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The IIPA in Partnership with the Government of Japan and the WBI

December 11-15, 2006Goa (India)

Workshop on Fiscal Decentralization and Local Governance in India

Session on

Local and Metropolitan Finance:For Urban Governments

By

Gautam NareshNational Institute of Public Finance & Policy,New DelhiTELE: 2656 9303; 26569780; 2656 9784; 2656 3305; 2656 9286; 2696 7935

Fax: 2685 2548E-mail: naresh@nipfp.org.in gautamnaresh@gmail.com

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Objective of the Session

• Most administrative services that are closely related to the lives of citizens are implemented by local governments.

• Local finance plays an extremely important role in securing and adjusting financial resources for administrative services to satisfy a variety of residents' needs particularly in an environment of fiscal decentralization.

• This session explore experiences from a variety of countries to construct local finance for better service delivery in urban areas.

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What are Local Governments? …• The definition of local government is difficult and the tortuous

debate regarding alternative definitions requires recourse to political science.

• Local government, as distinct from its role as a provider of public goods, affects the economic efficiency of the economy.

• The conventional economic argument is that the main role of local government should be limited to the allocation function, namely dealing with market failure.

• Attempts to adopt the distribution and stabilisation functions are likely to cause inefficiency.

• The regulatory role may, or may not, be undertaken on behalf of Central government.

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What are Local Governments?• In practice, however, local government actions may contain

elements of all four roles. • Hence, there is the distinct possibility that Central government

and local government roles may overlap. • While it may be difficult to resolve that duplication, it will be

diminished by the principle of jurisdictional restriction. • Models of local government are a subset of the general models

of government and explicitly take account of the distribution ofpolitical power within local democratic instructions.

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Economic Principles for the Functions of Local Government

• Local government should provide the majority of public sector services because their benefits are localised.

• Central government should only provide national pure public goods such as defence and foreign policy.

• Local government should restrict its provision of services to those cases where local market failure is high and the risk of government failure is low.

• This implies that local governments should restrict their service provision to core functions, irrespective of any powers of general competence conferred upon them by central government.

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Economic Principles for the Financing of Local Governments …

• Charges should be the primary means of financing local government services because most of them are not pure public goods.

• Where other forms of market failure occur, such as positive externalities, services should also be part-financed by local taxes.

• The size of the locally-financed subsidy should not exceed the monetary value of positive externalities or merit good characteristics.

• Subsidies should be targeted on users rather than on facilities.

• Local governments should tax bases that have low mobility, are not heavily redistributive, are evenly disturbed across the country, and whose revenues rise in line with service costs without having to raise the tax rate.

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Economic Principles for the Financing of Local Governments

• Intergovernmental grants-in-aid should generally be restricted to services where unavoidable spill-over effects are so great that significant allocative inefficiency would occur.

• Local governments themselves on the ‘Robin Hood’ principle best finance equalisation grants intended to archive horizontal equity.

• Otherwise, any centrally financed equalisation grants should be no greater than those levels required securing the required degree of equalisation.

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Salient Features of Local Finance …• The issue of local finance can be posed as under:• In a multi-level fiscal system, what should be the basic

principles of transfer of functions, resources and finances to local bodies?

• When revenue and expenditure heads are transferred to them, what are the guiding considerations in local taxation and expenditure programmes?

• Traditionally functional assignment was based on spatial limitation.

• Such functions were confined to the limits of a local body and scarcely have any spill-over effect are assigned to the local bodies, such as: sanitation and health, street lighting, water supply, primary education, roads and culverts, town planning, epidemic control, vaccination, etc. but both technology and economic development, over time the rigidity between assignment of functions between centre, state and local got softened.

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Salient Features of Local Finance …• For instance, water supply, primary education, epidemic

eradication are State functions, while conservation of environment, dairying, community hall, old age homes, nutrition, etc are increasingly becoming local functions.

• The Twelfth Schedule has demonstrated how many of the community-oriented or target-group service functions may be transferred gradually to local bodies in days to come.

• The local finances are based on benefit principle; therefore, any model of it should have resemblance to the market model. While the distribution and stabilisation functions are better discharged by the central government, the local governments should engage in such activities that reflect individual tastes and preferences. Nevertheless, certain local public goods can be internalised for the particular region(s). The local budgets have certain characteristics as compared to that of higher-level governments.

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Salient Features of Local Finance• The local finances are based on benefit principle; therefore,

any model of it should have resemblance to the market model. While the distribution and stabilisation functions are better discharged by the central government, the local governments should engage in such activities that reflect individual tastes and preferences. Nevertheless, certain local public goods can be internalised for the particular region(s). The local budgets have certain characteristics as compared to that of higher-level governments.

• These characteristics are income-inelasticity of the local tax receipts particularly, property taxes, and restraints on debt-financing of current expenditures. The inability of the municipal governments to bring about changes in tax structure makes taxes a residual item of their budget making exercise, more so, because the local governments have to provide for balanced budgets, as it is more analogous to individual consumer.

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Forms of Urban Local GovernmentsThe urban local government nomenclature is different in various

States. The basis of classification is normally population size and presence of certain civic provisions and size of resource raising capacity, as well as their commercial importance. State have right to set norms for assigning a locality urban status. They are named for example,• Municipal Corporations• Municipal Boards• Municipalities• Town Areas• Notified Areas• Cantonment Boards• Town Panchayats

The assignment of functions and powers to raise resources are also discriminated as per their status. Therefore autonomy is also different. Bigger sized municipal governments enjoy more of it.

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Twelfth Schedule (Added by the Constitution (74th Amendment) Act, 1992, section 4 to Article 243 W was added for urban local governments.

• Urban planning including town planning.• Regulation of land-use and construction of buildings.• Planning for economic and social development.• Roads and bridges.• Water supply for domestic, industrial and, commercial purposes.• Public health, sanitation conservancy and solid waste management.• Fire services.• Urban forestry protection of the environment and promotion of ecological

aspects.• Safeguarding the interests of weaker sections of society, including the

handicapped and mentally retarded.• Slum improvement and up-gradation.• Urban poverty alleviation.• Provision of urban amenities and facilities such as parks, gardens, playgrounds.• Promotion of cultural, educational and aesthetic aspects.• Burials and burial grounds; cremations, cremation grounds and electric

crematoriums.• Cattle ponds; prevention of cruelty to animals.• Vital statistics including registration of births and deaths.• Public amenities including street lighting, parking lots, bus stops and public

conveniences.• Regulation of slaughterhouses and tanneries.

Functional Domain of ULB

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Sources of Financing: Taxes …• Local government taxes must be levied in order to

finance the subsidies paid in respect of local positive externalities, local merit goods, and local public goods.

• The question then is how to decide what type of local taxes should be levied (direct and/or indirect) upon whom and upon which levels of sub-central government (that is, region or municipality).

• A local tax can be defined as one where the local authority (a) determines the tax revenue by setting the tax rate and/or defining the tax base, and (b) retains the resulting proceeds of the tax for its own purposes. At the local level the tax base has to be immobile such as land improvement and structures thereon.

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Sources of Financing: Taxes• If income is to be taxed, payroll is the part of the base, which

can be tapped most conveniently and cannot be lost by way of out-migration.

• Charges are of special importance in the local setting, where the benefits of public services more frequently accrue to particular groups of beneficiaries.– Taxes in income and property– Taxes on commodity and services

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Sources of Financing: Non-Taxes• Fees, fines, user charges. • Use of the term ‘charge’ rather than ‘price’ recognises the

administrative, rather than market, determination of payments.

• They are requited payments, i.e., payments made against some service rendered.

• The link between payment and service provided may vary considerably in terms of the degree of cost recovery.

• Pure public goods have to be provided free at the point of use because their non-excludability means that payment cannot be secured from ‘free-riders’ and any one person’s use of the service is not rival with that of other users.

• In contrast, pure private goods are both rival and excludable and charges should fully reflect the cost of their provision if allocative efficiency is to be secured.

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External Source of FinancingBorrowings• Institutional and • Market Inter-Governmental Fiscal Transfers• Revenue-sharing• Grants-in-aid

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Expenditure …• Composition of expenditure: The precise mix of local

government spending varies between countries reflecting differences in the service responsibilities attributed to them by their respective parent governments.

• The rationale for central government control of local government spending is based on both macroeconomic (demand-side) and microeconomic (supply-side) considerations.

• It may be classified by• Economic classification

• Non-plan expenditure, and• Plan expenditure.

• Further this classification may be truncated into • Current expenditure, and• Capital expenditure.

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Expenditure …• Functional classification

– General administration– Education– Street cleaning– Drainage– Water supply– Roads maintenance– Slaughter houses– Etc.

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Fiscal Stress• It occurs when there is a tendency for the costs of a given level

of service provision to rise faster than the revenue required financing it.

• This necessitates either higher local taxes and/or reductions inreal expenditures and in service levels.

• Put simply, fiscal stress is caused by the unbalanced growth of revenues and expenditures leading to a structural gap in the local public finances.

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Address to Fiscal GapIn fact, the problem of fiscal gap can be addressed, in principle, in four different ways:

– Increased local revenue effort;– Increased local revenue authority;– Increased transfers from higher levels of Government; and– Reduced local expenditure authority.

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