Steering of local government finances

Conclusions and recommendations of the National Audit Office

Steering of local government finances has a significant role in ensuring the sustainability of public finances. In 2015, the overall steering of local government finances (macroeconomic steering) was reformed as part of changes to the general government fiscal planning. The aim of the reform was to meet the requirements laid down in the EU Budgetary Frameworks Directive. The system of central government transfers and the provisions of the Local Government Act steering the finances of individual municipalities (microeconomic steering) have also been revised.

The objective of the audit was to assess whether the Ministry of Finance is coordinating the steering of local government finances in an effective and efficient manner, as well as to ensure transparency of the steering of local government finances. Furthermore, the aim was to assess the changes made to the steering mechanisms, as well as the reliability of the knowledge base for steering of local government finances.

Overall, the measures taken to reform the steering of local government finances have been effective

On the basis of the audit, it can be stated that the steering system for local government finances mostly functions well. Communication between the different parties has improved along with the introduction of the new steering model for local government finances, and the further needs for development have been well identified.

The budgetary position in ratio to GDP target separately set in the General Government Fiscal Plan for local government finances (the budgetary position target) and the limit for expenditure arising to municipalities from central government measures (the expenditure limit) connect the steering of local government finances as part of the overall steering of general government finances. The Local Government Finance Programme drawn up in connection with the General Government Fiscal Plan has also provided a deeper view of the state of local government finances and factors affecting it.

The reform of the Local Government Act also involved amendments to the provisions concerning local government finances. The new provisions steer the finances of individual municipalities more clearly towards the budgetary position target set for the entire local government sector. Another decision that has improved the efficiency of the steering of local government finances is that now corrections to the division of costs between central and local government, which is part of the system of central government transfers, are made annually.

The monitoring of the implementation of the expenditure limit and the principle of adequate financial resources is lacking

Setting a separate expenditure limit for the local government sector has improved the transparency of the funding of the basic services imposed by the state on municipalities. It has also become an important addition to the range of tools facilitating the achievement of the local government budgetary position target. However, the expenditure limit cannot alone guarantee that all central government measures targeted at the local government sector are in line with the objective of achieving the local government budgetary position target. Reduction in expenditure does not improve the local government budgetary position if revenues are also reduced at the same time.

Indeed, the expenditure limit is better suited to reflect the potential for savings in municipalities enabled by central government measures than actual reductions in the level of expenditure. On average, the savings impacts of measures performed to achieve the expenditure limit have been overestimated. The audit revealed that the justifications for the expenditure limit set, the monitoring of the implementation of the expenditure limit, and the related impact assessments are not reported in a systematic and open manner. Furthermore, the justifications for the expenditure limit do not specify the uncertainties related to the impact assessments performed or contain any impact assessments on alternative measures.

The Local Government Finance Programme provides information about the financial position of municipalities, but the practical impacts of the programme on the steering of local government finances and on local government decision-making remain limited. The Local Government Finance Programme also covers the implementation of the principle of adequate financial resources. The principle of adequate financial resources means that the state must ensure that the financing issued to municipalities to perform their statutory duties is adequate. However, the analysis provided in the Programme of the implementation of the principle of adequate financial resources is rather mechanical and does not take a clear stand on the question whether the principle of adequate financial resources is followed.

Microeconomic steering could better support the achievement of the macroeconomic targets

The budgetary position target set for the local government sector is determined on the basis of the concept of net lending according to National Accounts, while the thresholds for the steering of local government finances are based on the concepts of municipal accounting. The differences between these two accounting systems reduce the transparency and efficiency of the system for the steering of local government finances. Instead of deficit, a threshold determined on the basis of cash flows from operations and investments would be more compatible with the concept of net lending according to National Accounts, and its adoption would clarify the overall steering of local government finances. Cash flows from operations and investments has already been introduced as one of the key indicators in connection with the organisation of the steering of the regional government sector.

It seems that a group of municipalities of major economic importance still remains outside the scope of the microeconomic steering, although including them would be important in terms of the achievement of the macroeconomic steering targets. The purpose of the financial steering criteria laid down in the Local Government Act is to identify the municipalities in which the provision of the basic services is com-promised. The criteria emphasise the need to cover any deficit in the municipality’s balance sheet, which does not provide a sufficiently comprehensive view of the budget balance of the municipality. For example, depreciations have systematically been lower than what is recommended, which consequently has reduced the deficit. At the same time, investments in the local government sector have exceeded depreciations, which has enabled indebtedness to grow without breaching any thresholds set out in the Local Government Act.

The state contributes to the financing of basic services by means of central government transfers. The significance of central government transfers as the source of income for municipalities varies greatly: the significance is higher in municipalities with a higher need for services and a more limited revenue base. The system of central government transfers has been generally utilised in the practical implementation of adjustments to the financial relationship between central and local government, for example, to compensate municipalities for loss of tax revenue. Measures supporting the achievement of the macroeconomic steering targets, such as cuts in central government transfers or the incorporation of performance incentives into the system of central government transfers, could undermine the overall effectiveness of the system and have unintended consequences in municipalities.

The information base for local government finances and the steering processes do not support knowledge-based management

The efficiency of the steering of local government finances could be enhanced by developing the underlying information and its efficient and timely use. There is still room for improvement in terms of the comprehensiveness and comparability of data collected for the needs of municipal steering. The creation of standardised data specifications within the framework of the Local Government Data Programme (Kuntatieto-ohjelma) has enhanced the quality of the knowledge base, but more attention should be paid to making the specifications binding. In the steering processes, the focus of analyses is on the ex-post assessment of decisions and on the transfer of data between different actors.

Abolishment of the misaligned incentives between central and local government finances was one of the objectives of the reform of the system for the steering of local government finances. It is essential to take account of the overall situation of general government finances in order to achieve the national budgetary position targets. Consequently, it is also important to coordinate the steering of local government finances outside the influence of representation of interests of individual subsectors of general government finances. Otherwise, the risk for overemphasising the interests of central government finances increases in the preparation of measures targeted at the local government sector. Furthermore, attention should be paid to ensuring the independence of the party responsible for the coordination of general government finances.

Recommendations of the National Audit Office

Based on the audit, the National Audit Office recommends that the Ministry of Finance:

1. enhance the transparency of the justifications for the expenditure limit set, as well as the monitoring of its implementation;

2. further develop the comprehensiveness of the assessment of the implementation of the principle of adequate financial resources provided in the Local Government Finance Programme;

3. enhance the coordination of the microeconomic and macroeconomic steering systems, improve the transparency concerning the differences between the systems, and further coordinate the rules steering general government finances. The budget balance requirement set for individual municipalities should be specified so that it can better steer the municipality towards the macroeconomic balance targets;

4. further develop the contents of the information base according to the needs of the local government steering. The rules and guidelines governing the data contents should be made more binding.