Fiscal social contracts: Cities’ key to revolutionizing public finance?

Lessons from the Philippine city of Naga and the turnaround efforts of its former six-term mayor.
Despite initial difficulties, Mayor Jesse Robredo, seen here at left collecting post-typhoon donations in 2009, began transforming the city’s moribund finances by the end of his first year in office. (Facebook via Rappler.com)

When the late Jesse Robredo was elected mayor of Naga in 1988, the Philippine city was in dire financial straits. Its coffers were in the red, its tax base had eroded to only 2,000 enterprises and tax avoidance was endemic, exacerbated by rumours that local officials were receiving kickbacks from a gamut of illegal activities.

Yet over the next two decades, the six-term mayor spearheaded what would become a legendary reversal of the city’s fortunes. From the 1988 levels of PHP 13 million (about USD 250,000), Naga’s local revenues grew by an astounding 565 percent by 1998 (PHP 86 million) and 1,942 percent by 2010 (PHP 252.4 million).

Major improvements in governance and service delivery paralleled these developments in the city, which is today home to around 200,000 people. To begin with, Naga became the first local government in the country to create a “People’s Council”, allowing civil society groups to engage as full peers in city policymaking. With such gains came accolades — so much so that by the late 2000s, the Naga government could boast of being the most awarded of its kind in the Philippines.

[See: Breaking municipal finance down to its basics]

But unknown to most, this story behind Naga’s transformation tells us more about a promising strategy for driving inclusive gains in local public finance: that of local governments’ entering into fiscal social contracts with their taxpayers and citizens. Not only have such contracts been a prime historical means for sustained local fiscal expansion, but they often have catalyzed long-term advances in accountable governance and public service delivery — key thrusts of the New Urban Agenda’s vision of inclusive and sustainable cities.

Financing the New Urban Agenda

Some have seen the New Urban Agenda, ratified in October 2016, as heralding a paradigm shift in how cities and human settlements are to be planned, financed and governed. In particular, the document has garnered praise for enshrining the notion of the “right to the city” at the forefront of its “shared vision” for urban development.

“Over the long term, fiscal social contracts thus can spur virtuous cycles of heightened revenue, improved governance and better public services.”

But summoning the finance needed to meet the investment demands required by the agenda’s various commitments for realizing inclusive and sustainable cities will be no small feat. According to the World Economic Forum, for one, worldwide funding gaps for basic urban infrastructure investments are on the order of at least USD 1 trillion annually.

[See: How developing cities can improve their finances and attract investment]

The trillion-dollar question thus is: How can cash-strapped city governments close these funding deficits? While plaudits for innovative funding vehicles such as pooled financing, land-based financing and green municipal bonds peppered the New Urban Agenda negotiations, the reality is likely to be more prosaic.

Simply take the largest historical precedent to the present generation of development frameworks: the Millennium Development Goals (MDGs), which were in place from 2000 to 2015. In fact, based on estimates by Oxfam and Development Finance International, domestic public resources comprised 77 percent of all MDG-related spending across the world as of 2014.

Domestic public resources mean taxes. And for local governments empowered by fiscal decentralization, they will especially mean property taxes, local business taxes and local excise taxes (for instance, on motor vehicles). Yet in urban areas across the Global South, public revenue systems have been in poor shape. Local governments not only have been chronically underfunded but have tended to underutilize the bulk of tax instruments available to them.

Dismal property tax takes are a case-in-point. Despite their progressivity and potential for raising substantial and stable revenues, property tax collections have comprised only 0.7 percent of gross domestic product on average among developing countries (versus 2 percent for OECD countries), and have raked in next to nothing in low-income countries (0.1 percent of GDP).

[See: Turning cities’ focus back to land-based finance]

The factors behind such revenue malaise are hardly new. There is, for one, a host of institutional constraints on local governments around the world — widespread corruption, pervasive tax avoidance and evasion, limited technical knowhow and human resources, and a dearth of frameworks to support improved revenue-raising. And especially in functioning democracies, the fear of taxpayer resistance spilling over to the ballot boxes often saps local officials of the political will needed to reform and upgrade their fiscal systems.           

Torn between the rock of fiscal weakness and the hard place of fiscal contention, local governments usually find that the political trade-offs of securing long-term tax gains can be too costly to undertake. What can be done to resolve these collective action dilemmas that lie at the heart of local fiscal reform?

Treating taxes as the fulcrum of a fiscal social contract may be the crux of an answer.

Taxation as a social contract

Over and above the technicalities used by global tax experts, taxation ultimately consists of a set of negotiated relationships between states and citizens. Since the very act of taxing something tends to spark resistance, any tax system must somehow succeed at securing the compliance of a critical mass of taxpayers to remain viable. Yet such compliance hardly ever arises spontaneously, given that taxpayers have every incentive to complicate this process: if not to outright oppose the imposition of new taxes, then to extend demands over the burden of taxes and the spending and management of collected revenues.

“Property tax collections have comprised only 0.7 percent of gross domestic product on average among developing countries (versus 2 percent for OECD countries), and have raked in next to nothing in low-income countries (0.1 percent of GDP).”

Failure to deal effectively with bargaining between governments and taxpayers thus can prove fatal for national and local fiscal reform agendas. Unsurprisingly, numerous episodes of technically sound but decidedly non-consensual tax reform initiatives in developing countries show that tax reforms that bypass open bargaining between the state and citizens are unlikely to be sustained beyond the short term. Strong examples include Uganda and Peru’s experiences in reorganizing their revenue authority into autonomous agencies in the 1990s.

[See: How Dakar (almost) got its first municipal bond to market]

By comparison, proactively engaging in such bargaining can represent an especially promising avenue for long-term fiscal improvements — especially if they result in the formation of mutually beneficial social contracts in which citizens comply with tax obligations in exchange for states’ providing better governance and services. As much of the latest research has demonstrated, governments’ entering into such fiscal pacts has historically been one of the most reliable means of building up robust and effective tax systems (see here and here).

The appeal of this approach goes beyond raising revenue. Not only are tax compliance and fiscal stability likely to improve, but by compelling governments to make credible commitments on taxpayers’ demands, tax bargaining also can positively affect spending, services delivery and accountability. Over the long term, fiscal social contracts thus can spur virtuous cycles of heightened revenue, improved governance and better public services.

Local tax reform efforts around the world suggest that local governments, led by cohesive reform coalitions, can foster such contracts. The inclusive public finance record of Porto Alegre is perhaps the most iconic example, with its celebrated participatory budgeting mechanisms actually serving as a central venue for consensus building on tax reform initiatives that expanded its local revenues by an unprecedented 338 percent from 1988 to 2004.

Participatory budgeting in Brazil not only has been critical in empowering citizens in municipal budgeting processes but also in bargaining constructively over how to raise revenues. Participatory budgeting exercises in Recife, as seen in this 2009 event, have been linked with a significant increase in local revenues and tax compliance. (Waterlat Gobacit/Flickr/cc)

In a similar way, by encouraging open and inclusive negotiations over local revenue and spending policies, and adopting early transparency and accountability measures, local government officers can effectively shore up trust and lead to constructive debate between local public officials and taxpayers.

[See: How Boston gives youth control over part of the city budget]

Likewise, by adopting a few key strategies — such as increasing the visibility and directness of proposed taxes, linking them to an agenda for shared prosperity, ensuring that taxes are enforced in line with existing perceptions of fairness, and fostering citizen’s awareness and capacity on tax matters — city governments also can democratize public discourse on tax matters, motivate taxpayers to effectively bargain with them and support the building of a broader culture of tax compliance.

Inclusive public finance, governance

This brings us back to the story of Naga and then-Mayor Robredo, which illustrates the potential of such measures to make great strides forward in progressive revenue-raising, pro-poor public spending, and accountable and inclusive governance. Narrowly winning the mayoralty of a Naga city government that was PHP 1 million in debt in 1988, Robredo — working initially without a majority in the city’s legislative council — moved to curb local business tax avoidance, bolster the trust of constituents and ultimately secure a majority in the city’s legislature in subsequent elections.

Through a mixture of constructive negotiations with the local business community (such as pledging to reinvest taxes to revive Naga’s ailing economy) and firmer tactics (launching preliminary investigations into under-declaration of local business earnings), tax compliance improved by leaps and bounds, closing the city’s budget deficit within a year.

[See: Lessons from Mexico City’s green bond, the first municipal issuance in Latin America]

Trust-building measures followed, such as crackdowns on the city’s reviled but powerful illegal vices sector, instituting a merit-based system for the Naga government staff and forming alliances with progressive civil society organizations. These also met with notable success, delivering a landslide victory to all city council candidates under Robredo’s ticket in the 1992 elections.

Having secured a working political coalition, an energized bureaucracy and high levels of public trust, Robredo was able to undertake even bolder initiatives. Through open negotiations with Naga’s business community, Robredo secured the endorsement of the city’s Chamber of Commerce to raise property taxes in practically every subsequent term. This funded new physical (concrete roads) and social infrastructure (schools), improved general public services (garbage collection efficiency), and boosted social spending (urban poor housing, child nutrition programmes).

In 2009, Naga was conferred a “Hall of Fame” award for being consistently among the Philippines’ most outstanding local governments, which Robredo received from President Gloria Arroyo. (R. Baniquet/Philippine News Agency)

In turn, these paved the way for a local socioeconomic resurgence. The city’s per capita income grew by 17.3 percent annually between 1993 and 1998, even while malnutrition (a leading cause of child death in 1994) was largely eradicated as a major public health concern.

No less striking, due to its ambitious governance innovations — such as the 1995 landmark creation of the participatory People’s Council and a 2001 “i-Governance” platform that fully disclosed the city government’s financial operations — Naga rapidly built a reputation as a model local government worldwide. In 1999, it was even recognized as the “most improved” city in Asia by CNN’s Asiaweek magazine.

[See: New solutions to close the gap on municipal finance]

Throughout this transformation, Robredo has been described as forging a new social contract with active citizens and progressive organizations, in order to shift Naga city’s development pathway into one of “growth with equity.” Yet the potential for such turnarounds in local governance is not unique to Naga. Indeed, local governments around the world, including those facing major institutional constraints, can already make major advances in overcoming the challenges of funding inclusive development by spurring constructive bargains with their constituents on tax matters.

Although there are no quick fixes for financing inclusive cities, an approach focused on social contracts — premised on building mutually beneficial relations between accountable governments and empowered citizens — holds tremendous promise for shoring up long-term gains in local fiscal expansion, inclusive governance, pro-poor spending and quality public services. In the years to come, efforts to facilitate such contracts will be at the heart of turning the promise of sustainable and inclusive urban development into reality for all of the world’s cities.

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Jerik Cruz

Jerik Cruz is an economist and lecturer at the Ateneo de Manila University (Philippines) whose research focuses on public finance, political economy and urban development issues. This commentary is based on research he conducted for Public Services International on Tax Justice, Inclusive Cities, and the New Urban Agenda.