Public Finance: Theory and Practice of Welfare Economics

The small and fluctuating population, the economic characteristics and administrative capacity of small towns not only pose infrastructural challenges for providing services, but also limit the possibilities for generating local revenues for financing water infrastructure development and maintenance. This limited ability to generate local resources for water infrastructure is exacerbated by the way in which scarce public funds are allocated. A first concern is linked to an urban bias that characterizes allocation of funds by central governments. A second concerns the prioritization of other sectors by allocation decisions of local governments. These local governments often prioritize other sectors such as education, health and agriculture for the use of scarce local public resources. What this discussion highlights is that existing models used for financing water infrastructure development do not seem very applicable to the realities of small towns. Additional research and models are necessary to allow for solutions that are better tailored to these realities.

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Although it has a demonstrated an important role in infrastructure development, public finance has largely gone unaddressed in the literature. Instead, focus on financing has largely linked to the public-private debates over the past 25 years and concentrated on the promise and limitations of private sector investments (Winpenny, 2003). In line with this trend, research on public finance has largely been in terms of its deficiencies and the need for alternatives. This emphasis on private and blended finance stands in stark contrast with a finding from the World Bank, which states that two-thirds of all infrastructure in Africa was financed from domestically generated public revenue, with external aid supplying the remaining third (Foster & Briceño-Garmendia, 2009; Hall & Lobina, 2012). Data from the 1990s corroborate this finding as they demonstrate that almost 70 percent of infrastructure investments were sourced from the domestic public sector (Winpenny, 2003). Moreover, public finance will likely continue to be of importance as there has been a demonstrated lack of interest from the private sector to invest in water infrastructure in developing countries (Hall & Lobina, 2009).

Public finance is distinctly different from private finance as it is able to cheaply finance projects that benefit the public good (Hall & Lobina, 2012). Public finance is able to do this as it is backed by stable tax revenues and is able to invest in poorer areas, which are unattractive to commercial lenders (Massarutto et al., 2008). However, while the initial investment may be sourced from public finance, it must be clarified that public investment does not necessarily mean that the services provided will be managed by a public entity. These services provide social and economic benefits beyond the individual private benefits of connecting to water and sanitation services. Apart from public health benefits, it is estimated that for each US$1 worth of investment US$7 is generated in economic returns (OECD, 2011). As the social and economic benefits are spread over society rather than just the individual user, having these services as a focus of government investment would appear justified (Gunther & Fink, 2010). The nature of public finance and of water and sanitation services indicate that public revenue remains an important source of financing for this sector.

However, for this ambitious target to be achieved a considerable financing gap needs to be bridged. There is an estimated US$1.7 trillion investment gap for water and sanitation (Kolker & Trémolet, 2016a). As public finance comprises two-thirds of the available finance for water infrastructure, it is clear that the achievement of SDG 6 can only be achieved through significant public investment. This extremely large sum of money will likely be financed by the users, taxpayers, or from external aid (Winpenny, 2003).

Despite the importance of public funding in water supply and sanitation and the increasing prominence of small towns, both topics have received little attention in recent years. This article, which is based on a thorough review of existing (grey) literature, contributes to filling this gap. Public finance is used for both the development of infrastructure and on-going operations and maintenance. However, this paper primarily focuses on its role in infrastructure development. In doing so, this paper seeks to clarify the role of public finance through a review of the current sources of generation for public revenue, the different allocative theories, and the associated lines of accountability. This article then contextualizes the challenges of public finance for both infrastructure development in reference to small towns. Accordingly, this article highlights that while public finance plays an important role in the financing of water and sanitation infrastructure and should not be overlooked, there are significant challenges for its use in small towns.

At its most basic, taxation is the assessment of a levy by the government on an individual or legal entity (OECD, 2014). The main justifications for the levying of taxes are to generate revenues for public services, redistribute revenue for equity, internalize the externalities of the production of certain goods, and to ensure representation (Taxation and Finance, 2013). The revenues collected from these individuals or legal entities are then used to support general services for which the market will not provide (Hall & Lobina, 2009). Taxation comes in many forms; from sales taxes on the purchase of goods to the assessment of royalties on natural resource extraction. Taxes can be collected at the different levels of government, from local sales taxes to centrally collected income taxes (McLure Jr, 2001). The amount of revenue generated through taxation will depend on the size of the tax base. Therefore taxes collected at the central government level will provide a larger pool of money than those collected at the local level (Alm, 2015). Taxation is typically considered a relatively stable form of public revenue generation, as non-payment typically can lead to civil penalties (Taxation and Finance, 2013). However, to ensure proper enforcement, taxation systems require administrative capacity to manage the financial flows and properly assess taxes. Taxation typically makes up the significant portion of the public revenue generated for public services.

Tariffs are the other primary source of public revenue (Winpenny, 2003). In short, tariffs are payments for access to or use of services. This can be as simple as the use of a toll road or payment for water supply from a tap or piped network. These tariffs support the operations and maintenance of these services and can be used to cross-subsidize services (Winpenny, 2003). However as a source of public finance, tariff collection can be subject to instability. The instability is caused by conditions of uncertainty regarding the user base. If the user base decreases then tariffs may be insufficient to adequately fund the operations and maintenance of the service. Therefore while tariffs are an important source of public revenue they are likely less stable than revenues from taxation.

While revenue generated through taxation and tariffs is the foundation of public finance, they are typically insufficient to finance particular large capital expenditures needed for infrastructure works. Accordingly, governments at the central, subnational, and local level can take on debt to finance these capital expenditures. Governments will issue debt, when a large capital expenditure requires a lump investment upfront, but the benefits from the investment will be long lasting (Alm, 2015). These debt obligations attract investment from external and internal investors and are backed by promises of repayment from user fees issued on the infrastructure (USAID, 2003; Kolker & Trémolet, 2016b). Borrowing is based on the theory of intergenerational equity, which specifies that burden and risk of financing such projects should be shared by those who benefit now and those who benefit in the future (Martell, 2000).

Public revenue generated through these sources can be allocated consistent with different allocation principles of public finance. Broadly speaking, allocation happens in two ways. The first (subsidiarity principle) refers to the level of government that makes allocative decisions about the use of public revenue. The second (distributive equity) principle refers to specific allocative purposes for the use of the public finance.

The subsidiarity principle states that public service provision should be the responsibility of the lowest level of government that can do so effectively. This principle assumes that the local government is in the best position to understand the needs of their constituency and therefore will provide services efficiently by matching the supply of services with the demand for services. While this theory primarily addresses the management of public services, it has also been applied to infrastructure financing (Alm, 2015). As local governments are best positioned to understand the infrastructure needs of their populations, they are also in the best position to distribute the costs according to who benefits from the development of infrastructure. This is echoed by McLure Jr (2001), who argues that local governments are often better able to make tax decisions than central governments as they are closer to the people and therefore can efficiently provide government services. Regardless of the source of public revenue, allocation decisions are made with relative freedom by the local government as they are not constrained by earmarks or conditionalities by regional or central government authorities. Accordingly for water infrastructure, local governments have autonomy to determine the location and type of water infrastructure investments.