3.1 The fiscal functions of central and local governments are traditionally analysed in terms of their respective roles and responsibilities for income redistribution, expenditure provision, tax assignments and tax transfers. Questions about the extent of centralization and decentralization are critical when addressing the issue of inter-governmental finance. Which level of government will be responsible for providing specific services? How will those services be financed? This chapter discusses these questions.
3.2 Distributional and macroeconomic considerations generally argue against extremes that, on the one hand, assign all or most taxing powers to local governments or, on the other hand, assign such taxing powers to the central government. The option that is most frequently observed in countries around the world is one that assigns revenue sources such as taxes to each level of government, in combination with various types of inter-governmental transfers to bridge any gap between expenditures and locally-raised revenues.
3.3 There is no universally accepted solution as to how decentralization and local government investment should be financed. Lessons learned from numerous countries suggest that the first step is for the transfers of revenues and of expenditures on service to be matched as closely as possible from the start of the decentralization process. This implies that decentralization should be a fiscally neutral devolution of responsibilities. In order to accomplish fiscal neutrality, estimates should be prepared for the full costs of the services that are to be devolved to the local governments. This estimate should form the basis for an agreement on the mix of services and revenues that will ultimately be transferred.
3.4 The most direct way to finance infrastructure and to support decentralization is to turn over to local governments both the responsibility for providing services and the capacity for raising revenues. Many of the central and local governments in developing countries have tended, however, to resist this approach. On the one hand, central governments are reluctant to relinquish control over the principal national taxes as it suggests losing control of the revenue side of the national budget. On the other hand, most local governments are not eager to take on the major responsibilities of a taxing authority, and they do not want to establish locally generated taxes simply because they do not have the capacity to administer such taxes. However, much can be done to increase local capability and capacity to the point where local governments can administer the assessment and collection of local taxes under the regulatory supervision of the central government.
3.5 A strategy adopted by many countries is to attempt to strengthen local governments by giving them greater responsibilities in terms of the services they have to provide. While this may appear to create more independent local governments, the reality is that local governments will not be able to apply their new powers unless they are properly financed. The assignment of more responsibilities for expenditure to local governments than they can finance from their revenue sources results in the mismatching of functions and finances. This mismatch is referred to as vertical imbalance and it results in local governments being highly dependent upon transfers from the central government. Therefore, it is essential that those responsible for the design of local government responsibilities should be aware of the revenue sources that will be needed to fund them.
3.6 An additional problem that is at the heart of inter-governmental finance in many countries is the existence of horizontal balance. This occurs when local governments are not equal in terms of population, geographic area, level of urbanization and per capita income. Designing fiscal decentralization and equalization programmes to cater for this complex reality is a major challenge.
3.7 Decentralization is more likely to be effective when a local government can raise a relatively large share of its revenues locally. If the transfer of responsibilities from the central government is not matched by the ability to finance the carrying out of these responsibilities, there is a risk of creating a largely fictional decentralization. In such a case, local governments will tend to remain overly dependent on the goodwill of the central government to finance them. Since the central government sets the rules and generally takes the highest yielding taxes for its own use, local governments tend not to have access to tax revenue and sources that would effectively free them from dependence on transfers. Inter-governmental transfers are vital for local governments but they should not be used to prevent local governments from attaining an appropriately independent status. Without an adequate revenue source under the control of local government, a suitable degree of fiscal autonomy cannot be realized.
Reasons why the revenues of local governments should come from local sources:
3.8 Local governments should be able to raise revenue to finance the costs of proposed services from the beneficiaries of those services. The connection between beneficiaries and tax-payers is relevant from the perspective of public finance: public services should be decided by the beneficiary group who should also pay for their costs. That is, the ideal tax pattern is based on benefit taxation as far as the allocation function is concerned. Locally raised revenues that are spent locally for the benefit of local tax-payers illustrate the direct link of the tax to the benefits received by the community as a whole. This means that the local citizens should pay higher taxes if they want better services or if the local government is inefficient. This gives the right incentives for the local citizens at election time. A high level of own taxation also deprives the local government of the excuse of lack of money from the central government for any failure to deliver local services.
3.9 In practice, there is great variation in the proportion of resources raised locally, or over which local governments have a significant decision-making authority. This proportion is difficult to measure because such measurement requires an assessment of the share and nature of government transfers as well as the actual degree of autonomy of local governments in setting the level of locally raised resources (both tax and non-tax). However, there is a broad consensus that the autonomy of local governments in developing countries is still weak compared with practices in other countries. The advantage of increasing local taxes compared with increasing tax-sharing arrangements is that control over own taxation increases accountability. It affects the behaviour of the local population and the local governments in a positive way.
3.10 The composition of revenues varies greatly from one country to another but the main types of local government revenues are typically the following:
Revenue from the sale of services (non-tax revenues and user charges/fees).
Borrowing, e.g. for investment expenditure.
Different types of grants (e.g. general and specific) made available to local governments from the central government.
Tax revenues: local taxes (e.g. property tax) or shared national taxes.
3.11 Service fees are an important source of revenue, especially if local governments are viewed primarily as service providers. In part, this view is in agreement with the concept of decentralizing certain responsibilities to the local level by using efficiency criteria for the allocation of resources. Such services could therefore be financed through a charging system.
3.12 Grants from the central government are a key factor. While grants are declining they still remain a significant revenue source for local government. In a number of countries, 50 percent or more of a local budget is represented by transfers from the centre. Grants will remain important given the breadth of new local government responsibilities and the generally inadequate level of local revenue sources. Grants should normally provide only part of local revenue because local governments are usually more accountable for revenues that they raise directly, and because tax-payers are better able to link the receipt of public services and the payment of the taxes if both are housed within a single government.
3.13 Automatic revenue sharing of national (or regional) taxes to local governments is seen as a solution to financing decentralization in many countries. This approach allows central governments to retain control of tax rates and tax administration, while simultaneously ensuring that local governments receive a higher flow of revenues. However, automatic revenue sharing does not always provide a stable basis for financing decentralization and local infrastructure projects. Where the central government retains the power to adjust annually the share of centrally collected taxes, local governments continue to face a fundamental uncertainty about their revenues, which in turn makes it difficult for them to do advance budgeting and planning of capital finances.
3.14 Income tax rates have grown during the last two centuries, particularly in times of war, until reaching historically high levels in the 1980s. Since then individual tax rates, particularly those relating to the top slices of income, have fallen. Figures of the Organisation for Economic Co-operation and Development (OECD) show that the share of personal income tax as a proportion of tax revenue has fallen on average in member countries from 30 percent in 1975 to 27 percent in 1998. There are democratic and economic pressures that are likely to inhibit any significant change in the present situation.
3.15 Corporation taxes were once seen as an easy tax target. There were few votes to be lost if corporation taxes were increased. This has now changed as a consequence of the intense international competition to attract business to national or regional locations. Corporation tax rates are a significant factor in decisions by multilateral corporations of where to locate their businesses. This is therefore a major constraint preventing national governments from increasing corporation tax rates to previous levels.
3.16 Social security contributions have tended to rise in response to increasing social benefits and now constitute on average 25 percent share of taxation in OECD countries.
3.17 Consumption taxes as a source of revenue have remained on average constant in proportion to other taxes in OECD countries, but the emphasis is now on value added taxes. There are economic, competitive and democratic constraints that governments have to take into account when considering increasing consumption taxation rates.
3.18 Property taxes show a large variation in the ratio of property tax to total tax revenue. If wealth taxes and certain other taxes are included in the definition, property taxes account for more than ten percent of the total in the United Kingdom, United States of America, Canada and Japan. In previous centuries taxes on property formed the most important source of tax revenue for both national and local taxes. Property taxes have, however, seen a long-term decline in relative importance and now represent about five percent of tax revenues in OECD countries. However, the importance of the property tax is not in relation to the national tax base, but instead to the tax base of local governments.
3.19 The choice of a good tax for local governments is limited compared with the choices for central and even regional governments. This is because the higher levels of government are larger, cover jurisdictions having larger populations and have a greater capacity for tax administration. A number of conditions should be met for a tax to be a good own local tax:
The revenue of a good local tax should increase over time in order to match the natural growth in costs and to fulfil the growing need for local public services.
Local taxes should not be too sensitive to cyclical fluctuations.
A good local tax should be distributed relatively equally among local governments. Equalization of the revenue between local governments may be required to balance differences in access to tax bases.
The size of the potential revenue is important. If the local governments are allowed only relatively small yielding taxes, vertical imbalances will result (i.e. the assignment of more responsibilities to local governments than they can finance from their local revenue sources).
There should be a close relationship between the citizens who pay and the citizens who benefit.
The tax administration should be inexpensive to administer, i.e. the tax yield should be much higher than the administrative costs. A realistic target is that the cost of administering a property tax should be significantly less than five percent of the revenue generated.
3.20 According to the classification of the OECD, the extent of local government autonomy over revenues should be judged against two criteria: freedom to determine the tax base, and the setting of the tax rate. (The tax base is the collective value of the property assets subject to taxation, and the tax rate is the percentage of the value of a property asset that is paid as tax.) The following classification of own and shared revenues was developed by OECD, in accordance with the degree of local revenue autonomy:
Local government in control of both the tax rate and the tax base;
Local government sets the tax rate;
Local government sets the tax base;
Tax sharing arrangements;
Local government determines the revenue split.
As local taxes normally represent the greatest source of autonomous income for local governments, the ability to influence the tax base, the tax rate or the collected revenues is a very important condition. With such an ability, a local government is able to adapt the service level to its financial circumstances.
3.21 It is good practice that conflict of interests should be avoided. The actions of setting the tax base and the tax rate should be treated separately and independently. Setting the tax base is done by valuers and should be accountable through an appeal process. Setting the tax rate is usually the prerogative of elected politicians. Such a division of responsibilities should exist even if both the actions of setting the tax base and setting the tax rate are carried out at the same level of government. Conflict of interest can also be avoided by having actions carried out by different levels of government. For example, where local sources of revenue are scarce, local governments might be tempted to inflate the tax base in an attempt to increase their revenue, or locally influential people may exert pressure to have their tax liabilities reduced. In such cases, valuers of the central government might provide a more objective assessment of the tax base.
3.22 There is extensive literature on the criteria for good local taxes, and it is possible to evaluate each alternative tax against these criteria to see how well they perform. While an exercise like this may be useful, it is limited to some extent as there is no perfect local tax. There is, however, general international consensus about which local taxes are most satisfactory. The most common local taxes are property, income and sales taxes. Few countries have implemented large revenue-raising local taxes other than these.
3.23 Property tax is an effective local tax because the nature of property makes it relatively simple for local governments to identify tax-payers and to collect the taxes. Property tax is generally less attractive for central government because its revenues are usually much less than income tax, sales taxes and corporate taxes. Moreover, property tax is typically not considered as an instrument for broader social and economic policies which tend to be the domain of central government.
3.24 A property tax can be a good local revenue stream that is relatively predictable, stable and non-distortionary with regard to its impact on economic decisions. Of course, a property tax should not be considered on its own, but should be looked at in relation to other local and national taxes. The taxation system of a country is subservient to national social and economic aims. The detailed considerations required in the design or administration of any individual tax should not obscure a wider view, informed by a knowledge of history and international experience.
3.25 Property tax is an annual tax on real property. It is usually, but not always, a local tax. It is most commonly founded on the concept of market value. The tax base may be the land only, the land and buildings, or various permutations of these factors. For the purposes of this guide, property tax is restricted to annual taxes and excludes annual wealth taxes and once-off taxes on transfers and realized capital gains.
3.26 Rural property tax is usually applied to commercial, industrial and residential properties located in rural areas, in addition to agricultural land and buildings. The use of rural property taxes is not unique. Many countries around the world tax agricultural land and other rural properties. Rural property taxes are also not new. Property tax has been in existence for at least three millennia. The strengths and weaknesses of this type of tax are well known and possibly more widely understood than any other tax.
3.27 Many developing countries tend to focus on taxing urban property, at least initially, given that this is usually the most valuable property. Even when agricultural and forestry land are taxed, it is typically done at relatively modest rates in comparison to urban land. However, the inclusion of rural property for tax purposes in developing countries should be seen as an important policy directive to make the property tax base as extensive as possible. Such a broadening of the tax base creates one of the few stable revenue sources available to rural local governments.
3.28 Advantages of the tax are clear and include:
It is technically and administratively possible to introduce and maintain in almost any circumstances.
It is cheap to administer, and it is possible to aim for a cost yield ratio of two percent or less.
It is very difficult to avoid or evade, and collection success rates of 95 percent are readily achievable.
It is transparent.
The public understand the concept of market value (whether capital value or rental value) and therefore appreciate the basis of assessment.
In general, there is a good correlation between assessed value and the ability to pay.
If designed correctly, the tax can be marginally progressive.
The revenue is predictable and buoyant.
It is very well suited as a source of locally generated revenue for local governments.
It imposes political accountability on local elected officials. If they decide to increase the property tax, they face direct criticism from voters.
3.29 Disadvantages of property tax are less clear than the advantages. The tax is not perfect and is often not popular; although it should be remembered that there are no perfect taxes and taxation is never popular.
3.30 Some of the advantages incorporate hidden disadvantages. The transparency of the tax reveals any inconsistencies which may become magnified in public perception. These inconsistencies will be both those of assessment (which are inevitable in a valuation list of property tax assessments which may consist of thousands, or hundreds of thousands, of properties) and those of ability to pay. Other taxes, such as income tax, are very much less consistent in practice but the public only know how the tax should work and not how it is actually applied in practice. Confidentiality hides the actual results. With property tax the public see the tax system working with all its imperfections. In a similar way the difficulty of avoiding or evading property tax may make it unpopular. This is particularly the case in societies where the rich and powerful are accustomed to manipulating the tax system for their own advantage. These people tend to be the most articulate and politically influential and may effectively oppose or undermine the equitable operation of the tax at the political level.
3.31 There is also a more subtle and less well-understood shortcoming. In some circumstances property tax can provide representation without taxation for a large segment of the population. Universal suffrage means that not every voter will be a property tax-payer. If non-tax-payers greatly outnumber tax-payers, the link between democracy and taxation at the local level will be damaged. The adverse effects of this will be magnified if property tax forms the only local revenue over which the local authority has control. In this case, a modest increase in total revenues may require large increases in individual property taxes because of the small number of tax-payers.
3.32 There is also the problem of building buoyancy into property tax. Buoyancy refers to a change in tax revenues and, in the context of property tax, is a function of two mechanisms. The first of these is the revaluation of properties at regular intervals; in situations of rising market values, such a revaluation results in an increased tax base. The second is the increase in the rate of tax to produce the needed revenue. Both are highly political. In theory either one or the other could provide buoyancy. It is technically possible to increase tax rates on an out-of-date valuation list of property tax assessments. However, the experience from many countries is that the public do not understand and do not accept an out-of-date valuation list. There is always resistance to revaluations and the more out-of-date the valuation list, the greater the resistance. The biggest factor behind declining yields for property taxes in many countries is the failure to regularly carry out revaluations.
3.33 The difficulties of implementation should not be underestimated. Although the technical difficulties can be overcome, they can restrict progress, especially in the early stages of implementation. Such technical factors include:
The system is dependent upon a pool of technical expertise to create and maintain a valuation list, and to establish and conduct the appeals process. In many jurisdictions, there is a shortage of skilled personnel, especially at the local level.
Parts of the process can be time-consuming and expensive. Examples are compiling a comprehensive list of taxable properties (especially where records are poor or incomplete, or where there are large numbers of legal status issues); outsourcing services to the private sector; establishing a valuation tribunal to determine appeals, and administrative and infrastructure support (such as dedicated information technology for the valuation system and the financial accounting system for the billing, collection and enforcement procedures).
While it is true that the public generally understands the concept of market value, confusion does arise in the relationship between taxable value and setting the tax rate. This is particularly so where revaluations take place after a long interval, or where there has been political unwillingness to increase the tax rate. This often results in large numbers of unjustified appeals.
3.34 In addition to being a primary source of revenue for local governments, property tax can provide support for other functions of government. Valuation lists compiled for local government may be used by other bodies, particularly those that can be termed single function authorities such as water boards. Water charges are sometimes based on a propertys assessed value in the list of property tax assessments. Such procedures are very cost-effective and may have a reasonable correlation with water usage in many circumstances (although cases do exist where commercial and industrial properties have low water consumption but have relatively high values). Drainage boards can also be funded by charges related to the valuation list, which has advantages over charges related only to the surface area of the property.
3.35 Almost invariably the benefits of rural property tax will be local rather than national. It will be apparent in almost every country that the extension of the property tax to rural areas will have limited impact on the total national tax revenue. The rural tax base is typically very much smaller than the tax base constituted by the urban economy. Frequently a national capital city and two or three other major cities produce a major part of the national GDP. The relative size of the regional GDP gives a good indication of the magnitude of the tax base. Thus if, for instance, an improved property tax covering the entire country has a potential to produce ten percent of total tax revenues, the proportion arising from rural areas is unlikely to be more than 20 percent of this. In such circumstances the rural property tax base may constitute only two percent of the national tax total and may be disproportionately more expensive to administer.
3.36 In most instances the illustrative figures above will overstate the potential yield from rural areas. However, this does not diminish the importance of a rural property tax. It is a vital part of decentralization. It is not so much its size relative to the national tax base that is important, but its magnitude in relation to revenues available to a local government and especially to those revenues that are generated locally. This is why a property tax is a vital instrument in improving conditions in rural areas.
Factors listed below may lead governments to review the scope for introducing a property tax where it does not exist, and examining the administrative machinery with the purpose of making it more efficient.
Scope for increased yields: While many taxes are now reaching upper limits created by economic factors, international competition or public acceptance, in most countries property taxes could yield more. There are few examples of property tax accounting for more than about 12 percent of total tax revenue and this may represent a limit of public acceptance. Property tax in most countries is much less than this theoretical ceiling.
The relatively small size of the rural tax base: The rural tax base will always be comparatively small in comparison with the urban tax base. The importance of property tax in rural areas is of local significance. The benefits to the national economy are indirect.
Importance beyond its relative size: The importance of a property tax covering rural areas is greater in political terms than might be supposed from the absolute size of the property tax yield. As the foundation of local government autonomy, and as a means of financing some single function authorities, there is often sound justification for the introduction of the tax.
Administrative feasibility of property tax: The wide application of property tax and its long history shows that, if there is sufficient political will, there are no insuperable technical or administrative problems to the introduction of property tax.
Political will: All taxes require political determination and public acceptance. The openness and transparency of property tax mean that it is impossible to introduce the tax by stealth. Political determination is therefore essential. If there are substantial political doubts, do not waste time and money considering the introduction of property tax.