Financial Accounfabilify GY M a n a f m e n t , 5(2), Summer 1989 0267-4424 $2.50

CONTROL OF LOCAL GOVERNMENT FINANCE

NOEL HEPWORTH'

INTRODUCTION

The managers of local government in Britain will be required to understand and work within a completely new financial system. This new system will come into effect from 1st April 1989 in Scotland and from 1st April 1990 in England and Wales. It will be based upon a poll tax regime with the abandonment of a property tax for people living in each area and the nationalisation of the property tax (the rates) payable by business. The share of income raised locally by individual local authorities will fall from about 50 per cent to about 25 per cent. The remainder will he paid to local government as central government grant aid and the nationalised business property tax will be redistributed to local authorities on a per capita basis. Effectively, the latter will be another form of grant aid.

Within this new financial regime the controls over the amount of capital investment that local authorities can undertake will change. They will revert in effect to a control over borrowing but coupled with a strict control over the way in which local authorities can reinvest money obtained from the sale of existing assets.

A consequence of these changes is that local authority financial room to manoeuvre will be even more circumscribed and it will be heavily dependent upon two key decisions of the central government. The first is the decision about the way in which grant aid is to be distributed and the second is the decision abqut the way in which individual local authority capital investment is controlled.

A problem which the central government always has is how'should it allocate grant aid and investment approvals to individual local authorities?

In England, there are 404 local authorities, in Wales 45 and in Scotland 65. In both Wales and Scotland there is a much greater degree of affinity between the Welsh and Scottish Offices and local government than there is between the Department of the Environment and local government in England. However, in each country the central problem remains - how to allocate? Inevitably the decision will be somewhat arbitrary because allocations can only be made by formula and all formulae have arbitrary features because they cannot reflect individual local circumstances. (If they could, why have local

'The author is the Director of The Chartered Institute of Public Finance and Accountancy.

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government?) Also, as the central government, in the name of national economic management and political policy restricts those sums available, the impact of the inevitable arbitrariness increases.

What this therefore means is that the central government then shapes the revenue and capital investment policies of individual local authorities and that these policies no longer reflect the local expression of local needs. What is more, local authorities are then encouraged by this system to invest, or not invest, because of the central government decision, irrespective of the longer run financial consequences for the local authority and ultimately the local taxpayer.

The only alternative to this centralising approach is some form of self discipline. The difficulty with advancing any argument in favour of self discipline, given the present deplorable state of relationships between central and local government, is that local government fears that it will be seized upon by the central government to impose yet further controls upon local government. However, this article contemplates an alternative to centralisation involving self discipline. That self discipline is based around the concept of financial prudence. It is a concept which has been rejected by local authorities on basically three grounds. The first is the control argument set out above. The second is that local authorities will not default on their obligations and therefore financial prudence is not only an irrelevant concept, but is also divisive. The third is that a financial regime which involved the concept of financial prudence would have significant distorting results in the context of past decisions when such a regime did not apply and therefore the transitional arrangements would be difficult to introduce and would have the practical effect of undermining the idea. Therefore the judgement has been that it is more sensible to live with the present centrally managed regime, leaving local authorities to be treated as a single group, allowing them also to manoeuvre investment decisions by taking advantage of whatever uncertainties and loopholes lie within the centrally imposed systems of financial control.

These arguments of local government are pragmatic and yet serious because they have to be understood in the context of the present central/local relationship. This though does make it difficult to advance any alternative ideas which might ultimately result in more local freedom when such ideas do require a significant decision by the central government to relax its grip on the spending of individual authorities and concentrate instead upon the total level of investment. The necessary degree of trust which is required does not exist.

However, in an academic journal, the issues which a regime of hancial prudence for local government might raise could be explored without the need for the debate to produce any expectation of immediate effect. That debate ought to be around the principle rather than the mechanics. But for any such scheme to work an essential precondition is that the central government agrees to make qignificant concessions. Unless there is a clear recognition of this by the centrL, then local government will be most unlikely to embrace any regime

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which merely seems to add to control, even though longer run strategic opportunities might emerge.

CREATIVE FINANCING

The Chairman of the Audit Commission for England and Wales in the 1987 Annual Report of the Commission set out his and the Commission’s growing concern about some of the financial practices being operated by some local authorities. These concerns focused upon the forward commitments of future revenues which were being created. These commitments very often were being created without any regard being paid to the consequences that they would have for the local authorities involved.

Traditionally, local authorities have not been concerned about the extent of borrowing. The argument has been that the security of local authorities in the United Kingdom has been first class and that the same interest rates should apply throughout the market place for the same types of loan. In the local authority world it has been a point of pride that such financial disasters as befell, for example, New York could not occur here.

Can the traditional relaxed attitude to local authority indebtedness continue? Circumstances have changed substantially and the evidence of present trends

is that, unless there is a material rethinking of this area of local government finance, the only alternative will be more central control with less and less financial discretion being available to local government. As one clever financing trick is pursued, imitation will lead to inevitable regulation. The latest proposals for the control of local authority capital investment published by the Department of the Environment in “Capital Expenditure and Finance - A Consultation Paper” (‘July 1988) illustrate this dilemma for local government exactly.

The fundamental point that needs to be understood is that in reality basic local government security is now a function of central government political policy - the decisions about rate or community charge capping; the distribution of grant aid; the allocation of capital expenditure approvals. And that which is a function of central government political policy lacks the long run certainty that investors in local government need, if they are to be persuaded to provide the money to finance capital investment.

In the past, local government has been able to raise revenue through the local taxation system without restraint. With rate capping that has changed and this change will be continued with community charge capping. The security offered by local government is still its rate (or community charge) and revenues. But it does not now have unfettered freedom to increase its revenues in order to secure the rights of lenders. These revenues are also subject to significant change for reasons which are outside the control of an individual local authority. Government grant aid is not paid on a consistent basis from authority to

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authority year by year and is unlikely to be consistent under the new financial regime, although it may be more stable than under the present financial regime. Although local authorities always have been subject to borrowing controls, the pressure upon capital allocations has encouraged local authorities to look for ways of financing capital expenditure “off-balance sheet”. This practice has had three effects. First, expenditure has been incurred which brought with it heavy future revenue costs without any certainty about the local authority’s ability to fund that expenditure into the future. The only certain source of future finance is the restriction of other revenue expenditures - mainly staff. Secondly, some “off-balance sheet” finance and other similar schemes could give a particular lender a prior security against a particular asset, thus weakening the security of other lenders. Thirdly, authorities have been discouraged from making sensible forward financial planning decisions because the financial problems, when they emerged the next year, were always greater than the previous year. This exaggerated the political pressure to ‘do something’ which lessened the pain of difficult political decisions.

The recent changes in capital controls have removed virtually all local authority discretions to engage in off-balance sheet financial deals, although ingenuity will discover new ways of financing desired capital and revenue investment. However, the principal point is that where such arrangements were undertaken the implicit decision was about the immediate gain by providing the asset or facilitating an increase in revenue spending more than outweighing the often disproportionately heavy future costs. The message for local government is that attempts to circumvent current controls almost inevitably lead to added central control. Those central controls are arbitrary, frustrating and restrictive.

This is not to condemn all creative financing arrangements. Like most activities it is not the activity itself, but the extent to which and when this activity is practised that causes these problems. As the Chairman of the Audit Commission said ‘There is nothing wrong with adopting creative financing measures if these are patently in the long-term interests of those who ultimately have to foot the bill. What is questionable is the practice adopted by some authorities of deferring financial commitments into the future when they face intractable budgetary problems.’

T H E RESULTS O F CREATIVE FINANCING

One major consequence for local government as a whole (other than added control) has been the disintegration of the seamless web of local authority credit rating. Numbers of City institutions have lists of local authorities which they regard as in some sense or other as credit risks. The basis of these lists appears to be fairly arbitrary with at least some authorities regarded as credit risks by some institutions which knowledgeable observers would regard as totally credit

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worthy. The net result is that there is some potential danger to the general credit worthiness of local government and a multi-tier interest rate system has now established itself.

Underlying this uneasiness amongst lenders are the exceptional lengths to which some authorities have gone in seeking to raise funds. Their eagerness has been based on their strong wish to evade the sharp pressures on expenditure generated by both central government’s management of the grants system; and the restrictions on borrowing approvals.

CHECKS AND BALANCES

The system of local government finance and the arrangements for central funding which exists and which will exist in the future has no automatic system of checks and balances over the level of capital investment. Thus there is no automatic relationship between capital investment and the revenue ability to fund that investment. This lack of a direct relationship has allowed the central government to move in with its own controls. Originally the Public Works Loan Board provided the check because it would only grant a loan if satisfied that the local authority could repay. The question for local government is, is it in local government’s interest to find ways of introducing an automatic system of checks and balances and thereby create the opportunity for the local authority to be more in control of its own destiny?

The concern which local authorities have is that any thinking about change which leads to such a set of proposals will in its turn lead to an added set of controls imposed by Government on top of those which exist already.

PRUDENTIAL RATIOS

The basic security behind local authority borrowing has always been recognised to be not their stock of assets, but their ability to raise revenue. A system of prudential controls on local authority capital commitments could be developed. The main prudential ratio for local authorities would be defined as the ratio of income, or, resources providing income, to future capital commitments. If therefore a local authority wanted to increase its capital commitments then depending upon the point at which the prudential ratio was set such an increase would require to be preceded by an increase in income raised by the local authority. Increasing income would reduce the ratio between future commitments and income so increasing the scope for further commitments.

The use of prudential ratios would therefore almost ideally strengthen local accountability; by making it evident that no major investment programme with the expansion of local services could be entered into without there being a capacity to pay. This sort of evident signal to the local electorate is a necessary

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foundation for effective local independence. It is also a highly effective signal to the money market. National controls operating at the local level would thus become superfluous.

OBJECTIVES OF A PRUDENTIAL FINANCING REGIME

The objectives of a prudential control scheme would be to ensure that:

(i) a local authority does not over-commit itself financially; (ii) that a gradually increasing pressure is applied to the local authority the

nearer it gets to the prudential limits; (iii) specific support through the operation of the prudential rules is given

to those responsible for the giving of financial advice; (iv) creative financing designed to exploit legal loopholes is prevented where

the authority is at, or close to the prudential limits; (v) if in existence, the prudential rules would demand that other controls

be relaxed.

These objectives require a number of ideas to be explored. These ideas include:

(a) Financial over-commitment: At present there is no definition of what ‘over-commitment’ by a local authority means and no one has needed to think about it under the traditional financing regime. The considerations that local government needs to take into account in thinking about this proposition are:

(i) the obvious one of can the local authority be certain that it can meet its future liabilities without excessive damage to its existing clients, all other things being equal and

(ii) the less obvious, but nevertheless probably far more important consideration for the long run health of local government, is the authority acting in a manner over its financing arrangements which is seen to be prudent and sensible to the local elector and taxpayer? Dubious financing practices may seem clever but are they actually damaging in the longer run to elector and taxpayer credibility?

(iii) running through this thought is another idea which local government has not really had to grapple with. It is an idea to which members of all accountancy bodies are deemed to subscribe and which is enshrined in S A P 2 as a fundamental accounting concept viz the idea of a ‘going concern’. SSAPS talks about the entity having no necessity to ‘curtail’ significantly the scale of operation’.

Very little ability exists with the present local authority financing system to move gradually from one financial position to another - the authority

(b) Gradualness:

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either has borrowing approval or it doesn’t; it is rate capped or it is not. Any sensible system of controls should give signals when the strain

is getting serious. An automatic system like prudential ratios has the significant potential to give signals to a local authority to act with care as it gets nearer to the limits. But what is more it also allows the authority to take its own steps to move away from the limit - by increasing income or by changing the balance between borrowing and capital receipts.

The centres of power vary from local authority to local authority. In some authorities there is evidence that the pressure to increase commitments is greater than the pressure for responsible financing. A prudential regime would even up the centres of power. Those within the authority whether at political or officer level would be under less peer group pressure than they presently may be.

From local government’s point of view there are potentially major advantages in a change to a regime base upon prudential rules. Capital controls could be abandoned; capital expenditure should become a function of local revenue capacity.

The arguments in favour of the current rate and in future community charge capping are also significantly weakened.

Furthermore, on any future change of financing regime where some expenditures were encouraged by Government, the obvious and direct link between capital investment and income would force a different approach to any addition to local government’s financing burden. In other words, preskure to spend by Government would have to be accompanied by a clearer indication of revenue sources.

(c) Rebalancing of responsibility and power within the authority:

(d) Relaxation of other controls:

BASIC RULES OF A PRUDENTIAL REGIME

In devising the rules a number of questions need to be answered, i.e.: (i) Should the relevant income calculation be gross income or net income

after all operational expenses? (ii) Should all internal fund adjustments be netted out? (iii) What should the rule apply to - total debt, new capital commitments

or both? (iv) What should be the definition of total debt and should the definition

of commitments be wide enough to include all commitments whether treated by the local authority or not, as capital?

(v) Should the same rules apply to every type of authority? (vi) To what forward period should the rules apply beyond the current year?

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The answers to these questions should take into account the following:

(i) Gross income or net after operational expenses: The use of gross income (i.e. rates, grants, rents and other income) as a measure of the ability of the local authority to incur new capital investment assumes that other expenditure can be safely ignored. Except with housing, capital charges form such a relatively small proportion of expenditure that any judgement about whether or not the local authority should properly incur new capital investment should take into account all outgoings. Therefore any prudential rules probably ought to be based upon the net available income after all operational expenses.

Local authorities have an ability to shift funds (quite properly) between their general rate fund revenue account and other revenue accounts and into and from reserve funds. These movements may result in proper presentation of the operating income and expenditure on that particular revenue account in any one particular year. However, for the purposes of establishing prudential rules, what matters is the external position of the local authority - what is its total external resource availability? Therefore any calculations should be based upon the external position of the local authority and all internal adjustments, whether beneficial or adverse to the revenue accounts, should be ignored.

Before a local authority could incur new capital commitments then the prudential rules would apply. These prudential rules could be based upon the total debt of the authority or the extent of the new capital commitment it proposed to enter into. Commitments would need to be defined, (see iv below) but in the first instance it would be desirable to explore prudential rules which could apply to both total debt and commitments. The reason for this is that these would be new rules to cover a set of circumstances which had evolved over a time when no rules existed. The rules about total debt could be in addition to, or as an alternative to, rules about new commitments. (In devising these prudential rules the definition of total debt or new capital commitment would need to allow for income from asset sales and for capital financed from revenue.)

Total external debt is easily defined and is a specific number i.e. that represented by long term borrowing in the local authority balance sheet. Capital commitments is more difficult. It will not matter, if rules of prudence are introduced, if a local authority engages in creative accounting in order to increase its capital investment capability, if the authority is within the rules of prudence. The issue only matters if the authority is at the margin, or beyond it. The term capital commitments

(ii) Internal fund adjustments:

(iii) Total debt or new capital commitments or both:

(iv) The dejinition of total debt and of capital commitments:

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does therefore need to be all embracing. (As a precise legal definition may be difficult to prescribe or enforce, then the avenue of control may need to be a voluntary code backed up by audit surveillance but with the treasurer being required to make a technical declaration.)

(a) Any expenditure, or proposed expenditure, which is of value to the authority in the provision of its services beyond the end of the year of account should be treated as a capital commitment irrespective of how that expenditure, or proposed expenditure is financed (but see c below)

(b) Any expenditure, or proposed expenditure, which falls outside the definition but which is financed from loan or from any commitment of future revenues is to be treated for this purpose, as a capital commitment.

(c) Any expenditure, or proposed expenditure which would fall within the definition set out in a and b, but which is not material given the size of the authority or which could be consumed in the following accounting period, will be excluded from this definition.

A definition of capital commitments could be:

(v) Application to dtferent o p e s of authority: In theory, given the concept of prudence, the same rules should apply irrespective of the type of authority. No authority should be permitted to incur new commitments which are financially imprudent, whatever their size or responsibilities. However, a single regime will cause much greater transitional problems than a more flexible approach. But then what is the logic of a more flexible approach?

To make the prudence concept work and, given the inherent nature of capital investment, then the rules should operate on the basis of forward forecasts of cash. That forward forecast ought to cover a period of five years although, at a minimum, the forecast period might be three years. Given the uncertainties of forecasts, both of income and expenditure, some tolerance might need to be allowed in later years. But that tolerance should err on the side of caution so that the authority is not forced into imprudent marginal actions as the forecast year becomes the year of account.

The cash figures which are used in the prudential calculations ought ideally to be drawn directly from the published accounts of the local authority. Because the prudential rules would be based upon net available income after all operational expenses and after ignoring all internal fund adjustments, the most appropriate statement to use for the base calculation is the statement of source and application of funds (a statement that is presently seen as of little value to local government).

The total debt figures would be drawn from the consolidated balance sheet,

(vi) Forward period:

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i.e. expenditure financed by long term borrowing plus commitments revealed in the notes to the balance sheet. However, to meet the requirements of a prudential regime, the notes to the Consolidated Balance Sheet may need to be more precisely defined than at present. For example, they ought to include a statement of commitments entered into affecting the next, say, five years and a table allocating these commitments over time.

Because the proposed rules are prudential rules, the critical concern is the cash resources of the local authority. The more cash can be generated the greater the new capital investment that could be incurred. Therefore, to the figures which would flow from the analysis above, would need to be added cash available from the sale of assets and capital expenditure to be financed from revenue. The emphasis is on the word ‘cash’. So if, for example, the local authority has used its capital receipts for other purposes, such as to repay debt, then they are not available to finance new investment although that action, given a rule based upon total debt, may facilitate the incurring of new capital commitments. Again, a local authority would be able to increase its investment by improving its funds generated from revenue, e.g. higher rent income, lower outstanding rents, lower revenue expenditure. In other words, a prudential regime would allow a direct trade-off in a way which, at present, does not exist.

The forward forecast would take into account cash flows over the period of the forecast but then provisos would be needed:

(i) that where a material commitment was to be entered into which falls beyond the forecast period, it should be deemed to fall with the last year of the forecast period.

(ii) that for commitments beyond, say, year five, a statement would need to be made that nothing which had been agreed by the local authority to occur in the future would cause it to exceed the prudential ratios or, if that subsequently seemed likely, that its other activities would be so re-organised that any excess could be avoided.

(iii) that no contract for the creation of assets could be entered into which created commitments which covered a longer period than five years. (This is not to prescribe any year period, merely to ensure that commitments are not spread over so many years as to vitiate the effects of these rules.)

After these various adjustments the prudential ratios which could flow from these rules could be quite simple operating on total debt or Commitments or both as agreed. An example of a simple rule is that applying to the Chicago Water Company and called ‘The Additional Bonds Test’ i.e. additional debt may be issued only if revenues derived from the operation of the water system for the previously completed fiscal year were sufficient to pay all costs of operation and maintenance and leave a balance equal to at least 125 per cent of the maximum debt service for any succeeding twelve-month period on all

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Table 1

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Compliance with Additional Bonds Test with Issuance of the Series 1983 Bonds

Chicago Water System (in millions of dollars)

Net Present New Total Operating Operatins Operating Debt Debt Debt Revenue Expenses Revenue Service Service Service Coverage

Actual Audited 1982 $157.173 $118.662 $38.511 $18.445 - $18.445 2 . 0 9 ~

Test with Series 1983 Bonds $157.173 $118.662 $38.511 $18.445 $11.74 $30.185 1 . 2 8 ~

outstanding obligations of the water system, including any additional water revenue bonds to be issued. As can be seen in the example in Table 1, the 1982 coverage of the existing debt service, without the proposed new debt service for the Series 1983 Bonds was 2.09 times. With the addition of the debt service for Series 1983 Bonds, coverage would have been 1.28 times.

This “Chicago rule” would have the beneficial effect of forcing the local authority to plan a proper use of its capital receipts. It would not be in a position to create an ‘overhang’ by saving them up unless the local authority were well within the prudential ratios and then the issue of the ‘overhang’ would probably not be a problem anyway.

It may be desirable even if a simple rule were defined to gradually increase the pressure on the local authority as it came nearer to the limit of prudence so that there was no sharp cut-off. This arrangement should then trigger reports to the local authority and might encourage a more cautious approach.

OTHER CHANGES, GIVEN T H E ADOPTION OF PRUDENTIAL RULES

Once rules of prudence were adopted the initial objective should be to bring all local authorities within the operation of those rules. Once within the rules, other existing rules should be removed, i.e.

(i) rate and community charge capping (ii) capital controls on expenditure (iii) loan sanctions

But given that prudential ratios were in place then, if a local authority should be beyond them it should be required to systematically move within the rules over an agreed period.

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CONCLUSION

There is no doubt that in conceptual terms the idea of a prudential financing regime is an attractive one and in theory ought to be technically feasible. It could create new opportunities for local government and allow to a considerable degree, a shift of responsibility back to local government. However, there are a number of major problems:

First it makes explicit security differences between different local authorities. Second, unless other controls are relaxed the system will be seen as just

another added set of controls and the risk which local government might see is that it would be seized on by the central government as a way to add to the burden of local authority control.

Third, the transitional problems would be substantial and could have very severe effects on some authorities.

Fourth, although a voluntary scheme is desirable, in practice given the widely differing views of local authorities alliance to a Voluntary Code would be difficult to secure.

Fifth, local authorities would be denied the opportunity to make value judgements about the benefits of added investment today against the burdens that would be added to future community charge payers.

Sixth, the government would argue that such a regime would not give to it a sufficient control over local authority expenditure in order to manage the economy.

Against these need to be set from local government’s point of view, the present restrictive and arbitrary regime. From the point of view of central government if its arguments about the community charge and accountability are accepted, given also the effective 4:l gearing on average on additional expenditure by local authorities, then the significance of its public expenditure control policy towards local government ought to become less.

Local authorities so far have resisted the idea of a prudential regime. The time now for its introduction may be inappropriate given the tense relationship between central and local government. But it will not always be so, and if it is argued that such a regime is inappropriate now, would that be so for all time?

It is possible that Section 114 of the Local Government Finance Act 1988, which requires the chief financial officer to prepare a report if resources fall short of expenditure in a financial year (and this includes any forward year), will cause the development of a ‘prudential’ regime by another route. What would be helpful in these circumstances is a set of guidelines to help the chief financial officer make the appropriate decisions.