Guide To Municipal Finance

Guide to
Municipal
Finance
Guide to
Municipal
Finance
Nairobi, 2009
Sec1:i
The Human Settlements Financing Tools and Best Practices Series
Guide to Municipal Finance
First published in Nairobi in 2009 by UN-HABITAT.
Copyright © United Nations Human Settlements Programme 2009
All rights reserved

United Nations Human Settlements Programme (UN-HABITAT)
P. O. Box 30030, 00100 Nairobi GPO KENYA
Tel: 254-020-7623120 (Central Office)
www.unhabitat.org
HS/1146/09E
ISBN: 978-92-1-132113-5
ISBN(Series): 978-1-132027-5
Disclaimer
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Views expressed in this publication do not necessarily reflect those of the United
Nations Human Settlements Programme, the United Nations, or its Member States.
Excerpts may be reproduced without authorization, on condition that the source is indicated.
Cover design : Andrew Ondoo/UN-HABITAT

Cover photos: Xing Quan Zhang/UN-HABITAT
Acknowledgements:
Director: Oyebanji Oyeyinka

Principal Editor and Manager: Xing Quan Zhang
Principal Author: Enid Slack
English Editors: Eric Orina and Cilla Ng
Design and Layout: Andrew Ondoo
ii
Table of Contents
chapter 1 Definition of Municipal Finance and Objectives of the Guide 1

Definition of Municipal Finance 1
Objectives of the guide 1
Outline of the guide 2
chapter 2 Municipal Finance Issues, Challenges, and Trends 3
State of Municipal Finances 3
Issues and challenges 10
Recent trends in Municipal Finance 14
chapter 3 Principles of Municipal Finance 17
Role of local government in the economy 17
Major functions of municipal governments 18
The benefit model of local government finance 18
Public finance principles 19
Chapter 4 Municipal Revenues 21
Sources of municipal revenue 21
Characteristics of a good local tax 22
Taxes 23
User fees 33
Intergovernmental transfers 35
Types of transfers 35
Rationale for transfers 36
Design of transfers 38
Problems with transfers 38
Implementation and management of municipal revenues 40
chapter 5 Financing Capital Expenditures 41
Funds from operating revenues 41
Intergovernmental transfers 42
Mobilizing private capital 42
Municipal borrowing 43
Public-private partnerships 44
Development charges 45
Tax increment financing 50
Land value capture taxes 54
iii
chapter 6 Municipal Budget, Financial Reporting and Auditing 56
Expenditures at the local level 56
Municipal budgeting 56
Accounting standards 61
Accounting concepts 62
Auditing 63
Performance-based measurement 63
chapter 7 Municipal Borrowing and Access to the Capital Market 65
Role of municipal borrowing 65
Capital markets 66
Pooling municipal debt 66
Borrowing instruments 67
Credit ratings 68
chapter 8 Concluding Comments 71
REFERENCES 78
appendix 78
iv
LIST OF TABLES ,FIGURES AND boxes
Tables
Table 1 Distribution of Municipal Expenditures, Selected OECD Countries, 2006 (%) 4
Table 2 Distribution of Municipal Expenditures, Selected Countries in
Central and Eastern Europe, Asia, Africa, and Latin America, 2006 (%) 5
Table 3 Distribution of Municipal Revenues, Selected OECD Countries, 2006 (%) 6
Table 4 Distribution of Municipal Revenues, Selected Countries in
Central and Eastern Europe, Asia, Africa, and Latin America, 2006 (%) 7
Table 5 Local Government Expenditures as a Percentage of GDP
and Total Government Expenditures 9
Table 6 Urban Population by Major Area, Selected Periods, 1950-2050 10
Table 7 Percentage Urban by Major Area, Selected Periods, 1950-2050 11
Table 8 Sources of Municipal Operating Revenues for Selected Cities 22
Table 9 Base for Property Taxes 27
Table 10 Types of Intergovernmental Fiscal Transfers 36
Table 11 Development Charges, Greater Toronto Area, 2007 49
Table 12 The Steps in the Capital Budget 58
Figures
Figure 1 Public Debt, Spending and Investments – the Role of Local Governments (2000) 15
Figure 2 Different Financing Tools for Different Services 18
Figure 3 Calculating the Tax Increment 53
Figure 4 Steps in the Budgetary Process 59
Boxes
Box 1 Public Finance Principles 20
Box 2 Characteristics of a Good Local Tax 22
Box 3 How Property Tax Capitalization Works 23
Box 4 Road Pricing in Singapore 34
Box 5 Public Finance Principles for Designing Fiscal Transfers 39
Box 6 Types of Public-Private Partnerships 44
Box 7 Calculating Development Charges 47
Box 8 Implementation of Tax Increment Financing 50
Box 9 Steps for Tax Increment Financing 52
Box 10 Citizen Involvement Participatory Budgeting in Porto Alegre 60
Box 11 Municipal Finance and Management Initiative in Ghana 67
Box 12 Illustration of a Tax-Free Bond 67
v
ABBREVIATIONS AND ACRONYMS
CBD Central Business District

ERPS Electronic Road Pricing System
GDP Gross Domestic Product
IMF International Monetary Fund
IPSAS International Public Sector Accounting Standards
IU In-vehicle unit
GAAPs Generally Accepted Accounting Principles
MDGs Millennium Development Goals
OECD Organisation for Economic Co-operation and Development
PAYG Pay-as-you-go
P3s Public-Private Partnerships
TIF Tax Increment Financing
VAT Value added tax
vi
FOREWORD
The global housing And for this, we need innovative governance,

crisis, especially in and local thinking and reporting if we are
the developing world, to bring hope to the urban poor. Equally
is getting worse by importantly, we need to support our towns
the day making the and cities, indeed our countries, to adopt pro-
right to adequate poor policies and strategies that will obviate
shelter a quest that is the need for further slum creation.
becoming more and
more difficult to meet, It is against this background, that the Human
despite the targets set Settlements Financing Tools and Best
by the Millennium Development Goals. Practices series focuses on the development
of know-how, knowledge and tools in human
Such is the rate of urbanization – the influx of settlements financing, from which Member
people into towns and cities, and their natural States can learn in delivering affordable
growth – that the world has now reached a housing to the poor.
point where for the first time now, half the
global population lives in towns and cities.
By the year 2050, six billion people – two-

thirds of humanity – will be living in towns
and cities. And as urban centres grow, the locus
of global poverty is moving into towns and
cities, especially into the burgeoning informal
settlements and slums, of the developing world.
In the developing world, this is happening so
fast that slums are mushrooming in what is
termed the urbanization of poverty.
This makes it imperative that we use every

means at our disposal to ensure that we at UN-
HABITAT, and our partners, keep applying Anna Tibaijuka,
ourselves to Target 11 of the Goals – to achieve Executive Director, UN-HABITAT
significant improvement in the lives of at least Under-Secretary-General of
100 million slum dwellers, by 2020. the United Nations,
vii
viii
Definition of Municipal Finance
and Objectives of the Guide
CHAPTER 1
Definition of Municipal Finance and

Objectives of the Guide
Interest in cities around the world is on the rise, OBJECTIVES OF THE GUIDE
in large part, because more and more people
The objective of this Guide to Municipal
are living in cities in both developed and less
Finance is to introduce government officials,
developed countries. The rapid increase in the
policy makers, professional practitioners, civil
urban population has put pressure on local
society, and academics in UN member states
governments to provide a range of services
to the current issues in municipal finance
from water and sewer infrastructure to social
in countries around the world. The Guide
services and housing. To meet the rising
emphasizes the important role that municipal
demands of urbanization, municipalities need
finance plays in local service delivery,
adequate revenue tools to pay for services and
particularly in the context of globalization,
infrastructure.
decentralization, and a focus on sustainable
development. It highlights some of the new
DEFINITION OF MUNICIPAL FINANCE trends in financing services that are being
used in different countries around the world
Municipal finance is about the revenue such as increased reliance on the private
and expenditure decisions of municipal sector to invest in infrastructure and services.
governments. It covers the sources of revenue Finally, an important objective of the Guide
that are used by municipal governments – is to provide policy makers with some basic
taxes (property, income, sales, excise taxes), economic tools and a framework for analyzing
user fees, and intergovernmental transfers. public finance issues and evaluating different
It includes ways of financing infrastructure ways of financing both operating and capital
through the use of operating revenues and expenditures at the local level.
borrowing as well as charges on developers and
public-private partnerships. Municipal finance Given the length of the Guide, it is not
also addresses issues around expenditures possible to delve into all topics in depth and
at the local level and the accountability for some topics, such as the governance of cities
expenditure and revenue decisions, including and metropolitan areas, are not included at
the municipal budgetary process and financial all. It is also only possible to provide examples
management. of municipal finance techniques from a few
selected countries. For this reason, references
are provided throughout the Guide for those
who seek more information on specific topics
or specific countries.
1
Guide to
Municipal Finance
OUTLINE OF THE GUIDE Finally, because local governments in many

countries, particularly transition and developing
The Guide has eight chapters. Chapter 1 gives
economies, rely heavily on intergovernmental
a definition of municipal finance and sets out
transfers, Chapter 4 devotes a fair bit of time
the objectives of the Guide. Chapter 2 provides
to issues around the rationale and design of
some background on the state of municipal
transfers. Overall, the chapter stresses the
finance with reference to expenditures and
importance of local governments raising their
revenues at the local level in a number of
own revenues as much as possible to ensure
countries around the world. Although it
efficient service delivery and accountability to
is difficult to find global statistics on local
citizens.
government revenues and expenditures,
some information from the IMF Government Chapter 5 looks at financing capital
Finance Statistics gives an indication of the wide expenditures. Local governments often use
variation in local government expenditures operating revenues for capital purposes and,
and revenues around the world. The chapter in some countries, borrow to meet capital
also sets out the issues and challenges that requirements. More recent trends show some
cities face and some of the recent trends that local governments turning to the private sector
are emerging in municipal finance. for funds through charges on developers,
public-private partnerships, and land value
Chapter 3 provides the theoretical framework
capture taxes such as tax increment financing
for discussing issues in municipal finance
in the United States and land value increment
by starting with a description of the role of
taxes in parts of Latin America.
local government in the economy and the
benefit model of public finance. The benefit Chapter 6 turns to the expenditure side of the
model states that, as much as possible, local budget and looks at municipal budgeting. It
government services should be paid for on emphasizes the importance of the municipal
the basis of the benefits received from those budgetary process for accountability and
services. The last part of the chapter sets out highlights the participatory budgeting process
a series of public finance principles to design used in many Latin American countries.
municipal finance tools.
Chapter 7 focuses on municipal borrowing
Chapters 4 and 5 turn to ways local and access to the capital market. It stresses
governments pay for services – Chapter the important role that borrowing can play
4 is concerned with financing operating in financing capital expenditures at the local
expenditures; Chapter 5 deals with financing level while noting that municipal borrowing
capital investment. Chapter 4 provides an is restricted in many countries. It describes
extensive discussion of taxes – property, different borrowing instruments and stresses
income, payroll, consumption, and excise the importance of credit ratings for local
taxes. The focus of this part of the chapter is government borrowing.
on the property tax because of its widespread
use around the world and its appropriateness Finally, chapter 8 provides a brief summary of
as a local government tax. From an efficiency the issues of municipal finance and how they
point of view, user fees are an important have been addressed around the world. It also
source of revenue for local governments and provides some concluding comments on the
are discussed in Chapter 4. important principles to follow in municipal
finance.
2
Municipal Finance Issues,
Challenges, and Trends
CHAPTER 2

Local governments make expenditures on a It is difficult to draw conclusions from the

variety of services including transportation, information on expenditures in Tables 1
policing, fire protection, water and sewers, and 2. There appears to be wide variation
garbage collection and disposal, housing, in the expenditure responsibilities of local
health, recreation and culture, education, and governments around the world. For example,
social expenditures. They fund these services education expenditures represent a large
and the infrastructure associated with them proportion of expenditures at the local level in
from a variety of sources. This chapter looks most central and eastern European countries
at the state of municipal finances in selected in the tables but the proportion varies among
countries and identifies issues, challenges, and OECD countries. Expenditures on social
trends. protection account for a large proportion of
expenditures in Nordic countries but appear to
be less important in the other countries in the
STATE OF MUNICIPAL FINANCES tables. Housing expenditures as a proportion
Comparative statistics on local government of total local government expenditures are,
expenditures and revenues around the world on average, larger in central and eastern
are difficult to find. Tables 1 to 4 provide European countries than in other countries in
some information for selected countries from the tables.
the IMF Government Finance Statistics, which
is the only source that provides a breakdown
of local government finance information for
both developed and less developed countries.
The countries in these tables were chosen from
the countries in the IMF statistics because
they were the only ones for which information
was available on a disaggregated basis for
local government expenditures and revenues.
For most of the countries in these tables, the
data are for 2006 but for some countries, the
information is for earlier years. The years other
than 2006 are listed in the notes to the tables.
3
4
Table 1: Distribution of Municipal Expenditures, Selected OECD Countries, 2006 (%)
General Public Services Public Economic Total Environmental Housing & Health Recreation, Education Social Total
Guide to
Order, Affairs Protection community culture and protection expenditures.

Safety, amenities religion
Public debt Total Transport
Defense
transactions
Municipal Finance
Australia 1.6 24.4 2.6 21.5 26.7 9.5 13.7 1.2 15.7 0.4 5.8 100
Austria 0.5 16.9 2.1 n.a. 14.2 2.6 2.8 16.3 7.1 16.7 21.3 100
Canada 2.7 8.7 9.2 11.6 13.2 5.9 7.8 1.5 6.9 41.2 5.5 100
Czech Republic 0.7 14.5 1.8 18.9 21.4 7.3 9.1 2.2 7.5 27.5 8.7 100
Denmark 0.5 6.1 0.3 2.8 4.7 0.9 0.4 20.4 2.7 12.9 51.5 100
Finland 0.6 14 2.1 4.1 6.1 0.7 0.4 28.4 4.6 20.5 23.3 100
France 1.4 19.2 2.8 n.a. 13.1 6.9 15.2 0.6 10.2 16.2 15.8 100
Germany 3.2 17.4 5.4 n.a. 13.5 6.8 7.7 2.3 n.a. 7.2 39.7 100
Hungary 0.5 19.3 1.2 n.a. 5.7 3.9 6.9 15.4 4.8 29.9 12.8 100
Iceland 3.1 10 0.9 11 11.7 2.4 4.5 0.8 17.3 37.2 15 100
Ireland 0.9 11.4 3.2 n.a. 23.8 8.7 22.7 0 4.1 20.7 5.4 100
Italy 1.6 14.6 1.5 n.a. 14.8 4.6 4.7 43.9 3 8.3 4.5 100
Luxembourg 1.3 20.9 1.7 n.a. 15.9 12.1 7.6 0.3 13.1 24.6 3.9 100
New Zealand 2.9 18.3 0.5 29.7 35 21.3 7.3 0 12.1 0 5.5 100
Norway 2.7 10.7 1 4.9 6.5 3.6 4.2 15.2 4.8 28.4 25.6 100
Poland 0.8 9.4 1.8 13 14.8 4 5.6 15.3 5.2 29.6 14.2 100
Slovak Republic 0.7 17.5 1 11.3 15.9 6.2 9.9 0.3 7.1 35.4 6.6 100
Spain 1.3 33.4 7.8 9.8 14.5 10 9.6 1.2 10.9 4.5 8.1 100
Switzerland 3.3 14.3 5.2 7.3 8.7 5.3 2.5 20.5 5.6 21.7 16.2 100
Notes: Sub-categories of general public services include public debt transactions and general transfers between levels of government. Sub-categories of economic affairs include agriculture,
forestry, fishing, and hunting; fuel and energy; mining, manufacturing and construction; transport; and communications. Sub-categories of health include outpatient services, hospital services, and
public health services. Public debt transactions include interest payments and outlays for underwriting and floating government loans. Sub-categories of education include pre-primary and primary
education; secondary education; and tertiary education.
Information for Canada, Czech Republic, Denmark, New Zealand, Norway, and Slovak Republic are preliminary estimates for 2006. Information for France, Hungary, Ireland, Italy, and Switzerland are
for 2005. Information for Finland and Spain are preliminary estimates for 2005.
Source: International Monetary Fund, Government Finance Statistics, Yearbook, 2007, Table 7 and IMF Statistics Department, Government Finance Statistics Manual, 2001.
Table 2: Distribution of Municipal Expenditures, Selected Countries in Central and Eastern Europe, Asia,
Africa, and Latin America, 2006 (%)
General Public Public Order, Economic Affairs Environmental Housing & Health Recreation, Education Social Total
Services Safety, Defense Protection community culture and protection expenditures.
amenities religion
Public debt Total Transport Total
transactions
Central and Eastern Europe:
Belarus 0.2 7.1 2 5.2 13.3 0 16.8 21.3 5.1 28.5 5.9 100
Bulgaria 0.3 11.5 3.1 9.5 12.1 -6.7 26.3 4.7 5.3 35.7 8 100
Croatia 0.5 16.8 2.6 9.8 13.4 3.5 18.6 4.6 13.2 20.1 7.2 100
Georgia 0.6 9.2 2.1 0.1 -0.3 0 59.7 2.7 8.9 8.7 9 100
Kazakhstan 0.1 16.6 3.9 7.7 12.9 0.4 13.5 18.6 4.4 26 3.8 100
Kyrgyz 0 13.3 1.9 0.6 1.7 0 10.6 5.2 4.3 58.4 4.7 100
Republic
Latvia 0.8 13.5 1.4 7.5 8.1 n.a. 14.6 2.8 7.8 44.1 7.8 100
Lithuania 0.2 5 0.7 1.8 7.1 2.3 5.9 21.9 5.4 40.5 11.2 100
Moldova 0.5 12.7 3.1 2.8 9.6 0 17.7 1.7 5.1 45.9 4.1 100
Romania 0.4 10.7 1 14.6 16.7 2.8 18.9 0.7 5.6 30.9 12.8 100
Russian Fed. 0.4 10.7 1.7 2.7 3.4 0.2 19 14.1 4.2 38 8.7 100
Slovenia 0.1 9.5 1.4 8.4 13.2 4.5 5.1 11.8 8 42.5 4 100
Ukraine 0.4 9.9 0.2 4 10.6 0.6 10.3 20.9 4 28.7 14.9 100
Asia, Africa and Latin America:
China, PR 0.1 21.3 6.0 1.3 39.7 4.4 0.4 3.4 1.6 12.4 10.8 100
Kenya 0.2 32.7 0.0 9.4 45.6 0.0 6.3 6.6 0.0 6.7 2.1 100
Mauritius 0.2 30.9 0 22.4 30.2 0 17.7 1.7 5.1 45.9 10.2 100
South Africa 0 4.9 0.7 4.5 7.1 0.5 3.1 20.8 0.9 34.9 27 100
Uganda 0 24.4 0.8 n.a. 10.8 0.4 3.2 14.1 0.3 44.6 1.3 100
Bolivia 2.1 12.9 1 14.5 21.5 7.3 20.4 11.5 6.9 16.3 2.1 100
5
Notes and Sources: See Table 1. Also, information for Uganda is preliminary for 2006. Information for Romania, China, and Kenya is for 2005. Information for
South Africa is for 2004.
6
Table 3: Distribution of Municipal Revenues, Selected OECD Countries, 2006 (%)
Guide to
Taxes Social Grants Other Total

contributions revenue revenues
Individual Corporate Payroll Property Goods and Excise Other Total taxes
income income services
Australia 0 0 0 38.6 0 0 0 38.6 0 13.5 47.9 100
Municipal Finance
Austria 14.6 3.7 10.3 5.5 12.1 4.4 4.8 55.3 4.6 13.9 26.2 100
Canada 0 0 0 37.8 0 0 2.1 39.9 0 41.8 18.3 100
Czech Republic 13.2 13.5 0 1.4 18.8 0 1.3 48.2 0 39.9 11.9 100
Denmark 46.4 1.1 0 3.4 0 0 0 50.9 1.6 39.1 8.4 100
Finland 40.8 3.8 0 2.4 0 0 0 47.1 0.1 28.6 24.2 100
France 0 0 3.1 33.7 0 3.7 4.1 44.6 0.2 29.1 26.1 100
Germany 15.8 0.2 0 5.4 1.8 0 18.8 42 1.3 33.8 23 100
Hungary 15.8 0 0 4.5 13.1 0 2 35.5 0.2 48.4 15.9 100
Iceland 53.1 0 0 10.5 0 0 9.4 72.9 0 8.8 18.3 100
Ireland 0 0 0 9.4 0 0 0 9.4 3.5 59.6 27.6 100
Italy 7.9 0.7 0 5.7 2.2 2.7 25.3 44.5 0.6 43.4 11.5 100
Luxembourg 0 28.6 0 2.2 0 0 0.7 31.4 0.2 46.6 21.7 100
New Zealand 0 0 0 54.5 0 0.5 0 55 0 11.2 33.8 100
Norway 40.1 0 0 4.1 0 0 0.9 45.1 0 36.1 18.8 100
Poland 14.7 4.3 0 9.4 0 0 3.9 32.5 0 50.6 16.9 100
Slovak Republic 38.5 0 0 6.4 0 0 6.8 51.8 0.6 35.1 12.6 100
Spain 7.5 2.3 0 16 13.3 3.1 10 52.2 0.5 34.5 12.8 100
Switzerland 33.8 5.2 0 7.1 0 0 0.1 46.3 0 16.3 37.4 100
Notes: Social contributions are actual or imputed receipts from either employers on behalf of their employees or from employees, self-employed, or non-employed persons on their own behalf that
secure entitlement to social benefits for the contributors, their dependents, or their survivors. The contributions may be compulsory or voluntary. Grants are noncompulsory transfers received by
government units from other government units or international organizations. Grants may be classified as capital or current and can be received in cash or in kind.
Information for Canada, Czech Republic, Denmark, Finland, Ireland, New Zealand, Norway, and Slovak Republic are preliminary for 2006. Information for Spain is for 2004 and for Switzerland 2005.
Source: International Monetary Fund, Government Finance Statistics, Yearbook, 2007, Table 1 and IMF Statistics Department, Government Finance Statistics Manual, 2001.
Table 4: Distribution of Municipal Revenues, Selected Countries in Central and Eastern Europe,
Asia, Africa, and Latin America, 2006 (%)
Taxes Social Grants Other Total
contributions revenue revenues
Individual Corporate Payroll Property Goods and Excise Other Total taxes
income income services
Belarus 17.9 10.5 0 9.2 21.4 1.1 7.2 67.3 0 30.2 2.5 100
Bulgaria 0 0 0 20.1 0 0 0.1 20.3 0 69.9 9.9 100
Croatia 39.5 15.5 0 3.5 0.4 0 2.3 61.2 0 12.3 26.5 100
Georgia 50 2.1 0 11.1 0 0 3.7 66.9 0 28 5 100
Kazakhstan 17.2 0 24.6 5.9 0 3.3 5.3 56.3 0 43 0.6 100
Kyrgyz Republic 9.2 7.5 0 7.8 11.1 2.4 1.7 39.8 0 45.8 14.4 100
Latvia 48.4 0 0 6.5 0 0 0.8 55.6 0 31.3 13.1 100
Lithuania 30.2 0 0 4.1 0 0 0.9 35.3 0 57.9 6.8 100
Moldova 23.4 13.8 0 4.9 0.8 0.1 4.9 47.9 0 45.2 6.9 100
Romania 38.6 0.2 0 7.8 31.4 0 3.7 81.7 0 8.4 10 100
Russian 19.2 4.2 0 3.6 0 0 3.7 30.7 0 58.2 11.1 100
Federation
Slovenia 24 0 0 7.2 0 0 2.8 34.1 0 47.5 18.5 100
Ukraine 32.9 1.4 0.2 2.3 0 0.1 5 41.8 0 47.9 10.3 100
China, PR 2 5 0 2.4 18.4 0 2.2 30 13.3 28.9 27.9 100
Kenya 0 0 0 15.6 0 0 5.9 21.4 0 32.8 45.8 100
Mauritius 0 0 0 11.9 0 0 13.9 25.8 0 67.1 7.2 100
South Africa 0 0 0 16.8 0 0 2.8 19.7 0 24.9 55.4 100
Uganda 1.2 0 0 2.8 0 0 0.9 4.9 0 91.3 3.8 100
Bolivia 0 8.2 0 18.6 18 24.5 3.1 72.3 0 17.6 10 100
Notes and Sources: See Table 3. Information for South Africa and Uganda are preliminary for 2006.
7
Information for China and Kenya is for 2005. Information for Romania is for 2004.
Guide to
Municipal Finance
Tables 3 and 4 provide a breakdown of local One of the reasons for differences in
government revenues in selected countries. As expenditures and revenues at the local level
with expenditures, the dependence on various around the world is that the importance of local
revenue sources is different from country to government overall varies. Table 5 shows local
country. Property taxes, for example, are levied government expenditures both as a percentage
by local governments in all of the countries in of Gross Domestic Product (GDP) and as a
the tables but only provide a significant source percentage of total government expenditures
of local revenue in Australia, Canada, New (including all levels of government) for most
Zealand, and France. Property taxes are also of the countries in Tables 1 to 4. Table 5 shows
an important source of revenue in the United that local government expenditures account
Kingdom which is not included in these tables. for a significant portion of GDP and of
Income taxes are more important at the local total government expenditures in the Nordic
government level in Nordic countries where countries (especially in Denmark and Finland
social expenditures are also significant at the and to a somewhat lesser extent in Norway and
local level. For all local taxes, the extent to Iceland). Local governments are also significant
which local governments have the autonomy in some central European countries (such as
to set their own taxes is not clear from these Kazakhstan and Ukraine) and in China. Local
tables but, in many countries, local tax rate governments account for a very small portion
setting does not exist or is limited. of GDP and total expenditures in Australia
where the state governments perform many
Dependence on intergovernmental transfers by local functions. It is also very small in Kenya.
local governments is widespread but the extent
of that dependence varies in the different
countries. For example, government transfers
are still the most significant revenue source for
local governments in many countries but they
have been decreasing in many North American
and European jurisdictions. Finally, the
components of the “other revenues” category
are not set out but likely include user fees,
fines, and other miscellaneous local revenues.
These revenues appear to be less significant
in central and eastern Europe than in other
countries.
8
Table 5: Local Government Expenditures as a Percentage of GDP

and Total Government Expenditures
Local government Local government expenditures
expenditures as % of GDP as % of total government
expenditures
Selected OECD Countries:
Australia 2.4 6.7
Austria 7.9 15.9
Canada 7.3 18.5
Czech Republic 11.9 27
Denmark 32.9 62
Finland 19.7 39.3
France 11 20.4
Germany 7.3 15.6
Hungary 12.8 25.7
Iceland 13.2 30
Ireland 6.7 19.8
Italy 15.4 32
Luxembourg 5.4 12.5
New Zealand 4.1 10.8
Norway 13.1 30.7
Poland 13.2 30.4
Slovak Republic 6.8 18.2
Spain 5.9 15.5
Switzerland 9.9 25.9
Belarus n.a. n.a.
Bulgaria 5.9 15
Croatia n.a. n.a.
Georgia 6.3 28
Kazakhstan 10.6 40.4
Kyrgyz Republic n.a. n.a.
Latvia 9.5 26.3
Lithuania 8.3 24.2
Moldova n.a. n.a.
Romania 7.1 21
Russian Federation 6.3 19.8
Slovenia 9 19
Ukraine 12.6 37.8
China, PR 13.7 74.6
Kenya 0.06 1.3
Mauritius n.a. n.a.
South Africa 5.1 16.9
Uganda n.a. n.a.
Bolivia 11.3 26.6
Source: United Cities and Local Governments, Local Governments in the World, 9
Basic Facts on 82 Selected Countries, 2007 Edition prepared CGLU and DEXIA.
Guide to
Municipal Finance
Table 6: Urban Population by Major Area, Selected Periods, 1950-2050

Urban Population (millions) Annual average rate of change (%)
1950 1975 2007 2025 2050 1950-975 1975-2007 2007-2025 2025-2050
Africa 33 107 373 658 1,234 4.76 3.9 3.15 2.52
Asia 237 574 1,645 2,440 3,486 3.54 3.29 2.19 1.43
Europe 281 444 528 545 557 1.84 0.54 0.18 0.08
Latin America & 69 198 448 575 683 4.21 2.55 1.38 0.69
the Caribbean
North America 110 180 275 337 401 1.98 1.33 1.11 0.7
Oceania 8 15 24 30 37 2.6 1.44 1.17 0.89
World 738 1,518 3.293 4,585 6,398 2.89 2.42 1.84 1.33
Source: United Nations, Department of Economic and Social Affairs, Population Division (2008) World Urbanization
Prospects: The 2007 Revision, Executive Summary, New York: United Nations, p. 3 and 5.
ISSUES AND CHALLENGES Table 6 shows the urban population by major

area for selected years from 1950 and the
The challenge for local governments is to keep
average annual rate of change. Table 7 shows
cities economically viable by delivering a high
the percentage urban population by major
level of services and, at the same time, keeping
areas for selected periods from 1950 to 2050
taxes sufficiently low so as not to discourage
and the rate of urbanization. These tables
individuals and businesses from locating in
show that, historically, the process of rapid
their jurisdiction. Over the past two decades,
urbanization occurred in the more developed
local governments have faced a number of
countries. Over the next 40 years, however,
issues and challenges that have put stress on
the level of urbanization is expected to increase
their ability to meet this objective.
in all major areas of the developing world. In
particular, the urban population is expected to
Rapid Urbanization triple in Africa and double in Asia.
The urban population has been increasing

rapidly and is expected to continue to do so
over the next 40 years. The urban population
in the more developed regions of the world
is projected to reach 1.07 billion (or 86
percent of the total population) in 2050; the
urban population in less developed regions is
projected to increase to 5.3 billion people (or
67 percent of the total population) in 2050
(United Nations, 2008a). Overall, the urban
population is expected to be 70 percent of the
world population in 2050.
10
Table 7: Percentage Urban by Major Area, Selected Periods, 1950-2050

Percentage urban Rate of urbanization (%)
1950 1975 2007 2025 2050 1950-1975 1975-2007 2007- 2025-2050
2025
Africa 14.5 25.7 38.7 47.2 61.8 2.28 1.28 1.1 1.08
Asia 16.8 24 40.8 51.1 66.2 1.42 1.66 1.24 1.04
Europe 51.2 65.7 72.2 76.2 83.8 1 0.29 0.3 0.38
Latin America 41.4 61.1 78.3 83.5 88.7 1.56 0.78 0.36 0.24
& the
Caribbean
North 63.9 73.8 81.3 85.7 90.2 0.58 0.3 0.29 0.2
America
Oceania 62 71.5 70.5 71.9 76.4 0.57 -0.05 0.11 0.24
World 29.1 37.3 49.4 57.2 69.6 0.99 0.88 0.82 0.59
Source: United Nations, Department of Economic and Social Affairs, Population Division (2008) World
Urbanization Prospects: The 2007 Revision, Executive Summary, New York: United Nations, pp. 4 and 5.
The growth of the urban population has Challenges for Large

created and will continue to create serious Metropolitan Areas
challenges for municipal governments in both Not only is the world experiencing rapid
developed and less developed countries in urbanization but the number of mega-cities
terms of air and water pollution, transportation (cities with more than 10 million people) is
gridlock, shortage of affordable housing, also on the rise. Whereas in 1950, there were
inadequate waste collection, deteriorating only two mega-cities (New York and Tokyo),
infrastructure, mounting violence and crime, there were 20 mega-cities in 2005 and the
and income polarization. Local governments number is projected to increase to 22 by 2015.
are required to provide transportation and Developing countries will have 17 of the 22
communications networks, water and sewers, mega-cities in 2015 (United Nations, 2008a).
fire and police protection, parks, recreational
facilities, cultural institutions, social services, Large cities and metropolitan areas are
social housing, and public health. These different than smaller urban or rural
services and infrastructure are, in many cases, municipalities, in large part, because of the
already over-stretched and rapid population size of their population, the high degree
growth, combined with limited funding of concentration of population, and the
for infrastructure, has put further strain presence of a heterogeneous population in
on local governments to maintain existing terms of social and economic circumstances
services and meet future demands. The result (Freire, 2001). In many countries, large cities
is an infrastructure deficit that is large and also serve as regional hubs for people from
growing. neighbouring communities who come to shop
or to use public services that are not available
in their own communities (Slack, 2007a).
For example, Rio de Janeiro is surrounded
by heavily populated municipalities that
house most of the low income families in the
metropolitan area.
11
Guide to
Municipal Finance
The population outside of the city uses The “knowledge workers” who increasingly
services in the city that are not available in hold the key to economic success are attracted
the periphery with resulting impacts on water by such quality of life factors as diversity,
pollution, traffic, crowding of hospitals and tolerance, a lively arts scene, recreational
public schools, and crime rates (Rezende, opportunities, high quality public schools,
1998). strong neighbourhoods, and safety from crime
(Florida, 2002).
From a municipal finance perspective,
the unique characteristics of large cities Globalization also affects the ability of local
and metropolitan areas are reflected in the governments to raise revenues. The taxation
magnitude and complexity of the expenditures of non-residential properties, for example,
that local governments in those areas are is affected by the mobility of industries in
required to make on municipal services. These a globalized environment. Businesses are
characteristics are also reflected in their ability more mobile in this context and respond
to pay for services. Generally, large cities and to differential property taxes in different
metropolitan areas have greater fiscal capacity locations (Kitchen and Slack, 1993). Local
than smaller municipalities and rural areas, governments have to be aware of the impact
both in terms of greater responsibility for local of their tax policies on businesses. Cities also
services and greater ability to levy their own have to manage their finances responsibly to
taxes and collect their own revenues. attract private investors and to access capital
markets (Serageldin et al., 2008).
Rarely are large cities treated differently,
however, in terms of their taxing authority or
the intergovernmental transfers they receive. Millennium Development Goals
One possible exception is the German structure,
In 2000, leaders from 189 countries set out
which distinguishes among governments of
a vision in the UN Millennium Declaration
different sizes giving broader responsibilities to
to eradicate poverty and increase the welfare
“city-states” (Berlin, Bremen, and Hamburg)
of the world’s poorest by 2015. To provide a
and allowing other large municipalities to
framework to measure progress towards this
assume responsibilities of counties.
vision, they established eight goals, 18 targets,
and 48 indicators. The UN Millennium
Globalization Development Goals (MDGs) include:
eradicate extreme poverty and hunger; achieve
Globalization is another challenge facing universal primary education; promote gender
municipalities. To be globally competitive, cities equality and empower women; reduce child
need to provide the supportive infrastructure mortality; improve maternal health; combat
to attract business and they need to provide HIV/AIDS, malaria, and other diseases; ensure
a wide range of services: transportation, environmental sustainability; and develop a
water, sewers, garbage collection and disposal, global partnership for development (United
police and fire protection, parks, recreation Nations, 2008).
and culture, affordable housing, and social
assistance. Cities must also provide services
to attract and retain highly trained human
capital.
12
The challenge of achieving these goals Inadequate Revenues to Meet

is placing an increased burden on local Expenditure Needs
governments, in particular, because they are The amount of funding available to local
the level of government that is responsible governments is an important determinant of
for delivering basic services such as water and the quantity and quality of services that they
sanitation, housing, primary health care, and will be able to provide. Where locally raised
education. In order to deliver these services, revenues are limited, urban government
local governments need adequate resources, expenditures suffer (Bahl and Linn, 1992).
local autonomy, and increased capacity (Dirie, Over the last twenty years, a number of
2005: 4). countries have increased the powers and
responsibilities of local governments but they
Costs of Urban Sprawl have not matched those responsibilities with
revenues at the local level: “few countries
Along with rapid urbanization, many permit local governments to levy taxes
municipalities face the mounting costs of capable of yielding sufficient revenue to meet
urban sprawl which is generally characterized expanding local needs” (Bird, 2000: 114).
by relatively low density, development that
“expands in an unlimited and non-contiguous In short, revenues at the municipal level have
(leapfrog) way outward from a solidly built- not kept pace with the increased expenditure
up core of a metropolitan area” (TCRP, 1998: requirements (Montgomery et al., 2003;
6). Sprawl consumes exurban agricultural OECD, 2006). Not only do local governments
lands as well as environmentally sensitive depend heavily on intergovernmental transfers,
areas. Uncontrolled growth (or urban sprawl) their own revenue sources are inadequate.
threatens the sustainability of both local In most countries, municipal own-source
economies and the environment. revenues are generally based on property taxes
and user fees and not the more lucrative taxes
Sprawl is the result of land use policies and such as income, sales, and fuel taxes. In many
financing decisions that have provided countries, intergovernmental transfers are not
incentives for low-density developments reliable.
outside the urban core, such as over-
investment in highways and road transport Local governments in less developed countries
in North American cities and the lack of face even greater challenges when it comes
urban facilities in the peripheral areas in many to raising revenues (Dirie, 2005). First, the
Latin American countries, for example (Stren, local government revenue base is often weak,
2001). Urban sprawl significantly increases especially when compared to the revenue base
the cost of services, in particular the cost of of the central government. Second, they have
infrastructure: “when neighbourhoods are few own-source revenues, lack incentives to
spread out at low density, they require more generate their own revenues, and do not use
water, sewer pipes, power lines, and roads” the existing revenue potential from these
(O’Meara, 2001: 346). sources. For example, property taxes are
difficult to administer and collect (Bird and
The financing tools used to pay for growth Slack, 2004). Third, they often have little or
(for example, property taxes, user fees, and no control over the tax rates they can levy.
development charges) can provide incentives Fourth, central government transfers are
for sprawl. If these financing tools charge the not stable and predictable and the design of
same amount for services in all developments transfers is often not transparent.
regardless of the costs incurred, there is no
incentive to locate near existing services where
the costs would be lower (Slack, 2002).
13
Guide to
Municipal Finance
Fifth, most municipalities in developing Local investments as a percent of total public

countries are either not permitted to borrow or investments range from approximately 20
their borrowing is restricted by senior levels of percent in Greece to over 70 percent in Italy.
government. Each of these issues is discussed Local debt, on the other hand, is a much
further in the remainder of this Guide. smaller percentage of total debt in most
countries when compared to expenditures and
investment.
RECENT TRENDS IN MUNICIPAL
FINANCE In many countries, decentralization has meant
that national and provincial/state governments
Recent trends in municipal finance result, in have downloaded responsibilities onto local
part, from the need to find ways to pay for the governments. In some cases, the downloading
expenditures which local governments have to is part of an overall fiscal decentralization
make to meet local demands for services and whereby the central or provincial/state
infrastructure. In many cases, these trends government passes budgetary authority to local
relate to the financing of capital expenditures. governments to make taxing and spending
There are also some new trends in financial decisions. The intention is to provide services
management to address the demands for in a more efficient and effective manner but
accountability and transparency at the local often the taxing authority is not part of the
level. decentralization process. In other cases,
devolution has been a way for senior levels of
government to shift their debt burden onto
Fiscal Decentralization
municipalities by reducing their transfers and
An important trend in municipal finance directing responsibilities downward (Ebel and
is fiscal decentralization which has meant Vaillancourt, 2001).
the transfer of financial responsibility from
central governments to local governments The downloading of expenditure
forcing local governments to deliver and fund responsibilities to local governments without
an increasing number of services. Although adequate revenue sources (sometimes referred
many industrialized countries have a long to as “unfunded mandates”) compromises the
history of decentralization, it is much newer ability of local governments to provide services
in less developed countries. Since the 1980s, and puts pressure on municipal finances.
as many as 75 countries have implemented Regardless of the reasons for decentralization
decentralization policies as a means of ensuring or how much is decentralized to local
more efficient public service delivery and governments, the revenues under their direct
addressing poverty issues (Ingram and Hong, control rarely match their expenditures (Bird,
2007). 2001b). The exceptions are a few countries in
which local governments have few expenditure
Figure 1 shows the role of local government in responsibilities or in a few countries (such as
public debt, spending, and investments for 15 the Nordic countries) where local governments
Western European countries in 2000. Local have substantial access to large and elastic
expenditures as a percent of total government tax bases such as the income tax (Bird and
expenditures range from less than 5 percent in Vaillancourt, 1998).
Greece to almost 60 percent in Denmark.
14
Figure 1: Public Debt, Spending and Investments –

the Role of Local Governments (2000)
80%
70%
60%
50%
40%
30%
20%
10%
0%
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Sweden
United Kingdom
Local debt as % of the total public debt
Local expenditures as % of the total public expenditures
Local investments as % of the total public investments
Source: Dexia (2000) Local Finance in Eleven Countries of Central, Eastern and Baltic Europe (Paris) as reproduced
in Swianiewicz, P. (ed.) (2004) Local Government Borrowing Risks and Reward, A Report on Central and Eastern
Europe, Budapest: Open Society Institute, p. 17.
Emphasis on Land and Property Property tax is regarded as an important tool

Taxation for raising revenue at the local level. The tax is
As already noted in the discussion of revenue also often used to shape urban development
sources in Tables 3 and 4, almost all countries patterns and to foster rural land reform. Some
around the world rely, at least to some extent, countries, for example, are turning to land
on property taxes. Recently, many developing value capture taxes to pay for infrastructure
and transition countries have become more (such as tax increment financing in U.S.
interested in land and property taxes (Bird jurisdictions and valorization contributions
and Slack, 2007). China, for example, has in Latin American countries) and to capture
been considering the role of land and property revenues from increased land values arising
taxation in its rapidly growing urban areas from government actions that change land
(Bird, 2005). uses (for example, plusvalia or land value
increment taxes in Colombia).
15
Guide to
Municipal Finance
Land and property taxes thus have a role in Accountability in Budgeting

providing revenues and a role in affecting land
Democratic local governance has resulted
use (Slack, 2002). Property taxes are discussed
in increased demands for accountability
more fully in Chapter 4; land value capture
and transparency at the local level. In some
taxes are described in Chapter 5.
cases, increased accountability has meant
that municipalities are making the effort to
Public-Private Partnerships include the public in important decisions
on how revenues are raised and how funds
In many countries, municipalities have are spent. One example is participatory
turned to the private sector to deliver and budgeting, which began in Porto Alegre in
fund public sector services through explicit 1989 and has spread to other municipalities
public-private partnerships. The rationale for in Brazil and around the world. Bringing
private involvement in the delivery of local the public into budgetary decisions ensures
public services is to improve the efficiency that residents are represented in the decision-
and effectiveness of delivery. Municipalities making process and that municipal officials
also turn to the private sector, in some cases, are held to account for budget decisions (both
because they are not permitted to borrow in the previous year and in the coming year).
on the capital market or are not willing to It also increases transparency in the budgetary
borrow. An enhanced role for the private process. Participatory budgeting is discussed
sector has been most evident in areas such as in Chapter 6.
transportation, water supply, and solid waste
management.
Improved Financial Management
A principal advantage of public-private
partnerships is that they relieve municipalities Increased participation on the part of the
of the financial responsibility for up-front public, combined with limited resources at
capital costs (Tassonyi, 1997) and allow the local level, has increased pressure on local
them to build facilities without incurring governments for better municipal financial
municipal debt. The operation of facilities management. The imbalance between
and programs by private operators reduces expenditures and revenues at the local level
municipal operating expenditures and may makes it critically important that cities spend
enable additional revenue to be collected. the resources they have as efficiently and
Moreover, such operations permit the public effectively as possible (Bird, 2001b).
sector to draw on private sector expertise.
Reforms to existing management practices and
There are risks associated with public-private
the introduction of new financial reporting
partnerships, however, and these are discussed
techniques have resulted in improved
further in Chapter 5. The details of how such
accounting methods and budgeting processes.
arrangements are structured and how the
One example is the use of performance-based
risks are shared will determine whether or not
budgeting to evaluate how well resources
they will be successful from a public policy
are being used and the extent to which
perspective.
the municipality is meeting its objectives.
Performance indicators give some indication
of the outputs of local government services
(for example, how satisfied is the public).
Performance-based budgeting is discussed
more fully in Chapter 6 and Appendix 1.
16
Principles of Municipal Finance
CHAPTER 3
This chapter provides the theoretical framework According to the “subsidiarity principle”
that will be used to evaluate municipal financial (Barnett, 1997), the efficient provision of
tools in subsequent chapters. It begins with services requires that decision-making be
the appropriate role for local government in carried out by the level of government that
the economy, then describes the benefit model is closest to the individual citizen. As long as
of local government finance, and sets out some there are local differences in tastes and costs,
principles of municipal finance. there are clear efficiency gains from delivering
services at the local level. This principle goes
on to say that expenditure responsibilities
ROLE OF LOCAL GOVERNMENT IN THE should only be assigned to a higher level of
ECONOMY government if it can be demonstrated that it
can carry out the function more efficiently
In terms of economic theory, the major role
than the lower level. With few exceptions (such
assigned to local governments is to provide
as national defence and services that involve
goods and services within a particular
income redistribution), almost all public
geographic area to residents who are willing
services should be provided at the local or
to pay for them. Local governments should
regional level with local policy-makers making
not do stabilization policy because they do
decisions about what services to provide, how
not have access to monetary policy tools and
much to provide, and who should pay for
because capital and labour flow freely across
them.
local jurisdictions. They should also not
engage in redistribution because local efforts
to address income disparities will likely result
in the movement of high-income groups to
low-tax areas and low-income groups to high-
tax areas (Kneebone and McKenzie, 2003).
Although local governments do engage in
some redistribution through the act of taxing
and spending, redistribution should not be
the primary focus of what they do (Bird and
Slack, 1993).
17
Guide to
Municipal Finance
MAJOR FUNCTIONS OF MUNICIPAL The extent to which municipalities will be

GOVERNMENTS able to apply the benefits-received principle,
however, depends on the nature and
The functions of municipal governments differ characteristics of the services they provide.
among countries around the world but generally Figure 2 and the discussion which follows look
include transportation services (including at different types of municipal services and the
roads and transit), environmental services appropriate financing tools.
(including water, sewerage, and solid waste
collection and disposal), protection (including Services with Private Good
policing and fire protection), recreation and Characteristics
culture, planning and development, economic For services with private good characteristics
development, social services, housing, and (such as water, sewers, garbage collection and
health. Municipal governments in some disposal, transit, and recreation), user fees are
countries also deliver primary and secondary appropriate to fund at least some portion of
education; in some countries, education is the costs. In general, user fees are appropriate
delivered by school boards or by the province/ where there is a clear relationship between
state level of government. the fees charged and the benefits received, the
taxpayer has the choice about the extent to
which he or she uses the service, it is possible
THE BENEFIT MODEL OF LOCAL to collect the charge at a reasonable cost,
GOVERNMENT FINANCE and equity concerns can be addressed (for
Given this role of local government to provide example by lowering or waiving fees for low-
goods and services, the benefits-received income users). User fees can play an important
principle is the appropriate starting point for role in municipal finance by ensuring that
municipal finance (Bird, 1994). According to governments do what people want and are
the benefit model of local government finance, willing to pay for.
local government services, wherever possible,
should be paid for on the basis of the benefits
received from those services (Bird, 2001a).
Figure 2: Different Financing Tools for Different Services

Private Public Redistributive Spillovers
Water Police Social assist Roads/transit
Sewers Fire Social housing Culture
Garbage Local parks Social
Transit Street lights assistance
User Fees Property Tax Income Tax Transfers
18
Services with Public Good Services that Redistribute Income

Characteristics Services that redistribute income should be
Services with public good characteristics paid for by senior levels of government because
(for example, police and fire protection, they have a wider range of taxes than local
neighbourhood parks, local streets, and street governments and they generally have taxes
lighting) have collective benefits that are that are more closely related to ability to pay,
enjoyed by local residents but which cannot such as income taxes. Although the primary
easily be assigned to individual beneficiaries. role of local governments is to provide goods
These services are more difficult to charge for and services and not to redistribute income,
and require some form of local benefit-based however, many local governments do deliver
taxation such as the property tax. The property services that are redistributive in nature
tax allows individuals to express their demand (such as welfare assistance, health, and social
for services where benefits are consumed housing). User fees and benefit-based taxes
collectively. In this respect, the property tax such as the property tax are not appropriate
can be considered to be a generalized, or non- to fund these services. User fees defeat the
specific, user charge (Kneebone and McKenzie, purpose of redistribution and property taxes
2003). are more regressive than income taxes and thus
are not appropriate for financing redistributive
Services with Spillovers services. For these reasons, services that have a
There are other services where the benefits redistributive component should be funded
(or costs) spill over municipal boundaries but from local income taxes or from central and
where local provision is still desirable. Positive state/provincial revenues (which include
spillovers (externalities) occur if residents of income taxes).
neighbouring jurisdictions receive a service for
free or at less than the cost of providing the
service. For example, major roads constructed PUBLIC FINANCE PRINCIPLES
in one jurisdiction may be used by residents Following from the benefit model of local
of another jurisdiction without any charge to government finance, there are a number of
them. The result will be an under-allocation economics principles that can be used to design
of resources to that service because the or evaluate municipal finance tools. These
municipality providing the service would base principles are set out in Box 1. Achieving all
its expenditure decisions only on the benefits these principles at the same time is difficult.
captured within its jurisdiction. It would not For example, a tax system that is designed to
take account of the benefits to those outside the be equitable may not be simple to administer.
jurisdiction. One way to provide an incentive Local governments thus have to make choices
to the municipality to allocate more resources on which principles to apply based on their
to the service generating the externality is a priorities.
transfer from the provincial government.
19
Guide to
Municipal Finance
Box 1: Public Finance Principles

Economic efficiency is concerned with the allocation of resources to the production of goods and services
where society gets the largest possible bundle of goods and services. Economic efficiency is achieved
when the user fee or tax per unit of output of the service received equals the extra cost of the last unit
consumed (the marginal cost). The tax or fee indicates what consumers are willing to pay for the service
and the marginal cost measures the cost of resources used up in producing that service.
Fairness (equity) based on benefits-received is achieved when those who consume public services pay
for them, just as someone who benefits from a private good pays for it. Fairness based on ability to pay
suggests that those with similar ability should pay similar amounts in taxes and user charges (horizontal
equity) and those with different ability should pay different amounts (vertical equity).
Accountability means that taxes (charges) and expenditures should be designed in ways that are clear to
taxpayers so that policymakers can be made accountable to the taxpayers for the services they deliver and
the costs they incur. The more direct the relationship between the beneficiaries of a government service
and payment for that service and the less the complexity of the revenue system, the greater is the degree
of accountability.
Adequacy and Stability requires that revenues provide governments with sufficient funds to finance
services on a regular and continuing basis. Revenues should be stable and predictable so that
municipalities can budget and plan for future expenditures.
Autonomy means that municipal governments have autonomy and flexibility to set their own priorities.
To do this, they should minimize their dependence on revenues from other levels of government.
Ease and cost of administration means that the time and resources devoted to assess, collect, and account
for revenues should be minimized. Moreover, costs of compliance on the part of taxpayers should be
minimized.
20
Case Study of the Baan
Mankong (Secure Housing) Program
CHAPTER 4
Municipal Revenues
This chapter sets out the characteristics of a Table 8 illustrates the sources of municipal
good local tax and then discusses a number revenue for four cities – Cape Town (South
of taxes and user fees that have been or could Africa), Toronto (Canada), Madrid (Spain),
be used by local governments. Because the and Mumbai (India). As noted above, cities
property tax is levied by local governments generally rely on local taxes, intergovernmental
in many countries, there is an extensive transfers, and user fees for local services but
description and analysis of this tax. The the dependence on each varies across cities.
chapter also devotes considerable time to All four cities in Table 8 levy a property tax;
intergovernmental transfers because many in Cape Town and Toronto, the property
local governments rely to a great extent on tax is the only local tax.1 Mumbai levies an
these transfers. octroi (a tax on the entry of goods into a local
area for consumption, use, or sale). Madrid
levies a variety of local taxes (including a tax
SOURCES OF MUNICIPAL REVENUE on land value, vehicles, construction, and
The sources of revenue for municipal business). User charges (or service fees) are
governments vary across countries but levied by all four municipalities but are most
generally include taxes, user fees, and significant in Cape Town where they are levied
intergovernmental transfers. Other revenues for electricity, water, sewerage, and cleansing.
may include investment income, property Dependence on government grants also varies
sales, and licenses and permits, for example. In among municipalities.
terms of taxes, the property tax is levied by local
governments in many countries. Other local
taxes can include income taxes, general sales
taxes, and selective sales taxes (for example,
taxes on fuel, liquor, tobacco, hotel occupancy,
vehicle registration), and land transfer taxes
(or stamp duties). To meet capital expenditure
requirements, some municipalities charge
developers for growth-related capital costs. In
some countries, particularly in South America,
a land value capture tax is sometimes levied to
1 Starting in 2008, Toronto also levies a vehicle registration tax and
pay for infrastructure. a land transfer tax.
21
Guide to
Municipal Finance
Table 8: Sources of Municipal Operating Revenues for Selected Cities

Cape Town 2007-08 Toronto 2007 Madrid 2003 Mumbai 2007-08
% % % %
Property Taxes 25.4 41.5 12 19
Other Taxes 19 46
Services Charges 40.9 21.8 16 23
Government Grants 25.2 20.9 39 4
and Contributions
Other 8.5 15.8 14 8
Total 100 100 100 100
Notes: Madrid is the Municipality of Madrid and not the Community of Madrid. Other taxes in Madrid include
taxes on vehicles, land value, construction, and business. Other taxes in Mumbai include the octroi (a tax on the
entry of goods into a local area for consumption, use, or sale that has been abolished in most parts of India).
Source: Cape Town Budget: (http://www.capetown.gov.za/en/Budget/Documents/Draft_Budget-March_2008/
Budget%202008%202009.pdf); Toronto: Ontario Ministry of Municipal Affairs and Housing, Municipal Financial
Returns; Madrid: OECD Territorial Reviews: Madrid, Spain, 2007; Mumbai Budget (http://www.mcgm.gov.in/irj/
portalapps/com.mcgm.aaboutus_budgets/docs/E13.pdf)
CHARACTERISTICS OF Box 2: Characteristics of a

A GOOD LOCAL TAX Good Local Tax
The characteristics of a good local tax, as set 1. The tax base should be relatively
out by Bird (2001a) are listed in Box 2. immobile so that local governments
can vary the tax rates without losing a
To achieve the full range of desirable significant portion of the tax base.
characteristics set out above would require 2. The tax yield should be adequate to
that municipalities have access to a mix of meet local needs, increase over time as
taxes. Moreover, a mix of taxes would give expenditures increase, and be relatively
municipalities more flexibility to respond to stable and predictable.
local conditions such as changes in the economy, 3. The tax should not be one that is easy to
evolving demographics and expenditure export to non-residents.
needs, changes in the political climate, and 4. The tax base should be visible to ensure
other factors. For example, property taxes accountability.
can provide a stable and predictable source
5. Taxpayers should perceive the tax to be
of revenue but do not increase automatically reasonably fair.
with economic growth in the same way that
6. The tax should be relatively easy to
income and sales taxes do.
administer.
Source: Bird (2001a)
22
Whatever tax or taxes are chosen at the

local level, local governments need to be Box 3: How Property Tax
able to set their own tax rates. International Capitalization Works
experience tells us that the most responsible Property taxes are capitalized into the value
and accountable local governments are those of a property if, other things being equal, a
who raise their own revenues and set their higher property tax results in a lower property
value. Because property owners pay property
own tax rates (Bird, 2001a: 3). Unless local
taxes each year, estimating the present value of
governments can alter the tax rates, they will the property tax payments is necessary.
not achieve local autonomy or accountability.
Moreover, local tax rate setting provides The present value of a future flow is the
amount that someone would pay today in
predictability for municipal governments and exchange for receiving that flow in the future.
gives them the flexibility to change rates in The present value of US$1 to be received next
response to different circumstances. year is 1/(1+i), where i is the discount rate (the
return on an investment other than housing).
The present value of a dollar received in two
TAXES years is 1/(1+i)2 and so on. The present value
of avoiding property taxes every year from now
This section reviews property taxes, personal until the expected lifetime of the house is ∑1/
income taxes, corporate income taxes, payroll (1+i)n, which is closely approximated by 1/i.
taxes, general consumption taxes, and excise As an example, consider two houses, A and
taxes. B, identical except for the property taxes. The
annual property taxes on house A are $1,000
higher than on house B. Suppose that the
Property Taxes discount rate is 5 percent. The present value of
the stream of future property taxes would thus
As was evident in Tables 3 and 4, almost all be US$20,000 (1,000/.05) higher on house A
local governments worldwide rely, at least than on house B. Property taxes would be fully
to some extent, on property taxation. The capitalized if the market value of house A were
property tax is historically associated with local US$20,000 less than house B. Anything less
government, in part because real property is than US$20,000 would mean that the property
taxes were only partially capitalized.
immovable, that is, it is unable to shift location
in response to the tax. Although a change in
property tax may be capitalized into property
values in a particular community (see Box 3
for an explanation of how tax capitalization
works), and in the long run may affect where
people locate, these effects are of a smaller
magnitude than those that would occur with
income and sales taxes at the local level.
23
Guide to
Municipal Finance
Another reason why property taxes are A competing view sees the property tax as a
appropriate as a source of revenue for local tax on capital. For example, Zodrow (2000)
governments relates to the connection argues that the property tax in the United
between the types of services funded at the States results in distortions in the housing
local level and the benefit to property values. market and in local fiscal decisions. According
Fischel (2000), for example, has argued that to this view, the property tax (based on market
the property tax in the United States is like value) discourages building and results in
a benefit tax because taxes approximate the the underutilization of land. The amount of
benefits received from local services. Under capital per unit of land is less than what is
these circumstances, the property tax promotes economically efficient.
efficient public decisions because taxpayers
will support those measures for which the Both of these approaches have some validity.
benefits exceed the taxes. Both the benefits The property tax is not purely a benefits tax,
derived from local services (for example, good because homeowners who improve their
schools, access to roads and transit, and so houses will face higher taxes and will therefore
on) and the taxes are capitalized into property be discouraged from doing so. At the same
values. Because taxpayers are willing to pay time, the benefits and costs of local programs
more for better services and lower tax rates, are reflected in local property values.
this translates into higher property values.
Unique Characteristics of the
Of course, this analysis is based on a number Property Tax
of assumptions such as that local property There are at least four characteristics of the
taxes do finance services that benefit property property tax that differentiate it from other
values, that the incidence of such taxes is on taxes. First, the property tax is a highly visible
local residents, that both tax rates and service tax. Unlike the income tax, for example, the
levels are decided by local residents, that property tax is not withheld at source. Rather,
those who wish to ’buy’ other combinations taxpayers generally have to pay it directly in
of services and tax rates are free to move to periodic lump-sum payments. This means that
other jurisdictions, that – impelled by their taxpayers tend to be much more aware of the
sensitivity to property values – people will property taxes they pay. The exception is where
act rationally in response to such signals, and mortgage institutions include property tax
that local governments do what voters want payments with monthly mortgage payments.
them to do. The strength and validity of The property tax also finances services that
many of these links is obviously suspect in the are highly visible, such as roads, garbage
context of many developing countries (Bird collection, and neighborhood parks. Visibility
and Slack, 2004). Moreover, this argument enhances accountability but it restricts the
becomes particularly tenuous when it comes to ability of local governments to raise or reform
explaining the commonly found phenomenon than tax.
of higher taxation on non-residential property
(the over-taxation of non-residential property
is discussed further below).
24
Second, the base of the property tax does At the same time, this differential treatment
not increase automatically over time, because does not necessarily reflect the differential use
property values respond more slowly to annual of services by different property types. Indeed,
changes in economic activity than incomes. some observers have suggested that non-
It is said to be an inelastic tax. Furthermore, residential properties use fewer services than
very few jurisdictions update property values residential properties, but pay more in taxes.
for taxation purposes on an annual basis. This For example, users of nonresidential property
means that to maintain property tax revenues often provide their own garbage collection,
in real terms or to raise property tax revenues, security, and fire protection (Kitchen and
jurisdictions have to increase the rate of the Slack, 1993). Moreover, since businesses
tax. As with visibility, inelasticity leads to tend to be more mobile than homeowners
greater accountability (taxing authorities (in other words, they are more responsive to
have to increase the tax rate to increase tax tax changes), efficiency arguments lead to
revenues), but it also leads to greater taxpayer the conclusion that non-residential property
resistance. should be taxed more lightly than residential
property. For these reasons, some authors have
Third, the property tax can be an important suggested that the non-residential property tax
instrument of local autonomy to the extent is not a good tax for local government and have
that it is only levied by local governments. recommended that it be replaced by a business
To ensure local autonomy, however, tax rates value tax (Bird, 2001a).
must be set locally and not by a senior level of
government. Mechanics of the Property Tax
Fourth, the property tax commonly favors The property tax is levied on residential,
single-family, owner-occupied, residential commercial, and industrial properties. Several
properties over apartments and commercial steps are involved in the process of taxing
and industrial properties in most jurisdictions real property: identifying the properties
around the world (Bird and Slack, 2004). In being taxed, preparing an assessment roll that
most transition economies, enterprises tend contains a description of the property and the
to pay higher property taxes than individuals amount of assessment, setting the tax rate or
(Malme and Youngman, 2000). Favorable series of rates, issuing tax bills, responding
treatment of single-family residential properties to assessment appeals, collecting taxes, and
is achieved by deliberately under-assessing addressing arrears. This section of the chapter
single-family residential property compared focuses on property identification, assessment,
to apartments and commercial and industrial tax rates, and tax collection. For information
property of comparable value; by legislating on the other steps in the process, see Dillinger
lower tax rates on single-family residential (1992) and Bird and Slack (2004).
property; and by providing property tax relief
measures to residential property owners in the
form of tax credits, homeowner grants, or tax
deferrals. These measures are not generally
available to non-residential properties.
25
Guide to
Municipal Finance
Property Identification Assessment Base

The first step in levying a property tax is to The base of the tax is the assessed value of
identify ownership and assemble a complete real property. Some properties in all countries
list of properties. A fiscal cadastre requires are exempt from the property tax base.
information on each property: a description, Exemptions may be based on ownership,
a definition of its boundaries (using cadastral such as government-owned property; on the
maps), a notation of ownership, and the value use of the property, such as properties used
of land and improvements. Establishing a for charitable purposes; or on the basis of the
complete inventory of all properties and characteristics of the owner or occupier; such
assigning a unique property identification as age or disability (Youngman and Malme,
number to each parcel is necessary to permit 1994). Exemptions erode the tax base and are
the tracking of all parcels. Property identifiers difficult to remove.
also allow for the linking of assessment, billing,
Two general assessment methodologies
and property transfer records. Jurisdictions
are used for property taxation: area-based
must report the information collected in a
assessment and value-based assessment. Under
consistent way and establish a process for
an area-based assessment system, the tax
updating it on an annual basis (Slack, LaFaver,
jurisdiction levies a charge per square meter
and Shpak 1998).
of land area, per square meter of building, or
The process of property identification is often some combination of the two. Where both
more difficult in developing countries and measures of area are included, the assessment
transition economies. Examples of some of the of the property is the sum of an assessment
types of problems that have occurred include rate per square metre multiplied by the size
the nonexistence of base maps for property of the land parcel and an assessment rate per
identification, the absence of data on property square metre multiplied by the size of the
ownership because of disputed ownership, the building. A strict per unit assessment results
incomplete information on improvements, in a tax liability that is directly related to the
and the poor sharing of information on area of the land and buildings. With unit value
building permits (Dillinger, 1992, Malme assessment, the assessment rate per square foot
and Youngman, 2000, and Bird and Slack, is adjusted to reflect location, quality of the
2004). Further problems include land and structure, or other factors. Market value has
building records being maintained separately an indirect influence on the assessment base
by different agencies and not linked, tax through the application of adjustment factors.
records being identified by taxpayer and not For example, the assessment rate per square
by property, records being kept secret, and metre might be adjusted to reflect the location
official prices not being true indicators of of the property within a particular zone in
market value. the city. Even though the specific location of
the property within the zone is not taken into
account, properties in different zones will have
different values.
26
Value-based assessments use market value use and this is expected to continue, rental
(including site value assessment), rental value, value will bear a predictable relationship to
and self-assessment. Market value is defined market value: the discounted net stream of
as the price that would be struck between a net rental payments is approximately equal to
willing buyer and a willing seller in an arm’s- market value.
length transaction. Market value assessment
estimates the value that the market places on Self-assessments require property owners to
individual properties. Site value taxation is a place an assessed value on their own property.
special case of market value taxation where only In some countries, the taxing authority has
the land portion of the property is taxed; the the right to buy the property at the assessed
assessment base excludes any improvements to value. A system where the taxing authority
the land. can buy the property will only be credible if
it can and will buy property, but this right has
Under the rental value (or annual value) rarely been exercised, partly because of the
approach, property is assessed according to political impossibility of large-scale purchases
an estimate of rental value or net rent. One of residences.
rationale for using rental value is that taxes are
paid from income (a flow) rather than from Table 9 summarizes the different bases and
wealth (a stock), and thus taxing the net rental provides examples of countries where they are
value of real property is appropriate. In theory, used.
however, no difference should exist between a
tax on market value and a tax on rental value -
when a property is put to its highest and best
Table 9: Base for Property Taxes

Tax base Definition Measure used Examples of countries
where used
Market value Price that would be Comparable sales, Australia, Canada, Indonesia,
struck between a willing depreciated cost, or Japan, United States, South
buyer and seller in an income method Africa
arm’s-length transaction
Site value Price that would be Comparable Jamaica, Kenya, New Zealand
struck between a willing sales subtracting
buyer and seller in an improvements value from
arm’s-length transaction total property value
Rental value Value in current use Net rental income France, Morocco, parts of
India
Unit value Size of property adjusted Square meters of land Armenia, Czech Republic,
to reflect location, quality, and building area, Israel, Poland, Russia, Slovakia
or other factors adjusted
Self-assessment Sales price Determined by owner of Peru, Turkey
property
Transitional or mixed Combination of area and Market-priced zones Estonia, Latvia
systems market value for land or land and
buildings
Source: Slack (2006a: 206) and updated
27
Guide to
Municipal Finance
Where it is possible to use market value, it is Tax Rates

generally regarded as a better tax base (Slack,
To determine the tax liability, the assessed
2006a). First, the benefits from services are
value is multiplied by the tax rate. In
more closely reflected in property values
most North American jurisdictions, local
than in the size of the property. For example,
governments first determine their expenditure
properties close to transit systems or parks enjoy
requirements and then subtract non-property
higher property values. Second, market value
tax revenues available to them (for example,
has the advantage of capturing the amenities of
intergovernmental transfers, user fees, and
the neighbourhood, amenities that have often
other revenues) from their expenditure
been created by government expenditures
requirements to determine how much they
and policies. Under area-based assessment
need to raise from property tax revenues.
(particularly unit assessment), on the other
The resulting property tax requirements are
hand, two properties of identical size and age
divided by the taxable assessment to determine
but in different locations would pay the same
the property tax rate. By contrast, in many
tax even if one is located next to a park and
transition and developing economies, the
the other is adjacent to a factory. Third, area-
national government sets the rates for property
based assessment results in a relatively greater
taxes.
burden on low-income taxpayers than high-
income taxpayers when compared to value- Local governments may vary tax rates according
based assessment because average household to the services received. For example, in some
incomes in high-value neighbourhoods are jurisdictions a general tax rate applies across
higher than in low-value neighbourhoods. the city and a special area rate or additional
A tax on area taxes all properties that are the surcharge applies in those parts of the city that
same size the same amount, whether they are in receive services provided only to them, for
high-income or low-income neighbourhoods. example, garbage collection, street lighting, or
Similarly, older houses in a bad state of repair transit. Special area rates, which are earmarked
but with a large floor area will pay relatively for services in those locations, approximate a
high taxes. Furthermore, if a relatively poor benefit charge.
neighbourhood becomes richer, there would
be no tax change. A tax system that fails to Local governments may also vary tax rates
take account of changes in relative values over by class of property, for example, residential,
time will result in inequities. commercial, and industrial. Variable tax rates
by class of property may be justified on a
Many transition countries employ some number of grounds. On the basis of fairness
variant of area-based assessment. Unit value with respect to benefits received, the benefits
assessment is easier to understand and cheaper from local public services may be different
to administer than value-based assessments for different property classes. For example, as
particularly where the real estate market is not noted earlier, non-residential properties may
well developed. To some extent, this choice use fewer services than residential properties.
no doubt reflects the nature of the available
information on the physical area of building On efficiency grounds, some have argued that
and land recorded in the old central planning property taxes should be heavier on those
records. Over time, however, as zones become components of the tax base that are least elastic
more narrowly defined, it seems both likely in supply. Because business capital tends to be
and desirable that these systems will evolve more mobile than residential capital, efficiency
into something closer to a market value system arguments lead to the conclusion that business
(Slack, LaFaver, and Shpak, 1998). property should be taxed more lightly than
residential property.
28
In reality, however, tax jurisdictions generally Low collection rates can be attributed to lack
apply lower rates to residential properties. of political will, lack of transparent collection
On the basis that higher property taxes on and enforcement mechanisms, and lack of
buildings tend to slow development and that taxpayer confidence or understanding of
lower taxes speed up development, a municipal how the tax is levied, collected, enforced, and
policy to develop some neighborhoods instead used (Kelly, 2000). To improve compliance
of others would call for differential taxes in and collection, political will is needed and
different locations as well as for different administrative systems have to be improved.
property classes. In this case variable tax rates Local officials also have to be willing to use
are used to deliberately distort decisions to legal enforcement provisions. Local residents
achieve certain land use objectives. and businesses need to be convinced to pay
their taxes and this process can be facilitated
by improved service levels and the perception
Tax Collection that taxes are being administered fairly. In
Tax collection involves sending out tax bills, short, people are more willing to pay taxes if
collecting the taxes, and ensuring payment. they feel they are getting something for them.
Since the primary purpose of the property Community involvement in local decisions
tax is revenue generation, tax collection through mechanisms such as participatory
and enforcement are the most important budgeting (see section 6 below), for example,
components of the property tax system (Kelly, may also improve revenue collection.
2000).
Shortcomings of the Property Tax
If the property tax is not paid within a specified Although the property tax is generally regarded
time period after the due date, interest and a as a good tax for local governments, there are
late fee are generally charged. In cases of long- some problems in relying too heavily on this
term delinquency, other enforcement measures one tax. First, property taxes are costly and
are usually taken eventually leading to the sale difficult to administer well and these problems
of the property to satisfy the tax obligation. increase with the size of the tax burden (Bird,
Such sales are rare in most countries, 2001a). Lack of training, particularly in
however. Often, a more effective enforcement less developed countries, exacerbates these
mechanism (at least for properties transferred problems. Second, as noted earlier, there is a
within the formal legal system) is that property general tendency in most countries to over-tax
transfers are not permitted unless property non-residential properties which results in tax
taxes are paid (Bird and Slack 2004). exporting to residents of other jurisdictions
who are consumers of the products or services
Tax arrears reduce the revenues generated
produced in those properties. Tax exporting
from the property tax. Although tax arrears
reduces accountability because those bearing
as a proportion of taxes collectible are low in
the burden of the tax are not the same as
most developed countries (for example, 3 to
those enjoying the benefits. There is thus an
4 per cent in Japan and the U.K), they can be
incentive on the part of local residents to
very large in some less developed countries (for
demand greater expenditures because some of
example, 50 per cent in parts of Kenya and the
the cost is borne by others. Third, the property
Philippines). Tax arrears obviously tend to be
tax cannot finance major social expenditures
highest in countries that do not have sufficient
(such as social assistance, health, and
resources, expertise, or will to administer the
education) in most communities. The result is
property tax and where enforcement is weak.
that cities either have to restrict themselves to
delivering services such as garbage collection
and street cleaning or they have to rely on
intergovernmental transfers.
29
Guide to
Municipal Finance
Although the property tax is an appropriate The situation is somewhat similar in Iceland.
tax for local governments, it has been under- The local income tax is a big revenue raiser in
used particularly in developing countries Nordic countries yielding revenues of up to 15
where it accounts for only 0.6 percent of per cent of GDP.
GDP on average compared to more than 2
percent in industrialized countries (Bahl and Local income taxes have been levied only
Martinez-Vazquez, 2008). The main reasons occasionally in developing countries (Bahl
are inadequate administration and lack of and Linn, 1992) but subnational governments
enforcement. If decentralization continues in have been assigned significant shares of
developing countries and central governments income tax revenues in transitional economies
insist on local revenue mobilization, however, (Bird, 2001a). Local governments do not set
interest in local property taxes may increase the tax rates themselves, however. The result
significantly in the future (Bahl and Bird, is revenue sharing whereby local governments
2008). receive an intergovernmental transfer, the
amount of which is based on locally- collected
central government income tax revenues.
Personal Income Taxes
Unlike the property tax, the incidence of the
Although income taxes are used to some extent income tax is generally progressive though
at the local level, they are not as prevalent as it may not be clearly related to the benefits
property taxes. There are two quite different received municipal services. Moreover, income
types of income tax. The first, which is most tax revenues are more elastic than property tax
commonly used in Europe, is to levy a local revenues in that they increase automatically
income tax which is simply a proportion of as the economy expands. Of course, revenue
the central or state/provincial income tax or elasticity can be a problem when there is an
is at least calculated on the same tax base. The economic downturn.
second type is a separate, locally administered
income tax. The second type is less common One drawback of local income taxes is that the
because it is more difficult to implement and current practice in many countries is to lower
very expensive to administer. reliance on income taxation and increase
reliance on consumption-based taxes. This
Local governments in Nordic countries, which move, it is argued, creates fewer distortions
have large expenditure roles especially for social and reduces the deadweight costs associated
services and health, are permitted to impose with taxation (Boadway and Kitchen, 1999).
an income tax and to choose the rate of tax. Increasing local income taxes would counteract
Local governments set a flat tax that is applied current policy in those countries.
to the personal taxable income assessed for
national income tax purposes. The local flat Nevertheless, income taxes can be justified
rate is added to the national progressive rates. at the local level on the grounds that local
There is a risk that local authorities will use governments are increasingly being called
the income tax for excessive local tax increases upon to address issues of poverty, crime,
(Lotz, 2008). Although this is not a concern regional transportation, and other region-wide
in Sweden, this risk has led to a formalised needs. To the extent that local governments
system of negotiations in Denmark. In are required to provide social services, an
Norway, a maximum for the local tax rate was income tax is probably more appropriate than
established many years ago with the result that a property tax because the former is more
all Norwegian municipalities apply the capped closely related to ability to pay.
rate.
30
Corporate Income Taxes General Consumption Taxes

Corporate income taxes are levied on the General consumption taxes include value
income of corporations. Although the tax is added taxes (VAT) and retail sales taxes. In
often popular with residents, in part because most countries, the general sales tax that is
the tax can be exported to non-residents, levied is a value added tax (VAT) at the central
there are few advantages to levying a corporate government level, although there is some
income tax at the local level. Corporate taxes experience with state/provincial VATs as well
are generally imposed on a mobile tax base. (Bird and Gendron, 1998). Many U.S. states
As such, they are not a good candidate for (and some municipalities) levy a retail sales
local taxation. Corporate income tax revenues tax.
are volatile. Business taxes in general deter
economic development and spur competition The advantages of sales taxes are that they
between local governments trying to attract provide an elastic source of revenue – one that
business. Property taxes on the commercial/ grows with the economy. The rationale for
industrial sector already overtax business and a municipal sales tax as a supplement to the
thus there is no reason for an additional tax local property tax is similar to the rationale for
burden that bears no relationship to the cost a municipal income tax. As long as municipal
of municipal services consumed. Corporate services are funded only from property taxes
income taxes are difficult to administer because imposed on local residents, some users might
taxpayers have to determine how much of the escape paying taxes for services consumed.
income is attributable to the local jurisdiction Broadening the local tax base to include sales
imposing the tax. Because many corporations would help to address some of the externalities
conduct business in a number of jurisdictions, in municipal services (where some beneficiaries
both taxpayers and tax collectors have trouble of services, such as commuters and visitors, do
determining how much income is taxable in not pay for them), would give municipalities
any particular jurisdiction. greater flexibility and breadth in determining
their own tax structure, and would allow
municipalities to benefit from growth in the
Payroll Taxes economy. A sales tax is also preferred to an
income tax by economists because, unlike the
Payroll taxes are an income tax on payrolls. One
income tax, it does not tax savings.
advantage of a payroll tax is that it is easy to
administer and relatively productive at low tax Nevertheless, evasion problems can sometimes
rates. It taxes commuters thereby permitting be serious as well as economically distorting.
a municipality to tax those individuals who Large rate differentials between neighbouring
use city services but would not otherwise pay jurisdictions are unlikely to be sustainable
for them under the property tax (Chernick over long periods of time. Piggybacking onto
and Tkacheva, 2002). Some U.S. cities the central or provincial/state tax system with
tax commuters through a payroll tax. The an additional city “piggyback” sales tax of 1
disadvantage is that the tax acts as a barrier to or 2 percent, however, would avoid many of
employment and introduces distortions in the the problems associated with a local sales tax,
factor mix decision. including high administrative and compliance
costs.
31
Guide to
Municipal Finance
Excise Taxes should be subsidized from revenues generated

by selling a specific good or service or the users
Two types of excise taxes that are sometimes
of a specific good or service subsidized by local
levied at the municipal level are vehicle taxes
tax¬payers. Such cross subsidization from
(including fuel taxes and vehicle registration
user supported services or vice-versa may lead
fees) and hotel occupancy taxes.
to unde¬sirable distortions and a departure
from efficient and accountable pricing and
Vehicle taxes investment practices.
Fuel taxes can be viewed as benefit-based There may be problems with earmarking,
taxes to the extent that those who use the however. It can shield expenditure programs
road system pay a tax. Different cities could from the critical assessment that might
impose taxes at different rates but they would otherwise be received from budgetary
probably not be able to differ much from the authorities. There is no guarantee that it will
rates imposed by their neighbours, given the generate the amount of revenue required on
mobility of the tax base. To the extent that an annual basis as local circumstances change
a fuel tax is intended to price either the use nor that it will be evaluated relative to the
of publicly provided roads or externalities other priorities of local governments. In short,
(pollution and congestion, for example), it is a it may reduce municipal flexibility.
crude instrument. Congestion charges (tolls),
on the other hand, would function better
because they can vary by time of day and by Hotel occupancy tax
location. Vehicle registration fees would also be An occupancy or room tax is an additional
better because they can vary by vehicle age and levy imposed on the existing central or state/
engine size, vehicle axle weight, and location provincial sales tax rate on hotels and motels.
of vehicle. These factors affect the amount of Many local jurisdictions in the U.S. and some
pollution, congestion, and road damage more of the larger local jurisdictions in Canada levy
so than would fuel consumption. a hotel and motel occupancy tax. This tax is
justified on the grounds that it compensates
Fuel tax revenues are generally earmarked for
local governments for expanded services
local roads and public transit. Earmarking
provided for tourists or visitors (for example,
municipal fuel tax revenues offers a number
the additional police and fire protection, and
of potential advantages (Bird, 1997). First,
highway and public transit capacity needed to
if the funds are used to pay for roads and
meet weekend or peak convention and tourist
transit infrastructure, earmarking links the
demands).
cost of transportation to the users. Second,
earmarking is likely to improve the motivation Although income and sales taxes fall on both
and efficiency of local decision makers. If residents and non-residents, a hotel and
funds are not earmarked, for instance, surplus motel occupancy tax falls mainly on visitors.
revenues from the sale of goods and services As with local income or sales taxes, there
may be used to lower local tax rates. This are two methods of administration. Local
may discourage managerial efforts to improve governments could simply piggyback onto the
efficiency and to reduce costs because excess existing sales tax on hotel and motel rooms
revenues go elsewhere. It may also discourage through the addition of a few percentage
the introduction of innovative techniques points. Alternatively, local governments could
and future investment that could lead to cost set up their own administrative structure to
savings and efficiencies. Third, there is no administer and collect the tax.
solid economic reason why local taxpayers
32
As with other possible tax sources, the Public Prices

piggyback scheme is administratively less Public prices, on the other hand, include the
expensive even though local governments revenues received by local governments from
would have less flexibility and no potential for the sale of private goods and services (other
altering the tax base. than the cost of reimbursement). All sales of
locally provided services to identifiable private
The levying of a hotel and motel room
beneficiaries –whether they are public utility
occupancy tax in selected municipalities and
charges or entrance fees to recreation facilities
not in competing communities provides an
– are included under the category of public
incentive for individuals to stay in hotels and
prices. In principle, such prices should be set
motels in those municipalities without the tax.
at the competitive private level with no special
The extent to which the differences in price
tax or subsidy element. Tolls on highways,
created by those differential tax rates would
used throughout Europe, the United States,
actually deter visitors from renting rooms is
and some parts of Asia are an example of
uncertain, however. If the demand for hotel
public prices that are used to pay for roads but
and motel rooms is sensitive to price, then
also to discourage road use (see Box 4).
noticeable losses may occur.
Benefit Taxes
USER FEES The final category of user charges encompasses
specific benefit taxes. These taxes are different
A user fee is a charge per unit of output. User from service fees and public prices because
fees can take at least three forms – service fees, they do not arise from the provision or sale
public prices, and specific benefit charges (Bird of a specific good or service to an identifiable
and Slack, 1993). private individual. Taxes are compulsory
contributions to local revenues. These taxes
Service Fees
are, nevertheless, related in some way to the
Service fees include license fees (marriage, benefits received by the taxpayer. In contrast
business, dog, vehicle registration) and various to general-benefit taxes such as fuel taxes
small charges levied by local governments for levied on all road users or local taxes in general
performing specific services such as registering viewed as a price paid for local collective
a vehicle or providing a copy of a marriage goods, specific benefit taxes relate to the
license. In a sense, these fees represent the specific benefits received by specific taxpayers.
reimbursement of costs from the private sector Examples include front footage levies or
to the public sector. There is seldom much special assessments on the property tax to pay
revenue in recovering these costs, however. for sidewalks or street lighting on a specific
street.
33
Guide to
Municipal Finance
Efficiency of User Fees

Box 4: Road Pricing in Charges lead to efficiency in two ways (Bird
Singapore and Tsiopoulos, 1997): first, they provide
Road pricing began in Singapore in 1975 and is
information to the public sector about how
an important part of its overall transportation much users are willing to pay for the particular
strategy. The current scheme, the Electronic service. Second, they ensure that citizens value
Road Pricing System (ERPS), was implemented what the public sector supplies at least at its
in 1998. The user is required to insert a smart marginal cost (the cost to an additional user).
card into the in-vehicle unit (IU) which has Under-pricing a service (by not charging for it)
been installed in the vehicle. When the vehicle
passes through an ERP gantry, the appropriate
can result in over-consumption of that service.
charge is deducted from the smart card. If When users of the service do not have to pay
there is no in-vehicle unit or insufficient funds for it and are unaware of the cost of providing
left in the smart card, the vehicle license is it, they will demand more of the service than
photographed and a bill sent to the vehicle if
owner.
they had to pay for it. The resulting crowding
Publicity was an important aspect of the
program and was launched well before the
may be taken as a signal that government
IU fitting program and lasted more than a should provide even more of the under-priced
year. Vehicle owners were sent brochures and service. For example, user fees for water that
advertisements were placed in the print media are based on the marginal cost encourage water
and on television. conservation, discourage water consumption
Traffic volume into the central business district in low-value uses, and postpone the time
(CBD) was reduced by about 10 to 15 percent when new investment is needed (Dewees,
during the ERP operation hours, compared to 2002). User fees for garbage collection give
the earlier scheme. Although the charge was consumers a financial incentive to reduce
lower under the ERP scheme than the earlier waste collection by reducing, re-using, or
program, the ERP charge is applied to each
recycling garbage. User fees also ration the use
passing, whereas the earlier charge allowed for
multiple entries per day. The result was that of existing facilities and they give appropriate
many multiple trip-makers reduced the number capital investment signals. In other words, they
of their trips by using public transit to go to can reduce the demand for infrastructure. In
mid-day meetings or lunches, for example. short, “whenever possible, local public services
Source: Keong (2002)
should be charged for – of course, at prices
that are properly set – rather than given away”
(Bird, 2001a: 7).
34
There are cases where charging full user fees Finally, users often regard public sector
may not be appropriate, however. Where a pricing as a revenue grab on the part of
good or service exhibits externalities, pricing local governments. Not only is it difficult to
at the marginal cost may not be appropriate. implement pricing under these circumstances
Externalities are benefits or costs of services but it is difficult to increase public sector prices.
that are not priced and may therefore not be Unlike prices in the private sector, once prices
taken into account by the user. Recreation are set in the public sector, users believe that
programs for at risk youth, for example, have they should not increase. Local governments
significant external benefits in terms of success have not done a good job of explaining to the
in school, lower crime rates, etc. When society public the important role that user fees play
puts a high value on these positive externalities, (Bird and Tsiopoulos, 1997).
then below-cost provision or subsidies are
warranted.
INTERGOVERNMENTAL TRANSFERS
Problems with Pricing
Transfers from senior levels of government
The most important general public concern are an important source of revenue for
with user fees is that they have an adverse municipalities around the world. These
impact on equity: low-income families cannot transfers can take different forms, as shown in
afford to pay user fees and will either not Table 10.
use the services or will have to reduce their
consumption of other services. Many studies
have shown that it is untrue in large urban areas, Types of Transfers
however, that those who benefit most from
Transfers can be broadly categorized as
under-pricing services make the most use of
unconditional (general purpose) or conditional
them, and the poor are not well-represented in
(specific purpose). Unconditional transfers
this group (Bird and Miller, 1989). Relatively
have no conditions attached to their use; funds
simple pricing systems, such as low initial “life-
can be spent on any local service or they can
line” charges for the first block of service use,
be used to reduce local taxes. In some cases,
can deal better with any remaining perceived
unconditional transfers are given on a per
inequity by introducing more adequate pricing
capita basis; in other cases, the amount of the
systems. These schemes are used for water, for
transfer depends on a formula which might
example, and for basic recreation programs,
take account of the expenditure needs of the
such as swimming programs for children and
municipality, the size of its tax base, or other
youth.
factors.
Some further problems with user fees include
Conditional transfers have to be spent on
the cost of pricing. For example, charging the
specific expenditures, for example, roads, parks,
marginal cost of water requires the metering
or some other local service. Conditional grants
of water and the installation of meters has
are “fungible,” however, in the sense that, even
a cost attached to it. There are also costs
though they come with strings attached, there
associated with the cost of information that
is no guarantee that the recipient will spend
municipalities need to price services correctly.
the funds on what the donor government
For example they need to know long-term
intended. For example, municipalities that
capital costs, infrastructure investments,
are already spending considerable funds in the
etc. Many municipalities lack the necessary
area specified by the donor government will
expertise to price correctly.
be able to divert grant funds to other purposes
and still meet donor requirements.
35
Guide to
Municipal Finance
Within the category of conditional transfers, would have to raise their own funds to cover
there are matching transfers and lump sum the remaining 40 percent of the cost. Lump
transfers. Matching transfers require that the sum conditional transfers (also known as
municipality match donor funds. For example, block grants) do not require the municipality
the donor may offer a transfer that covers to provide matching funds.
60 percent of the cost of road construction.
Municipalities, under this type of transfer,
Table 10: Types of Intergovernmental Fiscal Transfers

Type of Transfer Characteristics
Unconditional No conditions attached to use; lump sum
Unconditional (equalization) No conditions attached to use; lump sum; based on
fiscal capacity and sometimes expenditure need
Conditional Non-Matching Has to be spent on specified functions; lump sum
Conditional Matching Has to be spent on specified functions; municipality is
required to match provincial funds
Rationale for Transfers (known as revenue sharing); on the basis of a

formula (for example, as a percentage of specific
There are four justifications for
local government expenditures or some other
intergovernmental transfers: vertical fiscal
characteristics of the local governments such
imbalance (fiscal gap), horizontal fiscal
as population); or on an ad hoc basis.
imbalance, externalities, and political
rationales such as the desire on the part of Under revenue sharing, the donor government
the donor government for local governments allocates a portion of one or more of its tax
to achieve minimum standards in service revenues to local governments. For example,
provision (Slack, 2007a). The type of transfer the donor government may agree to share a
that is appropriate depends on the underlying percentage of its personal income tax revenues
rationale. with municipalities. Once the total amount
of funds available for grants is determined,
Vertical Fiscal Imbalance funds can be allocated to municipalities on
(Fiscal Gap)
a derivation basis (on the basis of where they
When municipalities have inadequate own- were collected) or on the basis of a formula
source revenues (such as local taxes and user (for example, on a per capita basis). Revenue
fees) to meet their expenditure responsibilities, sharing on a derivation basis favours richer
there is said to be a fiscal imbalance or fiscal areas where revenue collections are the largest.
gap. The resulting gap can be closed by an Revenue sharing distributed on a per capita
unconditional (lump sum or block) transfer basis has an implicit equalization component
that allows the municipality to spend the because richer areas give up tax revenues to
funds in whatever areas it deems appropriate. poorer areas.
The total amount of the transfers allocated for
this purpose can be determined in one of three
ways: as a fixed proportion of the revenues of
the donor government
36
The advantage of revenue sharing over ad hoc Equalization grants, based on expenditure
grants is that the transfer to municipalities needs and the ability of local governments to
automatically increases as the yield from that levy taxes, can ensure that those municipalities
revenue source increases. To be a stable source with relatively small tax bases and relatively
of revenue to municipalities, however, the high costs and needs will be able to levy tax rates
percentage share going to municipalities has to that are comparable to other jurisdictions.
be maintained over time. Revenue sharing does
not enhance local autonomy, accountability, Externalities (Spillovers)
or efficiency because local governments do not Grants are also appropriate where services spill
set the tax rates or the tax base. over municipal boundaries. If the municipality
responsible for the service bases its expenditure
Fiscal gaps can be closed in other ways. decisions only on the benefits captured within
For example, senior levels of government its jurisdiction, it will likely under-allocate
can give additional revenue-raising powers resources to this service.
to local governments or they can reduce
the expenditure responsibilities that local One way to provide an incentive to allocate
governments are required to undertake. more resources to the service generating the
Moreover, municipalities themselves could externality is a transfer from a senior level
reduce their expenditures or raise their taxes of government. The type of transfer that is
to close the fiscal gap. appropriate for addressing externalities is a
conditional, matching grant. The grant should
Horizontal Fiscal Imbalance be conditional in that it has to be spent on
Horizontal fiscal imbalance refers to the the service which generates the externality. It
differences in resources among governments should be matching to reflect the extent of the
at the same level. Some municipalities are externality. For example, if 50 percent of the
unable to provide an adequate level of service benefits of highway expenditures spill over
at reasonable tax rates compared to other existing municipal boundaries, the matching
municipalities for three reasons. First, tax bases rate should be 50 percent. For services that
differ from one municipality to another and spill over municipal boundaries, a provincial/
thus, to collect the same amount of revenue, state transfer is appropriate. For services
a municipality with a small tax base will have that spill over provincial/state boundaries, a
to levy a higher tax rate than a municipality national transfer is justified.
with a larger tax base. Second, the costs of
providing public services may be higher in one Matching grants require that the municipalities
municipality than another so that more tax contribute a portion of the funds to deliver
revenues are required to provide the same level the service. A uniform matching rate tends
of service. Third, the need for particular public to favour richer municipalities because they
services may be greater in one municipality are more able to match funds than poorer
than another, thereby necessitating higher municipalities, unless there is an equalization
expenditures (and higher tax revenues). component to the grant. Moreover, a matching
grant will only stimulate spending if the
Under these circumstances, an equalization municipality has the power over expenditures
grant is appropriate (Bird and Smart, 2002). and the ability to increase taxes.
These grants are usually unconditional but
can be used for specific expenditure categories
(e.g. education).
37
Guide to
Municipal Finance
Another way to address spillovers and, more are set out in Box 5. As with any list of criteria,
generally, to coordinate service delivery across it is not possible to design one transfer that
municipal boundaries within a metropolitan simultaneously meets all of these objectives.
area, is to change municipal boundaries so Different types of transfers can be designed to
that the government jurisdiction coincides meet different objectives.
with the service delivery region. The drawing
of municipal boundaries in this way is rarely
done, however, with the possible exception Problems with Transfers
of South African metropolitan municipalities Although there are solid economic and political
where the Municipal Demarcation Board sets justifications for intergovernmental transfers,
the boundaries (for a discussion of different grant funding is not always the best way to
models for governing large metropolitan areas, address municipal fiscal problems: “these
see Slack, 2006b, Slack, 2007b, and Bird and systems of grants, although serving legitimate
Slack, 2008). purposes, can, under certain circumstances,
be a source of serious fiscal mischief ” (Oates,
Political Rationales 2008: 330).
In addition to the economic rationales for
intergovernmental transfers set out above, Transfers can distort local decision-making.
there are political rationales. For example, Conditional transfers require municipalities
transfers are often introduced in response to to spend the funds they receive according to
a public outcry over deteriorating services or provincial/state (or national) guidelines and
infrastructure. Upper levels of government often require matching funds on the part of
may also use grants to encourage local the municipality. A matching transfer, by
governments to provide at least a minimum lowering the price of some services, encourages
standard of service in areas such as road safety, municipalities to spend more on those services.
policing, or water and waste water treatment. In the presence of externalities, this change
Intergovernmental transfers are often used in behaviour may be appropriate. Where
to provide incentives for local governments there are no externalities, however, or where
to act as agents of the donor government. the amount of the grant exceeds the amount
In this way, the donor government benefits of the externality, the resulting distortion in
from local management in providing a service. municipal behaviour is inappropriate.
Conditional grants are sometimes given to
Funding from senior governments can also
acquaint local governments with services
lead to inefficient local revenue decisions. In
they would not have provided on their own
particular, there is no incentive to use proper
with the expectation that they will eventually
pricing when grants cover a large proportion
take over the funding for them and the senior
of operating and capital costs. Large grants
governments can withdraw. To meet these
for water treatment plants, for example, can
political objectives, conditional, lump sum
reduce the incentive to use volumetric pricing
grants are usually used.
to reduce the demand for water or to engage in
asset management. As noted earlier, charging
Design of Transfers wherever possible and getting the prices right
is important for local governments to ensure
The design of fiscal transfers has important efficient service delivery. Intergovernmental
implications both for local service transfers should not be working against
provision and for the overall fiscal health of that objective. Transfers can undermine the
municipalities. Ten public finance principles incentives for sound fiscal behavior (Oates,
that can be helpful in designing fiscal transfers 2008).
38
Box 5: Public Finance Principles for Designing Fiscal Transfers
Efficiency: Efficiency is achieved if the grant is neutral with respect to local government decisions on the
allocation of resources to different activities. The exception is where the grant corrects existing distortions
in expenditure practices. For example, municipalities do not have the incentive to provide the correct
level of services where the benefits extend to residents of other jurisdictions. A grant provides the
incentive to increase expenditures to the optimal level.
Fairness (equity): Equity dictates that all municipalities should be able to provide an adequate level of
service without resorting to unduly high tax rates. To achieve this objective, the transfer to municipalities
should vary directly with the fiscal need and inversely with the fiscal capacity of the municipality
(capacity to raise own-source revenues).
Clear Objectives: Grant objectives should be clearly specified.
Accountability: The donor government should be accountable for the design and operation of the grant
program. The recipient government should be accountable to citizens and the donor government for the
use of the funds.
Transparency: This principle is an extension of the accountability principle. Transparency is enhanced
when the recipient government and citizens/taxpayers have access to information about the grant formula
and the allocation of funds.
Stability and predictability: Revenues should be stable and predictable so that municipalities can budget
and plan for future expenditures.
Revenue adequacy: Municipal governments should have adequate revenues to discharge their expenditure
responsibilities.
Autonomy: Municipal governments should have autonomy and flexibility to set their priorities and not be
constrained by grant funding.
Responsiveness: The grant formula should be flexible enough to allow municipalities to respond to
changing economic circumstances.
Simplicity: The grant formula should be based on objective factors over which local governments have
limited control. The formula should be easy to understand.
Source: Based on Shah (2007)
Transfers can reduce accountability. When Local governments are more likely to carry
two or more levels of government are funding out their expenditure responsibilities in a
the same service, accountability problems responsible manner if they are also raising the
can arise. When users or taxpayers want to revenues to pay for them.
complain about the service, they are not sure
which level of government is responsible for Transfers are rarely a stable and predictable
the problem. Moreover, when the level of source of revenue. The amount of money
government making the spending decisions local governments receive varies from year to
(municipalities) is not the same as the level year, in part depending on the fiscal state of
of government that is raising the revenues the donor governments. Lack of predictability
to pay for them (provincial/state or national makes it difficult for municipalities to
governments), accountability is blurred. There plan expenditures. When grants decline,
is no incentive to be efficient when someone municipalities have to make up the lost
else is responsible for funding. revenue by increasing property or other taxes,
user fees, or other revenues or by reducing
expenditures.
39
Guide to
Municipal Finance
One way to get around the problem of User fees are appropriate for financing many
unstable and unpredictable revenues is to set local services but most countries make much
the transfer amount as a percentage of national less use of charging than is desirable and, where
or provincial/state government tax revenues or user fees are charged, they are generally poorly
as a percentage of Gross Domestic Product designed from an efficiency point of view.
(GDP). In this way, municipalities know that Designing and implementing user charges can
their grants will increase each year with the be difficult and costly because the municipality
growth in the economy. has to distinguish among services for which
charges can be levied, calculate the marginal
cost of the service, and find ways to exclude
IMPLEMENTATION AND MANAGEMENT people who do not pay for the service. Even if
OF MUNICIPAL REVENUES properly designed, however, user fees are not
very popular with citizens, administrators, or
According to the theory of fiscal federalism, the
politicians.
only good taxes for local governments are those
that are easy to administer locally, are imposed Vehicle taxes such as vehicle registration fees,
mainly on local residents, and do not raise especially if they are piggybacked onto central
problems of harmonization or competition or state/provincial taxes, are not that difficult
between local or regional governments or to implement. Other taxes (such as income,
between local/regional governments and sales, and hotel) can be very expensive to
national governments (Bird, 2006). The only administer at the local level. Piggybacking
major revenue sources that pass these tests are onto regional or national taxes, however,
property taxes and possibly taxes on vehicle allows municipalities to set local surcharges on
and user fees. these taxes and minimize administrative and
compliance costs.
Property taxes, however, are often costly and
difficult to administer and these problems Finally, transfers may appear, in some ways, to be
increase with the size of the tax burden. Even the easiest source of revenue for municipalities
though the property tax is a good tax for because they do not have to raise the funds
local government, it rarely provides sufficient themselves. The donor governments, however,
revenues to meet expenditure needs. Revenues may demand that a lot of conditions be met
are insufficient at least in part because of to receive grant funds and they may require
ineffective administration -- inadequate land documentation on how the money has been
registration systems, inefficient assessment spent. Grants are not a stable and predictable
practices, and deficient tax collection and source of revenue for local governments and,
enforcement. Moreover, property taxes are as noted earlier, they reduce accountability
never politically popular because of their because the government spending the funds
visibility and the inherent arbitrariness in is not the same as the government raising the
assigning values to individual properties. funds.
40
Financing Capital Expenditures
CHAPTER 5
Financing Capital Expenditures2
Municipal infrastructure is essential to the The remainder of this chapter describes the
economic, social, and environmental health different ways the local governments finance
of cities. Cities not only have to provide different types of infrastructure.
roads, transit, water, sewers, and other “hard”
services, they also have to provide “soft”
services that enhance the quality of life in their FUNDS FROM OPERATING REVENUES3
communities such as parks, libraries, social The use of current operating revenues to
housing, and recreational facilities. Cities finance capital spending is desirable to the
need adequate revenues to make the needed extent that the benefits of the spending accrue
infrastructure investments. to current users. Municipalities often use
The appropriate financing tool depends current operating revenues for assets with a
not only on the type of infrastructure (for short life expectancy (such as police cars or
example, roads, sewers, libraries, etc.) but also computers) or recurrent expenditures (such as
on the nature of the infrastructure investment the maintenance and upgrading of sidewalks
(Slack, 2005a). For example, there may be a and roads). Since operating expenditures
need to invest in new developments (provide (especially wages and salaries and supplies
infrastructure for greenfield developments and services) are often seen as the most
or intensification within urban areas), to urgent expenditures, however, maintenance of
provide new services in existing developments existing assets is often deferred (Serageldin et
(where communities are not fully serviced al., 2008).
or where the service has not been provided),
to maintain and replace old services (where
existing capacity has been exceeded because of
increased density in urban areas), or to invest
in mega-projects (for example, a transit system
or a water treatment plant that affects more
than one jurisdiction).
2 Capital expenditures generally refer to expenditures on goods
that have a useful life of more than one year. These expenditures 3 Operating revenues are revenues that the municipality collects
include, for example, the acquisition or construction of buildings, on a regular basis to meet current expenditures (for example,
structures, facilities, equipment, rolling stock or furnishings; wages, salaries, rents, and materials). Some municipalities set aside
expenditures on rehabilitation; and the purchase of land a portion of their total annual operating budget each year for
(Kitchen, 2003). capital expenditures.
41
Guide to
Municipal Finance
The use of borrowing or reserves is more MOBILIZING PRIVATE CAPITAL

appropriate for non-recurrent expenditures
Major infrastructure requires cities to make
(such as expenditures on large fixed assets)
significant capital expenditures. Revenues
or assets with long life expectancy (such as
from current sources (taxes, user fees, and
sewers). Reserves are created when a portion
intergovernmental transfers) are unlikely to
of current user fee revenue or taxes is set aside
be sufficient to meet the infrastructure needs
in a special account that accumulates (with
of municipalities. For this reason, cities
interest) until it is withdrawn to be used for
may also want to access private capital. Long
capital investments. Reserves are the opposite
term borrowing (discussed further below) is
of borrowing (see below). Instead of borrowing
appropriate where the infrastructure (such as
to finance capital expenditures now with debt
roads, water, sewers) will provide benefits for
repayment in the future, reserves reverse
a long period of time. Other ways to access
that timetable. This timing creates inter-
private capital are through public-private
generational inequities because users today
partnerships (discussed below). Direct charges
are paying for infrastructure that will benefit
on developers can also provide needed funds
future users. Since many municipalities around
to pay for infrastructure (development charges
the world are unable or unwilling to borrow,
are discussed below).
however, the use of current operating revenues
and reserves is not uncommon. For cities in most of the less developed
countries, the sources of municipal debt have
been limited to governments or government
INTERGOVERNMENTAL TRANSFERS financial institutions. Since the 1990s,
Another source of financing for infrastructure however, larger cities in some countries
is intergovernmental transfers, especially in (for example, Mexico, South Africa, and
less developed countries that have limited India) have accessed capital markets on the
resources and restricted access to capital basis of credit ratings through issuing debt
markets. Although there are justifications instruments on a non-guarantee basis (Cities
for intergovernmental transfers to finance Alliance, 2005). Cities in parts of Mexico and
infrastructure, as set out in Chapter 4, there are India have pooled financing needs to make the
also problems associated with the use of transfers financing demands more credible.
for capital investments. These problems were
Overall, the experience with mobilizing private
also set out in Chapter 4. In particular, the use
capital has been disappointing in less developed
of grants to pay for infrastructure significantly
countries (Annez 2006) in large part because
reduces the incentive to use proper pricing.
of the risks involved for both the public and
A further problem with transfers for capital
private sectors. From the lenders’ perspective,
purposes is that once the capital projects are
constraints include the lack of a transparent
built, it is often difficult for local governments
accounting system at the municipal level,
to maintain them. Although it is assumed by
the absence of collateral, and project revenue
the donor government that local governments
streams that rarely match commercial debt
will operate the facility and keep it in good
costs (Cities Alliance, 2005).
running order, local governments often do
not have the financial resources or the fiscal
capacity to do so (Bird, 2001b).
42
The use of private capital is limited in scope Long-term borrowing is generally restricted
to infrastructure that has a revenue stream. As to financing capital expenditures. For
Annez (2006) notes, even for infrastructure infrastructure whose benefits accrue to
such as water where it is possible to have future residents, fairness, efficiency, and
a revenue stream from user fees, full cost accountability are enhanced if these projects
recovery is rarely achieved. Although it is are financed by borrowing with annual interest
possible to attract private investment for charges and repayment of the borrowed funds
commercial activities (for example, water and coming from local tax revenues (for capital
toll roads), however, even these services tend assets that benefit the municipality in general
to involve considerable subsidies. Significant but for which specific beneficiaries cannot
subsidies on current operations significantly be identified) and user fees (for capital assets
reduce the attractiveness of the investment to that benefit specific users) imposed on future
the private sector. beneficiaries (Bird and Wilson, 2003: 24).
Examples of capital expenditures for which
borrowing is appropriate include fire and
MUNICIPAL BORROWING police infrastructure, recreational facilities,
Borrowing to make capital expenditures libraries, roads and streets, public transit, solid
permits municipalities to synchronize the waste facilities, and water and sewer systems.
costs and benefits of infrastructure over time. Long-term borrowing offers additional benefits.
A project built today will result in benefits over It spreads the impact on the operating budget
the next, say, 25 years. If funds are borrowed, over a number of years. It allows projects to be
the project is paid for over the next 25 years constructed simultaneously during a period of
through repayment of the principal and rapid growth and assessment. It may reduce
interest. This means that those who benefit the real cost of projects during periods of
from the facility (the users over the next 25 increasing cost inflation (this occurs when the
years) also pay the costs through taxes and user cost of labour and materials increases without
fees. Borrowing is more equitable and efficient any improvement in technology or quality of
when those paying for services are enjoying inputs). And it is a useful tool for handling
the benefits. emergency situations such as sudden declines
Borrowing allows a municipality to enjoy in other capital funding sources (such as
the immediate benefit from the capital grants) or sudden increases in capital needs.
improvement, which is not always possible The main disadvantage of borrowing from a
when relying on current revenues. Current municipal perspective is that potential revenues
revenues (taxes and user fees) are usually not are dedicated to debt repayment and are thus
sufficient to fund large expenditures on a “pay- not available for other uses. When the costs are
as-you-go basis” (PAYG). The pattern of capital spread over time, a significant portion of local
expenditures is lumpy and this means that budgets becomes a fixed obligation and debt
a municipality may find it needs substantial charges can constrain local fiscal flexibility.
funds to finance an infrastructure project for A municipality with low debt also has more
one year and then the need declines for a few flexibility to respond to unanticipated future
years. Borrowing allows municipalities to avoid events.
large year-to-year fluctuations in tax rates.
43
Guide to
Municipal Finance
Local governments in many countries are

restricted from borrowing. In some countries, Box 6: Types of Public-Private
such as China, local governments have found Partnerships
a way around these restrictions. They have
created independent, wholly-owned companies • Operate: The private sector operates the
whose activities are “extra-budgetary” (Wong facility for a fee. The public sector retains
and Bird, 2008). These companies are used responsibility for capital costs.
to provide funding for development projects • Lease/Purchase and Operate: The private
and, in particular, infrastructure. These special firm leases/purchases the facility from the
purpose bodies are permitted to borrow on public sector, operates the facility, and
the capital market and are backed by the assets charges user fees.
transferred to them by the municipality or the • Lease/Purchase, Build and Operate: This
revenue stream from their projects. Because of arrangement is similar to lease/purchase
their extra-budgetary status, however, they do and operate except that the private
not use standardized accounting and reporting sector firm would be required to build
or develop a new facility, or enlarge or
systems and do not face the same level of renovate an existing facility and then
public scrutiny. operate it for a number of years.
• Build: This is a turnkey partnership
in which the private sector is paid a
PUBLIC-PRIVATE PARTNERSHIPS fixed fee to build a facility according to
Public-private partnerships (known as P3s) government specifications and turns the
facility over to the public sector when it is
are partnerships between a government body
completed.
and a private sector party whereby the private
sector provides infrastructure or services that • BOT (Build, Operate, Transfer): The
have traditionally been delivered by the public private sector develops and builds the
required infrastructure, operates the
sector. P3s are widely used in the U.S. and facility for some specified period of
Europe, prompted by an interest in improving time, and then transfers it back to the
the efficiency and effectiveness of local public government.
service delivery. • Build and Operate: The private sector
builds and operates the facility and is
P3s can take many different forms, as shown
responsible for capital financing. The
in Box 6. In each of the cases in the Box, there operation is regulated and controlled by
is a partnership between government and the the public sector.
private sector. None of these cases involves full
• Build and Transfer: The private sector
privatization; the government body retains builds the infrastructure and then transfers
ownership of the assets and sets the policies ownership to the public sector.
and level of service.
44
One of the main advantages of partnerships is DEVELOPMENT CHARGES

that, by relieving municipalities of the financial
Many growing municipalities in North
responsibility for up-front capital costs, they
America levy charges on developers (known as
enable infrastructure to be built at times when
development charges, lot levies, and exactions)
government funding is constrained (Tassonyi,
to finance the growth-related capital costs
1997). Since many municipalities do not
associated with new development or, in some
like to borrow or are unable to borrow, P3s
cases, redevelopment. These charges are levied
are one way to get facilities built without the
for works constructed by the municipality
municipality incurring debt. Even where local
and the funds collected have to be used to
governments can borrow, the private sector
pay for the infrastructure made necessary by
often has access to a wider range of borrowing
the development (Slack, 2002). Development
instruments. The operation of facilities and
charges are appropriate to finance infrastructure
programs by private operators also reduces
in areas experiencing new growth. They are
municipal operating expenditures and may
less applicable to finance new services in
enable additional sources of revenue to be
existing developments or maintenance and
collected. Ancillary uses such as retail can be
replacement of old services.
accommodated within facilities to provide
another source of revenue. Finally, the public Other levies on developers include land
sector can draw on private sector experience dedications that require the developer to set
and skill. aside land for roadways, other public works,
school sites, or for environmental reasons;
There are, nevertheless, potential risks
parkland dedications that require a portion of
associated with public-private partnerships
the land used for development to be set aside
(Tassonyi, 1997: 195). For the private sector,
for parkland or that a cash payment in lieu of
there are risks that the regulatory framework
parkland be made; density bonusing whereby
could change and cause delays in the project.
developers are granted higher densities (than
For the public sector, there is the risk that the
permitted in planning documents) in return for
nature of the public services provided will not
meeting conditions such as providing day care
be what the public wants. The success of a
or preserving an historic building; connection
partnership depends on how the contractual
fees to permit developers to buy into existing
arrangements are structured and how the
capacity of water and sewer facilities; and over-
risks are shared. Municipalities need to ensure
sizing provisions (sometimes called front-end
that municipal objectives are being met. For
financing) that require developers to provide
example, in the case of a recreation facility, the
more infrastructure than is required for their
municipality may want to ensure that some
development. The municipality, in some cases,
programs are provided for specific users (such
agrees to recover part of the costs on behalf of
as youth) at specific time periods.
the developer from future benefitting owners.
P3s are appropriate for roads, highways,
The rationale for charging developers for off-
bridges, recreational facilities, and water
site growth related costs is that “growth should
and wastewater facilities. These types of
pay for itself ” and not be a burden on existing
infrastructure are large in scale, have an
taxpayers. A number of studies investigated the
identifiable revenue stream (user fees), and
issue of who ultimately pays the development
measurable results. These factors raise the
charge (see Slack, 2002 for a review of these
commercial viability and make it relatively
studies). These studies conclude that who bears
easy to assess the potential risks and rewards.
the burden of development charges – the new
homebuyer, developers, or pre-development
45
Guide to
Municipal Finance
landowners – depends to a large extent on the Box 7 sets out a methodology for calculating
demand and supply conditions in the market a development charge in eight steps. It also
for new housing. Most studies conclude that, describes the data that need to be collected
over the long term, development charges to estimate the charge and identifies some of
are borne by the new homebuyer. In some the policy decisions that need to be made in
cases, the predevelopment landowner, calculating the charge.
or some combination of the homebuyer,
predevelopment landowner, and the developer, Table 11 provides some examples of
may bear the cost. To the extent that the new development charges for municipalities in the
homebuyer bears the cost, then those who Greater Toronto Area for 2007 for different
receive the benefits from infrastructure are types of residential and non-residential
paying for them. properties. In each municipality, developers
are required to pay the development charge at
If properly implemented, development charges the local level as well as at the regional level.
can lead to efficient development patterns (i.e., In Georgina Township in York Region, for
discourage urban sprawl). To be efficient, the example, the residential development charge
charges have to be differentiated by location on single and semi-detached housing would
to reflect the different infrastructure costs. be under $20,000; in King Township, it would
For example, costs tend to be higher for be almost $26,000. The development charge
developments located further away from major on multiple units is generally lower per unit
facilities and for low-density developments. To than on single and semi-detached housing,
be efficient, development charges would have with the exception of Peel Region and its
to be higher in these locations. constituent municipalities where the charge
is the same as on single and semi-detached
One of the differences between levying housing. Apartments are charged less than
development charges and property taxes to multiple unit dwellings with apartments with
pay for capital costs concerns who borrows two or more bedrooms paying more per unit
the funds for the infrastructure. In the case than apartments with less than two bedrooms.
of the property tax, the municipality borrows On the non-residential side, retail is generally
funds; in the case of the development charge, charged more than industrial on the basis of
developers and new homebuyers borrow gross floor area, although in some cases the
funds. In developed countries, it is probably charge is the same. In a few cases, the city has
the case that municipalities can borrow chosen not to charge industrial properties any
funds more cheaply than new homebuyers development charge in an effort to promote
and probably more cheaply than developers. industrial development.
Development charges may thus be less efficient
than municipal borrowing in those countries.
In countries where municipalities are unable
to borrow, however, development charges may
provide a good alternative.
46
Box 7: Calculating Development Charges
The following sets out a methodology for calculating development charges in eight steps:
Step 1: Estimate growth
The first step is to provide a forecast of housing units (for the residential charge) and square metres of
non-residential building space (for the non-residential charge). Information is needed on the anticipated
population growth rate, the housing stock composition, and occupancy rates (number of persons per
unit) for different types of housing. The accuracy of the population projections is key to the development
charge calculation because the projections determine the need for services and the levels of service are
generally calculated on a per capita basis.
To project the number of square metres for non-residential building space, employment forecasts are used
to estimate floor space per worker which is then converted into gross floor area for new development.
Step 2: Determine the services that will be covered by the charge
In theory, any capital costs that are needed because of growth should be included in the charge. In
reality, however, some costs are easier to assign to growth than others. For example, it is not difficult
to determine the proportion of costs that are growth-related for hard services such as water, sewers and
roads. There are some “grey areas,” however, with respect to what is growth-related. For example, the
expansion of a municipally-owned museum is unlikely to be fully attributable to growth and determining
the proportion that is attributable to growth may be difficult. One can think in terms of a continuum
of services ranging from those that are relatively easy to determine the growth-related portion to those
that are fairly difficult (and will be harder to justify). At the easy end would be water and sewers. The
next group would include roads, transit, recreational facilities, police, fire, public works, libraries, parks
and waste management. At the most difficult end would be museums, city halls, art galleries, convention
centres, and tourist facilities.
Step 3: Estimate the total capital costs to service growth
For each service for which a charge is going to be levied, capital costs have to be forecast over a period of
say 10 years. The estimates of capital costs need to be quite detailed, noting when in the planning period
they will be required based on estimates of the future growth. Where possible, capital costs should be
identified by specific areas of the municipality and by specific project (e.g. roads, traffic signs, etc.). The
magnitude of the costs needs to be reasonable and defensible. Where land costs are involved, for example,
land prices need to be realistic given current trends.
The next step is to determine what proportion of the estimated total capital cost is growth-related. In
most cases, the proportion is determined as the percentage of new population to the total population
(existing and new) and/or by the percentage of new employment to total employment (existing and
new).
Step 4: Determine service standards
To determine what portion of the growth-related capital costs is eligible for the charge for each service,
it is necessary to determine service standards. Municipalities need to establish realistic service standards
and they need to show that they are not trying to fund levels of service that are in excess of what they are
currently providing.
Examples of service standards include the average standard over the past 10 (or 5) years, the highest
standard achieved in the last 10 (or 5) years, or the standard in the current year. There are problems
with using the highest level of service in the last 10 years, however. For many services, the highest level
occurred in a year in which there was a major capital expansion. To the extent that facilities were built
to accommodate future growth, the levels of service in that year contains a significant amount of excess
capacity.
47
Guide to
Municipal Finance
Box 7 (continued): Calculating Development Charges
Step 5: Estimate net capital costs by service

Charges are generally only imposed on the net capital costs. To determine net capital costs on a service
by service basis, an estimate of future grants, subsidies, and fees needs to be deducted from total capital
costs.
Step 6: Apportion costs to residential and non-residential properties
Net capital costs have to be apportioned to various land uses such as residential, institutional,
commercial, or industrial. To apportion growth-related costs between residential and non-residential
developments, for example, a number of methods are used. In some cases, all costs are attributed to
residential properties (e.g. shelters and housing). In other cases, 95 percent of costs are allocated to
residential properties on the grounds that there is limited non-residential use (e.g. recreational facilities,
libraries). Sometimes the apportionment to residential development is based on the growth in population
as a proportion of the combined growth in population and employment. Another method is to apportion
costs on the basis of residential versus non-residential assessment for property tax purposes.
Within each land use, such as the residential land use, charges can be calculated for different types of
residential development (for example, single houses, townhouses, small apartments, large apartments)
based on occupancy rates and the total per capita cost.
Step 7: Choose area-wide or uniform charges
A uniform charge is one that averages all of the costs, within a broad class, over all development. All
developments are charged the same amount. When specific projects have higher costs that are unique
to those projects, it is possible to have separate areas for charging purposes. Under area-wide charges,
each development pays the costs imposed by that development rather than averaging the costs over the
municipality.
Step 8: Determine what portion of costs to recover through charges
The municipality can decide to recover less than 100 percent of the eligible growth-related capital
costs. It can also decide to exempt some parts of the municipality from the charge (e.g. the downtown
core) or some property types (e.g. industrial properties) to encourage certain kinds of developments or
developments in particular locations.
48
Table 11: Development Charges, Greater Toronto Area, 2007

Residential ($CDN per lot) Non-Residential
($CDN per square foot
of gross floor area)
Apartments Industrial Retail
Single and Multiple unit 2 or more Less than 2
semi-detached dwellings bedrooms bedrooms
Toronto 10,415 8,288 6,755 4,198 - 7.77
York Region* 16,249 13,846 10,157 6,460 3.97 7.88
Aurora 10,173 8,081 5,985 4,490 2.32 2.32
East Gwillimbury* 5,462 4,528 3,414 2,350 1.48 1.48
Georgina 3,590 3,472 2,471 1,704 1.28 1.28
King* 9,598 8,310 5,813 4,002 4.05 4.05
Markham* 8,586 6,745 5,748 3,653 1.04 1.04
Newmarket 7,516 6,043 4,765 3,032 0.97 0.97
Richmond Hill* 8,859 7,341 4,809 4,809 0.97 2.35
Vaughan 9,568 8,202 5,332 5,332 1.54 1.54
Whitchurch-Stouffville* 7,488 5,154 4,255 3,806 4.36 4.36
Durham Region 13,332 11,198 7,758 4,921 - 5.02
Ajax 9,189 7,704 4,784 3,399 1.89 2.86
Brock 9,389 7,446 5,504 5,504 3.76 3.76
Clarington 9,383 8,229 6,353 4,043 2 3.64
Oshawa 7,094 6,300 4,244 3,358 3.14 3.14
Pickering 9,207 7,476 5,230 3,428 2.5 2.5
Scugog* 10,388 8,239 6,089 6,089 5.1 5.1
Uxbridge 9,413 8,560 5,704 5,704 - 3.61
Whitby 9,110 7,592 5,497 3,534 1.56 3.12
Peel Region 8,302 8,302 5,930 3,084 3.1 4.29
Brampton 16,214 16,214 11,922 6,199 3.4 5.23
Caledon 13,624 12,393 9,071 5,243 1.71 2.61
Mississauga 8,488 8,488 6,063 3,153 2.84 3.49
Halton Region 12,078 8,128 6,929 4,653 5.93 9.15
non-HUSP
Halton Region HUSP 20,092 13,982 11,687 7,862 9.83 9.83
Burlington* 7,682 4,191 4,090 2,791 2.69 2.69
Halton Hills 7,851 6,253 4,400 3,011 2.62 2.62
Milton 9,158 6,944 5,221 3,450 3.01 3.01
Oakville* 10,911 8,587 6,940 4,000 5.08 5.08
* Area specific charges may apply.
** HUSP is the Halton Urban Structure Plan for Water and Sewer Servicing to Halton Hills.
Source: York Region 2007 DC By-Law Review Background Study
49
Guide to
Municipal Finance
TAX INCREMENT FINANCING TIFs are applied differently in each jurisdiction

in the U.S. but they generally follow a similar
Tax Increment Financing (TIF) is a financing
approach as set out in Box 8. Within a TIF
mechanism used by cities in most states in
district, developers may benefit from obtaining
the U.S. to revitalize blighted urban areas,
more appropriate or more affordable sites
generally in the downtown core (see Wassmer,
but they are taxed at the same rate as other
1994 and Anderson, 1990 for a more detailed
landowners in the city.
discussion of how they work). Cities designate
a TIF area for capital improvements and TIFs are not the same as tax abatements.
then earmark any future growth in property Under a TIF, the development is financed
taxes to pay for investments in infrastructure from increases in tax revenue that it generates,
and other economic development initiatives. not from a subsidy. There is no transfer of
The rationale behind TIF districts is that funds from the municipality to businesses
revitalization can have a positive impact on nor is there a transfer from one business to
urban quality of life and future tax revenue. another. Taxes from the increased assessment
TIF districts are often the beneficiaries of base are used to finance public improvements
federal and state grants and tax incentives. in the district. If used to stimulate downtown
These additional sources of funds help to development, TIFs could encourage compact
achieve the revitalization objective. development and discourage urban sprawl.
Box 8: Implementation of Tax Increment Financing

• A TIF district is proposed, based on planning criteria and what is permitted in the enabling
legislation. The geographic boundaries reflect the area that is in need of redevelopment. Public
consultation is held and a redevelopment plan is developed.
• Once the area has been given official status, the annual property tax revenue accruing to all taxing
authorities within the district (the municipality, the county, school boards, etc.) is frozen at pre-
revitalization levels. These are known as the base level property taxes. For a period of time, generally
between 15 and 35 years, all or some portion of the incremental tax generated (above the base level)
accrues to the redevelopment agency (or the municipality) to be used for the redevelopment. In
some cases, state legislation limits the amount of property tax revenues that can be diverted into a
TIF.
• In order to spur the redevelopment, infrastructure investments (for example, roads, buildings
construction, sewage expansion) and/or land acquisition is undertaken. In some states, TIFs are
used to offset private development expenses such as site preparation and construction. The source
of financing for these front-end and periodic costs is usually borrowing or bonds issued against
expected incremental tax increases. In this way - lending on the basis of a district plan’s expected tax
increment -- the plan is financed through a public offering.
• After the TIF period expires, tax revenues from the expanded assessment base again flow through
the taxing authorities.
50
The widespread use of TIFs is, in part, because Debt repayment depends on future increments
they offer a way for municipalities to get in property tax revenues and the municipality
around borrowing limits; tax increment bonds has no obligation to pay bond holders if
are not subject to municipal debt limits or sufficient increment taxes are not generated.
public referendum requirements in most states.
This financing method results in more capital The calculation of the tax increment requires a
for infrastructure than would be available with comparison of expected property tax revenues
traditional general obligation bonds (different in the absence of any new development with
types of borrowing tools are described more the expected property tax revenues once the
fully in Chapter 7). development has occurred. The first part of
this calculation involves an estimate of the base
There are some potential problems associated level property taxes on all properties in the TIF
with TIFs, however. TIFs may not be able to district now and in the future. The second
generate the predicted tax revenues and the part involves the calculation of the estimated
resulting lack of funds could threaten efforts property tax revenues for the development.
to revitalize the designated area. Other taxing This latter estimate is based on a determination
authorities (such as school districts) resent of the ultimate use, built form, and density for
that their property taxes are frozen at a time all of the land that will be redeveloped as well
that they are experiencing growth in demand as the timing and location of the development.
as a result of the revitalization. TIFs may The detailed methodology used to determine
merely accelerate development that would the viability of a tax increment is set out in
have occurred anyway. TIFs target funds to a Box 9.
designated area and this targeting may be at the
expense of areas on the periphery of the TIF
district or at the expense of overall municipal
growth. Financing TIFs is expensive because
the default risk is transferred to bond holders
instead of the municipality.
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Guide to
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Box 9: Steps for Tax Increment Financing

Step 1: Calculate base level property taxes
Base level property taxes are what the property taxes are today and what they would be in the future if
there is no redevelopment. Two approaches can be used to estimate base level property taxes (see Figure
3). Under the first approach, the base level represents the actual property taxes prior to the development.
These taxes are flat lined over the period of the TIF. Any increment above the base level taxes goes toward
the redevelopment. Under the second approach, property taxes are increased from the base year over the
period of the TIF by the amount of natural growth. Natural growth in property taxes reflects that the
assessments will increase over the length of the TIF period even if there is no redevelopment, although
the increase is likely to be small. Property taxes are also expected to increase over the TIF period because
taxes generally increase from year to year. The argument behind using natural growth as the base case
is that the rest of the municipality should at least continue to receive what they would have received in
property tax revenues if there were no redevelopment.
To calculate base level property taxes with natural growth, it is necessary to project what the assessed
values would be on the properties in the TIF district in the absence of redevelopment and also what the
tax rates would be.
Step 2: Calculate the tax increment
The increment in property taxes arising from the development will result from an increase in property
assessment on the redeveloped properties. There may also be an additional “lift” resulting from the use
of TIF funds to finance some capital improvements in the district. One obvious example of “lift” is
transit improvements where capital expenditures have been supported, in part, by financing from the TIF
district.
To estimate the assessed values and ultimately the property tax increment to be generated from the
redeveloped properties, it is necessary to determine the ultimate use, built form, and density for all of
the land to be redeveloped within the boundaries of the TIF district. The challenge in this analysis is to
determine the final built form. This analysis often requires input from existing land owners/developers
to ascertain what plans they have for development and then to compare these to the existing planning
regulations for the land.
With this information, the next step is to have the assessment authority estimate the expected assessment
on the developed properties.
Once the assessments are received for all of the properties in the development area for the base year, the
next task is to project the flow of increased assessments and property tax revenues as the implementation
of the development takes place over the period of the project. This step require two additional inputs: the
first is the anticipated phasing of the development in the project. The second is the rate of increase in the
assessment between the base year and the year the new buildings (redevelopment) will be completed and
enter the assessment roll.
To estimate the flow of increased tax revenue generated from the TIF application over the life of the TIF,
it is necessary to determine the time frame for the implementation of the development. This estimate
requires an understanding of how the development will unfold in terms of timing and location.
Step 3: Determine expenditure requirements
The next step is to provide estimates of the infrastructure costs needed to develop the TIF district on a
year-by-year basis. It is also necessary to determine what portion of these expenditures can be funded
from TIF revenues. In the U.S., TIFs are generally used to cover the cost of studies, surveys, and
plans; professional service costs such as architectural, legal, engineering, etc.; property assembly costs,
including land acquisition, demolition, land clearing, etc.; costs of rehabilitation, reconstruction, repair
or remodelling existing buildings and fixtures; costs of construction of public works or improvements;
financing costs; capital costs resulting from the redevelopment project; and relocation costs.
52
Box 9 (continued): Steps for Tax Increment Financing

Generally, TIFs are not allowed to be used to pay for general government operations including, for
example, police and fire protection, road maintenance or similar operating costs or for the construction
or financing of government buildings. Some examples of projects that have been funded by TIFs in
U.S. cities include: a university expansion, theatre renovations, schools, transit stations, malls, library
renovations, convention centre expansion, arenas, museums, and retail and entertainment complexes.
Although much has been written in the U.S. on the types of expenditures that are financed out of TIF
revenues in different jurisdictions, no comprehensive criteria have been set out to assess how those
expenditures should be determined. There appear to be two criteria that are generally applied, however.
The first criterion is that TIFs can only be used for expenditures that meet the “but for” test. This test is
to ensure that the development would not have taken place “but for” these expenditures. Typically, the
expenditures that meet this test are those that put infrastructure in place for the development or reduce
the risk to developers so that they are willing to undertake the development. The second criterion found
in U.S. statutes specifies that TIFs can fund only those capital costs that are not part of any impact fee
(development charge).
Step 4: Estimate the timing of the TIF
The final step involves estimating the time it would take to pay back the borrowed funds used to make
the capital expenditures. The estimate of expenditures also needs to include borrowing costs because it is
anticipated that the flow of revenues and expenditures will not match over the TIF period. When there is
a shortfall of revenues, funds need to be borrowed to cover it.
In terms of project financing, the optimal timing for a TIF would be just long enough for the projected
increase in TIF revenues to pay the total project costs. There may also be a need to allow for a reasonable
increment to compensate for the uncertainty of the projections. Moreover, the time period should also
take into account the impact on the ability of the municipality to deliver public services out of general
revenues when the tax increment is unavailable to them.
Figure 3: Calculating the Tax Increment

12
Base taxes
10 Natural growth increment
Increment to TIF
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
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Guide to
Municipal Finance
LAND VALUE CAPTURE TAXES property owners in proportion to the benefits

conferred by the works (Bird, 2001b).
Land value capture taxes are levied to capture
the increment in land value attributable to The valorization charge is a lump sum levy,
public investment. These taxes are also known although it can be paid in instalments. The
as land value increment taxes, betterment cost of the project is calculated and divided
levies, special assessments, and valorization among benefitting property owners. The first
taxes. step is to calculate the cost of the project -- the
maximum that can be charged for a project is
Land value capture taxation has generally
the total cost of the public works (including
been proposed in situations where the public
the cost incurred to allocate the tax among
sector is contemplating a major infrastructure
benefitting properties and collection costs).
investment that increases the value of adjacent
If the property owners who benefit from the
land (such as a new subway, highway exchange,
tax are unable to pay it, the amount may be
school, park, or other public infrastructure).
smaller.
An investment of this nature requires a large
capital outlay immediately but the benefits will The second step is to determine the zone of
not be enjoyed for several years in the future. the project’s influence. In other words, it is
The tax is designed so that the costs incurred necessary to determine the geographic area in
in the current period are shared among future which it is assumed that property values will
beneficiaries (Slack, 2005b). be affected by the construction of the project
(Bird, 1984). The third step is to distribute the
The decision of the public sector to construct
tax within the zone. Generally, the formula
major infrastructure results in a windfall gain
that is used depends on the characteristics of
to owners of property nearby. For example,
the project. Some of the factors that are taken
a subway increases demand for housing and
into account include the size of the property
offices on properties located near it. Given
to be taxed, its distance from the project, the
normal demand and supply conditions, an
socio-economic characteristics of the affected
increase in demand will result in higher prices
district, and other factors. The distribution
being charged for these properties. Moreover,
of valorization charges thus involves a
zoning changes often accompany investment
considerable amount of administrative
in infrastructure: increased densities permitted
discretion (Bird, 1984).
along the subway line, for example, will result
in increased land values. A land value capture Once the valorization charges have been
tax is a way for the public sector to tax some or assigned to individual properties, they are
all of the windfall gain that it has created. generally collected before the construction
work begins. The total amount collected
TIFs, which were described in the section
is often less than the full cost of the project
above, are a form of land value capture tax.
because costs may have been under-estimated
Although TIFs are largely used only in U.S.
or the project delayed.
jurisdictions, there is experience in other
countries with similar taxes that capture the In addition to valorization contributions,
increase in land values associated with an Colombia has levied a plusvalia or land
infrastructure investment or change in land value increment tax since 1997. This tax
use. Some Latin American jurisdictions, for is designed to recoup the benefits that are a
example, finance street improvements, water consequence of “urban actions.” These urban
supply, and other local public services through actions include government changes in the
a system of taxation known as “valorization” classification of land from rural to urban
whereby the cost of public works is allocated to
54
or suburban use, changes in the use of the The land value increment tax is levied in
property by changing the use of all property addition to other taxes on property values
located in a certain zone of the city, increases such as the valorization contributions. When
in the level of exploitation by increasing the a valorization contribution has been imposed,
proportion of land on which construction is however, the factors in its determination cannot
allowed or the relation between the area of be considered in calculating the appreciation
construction and the area of land or both, and in property values for the land value increment
the construction of public improvements that tax. For example, if the municipality imposes a
are not financed by valorization contributions valorization to capture the cost of a new road,
(Bird, 2004: 277). the impact of the new road on property values
cannot be included in the calculation of the
The owners or occupiers are liable for the land land value increment tax.
value increment tax. The tax base is the amount
of the appreciation of land value which is Colombia has had considerable success in
calculated as the difference in the value of the recouping some of the benefits to adjacent
property before and after the “urban actions.” property owners from certain public
Municipal councils set the tax rate which investments using this tax (Bird and Slack,
has to be between 30 and 50 percent of the 2007). It is neither easy nor costless to
appreciation of the property. implement such a tax under conditions
found in most developing countries, however.
Perhaps this is why few developing countries
have managed to do much with this potentially
useful fiscal instrument.
55
Guide to
Municipal Finance
CHAPTER 6
Municipal Budget,
Financial Reporting and Auditing
Fiscal decentralization, coupled with a water, sewage treatment, roads maintenance,

growing demand for accountability and public transportation systems, garbage
transparency at the local level, has resulted in removal, recreational and cultural activities
greater public participation in the municipal and facilities); servicing of long-term debt
budgetary process and more rigorous financial (principal and interest payments); and capital
management techniques by local governments expenditures (for new infrastructure and long-
in many countries. Financial accountability is life equipment).
about promoting and reporting publicly on
performance and it requires transparent rules- The extent of municipal expenditures differs
based expenditure and financial management around the world, as noted in Tables 1 and 2.
systems that ensure that resources are allocated Although most municipalities provide solid
in accordance with citizens’ preferences waste collection and disposal, roads, lighting,
(Yilmaz and Beris, 2008). This chapter focuses parks and recreation, there is nevertheless wide
on various aspects of municipal financial variation in the extent to which they provide
management including budgeting, financial water, sewerage, social services, education, and
reporting, auditing, and performance-based hospitals, police protection, housing, and land
measurement. use regulation.
EXPENDITURES AT THE LOCAL LEVEL MUNICIPAL BUDGETING

Local government expenditures typically A municipal budget is a document that sets out
comprise everything that is necessary for the the local government’s plan for revenue and
day-to-day operations of the local government expenditure for an annual or multi-year period.
and the delivery of services. Expenditures The municipal budget serves two primary
include salaries and wages of municipal purposes. The first is to set out a program of
employees and any associated benefits; expenditures of the municipality during the
operating costs of municipal offices, including coming year and to forecast the revenues that
equipment and supplies; purchase of short- will be used to finance those expenditures.
life equipment; repairs and maintenance; The second is to provide a method to control
service delivery (including services such as fire expenditure so that municipal expenditures
and police protection, provision of drinking do not exceed municipal revenues (Wrenshall,
56
Municipal Budget,
1937). The budget is a very important Operating budgets may take different forms
document because, if properly prepared, and each form provides a different type
it will eliminate unnecessary expenditures, of information for fiscal decision-making
increase efficiency in the methods of collecting (Schaeffer, 2000). A line-item budget relates
revenues, and preserve the credit rating of the revenues and expenditures to commodities
municipality (Tassonyi, 2002). with the underlying purpose of control of
the municipal budget. A performance budget
Budgeting has always been important as relates revenues and expenditures to workload
a means of controlling expenditures and with the underlying purpose to achieve
identifying revenues. In recent years, however, management efficiency. A program budget
the importance of budgets has grown relates revenues and expenditures to public
significantly as cities face increasingly difficult goals with the objective of meeting planning
expenditure and revenue decisions in an goals.
environment of increased demands for services
and infrastructure. Not only do budgets serve The capital budget sets out the local
as a necessary management and planning tool, government’s long term plan which is to be
they also contribute to the accountability and carried out over a number of years, usually a
transparency of the overall financial system of period of at least five years. Capital budgeting
local governments and reduce the possibility sets out a plan to acquire or rehabilitate long
of corruption and misappropriation of funds. term assets such as roads, water and sewer lines
and treatment plants, public buildings, and
sanitary landfills. At the same time, this plan
Operating and Capital Budgets indicates how all capital expenditures are to
Municipalities generally prepare two budgets: be financed (own source revenues, borrowing,
(1) an annual operating or current budget that grants, or other revenues).
consists of projected revenues and expenditures
The capital budget is an important management
plus relevant capital asset transactions for
tool because it allows the municipality and the
the upcoming fiscal year and (2) a capital
public to be informed on the need for capital
budget that lays out future capital expenditure
expenditures (short term and long term)
projects and anticipated revenues for funding
and it allows them to make more informed
these projects.
recommendations with respect to future
Municipalities face expenditure obligations capital spending. Schaeffer (2000) describes
on a recurring basis to provide the day-to- five steps in the development of the capital
day operation of services. Operating budget budget; these stages are set out in Table 12.
expenditures include wages and salaries,
pension contributions, the purchase of short-
life equipment, the purchase of services from
other agencies, materials and supplies, and
expenditures on repair and maintenance.
They may also include recurring financial
transactions such as servicing the long-term
debt (annual interest cost and principal
repayment) and contributions to reserve funds
established for specific purposes. Current
funds may also be transferred to the capital
budget to provide a portion of costs of capital
projects.
57
Guide to
Municipal Finance
Table 12: The Steps in the Capital Budget

Stages of Capital Budget Description
Inventory of capital assets The first step is to provide an inventory and an assessment
of the current condition of all infrastructure facilities. This
information is important because it will help to determine
the need for renewal, replacement, expansion, and
retirement of current inventory.
Developing a capital investment plan The second step requires the establishment of goals for
the level and quantity of service in terms of measurable
indicators. These service goals help the municipality to
determine if they need to replace or upgrade infrastructure
or undertake a new investment. The development of a
multi-year investment plan compares the inventory of
assets and current level of service with the desired service
goals. The output of this stage is a list of capital investment
projects to meet the service goals and a priority list of when
the projects should be started and completed.
Developing a multi-year capital investment plan The multi-year capital investment plan sets out the time
schedule and costs for all capital investment projects being
considered. The total additional costs to complete these
projects beyond the 5-year recommended period should be
included in the plan.
Developing the financial plan The most critical stage of the capital investment program
is the financial analysis of the municipality’s capacity and
ability to undertake the investment program. The number
of improvements that the municipality can finance depends
on the level of recurring operating expenditures, the cost
recovery elements for individual projects and the potential
for revenue generation, the availability of funding from
other levels of government or the private sector, and the
debt carrying capacity of the municipality.
Implementing the capital budget At the final stage of the process, the completed capital
budget should have the full cost implications for all
projects, the annual capital costs, and the current budget
implications of each project.
Source: Schaeffer (2000)
BUDGETARY PROCESS Stages of the budgetary process

Budget preparation is undertaken in a series The process begins with policy direction
of stages before it is formally delivered to the or guidance from the local council. For
elected officials for discussion, debate, and example, the council may decide to focus on
approval. Throughout the budgetary process, transportation or housing in a particular year
there are a number of participants, each or it may decide that it wants a budget that
per¬forming different roles. brings in a zero tax increase. The budgetary
process then continues in five stages (Kitchen,
2003) as set out in Figure 4.
58
Municipal Budget,
Figure 4: Steps in the Budgetary Process

Step 1: Step 2:
Departmental budget
Initial requests at
requests and development
departmental level
of revenue constraint
Step 3:
Adoption of the budget
Step 5: Step 4:
Audit of municipal
Execution of the budget
financial records
The first stage of the budgetary cycle is the the implementation and monitoring of the
preparation of initial requests for funds on budget throughout the fiscal year by the chief
the part of each department (for example, financial officer. The fifth stage is the audit of
transportation, water, recreation). The second municipal financial records by an independent
stage of the budget cycle involves the various auditor after the completion of the fiscal year.
departments sub¬mitting their budgetary The audit ensures that the municipality has
requests to the chief administrative or financial adhered to legal requirements regarding local
officer. This officer compiles, combines, and expenditures and that local officials have not
coordinates all requests for funds. The chief misappropriated local funds intentionally or
financial officer and his/her staff are also unintentionally (auditing is discussed further
responsible for estimating the anticipated below).
revenue yields for the year and acceptable
tax increases. Given the revenue constraint, As with any fiscal process, there are practices
priorities are set among the competing and pressures that can adversely affect
demands for expenditures. Inevitably, conflicts the budgetary process (Tassonyi, 2002).
arise and need to be resolved (Kitchen, 2003). Extra-budgetary funds (commonly used in
Departmental requests may be denied or municipalities in China, as noted in Chapter 5)
the financial constraint may be expanded. are funds that are outside of municipal budgets
Ultimately, the chief financial officer arrives and therefore independent of the scrutiny of
at a budget that is presented to the budget the formal budget process. Earmarked funds
committee of the municipal council. (funds that are mandated by local governments
to be spent on specific services) are tied up in
The third stage is the adoption of the budget reserve funds and provide the municipality
by the council. In some municipalities in all with no flexibility to use them for any other
countries, the public (taxpayers) is invited purpose. Unpredictability (for example,
to comment at public meetings on the when the amount or conditions attached to
proposed budget prior to council approval. intergovernmental transfers change) makes
Public participation (described further it difficult for local governments to plan for
below) is designed to add transparency and the future. Finally, unreliable information
accountability to the budgetary process. The hampers the ability of local governments to
fourth stage of the budget cycle involves make sound financial decisions.
59
Guide to
Municipal Finance
Citizen involvement
Box 10: Citizen Involvement:
Participatory budgeting refers to the practice of Participatory Budgeting in
including citizens in formulating the budget. Porto Alegre
Anyone interested in participating can do so
The first city to engage in participatory
individually or as part of an organization (such budgeting is Porto Alegre, Brazil which
as a residents’ association). There are four main introduced the practice in 1989. It is now
features of participatory budgeting (Serageldin used by 180 municipalities in Brazil and many
et al., 2008: 28): The first is the representation countries in Latin America and elsewhere.
of residents in each sub-area of the municipality Participatory budgeting was introduced, in
in the decision-making process. The second is part, as a way to address severe inequalities in
services (especially water and sanitation) and
that municipal officials are held to account for quality of life around the city.
the previous year’s budget and for estimates of
expenditures and revenues for the current year Participatory budgeting gives residents
some control over the annual allocation of
in order to determine the budget allocations. capital expenditures. Residents can decide on
The third is transparency which is achieved local matters, such as the location of street
through direct popular participation and an improvements or a park, as well as citywide
open voting system. The fourth is objectivity issues such as programs for helping the
through the use of quantitative criteria to homeless population.
prioritize funding requests and the allocation Regular decision-making forums of elected
of resources. representatives have been created at a number
of levels: sixteen regional forums bring people
Participatory budgeting improves together from different parts of the city; five
communication and dialogue between city thematic forums (such as health, education,
hall and citizens. It fosters social inclusion housing, sanitation) bring together people
from throughout the city; and a municipal
by allowing the poorest citizens to have a
budget council comprises representatives of the
voice in budgeting decisions and it empowers regional and thematic forums.
neighbourhood associations and small
The process covers all capital expenditures
organizations. Nevertheless, it can take a long
which range from 5 to 15 percent of the total
time to implement budgetary decisions, in budget of Brazilian municipalities. In Porto
part because it is necessary to teach citizens the Alegre, the number of participants in the
details of how the process works. Moreover, budgeting process is now more than 14,000
the number of people from the community people per year.
that participate is often very small and they Source: Abers, 2001, Goldsmith and
are not always representative of the youngest Vainer, 2002 and Serageldin et al., 2008
or the poorest in the population.
One of the first municipalities in the world

to undertake participatory budgeting is Porto
Alegre, Brazil. Box 10 briefly describes the
mechanics of participatory budgeting in that
city.
60
Municipal Budget,
FINANCIAL REPORTING AND AUDITING Accounting records provide information on

debt and debt service costs and determine if
The way in which cities manage their affairs
the municipality can increase its debt load
and monitor their activities plays an important
(Kitchen, 2003). Accounting reports provide
role in their ability to improve service delivery
information on whether budget plans are on
and minimize wasted resources: “transparent
target, when capital funds are diverted to meet
and prudent local financial management has
operating expenditures, when expenditures
come to be recognized as critical to the integrity
are greater than revenues, and when the
of the local public sector and for gaining and
municipality is incurring financial obligations
retaining the trust of local residents” (Shah,
beyond its ability to meet them (Holder,
2007:1). Financial reporting and auditing are
1996).
an important part of financial management.
Municipal financial management is designed

to ensure that the municipality has sufficient ACCOUNTING STANDARDS
revenues to carry out its expenditure Public sector accounting standards, based
responsibilities, to provide information that on International Public Sector Accounting
shows the state of municipal government Standards (IPSAS) or Generally Accepted
finances, and to account for the sources Accounting Principles (GAAP), provide
and allocation of revenues. To achieve these information that is reliable, understandable,
objectives, municipalities must have in place timely, relevant, and comparable across
systems for accounting and auditing. governments (Schaeffer, 2008; Kitchen,
2003). They provide an accounting of the
Accounting is the “systematic gathering of
full nature and extent of the financial affairs
financial transactions and the compiling and
and resources for which the municipal
reporting of these transactions in a meaningful
government is responsible. Accounting
and consistent manner so that government
standards demonstrate the accountability of
decision-makers can measure progress towards
the municipal government for the financial
goals established in the budget; estimate
affairs and resources entrusted to it and
resources required to accomplish these
account for the sources, allocation, and uses
objectives; and effectively allocate resources
of financial resources in the period (Kitchen,
across competing goals and objectives”
2003). Finally, they provide information that
(Schaeffer, 2008: 147).
shows the state of the municipal government’s
Municipal accounting differs from private finances.
sector accounting because the emphasis
Accounting systems record revenues and
of municipal accounting is on cash flow,
expenditures in a consistent way to permit
transparency, and accountability to the local
comparisons between budgets and actual
electorate whereas private sector accounting
figures. Financial audits determine whether
emphasizes the reporting of profits and losses.
the municipality’s financial statements provide
Accounting and financial reporting standards
an accurate and reasonable picture of the
are often established by independent standard
municipality’s financial position and detect
setting authorities.
deficiencies in the system of internal financial
Municipal accounting systems and practices are control or failures to comply with accounting
central to the budgetary process. For example, principles and standards.
past accounting records provide important
information on revenue and expenditure
forecasts used to construct the budget.
61
Guide to
Municipal Finance
ACCOUNTING CONCEPTS Cash accounting omits information about

fixed asset values and changes in the value of
Municipal accounting systems use a fund-
long-term debt. As a result it does not permit
accounting approach whereby the municipality
the preparation of a balance sheet showing the
establishes a separate fund for each area of
assets and liabilities of the municipality. The
municipal activity, for example, libraries,
inability to prepare a balance sheet with assets
water and sewer operations, policing, etc.
and liabilities means that the net worth of the
Fund accounting uses self-balancing double
municipality cannot be presented (Schaeffer,
entry accounts from which the municipality
2008). Inventories, receivables, and payables
can prepare a balance sheet and a statement
do not typically appear in cash accounting
of operations. The fund basis of accounting
balance sheets because they are not accrued.
recognizes that most municipal assets are
not available for purposes other than those Accrual accounting records revenues and
for which they have been budgeted and that expenditures when they occur regardless
data on budgetary compliance is an important of when the expenditures are made or the
part of the stewardship responsibility of revenues received. For example, if taxes are
government (Kitchen, 2003). Accounting legally due on June 30 of a given year, they are
for distinct funds is necessary to ensure that recorded on June 30 whether or not they are
resources are devoted to their designated use. received that day. If they are not received for
Most municipalities maintain funds for general an extended period of time, they will appear
purposes, revenue funds for special activities, as tax arrears or receivables. Similarly, if a
funds for utility operations (for example, payment to a supplier is due on a particular
water, sewers, and electricity), sinking funds, date, this expenditure is recorded as a payment
capital funds, reserve funds, trusts, and agency on that date. If the supplier is not paid on
funds. time, the due payment becomes expense
arrears or payables (Vaillancourt, 2006). The
Municipalities can use cash accounting, accrual
main difference between cash accounting and
accounting, or modified accrual accounting.
accrual accounting is the treatment of arrears
Cash accounting records expenditures and
(Vaillancourt, 2006). Cash accounting provides
revenues when funds are actually disbursed
no information about the amount of arrears
or received. Although cash accounting is
whereas accrual accounting identifies arrears
relatively easy to implement, it can give a
under items that are payable or receivable.
misleading picture of municipal accounts
(Schaeffer, 2008). For example, cash received Modified accrual accounting differs from full
as a loan is recorded as revenue on the operating accrual accounting in that is does not include
statement but not as a liability on the balance depreciation and returns on capital assets
sheet. As a result, the available balance is over- as costs (Kitchen, 2003). Rather, principal
stated. Another example is when the full cost repayment and interest costs are recovered
of an item is charged against the budget in directly through user fees and local taxes in
the first year of its use when there are multi- the year in which they are due. Since principal
year benefits. This way of reporting the cost repayments are recovered each year as a
may over-state the expense in the first year but chargeable expense, municipalities using this
under-state it in subsequent years. system are less likely to face cash flow problems
than those using full accrual accounting. The
treatment of operating expenditures is the
same under full accrual and modified accrual
accounting.
62
Municipal Budget,
Many countries have implemented some Financial audits often focus on financial
form of modified accrual accounting in the statements and thus do not address the
past 10 years. However, only four OECD efficient use of resources or the achievement
countries (Australia, Finland, Iceland, and of performance standards. Value-for-money
New Zealand) have implemented full accrual audits or performance audits (which are
accounting and others, such as Canada and discussed below) examine areas of waste and
the U.K., are rapidly moving in that direction mismanagement to suggest how a municipality
(Schaeffer, 2008). One of the reasons for lack can improve the efficiency of its operations
of widespread use of accrual accounting is the (Schaeffer, 2008).
difficulty and cost of implementation. For
example, governments may not know the full Some of the problems with local government
amount of tax revenue they are likely to receive audits, particularly in developing countries,
at any given time (Schaeffer, 2008). Moreover, are summarized in Schaeffer (2008) along
it can be costly to develop new computer with some suggestions for improvement: local
systems to support accrual accounting. governments need to build staff capacity,
establish uniform and transparent accounting
and auditing procedures, and standardize local
AUDITING government financial information.
Financial audits are designed to detect problems

in the system of internal financial control, PERFORMANCE-
failures to comply with accounting principles BASED MEASUREMENT
and standards or with reporting requirements
set out by the central or provincial/state Performance measurement has been used at the
government, and misappropriations of funds. local level for some time in Australia and New
To maintain the integrity of the audit, the Zealand and was introduced more recently
auditor must be independent of government, in some Canadian jurisdictions. Performance
have a legal mandate to undertake the audit, measures are designed to assess the efficiency
and report the findings to the legislature (or and effectiveness of municipal services.
council in the case of a local government) Efficiency refers to the amount of resources
(Schaeffer, 2008: 161). It is critical that the used to produce a given amount of service;
audit information be released to the public for effectiveness refers to the extent to which a
general review and inspection. service is achieving its intended results (Burke,
2006). A performance measure, if correctly
Local government audits should do three determined, records the output rather than
things (Schaeffer, 2008: 163): first, they the input of municipal spending on specific
should analyze the financial position of the programs or services.
local government, including trends, quality
of revenues, and expenditures. Second, they Performance measurement (sometimes called
should evaluate the performance of the benchmarking) enhances accountability
government on various financial management by permitting municipal elected officials,
and accounting issues. Third, they should administrators, and taxpayers to monitor and
include audit observations on non-observance evaluate municipal expenditures over time
of rules and regulations, wasteful expenditures, and in comparison to other municipalities.
delays, and non-achievement of budget In this way, municipalities operate in a
objectives. more competitive environment and have an
incentive to provide services in a cost efficient
way (Kitchen, 2003).
63
Guide to
Municipal Finance
Performance measures reinforce managerial In terms of effectiveness, performance

accountability and provide an incentive to measurement is used to measure the extent
stimulate staff creativity and productivity. to which an activity contributes to the
Finally, performance measures help achievement of the stated goals, objectives, or
municipalities develop budgets based on targets. For example, building a road may be
realistic costs and benefits rather than on very efficient in terms of cost per kilometre, but
historical patterns. its effectiveness will depend on the usefulness
of the road in providing convenience, safety,
Performance measures require accurate and and economy for vehicle transporta¬tion. If it
complete information on input costs and is not possible to determine the benefits from
measures of outputs. Input costs measure the local services, the demand for services subject
total cost of an activity. Measures of output to quality standards might be measured
are relatively straightforward for services such through citizen surveys, studies of local
as sewage disposal, garbage collection, and economic conditions, reports on the number
water provision - services for which the unit of applications, requests or complaints
of out¬put is subject to quality standards can received, and expert evaluations of specific
be measured. Output measures, however, are needs (Kitchen, 2003).
considerably more dif¬ficult to measure for
education, social services, crime prevention, Appendix 1 sets out a number of municipal
and fire protection where the unit of output is services and the performance measures that
not clearly defined. For example, is the unit of have been used in one province in Canada.
output for education the number of students Over 50 performance measures have been
taught annually, the number of students who constructed for 12 municipal services
passed, or the test scores on standardized (general government, fire protection, police
tests? Similarly, the output measures for police protection, roads, transit, wastewater, storm
protection, fire protection, and social services water, drinking water, solid waste, parks and
are difficult to measure. Notwithstanding recreation, libraries, and land use planning).
these measurement problems, attempts The provincial government requires that
should be made to establish proxies for output municipalities report the results of these
measures. measures to taxpayers annually.
64
Municipal Borrowing and
Access to the Capital Market
CHAPTER 7

Municipalities in some countries are permitted Nevertheless, local access to capital markets is
to borrow to make capital expenditures. often heavily restricted in developing countries
This chapter looks at the role of municipal (Rodden et al., 2003). Smaller municipalities,
borrowing and borrowing instruments. It even in countries with well-developed capital
also sets out the factors that are used by bond markets, may be able to borrow only through
rating agencies to determine the credit rating a financing authority or state/provincial body,
of a municipality. partially to reduce borrowing costs by pooling
the requirements of different municipalities.
ROLE OF MUNICIPAL BORROWING In principle, provided there is no central

subsidization of such borrowing (e.g. through
Borrowing at the municipal level is quite guarantees, explicit or implicit), this method
different from borrowing by senior levels of financing capital investment is a good
of government. Unlike central and state/ idea. In practice, many developing countries
provincial governments, who can and do have experienced substantial difficulties that
borrow to meet operating requirements have resulted in tighter restrictions being
(such as to pay wages and salaries, purchase imposed on subnational borrowing (Rodden
materials, etc.), municipalities can generally et al.,2003). In most countries, some form of
only borrow to make capital expenditures. In limitation is placed on the amount of funds
most countries, municipalities are not allowed that can be borrowed by local governments.
to run a deficit in their operating budgets. The For example, the central government may
advantages of borrowing at the municipal level limit long-term borrowing to capital projects.
were discussed in Chapter 5. It may limit the aggregate amount of long-
When the benefits of a capital investment, term debt to a fixed share of the local tax
such as the construction of a water treatment base. Others place limits on debt charges such
plant, are enjoyed over a long period, it is both as debt charges (principal repayment plus
justifiable and efficient to fund the project interest) cannot exceed a specified percentage
partially through borrowing so that benefit of expenditures or own-source revenues.
and cost streams are balanced as the debt is
paid.
65
Guide to
Municipal Finance
Municipalities need to be concerned about If the capital market mechanism works,

maintaining a sustainable level of borrowing local fiscal conditions are disciplined by the
or optimal level of debt relative to future competition for credit. Poor fiscal performance
operating budgets and anticipated population will lead to restricted access to the credit market
and economic growth. Each municipality has or higher borrowing costs. Credit ratings also
its own level of tolerance for debt. In doing provide important signals to voters about the
so, they take account of the statutory limits performance of the government (Rodden et
set out by the senior levels of government, al., 2003: 18). As will be noted below, the
competition with other municipalities in function of the credit market depends on good
accessing capital markets, and maintenance of information including accounting principles
a good credit rating. and auditing.
CAPITAL MARKETS POOLING MUNICIPAL DEBT

The capital market consists of the “set of The cost of borrowing may be particularly
institutions by which the savings of savers high for smaller municipalities. Pooling
are made available to borrowers and investors of municipal debt is one way to lower the
who, in exchange, agree to remunerate savings costs of borrowing. When municipal debt is
with some payment such as an interest pooled, local governments issue bonds that are
payment or dividend payment” (Vaillancourt, purchased by a bond bank which is usually an
2006: 43). The nature of capital markets is independent authority established by central
different in different countries depending on or provincial/state statute. The bank can pool
the legal framework and degree of economic the issues and sell the larger, combined issue
progress. For example, some countries may on the national bond market at a lower cost
not have a subnational capital market and thus than can some individual municipalities.
subnational governments are prohibited from
borrowing. In countries with limited capital Financing authorities can then gain greater
markets, access to capital is predominantly access to national and international capital
through the central government through a markets and benefit from higher credit ratings.
development bank or a housing bank, for The credit risk of all municipalities combined is
example. Local governments can also rely on almost always less than that for each individual
their own savings to make capital expenditures. municipality. Municipal finance authorities
In China, subnational governments obtain generally issue bonds on a regular basis; some
credit on favorable terms through their state- only for municipal units but others also issue
owned enterprises in a process that involves bonds for schools, hospitals, utilities, and
the central bank, line ministries, and lending other municipal bodies.
institutions (Rodden et al., 2003: 19). Under The main advantage of financing authorities
these circumstances, lenders may lend to is lower borrowing costs as a result of pooling
subnational governments that have poor local government debt issues. The lower
economic and fiscal performance because they borrowing cost reflects mainly the reduced
believe that the central government will bail cost of capital but also lower administration
them out. In other countries, the existence costs to issue debt. A municipal finance
of subnational government banks means that authority substitutes one contract with an
local governments are permitted to borrow. underwriter for separate contracts between
each borrower and debt issuer. It should
be able to economize on transactions costs
66
because it issues debentures more frequently In the case of general obligation bonds, the
than most individual municipal borrowers government uses its general revenues to
and it operates in a volatile capital market that support the debt service payments. These
is subject to a large amount of uncertainty. It bonds would be used for activities that do not
can exercise a greater degree of flexibility over produce revenues such as public education,
issue terms and costs to municipal clients. Box health, and welfare expenditures. Revenue
11 shows an example of a municipal finance bonds, unlike general obligation bonds, are
authority that pools debt for municipalities in legally secured by a specific revenue source.
Ghana. For example, a revenue bond issued by a
water and sewer utility would be backed by
the specific revenues of that utility (generally
Box 11: Municipal Finance
user fees) rather than the general revenues of
and Management Initiative
in Ghana the municipality. The advantage of revenue
bonds is that they promote full-cost pricing
A major new urban development initiative has of services and shift the risk to the investors.
been launched by the Government of Ghana.
As part of this initiative, it has introduced
The disadvantage is that they are often charged
legislation to help local authorities to access higher borrowing rates because they are not
long-term financing for infrastructure backed by the government’s overall revenues
and service delivery. The government has and are therefore considered to be riskier.
established the Municipal Finance Authority
which will borrow from domestic and Tax-exempt bonds enable municipalities to
international markets and then on-lend to local issue bonds at a lower interest rate because the
authorities including metropolitan, municipal interest is tax-free. The interest income is not
and district assemblies.
taxable by the personal or corporate income
Source: Cities Alliance without Slums: tax. Box 12 illustrates how a tax-free bond
http://www.citiesalliance.org/mfmi/overview.html.
works.
Box 12: Illustration

of a Tax-Free Bond
BORROWING INSTRUMENTS
A bond is a document that indicates the Suppose the interest rate on bonds is 5
issuer’s obligation to repay a specified principal percent. A $1,000 bond would thus yield $50
amount plus interest on a specified date. A in interest. If the taxpayer’s marginal tax rate
bond represents a promise by the issuer (the is 40 percent, then the taxes would be $20
and the after-tax interest would be $30. The
local government) to pay back the bondholder effective interest rate is thus 3 percent. If the
(individuals or institutions) the principal municipality can issue a tax-exempt bond, then
and interest at given intervals (for example, it could pay 3 percent interest and provide the
quarterly or annually). same after-tax return to the investor.
67
Guide to
Municipal Finance
Municipalities in the U.S. have used tax-free CREDIT RATINGS

bonds for a long time. In 2001, bonds issued
A credit rating assesses the ability of the
by local governments in India were exempted
issuer of the debt to pay back the funds
from income taxes (Serageldin et al., 2008).
owed to investors who buy the bonds on
Tax-exempt bonds provide a direct advantage
time and in full. It is important to obtain a
to the bondholder. For a municipality, issuing
good credit rating because many investors
a tax-exempt bond means that they can
refuse to buy bonds that are unrated and, in
borrow funds at a lower interest rate than
some countries, the central government will
regular bonds because investors would be
not permit subnational governments to sell
willing to receive a lower interest rate if it is
unrated bonds. Moreover, the rating serves as
not taxable. Tax-exempt bonds tend to work
a key determinant of the interest rate that the
best in municipalities that have access to
bond issuer will have to pay. If the bond rating
capital markets but their application to other
agency feels that there is a risk that the local
municipalities has been limited.
government will not be able to make debt
The main criticism of tax-exempt bonds is service payments, it will issue a lower credit
that they are regressive because people with rating and the interest rate will be higher.
higher incomes benefit more than people with
Bond rating agencies use a number of
lower incomes from this tax incentive (TD
factors to evaluate the creditworthiness of
Economics, 2002: 13). High-income taxpayers
municipalities. These factors can be divided
are more likely to benefit because they have
into four main areas: economy, debt, finances,
the funds to invest in bonds. Moreover, for a
politics, management, and institutional
given amount invested, the benefits are larger
framework (Lipnick, Rattner and Ebrahim,
for taxpayers with a higher marginal tax rate.
1999 and Moody’s Investors Services, 2005).
Tax-exempt bonds have also been criticized
Economy: The state of the economy (and
because they require other levels of government
future trends) determines the extent to which
(central and/or state/provincial governments)
a municipality is able to generate revenues
to forego income tax revenue. In other words,
needed to support its debt and, at the same
municipalities (particularly large urban
time, pay for services. This aspect of credit
regions where infrastructure expenditures are
rating is not something that the municipality
likely to be highest) benefit at the expense
can control, however. Bond rating agencies
of the general population who pay higher
look at measures such as: credit quality
income taxes than otherwise to make up for
and market position of the region’s largest
the shortfall in income tax revenues. Another
employers; the strength and diversity of its
problem with tax-exempt bonds is that the
largest taxpayers; demographics; diversity of
amount of revenues foregone exceeds the
the economic base (the extent to which the
amount saved by local governments in lower
economic base is concentrated in a single
interest payments because of transactions fees
industry); unemployment rates; labour market
paid to brokers and bond traders.
performance; the regulatory environment;
retail sales; building permits; employment
data; overall wealth of community (measured
by the size of the taxable assessment base per
capita); and median family incomes.
68
Debt: The debt position of the municipality as a percentage of revenue. This indicator
is another factor that goes into its credit shows the portion of municipal revenues
rating. Some factors relate to the size of the used to pay debt service costs. It reflects the
debt; others relate to debt service costs. In debt burden in relation to recurrent annual
terms of the size of the debt, one variable that resources potentially available to cover debt
is used is total debt relative to market value service. A high debt ratio may mean that the
of taxable property. This measure reflects the municipality has taken too much debt but it
use of property taxes to pay for debt service could also mean that it is aggressively paying
charges. Typically, a growing municipality down debt to avoid interest costs. Similarly,
with new development has a greater need a low debt ratio could indicate that the
for infrastructure and therefore it will incur municipality is financially strong but it could
higher costs. At the same time, it will have an also mean that it has deferred capital projects
increasing tax base to finance the debt through and allowed infrastructure to deteriorate.
property taxes. A second measure is debt per Finally a fourth factor is debt service costs as a
capita. This indicator reflects the ability and/ percentage of the municipal levy. This measure
or willingness of residents to pay debt service shows the portion of the property tax that is
costs and allows the municipality to compare its used for debt service. It is possible that a high-
per capita debt with other municipalities and growth municipality could manage a higher
to determine how debt is changing over time. debt service cost ratio since its property tax
It does not take into account fiscal capacity, revenues are likely increasing with assessment
however, because the tax base (the assessment growth more so than for other municipalities.
base in the case of property taxes, for example)
could be growing faster than population. A Finances: The bond rating agencies look at the
third measure is the debt to income (GDP) trend in financial performance and control
ratio. This measure relates the amount of debt including budgetary planning, daily spending
to economic activity and reflects the potential control, spending growth, use of surpluses,
debt servicing capacity of the municipality. and shortfall contingency plans. Agencies also
look at the general fund balance relative to
The factors that relate to debt service costs revenues, a measure of the financial reserves
include debt service costs per capita. This potentially available to fund unforeseen
measure reflects the willingness and/or ability contingencies. They want to ensure that
of residents to pay debt service costs. This general fund balances are sufficient to address
indicator will be conservative if the tax base normal contingencies. Other factors include:
(for example, property assessment) is growing revenues and expenditures; control over setting
faster than population. A fast growing taxes and other own-source revenues; types
assessment base reflects the greater capacity of taxes available to municipal governments;
of the municipality to pay the debt service reliance on inter-governmental transfers, their
costs. A second factor is debt service costs as stability, and restrictions on use; annual growth
a percentage of operating expenditures. This or volatility in expenditures and revenues;
measure shows the proportion of the operating inter-fund transfers; composition of assets
budget that is devoted to debt service and the and liabilities; cash position; and financial
direct impact of its indebtedness on the budget. performance relative to budget.
It also reflects the amount of budget flexibility
a municipality will have. If debt service costs
represent a large percentage of expenditures,
there will be fewer funds available for other
functions. A third factor is debt service costs
69
Guide to
Municipal Finance
Politics, Management, and Institutional The bond rating agencies have recognized a
Framework: Elements of management number of concerns and challenges in rating
strength that are reviewed include: division emerging market subnational debt. These
of responsibilities, professional qualifications; include (Vaillancourt, 2006: 55): unpredictable
sufficiency of power to perform functions; legal and regulatory frameworks, risky debt
management strategies; debt practices; and profile, unaudited financial data, burdens
economic development policies. Political imposed by publicly-owned companies,
considerations include political dynamics changing intergovernmental political and
and social climate. The institutional fiscal relationships, incomplete demographic
framework includes constitutional powers data, inflation effects, enormous infrastructure
and responsibilities, borrowing authority, and needs, and uncollected taxes and user fees. If
intergovernmental relations. local governments are given permission to
borrow in these countries, they will need to
address these issues.
70
Concluding Comments
CHAPTER 8
Concluding Comments
Interest in cities is increasing around the world, The choice of revenue tools will also have an
in part, because more people are living in cities impact on the ability of local governments
than ever before and, in part, because recent to deliver services and attract business. The
trends towards fiscal decentralization and benefit model of local government finance
globalization have highlighted the importance starts with the premise that the main role
of cities. Fiscal decentralization has resulted in for local government is to deliver goods and
the devolution of powers and responsibilities services to local residents. Wherever possible,
from central and state/provincial governments local government services should be paid for
to the local level making local governments on the basis of the benefits received. Where
responsible for a wide range of services and the beneficiaries can be identified and where
infrastructure. Globalization has meant the services are not primarily redistributive
that it is cities that are competing on the in nature, user fees are recommended. Some
international stage. They not only have to services that are financed, at least in part in
provide the services and infrastructure needed some countries, by user fees include water,
to attract businesses and skilled workers but sewers, recreation, and transit. There may,
they have to maintain relatively low taxes on however, be scope for greater use of user fees
businesses so that they do not adversely affect for these and other services. Local governments
their competitive position. In short, cities are need to make citizens understand that user fees
critical to the success of the new economy. are not a tax grab but rather an important way
to gauge the quantity of services that people
A solid financial structure is essential to the want and are willing to pay for.
success of cities in meeting the challenges
of urbanization, decentralization, and
globalization. The financial structure affects the
quantity and quality of services, the efficiency
with which those services are provided,
whether the costs are shared across the city
in a fair and efficient way, and both citizen
access to government and local government
accountability to citizens.
71
Guide to
Municipal Finance
Where services provide benefits of a collective Finally, it is important to remember that “one
nature to the local community, a case can be size does not fit all” when it comes to the
made for property taxes or other local taxes finance of services and infrastructure by local
borne by local residents. Examples include governments. Not all of revenue tools described
local roads, policing, and fire protection. To in this Guide will be appropriate for all local
be truly local taxes, municipalities have to governments under all circumstances. It may
set their own tax rates (although it is often be necessary to treat different municipalities in
administratively easier for senior levels of different ways. For example, experience tells us
government to administer and collect the that large metropolitan areas can and should
taxes on their behalf ). Unless municipalities have greater fiscal autonomy than other urban
are given the freedom to set their own tax or rural areas. Autonomy means both greater
rates, even if it means making mistakes, responsibility for delivering local services and
truly accountable and responsive municipal greater ability to levy their own taxes. All local
government will never be a reality. governments, however, need to be responsible,
accountable, and efficient. To do so, they need
There is also a role for intergovernmental to raise their own revenues as much possible,
transfers in this model of local finance. Where adhere to an open and visible municipal
there are spillovers in the provision of local budgetary process, and engage in transparent
services but where local provision is still and prudent financial management.
desirable, for example, conditional transfers
may be used. Equalization transfers may also
be required to ensure at least a minimum
level of service is provided by those cities
with relatively little fiscal capacity. Where
intergovernmental transfers are used, however,
they should not be designed to discourage
municipalities from charging the right price
for services.
72
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77
Guide to
Municipal Finance
Appendix 1: Examples of Performance

Based Measures – Municipalities in
Ontario, Canada
Service Area Measure

General Government Operating costs for governance and corporate management as a percentage of total
municipal operating costs
Fire protection Operating costs for fire services per $1,000 of assessment
Police protection Operating costs for police services per person
Violent crime rate per 1,000 persons
Property crime rate per 1,000 persons
Total crime rate per 1,000 persons
Youth crime rate per 1,000 youths
Roads Operating costs for paved (hard top) roads per lane kilometre
Operating costs for unpaved (loose top) roads per lane kilometre
Operating costs for winter maintenance of roadways per lane kilometre maintained
in winter
Percentage of paved lane kilometres where the condition is rated as good to very
good
Percentage of winter events where the response met or exceeded locally determined
municipal service levels for road maintenance
Transit Operating costs for conventional transit per regular service passenger trip
Number of conventional transit passenger trips per person in the service area in a
year
Wastewater Operating costs for the collection of wastewater per kilometre of wastewater main
Operating costs for the treatment and disposal of wastewater per megalitre
Operating costs for the collection, treatment, and disposal of wastewater per
megalitre (Integrated System)
Number of wastewater main backups per 100 kilometres of wastewater main in a
year
Percentage of wastewater estimated to have by-passed treatment
Storm water Operating costs for urban storm water management (collection, treatment, disposal)
per kilometre of drainage system
Operating costs for rural storm water management (collection, treatment, disposal)
per kilometre of drainage system
78
appendix

Drinking water Operating costs for the treatment of drinking water per megalitre
Operating costs for the distribution of drinking water per kilometre of water
distribution pipe
Operating costs for the treatment and distribution of drinking water per megalitre
(Integrated System)
Weighted number of days when a boil water advisory issued by the Medical Officer
of Health, applicable to a municipal water supply, was in effect
Number of water main breaks per 100 kilometres of water distribution pipe in a year
Solid waste Operating costs for garbage collection per tonne or per household
Operating costs for garbage disposal per tonne or per household
Operating costs for solid waste diversion per tonne or per household
Average operating costs for solid waste management
(collection, disposal and diversion) per tonne or per household
Number of complaints received in a year concerning the collection of garbage and
recycled materials per 1,000 households
Total number of solid waste management facilities owned by the municipality with a
Ministry of Environment Certificate of Approval
Number of days per year when a Ministry of Environment compliance order
for remediation concerning an air or groundwater standard was in effect for a
municipally owned solid waste management facility, by facility
Percentage of residential solid waste diverted for recycling
Percentage of residential solid waste diverted for recycling
(based on combined residential and ICI tonnage)
Parks and recreation Operating costs for parks per person
Operating costs for recreation programs per person
Operating costs for recreation facilities per person
Operating costs for recreation programs and recreation facilities per person (Subtotal)
Total kilometres of trails and total kilometres of trails per 1,000 persons
Hectares of open space and hectares of open space per 1,000 persons
(municipally owned)
Total participant hours for recreation programs per 1,000 persons
Square metres of indoor recreation facilities and square metres of indoor recreation
facilities per 1,000 persons (municipally owned)
Square metres of outdoor recreation facility space and square metres of outdoor
recreation facility space per 1,000 persons (municipally owned)
79
Guide to
Municipal Finance

Libraries Operating costs for library services per person
Operating costs for library services per use
Library uses per person
Electronic library uses as a percentage of total library uses
Non-electronic library uses as a percentage of total library uses
Land use planning Percentage of new residential units located within settlement areas
Percentage of land designated for agricultural purposes which was not re-designated
for other uses during the reporting year
Percentage of land designated for agricultural purposes which was not re-designated
for other uses relative to the base year of 2000
Number of hectares of land originally designated for agricultural purposes which was
re-designated for other uses during the reporting year
Number of hectares of land originally designated for agricultural purposes which was
re-designated for other uses since January 1, 2000
Source: Ontario Ministry of Municipal Affairs and Housing.
Municipal Performance Measurement Program, 2007
80
Interest in cities is increasing around the world, in part, because of rapid urbanization in
developed and less developed countries but also because of recent trends towards fiscal
decentralization and globalization. These trends have put pressure on cities to provide
a wide range of services (for example, water, sewers, police and fire protection, solid
waste collection and disposal, roads, transit, social services, health, and housing) and to
maintain and expand infrastructure to meet the growing demands of the urban population.
Although local governments in many countries have experienced an increase in powers and
responsibilities in recent years, however, few countries have allowed local governments to
levy the taxes they need to match their expanding local needs.
This Guide to Municipal Finance describes the current issues in municipal finance and the
ways in which local governments finance services and infrastructure. It sets out a basic
economic framework that is used to evaluate the different aspects of municipal finance
and that can be used by readers to evaluate other options. The Guide emphasizes that
responsible, accountable, and efficient local governments need to raise their own revenues
as much possible, adhere to an open and visible municipal budgetary process, and engage
in transparent and prudent financial management.
HS/1146/09E
ISBN: 978-92-1-132113-5
ISBN(Series): 978-1-132027-5
UNITED NATIONS HUMAN SETTLEMENTS PROGRAMME

P.O.Box 30030,Nairobi 00100,Kenya;
Tel: +254-20-7623120;
Fax: +254-20-76234266/7 (Central office)
infohabitat@unhabitat.org
www.unhabitat.org

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Guide To Municipal Finance

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Guide to

Guide to Municipal Finance

First published in Nairobi in 2009 by UN-HABITAT.

Copyright © United Nations Human Settlements Programme 2009

All rights reserved

Cover design : Andrew Ondoo/UN-HABITAT

Director: Oyebanji Oyeyinka

chapter 1 Definition of Municipal Finance and Objectives of the Guide 1

CBD Central Business District

The global housing And for this, we need innovative governance,

By the year 2050, six billion people – two-

This makes it imperative that we use every

Definition of Municipal Finance and

OUTLINE OF THE GUIDE Finally, because local governments in many

Municipal Finance Issues,

Local governments make expenditures on a It is difficult to draw conclusions from the

Order, Affairs Protection community culture and protection expenditures.

Taxes Social Grants Other Total

Table 5: Local Government Expenditures as a Percentage of GDP

Table 6: Urban Population by Major Area, Selected Periods, 1950-2050

ISSUES AND CHALLENGES Table 6 shows the urban population by major

The urban population has been increasing

Table 7: Percentage Urban by Major Area, Selected Periods, 1950-2050

The growth of the urban population has Challenges for Large

The challenge of achieving these goals Inadequate Revenues to Meet

Fifth, most municipalities in developing Local investments as a percent of total public

Figure 1: Public Debt, Spending and Investments –

Emphasis on Land and Property Property tax is regarded as an important tool

Land and property taxes thus have a role in Accountability in Budgeting

Principles of Municipal Finance

MAJOR FUNCTIONS OF MUNICIPAL The extent to which municipalities will be

Figure 2: Different Financing Tools for Different Services

User Fees Property Tax Income Tax Transfers

Services with Public Good Services that Redistribute Income

Box 1: Public Finance Principles

Table 8: Sources of Municipal Operating Revenues for Selected Cities

CHARACTERISTICS OF Box 2: Characteristics of a

Whatever tax or taxes are chosen at the

Property Identification Assessment Base

Table 9: Base for Property Taxes

Where it is possible to use market value, it is Tax Rates

Corporate Income Taxes General Consumption Taxes

Excise Taxes should be subsidized from revenues generated

As with other possible tax sources, the Public Prices

Efficiency of User Fees

Table 10: Types of Intergovernmental Fiscal Transfers

Rationale for Transfers (known as revenue sharing); on the basis of a

Box 5: Public Finance Principles for Designing Fiscal Transfers

Financing Capital Expenditures2

The use of borrowing or reserves is more MOBILIZING PRIVATE CAPITAL

Local governments in many countries are

One of the main advantages of partnerships is DEVELOPMENT CHARGES

Box 7: Calculating Development Charges

Box 7 (continued): Calculating Development Charges

Step 5: Estimate net capital costs by service

Table 11: Development Charges, Greater Toronto Area, 2007

TAX INCREMENT FINANCING TIFs are applied differently in each jurisdiction

Box 8: Implementation of Tax Increment Financing