Strengthening Subnational Taxation within the Financing for Development Agenda

Last week saw the release of the zero draft of the Outcome Document for the Fourth International Conference on Financing for Development. The zero draft lays out a broader and more complete agenda for strengthening domestic revenue mobilization (DRM) than the 2015 Addis Ababa Outcome Statement.

Among the most notable new elements of the DRM section of the zero draft is expanded attention to the importance of subnational finance.

The text reads:

• We encourage strengthening subnational finance by enhancing local authorities’ technical, technological and human resource capacities, diversifying income and financing sources, including the development of municipal bond markets where appropriate, and promoting stable and transparent intergovernmental financial transfer systems and equalization mechanisms.
• We will support national and local governments to prioritize and strengthen their policies, strategies, and practices to implement effective infrastructure asset management over the lifecycle of assets and mobilize revenues as appropriate.

Expanded attention to subnational financing is extremely welcome: subnational governments often remain severely under-resourced despite rapid urbanization, significant decentralization and the key role of cities as dynamic drivers of development.

However, the zero draft focuses surprisingly little attention on the backbone of subnational finance: own source taxation.

In fact, the words “tax” does not appear at all.

The next draft should place a much clearer focus on subnational taxation, and property taxes in particular, as the foundation for funding subnational development.

Why We Should be Looking at Subnational Revenue Mobilization (and the Role of Taxation)

Over the past two decades there has been increased emphasis on the potential development benefits of decentralization in lower-income countries. Decentralization promises to bring development closer to citizens, increasing responsiveness to local preferences and providing more direct channels for building public accountability.

However, subnational governments have remained chronically underfunded and heavily dependent on central government transfers and aid donors. There is often a large gap between decentralized spending responsibilities and the resource available to deliver them. This has undermined service delivery, limited the ability of governments to manage rapid urbanization, restricted critical infrastructure investments to build dynamic cities, and undermined broader state-building.

Donors, international agencies and governments have frequently looked to external sources of financing to plug the gap.  This includes expanded intergovernmental transfers, new aid flows, municipal bond markets, public private partnerships and climate finance. This focus on external flows, and novel financing options, is reflected in the zero draft, which explicitly mentions only bond markets, central government transfers, improved asset management and diversifying funding sources.

These sources, while clearly valuable, are not an effective substitute for strengthening own source revenue mobilization, particularly in larger cities. In fact, depending on external funding undermines government autonomy and links to citizens. In turn, governments are more likely to successfully access external sources of finance if they first invest in building their own fiscal capacity. This message has been echoed by UN-Habitat in their submission to the FfD4 process, arguing that “OSR optimization is the cornerstone of local development and essential condition for accessing external finance as well.”

Property Taxes: the Backbone of Local Government Finances

Property taxes are the backbone of local government finances across the world and are likely to be at the centre of efforts to strengthen local revenue mobilization. This reflects their revenue potential, and other important advantages:

• they are economically efficient,
• are levied on an immovable tax base,
• are more progressive than alternative local revenue sources and;
• can play a key role in local state-building and building local accountability.

Yet property taxes are by far the most underperforming major tax type in lower-income countries, thus offering significant untapped revenue potential.

In higher income countries property taxes provide 2% of GDP, or more, in revenue.

By contrast, available data suggests that in most countries recurrent property taxes provide less than 0.2% of GDP, while weak administration also undermines fairness and equity. This has remained true despite rapid urbanization, and dramatic increases in urban property values, across lower-income countries. The Economic and Social Commission of Asia and the Pacific argued in their submission to the FfD4 process that, “weak property taxation is probably the greatest missed opportunity of public revenue mobilization for developing Asia-Pacific countries.”

More optimistically, there is a growing body of evidence that major and rapid improvements are possible, often through the adoption of simplified reform strategies better suited to the distinct contexts of lower income countries.

For example, a reform program in Freetown, Sierra Leone, supported by ICTD’s Local Government Revenue Initiative (LoGRI), led to a five-fold increase in revenue potential, tripling of revenue collection, major improvements in equity and improvements in service delivery and build public trust. It did so by stressing simplification, locally appropriate digitalisation and efforts to build trust with taxpayers.

Proposals for Revising the FfD4 Draft Outcome Document

Expanded attention to the importance of subnational finance is an important step forward in the zero draft. In the vast majority of countries strengthening subnational financing is critical to broader development goals.

However, the lack of any explicit attention to strengthening taxes to finance subnational development is a missed opportunity. Such taxes are the key to funding core recurrent public programs, and accessing transfers external financing. The FfD4 process can draw needed attention to what is the most underperforming area of revenue collection. In turn, a failure to mention taxes risks too much attention shifting toward external sources of finance which are not a substitute for robust domestic revenues.

Doing so would require only small, but consequential, changes to the text of the zero draft. For example, with additions underlined:

• We encourage the strengthening of sustainable sources of subnational finance by improving the collection of taxes for subnational development – including, where appropriate, taxes on property – and promoting stable and transparent intergovernmental financial transfer systems and equalization mechanisms.
• We will support efforts to enhance local authorities’ technical, technological and human resource capacities, and to adopt locally appropriate governance strategies, in order to strengthen revenue mobilization, improve revenue management and implement effective infrastructure asset management over the lifecycle of assets.
• Where appropriate to the level of development and capacity of individual governments we encourage them to explore the potential to diversify income and financing sources, while bearing in mind potential risks.

Such a text would retain every priority that appears in the existing text but would:

1. Foreground the importance of specific taxes for subnational development, and of intergovernmental transfers, as the foundation for sustainable subnational finance
2. Note the particularly underexploited potential of property taxes, and acknowledge recent learning about the importance of governance strategies adapted to local needs and constraints
3. Highlight the need to strengthen broader capacities, including for revenue and asset management, in order to enhance development outcomes
4. Retain mention of the potential for diversifying income and financing sources, but while being realistic that such sources (a) may not be accessible to many lower-income subnational governments, (b) that they are best understood as funding sources that build upon a strong foundation of local revenue mobilization and transfers, and (c) that alternative sources, and especially municipal bonds, can also carry important risks.