Chapter 7. Financing subnational and local governments: The missing link in development finance1
Unlocking the potential of territories at the local level is key to financing the amount of investment urgently needed to reach the Sustainable Development Goals (SDGs) and to meet the needs of the population. The series of international debates on development are paying increasing attention to city-level development financing, but local authorities are still not recognised as central to the debate. Focus should be brought first on improving the mobilisation of local endogenous resources, through expanding local taxation and relying on land-based finance and taxation of economic activities to improve local fiscal autonomy. Then, guarantee mechanisms should facilitate the process of leveraging external resources, encompassing private finance, climate finance, and borrowing, to finance long-term infrastructures.
Introduction
The intensive discussions taking place on the new sustainable development agenda2 will mean very little without adequate financing and renewal of financing mechanisms. While the major role that local and regional governments will play to achieve the SDGs is now widely acknowledged, the issue that is still pending relates to the effective implementation of the public policies and infrastructures necessary to reach these objectives, to make the transition towards green and inclusive regional territories.
Financing, together with inclusive planning and multi-level governance frameworks are the three main transformative levers of implementation upon which we must act. On one hand, multi-level governance provides structured dialogue between the various levels of government, and between subnational governments themselves, to ensure consistency and synergies of national and subnational goals and policies; on the other hand, local financing must be based on multi-annual investment plans and long-term strategies rooted in inclusive and flexible planning policies.
United Cities and Local Governments’ (UCLG) work is focused on bringing the voice of local and regional governments to the international development stage, to ensure the four pillars of sustainable development, i.e. the economic, social, environmental and cultural dimensions, are taken into account in territorial development strategies. Cities and territories are where people live, where poverty is tackled, where prosperity is generated, where access to fundamental rights must be guaranteed through access to health, culture and education services, and where ecosystems are protected. As a consequence of many decades of chronic under-investment in urban development, massive public and private investments will be necessary to improve access to basic services in these areas in order to eradicate poverty, cope with the impacts of climate change and prepare cities to host and protect the rights of 2.5 billion new urban residents over the next 3 decades, mostly in developing countries.
According to a number of studies, the amounts currently dedicated to these investments will have to be on average doubled, and even tripled, over the next two decades in order to meet this challenge. Sub-Saharan Africa, for instance, will likely need some USD 93 billion per year in the coming years, yet today such investments reach barely USD 45 billion per year (Foster and Briceño-Garmendia, 2010). Taking the additional costs of climate change into account, dedicated amounts should be tripled. According to a 2013 estimate by the World Economic Forum, the “investment gap” in green infrastructure could be as high as USD 700 billion a year. Likewise, the International Energy Agency (IEA) says that nearly USD 360 billion is invested annually to cope with the consequences and challenges of climate change – a massive figure, yet little more than one-third of the USD 1 trillion a year needed by mid-century.
As a result of the global decentralisation process, characterised by the transfer of key responsibilities, including the provision of basic services, to local and regional governments, “many of the investments to achieve the SDGs will take place at the subnational level and be led by local authorities,” according to the United Nations Secretary-General’s “Synthesis Report” on the post-2015 agenda (2014). Nonetheless, this transfer of responsibilities most often occurs without devolving the corresponding human and financial resources to exercise these new missions.
Local finance is the missing link in sustainable development finance, and we must advocate for the creation of financial mechanisms to unlock the economic potential of urban areas and territories. In response, the Global Task Force of Local and Regional Governments, an umbrella group of over 30 networks facilitated by UCLG, is mobilising member states and its accredited partners to support the implementation of adapted financial mechanisms at the local level.
A global imbalance between local government revenues and responsibilities is at the core of the deficit in infrastructures
The mobilisation of local and regional resources is becoming crucial to the future of many countries undergoing rapid urbanisation. High-level debates increasingly use the terms “endogenous” and “domestic” resources to encompass the full range of resources that could be mobilised. These resources come from the concentration of production factors, wealth and economic activities within urban centres and metropolitan areas all over the world. Cities are engines of growth, responsible for the major part of the investments in utilities networks that make these urban centres attractive to households and private entities. Their role to promote fair, responsible and creative economic development policies that meet the needs of their inhabitants should be fully acknowledged.
Yet, they are not equipped with the necessary fiscal autonomy and well-adjusted financial instruments to receive a fair return on investment from their contribution. Confronted with the combination of a rapidly growing urban population, and the impacts of pollution and disaster risks, local governments generally lack the buoyant tax sources that would produce revenue growth in line with their growing responsibilities. This inaction has a cost: economic, with the loss of income generated by the slowdown of infrastructures; social, with increasing inequalities and social unrest; and environmental, generating irreversible damage with negative impacts on living conditions.
A key challenge to tackling this issue is the wide diversity of local financing systems worldwide.
Local finances are closely related to the national and local institutional context, history, culture and political situation, among other things, and local expenditure must answer to specific needs on the ground. For instance, in the late 2000s, local governments spent around USD 3 000-4 000 per person annually in the United States and Europe but just USD 36 in Africa. In Eurasia, the average annual local government budget in terms of expenditure per person is around USD 232; in Latin America, USD 133; and in low- and middle-income countries in Asia, this figure is just USD 92 (UCLG, 2013). This is a highly diverse and creative field, with high potential for innovation, but as a consequence, one cannot advocate for a “one-size-fits-all model”. That is why we attempt to bring out our key fundamental principles, including those in economics, to build UCLG recommendations in favour of fiscal decentralisation.
In essence, this imbalance originates from an inequitable sharing of national financial resources. Depending on each economic context, intergovernmental transfers are key mechanisms for ensuring national solidarity and to mitigate horizontal inequalities that can be generated by decentralisation. However, systems of redistribution to local governments through transfers and grants do not guarantee equitable distribution, as a consequence of poor accountability, transparency and reliable data at the national and international levels. In addition, in the current context of decentralisation and budget austerity in most countries, local finances are perceived as adjustment variables and local development as a source for potential private business opportunities.
Another cause for the inconsistency of equalisation mechanisms is the hazardous identification of territorial needs. Yet, without precise knowledge of the costs, it is difficult to take well-informed decisions, and to finance properly these needs (unfunded mandates). The lack of clarity in local governments’ allocation of responsibilities is worsened by spillovers induced by the mismatch between the perimeters of local government jurisdiction and the economic development and residential maps.
Reliable and comparable data on subnational finance is essential, yet, the range of instruments available to obtain a better knowledge of the financial health of subnational governments, including cities, is very limited. UCLG, together with the OECD and the French Development Agency (AFD), are working on a study of prefiguration of a global observatory on subnational finances. Gathering financial data and qualitative information, the observatory will highlight the concrete financial capacities of local governments to implement the recommendations of the international community regarding urban development.
Financing the city by the city: Acknowledging the role of local governments to promote development policies
In order to compensate for this gap, local sustainable self-financing systems should then provide local governments with a necessary predictability on their resources to make best-planned decisions regarding the city-investment strategies. In other words, the city must be facilitated to better finance the city. This includes strengthened support for local financing in relation to land and property income as well as the productive urban economy. The history of urban development proves the potency of this opportunity, in particular for rapidly growing and economically dynamic cities.
Currently, mechanisms that would enable local public authorities to mobilise part of the wealth produced within their jurisdiction to be reinvested in local infrastructures are not in place in many low- and middle-income countries. Local taxation remains underdeveloped, and the tools and expertise needed to capture a portion of the capital gains in land value and economic activities are often lacking. Local tax systems rely too heavily on property taxation, which has low performance and high political cost. Therefore, diversifying fiscal instruments is crucial, and some countries do allow local authorities to benefit from national economic growth through the taxation of economic activities or individual income, while others resort to taxation of consumption sales.3 On the other hand, expanding local tax bases by investing in municipal staff, training and new technologies can rapidly improve tax collection.
Allowing cities to capture part of the land and property added value attributed to public investment, for instance in roads or new equipment, is another promising way to finance urban investments. This is especially important in countries undergoing rapid urban growth, by producing substantial immediate revenue that reduces reliance on debt. It also helps to enhance the efficiency of urban land markets and to direct urban growth toward areas most suitable to effectively accommodate that expansion. Recent experiences suggest the value-added contribution of land could represent between 10% and 50% of public investment made in the context of development or urban restructuring projects.
The use of such tools should be accompanied by well-adjusted regulations, participatory mechanisms, and profound knowledge of their impact and potential social and environmental consequences. Local authorities need to reform land rights and to have inclusive planning strategies, as well as the necessary instruments, such as updated land registries, accounting systems, and electronic networks.
Meet the deficit in infrastructures and finance basic services through enabling access to external resources
While these endogenous resources are the core base of the financial health of local governments, they also provide reimbursement capacity and, therefore, access to external resources to leverage the amounts of investments to effectively meet the urgency and magnitude of their needs. Knowing that financial conditions at the global level, characterised by low interest rates and abundant global saving, are in favour of long-term investment, local governments should have access to long-term prefunding. This access can be provided whether through direct loans or private capital contributions (including special purpose companies, public-private partnerships or infrastructure facilities).
In many low- and middle-income countries, however, local government borrowing remains legally constrained. Restrictive institutional frameworks, weak creditworthiness and local administrative constraints curb access to finance for local governments outside of metropolitan areas and large cities. Private investors and financial institutions require the sound financial management of local governments, including long-term stability and the ability to generate revenue sustainably. In the same vein, in directly funding a public service, investors conduct “due diligence” processes to ensure performance and long-term profitability. International and regional development banks also have a role to play in financing the infrastructure needed for basic services in urban areas. However, they rarely grant credit directly to local governments, with the exception of the French Development Agency which is moving in this direction. Such banks can play a key leverage role for local and regional governments, particularly in middle- and low-income countries.
Financial intermediation institutions such as special finance institutions (SFIs), national municipal corporations or bond banks, can enhance access for local governments of all sizes to external financing, in particular through pooling of resources, and to help overcome the mismatch between the duration wanted by investors and the depreciation of urban investments.
When these institutions do not exist, and in parallel to reinforcing local capacities and creditworthiness and creating such institutions, there is a need to develop appropriate guarantee mechanisms to secure investors and channel global savings, public and private, towards the local level. It is true these mechanisms have a cost, but they can represent a strategic way for official development assistance (ODA) and climate finance to exercise a multiplier effect on the amounts raised.
Indeed, local government access to global, regional and national climate-change-financing mechanisms – for instance, the Green Climate Fund or the Global Environment Facility – can trigger investments in mitigation and adaptation infrastructure. In this sense, it is necessary for national governments to involve local authorities in the design of the financial mechanisms and their management, as well as supporting them to generate climate friendly projects.
Towards fiscally capable local governments and effective local and regional financial institutions
In this context, providing increased institutional capacity to local governments should be a priority on both national and international agendas. Legal, institutional and financial decentralisation frameworks are critical to create enabling environments for local authorities. Particularly with risk and creditworthiness given such significant priority, commitments by central governments to support local governments is indispensable, having a direct impact on local authorities’ access to adequate resources.
Firstly, governments and international organisations have an important role to provide an enabling environment and legal framework towards more fiscally capable local governments and effective local financial institutions, through decentralisation reforms and to fight against corruption. Such reforms can lead to the creation of legal and regulatory frameworks for public-private partnerships, provide grants and credit enhancements for the development of infrastructure projects, secure investors and help to develop subnational debt markets. Help provided through prudential frameworks are all in favour of enhancing the relationship of trust between investors and the demand for long-term resources. This also encompasses the maturation of broader intergovernmental fiscal systems through reforms that focus on transparency, monitoring and evaluation, and simplifying institutional requirements for local and regional governments.
Secondly, accompanying local government access to external resources relies heavily on support with project preparation, to make an attractive project that meets the needs of investors. It is particularly challenging for low-emission and climate resilient projects to meet climate investors’ criteria. Indeed, the World Bank estimates project preparation to cost from 5% to 10% of the total project cost (CCFLA, 2015). Project preparation facilities can work on changing project selection criteria to improve the sustainability aspect of traditional infrastructure projects. In this sense, it is often necessary in developing countries to establish specialised operators to take part in these facilities, to accompany urban development operations and the delivery of basic urban services, which may take the form of public or semi-public companies.
In a global and local environment that is increasingly complex, characterised by multi-stakeholder involvement, comprehensive approaches, extensive requirements and regulations, there is also a crucial need for cities’ Chief Financial Officers and their teams to increase their expertise. They must be empowered to negotiate well-structured partnerships with private actors, ensuring a fair allocation of risk between all stakeholders involved and with sustainable partnerships that will last throughout the project timeline. Moreover, cross-sector management should be implemented to ensure the coherence of local policies. In this sense, capacity building in financial management and promoting innovation through learning from experience and peer-to-peer exchanges are assets highly needed to support the empowerment of local authorities.
Finally, we must highlight the crucial role played by political leadership for cities in developed and developing countries to directly seize economic opportunities and take over key fiscal responsibilities, when they have the necessary local legitimacy, institutions and support from the population, e.g. the case of Ulaanbaatar in Mongolia that hosts more than half of the country’s population.
Empower local authorities to play a key role in the transition towards sustainable territories
Recent achievements in international negotiations include many new references to local authorities in declarations and international statements. Paragraph 33 of the Addis Ababa Action Agenda promotes more financial autonomy and integrated urban planning at the local level as key to sustainable development. It underlines the importance of urban-rural linkages as well as the strengthening of debt management and municipal bond markets or financial institutions, when appropriate. References to local authorities have also been included in the Zero Draft of the Habitat III conference with regard to financing, mechanisms for monitoring progress and accountability, as well as capacity-building.
However, the global framework still does not recognise local authorities as crucial to these international debates. International development focus is progressively shifting towards municipal finance. This is due largely to the joint commitments of networks of local and regional governments, UN agencies and member states. Yet, local stakeholders remain in the background of the negotiations. The issue of local fiscal policies remains primarily a political decision to be taken by member states within their respective governments, closely linked to the decentralisation agenda. The only way for local elected officials and representatives to take part in the official negotiations is to be part of national delegations, whereas many mayors and local elected officials want to commit and get involved on this issue.
This is in stark contrast to the fact that two other important non-state actors – civil society and business – have been given specific roles and allocated seats at the roundtables of finance negotiations. Initiatives of non-state stakeholders are an attempt to give more unity and more visibility to coalitions of actors ranging from local governments, civil society and business sectors, as in the case of Climate Chance, to be held ahead of the COP22; on the other hand, local authorities have to work jointly with business and civil society committees to have a seat at official roundtables in the framework of Financing for Development.
The current debates are a critical step on the way to defining the post-2015 Development Agenda. Yet it will not reach its objectives without devoting substantive attention to local financing and offering bold new recommendations for strengthening related systems. The collaboration between UCLG and the OECD is a powerful message that shows the increasing awareness of the role territories have to play in development policies. The UCLG World Secretariat shares the values of the OECD Recommendation on Effective Public Investment across Levels of Government, which highlights the roles of all levels of government in ensuring sound investments for development. The dialogue between levels of governments is essential to the design of comprehensive development strategies. This dialogue must take into account local representatives, by involving national associations of local authorities, with the political legitimacy to ensure national priorities are in line with policies needed to ensure the needs of their inhabitants.
Bibliography
CCFLA (2015), The State of City Climate Finance 2015, Cities Climate Finance Leadership Alliance, New York, http://www.citiesclimatefinance.org/wp-content/uploads/2015/12/CCFLA-State-of-City-Climate-Finance-2015.pdf.
Foster, V. and C. Briceño-Garmendia (2010), Africa’s Infrastructure: A Time for Transformation, Agence Française de Développement and the World Bank, Washington, DC, http://siteresources.worldbank.org/INTAFRICA/Resources/aicd_overview_english_no-embargo.pdf.
UCLG (2013), Third Global Report on Local Democracy and Decentralization: Basic Services for All in an Urbanizing World: GOLD III, United Cities and Local Governments, Barcelona.
UN (2014), The Road to Dignity by 2030: Ending Poverty, Transforming All Lives and Protecting the Planet: Synthesis Report of the Secretary-General on the post-2015 agenda, http://www.un.org/en/development/desa/publications/files/2015/01/SynthesisReportENG.pdf.
Notes
← 1. This chapter should not be reported as representing the official views of the OECD or of its member countries. The opinions expressed and arguments employed are those of the author(s).
← 2. Financing for Development, the Sustainable Development Goals, Climate negotiations, Sendai Framework for Disaster Risk Reduction, Habitat III Conference.
← 3. Brazil, Chile and Colombia, for example, have adopted various types of local taxes based on economic activities; several countries in Europe and North America resort to a local tax or surcharge on personal income; taxes on local sales are notably used in Canada and the United States. Morocco, has given 30% of value-added tax (VAT) to local governments, but in the form of transfers.