Financing local government
State and local governments play an important
role in providing public services. Decentralizing
shares of total government revenuenot including
intergovernmental grants-also vary widely, rang-
both spending and revenue authority can improve
the allocation of resources in the public sector by
linking the costs and benefits of local public services more closely. To the extent possible, subnational government should charge for services, but,
where such charges are not feasible or desirable,
spending must be financed from local general revenue, loans, or grants from higher levels of government. This chapter examines subnational govern-
ing from 2.2 percent for Tunisia to 72.1 percent for
ment finance and focuses on reforming local
Yugoslavia.
The figures show that subnational governments
tend to be more important as providers of public
services than as collectors of revenues. Chinanot
in the sampleis an exception and relies heavily
on subnational governments to collect revenue
(see Box 7.1). In every sample country the revenue
raised by subnational government from its own
Patterns of subnational government finance
sources falls short of its spending. These shortfalls
range from 0.1 percent of GDP in Costa Rica, The
Gambia, and Sri Lanka to 4.2 percent of GDP in
India and are more than 2 percent of GDP in six
The role of subnational government varies from
country to countryfor political and historical reasons as much as for economic ones. The relative
sample countries. In several countries the combined state and local fiscal imbalance was more
than the total government deficit, which means
that central governments operated in surplus be-
revenue systems to allocate resources efficiently.
importance of the subnational level of government
is indicated by its share of total government spending. For a sample of eighteen developing countries
for which comparable data are available, this share
ranges from 2.5 percent in The Gambia to 74.9 per-
cent in Yugoslavia (see Figure 7.1). To capture
longer run patterns, all figures reported in this section are averages of data available for 1974 through
1986. The sample is diverse. India and Yugoslavia
conduct more than half of government spending at
the subnational level, while for seven other countries this share is less than one-tenth. India, Yugoslavia, and, to some extent, Brazil have high subnational spending because they are large countries
with strong state governments. The subnational
154
fore intergovernmental grants were disbursed.
In most countries own-source revenues at the
subnational level fail to cover even current spend-
ing (see Figure 7.2). When grants are included,
however, subnational government achieves fiscal
balance or surplus in most sample countries. Accordingly, net borrowing, which is equal to the difference between total spending and total revenue,
is a relatively minor source of funds for subnational governments.
Fiscal imbalances do not necessarily indicate inappropriate fiscal policies at the subnational level.
A grant may really be a shared tax, as in Brazil, or a
compensatory grant for the central government's
repeal of a local tax, as in Bangladesh, or a transfer
Figure 7.1 Size of subnational and local governments, averages for 1974 to 1986
U Subnational government spending
U Subnational government revenue
Local government spending
Local government revenue
Percentage of total government spending and revenues
80
60
40
20
0
!
5
Latin America
Africa
Asia
Europe, Middle East,
and North Africa
Notes: Only state data are available for Argentina and India. The subnational government data reported here for Indonesia are not separated
into state and local data.
Sources: IMF, Government Finance Statistics, and World Bank data.
to finance some centrally mandated expenditure
such as teachers' salaries, as in Kenya. Nonetheless, the allocation of spending and revenue responsibilities, and the resultant transfers between
levels of government, may induce an inefficient
use of resources that contributes to total government deficits.
Expenditure and financing measures can be combined to indicate the degree of fiscal decentraliza-
tion. The share of state and local governments in
total government spending reveals their importance as providers of public services. The extent to
which they are self-financing indicates their fiscal
autonomy, because outside financing may come
with conditions that limit local discretion in the use
of funds. Figure 7.3 looks at both aspects for the
sample of eighteen countries. Yugoslavia's posi-
tion in the upper right-hand corner indicates a
highly decentralized government sector. Not only
do the state and local governments account for a
large share of total government spending, but they
are largely self-financing. The Gambia is autonomous in the financing of subnational government,
yet the size of its subnational government is only a
small fraction of the government sector. Colombia,
Indonesia, and the Republic of Korea display the
opposite pattern: the subnational government has
a large role in the provision of services, but its
financing comes largely from central government
grants and revenue sharing.
Expenditure and financing measures, however,
provide only a partial indication of decentralization. Central governments that want to exert control over local finance usually have many instru155
Box 7.1
Local government finance in China
The financing of China's local governments presents
an interesting contrast to local government finance in
and "shared-up" to the higher levels. China has no
regular grant program to support capital projects or
most market economies. China has three distinct levels
current expenditures (all grants are on an ad hoc basis),
there is no mechanism or formal program for lending
of government: central, provincial, and local. They
share a common set of taxes, with policy decisions left
to the central government and tax assessment and collection to the local government. All tax rates and bases
are set centrally, and there are no truly local taxes at
either the municipal or provincial level. China's revenue sharing is primarily a division of sales and profit
taxes among the central, provincial, and local governments. Taxes are collected by the local governments
to local governments, and there are no guidelines for
local governments to develop beneficiary financing
schemes.
A combination of a backlog in infrastructure needs
and increased urbanization has put great pressure on
local budgets. The overall elasticity of taxes on profits
and sales may be relatively low, that is, revenues rise
less than proportionately with increases in profits and
Figure 7.2 Spending and revenue of subnational governments, averages for 1974 to 1986
El Total spending
El Total revenue
Current spending'
Own-source revenue
(including grants, excluding borrowing)
Percentage of subnational government spending
140
120
C
C
Latin America
Africa
a. Data for current spending are not available for Sri Lanka.
Notes:/Sources: See Figure 7.1.
156
Asia
Europe, Middle East,
and North Africa
Figure 7.3 Fiscal decentralization to the
subnational level, averages for 1974 to 1986
sales. This is a structural problem, possibly exacerbated
by weaknesses in the tax administration system. The
high tax rates may induce tax avoidance by enterprises
and perhaps even by the local governments that own
them. The lack of borrowing and self-financing mechanisms creates a bias against infrastructure investments
because the full cost is shifted onto the general public.
Options presently under discussion include reform of
the company tax, introduction of autonomous local
Subnational government spending
(percentage of total government spending)
80
Yugoslavia .
60
India
taxes, and, in particular, the institution of a local government property tax.
40
Republic of Korea
Colombia
.
Indonesia
ments, such as approval of budgets, spending
S
Thailand
limits on tax rates, and other fiscal constraints.
Many developing countries are actively exploring
ways to increase local fiscal autonomy to improve
public sector efficiency and reduce total government deficits.
Fiscal decentralization and the role
of subnational government
Romania
S
20
requirements, restrictions on the use of tax bases,
Argentina
The Gambia
Mexico.
Philippines.
Costa Rica
Malawi Chile\ Kenya
Tunisia
0
30
Brazil
50
SriLankal
70
S
90
Own-source revenue
(percentage of gross revenue)
Notes:/Sources: See Figure 7.1.
State and local governments usually provide a
range of public services that contribute substantially to raising living standards and growth. These
include basic health and education; street lighting
and cleaning; water, sewerage, and power; public
markets and refuse collection; major transport net-
tive capacity to collect revenue and prepare bud-
works; and land development for business and
residential purposes. Subnational government
must decide how much to spend for these public
services and how to finance them. Ideally each
subnational government provides both the level
portion of the capital resources available to them.
Second, improving local government's administrative capacity can unnecessarily duplicate the number and skills of staff at the central and local levels.
Decentralization should not inefficiently expand
and mix of public services and the means of financing these services that most closely meet the pref-
public employment. Third, the fact that public
erences of individuals in its jurisdiction. In this
efits or costs for other jurisdictions calls for involvement by higher levels of government. However, these problems can be addressed through
appropriate grant policies and other mechanisms
for strengthening local administration, as dis-
way decentralization promotes efficiency by allowing a close match between public services and the
multiplicity of individual preferences, and it promotes accountability and equity by clearly linking
the benefits of services with their costs. This is the
rationale for establishing state and local governments that are responsive to the wishes of their
citizens and not simply the instruments of central
government.
Decentralization faces certain practical problems.
First, local governments often lack the administra-
gets and investment plans. In Tunisia, because
municipal staff lacked expertise in project design
and implementation, municipalities used only a
services provided by one jurisdiction produce ben-
cussed below.
Assigning responsibility for services among levels of government should be as clear and simple as
possible for decentralization to work. Vagueness in
the division of responsibility can undermine local
accountability. In Brazil, because of an unclear di-
vision of functions between state and municipal
157
government, mayors can garner support for favored municipal projects from state governors instead of pushing for increased local taxes. This di-
minishes the incentive for generating local
revenue.
A common feature of government in developing
countries is joint responsibility at different levels
for providing the same service in a particular jurisdiction. In Turkey, for example, something as apparently local in nature as street lighting involves
all levels of government. The central government
shares responsibility for funding; a national
agency is mainly responsible for planning, execu-
tion, and operation and maintenance; and local
governments have the main responsibility for
funding and secondary responsibility for plan-
ning. In some caseseducation and health, for
examplethe structure of service delivery is unavoidably complex. But for services that are clearly
local, such as water and street lighting, it can generally be simple.
Many countries would benefit from periodic reviews of the assignment of functions and finances
to different levels of government. A review of in-
Box 7.2
Strengthening local government finance
Strengthening local government finance can improve the efficiency of the public sector and reduce
the need for transfers from central to local government, particularly in urban areas. Certain revenue
sources, such as user charges and property taxes,
are more easily administered by local government.
Strengthening these revenue sources is important
for stabilization and structural adjustment in developing countries such as Indonesia and Pakistan, where inadequate reliance on subnational
government finance has caused a heavy financial
drain on the central government.
The principles discussed in previous chapters
suggest four criteria for efficiency in raising local
revenue:
Fiscal decentralization in Colombia
Concerns about the assignment of fiscal responsibilities
among central, departmental, and municipal governments in Colombia led to the appointment of the Mission of Intergovernmental Finance in 1980. The mission
concluded that local resources should be relied on
more for local purposes. Subsequent legislation to
strengthen local government institutions and to decentralize both functions and finances marked a his-
toric point in Colombia's fiscal and institutional
development.
The finances of subnational governments were
strengthened by expanding their traditional revenue
sources. The most important changes were those relating to the property tax, in particular those relating to
the tax base. First, all cadastral values were updated to
a 1983 base by applying an annual increase of 10 percent for each year (up to a maximum of fifteen years)
since the last official valuation. Thereafter, in years
when properties were not revalued, their cadastral values were to be adjusted automatically each year by a
price index. Although political considerations have
kept the rate of adjustment consistently below the rate
of inflation, the adjustment has nonetheless slowed the
erosion of this important source of local revenues.
Property tax rates were also changed. The basic municipal rate can now be set between 0.4 and 1.2 per-
158
tergovernmental fiscal relations in Colombia was
the basis for comprehensive local fiscal reform and
showed that such reform is feasible (see Box 7.2).
The rest of this chapter focuses on reforming local
revenue instruments and overcoming problems in
local administration.
cent, compared with the previous fixed rate of 0.4 percent. This change was important because it introduced
an element of local discretion in rate-setting for the first
time.
The base and rates of the industry and commerce tax
were also reformed. Before 1983 this taxalthough important as a revenue source, particularly in the larger
municipalitieswas levied on a wide variety of bases,
generally with large variations in rates depending on
the type and size of the business. The reforms estab-
lished a uniform tax base (based on gross sales) and
reduced the variation in rates.
The flow of national transfer payments to the small
municipalities has substantially increased. The share of
the sales tax allocated to the subnational level is to rise
from 30 percent in 1986 to 50 percent by 1992. More-
over, for the first time in Colombia, the distribution
formula was changed to give a bigger share to small
municipalities that tried to raise their own resources. A
new law provided that the additional funds for municipalities above the 1986 share are to be spent solely on
investment, including maintenance and debt service.
Finally, the national government was given one year to
transfer functions to the municipal level so as to match
the transfer of additional revenues by 1992.
Table 7.1 Comparison of local public spending and revenue shares by major categories in selected cities
(percentage of total spending)
Spending and
associated
revenue category
Spending on general
urban servicesa
Local tax revenue
Spending and debt
service for public
utiitie&'
User charges and
borrowing
Spending on social
services'
Grants received
Republic
Colombia
Kenya
Ind
Pakistan
Brazil,
of Korea,
São Paulo, Bogotd, Cali, Cartagena, Nairobi, Mombasa, Seoul, Ahmedabad, Bombay, Calcutta, Gujranwala, Karachi,
1972 1974
1981
1981
1983
1984
1972
1981
1981-82 1982
1983
1982
30.2
68.7
17.3 22.6
14.0 16.9
37.2
27.1
10.3
34.1
7.9
75.6
34.0
44.2
23.2
61.4
12.4
47.0
42.2
61.3
33.1
98.4
16.8
85.9
36.3
69.1 74.5
61.2
53.0
28.0
29.1
48.9
69.8
46.4
55.4
52.3
30.8
72.0 80.4
60.1
52.1
-7.8
33.8
30.1
52.2
-16.2
-8.7
11.1
33.6
0.4
13.7
14.0
2.9
2.8
1.6
12.8
36.8
13.7
64.0
32.2
36.9
22.0
27.8
8.6
17.8
0.7
11.4
54.9
11.5
10.3
30.8
3.0
Note: For each city, spending shares (including debt service) add to 100 percent, except for rounding errors; likewise all revenue shares (including
borrowing) add to 100 percent.
Includes refuse collection, parks and recreation, industries, fire protection, law enforcement, general administration, employee pensions and
health care, grants and transfers, and other miscellaneous services. Local taxes include other miscellaneous revenues.
Includes water supply, sewerage and drainage, electricity, telephones, housing, markets and abattoirs, highways and roads, and public
transport. User charges include revenues from development charges, housing schemes, and so forth.
Includes education, health, and social welfare.
Source: Bahl and Linn, forthcoming.
The cost of providing local services should be
recovered, to the extent possible, from charges on
the beneficiaries. Such charges should be related to
individual consumption or, where this is not possible, to a measure of individual benefit received.
Services whose costs cannot be recovered
from charges can be financed from general taxes-
property taxes, business taxes, and sales taxeslevied within the relevant jurisdictions.
If the benefits of local services spill over into
other jurisdictions or produce nationwide benefits,
then grants from higher level governments should
finance such services in proportion to their outside
benefits.
Borrowing is an appropriate way to finance at
least some local capital investment, provided macroeconomic fiscal balance is maintained.
As these criteria indicate, the appropriate use of
local revenue instruments depends on the spending responsibilities assigned to local government.
Equity can dictate modifications of these criteria,
such as avoiding the imposition of user charges on
low-income households.
In the absence of detailed nationwide information, public finance data for a sample of cities provide some insight into the composition of spend-
ing by sector, and of revenue by source, for
should be financed by local taxes, public utilities
should be self-financing, and social services should
be supported by grants.
In Bogota and Cali spending and revenue have
closely matched the efficiency criteria. In Cartagena grants from other levels of government have
tended to support the nonsocial services. All the
other sample cities collected a surplus of local taxes
to help finance public utilities and social services.
Calcutta has received a large share of grants, apparently mostly to support public utilities.
Increasing local revenues-especially through
user charges-is often desirable, but it is difficult
when local governments do not have revenue authority commensurate with their spending responsibilities. Central government usually lets local
government use only a few revenue sources, and
even these are subject to limits. In Thailand, for
example, the proportion of local expenditure financed from local sources declined between 1977
and 1982 because of central restrictions on the rate
at which local taxes and charges could be levied.
Local authorities could, and should, be encouraged to raise more revenue locally. This might be
done through user charges, local taxes, borrowing,
and grants.
User charges
particular local jurisdictions (see Table 7.1). These
data make it possible to relate broad categories of
User charges can be of two types: consumption
spending with revenue sources. The four effi-
related and benefit related. They account for about
one-third of all locally raised revenue in a sample
ciency criteria suggest that general urban services
159
/
Box 7.3
Benefit financing: land readjustment in the Republic of Korea
and the valorization system in Colombia
In Korea urban land readjustment schemes involve the
consolidation of numerous small parcels of raw land at
duce municipal tax burdens.
The valorization system has been used most exten-
the urban periphery. Nothing is paid to the owners.
sively in Colombia, and its application in the capital
city, Bogota, has been carefully studied. At the height
This land is serviced and subdivided for urban use and
then returned to the original owners in proportion to
the value of their land contribution. Some of the land is
retained by the public authority, in part to meet the
needs of urban infrastructure (especially roads and
green spaces) and in part to provide a source of finance
to defray the cost of development. The land retained
for this latter purpose is sold at market prices in commercial transactions or auctions.
The scale of Korea's land readjustment program has
been impressive. By 1985 some 43 percent of Seoul's
total built-up area was covered by completed or ongo-
tive importance has decreased, but it has retained a
role in the financing of urban infrastructure in Bogota.
One of the practical problems encountered in the ap-
plication of the system has been its dependence on
large financial transfers from the city's general revenue. In practice, valorization charges have not fully
recovered the costs of all projects. An important reason
for this is that some projects have been designed to
ing schemes. The system has opened up new land for
urban uses and thus has helped to increase the supply
of housing and raise public funds. While it appears to
improve living conditions in low-income areas, and the
beneficiaries have not been expected to pay valorization charges. If a valorization program is to be main-
have conveyed its direct benefits mainly to middle- and
tained while pursuing subsidization of low-income
neighborhoods, the resulting need for transfers from
high-income landowners, some trickle-down effect
may have occured. The large scale of the program
probably reduced general urban land prices and rents
below the levels that would have occurred in its absence.
Land readjustment programs require fairly sophisti-
cated methods of public land management, including
effective land registration and cadastral records and
land redistribution formulas. Nevertheless the admin-
local general revenues should be recognized, explicitly
calculated, and met.
Arrears in the collection of charges have been another reason why valorization charges have failed to
recover costs. For projects undertaken from 1968 to
1986, arrears amounted to 16 percent of project costs.
The collection problem has arisen mainly from lack of
istrative feasibility of the schemes has been amply
payment by public agencies and by a few large properties. The introduction of interest charges on late pay-
demonstrated in Korea.
ments after 1981 reduced the recovery period for
In contrast to land readjustment programs, which
have been used mainly to develop new areas at the
project costs.
fringe of cities and towns, the valorization system often
applied in Latin American countries has principally
been used to finance improvements in infrastructure in
built-up areas. Street improvements, water supply,
and other services have been financed by this system of
taxation, in which the cost of public works is allocated
to affected properties in proportion to the benefits con-
ferred. Valorization charges are designed to recover
project costs, not to recapture all the benefits the
I
of its use in 1968 it contributed 16 percent to the financing of all local public expenditures, including spending
by local state-owned enterprises. Subsequently its rela-
project is expected to confer. The system is intended to
make urban services largely self-financing and thus re-
of twenty-five cities in developing countries. User
charges are especially important at the local level
because, being closer to beneficiaries, local public
services are more amenable to such charges than
services provided by higher levels of government.
User charges reduce the pressure to raise revenue
Finally, Bogota has demonstrated that the valorization system depends heavily on the quality of invest-
ment planning and project preparation. In years in
which infrastructure planning was weak, the system
receded in importance even though requirements kept
growing. Projects for which benefits were uncertain or
not clearly concentrated among the properties bearing
the valorization charge often created the greatest collection problems. The participation of beneficiaries in
planning and managing the project made the resulting
charges more acceptable to them.
frastructure are borne by its beneficiaries. Of
course, when the imposition of such charges is expressly not desired for equity reasons, as in subsidized improvement of poor neighborhoods, gen-
eral taxes or grants can provide the necessary
finance.
from general local taxes; this can improve effi-
A major benefit-related charge is the develop-
ciency because the costs of public services and in-
ment charge or "betterment tax": a lump sum
160
charge designed to recover the cost of infrastructure development from beneficiaries. A development charge may cover only a limited projectfor
example, a neighborhood paving scheme or the
construction of a sewage canalor it may cover the
full development of a new area. It is usually imposed on the owners of property in the areas that
are improved by public action, and it represents a
tax on the increase in land values that results from
new local infrastructure. It can be an equitable tax
because those who benefit from development pay
for its cost. Two particularly successful systems of
development chargesland readjustment in East
Asia and the valorization system in Latin
Americaindicate their potential (see Box 7.3).
The main difficulty with development charges
lies in administration and collection. Jakarta's betterment tax suffered from late notification of the
tax department that an area would be improved
and, hence, late notification of landowners; difficulties in tracing landowners because of unregistered land transactions; and a lack of data on land
values. A properly functioning property tax (discussed below) makes administering development
charges far more straightforward.
User charges are especially well suited to local
government finance, but they have often been underutilized. Colombian cities, such as Bogota, Call,
and Cartagena, were an exception because of their
relatively limited dependence on local taxes and
grants and much heavier reliance on user charges.
Two main factors account for this. First, in the
larger Colombian cities local governments provide
the important public utility services (water, sewerage, electricity, and telephones), whose cost can be
recovered through user charges. Second, local
governments in Colombia have placed a relatively
heavy emphasis on benefit charges to finance infrastructure.
When not relying on user charges, local governments often require inefficient transfers from central government that strain central budgets. For
example, in Pakistan increasing dependence on
federal grants to finance provincial services is attributed, in part, to the provinces' low reliance on
user charges. In Mexico municipalities have not
had the incentive to recover the cost of investments made with grants from states or the federal
government.
Local taxes
As the efficiency criteria indicate, another way to
raise revenue locally is through local taxes. These
can be either property taxes or other local taxes,
such as those on industry, commerce, and the
professions.
PROPERTY TAX. The property tax has several advantages as a local revenue source. First, all municipalities have some taxable real estate within their
boundaries. Unlike taxes on business and trade,
whose bases are concentrated in major cities, the
property tax can produce revenue in small outlying local governments as well as in large cities.
Second, within small towns the property tax base
is broad; thus the burden of such a tax can be
distributed across a large segment of the population, and significant revenue can be raised at low
tax rates. Third, because property values are enhanced by the provision of local government services, property taxation based on accurate property
valuation can recover the cost of services directly
from the beneficiaries. Relatively little of the tax on
residential property will be shifted from property
owners to others, whereas the tax on commercial
property can be shifted to consumers. Finally, the
burden of the property tax on the poor can be re-
duced or eliminated by reducing or exempting
taxes on properties below a certain value.
Despite these theoretical advantages, data for ur-
ban local governments in selected developing
countries indicate that property taxes account for
only 5 to 25 percent of recurrent receipts of local
government, except in Africa, where reliance on
property taxation is generally higher. Moreover,
the performance of the property tax over time has
been mixed. Property tax revenues have declined
in real terms in more than half of the Asian and
Latin American countries. The countries experiencing the greatest revenue erosion were generally
those with high rates of inflation, particularly in
Latin America. In most of Africa, however, property tax revenues have grown in real terms.
An obvious way to increase property tax yields is
to raise the tax rate. This is often a bad approach,
however. It exaggerates inequities by increasing
the burden on taxpayers whose properties are on
the tax rolls and who pay their taxes in full. A
better approach is to raise more revenue from delinquent taxpayers by collecting more efficiently.
Examining payment records to identify major de-
linquents, introducing a systematic method of
chasing them (such as reminders and warnings),
and conspicuous enforcement of penalties can together significantly increase collected arrears and
produce longer term improvements in the system.
In Delhi, for example, better property tax
161
collectionincluding rebates for timely payments,
penalties for late payments, better facilities for
making payments, and an improved management
information systemincreased revenue by 16 percent in 1985-86 and 96 percent in 1986-87. Another
major reason for improved collections was that tax-
payers had to pay their assessment before being
able to appeal it in court.
Improving collections works best when the tax
rolls are reasonably complete and valuations are
accurateat least in relative terms. Otherwise, in-
tax system needs continual updating. General revaluation of properties, which can be very expensive, can be done at five-year intervals if changes in
property characteristics are recorded promptly and
price increases are captured by indexing the tax
base or increasing the rate.
Experience with fundamental property tax reform in Brazil and the Phffippines demonstrates
the need to address all aspects of the problem (see
Box 7.4). Brazil, especially, shows that an efficient
property tax can be achieved only if intergovern-
creases in the efficiency of collection may exagger-
mental fiscal relations provide the right in-
ate existing inequities. More basic reforms may
then be necessary. The maintenance of accurate
property tax records, usually termed the fiscal cadastre, is a particularly important step in basic reform, because the tax base is constantly changing
in developing countries because of rapid urban
growth and high inflation. An accurate cadastre
centivesan important general rule for all countries.
also aids in planning and providing local services,
especially infrastructure, and in administering and
collecting development charges.
Valuation is a critical step in basic property tax
reform. One approach is to use the annual rental
value, which in many developing countries is de-
termined by asking renter occupants how much
they pay in rent and extrapolating from that to
owner-occupied property. The method is simple,
but open to inaccuracy and misrepresentation, especially for owner-occupied structures. A second
approach is based on the capital value, which is
calculated either by estimating the value of the
land and the cost of replacing the structure or by
extrapolating from recent sales of comparable
property. (A fundamental policy decision must be
made on whether to tax only land or buildings and
improvements as well.) In practice a pragmatic mix
of the two approaches will be needed depending
on the availability of rental and sales data. Valuations also require technical expertise and time. To
economize on scarce skills, local governments can
draw on a central valuation agency for information
and technical assistance, as was done in Malaysia.
Setting the property tax rate is the next key step
in basic reform. The rate should be high enough to
make the property tax worth collecting, and local
governments should be allowed some flexibility in
setting it, as in Colombia's fiscal reform (see Box
7.2). Flexible rates can ensure that property tax
revenues are maintained between valuations: by
adjusting rates, local governments can keep property taxes constant in real terms. When property is
revalued, the rate can be reset to where it was at
the previous valuation.
Once established, a well-functioning property
162
OTHER LOCAL TAXES. Taxes on industry, com-
merce, and the professions are usually another important source of local revenue. These taxes may
take several different forms, including a turnover
(gross sales) tax, a tax on the value of gross business assets, or specific levies tailored to the type of
enterprise. Local taxes on industry, commerce,
and services have accounted for more than 80 per-
cent of local revenue in San Salvador and more
than one-half in La Paz. In the Philippines, business license taxes are the second largest source of
locally raised revenue. The revenue from business
taxes can grow substantially, because with urbanization the number and size of business establishments increase and the taxable base grows. A flat
charge or exemption eliminates the need to assess
small firms.
Few local governments in developing countries
levy broadbased sales taxes partly because central
governments prohibit it and partly because sales
taxes are difficult to administer. To avoid adminis-
trative problems, a higher tier of government
might assess and collect a sales tax and then remit
part or all of it to the local authority. For example,
the sales tax could be a local surtax on the central
government tax, with the central government acting as collector. The local government could set the
rate, determine special exemptions and other details, and pay the central government a collection
charge. Local autonomy would be sacrificed only
in choosing the tax base and determining collection efficiency. One problem with this approach
and the reason it is rarely adoptedis that central
governments are generally unwilling to let the lo-
cal authorities share in so lucrative a revenue
source because it may limit the national government's ability to raise revenue from the base. Another is that such a tax might be less visible and
thus make local governments less accountable to
their taxpayers.
Some local governments use personal income
Box 7.4
Fundamental property tax reform in the Philippines and Brazil
The Philippine Real Property Tax Administration
(RPTA) Project was designed to address the problems
of a weak property tax system. The project's approach
was to change the system of valuation from one based
on owners' declarations to one based on a government
inventory. The project aimed to compile in each jurisdiction a comprehensive inventory of all land parcels,
which would incorporate missing parcels, eliminate
duplicate claims, and include an accurate measurement
of all land and building characteristics to be used in
valuation.
percent on low-value residential property), and fixes
the date on which new general revaluations become
effective. Interim indexation of values is not permitted.
As a result, effective tax rates before and after RPTA
were as low as 0.3 percent. Finally, the RPTA did not
improve collection. On average revenue collections increased by only 1 percent in the year after the project
began.
Brazil's property tax reform (known by the acronym
CIATA) was designed, like the RPTA, to address the
technical defects of a system producing very little reve-
The project was successful within its narrowly defined objectives. Average valuations increased by 50
percent. This was largely due not to the discovery of
missing parcels, but to the revaluation of existing parcels, based on property characteristics gathered in the
field. Contrary to the government's original diagnosis,
property owners were in the habit of declaring all parcels under their ownership. Owners did, however, understate the dimensions and quality of each parcel and
the improvements they had made to it.
The RPTA left several problems, however. First, the
nue. The objectives of the CIATA were to revise the
fiscal cadastre, in order to incorporate missing parcels
calculation of individual valuations remained highly arbitrary. Although the RPTA yielded more accurate data
using more accurate data on the physical characteristics
of individual properties.
Intergovernmental relations in Brazil were an obstacle to property tax reform. Unconditional transfers provide 80 percent of the recurrent revenues of local gov-
on the characteristics of individual properties, the
method used by valuers to convert that data into estimates of value was not improved. Second, property tax
liabilities remained low. The RPTA did not reform rate
setting and related policies. The central government in
the Philippines fixes the maximum tax rate on property, mandates fixed assessment ratios (as low as 15
and improve the accuracy of valuations, and to devise a
better system for monitoring collection and financial
reporting.
The short-run effect of the CIATA on municipal reve-
nues was dramatic. Municipalities typically reported
increases of 100 to 200 percent in revenues in the year
following implementation. Most of this increase was
due to improvements in the fiscal cadastre: missing
parcels were discovered, and values were recalculated
ernment. Because local governments could draw on
outside finances to deliver services, they had little incentive to raise property taxes for their constituents.
taxation as an alternative to business taxes. Local
income taxes have the same characteristics and
rising demand for investment in, and maintenance
of, street infrastructure and traffic management.
face the same problems as those at the national
The case for recouping these costs with a tax is
strong. Unfortunately not all urban governments
level, as described in Chapter 4: that is, they tend
to be narrow in coverage and often quite primitive
in administration. Thus most local "income taxes"
are really poll (head) taxes, wage taxes, or procedures for limited income tax sharing with higher
authorities. As with sales taxation, a local surtax
on the national personal income tax may be the
best way for local governments to raise revenue
from the base of individual income.
Taxing the ownership and use of urban motor
in developing countries are authorized to tax automobiles. For instance, local authorities in Manila
have been told not to levy taxes or fees on motor
vehicle registration. Furthermore, even where local governments can impose taxes, they generally
have not made a significant effort to tap this revenue source to its full potential. Jakarta and Seoul
are among the few exceptions. Jakarta proves that
automotive taxation, if turned over to local author-
vehicles can be an important source of local
ities and given sufficient attention, can make a
revenueand a reasonably efficient and equitable
one. Automobile use is growing rapidly in developing countries and is concentrated in urban areas
and among the better off. The increase in use has
been accompanied by greater traffic congestion
and air and noise pollution, as well as by rapidly
large contribution to local revenue; it accounted for
37 percent of local current revenue in 1983-84. In
Seoul automobile tax revenue more than doubled
between 1982 and 1986, while total local tax revenue increased 64 percent.
One of the most striking features of local govern163
ment taxation in developing countries is the proliferation of minor revenue sources, including selective excise taxes and a variety of license taxes, fees,
stamp, and poii taxes. While any one of these adds
little revenue, they may jointly make a significant
contribution. For example, local taxes and fees account for more than 20 percent of total local revenue in Indonesia. Often, however, their administrative and compliance costs are considerable, and
they are subject to wide discretion by tax collec-
tors. Fewer such taxes would be appropriate in
most jurisdictions.
Borrowing
As mentioned earlier, borrowing is generally a minor source of local government revenue in developing countries. This reflects both the conservative
financial policies of central and local governments
and their limited sources of loan finance. In principle, however, there is no reason why local governments should not borrow to finance at least a portion of capital project costs. Debt service payments
can be linked to user charges for local services gen-
erated by the capital projects for which the debt
was incurred. In this manner greater reliance on
borrowing favors self-financing projects. This need
not imply an increase in aggregate public sector
borrowing. Instead it would usually mean replacing intergovernmental capital grants with internal
loans from central to local government. Grant financing places the burden on central governments
and general taxpayers, rather than on local deci-
sionmakers and beneficiaries where it properly
belongs.
One way to provide local access to loans while
ensuring some central control to preserve macroeconomic balance is to create a municipal develop-
ment fund (MDF). Typically, MDFs have two
broad objectives. The first is to raise additional resources for public investment. This usually begins
with an initial injection of funds from a donor and
a counterpart contribution, usually larger, from
central or state government. In addition domestic
financial markets may be tapped through bond
and debenture issues. But ultimately most of these
programs aim to extract additional resources from
municipalities themselves through better revenue
administration and cost recovery.
The second objective is to improve the use of
resources. This can be done by developing appraisal criteria and enlarging local capacity for
sound financial analysis of the projects financed by
MDFs (as proposed in Brazil and Mexico), by as164
sisting municipalities with the design and execution of their investment programs (as in Turkey
and Venezuela), and by improving the operation
and maintenance of local infrastructure (as in Jordan, which is discussed below).
MDFs are not new. In the past thirty years they
have spread rapidly through Africa, Asia, and
Latin America. Historically, few have developed a
capacity for sustained assistance and funding for
municipal government on the scale needed. They
have tended to play a narrow and passive financing role by providing little technical or financial
appraisal to the investments they have funded and
offering little assistance to municipalities other
than capital finance. Furthermore repayment discipline has sometimes been weak. MDFs in Honduras, Kenya, and Morocco, for example, have experienced (and tolerated) substantial arrears, and the
latter two made new advances to borrowers in default.
Jordan's MDF has been notably successful. In
1979 the government established an autonomous
Cities and Villages Development Bank to provide
investment finance and assistance to municipal
and village councils, with the aim of extending access to infrastructure and employment. The bank
played a role in financing the spread of urban
physical and social infrastructure (for example,
paved roads, schools, clinics, piped water, and
electricity) to virtually all settlements, however
small and remote. It has also been instrumental in
maintaining and improving the quality of infra-
structure investment through its standards, appraisal, and monitoring. The bank has taken on an
increasingly active role in financial and technical
advice and in training for municipal authorities. It
has introduced new criteria that will allow municipalities to forecast their debt service capacity more
accurately.
Efforts are under way in many developing coun-
tries to strengthen existing MDFs or to set up new
ones. To succeed the local governments concerned
will need a buoyant revenue base to support debt
service. If MDFs are allowed to recover debt service from central government transfers to local governments, they will be tempted to induce local authorities to borrow more than they can afford.
Intergovernmental grants
Central government transfers to subnational gov-
ernments through shared taxes and grants are a
critical link in distributing expenditure responsibil-
ity and taxing authority between the two tiers.
Box 7.5
Effects of intergovernmental grants: the experience of Nigeria in the late 1970s
Nigeria embarked on a nationwide reform of its local
government system in 1976. It was intended to reverse
the deterioration in the treatment of local governments
by the states after the country achieved independence.
Specifically, many states had cancelled their grants.
Under the reform, grants from both the federal and
the state governments were to be substantially increased. In the first year local governments received in
grants from the federal government roughly five-anda-half times the amount they had received in the previous year. This increase followed from sharp increases
in revenue from oil exports and the reformed grant
allocation rules. The budgeted revenue of some local
governments increased 1,000 to 2,000 percent. As a
result local governments greatly expanded their provision of social services and economic infrastructure.
Some serious problems arose, however. State administrations sit between federal and local governments; all
but one of them failed to pay its full allocation to the
local governments. In many cases federal transfers
were diverted to other uses without consultation. In
addition virtually all the state governments approved
large salaries for state-appointed local government
officialsincreases, in some cases, of more than twothirds.
Federal grants to states depended in part on the
number of localities under state jurisdiction and thus
led to a widespread demand for more local government
units. The number of local governments increased
Furthermore the criteria for distributing transfers
placed too great an emphasis on the equality of revenue across jurisdictions, rather than on the generation
of local revenue. The transfers served as a disincentive
to local revenue effort. Local taxes, such as the property tax, remained grossly underdeveloped, and some
states decided to suspend or abolish important revenue
sources. Various explanations were given to justify abolition, but they all rested on the supposition that federal transfers made collection of local taxes unnecessary. So the cumulative effect of Nigeria's dramatic
increase in transfers to local government was to reduce
local governments' own contribution to local finance in
relative and absolute terms. For example, the number
of property tax payers in Ibadan City dropped from
27,000 persons in 1975 to 8,650 in 1979. Other cities
experienced similar declines.
The administrative burdens on local government increased as a result of the 1976 reform. The distribution
of increased transfers through states brought local gov-
ernments under stricter control. Local budgets had to
be approved by the states, which often caused severe
delays in program execution. In one case the budget
process had to go through eight stages of approval
with state officials before final approval by the state's
chief executive. The substantial increase in transfers to
local governments in Nigeria in the late 1970sin the
wake of the steep rise in oil revenuedid not enhance
local governments' autonomy or ability to act.
from 301 to 781 between 1979 and 1983, which led to a
severe shortage of skilled managerial and technical
staff.
Grants are needed because the benefits or costs of
public services provided by local governments can
spill over to other jurisdictions. For example, a
highway constructed through one jurisdiction is
likely to benefit residents in neighboring jurisdictions, or one jurisdiction's education services contribute to a productive labor force that can migrate
to other jurisdictions. Some local public services,
especially social services, may have national and
regional benefits as well.
Another objective of grants is to adjust for disparities in fiscal capacity among local jurisdictions
caused by variations in resources, tax bases, and
population. Grants can equalize local fiscal capaci-
ties, although obtaining adequate data to do this
by formula can be difficult.
Excessive reliance on grants, or unexpected increases in them, can result in poor use of public
finances. Nigeria's grant system expanded greatly
in the late 1970s, and this had severely detrimental
effects on local government finance and intergovernmental relations (see Box 7.5). Grants can encourage recipients to be less efficient. For example,
grant systems in Indonesia and Sri Lanka have
paid the salaries and allowances of virtually all lo-
cal government employees, including primary
school teachers. This cost reimbursement grant
guarantees a uniform pay scale for local government employees without regard for the financial
health of any single locality; its lack of cost sharing
can encourage local governments to employ inefficiently large numbers of people.
The experience of several developing countries,
including Colombia, Ecuador, and Mexico, reveals
that increasing reliance of local governments on
grants can decrease the fiscal autonomy of local
jurisdictions. Local governments come to view
grants as substitutes for local taxes and user
165
charges. Many intergovernmental grants are simply central government subventions of local activities. They have many undesirable qualities: they
are a drain on central revenue, they encourage inefficiency and worsen regional and urban-rural
disparities, and they reduce the accountability of
local government while giving it no assured access
to funds.
A formula-based grant system addresses these
problems by simultaneously meeting central government objectives and providing local governments with some degree of autonomy. Formulabased allocations require the granting government
to decide on the factors that are to be used in determining grant amounts. These may include, for example, indicators of need, such as population or
miles of road, or indicators of local revenue capacity, such as local income or taxable economic activ-
ity. The grants may be block grants, that is,
general-purpose, lump-sum transfers that provide
local governments with considerable autonomy, as
in the Philippines. Alternatively they may be categorical, that is, restricted to particular uses, sometimes requiring approval by the central govern-
ficult to implement effectively, and are open to
abuse or ad hoc political bargaining.
Local government administration
Decentralizing spending responsibility and revenue authority can assist development, provided local administrative capacity is adequate to the tasks.
An important reason for past shortcomings was
the failure to deal with the difficulties of planning
and implementation.
Many of the reforms recommended for public
spending in Chapter 5 apply at the local level also.
In particular, local governments should prepare
both a medium-term fiscal plan and a comprehensive annual budget. These force local governments
to evaluate the needs of their jurisdictions and to
make strong arguments for spending programs,
either current or capital, which then serve as the
foundation for strong fiscal efforts. They also help
central governments to coordinate municipal de-
velopment and provide a clearer picture of required intergovernmental transfers.
Effective local administration is hampered by
lack of finance and accounting skills because
ment. Categorical grants give the central gov-
skilled personnel frequently would rather work for
ernment more control over the allocation of funds
between sectors.
Categorical grants can be designed to cover only
part of the total spent locally in a sector, in which
case grant funds are said to "match" local funds.
The matching rate can be set to achieve an efficient
level of local spending. If a matching grant is used
to support spending that has spillover benefits, the
the central government. One approach to local
matching rate should ideally equal the ratio of
spilover benefit to total benefit, although the information needed to compute matching rates precisely is very difficult to obtain. A single grant cannot accomplish all objectives. For example, if the
principal objective is to equalize fiscal capacity
across jurisdictions, the goals of stimulating local
government tax effort and promoting local fiscal
autonomy are not likely to be well served. This
problem can be addressed by including different
types of grants in the system, for example, pure
shared taxes to provide adequate revenues for
large urban areas, formula grants to equalize
across jurisdictions, and matching grants to stimulate tax effort. Balancing the merits of shared taxes
and formula grants is a central issue in designing
grant systems.
Grant systems should be kept as simple as possible. Complex systems lack transparency, are likely
to introduce mutually offsetting incentives, are dif-
166
staffing is to assign central civil servants temporarily to local authorities. Also technical agencies at
the center can provide direct services to local governments. Malaysia's. central government lends as-
sistance in public health, sanitation, and food in-
spection, especially in rural areas, and has
assigned accountants to state governments. Technical assistance to local governments may be provided with either loan or grant finance. Municipal
development funds can enlarge the local capacity
for financial analysis and implementation of investment programs.
Training local officials is essential for better local
administration. Several Indonesian cities have pilot programs for local training to improve tax administration and financial management. In Nepal
local officials have attended training workshops on
techniques of financial analysis, current and capital
budgeting, and tax collection procedures (including records systems). As a result, at least initially,
locally raised revenues have increased.
Another option for local governments with staffing shortages is to buy services from the private
sector. Many services can be provided this way.
Contracting reduces staff requirements and gives
local governments the flexibility to provide a
changing mix of services.
Toward more efficient local government
revenue sources that they are best equipped to
use, such as property taxes and user charges. A
The structure of government in many developing
countries is inefficient. Often fiscal relations are
opaque because of political expediency rather than
properly designed system of grants can encourage
efficient provision of local services. Local govern-
lack of knowledge or skifi. This makes reform
much more difficult. Nonetheless more open and
transparent systems are urgently needed. Responsibility for many services can be devolved to local
government. Local government should rely on the
ments must be held responsible for their use of
public resources to those who provide them: for
user charges, the beneficiaries; for locally raised
revenue, the general public; for grants, the central government; and for borrowed funds, the
creditors.
167