Financial systems and instruments
The attractiveness of tangible locational factors depends to a large degree on the financial scope of manoeuvre at disposal on the side of the local authorities. The larger the financial resources, the higher is the potential for local governments to invest in local infrastructure and raise locational attraction. The question is, how this may be achieved, what are the financial instruments at hand for local authorities?
Central government transfers
In most of the developing countries, financial transfers from central government to subnational levels of government account for the dominant source of local revenue. Technically, there are different forms of transfers:
Matching transfers require local governments to come up with a share of the funding of its own. This means that without a financial contribution of the community, central government will not release the money. This is to spur resource mobilization efforts by the community itself and avoid an attitude of dependency on part of the local governments towards the centre.
Nonmatching transfers offer a given amount of funds without any complementary funding by local governments. Some of these are conditional, meaning that they can be spent for specific purposes only, whereas others are unconditional, with no constraints being put on the way it is spent.
At first glance, transfers from central government appear to be the easiest way to guarantee a flow of money to the local treasurer. However, with the rare exception of unconditional nonmatching transfers, the administrative procedures for accessing and reporting on their use are often cumbersome. Sometimes, for example, accounting procedures need to be changed, expenditures reclassified, special accounts have to be set up, and so forth. All this raises local administrative costs and uses up scarce resources.
In more general terms, grants may also serve as a sweet poison and undermine efforts and abilities to mobilize local resources.
Local taxes
By assigning local taxes, local governments are mobilizing local resources and thus become more independent from superior powers donating money to them. In most developing countries where there is a legislation on decentralization, local communities are attributed the right to assign local taxes. In doing so, one has to follow certain principles in order to really achieve the objective of local resource mobilization:
No strangulation of the local economy: The tax rates need to be carefully determined. Whereas minor or petty tax rates would not result in sufficiently high tax volumes, high rates might pose a heavy burden on the local business community and produce a slowing down of local economic growth. A golden path in the middle needs to be found.
Try to mix taxes: If one introduced only, say, a single tax, the tax burden would be confined to a specific group (for example the consumers, the salaried people, property owners). This is socially unfair, because most of the gains of local resource mobilization are open to the whole community, thus producing benefits also for those who did not contribute anything. Apart from this, the dependency on a single tax raises the vulnerability of the local government towards the ups and downs of a specific sector. Therefore, it is better to broaden the tax base and introduce a mix of different sources of revenue.
Transparency: It is important to demonstrate to local taxpayers for which purposes the money is spent. This will heighten credibility with the electorate and will make it easier in case any future changes in tax assignments will become necessary.
Consider administrative costs: Collection procedures should be as simple as possible in order not to waste scarce resources on administration and to retain a larger part for investment purposes. Take the so-called informal sector as an example. If you tried to assign an income tax as a percentage of a person's monthly or annual income, you would encounter innumerable difficulties to assess it somehow correctly. Using a nominal flat rate adjusted from time to time to the inflation rate would very much facilitate tax collection.
Cooperate with neighbouring municipalities: Often, neighbouring municipalities try to get a competitive advantage over one another by offering lower tax rates. They enter into a downward spiral as far as the rates are concerned, which, from a certain point onwards, produces negative results for the whole group of local areas. Cooperation between local areas can avoid this kind of hazardous rivalry.
Having given an overview of the principles that should rule the assignment of local sources of revenue, the question now arises what kind of taxes are more suitable for local assignment:
The individual income tax is considered by fiscal experts as a good choice for local governments. The burden of this tax would normally be borne by the beneficiaries - the local residents - of local government spending. There are cases that allow for an easy administration of this tax, especially in cases where local governments can opt for an add-on to the central government tax rate.
The property tax is seen as a very appropriate source of local government revenue, because it is visible and allows for a relatively easy identification and verification by local assessors. It is also difficult to export property and evade the tax. Apart from this, it is also a tax on wealth and thus serves certain redistributive objectives. On the other hand, experience shows that the property tax alone does not produce sufficient revenue.
Motor vehicles are considered another good source of revenue. The taxation of motor fuels, licenses, tolls and parking taxes are all considered being administratively feasible. The motor fuel tax offers the greatest potential for income, but very often central governments depend heavily on this source and would not easily share this cake with local governments.
Other taxes, such as the value added tax or the corporate income taxes are not considered good choices for local governments, as difficulties with international trade (zero-rated in the case of the value added tax) and with equity considerations may occur (if, for example, one municipality is the home of a big company that is an excellent tax payer, whereas other local areas in the neighbourhood do not have this privilege and therefore stay poor).
User charges
Charging the users for services offered by the local administration is another source of revenues. They may be charged for services related to "tangible" factors such as wastewater treatment, refuse disposal, real estate development and the provision of transport infrastructure as well as for "intangible" factors such as kindergardens, leisure facilities and local educational institutions.
Ideally, fees should be charged that cover at least the production costs of these services. This is easily said but in practice difficult to implement. In order to create a locational advantage, a local government might be tempted to offer high-quality services at a low price. This may be advantageous in the short-run but in the long-run, if the deficit in these operations is bridged by commercial borrowing, the debts incurred may in result in high debt-service payments limiting the financial scope of manoeuvre of the local administration enormously. In general, it might be more promising in the long run to achieve cost-recovery (including maintenance costs) in the operation of these services. Long-term stability and quality in the provision of services is more rewarding than short-term competitive advantages.Borrowing
Borrowing capital is, at least ideally, another option for local governments. Borrowing is especially important when it comes to financing larger capital investments. The benefits of such investments often last several decades and it seems only fair to let future generations also participate in its financing (via interest payments that last for decades as well). Another purpose for borrowing is the bridging of gaps between tax intakes and expenditures incurred. However, very often there is the danger of avoiding any sort of reform when the gap is not of temporary but of structural nature. Politicians are tempted to seek an easy way out of financial imbalances by resorting to borrowing, thus deepening these financial difficulties.
In principle, there are three different channels to source:
central government borrowing from the national central bank and on-lending to subnational tiers,
borrowing through a public intermediary such as a state-owned financial institution and
direct borrowing from capital markets.
In poor countries, local governments do usually not have the possibility of borrowing money from capital markets, as they very often do not dispose of the necessary guarantees and because capital markets are not developed.
Rural Finance (agricultural lending, non-farm rural lending, deposit services in rural areas)
One of the main activity areas of financial systems development in the recent past has been the development of financial systems and instruments for rural regions. Efforts were undertaken to identify those policies, practices, strategies and capacity building measures which need to be taken into account to ensure that rural populations have better access to effective financial services. These instruments aim at creating an awareness among governments, private sector and international development and donor agencies, of the need to apply appropriate policies and to set required rules of conduct.
Microfinance: An instrument for assessing the impact of implemented programmes is provided in the Guidelines for Impact Monitoring and Assessment in Microfinance Programmes.
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