Public finance policies to meet the goals of stable long-term growth, economic efficiency, and poverty alleviation vary from sector to sector in the developing world. Despite these differences, all sectors confront the same fiscal dilemma: tightening financial constraints make it impossible to maintain large subsidies across a wide range of public services and still provide adequately for priority needs and target groups. What can be done? The issues and policy options facing developing country policymakers are illustrated here in two sectors in which public finance has traditionally had a major role—urban services and rural infrastructure. Effective service delivery in these two sectors has economy-wide effects and is often a precondition for economic development.
Urban public finance issues
Despite the great diversity between and within countries, most urban services are provided by local governments and financed from local taxes, user charges, or transfers from higher levels of government. Infrastructure services, such as water, transport, and solid waste disposal, take up a substantial share of the municipal budget in many cities. Although there are good reasons in many cases for public involvement, it has contributed to three basic problems.
Underprovision of basic services. Both sides of the public finance equation—revenue and expenditure—have contributed to the underprovision of basic infrastructure services. Municipalities face tight budgetary constraints. Transfers from higher tiers of government may be unreliable, and many local authorities have neither the authority nor the know-how to coax more out of local revenues, the bulk of which come from property taxes. Services that rely heavily on general funding sources are therefore bound to suffer.
This article draws on Chapter 6 of the World Development Report 1988. Mr. Jimenez was a member of the core staff team that produced this Report for the Bank.
The fiscal problem is aggravated because public spending in many cities is not directed toward the appropriate services. Bus transport and housing construction can be efficiently provided by private suppliers, yet large public programs in these areas divert public resources from priority activities, such as traffic management and regulating property rights. The costly new metros in Caracas and Séo Paulo, for example, serve a small percentage of the urban population, place a considerable and continuous burden on the cities’ financial resources, and preempt improvements elsewhere.
A combination of tight budget constraints and failure to set priorities lead to underprovision of public services that are truly in the public domain—that is, those services for which alternative private sources are either unavailable or too small to be efficient. Private water vendors, who have an inefficiently small volume of business, operate in congested cities such as Lagos, Lome, and Nairobi, and charge two to four times the unit cost of piped water. Private manufacturing firms in Lagos have also found it necessary, at great cost, to provide almost all basic services themselves.
Inefficient spending. Heavily subsidized and publicly provided urban services are often inefficient. Public officials have little incentive to be cost-effective or to respond speedily to changing conditions. In Calcutta, the public bus corporation requires a subsidy of around $1 million a month, since its revenues cover only about half of the bus system’s operating cost. Yet, it has a lower fleet utilization rate, a higher staffing ratio, and a greater incidence of fare evasion than private sector bus companies. Similar findings hold for other cities (see table).
In electricity, weak investment planning, high transmission losses, excessive staffing, inefficient operation, and inadequate maintenance are common and growing problems. In some cases, the size and technical sophistication of the power sector has increased dramatically in the last decade without a corresponding improvement in management. In many other cases, these problems can be blamed on regulations which take away managerial incentives to be innovative and efficient—such as rules constraining prices, coverage of service, use of inputs, and pay. As a result, rates of return to new projects have been falling over the last decade.
Failure to serve the poor. Heavy subsidies for urban infrastructure often fail to benefit the poor. The poorest members of urban society do not use the most expensive forms of urban transport. For example, the poor tend not to demand the longer trips that subways will provide, and they neither live nor work on the main line. Middle-income groups typically benefit most. Similarly, one-quarter of the developing world’s urban population—the poorest—has no access to safe water. Access to piped water is often restricted to privileged groups.
Reforming urban services
The direction of reform needed to improve urban infrastructure depends on the service. Where a competitive private market is viable, such as in urban transport and housing, narrowing public involvement will release resources for better use elsewhere. Where direct provision is most efficient—as in water, power, and roads—the public provider should apply user charges or taxes that would cover its costs.
Priorities for urban transport and housing. Governments can do much to improve urban transport in developing countries. The most pressing task is usually to upgrade and extend the road network. Experience shows that urban highway investments offer high rates of return through faster journeys, reduced fuel consumption, and fewer breakdowns. Governments also have a role in traffic regulation and management, vehicle licensing, and the setting of safety and environmental standards in mass transit. These policies can serve as cheap, congestion-relieving alternatives to new transport systems. For example, in San José (Costa Rica), peak-hour parking restrictions, especially on bus routes, parking meters, and formal designation of loading areas, greatly improved the traffic flow.
Efficient private providers should be allowed to enter the market for bus services and to set competitive fares that create a favorable climate for efficient investment. In most cases, a greater reliance on competitive provision of bus services will not hurt the very poor, since many live in areas that are not served by subsidized bus routes. Indeed, competition may even increase access by extending service to areas not covered by subsidized public providers. In Bangkok, Istanbul, and Kingston Qamaica) for example, bus routes that public operators called “unprofitable” were contracted out to competitive private operators who earned profits without changing the fare structure.
In housing, instead of providing buildings, the public sector could try to make the private market work better through rationalizing land tenure; liberalizing financial markets; easing restrictions, such as rent control; and providing basic infrastructure, such as water, sewerage, and electricity. For the very poor, direct public intervention in housing will continue to be needed. However, such intervention is better focused on providing basic services and security of tenure rather than on dwellings. The kampung (neighbor-hood) improvement program in Indonesia—which emphasizes the provision of service roads, footpaths, drainage, and improved water supply and sanitation—has greatly improved a large proportion of poor neighborhoods without imposing a heavy fiscal burden on the authorities.
Setting efficient and equitable prices. Appropriate pricing is critical for allocational and internal efficiency in the absence of effective competition. In the absence of other factors, this generally means setting the price at marginal cost and using the proceeds to provide the service. (In the presence of externalities, scale economies, and budgetary restraints, efficient prices should also compensate for those effects.) Although there is no market-based reference point, efficient pricing is feasible in many cases. User charges are especially well suited to local government finance, where the link between provider and beneficiary is more direct.
Moving towards more efficient prices will generally ease the fiscal constraint. Rough estimates based on data from six African countries indicate that raising electricity prices closer to long-run marginal cost could add 5 to 10 percent to total central government revenue. Efficient prices would also lessen waste in consumption.
What about the poor? Often, increasing prices will have only a small effect since the poor do not benefit from the subsidy as much as the better-off group. Subsidizing the unit cost of electricity across the board encourages waste and fails to aid the small consumer who has few appliances. To reach the poor, subsidies should be targeted. For example, the utility might charge “lifeline rates”—free access up to a necessary minimum level of consumption, and then set prices at marginal cost thereafter. Alternatively, selective rebates on the connection charge, to allow easier access, are more visible and efficient than cuts in the unit price of consumption.
Rural public finance issues
In most cases, the central or provincial government—either directly or through state-owned enterprises—is the main provider of rural infrastructure—usually without charge or at highly subsidized rates. According to recent studies, user charges for residential water and electricity in rural areas are well below cost of delivery and production. In six Asian irrigation systems, revenues collected from farmers as a percentage of capital and recurrent costs ranged from a high of 25 percent to a low of 1 percent. It is impractical to charge directly for access to rural roads, although vehicle and gasoline taxes might be considered as indirect user charges.
As with urban infrastructure, although there are good reasons for some form of public intervention in rural infrastructure, its form and magnitude has affected resource allocation, internal efficiency, and equity, often in unintended and undesirable ways.
Underinvestment in water and roads. The need for more rural infrastructure is becoming more pressing partly because of the continuing rise in rural populations. Despite recent improvements roughly a third of the world’s population is estimated to be without access to potable water. In many low-income countries, more than half of all villages remain unconnected to all-weather roads. Progress is slow because of rising costs as well as tightening budgetary restraints. Economies of scale in the production and transmission of power and drinking water, for example, are offset by the high cost of serving far-flung communities.
At the same time, there is a tendency for public programs to be biased toward big new projects at the expense of more cost-effective solutions. In irrigation, the less expensive alternatives include improving existing systems, developing smaller community-controlled facilities, and improving rainfed farming methods. But studies conclude that irrigation agencies, which get most of their resources from central treasuries, often support large farmers’ demands for costly and highly subsidized investments.
Inefficient spending. Many rural infrastructure services are costly to run or are not properly utilized. This may be due to central authorities’ lack of information about local conditions. For example, Thailand’s government arranged for the digging of wells and installation of communal handpumps, only to find that the rural people preferred individual connections or their traditional surface water sources.
Another problem is lack of maintenance or improvements in existing systems. In Tanzania better access to potable water was provided without support for recurrent costs. The people wanted the new facilities, but the systems rapidly fell into disrepair. Similar problems arise in many irrigation projects. Seepage or evaporation from unlined or obstructed canals in most large surface systems means that only a small fraction of diverted water is available for irrigation. In Pakistan, reducing water losses in the Indus Canal system from 50 to 30 percent would match the contribution to irrigation supply of three dams the size of Tarbela, the largest in the country. Each of those dams would cost $3 billion!
Administrative problems are often a bottleneck. For example, studies indicate that in the road departments of national or provincial ministries, equipment is underused because of a lack of spare parts, poor training, lack of preventive maintenance, operator’s abuse of equipment, and inadequate workshop facilities. Government regulations make it difficult for roads departments to attract the right personnel, hire and fire staff, and provide incentives. Private contractors or highly decentralized rural construction units—as in Benin, Ghana, and Kenya—have been more cost effective.
Inequitable access by the poor. Contrary to intentions in many countries, poverty alleviation is not well served by the current system of uniform rural subsidies. Findings from a survey of 90 villages in India indicate that about 15 percent of the population was connected during the first few years of electrification and only 45 percent after 20 years. The poorest often live far from the main electricity lines and can rarely afford connections to them. Similar findings emerge from earlier studies in Colombia and Malaysia. There is also evidence of a regressive distribution of subsidies for rural water supply. For example, the proportion of the poorest families with connections to rural water services was about one-half that of higher-income households in Colombia, Kenya, and the Republic of Korea in the late 1970s. Without access in their local community, local women spend up to 15 percent of their time carrying and lining-up for water, detracting from their productive pursuits inside their homes and in agriculture.
The distribution of benefits from expenditures on rural roads and irrigation is more difficult to judge. Some studies have found that the rural poor tend to live outside areas affected by new roads. Subsidies for irrigation can be regressive if provided in response to political pressure, particularly from the larger landowners.
Improving rural infrastructure
Policymakers first have to set priorities and decide which services will be provided centrally rather than locally. Having set priorities, the next task is to arrange for appropriate financing of the services that will continue to be centrally provided.
Decentralizing public responsibility. Programs with community participation coordinated by village-level officials or private associations have been shown to be generally more successful than those without such participation. This is particularly so for rural roads and the distribution of water supply, where economies of scale and lower levels of technical difficulty make implementation easier and economic. In the previously-mentioned Thailand example, the underutilized handpump and standpipe system built by the central authorities was converted to individual yard taps after consultation with the community and, within five years, became almost fully functional and well-maintained, despite relatively high consumption charges. Water systems in Kenya built as part of harambee (self-help) efforts proved more reliable than those installed by the water ministry, which were hampered by lack of funds, poor organization, and failure to design according to the communities’ needs. The locally-run systems were highly reliable. Informal water users’ associations play an important role in Philippine irrigation programs.
These policy recommendations do not imply complete decentralization—nor even a diminution of the central government’s role. Rather they suggest a change in that role, away from direct provision of many local services and toward helping local communities to organize themselves. Unlike in urban municipalities, formal government in rural areas is generally weak, making it necessary to rely upon traditional household groupings. Central or regional governments can play a crucial role in training local organizers, motivating them, regulating their operations, and ensuring that self-serving elites do not dictate how local services are to be provided.
Efficient management and financial autonomy. In some countries and for some services, it may be neither desirable nor feasible to decentralize. However, national institutions need to strive for greater efficiency. The tendency for publicly subsidized central authorities to invest in new systems when it may be more cost-effective to maintain or improve existing systems can be partly countered by making them more financially accountable to users—local communities or individual farmers. One approach would be to set up public utilities for irrigation under the supervision of a regulatory body that included users’ representatives, as recently proposed in Algeria. Another would be to establish water districts empowered to impose fees or levies to finance improvements in services. In either case, the goal should be to establish a closer link between user and provider.
Such schemes hinge on the pattern of user charges. Paying for the service gives users an incentive to both consume economically and monitor the efficiency of provision. If development as well as operational costs are recovered, the bias in favor of expansion over maintenance is reduced. Farmers in the Philippines, although responsible for only a modest fraction of the cost of developing their irrigation system, lobbied successfully against the use of expensive components that they considered unnecessary for good service. In many cases where the use of meters for measuring consumption is uneconomic, other methods of cost recovery have to be relied upon. In water supply, for example, charges for connection and development, with exemptions for the poor, can be used instead of consumption charges. Levies for improvements or access charges are analogous to urban benefit taxes.
Emmanuel Jimenezfrom the Philippines, is an economist in the Policy, Planning and Research Staff of the Bank. He received his BA from McGill and PhD from Brown University and taught at the University of Western Ontario.
Central subsidization is necessary to protect the interests of the poor or because the costs of raising revenue from beneficiaries are too high. But even when subsidies from general sources are necessary, governments can devise ways to ensure that they are distributed efficiently. What is important is that subsidized consumers are, as far as possible, given an incentive to choose the most efficient alternative. Similarly, public providers must be free to choose efficient suppliers.
This article has used examples from urban and rural infrastructure to illustrate three recurring themes for action in the management of public finances of developing countries:
- Set priorities. Spending resources thinly across low-priority tasks is too common and wasteful. Spending needs to be limited to selected types of services and directed toward target beneficiaries.
- Mobilize financial resources. User charges and other benefit-related fees can improve economic efficiency as well as raise revenue. Charging provides incentives for efficiency in production and use. Distribution goals need not suffer if charges are levied on services used primarily by the rich and are differentiated by income.
- Decentralize. Shifting more administrative and financial responsibilities to those in closer touch with local conditions and client needs may improve efficiency and raise revenue.
Implementation of policy changes within sectors may be difficult, not only because of administrative costs, but also because inefficient financing arrangements, once entrenched, create vested political and economic interests. However, recent successful reforms in a number of developing countries have shown that these difficulties can be overcome.