Funding and financing of local government public investment

A framework and application to five OECD countries

In OECD countries, local governments not only play an essential role in public services provision, but also represent 41% of general government public investment. This is the focus of a recent OECD study.

The function of local government is vital to the economic, social, and environmental benefit of society because of their direct interaction with the public. However, they are often subject to more strict fiscal rules and less tax revenue and expenditure autonomy. Sponsored by the European Commission through the Structural Reform Support Program (SRSP), OECD economist Camila Vammalle and policy analyst Indre Bambalaite explore case studies from five OECD countries (Denmark, Finland, Ireland, The Netherlands, and New Zealand) and present a framework that identifies key factors contributing to local government’s financial capacity to carry out public investment.

The framework identifies 6 key factors that affect the capacity of local governments to finance public investment, including funding, fiscal discipline mechanisms, financial instruments, financial institutions, public financial management (PFM) systems, and multi-level governance. Each of the factors encompasses several elements. For instance, the capacity to fund public investment depends on revenue mix, expenditure autonomy, and donor funding. The framework also suggests four systems that ensure local fiscal efficiency and sustainability: market-based systems, cooperative approach to debt controls, rule-based systems, and direct controls systems.

In addition, the authors note that the interactions of different elements bring about higher effectiveness in different settings. For example, monitoring and enforcement mechanisms are particularly important in a cooperative approach system because the credibility of commitments is necessary to achieve agreements and relies on the trust that the commitments will be respected.

The authors interviewed local financial institutions from 5 OECD countries that represent different systems, but all enjoy some level of success in budgeting and financing local government public investment. These financial institutions all possess some, if not all, of the key factors and elements. For example, local governments in Denmark and Finland both have high levels of autonomy in taxation and strong discretion over expenditure. Ireland is an example of a control-based system. It highlights several good practices that lead to successful budgeting and financing of local government public investment such as a very clear vertical coordination mechanism in which the central government creates funds to ensure funding to implement local government investment plans. The Netherlands’ local government operates under a rules-based system. Well-developed national strategic planning practices and the possibility for municipalities and provinces to participate in the elaboration of these strategies are essential to the success of its local government public investment. New Zealand represents a market-based system. Certain conditions allow its local government to achieve effective public investment, including revenue-raising autonomy and strong planning and financial management on the local level.

The aforementioned successful case studies highlight some commonalities shared by local governments of the five OECD countries, particularly autonomy of revenue generation and discretion over expenditure. These practices decentralize fiscal capacity to the local level and nourish successful financing and budgeting of public investment.

Read the entire study on local government public investment:

Vammalle, C. and I. Bambalaite (2021), “Funding and financing of local government public investment: A framework and application to five OECD Countries“, OECD Working Papers on Fiscal Federalism, No. 34, OECD Publishing, Paris.

Photo: OECD/Hervé Cortinat