This section deals with municipal finance. It outlines the current situation and proposes a framework for a new municipal financial system, including local revenue instruments and policies, intergovernmental transfers and leveraging additional investment in municipal infrastructure.

A new framework for municipal finance which supports the developmental role of local government should:

• Address the root causes of the financial problems that face municipalities.
• Balance programmes for poverty eradication and equity with strategies to enhance growth, job creation and competitiveness.
• Empower municipalities to fulfil their constitutional mandate.

A new framework must also recognise and accommodate the differences between municipalities. Urban and rural municipalities, and even those in different metropolitan areas, are in very different financial circumstances, with very different prospects for providing adequate services at reasonable costs. Some municipalities, particularly those in rural areas, do not have adequate tax bases to fund the delivery of even a minimum level of basic services.

The underlying problems with the existing municipal finance system relate both to shortcomings in policy, and to poor implementation of the current system, such as inadequacies in financial management and service delivery. Interventions to improve the system should therefore include changes to both policy, and capacity-building initiatives.

1. The Current Situation
2. A Framework for a New Municipal Financial System
3. Leveraging additional Investment in the Municipal Sector
4. Budgeting, Accounting, Financial Reporting and Management
5. Concluding Comment

The aggregate size of the municipal budget in South Africa is substantial. In the 1996-97 financial year, municipalities budgeted for total expenditure of more than R48bn. This represents about 7,5% of South Africa's total gross domestic product, and is equivalent to 20,97% of the country's total public sector budget. Within this, municipal budgets vary enormously, from metropolitan areas with budgets of several billions, to small rural councils with negligible revenues.

Most local government revenue is generated by trading services (electricity, water and sanitation). In aggregate, revenue from trading services accounts for over 60% of local government revenue. Electricity, for example, constitutes the largest revenue source for many municipalities. While the surplus derived from the sale of electricity (i.e., the difference between revenue and total expenditure) is not large, it remains an important source of income for many municipalities. Alternative income from levies on electricity sales will be generated once restructuring within the electricity sector results in municipalities no longer playing a direct service provision role.

The major source of tax revenue for municipalities is property rates. These generate around 20% of total revenue. The Regional Service Council and Joint Services Board levies levied by District and Metropolitan Councils bring in an additional 5%.

The total amount budgeted for intergovernmental transfers from the central fiscus to municipalities in 1996-97 equalled more than R5,2bn, of which about R1,2bn was for agency payments, R1,2bn was for capital grants (excluding any receipts from the housing subsidy programme), and R2,2bn was for explicitly (cash) operating subsidies. The balance consisted mainly of implicit (non-cash) subsidies from national departments to the local level. In 1997-98 this total - excluding rollover funds* - rose to R5,9bn.

1.2. The Constitution

A restructured system of municipal finance needs to be founded on the Constitution.

Sections 229 and 230 of the Constitution grant municipalities considerable taxation and borrowing powers, but subject these powers to national legislation and regulation. Municipal taxation powers are also limited in that they cannot "unreasonably prejudice" national economic policies and economic activities. Borrowing powers are limited by the requirement that borrowings do not fund budget deficits. This means that the Constitution effectively prohibits deficit budgeting at the local sphere.

The Constitution addresses intergovernmental fiscal relations in two broad respects:

• Intergovernmental transfers: Section 227 entitles the local sphere to an "equitable share" of nationally raised revenue in order that it may "provide basic services and perform the functions allocated to it". Municipalities may also receive additional grants from national or provincial government on a conditional or unconditional basis.
• Oversight and regulation of the financial affairs of municipalities: Sections 139 (1)(a) and (b) and 155 (7) give national and provincial government executive and legislative authority to oversee the performance of municipalities with regard to their functions. Sections 229 (1)(b), (2)(b), 230 (1) provide for national regulation over the fiscal powers of a municipality. In addition, sections 215 and 216 and other provisions of Chapter 13 grant powers to the national Treasury to regulate the financial affairs of municipalities.

The proposed Treasury Control Act required under Section 216 of the Constitution will set financial controls for all spheres of government, and impose responsibilities and penalties on accounting officers and chief executive officers, as well as their political heads. Intervention in the event of gross financial mismanagement is also allowed in terms of Sections 100 and 139 of the Constitution. Sections 229 and 230 also provide for national regulation over the fiscal (i.e., taxing and borrowing) powers of municipalities.

1.3. Policy objectives

In order to meet the objectives of Constitution, the system of municipal finance will need to be restructured in line with a number of basic policy principles:

Principles for the new system

• Revenue adequacy and certainty: Municipalities need to have access to adequate sources of revenue - either own resources or intergovernmental transfers - to enable them to carry out the functions that have been assigned to them. Municipalities should be encouraged to fully exploit these sources of revenue to meet their developmental objectives. Municipalities should have reasonable certainty of revenue to allow for realistic planning.
• Sustainability: Financial sustainability requires that municipalities ensure that their budgets are balanced (income should cover expenditure). Given revenue constraints, this involves ensuring that services are provided at levels which are affordable, and that municipalities are able to recover the costs of service delivery. No bailout will be provided to a municipality that overspends its budget and/or fails to put in place proper financial management controls. It is the responsibility of the political leaders to ensure that they set realistic budgets. However, there is a need for subsidisation to ensure that poor households, who are unable to pay even a proportion of service costs, have access to basic services.
• Effective and efficient resource use: Economic resources are scarce and should be used in the best possible way to reap the maximum benefit for local communities. However, there are no mechanisms available to ensure that municipal decisions will indeed lead to an effective allocation of resources. It is therefore important that local residents provide the necessary checks and balances. They can do this by participating in the budgeting process to ensure that resources are being put to their best use. Efficiencies in public spending and resource allocation will ultimately increase the access of the poor to basic services.
• Accountability, transparency and good governance: Municipalities should be held responsible and accountable to local taxpayers for the use of public funds. Elected representatives should be required to justify their expenditure decisions and explain why and how the revenue necessary to sustain that expenditure is raised. The fiscal system should be designed to encourage accountability. Municipal budgeting and financial affairs should be open to public scrutiny, and communities should have a greater voice in ratifying decisions about how revenue is raised and spent. Community participation in budgeting should aim to incorporate those groups in the community, such as women, who face particular constraints in participating. It should also include a capacity-building component to ensure that people understand the process of prioritisation - why resources are allocated to one set of things rather than to another. Accounting and financial reporting procedures should minimise opportunities for corruption and malpractice.
• Equity and redistribution: Municipalities must treat citizens equitably with regard to the provision of services. In turn, national and provincial government must treat municipalities equitably with regard to intergovernmental transfers. Local government cannot be solely responsible for redistribution, and national government has a critical role to play in this regard, particularly with respect to subsidising the provision of basic services. The "equitable share" of national revenue* to which local government is entitled will be directed primarily at this purpose. In addition to targeted subsidies to poor households, funded from the "equitable share", municipalities can cross-subsidise between high and low- income consumers, both within particular services and between services. The extent of this cross-subsidy is a local choice that needs to be exercised carefully, within the framework of the municipal integrated development plan.
• Development and investment: Meeting basic needs in the context of existing service backlogs will require increased investment in municipal infrastructure. Public Private Partnerships such as leases and concessions, discussed in Section F: Administrative Systems, provide a mechanism for attracting private investment in municipal infrastructure.

Macroeconomic* management: Municipalities form an integral part of the public sector in South Africa, and their actions can substantially affect national policy. Municipalities need to operate within the national macroeconomic framework and their financial activities should not be such as to destabilise macroeconomic fiscal policy.

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2. A FRAMEWORK FOR A NEW MUNICIPAL FINANCIAL SYSTEM

2.1. Local revenue instruments and policies
2.2. Intergovernmental transfers

In order to achieve the objectives outlined above, the municipal fiscal and financial system needs to be restructured in four critical areas:

• Local revenue instruments* and policies.
• National-local intergovernmental transfers.
• Gearing in private investments.
• Budgeting, accounting and financial reporting systems.

Government's broad policy directions in each of these areas are outlined below. In each case the specific measures that are taken will need to be formulated in the context of government's overall macroeconomic and fiscal policies.

2.1. Local revenue instruments and policies

The power to tax is essential to sustainable and accountable local government. There are four important areas of local decision-making with respect to taxation:

• The choice of tax to be imposed.
• The definition of the tax base*.
• The choice of the tax rate*.
• Tax administration.

The choice of tax rate is the most critical means of promoting the fiscal autonomy* of local government. The freedom of municipalities to vary the tax rate strengthens local accountability, and enables communities to challenge municipalities about the value-for-money of services provided.

Any local tax policy must be seen within the framework of the total tax system and the need for a coherent and transparent tax system. Further, taxation policy must take into account any adverse consequences on the productive economy. National legislation must provide a framework within which local taxation policy must fit. The impact of property taxes and Regional Service Council and Joint Services Board levies must be assessed in terms of this framework and national macroeconomic objectives like job creation and the need for competitiveness.

Municipalities require access to adequate resources and budgetary powers to fulfil their assigned functions. On average, municipalities have sufficient revenue raising powers to fund the bulk of their expenditure, and finance 90% of their recurrent expenditure* out of own revenues. Own revenues include rates (19,89%) and trading services such as electricity (41,4%); water (11,8%); and sewage and refuse removal (8,22%).

These aggregate figures hide the fact there are great variations between municipalities across the country, and rural municipalities fund far less of their expenditure from own revenues than urban municipalities do. In fact, many municipal services are provided by national and provincial departments in rural areas. A more accurate picture will only emerge when rural local government becomes functional and assumes responsibility for the provision of these services.

2.1.1. Property taxation

The major source of local taxation is the property tax (rates). This is currently levied only in urban areas. The owners of property in municipal areas have to pay a tax based on a valuation of their properties in order to finance municipal services. While this tax is by no means the sole source of municipal revenue, it is an important source of discretionary own revenue* for local government and enables it to function effectively.

Rating in the country has historically been done differently in the various provinces. Each of the former four provinces had its own legislation in this regard. This legislation was never coordinated, despite the fact that the relevant circumstances in the former provinces did not differ much. The present system of property rating in South Africa is cumbersome, and a simpler and uniform system of valuation must be found.

Section 229(2) of the Constitution, which came into effect on 1 January 1998, states that the power of the municipality to impose rates on property may be regulated by national legislation. The provincial ordinances currently regulating property rating will, therefore, remain in force until they are replaced by national legislation in this regard.

Government will need to address four main issues with regard to property tax:

• First, the issue of bringing currently untaxed areas into the tax net. The newly amalgamated urban municipalities (which bring formerly black and white areas into one municipality) have decided in principle to extend the tax base to previously unrated areas. However, some of the former black areas remain outside the property tax net. Effective measures to integrate these areas into the property tax net need to be determined and implemented. Currently, property rates are still not being uniformly applied, and property valuations are often disputed.
• Second, there is the issue of variation in the rating system with regard to the tax base. The property (assessment) rates levied should be based on the market value of the property. The optimal method of valuation applicable to the South African situation should be determined. Possible rating systems that need to be reviewed are:
  • Site rating, or the valuation of land only.
  • The combined rating of land and buildings.
  • Differential or composite rating, where both land and buildings are rated together but at different rate levels, and where the rate levied on land is higher than that on improvements.
  • A rating system where a uniform rate is used for areas which were not previously rated, irrespective of the value of the property. (This is often called "flat-rating" in South Africa). The rate is usually lower than the actual value of the property.

The key decision that needs to be taken is whether there should be a uniform national system, or whether there should continue to be local choice in this matter.

• Third, the issue of valuation periods needs to be addressed. In many areas, properties are not valued regularly. A process of regular assessments of property values needs to be entrenched. Again, the question of national versus local choice in valuation periods needs to be determined.
• Fourth, there is a need to develop the criteria for evaluating alternative property valuation systems, within the framework of alleviating and addressing poverty. A municipality needs to develop a clear policy and set of procedures regarding the full or partial relief to those who are genuinely too poor to pay for rates. Any rebates or grants-in-aid* allowed on property tax (as prescribed in the relevant provincial/national legislation) should be clearly indicated in a transparent and consistent manner in the budget of a municipality.

It is important to note that local government should have the latitude to make certain decisions concerning the nature of the property tax in their area of jurisdiction, which reflect their unique circumstances and local economic objectives.

2.1.2. Regional Service Council and Joint Services Board levies

The Regional Service Council and Joint Services Board levies, are a source of revenue for Metropolitan and District Councils. Since their inception, the Regional Service Council and Joint Services Board levies have been controversial taxes.

The most serious problem with these levies is in the administrative costs of collection. They are collected by municipalities themselves rather than by a national collecting agency like the SA Revenue Services, and the scope for evasion is high. A second and even more serious problem is that the levy is a tax on staff or labour. This reinforces the bias against labour-intensive firms.

Despite these problems, these taxes are an important source of municipal revenue, and will need to be retained, at least until such time as a suitable alternative, yielding the same net revenue, is introduced.

The effectiveness of regional and establishment levies as engines of development will be assisted by the development of clear rules about the uses to which municipalities can put these funds. It is proposed that District and Metropolitan Councils should utilise the levies for the development and maintenance of infrastructure linked to the needs of the community.

The uncontrolled use and increase of regional and establishment levies could lead to sharp increases in the effective taxation of commerce and industry. Vastly differing levy rates could cause negative inter-jurisdictional spillover effects. However, as long as these levies are restricted to low levels and are ultimately subject to national control, these potential negative effects can be minimised. National oversight with regard to the determination as well as utilisation of these levies is therefore required to ensure an optimal system of Regional Service Council and Joint Services Board levies.

2.1.3. Fuel levy

Schedule 5 (Part B) of the Constitution determines that municipal roads are a functional responsibility of the local government sphere. In this context, consideration will be given to assigning a percentage of the fuel levy to local government. The fuel levy represents a potentially important source of revenue for local government due to its ability to grow, and the ease with which it is administered.

The issue of a local government fuel tax needs to be seen within the context of the national fuel levy. National government will develop a set of principles that will provide a framework within which these funds will be spent. One such principle is that fuel taxes are best suited for recovering the maintenance costs of roads.

2.1.4. User charges

An important source of local own revenue are charges which are directly related to the provision of public services. The majority of these are public utility charges - such as electricity and water - which have contributed significantly to the growth of revenue of municipalities.

Cost recovery* is an essential part of sustainable service delivery. However, municipalities will not be able to meet all the costs associated with addressing backlogs. National government has therefore provided a capital grant package, the Consolidated Municipal Infrastructure Programme to assist municipalities in meeting the capital costs of bulk and connector infrastructure. The new system of intergovernmental transfers is aimed at subsidising the operating costs of basic services to indigent and low-income households.

Government and stakeholders have agreed on a set of principles to guide tariff policy:

• Payment in proportion to the amount consumed: As far as is practically possible, consumers should pay in proportion to the amount of service consumed.
• Full payment of service costs: All households, with the exception of the indigent, should pay the full costs of the services consumed.
• Ability to pay: Municipalities should develop a system of targeted subsidies to ensure that poor households have access to at least a minimum level of basic services.
• Fairness: Tariff policies should be fair in that all people should be treated equitably.
• Transparency: Tariff policy should be transparent to all consumers and any subsidies and concessions which exist must be visible and understood by all consumers.
• Local determination of tariff levels: Municipalities should have the flexibility to develop their own tariffs in keeping with the above principles.
• Consistent tariff enforcement: A consistent policy for dealing with non-payment of tariffs needs to be developed. This must be targeted and enforced with sensitivity to local conditions.
• Ensure local economies are competitive: Local tariffs must not unduly burden local business through higher tariffs, as these costs affect the sustainability and competitiveness of such businesses and firms.

Municipalities need to develop a clear tariff policy, including a policy to ensure that indigent households have access to basic services. Tariff enforcement needs to be linked to improved credit control mechanisms.

2.1.5. Credit control*

It is vital to the long-term financial viability of any municipality that it collects the revenues due to it for services rendered. This means that appropriate credit control mechanism must be established.

As a first step, municipalities need to be able to measure the amount of services that households consume. This means that metering of services such as water and electricity must take place efficiently.

Secondly, households need to receive regular and accurate bills for the services they use, in a format which is easy to understand. In some areas special arrangements may be required to ensure that households receive bills regularly.

Thirdly, credit control measures will only be successful if targeted relief is available for those households who cannot afford to pay for services. Municipalities must establish accessible mechanisms to enable poor households to apply for a rebate on service charges.

Fourthly, municipalities need to take strong measures to deal with those households who can afford to pay for services but are not doing so. This means that municipalities must keep a proper record of outstanding debtors, and must take action against them after a given notice period. Such action can include cutting off services or court action to recover debts. It is fundamentally important that local government is able to retain the power to cut off electricity to consumers as a credit control measure, and amendments to the Electricity Act will be promulgated in this regard.

2.1.6. Financing municipalities in rural areas

Measures to improve the financial viability and revenue base of rural local government are required. A substantial portion of the share of the national fiscus reserved for local government will be directed at rural municipalities. In addition, the institutional restructuring of existing municipalities will result in increased financial viability. Directing sectoral funding for housing, water infrastructure and so forth via rural municipalities will also strengthen local capacity. However, other mechanisms to improve the financial viability of rural local government are required.

One option is the extension of the property tax to rural areas. Because property is immobile and allocation thereof cannot be distorted, property tax is an ideal local tax. The acceptability of extending property taxes to rural areas would be increased if the revenue raised is spent in the area where it is raised, with visible benefits for local communities. Revenue generated from property tax could be used primarily (but not necessarily exclusively) for rural infrastructure purposes, e.g. road infrastructure and maintenance of roads in rural areas. Although a property tax could be an important source of revenue for rural municipalities, the total amount raised would be limited.

The rate at which the property tax is extended should be approached cautiously. The rate should either be equal or less than the average rental return on land ratio*. The rate should also be high enough to cover the costs of administering the tax, and ensure that a reasonable return is yielded. When considering the applicable tax rate, the relation between the rural property tax and other local taxes (e.g., Regional Service Council and Joint Services Board levies) will have to be considered.

A combination of revenue-generating options, including betterment taxes, will need to be explored further to secure the financial viability of rural local government.

In addition to the above categories of revenue (property tax, metropolitan and district levies, user charges, and fuel tax) municipalities derive revenues from capital grants as well as intergovernmental grants for operating expenditure. Given local government's pivotal role in delivery and development, further consideration should be given to adding to the revenue-raising powers of local government.

2.2. Intergovernmental transfers

Intergovernmental transfers are important to the fiscal relationship between national and local government. There are three basic types of transfer:

• Agency payments paid by provincial governments to municipalities for services rendered by the latter on behalf of the former.
• Grants to subsidise the capital costs of investment in municipal infrastructure.
• Grants to support the operating budgets of municipalities.

2.2.1. Agency payments

Agency payments are fees rather than grants and there is no necessity for any change to this aspect of the transfer system. However, it is imperative that municipalities ensure that payments received from provinces are sufficient to cover the full cost of the services which municipalities deliver on their behalf.

2.2.2. Capital transfers

During 1996-97 a process of rationalising the various capital grants flowing to municipalities into a single funding channel, the Consolidated Municipal Infrastructure Programme, was initiated. Some further rationalisation of capital transfers flowing to municipalities - particularly those in rural areas - is required. In general, however, the Consolidated Municipal Infrastructure Programme has successfully begun to deal with the problems of fragmentation and duplication that characterised the capital grant programmes of the past. It is therefore not anticipated that there will be any major changes to this programme in the foreseeable future.

2.2.3. Transfers to fund operating costs

The current system of operating transfers, however, is highly problematic and requires urgent policy attention. In general, the current problems include:

• The grant system is inconsistent and inequitable.
• Grants are unpredictable - there is no certainty as to what any municipality will receive in any given year.
• The grants are not based on objective, rational policy criteria.
• The incentives in the current system sometimes encourage poor financial management behaviour by municipalities.

In order to address these problems, and so as to comply with Section 214 of the Constitution, government will fundamentally restructure the system of operating transfers to municipalities and - in so doing - will introduce an "equitable share" of national revenue for local government, beginning in the 1998-99 fiscal year.

The new system of intergovernmental transfers will need to address two key issues: the "vertical division" of revenue - the total share of revenue going to local government, and the "horizontal division" of this revenue - how the total amount is divided between municipalities.

The vertical split will be decided via the national budgeting (medium-term expenditure framework) process, taking into account the factors put forward in Section 214 (2) of the Constitution.

It should be noted that the "equitable share" covers only those transfers to fund the operating costs of municipalities. Capital transfers, for example, are classified as "additional conditional grants" in terms of the Constitution. The "equitable share" in other words should not be confused with the total amount of national revenue flowing to municipalities. The amount of the "equitable share" component of national-local flows can only be properly determined with due regard to the other transfers to municipalities. As certain subsidies to municipalities are phased out, the equitable share will need to expand.

The horizontal division of the equitable share between municipalities will need to be driven by five key objectives:

• Equity.
• Efficiency.
• Ensuring a basic level of administrative capacity in the most resource-poor municipalities.
• Predictability.
• Incentives for proper financial management at the local level.

In order to achieve this a transparent, formula-based system will be phased in over a period of four years for urban municipalities and seven years for rural municipalities. The dominant principle underlying this system will be equity - it should enable all municipalities to provide a basic level of services to low-income households in their areas of jurisdiction at affordable cost. A secondary principle will be effective administrative infrastructure: the system should ensure that even the most resource-poor municipality is able to build a basic level of administrative infrastructure to allow it to govern its area effectively. Many municipalities are already in a position to provide this without financial assistance from the national fiscus. Therefore, this aspect of the formula will need to have an equalising dimension to it.

A formula-based approach by its nature removes discretion over the allocation of funds to municipalities. The funds will therefore best be allocated directly from the central fiscus to municipalities rather than via the provinces. In order to ensure certainty it is also important that transfers are allocated to those municipalities which have actual expenditure responsibilities in respect of service provision and governance.

2.2.4. Targeting intergovernmental transfers

One of the key goals of restructuring the systems of intergovernmental transfers is to assist the indigent to access services. When fully operational, the new system of intergovernmental transfers will enable all municipalities to deliver a package of basic services to all low-income and indigent households in their areas. This funding will be complemented by capital grant funding channelled via the Consolidated Municipal Infrastructure Programme.

With a few exceptions, it will be difficult to ensure that intergovernmental transfers effectively reach particular target groups, such as the poor. Intergovernmental transfers are primarily intended to subsidise the provision of local public services, and it is difficult to pinpoint which particular individuals and groups will utilise such services. Unless the entire geographic community happens to be members of the target group (e.g. a poor rural community), transfers are unlikely to benefit only the intended target group. Transfers from national government to municipalities are therefore a blunt instrument to reach the poor, unless the individual municipalities use these transfers to provide those local services that impact positively on the lives of the poor. The actual targeting of these intergovernmental transfers, and ensuring that only eligible households have access to subsidised services, will therefore be the responsibility of individual municipalities.

2.2.5. Local government participation

Given the monitoring and oversight powers of provincial governments with respect to local government, provincial MECs responsible for local government should also participate in forums and processes related to local government finance.

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3. LEVERAGING ADDITTIONAL INVESTMENT IN THE MUNICIPAL SECTOR

3.1. Borrowing and investment powers of municipalities
3.2. Credit enhancement
3.3.Concessional loan finance

Previous government studies - such as the Municipal Infrastructure Investment Framework - show that in order to meet infrastructure backlogs and secure access for all to basic services, additional investment in municipal infrastructure from the private sector and public sector financial intermediaries is required. There are three key areas of municipal finance which support additional investment in the municipal sector, namely:

Borrowing and investment powers of municipalities.

Credit enhancement*.

Concessional loan finance*.

Private sector investment can also be encouraged through the regulation of public private partnerships and the establishment of a system to monitor the financial position of municipalities, which are discussed in Section C: Cooperative Government and Section F: Administrative Systems.

3.1. Borrowing and investment powers of municipalities

The Local Government Transition Act (Second Amendment Act) extended and introduced broad uniformity into the borrowing powers of municipalities. Consideration should be given to further expanding municipal borrowing powers. There is also a need to define the exact nature of the regulation of these powers by national legislation. The Second Amendment Act also liberalised the regulatory framework for municipal investment, and this trend may need to be extended.

Ultimately, a vibrant and innovative primary and secondary market for short and long term municipal debt should emerge. To achieve this, national government must clearly define the basic "rules of the game". Local government will need to establish its creditworthiness through proper budgeting and sound financial management, including establishing firm credit control measures and affordable infrastructure investment programmes. Finally, a growth in the quantum, scope and activities of underwriters and market facilitators (such as credit-rating agencies and bond insurers) will be required.

If private investment is to be encouraged, greater clarity needs to be achieved with respect to the security of loan investments. This will be facilitated by the development of a framework for monitoring the financial position of municipalities, building on current laws and practices (such as Project Viability). National government's approach emphasises the importance of achieving financial discipline through decentralised market relationships (between borrower and lender), rather than the direct, centralised control of local government. This is in line with the fiscally decentralised orientation of the Constitution.

The rules governing intervention in the event that municipalities experience financial difficulties need to be clearly defined and transparently and consistently applied. It is critical that municipalities, investors, as well as national and provincial government, have a clear understanding of the character of their respective risks. Risks should not be unduly transferred to national or provincial government.

3.2. Credit enhancement

Measures to enhance credit

National government will not provide sovereign guarantees of municipal debt. However, there are a range of other mechanisms which can be considered to enhance the credit of municipalities, including:

Municipal bond insurance*.

Treasury trusts*.

Interception of intergovernmental transfers*.

Debt syndication*.

Bond banking*.

Other measures which may indirectly enhance the credit of municipalities include introducing better municipal accounting systems, the provision of relevant and reliable information, a clear framework for supervision by other spheres of government, procedures for intervention when failure occurs, establishing fiscal certainty (grant flows, ownership of local tax bases, etc.) and clarifying the role of concessional loan finance.

3.3. Concessional loan finance

Although municipalities have fairly extensive borrowing powers, current conditions at local level and in the capital market effectively constrain the ability of municipalities to raise loans. Concessional loan finance - offered through a public sector financial intermediary - can play an important role in enabling municipalities that cannot gain access to credit from the capital market to borrow at an affordable price.

Specialised institutions for providing concessional loan finances to municipalities are not intended to replace the existing commercial financial institutions, but rather to complement them. Commercial and public sector financial institutions should play complementary roles.

Objectives of concessional loan finance

Public sector financial intermediaries are designed to achieve a range of objectives, including to:

Make credit accessible: One of the major obstacles facing municipalities is securing loans on the private capital market, and financial intermediaries have the potential to provide municipalities with access to credit.

Mobilise additional resources: Financial intermediaries can be granted sufficient powers to enable them to pool funds from various sources - including the domestic capital market - and then on-lend these funds to the various municipalities.

Provide technical assistance: Apart from the primary goal of ensuring municipalities have access to long-term capital financing, financial intermediaries can promote municipal capacity in order to improve the use of resources.

Financial intermediaries generally provide long-term credit financing for municipal investments, and could potentially play a critical role in funding municipal infrastructure.

It should be noted that:

Where public sector financial intermediaries are involved, care must be taken to ensure that government does not subsidise the borrower in a manner which is not transparent or clearly quantified so that the subsidy is not absolutely clear.

Public sector financial intermediaries should not "crowd out" or discourage private sector investment. In fact, they are key agents to support the development of an effective market for municipal debt and to enhance the overall level of investment in the municipal sector. Within the framework of the RDP, public sector financial intermediaries should actively support financial markets and endeavor to engage the private sector in these markets.

Concessional finance sources could introduce the discipline of loan finance to municipal institutions which find it difficult to access private markets. This discipline in the way municipalities conduct their financial affairs should be a basic principle of concessional loan finance so that, in the long term, such municipalities will be able to satisfy the requirement of the markets and so gain access to private sector investment.

Public sector financial intermediaries clearly have an important role to play in making loan finance available to municipalities. The role of such institutions should be constantly monitored, refined and streamlined in relation to the private sector's role in the municipal sector. Through targeted loans and technical assistance they can support the development of a municipal debt financing system.

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4. BUDGET, ACCOUNTING, FINANCIAL REPORTING AND MANAGEMENT

Municipal budgets are a critical tool for re-focusing the resources and capacity of the municipality behind developmental goals. To this end, budgets must be developed in relation to the policies and programmes put forward in municipal integrated development plans.

Given that resources are scarce, community participation in the development of both integrated development plans and municipal budgets is essential. Participation provides an opportunity for community groups to present their needs and concerns. It enables them to be involved in the process of prioritisation, and to understand and accept the trade-offs which need to be made between competing demands for resources.

Current budgeting, accounting, financial reporting and financial management practices of municipalities suffer from a number of weaknesses. These weaknesses may act as disincentives to community participation and to private investment. In some municipalities these weaknesses include:

• Unrealistic budgeting.
• Poor credit control.
• A lack of budgetary and financial discipline.
• A lack of user-friendly and accessible information on the budget process.

Addressing these problems requires local political will and improved management efficiency. It also requires a number of national changes to systems.

4.1. Generally accepted accounting practice for municipalities

Much progress has been made in recent years in defining and introducing generally accepted accounting practice standards for local government. Only minor changes are now required, except in the case of accounting for fixed assets*. Applying accounting principles specifically tailored for municipalities will promote transparency. It will enable the content and presentation of financial statement information to be consistent and so enable informed decision-making on risk and returns.

4.1.1. Reserves, provisions and funds

Current accounting principles and disclosure of the internal financing of fixed assets is complex. This does not promote transparency. It does not enable councillors, management and the public to gain an understanding of the true financial position of the municipality. For example, the extent to which funds or reserves have been used to finance fixed assets or make temporary advances to the operating account cannot be easily determined.

In order to address this - and to prevent excessive taxation before there is a need - there needs to be a limitation on the number of reserves permitted. However, all municipalities should establish a working capital reserve, which should be based on debtor balances and take into account the possible non-recovery of income included in the annual budget.

Existing funds should also be consolidated as far as possible and the accounting entries relating to the internal financing of the fixed assets simplified. This should enable external users, particularly financial institutions, to obtain a clearer understanding of the financial position of the municipality concerned.

4.1.2. Capital accounting

A fundamental difference between existing municipal accounting principles and generally accepted accounting practices relates to accounting for fixed assets. At present, fixed assets are recorded at historic cost (their original purchase cost). No account is taken of wear and tear incurred in the provision of the services. As a result, there is some risk that the true cost of rendering services is understated. This has a negative impact on proper price and tariff setting. More realistic fixed asset values will facilitate more accurate decision-making in a range of areas, including the valuing of services for public-private partnerships, relating maintenance expenditure to replacement costs, and providing for sustainability and replacement costs through depreciation.

4.1.3. Internal reporting

The lack of minimum internal reporting standards in the past limited the effectiveness of senior management and councillors - key financial information was not presented on a regular basis or in a clear and easy-to-understand format. As a result, it was difficult for management and councillors to react proactively to a change in the financial position of the municipality. The recently promulgated regulations on financial reporting by municipalities under the Local Government Transition Act will in future regulate such reporting. Further guidelines on the content and frequency of internal reports need to be formulated to improve financial management.

4.1.4. External reporting

An important policy principle in ensuring accountability in municipal finances is the submission of annual financial statements to an external body such as the Auditor General. LGTA spells out the chief executive officer's responsibilities with respect to the compilation and submission of annual financial statements to the Auditor-General. Annual financial statements need to portray financial viability and enable an accurate assessment of the risk to be undertaken if the use of private sector funding, in whichever form, is to be undertaken.

In respect of reporting to the community, there is a perceived lack of transparency as municipalities often do not understand the information needs of the community. It is unlikely that there will be significant demand for audited annual financial statements. Therefore municipalities need to consider preparing Mayoral budget addresses and annual reports as a way to present information which is credible and understandable, and allows citizens and communities to assess municipal expenditure against the municipal integrated development plan.

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5. CONCLUDING COMMENT

The restructuring of local government in South Africa has caused the newly formed municipalities to experience a variety of financial challenges. These have included:

• Dramatically increased services responsibilities.
• Increased administrative costs.
• Upward pressure on salaries.
• Cuts in operating subsidies.
• Reductions in experienced personnel, especially in the financial sector.

These challenges have placed significant pressure on municipalities' cash flows and have led to a reduction of their financial resources. Although various actions have been taken by government to address the current crisis situation in municipalities in the short to medium-term, long-term solutions are required to restore financial discipline, eliminate outstanding debts and generate the necessary cash flows.

Moreover, it is vital that provincial and national government assist municipalities and councillors in this process. They need to communicate to municipalities the importance of making affordable choices up front. They also need to communicate the total commitment of government to building a financially independent and viable system of local government in the long-term.

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  Contents | General | Section A | Section B | Section C | Section D | Section E | Section F | Section G | Section H | Annexure A | Annexure B | Annexure C | Annexure D | Glossary | Obituary