Capital investment programming and its financial implications

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Capital investment programming and its financial implications

  1. 1. CAPITAL INVESTMENT PROGRAMMING AND ITS FINANCIAL IMPLICATIONS Budgeting and Financial Management for Local Government April 2000David C. Jones, C.P.F.A., F.C.C.A.(UK), and as:Research Fellow & Visiting Instructor, President, Farsight Inc.Center for Urbanization Studies, International Financial & ManagementGraduate School of Design, ConsultantsHarvard University, 4936, Andrea Avenue,48, Quincy Street. CAMBRIDGE. Annandale,Massachusetts Virginia. 22003. USATel: 617-495-4964 Fax: 617-495-9347 Tel: 703-978-8564 Fax: 703-978-8014E-mail: djones@gsd.harvard.edu E-mail: dcjones2@cox.com
  2. 2. CAPITAL INVESTMENT PROGRAMMING AND ITS FINANCIAL IMPLICATIONS BACKGROUND AND FINANCIAL FRAMEWORKGeneralCapital Investment Programs are usually thought of as building things. This includes:development of land; erection of buildings; installation of roads, bridges, pipes and otherinfrastructure – above, on and under the ground; or, the supply of equipment for use on a semi-permanent basis.Primary participants in these activities are mainly engineers. Thus, it is natural that they will beconcerned to build and install, as rapidly as possible, the infrastructure and other fixed assetsperceived to be urgently needed. They, after all, have the primary expertise for this task. Aprincipal limit on the pace and magnitude of their work is, clearly, financial resources. A capitalinvestment program, therefore, is an opportunity for prioritization of fixed asset implementationactivity and the related access to urgent and important funding sources. It will also show how thevision and operational strategy of a community is reflected in the program for capitalexpendituresBecause of the very large Capital Investment Programs (CIP) to be financed, failure to considerthe availability of funding could give rise to an undue sense of urgency. That might engender adisregard for the need to carefully examine each project component with due diligence. It isimportant, of course, to ensure that the necessary funding will be available, in full and on time, asand when needed for each project component. However, it is also important to ensure that: (a) each project component, as well as its size and scope, is selected on the basis of a rational prioritization, with reference to its financial and economic costs, measured against its benefits or effectiveness – economic, financial, social and equity; and (b) each project component represents the least economic cost of providing a sound solution to the concern being addressed.These should be addressed on the basis of life-cycle costs. These allow for the capital costs andalso the impact of these on recurrent finances, together with costs of operation, maintenance andadministration. Also to be considered are the costs of replacement or rehabilitation of equipmentthat will not continuously serve with optimum efficiency, or even become unserviceable, duringthe life-cycle of the principal project assets. Analyses will need to allow for expenditure in lateryears to be discounted against earlier expenditures.It is also important to take account of the extent and timing of revenue flows from the use ofvarious infrastructure items. Some components, such as water supply, will provide immediateindividual benefits and may well be connected with optimum promptness. 1
  3. 3. Others, such as sewerage, provide benefits that are only partially directed to individualhouseholds. Some benefits accrue to the community as a whole. They are also more diverse andless immediately obvious. It may be that there will be a greater reluctance by individualhouseholds to connect to the system. Solid waste services also exhibit some of the samecharacteristics.Sometimes, financial revenues may still be collected, by levying charges whether there is a directhousehold service or not. However, this may well be contentious, especially for sewerage. Forexample, households that can ill-afford this may need modifications to internal plumbing.Moreover, lack of connection will likely have technical shortcomings. Low flows will potentiallyharm the sewer pipes, while a lack of connections will limit public health benefits to the widercommunity.Some infrastructure, such as roads and drainage, will likely provide benefits that are of a generalpublic nature, rather than to individuals. Road improvements1, moreover, are likely to improvethe efficiency of other public services that rely on transport, especially solid waste removal,police, fire and ambulances. The operation and maintenance of roads and storm drainage,together with necessary capital cost recovery, will need to be borne mainly from general taxes.Thus, it is important to ensure that the necessary increases in general tax revenues are engenderedfrom: buoyant increases in the tax bases; politically acceptable and administratively sustainableincreases in the tax levies; or, reductions in other tax-borne expenditures. The last-named wouldneed to result either from efficiency improvements or curtailment of other services.All of these matters are the concern of both technical and financial expertise. Moreover, theyhave financial and economic effects beyond the scope of the individual projects. They impactupon the entire financial framework of the local government unit, and way beyond it, to otherentities. Engineering specialists should, therefore, work closely with financial colleagues. Thiswill provide greater assurance that appropriate costs are budgeted and accounted for, in ways thatwill be both credible for reporting and useful for effective action. Most importantly, these arepolicy issues.Cost RecognitionThe above view of Capital Investment Programs has focused on the raising and spending of cash,to provide the infrastructure and other assets. Some attention has also been given to the provisionof funds to operate and maintain these.Certainly, cash-flow management is important, for a variety of reasons. However, other than byblind coincidence, "cash-flow," is unlikely to be synonymous with "cost." Cost definition cannotbe meaningful unless based on economic principles. Therefore, it should relate as closely aspossible to the concept of resource consumption, rather than to the mere receipt and payment of1 These need not be major or massive improvements. Sometimes, improved access to pedestrians and non-vehicular transport canbring notable economic and social benefits, relating to access and egress at awkwardly located spaces. 2
  4. 4. cash. It should also incorporate, where possible, recognition of the recovery of capital costs.Therefore, costs – in terms of resource use – of any business or public activity2 should includeproperly recognized and recorded expenditures on the following: (a) operation of the activity - in terms of the production of goods and services; (b) maintenance of all premises, plant and equipment in a satisfactory condition to perform its operations in a safe and efficient manner for its entire working life; (c) administration and management of the activities, together with the payment of taxes, necessary to ensure that operations are efficiently effected; and, (d) the rental cost (capital cost recovery factors) of fixed and working capital, comprising, either (for property not owned) the market rent, or (for property owned): (i) consumption of capital, typically recognized as depreciation of premises, plant and equipment; (ii) adjustment of value, either in terms of changes in real values (opportunity costs) of property or in recognition of the effects of changes in monetary values (inflation and deflation); and, (iii) return on investment, including interest on debt and an expected and reasonable return on contributed (equity) capital, either by dividends to owners or by retained earnings.After covering all the above, which are resource costs, it would be prudent to expect that thebudgeted activity costs would also allow for an additional (albeit small) "surplus," over andabove the expected and reasonable costs of capital. This would allow for periodical fluctuationsin financial fortunes, more specifically: risk; uncertainty; new activity; and, longer-term stability.Return on InvestmentIncluded as part of the "return on investment" is the provision for dividend and retained earnings,typically accruing to the owners (shareholders) of an entity. These are items which, according to"generally accepted accounting principles" are not treated as costs but as allocations of "profit."The distinction arises because financial accounts reflect “property rights” rather than economicprinciples. Thus, the interests of owners (shareholders) are reported as the earnings (profits) after2 This concept is referred to elsewhere (e.g. in a set of training slides) as “OMAR’S CAR.” It reflects that the COSTS of anybusiness or activity are synonymous with those of a taxi-owner (called Omar). His costs must cover: Operation; Maintenance;Administration & taxes; Rent (capital recovery) and Surplus. The Rent concept (CAR) covers: Consumption of capital(depreciation); Adjustment of Value (revaluation); and Return on Investment (interest, dividend and retained earnings). 3
  5. 5. all claims have been met from outside of the entity, including those of lenders.There is, however, common agreement among economists that what are considered to be"normal" profits are no more than a part of the "opportunity cost of capital." Only extra-ordinaryearnings are typically regarded as true "profits." This is somewhat analogous to what is describedas "surplus" in the above set of distinctions3. Furthermore, the standard practices of financialanalysis deal explicitly with costs of capital, the return on total net assets, as the weightedconsolidation of the separate and specific returns to debt and equity financing4.This has a parallel in the public sector. In some countries, notably in the USA and UK, it had inthe past typically been standard practice for state and local governments to finance up to andincluding 100% of many items of capital expenditure by the borrowing. This usually hadamortization periods closely related to the working life of the fixed assets acquired.However, even where all or part of these assets may have been financed from sources other thandebt5, the funds used for this purpose still have an opportunity cost. Indeed, the financing ofcapital expenditure from general government revenues (local, state or central) will do one of twothings. Either it will add to the overall "deficit," which will have to be borrowed, with interest, orit will eliminate some part of the overall "surplus," which will create a loss of interest on therelated monetary investment. Even if the deficit is covered by increased taxes, the taxpayers(effectively the "shareholders" of the government) will (collectively) lose the equivalent ininterest on what would otherwise have been their own money6. They will also forego the use ofthe principal sum.The issue of cost definition has been fully stressed and explained because it forms the basisagainst which all related aspects will need to be assessed. For example, it affects, or is affectedby: cost accounting systems; prices; allocation of overheads; budgetary management; fiscaldeficits; maintenance of assets; and, inter-governmental transfers. Costs of service cannot becredibly stated, nor fully recovered, unless they include reference to all of these various factors.Effective decisions on public service delivery, depend upon whether, and in what form, the costsof these are determined. Furthermore, cost recognition, to be consistent, should relate to themaintenance, use and consumption of resources and not to the manner in which these resourcesare originally financed. Sometimes, subsidies are appropriate, for economic or social reasons.However, unless costs are determined in an authentic fashion, there is no way to know whether,or to what extent, the subsidies already exist (such as in the initial capitalization) or areultimately justified, as in transfers from other accounts, funds or governmental entities7.3 Economists sometimes refer to this as “economic rent,” a concept introduced by the classical economist, Ricardo.4 Equity includes "retained earnings." These are somewhat analogous to situations where borrowers retain compound interest, inthat they are expected to earn returns.5 This includes grant financing, of the type used for the various capital programs supported by state or local governments.6 This is not an argument against the financing of fixed assets from taxes - only an explanation of its consequences.7 An example is the Washington Metro-rail transit system. In many presentations (of this and other urban transit systems), “costs”are postulated only as operating costs, completely ignoring the impact of the costs of the use and deterioration of the fixed capitalassets. Then, when these become pervasive, it is necessary to “shop around” for capital funding from constituent governments. 4
  6. 6. An example of the presentation and use of financial statements, incorporating full accounting forresource use costs, is given in the annual financial statements of the City of Birmingham,England8. As required by law, it follows the “Code of Practice on Local Authority Accountingin Great Britain” and the “Statements of Standard Accounting Practice” (SSAP) required by theChartered Institute of Public Finance and Accountancy and other UK professional accountingbodies. These include stipulations for full accounting of all fixed assets, irrespective of themethod of financing. It includes imputed rental, depreciation and interest costs, whereappropriate at current (replacement) values.Government GrantsCentral governments, of many other countries, are attempting to encourage and support activityby the local government units. This includes activity that it favors or for which there is someclear justification on national grounds. However, the prime responsibility is, increasingly, that ofthe local government units.A most important means of financial support by the central government of local governmentunits is the government grant. Among the many reasons for government grants are the following: (a) transfer to local government units of a proportion of revenues collected in or for their areas, but which can be collected more efficiently at national level (e.g. income tax, sales tax, VAT and customs duty); (b) support for services in which national government has an interest but which may be better performed locally, with input from local people (e.g. primary and secondary education, local roads and public health); (c) equalization, to some degree, of the needs and resources among different areas; (d) provision for specific burdens upon individual areas not shared generally; (e) encouragement of practices which are consistent with national social, economic or financial policies (and discouragement of those which are not); (f) enhancement of limited local resources to provide reasonable flexibility in decision-making on the provision of services; (g) major shifts in political, economic or social characteristics of a nation, group of nations or region (e.g. the massive political changes resulting from the liberalization policies in Eastern Europe).An August 2004 press article, indeed, refers to “Urgency Drives New Metro Pitch for Funds.”8 These statements are available separately. 5
  7. 7. There needs to be a great deal of common sense and political wisdom, as well as economic logic,in the administration of a grant structure. For example, whatever may be argued for the needs of aparticular area, it may also be one of the most important commercial centers, with a great dealmore economic potential than elsewhere. Thus, there might be a strong economic or equity-basedcase for a net transfer of resources away from the area, in favor of much poorer areas9.Capital GrantsGrants may be given towards specific capital projects or to support recurrent operations. Inprinciple, capital grants have a distinct disadvantage. They will tend to support new capitalschemes, perhaps too soon, too large or even not justified at all, instead of encouraging thecontinuance of a service using existing available equipment and infrastructure. This is veryserious in any country where capital resources, especially in foreign currency, are scarce and thuscostly.Faced with a choice of spending its own resources on maintenance or getting a grant for newcapital investment, a local government unit may be strongly tempted to opt for a capital grant. Amore appropriate financial support for capital expenditure would be a loan, for the life of the newasset, at market interest rates. Then, the local government would be faced with a more even-handed financial choice. It would either continue to pay operation and maintenance costs for theold (probably inefficient) asset or pay debt service (more strictly, capital charges) on the new one.However, in practice, application of these principles may often be difficult, even inappropriate.First, much local infrastructure is in a very poor state and in urgent need of replacement. Indeed,there are some areas or communities that have been so disadvantaged that there is little or nodecent infrastructure to begin with10. Second, there is no reasonable supply of market-drivenmedium-term or long-term capital. Even if there were, there is no satisfactory mechanism toadminister it. Third, many local government units lack credit-worthiness, at least until revenuesare greatly stabilized and enhanced. Finally, with the meager and uncertain financial resourcesavailable to the central government, capital grants at least represent one-time payments for whichthere is no continuing obligation beyond the duration of a particular program11.9 For example, the Northern Virginia suburbs of Washington DC, USA, arguably comprise the Nation’s wealthiest area. It makesgood local politics (albeit, poor distributive economics) to complain of local tax revenues “sent elsewhere in the state.”10 This is the situation in many formerly – and still currently – disadvantaged communities, emanating from socialist or othercentrally-planned economies, such as those in the former Soviet Empire. Central governments sometimes use capital grants as“pump-priming” mechanisms, for installation of, or access to, infrastructure in areas where little or none had, hitherto, existed.11 This may not be exactly correct. Until local recurrent financial resources grow sufficiently robust to operate and maintain thenew infrastructure, there may be a case for declining annual interim central government support towards this expenditure. 6
  8. 8. Thus, capital grants offer the opportunity to assist with the initial installation, expansion,reconstruction and rehabilitation of infrastructure. They can also be highly selective, givingpreference to areas of greatest need and with the poorest resources. Where used, they will almostalways represent a proportion of an approved capital cost, after careful examination and appraisalof the project by central government officials, or those acting on their behalf (e.g. staff of a"development fund" or "municipal bank").Sometimes, as an alternative, projects will qualify if they meet pre-determined conditions thatapply to all similar and relevant circumstances. This suggests that the central governmentministry responsible for local government should try to develop an improved capability forproject appraisal. This could provide significant assistance to local government units in planningtheir development, even without grant support.Recurrent GrantsHowever capital expenditure is financed or supported, there will usually be some need forcontinuing support of recurrent operations. Thus, methods must be found to provide this support.To some degree, at least, this may also need to be supplied by central or state government grants.Usually, there is a system which combines a local government’s own revenue sources withrecurrent grants from state or central governments.Some of the methods to be considered for the administration of a recurrent grant system are setout below. However, it must be realized that, at present, many would need to rely upon statisticalinformation that is simply not available or reliable. The ministry of “local government” or of“finance” should, therefore, attempt to build a data-base for this and many other purposes.Possible assessment and distribution methods for recurrent grants are: (a) budget review – central government reviews each local budget in turn, assesses its credibility and provides a grant to cover all or some of any expected recurrent deficit; (b) policy support – central government undertakes to reimburse local government units for the costs of nationally mandated policies, such as nation-wide salary increases; (c) reimbursement – central government effectively pays for the costs of delegated services, properly the primary responsibility of the central government; (d) revenue compensation – central government covers losses resulting from curtailment of local revenues as a result of national policy (e.g. abolition of a local tax based on incomes or the imposition of rent controls affecting property tax valuations); (e) percentage – central government provides a percentage of the cost of local services, with percentages, typically, varying from service to service; 7
  9. 9. (f) population – central government provides a lump sum per head of population, which could vary among age-groups to take account, for example, of the special needs of children and the elderly, with respect to education, health and welfare; (g) unit – central government provides a lump sum per unit of service or potential service (eg. per mile of road, per patient at clinics, per refuse vehicle); (h) revenue potential – central government compensates for potential loss of revenue, for example, based on property tax values or assessed incomes for graduated tax, relative to total population and national average tax potentials; (i) revenue sharing – government designates all or part of nationally-collected revenues (eg. vehicle licences) to be shared among local government units; and (j) formula – a variety of factors is taken into account to provide a grant structure which meets multiple objectives.All of these procedures are appropriate for most sets of circumstances, although only some ofthem may be chosen for practical use. 8
  10. 10. STRATEGIC PLANNING FOR CAPITAL INVESTMENTIntroductionWhen looking at a strategy for a Capital Investment Program, it might be well to remember somewords used by John Muir, ecologist and environmentalist: “When we try to focus on one thing by itself, we find it hooked to everything else in the universe.”A local government unit, establishing a capital investment program, can hardly be so profound.However, it can surely do better than just to prepare a list of projects that then need to be,somehow, financed. In a local or regional community, failure to visualize linkages, among thevarious concerns, constraints and opportunities inherent in any community can lead to veryserious shortcomings. This is especially the case with capital investment programs, because ofthe large expenditures, the significant consumption of space and time and the specialist and oftensingle-purpose nature of the assets installed.Even in the physical sense, there are many, many, linkages. New buildings need new investmentsin roads, footpaths, surface drainage, water supply, sewerage, electricity supply, and telephoneservices. All of these infrastructures, if already at capacity use, will need to be either developedor expanded. If not, they will be overloaded, operating with increasing inefficiency. For example,the much-heralded “Big Dig,” for a $15 billion massive road improvement in Boston, USA,required huge expenditures for construction, realignment and compensation for objects andactivities that had nothing to do, directly, with the actual road improvements. They were,however, impacted by the construction, realignment and tunneling for this.If social concerns are added, one must also recognize that buildings will almost always haveoccupants. Thus, there will be a need for shops, offices, schools, theatres, parks and many otherdevelopments to house or supply the goods and services needed by these people or their families.Also, if there is to be reasonable communication among residents, public or private transportsystems will be needed.It might be argued that almost everything in a community is concerned with transportation, inone form or another. Indeed, one way of perceiving a community is as a giant transportationsystem: for people, goods, services, information and waste products. At least two other concernswill influence the development of a capital investment program within a community. Firstly,there is the history, tradition and heritage of the community. No community on earth just sprangup, in the middle of the night, so to say. Every community is coming from somewhere. It hashistory, traditions, heritage, habits and prejudices. Many of these are reflected in the buildingsand other structures, some very beautiful, some quite ugly. By consensus among residents andwith pressures and influences from outside of the community, some of these structures will bepreserved; some will be destroyed or significantly altered. Change is inevitable and continuous. 9
  11. 11. Change is the motivator for the other concern. That is the need for vision. Someone, or a smallgroup of people, must have an idea about where the community is going. What will it become?How will its residents behave? What might have to be done to influence, sustain or curtail thisbehavior? How intrusive, coercive, supportive, permissive, benevolent, helpful, officious orcharitable should be the collective governance system? How reliant upon the free-market or howtolerant or corrective of market failure should it be?Reaching consensus, even on a single issue, is difficult. Reaching consensus on a whole range ofcommunity issues often seems nearly impossible. The mechanisms for doing this, even at locallevel, are by their nature clumsy and inefficient. Full and free citizen participation must bematched with constitutional rights, legal requirements and effective government. Individualconcerns must be tempered by sensible and efficient governance, planning, management andservice delivery.All of these concerns form a background to strategic planning, as a precursor to the establishmentand timing of a capital investment program. A major constraint will be that of finance. Indeed, asexplained later in this document, if a capital project cannot be financed, it cannot beimplemented. However, from a strategic perspective, one must examine not only whether anindividual project can be financed but also whether all of the financial implications of itsimplementation can be efficiently coped with.For example, if there is enough funding for a water supply extension, will there also be enough todeal with the inevitable increase in sewage disposal requirements? If so, will the potentialadverse impacts on the environment be overcome. Finally, if sewerage is to be installed, it mightrequire substantial and costly modifications to the internal plumbing of residences and otherbuildings. Unless this is affordable to the owners, the sewerage service will not be able to operateproperly. Consequently, some understanding of the ability and willingness to pay, even for theprivate parts of the service, is necessary.Strategic Planning for ActivityThe management of a local government unit, or of almost anything else, will need to deal dailywith predicaments. These arise from the local government’s formal or informal mandate (long-term) its policies (medium-term) or its (short-term) provocations. Each will overlap and impacton the others. Each will create predicaments, which will need to be addressed in some way by themanagement.There are, perhaps three main reactions that can take place. Firstly, the managers may decide thatthey have no concern to deal with. This may be because it is beyond their mandate or contrary totheir policy to become involved. Indeed, the predicament might be quite a serious one. However,it may not be one with which the local government unit is willing or able to become involved.Consequently, as an institution, it can be at peace. There is nothing for it to do. 10
  12. 12. Secondly, the managers may decide that the provocation is the responsibility of the localgovernment unit to deal with, as a concern. It comes under its mandate and is addressed by itspolicy. It may decide, however, for a variety of reasons, that it is either unable, unwilling or both,to address it as a concern, at this particular time. It therefore remains a problem and the peopleinvolved or affected by it will continue to suffer.Finally, the local government’s management may decide that the provocation creates apredicament that the local government will address, at this time. It comes under its mandate, itcan be dealt with under its policy and is accepted as a concern. Therefore, it must follow thatthere will be activity. Under the principles of activity-based management, incorporating activity-based budgeting and costing, the only phenomenon that operators and managers can be heldaccountable is activity. For example, it might be very interesting to know: what the mayor of acity thinks about a new water supply system; what a public works director feels about the roadmaintenance program; or, what a chief financial officer knows about accounting. However, whatthey will be held accountable for is what they do about these concerns. In other words, they areaccountable for their activity: signing a contract for a water supply system; repairing potholes andother road damage; or, publishing a set of financial statements.Under the concepts of activity-based management, only activity can be budgeted, costed or heldaccountable for. Thoughts, ideas and concepts, however profound, do not find directly findplaces in the financial interpretations of activity.Activity begins with a purpose. If an activity has no purpose, it is relatively meaningless.Usually, money spent on it cannot be justified. The purpose should be carefully defined, both intactical and strategic terms. From a tactical perspective, the purpose should indicate clearly anddirectly how the particular activity is expected to achieve it. From a strategic perspective, thepurpose should indicate what it is that the activity, together with its tactical purpose, is expectedto contribute to the wider vision, goal or perspective. In some respects, this is similar to thedistinctions drawn between outputs and outcomes.The VisionOutputs achieve tactical purposes. Outcomes achieve strategic purposes. It is, typically, theoutcomes that relate to the visions of those with the wider views on policies. For example, for theLondon Docklands Development to have succeeded, as it has done substantially to date, it isdoubtful whether this could have been achieved just by any number of tactical activities,however well-coordinated. Its managers were faced with a ramshackle and moribund collectionof derelict buildings, rusting ship-hulks, shabby storage sheds and polluted sites.Only a strategic vision of future possibilities could have served to create the resurrection andtransformation of this. Therefore, it was sometimes said that one of the first managers of theproject had: “Both feet firmly planted in mid-air!” This encapsulates what is often meant by –and needed – as vision. 11
  13. 13. Purposes, Outputs and OutcomesWhen purposes have been established, resources must be assembled. These must be organized towork efficiently. Assessments need to be made about the time-span of the activities and also theirspatial coverage. With capital development projects, rather than programs of operationalactivities, one is often talking about long time spans, with fairly narrow spatial coverage. Thelatter is often confined to a single site or project area. However, the strategic implications, as wellas the operational impacts, could cover much wider spatial dimensions. They could be perceivedof in shorter-term time packages, perhaps linked to much longer strategic time-frames. Forexample, a project to deliver additional electricity will confine its construction activity to theproject site and to any new transmission facilities. It may well, however, be implemented over afive to ten year time frame.When completed, the operation and maintenance of the project will not be so isolated. Instead, itwill be integrated within the entire system of electricity delivery. Concurrently, the supply ofelectricity will be perceived of in yearly or other relatively short-term time packages.Strategically, however, planning will need to be looking far ahead of the present, to identify newsites, new fuels, environmental concerns, growth of new areas and many other considerations.This will need to link up to predictions about the movements and demography of people, as wellas about the operations of a variety of related activities.Design and implementation of a capital project will need to take account of its ultimateoperations. Different modes of operation will apply in different circumstances, especially withrespect to the prices and availability of (say): trained workers; raw materials; transport facilities;and, maintenance facilities. Much of this will be directed towards economic efficiency. This,again, needs to be both tactical and strategic in outlook.With respect to efficiency of operations, it will be necessary to examine the motivations andincentives of those involved, whether inside or outside of the primary activity. There are manystakeholders and all will expect to be considered. Finally, there is a need to keep abreast ofevolving technologies. In modern times, some technological changes are unfolding with breath-taking speed. It is very hard to keep up with this phenomenon.Tactical Planning for ActivityIn the language of Capital Investment Programs, an activity is often referred to as a project. Asalready indicated, it is typically bounded by time, space and tactical purpose. It is, however, theunit of activity which can be implemented, budgeted and costed, to deal with a specificpredicament or concern. Predicaments engender responses. These will often begin with feelings,then thoughts and ideas. Eventually, however, a response to a predicament must be in the form ofactivity. The first activities will likely be plans, programs and budgets. Then there may beintellectual and physical work on project implementation. 12
  14. 14. Unfortunately, project implementation will hardly ever run smoothly. The activities, howeverwell-planned or well-executed, are virtually certain to encounter obstacles. These may bepolitical, technical, financial or of many other kinds. They will all need to be mitigated orresolved, so that the activity can continue and the purpose achieved. This can absorb, sometimes,a great deal of time, energy, money ad frustration. They may be as often administrative asphysical. Hidden blockages may appear under the ground or in the office! Explosions may occurwhen blasting out rocks or blasting out people. All must be resolved and the funds to do thisshould have been allowed for.Activities, therefore, have many implications involving decisions. Each of these will havefinancial and operational implications. Sometimes, major tactics and even entire strategies willneed to be revised. This will usually have even larger financial and operational implications.Each new situation, moreover, will become a new predicament. Each will have its own new setof tactical, strategic and other concerns, until the project is again brought into equilibrium or isfinally completed. 13
  15. 15. FINANCING OF PUBLIC SECTOR INFRASTRUCTUREOverall Financial RequirementsFrom the overall perspective of various entities dealing with public utilities and infrastructure, it isclear that in many situations, world wide, future demands on public financial resources will beformidable. This will apply to the funding of ongoing public services as well as to capitalinvestment.For example, in many situations, road-space, drainage and sewerage systems are totally inadequateto deal with even the current needs of residents. Underground piping is also old and worn. Thedevelopment of new residential and commercial areas typically demands large inputs of primaryinfrastructure. Where cities are, as is common, located astride rivers, there is also need forsubstantial upgrading of river crossing facilities. Often, sites formerly used for other purposes,especially industrial ones, will need to be cleared and then made environmentally safe.Where underground rapid-rail systems are planned or under construction, capital-financingrequirements will be huge. Moreover, subsequent operation and maintenance will likely requiresignificant annual subsidies. Bus, streetcar, gas, electricity and water supply services often operateunder policies dominated by public welfare considerations. Thus, prices are inadequate to coveroperation, maintenance and capital-cost recovery. As a result, current budgets of municipalgovernments must often provide for heavy annual subsidies of these, too.Basic Capital Financing PrinciplesThe search for alternative financing of public services and infrastructure should clearly explorepossible new approaches. In particular, there may be considerable potential to use leasing, sale orgrant of concessions for publicly owned land, in exchange for private sector financing of publicinfrastructure. Indeed, it is likely that some attractive packages can be arranged, with both local andforeign investors. It should, however, be cautioned that the search for innovative financing optionsshould not overshadow the need to apply some well-known and commonly used principles. These,valid in most situations in the world, must be the inevitable fallback positions, if more creativeoptions are not available. These basic principles may be summarized as follows: a. long-term borrowing should be confined to the financing of investment in land, buildings, permanent works and equipment, intended to provide a future flow of benefit to the community; b. borrowing periods should be related, as closely as possible, to the working lives of the assets to be financed and to their ability to efficiently deliver the future benefit flows12;12 It is often just as financially imprudent to finance long-life assets from short-term loans as to borrow for too long a period. Itcreates additional burdens on current finances, not justified by the longer utilization of the assets, but inevitable unless the loans can 14
  16. 16. c. long-term loans should be fully repaid, together with all interest, within the working lives of the assets financed; and, d. all expenditures relating to the current delivery of public services, including operation, maintenance and debt service on fixed assets should be met, on an annual basis, from stable and growing sources of local revenue, from either taxes or user charges.It follows that municipal governments and public utilities must continuously operate within theframework of a balanced recurrent budget. Furthermore, the various revenues used to bring therecurrent budgets into balance must exclude revenues from sales of land and other public assets.They must also exclude other one-time financial inflows, such as capital grants and donations,public utility consumer contributions and receipts from the disposal of public enterprises tocommercial interests. These funds flows are of a "windfall" nature. They should, thus, be reservedfor capital expenditures13.Public Sector InstitutionsBased on institutional performance in many places, it is possible to postulate a number of optionsfor service delivery entities, within the jurisdiction of a municipal government. The distinctionsamong them largely relate to the extent to which the services provided will be (wholly or partly)directly revenue seeking or tax-borne.The options often postulate some form of corporate structure, to some degree separate from theoverall administration of the municipal government. This has one important advantage. It allowsthe setting, by the national or municipal government, of a specific set of concerns to be addressedby each individual entity. Against these, it can be held accountable for both financial stewardshipand operational performance. The formulation of a corporate structure for each set of objectivesoffers the opportunity that the activity of each autonomous entity will be substantially immune fromthe likely changing political agendas of the core governance function.It is important to note, however, that the establishment of a corporate structure for wholly orpartially autonomous operations is not necessarily consistent with the concept of the private "jointstock company." This is frequently referred to in discussions about the restructuring of state ownedenterprises. Instead, a circular set of discontinuities can be perceived. They concern: financialmarkets; ownership; control and management; and, institutional structure. First, capitalization fromfinancial markets does not necessarily provide for effective ownership. Such capitalization maycome from bonds (lending), rather than stocks (ownership). Furthermore, the issue of differentbe rolled over or refinanced. This may preempt more important and urgent recurrent expenditures. Because short-term financing isoften more readily available than that for longer terms, it creates a great temptation for municipal governments to rely upon it tooheavily.13 By contrast, the United Kingdom central government credited the proceeds of its privatization activities to its recurrent budget.This practice was severely criticized by many public sector financial specialists. 15
  17. 17. classes of stock may result in the trade-off of decision-making power for security, as in the case ofso-called "preference shares." Finally, holdings by minority stockholders may endow them withonly nominal (legal) ownership, with no effective control or management. Thus, in the "Western"system, if there is really no intention to give effective ownership to investors, as in the case ofpublicly owned utility corporations, virtually all capitalization is from bond issues.Second, legal ownership, through stockholding, does not necessarily, imply effective control ormanagement14. Apart from the potential ineffectiveness of minority stockholders, it is virtuallyimpossible for the stockholders, as a group, to manage the day-to-day affairs of the corporation.This function must be delegated to a board, which may, in turn, be dominated by the chief executiveand managers. Neither the board nor the managers necessarily have identical agendas to those of the(stockholder) owners15.For example, the principal goal of the stockholders may be that of profit, whereas the personal goalsof the chief executive – especially if not a substantial stockholder – may concern benefits, power,control and "perks." Furthermore, where the public interest is present, the pure profit-seekingmotive of the stockholders may be significantly over-ridden by regulation, of either operations orprices. This is particularly true when dealing with activities that are considered as "naturalmonopolies."Third, autonomous control or management need not necessarily imply the use of a corporatestructure – and certainly not in the "joint-stock" form. In the public sector, there are many otherforms of delegation to individual entities. These may range from the establishment of quasi-independent government departments or operational units (such as schools, hospitals or colleges) towholly owned government corporations, with no private stockholdings and no intention to createthem. In the UK, for example, some of these have been collectively designated as: “quasi-autonomous national government organizations” (QUANGOs); “quasi-autonomous localgovernment organizations” (QUALGOs); and “arms-length management organizations” (ALMOs).Finally, a financially autonomous corporate structure may not necessarily imply the use of capital-market financing. It is quite common for public assets, within publicly-owned autonomouscorporations, to be wholly financed from direct government loans or grants. Thus, the "equityinterest" of the government is often merely a formal, legal, artifact, as with London DocklandsDevelopment.In summary, therefore, the establishment of financially autonomous entities, for the delivery ofpublic services, offers a range of options which might be substantially different from what iscommonly now known as "privatization." Some might involve corporate structures, some not.Policies of institutional restructuring should be evaluated not only with regard to a set of given14 There is a great deal of literature on the economics of the “principal-agent” situation.15 This has been dramatically illustrated by the disgraceful (and illegal) behavior of some US companies delivering “publicutility” services (electricity, telephones, gas and solid waste management). Among the most notorious have been Enron,WorldCom and Waste Management Inc. The related demise of the accounting firm, Arthur Andersen is well-known to all! 16
  18. 18. objectives but also in terms of how those objectives might be achieved in alternative ways. It isappropriate, therefore, not to regard "privatization" as a panacea, because it most certainly is not.Instead, it should be regarded as one of the tools, albeit it an important and powerful one, forfulfilling the political and operational objectives of a local, state or national government. 17
  19. 19. Contracting-Out of Public Services16There is an alternative to the delivery of all services by the employment of direct labor by publicsector institutions. Many activities offer opportunities for contracting, by open competition, for suchservices to be provided by enterprises outside of the direct control of a public entity. This couldapply to both core governance activities, as well as those provided by autonomous enterprises.The normal "Western" practice would be to allow the public sector "direct service" units toparticipate in the tendering, after being formed into quasi-independent "direct serviceorganizations." An essential feature of such re-structured units is the establishment of cost-accounting systems that are consistent with those of outside contracting entities, to ensure faircompetition. This arrangement often leads to the "internal" entities actually winning and performingthe contracts but with the added advantage of doing this under competitive conditions17. For such asystem to work consistently, it must result in improved productivity in service delivery – in thesense of more service for lower unit cost. Thus, opportunities must be present for the public sectorto save on costs – otherwise there would be no incentive to "contract out." It is, also, necessary forthe commercial enterprise to earn profits – otherwise, there would be no incentive to tender.Often, the savings and profits come about as a result of improvements in labor productivity.Whether or not this is always shared by workers, in terms of improved benefits, is often one of themore contentious issues. There is no shortage of examples of "contracting-out" where major"savings" to the contractor have been as a result of paying lower wages, with very few “fringe”benefits, to less-skilled staff, delivering a lower standard of service to the public.It is usually appropriate for "contracting out" to be approached gradually. Furthermore, it is oftenmost useful to divide work in such a way that it can be delivered by several commercial enterprises,in competition with one another. If this is not done, there is a greater potential for a singlecommercial contractor to develop monopoly power of its own. This, it can do by graduallydeveloping an incumbency position, especially by preempting the public sectors ownership ofessential equipment.For example, if the garbage-collection service were to be fully "contracted-out" by (say) a municipalgovernment to a single – or very few – commercial enterprises, these would, after a short time, ownall the essential vehicles, plant and disposal sites, leaving the enterprises with a significanttendering advantage18. This would inhibit competition, on equal terms, by other competentcontractors. It would also inhibit the return of the service to a restructured and more efficient localgovernment unit. A very well-known technique is possible, where a quasi-monopolist bids forindividual small packages of work. This is loss-leading: under-pricing the initial bid – to gain a16 Conditions normally acceptable for efficient contracting-out of services are listed in Annex 2.17 Much is currently written about the merits of competition. This is not a panacea either, because under certain conditions, itmay well create unacceptable quality for the lower prices. There may also be increased “economic externalities.”18 Indeed, this has already occurred. For example, Waste Management Inc. has gained a significant foothold in the industry,which it then chose to abuse, in collusion with its auditors (Arthur Andersen), by presenting falsified financial statements. 18
  20. 20. foothold – by using financial support from the bidder’s other operationsThere are other factors. The importance to a commercial enterprise of consistently winning thecontract could make it vulnerable to "trade union" type pressures from its own work-force. Theresult could be the shifting of most of the cost-saving advantages away from the public sector, intothe pockets of either workers or commercial enterprise shareholders.An additional cost, sometimes claimed in economic writings, is that referred to as "directlyunproductive profit-seeking." This postulates that the advantages of obtaining a complete or partialmonopoly on the delivery of public services makes it seem advantageous for potential contractors toemploy lobbying and other methods of influence. These are not all, or always, ethical. Indeed, theymay be illegal. These have social costs in themselves. Furthermore, to those who win – as well as tothose who fail to win – a particular contract, their expenses may represent a dilution19 of theintended tangible gain to the public by shifting some of the net benefit elsewhere in the economy.Finally, with "contracting out" the public entity often cannot divest itself of the ultimateresponsibility for efficient public service delivery. Thus, it will retain the risk that it will receive lessthan adequate service from its paid contractor. This, it will either have to remedy, at further publiccost, or else allow the public to suffer the inevitable shortcomings. In "Western" systems, theenforcement of either financial penalties or performance obligations against recalcitrant contractorsoften proves costly, time-consuming, contentious and ineffective20.One important cost of "contracting out," often overlooked, is that of contract administration. Theemployment of many individual contractors will pose different management concerns to the servicedelivery entity than those for its direct labor. The means to address these concerns need to belearned, gradually and by experience. As the learning process results in improved managerialproductivity, administrative costs of "contracting out" will gradually fall. However, if an increasingnumber of contracts are entered into, the overall administrative costs will, clearly, rise.As these costs, overall, become material, there will be an ever more urgent need for them to beaccurately and appropriately accounted for. Furthermore, in assessing the net benefits from the useof contracting, the extra administration costs must clearly be offset against the direct productivitysavings in service delivery. Thus, the net benefits will arise only after all contract administrationcosts are fully allowed for.19 This shift arises because there could be less real direct economic gain to the municipality and its public. Instead, there might be ashift of money to the lawyers, lobbyists, Mafia organizations, etc. who would then reap the related economic benefits. This contraststo original expectations of the "contracting-out" arrangements, whereby direct economic gains to contractors, after deducting losseswhich might be suffered by (say) direct public employees, would result in greater net benefits to the local public.20 For more on this, see: Allyson Pollock and David Price “The public pays the price when contractors pull out of projects” (© TheGuardian, Tuesday July 27, 2004). It includes the words: “The idea that PFI is a partnership between government and business looksa hollow joke, as private finance gets repaid while the public sector carries the extra cost of keeping services going and communitiessuffer. For all the political brouhaha about partnership, nothing can compel the private sector to ensure continuity of provision whilegovernment-backed compensation arrangements ensure that profits can be earned at little or no risk to investors.” 19
  21. 21. In summary, therefore, public entities should exploit opportunities for alternative methods in thedelivery of services and the performance of public activities. They should do so, however, not asseeking a panacea but with a prudent balancing of productivity improvements against risks,safeguards and administrative costs.Public Borrowing - Control and AllocationWhatever other financing methods are used, the financial resource requirements for public utilitiesand infrastructure will require significant borrowing. This will demand that attention be given, atthe highest level of any municipal or other public sector entity, to suitable systems of control andregulation of borrowing, throughout the entire financial management domain under its control.Prudent financial management predicates that all public sector borrowing, for whatever purpose andby whatever subsidiary public entity, be brought firmly under the control of the central financialmanagement function of the entity. Thus, the "Director of Finance" will need to take a leading rolein advising on the allocation of loan resources and on providing guarantees of loans raised by or forthe various entities. Moreover, it is a fundamental principle of democracy that only an electedcouncil or board21 may approve, by resolution, the raising of loans by a local government entity.This is of crucial importance when the borrowing is for services that will be wholly or mainlyfinanced from general revenues, including taxes. It applies whether these revenues are used tofinance the direct governmental functions of the municipality or – absent any ability or willingnessto cover costs from charges – as increases in public utility subsidies. This could be especiallyburdensome, for example, for new rapid-rail transportation systems.Pending the establishment of efficient and effective financial markets, it may well be necessary forcentral governments to establish or adapt a centralized financing entity, through which to channelall or most of its public borrowing. For example, there might be the establishment of (say) a "PublicWorks Investment Corporation."This could well be designed to function as a "Consolidated Loans Fund," or "Capital Fund."Alternatively, it could manage such a fund, in addition to other activities and obligations. Such afund would raise all public debt for the governmental, utility and infrastructure functions of thelocal governments, on whatever terms and conditions were available in the market place. It wouldthen re-package this debt, so as to lend to the various municipalities or operational entities. Thiswould be in exchange for obligations to service the principal and interest obligations, from eitheroperational revenues or budgetary allocations. For a particular entity, this obligation would need tobe undertaken in close consultation with the Director of Finance, to ensure that long-term chargeson general revenues be given priority over new expenditures, especially new capital expenditures.21 Sadly, in the UK for example, much public expenditure is now controlled by organizations such as the QUALGOs andQUANGOs, whose boards have NOT been elected. Often, they have followed the traditional British practice of being appointedfrom among what are sometimes termed “the great and the good’ of British society. Thus, among managements and boards ofdirectors, knighthoods and peerages abound! 20
  22. 22. There are now many situations where nations and communities are emerging from "planned" to"market" economies. For them, an important feature in re-structuring the debt-management functionof the municipalities or public utilities will be a shift of emphasis from an "allocative" approach to a"contractual" one. Lenders, in the public market place, must be assured that their debt serviceentitlements will be met in full and on time. Public service entities, in turn, must be aware that theywill be held ruthlessly accountable, from their annual budgets, for the full allocation of debt serviceobligations, either directly or through a "Consolidated Loans Fund." Indeed, such a debt-management approach will require that all parties view their debt obligations as virtually "notnegotiable."To facilitate the allocation of borrowing and other capital-financing resources against priorityprojects, it would be necessary to establish a centralized project appraisal capability. This couldwell be formed as part of (or as an adjunct to) the "Public Works Investment Corporation." It willneed to use criteria which will be established in consultation with (or prescribed by) the nationalMinistry of Finance. Indeed, even though the borrowing and appraisal activities may be carried outwithin the Investment Corporation, it will be important for the Ministry of Finance to exercise ameaningful oversight and audit function. This accords with its overall responsibility for theallocation of public funds, through the budgetary process. It also allows the Ministry of Finance tofulfill its role as a macro-economic manager of the nation’s resources.Although the appraisal of capital projects will require guidance, direction and monitoring from thecenter, the primary responsibility should gradually be delegated to the entities most directlyresponsible. The process will then form part of the overall planning, programming and budgetingcapability, which each service-delivery unit should develop for itself.Public Borrowing – Foreign Exchange RequirementsIn many countries, some of the capital financing requirements will need to be raised in foreigncurrency. These will likely be for the importation of foreign goods and services. However, if acommunitys domestic resources are inadequate to meet its infrastructure needs, it may be that partof its future borrowing – or its equity financing – even for locally procured goods and services, willcome from foreign sources.In either case, a communitys contractual obligations, with respect to its debt service, will extend tothe foreign exchange requirements. In particular, if the value of the local currency deterioratesagainst the foreign currency of any loan, more local currency will be required to finance the debtservice. Public sector activities will likely make significant indirect contributions to the earning offoreign exchange. For example, infrastructure improvements will facilitate both foreign trade andtourism.However, in practice, these activities will not generate foreign exchange directly. Thus, it will benecessary for the debt servicing entities to have access to foreign exchange earnings of thecommercial sector. This will either be by contracts with commercial enterprises or – more likely – 21
  23. 23. through the national banking system.Public Borrowing – Financial MarketsTo ensure the most economical raising and use of public funds for infrastructure development, itwill be necessary for financial markets to develop and sustain a significant capacity for the raisingof funds. A large proportion of this funding will likely be in the form of bonds, rather than equity,consistent with the likely wish of many public sector entities to retain effective ownership in thehands of government.A most important feature to develop in the financial market, for both public sector and commercialfinancing, is that of trust. Investors must develop confidence that borrowing entities have thecompetence, sincerity and reliability to service their debts. This means that the financial marketplace must be provided with reliable information, which can be so assessed by independent bodies.These will comprise the regulators of the financial markets, as well as those with a fiduciary duty tothe investing public, such as auditors, underwriters, issuing houses and rating agencies. Suchbodies, where not already existing in adequate form, will need to be established, upgraded orimproved.As already indicated, the sums needed to finance the services and infrastructure of manycommunities are formidable. Thus, the development of the quality of the administrativemanagement of the financial market place will need to be matched by an adequate expansion andsustainability of its capacity to raise the required sums of capital.Investment Financing – The Competitive EnvironmentCompetition for investment capital will largely be based on perceived risk and return. For publicsector bond issues, this will depend upon the interest rate, combined with the reliability and qualityof the expected revenue earnings. These, in turn, will be based on either the expected operationaland financial performance of the borrowing entity or the underlying strength of the local(municipal) taxing structure. Thus, sound pricing and taxing systems will be essential, in thepromotion of bonds and other capital financing instruments. Also, there will be competition forfunds from commercial activities. This may be significantly oriented towards equities. Moreover,for potential private investors in emerging economies, it might well be that their interests will liemore towards the opportunity for making fast profits than for longer-term goals. This situation maybe reinforced by the fact that, under currently sustained social safety nets, investors will perceivethat their basic long-term needs are provided for22. Discretionary funds may therefore be morewillingly channeled into "glamour" security issues, albeit for more fickle purposes than fordevelopment of infrastructure. The latter, by contrast, may be considered, in the short term, dull anduninteresting as backing for security issues. Also, the commercial market place will not always22 This has a parallel in the U.S.A. There, it is claimed, federal insurance of the funds of depositors of "savings and loan associations"permitted a degree of public indifference towards reckless use of such funds by their unscrupulous or incompetent managements. 22
  24. 24. provide more economically efficient alternatives to public sector activity23. It is, unfortunately,highly speculative. The combination of empty offices and deteriorating public infrastructure in (say)the U.K. and U.S.A. is a current testimony to this, especially when there is so much consumerspending on trivial distraction, entertainment and amusementIt may well be important, therefore, for national and local governments to embark upon programs ofpublic education, to encourage potential investors to channel funds towards public utilities andinfrastructure. The costs of such a campaign might well be offset by the refinement of interest ratesfor public borrowing and the greater availability of funding. Both will bring net economic benefits.It is equally important to note that, in a market-friendly environment, the allocation of investmentresources will be through investor perceptions of risk and return. Failure to recognize this, resultingin a return to a process of political allocation, will result in long-term economic inefficiency and asignificant reversal of any economic reform principles.Resource MobilizationCompetition for funds will not be only among opportunities for investment. As nations andcommunities move further towards a commercial environment, investment demands will competeagainst consumption opportunities, for both commercial and publicly provided goods and services.This may be all the more pervasive as an emancipated public seeks for immediate satisfactions, inthe form of increased enjoyment and reduced suffering – of both inconvenience and privation.These attitudes, combined with the availability of savings, will determine how much funding isavailable for the different claims of public, commercial and private sectors.An important aspect of resource mobilization, as well as mitigating demands on general publicrevenues, will be through the use, where possible and appropriate, of economic efficiency prices,such as for public utility services. An essential part of any public information system will be toencourage the economic signals to be given by prices. In other words, a most effective way to getthe attention of the public will be to charge full prices for services. The only significant opportunityfor coercion, in these circumstances, is that common in all market or controlled economies –adjustment in the level of taxes. Local taxes will need to be set high enough to cover all recurrentpublic expenditures, including the service of debt. Chosen levels, of taxes and charges, will havepolitical and economic limits on the public capacity to bear them. This will also affect the level ofcapital investment.Public Sector Financial ManagementThe economic reforms undertaken in many countries, especially those of Eastern Europe, will likelylead to: a. a tightening of the allocative process;23 A significant market failure in this respect is that quicker private profits may often bring much higher investment returns thanthe more slow and ponderous – but eventually more enduring – public infrastructure improvements. 23
  25. 25. b. a need for fuller public information to support investment financing; c. increased importance of financial reporting, accountability and control; and, d. greater participation by citizens in the conduct of public affairs.These will require much greater attention to financial management. Thus, accounting, auditing,budgeting and financial control practices will all require enhancement, throughout thegovernmental and operational entities of all communities. A key factor is to introduce a budgetarysystem that separates capital expenditure (and its financing) from recurrent revenues andexpenditures.Providing for improvements in overall accounting and financial management systems will benecessary ingredients in a more transparent and open system of accountability for stewardship offunds and performance of activities. However, more is required. Directors of finance must alsoconcentrate on development of management accounting information, for all public sector activities,whether providing revenue-seeking or tax-borne services. It should be a responsibility of thefinance department to organize and arrange flows of financial and other information to theoperational units, so that their managements may make better-informed decisions24.This does not necessarily imply a centralized accounting or financial information system. Inorganizations of the size and diversity of large municipal governments, this is clearly inappropriateand inadvisable. What it does imply, however, is that finance departments retain and enhance theircapability to hold the operational units fully accountable to the community as a whole.To achieve this, in a decentralized system, requires the development of appropriately standardizedprocedures that are still flexible enough to allow for the individual operating characteristics of thedifferent entities. It will be important that a director of finance provide guidance, support,instruction, training and some degree of control to operational units, to facilitate both accounting fortheir managements and overall fulfillment of reporting requirements, to the municipality and itspublic. Also, training programs of finance department officials should include secondment tooperational units.One feature of management accounting for decision-making is the use of "life-cycle-costing."Currently, many assets, such as buses and other operational vehicles, are required to be used for lifespans determined by governmental edict. Often, this has proven to be far too long for economicoperation, typically because of high repair costs in later years. Introduction of life cycle costingwould draw attention to a need to scrap or dispose of assets when their continued use is no longereconomic.24 A comprehensive textbook on these various aspects of accountability is "Municipal Accounting for Developing Countries" byDavid C. Jones (© Chartered Institute of Public Finance and Accountancy (UK) and World Bank – 1982). 24
  26. 26. The use of management accounting will also provide information about the use of appropriatetechnology. For example, one can often be impressed by laborsaving achievements observed in(say) U.S.A., Japan and Western Europe, through the use of high technology equipment. Theintroduction and development of appropriate technology should be encouraged everywhere.However, there is no assurance that the same blend of capital and labor, as used elsewhere, willautomatically be the best for a particular country or – more specifically – for an individual localcommunity. 25
  27. 27. Planning, Programming and BudgetingGovernmental and operational entities should be encouraged in the use of appropriate proceduresfor planning, programming and budgeting of their activities, within the framework of an overallperformance budgeting approach. Arrangements are also required for both tactical and strategiccash management, including the overall management of debt.It is important, for these procedures to reflect the predicted economic, physical, spatial, commercial,fiscal, population and social changes, especially significant growth or decline. Attention must alsobe paid to financial commitments that a municipal government - or any of its entities - will be"locked into" over significant time-periods. This would include debt-service and unavoidablesubsidy obligations.Public Utility Pricing and SubsidySome public utilities operate as natural monopolies, at least in the short term. To optimize theeconomic efficiency of their operations, and limiting demands upon scarce general revenues, allsuch entities, wherever possible, should be encouraged to charge economic efficiency prices. Theseshould be consistent with full-cost recovery of economic resources and coverage of all financialrequirements. Thus, in principle, public utility companies should set charges which are intended tocover operation, maintenance, depreciation (at current values) and a real return on assets, valued incurrent prices. The entities should also be required to generate funds from operations to cover debtservice and to contribute towards expansion of facilities and plant.Where claims are made for subsidy, on grounds of economics, welfare or financial hardship, theseshould be carefully evaluated. They should, however, be allowed only where fully justified and canbe implemented in an efficient manner. In general, the overall subsidy of service delivery systems isvastly more inefficient than the individual subsidy of deserving consumers. Where used, it is oftenbecause the individual consumers cannot readily be identified, evaluated and compensated.Moreover, the service characteristics should be conducive to a reasonable assurance that targetedconsumers are most likely to benefit. Sometimes, because of administrative costs, the perfect is theenemy of the good. The principal justification for subsidies to entities lies in cases where there arehigh transaction costs, uncertainties or resentments in directing them to individuals. This mayapply, for example, in the administration of "means tests."This concern applies to both economic efficiency and equity considerations. If care is not taken, apoorly directed subsidy may merely mean that the more profligate (and likely better off) consumerswill (at standard unit prices) receive the highest cash subsidies.The situation is different where the direct recipient of the service is not assessed as the sole, orprincipal, beneficiary. This is an argument sometimes applied, for example, to rapid rail systems,with respect to the diversion of road congestion, accident risk and air pollution. It is, however, evenin this case, still very contentious. Moreover, even when there is broad agreement on the economic 26
  28. 28. principles, there can often be serious disagreement about the extent and amounts of subsidies.To the extent that either publicly owned or commercial enterprises are in a position to chargemonopoly prices, there should be provision for the regulation of such prices by independentnational or local government agencies. These should have the power to over-ride both the politicalagendas of government and also the pure profit-seeking agendas of the enterprises, after holdingpublic hearings on all applications for price adjustments. However, many witnesses seeking to beheard at such public hearings are less likely to be in favor of socio-economic-efficiency pricing thanin imposing their private agendas, or those of their interest groups. Thus, it may well be found thatthe role of an independent regulator must be to ensure that prices are set at levels which are highenough to fully cover costs, as well as to ensure that legitimate equity considerations are dealt withfairly.Land ManagementA major asset, available to many developing cities, is the ownership, control or management ofsubstantial public land. This can be exploited in a variety of ways, for the purpose of financinginfrastructure. Increasingly, such land will be subject to activity based on commercial valuations.Sometimes, much of the land required for infrastructure development may already be in publichands. This results in significant potential savings, or financing opportunities, over situations foundelsewhere, with the majority of required land in private ownership. The more that public landincreases in value25, the more savings accrue to the public sector, in terms of the opportunity costs(or benefits) of its acquisition or disposal. In addition, there are notable savings in the transactioncosts of land acquisitions, especially where this might otherwise involve compulsory purchase. Fordirect funding purposes, receipts from the sales of public land, not required for municipal purposes,can be used for related infrastructure costs. As alternatives to receiving all sales revenues in cash,contracts can be made with developers to provide a part of the sales price in the form ofinfrastructure.Prime development land is sometimes located in the vicinity of significant public infrastructure,such as a river bridge or a metro station. In such a case, it becomes possible for a developer toaccept a parcel of land, at no cash cost, in exchange for the construction of the entire publicinfrastructure. The rest of the land can then be used for commercial facilities, for the developersown benefit. Where such exchanges take place, it will be important for them to be properlyevaluated and accounted for. As indicated, such one-time sales or exchanges should not be regardedas recurrent revenues. Cash proceeds not immediately used for development should be reserved forfuture capital expenditures.A feature of the final disposal of land – whether in exchange for infrastructure or not – is that itrepresents the disposal of claims to future revenues from this land, with the exception of property25 This is particularly important where such public land is derived from abandoned or curtailed activities. Examples occur where landoccupied by railway yards, shipping or military interests is no longer needed for its earlier purpose. Often, it has become derelict andunattractive, as well as having no public facilities and infrastructure suitable for new development. Thus, its initial value is very low. 27
  29. 29. taxes26. It will kill the goose that lays the golden eggs! Thus, the prudence of land disposal – and ofits extent and timing – will be influenced by the financial needs of the local government and itsentities. This is another reason for careful matching of budgetary requirements to overalldevelopment activity.An important point is that as future real land values increase, rents – in real terms – can be adjustedto allow for this. Sale prices, by contrast, are fixed on a "once for all" basis. In the absence of a fullydeveloped land-price information system, it might well be found that early disposal of land is – inreal terms – under-priced. This would represent a partial gift to the purchaser, who is, effectively,purchasing the present value of all future real land rents.Where land is not disposed of by final sale, it will, of course, continue to yield rents to its publicsector landlord. These, along with other revenues, will be available to the general (recurrent)revenue pool to finance debt service. Where the local government (or a development authority) hasthe power to grant planning (zoning) permission over privately-owned or rented land, this might beaccompanied by a requirement that the owner (user) provide some degree of public facilities, inexchange for the valuable (monopoly) development right27.This cannot, however, be pressed too far. First, an excessive demand, causing a potential loss to thedeveloper, will cause a backing away from the whole enterprise. Second, the local government ordevelopment authority may sell land, with planning permission already included in the price. Toavoid disputes, it is important for the seller and the purchaser to be certain whether or not this is thecase.In some cases, a municipality (or one of its entities) will own land rights in connection with theoperation of public facilities. An example would be the air rights over a "metro" or mainline stationentrance. These rights can, of course, be leased to developers to help cover the costs (or related debtservice) on the principal facilities. The extent of this will be facilitated or curtailed, for example, byregulations regarding building height. Finally, when land is in the hands of commercial enterprisesor is privately owned, it can be subject to property tax, either on the land alone or also onimprovements.Even land owned by public sector entities should be subject to tax. This is not, usually, to bring inadditional revenue, although the setting of public utility prices, to cover such taxes, will do just that.What the taxing of public facilities does achieve, however, is to militate against distortions withinthe allocative process of the public sector. In particular, it will prevent hidden subsidies to (say)public utility enterprises that own substantial real property. In addition, taxation of public facilitieswill indicate the extent to which revenue is being foregone, by retaining them within the public26 Even these may be curtailed or postponed if the land is part of an "enterprise zone." Property taxes may then not be collected forseveral years into the future, to encourage developers to risk new activities on the land.27 This is known, in the U.S.A., as an "exaction." Sometimes, state or local law forbids this. In such case, developers typically makeoffers to provide public facilities, then known as a "proffer." In Britain, authorities have had, until recently, very limited scope tosecure developer contributions for infrastructure. The "Planning and Compensation Act 1991" changed that position dramatically.Developers can now be made to bear the costs of infrastructure and community facilities, as a condition of being granted planningpermission. 28
  30. 30. domain.Environmental AccountingIncreasingly, it will become necessary to provide in the accounts of public entities for potentialcosts to remedy current environmental degradation. This may arise from technologically inefficientoperation of current service delivery. For example, if a sewage treatment works is operating withoutproducing adequate effluent quality or disposal of sludge, this may create costs to be incurred in thefuture. 29
  31. 31. To the extent that these are only delayed – but eventually inevitable – they resemble future "debtservice" on current "borrowing." Another example would be future closing costs of currentlyoperating garbage disposal sites. In this particular case, it is ecological, rather than financial,borrowing. However, the future resource demands, from either charges or taxes, will be virtuallyidentical. Tightening of environmental standards will – as a direct outcome – increase the costs ofsuch ecological borrowing.Necessary ImprovementsThe means to achieve economic development and reform do not necessarily, or principally, lie inthe restructuring of institutions. Furthermore, many of the activities to be undertaken by themunicipal governments or development authorities will have to be coordinated with manydepartments, agencies, bureaus and commissions of a central or state government. Indeed, policiesof institutional reform and restructuring, including privatization, should be evaluated not only withregard to a set of given objectives but also in terms of how those objectives might be achieved inalternative ways.For example, the conversion of (say) a municipal water company from a publicly ownedcorporation to a commercially owned one may be less important than a rationalization of its pricingstructure. If the latter can be achieved under public ownership, institutional change might not benecessary, appropriate or desirable. However, the public authorities should not use this furtheropportunity for reflection as merely a means to validate current practices or excuse itself from theneed to take effective actions. A great deal of institutional, administrative, financial and operationalreform must often be undertaken. In addressing overall goals of reform, as contrasted with specificactivities or reorganizations, the following should rank as among the most important: a. mobilization of resources for both recurrent and capital expenditures; b. identification, exploitation and implementation of alternative methods of infrastructure financing; c. improvement and consolidation of debt management; d. overall management and administrative efficiency; e. economy, efficiency and effectiveness in the delivery of public services; f. where appropriate and feasible, recoveries of full costs of service from direct users, by economic efficiency pricing; g. introduction and use of appropriate technology; h. use of "market-friendly" approaches in the procurement of the factors of production, 30
  32. 32. in the form of goods and services; i. limitation of otherwise unconstrained demands upon the general revenues of the public budgets; and, j. maximization of the operational autonomy of entities, consistent with optimal accountability for both stewardship of resources and performance of activities. Finally, as much of the activity under the control of public entities is clearly concerned withgovernment and public service delivery, it is essential that their activities be (and be seen to be)consistent with the prevailing political agenda. 31
  33. 33. FINANCIAL, ECONOMIC AND SOCIAL IMPACTS ON LOCAL COMMUNITIESCommunity Balance Of Payments (1)Within the overall national and international economy, a local community must either sustain itselffrom its own production and exchange of satisfactions or else be supported by transfers fromelsewhere, usually governmental. If neither of these occur to a sufficient extent, the communityseconomic and social structure will deteriorate. This will often leave in its wake a declining physicalinfrastructure and derelict buildings, together with a discouraged and increasingly disadvantagedpopulace28.The oft-perceived, though commonly simplistic, remedy is the creation of more job opportunitiesfor the local populace. This can be sustained, however, only by the maintenance of a substantialbalance between financial flows of funds into and out of the local community. This concept ismore intuitive than statistical, because economic data gathering does not normally encompass adetailed analysis of this type, by individual communities. It is made more difficult, indeed virtuallyimpossible, by the concern of making distinctions as to what constitutes a community29. However,for each development decision or strategy, it should be possible to assess (or at least to intelligentlyspeculate) some of the local "balance of payments" effects. Even an educated guess as to the likelydirection of net incremental funds flows will be of decision-making value. This can be done only ifall the principal flows are examined. They can then be used, refined or discarded, depending ontheir reliability and the concerns to be addressed.Commercial activity will bring inflows of funds to a community (from community non-residents) asa result of: (a) external work locations; (b) remitted earnings from outside the community; (a) tourism within the community by non-residents; (b) local taxes; and, (c) investment earnings by community residents (including rents) from financial markets and assets elsewhere.28 For a detailed explanation of these effects – and the need for commercially viable remedies – see "The Competitive Advantage ofthe Inner City” (11/1/94) by Professor Michael E. Porter of the Harvard Business School. 29 It is important not to be misled into a perception that the funds are flowing though a particular official entity, such as the localgovernment unit or a particular bank. They are not. The balance of payments is an assessment of the net flow of funds - if it could bemeasured – for all community transactions with the outside economy, arising separately and independently in the normal course ofpersonal, commercial, and governmental activity. These will include (but not wholly comprise) payments to and by banks andgovernments. Even transfers between different branches of the same government entity or commercial enterprise are included. 32
  34. 34. The same kind of commercial activity will also bring about outflows of funds (to community non-residents) as a result of: (a) purchases of goods; (b) services by non-residents (including outside residents commuting to local businesses); (c) remitted earnings by non-residents from local businesses; (d) external tourism by local residents; and, (e) investment earnings (including property rents) by non-residents in local financial markets or on local assets.Other outward funds-flows will likely arise from local taxes payable by residents to other than thelocal government (e.g. state and national taxes) and by welfare and subsidy payments out of thecommunity. For working communities, whose retirees move elsewhere, there may well be netpayments for pensions, to non-residents formerly working locally. Were all these transactions offset(in practice they are – it is just difficult or impossible to measure them!) an assessment could bemade of the net current balance of the community. This would be the net amount owed, relative tothe local community as a whole, by or to the rest of the economy30.Community Balance Of Payments (2)The first stage of any assessment of a community balance of payments will only show the netcurrent balance. This is the result of the day-to-day transactions among business, household,government and utility entities. As the net balance relates, by definition, to claims against futuresatisfactions (goods and services) it must be held in some form until these future satisfactions areprocured and paid for.The second stage of the community balance of payments, therefore, deals with capital transactions.These are not of a day-to-day nature. Instead, they result in some form of longer-term saving,investment, financing or borrowing.30 A dramatization of this concept might help. Suppose all transactions to be in cash. Further suppose every member of a localcommunity to have settled their accounts with one another and then brought to the "community hall" all their remaining invoices ormoney earned from transactions with those outside their own community. Using the available money to pay the invoices, all nowowed to outside parties, what remains would be a smaller quantity of either invoices or money. If money, it would be the local"balance of payments" surplus, on current account. If invoices, it would be the current deficit. The money would represent anincreased claim on the rest of the nation or the world for its future goods and services. Invoices would be a claim by the rest of nationor the world on future goods and services of the local community. (The local community might well be in a muddle about whosemoney had paid which invoices. This, however, would not be a balance of payments concern. It would be one to be resolved entirelylocally. Indeed, official national balance of payments statements usually include large components for "errors and omissions.") 33
  35. 35. If the community accumulates a current surplus, this will facilitate the participation of its residentsin: (a) purchases of property from non-residents31; (b) repayment of loans, earlier granted by non-residents, or non-resident financial institutions; (c) withdrawal of capital from local businesses by non-residents, perhaps (though not necessarily) being replaced by local capital32; and, (d) capital investments or loans by local residents and businesses or capital grants by local governments, all to non-residents or non-resident entities.If the community accumulates a current deficit, this will need to be covered by the participation ofnon-residents in the making of capital payments to resident households, businesses, governments orpublic utilities, for: (a) property purchases from residents33; (b) repayment of loans earlier made by resident financial institutions; (c) infusion of capital into local businesses, perhaps (though not necessarily) replacing local capital34; and, (d) local capital investments or loans by non-residents, or locally-used capital grants, by outside (e.g. national or state) governments.Community Economic ResultsA balance of payments for a local community deals only with flows of funds. It does not directlyaddress the economic activity to which the funds relate. Thus, it is possible for a local31 For balance of payments purposes, it is irrelevant whether the property is located within or outside the local community. Itspurchase will absorb local cash, equal to its price. What is important is that the vendor be a non-local-community resident.32 Local capitalization of local business is not a balance of payments activity. Thus, to the extent that external business capital is notreplaced by local capital, the affected businesses will be de-capitalized. If they are over-capitalized already, this could be anadvantage. If not, activities might have to be curtailed.33 For “balance of payments” purposes, it is irrelevant whether property is located within or outside the local community. Its purchasewill provide locals with cash, equal to its price. What is important is that the purchaser be a non-local-community resident. Ananalogy is that the US accumulated current balance of payments deficit is supported, to some extent, by holdings of US property byforeigners. However, a US balance of payments deficit could be (partially) covered by the sale of London (physical or financial)property by a US resident to a German resident.34 Local de-capitalization of local business is not a balance of payments activity. To the extent that external capital does replace localcapital, the affected businesses will be further capitalized. If they are under-capitalized already, this could be advantageous. If not,activities might be expanded. This would be an advantage only if there is potential increased demand for the local product. 34

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