8. Funding and financing of local government public investment
The bulk of government investment is done at the local level in OECD countries, representing on average 41% of total public investment. Most studies on subnational government debt focus on the regional or state level, and very few studies analyse public investment specifically by local governments. This chapter aims at filling this gap, presenting a framework to analyse the key factors, which affect the capacity of local governments to fund and finance public investment, and illustrates the framework with five countries: Denmark, Finland, Ireland, Netherlands and New Zealand.
Local governments (LGs) represent on average about 23% of general government expenditure, 41% of general government public investments and only 10% of general government debt in the OECD (Figure 8.1). While most studies analyse subnational governments (SNGs) in general (i.e. both regional governments1 and LGs), few focus on the specificities of LGs. Yet, LGs play an essential role in the provision of public services and goods to citizens, but often have less revenue and expenditure autonomy than RGs2 and are often more constrained by fiscal rules (FRs).3 In particular, the funding and financing frameworks for municipal public investments often constrain their capacities to carry out public investments which could provide a positive economic, social or environmental benefits and increase the welfare of their citizens.
This chapter aims at filling this gap, presenting a framework to analyse the key factors which affect the capacity of LGs to fund and finance public investment. The framework presented here is aligned with the OECD (2014[1]) Council Recommendation on Effective Public Investment across Levels of Government.
This chapter presents the analytical framework developed in a European Commission project to analyse countries’ municipal investment funding and financing frameworks (Vammalle and Bambalaite, 2021[2]).4 It highlights the different elements which affect municipal investment funding and financing capacity, and how they work together successfully. The overall objective of a municipal investment funding and financing framework is to allow municipalities to carry out efficient public investment while ensuring municipal and national fiscal sustainability.
The second section describes the funding and financing sources and the multi-level governance drivers affecting the capacity of local governments to finance public investment (Box 8.1). The third section outlines how these different elements need to work together in a coherent way to ensure both efficiency and sustainability of the municipal investment-financing framework. It identifies four types5 of local fiscal and financial systems to ensure fiscal sustainability: market based, co-operative approach, rules-based, and direct control based.
Note: OECD refers to unweighted averages; Panel A: data unavailable for Australia, Chile, Japan, Korea, Turkey and United States (USA); Panel B: Gross capital formation is used as a proxy for investment (GP5P), data unavailable for Australia, Chile, USA, data for New Zealand refers to 2017; Panel C: data unavailable for Israel, Australia, Chile, Iceland, Korea, Mexico, USA. In Norway, LG debt is comparatively high, partially due to the CG deficit being covered by transfers from the Government Pension Fund Global and not by borrowing.
Source: Panel A: OECD Fiscal Decentralisation Database; Panel B: Calculations based on OECD (2019[3]); Panel C: OECD (2019[4]).
Following the 2008-09 Global Financial Crisis and the trend towards tighter fiscal rules, in particular for sub-national governments (SNGs), local public investment declined in the European Union, from 1.6% of GDP in 2009 to just above 1% of GDP in 2017 (EUR 171 billion) in the EU-28 countries.
Not all languages have a distinction between the terms “funding” and “financing”, so it is important to clarify the concepts behind these two terms, and explain why they are different in English.
Financing refers to the money needed to meet the up-front payments for public investment. Financing sources typically consist of borrowing (from commercial banks, the central government or other financial institutions), PPPs or institutional investors.
Funding refers to how the investment is ultimately paid for (loans repayments, PPP payments or investors returns). Funding typically comes from taxes, intergovernmental grants, fees, tariffs other mechanisms such as capturing land value, commercial activities, etc.
The two elements are interlinked and both are needed: indeed, if SNGs are in theory allowed to borrow (financing), but do not have sufficient capacity to increase their future revenues (funding) in order to repay the debt, they will, in practice, not be able to borrow.
The largest sources of funding and financing for LG public investment in the EU are (Dexia, 2012[5]):
Self-financing: own current revenues, or reserves accumulated through past budget surpluses.
Capital transfers: either from CG or from supra-national institutions (such as the EU).
Private stakeholders: through off-budget schemes such as public private partnerships, which have grown in importance in many countries over the past decade.
Debt: borrowing on the markets, from public institutions, or CG.
The share of each funding source varies across countries and over the years, with debt-financed funding making up only a relatively small part of total local public investment.
The drivers shaping the availability of funding and financing for local public investment can be divided into six groups (Figure 8.2): the funding framework, fiscal discipline mechanisms, financial instruments, financial institutions, the public financial management system and multi-level governance.
Note: CG – Central Government, LGs – Local Governments, LGFAs – Local Government Financing Agencies, MLG – Multi-Level Governance, PFM – Public Financial Management, PI – Public Investment, PPPs – Public Private Partnerships.
Source: Vammalle and Bambalaite (2021[2]).
The funding framework
The funding framework refers to how the investment is ultimately paid for (Table 8.1). The capacity to fund public investment depends on the revenue mix, the expenditure autonomy and the donor funding.
Revenue mix and expenditure autonomy
The revenue mix refers to the share of own revenues (mainly taxes and fees) and transfers (earmarked grants and general purpose grants) in the revenues of LGs. The revenue mix determines the capacity of LGs to increase their own revenues (by raising their tax rates for example). Revenue autonomy affects LG capacity to carry out public investment, either by increasing revenues, or by borrowing (as it determines the capacity to repay loans, thus the risk and the cost of borrowing).
The expenditure autonomy, on the other hand, allows LGs to reallocate funds to higher priority areas, in particular public investment. Expenditure autonomy encourages efficiency gains as the savings can be used to fund other expenditure, in particular investment projects.
For example, in the Dutch revenue mix, SNGs substantially rely on CG transfers which represent over 74% of total SNG revenues (OECD, 2019[4]). The grant system is rather complex, and municipalities and provinces receive both general purpose grants (47% of total revenue) and earmarked grants (around 12% of total revenue), which are subject to checks by the Ministry of Interior (VNG, 2018[6]). Local tax-raising capacity in the Netherlands is relatively weak and represents around 17% of total LG income and 2.7% of total tax revenue (OECD, 2019[4]). Property taxation constitutes the largest share of local tax revenue. Dutch LGs can also collect administrative charges and fees, but these can only cover the costs of providing the associated services. On the expenditure side, in 2004, the Dutch principle of subsidiarity "local if possible, central if necessary" was anchored in the Inter-Governmental Code. This code is meant as an informal agreement between the CG and SNGs to organise and streamline inter-governmental relations (VNG, 2018[6]). In the last decades, there has been a tendency to transfer services to the lower levels of government (e.g. social services since 2015). However, these changes are sometimes not accompanied by sufficient funding, thus negatively affect reserves of municipalities (Geißler, Hammerschmid and Raffer, 2018[7]).
At the opposite of the Netherlands, New Zealand LGs have high revenue and spending autonomy, within a limited scope. LGs in New Zealand are largely funded by their own communities. Property tax (called “rates” in New Zealand) represents about half of LG revenues (New Zealand Productivity Commission, 2019[8]). Other sources of revenues include grants from the CG (about 14% of LG revenues), sales and user charges (about 25% of LG revenues), development contributions (about 4% of LG revenues), or interests and dividends from LG owned enterprises (such as ports, airports, etc.) (about 8% of LG revenues). Furthermore, reliance on services fees are quite strong and there are plans to further increase them. This is coherent with New Zealand’s focus on the “benefit principle”, which states that “those who benefit from, or cause the need for, a service should pay its costs”. However, borrowing is justified to finance public investment, as it enables the cost of assets to be matched with their benefits over their life. This promotes intergenerational equity, since those who benefit from the infrastructure contribute to its cost (New Zealand Productivity Commission, 2019[8]). On the expenditure side, councils have “power of general competence”, meaning they have the ability to choose the activities they understand to fulfil their statutory role and how they should undertake them, subject to public consultation.
Donor funding
It refers to capital grants from international or national institutions (other than CG). In EU countries, the main source of donor funding are the EU Cohesion and Structural Funds, which typically takes the form of capital grants. Other sources could be for example donations from philanthropy or crowdfunding.
Fiscal discipline mechanisms
Fiscal discipline mechanisms consist of fiscal rules and direct controls, monitoring and enforcement mechanisms and insolvency frameworks (Table 8.2). Fiscal discipline mechanisms affect mainly the capacity of LGs to borrow to finance public investment. Indeed, while fiscal rules with stringent monitoring and enforcement mechanisms may limit the capacity of LGs to issue debt, they also increase the credibility of LG’s solvability, thus making access to credit easier and lowering its cost.
In the Netherlands, municipalities are subject to a balanced budget rule, which is anchored in Municipalities Act. LG must prepare multi-year budgets, for the current fiscal year and three following years. LG budgets must include a special section on budgetary risks which may significantly affect the financial position of a municipality. The Dutch municipalities are also subject to borrowing limitation, which relate to the term structure of government debt and not the total debt levels. Furthermore, since 2013, Dutch local authorities are subject to an annual deficit limit, which aims to limit risks of government exceeding EMU deficit limit of 3%. An aggregate deficit limit of 0.5% of GDP is applied to local authorities: 0.38% for municipalities, 0.07% for provinces and 0.05% for the water boards (OECD, 2021[9]).
Financial instruments – debt, PPPs and alternative financing
Financial instruments consist on debt (loans and bonds), PPPs, and alternative financing (Table 8.3). Loans can be regular loans from private banks or multi-lateral financial institutions (such as the European Investment Bank (EIB)), from local government financing agencies or from the CG. Unlike loans which are a bilateral contract between a borrower and a lender, bonds are issued on financial markets and traded amongst a large number of investors. Bonds usually have longer maturities than loans, however, to attract investors, they must have a sufficient size and liquidity, which is rarely possible for small LGs to achieve. Alternative sources of financing are the availability of private partners to enter into public-private partnerships to finance local investment for example, special purpose vehicles or lease contracts, crowdfunding, etc.
In Ireland, PPPs are governed by a statutory framework, and supported by a national competence centre, the National Development Finance Agency. In 2019 ,there were 29 PPP projects in operation or construction stage, with a total construction capital cost of EUR 5 177 million. An additional EUR 500 million has been earmarked for a further 3 project bundles. It is not unusual for several projects of the same nature are to be bundled together to reach a minimum size of EUR 100 million. Furthermore, guarantee schemes are also an important institution which can reduce cost of borrowing for LGs, and in some cases, enable them to access financial resources. Guarantees can be provided directly by the CG, or through a guarantee fund. Guarantees can be provided to individual LG loans or to pooled LGs loans.
Another example is New Zealand, which is currently discussing the creation of a new financial instrument to overcome limits from debt ceiling. In New Zealand, municipalities are submitted to a 250% net debt to total revenue ratio (see Box 2.2 in Vammalle and Bambalate (2021[2])), which is quite high but sometimes defer needed public investment, in particular in LG with special characteristics (e.g. fast-growing LGs, LGs coping with the effect of climate change, etc.). One key barrier to the supply of developable urban land for example, is the councils’ ability to borrow to build the necessary supporting infrastructure (Treasury, 2019[10]). Today, New Zealand has three models for financing and funding public infrastructure: CG transfers (mainly used for roads), LG property taxes, and development contributions:
LG’s property taxes financing model: The council borrows money to finance the supporting infrastructure for developing new land and is responsible for the construction of the assets (i.e. debt to revenue ratio of council increases). Developers build houses on this land which they sell to home owners. Once houses are sold and new home owners arrive, property tax income of the council will increase and be used to repay the initial loans.
Development contributions model: In this model, the council borrows to finance the supporting infrastructure, and is responsible for construction of the infrastructure assets. Developers building the houses on the new land pay a contribution to the council, which is used by the council to repay the loans. The advantage compared to the previous model is that the council receives the revenues for its investments faster, reducing the time mismatch between disbursement of funds and collection of revenues. However, it still increases LG’s debt to revenue ratio and is therefore subject to the celling.
Moreover, New Zealand is currently discussing an “Infrastructure Funding and Financing Bill”, which would set up a fourth model to finance public infrastructure.
The contemplated Levy model proposes to create a special purpose vehicle (SPV) which would borrow on the market to build the infrastructure asset and would be responsible for the construction of the asset. The SPV debts would be backed by a newly authorised “Levy” (similar to a property tax but earmarked for financing the infrastructure investment) on the owners of the properties which benefit from the infrastructure. The LG would collect the Levy on behalf of the SPV, but if levy payers defaulted, the SPV could seize their property to repay their debts. The SPV would thus be guaranteed by the owners of the properties benefitting from the infrastructure investment, and ultimately, by the properties themselves (i.e. not guaranteed either by the LG or by the CG). In this way, the borrowing for the infrastructure would not be in the LG’s books, and would therefore not be subject to or deteriorate the LG’s debt ceiling.
Financial institutions
Financial institutions refer to the intermediaries and institutions which make funds available to LGs for public investment, determine the criteria under which these funds can be accessed, and the conditions for accessing them (Table 8.4). The most frequent financial institutions for LG public investment are local government financing agencies (LGFAs) and public investment funds (created and funded by the CG or supra-national institutions such as the EU). Public investment funds refer to funds created by CGs or other public institutions to finance local public investment. These provide, for example, subsidised loans or capital grants (see Box 8.2).
The Danish KommuneKredit is a specialised publicly owned non-profit financial institution providing loans to Danish regions, municipalities, municipal-owned enterprises and companies undertaking regional or municipal tasks. It issues bonds on national and international markets and lends to its clients with only a small administrative margin.
KommuneKredit liabilities are jointly and severally guaranteed by all members, meaning that each member assumes the liability for the entire amount owed by KommuneKredit. The guarantee of the members can be called upon without a preceding court decision, and all municipalities are obliged to pay the creditors immediately. This guarantee is a cornerstone of the successful functioning of the institution and a key factor behind its triple-A credit rating. However, the system and monitoring procedures are such that exercising the guarantee has not been needed so far. Municipalities and regions apply to KommuneKredit funding both individually and jointly. Importantly, municipalities themselves guarantee the timely payment of the loans taken by the municipal-owned enterprises and companies undertaking regional or municipal tasks. In addition to loans, KommuneKredit also offers financial leasing, advisory services and funding for PPPs.
Finnish municipalities enjoy extremely low borrowing costs thanks to the joint work of two financial institutions: MuniFin and the Municipal Guarantee Board.
MuniFin is a specialised financial1, 2 institution owned primarily by the Finnish municipalities.3 MuniFin pools the funding needs of Finnish municipalities, municipal enterprises and non-profit organisation, and issues bonds on global financial markets. It is explicitly guaranteed by the Municipal Guarantee Board, which allows MuniFin to place bonds at very favourable conditions. The Municipal Guarantee Board uses the loans from MuniFin as collateral and can only guarantee loans issued by MuniFin. To ensure the quality of the collateral, the Municipal Guarantee Board could refuse a loan as collateral, in which case, MuniFin would also reject that loan. MuniFin and the Municipal Guarantee Board have low operating expenditure and do not seek to make profits, and therefore lending rates from MuniFin to municipalities are extremely low and competitive. As a result, around 80% of municipal debt is financed through MuniFin (André and García, 2014[11]).
The Municipal Guarantee Board (MGB) purpose is to safeguard and develop the joint funding of Finnish municipalities. The MGB provides zero-risk weighted explicit guarantees for MuniFin funding, backed by the unlimited right of municipalities to levy taxes. The MGB guarantees carry AA+ ratings, which are capped to the rating of the State of Finland. The MGB provides a supporting function. It can inject any amount of money to keep the MuniFin from collapsing. In particular, the MGB can access the municipal tax base if needed. Importantly, the MGB guarantees MuniFin’s loans/bonds, not municipalities’ individual loans. Each entity is responsible for its own loans.
The Municipal Bank of the Netherlands (BNG Bank) is a funding agency established by the Dutch Association of Municipalities in order to help municipalities’ access credit markets. Half of the bank's share capital is held by the CG and the other half by municipalities, provinces and a water board. The BNG provides loans to housing associations, healthcare institutions and public utilities under different conditions than for municipalities. The financial relationship between central and local government in the Netherlands is structured in such a way that the credit quality of Dutch municipalities is equal to that of the State of the Netherlands, rated Aaa by Moody's (stable outlook), AAA by Standard & Poor's (stable outlook) and AAA by Fitch (stable outlook). Dutch municipalities are not rated individually. Loans to Dutch municipalities are 0% risk weighted by the Dutch central bank.
In New-Zealand, the Local Government Funding Agency (LGFA) is a publicly owned financial institution very similar to the KommuneKredit in Denmark or the MuniFin in Finland. LGFA provides about 90% of LG loans, and de facto imposes a strict (though high) debt ceiling of net debt ratio below 250% to access its loans. As its Nordic peers, it issues debt and bonds on national and international markets and lends to LGs charging only a small margin to cover administration fees and dividends to its shareholders. It is guaranteed by all shareholders (except the CG) and all LGs which have outstanding loans above NZD 20 million. Only 30 LG councils are shareholders of LGFA (meaning they will receive dividends on their shares). However, borrowing from LGFA is not limited to shareholders. When borrowing from the LGFA, the LG automatically becomes a member of LGFA, and a guarantor if its loans are above NZD 20 million. LGFA can only lend to LGs (not to LG controlled enterprises). LG loans from LGFA are guaranteed by their property tax income: in case of default, LGFA could appoint a receiver to directly collect the tax. To beat alternative commercial banks costs of borrowing, the LGFA must maintain a credit rating as high as the sovereign. To achieve this, the LGFA imposes a number of financial commitments (“covenants”) consistent with A+ rating on LGs which borrow from them. If a council breaches the covenants, they enter an “event of review”, and after 30 days, LGFA can seek repayment of their outstanding loans.
← 1. The Financial Supervisory Authority supervises the MuniFin and the ECB acts as a watchdog.
← 2. The MuniFin is not allowed to take deposits thus cannot be considered a bank.
← 3. The municipalities own 53% of MuniFin shares (all municipalities participate), KeVa (the largest pension fund): 31%, and the state: 16%.
Ireland does not have a LGFA, however, in 2018, it established two funds to fund public investment by local authorities: the Urban Regeneration and Development Fund (URDF) (EUR 2 billion) within the Department of Housing, Planning and Local Government, and the Rural Regeneration and Development Fund (RRDF) (EUR 1 billion) within the Department of Rural and Community Development. These funds are inspired by the EU structural funds’ competitive bid process and matching requirements and are fully funded by the state budget.
The differentiation between urban and rural funds allows LGs with different needs, size and administrative capacities to access funding, avoiding competition for funding between rural and urban areas and projects. Eligibility criteria for these funds ensure that all local authorities are entitled to apply to one of the two funds. Importantly, the funds are not bounded by thematic or sectoral requirements.6 On the contrary, the key evaluation criteria create incentives for Irish LGs to come up with complex and multi-dimensional and multi-sectoral projects, further strengthening their capacities. Irish LGs participating in these measures are required to co-finance at least 25% of the project.
Moreover, local authorities can borrow to a centralised borrowing agency, guaranteed by the central government. The Housing Finance Agency Ireland (HFA) is a company under the aegis of the Minister for Housing, Planning and Local Government of Ireland. It provides loans at preferential rates to local authorities, voluntary housing sector and higher education institutions to finance housing related projects. The HFA offers Irish local authorities long-term fixed interest rates with 20-30 years maturities and lends to local authorities at very competitive rates. It raises its funds on the domestic and international capital markets, and its funding is explicitly guaranteed by the CG, allowing the HFA to borrow very cheaply. Moreover, the fact that Irish LGs cannot default7 also acts as an implicit guarantee.
Public financial management (PFM) systems
PFM systems are composed of budgeting practices, strategic planning practices and administrative capacity of LGs (Table 8.5). Good PFM practices are necessary to plan and design quality public investment projects, increase the appetite of lenders to finance LGs’ investment projects – thus increasing the capacity of LGs to borrow – and help attracting alternative funding, such as private partners for PPPs.
For instance, during its transition towards a developed economy, Ireland has benefited from the EU structural funds not only in monetary terms but also in building a solid capacity for executing capital investments. Ireland has endorsed through its local legislation the discipline elements taken from the EU structural funds framework: evaluations, appraisals, multi-annual development and budgetary plans. This was reinforced by Ireland’s strong focus on investments in human capital.
Moreover, one of the cornerstones of the Irish public investment financing framework is comprehensive multi-annual planning involving multi-stakeholder public consultations and strong enforcement of policy priorities: “Funding follows policy, not policy follows funding”. Ireland has a strong integration of financial plans with regional development plans. In 2018, it launched Project Ireland 2040, which articulates the National Planning Framework to 2040 and the National Development Plan (to 2027). These plans also set the context for Ireland’s three regional assemblies to develop their regional spatial and economic strategies, co-ordinating with the local authorities, to ensure that national, regional and local plans align.
Another noteworthy example is New Zealand, where financial management, public consultation and transparency are very strong. New Zealand councils are required by the Local Government Act (2002) to provide financial strategies quantifying limits on the property tax rates, and to set prudent debt limits in consultation with their citizens.8 The Local Government Act sets out a range of planning instruments relating to the provision of infrastructure. These include a 30 year infrastructure strategy, 10 years plans of activities and services, related to a financial strategy, and annual plans and reports. In addition, Local Government New Zealand (the LG association) has recently introduced the “CouncilMARK Programme”: a council improvement and evaluation framework which aims to improve the public’s knowledge of the work councils are doing in their communities and to support individual councils further improve the service and value they provide.
Multi-level governance (MLG)
Multi-level governance consists of vertical and horizontal co-ordination mechanisms (Table 8.6). Vertical co-ordination mechanisms are necessary to align policies across levels of government, ensure monitoring of LGs’ situation, and when needed, provide them technical support. Horizontal co-ordination allows to increase efficiency by avoiding redundancies of projects, and pooling resources together.
For example, Ireland put in place a strong vertical co-ordination mechanism through the Department of Housing, Planning and Local Government, which has the overall responsibility for municipal affairs. Within the Department, the Local Government Division co-ordinates planning and monitors the financial health of local authorities, offering guidance and advice for sustainable financial planning. If a local authority faces severe financial difficulties, the Local Government Division elaborates a plan and a funding package for five years, with special financial targets to be achieved by the local authority.
In the Netherlands, municipalities are supervised by provinces, which, in turn, are supervised by the Ministry of Interior. Provinces are assigned the task of supervising municipal finances (vertical supervision) for the municipalities within its own province. The financial supervision is based on the principles of “a premise of trust in the own responsibility of municipalities by staying alert to financial problems’ and “checks on information quality’. The main focus is on retrospective supervision, also referred to as repressive supervision. Provinces may signal to the council and alderman (the daily management) to make the necessary adjustments in their budgets. However, provinces cannot impose measures on Dutch municipalities unless for specific situations.
Similarly, Finland implemented a strong vertical co-operation structure in the Ministry of Finance. The Ministry of Finance develops regulations that generally relates to the local authorities. Over the last decade, multiple reforms have reinforced the central role of the Ministry of Finance in municipal affairs.9 The Local Government Affairs department monitors and assesses the status and development of the finances of municipalities. It follows a set of indicators and meets regularly with the financial unit of municipalities. The Local Government Affairs department is now responsible for more than 80% of grant allocations to municipalities. Moreover, the Local Government Affairs department at the Ministry of Finance closely collaborates with the Association of Finnish Local and Regional Authorities, which can take part in workgroups of ministries, when they prepare reports.
Fiscal and financial frameworks vary greatly from country to country (Figure 8.3), with some countries like Denmark or Finland, giving large autonomy to LGs, in terms of revenue-raising capacity, expenditure decisions or borrowing rules for example.
Denmark is one of the most decentralised countries in the OECD. The Danish local sector is highly relevant both from the political and economic perspective, representing nearly two-thirds of total public expenditure. This is the highest rate among unitary OECD countries and nearly triple the OECD average of 23%.The main source of LG revenue is the municipal income tax, which represents up to 70 or 80% of LG revenues (and about 27% of total general government revenues). Danish local investments represent nearly half of total public investments in Denmark (46%). Moreover, Danish LG debt (about 22%) is above the OECD average of 11%.
In the same way, Finland, is a highly decentralised country, with a very large role of LGs in public investment. About 57% of public investment is carried out at the local level. LG expenditure level as a share of general government expenditure (40%) is well above OECD average. Moreover, LGs’ tax raising capacity is relatively high compared to OECD counterparts, representing about 23% of total public tax revenue. Municipal debt accounts for 18% of total general government debt in Finland.
At the opposite, other countries, like Ireland, place a much tighter grip on LG autonomy and decision-making power. Ireland is one of the most centralised countries across OECD. The thirty-one local authorities in Ireland carry out only 22% of total public investment – the lowest number among OECD. Municipal expenditures represent only about 9% of general government expenditure and LGs’ tax raising capacity is particularly low, only 2% of total public tax revenue.
Between Denmark and Ireland, the Netherlands is a moderately decentralised unitary country with LG expenditure representing 30% of total general government expenditure. The Netherlands has two tires of subnational government: provinces10 and municipalities. The later (LGs) are responsible for most of the SNG expenditure and debt, while provinces’ main role consists of the supervision of municipal financial management, and spatial planning. LGs in the Netherlands are of particular importance in terms of public investment carrying out about 52% of all public investments.
An interesting case is New Zealand, where the LGs are smaller than in most OECD countries in terms of spending ratios, but within their functions, LGs are extremely free to raise taxes (property tax represents 50% of their revenues), spend or borrow. As they are not responsible for health, social protection or education, LGs in New Zealand have a smaller policy role than in most OECD countries. However, they do play a significant role in public investment. In 2016, one-third of LGs’ expenditure was dedicated to investment (roads, transport and utilities), which represented 1.3% of GDP (OECD, 2021[9]).
Note: Panel A: data unavailable for Australia, Chile, Japan, South Korea, Turkey and USA; Panel B: data unavailable for Australia, Japan, Mexico; Panel C: Gross capital formation is used as a proxy for investment (GP5P), data unavailable for Australia, Chile, USA, data for New Zealand refers to 2017; Panel D: data unavailable for Israel, Australia, Chile, Iceland, South Korea, Mexico, USA.
Source: Panel A: OECD Fiscal Decentralisation Database; Panel B: OECD (2018[12]); Panel C: Based on OECD National Accounts database; Panel D: OECD (2019[4]).
The different elements affecting LGs’ capacity to finance and fund public investment are not independent of one another but are often put together to form various types of financing systems. In particular, there are different ways for ensuring LGs do not issue too much debt which could be a threat to the national fiscal sustainability.11 Following a standard classification, there are four types of systems for ensuring SNG’s fiscal sustainability. These systems also apply to LGs:12
Market-based systems
Market-based systems mainly rely on lenders to monitor local debt, ensuring the quality of debt-financed investment projects and fiscal sustainability. Market-based systems are very close to borrowing frameworks for sovereign governments. Thus, to borrow in good terms on financial markets under such systems, LGs must have a high level of capacity and autonomy. In addition, there are some pre-requisites for such systems to work effectively. For example, the “no-bailout” clause must be credible. This implies first, that LGs must be able to increase their revenues to repay their debt (for example, by having a relatively high share of taxes in LG revenues, and a high level of tax autonomy), and second that an insolvency framework provides rules to resolve unsustainable local borrowing. Lenders must have high-quality financial information on the LG, thus implying high-quality PFM systems, requiring well-functioning deep and diversified financial markets. In this type of system, fiscal rules are not very relevant, or could be self-imposed by the LG themselves.
For instance, the New Zealand system strongly rely on market mechanisms. A great number of LGs (31 out of the total 78) have a credit rating from a rating agency. These ratings are used as a simple and transparent “proxi” to evaluate the management of a LG, and all mayors have strong incentives to remain in the very high grades (in June 2020, 3 councils had AA+ ratings, 19 councils had AA ratings, six had AA- and one had A+). In addition, the cost of loans from LGFA (Box 2.2) is directly linked to the credit rating of the LG, which gives a second incentive to keep it high. This credit-rating based incentive is one of the main drivers for LG fiscal discipline in New Zealand.
Co-operative approach to debt controls
Here, limits on the indebtedness of LGs are not dictated by the CG, but rather negotiated amongst the different levels of government. Under this approach, SNGs participate actively in the definition of the macroeconomic objectives and the allocation of deficit and debt targets across levels of government. According to Teresa Ter-Minassian (1996[13]), “The cooperative approach has clear advantages in promoting dialogue and exchange of information across various government levels. It also raises the consciousness, in subnational-level policy makers, of macroeconomic implications of their budgetary choices. It seems, however, to work best in countries with an established culture of relative fiscal discipline and conservatism. It may not be effective in preventing a build-up of debt in conditions where either market discipline or the leadership of the central government in economic and fiscal management are weak”.
Denmark illustrates this statement (Mau Pedersen and Jensen, 2021[14]). Its highly institutionalised system is the result of a long tradition of a co-operative approach to local finances, where instead of market or CG setting the binding limits on expenditure and borrowing, these are achieved through active negotiation between different stakeholders. The Danish CG sets every years aggregate ceilings for municipal expenditure and tax revenues, and determines additional loans options for LGs. The local government association (LGDK)13 represents the municipalities14 in the negotiations of these ceilings, called “economic agreement”, with the CG. Once these ceilings are set, the LGDK also play a crucial role in the negotiations between the municipalities, for allocating the spending, taxing and borrowing space among themselves. The local government association plays a pivotal co-ordinating role in ensuring that agreed expenditure levels are met in both budgets and accounts. Such a system provides benefits to both CG and LGs. The Danish CG can limit expenditure growth while allowing for local decision making and sharing political responsibility for sometimes unpopular decisions. Moreover, LGs have an opportunity to influence public policy on a national scale while maintaining an overall flexible framework for the individual municipality (LGDK, 2019[15]).
Rules-based systems
Decisions on borrowing are made by LGs within limits set by central-government-set fiscal rules. Fiscal rules typically consist of limits to the absolute level of LG indebtedness, restricting borrowing to specific purposes (typically investment), setting limits to the debt-service to revenues ratio, or requiring repayment of short-term liquidity loans before the end of the fiscal year. The role of the CG in this system is usually limited to ensuring compliance with the rules. Vertical co-ordination mechanisms are thus very important, as well as monitoring and enforcement mechanisms. CGs rarely interfere in the choice of the investment, hence requiring a high level of capacity from LGs (to design strategic plans, procure the projects, develop the financial instruments, etc.), and good quality PFM. Rules-based systems are praised for being transparent and equitable and provide an environment in which both investors and borrowers can assess the risk of the transaction. However, they are criticised for their lack of flexibility and are often prone to circumventing of the rules (through creative accounting practices or use of debt instruments, which are not included in the fiscal rules).
In Denmark, in addition to the collective current expenditure and tax limits, individual municipalities are subject to a structural balanced budget rule (zero structural deficit). Moreover, in general, municipal borrowing is not permitted and municipalities typically have enough fiscal space to finance investment projects with their own funds. However, several exceptions exist. In particular, municipalities are allowed to borrow for investments in utilities as these are expenditure-neutral. This is subject to the collective capital expenditure limit or other types of investments. For other types of investments, municipal borrowing is subject to the annual loan pool limits, which determines the maximum aggregate amount municipalities can borrow. Application to the loan pool is held once every year and the Ministry of Interior takes a discretionary decision for each borrowing request. When certain rules are breached, the Ministry of Interior directly intervenes, as bankruptcies are not legally permitted. However, a strong system of supervision and early detection of financially unsustainable behaviours allows to avoid the need for bailouts and hence limit moral hazard and potential free-riding.
Direct controls systems
At the other end of the spectrum, some countries rely on direct CG control over LG borrowing. These controls can take different forms, such as setting annual limits on individual LG debt, an ex ante CG review and approval of LG debt transactions, the centralisation of all borrowing at the central level, and on-lending to LGs for specific projects (usually public investment). In this type of system, the quality of investments and sustainability of LG finances is essentially ensured by CG control. Fiscal rules become almost irrelevant, with CG explicitly or implicitly guaranteeing LG debt. The responsibility to ensure sufficient revenues for LGs to repay their debts therefore lies with the CG, and revenue autonomy is not important and insolvency frameworks are not necessary. In such systems, LGs tend to have a low level of investment funding capacity, as the decision power lies at CG level. In addition, the CG itself lends to LGs, as it can do so on better conditions than private lenders. A common criticism to this type of system is that the criteria used to review and authorise borrowing operations may be variable or unclear. Insufficient capacity of LGs is often quoted by CGs to justify direct controls. However, it is rational for LGs not to develop the capacity if they do not need to use it. Moving away from this type of system thus requires measures to reinforce the capacity of LGs.
In Ireland, the investment funding system can be considered as direct control. The CG has significant control over LG affairs, and LG autonomy is very limited both in terms of own-revenue raising capacity and discretion over spending. Nonetheless, Irish municipalities are allowed to borrow15 from state-owned agencies with prior CG approval.
In practice, most national frameworks consist of a mix of these four systems, although some lean more towards one or the other.
For instance, the Finnish municipal borrowing framework can be considered as a mix of rules-based and market-based systems. Finnish municipalities, which enjoy high levels of fiscal autonomy16 are under a tight fiscal supervision coupled with strong enforcement mechanisms: if there are no formal borrowing rules, they are subject to a balanced budget rule.17 Breaching specific financial sustainability criteria set by the Ministry of Finance triggers a special assessment process: officials from the Ministry of Finance visit municipalities “in crisis” providing advice on how to improve their financial situation and assist them in developing correction plans. In case of severe non-compliance, CG has the legal authority to force municipal mergers. Such forced mergers are rare, but have happened four times since the introduction of the mechanism in the year 2015, and being a municipality “in assessment” carries a negative connotation in terms of public image This tight fiscal supervision, coupled with strong enforcement instruments, acts as a strong preventative measure incentivising Finnish municipalities to manage their finances sustainably. Furthermore, all Finnish municipalities face strong peer pressure and market incentives. The Finnish municipalities jointly guarantee the Municipal Guarantee Board,18 and indirectly guarantee all other municipal loans. Municipalities therefore have a strong incentive to maintain strong financial positions, as otherwise, they would not be able to access the low-cost financing through MuniFin. Finland enjoys a long tradition of municipal autonomy and bottom-up policy making. Municipal self-government is anchored in the Constitution. These long-standing multi-level governance relations created a high level of trust in a municipal decision-making capacity, in turn creating conditions for building up administrative capabilities necessary to carry out complex tasks. These three institutional and governance elements play a crucial role in ensuring the high average creditworthiness of Finnish municipalities, giving them a credit rating close to the sovereign.
Another noteworthy practice is the horizontal co-operation for cost-efficiency and improved quality of service delivery. In the Netherlands, there are over 900 inter-municipal co-operation structures (The Ministry of Interior and Kingdom Relations, 2020[16]) indicating that horizontal co-operation is a wide-spread practice. Many formal and informal co-ordination arrangements emerge not only between municipalities but also with water boards, provinces, and CG. The increase of different inter-municipal arrangements over time is mainly driven by the CG, increasingly transferring responsibilities to the lower levels of government (OECD, 2014[17]). Such a wide-spread practice of horizontal co-operation positively contributed to the quality and cost of the services provided by municipalities. Municipalities sometimes choose to engage not only in joint funding but also in joint levy of taxes (Brand, 2016[18]).
As such, it is important to highlight the need for internal coherence among the different elements (Table 8.7), which is a precondition for efficiency and sustainability of local public finances. There is not one system or mix of system which could be considered as the optimal or more effective system. Indeed, different combinations of the elements can yield similar outcomes. In addition, while the government could influence some of these elements, many are constrained by exogenous factors such as the institutional framework, the existence of supra-nationally imposed fiscal rules, the level of capacity of LGs, the culture of the country and the preference of people.
High
Moderate
LowReferences
[11] André, C. and C. García (2014), “Local Public Finances and Municipal Reform in Finland”, OECD Economics Department Working Papers, No. 1121, OECD Publishing, Paris, https://dx.doi.org/10.1787/5jz2qt0zj024-en.
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[18] Brand, D. (2016), Local Government Finance, SUN MEDIA, https://doi.org/10.18820/9781920689988.
[5] Dexia (2012), Finances publiques territoriales dans l’Union européenne.
[7] Geißler, R., G. Hammerschmid and C. Raffer (eds.) (2018), Local Public Finance in Europe: Country Reports - the Netherlands, Bertelsmann Stiftung, https://doi.org/10.11586/2019052.
[21] Hulbert, C. and C. Vammalle (2014), “A Sub-national Perspective on Financing Investment for Growth I - Measuring Fiscal Space for Public Investment: Influences, Evolution and Perspectives”, OECD Regional Development Working Papers, No. 2014/2, OECD Publishing, Paris, https://dx.doi.org/10.1787/5jz5j1qk8fhg-en.
[15] LGDK (2019), Local Government Denmark (presentation).
[14] Mau Pedersen, N. and J. Jensen (2021), Local government borrowing and the role of KommuneKredit: An international comparative analysis, VIVE – The Danish Center for Social Science Research, https://www.vive.dk/media/pure/16718/6190243.
[8] New Zealand Productivity Commission (2019), Local Government funding and financing. Final paper.
[9] OECD (2021), OECD Fiscal Decentralisation Database, OECD, Paris, https://www.oecd.org/tax/federalism/fiscal-decentralisation-database/ (accessed on 30 August 2019).
[3] OECD (2019), “Government deficit/surplus, revenue, expenditure and main aggregates”, National Accounts, OECD, Paris, https://stats.oecd.org/Index.aspx?DataSetCode=SNA_TABLE12.
[4] OECD (2019), “Public Finance and Economics”, in Government at a Glance 2019, OECD Publishing, Paris, https://www.oecd.org/gov/government-at-a-glance-2019-database.htm.
[12] OECD (2018), Global Revenue Statistics, OECD, Paris, https://www.oecd.org/tax/tax-policy/global-revenue-statistics-database.htm.
[22] OECD (2016), “Monitoring sub-central government debt: Trends, challenges and practices”, in Fiscal Federalism 2016: Making Decentralisation Work, OECD Publishing, Paris, https://dx.doi.org/10.1787/9789264254053-7-en.
[17] OECD (2014), OECD Territorial Reviews: Netherlands 2014, OECD Territorial Reviews, OECD Publishing, Paris, https://dx.doi.org/10.1787/9789264209527-en.
[1] OECD (2014), Recommendation of the Council on Effective Public Investment aross Levels of Government, OECD/LEGAL/0402, OECD, Paris, https://legalinstruments.oecd.org/en/instruments/OECD-LEGAL-0402.
[13] Ter-Minassian, T. (1996), “Borrowing by Subnational Governments: Issues and Selected International Experiences”, IMF Paper on Policy Analysis and Assessment, https://doi.org/9781451973280/1934-7456.
[16] The Ministry of Interior and Kingdom Relations (2020), Staat van het Bestuur 2020, https://kennisopenbaarbestuur.nl/media/257751/staat-van-het-bestuur-2020.pdf.
[10] Treasury (2019), Urban Growth Agenda: Infrastructure Levy Model – Development Contributions Information Release.
[20] Vammalle, C. and I. Bambalaite (2021), “Fiscal rules for subnational governments: The devil’s in the details”, OECD Working Papers on Fiscal Federalism, No. 35, OECD Publishing, Paris, https://dx.doi.org/10.1787/531da6f9-en.
[2] Vammalle, C. and I. Bambalaite (2021), “Funding and financing of local government public investment: A framework and application to five OECD Countries”, OECD Working Papers on Fiscal Federalism, No. 34, OECD Publishing, Paris, https://dx.doi.org/10.1787/162d8285-en.
[6] VNG (2018), Local Governments in the Netherlands, https://bit.ly/2ZR1XFi.
Annex Table 8.A.1 presents the main elements identified in the analytical framework, together with the summary of the relative importance that each of these elements plays in the benchmark countries’ frameworks.
Notes
← 1. The term ‘regional governments’ here refers to the first level of subnational governments only: regions, provinces, states, länders, etc.
← 2. North European countries appear to be an exception to this statement, as municipalities in these countries have stronger legal status and roles than regions.
← 3. See Vammalle and Bambalaite (2021[20]).
← 4. This framework draws heavily on: Vammalle and Hulbert (2014[21]) and the Council Recommendation on Effective Public Investment across Levels of Government (OECD, 2014[1]).
← 5. Based on Ter-Minassian (1996[13]).
← 6. The only constraint is that these funds should not finance projects which benefit from funding streams from line departments (e.g. housing related projects).
← 7. Direct CG controls and transfers ensure no LG defaults.
← 8. The most common indicators used to set debt limits are: interest payments as a share of total revenues, interest payments as a share of total property tax income and total debt as a share of total revenue.
← 9. See Blöchliger and Vammalle (2012[19]).
← 10. Provinces in the Netherlands corresponds to the regional level rather than state level as in the case of Canada.
← 11. For a deeper discussion on the potential risks of SNG debt, see: OECD (2016[22]).
← 12. These three LG investment financing frameworks draw on the SNG borrowing frameworks presented in: Ter-Minassian (1996[13]).
← 13. LGDK currently is one of the most influential interest organisations in Denmark. The association is not an administrative authority and thus not a part of public administration. Membership in the association is voluntary. Nonetheless, all 98 municipalities are members of LGDK. The main functions of the association include formal negotiations of economic agreements with the Ministry of Finance; mediating negotiations between individual municipalities; negotiating collective bargaining agreements on behalf of municipalities with labour unions; lobbying and promoting common municipal interests; counselling and shared services towards the municipalities; ensuring that the municipalities are provided with all relevant and up-to-date information regarding tasks, and communication and branding of the municipal sector (LGDK, 2019[15]).
← 14. Similarly, regions are represented by the association of regions – Danske Regioner.
← 15. The CG establishes each year a total debt ceiling for LG new borrowing (it is EUR 200 million for 2020 for example).
← 16. Own taxes represent on average 50% of Finnish municipal revenues, and they can freely set the municipal personal income tax rate.
← 17. Finnish municipalities must present financial plans in balance or surplus and must cover any deficit within a period of four years.
← 18. The Municipal Guarantee Board assesses the sustainability of municipalities before approving a guarantee, and MuniFin follows that advice for approving loans.