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  1. 1. CAPITAL INVESTMENT PROGRAMMING AND ITS FINANCIAL IMPLICATIONS Budgeting and Financial Management for Local Government April 2000 David 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 & Management Graduate School of Design, Consultants Harvard University, 4936, Andrea Avenue, 48, Quincy Street. CAMBRIDGE. Annandale, Massachusetts Virginia. 22003. USA Tel: 617-495-4964 Fax: 617-495-9347 Tel: 703-978-8564 Fax: 703-978-8014 E-mail: E-mail: CAPITAL INVESTMENT PROGRAMMING AND ITS FINANCIAL IMPLICATIONS
  2. 2. BACKGROUND AND FINANCIAL FRAMEWORK General Capital Investment Programs are usually thought of as building things. This includes: development of land; erection of buildings; installation of roads, bridges, pipes and other infrastructure – 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 be concerned to build and install, as rapidly as possible, the infrastructure and other fixed assets perceived to be urgently needed. They, after all, have the primary expertise for this task. A principal limit on the pace and magnitude of their work is, clearly, financial resources. A capital investment program, therefore, is an opportunity for prioritization of fixed asset implementation activity and the related access to urgent and important funding sources. It will also show how the vision and operational strategy of a community is reflected in the program for capital expenditures Because of the very large Capital Investment Programs (CIP) to be financed, failure to consider the availability of funding could give rise to an undue sense of urgency. That might engender a disregard for the need to carefully examine each project component with due diligence. It is important, of course, to ensure that the necessary funding will be available, in full and on time, as and 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 and also the impact of these on recurrent finances, together with costs of operation, maintenance and administration. Also to be considered are the costs of replacement or rehabilitation of equipment that will not continuously serve with optimum efficiency, or even become unserviceable, during the life-cycle of the principal project assets. Analyses will need to allow for expenditure in later years to be discounted against earlier expenditures. It is also important to take account of the extent and timing of revenue flows from the use of various infrastructure items. Some components, such as water supply, will provide immediate individual benefits and may well be connected with optimum promptness. 2
  3. 3. Others, such as sewerage, provide benefits that are only partially directed to individual households. Some benefits accrue to the community as a whole. They are also more diverse and less immediately obvious. It may be that there will be a greater reluctance by individual households to connect to the system. Solid waste services also exhibit some of the same characteristics. Sometimes, financial revenues may still be collected, by levying charges whether there is a direct household service or not. However, this may well be contentious, especially for sewerage. For example, households that can ill-afford this may need modifications to internal plumbing. Moreover, lack of connection will likely have technical shortcomings. Low flows will potentially harm the sewer pipes, while a lack of connections will limit public health benefits to the wider community. Some infrastructure, such as roads and drainage, will likely provide benefits that are of a general public nature, rather than to individuals. Road improvements1, moreover, are likely to improve the 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 engendered from: buoyant increases in the tax bases; politically acceptable and administratively sustainable increases in the tax levies; or, reductions in other tax-borne expenditures. The last- named would need 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, they have financial and economic effects beyond the scope of the individual projects. They impact upon the entire financial framework of the local government unit, and way beyond it, to other entities. Engineering specialists should, therefore, work closely with financial colleagues. This will provide greater assurance that appropriate costs are budgeted and accounted for, in ways that will be both credible for reporting and useful for effective action. Most importantly, these are policy issues. Cost Recognition The 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 provision of funds to operate and maintain these. Certainly, cash-flow management is important, for a variety of reasons. However, other than by blind coincidence, "cash-flow," is unlikely to be synonymous with "cost." Cost definition cannot be meaningful unless based on economic principles. Therefore, it should relate as closely as possible to the concept of resource consumption, rather than to the mere receipt and payment of cash. It should also incorporate, where possible, recognition of the recovery of capital costs. 1 These need not be major or massive improvements. Sometimes, improved access to pedestrians and non-vehicular transport can bring notable economic and social benefits, relating to access and egress at awkwardly located spaces. 3
  4. 4. Therefore, costs – in terms of resource use – of any business or public activity 2 should include properly 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 the budgeted activity costs would also allow for an additional (albeit small) "surplus," over and above the expected and reasonable costs of capital. This would allow for periodical fluctuations in financial fortunes, more specifically: risk; uncertainty; new activity; and, longer-term stability. Return on Investment Included 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 economic principles. Thus, the interests of owners (shareholders) are reported as the earnings (profits) after 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 2 This concept is referred to elsewhere (e.g. in a set of training slides) as “OMAR’S CAR.” It reflects that the COSTS of any business 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). 4
  5. 5. "normal" profits are no more than a part of the "opportunity cost of capital." Only extra-ordinary earnings are typically regarded as true "profits." This is somewhat analogous to what is described as "surplus" in the above set of distinctions3. Furthermore, the standard practices of financial analysis deal explicitly with costs of capital, the return on total net assets, as the weighted consolidation 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 in the past typically been standard practice for state and local governments to finance up to and including 100% of many items of capital expenditure by the borrowing. This usually had amortization 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 than debt5, the funds used for this purpose still have an opportunity cost. Indeed, the financing of capital expenditure from general government revenues (local, state or central) will do one of two things. Either it will add to the overall "deficit," which will have to be borrowed, with interest, or it will eliminate some part of the overall "surplus," which will create a loss of interest on the related monetary investment. Even if the deficit is covered by increased taxes, the taxpayers (effectively the "shareholders" of the government) will (collectively) lose the equivalent in interest on what would otherwise have been their own money6. They will also forego the use of the principal sum. The issue of cost definition has been fully stressed and explained because it forms the basis against which all related aspects will need to be assessed. For example, it affects, or is affected by: cost accounting systems; prices; allocation of overheads; budgetary management; fiscal deficits; maintenance of assets; and, inter-governmental transfers. Costs of service cannot be credibly 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 costs of these are determined. Furthermore, cost recognition, to be consistent, should relate to the maintenance, use and consumption of resources and not to the manner in which these resources are 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 are ultimately 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, in that 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 capital assets. Then, when these become pervasive, it is necessary to “shop around” for capital funding from constituent governments. An August 2004 press article, indeed, refers to “Urgency Drives New Metro Pitch for Funds.” 5
  6. 6. An example of the presentation and use of financial statements, incorporating full accounting for resource 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 Accounting in Great Britain” and the “Statements of Standard Accounting Practice” (SSAP) required by the Chartered Institute of Public Finance and Accountancy and other UK professional accounting bodies. These include stipulations for full accounting of all fixed assets, irrespective of the method of financing. It includes imputed rental, depreciation and interest costs, where appropriate at current (replacement) values. Government Grants Central governments, of many other countries, are attempting to encourage and support activity by the local government units. This includes activity that it favors or for which there is some clear justification on national grounds. However, the prime responsibility is, increasingly, that of the local government units. A most important means of financial support by the central government of local government units 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). 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 8 These statements are available separately. 6
  7. 7. a particular area, it may also be one of the most important commercial centers, with a great deal more economic potential than elsewhere. Thus, there might be a strong economic or equity- based case for a net transfer of resources away from the area, in favor of much poorer areas9. Capital Grants Grants may be given towards specific capital projects or to support recurrent operations. In principle, capital grants have a distinct disadvantage. They will tend to support new capital schemes, perhaps too soon, too large or even not justified at all, instead of encouraging the continuance of a service using existing available equipment and infrastructure. This is very serious in any country where capital resources, especially in foreign currency, are scarce and thus costly. Faced with a choice of spending its own resources on maintenance or getting a grant for new capital investment, a local government unit may be strongly tempted to opt for a capital grant. A more appropriate financial support for capital expenditure would be a loan, for the life of the new asset, 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 the old (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 no decent infrastructure to begin with10. Second, there is no reasonable supply of market-driven medium-term or long-term capital. Even if there were, there is no satisfactory mechanism to administer it. Third, many local government units lack credit-worthiness, at least until revenues are greatly stabilized and enhanced. Finally, with the meager and uncertain financial resources available to the central government, capital grants at least represent one-time payments for which there 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 makes good 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 other centrally-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 the new infrastructure, there may be a case for declining annual interim central government support towards this expenditure. 7
  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, giving preference to areas of greatest need and with the poorest resources. Where used, they will almost always represent a proportion of an approved capital cost, after careful examination and appraisal of 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 that apply to all similar and relevant circumstances. This suggests that the central government ministry responsible for local government should try to develop an improved capability for project appraisal. This could provide significant assistance to local government units in planning their development, even without grant support. Recurrent Grants However capital expenditure is financed or supported, there will usually be some need for continuing 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 with recurrent grants from state or central governments. Some of the methods to be considered for the administration of a recurrent grant system are set out below. However, it must be realized that, at present, many would need to rely upon statistical information 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; (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 8
  9. 9. 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 of them may be chosen for practical use. 9
  10. 10. STRATEGIC PLANNING FOR CAPITAL INVESTMENT Introduction When looking at a strategy for a Capital Investment Program, it might be well to remember some words 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 the various concerns, constraints and opportunities inherent in any community can lead to very serious shortcomings. This is especially the case with capital investment programs, because of the large expenditures, the significant consumption of space and time and the specialist and often single-purpose nature of the assets installed. Even in the physical sense, there are many, many, linkages. New buildings need new investments in roads, footpaths, surface drainage, water supply, sewerage, electricity supply, and telephone services. All of these infrastructures, if already at capacity use, will need to be either developed or 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 and activities 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 have occupants. Thus, there will be a need for shops, offices, schools, theatres, parks and many other developments 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 transport systems will be needed. It might be argued that almost everything in a community is concerned with transportation, in one form or another. Indeed, one way of perceiving a community is as a giant transportation system: for people, goods, services, information and waste products. At least two other concerns will 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 sprang up, in the middle of the night, so to say. Every community is coming from somewhere. It has history, traditions, heritage, habits and prejudices. Many of these are reflected in the buildings and other structures, some very beautiful, some quite ugly. By consensus among residents and with pressures and influences from outside of the community, some of these structures will be preserved; some will be destroyed or significantly altered. Change is inevitable and continuous. Change is the motivator for the other concern. That is the need for vision. Someone, or a small group of people, must have an idea about where the community is going. What will it become? 10
  11. 11. How will its residents behave? What might have to be done to influence, sustain or curtail this behavior? How intrusive, coercive, supportive, permissive, benevolent, helpful, officious or charitable should be the collective governance system? How reliant upon the free-market or how tolerant or corrective of market failure should it be? Reaching consensus, even on a single issue, is difficult. Reaching consensus on a whole range of community issues often seems nearly impossible. The mechanisms for doing this, even at local level, are by their nature clumsy and inefficient. Full and free citizen participation must be matched with constitutional rights, legal requirements and effective government. Individual concerns must be tempered by sensible and efficient governance, planning, management and service delivery. All of these concerns form a background to strategic planning, as a precursor to the establishment and timing of a capital investment program. A major constraint will be that of finance. Indeed, as explained later in this document, if a capital project cannot be financed, it cannot be implemented. However, from a strategic perspective, one must examine not only whether an individual project can be financed but also whether all of the financial implications of its implementation can be efficiently coped with. For example, if there is enough funding for a water supply extension, will there also be enough to deal with the inevitable increase in sewage disposal requirements? If so, will the potential adverse impacts on the environment be overcome. Finally, if sewerage is to be installed, it might require substantial and costly modifications to the internal plumbing of residences and other buildings. Unless this is affordable to the owners, the sewerage service will not be able to operate properly. Consequently, some understanding of the ability and willingness to pay, even for the private parts of the service, is necessary. Strategic Planning for Activity The management of a local government unit, or of almost anything else, will need to deal daily with 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 impact on the others. Each will create predicaments, which will need to be addressed in some way by the management. There are, perhaps three main reactions that can take place. Firstly, the managers may decide that they have no concern to deal with. This may be because it is beyond their mandate or contrary to their 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. Secondly, the managers may decide that the provocation is the responsibility of the local government unit to deal with, as a concern. It comes under its mandate and is addressed by its 11
  12. 12. policy. 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 people involved or affected by it will continue to suffer. Finally, the local government’s management may decide that the provocation creates a predicament that the local government will address, at this time. It comes under its mandate, it can be dealt with under its policy and is accepted as a concern. Therefore, it must follow that there 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 held accountable is activity. For example, it might be very interesting to know: what the mayor of a city thinks about a new water supply system; what a public works director feels about the road maintenance program; or, what a chief financial officer knows about accounting. However, what they will be held accountable for is what they do about these concerns. In other words, they are accountable for their activity: signing a contract for a water supply system; repairing potholes and other road damage; or, publishing a set of financial statements. Under the concepts of activity-based management, only activity can be budgeted, costed or held accountable for. Thoughts, ideas and concepts, however profound, do not find directly find places 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 in tactical and strategic terms. From a tactical perspective, the purpose should indicate clearly and directly how the particular activity is expected to achieve it. From a strategic perspective, the purpose should indicate what it is that the activity, together with its tactical purpose, is expected to contribute to the wider vision, goal or perspective. In some respects, this is similar to the distinctions drawn between outputs and outcomes. The Vision Outputs achieve tactical purposes. Outcomes achieve strategic purposes. It is, typically, the outcomes that relate to the visions of those with the wider views on policies. For example, for the London Docklands Development to have succeeded, as it has done substantially to date, it is doubtful 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 collection of 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 and transformation of this. Therefore, it was sometimes said that one of the first managers of the project had: “Both feet firmly planted in mid-air!” This encapsulates what is often meant by – and needed – as vision. 12
  13. 13. Purposes, Outputs and Outcomes When purposes have been established, resources must be assembled. These must be organized to work efficiently. Assessments need to be made about the time-span of the activities and also their spatial coverage. With capital development projects, rather than programs of operational activities, one is often talking about long time spans, with fairly narrow spatial coverage. The latter is often confined to a single site or project area. However, the strategic implications, as well as the operational impacts, could cover much wider spatial dimensions. They could be perceived of in shorter-term time packages, perhaps linked to much longer strategic time-frames. For example, a project to deliver additional electricity will confine its construction activity to the project site and to any new transmission facilities. It may well, however, be implemented over a five to ten year time frame. When completed, the operation and maintenance of the project will not be so isolated. Instead, it will be integrated within the entire system of electricity delivery. Concurrently, the supply of electricity 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 new sites, 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 well as about the operations of a variety of related activities. Design and implementation of a capital project will need to take account of its ultimate operations. Different modes of operation will apply in different circumstances, especially with respect 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 and incentives of those involved, whether inside or outside of the primary activity. There are many stakeholders and all will expect to be considered. Finally, there is a need to keep abreast of evolving 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 Activity In the language of Capital Investment Programs, an activity is often referred to as a project. As already indicated, it is typically bounded by time, space and tactical purpose. It is, however, the unit of activity which can be implemented, budgeted and costed, to deal with a specific predicament 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 of activity. The first activities will likely be plans, programs and budgets. Then there may be intellectual and physical work on project implementation. Unfortunately, project implementation will hardly ever run smoothly. The activities, however well-planned or well-executed, are virtually certain to encounter obstacles. These may be 13
  14. 14. political, technical, financial or of many other kinds. They will all need to be mitigated or resolved, 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 as physical. Hidden blockages may appear under the ground or in the office! Explosions may occur when blasting out rocks or blasting out people. All must be resolved and the funds to do this should have been allowed for. Activities, therefore, have many implications involving decisions. Each of these will have financial and operational implications. Sometimes, major tactics and even entire strategies will need 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 set of tactical, strategic and other concerns, until the project is again brought into equilibrium or is finally completed. 14
  15. 15. FINANCING OF PUBLIC SECTOR INFRASTRUCTURE Overall Financial Requirements 00000000From the overall perspective of various entities dealing with public utilities and infrastructure, it is clear that in many situations, world wide, future demands on public financial resources will be formidable. This will apply to the funding of ongoing public services as well as to capital investment. For example, in many situations, road-space, drainage and sewerage systems are totally inadequate to deal with even the current needs of residents. Underground piping is also old and worn. The development of new residential and commercial areas typically demands large inputs of primary infrastructure. Where cities are, as is common, located astride rivers, there is also need for substantial 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-financing requirements will be huge. Moreover, subsequent operation and maintenance will likely require significant annual subsidies. Bus, streetcar, gas, electricity and water supply services often operate under policies dominated by public welfare considerations. Thus, prices are inadequate to cover operation, maintenance and capital-cost recovery. As a result, current budgets of municipal governments must often provide for heavy annual subsidies of these, too. Basic Capital Financing Principles The search for alternative financing of public services and infrastructure should clearly explore possible new approaches. In particular, there may be considerable potential to use leasing, sale or grant of concessions for publicly owned land, in exchange for private sector financing of public infrastructure. Indeed, it is likely that some attractive packages can be arranged, with both local and foreign investors. It should, however, be cautioned that the search for innovative financing options should 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 creative options 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. It creates additional burdens on current finances, not justified by the longer utilization of the assets, but inevitable unless the loans can be rolled over or refinanced. This may preempt more important and urgent recurrent expenditures. Because short-term financing is often more readily available than that for longer terms, it creates a great temptation for municipal governments to rely upon it too heavily. 15
  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. 0It follows that municipal governments and public utilities must continuously operate within the framework of a balanced recurrent budget. Furthermore, the various revenues used to bring the recurrent 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 to commercial interests. These funds flows are of a "windfall" nature. They should, thus, be reserved for capital expenditures13. Public Sector Institutions Based on institutional performance in many places, it is possible to postulate a number of options for service delivery entities, within the jurisdiction of a municipal government. The distinctions among 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 the overall administration of the municipal government. This has one important advantage. It allows the setting, by the national or municipal government, of a specific set of concerns to be addressed by each individual entity. Against these, it can be held accountable for both financial stewardship and operational performance. The formulation of a corporate structure for each set of objectives offers the opportunity that the activity of each autonomous entity will be substantially immune from the likely changing political agendas of the core governance function. It is important to note, however, that the establishment of a corporate structure for wholly or partially autonomous operations is not necessarily consistent with the concept of the private "joint stock company." This is frequently referred to in discussions about the restructuring of state owned enterprises. Instead, a circular set of discontinuities can be perceived. They concern: financial markets; ownership; control and management; and, institutional structure. First, capitalization from financial markets does not necessarily provide for effective ownership. Such capitalization may come from bonds (lending), rather than stocks (ownership). Furthermore, the issue of different classes of stock may result in the trade-off of decision-making power for security, as in the case of so-called "preference shares." Finally, holdings by minority stockholders may endow them with only 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 of publicly owned utility corporations, virtually all capitalization is from bond issues. 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. 16
  17. 17. Second, legal ownership, through stockholding, does not necessarily, imply effective control or management14. Apart from the potential ineffectiveness of minority stockholders, it is virtually impossible 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 executive and 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 goals of 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- seeking motive of the stockholders may be significantly over-ridden by regulation, of either operations or prices. This is particularly true when dealing with activities that are considered as "natural monopolies." Third, autonomous control or management need not necessarily imply the use of a corporate structure – and certainly not in the "joint-stock" form. In the public sector, there are many other forms 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) to wholly owned government corporations, with no private stockholdings and no intention to create them. In the UK, for example, some of these have been collectively designated as: “quasi- autonomous national government organizations” (QUANGOs); “quasi-autonomous local government 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 autonomous corporations, to be wholly financed from direct government loans or grants. Thus, the "equity interest" of the government is often merely a formal, legal, artifact, as with London Docklands Development. In summary, therefore, the establishment of financially autonomous entities, for the delivery of public services, offers a range of options which might be substantially different from what is commonly 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 given objectives but also in terms of how those objectives might be achieved in alternative ways. It is appropriate, 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, for fulfilling the political and operational objectives of a local, state or national government. 14 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 “public utility” 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! 17
  18. 18. Contracting-Out of Public Services16 There is an alternative to the delivery of all services by the employment of direct labor by public sector institutions. Many activities offer opportunities for contracting, by open competition, for such services to be provided by enterprises outside of the direct control of a public entity. This could apply 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 to participate in the tendering, after being formed into quasi-independent "direct service organizations." 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 fair competition. This arrangement often leads to the "internal" entities actually winning and performing the contracts but with the added advantage of doing this under competitive conditions 17. For such a system to work consistently, it must result in improved productivity in service delivery – in the sense of more service for lower unit cost. Thus, opportunities must be present for the public sector to save on costs – otherwise there would be no incentive to "contract out." It is, also, necessary for the 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 the more 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 often most 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 single commercial contractor to develop monopoly power of its own. This, it can do by gradually developing an incumbency position, especially by preempting the public sector's ownership of essential equipment. For example, if the garbage-collection service were to be fully "contracted-out" by (say) a municipal government to a single – or very few – commercial enterprises, these would, after a short time, own all the essential vehicles, plant and disposal sites, leaving the enterprises with a significant tendering advantage18. This would inhibit competition, on equal terms, by other competent contractors. It would also inhibit the return of the service to a restructured and more efficient local government unit. A very well-known technique is possible, where a quasi-monopolist bids for individual small packages of work. This is loss-leading: under-pricing the initial bid – to gain a foothold – by using financial support from the bidder’s other operations There are other factors. The importance to a commercial enterprise of consistently winning the 16 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, it may 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
  19. 19. contract could make it vulnerable to "trade union" type pressures from its own work-force. The result could be the shifting of most of the cost-saving advantages away from the public sector, into the pockets of either workers or commercial enterprise shareholders. An additional cost, sometimes claimed in economic writings, is that referred to as "directly unproductive profit-seeking." This postulates that the advantages of obtaining a complete or partial monopoly on the delivery of public services makes it seem advantageous for potential contractors to employ lobbying and other methods of influence. These are not all, or always, ethical. Indeed, they may be illegal. These have social costs in themselves. Furthermore, to those who win – as well as to those who fail to win – a particular contract, their expenses may represent a dilution19 of the intended 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 ultimate responsibility for efficient public service delivery. Thus, it will retain the risk that it will receive less than adequate service from its paid contractor. This, it will either have to remedy, at further public cost, or else allow the public to suffer the inevitable shortcomings. In "Western" systems, the enforcement of either financial penalties or performance obligations against recalcitrant contractors often proves costly, time-consuming, contentious and ineffective20. One important cost of "contracting out," often overlooked, is that of contract administration. The employment of many individual contractors will pose different management concerns to the service delivery entity than those for its direct labor. The means to address these concerns need to be learned, gradually and by experience. As the learning process results in improved managerial productivity, administrative costs of "contracting out" will gradually fall. However, if an increasing number 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 be accurately and appropriately accounted for. Furthermore, in assessing the net benefits from the use of contracting, the extra administration costs must clearly be offset against the direct productivity savings in service delivery. Thus, the net benefits will arise only after all contract administration costs 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 a shift of money to the lawyers, lobbyists, Mafia organizations, etc. who would then reap the related economic benefits. This contrasts to original expectations of the "contracting-out" arrangements, whereby direct economic gains to contractors, after deducting losses which 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” (© The Guardian, Tuesday July 27, 2004). It includes the words: “The idea that PFI is a partnership between government and business looks a hollow joke, as private finance gets repaid while the public sector carries the extra cost of keeping services going and communities suffer. For all the political brouhaha about partnership, nothing can compel the private sector to ensure continuity of provision while government-backed compensation arrangements ensure that profits can be earned at little or no risk to investors.” 19
  20. 20. In summary, therefore, public entities should exploit opportunities for alternative methods in the delivery of services and the performance of public activities. They should do so, however, not as seeking a panacea but with a prudent balancing of productivity improvements against risks, safeguards and administrative costs. Public Borrowing - Control and Allocation Whatever other financing methods are used, the financial resource requirements for public utilities and infrastructure will require significant borrowing. This will demand that attention be given, at the highest level of any municipal or other public sector entity, to suitable systems of control and regulation of borrowing, throughout the entire financial management domain under its control. Prudent financial management predicates that all public sector borrowing, for whatever purpose and by whatever subsidiary public entity, be brought firmly under the control of the central financial management function of the entity. Thus, the "Director of Finance" will need to take a leading role in advising on the allocation of loan resources and on providing guarantees of loans raised by or for the various entities. Moreover, it is a fundamental principle of democracy that only an elected council 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 mainly financed from general revenues, including taxes. It applies whether these revenues are used to finance the direct governmental functions of the municipality or – absent any ability or willingness to cover costs from charges – as increases in public utility subsidies. This could be especially burdensome, for example, for new rapid-rail transportation systems. Pending the establishment of efficient and effective financial markets, it may well be necessary for central governments to establish or adapt a centralized financing entity, through which to channel all or most of its public borrowing. For example, there might be the establishment of (say) a "Public Works 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 a fund would raise all public debt for the governmental, utility and infrastructure functions of the local governments, on whatever terms and conditions were available in the market place. It would then re-package this debt, so as to lend to the various municipalities or operational entities. This would be in exchange for obligations to service the principal and interest obligations, from either operational revenues or budgetary allocations. For a particular entity, this obligation would need to be undertaken in close consultation with the Director of Finance, to ensure that long-term charges on 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 and QUANGOs, whose boards have NOT been elected. Often, they have followed the traditional British practice of being appointed from among what are sometimes termed “the great and the good’ of British society. Thus, among managements and boards of directors, knighthoods and peerages abound! 20
  21. 21. 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 function of 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 service entitlements will be met in full and on time. Public service entities, in turn, must be aware that they will be held ruthlessly accountable, from their annual budgets, for the full allocation of debt service obligations, 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 "not negotiable." To facilitate the allocation of borrowing and other capital-financing resources against priority projects, it would be necessary to establish a centralized project appraisal capability. This could well be formed as part of (or as an adjunct to) the "Public Works Investment Corporation." It will need to use criteria which will be established in consultation with (or prescribed by) the national Ministry of Finance. Indeed, even though the borrowing and appraisal activities may be carried out within the Investment Corporation, it will be important for the Ministry of Finance to exercise a meaningful oversight and audit function. This accords with its overall responsibility for the allocation of public funds, through the budgetary process. It also allows the Ministry of Finance to fulfill 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 the center, the primary responsibility should gradually be delegated to the entities most directly responsible. The process will then form part of the overall planning, programming and budgeting capability, which each service-delivery unit should develop for itself. Public Borrowing – Foreign Exchange Requirements In many countries, some of the capital financing requirements will need to be raised in foreign currency. These will likely be for the importation of foreign goods and services. However, if a community's domestic resources are inadequate to meet its infrastructure needs, it may be that part of its future borrowing – or its equity financing – even for locally procured goods and services, will come from foreign sources. In either case, a community's contractual obligations, with respect to its debt service, will extend to the foreign exchange requirements. In particular, if the value of the local currency deteriorates against the foreign currency of any loan, more local currency will be required to finance the debt service. Public sector activities will likely make significant indirect contributions to the earning of foreign exchange. For example, infrastructure improvements will facilitate both foreign trade and tourism. However, in practice, these activities will not generate foreign exchange directly. Thus, it will be necessary for the debt servicing entities to have access to foreign exchange earnings of the commercial sector. This will either be by contracts with commercial enterprises or – more likely – through the national banking system. 21
  22. 22. Public Borrowing – Financial Markets To ensure the most economical raising and use of public funds for infrastructure development, it will be necessary for financial markets to develop and sustain a significant capacity for the raising of 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 the hands of government. A most important feature to develop in the financial market, for both public sector and commercial financing, is that of trust. Investors must develop confidence that borrowing entities have the competence, sincerity and reliability to service their debts. This means that the financial market place 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 to the investing public, such as auditors, underwriters, issuing houses and rating agencies. Such bodies, where not already existing in adequate form, will need to be established, upgraded or improved. As already indicated, the sums needed to finance the services and infrastructure of many communities are formidable. Thus, the development of the quality of the administrative management of the financial market place will need to be matched by an adequate expansion and sustainability of its capacity to raise the required sums of capital. Investment Financing – The Competitive Environment Competition for investment capital will largely be based on perceived risk and return. For public sector bond issues, this will depend upon the interest rate, combined with the reliability and quality of the expected revenue earnings. These, in turn, will be based on either the expected operational and 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 the promotion of bonds and other capital financing instruments. Also, there will be competition for funds 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 lie more towards the opportunity for making fast profits than for longer-term goals. This situation may be reinforced by the fact that, under currently sustained social safety nets, investors will perceive that their basic long-term needs are provided for22. Discretionary funds may therefore be more willingly channeled into "glamour" security issues, albeit for more fickle purposes than for development of infrastructure. The latter, by contrast, may be considered, in the short term, dull and uninteresting as backing for security issues. Also, the commercial market place will not always provide more economically efficient alternatives to public sector activity 23. 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 consumer 22 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. 23 A significant market failure in this respect is that quicker private profits may often bring much higher investment returns than the more slow and ponderous – but eventually more enduring – public infrastructure improvements. 22
  23. 23. spending on trivial distraction, entertainment and amusement It may well be important, therefore, for national and local governments to embark upon programs of public education, to encourage potential investors to channel funds towards public utilities and infrastructure. The costs of such a campaign might well be offset by the refinement of interest rates for 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 investment resources will be through investor perceptions of risk and return. Failure to recognize this, resulting in a return to a process of political allocation, will result in long-term economic inefficiency and a significant reversal of any economic reform principles. Resource Mobilization Competition for funds will not be only among opportunities for investment. As nations and communities move further towards a commercial environment, investment demands will compete against 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, in the 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 is available for the different claims of public, commercial and private sectors. An important aspect of resource mobilization, as well as mitigating demands on general public revenues, 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 to encourage the economic signals to be given by prices. In other words, a most effective way to get the attention of the public will be to charge full prices for services. The only significant opportunity for 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 recurrent public expenditures, including the service of debt. Chosen levels, of taxes and charges, will have political and economic limits on the public capacity to bear them. This will also affect the level of capital investment. Public Sector Financial Management The economic reforms undertaken in many countries, especially those of Eastern Europe, will likely lead to: a. a tightening of the allocative process; 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. 23
  24. 24. 0These will require much greater attention to financial management. Thus, accounting, auditing, budgeting and financial control practices will all require enhancement, throughout the governmental and operational entities of all communities. A key factor is to introduce a budgetary system that separates capital expenditure (and its financing) from recurrent revenues and expenditures. Providing for improvements in overall accounting and financial management systems will be necessary ingredients in a more transparent and open system of accountability for stewardship of funds and performance of activities. However, more is required. Directors of finance must also concentrate 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 the finance department to organize and arrange flows of financial and other information to the operational units, so that their managements may make better-informed decisions24. This does not necessarily imply a centralized accounting or financial information system. In organizations of the size and diversity of large municipal governments, this is clearly inappropriate and inadvisable. What it does imply, however, is that finance departments retain and enhance their capability 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 standardized procedures that are still flexible enough to allow for the individual operating characteristics of the different 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 for their managements and overall fulfillment of reporting requirements, to the municipality and its public. Also, training programs of finance department officials should include secondment to operational 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 life spans determined by governmental edict. Often, this has proven to be far too long for economic operation, typically because of high repair costs in later years. Introduction of life cycle costing would draw attention to a need to scrap or dispose of assets when their continued use is no longer economic. The use of management accounting will also provide information about the use of appropriate technology. 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. The introduction 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, will automatically be the best for a particular country or – more specifically – for an individual local community. 24 A comprehensive textbook on these various aspects of accountability is "Municipal Accounting for Developing Countries" by David C. Jones (© Chartered Institute of Public Finance and Accountancy (UK) and World Bank – 1982). 24
  25. 25. Planning, Programming and Budgeting Governmental and operational entities should be encouraged in the use of appropriate procedures for planning, programming and budgeting of their activities, within the framework of an overall performance budgeting approach. Arrangements are also required for both tactical and strategic cash 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 also be 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 unavoidable subsidy obligations. Public Utility Pricing and Subsidy Some public utilities operate as natural monopolies, at least in the short term. To optimize the economic efficiency of their operations, and limiting demands upon scarce general revenues, all such entities, wherever possible, should be encouraged to charge economic efficiency prices. These should be consistent with full-cost recovery of economic resources and coverage of all financial requirements. Thus, in principle, public utility companies should set charges which are intended to cover operation, maintenance, depreciation (at current values) and a real return on assets, valued in current prices. The entities should also be required to generate funds from operations to cover debt service and to contribute towards expansion of facilities and plant. Where claims are made for subsidy, on grounds of economics, welfare or financial hardship, these should be carefully evaluated. They should, however, be allowed only where fully justified and can be implemented in an efficient manner. In general, the overall subsidy of service delivery systems is vastly more inefficient than the individual subsidy of deserving consumers. Where used, it is often because the individual consumers cannot readily be identified, evaluated and compensated. Moreover, the service characteristics should be conducive to a reasonable assurance that targeted consumers are most likely to benefit. Sometimes, because of administrative costs, the perfect is the enemy of the good. The principal justification for subsidies to entities lies in cases where there are high transaction costs, uncertainties or resentments in directing them to individuals. This may apply, for example, in the administration of "means tests." This concern applies to both economic efficiency and equity considerations. If care is not taken, a poorly directed subsidy may merely mean that the more profligate (and likely better off) consumers will (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, or principal, 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, even in this case, still very contentious. Moreover, even when there is broad agreement on the economic 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 charge 25
  26. 26. monopoly prices, there should be provision for the regulation of such prices by independent national or local government agencies. These should have the power to over-ride both the political agendas of government and also the pure profit-seeking agendas of the enterprises, after holding public hearings on all applications for price adjustments. However, many witnesses seeking to be heard at such public hearings are less likely to be in favor of socio-economic-efficiency pricing than in imposing their private agendas, or those of their interest groups. Thus, it may well be found that the role of an independent regulator must be to ensure that prices are set at levels which are high enough to fully cover costs, as well as to ensure that legitimate equity considerations are dealt with fairly. Land Management A major asset, available to many developing cities, is the ownership, control or management of substantial public land. This can be exploited in a variety of ways, for the purpose of financing infrastructure. 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 public hands. This results in significant potential savings, or financing opportunities, over situations found elsewhere, with the majority of required land in private ownership. The more that public land increases 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 transaction costs of land acquisitions, especially where this might otherwise involve compulsory purchase. For direct 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 of infrastructure. 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 to accept a parcel of land, at no cash cost, in exchange for the construction of the entire public infrastructure. The rest of the land can then be used for commercial facilities, for the developer's own benefit. Where such exchanges take place, it will be important for them to be properly evaluated and accounted for. As indicated, such one-time sales or exchanges should not be regarded as recurrent revenues. Cash proceeds not immediately used for development should be reserved for future capital expenditures. A feature of the final disposal of land – whether in exchange for infrastructure or not – is that it represents the disposal of claims to future revenues from this land, with the exception of property taxes26. It will kill the goose that lays the golden eggs! Thus, the prudence of land disposal – and of its extent and timing – will be influenced by the financial needs of the local government and its entities. This is another reason for careful matching of budgetary requirements to overall 25 This is particularly important where such public land is derived from abandoned or curtailed activities. Examples occur where land occupied by railway yards, shipping or military interests is no longer needed for its earlier purpose. Often, it has become derelict and unattractive, as well as having no public facilities and infrastructure suitable for new development. Thus, its initial value is very low. 26 Even these may be curtailed or postponed if the land is part of an "enterprise zone." Property taxes may then not be collected for several years into the future, to encourage developers to risk new activities on the land. 26
  27. 27. development activity. An important point is that as future real land values increase, rents – in real terms – can be adjusted to allow for this. Sale prices, by contrast, are fixed on a "once for all" basis. In the absence of a fully developed land-price information system, it might well be found that early disposal of land is – in real 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 public sector 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) has the power to grant planning (zoning) permission over privately-owned or rented land, this might be accompanied by a requirement that the owner (user) provide some degree of public facilities, in exchange for the valuable (monopoly) development right27. This cannot, however, be pressed too far. First, an excessive demand, causing a potential loss to the developer, will cause a backing away from the whole enterprise. Second, the local government or development authority may sell land, with planning permission already included in the price. To avoid disputes, it is important for the seller and the purchaser to be certain whether or not this is the case. In some cases, a municipality (or one of its entities) will own land rights in connection with the operation of public facilities. An example would be the air rights over a "metro" or mainline station entrance. These rights can, of course, be leased to developers to help cover the costs (or related debt service) on the principal facilities. The extent of this will be facilitated or curtailed, for example, by regulations regarding building height. Finally, when land is in the hands of commercial enterprises or is privately owned, it can be subject to property tax, either on the land alone or also on improvements. Even land owned by public sector entities should be subject to tax. This is not, usually, to bring in additional 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 within the 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 facilities will indicate the extent to which revenue is being foregone, by retaining them within the public domain. Environmental Accounting Increasingly, it will become necessary to provide in the accounts of public entities for potential costs to remedy current environmental degradation. This may arise from technologically inefficient operation of current service delivery. For example, if a sewage treatment works is operating without 27 This is known, in the U.S.A., as an "exaction." Sometimes, state or local law forbids this. In such case, developers typically make offers to provide public facilities, then known as a "proffer." In Britain, authorities have had, until recently, very limited scope to secure 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 planning permission. 27
  28. 28. producing adequate effluent quality or disposal of sludge, this may create costs to be incurred in the future. 28
  29. 29. To the extent that these are only delayed – but eventually inevitable – they resemble future "debt service" on current "borrowing." Another example would be future closing costs of currently operating 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 virtually identical. Tightening of environmental standards will – as a direct outcome – increase the costs of such ecological borrowing. Necessary Improvements The means to achieve economic development and reform do not necessarily, or principally, lie in the restructuring of institutions. Furthermore, many of the activities to be undertaken by the municipal governments or development authorities will have to be coordinated with many departments, agencies, bureaus and commissions of a central or state government. Indeed, policies of institutional reform and restructuring, including privatization, should be evaluated not only with regard to a set of given objectives but also in terms of how those objectives might be achieved in alternative ways. For example, the conversion of (say) a municipal water company from a publicly owned corporation to a commercially owned one may be less important than a rationalization of its pricing structure. If the latter can be achieved under public ownership, institutional change might not be necessary, appropriate or desirable. However, the public authorities should not use this further opportunity for reflection as merely a means to validate current practices or excuse itself from the need to take effective actions. A great deal of institutional, administrative, financial and operational reform must often be undertaken. In addressing overall goals of reform, as contrasted with specific activities 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, in the form of goods and services; i. limitation of otherwise unconstrained demands upon the general revenues of the 29
  30. 30. public budgets; and, j. maximization of the operational autonomy of entities, consistent with optimal accountability for both stewardship of resources and performance of activities. 0 Finally, as much of the activity under the control of public entities is clearly concerned with government and public service delivery, it is essential that their activities be (and be seen to be) consistent with the prevailing political agenda. 30
  31. 31. FINANCIAL, ECONOMIC AND SOCIAL IMPACTS ON LOCAL COMMUNITIES Community Balance Of Payments (1) Within the overall national and international economy, a local community must either sustain itself from its own production and exchange of satisfactions or else be supported by transfers from elsewhere, usually governmental. If neither of these occur to a sufficient extent, the community's economic and social structure will deteriorate. This will often leave in its wake a declining physical infrastructure and derelict buildings, together with a discouraged and increasingly disadvantaged populace28. The oft-perceived, though commonly simplistic, remedy is the creation of more job opportunities for the local populace. This can be sustained, however, only by the maintenance of a substantial balance between financial flows of funds into and out of the local community. This concept is more intuitive than statistical, because economic data gathering does not normally encompass a detailed analysis of this type, by individual communities. It is made more difficult, indeed virtually impossible, by the concern of making distinctions as to what constitutes a community 29. However, for each development decision or strategy, it should be possible to assess (or at least to intelligently speculate) some of the local "balance of payments" effects. Even an educated guess as to the likely direction of net incremental funds flows will be of decision-making value. This can be done only if all the principal flows are examined. They can then be used, refined or discarded, depending on their reliability and the concerns to be addressed. Commercial activity will bring inflows of funds to a community (from community non-residents) as a 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 of the 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 local government unit or a particular bank. They are not. The balance of payments is an assessment of the net flow of funds - if it could be measured – for all community transactions with the outside economy, arising separately and independently in the normal course of personal, commercial, and governmental activity. These will include (but not wholly comprise) payments to and by banks and governments. Even transfers between different branches of the same government entity or commercial enterprise are included. 31
  32. 32. 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 the local government (e.g. state and national taxes) and by welfare and subsidy payments out of the community. For working communities, whose retirees move elsewhere, there may well be net payments 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 be made of the net current balance of the community. This would be the net amount owed, relative to the 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 net current 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 future satisfactions (goods and services) it must be held in some form until these future satisfactions are procured 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 local community to have settled their accounts with one another and then brought to the "community hall" all their remaining invoices or money earned from transactions with those outside their own community. Using the available money to pay the invoices, all now owed 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 an increased 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 nation or the world on future goods and services of the local community. (The local community might well be in a muddle about whose money had paid which invoices. This, however, would not be a balance of payments concern. It would be one to be resolved entirely locally. Indeed, official national balance of payments statements usually include large components for "errors and omissions.") 32
  33. 33. If the community accumulates a current surplus, this will facilitate the participation of its residents in: (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 of non-residents in the making of capital payments to resident households, businesses, governments or public 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 Results A balance of payments for a local community deals only with flows of funds. It does not directly address the economic activity to which the funds relate. Thus, it is possible for a local community to derive a great deal of funding from outside, yet indulge in little or no economic 31 For balance of payments purposes, it is irrelevant whether the property is located within or outside the local community. Its purchase 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 not replaced by local capital, the affected businesses will be de-capitalized. If they are over-capitalized already, this could be an advantage. 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 purchase will provide locals with cash, equal to its price. What is important is that the purchaser be a non-local-community resident. An analogy is that the US accumulated current balance of payments deficit is supported, to some extent, by holdings of US property by foreigners. 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 local capital, 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. 33