Three basic financial problems face local governments around the world, but especially in the South and among transitional countries:

local governments do not have enough money to carry out the functions assigned to them;

some local governments have a lot more money than others; and

matters are getting worse rather than better because local revenues are not adequately responsive to changing needs.

Local government finance is important for several reasons. First, in countries as diverse as the Republic of Korea and Denmark, local governments already mobilize significant resources; in both these countries, in the late 1980s, local government revenue represented 31 percent of total government revenue (see Table 5.2). Locally generated resources may also be becoming more important; in many more countries, both North and South, hard-pressed national governments are increasingly shifting functions to local governments in the expectation that additional local resources can be mobilized to pay for them. Local expenditures and local revenues are thus likely to constitute an increasingly important component of total public sector activity.

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Notes:*In addition, there is another significant level of subnational government.

The figures shown for third world countries, transition countries, and Western Europe, North America and Australia are unweighted averages.

Expenditure ratio is local government expenditure as percentage of total government expenditure.

Revenue ratio is local government revenue as percentage of total government revenue.

Autonomy ratio is local government revenue as percentage of local government expenditure.

Control ratio is local government revenue as percentage of total government expenditure.

SOURCE: Calculated from UNDP (1993), p. 69.

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A second reason why local government finance is particularly important is that, regardless of how large local governments may be, in most countries they have an important role in the provision and utilization of local public infrastructure and public services. These include both those that are essential to good quality housing and living conditions and those that contribute much to economic development. How local services are financed may have significant implications for national development patterns as well as for the political accountability and administrative efficiency of local government institutions themselves.However, as Table 5.2 shows, many local services, in many countries, are still financed to a considerable extent by transfers from central (or state) governments. Others are provided directly by central or regional agencies or by various groupings of local governments. Still others are provided by a wide variety of non-governmental organizations at the community level or by private firms; Box 5.2 shows the diverse range of government, mixed private-public and private institutions that may provide local services. The optimal role and structure of local government finance for any country depends in part upon the actual and potential role of different actors or institutions in providing local public services.

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1. Central Government: (a) Department

(b) Decentralized Agency

(c) Enterprise

2. Regional Government: (a) Department

(b) Decentralized Agency

(c) Enterprise

3. Local Government:(a) Department

(b) Decentralized Agency

(c) Enterprise

4. Central-Regional Arrangement

5. Central-Local Arrangement

6. Central-Regional-Local Arrangement

7. Regional-Local Arrangement

8. Association of Local Governments

9. Special-Purpose Local Authority:

(a) Encompassing more than one local government

(b) Coterminous with a local government

(c) Covering less area than a local government

10. BOT or BOO (Build-Operate-Transfer or Build-Own-Operate) Arrangements

11. Other forms of public-private "partnerships"

12. Development charges, exactions, and similar schemes

13. Compulsory provision by developers

14. Compulsory provision by individuals: (a) Vouchers

(b) Self-financed

15. Voluntary provision: (a) Formal Arrangements

(b) Informal Arrangements

16. Provision by Non-governmental Organizations (churches, enterprises)

Even this extensive list is less than complete. Many of the arrangements listed have a number of possible variants, and of course there are various possible combinations of all these organizational structures. Moreover, different structures might apply for e.g. policy-making, regulation, financing, production (delivery of services) and so on.

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The structure of local government finance in any country is invariably unique, reflecting the complex of historical and political factors that define governmental institutions in that country. Many countries have more than one level of local government, and a few countries, especially some of the larger ones, also have an important intermediate (state or regional) level of government that has a larger role in public finance than the municipal and local level (see Box 5.3). Although the focus of this section is on local government, meaningful comparisons of purely "local" governments across countries are difficult because of the different governmental structures in different countries, the different functions and finances of various jurisdictional levels, and the deficiencies of available data. The term "subnational" will be used to refer to all levels of government below the national or central level, while the term "local" excludes the intermediate or regional governments, particularly those in federal states.

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Many countries have not one but two (or more) subnational levels of government. Sometimes the intermediate (state or provincial) level has a more important role in public finance than the municipal or local level, as in the case of Canada's provincial governments; sometimes it is less important, as with Colombia's departmental governments. Countries in which the intermediate level of government is more important are often countries that are at least nominally "federal", such as Canada, Germany, India, Papua New Guinea, and Nigeria. In such countries, most transfers from the central government go at least in the first instance to the states, and the states often have a tutelary or supervisory role with respect to the municipalities. The latter feature means that the degree of autonomy of local governments - which may themselves have two or three tiers - may vary significantly from state to state in such countries.

As wide a range of institutional structures and relations is found within federal as within unitary countries. Indeed, the difference between a "tight" federation such as Malaysia or Germany and most unitary countries is probably less than that between such federations and "looser" federations such as India and Canada, in which state governments have more power to act independently with respect to expenditure and taxing patterns. The constitutional label matters less than the reality of how the intergovernmental relations that constitute the essence of the public sector in all countries work out in practice. If, as is usually the case, especially in the South, the central government basically confines the range of action of subnational governments to a very limited domain, those governments may for most purposes be considered to be more agents of the central government - or, in some federal countries, of state governments - than independent actors. On the other hand, where there are real geographic or ethnic differences within a country, a certain degree of local "autonomy" often emerges in practice even if the constitutional structure is formally unitary. In particular, in most countries central governments must work with the local governments they have, in the sense that even if the central government is ultimately responsible for the size, structure, and functioning of local governments, these characteristics can ordinarily be altered only in an incremental fashion. Since the essence of the federal finance problem is how to adjust intergovernmental fiscal transfers to achieve tolerable results in the face of what is generally a clearly nonoptimal assignment of functions and finances, the intergovernmental problem in every country is in this sense "federal" to some extent. It is only in the few "true" federations that such a constraint is long-term in nature, however. In other countries, a closer approach to an efficient public sector may in principle be attained over time by judicious and feasible restructuring of the functions and finances assigned to each level of government.For simplicity, the case of federal states in which the intermediate level of government has a special degree of policy autonomy is not discussed further here.

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Despite this diversity, among certain broad patterns that recur in many countries, three are particularly important. The first is that local governments almost invariably have inadequate "own resources" to finance the expenditure functions with which they are charged; thus, they are dependent upon transfers from higher levels of government. This is sometimes called the problem of "vertical imbalance." The second is that not all local governments are equal. In even the smallest and most homogeneous countries, there are big cities and small cities, heavily urbanized municipalities and rural municipalities, rich areas and poor ones. The resulting unevenness in access to local public resources gives rise to what is known as "horizontal imbalance." The third is that few countries permit local governments to levy taxes that are both economically sensible and capable of yielding enough in revenue to meet expanding local needs.

The data needed to establish the importance of local finance within total public finance is surprisingly hard to find - and this perhaps accounts for the fact that different studies give rather different answers. In one study covering 21 countries in the South, local governments accounted for between 6 and 50 percent of total government spending, with a median share of 23 percent. In eight transitional countries, the share of subnational governments similarly ranged from 11 to 53 percent of total expenditure with an unweighted average share of 26 percent. In ten OECD countries, local expenditure ranged from 12 to 45 percent of total expenditure, with an average share of 21 percent. Table 5.2 shows that the average share of local government expenditure (the expenditure ratio) is 22 percent for a broader sample of 18 wealthy countries , and 20 percent for a smaller sample of four transitional countries. On the other hand, the average share for the 16 countries from Africa, Asia and Latin America included in this Table is only nine percent, although it is much higher in a few countries (notably Republic of Korea and Zimbabwe).

In many more countries local governments are important for the wide variety of important services they deliver. For example, local public utilities are responsible for such essential services as water supply, sewerage, electric power, public transit, and sometimes also for telecommunications. Local governments (and related agencies) also provide local streets and a variety of related services including refuse removal and disposal, street lighting, and street cleaning. In addition, local governments in most countries are responsible for providing police and fire protection, and in some countries they also have an important role in providing such social services as primary education, health care, and social assistance. In the transition countries, local governments are also largely responsible for housing and heating. Other local activities found in different countries include the provision of markets and slaughter houses, tourist services, and sports and cultural facilities, including parks.

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Notes: *Preliminary.

SOURCES: GDP per capita from World Bank (1993), pp. 238-39; Other data from country tables in IMF (1993) - population and exchange rate for year indicated from summary table, and local government data from Table L.

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In most countries in Africa, Asia and Latin America, the absolute level of resources available to local governments is seldom adequate to provide even the most minimal level of many of the services with which they are charged. In 1991, for example, local governments in the United States spent, on average, over US$2,000 per capita (see Table 5.3), and state and local governments combined spent about $3,000. In contrast, in the early 1980s, although some Korean cities spent as much as US$200 per capita, other cities such as Dhaka in Bangladesh spent less than US$2 per capita. A very similar picture is shown for the countries contained in Table 5.3. If anything, this estimate seems on the low side for such low-income countries as Malawi and Paraguay. What is also notable in Table 5.3 is the very low level of local capital expenditures per person for local governments in most countries.

However much local governments spend in different countries, the revenues under their direct control are invariably less. In the United States, for example, only 65 percent of local expenditure was financed out of local revenue in 1989 (see Table 5.2). The comparable unweighted average figure for 18 countries in West Europe, North America and Australia was 62 percent, but the range was between a low of 16 percent in the Netherlands and a high of 87 percent in Switzerland.

In seven transitional countries, if shared taxes are counted as local revenues, the average (for subnational governments) was 63 percent, ranging between a low of 15 percent in the Czech Republic and a high of 95 percent in Russia. If shared taxes are instead considered to constitute revenues of the central government (see Box 5.4), the average increases to 74 percent for the four transitional countries included in Table 5.2. ____________________________________________________________________________________

Strictly speaking, a "local" tax might be defined as one that is (1) assessed by local governments, (2) at rates determined by local governments, (3) collected by local governments, and (4) with its proceeds accruing to local governments. In many countries, few taxes have all these characteristics.

In Hungary, for example, part of the income tax accrues to local governments, but the rates of the tax are set by the central government, which also assesses and collects the tax. The result is the same as if the central government simply allocated a grant to local governments in proportion to the amount of national income tax collected locally. In contrast, in Canada, where the central government similarly assesses and collects the income tax, the provinces can set different rates and therefore affect through their own actions the amount of revenue accruing to them. (On the other hand, Canadian local governments cannot levy income taxes of any description.) Unlike the Hungarian case, the Canadian provincial income tax is usually considered to be a provincial "own-source" revenue. Somewhat similar systems exist in the five Nordic countries (Denmark, Finland, Iceland, Norway, and Sweden), where local governments can set their own tax rates on the same tax base as the national income tax and where the local taxes are collected by the national government and remitted to the taxing local authorities. Other Northern countries with significant subnational - state or local or both - income taxes of various sorts include Belgium, France, Japan, Germany, and Switzerland (see Table 5.4).Although local income taxes have occasionally been levied in a few African cities, they are not common in Africa, Asia or Latin America. In contrast, in many transitional economies, subnational governments have been assigned significant shares of income tax revenues. In Russia, for example, they receive all of personal income tax revenues, in Bulgaria, 50 percent, in Poland, 30 percent, and in Hungary (as noted above), 25 percent. Since in none of these countries, however, do local governments have any freedom in establishing the tax rate, the resulting distribution of revenues seems better considered as a combination of a national tax and a related intergovernmental fiscal transfer based on locally-collected national tax revenues rather than as a really "local" source of revenue. If local governments are not politically responsible for the revenues they receive, it seems to stretch reality unduly to consider such revenues as local taxes.The principal reason local governments have seldom been given access to income taxes in the North is because of the reliance of central governments on this source of revenue. In the South, of course, even central governments have trouble collecting much from the income tax and tend to rely more heavily on taxes such as the value-added tax which are inherently less suitable for local government use

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The variation found within countries in the South is similar. A study of 18 such countries found that own-source revenue provided as little as 30 percent of total local revenue in some countries but over 90 percent in others. A similar pattern is shown for the 16 countries in Table 5.2. In some instances, local revenues even exceed local expenditures, while in others local revenues are inadequate to finance even the current spending of local governments. In their survey, Bahl and Linn found the median share of local expenditures financed by local revenues in the cities they studied to be 78 percent, with the range being between a low of 30 percent in Kingston, Jamaica, and a high of over 100 percent (owing to negative borrowing) in Dhaka, Bangladesh. The data for later years for all local governments in Table 5.2 shows a similar variance, with a somewhat higher unweighted average of 88 percent.

Such "vertical imbalance" is sometimes thought to show the importance of central transfers as a source of local revenues. In fact, the situation with respect to transfers appears to be rather different in the North and the South. In the OECD countries, 37 percent of local revenue (and 39 percent of all subnational government revenue) came from such transfers. As noted above, the dependence on central transfers (including shared taxes) is even higher in the transitional countries. In contrast, in the sample of countries from Africa, Asia and Latin America, only 22 percent of local revenues came from transfers (including shared taxes). Indeed, as the authors note, "it is not even clear that large cities in developing countries are on average more dependent on grants than are large cities in industrial countries." Along related lines, a recent study of Chile found that the local governments within the metropolitan area of Santiago on average received fewer transfers per capita and spent more out of their own resources than did local governments in the country as a whole. Direct central spending in the Santiago metropolitan area was also much lower - less than half in per capita terms - than the national average. In appears that some local governments in at least some low and middle income countries are more dependent on their own resources - scarce as those resources may be - than local governments in rich countries.

A similar pattern is shown in Table 5.2, where on average local governments in the South are more "autonomous" in the sense of financing their expenditures out of their own resources than is the case in the countries in the North. At the same time, however, since local government spending is much more important in OECD (and transitional) countries than in the South, on average local governments in the former groups "control" (i.e. finance out of their own resources) twice as large a share of total public sector spending as in the South. Nonetheless, sweeping conclusions are hard to come by in the complex and varied world of local government finance, and it should be noted that the variance within each of the three groups of countries shown in Table 5.2 considerably exceeds the differences between the group averages.

The variations in the size and structure of local government finance between countries at comparable income levels are striking. What is often even more striking are the variations between apparently comparable units within particular countries. In the United States, for example, expenditures in the lowest state were less than one-seventh of those in the highest state. In Romania in 1992, the ratio of per capita budgeted local expenditures in the lowest district (judet) was a quarter that in the highest. In Chile, in 1990, the ratio of per capita municipal revenues in the lowest "zone" was 44 percent of that in the highest while in Indonesia in 1990/91, it was only 7 percent. In the case of Chile, the variations within the metropolitan area were equally marked, with the city of Santiago receiving less than six percent of its revenues from Chile's local "equalization" fund (designed to even out the resources available to local governments to some extent), and other municipalities receiving 60 percent. Similar variations are likely to exist in other countries.

A striking feature in almost every country is the difference between big cities and other local governments. In Colombia in the late 1970s, for example, per capita tax revenues were ten times higher in the capital, Bogota, than in the many small rural municipalities. In Canada in the same period, the ratio of per capita local revenues among provinces was almost the same, with the more urbanized areas having ten times the "own-source" per capita revenues of the more rural areas. Such variation reflects two different factors in most countries: big cities are richer, and they tend to carry out a wider range of functions.

Direct comparisons across countries among local governments are difficult to make, but interprovincial variations similar to those in Canada have been observed in many other countries, both in the North and in the South. A recent example from India shows this but such variations may reflect not only differences in wealth but different policy choices. Kerala and Tamil Nadu, for example, are two states in India at more or less the same income levels; but Kerala has chosen to levy higher taxes and to spend much more on education and health in both relative and absolute terms (see Box 5.5).

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Even when the incentives facing local government are perverse, a number of examples around the world show that local policies can make a real difference. A recent comparison of the provision of education in China and India, for example, found China far ahead in most respects. But one state in India, Kerala, with universal literacy among adolescent males and females and near-universal literacy among the adult population came out better than any province in China. In the words of the study: "This remarkable achievement reflects more than a hundred years of creative interaction between state commitment to, and public demand for, the widespread provision of public education." Another study of state finance and poverty alleviation in India similarly found that Kerala was much more successful in this field than either its income level or its state revenues would suggest.Similar "anomalies" exist in many countries. In Brazil, for example, a few cities are well-run and efficiently provided with services; others, superficially similar in character and resources, are poorly run and equipped. In Colombia, some departments (regional governments) provide superior health services than others with similar resources. Almost everywhere, some local governments in at least some areas do much better than others. The reason may be because of historical circumstance: for one reason or another they started to do something well some time ago, and they continue to do so. Or it may be because of a caring and charismatic local leader or some other chance circumstance. Whatever the cause, such experiences emphasize two important points: (1) even in the perverse situations in which many local governments are placed by inappropriate central policies, there is usually some scope for local initiative; and (2) such local initiative can make a real difference in the lives of local people. The aim of effective decentralization is to make it easier for such "good examples" to occur and to be emulated elsewhere.

As the example just mentioned illustrates, local choices can and do make a difference. On the whole, however, the patterns of local finance sketched above for the most part result from conscious choices made by the central governments in the various countries.

The size and pattern of local government taxation varies greatly from country to country; Table 5.4 shows this for OECD countries. Income taxes are the most important source of local tax revenue in all of the ten countries where local taxes account for more than 10 percent of total taxes. However, only in one of these countries (Sweden) are income taxes the sole important local tax. In contrast, there are four countries in which property taxes are the only significant local tax. Consumption taxes (often local "business" taxes of various sorts rather than conventional sales taxes) account for more than 10 percent of local tax revenue in nine countries, property taxes in 13 countries, and income taxes in 15 countries. Only a few countries have a "balanced" local revenue structure in the sense of not being dominated by just one tax. Nine OECD countries may be categorized as income-tax countries and five (all predominantly English-speaking) as property-tax countries in the sense that over 75 percent of their local tax revenue comes from the source indicated.

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SOURCE: Calculated from OECD (1990)

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The structure of local revenues in the OECD countries suggests several tentative conclusions:

Although the data are even less tractable for Africa, Asia and Latin America, similar variations are apparent within this heterogeneous group of countries. Although a large variety of local taxes are levied in different countries, the property tax is both the most common and often the most important source of local revenue. The median share of property tax revenues in local tax revenues in the 37 cities in 21 countries covered in the Bahl and Linn Study was 42 percent, with a marked decline in this share being apparent over the 15 years or so covered in this study.

The only other major source of "own" revenue in a number of countries is some form of business tax such as the octroi (tax on goods entering cities) in India and Pakistan and the industry and commerce tax or patente in a number of countries of Latin America and Africa. Such taxes have been much more successful than property taxes in providing revenues that expand with economic activity and expenditure needs. Unfortunately, most local business taxes are both economically distorting and to some extent conducive to political irresponsibility, owing to the ease with which they lend themselves to "exporting" part of the tax burden to non-residents.

Apart from taxes, which accounted for about half of local revenues, the only other significant source of local financing in most countries in Africa, Asia and Latin America are user charges levied by "self-financing" public utilities, again with wide variations from country to country, depending upon the extent to which such utilities are under the control of local governments and upon the pricing policies that are adopted. In a few countries such as Colombia and the Republic of Korea - as also in some countries in the North such as the United States - significant use is also made of "benefit-related" charges in financing urban infrastructure, as discussed later.

Trends and patterns in local government own revenues are important. As Bahl and Linn conclude with respect to their sample of cities in the South:

The generally low "control" ratios for Third World countries shown in Table 5.2 suggest that, viewed from this perspective, local government expenditure is probably "thriving" in very few countries.

If a central government wishes local governments to play an active and expanding role in the provision of public services, it must both provide them access to an adequate revenue source (such as the income tax or, less desirably owing to the possibility of tax export, some form of local sales or business tax) and permit and encourage them (e.g. through the design of intergovernmental fiscal transfers, as discussed below) to make efficient use of the resources thus provided. Essentially for this reason, some transitional countries that have devolved significant expenditure responsibilities to local governments have been urged to give more power to local governments to levy supplementary local surcharges on the national income tax (see Box 5.4). Taxes on real property, although a useful and appropriate source of local revenues, are unlikely to be able to provide sufficient revenue in the near future in such countries. Even countries that have devoted considerable effort and attention to improving property tax valuation and collections, such as Colombia have seldom managed to do more than to maintain the relative importance of this tax (see Box 5.6).

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Property tax is the most widespread form of local taxation. Unfortunately, experience suggests that such taxes are not easy to administer, particularly in countries where inflation is endemic (e.g. Brazil), and that they are never politically popular owing to their visibility and to certain inherent administrative difficulties. Even in the most sophisticated countries, local property taxes can seldom yield enough to finance local services. As noted elsewhere, no country in the North which depends significantly upon property taxes for local fiscal resources has a local government sector that accounts for more than 10 percent of total public spending. Similarly, property taxes seldom account for more than 20 percent of local current revenues - or less than 1 percent of total public spending - in Third World countries. Moreover, despite substantial efforts in some countries and considerable foreign assistance, these figures have not changed. The property tax, it appears, may be a useful, even a necessary, source of local revenue, but it is most unlikely to provide sufficient resources to finance a significant expansion of local public services in any country. Indeed, countries have often been hard-pressed even to maintain the present low relative importance of property tax revenues in the face of varying price levels and political difficulties.A recent study concludes that a number of conditions must be satisfied for local property taxes to play a more important role in financing local activities. The political costs of reliance on the property tax are so high that no government with access to "cheaper" sources of finance will willingly do so. Intergovernmental transfers which can be spent as local governments wish, like access to taxes on business which can largely be exported, must therefore be curtailed not simply to make property taxes more attractive but, more importantly, to confront local decision-makers with the true economic (and political) costs of their decisions. Even if this essential structural pre-condition is met, a number of other policy reforms are needed to turn the property tax into a responsive instrument of local fiscal policy. First, and importantly, local governments must be allowed to set their own tax rates (see Box 5.4); very few central governments give their local governments freedom in this respect. Secondly, the tax base must be maintained adequately; in countries with high inflation, some form of index adjustment is advisable. In other countries, the assessing agency must be provided direct financial incentives to keep the tax base up to date. Finally, a series of procedural reforms is often needed to improve collection efficiency, valuation accuracy, and the coverage of the potential tax base. None of these steps is easy, either politically or, in some instances, in terms of available technical resources. Nonetheless, countries that want to have local governments that are both responsive and responsible must follow this difficult path; there are no short cuts to successful local property taxation.

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One reason for concern about the possible effects of decentralizing public sector activities is the poor quality of local government administration in many countries. To a considerable extent each country gets the local government that those in power want. Local government officials, like central government officials, respond to the incentives with which they are faced. If those incentives discourage initiative and reward inefficiency and even corruption, then it is not surprising to find corrupt and inefficient local governments. The answer to this problem is obviously to alter the incentive structure to make it possible and attractive for honest, well-trained people to make a career in local government. Similarly, one answer to local governments that make "wrong" decisions is to provide an incentive structure that leads them, in their own interests, to make the "right" decisions, that is, decisions that are both economically efficient and politically acceptable.

It is, as always, easier to state such propositions in general than it is to demonstrate concretely how they may be implemented in particular circumstances. Nonetheless, as a recent World Bank study notes, the institutional settings within which many local governments in Africa, Asia and Latin America must work may be categorized into three groups: (1) the over-controlled local public sector, (2) the under-controlled local public sector, and (3) the perversely regulated local public sector. The first of these categories is perhaps the most commonly observed: central governments control all the details of local government - who they hire, what salaries they pay, even where the buses run ... - and leave no freedom of action for local initiative. In such countries, local citizens tend to look to the national government to fix potholes on their street - and they are generally right to do so.

While less common, the opposite ill of "under-control" is beginning to emerge in a number of countries as a result of inappropriate decentralization strategies. For example, a number of transitional countries in eastern and central Europe have given their local governments access to a substantial share of centrally-raised revenues as well as responsibility for important public service functions. In most cases, these countries have not yet established an adequate institutional structure to ensure that the central funds are being properly spent in, say, maintaining minimum standards of service in education or health.

Finally, whether over- or under-controlled, local governments in all too many countries receive perverse signals from national governments in a number of ways. In some countries, for example, the amount of national funding received depends upon the size of the local budget deficit - a rather perverse way of encouraging over-spending and poor budget management. In others, national funding is available for infrastructure investment at no cost but there are no funds for operation and maintenance. It pays localities to let existing facilities deteriorate (since they would have to pay maintenance out of their own funds) in order to strengthen the apparent need for new facilities (which the central government will pay for).

The lack of an appropriate central government structure to monitor and support local governments is a common problem in transitional economies and in the South. Among the tasks for which central governments should in principle be responsible is that of monitoring and assessing the finances of subnational governments, both in total and individually. Central authorities need to have a much better understanding of both the existing situation of their local governments and of the likely effects of any proposed changes in local finance than is usually the case.

Local governments, particularly in the larger urban areas of the South in principle have a critical role in providing the basic infrastructure without which modern economic life would not be possible. But how can this infrastructure be financed? The meagre tax resources available to most local governments, especially in the South make it difficult for them to finance costly projects from their own current revenues, so three other approaches to infrastructure finance are often considered. The first possibility is to borrow the money. A second possibility is for users, actual or prospective, to finance the infrastructure. And a third is for the investment to be financed by the central government, with the local government being responsible only for financing the recurrent costs of operation. Each of these approaches, has its own difficulties.

When the benefits from infrastructure projects are enjoyed over a period of time, in some instances it may be both fair and efficient to finance such projects in part or whole by borrowing. In any case, borrowing may often be the only practical way to finance large capital projects without large and undesirable fluctuations in local tax rates from year to year.

In most countries, however, local government access to capital markets is limited in practice both because capital markets themselves are poorly developed and because central governments are seldom keen to allow any but very restricted access by local governments. When local borrowing is permitted, it generally requires central approval and is heavily restricted (see Box 5.7). In many cases, local capital finance through borrowing takes place mainly from government-sponsored and financed agencies such as municipal development funds. Unfortunately, the record of such agencies in most countries is poor, with many loans not being repaid and local governments having few incentives to repay.

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Local government access to capital markets is often restricted. Since central governments generally implicitly guarantee local debt at least to some extent, they understandably wish to restrict and control local governments' access to the treasury and to obviate the possibility of local bankruptcy and hence demands on central funds.In Canada, for example, local government borrowing is severely restricted in a number of ways: the amount of debt, the type of debt instrument, the length of term, the rate of interest, and the use of debt funds, are all, as a rule, strictly controlled. Some provinces require provincial government approval before debt is issued; others require the specific approval of local electors. Sometimes the restrictions are different for different categories of municipalities or for short-term as opposed to long-term debt. But in no case are local governments allowed to borrow as they wish.In Colombia, it was estimated a few years ago that a local government wishing to borrow required the approval of over 100 officials, and that it took, on average, at least a year to achieve the needed approvals.In Hungary, on the other hand, local governments have, by law, unlimited borrowing authority, subject only to the approval of the local assembly: some analysts have expressed concern about the possibility of inexperienced local authorities getting into difficulty by injudicious borrowing and have urged that controls should be instituted to ensure that local access to capital markets does not cause unwanted difficulties.

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Some transitional countries in eastern and central Europe appear to have given their newly-created local governments virtually unlimited authority to borrow from commercial banks or other sources (see Box 5.7). This is likely to prove a mistake. Unrestrained local access to credit in a situation in which financial markets are not well-regulated and local governments are desperate to expand local economic activity may result in disaster. A better alternative, despite the problems mentioned in the preceding paragraph, might be to develop more appropriate modalities for local government capital financing and borrowing, in the first instance through centrally-controlled sources. Such borrowing, however, should be on close to commercial terms: operating redistributive policy through loan finance is even less appropriate than through matching grants (see below).

An attractive and feasible way to finance local infrastructure in some instances may be through some variant of benefit taxation. In Latin America, for example, street improvements, water supply, and other local public services have been financed by a system of taxation known as "valorization," in which the cost of the public works is allocated to affected properties in proportion to the benefits estimated to be conferred by the work in question. Such systems have had varying success in different circumstances.

Studies in Colombia, where valorization has been most used, suggest that critical to its success are careful planning and execution of projects, participation of beneficiaries in both planning and managing projects, an effective collection system, and, in many instances, significant initial financing of the valorization fund from general government revenues (so that works can be begun in a timely fashion, without requiring prospective beneficiaries to put up all the funds in advance). Somewhat similar lessons have emerged from experience with an alternative approach called "land readjustment" in Korea, in which large land parcels are consolidated and developed by the local government and then part of the property is returned to the original owners in proportion to their ownership, while the balance is sold by the government at market prices in order to recoup development costs. Again, careful planning and fairly sophisticated management are required for success.

These experiences demonstrate that local governments can in some circumstances develop urban infrastructure, in effect by playing the role of a developer. Recently, another way in which beneficiaries may finance local infrastructure has been developed extensively in North America through the use of so-called "exactions", "lot levies", "development charges", and similar systems, under which governments impose levies on would-be property developers in proportion to the estimated costs the development will impose on the urban infrastructure. For example, if new residences are to be erected, and the average cost of adding them to the urban water and sewerage system is $100, the development charge - to be paid up front before the project is authorized - would be $100 (or possibly some discounted equivalent). While such schemes are far from perfect, they have been increasingly used in some countries by financially-pressed urban governments to accommodate population expansion without deteriorating service levels, though not always successfully (see Box 5.8).

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Some countries have turned in recent years to "mixed" public-private financing of urban infrastructure such as roads and transit systems. Such schemes have potential and deserve careful consideration where they seem appropriate. However, care must be taken to ensure that certain conditions are satisfied if such "mixed" financing is to produce beneficial results.As in the case of Colombia's valorization or Korea's land adjustment schemes, for example, mixed financing is most likely to prove successful when projects are carefully designed and implemented, and when the responsible public agencies are technically and financially able to meet their responsibilities. Weak governments cannot rely on private agents to overcome their weaknesses and expect to make the best possible bargains for the public they represent. In particular, governments must be careful that they do not end up assuming the "downside" risk of projects, while allowing their private partners to reap any "upside" gains. Similarly , care must be exerted to ensure that what occurs is not simply the replacement of public sector borrowing by (often more expensive) private sector borrowing, as some have said has occurred in Canada's "development charge" financing of projects. Both the economic and the budgetary gains of such arrangements may leave much to be desired. Even sophisticated local governments in wealthy countries have arguably made major errors along these lines in recent years. Inevitably, weaker local governments in Third World countries seem even more prone to such mistakes. As in other spheres, "privatizing" the design, construction, and operation of urban infrastructure may have many merits: but it neither a panacea, nor is it free.

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Of course, all formal systems of "user-pay" infrastructure development can operate successfully only in the formal sector. To the extent that housing and urban development takes place primarily outside this sector - for instance in illegal subdivisions or squatter settlements - less formal systems must be used if there is to be any beneficiary-related finance. Chapters 10 and 11 include several examples of less formal systems of infrastructure and service provision that have been successful within illegal or informal settlements, including those that are independent of external agencies and those that have been done in partnership with governments and international agencies.

A pervasive feature of local government finance in the South is the prevalence of earmarking. In Gujarat state in India, for example, a portion of the state entertainment tax is earmarked for urban local governments, and some of this portion is in turn earmarked for investment in capital projects that are co-financed by the municipalities. In many Latin American countries, the earmarking of substantial parts of intergovernmental transfers to localities to local infrastructure investment has characterized much of the recent decentralization: this feature is found in Argentina (for housing) and in Brazil, Colombia, Chile, Ecuador, Guatemala, and Venezuela. Although earmarking is seldom fully effective - there is usually some substitution of transfers for own-source revenues - the result of this practice may be to expand capital spending to some extent, while exacerbating the already difficult problem of funding operating and maintenance expenditures. Presumably motivated by the desire to prevent local governments from "wasting" transfers on expanding local payrolls, such earmarking may have the paradoxical effect of exacerbating local fiscal problems.

In general, the earmarking that marks local finances in many countries has little to recommend it. It distorts local preferences, exacerbates perverse incentives already found in the local finance system, and sometimes (as in the Gujarat case) connects revenue sources with expenditures in totally illogical ways. Such earmarking has often deservedly received criticism. Yet there is also "good" earmarking. When there is a strong benefit link between the payment of an earmarked tax (or fee) and the use of the tax to finance additional expenditures, not only is the source of financing eminently sensible in equity and political terms, but it may also serve the important efficiency purpose of signalling local preferences.

Well-designed earmarked benefit taxes are, in effect, surrogate prices. Like prices, when set appropriately such taxes may provide useful guidance both to the more efficient utilization of existing infrastructure and to better investment decisions. In the conditions of many countries in Africa, Asia and Latin America, to establish such prices may seem a counsel of perfection. Nonetheless, the interdependence of pricing and investment decisions, and the potentially important role of earmarking in linking revenues and expenditures, means that this practice deserves careful consideration when it comes to financing local infrastructure.

Most countries in the South are clearly short of capital. Even when capital projects get built, they are often inadequately maintained. In many countries, local governments, even when (as is usually the case) they have not been involved in the selection or execution of projects, are assumed to be willing and able to look after the subsequent costs required to keep the infrastructure operating and in good condition. This assumption is often mistaken: not only may local governments lack the financial resources or technical capacity to undertake this task, but the incentives facing them seldom encourage them to do so. These incentives are often perverse in the sense that the less a local government does to maintain its infrastructure the more likely it is to be rescued from above.

Funding recurrent costs through user charges are often criticized for their distributional effects, but these have little validity when the underfinancing of recurrent costs means that any redistributive objective sought through the free or subsidized supply of services cannot be achieved. On the other hand, it is not particularly difficult to design pricing schemes that incorporate some relief for low-income users but are nonetheless economically efficient. As Davey argues:

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The traditional analysis of intergovernmental finance examines the fiscal functions of local and central governments in terms of their respective roles and responsibilities for stabilization, income distribution, expenditure provision, the appropriate assignment of tax functions, and the design of a transfer system that provides appropriate incentives. The "benefit model" of service provision described in Box 5.9 suggests that local governments -- whose role in this analysis is essentially that of service provider -- should be financed to the extent possible by charging for the services they provide, with local taxes making up the remaining gap, supplemented as appropriate by transfers and, perhaps, some limited borrowing.

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Two models of local government finance may be found in the literature. The first views local government, like any other government, primarily in an "ability-to-pay" framework. The second, in contrast, views local governments, unlike general national governments, primarily as agencies providing identifiable services to identifiable local residents and thus applies what is called a "benefit" framework of analysis.The "benefit" model of local finance fits best into economic analysis. In this framework, local governments are essentially viewed as firms that provide services, for the last (marginal) units of which recipients are willing to pay a price or charge that is just equal to the benefit they receive. This approach to local finance is logically appealing (at least to economists), equitable in the sense that no one pays less (or more) than he or she would be willing to pay in a free market, and economically efficient. There are, however, two problems with the benefit model. First, it is difficult to implement appropriate pricing policy for local public services; and second, it is not politically appealing.The first of these problems may be dealt with to some extent by structuring local government finances along the following lines:[1] Price appropriately those services that flow to identifiable individuals;[2] Where such pricing is not possible, link local expenditures and revenues through such devices as earmarking and matching service benefit areas and the spatial dimension of the financing sources; [3] Ensure that taxes financing local services are raised primarily from local residents; and[4] Design intergovernmental transfers to ensure that, at the margin, the costs and benefits of local fiscal decisions are borne locally, while taking adequately into account such interjurisdictional spillovers as are deemed relevant.Imposing a "hard budget constraint" on local decision-makers in this way will never be politically popular, either with local decision-makers or, in most instances, with their constituents. In contrast, the political attractiveness in many countries of the ability model is undeniable, although it is often as nebulous how "ability" is to be assessed in this framework as to how "benefit" can be measured in the benefit framework. In countries in the South, where most tax bases are occupied by the central government, what an ability approach to local government usually means is that central transfers (or the analytical equivalent of a national tax "shared" according to some formula) end up financing most local services. There is no assurance, of course, that the local recipients of central largesse are necessarily less "able" to pay for what they get than those whose incomes are reduced as a result of the central taxes. If local governments themselves attempt to implement differentiated "ability" taxes, their tax bases are likely to leave for more congenial climes, with the result that the package of local services provided may be lower than it would be if the benefit approach were followed. In particular, richer local governments are likely to attract tax base from poorer ones, thus accentuating disparities. Overall, pursuing active distributional policies through local finances seems unlikely to be a very sensible strategy.

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This perspective is also important in the transitional economies. The obvious need for flexibility in today's rapidly changing environment has led many central governments to attempt to preserve some degrees of freedom by continuing with the "negotiated" tax sharing systems of the past under which local governments received a variable share of central revenues as determined virtually unilaterally by the central government. Such an approach seems unlikely to be acceptable for long in countries in which demands for "fair" treatment and equalization are strong, and local governments are seeking greater autonomy (see below). New intergovernmental fiscal arrangements are therefore under discussion in virtually every transitional country of Europe - and similar concerns are likely to surface in other countries (e.g. Vietnam) that had adopted similar "planning" structures.

Discussion of this issue is rendered more difficult in transitional economies by several key features of local government roles, responsibilities and economic functions. The first is the important roles of local government as producer and as owner, as well as the complicated and critical relationships between enterprises and local government in most transitional economies, must be taken into account. Local governments have a major role as potential impediments to, or supporters of, privatization. Moreover, the asset stock conferred on them in the decentralization process represents a potential source of revenue (or, in some instances, loss). The interaction of local government finance and privatization thus merits careful attention in the transitional economies.

Second, the traditional approach ignores the shrinking role of government in general as shown in Table 5.5. Under the former system, government, both local and central, had a major production role. It was also the major investor in the economy, and the expenditure side of the budget was full of expenditures - not only subsidies, but direct investment, inventory finance and wages - which in a more market-oriented economy are not the responsibility of government. In all the transitional countries government revenue is declining more rapidly than governments are able to divest themselves of these expenditure responsibilities, thus contributing to stabilization problems. One response in countries such as Russia has been to try to shift the deficit downwards by making local governments responsible for more expenditures, while simultaneously reducing central transfers to the subnational sector. This approach seems unlikely to be sustainable for very long.

A third important factor is related to the present role of local governments with respect to the so-called "social safety net" that varies from country to country. Problems are likely to arise in the future because of the combined effect of weakening central government capacity to maintain social protection and a growing need for such assistance as a result of economic restructuring. Even if the need for the bottom (local) layer of the social safety net increases, it is unlikely that local governments, even if they may sometimes be the appropriate executing agencies, should or can be responsible for financing such assistance. At present, for example, state enterprises provide a wide range of social sector outlays: with privatization, many of these outlays will have to be taken over by local governments. Since the revenue sources assigned to local governments in most countries seem unlikely to be adequate to finance even "ordinary" local activities, one result of thus shifting responsibility for distributional expenditures downward may be, paradoxically, an increased demand for intergovernmental transfers.

Central governments in most transitional countries appear to view fiscal decentralization as an opportunity to reduce central expenditures in two ways: by spinning off expenditure responsibilities to the subnational level and by reducing fiscal transfers - purportedly to make local governments more "independent," but with the welcome side effect of reducing central outlays. In particular, some countries are transferring increasing responsibility for social expenditures and the social safety net to local government.

The most dramatic example is that of Russia, where the central government transferred social expenditures equivalent to some 6 percent of GDP (l992) to the subnational level, with the objective of "pushing the deficit down." Since Russia is a federal country, in the first instance the shift has been to the regional (oblast) level. Many oblasts seem, in turn, to have passed the pressure on to the local (rayon) level of government. The hope seems to have been that lower-level governments would perform the politically painful cutting required. More recently, responsibility for key national, interjurisdictional investments (e.g. in transport) has also been transferred to the subnational sector. In contrast, in Albania, although responsibility for social assistance has similarly been pushed "downstairs," the central government has retained primary responsibility for financing such assistance.

Fiscal difficulties at the national level have led some countries to reduce intergovernmental transfers. The principle of "budgetary independence" has been interpreted to mean that subnational governments should be financially self-sufficient, which in turn implies that direct transfers should be reduced and even eliminated. However, in most of the transition economies, central transfers to local government sector remain very large (see Table 5.6), reflecting the rudimentary tax bases that have been made available to local governments as a result of the centre's reluctance to give local governments access to any major tax base.

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1/ 51.4% as grants and 17.1% as Social Security Funds transfers.

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The amount and distribution of intergovernmental transfers in most countries continues to be determined annually on a discretionary basis in accordance with central fiscal exigencies. Such budgetary flexibility is clearly desirable from the central government's short-run view. Nonetheless, it is a mistake to view intergovernmental transfers as an easily compressible portion of the national budget. Many of the services provided by subnational governments, particularly in view of the "pass-down" phenomenon already discussed, constitute essential expenditures for political stability or for future economic development. The many small local governments that have been created in response to political pressures in most countries cannot finance the provision of these services at an adequate level out of their own resources (see Box 5.10).

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In many countries, the average size of local governments is small. In six transitional economies in eastern Europe, for example, the average population of the newly-created local governments is less than 10,000. In Hungary, three-quarters of the new local governments have less than 2,000 inhabitants. Similar situations exist in many countries in Africa, Asia and Latin America. Many of these local governments are too small to provide efficiently all the public services demanded from them. Some countries in the North have developed "two-tiered" local government structures in response to this problem. In Finland, for instance, where the average population of local governments is little more than 10,000, the 460 local governments (communes) are organized on a voluntary basis to provide particular services. There are 100 such federations in the health care field, for example. Similar special purpose municipal federations exist in other Nordic countries to provide such services as health care and certain types of education. Other services are provided by so-called "secondary communes", or counties, which are responsible for certain services provided to an area encompassing a number of communes. Still other services are provided by regional agencies of the central government such as highway construction and maintenance and, in some cases, the collection of local taxes.Canada too has developed a number of variant forms of "two-tiered" local government. In the province of Ontario, for example, regional governments are responsible for some social and health services, water supply, sewage treatment, and refuse disposal, while local governments are responsible for refuse collection, fire protection, parks, and recreation. Some functions, such as water distribution, police, and roads, are jointly controlled. Primary and secondary education is provided by special-purpose school districts.

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In the current macroeconomic environment, an underfunded local government sector seems all too likely to result in a situation in which the only way local governments can cope with budgetary pressure is by using economically undesirable sources of revenue such as profits derived from the exploitation of income-earning assets transferred to them and from direct public ownership of local businesses. At the same time, local governments' open-ended expenditure responsibility for social assistance in some countries may result in emergency recurrence to the central government for additional funds, or simply the unsustainable accrual of arrears through short-term borrowing, as has happened in Russia. One way or another, intergovernmental transfers seem likely to be an important component of the central budget for years to come in most transitional countries.

The level, design and effects of intergovernmental fiscal transfers obviously constitute key elements in the emerging intergovernmental and local finance systems of the transitional economies - as they do in other countries. Critical decisions must be made in regard to the overall size of such transfers (the "distributable pool") and to the distribution formulas to be employed. These must take into account both the severe fiscal pressures on the central government and the vital tasks to be performed by the local governments in the emerging new structure of the public sector (see Box 5.11).

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Three aspects of intergovernmental fiscal transfers need further attention in most countries: the size of the "distributable pool," the basis for distributing transfers, and conditionality. Some countries (e.g. Morocco) set aside a fraction of a particular central tax as the amount to be distributed to local governments but this can introduce an undesirable bias into national tax policy. Finance ministries will be reluctant to raise taxes for the benefit of other governments. A better solution is, as in Colombia, to establish a certain percentage of all central revenues as the "pool" to be distributed to local governments. This approach both provides more certainty to local governments than a purely discretionary system and permits the central government to retain budgetary flexibility. Another approach would be to have a "horizontal equalization" transfer, as in Germany and Denmark, under which, in effect, rich local governments directly transfer resources to poor localities without directly affecting central revenues. Chile appears to be the only country in the South to have such a system.A good transfer system should distribute funds on the basis of a formula. Discretionary or negotiated transfers, such as are still common in many countries in East and Central Europe and the South are clearly undesirable. The essential ingredients of most formulas for general transfer programs (as opposed to "matching grants" which are specifically intended to finance narrowly-defined projects and activities) are needs, capacity, and effort. Needs may be adequately proxied in many cases by some combination of population and the type or category of municipality. Effort may be adequately taken into account by a proper specification of capacity. The key ingredient is some measure of the "capacity" of local governments to raise resources, given the revenue authority at their disposal. Once the total amount to be distributed has been decided, and the basic distribution formula determined, the remaining question is whether the transfer should be made conditional on the provision of certain services at specified levels. As a general rule, in the circumstances of most countries in Africa, Asia and Latin America, in which the "benefit" model of local governments (see Box 5.9) seems applicable, such conditionality seems desirable, though matters may be different for regional governments in some federal states (see Box 5.3).

Many local expenditures cannot be postponed until the revenue side is improved. Even if local expenditures are rationally assigned, and designed, the paucity of locally-controlled tax resources in most transitional countries, when combined with the universal reluctance of politicians to tax constituents too directly and openly, makes it almost inevitable that hard-pressed local governments will turn to other avenues for revenue. They will demand increased transfers, they will try to borrow, and they will try to exploit to the full the new assets they have acquired as part of the decentralization-privatization process. Each of these paths carries with it dangers for the transition process as a whole.

While many of the problems and critical areas in the transitional economies are similar to those in the South generally, a broader framework than usual is thus needed to analyze fiscal decentralization and local and intergovernmental fiscal issues in the transitional economies. This framework must incorporate such elements as the likelihood of continuing structural changes in the economy and continuing political shifts, the need to undertake intergovernmental reforms while coping simultaneously with stabilization pressures and the increased importance of the social safety net, the likelihood of continued (local) public ownership on a significant scale, the financial implications of such ownership and its possible conflicts with the overall privatization objective, and continued vestiges of price and wage controls and other rigidities. Each country is different, and each will need close examination to determine the precise structure of the relevant incentives, constraints, and opportunities in order to design as "hard" a budget constraint as may prove acceptable.