise the world’s municipal authorities. Fulfilling the goal depends not only on successful programs of taxation and spending, but also on coordination among local government units, such that they help each other work efficiently, and together enable citizens to easily access government services and assistance.

Local government revenue can be split into two main sources (as depicted in Figure A). The first is internal revenue, which is collected by local governments themselves according to their rules and mandates. The types of revenue that a local government can collect are defined by law and vary enormously among countries. However, generally speaking, local governments often collect taxes or fees for the services they provide (such as garbage collection or organizing parking spaces), and collect property taxes or rates on privately owned properties within their jurisdiction.

The second form of revenue that local governments receive is external revenue from outside sources. Usually, local governments receive support in the form of intergovernmental transfers, whereby national governments allocate a portion of their revenue to their local counterparts. National governments can also provide backing for local governments to take out loans, if such loans are agreed upon as important for development, and if it is believed the local government can repay them in time. A further type of external revenue is development assistance, which can come directly from the national government in times of need (for example, following an earthquake that has affected some parts of the country more than others), or from international development institutions as part of an aid package. Generally speaking, a municipal government must ensure that over time the sum of its revenue equals the sum of its expenditure.

Figure
A
:
Typical local government revenue sources
Figure A

Why does municipal finance matter?

Municipal finance matters for the sustainability of local government provision of goods and services. With global recognition of the need to pursue Sustainable Development Goals (SDGs),2 it is clear that these can only be achieved hand-in-hand with the reform and enhancement of municipal governments across the world. Municipal governments are uniquely suited to respond to challenges of poverty, education, water, and the environment; an over-reliance on central government and international institutions risks the danger that responses become out of touch with local people and therefore harder to implement. Well-functioning municipal governments are especially necessary for SDG 11, which seeks to make cities and human settlements inclusive, safe, resilient, and sustainable.

Developing more effective municipal finance is essential for a number of reasons (Figure B). Without strong and consistent revenue flows, it is not possible to develop sustainable towns and cities. One implication of this is that municipal authorities will lack the resources that they need to effectively plan for the impact of urbanization. This is likely to have a negative effect both on the livelihoods of citizens but also on the way in which high levels of in-migration impact the environment. In turn, this can have long-term implications for residents’ quality of life and for the ability of the area to attract investment in the longer term. At the same time, unless clear lines of revenue generation from local citizens are established, ties of financial accountability—through which society holds the government responsible for its use of tax revenues—are unlikely to develop, which can stymie pressure for good governance.

Figure
B
:
Why does municipal finance matter?
Figure B

How can local authorities enhance the sustainability of municipal finance?

There is a great need to improve the sustainability of municipal government finances across the world. Given how much depends on the successful performance of local governments, poor finances can make local service delivery faulty and inconsistent, and can damage future development prospects. Unfortunately, attempts at reforming local government revenue through decentralization have often proven more challenging than originally envisaged. International expert Paul Smoke writes3:

  • 3. Paul Smoke, “Urban Government Revenues: Political Economy Challenges and Opportunities,” in The Challenge of Local Government Financing in Developing Countries (n.p., United Nations Human Settlements Programme, 2014), p. 9.

Fiscal decentralization has been particularly disappointing given how much consensus there has been on specific reform advice, with own source revenue generation arguably being the most problematic of fiscal concerns. Available empirical literature strongly indicates that subnational revenue generation, more often than not, falls short of expectations

If subnational revenue generation often falls short of expectations, how can it be improved to become a more sustainable feature of municipal government?

This question is not easy to answer. To begin, it is important to realize that there are many differ-ent ways in which countries decentralize political administration to allow for local decision-making. This means it is not always appropriate to recommend the same policy across the board. Some countries allow very little discretion for local governments, while others allow a great deal. The level of discretion afforded depends on the constitutional provisions of what municipal governments can and cannot do.

Figure C illustrates the different levels of decentralization around the world. Those in yellow are federal states: countries where most decision-making power is held at the level of regions, provinces, or sub-national states. Some of the most well-known examples of federal states include Nigeria, the United States of America, and Brazil. Federal constitutions usually provide the greatest degree of regional autonomy, allowing local governments wide discretion over the types of taxes they collect.

Those countries displayed in red are unitary states with a centralized political administration, but whose constitutions provide for devolution. Devolution is a constitutional provision that allows for regional decision-making over a set list of government functions. The functions for which there is local political autonomy are established by the political center, and usually cannot be changed without difficulty (for example, requiring constitutional amendment). In terms of local government finance, some discretion is usually given under devolution for local political actors to set budgets and decide the taxation levels to be implemented. While, like under federalism, this has the potential complication of varied tax rates and levels of spending among different provinces or counties, large benefits can be realized by involving citizens in decision-making through electing local representatives, and through engaging in public participation when planning how to carry out local government functions.

In blue, the map shows non-federal and non-devolved unitary states. This kind of heavily centralized political system prevails in Africa and the Middle East.

Figure
C
:
Level of decentralization, by country
Figure C

Constitutional law and national legislation dictate what powers local governments hold, and what they can do to meet their costs through revenue generation. This is important not only for ensuring municipal governments do not engage in any activity that lies outside their purview, but also for encouraging appropriate care when drawing comparisons among case studies of success or failure in municipal finance. Some examples, however good, cannot be repeated in one’s own jurisdiction because it is not possible to raise funds in that way, given the constitutional and legal context. A starting principle of municipal finance, therefore, is to follow the law at all times—both those laws that pertain to local government and those enumerated in a country’s constitution—and to design revenue generation and expenditure plans accordingly.

What should count as local, and what as national?

At times the law provides for discretion over choosing what taxes and public service provision should be done locally, and what should be left to national government. This is a crucial issue for many involved in municipal finance, and can mean the difference between a sustainable municipal government and one bloated with too many duties, or starved with insufficient funds.

A key principle for answering this question is the principle of subsidiarity. The legal philosopher John Finnis describes the principle of subsidiarity as requiring “that larger associations should not assume functions which can be performed efficiently by smaller associations.4 The basic idea is that government is best when it is local, and one should only take away the decision-making of local actors when there are clear efficiency gains to be realized. As Finnis describes further, “[T]he proper function of association is to help the participants in the association to help themselves or, more precisely, to constitute themselves through the individual initiatives of choosing commitments […] and of realizing these commitments through personal inventiveness and effort in projects.”5 The need for cherishing individual initiative is not just a case of citizens versus government, but among government institutions themselves. At times, the greater authority of those higher up in government can be used to nullify individual creativity among local government practitioners, and this can harm municipal governments’ capacity to grow their revenue base.

  • 4. John Finnis, Natural Law & Natural Rights, 2nd ed. (Oxford, Oxford University Press, 2011), pp. 146–147.
  • 5. John Finnis, Natural Law & Natural Rights, 2nd ed. (Oxford, Oxford University Press, 2011), p. 146.

Principles of municipal finance: The “benefit principle” and the “ability-to-pay” principle

There are two main principles around which systems of taxation can be arranged. One is the “benefit principle,” a long-held idea put forward by public finance theorists, which argues that “an equitable tax system is one under which each taxpayer contributes in line with the benefits which he or she receives from public services.”6 This approach ties taxation to public service delivery, helping develop a close correlation between the money generated in tax revenue and the money spent delivering the particular good or service.

To help understand the benefit principle, it can be contrasted with an alternative approach, the “ability-to-pay principle.” As the name suggests, this principle entails that “each taxpayer is asked to contribute in line with his or her ability to pay.”7 The difference between this and the benefit principle is that there is no direct connection with what is being paid for. Citizens contribute according to their ability without necessarily seeing the results of their contributions.

In reality, most tax systems combine elements of both approaches, with wealthier citizens contributing more, but some contributions being directly linked to services. The advantage of this approach is that linking taxation to services helps to generate a social contract between citizens and the government, such that citizens know what they are contributing to and are able to witness its effects. This, it is believed, will help increase compliance in taxpaying. There is an element of fairness in consumers of a publicly provided service being the ones who pay for it.8

In order to maximize the advantages of the benefit principle, some practitioners have recommended earmarking certain taxes for specific uses.9 This can make citizens more willing to pay the tax because they know exactly where the money goes, and can also help reduce corruption. Tax expert Wilson Prichard writes10:

  • 6. Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and Practice, 5th ed. (New York, McGraw-Hill Book Company, 1989), p. 219.
  • 7. Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and Practice, 5th ed. (New York, McGraw-Hill Book Company, 1989), p. 219.
  • 8. Harvey S. Rosen and Ted Gayer, Public Finance, 10th ed. (Maidenhead, United Kingdom, McGraw-Hill Education, 2014), p. 355.
  • 9. Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and Practice, 5th ed. (New York, McGraw-Hill Book Company, 1989), p. 222.
  • 10. Wilson Prichard, Taxation, Responsiveness and Accountability in Sub-Saharan Africa: The Dynamics of Tax Bargaining (Cambridge, Cambridge University Press, 2015), p. 257.

The aim of such tax earmarking is to build greater trust between governments and taxpayers, while providing a foundation for improved monitoring of public expenditures. The case for such tax earmarking is particularly strong in low-income countries where trust is frequently limited and monitoring particularly difficult.

Prichard describes the example of increases in value-added tax (VAT) in Ghana, which was implemented by connecting VAT to the provision of specific public services, and “served to increase trust amongst taxpayers while also making it somewhat easier for the public to monitor government performance.”11

  • 11. Wilson Prichard, Taxation, Responsiveness and Accountability in Sub-Saharan Africa: The Dynamics of Tax Bargaining (Cambridge, Cambridge University Press, 2015), p. 257.
Accra, Ghana

Nevertheless, criticism has been levied at the benefits approach. Some counter argue that tying taxes to specific benefits restricts governments’ spending autonomy. Because a government’s hands are tied by the decision to earmark the money, it cannot change the way in which the money is used if something more urgent arises. Secondly, this approach may lead to favoritism in the provision of public services; if only some are paying for the service, why should anyone else gain access? Such arguments threaten to turn the public good into a “club” good received only by a select group. Finally, public service provision is good for development in the long term because it can solve coordination problems by adopting a multi-sector approach and providing services on a large scale that generates greater efficiency and reduces costs. However, providing more public services to those who pay more taxes can exacerbate economic inequalities over time by developing more public services in rich areas than in poor areas. For all of these reasons, a mixture of the benefits approach and the ability-to-pay approach is often thought to be the most suitable.

Principles of municipal finance: Local government autonomy

To meet some of the shortcomings of the benefits approach, theorists have begun placing greater emphasis on the need for local governments to be given the autonomy to determine what works best for their local economy. Among these suggestions are the following:

  • Local governments should be allowed to set local tax rates.
  • The tax rate should be in line with expenditure responsibilities across the area of jurisdiction
  • Incentives should be in place to help local governments be fiscally responsible.12

Development economists such as Amartya Sen believe that it is not just a question of fiscal autonomy, but of providing the freedom for citizens and public policy practitioners to engage with local notions of development when making governance decisions.13 If local government is to work for citizens, it must be in dialogue with the goals and aims of local residents.

When it comes to the principles of municipal finance, this new emphasis takes the form of advocating greater freedoms for local governments to experiment, so as to determine what works and what does not in their area. This is not, however, a license for bureaucrats to do whatever they feel like; the aim is to promote a sense of responsibility for decision-making among local government personnel. As much as possible, city leaders should know the revenue coming in and the costs of the services currently provided, and be able to nurture the link between these two so that all involved act with responsibility and care—citizens and bureau-crats alike. Ilias Dirie, a municipal finance expert, explains:14

  • 12. Hamish Nixon, Victoria Chambers, Sierd Hadley, and Thomas Hart, Urban Finance: Rapid Evidence Assessment (London, Overseas Development Institute, 2015), p. 6.
  • 13. Amartya Sen, Development as Freedom (Oxford, Oxford University Press, 1999). For an explanation and defense of the wideness of Sen’s acceptable notions of development, see Sabina Alkire, Valuing Freedoms: Sen’s Capability Approach and Poverty Reduction (Oxford, Oxford University Press, 2002), pp. 8–10.
  • 14. Ilias Dirie, Municipal Finance: Innovative Resourcing for Municipal Infrastructure and Service Provision (London, Commonwealth Local Government Forum, 2006), p. 260. Quoted in Hamish Nixon, Victoria Chambers, Sierd Hadley, and Thomas Hart, Urban Finance: Rapid Evidence Assessment (London, Overseas Development Institute, 2015), p. 6.

The development of responsible and responsive local government is thus dependent on local government having at least some degree of freedom with respect to local revenues, including the freedom to make mistakes and be held accountable for them. This means that local government must have control over the rates of some significant revenue source if they are to be fiscally responsible and able to innovate as to the way they finance basic services.

For federal or devolved states, fiscal responsibility can also involve political responsibility as citizens vote on representatives who are in a position to lead and direct local governments. When this is the case, it is all the more important that a social contract is developed between citizens and the government, where both sides understand their duties towards the common good, and both realize the benefits of good governance.

Political representatives also have a responsibility to ensure that national–local relations are fostered in support of the sustainability of municipal finances. As a 2015 UN-Habitat report explains:15

  • 15. UN-Habitat, The Challenge of Local Government Financing in Developing Countries (Nairobi, United Nations Human Settlements Programme, 2015), p. 8.

Where local authorities are able to derive revenues from property taxes and service charges, meaningful tax increases are sometimes refused or delayed by central governments for fear of eroding political support from the urban population; or even rejected by the local authorities themselves for fear of political backlash from local taxpayers.

It can be difficult to achieve sustainable municipal finances within the narrow time of an electoral cycle. However, the accountability provided by elections can act as an excellent check on corruption, and the disruptive impact of elections often declines over time.16 In addition, changes in leadership can create new opportunities for thorough monitoring and evaluation of systems of municipal finance by city leaders.

  • 16. Staffan I. Lindberg, Democracy and Elections in Africa (Baltimore, John Hopkins University Press, 2006).

Conclusion

 

The demands placed on municipal governments are likely to increase with the growing urbanization of the world’s population. At the same time, there are clear principles that allow local government practitioners to guide their finances towards a position of self-sustainability. Robust municipal finances are integral to development, and play a unique role in governance because of the closeness of local governments to citizen needs.

The discussion in this first chapter has generated the following checklist that can foster reflection on the sustainability of one’s municipal finances:

  • Are the powers of taxation exercised by my government lawful and in line with the constitution?
  • Is my government reliant more on internal or external revenue sources?
  • Have the benefits of the goods and services my government provides been tied to specific taxes or service fees?
  • Do government decision-makers feel they have the freedom to change policies based on citizen needs? Do they have room for experimentation in seeing what might work better?
  • Have we given sufficient care and attention to the need to build citizen support for our taxes and fees, and to the question of how we can form an effective social contract?
  • Could our relations with the national government be improved to avoid unnecessary volatility in our budget?

In the midst of all of these concerns and decisions, it is important to keep in mind the principle of subsidiarity: Those duties carried out locally are done so because they can be implemented with efficiency and local creativity. This principle can aid in assessing the appropriateness of government duties at the local level.