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Local-government finance

The right balance

by Ulrich Nitschke, Tim Auracher

In depth

Local governments fiscally benefit from business activities: manufacturing soap in Benin

Local governments fiscally benefit from business activities: manufacturing soap in Benin

Benin has introduced a system to transfer funds from the central government to local authorities. The country has also introduced a new local tax. Both innovations set standards in Africa. Next, Benin needs to achieve a sensible balance between local revenues, government allocations and donor contributions. [ By Ulrich Nitschke and Tim Auracher ]

Decentralisation is a challenging affair. The connectivity principle is crucially important. It states that, when a government devolves powers to local authorities, it also needs to ensure that they have the funds required to rise to their new responsibilities. For this purpose, Benin introduced the Fonds d’Appui au Dévelopement des Communes (FADeC – fund to support municipal development) in 2008.

The country, moreover, has recently reformed its system of local taxation. On top of levying the usual property and business taxes, local authorities now also collect the Taxe de Développement Locale (TDL – local development tax). This innovative tax focuses mainly on agricultural activities and is similar to a value-added tax. It builds upon several models that local authorities developed in legally grey areas in the past.

Whereas government allocations ensure a minimum of uniformity of living standards across a nation, local taxes strengthen the autonomy of local authorities. Both goals are important. The crucial thing is to find the right balance – and to make sure that international development partners play an appropriate role.

The FADeC

The government transferred the first FADeC money to local authorities shortly after respective legislation was approved in May 2008. The results became visible soon. In 2009, nearly nine percent of total government spending was channelled through local authorities – twice as much as in 2007.

Up to 2009, FADeC was financed exclusively through the national budget. In 2010, however, donors started to support the Fund. International development partners, however, are still reluctant financiers. Support for FACeC means they must give up a degree of control because there is no way to distinguish between national and donor contributions in FADeC’s allocations. At the same time, FADeC is an example of how to live up to the principles of the Paris Declaration on Aid Effectiveness: it is run entirely by Benin institutions (“ownership”) and standardised procedures are in place for financing, transfer, resource allocation and verification criteria (“alignment”).

FADeC transfers funds to local authorities according to the connectivity principle. It also monitors how the money is used. In contrast to similar funds in Mali or Ghana, FADeC is not a parallel fund that grants local governments money for investments on the basis of their applications.
FADeC distinguishes between funds for current expenses and investments. Former have been around for a fairly long time, but are now channelled through FADeC. What is really innovative is the mechanism for funding investments. Investment funds fall into two categories: earmarked funds and uncommitted funds.

Local authorities are free to use uncommitted funds within their jurisdiction with hardly any restriction. The basic rule of thumb is that investments need to be in line with "Municipal Development Plans". The National Commission for Local Finance (CONAFIL), in which mayors and high-ranking ministry officials are represented in equal numbers, decides on the allocation of funds to local authorities on the basis of a clear set of rules. These rules define
- uniform basic allowances,
- socio-democraphic criteria (population, area, poverty level) and
- performance criteria (relating to indicators for local administrations, elected officials and the fiscal administration).

Earmarked investment funds, on the other hand, serve to meet local governments’ finance needs that relate to the devolution of responsibilities in sectors such as health, water supply and basic education. The relevant ministries determine the volume of funding for each Département. Local authorities, in turn, report their requirements to the Département. The prefects, the heads of the Départements, must negotiate fund allocations with the mayors and various lower government bodies.

So far, Benin’s ministries as well as the international donors have somewhat shied from FADeC. The procedures for allocating earmarked funds are not running smoothly yet. But the institutional framework is in place and responsibilities have been defined, so the pressure is growing to use the new mechanism.

In the future, the flow of both earmarked and uncommitted funds to local governments will increase sharply. Accordingly, local revenues will figure less and less prominently in municipal budgets. Indeed, the total share of local revenues in municipal budgets went down by more than ten per cent from 2007 to 2009, even though the volume of those revenues actually grew by around 21 %.

Local tax revenues

Thanks to the new TDL, however, local revenues are now likely to grow vigorously, especially in rural areas. In the past, classical taxes on property and business were the main sources of revenue for Benin's local authorities. Thanks to a computer-based property register, these taxes generate healthy revenues in urban centres. In the rural areas, however, they only result in meagre funds.

The TDL will reduce this imbalance. The biggest challenge in introducing this innovative VAT-like instrument lay in efficiently taxing the sale of goods from producers to dealers. The lawmakers took their cue from various fiscal practices that were already been in place in different parts of the country.

The TDL is thus an amalgam of numerous levies that local governments created in order to participate fiscally in the local economy. One advantage of the TDL is its coherent legal form. The various revenue practices have been standardised, and there is no longer any double taxation. Widespread TDL application will significantly boost the revenue of many local governments.

Looking forward

Benin has shored up its domestic public-finance system. Today, the country offers international development partners an up-to-date mechanism for granting financial support to local authorities.

What still needs to be clarified, however, is the balance between locally generated revenues, government allocations and donor transfers. This is not an academic debate about optimal ratios according to various model assumptions. What is at stake is a political issue: how will the various political forces interact henceforth to constantly and dynamically redefine the necessary balance? Important questions are:
- How much money does the state make available to local authorities through FADeC? At present, there is no legal standard. A group of like-minded donors agrees that the contribution from the national budget should be at least as high as in the previous year. This criterion is evidently not designed for the long term.
- How much should international development partners contribute to FADeC? As far as uncommitted funds are concerned, it may be enough for the donors to put up at most half of the money. The question is more difficult in the case of earmarked funds, because many development partners are active in sector programmes that relate, for instance, to health, water supply or education. These programmes are often funded through financing baskets and tend to impinge on, or overlap with, the responsibilities of local governments.
- How can local-government revenues be boosted without excessively burdening tax payers? The introduction of the TDL was a sensible way to strengthen autonomy of local authorities, ensure planning stability and prevent double taxation. But the instrument has reached its limits. What is needed next is some kind of tax that benefits different levels of government according to a fixed formula (“shared taxes”). A value-added tax would be an option, for instance.
- What co-determination rights must local authorities have? A start has been made, since half of the national finance commission CONAFIL’s members are mayors. But the statutory framework is still dictated by the national parliament alone. In 2009, parliament approved exemptions from business taxes with the result that, after vigorous growth in previous years, local-government revenues from business taxation fell by 20 %. It would be sensible to make consultation of the ANCB (the National Association of Municipal Governments) mandatory ahead of every decision with an immediate impact on municipal finances. Even better would be a a chapter in the constitution that regulates financial relations between the different levels of government.

Benin has taken important steps to decentralise government responsibilities and ensure that local authorities have the financial means to rise to their new duties. There is political will to press on with reform in this direction. The models developed in Benin set standards for other countries. Nevertheless, the reform process is not yet complete.