Closing the Urban Fiscal Gap: Some Considerations

Philippine Institute for Development Studies

Policy Notes March 1999

Closing the Urban Fiscal Gap: Some Considerations

Rosario G. Manasan

This Notes issue takes a brief look at the urban fiscal gap problem and at the factors and interventions that could help overcome the barriers brought about by this gap.

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There are, however, also certain problems which urbanization is associated with. Congestion is one. It leads to diseconomies like air and water pollution, slum settlements, and increased need for disease control and fire/ police protection which then offset the positive effects of technological economies of scale on input costs. Of course, basic services like potable water supply, telephones and health facilities also become critically inadequate in many large cities.

Two types of responses are known to have been made to address these problems. One is to impose controls on rural-urban migration and rapid population growth.

Another is to find efficient ways to manage and finance the urban sector. This paper focuses on the latter— searching for ways to finance and deliver adequate public services in urban areas.

The heart of the problem The immediate cause of the shortage and at times, near absence, of basic public services in large cities is the inability of governments to fund the delivery of the right quantity and quality of these services. In short, ur-

Introduction Urbanization has certain advantages. Agglomeration economies result in higher productivity as compared to the rest of the economy. As urbanization proceeds, cities are better able to capture the benefits from economies of scale, bringing about reductions in unit cost of delivering certain types of services like sewerage treatment, public transportation and the like. Urbanization also induces increases in the taxable capacity of cities such that more revenues can be mobilized from the same jurisdiction.

PIDS Policy Notes are observations/analyses written by PIDS researchers on certain policy issues. The treatise is wholistic in approach, and like the PIDS Executive Memo, it aims to provide useful inputs for decisionmaking.

Wilbert R. San Pedro and Jennifer P.T. Liguton helped in repackaging this PIDS Discussion Paper No. 98-37 entitled "Financing and Delivery of Urban Services in the Philippines: An Overview" by the author, Research Fellow at the Institute. The views expressed are those of the author and do not necessarily reflect those of PIDS or the United Nations Fund for Population Activities (UNFPA), the study's sponsor.

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ban local government units (LGUs) typically face a financing problem known as "fiscal gap." This is defined as a gap between perceived service needs and available financial resources. This fiscal gap is different from the concept of fiscal deficit which reflects a shortfall of actual revenue collections relative to actual LGU expenditure. It is important to note this difference at the outset since in the Philippine context, LGUs are not encouraged to engage in deficit financing of recurrent expenditures.

How does urbanization influence the fiscal gap?

To be able to answer this, one should first take a look at how urbanization and population growth affect the expenditure requirements and revenue collections of urban LGUs. The increase in demand for public services is mostly driven by growth in population induced by natural growth and migration. In order to sustain a given level of service, some argue that LGU expenditures have to increase at a rate that is at least proportional to the rate of population growth. In cases where service provision entails an increasing marginal cost, the need for such response becomes even more pronounced.

Clearly, urbanization exerts an upward pressure on local government budgets. However, LGU revenues may not respond as quickly and strongly to rapid population growth. Thus, while population growth, urbanization and the associated growth in per capita income all tend to expand the revenue capacity of urban governments, the growth in LGU revenue may not automatically expand since it is held back by the LGUs' limited taxing authority and lagging revenue efforts.

One example is in terms of property values. While they tend to rise with urbanization, the increase is not immediately reflected in the statutory tax base unless assessment values are automatically indexed.

Another illustrative case is the issue of inflation.

Inflation drives up government spending requirements almost instantaneously, what with the rise in the cost of materials and supplies and the pressure to increase gov-

Policy Notes

March 1999

ernment employees' salaries to be able to cope with the higher costs of living. Yet, LGU revenues are not as responsive. Again, this is because there is, among others, no automatic indexation of the assessed values of real property for tax purposes in most places.

To bring adequate public ser vices to the urban sector, then, it becomes critical to close the fiscal gap. To close the fiscal gap, more money should flow into governments. Conversely, service delivery must be made more efficient or innovative in order that some money may be saved and put into the government coffers.

"...While population growth, urbanization and the associated growth in per capita income all tend to expand the revenue capacity of urban governments, the growth in LGU revenue may not automatically expand since it is held back by the LGUs' limited taxing authority and lagging revenue efforts."

Dissecting the urban fiscal problem It is useful to analyze and evaluate the determinants of the city local government units' (CLGUs) revenue performance and expenditure behavior to understand where and how more funds (and savings) can be sourced for the city government coffers thereby closing the fiscal gap.

Determinants of revenue performance Reviewing the 1991–1995 period, the study measures LGU revenue performance in terms of per capita total LGU income and two components of per capita locally-generated revenues: per capita local business tax revenue (PCLBT) and per capita real property tax revenue (PCRPT).

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Results of a series of regression runs indicate that the degree of urbanization has a positive and significant effect on PCLBT. It is likewise positive—but not significant—in terms of its relationship or effect on the PCRPT. The latter apparently shows that real property tax systems have not been able to fully capture the positive effects on land values brought about by urbanization.

Cities earn income from both local and external sources. Local sources come mostly from local business tax and real property tax while external sources are largely accounted for by the internal revenue allotment (IRA). A previous Manasan study (1995) showed that instead of acting as a stimulant for LGUs to raise their local revenue generation effort, the IRA served as a disincentive to local government's resource mobilization effor t since it became a substitute source of income for LGUs. In view of this and because, as noted earlier, efforts in generating potential tax earnings from highervalued real property brought about by urbanization were not fully realized, it is therefore not surprising to find that the effects of urbanization and population growth on per capita LGU total income had simply been neutral.

Determinants of CLGU expenditure behavior Meanwhile, the growth in demand for public services is often associated with the increase in population.

Logically, LGU expenditures are expected to grow more or less proportionately with respect to population in order to maintain a constant level of service.

Ditto with the effects of urbanization. As urbanization proceeds, per capita personal income tends to rise.

"Logically, LGU expenditures are expected to grow more or less proportionately with respect to population in order to maintain a constant level of service."

No. 99-02

With the increase in per capita personal income is the tendency to have an increase in the demand for most public services. Subsequently, too, the level of per capita expenditure is expected to rise.

However, results of the regression analysis conducted by Manasan using data on Philippine LGU expenditures show that in 1995, the degree of urbanization and per capita LGU expenditure (PCLGUEXP) were negatively and significantly related. For the other years, except 1994, while the urbanization coefficient turned out to be positive, it was nonetheless not significant.

When the regression analysis was further extended to take a look at the effects of urbanization and population growth on the per capita LGU expenditure for health and education, the results showed that except in 1991, the association had been negative and statistically significant. Said result is contrary to initial expectations and to what have been obtained in other countries, notably developed countries.

What accounts for such difference and what is its implication?

The unfortunate consequence Put simply, the results showing a negative relationship between urbanization and population growth, on the one hand, and per capita CLGU expenditure, on the other, means that instead of increasing as would have been expected, the actual CLGU per capita expenditures, specifically for health and education services, declined as population growth rates and the degree of urbanization rose.

Consequently, the fiscal gap is not reflected in terms of a higher LGU fiscal deficit, as in other countries, but rather in reduced level of per capita expenditures. The implication of this is that the delivery of basic services, notably health and education, is adversely affected.

It therefore becomes not merely a fiscal problem but, sadly, a shortage and deterioration of urban service

Policy Notes

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delivery especially in the areas of health care and education.

Recommendations: Interventions to close the urban fiscal gap The urban fiscal gap can be closed in four ways: increasing local revenue effort with unchanged revenue authority, ] increasing LGU taxing authority, ]

"To address the problem of CLGU real property tax systems not fully capturing the rise in urban land values, the Local Government Code should be amended in favor of automatic indexation of the schedule of fair market value between general revisions."

]

increasing transfers from central government,

and ] more efficient use of existing financial resources in service delivery.

Increasing local revenue effort. To counteract the substitutive effect of the IRA distribution formula on local source revenue, tax effort may be explicitly taken into account in the IRA allocation formula. Alternatively, the IRA distribution formula may also be allocated to the different LGUs based on equalization of net fiscal capacities (revenue capacity net of expenditure needs).

To address the problem of CLGU real property tax systems not fully capturing the rise in urban land values, the Local Government Code should be amended in favor of automatic indexation of the schedule of fair market value between general revisions. This will protect the real property tax base from inflation during the years when

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March 1999

no general revision is undertaken. By avoiding the need to make lumpy adjustments in the schedule, it will also narrow the gap between the official schedule of fair market values and the true market values of real property in the medium term. Moreover, to counter the tendency of local assessors to value real property below its true market value, the use of the zonal values of real property (on which the BIR bases its assessment of transfer taxes) should be considered.

On the collection side, there is a need to separately monitor current real property tax collectibles from delinquent accounts. Aggressive collection and enforcement after each quarter through notices of delinquencies would do the government good. At the end of the second quarter, when an account becomes delinquent, warrants of levy should be issued. If by the end of the third quarter, the account is still delinquent, auction notice should be issued.

For local business taxes, the biggest problem is the underreporting of gross receipts of establishments.

Requiring taxpayers to submit their income tax returns (ITRs) filed with the Bureau of Internal Revenue is perhaps the most direct way of obtaining information. Given the present tax calendar, this implies that local business tax be initially assessed on the basis of the previous year's ITR and adjusted later in the year as the current ITR becomes available. In addition, local treasurers may require large establishments to submit supplementary accounting records. In large urban areas, local treasurers should be trained in field examination to check the veracity of reported gross receipts. The use of presumptive income levels, particularly for small establishments, should also be explored.

To improve collection and enforcement of nonreal property taxes, meanwhile, the following may be considered: ] establishing a roll for each type of tax (the conduct of a tax census and the development of a revenue data bank are key steps in this regard),

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] maintaining systematic records where tax payments are automatically entered as they occur, ] sending tax bills and conscientiously monitoring tax payments and delinquencies, and ] strictly implementing sanctions and penalties on erring taxpayers.

A good number of cities has already implemented user charges to defray hospital expenditures. To supplement the effort, local sanggunians need to pass legislation removing restrictions on the retention of income generated by these hospitals since such restrictions discourage hospitals from collecting user fees.

Meanwhile, the poor financial performance of CLGU business enterprises is becoming worrisome. Cost-based pricing is a way of addressing the problem. Still another way is through management contracts with the private sector.

Increasing LGU taxing authority. In the medium term, the assignment of taxing powers to various levels

"LGUs in best practice cases took different routes in addressing the fiscal gap. Some introduced user fees...some tapped additional funds from higher levels of government and the private sector."

of government must be reviewed. Theory suggests that residence-based taxes and taxes on immobile factors such as the real property tax are appropriate for local taxation. Motor vehicle taxation is also suitable for CLGUs. Betterment levies (a tax aimed at recouping the public costs of providing urban infrastructure from the beneficiaries) should also be explored. Such charges have had positive effects in Korea and Colombia.

No. 99-02

Improving efficiency and effectiveness in service delivery. Case studies of best practices in LGU service deliver y indicate that much improvement could be achieved in this area. Below are three major characteristics of selected Philippine cities which, faced with inadequate funds to finance urban services, shifted strategy by innovating and making more efficient the delivery of services.

One, there is greater participation of various stakeholders (local institutions and people) in the implementation process and funding. This helps ensure efficient and effective program results and sustain implementation. For example, Surigao City and Lapu-lapu City mobilized their women's groups to deliver health services.

Naga City tapped community organizations to identify and come up with the financial counterpart of housing program beneficiaries while Puerto Princesa's citizens participated widely in cleanliness and reforestation programs.

Two, LGUs in best practice cases broke free from the financial constraints that face most urban LGUs. They took different routes in addressing the fiscal gap. Some introduced user fees (as in Olongapo City) while others designed well-planned cost recovery schemes (as in San Carlos City). Still other LGUs focused on mechanisms that reduced the cost of service production and delivery.

Cotabato City used barangay halls and private homes in the absence of barangay health stations. Cotabato, Olongapo and Naga mobilized health volunteers. Other LGUs tapped additional funds from higher levels of government and the private sector. Olongapo City required its barangays to allocate five percent of their IRA to health and welfare. Surigao City obtained P1.5 million for the construction of a training center from the Countrywide Development Fund (CDF) of a senator. Partnership with the private sector was a popular option. Other LGUs maximized own-resource use to finance development. San Carlos City set aside 30 percent of its IRA (instead of the mandated 20 percent) for its Local Development Fund.

Three, the laudable programs are characterized by an integrated and intersectoral development strategy in

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order to capture the synergy from program interdependencies. Puerto Princesa's Low-Cost Housing Project is, in reality, just one component of a wider program called Bantay Dagat program. Olongapo City strengthened the link between health and sanitation by integrating its environment program with health activities. 4

Reference Manasan, Rosario. "Revenue Mobilization in Local Government Units: The Early Years of Local Government Code Implementation."

PIDS Discussion Paper Series No. 95-02. Makati: Philippine Institute for Development Studies, 1995.

List of Discussion Papers for 1998*

March 1999

For further information, please contact The Research Information Staff Philippine Institute for Development Studies NEDA sa Makati Building, 106 Amorsolo Street Legaspi Village, Makati City Telephone Nos: 8924059 and 8935705; Fax Nos: 8939589 and 8161091 E-mail: rmanasan@pidsnet.pids.gov.ph jliguton@pidsnet.pids.gov.ph

98-23 The "Lote Para sa Mahihirap" Housing Program of San Carlos City, Negros Occidental Anicia C. Sayos and Estela F. Paredes

98-12 Metro Iloilo: A Struggle for Acceptance and Organization (Revised) Ruben G. Mercado and Raul S. Anlocotan

98-24 "Kaantabay sa Kauswagan" (Partners in Development) Mass Housing Strategy: The Case of Naga City Anicia C. Sayos

98-13 Metropolitan Naga: A Continuing Challenge of Local Autonomy and Sustainability (Revised) Ruben G. Mercado and Victor B. Ubaldo

98-29 In Search of Metropolitan Definitions: Lessons from Metro Davao Ruben G. Mercado

98-14 Providing a Metropolitan Perspective to Development Planning: Cagayan de Oro (Revised) Ruben G. Mercado and Casimira Balandra

98-30 Megalopolitan Manila: Striving Towards a Humane and World Class Megacity Ruben G. Mercado

98-15 Metropolitan Cebu: The Challenge of Definition and Management (Revised) Ruben G. Mercado

98-31 Metropolitan Arrangements in the Philippines: Passing Fancy or the Future Megatrend?

Ruben G. Mercado and Rosario G. Manasan

98-16 Owning the Metropolitan Vision: The Case of BLIST (Revised) Ruben G. Mercado and Carmel P. Chammag

98-32 Environment and Natural Resources Management: Lessons from City Program Innovations Ruben G. Mercado

98-17 Financing and Delivery of Health and Sanitation Services through Effective Resource Mobilization and Inter-governmental Coordination: A Case Study of Cotabato City (Revised) Virginia S. Pineda and Ma. Lourdes Lim 98-18 People Power at Work: The Case of the Surigao City Primary Health Care (PHC) Federated Women's Club (Revised) Virginia S. Pineda and Johnny Lim 98-19 Emergency Rescue Naga: An LGU-Managed Emergency Rescue Project (Revised) Virginia S. Pineda and Rose Buan 98-20 Puerto Princesa City's Satellite Clinics: A Curative Rural Network (Revised) Virginia S. Pineda 98-21 Reaching Out: Gingoog City's Total Integrated Development Approach (G-TIDA) (Revised) Virginia S. Pineda and Clark Clarete 98-22 The Low-Cost Housing Program of Puerto Princesa City, Palawan Anicia C. Sayos and Antonio C. Fernandez

Policy Notes

98-33 The Case of Butuan City: A Consistent Regional Outstanding Winner in Nutrition (CROWN) Virginia S. Pineda and Jazmin D. Berido 98-34 Olongapo: A Healthy City Virginia S. Pineda and Aurora Joson 98-35 Partnership for Health: A Case Study of Lapu-lapu City Virginia S. Pineda 98-36 Health Management: Strategies from Selected Cities Virginia S. Pineda 98-37 Financing and Delivery of Urban Services in the Philippines: An Overview Rosario G. Manasan

* This list consists of studies under the UNFPA PIDS project on "Population and Urbanization: Managing the Urbanization Process under a Decentralized Governance Framework."