Key message 1 – Tapping into well-administered, diverse, local sources of revenue can decrease cities’ reliance on central government transfers.
There are over 20 potential principal revenue sources that local governments can explore, summarised into four main categories: revenues from taxes they levy, revenues from non-tax sources they have control over, transfers from central government, and external revenues (Dewvas, Munawwar and Simon, 2008).
As noted, many developing country cities are still overly reliant on central government transfers as their main source of revenue. For example, in Brazil, up to 91% of financing for small municipalities came from intergovernmental transfers in 2006 (Freire and Garzon, 2014).
Central government transfers are in most cases neither large nor stable enough to efficiently and effectively finance a rapidly growing city. In countries like Rwanda, which are going through a process of decentralisation, more responsibilities will be given to local authorities for public service delivery. However, for a number of reasons, transfers from central government may not be able to increase to commensurate levels (Kopanyi, 2015a). In light of this, municipalities will increasingly need to focus on increasing revenues from sources over which they have influence and therefore should provide a more stable flow.
The ability of cities to raise finances depends significantly on the relevant authority’s administrative capacity and on the country’s legislative framework. There may be instances where national legislation does not permit city authorities to raise revenue the way they want. However, it will be beneficial for them to begin working within these frameworks and exploring further sources of municipal revenue, as changing national legislation, which
can still be pursued in parallel, can be a very time-consuming process.
It is not feasible for municipal authorities to try out all options for raising more revenue locally at once. Rather, it is advisable to focus on those with the greatest potential. These are usually sources that are in the city’s mandate and authority to adjust (i.e., without having to change national legislation), and where the largest gains can be made – either because there are a number of large taxpayers involved, there is unrealised potential, or they are administratively easier to levy.
Two important principles to be considered when raising municipal revenues (Freire and Garzon, 2014):
1. It is beneficial for service provision to be clearly linked to the revenue sources required for its financing; and
2. To the extent possible, services can be financed either directly or indirectly by the beneficiaries using them.
A third major principle to take into account when determining other revenue sources is that they are mostly more effective when they are simple and transparent. This is often reflected in the cost of administering the tax or the fee for the authority, as well as the cost of compliance for the user. If these taxes and fees are not well-administered, there is significant risk that they will have prohibitive, distortionary, or unwanted distribution effects (Fjelstad and Heggstad, 2012).
For example, many municipalities like raising revenue through business license fees. However, fees that are too high or complex may make it impossible for small and medium firms to comply. This in turn may either hurt their prospects of survival or result in their evading formalisation so they do not have to pay these fees at all, which in turn lowers the revenue from these sources.
Other examples of fees having adverse effects include charges in excess of cost of provision that are levied on utilities such as water or electricity. While these may be favourable in terms of linking users to services, they could, at the same time, adversely affect the equitable distribution of these services if the fees are too high, rendering poor households unable to access them. However, any subsidies to utility charges must be explicitly funded by other revenue sources to avoid undermining the financial sustainability of utility provision and ultimately reducing access through service interruptions.
With each new fee and tax, the overall system becomes more complex for the authorities to administer but also for the user to understand and comply with. This in itself can have adverse effects on revenue collection as it creates more avenues for potential corrupt practices and may contribute to a general decline in compliance. Therefore, when tapping into new sources, it is advisable for authorities to ensure that the system is transparent, well-administered, and reflects taxpayers’ ability to pay in order to ensure its success in raising revenues overall.