Chapter 4: Decentralization and Local Government Financing

Armando Morales
Armando Morales is the IMF resident representative in Kenya, and has worked on different multi-country studies on economic policy issues in Latin America, Asia, and Africa.
Daniel Platz
Daniel Platz is the focal point for stakeholder engagement in the Financing for Development Office of the UN, where he is part of a team that monitors and promotes the implementation of the Addis Ababa Action Agenda, the Doha Declaration on Financing for Development, and the Monterrey Consensus.
Leonardo Letelier
Leonardo Letelier is the director of graduate studies at the Institute of Public Affairs at the University of Chile, and has published extensively on fiscal decentralization, a field in which he has worked as a consultant for the UN, the Inter-American Development Bank, and the World Bank.

Introduction

Fiscal decentralization—which entails shifting some responsibilities for expenditures and/or revenues to lower levels of government—has become a mainstream alternative framework for fiscal policy. It is generally a response to unsatisfied political demand for greater regional autonomy, or the result of a large economic divide between rich and poor regions. In a few cases, linguistic and cultural divides explain such trends. In many emerging and low-income countries, all these factors play a role, with tensions among ethnic groups an additional factor exerting pressure for decentralized public service delivery.

The debate over decentralization entails political, administrative, and fiscal dimensions. The philosophical debate can be traced to Alexander Hamilton and Tocqueville in the 18th and 19th centuries. A new wave of academic and political interest in the subject arose in the wake of the Soviet collapse as a framework to assess policy options for the so-called transition economies. Soon after, the wave hit Latin American countries, coinciding with the recovery of democracy in some cases, and the end of violent internal conflicts in others. Some conservative governments in Europe also promoted decentralization in the 1980s and 1990s, in part because of a pro-market impulse promoted by globalization.1

 

  • 1. 1 V. Tanzi, “The Future of Fiscal Federalism,” European Journal of Political Economy, vol. 24 (2008), pp. 705–712.

Fiscal decentralization has emerged as an effective policy tool for improving the efficiency of public expenditures and revenue generation

More recently, fiscal decentralization has emerged as an effective policy tool for improving the efficiency of public expenditures and revenue generation. This chapter reviews how fiscal decentralization is implemented, arguments for and against fiscal decentralization, challenges facing subnational governments in managing their local finances, tools that local governments can use to enhance their fiscal autonomy, and international experience with fiscal decentralization in both developed and developing countries.

How does fiscal decentralization work?

The fiscal decentralization process varies by country. Unitary and federal governments differ in the way that central governments interact with local governments. In unitary governments, some degree of decentralization is possible, depending on the framework for interaction among central and subordinate levels of government (e.g., central, provincial, and district levels). In comparison, federal governments, by definition, are composed of subnational governments with greater autonomy granted in legislation. Decentralized decision-making allows for local participation in development in line with national objectives.

Public services are allocated to local or regional governments based on the combination of different criteria. These may include population size, fiscal capacity, development needs, and idiosyncratic socio-economic features. Specific functions are usually shared between higher levels of government, which exercise a regulatory or policy role, and lower levels of government responsible for service delivery. For example, the technical specifications for bridge construction might come from a higher level of government, with the local government being in charge of construction and maintenance at the local level.

The allocation of resources to local governments must be consistent with their expenditure responsibility, as this will result in better accountability for service delivery. Additional institutional arrangements are needed for intergovernmental coordination, planning, budgeting, financial reporting, and implementation. For such arrangements to work, transparency and accountability to local constituencies should be encouraged by adequate reporting and oversight of local fiscal performance. By contrast, detailed central control may render decentralization ineffective. Clear rules for the transfer and use of fiscal resources combined with appropriate coordination between different levels of government could go a long way towards ensuring efficient use of resources thanks to more effective service delivery.

Pros and cons of fiscal decentralization

Two questions are useful for understanding the pros and cons of fiscal decentralization: (1) Why are some countries more fiscally decentralized than others? and (2) What are the potential effects of decentraliza-tion on the quality of the delivery of public goods? If decentralization were the result of exogenous factors such as median voter income, the degree of demo-graphic heterogeneity, or the type of political institutions involved, there would be little room for the national government to promote decentralization from above. If instead decentralization is seen as the best way to ensure optimal public service delivery, it should be treated as an integral part of fiscal policy.

Arguments in favor of fiscal decentralization

One of the powerful normative arguments in favor of decentralization is the proper representation of local voters. Limited knowledge of individual preferences by central government officers has often translated into sub-optimal decisions on the best allocation of public resources. This line of thought is an extension of Hayek’s lucid defense of the market economy.2 In this view, local bureaucrats and political leaders are likely to know more about people’s preferences than are central government officers. A variation of this argument is that, while centralization is associated with the homogenous provision of public services for all citizens across the nation,3 this may collide with heterogeneous local preferences across jurisdictions. Thus, devolution of fiscal and political powers to lower tiers of government would be a way to promote an efficient allocation of resources through which local demands are fully understood and properly attended to at the local (subnational) level of government.

A second strand of normative arguments sees local political jurisdictions as operating in the same way as an efficient and competitive private market.4 Local governments come to exist in the same way as private firms enter a particular industry, in response to demands from a particular community. Likewise, they can eventually be removed from the “local public goods industry” if the administrative cost of operating a particular jurisdiction becomes too high with respect to residents’ tax-revenue-generation capacity. Local jurisdictions may become “spatialized” by providing specific types of local services in the same way as different firms produce differ-ent varieties in line with differences in consumer desires and in the intended use of market products. Autonomous jurisdictions would compete in the provision of local public services tailored for differ-ent communities based on their own preferences. Conceptually, voters would “reveal their preference” for local public goods through the political process, by supporting (penalizing) good (poor) performance of local governments, holding them accountable for the quality of local service delivery. This “accountability advantage” would be diluted at the national level, in which political responsibilities are widespread, and voters’ capacity to oversee government performance is weaker.6

An alternative view depicts the government as a “rent seeking” economic agent trying to take advantage of its power to extract Ricardian rents from taxpayers. Following this line of reasoning, decentralization may be seen as an institutional device to protect individuals from governments,6 in the same way as central banks safeguard monetary policy from undue influence from government. National governments are regarded as being no different from private monopolies, to the extent that they are the sole entities collecting taxes and/or delivering public goods. As a result, they would tend to charge higher prices (taxes) and deliver lower-quality public goods relative to a competitive situation. As voters become more aware of the dangers of the “Leviathan,” this theory predicts that the median voter will automatically bias his political preferences towards more decentralized institutional arrangements. This partly explains why high-income countries tend to be more decentralized.7 In line with this hypothesis, an extensive empirical literature has attempted to provide evidence that fiscal decentralization leads to a lower tax burden, with inconclusive results.

Arguments against fiscal decentralization

Alternative views challenge three major assumptions of theories that treat the dynamics of the “local public goods industry” as equivalent to those of private competitive markets. These alter-native views challenge the assumptions that (1) local governments are genuine representatives of their constituencies and try to compete to please residents through the best possible combination of prices (taxes) and local public goods quality; 2) the “local public goods industry” is broadly competitive, with no externalities among jurisdictions, and with all local costs and benefits fully internalized by local residents, and 3) local voters not only vote at the ballot box, but also do so with “their feet” by choosing the jurisdiction where they want to live, taking into account the type of local government they want to have.

At the core of these challenges is the fact that the revelation of citizens’ preferences may be rather imperfect, seeing as how many national and local governments do not face the necessary incentives to compete and/or maximize the welfare of their constituencies. This is because a well-functioning democracy is not always in place at both the national and the local levels, especially in develop-ing countries.8 Moreover, decentralization in imperfect democracies could result in excessive closeness between local authorities and big local private interests, which may lead to corruption and elite capture. Finally, there is some empirical evidence pointing to stronger professional qualifications and better availability of information for central government officers relative to local authorities.

Additionally, the assumption of high mobility across jurisdictions is not confirmed by empirical evidence. First, family and labor ties may prevent mobility from occurring in a Tiebout fashion. In other words, for various reasons, citizens may be unable to change locations in order to maximize their individual utility. Political scientist Daniel Treisman argues that poorly performing local governments are unlikely to be disciplined by residents’ mobility,

as the quality of local services is mainly capitalized into property prices, making “voting with their feet” a costly affair for homeowners and tenants.9 Moreover, subnational governments may not have the necessary incentives to target the local poor, for which mobility is more costly. In addition, excessive mobility across jurisdictions could also be a problem, as it may translate into additional fiscal pressures on local governments showing above-average performance because of an increasing number of potential beneficiaries coming from other jurisdictions.

The potential for fiscal imbalances resulting from fiscal decentralization deserves separate mention.10 A moral hazard problem may arise if local governments expect a “guarantee” from the national government at the time they decide on tax bases and tax rates, leading to over-borrowing.11 A moral hazard problem arises because of the possibility of a bailout of local governments by the central government.12 This is more likely in countries with weak and poorly designed institutions, often found in developing countries.

The case for fiscal decentralization

The case for decentralization is necessarily empirical. Recognizing that government functions encompass a wide range of specific tasks, Letelier and Saez postulate that two effects should be distinguished when it comes to the optimal degree of decentralization.13 On the one hand, if power is delegated to jurisdictions that are too small, a loss in economies of scale could result (“scale effect”), raising the cost of public goods and rendering decentralization a cost-inefficient solution. On the other hand, the “Von Hayek effect” over time would lead to better knowledge by local governments about people’s needs as decentralization takes root and allows collective demands to arise from below. Thus, the optimum degree of decentralization would depend on the balance between both effects.

  • 2. Friedrich Hayek, “The Use of Knowledge in Society,” American Economic Review, vol. 35, no. 4 (1945), pp. 519–530.
  • 3. W. Oates, Fiscal Federalism (New York, Harcourt Brace Jovanovich, 1972).
  • 4. J. Tirole, “The Internal Organization of Government,” Oxford Economic Papers, vol. 46 (1994), pp. 1–29; C. M. Tiebout, “A Pure Theory of Local Expenditures,” Journal of Political Economy, vol. 64 (1956), pp. 416–424.
  • 6. G. Brennan and J. Buchanan, The Power to Tax: Ana-lytic Foundations of a Fiscal Constitution (New York, Cam-bridge University Press, 1980).
  • 7. S. L. Letelier, “Explaining Fiscal Decentralization,” Public Finance Review, vol. 33, no. 2 (2005), pp. 155–183; U. Panizza, “On the Determinants of Fiscal Centralization: Theory and Evidence,” Journal of Public Economics, vol. 74, issue 1 (1999), pp. 97–139; S. L. Letelier and J. M. Saez Lozano, “Fiscal Decentralization in Specific Areas of Govern-ment: An Empirical Evaluation Using Country Panel Data,” Government and Policy: Environment and Planning, vol. 33, issue 6 (2014), pp. 1344–1360.
  • 8. R. Prud’homme, “The Dangers of Decentralization,” World Bank Research Observer, vol. 10, no. 2 (1995), pp. 201–220.
  • 9. D. Treisman, The Architecture of Government: Re-thinking Political Decentralization (Cambridge, Cambridge University Press, 2007).
  • 10. T. Terminassian and J. Craig, “Control of Subnational Government Borrowing,” in Fiscal Federalism in Theory and Practice, ed. T. Terminassian (Washington, IMF, 1997).
  • 11. S. L. Letelier, “Theory and Evidence of Municipal Borrowing in Chile,” Public Choice, vol. 146, no. 3–4 (2011), pp. 395–411.
  • 12. A. Alesina, E. Glaesser, and B. Sacerdote, Why Doesn’t the US Have a European-Style Welfare State? (Washington, D.C., Brookings Institution, 2001); Signe Krogstrup and Charles Wyplosz, “A Common Pool Theory of Supranational Deficit Ceilings,” European Economic Review, vol. 54, issue 2 (2010), pp. 269–278; G. Pisauro, Fiscal Decentralization and the Budget Process: A Simple Model of Common Pool and Bailouts (Perugia, Italy, Societa Italiana di Economia Pubblica, 2013).
  • 13. S. L. Letelier and J. M. Saez Lozano, “Fiscal Decentral-ization in Specific Areas of Government: A Technical Note,” Economía Mexicana NUEVA EPOCA, vol. 22, issue 2 (2013), pp. 357–373.
Nairobi skyline, Kenya

How to maximize potential benefits and contain fiscal risks in decentralized fiscal systems

Fiscal decentralization should be seen as part of a comprehensive fiscal framework. Isolated changes may eventually create inconsistencies across government levels, undermining the effectiveness of fiscal policy and increasing macroeconomic risks.14 Case Study 1, which examines decentralization in sub-Saharan Africa, and Case Study 2, which looks at the decentralization process in Colombia, illustrate the challenges entailed in containing fiscal risks in decentralized systems.

Experience suggests that the essential elements of a comprehensive decentralization framework that maximizes potential benefits while minimizing risks include (1) clarifying spending responsibilities across levels of government, (2) allowing subnational government to raise own-source revenues to increase fiscal responsibility, (3) designing a transfer system that aligns incentives, and (4) imposing a hard budget constraint on subnational governments.

Clarity in spending assignments is required for efficient provision of public services. For example, separating investment and maintenance functions risks suboptimal outlays for both categories, as no level of government is fully accountable for the delivery of the final good. In Mexico, for instance, the education sector suffered a deterioration of physical infrastructure precisely because of this vicious circle.15 Physical capital such as water supply systems, sewerage systems, roads, and power plants also require long-term maintenance to ensure services provided are of high quality. Unfortunately, asset management has often been neglected in developing countries because of capacity constraints.16

By contrast, a prolonged mismatch between spending responsibilities and the allocation of resources could lead to waste and/or to deterioration in the quality of service delivery. In some cases (e.g., China and Brazil) the devolution of resources significantly outpaced that of spending, leading to inefficiencies in the use of resources. In other cases (e.g., the transition economies in the early 1990s) available resources were not consistent with spending mandates, leading to the accumulation of debt or arrears and/or the significant deterioration in the quality of decentralized public services.

Potential incentives to relax fiscal discipline in the process of fiscal decentralization should be addressed. A common pool problem opens up when local governments have a reasonable expectation of receiving significant transfers from the central government over a sufficiently long period of time and therefore are encouraged to spend beyond their nominal budget constraints.17 In addition, soft budget constraints, interregional competition, unfunded mandates, and short electoral cycles could make the common pool problem even more complex.18

Market discipline should be instilled by limiting government financing or guarantees within a well-defined transfer framework. However, this may conflict with the aspirations for greater autonomy by local governments. Alternatives to be considered include administrative constraints (debt ceilings, government guarantees); the introduction of fiscal rules at the county level in an effort to minimize the risk of reporting distortions aimed at escaping the rule (such as off-balance transactions in the case of China, or improper reclassification of current spending as capital expenditure in Denmark); and/ or cooperative schemes to raise awareness among local governments of the implications of their decisions (e.g., Australia). A combination of all these alternatives would require strong leadership by the central government and high management standards to avoid a bureaucratization of the process.

A particular problem arises in the case of countries with sizable actual or potential natural resources. The challenge of managing resource revenue exhaustibility and volatility while transforming sub-soil assets into financial, physical, and human capital assets becomes more complex for federal or decentralized systems. Regions feel entitled to benefit directly from fiscal resources coming from the exploitation of natural resources in their jurisdiction. This may lead to a detraction of resources from their optimal use, especially in the absence of fiscal rules addressing demand management (short term) and inter-temporal solvency (long term). The fiscal policy framework should be country-specific by incorporating particularities of regional needs, the resource horizon (temporary versus long-last-ing), sensitivity to revenue volatility (high or low), domestic capital scarcity/development needs, absorption capacity, and public investment efficiency. As a general rule, a high proportion of resource revenue should go to savings and domestic investment, while smoothing spending by delinking it from resource revenue dynamics.19

  • 14. International Monetary Fund, Macro Policy Lessons for a Sound Design of Fiscal Decentralization—Background Studies (Washington, IMF, 2009).
  • 15. World Bank, “Conflict, Security and Development,” in World Development Report (Washington, World Bank, 2011).
  • 16. World Bank, Municipal Finances: A Handbook for Local Governments (Washington, World Bank, 2014).
  • 17. C. Wyplosz, Fiscal Rules: Theoretical Issues and His-torical Experiences (Cambridge, Mass., National Bureau of Economic Research, 2012).
  • 18. A. Plekanov and R. Singh, How Should Subnational Borrowing Be Regulated: Some Cross-Country Empirical Evidence (Washington, IMF, 2007).
  • 19. International Monetary Fund, Macroeconomic Policy Frameworks for Resource-Rich Developing Countries (Washington, IMF, 2012).
Pedestrians in Guadalajara, Mexico

Financing arrangements for subnational governments

Increased urbanization and political decentralization have led to large subnational infrastructure financing needs around the globe. Successful decentralization will increase local expenditure responsibilities as well as local governments’ capacity to fund them, including financing arrangements to enable subnational governments to mobilize sufficient resources for capital investments. Capital investment is needed to construct, retrofit, restore, or upgrade capital assets related to the provision of social infrastructure (water supply, sanitation, sewage disposal, education, and health) and physical infrastructure (transportation, power, and information and communication technologies). Implementing the 2030 Agenda for Sustainable Development at the local level, including the mitigation of or adaptation to climate change, will further increase the need for green infrastructure investments.

Long-term finance can help address large upfront costs of infrastructure projects and their long amortization periods. Access to long-term finance would also allow local governments to smooth out the pro-cyclicality of intergovernmental capital transfers or excessive volatility of revenue sources. However, when municipalities take out loans to finance their infrastructure requirements, local own-source revenues and intergovernmental transfers need to be sufficient to cover repayment in the long term. Local revenues need to be strengthened before local authorities can become creditworthy borrowers. Domestic financial markets need to be developed as well, since even the most creditworthy municipalities may be ill-equipped to borrow sufficiently from international markets without additional guarantees. Thus, lack of creditworthiness at the local level is the major demand-side constraint to optimal decentralization, while shallow financial markets constitute a major supply-side constraint. As demand- and supply-side constraints are removed, well-designed and engineered financing arrangements can unlock the long-term funds needed for local infrastructure investments.20

Overcoming demand constraints: Achieving creditworthiness

Raising subnational borrowing necessarily requires a demonstrated ability to maintain a reliable surplus of revenues over expenditures. Local revenue sources may include user fees and charges, taxes/ levies, and intergovernmental transfers, sometimes supplemented by bilateral or multilateral development assistance. Further potential sources include investment income, property sales, land value capture, and licenses. User charges and fees are mostly levied where people pay for the benefits and utilities they receive (e.g., water supply, sanitation, energy, parking space). At the same time, taxes are the more appropriate tool to finance the provision of public goods for the entire community, such as police, ambulance, firefighters, streetlights, etc.

Local governments in developing countries remain largely dependent on intergovernmental fiscal transfers and tax-sharing mechanisms to fund priority investments. Resource flows from higher to lower tiers of governments average 70–72 per cent of local government funding in developing countries and 38–39 per cent in developed countries.21 If well-designed, these transfers may further crowd-in local revenue generation. In Tanzania, a one per cent increase in intergovernmental transfers has led to an extra 0.3–0.6 per cent increase in own-source revenue generation for local government authorities.22 Governments and donors should provide incentives for local governments to improve their capacity for revenue generation. For example, performance-based grants and subsidized lending followed by market-based incentives would help local governments develop borrowing practices over time, empowering them to fund the capital investment needed to meet their sustainable development objectives.23

Sound management will support local governments’ financial health. The four tenets of sound financial management include budgeting, account-ing, reporting, and auditing. Funds should not only be appropriately spent and monitored, but availability of information should be adequate for proper planning and budgeting. More broadly, good management has a direct impact on the quality of services that may translate into higher revenue potential. A successful experience in Kampala, Uganda, shows significant progress in expand-ing the city’s rates and fees base by updating its property register, licensing taxis and other business-es, and improving debt collection, which translated into an 80 per cent increase in internal revenue in two years.

Strengthening the supply side: Building inclusive and resilient local credit markets

Policies that build active government bond markets create benchmarks for investors interest-ed in subnational debt. In the Addis Ababa Action Agenda, countries agreed to strengthen long-term bond markets as a source of development finance, along with capital market regulations designed to reduce excess volatility and promote long-term investment aligned with sustainable development. Recent research shows that local currency bond market development is positively related to sound regulatory frameworks, adequate rule of law, and greater trade openness.

A proper legal and regulatory environment is crucial for a sustainable municipal credit market. Effective judicial frameworks, including a government bankruptcy framework (e.g., Chapter 9 in the United States), help sustain the municipal bond market by protecting the rights and obligations of creditors and debtors at the subnational level. In some countries, mandatory provisions for municipal revenue cushions (“master trusts”) and mandatory issuer ratings have promoted investor interest in municipal bonds and increased municipalities’ access to long-term bank loans.

Rating agencies can help overcome the lack of investor familiarity with the risk profile of local capital investments. At the local level, the challenge is the municipalities’ lack of engagement (Figure A). Indeed, even in developed countries outside the United States (where over 12,000 municipalities are rated by S&P alone), few subnational entities have requested ratings from any of the three major rating agencies. For subnational entities in many low-income countries, ratings are simply not afford-able, as the major agencies are not active in these countries. International development agencies can play a critical role in lowering the entry barrier of rating agencies by paying for the first few municipal credit ratings so that the first issuers do not have to bear the costs.

  • 20. Daniel Platz and David Painter, Sub-Sovereign Bonds for Infrastructure Investment (Washington, G24, 2010).
  • 21. Munawwar Alam, Intergovernmental Fiscal Transfers in Developing Countries: Case Studies from the Commonwealth (London, Commonwealth Secretariat, 2014).
  • 22. Takaaki Masaki, The Impact of Intergovernmental Grants on Local Revenues in Africa: Evidence from Tanzania (Ithaca, N.Y., Cornell University, 2015).
  • 23. Paul Smoke, “Financing Urban and Local Development: The Missing Link in Sustainable Development Finance: A Briefing on the Position of the Role of Local and Subnational Governments in the Deliberations Related to the Financing for Development Conference,” United Nations, “The Addis Ababa Action Agenda,” 2015.
Figure
A
:
Number of local authorities that have received ratings from at least one of the three major global agencies, by country and income group (2009 and 2015)
Figure A
Note:
In the United States (not included in the figure), over 12,000 municipalities are rated by one of three major agencies.

Promoting local rating agencies could create a more favorable environment to rate local governments less familiar with international agencies. For example, in recent years a few regional rating agencies have emerged in Africa and gained reputational capital with investors, such as the West African Ratings Agency (established in 2005) and Bloomfield Financial (established in 2007), joining the ranks of older agencies such as Agusto and Co. (1992) and the Global Credit Ratings Company (GCR). Dakar and Kampala in Uganda have received high ratings from local agencies. Kampala received an A in the long term from GCR, its highest global rating.

Entering the municipal credit market

Lending from banks—often government-owned financial institutions and development banks—is the primary source of local credit financing in most advanced economies outside the United States. Municipal bonds are dominant in the United States, where even the smallest of towns can raise millions of dollars in bond issuances. Its US$3.7 trillion municipal bond market remains unique in the world. Other large cities have only gradually entered the municipal bond market. In middle- and low-income countries, subnational access to capital markets is circumscribed to larger cities; some municipal bonds are floating in African markets such as South Africa, Nigeria, and Cameroon. Local governments without access to private or public credit rely entirely on capital grants from central governments to fund large-scale investments.

Project design matters. General creditworthiness of the municipality is crucial, but infrastructure projects need to be carefully planned, engineered, and costed to be successfully financed. This requires upfront investment in project development services from market demand analysis to detailed engineering design. Many municipalities and public utilities, especially in developing countries, do not have the resources to pay for this initial work. Specialized “project development facilities” could help overcome this problem. They can play differ-ent roles depending on specific needs. For instance, in the early 2000s, bilateral donors supported the Municipal Infrastructure Investment Unit (MIIU) in South Africa, which then successfully provided financial, technical, and managerial support to municipalities and public utilities. More recently, the Rockefeller Foundation and the International Finance Corporation have created a “Project Development Facility for Resilient Infrastructure” to finance legal, technical, and financial advice from highly skilled consultants for cities seeking to finance infrastructure projects.

Different forms of credit enhancements can further help subsovereign issuers lower default risk. Credit enhancement mechanisms can take the form of revenue cushions for payback (e.g., “sinking funds” in the United States, “federal tax-sharing grants” in Mexico, or “bond service funds” in Tamil Nadu, India), partial or 100 per cent external guarantees for bond repayment (e.g., USAID partial guarantees for repayment of the first Johannesburg bond), or the use of pooled financing. A well-structured bank loan or bond may make use of several credit enhancement mechanisms at the same time. Complementarily, national, regional, and multilateral development banks play a crucial role, as they can lend to municipalities directly under favorable conditions (both in terms of rates and maturities). Development banks can build investor confidence by underwriting, guaranteeing, or investing in municipal debt, including securities, enabling local governments to build up their credit histories.

The global landscape of municipal credit markets

Advanced municipal finance tools are available once demand- and supply-side barriers are overcome (see Table 1). These include local government-based financing options (e.g., general obligation bonds, revenue bonds, green bonds), development exactions (e.g., linkage fees, impact fees), public and private options (e.g., public–private partnerships [PPPs], pay for performance), and mechanisms to leverage the private sector (e.g., loan guarantees, tax increment financing). Although the use of such market-based financing mechanisms is growing, they are largely confined to prosperous municipalities in advanced economies (e.g., the United States, Western Europe, and some other OECD countries). Some require the participation of several partners, including private capital, and others largely rely on the coercive power of local governments.

A number of borrowing mechanisms have been used by municipalities that are not yet investment-grade creditworthy but have undertaken significant efforts in this direction:

  • Municipal development funds operated by national or state government entities mobilize resources from private lenders, the central government, and donor agencies, and on-lend these resources to subnational governments to finance capital investment programs. Terms are normally concessional, although capacity to repay debt obligations is an important criterion to access these funds. More complex arrangements may pursue the dual objective of financing local infrastructure investments and strengthening local credit markets. In Colombia, the Findeter Fund used external borrowing to rediscount loans made by private commercial banks to public local authorities and local private entities for investing in urban services and utilities. The success of a model like Findeter depends on the depth of the local financial markets and the availability of capable financial institutions that can take on credit risk related to municipal and urban services loans at a substantial scale.
  • In poor countries, hybrid financing, a combination of market loans and grants, helps local authorities keep debt service affordable. In Burkina Faso, the hybrid financing for the reconstruction of Ouagadougou following the destruction of its central market by fire, comprised access to long-term resources from the Agence Française de Développement (AFD) and a €3 million grant, without using a central government guarantee.24
  • Many large cities across the globe have used land-based revenues to finance capital investments. For example, in Shanghai, 46 per cent of urban growth was funded through land-based financing mechanisms by which the city sold developed land to operators of commercial or industrial zones, and revenues were reinvested in municipal infrastructure. In the case of land development or concession development PPPs, land is sold to developers for the construction and operation of an infrastructure facility. Other methods to capture revenues from land include buying land and reselling it at a higher value following service improvements (e.g., through public transportation improvements) or levying impact fees on the population that benefits from development projects. While these mechanisms are not without practical hurdles (particularly in terms of evaluating gains and identifying beneficiaries), their potential has to be fully tapped, especially in cities where most land is held by the central government.25 However, it is important to recognize that land value can also be exposed to market volatility, and sharp increases in value during economic booms can lead to excessive borrowing, creating macroeconomic risks.26
  • Assisted pooled financing holds potential in developing countries with heterogeneous municipalities. In this case, a credible intermediary, such as the national or state government, issues a single debt instrument backed by a diversified pool of loans to municipal utilities and covered by a pre-established debt service fund. This scheme offers investors access to a diversified portfolio of borrowers. For example, the State of Tamil Nadu, India, used a pooled financing facility to finance water and sanitation projects for 13 small municipalities, at longer tenors and lower cost than would have been otherwise possible. However, coordination costs could be high, and highly rated subnational governments may be reluctant to participate. Combining pool financing with credit enhancements supported by donors and private sector companies to identify and put together a pool of investable infrastructure projects could allow access to local bank and capital market financing on a non-recourse basis.27
  • 24. Thierry Paulais, Financing Africa’s Cities: The Impera-tive of Local Investment (Washington, Agence Française de Développement and the World Bank, 2012), p. 43
  • 25. Thierry Paulais, Financing Africa’s Cities: The Imperative of Local Investment (Washington, Agence Française de Développement and the World Bank, 2012), p. 43
  • 26. World Bank, Planning, Connecting, and Financing Cities—New Priorities for City Leaders (Washington, World Bank, 2013).
  • 27. Daniel Bond, Daniel Platz, and Magnus Magnusson, Financing Small-Scale Infrastructure Investments in Developing Countries (New York, United Nations Department of Economic and Social Affairs, 2012).
Table
1
:
Advanced municipal finance tools
Table 1

Conclusion

Fiscal decentralization can serve as an effective policy tool for improving the quality and provision of public services, government accountability, and the efficient use of local financial resources. However, in order to achieve successful fiscal decentralization, central and local governments must be strategic in how they decentralize fiscal responsibilities to local governments both in terms of revenue generation and expenditures. Moreover, the decentralization of fiscal authority to subnational governments must consider both the local capacity of municipal governments and the legal and regulatory framework in which they will assume these responsibilities.

Delegating local expenditure and revenue generation responsibilities to municipal governments connects the consumers of public goods and services directly with local government officials who determine how public funds are allocated and what tax policies are implemented. If strong institutions, good governance, and a supportive legal and regulatory framework are in place, fiscal decentralization can support and enhance municipal finance.

Case study
1
:
Challenges in building institutions in sub-Saharan Africa

In the case of sub-Saharan Africa, rapid fiscal decentralization has been introduced in part as a way to defuse ethnic tensions. In sub-Saha-ran African countries there is a clear legal definition of powers and functions in the various levels of government. Functions assigned to the national level relate mainly to policy and standard setting, and the provision of public goods such as national security. Subnational governments, on the other hand, are responsible for policy implementation and local service delivery, such as health, water, local roads and transportation, most agriculture extension services, and primary education (except for Kenya, where only preschool education is provided by subnational governments). In Kenya (2010) and Nigeria (1967) devolution started as an alternative to ethnic dominance in centralized systems, while in Uganda (1986) it followed a civil war. In South Africa fiscal decentralization followed the collapse of the apartheid system in 1994. Initial capacity limitations in South Africa led to the introduction of a reporting system by subnationals, which eventually led to the implementation of a multi-year budget framework. In Kenya, initial challenges pertaining to service delivery are being addressed, but there are lingering budget preparation problems at the national level and particularly at the county level.

Efforts to improve budget processes appear more urgent in the face of fiscal decentralization. Kenya and South Africa addressed simultaneously the problems of capacity, information, and financial management. In South Africa, the authorities showcased the subnational governments that had demonstrated their capacity to perform through a peer learning and mentorship approach, combined with benchmarking to identify and address the main cost drivers. In that context, improving budget formats, introducing a new fiscal classification system, improving accounting standards, and reforming the chart of accounts were essential elements for reforming the financial management system, and improving information for benchmarking. In Kenya, inter-governmental coordination during the transition has been supported by a Transition Authority and by the Intergovernmental Budget and Economic Council, with the participation of all 47 county governors and the cabinet secretary for the National Treasury, chaired by Kenya’s Deputy President of the Republic.

Sound fiscal rules have been generally successful so far at preventing excessive borrowing by subnational governments. Specifically, borrow-ing by subnational governments is limited to financing development projects and for short-term liquidity management. In addition, any long-term borrowing in Kenya, Nigeria (for external debt only), and Uganda is subject to approval by the national government (this requires a guarantee in the case of Kenya and Nigeria), and there is an overall cap on the stock of debt for subnational governments in both countries (20 per cent of last year’s audited revenue in Kenya, 50 per cent in Nigeria, and 25 per cent in Uganda). In South Africa, legislation prohibits the guaranteeing of subnational government debt by the national government. Instead, a transparent mechanism for public bankruptcies is in place, complemented by tough sanctions if subnational governments ignore public finance management rules. In Nigeria, sharing oil proceeds with oil-producing states has exposed the latter to large swings in revenue, undermining the regional income equalization objective. As a result, the reduction in federal and state revenue has been larger than the related fall in oil prices.28 This has conspired against a sound budget process, often leading to salary arrears, default on bank obligations, and partial bailouts by the federal government.

  • 28. E. Ahmad and R. Singh, Political Economy of Oil-Revenue Sharing in a Developing Country: Illustrations from Nigeria (Washington, IMF, 2003).
Downtown Nairobi, Kenya

Case study
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Improving fiscal management and decentralization in Colombia

29During the 1990s, fiscal decentralization policies in Colombia mandated sizeable intergovernmental transfers to subnational governments. While there is good reason to believe that subnational governments are better positioned to provide local public goods and services and respond to local needs, intergovernmental transfers should be matched with spending mandates that reinforce subnational expenditure account-ability. In the absence of such mandates, fiscal discipline at the subnational level was significantly weakened. Moreover, Colombia’s fiscal decentralization policy lacked incentive mechanisms that would support own-source revenue generation at the local level.

In an effort to address these policy shortcomings, several reforms were implemented beginning in the mid 1990s. For example:

“Law 819 improved fiscal coordination among different levels of government, requiring both the central administration and local governments to present each year a consistent 10-year macroeconomic framework…budgets would need to be balanced over a 10-year period. It further stipulated that fiscal management at all levels of government, including expenditure authorization and revenue collection, had to be consistent with the medium-term macroeconomic framework.”30

Other reforms addressed incentive mechanisms for subnational governments to generate own-source revenues, municipal expenditure requirements, and earmarking policies that had proven ineffective.

The case of Colombia demonstrates the importance of establishing a legal and regulatory framework that aligns the goals of fiscal decentralization with expenditure incentives and accountability mechanisms. Moreover, this case highlights the importance of reforming fiscal decentralization policies over time and incorporating lessons learned into policy design and implementation.

  • 29. A. Fedelino and T. Ter-Minassian, Macro Policy Lessons for a Sound Design of Fiscal Decentralization (Washington, D.C., International Monetary Fund Fiscal Affairs Department, 2009). Available from http://www.imf.org/external/ np/pp/eng/2009/072709.pdf.
  • 30. Annalisa Fedelino, Making Fiscal Decentralization Work: Cross-Country Experiences (Washington, D.C., International Monetary Fund, 2010).
Rocinha in Rio de Janeiro, Brazil