1. Local Finance

2. Outline of Presentation Revenues: – Theory of revenue assignment – Which financing tools for which services? Expenditures: – Theory of expenditure assignment – Main Municipal roles and responsibilities in different countries 2

3. Introduction The main elements of local finance are the system of revenues, the system of expenditures, local budgets and local financial administration.

4. Framework for Fiscal Decentralization

5. 5 Fiscal Decentralization Three Things to Think About What is it? Why do it? How to do it?

6. 6 What is Fiscal Decentralization Empowering People By Empowering Their Local Governments

7. 7 Why Do It? What Is To Be Gained?

8. 8 Why Decentralization? Economic Development Elected Government Inefficient Centralization Uniformity Not Acceptable Local Government Capacity Autonomy v. Backdoor Approaches Poor Service Delivery

9. 9 The Benefits Better Local Services Citizen Participation Increased Revenue Develop Local Capacity

10. 10 What is Necessary to Capture the Benefits of Fiscal Decentralization Elected councils and chief local officers Local taxing powers Significant, clear, expenditure responsibility and autonomy Hard budget constraints and less central paternalism Central government leadership A champion

11. 11 Macroeconomic Control, Stabilization Policy Direction of Investment in Social Overhead Equalization Potential Central Competence and Honesty Reduces Central Bureaucratic Control The Arguments for Fiscal Centralization

12. 12

13. 13 What Kinds of Countries Choose Decentralization? Large More developed More heterogeneous Internal discord and natural resources

14. 14 How To Implement Fiscal Decentralization

15. 15 The Process for Decentralization (Theory) National Debate, White Paper Develop A Detailed Plan The Law Implementing Rules, Regulations Implementation Monitor/Evaluate

16. 16 1. Intergovernmental Fiscal Relations (Fiscal Decentralization) is a system, and all of the pieces must fit together. Rules

17. 17 2. First, fix the assignment of expenditures, then assign revenues in amount that will correspond to the expenditure needs. Rules (cont’d)

18. 18 3. Begin fiscal decentralization with a strong central ability to monitor. Rules (cont’d)

19. 19 4. One system will not fit the urban and rural sectors. Rules (cont’d)

20. 20 5. Accountability of local government officials requires significant local fiscal autonomy. Urban local governments must have some taxing powers. Rules (cont’d)

21. 21 Good Local Tax Bases Payrolls, Wages Property, Land Value Motor Vehicles Business Activity User Charges

22. 22 6.The central government must honor its commitment to decentralization by following the rules it makes. Rules (cont’d)

23. 23 7.Keep it simple. Precision in tax administration and grant distribution is probably not possible in most cases. Rules (cont’d)

24. 24 8.Grants and shared taxes must play an important role in almost any decentralized fiscal system in a developing or transition country. Transfers may be designed as more centralized or more decentralized. Rules (cont’d)

25. 25 9.There is an intraprovince dimension to intergovernmental fiscal relations and this should be taken into account in planning the system. Rules (cont’d)

26. 26 10. Impose a hard budget constraint on local governments. Rules (cont’d)

27. 27 11.Recognize that intergovernmental systems are always in transition, and plan for this. Rules (cont’d)

28. 28 12.There must be a champion. Rules (cont’d)

29. 29 Potentially Strong Supporters Comments The People and their elected representatives Demand for more participation in governance at the local level. The PresidentDecentralization is a popular policy with the electorate. However, the President must also be very mindful of stabilization concerns with the decentralization, since inflation and unemployment are usually the greatest danger to his/her political standing. The Parliament or Congress Decentralization is a popular policy with the electorate. Parliament would like to identify with specific local projects they could “ bring home, ” therefore, they will favor a less transparent and less structured system. Champions of Fiscal Decentralization

30. 30 Potentially Strong Supporters Comments Urban Local Governments “ Give us the autonomy to tax and spend. ” Urban local governments are often most concerned with how their autonomy is circumscribed, and how their access to their tax base is limited. External DonorsThis provides encouragement and some technical assistance to get the process underway, but is no substitute for an in- country champion. Champions of Fiscal Decentralization (cont’d)

31. 31 Potentially Weak Supporters Comments Ministry of FinanceWould propose strict limits to decentralization in order to hold the main fiscal tools for stabilization policy purposes. Ministry of EconomyWould like to control the type of investment made, as well as the regional distribution of investment. Typically interested in programs with big externalities versus local benefit programs. Line MinistriesDelivery, and often would like to hold an approval or sign-off power. Champions of Fiscal Decentralization (cont ’ d)

32. 32 Ambivalent SupportersComments Ministry of Local GovernmentWould favor a greater guaranteed share for local governments, but would like to control the distribution of those resources. Weaker local governmentsWould like a guaranteed transfer of resources from the urban and wealthier local governments to the rest. More interested in a transfer system than in a local taxing system. Champions of Fiscal Decentralization (cont ’ d)

33. Revenue Assignment

34. Revenue Assignments Local bodies are entrusted with fiscal powers to raise their revenue bases to finance their functions. While assigning revenue responsibilities utmost care is required to be taken so that no overlapping and duplication in the provisions would crop up.

35. Theory of revenue assignment Guidelines for revenue assignments: 1.Federal and provincial governments should levy broad-based taxes (e.g. income and sales) 2.Small local governments should focus on user charges and benefit taxes especially taxes on immobile factors (e.g. property tax, motor vehicle taxes); additional local taxes for large local governments (depending on services) 35

36. Theory of revenue assignment Guidelines for revenue assignments (cont’d): 3.Taxes should be borne by residents of same jurisdiction where benefits are enjoyed (minimize tax exporting) 4.Local taxation (at least local tax rate setting) promotes efficiency 5.Intergovernmental transfers are appropriate to address spillovers, equalization 36

37. 37

38. Principles of revenue assignment Three fundamental concepts 1.Economic role of government 2.Concept of Benefits and Assignment of Sub- national Tax 3.Revenue subsidiarity

39. Economic role of government Economists have categorized three major functions of government: a.Macroeconomic stabilization, to assure the achievement of high employment and price stability b.Income redistribution justice, to achieve an equitable distribution of income, and c.Resource allocation to see that resources are used efficiently.

40. Allocation related functions, involving provision and financing of public services, are commonly assigned to LGs. Services are to be paid for by the beneficiaries through user fees or charges. Each level of government should be assigned taxes that are related to the benefits of its spending. Thus, the proper assignment of taxes that are related to benefits depends on the assignment of expenditure functions. In essence these are considered most appropriate source of finance to LGs.

41. Concept of Benefits and Assignment of Sub-national Tax There are two kinds of benefits: specific to the direct user (specific benefits) and generalized to a broader community (generalized benefits).

42. Charges/fees related to specific benefits include Direct use of a facility or consumption of a service. Examples are utility consumption, trash and garbage collection, sewer services, school meals, parking, road and canal tolls, entry fees to facilities such as museums, sports facilities, and parks; airline landing/slotting, and road use (which may be structured as a tax as for example on motor fuel or other vehicle characteristic) License fees paid for having the privilege of an activity (business establishment, driving permits, vehicle use; registration fees such a land transfer and entitlements); and Betterment levies to pay of local infrastructure (measured by increases in land values; fees paid to cover on-site costs of infrastructure such as for sidewalk construction and repair)

43. Therefore… For the CG, either taxes such as that on personal income or payroll or a consumption value added tax is commonly agreed as appropriate. For the Sub-national government production-base tax such as a tax on payroll levied where the employment occurs can be considered appropriate.

44. Revenue subsidiarity Well functioning Sub-national governments are able to access some tax bases more readily than a central government i.e those (i) relatively immobile (real property, land and, to a lesser extent, buildings); payroll, depending on the degree of resident/worker mobility; and (ii) for which the benefits of Sub-national services (expenditure assignment) can be identified. A range of specialized taxes (excises and narrow based consumption levies) and fees and charges (road user and property improvement) fit this criterion.

45. Key principles There are a few principles that govern the decision relating to revenue assignment. Crucial of them are discussed in brief. 1.Efficiency of Market 2.National Equity 3.Adequacy of Fiscal Need 4.Administrative Costs 5.Political acceptance 6.Tax exporting 7.Locational distortions 8.False constraint: Unique assignment

46. Efficiency of Market Revenue assignment should be done in such a manner that the tax assignment has no adverse impact on the functioning of market forces. The tax system should not bring any distortion in the movement of the resources forces (capital, labor, goods and services) in the market.

47. National Equity People should pay taxes in accordance with their ability to pay; i.e., those with greater ability should pay more. Equity is a national issue, since all LGs might not have same priorities for redistribution, which should be addressed by a well-designed Sub- national taxation system. As with the efficiency case, LGs need to have a well coordinated tax policies to reduce differences in redistributive benefits for residents of different jurisdictions.

48. Adequacy of Fiscal Need Local Bodies should be assigned such revenue sources that they can raise substantial amount that is commensurate with the functions and services they are held responsible. If this does not happen then the benefits of local autonomy will suffer. Therefore, LBs should be given tax authorities that are matching with the responsibility for different services they are held responsible.

49. “buoyancy of resources” The revenue of local bodies should increase proportionately with an increase in personal income level and business activities. A tax rate fixed as a percentage and not as absolute figures is one means to achieve this. For example tax on property is normally not buoyant, whereas that on business volume is buoyant, as it grows automatically with an increase in the economic activities.

50. Administrative Costs The decentralization of revenue authority can also serve to increase the costs of collection and compliance, both for the government and the taxpayers. The possibilities for evasion and avoidance will increase with decentralization for some types of taxes. This will be true where the tax base is mobile, or where the tax base straddles more than one jurisdiction.

51. Political acceptance Tax system should be politically acceptable. The more inclusively a decision is made in this regard the higher is the chance that it becomes acceptable to different strata and group of people.

52. Tax exporting Some taxes levied by a LB may in fact be borne by people of another jurisdiction. Such a situation is called tax exporting. Such a situation is not considered good, since the decision of a LB affects the life of people in other LBs.

53. Locational distortions Some taxes are acceptable to be imposed by central government, and may not acceptable if assigned to local bodies. (e.g., of trade and investment).

54. False constraint: Unique assignment When one discusses what tax is better suited for a level of government, then it should not be meant that revenues from that source be assigned to only one level. A given source can be assigned to more than one level, provided that it is acceptable, it does not invite economic distortions, and is easy to administer.

55. Tax Assignments

56. The 5 methods in which revenue allocation to LBs is done Independent local taxation Centrally assisted local taxation Local surcharge Tax sharing Central revenue sharing

57. Often a combination of these different methods needs to be followed and there should be close coordination among levels of government. In discussing these alternatives, it is convenient to distinguish four features: a) who chooses the taxes b) who defines the tax base(s), c) who sets the tax rate(s), and d) who administer the tax(es).

58. Criteria for Making Sub-national Tax Choices Accountability: Local policymakers responsive to citizen preferences Revenue Productivity: Taxes that promote “adequacy” in order to finance an agreed flow of public services. Benefits-Received: To extent possible taxes should function as a “price” for flow of services that accrue to the taxpayer/ citizen Tax Equity: Tax burden should be reasonable and fair

59. Non-Distortion: Taxes should not Unintentionally interfere with private decisions consumers, factor suppliers and producers; they should be “neutral” Simplicity: administration & compliance

60. Purposes of Tax Assignment Provide subnational governments with revenues they can control to implement their expenditure responsibilities (improved resource allocation)  Own taxes and levies  Shared taxes

61. Purposes of Tax Assignment (cont.) Increase the accountability and responsibility of subnational government officials to their constituencies  Subnational governments can significantly affect their total revenues at the margin through their choices of taxes, bases, or more preferably tax rates  Subnational governments should operate with a hard budget constraint. Revenue sharing and grants should be infra-marginal funding. The expansion (or contraction) of the budget should remain a subnational government responsibility

62. Purposes of Tax Assignment (cont.) Macroeconomic stabilization and redistribution of income should be generally left as responsibilities of the central government

63. DESIRABLE FEATURES OF SUBNATIONAL TAXES Linkage between taxes and benefits derived from local government services (using the “ benefit principle ” )  Employ user charges and fees whenever possible: for excludable and individual benefits. (User charges act as quasi-prices by rationing and signaling demand and they tend to be fair)  For public services with generalized benefits use “ consumption and residence- based ” taxes if benefits are provided to individuals and “ production and origin-based ” taxes if benefits are provided to businesses

64. DESIRABLE FEATURES OF SUBNATIONAL TAXES (Cont.) Administrative feasibility  Administration costs and compliance costs (time and money employed to file taxes) and political acceptability are taken into account

65. DESIRABLE FEATURES OF SUBNATIONAL TAXES (Cont.) Revenue stability and revenue elasticity  Subnational governments typically cannot run deficits and have more limited ability to borrow. More unstable sources should be assigned to the central government  Subnational revenues should increase with income as much as the demand for services

66. DESIRABLE FEATURES OF SUBNATIONAL TAXES (Cont.) Minimizing excess burdens and distortions in the location of economic activity  Unlike revenue burdens, excess burdens are avoidable losses, which arise from people trying to avoid taxes by working less, changing the level and composition of consumption and investment, etc.  Taxes levied at the origin of production or source of income tend to distort location more than taxes on consumption or place of residence

67. DESIRABLE FEATURES OF SUBNATIONAL TAXES (Cont.) Controlling tax exporting (taxes are paid by non-residents who derive no benefit)  Tax exporting can lead to over spending  It is unfair and undermines accountability

68. DESIRABLE FEATURES OF SUBNATIONAL TAXES (Cont.) Preventing predatory tax competition  By jurisdictions that provide a haven to smugglers, those that misstate residence, or practice profit shifting through transfer pricing  However, there is also “ healthy ” tax competition, as when taxpayers relocate to enjoy a preferable package of taxes and public services

69. THE CHOICE OF SUBNATIONAL TAXES There are hardly any taxes that comply with all the desirable features for subnational taxation But clearly, there are better and worse tax assignments

70. THE CHOICE OF SUBNATIONAL TAXES (cont.) At minimum tax assignments should provide:  Autonomy at the margin  Stable assignments over time  Sufficient revenues for the wealthiest subnational governments to be fiscally autonomous

71. COMMON PROBLEMS WITH REVENUE ASSIGNMENTS Vertical imbalance (inadequate correspondence between expenditure responsibilities of subnational governments and their assigned sources of revenue)  Tax autonomy and increased use of subsidiarity in taxation (taxes should be assigned to the lowest level of government that can implement them) are preferable to transfers

72. COMMON PROBLEMS WITH REVENUE ASSIGNMENTS (cont.) Lack of meaningful tax autonomy  Predominance of shared taxes and transfers Unstable Assignments  Assignments are decided in the annual budget rather than stated in the laws and fixed for a number of years

73. COMMON PROBLEMS WITH REVENUE ASSIGNMENTS (cont.) Wrong incentives and lack of uniformity: the “ regulation ” of taxes  Tax assignments are customized for each local government to fit a “ minimum budget ” Confused system resulting in the misallocation of resources and significant administration and compliance costs

74. COMMON PROBLEMS WITH REVENUE ASSIGNMENTS (cont.) Unfair apportionment of tax revenues among subnational jurisdictions  The exclusive sharing of taxes on a “ derivation basis ” (usually paid at the headquarters of the firm) leads to the unfair allocations of VAT and CIT revenues

75. COMMON PROBLEMS WITH REVENUE ASSIGNMENTS (cont.) Large horizontal disparities  The uneven distribution of tax bases requires the introduction of equalization grants  The problem is more acute with the sharing of natural resource taxes

76. CHOICES IN PROVIDING TAX AUTONOMY Which taxes should subnational governments be allowed to levy?  Closed lists are preferable to freedom to legislate new taxes (less complexity, fewer inequities and distortions)

77. CHOICES IN PROVIDING TAX AUTONOMY (Cont.) Discretion or not to modify tax bases  Discretion also leads to complexity and inequities  Surcharges or taxes piggybacked on a central government tax base are easier to administer

78. CHOICES IN PROVIDING TAX AUTONOMY (Cont.) Discretion to set the tax rate is the simplest and most effective form of tax autonomy  National legislation can set, when desirable, maximum and/or minimum rates

79. CHOICES IN PROVIDING TAX AUTONOMY (Cont.) Separate tax administrations for subnational governments may be desirable but are not always necessary if incentive compatible arrangements between levels of government are set in place Tax sharing does not contribute to subnational revenue autonomy

80. CHOOSING AMONG DIFFERENT TAXES AT THE SUBNATIONAL LEVELS Good choices for local (municipal) governments  Fees and user charges  Real estate property tax  Betterment and improvement levies  Vehicle and transportation taxes  Piggyback flat rate personal income tax

81. CHOOSING AMONG DIFFERENT TAXES AT THE SUBNATIONAL LEVELS (Cont.) Good choices for regional governments  Piggyback flat rate personal income tax  Piggyback for selected excises  Business value tax (BVT) falling on wages and profits  A regional VAT, if tax administration is adequate, is superior to a retail sales tax.

82. Features of a sound assignment of revenue sources Correspondence: Sub-national governments should be assigned taxes that are related to its assigned expenditure responsibilities. Tax assignment should provide adequate revenue for LBs. The revenue base should Correspond to the benefits or benefit area of LB jurisdiction, and avoid "Tax exporting". The problem of tax exporting can be understood better by analyzing the fiscal incidence – that is who really pays the tax? The fiscal incidence (who bears the economic burden of a tax) does not depend on the "legal incidence" or point of collection of a tax.

83. Cont., Fiscal autonomy and stability: Sub-national governments should have at least some control over one or more significant sources of revenue will not have fiscal autonomy. When their fiscal autonomy is jeopardized they cannot run as autonomous institutions. LBs who have to rely on external resources cannot contribute to the purpose of fiscal decentralization, which is to respond to the local needs.

84. Cont., Local bodies need to provide certain social services (education and health) over and above what central government provides because of their proximity as well as the responsibility they carries in their jurisdiction. The cost of such services will at least remain same or rather increase. For providing services of such permanent nature revenue of LBs should be stable and predictable. Therefore revenue assignment should allow for stable local revenue sources over time.

85. Cont., Local administration: Assignment of tax authority should also take into account the feasibility of administering taxes. Certain revenues are inherently better administered at the local level. Certain revenues are poorly administered at the local level. The organizational capacity of local bodies is another aspect for consideration.

86. Constraints on tax assignment Some tax assignments are undesirable to local bodies: Such taxes include those that correspond to responsibility of macroeconomic stabilization and income redistribution, that are prone to tax exporting, or that interfere with international commerce Some assignments elicit particularly strong political reactions Some assignments cannot easily be administered Tax assignments that make sense on conceptual, political, and administrative grounds may lead to vertical imbalance or horizontal disparities among LBs at a given level

87. Assignment of Specific Tax and Non- Tax Sources

88. Revenue sources of LBs

89. Assignment revenue sources for local governments Taxes that are suitable for economic stabilization should be retained at the central level while local taxes should be cyclically stable Progressive taxes that are suitable for income redistribution should be retained at the central level Unequally distributed tax bases should be taxed at the central level to avoid exacerbating disparities Local governments should tax bases with low mobility between jurisdictions to avoid locational distortions and tax exporting Benefit taxes and user charges should be used by all levels of government

90. Tax on business income and profit It is considered intended for macroeconomic stabilization and redistributive purposes. Tax on income and profit of an individual or a firm is generally not suitable source for a LB because, in a free market where capital and labor flow freely, it is difficult to attribute the income or profit to the services rendered by the LB.

91. Individual income taxes They are suitable for use by several levels of government. It is appropriate for the central government to use a progressive income tax for stabilization ad redistribution. Subnational governments can employ a flat- rate tax to public for the generalized benefits they provide.

92. Tax on consumption Key taxes on consumption include VAT, general sales taxes and excises. It is considered that VAT is more appropriate for central government; the sales tax and excises can be assigned to LBs. Generally sales taxes and excises are good candidates to be assigned to the intermediary local bodies

93. General sales taxes (e.g., VAT and retail sales tax) are suitable for the finance of generalized benefits provided by both the central government and local bodies. If Sub-national governments are assigned such taxes it should be done primarily to the jurisdiction where consumption occurs with a view to taxing the beneficiaries. Retail Sales tax may be good for them with assumption that such taxes fall on the residents – US and Canada experience shows that these can be locally administered.

94. Natural resources tax Natural resource tax, also known as environmental levies, is considered appropriate for LBs with a view to compensate for degradation of the environment. This will compensate the LBs the loss they bear due to exploitation of the natural resource for financing localized social services. If the exploited resource transcends LB boundaries then a higher- level government should be assigned revenues.

95. Property tax Property taxes are levied in different forms – tax on transaction and holding property, and tax on house roof. Property related taxes are considered best suited for LBs.

96. Tax on transaction Foreign trade tax is more appropriate to central government. The arguments for this include efficiency, macroeconomic stabilization and benefit area. Export tax authorized on DDCs on agricultural produces appears somewhat contrary to this notion. Whereas the tax on international transaction is considered not good for LBs as the incidence of tax is most often not confined to the jurisdiction of a LB; the tax on transaction of properties is considered appropriate.

97. User charges User charges are considered most appropriate source of revenue for LBs, but should be considered carefully. User charges may be levied on something that is mandatory for the citizens such as marriage certificate. The other kind of user charge can be on use of services of private nature (commercial ventures) produced by LBs such as rest house, conference hall, park entry and so on. A tax levied on motor vehicle or fuel can also be taken as user charge.

98. The objectives of revenue assignments To provide sufficient revenues for the central government to manage macroeconomic stabilization functions To provide sufficient revenues to achieve the government’s redistribution functions, and To provide sufficient revenue for the central and local government to achieve their objectives of generating allocative efficiency and providing essential government goods and services.

99. Tax autonomy and decentralisation in OECD countries. Network on Fiscal relations across levels of Government

100. Tax Decentralisation

101. Tax Autonomy

102. Tax Decentralisation vs. Tax Autonomy

103. Real Tax autonomy structure

104. Tax Autonomy and disparirites. What happen when equalisation is small?: CANADA S/RSWITZERLAND S/R FRANCE (Departments)

105. Tax Autonomy and disparirites. What happen when equalisation is high?: SWEDEN LOC PORTUGAL LOC DENMARK LOC FINLAND LOC

106. Tax Autonomy and disparirites. What happen when equalisation is very high?: SPAIN (Regions)

107. Tax autonomy and Tax rate evolution

108. Tax autonomy and tax rate evolution, an ideal evolution?

109. OECD Network on Fiscal relation across levels of government Created in 2003 and managed by 3 OECD Directorates: –Tax Policy and Administration (CTP) –Economics Department (ECO) –Directorate for Public Governance and Territorial Development (GOV) Providing OECD countries with the analytical and statistical underpinnings for decisions on how to organise the relationships among central, regional and local governments A high level, multidisciplinary policy dialogue platform, between policy makers for taxation and expenditure. Participants: –17 OCDE countries, –25 countries are providing statistical data and policy information –The International Monetary Fund, the World Bank, the Council of Europe and the European Commission participate in the Network

110. Fiscal Network. Current tasks Reforming Fiscal Relations across Levels of Government: –the way in which political and institutional factors influence the design, decision-making process, adoption and long-term implementation of fiscal federal reforms. –Two kind of results are foreseen: A summary report with the basic elements to task into account when reforming fiscal relations Some country case analysis Sub-Central Tax Competition: –What means tax competition at sub-central level? –What impact has the tax competition? –What are the potential framework conditions to make it beneficial for fiscal policy and fiscal outcomes?

111. Thank you for your attention 111