Local and Metropolitan Finance Harry Kitchen* August 2004 Language: English Prepared for the program on: Fiscal Management For Better Governance: Learning from Each Other A Joint Program of the Ministry of Finance, China, the Canadian Agency for International Development and the World Bank Institute Web: www.worldbank.org/wbi ---------------------------------------------------------------------------------------------------------------------------------------- * The author is a professor at Trent University, Canada. This presentation was made at the International Seminar on Local Public Finance and Governance, held in Dali, Yunnan Province China, August 9-12, 2004. The seminar is one of series of events organized under the program, Fiscal Management for Better Governance. The program is directed by Dr. Anwar Shah (ashah@worldbank.org), Lead Economist and Program Leader on Public Sector Governance, World Bank Institute, 1818 H Street, NW, Washington, DC 20433, USA. For further information, please contact Chunli Shen (cshen1@worldbank.org). 1 Local and Metropolitan Finance A Workshop on Strengthening Responsive and Accountable Local Governance in China Dali, Yunnan Province, China August 9, 2004 Harry Kitchen Economics Department,Trent University, CAN. Analytical Model Constitutional status - metropolitan and local government Principal agent framework Benefits-based financing - economic efficiency - accountability - transparency - fairness 3 Application to Financing Local & Metropolitan Services User fees for services with private goods characteristics water, sewer, solid waste. Local taxes for services with public goods characteristics streets, roads, street lighting. Conditional grants for services with spillovers. Unconditional grants for fiscal gap and equalization purposes. Expenditure role for senior governments. 4
Current User Fee Structure Range from fixed charges to charges based on consumption or a mix of charges. May cover all costs or only a portion of costs. Designed to raise revenue rather than to ration output and signal demand. Generate unwanted income redistribution. How Should User Fees Be Set? Price equals marginal cost but this may not be possible - If marginal costs are not calculated. - use average cost pricing; or - average incremental cost pricing. - If economies of scale exist. - use a multipart pricing structure with a variable charge and one or more fixed charges. 5 6 User Fee Structure (cont.d) - If capacity constraints exist. - need a two-part fee structure with a variable and a fixed component. - If peak & off-peak demand differs. - off peak fee equal to marginal operating cost. - peak period fee equal to marginal operating plus capacity cost. User Fee Structure (cont.d) If distance from source affects costs. - fees should vary with distance from source - zone charges If second best conditions exist. - fee in controllable market (public transit) should differ from P=MC if local government has no control over a substitute (roads and cars) or complementary service. 7 8
User Fee Structure (cont.d) If externalities or spillovers exist. - user fees should not cover all costs - conditional grants from senior governments would be justified or revenues collected from other communities that benefit from this service. User Fees For What Services? Water and sewage treatment Solid waste collection & disposal Public transit & transportation Public recreation 9 10 Water and Pricing Current practice for water: Fixed charge unrelated to consumption. Three volumetric rates: - constant unit rate - declining block rate: common but not not preferred by conservationists - increasing block rate: not common but favoured by conservationists Seldom do these approach marginal cost pricing. Sewage Pricing Recovered through surcharges on water bills. Flat rate charges are the most common. A percent of water bill charge is less common. Very seldom are rates based on sewage volume and where this happens, it is usually for commercial and industrial customers. 11 12
Current Problems with Pricing Practices for Water and Sewer Only accounting costs tend to be reported - opportunity costs of raw water etc. are ignored. Marginal cost of water & sewer services exceeds price Marginal cost greater than price leads to overconsumption, over-investment and wasted resources. Norwegian study concluded that sound pricing for sewage reduced volume & costs. Chilean studies indicate that under-pricing leads to locational distortions. Under-pricing discourages technological innovations. Efficient Water Pricing Meters are necessary. Conservation oriented pricing that approximates marginal cost pricing. Use multi-part pricing to capture fixed and operating costs. Include annual asset replacement in annual operating costs and in prices. Set prices to capture costs attributed to distance from source and time of day or season. 13 14 Solid Waste: Fees or Local Taxes Fee per bag/container is most efficient. Studies comparing fees with local taxes indicate less garbage with fees, more recycling, and increase in composting. Fee should cover all operating and opportunity costs (cost of space, for example) of landfill site. 15 Public Transit & Transportation Transit fares should vary by zone and time of use. Fares should cover all costs To prevent excessive auto use & encourage public transit, municipalities should be permitted to: - tax parking lots - impose variable vehicle registration fees - issue differential drivers licence fees - impose a municipal fuel tax - impose congestion charges 16
Public Recreation Fund from user fees rather than local taxes. Adopt a peak-load pricing policy. If fares are lower for children, students, and seniors, limit their use to off-peak hours. For annual membership, use a two-part pricing policy - an annual fixed levy plus an admission charge for each use of the facility. Should User Fees Be Regulated? No, if they are set by municipal councils along with local tax rates. Yes, if service provide by an independent local government agency or enterprise. Price regulatory schemes generally include: - rate of return - price cap 17 18 Local Taxation Includes property, income, & consumption taxes. Some local governments have access to a range of taxes and others to only one major tax. Access to a specific tax or taxes depends on local government s capacity to administer the tax; types of expenditures that local government must fund; willingness of a senior level of government to assign taxes to local government; constitutional and legislative requirements; and so on. 19 Fiscal Autonomy: Local Taxation Greatest when local govt. can determine tax rate and tax base. Local control of tax base can be expensive and create distortions. Tax rates must be set locally. Tax sharing arrangements yield varying degrees of local autonomy 20
Criteria for A Good Local Tax Immobile tax base, therefore, borne primarily by local residents (not exported); Do not create problems with harmonization or harmful competition between local governments or local governments & senior governments; Generate sufficient, stable & predictable revenues; Visible to ensure accountability and transparency; Perceived to be fair; Easy to administer locally. Issues: Which Tax or Taxes? Property tax based on property value or unit value satisfy the criteria, especially for local governments. Income tax is more progressive in impact, more revenue elastic, & able to tax commuters good as a metropolitan tax. Consumption based taxes also play a role. 21 22 Mix of Local Taxes Metropolitan Governments Advantages: One tax may crate distortions offset by a mix of taxes. Improves flexibility in adapting to local conditions and circumstances. Increase revenue elasticity. May avoid large increases in the highly visible property tax. 23 Who Should Set Local Tax Rates? Level of government making the spending decision should set the tax rate. Local and metropolitan government may have access to same tax base, but each should set its own tax rate. Only need one collection agency, however. 24
Uniform or Differential Tax Rates? Property tax: Differential rates should apply if the cost of servicing properties varies by property type or location. Income tax: Differential rates could apply to commuters versus residents. Consumption-based taxes; Could not apply differential rates. Should Tax Rates Be Regulated? No, if local & metropolitan government use taxes only in their domain & if they fund local services. Yes, if local & metropolitan government share tax base with senior govt. Yes, if local & metropolitan government tax business. 25 26 Should Local & Metropolitan Govt. Tax Business? Practice is to over tax business property tax, capital tax, corporate tax, & so on. Yes, tax is appropriate if the tax covers only the cost of services consumed. Current taxes in most countries create distortions: - fixed charges are unrelated to profits - they may be exported, weakens accountability - they affect locational choices - they create harmful tax competition Suggested solution a business value added tax 27 Should Local & Metropolitan Govt. Have Different Taxes? Maybe yes, maybe no it depends on service responsibility. Metropolitan governments are closer to provincial/state governments & generally have a wider range of responsibilities. Therefore, should have access to a wider range of taxes (property, income & consumption based). 28
Intergovernmental Grants Advantages: Fund services generating spillovers conditional grants; Filling fiscal gap & equalization unconditional grants. Disadvantages: May distort local spending decisions; May work against proper pricing/taxation practices; May encourage people to stay in remote areas; Reduce local accountability May be more appropriate for local than metropolitan governments. 29 Fiscal Sustainability Depends on: The cyclical sensitivity of local government funding responsibilities; The capacity of the local revenue base and local taxes to keep pace with expenditure responsibilities; The ability of local governments to control their own destiny. 30 Summary Summary (cont.d) Financing for local & metropolitan services should be based on benefits received. User fees should be set to establish a clear link between beneficiaries and service cost. Local and metropolitan governments should provide services that benefit the local community. These governments should raise the revenue they spend. Local taxing authorities should set their own tax rates. 31 A wider range of taxes may be desirable for metropolitan governments when compared with local governments: these may include property, income, & consumption taxes. Differential tax rates and user fees should be used to capture differences in the cost of delivering local services; In general, local taxes and user fees should not be regulated; 32
Summary (cont.d) Local & metropolitan governments should not overtax businesses as they do in most countries; Senior governments must ensure that local and metropolitan governments have the fiscal tools to ensure fiscal sustainability; Intergovernmental grants should not distort local decision making, lead to incorrect pricing and taxation practices, and reduce local accountability. 33