Financing local government

Many developing countries would benefit from an increase in the responsibility of state and local governments for certain public functions. Decentralization is advisable for goods and services that are regional or local, rather than national, in character, such as water supply and sanitation, transport and some health and education services. In such cases it can increase public accountability and responsiveness to local preferences. The scope for decentralizing is greatest in urban areas, but broadening the involvement of rural communities in water supply, irrigation and rural roads can also improve the quality of public services.

Despite these benefits, state and local governments frequently face restrictions in raising resources to finance present or potential spending. Central authorities often regulate the few local sources of revenue by controlling tax rates, prohibiting increases in user charges and limiting the means for revenue collection and enforcement. As a rule these restrictions can be safely eased, which increases the revenue-raising capability of subnational governments and reduces their dependence on central transfers. User charges are especially helpful at the local level because local governments generally concentrate on services whose direct cost can be recovered.

Among local taxes the property tax has many desirable features but is often administratively and politically difficult to collect. Even so, property tax reform should be considered as part of any broader local finance reform. Other local taxes, which are often complex and excessive in number and thus costly to collect and poorly enforced, can generally be streamlined to reduce administrative costs.

Central or state government grants are also common sources of local finance. If properly designed and administered, these grants can adjust for income differences, ensure national benefits from certain local public functions such as education and provide incentives for greater local fiscal effort. Credit can provide an alternative way to finance local capital investment. Municipal development funds have been successful in some developing countries in channelling credit, training, and technical assistance to local governments.

Although central government restrictions, lack of local technical expertise and political opposition may limit the extent of charging, local governments in some developing countries have managed to develop successful cost recovery programmes, usually in conjunction with improved service.