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Strengthening

Subnational Finance in LDCs

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Table of Contents

(I) Setting the stage – Municipal finance and the 2030 Agenda for Sustainable Development ...... 4

Localizing the new global development agenda ................................................................................. 4

Financing challenges at the local level ............................................................................................... 5

Special challenges for subnational finance in LDCs........................................................................... 7

Urbanization in LDCs ......................................................................................................................... 8

Challenges to fiscal decentralization efforts in LDCs....................................................................... 11

The global economic context ............................................................................................................ 14

(II) Challenges in raising subnational revenues ............................................................................... 14

Taxation at different levels of government ....................................................................................... 15

The challenges of levying common local taxes: property and business taxes .................................. 19

Perspectives on business taxes .......................................................................................................... 22

Subnational revenue composition in African LDCs ......................................................................... 23

Examples of subnational revenue composition in Asian LDCs ........................................................ 25

Introduction of user charges, fees and licenses ................................................................................. 27

Intergovernmental transfers in LDCs ................................................................................................ 30

Surcharges as a complement to intergovernmental transfers ............................................................ 31

(III) LDC experiences in improving municipal revenue generation .............................................. 33

Lao PDR (1): Land titling as a road to better property taxation ....................................................... 33

Mozambique (1): Facilitating intergovernmental transfers through implementation of a treasury single account.................................................................................................................................... 35

Ethiopia: Implementing a land value capture system during rapid urbanization .............................. 36

Uganda (1): The role of grants and intergovernmental transfers in a second-tier city – perspectives from Busia Municipal Council .......................................................................................................... 38

Lesotho: Local governments and revenue generation in Lesotho-Legally empowered but politically constrained ........................................................................................................................................ 39

(IV) Challenges in municipal financial management ....................................................................... 41

(V) LDC experiences in developing local participatory budgeting ................................................ 47

Nepal: Increasing citizen participation with participatory planning (PP) ......................................... 47

Bangladesh (1): Experimenting with inclusive budgetary processes at the local level .................... 48

Solomon Islands: Tackling local governance challenges in a small island developing state ........... 48

Senegal (1): The experience of PB experiments in Fissel and Ndiaganiao ...................................... 49

Madagascar: Building capacity for PB through donor support ......................................................... 50

Mozambique (1): Evolving PB approaches in Maputo ..................................................................... 50

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(VI) Challenges in accessing long-term finance for capital investments ........................................ 52

Municipal bonds................................................................................................................................ 53

Institutional investors: an untapped source for sub-national infrastructure investment? .................. 64

(VII) LDC experiences in mobilizing long-term finance for capital investment ........................... 69

Uganda (2): A project-based partnership to finance municipal transportation in Busia ................... 69

Lao PDR (2): The Morphu Village water supply project: a local PPP done right ............................ 70

Bangladesh (2): Establishing a municipal development fund to finance local infrastructure ........... 71

Tanzania: Dar es Salaam’s water supply: a local PPP gone wrong .................................................. 72

Senegal (2): Dakar’s experience in (almost) getting a municipal bond to the financial market ....... 73

(VIII) International cooperation on municipal finance ................................................................... 75

Climate finance for subnational governments................................................................................... 77

How to strengthen international cooperation for subnational finance? ............................................ 78

(IX) Bibliography ................................................................................................................................ 81

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(I) Setting the stage – Municipal finance and the 2030 Agenda for Sustainable Development

With the adoption of the 2030 Agenda for Sustainable Development, the Addis Ababa Action Agenda

(Addis Agenda), and the Paris Agreement in 2015, the international community has laid out a clear

vision and roadmap for achieving sustainable development in all of its three dimensions—economic,

social and environmental.1 Yet, while the 2030 Agenda is global, most of its implementation will

ultimately happen at the local level with the participation of subnational governments and local

stakeholders. Being closer to the people than central governments, local governments, and local

stakeholders are uniquely positioned to identify development needs and contribute to the development

of adequate policy measures to address them.

The importance of the local dimension has been recognized by world leaders. All landmark

agreements of 2015—the year of “global action” —recognized the imperative to work with local

authorities and at the local level. Sustainable Development Goal (SDG) 11 is a local objective in itself

and calls for cities and human settlements to be “inclusive, safe, resilient and sustainable”. The local

dimension permeates other SDGs, targets, and means of implementation, including those on basic

public service provision in health, energy, water and sanitation, education and other areas, climate

change-related planning, sustainable tourism, ecosystem and biodiversity, and the capacity of local

communities to pursue sustainable livelihood opportunities.

Localizing the new global development agenda

The Secretary-General of the United Nations, Mr. Ban Ki-moon, emphasized that “our struggle for

global sustainability will be won or lost in cities.” How to win that struggle and “localize” the 2030

Agenda and other landmark UN agreements of recent years is at the heart of the deliberations leading

up to the Third United Nations Conference on Housing and Sustainable Urban Development (UN

Habitat III, 17-20 October 2016). The Conference presents a timely opportunity to chart new

pathways in response to the challenges of urbanization and the implementation of the 2015 landmark

agreements. The outcome document of UN Habitat III, “The New Urban Agenda”, is envisaged to

promote a new model of urban development, one that integrates all dimensions of sustainable

development and helps align national and subnational priorities in support of inclusive and equitable

1 Lead authors were Daniel Platz (FFDO, UN-DESA), Vito Intini (UNCDF) and Tim Hilger (UNCDF). All EGM

participants (both Africa and Asia made important substantive contributions (annex forthcoming). Patrick Nally, Yixiao Fang and Yijun William Wu provided excellent research assistance. Comments from Paul Smoke, Dominika Halka and Shari Spiegel are gratefully acknowledged. The views and opinions expressed in this informal background paper are those of the lead authors and do not necessarily reflect those of the United Nations Secretariat or UNCDF. The designations and terminology employed may not conform to United Nations practice and do not imply the expression of any opinion.

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economic and social development. Implementing the New Urban Agenda will rest on three pillars:

sound urban rules and regulations, farsighted urban planning and design, and strengthened municipal

finance.

Financing challenges at the local level

The financing required to implement the 2030 Agenda is estimated to be of the order of several

trillion dollars per year, and a significant portion of it will have to be mobilized and spent at the local

level. Indeed, mobilizing adequate funding for long-term investments in support of inclusive and

sustainable local development is perhaps the greatest challenge that local authorities face. The Addis

Agenda provides a natural starting point to discuss local finance in the context of the 2030 Agenda. It

presents a coherent framework for financing the 2030 Agenda for Sustainable Development, including

the Sustainable Development Goals, and puts forward a comprehensive set of corresponding policy

actions. In the Addis Agenda, Member States committed to fully engage local authorities in their

implementation efforts. Furthermore, the Addis Agenda promotes greater international cooperation

“to strengthen capacities of municipalities and other local authorities” (paragraph 34).

To meet the financing challenge, the Addis Agenda highlights the need to draw upon all sources of

finance (public, private, national, and international) and puts forward a policy framework that realigns

financial flows with public goals. It calls for an enabling environment comprising appropriate public

policies and regulatory frameworks that help unlock the transformative potential of people and

incentivize changes in consumption, production, and investment patterns in support of sustainable

development.

The comprehensive approach of the Addis Agenda translates well to the local level. For local

authorities, drawing upon all sources of finance implies the need to more effectively mobilize internal

(e.g., local taxes, user fees, land value capture) and external revenue streams (e.g., intergovernmental

transfers, donor support), in order to provide public goods and services and to finance large-scale

capital investments. A policy framework that realigns local financial flows with local public goals

implies a well-coordinated fiscal, political, and administrative decentralization effort, where local

expenditure responsibilities are backed by reliable intergovernmental transfers and fiscal

empowerment (e.g., the legal and technical capacity to levy taxes).

This report places particular emphasis on the challenges faced by local governments in least

developed countries (LDCs, see Box 1). The Addis Agenda pays special heed to LDCs as the most

vulnerable group of countries. It calls for global support to overcome the structural challenges they

face. It encourages donor countries to increase the allocation of official development assistance

(ODA) to the world’s poorest nations to 0.2 per cent of national income. The European Union

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committed to do so by 2030. A major challenge for LDCs and donors alike will be to ensure that those

resources are effectively directed to and spent at the local level—where they are needed most.

Box 1.1: What are least developed countries (LDCs)?

LDCs are the poorest and most vulnerable countries. They comprise more than 880 million people*, or around 12 per cent of the world’s population, but account for less than 2 per cent of world GDP.

The low level of socio-economic development in LDCs is linked to weak human and institutional

capacities, low income converging with high inequality, and a lack of domestic financial resources.

Governance crises, political instability, and, in some cases, internal or external conflicts often

exacerbate the situation. LDCs often suffer from low productivity and low investment. Furthermore,

they are exposed to external shocks, for example from their dependency on the export of a few

commodities as the primary source of revenue or their often high vulnerability to climate change.

The United Nations define least developed countries (LDCs) as low-income countries suffering from

structural impediments to sustainable development. Every three years, the list of LDCs is reviewed by

the Committee for Development Policy (CDP), which gives recommendations for inclusion and

graduation of countries. Recommendations are then endorsed by the Economic and Social Council

(ECOSOC) and decided on by the General Assembly. The criteria used by the CDP for inclusion in

the list are (1) gross national income per capita; (2) the human assets index (HAI); and (3) the

economic vulnerability index (EVI). The CDP sets thresholds on each of the three criteria, and

country must satisfy all three at one triennial review to be added to the list. In addition, its population

must not be larger than 75 million inhabitants. However, decisions about inclusion and graduation are

not only based on the assessment of the three criteria, but also factor in country-specific information

and views from the government. To leave the LDC category, a country must cease to meet any two

criteria through two consecutive reviews.

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Table 1.1: List of least developed countries as of May 2016 (year of inclusion in brackets):

Africa:

Angola (1994)

Benin (1971)

Burkina Faso (1971)

Burundi (1971)

Central African Republic (1975)

Chad (1971)

Comoros (1977)

Dem. Rep. of the Congo (1991)

Djibouti (1982)

Equatorial Guinea (1982)

Eritrea (1994)

Ethiopia (1971)

Gambia (1975)

Guinea (1971)

Guinea-Bissau (1981)

Lesotho (1971)

Liberia (1990)

Madagascar (1991)

Malawi (1971)

Mali (1971)

Mauritania (1986)

Mozambique (1988)

Niger (1971)

Rwanda (1971)

Sao Tome And Principe (1982)

Senegal (2000)

Sierra Leone (1982)

Somalia (1971)

South Sudan (2012)

Sudan (1971)

Togo (1982)

Uganda (1971)

United Rep. of Tanzania (1971)

Zambia (1991)

Asia and the Pacific:

Afghanistan (1971)

Bangladesh (1975)

Bhutan (1971)

Cambodia (1991)

Kiribati (1986)

Lao People’s Dem. Republic (1971)

Myanmar (1987)

Nepal (1971)

Solomon Islands (1991)

Timor-Leste (2003)

Tuvalu (1986)

Vanuatu (1985)

Yemen (1971)

Latin America and the Caribbean:

Haiti (1971)

Special challenges for subnational finance in LDCs

The state of subnational finance in LDCs is affected by conditions and developments at the local,

national and global levels. Certain megatrends, such as rapid urbanization, changes to the global

economic context, climate change, and natural disasters have particularly strong impacts at the local

level. Limited subnational financial capacities reduce the ability of local government authorities in

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LDCs to effectively manage these impacts, as well as to improve local service delivery and finance

local infrastructure development. In addition to global megatrends, LDCs are confronted with

additional challenges from the national and local level in most areas of subnational finance. Weak

human and institutional capacities, low per capita income, low productivity, and shallow financial

sectors are frequently combined with political instability and high vulnerability to terms-of-trade

shocks due to the reliance on a limited number of commodities for export. At the subnational level,

these characteristics may translate into small local revenue bases; limited financial, expenditure, and

asset management capacities; unpredictable and insufficient intergovernmental transfers; and little to

no access to private capital. Other political constraints, e.g., insufficient local revenue authority, may

pose further challenges for subnational finance in LDCs.

Urbanization in LDCs

Cities around the world are expanding as a result of overall population growth and continuous

migration from rural to urban areas. Since 2007, the majority of the world’s population has been

living in urban areas. Africa and Asia are urbanizing faster than any other region. By 2050, an

additional 2.5 billion people are expected to live in cities, with almost 90 per cent of the growth

located in Africa and Asia (see Figures 1.1-1.3: Urban agglomerations in LDCs in 2000, 2014 and

2030)

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Figure 1.1: Urban agglomerations in LDCs 2000:

Figure 1.2: Urban agglomerations in LDCs in 2014:

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Figure 1.3: Projected urban agglomerations in LDCs in 2030:

The proportion of the urban population in LDCs is expected to increase from 31 per cent in 2014 to 49

per cent in 2050. LDCs such as the Democratic Republic of the Congo, the United Republic of

Tanzania, and Bangladesh are predicted to increase their urban population by 50 million people each.

While Kinshasa is currently the only megacity (more than 10 million inhabitants) in an African LDC,

Dar es Salaam and Luanda are both expected to surpass the 10 million mark by 2030. Rapid

urbanization affects not only the largest cities, but also smaller cities, in particular those with less than

500,000 inhabitants (Figure 1.4 shows the number of cities in LDCs by size). At the same time, rural-

urban linkages will remain critical in African and Asian countries, since around 44 per cent of the

African population and 33 per cent of the Asian population will still live in rural areas in 2050.

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Figure 1.5: Urbanization: Number of cities in LDCs in 2000, 2015, and 2030

Red: megacities (10 million inhabitants or more); Green: large cities (5-10 million inhabitants)

Purple: medium-sized cities (1-5 million inhabitants); Turquoise: cities (0.5-1 million inhabitants)

Source: UN-DESA Populations Division (2015).

Challenges to fiscal decentralization efforts in LDCs

Decentralization is often seen as integral to the promotion of sustainable development at the local

level. It is suggested that decentralization increases democratic accountability of governments while

responding to the specific needs of the local population and strengthens local bureaucracies and

administrations in their efforts to provide public goods and services. However, practical experience

has shown that for several reasons, such high expectations are not always met. In many cases,

decentralization has resulted in increasing inequality among different local administrative regions.

Weak local institutions with a lack of implementation capacities and strong political elites are among

the factors that have limited the success of decentralization processes. One significant impediment is

often the power struggle between the central and local level (see case studies for Busia and Lesotho).

Furthermore, even though many countries have announced to take steps towards decentralization, few

changes have been observed in the areas of local revenues and spending. In fact, between 2006 and

2014 the central government’s share of total government revenue and expenditure has generally

remained stable in LDCs, lower-middle-income economies, and high-income economies (see figures

1.5-1.6). LDCs and lower-middle-income economies tend to have high levels of centralization, with

central governments accounting for over 90 per cent of revenues and expenses of all levels of

1

1

21

17

2

3

30

30

2000 2015 2030

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governments, while high-income economies show more advanced fiscal decentralization with ratios

below 70 percent. 2

Figure 1.6: Local revenue as share of central government revenue

Source: IMF Government Finance Statistics Yearbook database

2 These findings build off of those from Dziobek, Mangas, and Kufa (2011), who found that with the exception

of countries transitioning from command to market economies, between 1995 and 2008, the level of decentralization has seen little change regardless of countries’ level of development or population.

2006 2007 2008 2009 2010 2011 2012 2013 2014

Afghanistan (LDC) 99 99 100 99 100 100 99 100

Bhutan (LDC) 100 100 100 100 100 100 100 100 100

Kiribati (LDC) 98 98 99

Timor-Leste (LDC) 100 100 100 100 100

Armenia 97 97 98 97 97 95 96 96

El Salvador 98 96 96 95 95 96 95 90

Honduras 95 99 96 95 95 95 95 98 96

Indonesia 91 89 87

Canada 47 47 46 45 45 44 45 45 46

Germany 66 65 65 66 66 65 65 65 65

Sweden 66 66 63 62 63 67 65 65 65

Switzerland 51 51 54 53 53 54 54 54

United States 57 57 54 55 56 57 57 60 60

0

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40

60

80

100

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Figure 1.7: Local expenditure as share of central government expenditure

Source: IMF Government Finance Statistics Yearbook database

The level of local revenues and expenditures in comparison to total revenues and expenditures also

varies among regions (Table 1.2). In developing regions, countries in Latin America and South-East

Asia show slightly higher rates for local revenues and expenditures as a share of total revenues and

expenditures than Africa.

2006 2007 2008 2009 2010 2011 2012 2013 2014

Afghanistan (LDC) 101 99 100 100 100 100 100 100

Bhutan (LDC) 100 100 100 100 100 100 100 100 100

Kiribati (LDC) 97 97 98

Timor-Leste (LDC) 100 100 100 100 100

Armenia 97 97 98 98 98 96 96 97

El Salvador 102 99 99 99 99 100 99 93

Honduras 99 104 101 99 99 101 101 97 101

Indonesia 103 99 100

Canada 46 46 46 45 45 44 43 43 43

Germany 66 66 65 66 67 65 64 64 64

Sweden 64 64 62 63 64 67 67 67 67

Switzerland 54 58 55 53 54 54 53 53 52

United States 60 60 61 66 67 66 64 64 64

0

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40

60

80

100

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Table 1.2: Local revenues/expenditures as shares of total revenues/expenditures

Local revenues as percentage of

total revenues

Local expenditures as percentage of

total expenditures

Africa 3.2 7.9

South Asia 1.5 16.0

East Asia 20.0 40.0

South-East Asia 5.3 15.5

Europe (2008) 13.0 23.9

Latin America 4.0 11.1

Middle East &

Western Asia

N/A 4.6

Eurasia N/A 26.5

North America 17.8 26.8

Source: United Cities and Local Governments, 2010.

The global economic context

Since most local governments in LDCs depend heavily on intergovernmental transfers, any global

economic development that affects national governments of LDCs will also have a significant impact

at the local level. Even though LDCs are generally less integrated in the global financial system than

emerging economies, they can be severely affected by global economic trends. For example,

economic growth in LDCs has been weak in 2015 due to reduced demand for exports from emerging

economies, lower commodity prices, net capital outflows and low investment growth. The adverse

effects of such trends were exacerbated by conflict situations and the impact of extreme weather

events on agricultural output. Gross domestic product (GDP) growth forecasts for LDCs (4.5 per cent

for 2016 and 5.5 per cent for 2017) are well below potential and the target of 7 per cent set in SDG

8.1. LDCs that depend on commodity exports are especially under threat not to be able to reach the

necessary level of public spending, which would increase the constraints imposed on local

governments.

(II) Challenges in raising subnational revenues

Experts have argued that there are three criteria that should be followed in assigning subnational

revenue (Smoke, 2013). First and foremost, there must be a reasonable division of revenue sources

between central and subnational governments according a set of generally accepted principles. Those

principles are …

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Second, individual revenue sources should be designed to follow a set of principles in a consistent

way (see below). Third, revenue system must be effectively implemented on the ground.

The most common subnational revenue sources in LDCs include user fees and charges, taxes/levies,

as well as intergovernmental transfers, sometimes financed or supplemented by foreign aid.3 These

sources may be supplemented by investment income, property sales, and licenses. User charges and

fees are mostly levied where people pay for the benefits and utilities they receive (e.g. water supply,

sanitation, energy, parking space). At the same time, the municipality typically provides a range of

public goods (police, ambulance, firefighters, streetlights etc.) whose consumption is not exclusive

and whose benefits it cannot directly assign to the individual consumers. In such cases, taxes are the

more appropriate tool as they target the entire community that stands to benefit from the service.

In general, revenue mobilization and management are very challenging in LDCs both at the national

level and subnational levels due to narrow tax bases

Taxation at different levels of government

Inconsistencies in the overall fiscal framework are not uncommon across the globe and they may be

more pronounced in countries with institutional settings, such as LDCs. Inconsistencies may appear in

the form of insufficient harmonization of central and subnational taxes. Limiting overlap with central

taxes and reducing revenue disincentives in transfer and lending mechanisms are important to ensure

that the full set of subnational revenues is consistent with the rest of the national fiscal system.

When it comes to the revenue potential at the local level, evidence suggests that, in general, there is a

positive correlation between the size of the local government (in terms of its population) and the role

of own-source revenues. For example, taxes and other local sources of revenue can account for as

little as 9 per cent of total revenue in small Brazilian municipalities (less than 5000 people) and over

50 per cent in large cities. The fact that larger local entities have more institutional capacity to raise

revenue is not surprising, all other things being equal, but where countries face severe institutional

constraints at all tiers of government, as is the case in most LDCs, the positive correlation may often

not hold. Indeed, in most cities in LDCs, the correlation is less pronounced, with even large cities

struggling with generating more than 10 per cent of their revenues through user fees and taxes (World

Bank, 2006).

3 Many publications on subnational finance list borrowing as a source of income. This paper treats borrowing separately.

Borrowed money is not income unless the loan or debt is forgiven. For example, a debt/income ratio, an important measurement of financial health, does not make sense if income includes debt.

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The appropriate choice of which taxes to impose, how much to charge, and how to structure them

depends on a wide range of factors such as the size, the level of economic development, and the

demographic composition of the local authority. Across LDCs, one finds a wide array of local taxes at

both at the national and local levels (Table 2.1).

Table 2.1: Taxes assigned to/levied by different levels of selected LDC governments

Country Tier of Government Tax Authority

Burundi National Customs duties, VAT, excise duties, PIT, BPT

Local Vehicle tax, real estate tax

Rwanda National Customs duties, VAT, excise duties, PIT, BPT

Local Property tax, rental income tax, and trading licenses

Mali National Customs duties, VAT, excise duties, PIT, BPT

Local Regional and local development tax, income tax from local

civil servants, Property taxes, other taxes

Tanzania National Customs duties, VAT, excise duties, income tax

Local Development levy, property tax, service levy, business

license, fee on trade, crop and` livestock cess*, other fees

and user charges

Uganda National Customs duties, VAT, excise duties, PIT, BPT

Local Rents, rates, royalties, stamp duties, crop and livestock

cess, fees on registration and licensing and other fees and

taxes that parliament may prescribe (property taxes, license

and user charges)

Afghanistan National Customs duties, withholding tax, business receipts & CIT,

PIT, capital gains tax

Local Vehicle registration tax, toll tax, advertisement tax,

property tax, road tax

Bangladesh National Customs duties, excise duties, supplementary duties, PIT,

CIT, VAT, capital gains tax

Local Tolls, lighting rates, conservancy rates, holding tax, vehicle

tax, animal tax, marriage tax

Bhutan National Customs duties, excise duties, PIT, BIT, CIT, sales tax

Local Property taxes, property transfer tax, land taxes, cattle tax,

grazing tax, advertisement tax

Cambodia National Customs duties, excise duties, VAT, CIT, PIT, stamp duty

Local Property taxes, administrative fees (civil registry

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functions), user fees and charges, land taxes

Lao PDR National Customs duties, excise duties, VAT, CIT, PIT, stamp duty

Local Property taxes, vehicle taxes, fuel taxes, fees and

administrative charges

Myanmar National Customs duties, excise duties, CIT, PIT, stamp duty,

capital gains tax

Local Property taxes, land taxes, development affairs

organization fees (public services including water, sewage

and trash collection), wheel tax

Nepal National Customs duties, excise duties, CIT, VAT, capital gains tax

Local Property taxes, municipal business tax, municipal tax on

vehicles, local development fee

Timor-Leste National Customs duties, excise duties, CIT, PIT, petroleum tax

Local NA

Yemen National Customs duties, excise duties, PIT, CIT, general sales tax

Local Property taxes, municipal business tax, administrative

service fees

PIT: Personal Income Tax, BPT: Business Profit Tax, VAT: Value Added Tax. * Cess: a tax

introduced in colonial times, often levied on livestock and produce.

Sources: Khadka (2015), Urban Management Centre (2010), World Bank (2015), IMF (2013), IMF

(2010), Huda (2009), Taliercio (2005), Crowe Horwath International (2015), Dickenson-Jones (2015),

Shrestha (2002), Remeo (2015).

Over the years, many attempts have been undertaken to evaluate local revenue sources according to a

set of key principles (Smoke, 2013). Such principles include:

Revenue adequacy: covering subnational budgetary needs (based on the “finance follows

function” principle).

Revenue buoyancy: growing in proportion to the economy and expenditure needs.

Stability: avoiding large fluctuations in revenue yields that would undermine the ability of

subnational governments to provide services.

Correspondence between payments and benefits (including limiting tax exporting).

Distortionary Impact: minimizing distortions of economic decisions made by individuals and

firms (e.g. resulting from differentiated base assessment and rates).

Autonomy and Accountability: allowing subnational governments discretion to make

independent decisions (creating a link between revenue generation and service delivery).

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Administrative feasibility: ensuring the scale and complexity of administration is consistent

with capacity and affordable to the subnational government.

Political feasibility: maximizing the likelihood of acceptance of a source through consistency

with political reality, e.g. taxpayers see value for money, fair treatment, less visible/onerous

(small payments over time versus large lump sums).

Equity: ensuring fair treatment among equals (horizontal) and across different groups (equals)

framed in terms of income but can use other points of reference.

Table 2.2 illustrates some of the major challenges in adhering to these key principles at the local

level.

Table 2.2: Challenges in implementing principles for subnational taxes in LDCs

Principle Major challenge

Revenue adequacy Determining overall revenue adequacy (including transfers), is not simple since functional assignments from the central government are often vague, inconsistent and may be not fully adopted at the local level. Where functional assignments are clear and local revenues are deemed inadequate, typical challenges that may lead to low local revenues include low intergovernmental transfers, low functional capacity in tax administration and outdated valuation of the tax base as well as a low overall revenue base due to low per capita income and large informal sectors.

Revenue buoyancy Adequate revenue buoyancy is often elusive due to lack of administrative actions needed to ensure growth of the revenue base (e.g., revaluing and indexing property assessments).

Stability Stability requires good administration and a strong commitment to enforce collection during more difficult economic times or periods of political pressure, especially in periods leading up to subnational elections.

Correspondence between payments

and benefits

The correspondence between payments and benefits can be compromised by differential treatment of taxpayers or sectors in pursuit of policy objectives, poorly developed or enforced assessment and collection and tax exporting. i.e., the ability to shift tax burdens to people who live outside the city (although this is not universally opposed and may be to some extent seen as desirable in certain instances, such as taxes that fall primarily on foreign tourists).

Local Autonomy Revenue autonomy varies considerably, but it is often limited by the central

government due to concerns over national fiscal policy management and/or local capacity. At the same time, subnational governments may fall to take advantage of autonomy that is granted because they do not know how to do so where decentralization is new or capacity is weak. Alternatively, disincentives in the fiscal system or political conditions may undermine the

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motivation of subnational governments to exercise their revenue powers.

Administrative feasibility

Administrative feasibility may be compromised by pursuing non-revenue raising objectives and or adopting poorly defined or unduly complex administrative procedures.

Political Feasibility

Political feasibility is often difficult to determine and effective adoption of subnational taxes may be challenging in developing country environments, especially in the poorest countries where citizens are not used to receiving and/or paying for services.

Equity Horizontal equity is generally a greater concern of subnational tax policy than vertical equity given potential spatial inefficiencies created by subnational redistributive taxation. Equity can be affected, for example, if there is preferential treatment of certain taxpayers or groups due to subnational tax regulations and weak or selective administration.

Source: based on Smoke (2013) and Bird (2010).

The challenges of levying common local taxes: property and business taxes

Property and business taxes are common taxes levied at the local level. However, their revenue

potential remains underutilized in LDCs, especially in the case of property taxes. There are little data

for LDCs but available evidence suggests that the share of property taxes to GDP in LDCs is

significantly lower than that of other country groups (see Figure 2.3).

Figure 2.1: Local government's property tax revenue as per cent of GDP

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

0.03

0.29

0.47

0.89

Average: 0.42

20

Source: IMF Government Finance Statistics Database, accessed August 2016.

Yet, important progress has been made in a range of LDCs. For example, figure 2.4 suggests the

performance of key taxes in Maputo, the capital of Mozambique, increased significantly between

2010 and 2014. In particular, the “SISA”, a set of tax levied on transfers of real estate, plays a

significant role in Maputo’s local revenue (figure 2.5).

Figure 2.2: Tax and fees coverage in the municipality of Maputo, 2010-2014

Source: Cumbe, 2016.

0

50,000

100,000

150,000

200,000

250,000

2010 2011 2012 2013 2014

Municipal Property Tax

Municipal Personal Tax

Real Estate Transfer Tax

Annual Vehicles Tax

Tax for Economic Activity

Tax for Building permit

Tax for Use of Municipal Land

Municipal Market Taxes

Advertising Taxes

Parking tax

Tax for Collection and treatment ofwasteOther Revenues

21

Figure 2.3: Composition of local tax revenue in the municipality of Maputo (per cent based on

average for 2010-2014)

Source: Cumbe, 2016.

One of the major challenges with levying property taxes in LDCs is the lack of proper titles for

residential premises and tax exemptions for low-value properties. For example, it is estimated that less

than 10 per cent of land in Africa, where most LDCs are located, is properly documented

(Byamugisha, 2013). Moreover, given the lack of suitably qualified staff and resources for local

governments in many LDCs, rising land values are not regularly assessed, leading to substantial

revenue shortfalls as old property values remain on the books. Consequently, where property taxes are

levied, they often do not keep pace with economic development. For this reason, some LDCs in

Africa have refused to establish direct property taxes and instead tax only rental income (Cameroon)

or apply a simplified occupancy tax (Burkina Faso). Property taxes also suffer from broader

challenges that affect other types of national taxes such as low nominal tax rates and low collection

rates.

Where title registration systems and fiscal cadastres (i.e. comprehensive and perpetual inventories that

describe and assess the value of landholdings) are not well developed, ‘street addressing’ (i.e. giving

streets names and/or numbers) is a constructive first step towards determining the tax base and

increasing tax revenues. Street addressing allows locating residents and greatly facilitates municipal

service provision. It also helps enforce the collection of user fees for water and electrical utilities. It is

important to see the building of fiscal cadastres and street addressing as complementary practices.

0.00

5.00

10.00

15.00

20.00

22

Indeed, the reconciling of street indices with fiscal registers can lead to substantial local revenue

increases (Habitat III, 2015).4

A property tax reform approach that places emphasis on updating the property tax roll through

building a fiscal cadastre and improving the accuracy of property valuation is generally referred to as

a “valuation-pushed reform”. Such a reform sometimes assumes that non-valuation administrative

processes are functional and that a major improvement in property tax revenue comes from improving

property valuations (Bird, 2015). Most academic literature, however, favours a “collection- led” to a

“valuation- pushed” reform in low-income and LDC countries (McCluskey 2015). It is argued that in

these countries non-valuation administrative functions are frequently not fully functional, i.e. that

efforts should be placed on improving collection and enforcement of the tax system and ensuring legal

enforcement rather than on valuation. Yet, over the past decades, reforms in LDCs like Sierra Leone

(Freetown), Tanzania (Dar es Salaam), and Uganda (Kampala) have focussed primarily on valuation

(Mc Clusky 2015). Whereas both approaches are essential components of a holistic reform effort, it is

important to find the right balance and appropriate sequencing of reforms (see Lao PDR Case Study

(1), Ethiopia Case Study). While valuation-based reforms may make sense in large cities in LDCs,

their applicability may be more limited in smaller urban and rural jurisdictions with limited local

administrative capacities and no central administrative support. Contrary to the current trend to push

new valuation techniques, many LDCs may therefore think about directing their scarce resources

towards “collection-based reform efforts” first, especially where institutional capacities are weak.

Perspectives on business taxes

In economic theory, business taxes at the local level are often seen as inefficient mechanisms of own

source revenue generation. It is argued that such taxes may discourage business formation, have

adverse effects on growth and investment, and lead to distorted capital allocation. At the same time,

subnational entities may compete in lowering their business taxes in a “race to the bottom” that erodes

the tax base and revenues.

However, there is no solid empirical evidence that business taxes have implications on growth, and in

practice, virtually every country imposes some sort of business tax, either at the national or local

level. Bird (2006) notes there are efficiency, equity, and political arguments that support the case of

the local business tax. The efficiency and equity rationale is captured in the principle of benefit

taxation. If firms receive identifiable, cost-reducing benefits through public sector services, they

should pay for the costs incurred in the provision of such benefits, e.g. wear and tear from large trucks

4 In the context of Sub-Saharan Africa, some non-LDCs like Botswana, Namibia and South Africa have well-developed

property markets. Their experience could help African LDCs in their property market reforms.

23

on a road or waste disposal expenditures. In this connection, business taxes are efficient in that they

ensure that someone pays for the costs related to providing a particular service. At the same time, they

are equitable and fair in that they ensure that firms pay for a service rendered by local authorities and

not just their citizens. In addition, taxing larger domestic and foreign businesses or corporations may

make political sense since negative externalities, such as environmental costs, may outweigh positive

effects, such as local job creation or skills transfers, as is often the case with extractive industries.

Local business taxes are also easier to administer and more elastic than property taxes and are

therefore a crucial source for expanding infrastructure and local services.

Subnational revenue composition in African LDCs

In many LDCs, business taxes are widely used. In West African LDCs, the “patente,” a differentiated

set of fixed tax rates that is based on size of premises, type of business, and number of employees has

made up for a sizable share of local revenues (Figure 2.6). In East Africa, Tanzania levies a local

business tax named ‘City Service Levy’ at a fixed percentage on the firm’s turnover. In the rest of

Anglophone Africa, local business licensing generates between 5 and 30 per cent of local government

own revenues in urban councils (Fjeldstad, and Heggstad, 2012). More research is needed on how

local business taxes should be imposed, structured, and administered in order to maximize their

revenue potential and effectiveness. Such research must also acknowledge that corporate tax evasion

remains a major challenge for imposing local business taxes, especially in the case of transnational

companies that may apply methods such as transfer or trade mispricing to deceit national local tax

authorities.5

5 See Report of the High Level Panel on Illicit Financial Flows from Africa, 2015, commissioned by the AU/ECA Conference of Ministers of Finance, Planning and Economic Development.

24

Figure 2.4: Composition of local tax revenue in West African LDCs (Averages for 1995-2008)

* The global tax (impôt synthétique) is levied on small business and combines taxes on commercial

and industrial profits, business licenses and value added tax.

Source: IMF, 2015.

Box 2.1: Lessons learned from UNCDF‘s efforts to improve local revenue collection in West African LDCs In order to strengthen self-management capacities of the local authorities, especially in rural areas, the United Nations Capital Development Fund (UNCDF) developed the Local Authorities Financial and Institutional Analysis System (LAFIAS). The system was initially introduced in three West African countries, Guinea, Mali and Benin. Initial experiences with the progamme highlight the strong effect of improved local management on revenue raising capacity. The following conclusions are highlighted in the report:

1. A minimum level of organization and capacity of local authorities (own services and personnel) is

essential for local development.

2. A minimum level of information on the potential resources in their territorial jurisdictions is

important for local authorities to play a more important role in mobilizing own source revenues.

3. The local tax system in West African LDCs—Mali is a prime example—includes many rural taxes

that are difficult to mobilize and that yield low revenue in the urban context, while the largest

potential resource -urban property- remains largely untapped. In addition, a simplification of the tax

code and flat-rate taxation could be explored to further strengthen revenue collection.

4. Quality beats quantity. It is important that levies/taxes not be too numerous and dispersed to avoid

high transaction costs.

25

5. Great resource potential lies in market activities and facilities (markets, terminals and other

income-generating infrastructures). A proper management of these facilities will allow the authorities

to diversify and considerably improve their resources.

6. The existence of economic infrastructures is a determining factor in resource potential and

consequently, the revenue of local authorities. For example, a lack of economic infrastructure explains

the challenges of the Socoura commune, which has the largest population size in the standard

communes in Mali, but has the lowest level of local revenue.

7. The LAFIAS analyses showed the limitations of a true economic development within the rural

spaces that make up the local authorities. Creating inter-community cooperation between local

authorities based on “development hubs” or “local cooperation territories” can help take advantage of

the socio-cultural, geographical, historical and economic opportunities that two or several local

authorities share together.

8. Finally, investment per se cannot stimulate improvement in local finances; it must be supplemented

by taxation support measures, but also communal management and local governance.

Source: UNCDF (2012).

Examples of subnational revenue composition in Asian LDCs

As shown in Figure 2.5, one third of municipal income in Nepal comes from central government

grants and revenue sharing. The second largest source of municipal income in Nepal is the Local

Development Fee, which is being collected by the central government at the rate of 1 per cent on

certain imported goods (Lamichhane, 2012).

26

Figure 2.5: Source of Income of municipalities in Nepal, 2006/07

Source: Lamichhane (2012).

In Afghanistan, many municipalities raise their own revenue by selling locally owned land. As shown

in Figure 2.6, nearly one third of local revenue in Kabul comes from land sales. The second largest

source of local revenue is the Safay’i tax , a fee collected for each house or business for city

maintenance cost (USAID, 2012). Central government transfers accounted for an average of 11.7 per

cent of Kabul’s revenue between 2009 and 2012 through project funding provided by the Ministry of

Finance. Kabul is the only municipality to receive direct intergovernmental support from the central

government in Afghanistan (World Bank, 2008).

The “city entry tax” used to be a popular tax applied in every major municipality in Afghanistan. In

Kabul, the city entry tax contributed to 6 per cent of total revenue between 2009 and 2012. But, since

the Afghan government had expressed concern that the city entry tax hindered the development of

commerce and presented a potential source of corruption, the tax was abolished in November of 2012

(USAID, 2013). Ideas on converting the city entry tax into a municipal road toll are still under

consideration. Supplementary revenue sources include licenses, property taxes and other fees.

0%

5%

10%

15%

20%

25%

30%

35%

CentralGovernment

Grant andRevenueSharing

LocalDevelopment

Fee

Property Tax Rent ofMunicipalProperty

Fees andFines

Other Tax Other FiscalRevenue

27

Figure 2.6: Kabul Municipality Revenue *by Revenue Source (Averages for 2009-2012)

*Licenses include business license and vehicle license fees; Fees include market & parking fees and

construction fees

Source: USAID (2013).

Introduction of user charges, fees and licenses

User charges and fees comprise service charges (water, sewerage and parking), administrative fees

(building permits, registration) and business license fees. User charges are typically defined per unit

of consumption. They can promote an optimal level of consumption when the price equals the cost of

providing an additional unit of the service, which also referred to as marginal cost pricing. Some have

therefore argued that, “(whenever) possible, local public services should be charged for rather than

given away” (Bird 2001). However, getting prices right is easier said than done where the

infrastructure and capacity to set prices, measure usage, and collect fees are heavily constrained and

where many users live in abject poverty. Consequently, in a number of LDCs, user charges are

frequently set below costs, infrequently revised, and often inefficiently billed.

When setting their tariff structures, local governments typically try to take social justice concerns into

consideration and facilitate access to low-income households. Cross-subsidies, where richer segments

of the population subsidize access to services for the poor, have shown success in some countries.

0%

5%

10%

15%

20%

25%

30%

35%

28

One popular mechanism for cross-subsidies is a pricing system, whereby the per unit price of

consuming a municipal service, e.g. electricity, increases as more of it is consumed and may even be

free up to a designated level. Cross-subsidies are also possible between sectors. For example, cross-

subsidies are frequently used to reduce or eliminate user charges for health services, since these tend

to have a particular detrimental effect on the poor (Lagarde and Palmer, 2008). The elimination of

user charges for health services has led to significantly higher health system utilization rates. While

greater health care is likely to pay large dividends in the future, including through greater tax

revenues, the challenge for local governments is to replenish the lost revenue in the short and

medium-term through instruments like sectoral cross-subsidies, additional taxes or donor

contributions.

Whereas economic theory suggests that marginal cost pricing is the most efficient pricing method, it

works only in perfect market conditions where providers have complete information on the cost of the

product, as well as the opportunity cost. More practical methods include average cost pricing, where

expenditures required for providing a service are divided by the number of consumers or the volume

sold and average incremental pricing, which calculates how much it would cost to serve an additional

consumer based on the average cost price. There are also multipart tariffs, similar to those discussed

earlier, which include fixed charges for basic consumption and higher charges for greater

consumption and thus effectively cross-subsidize the consumption of low-income customers. Where a

clear pricing strategy is applied, average cost and multi-tariff bundling are more widespread than

marginal cost pricing, since these are easier to calculate and administer (World Bank, 2014).

The important role of intergovernmental transfers

There are no subnational governments in the world that can fully function without a certain level of

intergovernmental support. In practice, finance often does not follow function, and central

governments across the globe give local authorities more expenditure responsibilities than those can

finance from their own revenue sources. Generally, greater capacity to generate their own revenues

make subnational governments in developed countries less dependent on support from higher tiers of

governments than those in developing countries. Consequently, resource flows from higher to lower

tiers of governments average 70-72 per cent of local government funding in developing countries and

38-39 per cent in developed countries (Alam, 2014).

The traditional rationale for intergovernmental transfers is the objective for a welfare maximizing

government to reallocate resources between richer and poorer jurisdictions in order to reduce both

horizontal (same tiers of government) and vertical (different tiers of government) imbalances, and to

correct for externalities. The actual drivers for intergovernmental transfers can vary, however. Public

finance literature explores factors that are shaped by equity and efficiency considerations such as the

29

correction for vertical and horizontal imbalances. Public choice theory highlights how transfers can

become tools for political influence. Frequently, electoral concerns determine the distribution of fiscal

resources to local jurisdictions (Boex and Martinez-Vazquez, 2005). Political economy research

focuses on how intergovernmental transfers are shaped by political influence through the impact and

bargaining power of political interest groups. There is robust empirical evidence that local

governments with higher political representation per capita benefit from greater intergovernmental

transfers (Wright, 1974, Porto and Sanguinetti, 2001, Khemani, 2007, Caldeira, 2011).

The impact of intergovernmental transfers on local revenue generation remains under debate. Some

have argued that large unconditional intergovernmental grants lead to lump-sum tax reductions or

lower the incentives for local governments to collect fees and taxes, thus ‘crowding out’ own source

revenue mobilization. Others argue that most fiscal transfers are spent on the provision of public

goods and services, increasing local economic development and tax compliance, and consequently,

‘crowd in’ local tax revenues. Studies that highlight the crowding out effect mostly focus on more

developed countries with relatively well-developed fiscal systems and significant own source revenue

generation (Kalb, 2010; Zhuravskaya, 2000).

However, such capacity is highly constrained in most LDCs. In cases where local capacity to generate

own-source revenue is weak, intergovernmental transfers are a crucial lifeline and may further crowd

in local revenue generation. For example, evidence suggests that in Tanzania, a 1 per cent increase in

intergovernmental transfers leads to an extra 0.3-0.6 per cent increase in own source revenue

generation for local government authorities (LGAs) (Masaki, 2015). Moreover, intergovernmental

transfers are often the only regular source of local income for reasons of political interference in own

source revenue generation. In many LDCs, local governments are frequently dependent on central

government approval for taxes, fees and charges they wish to impose. In certain cases, local

governments may wait for years or even decades to get such approvals (see Lesotho Case Study).

Smoke (2015) argues that intergovernmental transfers make sense as part of smart division of

responsibilities between the central and local government based on their core advantages and

competencies. In this connection, the author highlights that “central governments have inherent

advantages in generating revenues and local and regional governments have inherent advantages in

providing certain key services, invariably necessitating intergovernmental transfers.” At the same

time, LRGs must be able to raise an adequate share of the resources to (i) reduce demands on central

budgets, (ii) create a fiscal linkage between benefits of local services and the costs of providing them,

and (iii) help repay loans on long-term capital investments (Smoke, 2015).

30

Intergovernmental transfers in LDCs

Figure 2.7 illustrates widely divergent sizes of intergovernmental transfers in LDCs, in particular in

Francophone and Anglophone Africa. Most Anglophone LDCs receive the majority of their income

through intergovernmental transfers. In Francophone and some other LDCs, the share of total local

resources to total public resources reveals some of the lowest ratios in the world (IMF, 2015).

Francophone countries tend to rely more on local taxes. However, those taxes are often set, collected

and disbursed by the central government, i.e. they are not “true” local taxes. The low levels of

transfers may also be the result of sectoral policies of the central governments that leave little

resources for local authorities, thus limiting resources and functions of local authorities and

compromising the decentralization process (UCLG, 2009).

Figure 2.7: Intergovernmental transfers in per cent of total local revenues in selected LDCs

Source: IMF Government Finance Statistics Database, accessed August 2016.

Yet, both groups of countries face enormous challenges in meeting their local expenditure, as

transfers are often neither adequate nor reliable and low central government support is not met with

adequate increases in local revenue generation. For example, in the case of Senegal, revenues at the

local level have increased over recent years but remain at a mere 6 per cent of the central tax

revenues. As a result, local resources remain insufficient to provide local basic public services.

Moreover, horizontal fiscal imbalances have become a problem: the resources of the ten poorest

0

20

40

60

80

100

Grey: Non-African LDCs Red: Francophone African LDCs Blue: Anglophone African LDCs

31

communes represent 1 per cent of the resources of the five richest ones (Caldeira, 2011)6. In Mali,

local taxes generate insufficient revenue and rely on a wide range of obsolete taxes that are

particularly difficult to collect.

The fact that LDCs with widely different transfer/total revenue ratios continue to face similar

development challenges at the local levels suggests that the share of central government transfers in

local revenues says little about the local authority’s capacity to generate sufficient own source

revenue. Whether the major source of subnational income comes from intergovernmental transfers or

local taxes does not matter if the total income is grossly inadequate. People will bear the

consequences in terms of poor quality and access of local service delivery. Cutting intergovernmental

transfer does not make sense where own-source revenue generation cannot fill the gap. To make

matters more complicated, international financial institutions, especially those that focus more on

overall macroeconomic stability than development, have frequently put pressure on LDCs to reduce

intergovernmental transfers in an effort to reduce central government deficits. Such a recommendation

must be weighed carefully against the adverse effects of lower transfers on access and quality of basic

services, especially where the capacity for own source revenue generation is low.

Surcharges as a complement to intergovernmental transfers

Surcharges are a form of subnational “piggybacking” on national or regional taxes, like income taxes.

For local surcharges, a higher level of government defines the tax base, collects both the tax and the

surcharge set by subnational governments, and remits the surcharge revenue to the local government.

While the national government collects the tax, surcharges are clearly local taxes in that local

governments are responsible for imposing the tax and spending the revenues.

This approach avoids the problems that occur when subnational jurisdictions define their tax base in

conflicting ways, use different apportionment formulas, and administer the tax in different ways. For

example, two local authorities may try to impose taxes on the same company since there are different

opinions as to where and in which subnational jurisdiction the firm operates. In such a case, it is more

practical for higher levels of governments to define the tax base and forward a share of the revenues

to the local authorities. However, surcharges are not a substitute for, but rather a complement to

intergovernmental transfers, since they do not provide for vertical or horizontal redistribution among

subnational jurisdictions. Looking ahead, more data and research is needed on how and to which

extent local surcharges are used effectively in LDCs.

6 Senegal is divided into eleven regions (règions) which are subdivided into 67 communes, 43 communes d’ arrondisements

which are further divided into 320 communautès Rurales (Caldeira, 2011).

32

The formulation of the most welfare-enhancing combination of local and central governments taxes is

a politically difficult balancing act. Another key challenge for central governments is to provide

incentives to local governments to collect all the taxes they are supposed to collect. While some

central government fund transfers have been linked to a reform agenda, there has been little

improvement in own source revenue collection in most cities (Habitat III, 2015). Frequently, politics

get in the way of empowering local governments to raise their own revenues (See Lesotho Case

Study).

33

(III) LDC experiences in improving municipal revenue generation

Lao PDR (1): Land titling as a road to better property taxation

Policy Lesson: Land titling initiatives must be accompanied by strong and transparent government

institutions in order to play a role in improving subnational revenue.

In 1975, the rise of the socialist government following a prolonged civil war meant that all land in

Laos became the property of the state. Despite this, land use rights became informally recognized over

time, and the government developed a system of administering and recording property transactions.

The decision in 1986 to turn towards market-oriented reforms in this sector was driven by the lack of

clear property rights and information as well as the fact that the majority of property transactions

occurred outside the purview of the government. In 1996, Laos’s national government, with donor

support, began a land titling project to provide a system of clear and enforceable land-use ownership

rights and developing a land valuation capacity. The project also supported national and provincial

governments in systematic land registration through mapping, computerization of land records,

development of a land registration system, and extensive training of government officials in the

process of land titling. It originally covered the Vientiane capital as well as urban and semi-urban

areas in four provinces, with four additional provinces added later. A second Land Titling Project,

also with donor support, built upon the first with efforts to further develop land policy and regulatory

framework, educate government officials, institute a land registration system, and accelerate land

titling through systematic registration. It also broadened the scope to all provinces of the country.

The first project resulted in the Law on Land of 1997, which formally established regulations for land

registration and administration. It also led to the registration of roughly 190,000 parcels of land,

which came at a time when registration was rare but fell significantly short of the original goal of

300,000. Efforts were hampered by initial shortages of government staff, technical issues, lack of

incentives for government officials, and lack of government funds. The nominal figures found in the

World Bank Implementation Completion and Results Report (ICR) suggest there was a remarkable

1087 per cent increase in government revenue from land taxes and land-related fees between fiscal

years 1995/1996 and 2004/2005; however, Laos’s high inflation over the period means that the real

gain in revenue was only 1.6 per cent over the entire nine year period and that land-based revenue

shrunk from .20 per cent of GDP to .14 per cent of GDP. The second project exceeded projections and

led to titling of approximately 382,000 parcels of land. It also coincided with an 86 per cent rise in

real land-related government revenue (FY 2002/2003-2008/2009); however, the rise was related

primarily to increases in land value determined to be unrelated to titling, and the project design did

not collect sufficient data to discern how much of an impact land titling had on government revenue.

Moreover, the revenue gains did not aid village and district revenue as much as they could have.

34

Anywhere between 4 and 60 per cent of the revenue stayed at the village level, of which 60 per cent

was used to pay the tax collector’s salary and 40 per cent is used to cover administrative expenditures.

At the district level, the money was used “mainly to pay for recurrent expenditures, including salary

and operational costs,” rather than service delivery or infrastructure projects. One issue is that Laos’s

government did not implement reforms or allocate special funding towards land administration and

tax collection, nor did donors successfully train government officials in these areas. Another is that

land registration fees varied wildly both between and within provinces, and they were not always

clearly stated, which called into question the integrity of the offices responsible for collecting them

and promoted informal transactions. Because the government of Laos did not commit to a long-term

land administration programme or allocate an adequate budget, the projects were donor-dependent

throughout their implementation, and with the withdrawal of donors in 2009, project sustainability has

come into serious doubt. Moreover, Laos has long struggled with transparency regarding land rights,

which severely limits the efficacy of land titles; there are even concerns that some land holders have

not received proper compensation when their land was expropriated by the government. There is no

evidence that either project led to a better regulatory framework or better enforcement of land rights,

or had discernible impacts on land values, local ability to borrow, or the frequency of land disputes.

A number of policy lessons emerge: For a land titling project to successfully impact government

revenues from land and property, government, from the local to national level, must first respect the

integrity of land rights, use eminent domain rationally and responsibly, and have clear legal and

regulatory systems in place to promptly settle disputes. Additionally, a government must commit to a

long-term programme of land administration and set up a transparent and well-funded body to ensure

sustainable impacts. Fees and taxes should be clear and uniform, and all concerned levels of

government should be mindful of administrative costs and have a plan to translate enhanced revenues

into better service and infrastructure delivery. Land titling must be introduced with broader policy and

regulatory reforms if it is to have any teeth. Lastly, in order to judge the impacts of a land titling

project, land values alone will not suffice; rather, a baseline survey, comparisons between titled and

untitled land, and data on the number of registered land transactions is necessary to determine whether

and how much titling matters. Land titling is a powerful tool for property/land tax efficacy, but it must

be treated as only one piece of the puzzle.

Sources: World Bank (2006. 2010a,b, 2016a,c)

35

Mozambique (1): Facilitating intergovernmental transfers through implementation of a treasury single account

Policy Lesson: Unifying public revenue and expenditure data through an electronic system can help

build trust with international donors and facilitate state-to-local government revenue transfers.

Over the past 18 years, Mozambique has embarked on a country-wide effort towards municipalisation

in order to bring the decision-making process for many government functions closer to the people

affected. When Mozambique began the process in 1998, 33 municipalities were established,

expanding to 53 in 2013. In Mozambique, municipalities are locally elected bodies that govern their

electorate directly and whose responsibilities generally include things such as service infrastructure,

public parks, public hospitals, and local roads. Mozambique has also strengthened and expanded its

use of districts governments, which are appointed by the federal government and responsible for

implementing federal policies at a more localized level.

One of the main challenges for Mozambique’s municipalities since decentralization has been trying to

match new revenue to new responsibilities, as the two often do not come hand in hand. Under current

law, municipalities are expected to make own-source revenue two thirds of their total, but most

struggle with poor revenue generation due to a lack of human, material, and financial resources as

well as poor tax implementation. The result is a lack of implementation capacity for basic services

including water, sanitation, electricity, roads, and housing; 45.5 per cent of urban residents lack access

to electricity, and 57.6 per cent lack access to improved sanitation. While there are laws on the books

for municipal taxes, the implementation of these laws is typically limited and haphazard. Municipal

property taxes and real estate transaction taxes in Mozambique are supposed to align with the current

market value of a given property, but property values for the most part have not been updated since

the colonial era (pre-1975), which means that many properties end up undervalued. Municipalities

own all land within their borders, which allows them to sell licenses for any land targeted for new

development, but this system is typically not coupled with a property tax registry, so often

municipalities receive a one-time windfall but not sustainable revenue. The last major potential

revenue source, the economic activity tax, is supposed to track commercial and industrial production

but instead is administered at a set rate by area, which limits its effectiveness.

With these limitations in place, most municipalities have failed to improve service delivery and many

refuse new responsibilities, knowing that they are often more of a burden than an opportunity. The

federal government’s response has been to put into place enhanced systems of government transfers

and accountability. It has established the Municipal Compensation Fund, which is a provision in the

federal budget that designates a minimum of 1.5 per cent of fiscal revenue for non-conditional use by

cities, as well as the Investment Fund for Municipal Initiative, which designates another 0.75 per cent

36

of federal fiscal revenue for conditional use, taking into account municipalities’ infrastructure needs

and justifications for funding requests. One of the main drivers behind the federal government’s push

for fiscal decentralization has been the implementation of a treasury single account (TSA) known as

e-SISTAFE, a unified electronic system that tracks the allocation, management, and spending of

government funds across all levels, from the ministry of finance down to municipal governments. The

legislation authorizing the development of e-SISTAFE was in part the result urgings by international

donors in 2002, and its implementation was aided by the IMF. It was fully implemented across all

levels of government in 2007. E-SISTAFE allows government (and international) officials to better

track where money is sent, helps budgets better align with regulations, and makes local governments

more accountable for the money they receive. This has helped make federal legislators and officials

more comfortable with the idea of increasing government transfers to local governments. State-to-

local government transfers went up from $23.4 million (1.17 billion Meticais) in 2010 to $60 million

(3.13 billion Meticais) in 2015. At the same time, much of the funding for federal initiatives has been

delegated to the district level. Between 2007 and 2016, district fiscal capacity increased from just 3

per cent of the total central government budget to 17 percent. Moreover, the transparency e-SISTAFE

provides has increased the willingness of international donor agencies to provide general budget

support to Mozambique’s government, rather than sector-specific or project-specific funding.

However, while it has helped improve the flow of government transfers, e-SISTAFE has not

addressed the other part of the revenue equation, local revenue generation. There is no such system to

track things like property valuations, commercial revenues, and land license fees; local own-source

revenues remain anemic. As a result, municipalities’ implementation capacities remain limited, access

to basic infrastructure has not significantly improved, citizens are frustrated, and they are not on a

path towards self-sustainability. E-SISTAFE is an example of how a treasury single account can play

a key role in decentralization efforts.

Sources: Pattanayak, Sailendra and Israel Fainboim(2010); World Bank, 2016c ; Dabán and Pesoa

(2007).

Ethiopia: Implementing a land value capture system during rapid urbanization

Policy Lesson: Land value capture systems differ among LDCs depending on the legal context, as

well as socio-economic and regulatory environment. Land value capture can provide additional

resources for local capital investments, but their implementation requires significant administrative

capacity. The tying of land value reform to the introduction and systematization of property taxes

would significantly increase the revenue potential of locally owned properties.

As of 2015, just 17.4 per cent of Ethiopia’s 86.6 million people live in urban areas, but this is rising

quickly and projected to reach 30 per cent by 2030. Urban governments in Ethiopia were first formed

37

in 1991 after decades of centralized rule. Ethiopia’s capital, Addis Ababa, and its second largest city,

Dire Dawa, were granted Charter City status at the time of decentralization, which places them

directly below the federal government and at the same level as the country’s nine regions, under

which the country’s other cities operate. An unusual feature of Ethiopian cities is that they possess

ownership of all land within their boundaries. The roots of this system trace back to 1974 with the rise

of the Derg, a Soviet-backed communist military dictatorship that placed all land in the hands of the

state; despite the Derg’s fall and political changes in the ensuing decades, land remained state

property and was delegated to city governments (where applicable) as part of the 1991

decentralization efforts.

This led to a land value capture system by which city governments either auction land leases off to

whoever makes the best offer or allocates the land at limited or no cost for institutions such as

government agencies, religious institutions, or certain manufacturing industries. Leases vary from 99

years for uses such as residential development to 5 years for short-term commercial use, and while the

land itself is leased, whatever is built on it is the property of the lessee. Federal law dictates that 90

per cent of lease revenue goes towards a general city fund for infrastructure and low-cost housing

developments. The most robust example of this system in action comes from Addis Ababa, whose 3.8

per cent growth rate makes it one of the fastest growing cities in the world and has tasked it with

rapidly expanding road, water, sanitation, and electrical infrastructure. All land targeted for

redevelopment in the Ethiopian capital goes through the auction or allocation process, which is used

both to raise revenue and to control the nature and pace of urban development.

However, despite the magnitude of this undertaking, revenues from land value capture represent just

six per cent of Addis Ababa’s revenue and nine per cent of infrastructure finance. Most of Addis

Ababa’s revenue comes from its tax sharing agreement with the federal government, which allowed it

to increase revenues from $50 million in 2003 to over $900 million in 2014. This money comes

primarily from VAT, income tax, and a tax on enterprises. The city spends 61 per cent of its revenue

on capital projects, but its infrastructure still cannot keep pace with the rapid pace of urbanization; in

2008, 80 per cent of the city’s settlements were considered slums by UN Habitat.

The lease system in Addis Ababa has helped it dramatically expand infrastructure, though it still has

not been able to keep up with demand. Water and electricity are available in almost the entire city but

are plagued by regular outages. Other services such as public transport and waste management are

also reaching more people but not keeping up with population gain. A major challenge is the lengthy

process the city government in Addis Ababa has to follow in preparing land for lease. Federal law

dictates that in order for land to be auctioned or allocated, the city first must negotiate with and

remove any existing users (typically farmers), pay them on the value of whatever property was there

38

before, and fully supply service infrastructure. These strict conditions together with low

implementation capacity caused by a lack of qualified government workers severely slows down the

process by which land comes to market in a city whose population and economy are expanding at a

breakneck pace. As a result, there is a very limited supply of land available for auction at any given

time, which inhibits private development and inflates the cost of any land that is available. This is part

of the reason that cooperatives represent just seven per cent of new residential construction and

private development just three percent. The other 90 per cent of residential development in recent

years has come in the form of public housing, though that too is hampered by the prerequisite of clear

and serviced land; as of 2015, over 900,000 households were on a waiting list to receive public

housing. With such a slow rate of land turnover and a dearth of private developers, Addis Ababa’s

growth potential is not being met. Most experts in the area agree that it is the implementation

challenge, rather than a lack of revenue, that represents the chokepoint in this expanding city.

However, it is still worth noting that systemized leasing has not given rise to systematized property

taxes; their sporadic enforcement means that the government captures very little value from existing

properties. This is not a particularly big issue now, but it could prove painful if the demand for new

development slows down at any point in the coming years. Despite these issues, the land value

capture system in place in Ethiopia is remarkable for being formal, systematized, and important to

municipal revenue. It has also helped produce tangible infrastructure improvements. Its potential for

improvement depends on the government’s ability to adapt is regulations and administration to better

deal with unrelenting urbanization.

Source: UK Aid and the African Centre for Cities, 2015.

Uganda (1): The role of grants and intergovernmental transfers in a second-tier city – perspectives from Busia Municipal Council

Policy lesson: Intergovernmental transfers and donor support could be more effective if they were less rigid, better timed, and designed in line with local needs and priorities.

Busia Municipal Council is one of the youngest of Uganda’s 22 municipal councils. It is located

200km east of the Ugandan capital city Kampala, and its population is about 100,000. The council

receives intergovernmental transfers from the central government on a quarterly basis. Conditional

transfers target road maintenance, health expenditures, school facilities, and other interest groups.

Unconditional transfers facilitate council sittings, garbage management, servicing of equipment's and

vehicles, and office management. Intergovernmental transfers are complemented by own-source

revenues that come from trading licenses, tendered out revenue sources of markets and transport

terminals, property taxes, local service taxes, hotel taxes, land registration tax, and building plan

approval fees. The Council also receives limited direct donor support for youth development and

traditional city functions like garbage disposal.

39

As a recipient of intergovernmental transfers and donor assistance, Busia has encountered a variety of

challenges. First and foremost, conditional intergovernmental transfers, which constitute about 85 per

cent of all local funds, are too low and only cover a small portion of the funds needed for wages and

salaries as well as service deliveries, which are particularly underfunded. Second, transfers are too

rigid as they do not allow municipalities to reallocate funds to new and emerging local priorities. Only

if the Council gets permission from specific line ministries can funds be reallocated for new purposes

and such permission involves a lengthy bureaucratic process. Another challenge is represented by the

delayed release of the funds. Frequently, transfers are only received one month before the close of the

financial year, and as a result, a significant portion of them is returned. As regards donor funds, most

donors support project lacks local government involvement at the design stage which can lead to

project failure and abandonment later. Moreover, there is also a tendency to impose projects on local

authorities that are not necessarily perceived as top priorities. To overcome these challenges, the

Council has recommended the following actions to the Ugandan Government and interested donors:

Conditional grants should be flexible and be allowed to adjust to local priorities and realities, the

general budget allocation for local governments should increase from 12 per cent to 30 per cent of the

national budget and funds should be released in a timely fashion, and donors should fully involve all

stakeholders at the project design stage.

Source: Municipal Council, Busia.

Lesotho: Local governments and revenue generation in Lesotho-Legally empowered but politically constrained

Policy lesson: Even where municipalities are legally empowered to raise revenues and borrow, political inertia can stand in the way of effective fiscal decentralization.

Lesotho is divided into ten districts, which are further subdivided into constituencies that consist of

64 local community councils and 11 urban councils. The prime agencies for collecting local revenues

at the district level are community and urban councils. The Lesotho Local Government Act (1997)

legally empowers councils to raise own revenues. Such revenues include taxes, rates and charges,

licenses and permits, fines and penalties, property taxes, and other commercial income generated from

the sale of district councils’ assets including natural resources. The law provides that “the Minister

shall publish in a gazette a list of items from which councils may collect revenues by way of tax or

levy of charge.” However, up until November 2015, the ministry did not publish such information.

Consequently, district councils have had no own source of revenue, which remains a major source of

frustration. The councils only act as collection agents for the central government. If a new source of

revenue is identified, the local authority is obliged to notify the central government, which will

provide guidance on the rates and their application. The role of the councils is limited to recording

and reporting revenue receipts and to remitting local revenues to the central government. According to

40

local authorities in Lesotho, the lack of power and autonomy over sources of revenues has

significantly limited their incentive to maximize revenue collections. With support from UNCDF,

UNDP, EU and GIZ, the Governments has formulated and passed a new decentralization policy in

February 2014. The policy proposes local fiscal autonomy with zero tolerance for corruption and strict

adherence to laws. The capital city Maseru serves as a pilot for the new programme. Five line

ministries, including health, social development, forestry, and energy, have started publishing

functions for devolution to the local level. To what extent the new policy will include other ministries

and be expanded to other districts will depend on many factors, including political commitment from

the central government.

Source: Interviews with local stakeholders.

Questions for further research and discussion:

What determines the effective choice, combination and design of appropriate revenue tools? How

can local authorities improve revenue collection? What are the right policies to ensure

affordability to pay? How should local authorities take other factors into account in the policy

design when choosing the right tax and user fee revenue policies (e.g. efficiency, equitability,

impact on the distribution of income, environmental impact, and political considerations)? How

can the coordination of different government levels be improved? How can intergovernmental

transfers improve the capability of subnational governments to deliver public services and also

strengthen the institutional capacity to generate revenues?

41

(IV) Challenges in municipal financial management

Municipal management is relevant for all activities related to subnational finance. Municipal

management encompasses financial, expenditure, and asset management. All three types of municipal

management are closely inter-related.

The four tenets of public financial management include budgeting, accounting, reporting, and

auditing. Expenditure management is somewhat broader in that it focuses on whether funds are

appropriately spent and monitored and whether information is available for proper planning and

budgeting. Its basic tasks are performed within a cycle that begins with planning of resources and

expenditures and moves towards allocating and transferring funds, controlling and executing

expenditures, and, eventually, evaluating financial performance. Whereas financial management is

largely the business of the treasurer and its staff, sound expenditure management requires a broader

and more inclusive approach. For example, planning resources and expenditures and monitoring of

results requires the direct involvement of the Mayor and the council, whereas line departments will

execute expenditures in their sector. Asset management refers to municipal management of both

physical (land, infrastructure, equipment) and financial assets (investments, ownership, bank

deposits).

Figure 4.1: Public financial management subnational performance indicators in selected African LDCs

(based on Public Expenditure and Financial Accountability (PEFA) assessments)

Top 5 indicators:

•Transparency of inter-governmental fiscal relations

•Accounts reconciliation

•Procument systems

•Orderliness and participation in annual budget process

•Payroll controlls

Bottom 5 indicators:

•Multi-year perspective

•Alignment of aggregate revenue with budget

•Tax collection

•Alignment of aggregate expenditure with budget

•External auditing

42

*Notes:

Countries included: Ethiopia, South Sudan, Burkina Faso, Madagascar, Senegal, Sierra Leone,

Tanzania

The data were averaged first among all rated subnational governments within a country, then

between the included countries.

No data for non-African LDCs is publicly available.

A comprehensive treatment of challenges in municipal management, of which there are many,

especially in LDCs, is beyond the scope of this chapter. Our focus is on municipal budgeting, as it

speaks to the core challenge of municipalities, namely, to allocate scarce resources to large and ever-

growing demands for essential public services, and to do so in an equitable and sustainable fashion.

Budgeting is also an area where exciting institutional changes are taking place, especially in the form

of participatory budget processes, which are highlighted in a number of brief case studies at the at end

of this chapter.

Municipal budgets should clearly delineate and quantify the different types of planned local

expenditures. They should explain what the money will be spent on and clarify how it will be funded.

Traditionally, budgets have been prepared with a one-year horizon. However, some LDCs have

moved to three to five year horizons in order to better link their local budgets to longer-term

development objectives. For example, municipalities in Tanzania are required by law to prepare

medium-term budget frameworks that are in line with national development strategies. To implement

the new requirement local government officials have received training in medium-term budgeting

processes, as well as in the use of relevant software that allow for better planning of longer-term

infrastructure investments.

However, many local authorities in LDCs and developing countries still lack a medium-term outlook

in their local budgets. The focus remains predominantly on current and operating expenditures, which

are captured in the current account. Infrastructure investments and other investments whose benefits

extend well beyond one year are often not accounted for, since many LDCs do not legislate capital or

development budgets at the local level. Creating a comprehensive budget is a complex task and

requires enormous amounts of information and data from different local units as well as consultations

with the community on spending priorities and possible changes in user fees and taxes. Planning

ahead and setting up a calendar is crucial so that each specific unit knows when to produce certain

types of data. Figure 3.1 shows a typical subnational budget process in a developed country.

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Figure 4.2: Subnational budget process

Source: based on budget guidelines for municipalities in Washington State, US.

There are a range of challenges that LDCs face in the timely preparation of such a comprehensive

local budget. More than in developed countries and most other developing countries, budgets by local

authorities in LDCs are affected by central government budget constraints: Central governments in

LDCs are often highly dependent on ODA and revenues from commodity export and both sources are

of a volatile nature. As a result, intergovernmental transfers to local authorities may be reduced and

result in decreased local government programs and initiatives. The volatile nature of

intergovernmental transfers also limits the information available to local authorities to plan ahead.

Moreover, the central government often allocates budgets to line ministries instead of routing it

through local governments resulting in fragmented planning and tensions between local governments

and the line departments. Another challenge lies in the fact that budgets are not synchronized. For

example, it is typical for the central governments to approve development grants very early in the

fiscal year, rather than the year before, making it hard to include them in the planning process at the

local level and leading to unspent funds in many cases.

A common result of these complications is a high ”budget-actual variance” in many cities in LDCs,

i.e. actual expenses and those that were budgeted differ to a large degree that (often more than 10 per

cent in many local authorities in LDCs) (World Bank, 2014).

44

As mentioned earlier, an important step to improve the transparency of local budgets has been the

introduction of participatory budgeting processes

Participatory budgeting

Participatory budgeting (PB) allows non-elected citizens to participate in the allocation of public

finances. In local PB, citizens decide directly on how to spend all or a certain share of the sub national

budget. In certain cases, PB may go beyond determining spending priorities and encompass

democratic processes that allow community members to determine the actual design of the budgeting

process. The shape, depth, and breadth of PB varies across the world. For example, in some local

governments, entire municipal budgets are allocated through PB while many other local authorities

limit PB to a certain share of the budget or directly allocate a small amount to neighbourhoods, who

decide on their own spending priorities (see Maputo example).

Given the many shapes and forms PB can take, most experts and practitioners agree on five basic

criteria. PB is a process where: (1) budgetary decisions are made; (2) local authorities are involved;

(3) the process is not a one –off exercise, i.e. it has to be repeated; (4) there has to be public

deliberation on spending priorities; (5) accountability is required (Sintomer et al, 2010).

Within this broad definition, PB and its implementation varies significantly, but some common

threads can be identified. Decisions are usually made in regular local assemblies and meetings where

residents meet to discuss the most important local needs and identify spending ideas. A smaller

number of selected representatives (preferably those with some financial or budgeting expertise) then

develop concrete projects that address these priorities and present them to the residents (the Nepal

case study present a variation of this framework). Once residents vote which of the proposed projects

to fund, the local government allocates the funds to implement the chosen projects. Since

accountability for implementation lies with the local authority, the government should report back

regularly to local assemblies on the status of implementation. In short, the process can thus be

described as one of diagnosis, discussion, decision making, implementation, and monitoring.

There are various welfare, ethical, political, and economic arguments in favour of participatory

budgeting, sometimes also referred to as “participatory promises”: On the welfare side, it is argued

that PB produces better and more equitable service delivery as local residents know their own

priorities better than central or subnational government representatives.

Consequently, PB helps direct local government expenditures towards communities with the greatest

needs. If carried out effectively and in line with the principles described earlier, PB will result in

greater access to basic services and improved living conditions. From an ethical angle, PB is an end in

45

itself, as by its very nature PB stands for empowerment and emancipation. Citizen empowerment can

reduce the scope for catering to a limited clientele, elite capture, and corruption through greater public

oversight. PB also represents an important political tool both for governments and its citizens. New

structures and opportunities for participation promote community building and the understanding of

complex political issues. They can be important opportunities for experiencing democratic decision-

making from the ground up (see Bangladesh case study). Citizens may also feel more connected to

their city, leading to a “political stability” argument. Through PB, politicians can build closer

relationships with their constituents and vice versa which may help thwart civic unrest and violence in

unstable settings. As we will discuss below, such arguments may explain why PB has become popular

even in less mature democracies in LDCs. On the economic side, PB may help mobilize domestic

resources for development, especially at the subnational level. The willingness to pay taxes is likely to

increase where public money is spent on visible improvements in line with clearly defined priorities

of citizens.

The full-fledged PB was “invented” in the Brazilian city of Porto Alegre in 1989. Since then, as many

as 50,000 people have participated each year to decide on as much as 20 per cent of the Porto

Alegre’s budget. Since 1989, by some counts, PB has spread to over 1,500 cities in Latin America,

North America, Asia, Africa, and Europe. PB has also become a mainstay policy tool that has been

heavily promoted by United Nations Development Programme, including UNCDF, the World Bank

(see Mozambique case study), and regional development banks around the world.

PBs in LDCs have spread as a “result of a set of forces deployed by individuals and institutions, a

constant work of legitimating participatory governance, connecting players through international

events, training teams and producing technical material” (Nelson Dias,2014). Many instances are still

under development and more of a consultative nature than linked to actual decision-making at the

local level. The more advanced experiments of PBs are present mostly present in African LDCs (with

the exception of Cameron), namely, Madagascar, Senegal, and Mozambique. However important

steps toward greater participation in budgetary matters at the local level have also been taken in Asia

and the Pacific region.

46


Are the instructive examples of how local authorities in the region have ensured effective

monitoring and analysis of both operating and capital expenditures? How should they manage

subnationally owned physical assets (land, buildings, infrastructure, and vehicles and equipment)

in support of subnational finance for sustainable development? How can they ensure long-term

planning of both capital investment projects and financing? How should they implement

transparent and competitive procurement? How can they ensure strong capacities for contract

management?

47

(V) LDC experiences in developing local participatory budgeting

Nepal: Increasing citizen participation with participatory planning (PP)

Policy lesson: Where structures for PBs are not in place, PP is an important first step. Similarly PB

initiatives can be piloted in certain sectors before they are scaled up.

Some LDCs have taken important steps toward citizen empowerment that have great potential to

evolve, over time, into more advanced engagements like PB. In Nepal, participatory planning (PP)

involves the local community in the strategic and management processes of urban planning, i.e.

community-level planning processes. The modern form of PP was ushered in through the “Local Self

Governance Act”, introduced in April of 1999. The act laid the foundation for increased citizen

participation and called for “the enjoyment of the fruits of democracy through the utmost participation

of the sovereign people in the process of governance by way of decentralization.” Since the

introduction of the Local Self Governance Act, development agencies, the UN system, as well as

international and local NGOs have been actively working with the Government of Nepal to provide

training for local citizens as well as strengthening the administrative capacity of local bodies in

support of greater participation in local decision-making processes, including planning and budgeting.

Participatory planning in Nepal varies across different villages, municipalities, and districts. In most

cases, community-based organizations are invited to deliberate policy and budget guidelines presented

through a Ward Committee, which comprises government-appointed officials. Deliberations are open

and take place in public spaces. The resultant recommendations are forwarded to the Ward Committee

office which then organizes a comprehensive workshop (Ward-Bhela) with selected representatives of

community-based organizations to further discuss the decisions at the community level. The Ward-

Bhela makes its own recommendations, which are forwarded to the municipal/village secretariat. The

municipality reviews all the proposals with regard to their technicality and financial viability. The

refined proposals are sent to an “Integrated Planning Formulation Committee” (IPFC) which

comprises all the representatives of communities, NGOs, and sectoral organizations. The outcome of

its deliberation on the refined proposals is then endorsed by the centrally appointed Ward officials. In

Nepal, participatory planning is therefore still ultimately in the hands of central government appointed

bureaucrats. To make PP even more inclusive, an important step could be to allow for local elections

of ward officials. Yet, local elections have not been taken place for a decade. However, given the

political and institutional constraints Nepal has faced through the past decades (see example on

political decentralization), the country has come a long way in empowering citizens at the local level.

In certain areas, especially the water sector, PP and PB are even further advanced. Indeed, many water

supply projects are initiated, financed, and implemented by water user communities through a

combination of central government grants, own source revenues, and loans.

48

Source: World Bank, 2014.

Bangladesh (1): Experimenting with inclusive budgetary processes at the local level

Policy lesson: Donors and NGOs (international and local) can “wet” citizens’ appetite for PB

through encouraging local authorities to experiment with different forms of inclusive budgetary

processes at the local level.

Bangladesh has made important strides in involving citizens in local decision-making through a range

of donor projects undertaken in collaboration with the Government. While falling short of

institutionalizing PB as a municipal management practice, these projects sparked great interest and

even enthusiasm for the idea of PB, which could pave the way for sustained citizen engagement in

local budgeting processes in the future. For example, as part of the Sirajganj Project in the early

2000s, co-sponsored by UNDP and UNCDF, participatory planning and budgeting meetings were

organized at a number of Union Parishads (UP), which are the smallest rural administrative and local

government units in Bangladesh. Also, The Hunger Project, a global NGO to combat hunger and

malnutrition, helped organize open budget session at UPs all over Bangladesh, giving citizens the

chance to convey concrete project proposals that would meet their practical needs. A local NGO

called Agrogati Sangstha carried out a similar type of exercise by organizing a meeting in which the

chairman of a UP declared the budget of the UP before some 500 local citizens, many of whom posed

concrete questions about revenue and development expenditures. Building on these experiences and

similar exercises, the Government in 2007 launched a national decentralization programme, known as

the Local Government Support Programme (LGSP), with the aim of improving local governance and

local service delivery. As the programme ended in December 2011, UNCDF and UNDP developed

the Union Parishad Governance Project (UPGP) and the Upazila Governance Project (UZGP), which

scale up promising innovations tested in previous pilots.

Solomon Islands: Tackling local governance challenges in a small island developing state

Policy lesson: PB faces particular challenges in Small Island Developing States (SIDS) due to

geographical constraints. As a result, capacity-building efforts must take into consideration how such

constraints affect local governance as well as the interaction between local and central governments.

The case of the Solomon Islands highlights the particular challenges of small island developing states

in promoting local participation in economic decision-making. It also shows the potential for

performance-based grants to promote good governance and lay the groundwork for participatory

budgeting approaches. The Solomon Islands’ population is culturally diverse with some 80 different

languages reflecting geographical dispersal across some 300- 400 inhabited islands. Experts have

identified some major challenges for participatory approaches to local governance. First,

49

transportation and communication links across the country are very poorly developed, restricting

opportunities for engagement in the formal economy. Second, the financial, technical, and human

resources available to provincial governments are severely below what is necessary to maintain basic

services, i.e. there is reportedly poor devolution of funds from central government to provincial

governments (Bennet et al, 2014). Third, there is complex institutional landscape of interventions at

the subnational level, which complicates local planning processes. Fourth, there are governance

challenges at the local level, including corruption and transparency issues.

The central government has taken concrete steps to tackle these challenges. For example, in April

2013, the Ministry of Provincial and Institutional Strengthening formally launched a process to

develop Ward Profiles for each of the 170 Wards and Strategic Plans for each Province. To promote

good governance at the local level, the Provincial Governance Strengthening Programme provides

access to the Provincial Capacity Development Fund ($33.5 million) for provinces that meet

minimum conditions for principles of transparency and accountability. Provinces that meet the

requirements (seven out of nine in 2015) can tap the fund for investments for small scale

infrastructure projects.

Senegal (1): The experience of PB experiments in Fissel and Ndiaganiao

Policy lesson: Embedding PB in a sound institutional and legal framework at the national level could

help it survive political change at the local level.

Senegal has a long tradition of decentralization dating back to 1972, and in 2003, the country

launched new PB experiments in Fissel and Ndiaganiao. Participatory budgeting in Fissel followed a

programme for strengthening citizen participation that had started in 2001 (Gaye, 2005, p.1). Fissel

also benefitted from having a long tradition of social mobilization through, for example, the launch of

community radio by grassroots organisations in the mid-1990s, and a local civil society organization

called Regroupement Communautaire pour le Développement (Recodef), played an important role in

launching the initiative. The Fissel experiment was successful *in improving local revenue

management because its citizens were consistently active and its politicians receptive,* and it

demonstrated that PB can be successful in a rural context. Since then, the major challenge has been to

establish PB as a permanent and accepted tool of governance. Frequently, as was the case in

municipalities like Matam and M’Bao, newly elected mayors abandon the concept because it is

associated with their predecessors. It is thus important to institutionalize the principles of PB. In order

to ensure that PB survives beyond election cycles, the national Constitution could make citizen

participation a legal requirement for municipalities rather than just encouraging it. 12 years after

Fissil, Senegal is embracing PB in earnest with legislative changes and new pilot projects with the

ultimate aim of ensuring that there is PB in all 45of its départements.

50

Source: Sintomer, Allegretti and Herzberg, 2012.

Madagascar: Building capacity for PB through donor support

Policy lesson: A one size fits-all approach to PB should be avoided.

Participatory budgeting in Madagascar started in 2008 with 9 municipalities, six of which were in

mining areas. As a result of PB, revenue collection increased dramatically in some areas: For

example, the Ambalavao rural municipality raised its revenues from land and property taxes more

than six fold to 52 percent, an impressive jump that has been attributed to citizens’ greater willingness

to contribute financially in PB scenarios. PB in mining areas also facilitated a more transparent and

fair management of mining royalties paid by mining companies to the State. Following the positive

initial experience, the Government of Madagascar’s Local Development Fund was

decentralized, participatory budgeting of 50 selected municipalities was rolled-out, and training of

206 community facilitators was financed. One shortcoming identified by stakeholders was that the

World-Bank-led project provided the same capacity building activities and amount of financial

resources to all municipalities. In this context, it was stressed that municipalities are heterogeneous in

terms of size, capacity, and commitment to reforms and that the one-size fits all approach adopted by

the project severely limited its impact.

Mozambique (1): Evolving PB approaches in Maputo

Policy lesson: Good governance is good politics

Mozambique has one of the largest urban populations in Africa, with a predicted 60 per cent of the

population living in urban areas by 2030. The emergence of PB in Maputo has been referred to as a

‘historical puzzle’ (Levi, 2010) given that Mozambique features a ‘party based authoritarian regime

that emerged out of violent, ideologically-driven conflict’ similar to other LDCs such as Eritrea,

Ethiopia, Uganda and Zimbabwe (Levi, 2010). In the context of concerns over stability of the regime

and the discovery of vast resources of coal and natural gas, Mozambique received increasing levels of

ODA and became a haven for FDI, with 40 per cent of its budget financed by its donor community

(However, development funds have come with strings attached, one of which committed the

government to implement a series of ‘good governance’ reforms, including PB. The current form of

PB in Maputo, which has evolved over the past decade, rotates through 16 neighbourhoods each year

on a three-year cycle, with each neighbourhood able to spend up to 1.5 million meticais (roughly US$

50 000) on its priority project(s). More recently, the World Bank doubled its funding and shortened

the cycle from three to two years. The Maputo model highlights that beyond the benefits a well-

51

framed PB brings to the population; it is also good politics as it helps reconnect the local party-state to

the population in a face-to-face manner with benefits going beyond the usual partisans.

Sources: Mozambique Economy Profile, 2013; Reaud, 2012, United Nations, cited in World Bank,

2009-update.


Are there instructive examples of how local authorities in the region have ensured effective

monitoring and analysis of both operating and capital expenditures? How should they manage

subnationally owned physical assets (land, buildings, infrastructure, and vehicles and equipment)

in support of subnational finance for sustainable development? How can they ensure long-term

planning of both capital investment projects and financing? How should they implement

transparent and competitive procurement? How can they ensure strong capacities for contract

management?

52

(VI) Challenges in accessing long-term finance for capital investments

Urbanization has led to enormous municipal infrastructure financing needs around the globe. While

own-source revenue generation and sound public financial management are crucial, domestic capital

markets may offer additional opportunities for cities and local authorities in LDCs to leverage their

budgetary resources to invest in infrastructure.

Figure 6.1:

Source: Pozhidaev and Farid (2016).

Capital markets are the part of a financial system concerned with raising capital for long-term

investment,which is the type of investment needed for infrastructure improvements at the local level.

Capital for long-term finance can be raised in the form of equity and debt.

Raising finance by selling equity to private investors by the project owner is more complex and

expensive than selling debt. It essentially requires a municipal company or a special purpose vehicle

to be listed on the stock exchange, where the entity can issue equity for sale to interested investors.

Such financial infrastructure is rarely in place in developing countries at the local level, let alone in

LDCs. However, as argued by Pozhidaev and Farid (2016), private equity may be attracted through

non-market mechanisms. For example, in Busia, Uganda, a private entity has committed equity

to a new infrastructure project through a project-based partnership arrangement with a

municipality (see Uganda case study (2) in this chapter).

Financial markets

Money

market

Foreign exchange

market

Capital market Commodities

market

Credit

market*

Bond and long-term

debt market

Equity

market

* The credit market is defined narrowly as a marketplace for trading, structuring, and investing in

the credit/credit risk of public and private borrowers through short-term lending or through credit

derivatives and structured credit products.

53

Since it is less complex and often cheaper, debt financing is much more common than equity

financing. There are two avenues for local governments to access municipal credit: bank lending and

municipal bonds. Out of these two options, long-term bank lending is by far the most common type of

local debt and represents the predominant form of municipal credit in most developed and developing

countries. Municipal bonds are less common and represent the most sophisticated instruments for

raising finance at the local level (the section on municipal bonds in this chapter provides a more

detailed discussion on their role and potential in developing countries and LDCs).

Municipal bonds

As of late, municipal bonds have received renewed attention in the international development

community as a potentially effective means to mobilize additional resources for local development

from private investors. However, whether they are a realistic pursuit, is subject to debate, as municipal

bonds belong to a set of government financing options (Table 4.2) that are typically applied in more

advanced financial economies with diverse and mature financial sectors .

Table 6.1: Advanced municipal finance tools

Government-based

Finance Options

General Obligation Bonds

Revenue Bonds

Industrial Revenue Bonds

Qualified Energy Conservation Bonds

Social Impact Bonds

Public Benefit Funds

Linked Deposit Programs

Energy Efficiency Loans

Property-Assessed Clean Energy Programs

Greenhouse Emissions Allowance Auctions

Development Exactions Dedication Requirements

Linkage Fees

Impact Fees

Public and Private

Options

Public-Private Partnerships

Pay for Performance

Securitization and Structured Finance

Private Sector

Leveraging

Loan Loss Reserve Funds

Debt Service Reserves

Loan Guarantees

54

Pooled Bond Financing

Pooled Lease- Purchasing Finance

Tax Increment Financing

Source: Center for Urban Innovation at Arizona State University, 2015.

For an informed discussion, it is beneficial to look at how common and successful these instruments

have been how around the world.

The US boasts a USD 3.7 trillion municipal bond market, representing more than 22 per cent of its

GDP, where even the smallest of towns have raised millions of dollars in bond issuances. A market of

such size remains unique in the world. Canada comes in a distant second with outstanding local debt

representing just under 3 per cent of its GDP. Indeed, municipal bonds are not the predominant source

of finance in most developed countries. Outside the US, most states, cities and towns that access the

financial market for credit do so through bank loans, often from government-owned financial

institutions, and banks, such as development banks, with which they have a long-standing

relationship. In middle and low-income countries, subnational access to capital markets is even more

limited and applies to selected larger cities at best. Many local authorities do not access private or

public credit at all and rely entirely on capital grants from the central governments to fund large-scale

investments. This is often due in part to federal laws restricting local borrowing. (Table 4.3))

Table 6.2: Limitations on LGs’ borrowing ability in selected Asian LDCs

Afghanistan Cities can only borrow from the Central Government.

Bangladesh LG borrowing from external sources is allowed with central government approval.

Urban Local governments can and do borrow from the Bangladesh Municipal

Development Fund.

Bhutan LGs may borrow funds through the Ministry of Finance or with its approval.

Nepal Municipalities can borrow using collateral or CG guarantees

Source: World Bank (2016b).

A cursive look at the BRICS, the group of the most advanced emerging markets, confirms the

immature stage of municipal bond markets around the developing world. The BRICS country with the

biggest potential for municipal bonds is China. After a subnational borrowing crisis in the early

1990s, municipalities were not allowed to take out direct credit. As a result, a plethora of semi-

autonomous local government investment vehicles emerged that borrowed on behalf of local

authorities. Local government debts issued through these financing vehicles amounted to 18 trillion

55

yuan ($2.9 trillion) in 2014, more than a quarter of China's GDP. Alarmed by this amount and set to

bring subnational borrowing out of the shadows, a handful of cities, including Beijing, were

authorized to issue almost 600 billion yuan ($90 billion) in bonds in 2015.Whereas for the time being

the municipal bond market remains small, representing only 1.3 per cent of its GDP, it could grow

significantly. Much depends on the extent to which these issuances can help reign in local government

debt and increase transparency.

Compared to other developing countries, India has a longstanding history of municipal bonds. In

1998, Ahmedabad became the first Indian city to sell municipal bonds to finance infrastructure

improvements. Yet, the municipal bond market has remained in a nascent stage. In the past decade

and a half only 25 municipal additional bonds have been issued.

In Brazil, the central government authorized 21 states to borrow up to 60 billion ($25 billion) from

2013 through 2014, a move that ended a ban on municipal debt that dated back to a 1997 after a

subnational debt crisis required a federal bailout. the central government authorized 21 states to

borrow up to 60 billion real ($25 billion) from 2013 through 2014 However, only a year after the ban

was lifted it was reinstated after two large international banks provoked a central government

backlash by collecting a federal government guarantee and charging the state of Minas Gerais more

than if Brazil would have sold its own sovereign bonds (collecting $140 million in fees in the

process).

In South Africa, municipal debt makes up less than two per cent of bonds listed on the Johannesburg

Stock Exchange, with only four metropolitan areas – Johannesburg, Cape Town, Pretoria and

eThekwini – able to access the market (albeit with government guarantees). In Russia, the volume of

municipal bond market amounted to 0.5 trillion Roubles, less than one per cent of its GDP.

As most of the economic powerhouses outside the OECD countries have only gradually entered the

municipal bond market and have done so at a deliberate pace (perhaps to avoid pitfalls, i.e. federal

bailouts from the past) it comes as no surprise that municipal bonds in poorer countries are far and

few between. For example, there is no municipal bond floating the market in Africa outside of South

Africa, Nigeria, and Cameroon. Table 6.3 provides an overview of subnational bond issuances in

developing countries, as defined by having membership in G77. Overall, 15 developing countries (out

of 134) have experiences in issuing bonds at the sub national level.

Table 6.3: Outstanding bond issuances in Developing Countries

56

Country Total Outstanding Subnational Bonds (million $)

Outstanding Dollar or Euro-Denominated Subnational Bonds (million $)

Outstanding Local Currency Subnational Bonds (Equivalent in million $)

Information

Argentina 14050 14050 0 This subnational bond market exclusively comprises provincial bonds

Belize 10 0 10 Belize city is the only subnational entity to with outstanding bonds

Bosnia and Herzegovina

284 0 284 The Municipality of Laktaši issued the country’s first municipal bond in 2008

Brazil* 1932 1932 0 Subnational debt rose from 1 percent of GDP in the early 1970s to 20 percent in the mid-1990s Excessive subnational debt and macroeconomic stability has led to three rounds of bailouts for Brazil’s states and two for its municipalities. The central government authorized 21 states to borrow up to 60 billion ($25 billion) from 2013 through 2014 However, only a year after the ban was lifted it was reinstated

China 1531 30 1501 China began its municipal bond market in 2015 with a $590 billion issuance Most of this money went towards debt swaps intended to reduce interest rates for local debt This previous debt, known as local government financing vehicle debt (LCFV), was the equivalent of 38 percent of China’s GDP in 2014

Costa Rica* 14 0 14 San Jose became its first municipality to issue bonds in 2002

El Salvador 43 0 43 The Fideicomiso de Restructuración de Deudas de las Municipalidades, created to restructure and consolidate municipal debt, sold $43 million worth of municipal bonds in 2011

India 7379 3500 3879 Municipal bond issuances were on the rise up until 2005 but have dropped sharply since

Nigeria 1664 0 1664 Nigerian states had $14.2 billion in debt as of December, 2014 This represents 21 percent of total government debt in the country History of state-level bonds dates back to 1978

Paraguay* 7 0 7

Peru* 220 0 220 The City of Lima issued a PEN 593 million ($220 million) bond in 2013, which was given a Baa3 rating by

http://enaun.mrecic.gov.ar/

http://www.un.int/bosnia/

http://www.un.int/bosnia/

http://www.un.int/brazil/

http://www.china-un.org/eng/

http://www.un.int/wcm/content/site/costarica

http://www.un.int/wcm/content/site/elsalvador

http://www.un.int/india/

http://www.un.int/nigeria/

http://www.un.int/paraguay

http://www.un.int/wcm/content/site/peru

57

Moody’s Philippines* 120 0 120 In 1998, created the Local

Government Unit Guarantee Corporation (LGUGC), which guarantees local government, water district, and electric cooperative bonds with financial assistance from USAID

South Africa 1359 0 1359 In 2004, Johannesburg became its first municipality to issue municipal bonds

Viet Nam* 875 0 875 Five cities/provinces have issued municipal bonds The first municipal bonds were issued in 2003

Zimbabwe 0 0 0 Zimbabwe had a thriving municipal bond market since the 1980s that declined together with the central government’s financial stability and the country’s macroeconomic stability in the early 2000s From 1990-1996, bonds funded about 20 percent of local capital budgets As of July, 2016 there, are plans in the capital city Harare to issue a $15 million in bonds

Totals 14912 4936 9976 *Numbers come from source other than Cbonds database.

Note: Zimbabwe is the only known least developed country in which subnational bonds have been

issued in the past 25 years, although there are currently no outstanding isssuances.

Sources: Abal, (2013), Asian Development Bank, Bevilaqua (2002), Cbonds, CentralAmericaData, City of Johannesburg, Ekpo (2015), LGUGC, Moody’s, Singh, Charan and Singh, Chiranjiv (2015), Stefania (2016) Tarik (2014), USAID, White and Glaser (2004)

Given the underdeveloped markets for municipal bonds in developing countries, the question beckons

as to whether and when municipal bonds are a realistic objective for raising long term finance in

LDCs.

When contemplating the issuance of a municipal bond, it is important to ask whether the national

government issues bonds, since those can serve as important pricing benchmarks for potential

investors in local debt. It is safe to say that municipal bond markets are unlikely to thrive where

central governments have not yet accessed domestic capital markets. More specifically, municipal

bonds (unless heavily guaranteed by external parties) are unlikely to break through the 'sovereign

ceiling’, i.e. in the vast majority of cases the creditworthiness of a subnational entity is likely to be

equal or less than that of the central government. Because municipalities are generally ill-advised to

take on exchange rate risk (given that their revenue streams are in local currency) they are likely to

contemplate municipal bond issuances in local (and not foreign) currency. It can therefore be argued

http://www.un.int/philippines/

http://www.southafrica-newyork.net/

http://www.un.int/vietnam/

http://www.un.int/wcm/content/site/zimbabwe

58

that government bonds in local currency are the real benchmarks for municipal bonds (as opposed to

those issued in USD or Euros). As shown, in table x there are quite a few LDCs that have not

accessed international markets but have issued government bonds in local currency on domestic

capital markets. More specifically, as of 2016, 18 out of 48 LDCs have floated bonds. Only 9 have

raised funds internationally. Other LDCs (e.g. Burkina Faso, Cambodia, DRC, Lesotho, Solomon

Islands, Uganda) have taken preparatory steps to float bonds in the foreseeable future,such as

applying for international credit ratings.

Table 6.4: List of LDCs with government bond issuances within the last decade

LDC Comments Major Agency Ratings

Total Out-

standing

Bonds

(US$ million)

Local Currency

Outstanding

Bonds

(equivalent in

US$ million )

Foreign

Currency

Outstanding

Bonds

(US$ million)

Angola Moody’s, B1 S&P, B Fitch, B+

6145 3645 2500

Bangladesh Plans for bonds in US

Dollars discussed by

ministry of finance

in 2013, but now

stalled

Moody’s, Ba3 S&P, BB- Fitch, BB-

15763 15763 0

Benin N/A 1387 1387 0 Bhutan N/A 15 15 0 Burundi N/A 49 49 0 Chad N/A 356 356 0 Ethiopia Moody’s, B1

S&P, B Fitch, B

1000 0 1000

Guinea N/A 55* ND ND Guinea-Bissau N/A 11000 0 11000 Lao People's

Dem. Republic

N/A (rated by a Thai agency) 759 577 182

Madagascar N/A 850* ND ND Mozambique Moody’s, Caa3

S&P, CCC Fitch, CC

727 0 727

Niger N/A 574 0 574 Rwanda Moody’s, B2

S&P, B Fitch, B+

400 0 400

Senegal Moody’s, B1 S&P, B+ 3139 2139 1000

Togo N/A 913 913 0

59

United Rep. of

Tanzania

N/A 600* ND ND

Zambia Moody’s, B3 S&P, B Fitch, B

3843 843 3000

Sources: Amadou (2015), Tyson (2015), DiBiasio (2015), Khmer Times (2014), Janssen (2015),

Kerdchuen (2015), Hammond (2015).

While the presence of local capital markets, where government debt can be bought and sold by

domestic investors on secondary markets, is an important prerequisite for issuing a municipal bond,

there are many other hurdles local authorities have to overcome to sell their debt to investors. To

begin with, issuing a bond is a complex and time-consuming process that requires a wide range of

preparatory steps, all of which pose distinct capacity and cost challenges, especially in an LDC

setting. The typical steps are: (a) the compilation of a corporate plan and capital improvement plan;

(b) the completion of a feasibility study; (c) the identification and involvement of all essential

stakeholders, including underwriter, legal advisor, financial advisor, auditor, trustee/paying agent,

notary and guarantor (if needed); (d) the completion of a public audit; (e) the preparation of

documents, including an offering circular that presents the basic terms of the transaction to potential

investors (prospectus), financial information on the issuer and a fiscal agency agreement (trust

indenture), containing legal rights of investors and obligations of issuer; (f) obtaining a rating from

national/international credit rating agency; (g) the registration with the responsible capital market

supervisory agency; and (i) the public sale or private placement of the bond.

At the time of writing, only one city in an LDC has come close to issuing a municipal bond. The

experience in Dakar, Senegal, (see case study) is encouraging. The example illustrates that with a

common goal in mind and well-coordinated donor support, even cities in the least developed countries

can come a long way in improving their finances through dedicated efforts to build fiscal

responsibility and creditworthiness. However, it shows that central government buy-in and sustained

support remains crucial when embarking on the ambitious project of a municipal bond.

Consequently, a more general goal of improving access of local governments to more market-based

borrowing principles is perhaps more attainable in most LDCs. For example, donors could provide

incentives for local governments to improve their capacity so that they can begin to borrow, initially

through special mechanisms such as subsidized lending and later on more market-based terms.

Ideally, this would help local governments develop borrowing practices over time and empower them

to fund their capital investment needed to meet their sustainable development objectives (Smoke

2015).

60

Other borrowing alternatives

A number of borrowing mechanisms have been used by municipalities that are not yet investment-

grade creditworthy but have undertaken significant efforts in this direction:

Municipal development funds operated by national or state government entities mobilize resources

from private lenders, the central government, and donor agencies, and on-lend these resources to

subnational governments to finance capital investment programs (see Bangladesh Case Study). Terms

are normally concessional, although capacity to repay debt obligations is an important criterion to

access these funds. More complex arrangements may pursue the dual objective of financing local

infrastructure investments and strengthening local credit markets. In Colombia, the Findeter Fund

used external borrowing to rediscount loans made by private commercial banks to public local

authorities and local private entities for investing in urban services and utilities. The success of a

model like Findeter depends on the depth of the local financial markets and the availability of capable

financial institutions that can take on credit risk related to municipal and urban services loans at a

substantial scale.

In poor countries, hybrid financing, a combination of market loans and grants, helps local authorities

keep debt service affordable. In Burkina Faso, the hybrid financing for the reconstruction of

Ouagadougou following the destruction of its central market by fire comprised access to long-term

resources from the Agence Française de Développement (AFD) and a €3 million grant, without using

a central government guarantee.

Many large cities across the globe have used land-based revenues to finance capital investments. In

the case of land development or concession development PPPs, land is sold to developers for the

construction and operation of an infrastructure facility (see section on PPPs and land value capture for

capital investments).

Assisted pooled financing holds potential in developing countries with heterogeneous municipalities.

In this case, a credible intermediary, such as the national or state government, issues a single debt

instrument backed by a diversified pool of loans to municipal utilities and covered by a pre-

established debt service fund. This scheme offers investors access to a diversified portfolio of

borrowers. For example, the State of Tamil Nadu, India, used a pooled financing facility to finance

water and sanitation projects for 13 small municipalities, at longer tenors and lower cost than would

have been otherwise possible. However, coordination costs could be high, and highly rated

subnational governments may be reluctant to participate. Combining pool financing with credit

enhancements supported by donors and private sector companies to identify and put together a pool of

61

investable infrastructure projects could allow access to local bank and capital market financing on a

non-recourse basis.

Policy interventions to strengthen long term finance at the local level

A wide range of factors influences a government’s capacity to access market-based, long-term

finance, as well as the investor’s willingness to invest into local capital. This section focuses on

challenges that lend themselves to immediate and concrete policy interventions. On the demand

(debtor) side, it emphasizes the importance of capacity for project development, debt service and

management, as well as the use of credit enhancements. On the supply or creditor side, it highlights

the importance of promoting a diversified (but not necessarily deep) financial sector, increasing

debtor familiarity and confidence, and providing a suitable regulatory and legal environment (Platz,

Painter 2010).

Infrastructure projects need to be carefully planned, engineered, and costed to be successfully debt

financed. This requires up-front investment in project development services from market demand

analysis to detailed engineering design. Most municipalities and public utilities in LDCs do not have

the resources to pay for this initial work. They may also lack the experience managing project

development. The lack of funds and management capacity means most cities cannot translate their

need for infrastructure into investible and good projects. To assist in overcoming this problem,

specialized “project development facilities” can be created. A project development facility can take

many forms and perform different roles depending on the need. In smaller or centralized countries, the

facility may be national in character. In larger or decentralized countries, the facility may operate at a

regional or state/provincial level. For instance, in the early 2000s, bilateral donors supported the

Municipal Infrastructure Investment Unit (MIIU) in South Africa, which then successfully provided

financial, technical, and managerial support to municipalities and public utilities. The project

development facility may also help to carefully structure and market the loan instruments (e.g., a sub-

sovereign bond) to meet domestic investor community needs. Greater project development capacities

should be part of a national sustainable development strategy, which focuses on the importance of

infrastructure plans, as emphasized in the Addis Ababa Action Agenda.

The capacity to support subnational debt depends on the ability of the borrower to maintain a reliable

surplus of revenues over expenditures. As previously discussed, the revenue potential of taxes in

LDCs is often low. Consequently, strengthening the revenue base and improving municipal

management are fundamental prerequisites for sustainable market borrowing.

Once a municipality is deemed fit to take out long–term loans, it should avoid potentially costly risk

exposure to exchange rate fluctuations driven by external factors. Local revenues are earned in local

62

currencies. Consequently, debt should be geared towards the domestic investor community and taken

out in local currency. Different forms of credit enhancements can help lower default risk. Credit

enhancement mechanisms can take on the form of revenue cushions for payback (e.g., “sinking funds”

in the US, “federal tax-sharing grants” in Mexico, or “bond service funds” in India), partial or 100 per

cent external guarantees for debt repayment (e.g., USAID partial guarantees for repayment of the first

Johannesburg bond), or the use of pooled financing, i.e. “pool” the debt of multiple municipalities or

other subnational entities in order to improve credit ratings, borrow more, or lower the cost of debt

(e.g. Philippines Local Government Unit Guarantee Corporation). . A well-structured bank loan or

bond may make use of several credit enhancement mechanisms at the same time.

Pooled financing could be particularly promising in developing countries with heterogeneous issuers.

In this scenario, a credible intermediary, such as the national or state government collects the

borrowing needs of a group of municipalities and issues a single debt instrument backed by a

diversified pool of loans to municipal utilities and covered by a debt service fund established before

the bond is issued. This technique offers investors access to a diversified, geographically dispersed

portfolio of borrowers, thus limiting exposure to narrowly focused credit problems. It is worthwhile to

explore whether a carefully calibrated pooled project finance approach combined with technical

assistance and credit enhancements, could help generate the municipal resources in LDCs. In that

context, some have proposed that local governments could follow a pooled project finance approach

and work with donors and private sector companies to identify and put together investible

infrastructure projects that can be financed by local banks and capital markets on a non-recourse basis

(Bond et al, 2012).

Some evidence suggests that financial sector composition matters more than relative size for the

emergence of a municipal debt market (Platz, 2009). Policies that help build active government and

corporate bond markets provide critical investment opportunities that can serve as benchmarks for

investors interested in sub-sovereign bonded debt. Moreover, central governments should consider

strengthening development banks. National development banks play a crucial role as they can lend to

municipalities directly under favourable conditions (both in terms of rates and maturities) when no

one else does. Their investments into local authorities will enable those to build up their credit

histories in the long-term. When municipalities are ready to access the markets, national development

banks (as well as regional or multilateral development banks) can also build investor confidence by

underwriting, guaranteeing or investing into municipal debt, including securities.

Another challenge relates to the lack of investor familiarity with the risk profile of local capital

investments. Rating agencies can help overcome this information gap. After the world financial and

economic crisis, rating agencies have come under increased scrutiny. As a result, world leaders have

63

called for increased competition, as well as measures to avoid conflict of interest in the provision of

credit ratings. Such measures are certainly necessary and would strengthen the rating industry. Yet at

the local level, the major challenge is not related to how these agencies conduct their business but

their lack of engagement in the first place. Indeed, even in developed countries outside the US (where

over 12 000 municipalities are rated by S&P alone) few subnational entities have ratings from any of

the three major rating agencies, which together hold more than 90 per cent of the global market share.

There is no rating for an LDC from any of the three major rating agencies at the sub-national level

(Figure 4.1). The relatively low number of subnational ratings worldwide can be explained by the fact

that most municipalities in developed countries do not access bond markets and rely on

intergovernmental transfers and long-standing relationships with local banks. For subnational entities

in LDCs and low-income countries, ratings are simply not affordable, as the major agencies are not

active in these countries.

The number of subnational ratings further decreased in developing countries after the world financial

and economic crisis. That decline may be due to a loss of confidence in the major rating agencies, less

demand at the local levels due to the direct adverse impact of the crisis on local finances, as well as

decreased interest of rating agencies in emerging market and developing economies.

However, a healthy and competitive local rating industry could play a crucial role in marketing

subnational debt to investors in LDCs. Domestic investors in LDCs, where subnational entities

attempt to tap private finance for capital investments for the first time, are typically not familiar with

subnational debt issuers and ratings may be a ‘sine qua non’ for their engagement. One of the major

reasons these agencies have not rated local authorities in LDCs is the extraordinary costs of

developing a national rating scale and adapting the rating methodology to data available in the

country. As a result, initial fees may be in the range of several hundred thousand dollars, despite

relatively small issuances. Consequently, even creditworthy local authorities in LDCs cannot afford to

pay for ratings.

Here, international development agencies can play a critical role in lowering the entry barrier for

rating agencies by paying for the first few municipal credit ratings so that the first issuers do not have

to bear the costs. Such a rating may be a confidential one that allows municipalities to get an

independent assessment of their financial marketability without deterring potential investors (see

Senegal Case Study 2). Indeed, it is strongly advisable to have confidential ratings at the earlier stages

as public negative ratings may do a lot of harm in the long term for municipalities that seek to

increase investor confidence.

Ideally, donors would focus their efforts on supporting the growth of local rating agencies. Increased

competition and greater issuer familiarity are important benefits of widening the market for local

64

rating agencies. At first, new linkages between local and international agencies could increase the

reputational capital of domestic ratings companies. After some time and with sufficient reputational

capital, local agencies can act more independently. Once a local industry develops, fees may decrease

dramatically.

Over recent years, a few regional rating agencies have emerged in Africa and gained reputational

capital with investors, such as the West African Ratings Agency (established in 2005) and Bloomfield

Financial (established in 2007) joining the ranks of older agencies, such as Agusto and Co. (1992) and

the Global Credit Ratings Company (GCR). Dakar (see case study) and Kampala in Uganda have

been among cities in LDCs that have received high ratings from local agencies. Kampala received an

A in the long term form GCR, its highest global rating. The high rating resulted from significant

progress the Kampala Capital City Authority (KCCA) has made in expanding its rates and fees base,

including through an improved property registry, and licensing taxis and other businesses. Combined

with improved debt collection these important steps led to a revenue increase of 80 per cent from

2012 to 2014.

Institutional investors: an untapped source for sub-national infrastructure investment?

As of late, much debate has centred on the potential of institutional investors (e.g., pension funds,

insurers, Sovereign Wealth Funds) as potential sources for long term investment, even though to date

such investment has been very limited and mostly directed towards developed countries. There are

three broad arguments that support greater engagement of pension funds in national and local

infrastructure. First, infrastructure investments are long-term investments that match the liability

profile of these investors. Second, infrastructure investments have performed well in comparison with

other asset classes such as equities and real estate securities; there is evidence that risks turned out to

be significantly lower for infrastructure investments than those for equities and real estate (Inderst,

2009). Third, in the case of domestic pension funds and insurers, these investments could raise the

productive capacity of the economy. Infrastructure investment from a domestic fund could raise

economic development and promote the living standard, well-being, and financial health of the work

force, i.e. the capacity for plan members themselves (figure 4.2). UN Member States acknowledged

these arguments by including a call to pension funds to allocate a greater percentage of their

investment to infrastructure in developing countries in the Addis Agenda (paragraph 47).

Figure 6.2: Domestic infrastructure investment and pension funds-the potential for a virtuous circle

65

Special emphasis has been put on pension funds since their number and size is likely to grow in

developing countries given the low effectiveness of current social security systems and a growing

ageing population. Moreover, there has also been a trend away from defined benefit and towards

mostly defined contribution plans, which are typically privately managed pension funds. This trend

may further raise the growth prospects for pension fund assets. Data on the size of pension funds in

LDCs is only partially available but numbers suggest a significant gap between LDCs and non-LDCs,

with some exceptions (figure 4.3). Data on the asset allocation of pension funds is not readily

available for LDCs. However, available evidence suggests that investment practices of pension funds

in LDCs traditionally favour short-term government securities, bank deposits and real estate. Those

pension funds in countries with the shallowest financial sectors invest most of their assets in large

illiquid assets.

Information on pension funds’ investment into different types of infrastructure projects remains sparse

since infrastructure is not listed as a separate asset class on their balance sheets. Yet, recent

information and anecdotal evidence point to a low ratio. Global estimates suggest that pension funds

invest less than 1 per cent of their deposits into listed and unlisted infrastructure. That ratio is likely to

be even lower in LDCs where the risk profile of infrastructure investments is usually much higher

than in developed countries. Yet, recent years have seen some modest headway. For example, while

most pension funds in LDCs in Africa have not directly invested into infrastructure projects, half a

dozen funds have invested in Harith General Partners Ltd., a Johannesburg-based infrastructure fund

that holds $630 million and has been involved in more than 70 African projects.

Table 6.5: Pension fund assets under management in selected LDCs

Country Assets under Management in US$ million

66

Burundi 13

Rwanda 557

Tanzania 3,800

Uganda 1,259

Zambia 1,609

Malawi 1,000

Bangladesh 4,007

Nepal 1,788

Bhutan 100

Myanmar 1,170

Cambodia* 0

Total for OECD countries 31,200,000

Sources: For African LDCs: Riscura, 2015; For Malawi: Pension Markets in Focus, 2015 edition; For

Nepal: Website of Employees Provident Fund (Sum of Provident fund and Reserve Fund), accessed

July 2016; For Bangladesh: Mansur, 2015 (Data estimate from 2013); For Bhutan: IMF Country

Report 14/178; For Myanmar: Thant 2015.

*The Government plans to introduce the country's first comprehensive national pension fund by 2020.

In addition to a conducive regulatory environment, more reliable data on the size, risk, return, and

correlations of infrastructure investments in LDCs would go a long way in incentivizing pension

funds and other institutional investors to allocate more of their assets in infrastructure investments at

the international, national, and local levels.

Figure 6.3: Number of local authorities worldwide that have received ratings from at least one of the

three major global agencies, by country* and income group (2009 and 2015)

67

Sources: Information provided by Fitch, Moody's, S&P.

* Note, in the US (not included in the figure) over 12000 municipalities are rated by one of three

major agencies.

The proper legal and regulatory environment can promote the development of a municipal debt

market. Effective judicial frameworks, including a government bankruptcy framework (Chapter 9 in

the US) helped sustain the municipal bond market in the US by protecting the rights and obligations

of creditors and debtors at the sub-national level. Moreover, debt ceilings, introduced in the earlier

stages of the US municipal bond markets, have helped keep municipal debt in check. However,

important exceptions to debt limits were made for essential revenue-generating public improvements,

like water supply systems. Overly stringent credit ceilings should not impede the development of the

municipal debt market, which can channel productive investment to providing essential local services

of municipalities that would otherwise have no access to long-term finance.

Other less market oriented type regulations may also help the development of the municipal debt

market in LDCs. For example, the Reserve Bank of India is obliged to invest 21.5 per cent of assets

into government-owned securities. Finally, in some countries, mandatory provisions for municipal

revenue cushions (“master trusts”) and mandatory issuer ratings have promoted investor interest in

municipal bonds and increased access of municipalities to long term bank loans. Regulatory changes

that enhance the creditworthiness of the issuer and promote the local rating industry are therefore

important reform measures to deepen the market for sub-sovereign debt.

68

69

(VII) LDC experiences in mobilizing long-term finance for capital investment

Uganda (2): A project-based partnership to finance municipal transportation in Busia

Policy lesson: In LDCs, private equity may be attracted through non-market mechanisms, such as

when a private entity (including an institutional investor) commits equity to a new infrastructure

project through a project-based partnership arrangement with a municipality

In Busia, Uganda (see case study 1 for more information on the local context), UNCDF facilitated a

municipal project,that includes a multi-purpose parking project in the District of Busia on the border

with Kenya. The project uses the strategic border location of the district and is designed to facilitate

cross-border movement and trade between Uganda and Kenya. UNCDF helped develop and design

the project as a tripartite public–private partnership among the local government, the Church of

Uganda, and a private investor (Agility Uganda Limited). De-risking the project through local

economic analyses, feasibility studies, and structuring and financial modelling resulted in leveraging

70 per cent of the total cost of this US$2.5 million project in private equity and debt. The project

(currently under implementation) will greatly improve traffic flow and improve the town’s

environment; boost business in the region; create over 100 jobs directly or indirectly; and, in addition

to the license fees collected from traders, allow the local government to receive 10 per cent of the

project revenue quarterly.

Figure 7.1: Rendering of multi-purpose parking project in Busia

70

Lao PDR (2): The Morphu Village water supply project: a local PPP done right

Policy lesson: Sometimes local PPPs in the water sector can add value, especially in the context of

small and scattered settlements. To succeed, they should be community-driven, subject to strong

oversight and have access to donor support. There should also be a high degree of trust between the

implementing partners.

The geographical conditions and dispersed nature of Lao towns are suited to small scale water supply

projects. An early example of a PPP in Lao PDR concerns such a small scale project in Morphu

Village, in the southern province of Champasack. Documentation from 2004 shows that the Build-

Operate-Transfer (BOT) project had a very short implementation time, with an initial meeting

between the community and the private partner in June 2000, a three-month construction period in

early 2001 and services commencing in April, 2001 (Aphaylath, 2004). The population of Morphu

Village consisted of 1,032 people living in 182 households. While the relatively small size of the

population rendered many water supply solutions uneconomical, it also allowed the village

community to find a solution to fit their own unique conditions. The PPP was therefore initiated by

the community, who requested a private building repair and construction company, the Phonekham

Construction Company (PCC), to provide a piped water supply system. PCC requested technical

support from government agencies as well as assistance with obtaining approval and permits. A

relatively simple system was constructed which consisted of a large water tank, a pump for

transferring groundwater into the tank, and pipes to convey the water to houses. Each household pipe

is connected to a meter. The Morphu Village water supply system was initially operated by PCC, but

this role was later transferred to the village authority. Although only 30 households were initially

connected to the water supply system, by 2004 water was being piped to 120 houses. Hailed as a

success in 2004, the Morphu Village project recovered construction costs earlier than expected. This

was attributed to strong support from the community. On transfer of management to the village, the

water system contributed revenue to the village community. Further outcomes noted include an

improvement in villagers’ health, increased free time for the community, employment opportunities,

and training for some villagers. Benefits to the private sector resulted in PCC carrying out similar

projects in other villages in surrounding areas. These projects are evidence of the success of PPPs at a

local level where a high degree of trust is present between partners. They also demonstrate the

effectiveness of local PPPs in the Lao context of small and scattered settlements.

Sources: Sakar, (2014), Aphaylath, (2004)

71

Bangladesh (2): Establishing a municipal development fund to finance local infrastructure

Policy lesson: Establishing a municipal development fund can help depoliticize intergovernmental transfers and build borrowing capacity at the local level, but its successful operation requires close coordination with a large number of stakeholders, project development capacity, and evidence of added value to secure sustained external funding.

There are 313 municipalities in four major cities in Bangladesh with populations ranging from 50,000

people up to 10 million in Dhaka municipality. Many municipalities lack the institutional capacity to

plan, finance, implement, and operate urban infrastructure services in an efficient and sustainable

manner. In response to this infrastructure financing gap, the Government of Bangladesh, with

technical and financial assistance from multilateral institutions, set up the Bangladesh Municipal

Development Fund (BMDF) in 2004. The BMDF is financed by loans from development partners to

the Government of Bangladesh and disburses loans to municipalities based on its own reviews of

project proposals. Its finance is a blend of grants, loans, and the municipality's own contribution for a

project. Over the course of the last decade, 154 municipalities have received BMDF financing for

infrastructure projects. The model has been fully driven by demand from municipalities, which has

limited political interference of the central government. In addition, the fund’s tax revenue

requirements and the competitive nature of its allocations have helped steer municipalities towards

increasing their tax revenue by an average of 17.5 percent, though this has fallen short of World Bank

targets due to considerable variability between the municipalities. The BMDF’s administrative costs

and consulting services have been low, drawing on only 3 per cent of the seed funds. However, the

Fund has also encountered challenges. Due to shortages of resources, BMDF projects have addressed

only a subset of municipalities. Many towns are overlooked or need to wait years for to receive

financing for another project. A related challenge has been the sustainability of the Fund, which

remains donor dependent. While BMDF has supported nearly 600 sub-projects in a variety of sectors,

donors can not clearly discern the added value of the BMFD, as little information on the level of

municipal investments (mostly financed by central government block grants) prior to BMDF has been

accessible. Consequently, due to such a perceived lack of added value and discomfort with disparate

investments, the BMDF has experienced periods when it was in danger of closure due to a lack of new

capital. There is also a need for closer coordination between the BMDF and other government driven

local development programmes. Moreover, technical assistance at the local level must be built into

projects like the BMDF, since many municipalities lack the capacity and expertise to formulate

investible project proposals, especially due to a lack of engineers.

Source: Independent evaluation reports from Asian Development Bank and World Bank; BMDF

website; expert interviews.

72

Tanzania: Dar es Salaam’s water supply: a local PPP gone wrong

Policy lesson: A local PPP that is financially viable and leads to improved services requires considerable municipal capacity to perform due diligence in selecting the right partner and understanding the allocation of risks in the contract.

In 2002, most of the water produced by the public Dar es Salaam water supplier DAWASA was lost

due to leaks, non-metered connections, and illegal usage. Water supply was sporadic in most areas.

Moreover, less than 10 per cent of the urban population was connected to a sewerage system. As a

result, the city suffered from outbreaks of water-borne diseases. To improve services, the city actively

looked for private partners to enter into a PPP. Following six years of negotiations with private

companies and two failed bidding processes the German/British company BGT was finally a awarded

a lease. Together with a Tanzanian investor, BGT created the operating company, City Water Services

Limited (CWS), of which BGT owned 51 per cent (the minimum required of the bidder) and the

Tanzanian investor Super Doll, 49 percent. The contract entered was a lease in which CWS was

obliged to provide the water supply and sewerage services and maintain assets, while DAWASA

remained responsible for funding and implementing capital investments. The project was mainly

financed through external loans, with CWS contributing $8.5 million. The major problems in this PPP

resulted from unmet obligations by the private provider. CWS set out to create a new customer

database and new billing software. However, only limited progress was made in cleaning up the

customer database (out of the 150000 contacts in the database, less than 25,000 were active and

potentially billable.) At the same time, the company failed to purchase 170,000 water meters, as

required by the Procurement of Goods (POG) subcontract. Less than 19,000 meters where purchased

and less than 2500 installed in the first year. As a result, the company's average monthly collections

were 21per cent lower than DAWASA's had been in 2002/03. By May 2005, Government arrears for

water and sewerage services amounted to US $1.5 million. In addition, the company did not pay the

Rental Fee to DAWASA regularly, periodically withheld tariff collections to pay its own operating

costs, and failed to deposit first time connection tariffs into the account for that program. In May of

2005, DAWASA served a notice of termination of the contract. However, in light of the fact that

CWS would not agree to the termination, the Minister of Water terminated the arrangement and

expelled its expatriate managers from the country. The experience highlights the need for a careful

consideration of key challenges that can make or break a successful PPP, such as the preparation of

the public-private partnership (PPP), the selection process, the allocation of risks in the contract, as

well as expectations regarding financial viability and service improvements.

Sources: World Bank (2012); expert interviews.

73

Senegal (2): Dakar’s experience in (almost) getting a municipal bond to the financial market

Policy lesson: Issuing a municipal bond can be a rallying point for concerted efforts to improve the financial situation of city but requires sustained political support from the central government.

Dakar’s experience in (almost) getting a municipal bond to the financial market provides invaluable

lessons for other cities. The reason the bond has not yet been sold is due to a last-minute intervention

by the ministry of finance. However, getting to the point where Dakar is technically ready to raise

market resources and overcome the long-term finance challenges discussed in this section, has been

the result of a concerted effort of a talented local municipal finance team and targeted and well-

coordinated donor support. First, through a consultative process with a wide range of stakeholders,

including district leaders and NGOs, the construction of a marketplace for more than 4,000 street

vendors was identified as the bankable project the bond would fund. It was envisaged that revenue for

the bond would come from affordable fees to street vendors relocating their business to the hall. A

municipal finance management team was put in place to get the city’s finances in order. The team

could build on a track record of solvency, since Dakar has been a reliable creditor to commercial

banks, the French Development Agency, and the West African Development Bank since 2009.

Moreover, political stability also helped build investor confidence. Efforts by the management team

were further guided by a confidential rating from Moody’s, which provided an independent

assessment of their work and pointed to areas of further improvement. Credit enhancements were

crucial as well, including a 50 per cent partial risk guarantee from USAID as well as the setting up of

separate fund by Dakar earmarked to pay the debt. All of these factors allowed Dakar to get a rating

of BBB+, a middle-tier ranking that qualifies as ‘investment grade’ from Bloomfield Investment, a

West African rating agency. The sale of the bond would also draw on a diversified financial sector

since Dakar planned to place it on the Bourse Régionale des Valeurs Mobilières, a common securities

market that allows institutional and other investors from 14 Francophone countries with common

currencies to buy debt without foreign exchange rate risk. However, the last minute objections from

the Ministry of Finance points to the challenges a large number of countries face in ensuring a

political environment suitable for subnational finance innovations.

Sources: Swope and Kasse (2015), expert interviews.

74


How can local authorities identify projects that are worthwhile to finance with market

(expensive) resources? What does it take to formulate investible project proposals and how can

they strengthen the capacity in project development? How should the macroeconomic

environment and financial sector depth shape the decision to borrow? What, if any, is the

potential for pooled finance to lower borrowing costs in LDCs? What potential do subnational

bonds hold in the most vulnerable countries, especially LDCs, where these instruments have not

yet been effectively utilized? How can development banks and development funds assist in

promoting access to market finance for subnational governments? What is the potential role for

public-private partnerships in reducing risks for issuer and investor (e.g. through guarantees and

other credit enhancements)? What are the experiences with different PPP models (build-operate-

transfer, build-own-operate-transfer, etc.)? How can the development of subnational ratings

agencies help build investor confidence? What is the prospect of PPP in LDC cities? What is the

potential for land value-capture as a source of revenue in LDCs? Is there any potential for

introducing innovative instruments on LDC markets? How can these instruments be

progressively introduced? Is there any risk of crowding out vis-a-vis more traditional financial

instruments? How can local authorities capture new funding sources such as philanthropic

foundations and sovereign wealth funds?

75

(VIII) International cooperation on municipal finance

Many of the challenges and policy recommendations described in this paper suggest the need for a

more concerted effort, greater coordination, and a calibrated interplay among subnational finance

stakeholders, such as municipal officials, relevant ministries, regulatory agencies, tax collectors,

investors, creditors, and citizens themselves. How does the call for more international cooperation on

municipal finance, as expressed in paragraph 34 of the Addis Agenda, fit into this largely domestic

agenda?

International cooperation on municipal finance in developing countries can take place at many

different levels. It includes knowledge-sharing, technical assistance, capacity building and direct or

indirect financial assistance in the form of grants, loans and guarantees. It may take on the form of

North-South, South-South, or triangular cooperation. It may focus on emerging market economies,

middle-income countries, low-income countries, or LDCs.

ODA to LDCs increased in 2015 for the first time in several years but still remains far below the

United Nations target of 0.15-0.20 per cent. Data on subnational finance are difficult to obtain and the

exact level of Official Development Assistance (ODA) directed towards municipal development

efforts remains unclear. The limited available evidence points to a very low share of total ODA for

urban projects (low cost housing, housing policy, urban development and management) in LDCs

(figure 8.1). Moreover, very little ODA has been directed towards capacity-building for municipal

finance.

76

Figure 8.1:

Source: OECD International Development Statistics.

Figure 8.2 presents the share of bi- and multilateral ODA commitments for urban projects by recipient

income group. The data show that more than 75 per cent of ODA for these projects goes to middle

income countries, while least developed countries (LDCs) receive less than a quarter of the funds.

Given that the proportion of the urban population in LDCs is expected to raise from 31 per cent in

2014 to 49 per cent in 2050, current ODA allocation levels will not suffice to bridge funding gaps and

build the required capacities.

Current ODA to LDCs:

$41 billion

Total ODA for urban projects in

LDCs: $0.3 billion

An insufficient share for capacity-

building for municipal

finance

77

Figure 8.2: Bi- and multilateral ODA commitments for urban projects (low-cost housing, housing policy, urban development and management) by recipient income groups

Source: OECD International Development Statistics.

Several multilateral organisations are active in the area of subnational finance and urban development;

the World Bank, regional development banks and the European Union being the most prominent. At

most, these organisations allocate about 8 per cent of their overall contributions to this area. Among

the bilateral donors, the US, Germany, the United Kingdom, France, and Japan have portfolios for

local development. These countries on average assign about 2.5 per cent of their overall ODA

contributions to urban development. Depending on the donor, between 5 and 25 per cent of their

contributions in this area goes to LDCs (Source: AidData).

However, these figures only provide a snapshot of international assistance to subnational levels and

actual amounts are likely to be higher. Many other bi- and multilateral assistance projects in other

sectors, e.g. water and sanitation, energy, health, education, transport, etc. will have more or less

direct impacts on cities. Some estimates suggest that including these projects would roughly double

the figures presented in Figure 8.2. Also, there is a lack of reliable data on South-South cooperation,

which is becoming an increasingly important factor, for example through infrastructure investments,

loans and knowledge exchange mechanisms.

Climate finance for subnational governments

There are no comprehensive estimates available on the amount of climate finance going to

subnational governments. Nevertheless, some data provide an initial indication of the available

24.4%

36.7%

38.4% Least Developed Countries,Total

Lower Middle IncomeCountries, Total

Upper Middle IncomeCountries, Total

78

resources. Mitigation accounted for 93 per cent of total climate finance in 2014, while adaptation

measures, which are often critical for cities especially in developing countries, reached only 7 per cent

(Climate Policy Initiative 2015). A survey of nine development banks showed that about 30.6 per cent

($19 billion) of the surveyed banks’ climate finance in 2014 was allocated to cities. On average, urban

climate finance accounted for 8.6 per cent of overall development bank financing commitments.

Similar to global climate finance trends, development banks’ urban climate finance also displayed a

much higher share (72 per cent) for mitigation measures, especially in energy and transport. The

remaining 28 per cent for adaptation measures was mainly spent on water and waste management.

Additional data from multilateral climate funds shows that out of over 700 projects, 47 focused

explicitly on urban mitigation or adaptation objectives. These projects had a combined value of $842

million, or $168 million on average per year. In total, this is just above 11 per cent of projects

approved by multilateral climate funds. More than 76 per cent of the contributions are from the Clean

Technology Fund. Less than 10 per cent was spent on cities in LDCs, and this share is dominated by a

major infrastructure project for coastal cities in Bangladesh (Cities Climate Finance Leadership

Alliance, 2015).

In general, approximately 75 per cent of climate finance is available at market rates (Cities Climate

Finance Leadership Alliance, 2015). However, many critical climate change resilience projects at the

urban level in developing countries do not offer adequate returns for this form of project finance. In

addition to increased total amounts of climate finance available to cities, a higher share of

concessional funding would be required to ensure support for resilient and environmentally sound

urban infrastructure in developing countries, especially LDCs.

How to strengthen international cooperation for subnational finance?

The low level of ODA and climate finance directed towards local authorities in LDCs cannot be

justified by a lack of success. In terms of their immediate development impact, the success of urban

projects seems to be equal to or greater than projects in other sectors. Moreover, for the World Bank’s

municipal development projects, performance in Africa and its LDCs is above average worldwide

(Kharas and Linn, 2013). However, whereas the overall impact is high, the sustainability of urban

projects has been significantly lower. The principal reason lies in the long-term financial viability of

the project. Weak subnational finance, i.e. inadequate local financial resources and capacities for asset

management may frustrate donors support. There is therefore a need to place greater emphasis on

urban and rural finance. Yet, donors have paid little attention to these aspects in the design,

implementation and evaluation of their development projects.

Bahl, Linn and Wetzel (2013) identify several key objectives for donors that, if met with success,

could significantly improve and enhance international cooperation on municipal finance, as called for

in the Addis Ababa Action Agenda. First and foremost, there is a greater need for partnership

79

development, better donor coordination and a more focused division of labour. The authors further

highlight that urban development requires long-term engagement on the side of the donors geared

towards a systematic hand-off to the local partner and/or other international partners to assure

sustainability and scaling up of successful interventions. In this connection, a longer-term, more

programmatic and better sequenced approach to donor engagement in local development is crucial.

Such an approach only works if there is central government buy-in, i.e. a convergence of views

between donor and recipient countries on the need for the empowerment of local authorities, as well

as rules-based, transparent and predictable intergovernmental transfers. Often, donor interventions

take place on a non-objection basis by the central government (see the example of Dakar) but lack its

sustained support. It is therefore crucial to realistically assess the government’s plan for

decentralization, looking both at the legal framework and its actual implementation. A longer-term,

more sequenced approach also requires a realistic comprehensive fiscal plan both at the central

government and at the local levels.

More focus could be put on adequate financial support for capacity building in urban financial

institutions with sustained assistance that goes beyond short-term training to helping develop policy

and implementation planning and management capacity. Capacity building could focus explicitly on

the urban finance dimension as a key element supporting sustainability of donor financed programs.

Consequently, future donor engagement could focus more on improved urban finance mobilization

and management, as well as judicious debt management and municipal borrowing practices. Another

important area for greater donor engagement in municipal finance is risk mitigation. For example,

market risks, including foreign exchange risk, need to be carefully assessed and either hedged or

removed from municipal responsibilities. Finally, donors could work together to establish clear results

metrics for financial outcomes as part of more effective monitoring and evaluation. There are thus

multiple entry points for more effective international cooperation on subnational finance that could

help pave the way for a successful implementation of the 2030 Agenda for Sustainable Development

at the local level.

80


How can donors ensure a holistic approach that addresses capacity, revenue and regulatory

constraints? With limited resources, which projects can add the highest value? How can the

international community best reconcile national, subnational and donor priorities? How should

the international community mainstream the 2030 Agenda and the Addis Agenda into

international cooperation on municipal finance? What steps can the international community

take for greater bilateral and multilateral collaboration and coordination? How can the

international community ensure donors extend their assistance beyond one-off engagements and

take a longer-term, systematic and sequenced approach to engagement of development partners?

Where is the greatest potential for South-South Cooperation and what role is it already playing?

How can we increase subnational access to ODA and climate finance? How can donors

coordinate more effectively with central governments on subnational priorities?

81

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