Should the local authorities get themselves into debt?

Julio Gómez Pomar. Director. PricewaterhouseCoopers & IE Centre for the Public Sector.

4 November 2010

When the levels of debt of city councils rise, it all too often results in the state having to bail them out using taxes paid by everyone.

There has been recent controversy concerning the government´s announcement that it has finally decided to authorise local authorities to work on credit as long as their accumulated debt is not higher than 70% of their current revenue. Beyond the poor image of a government that appears to be randomly bouncing off one wall on to another in such serious matters, the law on public funds has allowed local authorities to get into debt as long as they are either temporary cash account transactions or their budgets include a positive net saving and their debit balance, including the proposed transaction, is below 110% of their liquidated current revenue. If the accumulated debt is higher than said percentage, the transaction has to be authorised by the Treasury.

Following the first law on budgetary stability was passed by the Spanish Conservative government of 2001 (Partido Popular), the authorisation of credit transactions and the debt issue by local authorities were bound to the fulfilment of a stability target that required a balanced budget or surplus. However, the Solbes reform of 2006 brought a significant slacking-off of the budgetary balance principle by allowing deficit in the contracting phases of the economic cycle when it was used to finance further investment.

In short, the first laws on budgetary stability tightened the belt on local authorities getting into debt by taking into account the fulfilment of the balance target before authorising credit transactions; however, the 2006 reform returned many things to the way they were.

We have just witnessed the latest episode. The vice-president of the government, Elena Salgado, has presented a royal decree law that turns off the credit tap; the date on which the measure was to come into effect was then deferred for the "correction of errors" (which also means that its urgency was deferred, something that is improper of a royal decree law) and then she announced last week that she is now going to allow local authorities to resort to debts.

With so much to-ing and fro-ing, there is room for at least one question: which policy is the right one? In my opinion, the vice-president was right for the few moments during which her first proposal saw the light. There are more arguments for prohibiting local authorities from resorting to debt than there are for allowing them to do so. First of all, past experience shows that the state has, on more than one occasion, had to rescue the local authorities´ debt because they were incapable of repaying it themselves. In other words, it is easier to put pressure on the state for it to assume the debt than have the citizens in the municipality pay higher taxes. Secondly, the argument put forward in the law to allow debt (to finance investments) is a fallacy. The reason is as follows: we need to implement investment projects that are spread over more than one year and it is logical for that greater budgetary effort to be sustained by debt than make payments over several years; the ones over which the investment reaps its rewards. The aim is to compare the way businesses behave with the way local authorities behave. But things are not like that.

Businesses use debt to finance an investment project because they expect to obtain revenue in the future to service and amortise the debt and also obtain a profit. But the local authorities do not sell services on the market and can only obtain future revenue from taxes on their inhabitants or from the state through transfers that are again paid with everybody´s taxes. So, if in the end citizens are going to have to pay more taxes, why not simply increase municipal taxes instead of getting into debt? A good question. Perhaps because in the end somebody else pays it (the state or the next mayor).

The actual situation is that many local authorities use debt as a source of finance, not temporary finance, but rather additional and permanent finance for their other revenue so that they can deal with their ordinary expenses. The strategy works until it stops working because the financial snowball grows to a size that can no longer be managed.

The local authorities should inform citizens about their pluri-annual projects and the repercussions they are going to have on the taxes they pay and not use debt as a way of covering up costs for taxpayers. Whenever possible, they should also use the prices and taxes formula instead of just taxes. Given the financial situation of the various levels of government and, in particular, local government, the level of municipal spending will only be reduced by prohibiting access to credit.

There is one final question that is starting to find its place in the debate and I would not like to overlook it here: size and number. Since the local authorities of the 21st century are essentially citizen services providers and managers of a high volume of income and expenses, their action area (the municipal district) should be determined not so much on the basis of history, politics or culture, but rather on the basis of economics. Consideration needs to be given to the need for grouping municipalities together to create the right size for providing citizens with the right services. There would be many citizens who, if they were showed the accounts as they should, would see municipal matters in a very different light.

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