material about local finance

7/28/2019 Material about local finance

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1. The Role of Local and Regional Government

This chapter:

introduces the theory of fiscal federalism and wide-world trend to decentralization

specifies possibilities of decentralization of basic functions of public finance

describes the different types of institutions which make up the pattern of subnational government in different countries

classifies the varying functions conferred upon, or exercised by, local and regional authorities

describes the main objectives and questions of intergovernmental financial system

Local self-government denotes the right and the ability of local authorities, within the limits of the law, to regulate and manage a substantial share

of public affairs under their own responsibility and in the interests of the local population.... Public responsibilities shall generally be exercised, inpreference, by those authorities which are closest to the citizen. Allocation of responsibility to another authority should weigh up the extent andnature of the task and requirements of efficiency and economy. (European Charter of Local Self-Government: Article 3 and 4)

1.1 A General Move towards Greater Decentralization

The traditional approach to regional and local government economics is that of fiscal federalism. This is the result of the development of

local and regional government economics in federal countries, particularly in the USA, Canada, but also in Austria, and Germany etc. The fiscal

federalism literature uses efficiency criteria for assigning individual public sector activities and revenue sources to the various levels of

government within the federal system. It refers to market failure, tax incidence, public choice, and other theories to determine the level of

government most appropriate for delivery of specific public sector outputs. There is a presumption in favour of decentralisation because it facilitates

the matching of public sector outputs and local preferences, so promoting allocative efficiency.

Although developed predominantly for the federal system of American government (see more Oates 1972, Musgrave and Musgrave, 1984),economic literature emphasizes the general applicability of the prescription of fiscal federalism to non-federal countries. Those prescriptions

can be used to analyze the design and operation of multi-level government in any country.

However, this text is not solely restricted to fiscal federalism. Regional and local government has become much broader during 1980s and

1990s. The explosive growth of the public sector in the industrial countries in the post war period, which was associated with the expansion of

central government's role in income maintenance, income redistribution, and stabilisation, has recently led to strong reactions. At the political level,

the 1980s and 1990s have seen a swing towards more conservative attitudes, and especially the suspicion towards powerful central governments. The

view that greater reliance should be placed on the market has been accompanied by the parallel view that less power should remain in the hands of

the central government. Some influential economists have questioned the effectiveness of government action in stabilizing the economy and

improving the distribution of income, thus reducing poverty and unemployment. This challenge has reduced the legitimacy of central government's

action and created a presumption in favour of reducing the size of the public sector while giving more power to both the market and local

jurisdictions. Many countries are considering devolution of some functions to local jurisdictions. In terms of resource allocation various

arguments have been advanced to support the view that privatisation and decentralisation would lead to greater efficiency and a leaner public sector.Developments in specific countries, such as Canada, China, and some of the new states of the former Soviet Union, have forced a

reassessment of multilevel finance. In China they were driven by the need to re-establish some control over national public revenue. In the states

that emerged from the break-up of the Soviet Union there was a need to create new fiscal arrangements and to give significant responsibilities to

subnational governments from scratch. This proved difficult especially in Russia, with its regions of widely diverse cultural, ethnic, and economic

composition. The interest of fiscal federalism in these countries was the logical outcome of discussion about what political organisation these

countries should have after the breakup of centralized policy making. Other countries, such as Ethiopia, have been driven towards decentralization

(or reorganisation) by ethnic diversity and by the belief that decentralisation would help hold the country together. During the 1980s another group

of countries, including Argentina, Brazil, India and Nigeria, experienced macroeconomic problems that required major adjustment in their fiscal

account, through revenue increases or expenditure cuts.

In the last twenty years, European countries have also implemented reforms in favour of a greater decentralisation for local

governments: increasing their responsibilities, apriori controls removed, tax autonomy consolidated, decreasing in the level of earmarked financial

transfers in favour of general transfers, creation of new subnational government tiers. A number of these reforms concerned the regional level. Thisgeneral move towards a consolidation of regions was undertaken with several goals in mind, such as the improvement of country planning or better

living standards for local inhabitants.

We can say that decentralization is an increasingly important phenomenon in many countries around the world, both large and small

(Tanzi, 1995). Whatever the causes, the debate on decentralization raises serious questions about its potential impact, merits, and dangers. Whether

the decentralization is appropriate often depends on many country-specific factors. However, many general issues are relevant to every country.

1.1.1 Defining Decentralization

Before discussing the relationship between decentralization and economic efficiency it is useful to distinguish three forms of

decentralization:

1) Economic decentralization is concerned with thelocationofeconomicdecisions,

these being decentralized by definition within perfectly competitive markets (that is consumer sovereignty). Economic decentralization

exists when subnational governments have the power, given to them by the constitution or by particular laws, to raise (some) taxes and carryout spending activities within clearly established legal criteria. Examples of this decentralization include the fiscal federations in Argentina,

Australia, Brazil, Canada, India, Germany, Nigeria, Switzerland, and the United States (Tanzi, 1995).

2) Political decentralization refers to devolution of political decision-making to local and regional governments. Subnational governments

have powers to levy their own taxes and user-charges to finance provision of a self-determined and level of public sector outputs. (This is

the form of decentralization to which European Charter of Local Self-Government refers).


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3) Administrative decentralization refers to the criterion of regional offices of central government departments with or without decision-making powers independent of sanction by the centre. The former is administrative discretion (that is the ability to make operational decisionwithin set policy parameters). The latter is simply administrative decentralization. According to Tanzi (1995, p. 297) administrative decentralizationexists when most taxes are raised centrally, but funds are allocated to decentralized entities that carry out their spending activities as agents of thecentral government and according to the guidelines or controls imposed by the central government 1. An example of administrative decentralization isprovided by Italy, where in 1992 local entities raised about 8 percent of the total net revenue of the general government but spent about 37 percent of total net

expenditure.

However, these three forms of decentralization are not necessarily mutually exclusive.

The main economic justification for decentralization rests largely on allocative or efficiency grounds. There can also be a political

argument for decentralization if a country's population is not homogeneous and if ethnic, racial, cultural, linguistic, or other relevant characteristics

are regionally distributed (as they are in Russia and Ethiopia). Decentralization may be needed to induce various regions to remain part of afederation. According to this argument, decentralization would be more desirable in, say, Russia than in Japan. By the same token the goal of

national unity often has pushed non-democratic governments towards the forced elimination of regional differences. In democratic societies the

economic and political arguments for decentralization tend to converge, since it is argued that decentralization strengthens democracy. Most people

are more inclined to engage in local political activities because local policies have a more direct impact on their daily lives.

1.2 The Economic Rationale for Decentralized Government

The conventional argument for subnational government is that it secures the public interest in facilitating representative democracy, a crucial

component of the democratic state in promoting pluralism, participation, and public choice. Pluralism refers to the capacity of the system of

government to accommodate alternative political views so as to avoid a tendency towards centralized authority. Participation refers to the role of

subnational government in providing opportunity for people to take an active part in government. Public choice refers to the role of subnational

governments in providing services accordance with local and regional needs and preferences, rather than according to uniformed national standards.

1.2.1 Possibility of Decentralization of Public Finance Function

The economic theory emphasizes the four main economic roles of subnational governments: allocative, distributive, regulatory and

stabilization roles. I t is usually argued that stabilization and income distribution are properly the concern of the central (national) government while

resource allocation is primarily the concern of subnational governments. Although it is also usually argued that the regulatory function is best

undertaken by central government, the division of that function between central and subnational necessarily reflects the division of service

responsibilities between those tiers of government.

The market failure in achieving allocative efficiency is usual justification for government intervention in the economy. Market failure at

local and regional levels may relate to natural monopolies (such as water and sewerage services), to public goods (for example local street lightning,

local environmental health), to merit goods (such as housing of adequate standard) or to externalities (for example relating to unacceptable or

beneficial use in neighborhood).

According to fiscal federalism and public choice literature, the subnational governments should not undertake redistribution of income (via

taxis and subsidies) because of the inefficiencies it would create. The traditional argument for centralizing the redistribution policy is based on themobility hypothesis (Thiebout, 1956), which applies particularly at the local government level, where there is a relatively high mobility of taxpayers

between neighboring jurisdictions - especially within urban regions. The question one has to ask is whether a local government can implement an

aggressive redistribution policy without jeopardizing its own existence in the long run (Oates, 1972). Subnational governments adopting programmes

with substantial redistribution objectives would have to tax high-income groups in order to pay subsidies to low-income groups. Low-income groups

would have an incentive to move in. As a result, tax rates on the higher-income groups would have to rise in order to compensate for the diminishing

per capita tax base. In turn, this would increase the incentive for high-income groups to move out. So, it has long been argued by Oates (1972),

Musgrave and Musgrave (1984) and others that redistributive policies are best undertaken by central government, since it reduces the

incentives for migration of income groups from one local government to another.

There are, however, a number of counter-arguments that may apply in practice.

1. First, owing to several economic and non-economic reasons (particular local customs, established interpersonal relations, geopoliticalidiosyncrasies, ethnic and religious factors, language barriers, social security heteronomy, labour market organizations, and so on), inter

jurisdictional mobility is not very high, at least in the long run, thus allowing decentralized redistribution policies to be effective.2. Second, if central and subnational governments have heterogeneous preferences for local public goods, it may be optimal, on Pareto-

efficiency grounds, to decentralize redistribution policies (Dafflon, 1992).

3. Third, it is often argued that costly information about the potential recipients of these policies can be obtained more effectively by thelower (or lowest) government tier.

Despite these particular counter-arguments, there is still a strong presumption for centralizing redistribution policies.

Economic literature also argued that responsibility for stabilization policy cannot be left to local or regional government but must be

conducted in a central fashion.

Subnational governments will be ineffective in dealing with unemployment or inflation, because markets are interrelated so leakages will result.

Such will clearly be the case within the national government where subnational governments share in an open market and resources and capital can

flow freely. However, it also becomes increasingly the case across nations, thus calling for international coordination of macro policies.

Among economic policy makers, the consensus for centralizing the stabilization function is general because of free-riding problems thatexist with decentralized counter cyclical fiscal policy intended to enhance macroeconomic performance.

In most cases local and regional governments will be acting as agents for central governments in carrying out the regulatory function.

Regulatory functions may relate to town and country planning, policing central legislation relating to trading standards, the local or regional

environment (for example pollution) etc.

The Economics of Allocative Efficiency


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Allocation theory applied to the public sector says that public services should be provided and their costs shared in line with

preferences of the residents of the relevant benefit region. Moreover, given the fact that a political process is needed to secure preference

revelation, it follows that particular services should be voted on and paid for by the residents of this region. This theory is based on the realization

that not all public goods have similar spatial characteristics. Some, such as defence, benefit the entire country. Others, such as regional

transportation systems or forestry services, benefit regions. Still others, such as street lighting or cleaning, benefit only municipalities, or particular

districts. Furthermore, different areas have different preferences for public goods. Thus the supply of public goods must be adjusted to the different

requirements of different groups. A centralised government might ignore these spatial characteristics and this diversity of preferences, or

might not be well informed about them and thus might supply a uniform package to all citizens. When "the jurisdiction that determines the

level of provision of each public good includes precisely the set of individuals who consume the good" there is "perfect correspondence" in the

provision of public goods (Oates 1972, p. 34).

The Figure 1.1 illustrates the situation when centralization is costly if it leads the government to provide a bundle of public goods different

from the preferences of the citizens of particular regions, provinces or local governments. If these preferences vary geographically, a uniform

package chosen by a national government is likely to force some localities to consume more or less than they would prefer to consume.

Figure 1.1 Oates' Decentralization Theorem

Source: Bailey, S.,J.(1999)Local Government Economics,p. 20

Assume constant costs in producing the output such that the cost function is a horizontal straight line (so that average cost,AC,equalsmarginalcost,MC). Assume also that society is either composed of only two individuals (or, alternatively, of two groups with identical

preferences within the group but different preferences between them) represented by demand schedules D1 and D2. Assume further that national

government would decide to produce output Q2. However, at price P,group 1 demands Q1 while group 2 demands Q3, respectively less than and

greater than Q2. Group 1 is therefore forced to consume more of the output than it wishes, the cost of the additional enforced consumption (Q1ACQ2)

being greater than willingness to pay (Q1ABQ2). Likewise, group 2 is deprived of extra consumption for which it would be willing to pay Q2EDQ3,

compared with a cost of only Q2CDQ3. Hence group 1 incurs a deadweight loss of welfare measured by the area ABCwhile group 2 experiences a

loss ofCDE.

The creation of two local governments would therefore lead to a welfare gain through improved allocative efficiency compared with choices

at national level. Decentralized public choices are Pareto efficient because of the removal of the deadweight loss of consumers' surplus. This result is

referred to as Oates' decentralization theorem (Oates 1972).

The actual size of allocative inefficiency or welfare loss depends on:

1) The size of the disparities between central and local choices: the greater the heterogeneity of preferences, the greater the welfare losses,because the distance between the two demand patterns increases, and so do sizes of areasABCand CDE.

2) The slopes of the two demand schedules: the more inelastic (and hence steeper) they are, the larger are areas ABCand CDE (D1 andD2each pivoting onA andD respectively). Hence, deadweight loss varies inversely with the price elasticity of demand. The deadweight loss of

consumer surplus will vary from service reflecting the heterogeneity of preferences and price elasticises of demand.

3) The extent of any economies of scale in production of the output: assuming ceteris paribus, an inverse relation between the rate of outputand unit costs increases the optimum size of subnational government acting as a trade-off against loss of consumer surplus.

In addition to Oates's theoretical argument, which is based largely on the spatial characteristics of public goods, decentralization can be

defended on the basis of other, more practical considerations. The other argument of allocative efficiency is linked to the Tiebout hypothesis

discussed above that agents are mobile and can thus "vote with their feet" to choose the jurisdiction offering the combination of local public goods

and tax system closer to their preferences (Tiebout, 1956). According to this, decentralized system can become a surrogate for competition,

bringing to the public sector some of the allocative benefits that a competitive market brings to the private sector. The third criterion assigns the

allocation function to the government tier that can provide a particular level of public goods at the lowest unit cost.

Another potentially important advantage of decentralization is that it allows experimentation in the provision of the output. When the

provision of a public service (e.g. education) is the responsibility of local jurisdictions and when these jurisdictions are free to provide the service in

any way they see appropriate, some jurisdictions will discover better ways of providing the service, and other jurisdictions will emulate the

successful ones. The more jurisdictions there are, the more simultaneous experiments will take place. When the service is imposed by a national


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monopoly, which adopts a uniform approach to providing the service, there will be little or no experimentation, and thus dated methods may

continue to be used even when there are better alternatives. This outcome is often noted by the supporters of decentralization, who point to the

outmoded curriculums in countries with centralized educational systems.

Still another argument in favour of decentralization emphasizes that individuals who are responsible for the results of their actions, and who

thus have ownership rights over the outcome, are likely to have stronger incentives to perform better. Therefore, when local officials are directly

responsible for providing a public service, and are praised for success and blamed for failure, they will have a greater interest in succeeding. In such

cases the community may develop a sense of pride in successful service delivery.

Additionally, when the cost of providing a service is borne by the local jurisdiction, the service is more likely to be provided cost-

efficiently - to the point where marginal benefits equal marginal costs. This view, that accountability brings responsibility, motivates much of the

support for the decentralization of various functions.

Finally, at a time when large public sectors are considered wasteful and inefficient, some literature has argued that decentralization is

desirable because it is likely to be associated with a smaller public sector and a more efficient economy (Ehdaie 1994).

All the criteria converge on the idea that there ought to be a close correspondence between those who determine the level of provision of

public goods, those who pay for this production to take place, and those who actually benefit from it. In fact, when there is an explicit, and

simultaneous, link between the benefits of public goods and the taxes or user charges levied to finance them, fiscal accountability is enhanced and

allocative efficiency can be attained more easily.

1.2.2 Challenges to Decentralization

These arguments help explain why decentralization has become so popular in recent years. Some writers, however, have advanced

counterarguments that challenge some of the above conclusions or, at least, outline conditions in which decentralization could be a less attractive

policy. The point of this discussion is to identify situations in which decentralization might not lead to the expected results unless important

changes are made in the existing conditions.

While the theoretical case for decentralization is relatively straightforward, the practical case may be less so (Prud'homme 1994; Bird 1994;

Oates 1994). As Oates (1994, p.1) puts it, "fiscal decentralization has much to offer, but it is a complicated enterprise".

Insufficient Information

As discussed earlier, part of the case for decentralization rests on the spatial characteristics of public goods - some benefit only certain areas

of a country. As a result the central government may tend to under produce or overproduce them because it does not have the necessary information

on local preferences, or it may not have the right incentives to act on the available information.

The argument related to lack of information has been challenged on the grounds that central governments can and do assign government

officials to local offices and that these officials may be capable of determining local preferences. The central governments of unitary countries

often have representatives (for example, the prefects in France and Italy or the intendentes in Chile) who closely follow local developments and

assess local needs. These agents are often highly trained and might even have an incentive to exaggerate the local demand for some public services

in order to increase their own power or importance. Therefore, the main question is whether the information these individuals send back to the centreis any more or less correct or biased than that available to local policymakers.

Whether local governments are more or less likely than the central government to respond to local preferences depends, of course, on the

strength of various incentives and on how political decisions are made. A national government interested in local votes may have a strong

interest in meeting local needs. A local government that is not democratic may have little interest in meeting these needs. It should not be

automatically assumed that subnational governments are made up of democratically elected officials who necessarily have the public (though local)

interest in mind. Where they do, decentralization has a greater chance of succeeding. The basic presumption behind the arguments made by

proponents of decentralization is that local democracies are in place and do work. When they do not, the case for decentralization becomes weaker.

Corruption

Some authors (Prud'homme, 1994 and Oates, 1994) also mention corruption. Oates does not conclude whether corruption is likely to be

greater at the local or central level. Prud'homme believes that corruption is a greater problem at the local level and mentions France and Italy to

support his view. This issue cannot be settled by empirical evidence, so we must rely on impressions. According to Tanzi (1995) corruption may be

more common at the local level than at the national level, especially in developing countries. The reason is that corruption is often stimulated by

contiguity, that is, by the fact that officials and citizens live and work close to one another in local communities. They have often known each other

all their lives and may even come from the same families. Contiguity brings personalism to relationships, and personalism is the enemy of arm's

length relationships. When this occurs the public interest often takes a back seat, and decisions are made that favor particular individuals or groups. It

should be emphasized that governance issues are problems at all levels of government in many countries; in some countries the local bureaucracy is

certainly more honest than the national bureaucracy.

The Quality of Local Bureaucracies

Another factor that may reduce the benefits of decentralization is the quality of local bureaucracies relative to national bureaucracies. Central

government bureaucracies are likely to attract more qualified people because they offer better careers, more possibilities of promotion and better

salaries. This conclusion is strengthened by the argument that talented individuals tend to choose fields that offer better opportunities for

advancement over the longer run. To the extent that national bureaucracies offer better opportunities to able individuals than do local

bureaucracies, they may attract more qualified and more able individuals. But where qualified individuals are abundant, as is often the case in

industrial countries, subnational governments may have staff as qualified as do national governments. On the other hand, where educational

standards are low and there is a smaller pool of potentially efficient employees, the argument above carries more weight. This scarcity of local talent

may impede decentralization efforts in, say, Ethiopia and other African countries.


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Within countries there are often wide differences across regions in the quality of the personnel of local administrations. In Argentina

there is a huge difference between Buenos Aires and some of the other provinces, and in Colombia between Bogota or Medellin and some other

provinces. These differences are partly explained by differences in available resources, but cultural factors also play a role.

Composition of Local Jurisdictions

Another practical issue is that in most countries the composition of local jurisdictions is based on past political, rather than economic,

considerations (apart from exceptional circumstances in which multilevel arrangements can be created from scratch and can thus be influenced by

knowledge about the spatial characteristics of important public goods). Thus the sizes of states, provinces, regions, and metropolitan areas are fixed

and largely the result ofhistorical accidents. These are the subnational governments to which decentralization allocates fiscal responsibilities. The

chance that the spatial characteristics of the public goods or services whose responsibility is assigned to the subnational jurisdictions will match the

areas covered by these jurisdictions - and so achieves the "perfect correspondence" described by Oates - seems slim indeed. The smaller the degreeof correspondence is, the smaller the potential economic advantages of decentralization are.

Technological Change and Increased Mobility

Two other aspects are important in today's world. First, the characteristics of public goods and services are subject to rapid change.

Technological and economic developments ensure that new needs for public sector intervention arise continuously. For example, in the past there

was a need to protect a city's population from outside attacks and to provide it with information about the time of day. Walls were built around cities

and clocks were placed on bell towers to satisfy these needs. The public goods provided by these public services are no longer needed. On the other

hand, the need to protect citizens from crime and pollution has become more important.

Second, changing technology, combined with greater mobility on the part of citizens, implies that the spatial characteristics of public

goods are also likely to change.

For example, when mobility is limited, many of the benefits associated with public education are internalized by the jurisdiction that provides the

service. But when mobility is high, extra jurisdictional externalities become important. The jurisdiction that finances education may not reap its

benefits if those who are educated in its public schools move to another jurisdiction. Similar considerations apply to spending for health and many

other services. On the other hand, this spillover problem can be partly solved through a reciprocity rule, especially if services can be standardized

across regions. In such cases the existence of the spillover does not reduce the advantage of providing the service locally. But standardization

eliminates one of the basic reasons for decentralization.

These two aspects imply that, to be optimal, decentralization arrangements should be flexible over time. Either the geographical areas

covered by local jurisdictions -and thus the number of these jurisdictions - should change over time, or the characteristics of public goods should be

continuously reexamined in order to reallocate some of them across the existing jurisdictions. There is no simple mechanism that allows this process

to take place. Once a federal structure is determined, local politicians and officials fiercely oppose major changes to borders and tasks. Consequently,

fiscal federalism is at times characterized by a mismatch between the spatial characteristics of public goods and the responsible jurisdictions.

1.2.3 Definition of Local and Regional Government

Types of Regional Authority

Financing the regional and local governments means the system of decentralized administration - the range of public agencies responsible

for undertaking public services and developmental programmes at the subnational level. For convenience, all types of decentralized government

agency - state governments in federations, provincial administrations, local authorities, regional-urban development corporations, etc. - will

be described as regional authorities.

Such types of agency include:

a) State/provincial governments under a federal constitution;

a) Regional/provincial/local administrations comprising various branches of central government departments grouped under the leadershipof the regional administrator (titles varying from governor or prefect to commissioner or collector);

a) Local and regional governments/authorities directed by representative assemblies or councils;

b) Regional development authorities - public corporations with a responsibility for the comprehensive development of a particular area;

c) Single-purpose authorities: bodies with corporate status but responsible for a single function only; and

d) Regional branches of central government departments responsible only to the latter.

Regional and Local Governments

The general system of local and regional governments in any particular country we will call in this text as subnational government. This

term will be used for describing any size or administrative level of subnational area from federal state - a province, a district, a town, or a village.

Local governments (the term being used interchangeably with "local authorities", "councils" and "municipalities") are sometimes simply

referred to in economic literature as "subnational authorities". Local governments can be thought of as democratically-elected bodies whose

jurisdiction is of a local (rather than regional or national) scale, have powers to levy local taxes by which to exercise genuine discretion over

services provision. However they vary substantially in (both geographic and demographic) size, often share subordination to the centre with other

non-local public sector organisations, sometimes including non-elected bodies such as agencies mentioned above. Hence, there is no subset of

characteristics by which to define 'pure' local government and distinguish it from regional, state or provincial government or from other subnational

public bodies.

The defining characteristics of local and regional government are its position on a continuum of more or less local criteria, rather then there

being clearly distinct categorical differences between these various subnational bodies. Difficulties in deriving a clear definition of local and regional

government make comparative analysis questionable because it is not possible to compare like with like. It may be even be difficult to construct a

precise definition of local and regional government in a single country at a particular point of time.


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Structurally, state governments in a federal system and local governments have much in common. They are bodies corporate with their own

legal identity, their own property, budgets and accounts. They employ their own staff (though these may be seconded from central government

service or from a central pool of regional authority personnel). They are normally governed internally by a representative assembly, elected as a

whole or at least from its major part. Some part of their revenue is derived from direct taxation of their population.

The differences between regional governments and local governments are in status, scale and function. Regional and state

governments derive their existence and their authority from the constitution, while local governments are creatures of central governments legislation

(or a state government in a federation). Regional governments customarily govern far larger territories in area and population and normally exercise

a wider range of functions.

This international practice only partially reflects the distinction between federal government at the centre and the subnational governments in

regions, states or provinces. However, over 80 percent of world's nations are unitary states, the national parliament being the single source ofconstitutional power and legislative authority. In many European unitary states the constitutional status of local government is formalized and

protected in a written constitution which guarantees the principle of local self-government. But there are exemptions - for example the UK has no

such written constitution and local government is therefore constitutionally subordinate to central government.

Regional Administrations

Regional administrations are essentially deconcentrated arms of central (or state/regional) government. Their basic characteristic is some degreeof integration of technical departments under the leadership of an administrator. Their status varies - a centrally appointed politician, a civil servant, a

locally-elected governor. Their authority varies too - from formal control over all or most public services, including the direction of technical staff, toa purely informal leadership derived from prestige, from a responsibility for general order, or from control of particular resources.

In some countries - notably with French and Ottoman traditions of administration - a regional administration has a dual character, operating

partly as a deconcentrated arm of government and partly as a local authority, with staff exercising a dual loyalty.

Regional Development Authorities

Regional development authorities are more specialized institutions, outside the normal machinery of regional and local government. They

are public corporations, usually established by statute, and managed by a board of directors appointed by the constituting authority -

normally central government but occasionally state or local government. They are similar in structure to other public corporations running public

utilities, nationalized industries, agricultural marketing, etc. but are distinct in being responsible for a delimited area and its comprehensive

development. This responsibility may be for all developmental or service functions within the area, or alternatively with those functions closely

related to a particular type of development - for example the provision of irrigation (involving water engineering, drainage, survey and plot

demarcation, agricultural extension) or the construction of a new housing area (involving housing, roads, water, sewerage and community facilities).

The establishment of such authorities is usually associated with a development project attempting a transformation of a particular area

of its people. Such authorities maybe created to integrate the various skills required for a project, to overcome territorial fragmentation of a project

area between regional administrations or local authorities, or because the project is thought to demand a dynamic commercial approach to its

management.

1.2.4 Local and Regional Government Functions

To understand the variety of funding arrangements for subnational governments, we have to appreciate the diversity of the functions

conferred upon them. The function can be classified in five groups:

The first set of functions, most traditionally associated with local and regional government, is the provision of social and environmental

services. The environmental services: local roads maintenance, cleansing, drainage, street lighting, refuse disposal, sewerage, parks and recreation,

are habitually undertaken by local authorities although urban development authorities sometimes carry out the initial installation. Responsibility for

trunk roads, flood control, and irrigation varies widely, from state governments to provincial governments (with much direct central funding).

What varies widely is local government involvement in:

a) public utilities, chiefly water and sewerage (sometimes provided by a national corporation, or typically by a metropolitan corporationor a municipally controlled enterprise) and electricity, (usually a national utility responsibility, but sometimes generated or distributedby local government);

b) social services (local governments often provide primary schools and clinics, less frequently secondary education and hospitals);

c) public protection (fire services are frequently municipal but police forces less frequently so outside Europe and North America);

d) trunk roads (which can be a national, provincial or local responsibility);

e) provision of rental or purchase housing or serviced sites (sometimes a local government activity, sometimes that of a special purposeauthority);

f) regulation of land use and development (usually local governments, but on occasion a provincial or metropolitan authority function).

The second group of functions may be regarded as regulatory - making or enforcing rules. Whilst defense and armed forces are invariably

the central government responsibility, the maintenance of general law and order is frequently delegated to state government in a federation, to the

heads of regional administrations (provincial governors, district collectors, etc), or even, as in France, to elected mayors. Most common to local

authorities is power to regulate specific activities - land use, building standards, entertainments, the liquor trade, etc.

A third group may be regarded as development functions. Subnational governments may engage directly in forms of economic activity

such as the operation of factories, plantations, forests, or trading companies. The more widespread concern, however, is to promote and support

private enterprise through the provision of infrastructure - industrial sites, employee housing, irrigation, warehousing, road access, etc. - or through

extension services to the public in fields such as agriculture, animal husbandry, fisheries, or small industry. Some continental differences remain

here. In Europe, direct concern with industry and agriculture has been largely a central government preserve, although regional authorities are

heavily involved in the provision of infrastructure. In much of Africa and the Middle East, developmental responsibilities are devolved upon regional


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administration; local authorities have little share in them. In parts of South and South-East Asia, however, rural local government is intended to play

a largely developmental role with a prime emphasis on agricultural production. An obligation is frequently laid upon low-level governments to assist

in communal mobilization - to promote literacy and adult education or to stimulate self-help schemas - but without major financial implications if

these authorities do not have mainstream functional responsibilities.

The representative function of subnational government - of expressing local opinion on matters outside its field of executive

responsibility - is associated largely with state government and local governments. It is important in determining the weight and influence of local

and regional governments, but has little direct financial significance.

The final role of regional government lies in the coordination and planning of regional investment and land use. In Third World

countries this is usually a role of deconcentrated regional administrations or special development authorities; it is rarely a local government function.

Planning and co-ordination is not in itself a major spending function, but the role may attract responsibility for the execution of major internationallyor centrally financed development programmes.

The allocation of these major functional responsibilities between arms of decentralized administration is crucial to understanding the

intergovernmental financial system of any particular country. They determine the scale of demands upon the financial resources with which regional

authorities are endowed.

1.3 Objectives of Intergovernmental Financial System

The determination of the spending responsibilities of subnational governments precedes the question of how resources will be

generated to pay for the spending . The financing of the spending is often almost an afterthought. Yet for decentralization to be successful, it must

include the decentralization of both spending and revenue, and these decisions must be made at the same time. It is therefore critical to

understand the actual and potential impact of intergovernmental relationship on such key questions as the ability of central government to behave in

a fiscally responsible way, and the efficient and accountable delivery of public services. In particular, four questions must be answered with respect

to intergovernmental finance in any country:

1) Who does what? - the question ofexpenditure assignment.

2) Who levies what taxes? - the question ofrevenue assignment.

1) How is any imbalance between the revenues and expenditures of subnational governments that results form answers to the first twoquestions to be resolved? -The question ofvertical imbalance.

2) To what extent should fiscal institutions attempt to adjust the different needs and capacities for different governmental units at thesame level of government? - the question ofhorizontal imbalance orequalization.

These questions of fiscal relationship and financial system must be answered "locally" in each particular country. Nonetheless, there are

certain aspects of these complex questions that should be considered as "universal" principles.

This means that the financial system should provide a rational distribution of power between levels of government over rising

revenues and expenditure of public resources. Financial system should ensure that the devolution over financial resources is consistent with the

general delegation of responsibilities. The system should ensure accountability to the public for the use of resources; those who determine levels of

expenditure should have to face the taxing consequences for the community.

The system should provide an adequate share of public resources as a whole for the functions - service and developmental - operated by

local and regional government.

The system should, so far as possible, distribute public expenditure equitability between regions. The cumulative effects of historic

concentrations of development in particular regions and of different resource endowments cannot be corrected overnight or, indeed, completely. But

the financial system can and should be sensitive to them, seeking improvements in distribution wherever possible, and giving priority to equalization

of certain basic services such as education, at least.

Finally, taxing and charging by subnational governments should conform with an equitable distribution of the total burden of public

expenditure on the community. What matters primarily to the citizens is his total tax burden; wherever the taxes he pays go to central, regional or

local government is of secondary importance for him.The text concentrates more on subnational government revenue. Expenditures is of concern only in its nature and scale affect the needs of

subnational governments for revenue, the way in which it is allotted to them, and its use determined or influenced by higher levels of government.

The next chapter will classify these resources and the different approaches to the matching of resources and functions.

Conclusions

The traditional approach to regional and local government economics is that offiscal federalism. The fiscal federalism literature uses efficiencycriteria in assigning individual public sector activities and revenue sources to the various levels of government within the federal system. It refers

to market failure, tax incidence, public choice, and other theories to determine the level of government most appropriate for delivery of specific

public sector outputs.

During the 1980s and 1990s the decentralization became an increasingly important phenomenon in many countries around the world, both largeand small. There were several reasons: a decrease of reliance credit of central government to be able to stabilize economies efficiently, too large

and inflexible public sector to allocate resources effectively. Further on, a political and economic development in some countries led toreassessment of multilevel finance system. Decentralization may be needed to induce various regions to remain part of a federation if ethnic,

racial, cultural, linguistic, or other relevant characteristics are regionally distributed. European countries have implemented reforms in favour of a

greater decentralization: a consolidation of regions or creation of new subnational government tiers.


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We can recognise three forms of decentralization: economic, political and administrative decentralization. They are not necessarily mutuallyexclusive. In democratic societies the economic and political arguments for decentralization tend to converge, since it is argued that

decentralization strengthens democracy. Decentralization promotespluralism, participation and public choice.

The economic theory emphasizes the four main economic roles of government: allocative, distributive, regulatory and stabilization roles.According to fiscal federalism and public choice literature, the subnational governments should not undertake redistribution of income (via taxis

and subsidies). The traditional argument for centralizing the redistribution policy is based on the mobility hypothesis (Thiebout, 1956). Also the

responsibilityfor stabilization policy must be conducted with the central government. It is also usually argued that the regulatory function is best

undertaken by the central government, but in most cases local and regional governments should act as agents for central governments in carrying

out this function.

Within the context of fiscal federalism and allocation theory the most appropriate function for subnational governments is the allocative function.It is based on the fact that the various goods and services have different spatial characteristics and benefit incidence. The spatially limited natureof benefit incidence thus leads to a fiscal structure composed of multiple service units, each covering a different sized region within which supply

of a particular service is determined and financed. This results in allocative efficiency and is illustrated by the Oates' decentralization theorem.

Another argument in favour of decentralized system is that it can bring competition into the public sector, it can provide public goods at the lowestunit costs, allows experimentation in the provision of the output, the officials at lower tiers of governments have stronger incentives to perform

better and the service is more likely to be provided cost-efficiently -which means that accountability brings responsibility.

There are some counterarguments that may reduce the benefits of decentralization. They depend on many country-specific factors and on existingconditions. This is the case ofinsufficient information when at the subnational level the officials should not necessarily have local interest in mind,

the case ofcorruption at the local level, the quality oflocal bureaucracies relative to national bureaucracies, the composition oflocal jurisdiction

based on past historical, political, rather than economic considerations and spatial characteristics and rapid change of public goods and services

characteristics, technological changes and greater mobility ofcitizens implies the changes in demand for public services, creates the problems

with externalities and spillover effects.

Among all types of decentralized administration which are responsible for undertaking public services at subnational level we include: state orprovincial governments in federations, regional/provincial/local administrations comprising various branches of central government departments,

local and regional governments/authorities directed by representative assemblies or councils, regional development authorities, single-purpose

authorities, regional branches of central government departments.

Local governments can be thought of as democratically-elected bodies whose jurisdiction is of a local (rather than regional or national) scale.They have powers to levy local taxes by which to exercise genuine discretion over services provision. Local and regional governments are bodies

corporate with their own legal identity, property, budgets and accounts.

The differences between regional governments and local governments are in status, scale and function. Regional and state governments derivetheir existence and their authority from the constitution, while local governments are creatures of central governments legislation (or a state

government in a federation). Regional governments customarily govern far larger territories in area and population and normally exercise a wider

range of functions.

Regional administrations are essentially deconcentrated arms of central (or state/regional) government with some degree of integration of

technical departments under the leadership of an administrator. Regional development authorities are more specialized institutions. They are

public corporations, usually established by statute, and managed by a board of directors appointed by the constituting authority. The establishment

of such authorities is usually associated with a development project attempting a transformation of a particular area of its people.

The functions conferred upon subnational governments can be classified in five groups: theprovision of environmental and social services, regulatory functions, development functions, the representative function, the coordination and

planning of regional investment and land use.

For understanding financing the subnational governments it is crucial to answer to four questions: the question ofexpenditure assignment(what

spending responsibilities of subnational governments are); the question of revenue assignment(how resources will be generated to pay for the

spending - who levies the taxes); the question ofvertical imbalance (how any imbalance between the revenues and expenditures is resolved) and

the question of horizontal imbalance,o requalization (how fiscal institutions adjust for the differences in needs and capacities of different

governmental units at the same level of government).

2. Revenue Generation - IntroductionThis chapter:

introduces the alternative methods of funding subnational governments describes the different types of transfers from central government as grants, tax sharing, loans from central government budget and equity

specifies in general the problem of tax assignment by different level of government, and the possible forms of tax revenues raised by subnationalgovernment

discusses the grounds for charging as another source of revenue

classifies other sources - borrowing and generation of revenues from the operation of commercial or productive enterprises of subnationalgovernments

discusses the different approaches to the financial relationships between central and subnational governments

Local authorities shall be entitled, within national economic policy, to adequate financial resources of their own, of which they may dispose freelywithin the framework of their powers. Local authorities' financial resources shall be commensurate with the responsibilities provided for by the

constitution and the law...The financial systems on which resources available to local authorities are based shall be of a sufficiently diversified and

buoyant nature to enable them to keep pace as far as practically possible with the real evolution of the cost of carrying out their tasks. (European

Charter of Local Self-Government: Article 9)


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2.1 Financing the Activities of Local and Regional Governments

In this chapter we introduce alternative methods of funding subnational governments. At this introductory stage it is useful to classify

funding sources as a guide to a detailed discussion in the remaining chapters. This chapter also looks back to the previous chapter by describing

briefly alternative approaches to the relationship between functions and resources.

Local and regional governments in most countries have to meet the costs of constructing and maintaining services that are rising because of

inflation and the fact that more powers to provide goods and services are being shifted on them; and expanding because of an increasing population

(mainly in the third world regional authorities). A major task is to raise adequate revenue for both capital investment and for recurrent expenditure -

the employment of staff, operation and maintenance and the servicing of debt. Such revenue will only be adequate if it grows with the demands made

on it, i.e. in line with rising costs.

According to Bird (2000, p.13) two basic principles of assigning revenues to subnational governments may be suggested. First, "own" source

revenues should ideally be sufficient to enable at least the richest subnational governments to finance all locally provided services primarily

benefiting local residents from their own resources. Second, to the extent possible, subnational revenues should be collected only from the local

residents,preferably in relation to the perceived benefits they receive from local services. This approach is in turn based on principles:

1) more attention should be paid to matching expenditure and revenue needs at different levels of government;

2) in addition, more effort should be made to ensure that all governments bear significant responsibility at the margin for financing theexpenditures for which they are politically responsible;

3) and finally, subnational taxes should not distort the allocation of resources.

2.1.1 Central Government Allocations

Allocations from the central government budget - appropriations from revenue accruing in the first instance to national government - are a

significant and often predominant source of funding for subnational governments. They are frequently described as "transfers" and take severalforms.

Grants

Allocations to devolved authorities, such as state governments in a federation or local governments, more frequently take the form of grants

orsubsidies (interchangeable terms). Although these are appropriations from the central budget, they involve a transfer of cash to a self-accounting

recipient; (exceptionally a transfer may take another material form - services of seconded staff, or supplies from centrally purchased stores - but the

cash value would nevertheless be reflected in the books of both granting and receiving authorities). Grants and subsidies take many forms - multi-

purpose, single-purpose, unit cost, percentage, equalization, deficiency, and so on.

Tax Sharing

The other type of allocation is the tax sharing. The sharing may be of (at least) two kinds. Different levels of government may tax the

same base orone level may collect the tax from a given base and share the revenue with other levels.

Examples of the first kind are the taxing of personal income in the United States and the taxing of sales in Argentina. In the United States

personal income is taxed by both the federal government and by most states. Counties and municipalities surcharge on states' income taxes, which is

sometimes called "piggy-backing". An example can be Scandinavian countries, where there is a surcharge on personal income tax. In Argentina,

sales are taxed with a value-added tax at the national level and with a cascading turnover tax at the provincial level.

When two government levels tax the same tax base, each retains its independence of action even though an increase by one level in its

dependence on that base may limit the scope for the other level to tax the same base. At the subnational level the limits on effective tax rates on a

given tax base are generally imposed by tax competition and by the potential mobility of the tax base.

Examples of the second kind of tax sharing are quite common. They exist in Argentina, Brazil, Colombia, Pakistan, Russia, and in European

countries, including the Czech Republic.

Whether such shares should be regarded as a central allocation or direct regional revenue is open to question. In a unitary state, the

sharing would normally be a purely discretionary act on the part of central government - virtually an alternative form of grant. In a federation,

however, tax assignments may be built into the Constitution; central collection and transfer is an administrative device which is not (or should notbe) abrogated by the "rights" of the State to their stipulated share of the proceeds. In practice, even this constitutional distinction may be blurred. For

example the Indian Constitution guarantees the rights of the states to a share of income tax, but does not stipulate the size of the share or the manner

of its territorial distribution.

Two further refinements must be mentioned at this stage. The amount assigned to regional authorities may be the total yield of a tax or a

fixed proportion of it. The share received by an individual authority may relate to the amount of tax derived from its region; alternatively, the

assigned proceeds may be pooled and distributed to regions according to some formula unrelated (or at least, not wholly related) to their

geographical derivation.

Loans

Loans constitute a further type of central allocation to subnational governments, particularly common to the funding of development

corporations, but also provided to regional governments and local authorities for capital investment and, occasionally, for short term debt relief. They

are distinguished from other forms of central allocation in that they specifically require repayment. They may, nevertheless, involve an indirect

element of subsidy if they are interest-free or interest is charged below market rates.

Equity

The final form is central government investment of equity capital in a regional or local government. The recipient authority would normally

be expected to operate in a quasi commercial manner and to invest the capital in a "self-liquidating" operation, i.e. in an activity which would earn

revenue tocover its current costs and possibly yield a surplus to finance expansion or pay dividends. Central government will not expect to recoup


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the capital sum invested, though it might hope to receive a return through dividends. Such funding is most typical of regional development

authorities. It might be provided also to a semi-commercial undertaking run by another form of regional authority - a municipal water enterprise, for

example.

2.1.2 Taxation

It has generally been argued that local governments should finance their spending through "benefit pricing" or benefit taxation. For example,

Musgrave and Musgrave (1989, p. 517) write that "the choice of tax instruments to be used by 'local' jurisdictions ... should conform to the rule that

each jurisdiction pays for its own benefits."This is necessary because "benefit taxation - requiring as it does a balance of tax burdens and benefit

gains -neutralizes the impact of fiscal operations on location choice" (p. 518). This is, of course, necessary for the result to be Pareto-optimal.

However, Musgrave and Musgrave also recognize, however, that "the assumption of universal benefit taxation ... is unrealistic"(p. 518).

The first approach, already discussed, is the sharing of taxes levied and collected by the central government.

Secondly, subnational governments may impose a surcharge on a tax levied and collected by central government. Taxpayers within their

jurisdiction normally pay this excess charge with their basic tax to the central government, which then pays over the proceeds of the surcharge to the

regional authority. Swedish local authorities, for example, impose a surcharge on national income tax; in parts of the United States, local authorities

place a surcharge on the state level sales tax; some Indian panchayats (rural local authorities) benefit from surcharges on land tax. The surcharge may

be levied as an additional percentage of the tax base (e.g. of taxable income, in the case of income tax) or, alternatively, as a percentage addition to

the actual tax paid to the central (or regional) government.

The third source of tax revenue is the levies which subnational governments collect and retain themselves. (There are examples of

subnational governments sharing the proceeds of their own collections with central government, but these are rare.). There is an almost infinite

variety of such taxes. A major variable, however, is the legislative base. A tax collected by subnational government may be levied under central

government legislation which may, in turn, be mandatory or permissive, i.e. it may require subnational governments to collect it or merely give them

discretion to do so. The central legislation may also stipulate the tariff or leave this to the discretion of regional authorities within or without limits.

Alternatively, taxes may be imposed by regional authorities under their own legislative power.

The question of tax assignment by level of government has been discussed by many authors. The assignment of tax revenue to multilevel

governments can follow several options.

The first option is to assign all tax bases to the local authorities and ask them to transfer some of the revenue to the central

government to allow it to meet its spending responsibilities. The amount transferred upward could be determined by rule, formula, or negotiation.

This option is often unattractive and inefficient for a number of reasons. It is inconsistent with a national policy that aims to redistribute income

through the tax system. It is inconsistent with a policy that calls on the public sector to stabilize the economy, using the tax system to achieve this

objective. It may result in excessive fragmentation of the tax system, and it may provide the wrong incentives to the subnational jurisdictions if they

know that part of the taxes they collect will be shared with the national government. There is also evidence from some countries (for example China

and Mexico) that this policy leads to inefficient tax administration.

The second option is forthe central government to collect all taxes and transfer some of the revenue to the subnational governments.

The transfer of funds to the subnational governments can be done by sharing total tax revenue or by sharing specific taxes. As argued earlier, the firstapproach is superior because it gives local governments a morestablerevenuesourceandgivesthenationalgovernmentmorefreedominpursuingits tax

policy options. Still, there are problems with this option. Breaking the connection between decisions to collect tax revenue and decisions to spend

that revenue destroys the concept of the tax price for public spending (that is, the idea that spending decisions carry a specific cost expressed through

the taxes paid). Local officials and taxpayers may not connect the benefits they derive from public spending with the taxes they pay. Therefore localofficials may not exercise the required restraint on spending, and taxpayers will be less willing to pay taxes.

The third, most common option is to assign subnational governments some taxing power and, if necessary, to complement the revenue

raised locally with grants from the central government. The taxing power can be provided to the subnational governments by assigning them

exclusive use of some tax bases, allowing them to share some bases with the central government, or allowing local governments to surcharge on

some national taxes.

The assignment of tax bases to subnational governments must take into account several considerations.

1) The first is the importance of the objectives (other than raising revenue) being pursued through taxation. The more important these

other objectives are, the less advantageous it is to leave these tax bases to subnational governments. For example, if the government

assigns considerable weight to income redistribution (through progressive taxation) or stabilization (through built-in stabilizers), certain

tax bases, such as the progressive income tax and the corporate income tax, should be left to the national government.

The second consideration is the mobility of the tax base. If a tax base can easily escape taxation at the local level by moving to another

jurisdiction, that base is not a good candidate for local taxation. Thus, the more mobile the tax base, the more desirable that it remains at

the national level.

The third consideration involves economies of scale. Depending on informational requirements (for example, the need for a national

taxpayer identification number), technical requirements (the use of large computers), or other factors, economies of scale in tax

administration for a given tax argue for leaving that tax to the national government. This consideration implies that the value-added tax

and the global income tax should be nationally collected taxes.

Regional governments and local authorities habitually derive part of their revenue from taxation, although in greatly varying proportions.

Regional development authorities and deconcentrated regional administration might collect central government taxes as agents or receive tax shares

but are rarely taxing authorities in their own right since they are not directly representative bodies; the traditional link between taxation and

representation survives even under largely autocratic regimes.

2.1.3 Charging


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Taxes normally have to be paid by members of the public as a legal obligation regardless of the extent to which they personally benefit from

the services they finance. Charges,by contrast, are paid directly by those who consume a service and are normally appropriated to meeting all its

costs or at least part of them. Examples may include rents for local authority houses, irrigation charges, and swimming pool entrance fees.

The grounds for charging - the justification for charging the cost of a service directly to the consumer rather than the taxpayer at large - will

be discussed in Chapter 4. The border line between charges and taxes is not always clear. A charge may fall on consumers only, but may have

something of the character of a tax where variations in its scale are not strictly related to the volume of consumption - water rates based on property

values rather than metering, for example - or where revenue exceeds service costs and is appropriated to other purposes.

When making decisions whether a service should be financed by the means of charges or taxes, several aspects have to be concerned: What

distinguishes a service financed by consumers from one funded by taxpayers?

The first consideration is fairness. Broadly speaking, those who benefit should pay.

If a service or, to be specific, the unit of a service benefits one person exclusively, that person should pay for it through a consumer charge.

Examples might be a domestic electricity supply or a telephone extension. If a service benefits everyone collectively and indiscriminately, like

defence or disease control, the cost should be borne by taxation.

Many services fall between these two categories (known respectively as private and public goods). A service may benefit one person

particularly but nevertheless have some impacts on others; such impacts are known as externalities and may be positive ornegative. Domestic

water supplies benefit the individual household and their cost can by measured; but they reduce communicable disease and therefore have wider

benefit. Where the benefits are both private and public, a consumer charge subsidized from taxes may be justified if it enables or encourages a wider

number of people to use the service. The mix of charge and subsidy should depend upon the balance of private and public benefit. Where the impacts

are negative - for example, the congestion or pollution caused by city centre parking - one may wish to make the charge punitive, i.e. above the level

of the service cost, - to discourage consumption.

There is a further aspect of fairness. Some services may be largely private goods with little externality, but nevertheless regarded as "merit

goods", i.e. basic human needs. Subsidisation or even total financing from taxation may be regarded as right if it enables consumption by those who

are too poor to meet a full consumer charge. This is often applied to primary education, medical care and even housing, its extent depending on what

an economy can afford and what contemporary values regard as a minimum standard of living. Critics argue, however, that such subsidisation should

be directed to general income support so that the poor can exercise choice over the services they use.

A second major consideration is economic efficiency. Where individuals are free to choose how much of a service they consume, charging

enables the price mechanism to play a crucial role when allocating resources through:

rationing demand: on the basis that those who value the item or service most will be prepared to pay most

providing the incentive to avoid waste providing signals to the supplier concerning the scale of production

providing the resources to the supplier to increase supply.

Without a price, demand and supply are unlikely to be brought into equilibrium and thus the allocation of resources will not be economicallyefficient. Water supplies and medicines are examples of costly goods for which charging is particularly supported on efficiency grounds.

The problem, however, is that the market mechanism does not act perfectly. In many cases government is a monopoly supplier, and may be

tempted to charge more than the necessary cost of a service, either to reallocate resources or because of inefficient provision.

A third factor is administrative convenience. Charges are often a relatively easier form of revenue to collect than taxes, because they can in

most cases be enforced through cutting off a service.

Charging is a revenue source common to all forms of local and regional governments; it may well be the predominant source of current

income for regional development authorities.

2.1.4 Borrowing

Loans have been mentioned as a channel of central government finance. Regional authorities in different countries borrow also from a

variety of other sources, including international and foreign agencies, centrally operated credit funds, commercial banks and other financial

institutions (insurance societies, for example), private investors, or internal reserve funds. These will be discussed in Chapter 6. Borrowing serves

different purposes:

1) funding short-term cash flow deficits;

2) financing investment which is expected to earn income; or

3) paying for long-term capital development.

Regional development authorities are frequently capitalized by long-term loans and many regional governments borrow extensively for

capital development. The extent of local authority borrowing varies radically between countries, both in legality and scope. Regional administrations

normally lack the corporate status necessary for borrowing money in their own right.

2.1.5 Enterprise

Subnational governments may generate revenue from the operation of commercial or productive enterprises as a source of net income. The

base, of course, is charging - but charging with the intention of profit to finance other purposes, not just to operate the enterprise itself. Suchactivities often represent incursions into what are otherwise private sector fields such as retailing, entertainment, or catering.

Their significance in their contribution to general subnational government revenue is only occasionally large. All forms of regional authority

may engage in profitable enterprise; there is often a greater bonus upon regional development authorities to do so.

2.1.6 Resources and Responsibilities


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The previous chapter outlined a range of functions which may be discharged by different types of subnational governments and authorities

in different countries. In this chapter we outlined a wide range of sources which subnational governments can use to finance their activities. Clearly,

the critical elements of all the possibilities are:

1) the relationship between the allocation of functional responsibilities and the assignment of revenue sources - the match oftasks and resources, and

2) the degrees regional discretion attached to the management of each. This is the nub of the central-regional financial relationshipsenshrined in the constitution, the statutes or the fiscal and budgetary policies of each nation.

These financial relationships vary enormously in detail, but are characterized by three different approaches. The first approach is based upon

the assignment of income sources.

In practice, subnational governments are given certain revenue sources (mainly taxes) to exploit, or a certain proportion of central tax

revenues. The scale of their expenditure, and therefore the scope of the responsibilities they undertake, is effectively determined by the yield of these

revenues. Some modifications may be made. Grants may be paid to standardize the potential revenue from the assigned resources - to compensate

areas with lower fiscal capacity. The sharing of central taxes may be weighted in favour of areas with above-average expenditure needs. Basically,

however, financial relationships revolve around the assignment of income rather than the financing of set levels of expenditure. Local and regional

governments do what they can afford to do.

The second approach might be defined as the expenditure approach. Grants, loans, and other allocations are based upon expenditure

estimates - upon the cost of exercising a particular function at a particular level. This costs estimate may be the actual cost or some standard

projection of what needs to be spent, and the central allocations may meet all or only part of the cost. But the financial relationships focus upon

financing, by one means or another.

Finally, there is a comprehensive or deficit approach. Revenue sources are assigned to subnational governments. Responsibilities are

allocated too, with assumptions about their expenditure implications. Grants are paid to bridge the gap between these revenue sources andexpenditure needs. These grants may be calculated according to actual revenue and actual expenditure, or upon estimates of revenue potential and

expenditure need, using standard criteria. Either way, the financial relationships attempt an integrated matching of resources and functional

responsibilities.

These approaches are not mutually exclusive. A single authority might receive loans for self-liquidating projects, unit cost or percentage

grants for a specific service, and tax shares attached to non-defined expenditure need (beyond, perhaps, a matching contribution to a percentage

grant). The different approaches might apply to the financing of a local and regional government as a whole, or to different functional fields.

The relationship between responsibility and resources can be seen in two ways: resources create functions, or functions search for

resources. Two opposing principles are at stake. The first assigns resources to subnational governments and then permits them to undertake those

functions appropriate to their means. The second principle assigns functions to subnational governments and then seeks to allocate the resources to

match them. Practice tends to fall between these opposites. Some functions may be mandatory, implying a right to allocation of enough resources for

at least some basic level of performance;

other tasks may be purely optional and dependent upon what an authority can and wishes to afford. Functions can be assigned with varying

degrees of prescription over their performance and thereby their resource requirements.

This brings us to the second point. Delegation of responsibility and resources to regional government is not necessarily an absolute; it

can be a matter of degree. Delegated discretion to spend money can vary from an unlimited right to spend any amount on any purpose, to achoiceof

whether to buy blue or red paint. The right to raise revenue can vary from a constitutional discretion to impose any tax not specifically reserved

for another level of government on the one hand, to collection of a tax according to predetermined assessments and tariffs on the other. Finally, the

exercise of discretion is firmly constrained by the political, economic, and geographical environment within which subnational government

operates.

Individual types of revenue generation and their participation on composition of subnational government financial resources may be clearly seen in

the following Figure 2.1.Figure 2.1 Composition of subnational government financial resources (As a percentage of total financial resources,1991)


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1. For non-tax revenue: 1984 for Switzerland, 1997 for France, Ireland, Luxembourg, the Netherlands and Spain, 1998 for Iceland,Norway, Portugal and the United Kingdom.

2. Non-tax revenues include: operating surpluses of public enterprises controlled by subnational governments; property income; fee,sales and fines; contributions to government employee pension funds and capital revenues.

Source: Joumard, I., Kongsrud, P., M. (2003)Fiscal Relations across Government Levels. OECD Economic Studies No 36, 2003/1, p.183

ConclusionsThis chapter has classified the financial resources which may be made available to local and regional government. A wide range of options

include: loans, equities, grants, tax shared, taxes delegated, locally imposed taxes, fees, charges, trading profits.

Allocations from the central government budget are a significant and often predominant source of funding for subnational governments. They arefrequently described as "transfers"and take several forms:grants, tax sharing, loans and equity.

Allocations to state/provincial governments in a federation or local/regional governments, more frequently take the form of grants orsubsidies

(interchangeable terms). They take many forms - multi-purpose, single-purpose, unit cost, percentage, equalization, deficiency, and so on.

The tax sharingmay take (at least) two forms. In the first form different levels of government may tax the same base (e.g. personal income tax in

United States); in the second form one level of government may collect the tax from a given base and share the revenue with other levels. This tax

sharing arrangement is quite common in many countries - Argentina, Russia, Pakistan, and European countries, including the Czech Republic.

The amount assigned to regional authorities may be the total yield of a tax or a fixed proportion of it. The share received by an individual

authority may relate to the amount of tax derived from its region; alternatively, the assigned proceeds may be pooled and distributed to regionsaccording to some formula unrelated (or at least, not wholly related) to their geographical derivation.

Loans are provided to subnational governments for capital investment and, occasionally, for short term debt relief. They specifically require

repayment and may involve an indirect element of subsidy if they are interest-free or if interest is charged below market rates.

Another form of central allocation is central government investment of equity capital in a regional or local government. Such funding is most

typical of regional development authorities. It might be provided also to a semi-commercial undertaking run by another form of regional authority - a

municipal water enterprise, for example.

The sources of revenues from taxation of subnational levels of government may take form ofshared taxes levied and collected by the central

government, or subnational governments may impose a surcharge on a tax levied and collected by central government; or subnational governments

impose and collect taxes themselves.

The assignment of tax revenue to multilevel government may be made by assigning all tax bases to the local authorities and asking them to

transfer some of the revenue to the central government to allow it to meet its spending responsibilities; by collecting all taxes by central government

and transferring some of revenue to the subnational governments; by assigning subnational governments some taxing power and, if necessary, to

complement the revenue raised locally with grants from the central government.

The assignment of tax bases to subnational governments must take into account the importance of the objectives (other than raising revenue)pursued through taxation, the mobility of the tax base and economies of scale.

Charges are paid directly by those who consume a service and are normally appropriated to meeting all or part of its cost. In decision making

whether the service should be financed through taxation or through charging it is necessary to consider several aspects: fairness, externalities of

goods and services, regarding good as a "merit good", economic efficiency, and administrative convenience.


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Subnational governments borrow also from a variety of other sources including international and foreign agencies, centrally operated credit

funds, commercial banks and other financial institutions (insurance societies, for example), private investors, or internal reserve funds. The extent of

local authority borrowing varies radically between countries, both in legality and scope.

Subnational governments may generate revenue from the operation of commercial or productive enterprises as a source of net income. Theirsignificance in their contribution to general subnational government revenue is only occasionally large.

Since there is a significant diversity of financial resources to be used by subnational governments, it is essential to focus on the relationship

between the allocation of functional responsibilities and on the assignment of revenue sources; and the degrees of regional discretion

material about local finance

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