The Sustainability of Local Government Finances in England, Germany, and the Netherlands: The Impact of Intergovernmental Regulatory Regimes

Abstract

De Widt investigates how local government financial sustainability is influenced by the regulatory framework in which local governments operate. Applying a comparative constitutional approach, the chapter analyzes the regulatory regimes on local finances in England, Germany, and the Netherlands. The regimes are investigated by concentrating on the impact of fiscal rules, and the monitoring structures in place to impose their implementation. Special attention is paid to the institutional arrangements that apply to non-compliant local authorities. The author demonstrates that growing local financial stress is partly met by regulators with a relaxation of fiscal rules, carrying considerable risks for the sustainability of local and intergovernmental finances. The chapter concludes with policy recommendations on how to improve the robustness of the regulatory regimes that govern local finances.

1 Introduction

Since the Great Recession of 2008–2009, local governments (LGs) across Europe have experienced increased financial stress. The impact of cuts in funding from higher government levels, combined with increased local expenditure especially in the social welfare domain, has led to growing concerns over the sustainability of local government (LG ) finances (e.g., Cohen et al. 2012). It can be expected that the regulatory framework in which LGs operate, such as the accounting rules in place and their monitoring in practice, affect the financial sustainability of LGs and that of the public sector more widely. However, little is known about how regulatory regimes influence the financial sustainability of LGs. There are several reasons for this lack of understanding.

First, there is limited scholarly work about the financial regulation of LG finances. Available studies on European systems tend to be outdated (e.g., Dafflon 2002), not the least because of the large-scale reforms many intergovernmental regulatory regimes went through in the last decade. Most available studies are US based (e.g., Jacob and Hendrick 2013) and apply specifically to the US constitutional structure, limiting the relevance of these studies for the understanding of local-level financial sustainability in the European context. The diverging US framework is particularly reflected in the presence of municipal bankruptcy legislation, which is absent in most European systems. Second, few studies investigate the relationship between regulatory regimes and LG financial sustainability from an empirical approach. The dominant scholarly focus tends to be on formal regulation, excluding its implementation in practice (Ter-Minassian 2007). A third reason follows from the narrow focus of empirical studies available. In particular, the lack of country comparisons, and the dominance of short time frames, omits the evolutionary nature of regulatory regimes and fails to recognize their interaction with wider financial and institutional trends.

To improve understanding of how regulatory regimes affect financial sustainability of LGs, this chapter investigates the following question: What effects do intergovernmental regulatory regimes have on the financial sustainability of local government ( LG )?

The question is investigated by analyzing regulatory regimes in different intergovernmental contexts, especially by focusing on the impact of the regimes on deficit and debt-making by LGs. A regulatory regime is defined as the combination of fiscal rules and the monitoring structures that are in place to impose their implementation. A country comparative research design is most appropriate to this aim, given the fact that in most systems the regulatory frameworks on local finances are managed at the macro level. Prior to the selection of cases, the comparative method requires the researcher to choose a research design that uses either the most similar or most different cases (Mill 1843/1872).

In a most similar systems research design (MSSD), cases show large similarity with respect to their explanatory variables, but differ regarding their dependent variable. A most different systems design (MDSD) instead consists of highly heterogeneous cases, all of which have the same dependent variable in common (Anckar 2008). A major difference between the MSSD and MDSD is that whereas the former is concerned with the independent variable, the latter focuses on the dependent variable. Although some scholars argue that a MDSD requires a constant dependent variable (Landman 2008), this is a controversial issue in the literature as a constant variable only allows the researcher to identify the necessary conditions of a phenomenon (King et al. 1994). A further relevant feature of the MDSD is its specific research design, which can be more deductively or inductively orientated. In case a deductive strategy is pursued, the aim of the MDSD is to study if the independent variable is present in all cases, whereas a more inductive strategy is aimed at identifying the determinant of the dependent variable with an open mind, without an a priori notion of the relevant explanatory variable (Anckar 2008).

Given the aim of this chapter to identify the impact of regulatory regimes on the financial sustainability of LGs, a research design is needed that maximizes the variation on the institutional dimension, the independent variable in this research. Hence, the MDSD is most suitable for this purpose, with LG debt and deficit indicators used as comparable dependent variables. In order to have a high degree of variation on the institutional dimension, the chapter analyzes the regulatory frameworks on local finances in three divergent constitutional systems: the UK, Germany, and the Netherlands. In the UK’s case, the analysis is limited to England, which reflects the UK’s traditionally highly centralized government structure. In line with Germany’s federal structure, the regulation of LG finances is a state-level responsibility and hence differs among the German Länder. Research pertaining to Germany concentrates on North Rhine-Westphalia (NRW). As Germany’s largest state, both in terms of inhabitants and the size of its economy, NRW provides a relevant illustration of the intergovernmental regulation of LG finances in Germany. The Netherlands is selected as the representative of a unitary-decentralized system (Hendriks 2001). Although the absolute size of LG debt differs across the three systems, the dependent variable contains a strong similarity with LG debt demonstrating a strong increase in all three systems in recent years (see Sect. 2). The chapter findings demonstrate that despite their high degree of institutional heterogeneity, all three regulatory systems demonstrate flaws in practice that decrease financial sustainability of local government .

The rest of this chapter is structured as follows. First, the chapter explains the relevance of regulatory regimes and explains why deficit and debt are relevant indicators for analyzing LG financial sustainability . Section 3 provides a comparative overview of the fiscal rules in place on local finances in the Dutch, English, and German/NRW systems. The monitoring of the fiscal rules is discussed in Sect. 4, followed in Sect. 5 by an analysis of the special institutional arrangements in place to respond to LG financial emergency situations. Section 6 concludes.

2 On the Relevance of the External Regulation of LG Debt and Deficit Making

In each of the three systems, the primary responsibility for LG finances rests with local politicians. There are several reasons to complement scrutiny of the local budget by local politicians with external regulation. First, LGs receive none, or only very limited pressures from private market institutions to restrain their borrowing, leading to limited protection for residents against inefficient LG spending. A large part of LG borrowing in the three systems occurs via specialized LG lenders, such as the Public Works Loan Board (PWLB) in the UK, the Bank of Dutch Municipalities (BNG) in the Netherlands, and the NRW.Bank in NRW. These lenders, which are wholly or partly part of the public sector, set interest rates at a uniform level across LGs. This means that the specific credit position of a LG does not have any impact upon its borrowing costs, leading to a situation where no penalty costs are inflicted by private market actors on LGs that mismanage their finances.

A second reason for external regulation is shortcomings in monitoring by local politicians. As many public goods provided by LGs are characterized by non-excludability and therefore suffer from a free-rider problem (Stiglitz 1986), the relationship between local voters and those who profit from local public goods is suboptimal and hence provides less correction capacity compared to, for example, the private sector relationship between board and shareholders. Another risk of local political scrutiny is that with voters being both consumers and funders of LG services, local political systems provide incentives for building political interest groups that externalize costs to others, including future generations in the form of borrowing (Glöckner and Mühlenkamp 2009).

LGs in England, Germany/NRW, and the Netherlands face significant financial pressures but the different financial arrangements and cutbacks through burden-shifting by higher government levels make it difficult to collate comparative statistics on LG financial conditions . One useful indicator, however, is provided by the evolution of debt. In the public finance literature, debt, rather than other financial indicators , is used as a primary indicator to evaluate the financial position of government entities (Musgrave and Musgrave 1980). Debt is an important determinant of what has been referred to as the ‘fiscal health’ of government entities (e.g., Levine et al. 2013). Examples are the fiscal abilities or ‘solvencies’ of a government, such as its budgetary, long-run, and service-level solvency , or different elements of financial condition , including financial sustainability , flexibility , and vulnerability (Jacob and Hendrick 2013). Previous studies indicate that the maturity of debt, the source of borrowing, and the overall debt capacity may critically affect fiscal health indicators and, in a worst-case scenario, put the very independence of a jurisdiction at risk (Hildreth and Miller 2002; Kloha et al. 2005; Kriz and Wang 2013).

Using index numbers, Fig. 1 shows that in all three systems LGs have experienced a growth in debt. LG debt shows most gradual and consistent growth in NRW, whereas in the English system it has grown dramatically since 2005. The Dutch system shows the most minimal growth in LG debt, although after a period of reductions, debt has increased rapidly since 2007.

Fig. 1

Source: Own illustration; based upon national statistics (CBS, IT.NRW, DCLG & ONS) & own calculations

Index LG debt evolution, 1995–2012 (1995 = 100)

Despite the fact that Dutch, English, and German LGs can legitimately incur debt for capital investment purposes, LG debt poses an increasing risk for local finances. As this chapter shows, deficient monitoring structures on local finances lead to a ‘capitalization’ of local financial stress. In addition, current revenue pressures in Germany are widely dealt with at the local level by issuing short-term debt. Although offering substantial interest rate benefits, short-term liquidity poses significant interest rate risks and refinancing risks to LGs, hence increasing the vulnerability of local government to sources of funding outside its control or influence (cf. Justice and Scorsone 2013). As English and German LGs are involved in the provision of core services to citizens, and intergovernmental liability structures in the potential case of a local financial default are marked by ambiguity, growing local debt may have serious implications for the sustainability of local service delivery (De Widt 2016). Hence, this chapter concentrates on the impact of regulatory frameworks on the financial sustainability of LGs, with a focus on deficit and debt indicators .

3 Fiscal Rules on LG Debt and Deficit Making

Fiscal rules provide the official boundaries within which local financial decision-making needs to occur. Fiscal rules can be divided in procedural rules and substantive rules. While procedural rules regulate local financial decision-making and accountability processes, substantive rules provide explicit financial norms LGs have to abide with. In all three systems, substantive rules influencing LG financial sustainability are most explicit with respect to LG deficit and debt-making. Procedural and substantive regulations can be identified at three different institutional levels. The first layer contains macro-level regulations that distribute the aggregated borrowing space among government levels. Next, meso-level regulations apply to all LGs individually. Finally, LGs might be affected by tailored micro-level regulations, which particularly apply to LGs that repeatedly run an unbalanced budget , and are subsequently subjected to special intensified intergovernmental supervision. Sections 3.1 and 3.2 discuss the aggregate level and meso-level regulations, while micro-level regulations applying to non-conforming LGs are discussed in Sect. 5.

3.1 Aggregate Level Regulations

Out of the three systems, England has the longest history of controlling expenditure and deficit at a level related to the entire public sector. Introduced as the Public Sector Borrowing Requirement (PSBR) in the 1970s, the UK has strongly designed its borrowing policies around financial aggregates that apply to the country’s entire public sector (Thain and Wright 1995). Aggregate figures on local finances have been an integral part of central government policies, resulting in aggregate local borrowing being strictly controlled by the Treasury. Central control of local borrowing has been a reason for intergovernmental tensions but also explains long periods of moderate borrowing among English LG (Fry 2008).

National government budgeting based upon public sector financial aggregates is from a more recent date in the Dutch and German systems. In both, the introduction of the fiscal responsibility conditions of the Maastricht Treaty in 1993 incentivized a discussion about how to share the newly established borrowing limits among government levels. As the intergovernmental negotiations proceeded slowly, the discussion about sharing the Maastricht borrowing limits was not resolved in Germany with any definitive result in the 1990s (Farber 2002). A reform of Germany’s fiscal federalism in 2009, however, resulted in the introduction of specified debt restrictions for the federal government and the Länder, but not the local level. The exclusion of the local level from the debt brakes has given rise to local-level fears about potential debt shifting strategies by Länder governments towards the local level (e.g., Städtetag 2015, 30). This risk, however, seems limited as EU deficit regulations apply to the entire German public sector, including the local level.

Discussions in the Netherlands about the intergovernmental sharing of borrowing limits were particularly incentivized after the signing of the European Fiscal Compact in 2012. The Dutch Ministry of Finance initially aimed to set maximum deficit levels for each individual municipality , including a sanction option in case the municipality violated its deficit limit. Severe opposition by Dutch LG associations prevented the law from being implemented. From 2014 onwards, the EMU’s maximum public sector deficit level of 3% GDP is annually divided by central government between the Dutch government layers, following a process of intensive intergovernmental consultation. So far, the consequences of the borrowing limits have been limited as they have not significantly reduced the borrowing space of Dutch LGs for capital investment.

Due to European developments, cross-country differences in macro-level regulations have converged in recent years with the concept of aggregate public sector deficit now constituting the main indicator in budget policies in the three constitutional systems. However, country-specific trends are still relevant and may counteract European developments. The implementation of state-level debt brakes in several German Länder, combined with large inter-state financial heterogeneity, means that large local deficits within some German Länder do not necessarily result in a negative aggregate EMU balance for the German public sector. In parallel, macro-level regulations also have a limited impact on the deficit levels of individual LGs in the Dutch and English context, because their deficits can be compensated by LGs with budget surpluses. As a result, Dutch, English, and German macro-level regulations prevent debt accumulation at the local level, but have little impact on preventing debt concentrations within individual LGs. It may be expected that regulations that uniformly apply to LGs, rather than the local or public sector at an aggregate level, are more effective in restraining budget deficits.

3.2 LG Meso-Level Regulations

In all three systems, meso-level regulations applying to all LGs show a fundamental distinction between borrowing for current revenue purposes versus capital investment. In general, current revenue borrowing is restricted to its function of bridging over temporary funding gaps, while LGs have more autonomy to borrow for capital investment. Regarding capital investment borrowing, the principle of the ‘golden rule’ can be recognized in each system as borrowing for investment purposes is allowed as long as it can be realized in combination with a balanced budget on the current revenue account. Despite the general similarities, the operationalization of these principles in fiscal rules differs strongly between the systems.

3.2.1 LG Meso-Level Regulations in the Dutch System

Table 1 illustrates that only Dutch regulators apply specified debt norms. The Wet Fido, or the Law on the financing of sub-central governments, provides the main Dutch regulatory framework for LG borrowing. Fido tightened the relatively liberal Dutch subnational treasury framework in 2000, as a response to the secret commercial banking activities by the province of South Holland, which led to a loss of more than 20 million €. ¹ With regard to current expenditure, Fido provides a cash limit (kasgeldlimiet), stating that short-term debt is not allowed to exceed 8.5% of the total municipal exploitation costs. Fido’s interest risk norm (renterisiconorm) provides the main regulation on capital expenditure borrowing and prohibits LGs from refinancing debt that exceeds 20% of their total annual budget . This illustrates that in contrast to the norm’s title, it is not interest risk but the annual borrowing amount to be refinanced that is observed as the main risk in long-term local borrowing. Because of these criticisms, the main advantage of the Dutch interest risk norm is that it forces LGs to pay attention to a proper spread of the maturity of their debt portfolio in time (Zanten-Lagen-Daal and Wijnands 2001).

Table 1 System comparison of regulations on local capital and current expenditure borrowing

The balanced budget rule is operationalized in the Dutch system by focusing upon a materially balanced budget . Materially balanced is defined as the structural costs being covered by structural income, whereby structural refers to a period of 3 years. Other relevant regulations affecting borrowing behavior by Dutch LGs are included in the BBV (Besluit Begroting en Verantwoording Provincies en Gemeenten—Decision Budget and Reporting Provinces and Municipalities ), which tightened the Dutch regulatory framework for the activation of current expenditure on the municipal balance.

3.2.2 LG Meso-Level Regulations in the English System

In the English system as well, there have been substantial changes in meso-level borrowing regulations . Local borrowing autonomy for capital investments significantly increased with the introduction of the prudential borrowing framework (PBF) in the Local Government Act of 2003. Until 2003, a strict central government monitoring system on English local capital expenditure borrowing was in place, including a system of Credit Approvals through which central government annually set a credit limit for each local authority (outlined in detail in the Borrowing Act, part of the Local Government Housing Act 1989). LGs that exceeded their approved credit limit were confronted with intensive government sanctions, including the possibility of a personal surcharge imposed upon culpable LG officers and councilors (in place up to 2000).

The introduction of PBF in 2003 removed the centrally set capital borrowing limitations. The UK Treasury possesses a reserved power to impose borrowing limits upon the entire English local level, or individual LGs, but the power has not been used hitherto (Local Government Act, Section 4, 1 & 2). According to the prudential borrowing regulations , an English LG has only the obligation to ‘determine and keep under review how much money it can afford to borrow’ (Local Government Act 2003, Section 3, 1). This duty has been operationalized in the Prudential Code, developed by the accountancy body CIPFA . The Code obliges all LGs to base their capital expenditure decisions on a set of ‘prudential indicators ,’ which should ensure that local capital investment plans are ‘affordable, prudent and sustainable’ (CIPFA 2011). Although the Code has received legislative backing in 2004, its implementation is not policed in practice and the operationalization of the budget indicators leaves substantial interpretative leeway to LGs.

Compared to the Dutch and NRW regulations , CIPFA ’s Prudential Code is most explicit in its attention for debt. English councils are required to set an authorized limit for external debt, which establishes the outer boundary of a LG ’s borrowing based on a realistic risk assessment (Local Government Act 2003, Section 5). This debt indicator applies to the entire local debt volume, including short-term debt. Although the CIPFA Code pays attention to debt, the Code only provides guidelines regarding procedures on how to decide about the level of debt, while the actual debt levels are solely determined at the local level. While the guidelines leave a lot of space to LGs, the balanced budget rule is strictly enforced at the English local level, especially due to the authoritative role of the local Chief Financial Officer (CFO), also known as Officer 151. In practice, the enforcement of the balanced budget rule sets strict boundaries on short-term borrowing by English LGs, something that is reflected in the very small amount of short-term liquidity held by English LGs (around 1% of total English LG borrowing in 2014 (DCLG 2015)).

3.2.3 LG Meso-Level Regulations in the German/NRW System

The NRW system has undergone some major changes in the 1990s regarding the regulation of short-term liquidity. Until 1994, NRW applied a proportional limit similar to the Dutch system, which restricted an authority’s amount of short-term borrowing to a maximum of 1/6 of a locality’s total annual income. In case a LG was planning to exceed the cash limit, it had to acquire pre-approval from its intergovernmental supervisors. The revision of NRW’s Gemeindeordnung (Local Government Act) in 1994 removed the cash ceiling and essentially gave LGs total freedom in setting their maximum level of short-term liquidity. ² In theory, the relaxation of the liquidity credits has not replaced NRW’s balanced budget rule, since liquidity credits are only allowed to balance annual budget fluctuations. However, with liquidity credits perceived as budgetary neutral transactions, they are not an integral part of the municipal budget report. Since the removal of the credit ceiling, short-term liquidity in NRW LG has strongly increased, from an amount just above 1 billion € in 1992 to 26.5 billion € at the end of 2014, exceeding long-term debt held by NRW LG (22.3 billion € at the end of 2014) (IT.NRW 2015).

The gradual implementation in NRW of an accrual-based accounting system from 2006 onwards also changed NRW’s borrowing regulations . Parallel to the obligation for LGs to draft an opening balance sheet, NRW’s Local Government Act was changed to allow the inclusion of a so-called ‘balancing reserve facility.’ ³ NRW LGs include this facility as a separate asset post on their balance. As long as the facility does not exceed 1/3 of the total municipal assets, and 1/3 of the total annual local income from taxes and grants, LGs are allowed to use the facility to balance annual deficits if faced with such a situation. Even though LGs that use the facility have a deficit in practice, the regulatory framework regards them as formally balanced if they are able to balance their budget by reducing their assets within the defined maximum of the balancing reserve facility (e.g., Gröpl et al. 2010). ⁴ Hence, many NRW LGs have absorbed their short-term debt in the ‘balancing reserve facility.’

The comparative analysis in this section of the fiscal rules that frame local budgeting shows that despite the emphasis put on prudential budgeting in every system, the local level has substantial scope as to how it implements prudential budgeting. After the introduction of PBF in England, this observation applies to all three systems. The NRW system provides most space for local debt-making. Arguably, the unique financial circumstances of individual LGs and the need for local budgetary flexibility make it virtually impossible to prescribe detailed guidelines for local budgeting. With strong arguments against detailed budgeting rules, the formulation and manner of monitoring of the few rules that are present become even more relevant. The next section analyzes the institutional arrangements in the different systems for monitoring LGs that do not conform to the few budgetary regulations in place.

4 Monitoring Regimes in Comparative Perspective

In all three systems, multiple actors are involved in the monitoring of LG finances. Relevant at the local level are the local council and, in most cases, a local audit committee. In addition to local-level actors, LG finances are monitored by external auditors and by higher government actors. In all three systems, the ministry responsible for LG at the central level carries the main responsibility for the regulatory framework in which LGs operate. Since the organization of LG is a state-level responsibility in the German system, the relevant ministry in the German context is based at the NRW state level. In the Dutch case, the ministry responsible for LG is known as the Ministry of the Interior and Kingdom Relations (BZK), in NRW as the Ministry for the Interior and Local Government (MIK), and in the English/UK case as the Department for Communities and Local Government (DCLG). For convenience, the departments are referred to as the Interior Ministries.

In all three systems, the Interior Ministries are not themselves responsible for ensuring regulatory compliance at the local level. The Interior Ministries fulfill a policy responsibility regarding the laws and regulations that provide the statutory basis of the regulatory framework, and they coordinate and facilitate the activities of the actual regulators. The Interior Ministries only act as active regulators in case a LG infringes the regulations in place or faces a financial emergency (see Sect. 5). In this section, the standard regimes for the monitoring of LG finances are compared.

4.1 The English Monitoring Regime on LG Finances

As shown in Fig. 2, the actual regulators differ among the three systems. In England, during the period leading up to 2014, the Audit Commission constituted the main regulator of English LG finances. The Audit Commission was established as a statutory corporation in 1983, which meant that only its chair and the Commission’s board members were appointed by ministers, whereas its members were not to be regarded as civil servants. The Audit Commission fundamentally changed British public sector auditing by making auditors only answerable to the public and the courts rather than to their public sector ‘clients’ in the field (Campbell-Smith 2008). The mediating function fulfilled by the Audit Commission between LGs and auditors gave English auditors a highly autonomous position towards their LG clientele.

Fig. 2

Schematic representation monitoring structures on LG finances

The independence of English auditors was also strengthened by the Local Government Act 1988, which gave auditors the power to issue a ‘prohibition order.’ This order enables English auditors to pre-empt any local decision that they believe would lead to a breach of the law. Before 2012, the Audit Commission was responsible for appointing all LG auditors and allocated them to specific LGs. The auditors were a mix of around 70% direct employees of the Commission, and a segment of around 30% from the private sector.

The Audit Commission fulfilled its oversight role by conducting analyses that stretched beyond ordinary financial compliance checks. The Commission obliged its auditors to not only check and conclude local accounts based upon traditional regularity criteria, but to also include a full professional opinion on the economy, efficiency, and effectiveness of local spending (the so-called ‘Value-for-money conclusions’). To identify aggregate trends in LG performance, the Commission developed increasingly sophisticated and time-consuming benchmarking systems. The performance measurement systems reduced support for the Commission’s work among the local sector, partly explaining why the Conservative-led coalition government faced limited opposition when it decided, in an attempt to reduce costs, to abolish the Commission in 2010. According to many observers, the Commission had gone off track by developing benchmarking systems that were putting increasing demand on local resources. Despite a lack of support within the public sector to keep the Audit Commission alive, the decision to close it was criticized by the rating agencies for its reduction in central government ’s monitoring capacity of English LG finances (e.g., Moody’s 2010).

As shown in Table 1, after 2014 the responsibility for appointing local auditors is no longer based at the central level in the English audit regime. In line with the localism vision of the Conservative-led coalition government (2010–2015), LGs themselves appoint their own auditors. To address concerns regarding the independence of auditors in the new framework, auditors are not directly appointed by the local council but through council-appointed auditor panels. It is uncertain if the audit panels will be able to ensure the independence of local auditors. A second risk of the post-2014 English structure is that with the absence of an independent body standing behind auditors, auditors may be less willing to expose local malpractices out of fear of being dismissed. Third, the localized English auditing structure has reduced central government ’s oversight on LG finances. Although the inspection of individual LGs—a task that was previously conducted by the Audit Commission—has been transferred to the Interior Ministry (DCLG), this transfer will only provide partial compensation for the loss of oversight. These so-called corporate governance inspections have been hitherto only commenced after clear indications of regulatory non-compliance have been received. Hence, only 20 corporate governance inspections were carried out by the Audit Commission between 2000 and 2010, and it is unlikely that this number will increase after its transition to the Interior Ministry. ⁵

4.2 The German/NRW Monitoring Regime on LG Finances

External regulation of LG in the German state NRW is exercised in a horizontal way through traditional auditing, and vertically through inspections by higher government levels. The identity of the financial supervisor in the vertical chain depends on the type of LG . As shown in Table 1, upper-tier LGs in NRW—i.e., county-free cities and counties—are monitored by government districts (Bezirken). The three government districts in NRW represent the state government and their head is directly appointed by NRW’s prime minister. While being part of the state administration, the government districts have significant autonomy in the execution of their monitoring duties. Hence, some districts are known for having a tougher monitoring approach than others (Glöckner and Mühlenkamp 2009).

While the government districts are responsible for monitoring LGs that have the largest budgets, most LGs in NRW are based within counties and so fall outside of the monitoring powers of the government districts. As illustrated in Table 1, vertical financial supervision of the lower tier in NRW’s counties is conducted by the county administrations. In comparison to the government districts, the quality of supervision conducted by the county administrations has to be critically reviewed due to the existence of strong financial interdependencies between counties and districts. Most problematic is that the counties raise around 60% of their income via a contribution fee (Kreisumlage) levied among their districts. These county contribution fees constitute one of the main explanations for debt-making among NRW’s districts (Buettner et al. 2008). At the same time, the counties are the main financial regulator of districts, which, given their financial dependence upon the districts, puts them in a rather ambiguous position.

The monitoring performance of NRW counties is also impeded by political aspects. In the counties, the final responsibility for financial supervision rests with the popularly elected county leader (Landrat). Since the similarly popularly elected mayors of the districts often share their party political background with the county leader, political considerations undermine the firmness of county supervision. In addition to vertical monitoring, all LGs in NRW are audited by NRW’s Municipal Audit Institute (GPA NRW). Established by NRW’s state government in 2003, the Audit Institute is the compulsory auditor for every LG in NRW. Next to auditing, the Audit Institute provides consultancy advice to LGs. NRW’s LG sector is strongly involved in the Audit Institute; of the ten members in the board, nine are equally divided among NRW’s three main LG representative organizations (county-free cities, counties, and districts) with the remaining board member representing the NRW Interior Ministry. Although the quality of the Audit Institute has been praised (Ebinger and Bogumil 2012), the standard setting role of the organization can be questioned due to the strong involvement of the LG sector in the Audit Institute’s leadership.

4.3 The Dutch Monitoring Regime on LG Finances

In the Dutch system, the provincial level carries the main responsibility for monitoring LG finances. The twelve Dutch provinces conduct local financial supervision on behalf of the Interior Ministry. However, as a separate government layer in the Dutch constitutional system, the provinces enjoy significant autonomy in their supervision. The responsibility of supervision at the provincial level rests within the College of Provincial Executives, who, with the exception of its chair who is appointed by the national cabinet, are elected by the popularly elected Provincial Council. Decision-making in the college is collegial, but one provincial executive carries the primary responsibility for intergovernmental financial supervision. In practice, substantial differences exist among Dutch provincial executives regarding their interests for—and dedication to—the monitoring of LG finances. Some provincial executives show high interest in improving the effectiveness of LG supervision, whereas others pay only marginal attention to it.

Political aspects also affect the monitoring decisions by provincial executives. According to Dutch regulations , LGs must be put under an intensified, so-called preventive form of supervision if they are unable to set a materially balanced budget (see also Sect. 3.2.1). However, as the label ‘preventive supervision’ attracts considerable media attention and negative publicity for the local politicians involved, the decision to install preventive supervision is not taken lightly by provincial authorities. The decision about whether or not to install preventive supervision is affected by the existence of party political similarities that often exist between provincial executives who are popularly elected politicians and municipal politicians. In some cases, provincial executives continuously refuse to follow advice from their administrative staff to install preventive supervision. ⁶

Institutional reforms implemented in Dutch LG in the early 2000s have also influenced the Dutch monitoring regime. These so-called dualism reforms increased the council’s control over the local executive and have reduced financial supervision by the provinces. As part of the reforms, the primary responsibility for the local finances has become more explicitly located with local actors, with provincial supervision labeled ‘complementary’ to monitoring by the local council and local auditor. More than 10 years after the implementation of dualism, the expected benefits of the reforms regarding the council’s control over local finances have not materialized. Instead, the program budgets that were introduced as part of the dualism reforms have reduced the financial steering possibilities of Dutch councils (BMC 2010).

In addition to political aspects, the Dutch provincial monitoring regime is affected by policy relationships between the Dutch provincial and local levels. Most relevant for the financial position of LGs are the spatial planning responsibilities held by the provinces. By translating central government ’s spatial policies into area-specific plans, the provinces traditionally play a key role in Dutch spatial planning. With the economic opportunities for commercial and private property development strongly increasing in the Netherlands during the 1990s, provinces facilitated and incentivized LGs to initiate large-scale real-estate projects. By reselling former agricultural land to commercial developers, municipalities were able to generate huge profits. In 2006 alone, 900 million € of LG income derived from property projects, while the average share of property profits to the total income of LGs with more than 100,000 inhabitants amounted to 17.4% in 2008 (Ten Have 2010, 29). Commercial interests in construction sites evaporated with the economic crisis in 2008 and municipal profits started to decrease strongly. Since many Dutch LGs had acquired substantial areas for real-estate developments and made large infrastructure-related investments to prepare areas for construction, the sites turned from being a very profitable activity into an expensive undertaking. The financial loss suffered by Dutch LGs between 2010 and 2014 amounts to 4 billion € (Binnenlands Bestuur 2015). Although the role of the provinces in the local real-estate debacle has not been subject to separate analyses, the provinces have been criticized in several reports for their long-time reluctance to enforce better financial risk management of real-estate investment within the municipalities (e.g., Rekenkamer Oost-Nederland 2013).

As illustrated in Table 1, local auditors in the Dutch system are directly appointed by their clientele LG . Auditing of Dutch LGs has been run by private sector auditors since 1997. In 2015, only two Dutch LGs had their own auditing service (Amsterdam and The Hague), while others are audited by external firms, mostly the Big-4 (Deloitte, EY, KPMG, and PwC). The quality of audits conducted by the Big-4 has been strongly criticized by the Dutch independent government regulator for financial services (AFM 2014). Problems have been related to the mix of auditing and consultancy that characterized the work of auditors from the Big-4, which alerted to the serious moral hazards in the Dutch accounting profession. The implementation of the EU Audit Reform in 2014, however, can be expected to have improved the quality of LG auditing, as auditors are no longer allowed to provide consultancy services to clients for whom they are also the statutory auditor.

5 Financial Emergency Procedures: Rules and Approach

The Dutch, English, and German systems do not have legislation in place facilitating LG bankruptcies. However, most European countries have special institutional arrangements in place to respond to local financial crises. The degree of formalization of the arrangements for situations of high financial stress differs strongly among the countries. This section compares the financial emergency arrangements in place in the three selected systems.

5.1 Intensified Supervision in the German/NRW System

The regulatory regime in NRW applies different intervention stages once a LG is unable to set a balanced budget . As illustrated in Table 2, it starts with a situation in which a LG is unable to produce a balanced budget , in which case the LG faces an intensification of intergovernmental supervision. The LG is now only allowed to borrow for investments that generate revenues and is no longer allowed to adopt any new voluntary tasks, and significant limitations are implemented upon its personnel management (Busch 2005). In addition, the budget concept needs to illustrate that in the most recent 5 years since the start of the 4-year budget balancing period, the remaining old debts will be phased out via budget surpluses—assuming that no extraordinary financial setbacks will occur.

Table 2 Intervention steps towards non-conforming LGs

In 2011, a major change was implemented in NRW’s local budget regulations that has changed the point at which intensified supervision kicks in. Up to 2011, a rebalanced budget needed to be realized by the fourth year after the start of the budget balancing concept. Since 2011, the period has been extended to the tenth year after the start of the procedure (GO NRW § 76, 2). Figure 3 illustrates that in the period leading up to 2011 81% of NRW LGs had a non-approved budget status. The amendment of NRW’s LG budgetary law in 2011 reversed this situation and 83% of NRW LGs set an approved budget in 2012. The regulatory change hugely alleviated pressures on the State financial regulators, who, without having had any substantial increase in resources, had experienced a steady growth in the period up to 2011 in the number of LGs requiring intensified supervision.

Fig. 3

Source: Own graph, based upon data from NRW Interior Ministry (MIK)

Graph of approved and non-approved budgets NRW, 2004–2013

The final stage of intervention action available in the German system is to send in a state commissioner. Given the strong interference with the constitutional principle of local self-autonomy , state commissioners are used very infrequently. The NRW Interior Ministry used the instrument in 2013 for the first time. The state commissioner was sent to a LG —Nideggen—who had committed itself to the implementation of a set of austerity measures in exchange for additional financial support from the state. As the NRW State regarded Nideggen’s speed of implementing the measures insufficient, it decided to send in the commissioner.

5.2 Intensified Supervision in the Dutch System

In the Dutch system, the provinces monitor LG budgets to identify those that exceed their balance over a period up to 3 years. As explained before, a LG is allowed to show a budget deficit in the current budgetary year but should be able to present a balanced budget in its 3-year estimates. This indicates that, at least in theory, a municipality is able to have a continuously unbalanced budget without getting into trouble with the provincial regulator, as long as it can present a balanced budget in its 3-year forecasts. Data on the number of Dutch LGs that are unable to set a balanced budget in the upcoming budgetary year are not systematically disclosed. However, some indications of the scale of unbalanced budgets can be obtained from data disclosed by the provinces of Utrecht, North Brabant, and South Holland. In correspondence from 2015 with the Dutch Interior Ministry (BZK 2016), Utrecht reports 76.9% of its LGs that set an unbalanced budget (20 out of a total of 26), North Brabant, 47.0% (31 out of a total of 66), and South Holland 20.7% (12 out of a total of 58). Notwithstanding the large disparity in the budgetary status of LGs among the Dutch provinces, the figures demonstrate that a substantial number of Dutch LGs are unable to set a balanced budget .

If a LG is unable to present a balanced budget within its 3-year budget plans, the Dutch provincial authorities are legally obliged to put the LG under ‘preventive supervision.’ In this stage, a LG needs to send its budget and any budget changes its plans during the budgetary year for approval to the provincial regulators. The number of Dutch LGs under preventive supervision has been small and decreased sharply more recently. Whereas 6.4% of the total number of Dutch LGs were under preventive supervision for financial reasons in 2005 (or 30 LGs), this was only 4.1% in 2015 (or 16 LGs). These numbers have been met with criticism, especially due to the fact that at a time when Dutch local finances are under increasing pressure the number of LGs facing intensified financial supervision is reducing (Bekkers 2014). One reason for the small number of LGs facing intensified supervision is an extension implemented in 2013 in the period in which LGs that have been affected by the property bubble are allowed to balance their budget—from three to 10 years.

If the municipal finances do not improve under preventive supervision, a Dutch municipality can apply to central government for Section 12 status, which provides the municipality with a temporary annual funding amount in addition to the normal allocation it receives from the Dutch Municipal Fund. To prevent common pool problems (Ostrom 1990), entrance to Section 12 funding is decided after a tightly organized process lasting approximately one and a half years in which the locality’s finances are scrutinized by Section 12 inspectors from the Interior Ministry (BZK). ⁷ Once a municipality receives Section 12 funding, the municipality is put under intensive supervision, resulting in the virtual abolishment of local financial decision-making freedom. Four Dutch LGs were receiving Section 12 funding in 2015, with a similar annual average over the period since 2001. Historically, this is a relatively small number. For example, in 1955 more than 700 of the then 1,000 Dutch LGs were receiving additional funding (Financial Relations Council 1996). By improving municipal income with an introduction of a local property tax in the 1970s and through continuously sophisticating the Dutch mechanisms for the distribution of grant funding, Section 12 funding has developed from a popular opportunity to get something additional into a safety net of last resort.

5.3 Intensified Supervision in the English System

Compared to the Dutch and NRW systems, procedures as to how intergovernmental regulators should operate in case councils are unable to set a balanced budget is least institutionalized in the English system. The English system puts strong emphasis on the role of the local Chief Financial Officer (CFO) as a key actor in safeguarding a balanced budget . The role of CFO, or Officer 151, has traditionally been defined in a broader sense, with responsibilities that exceed those owned to the local council. ⁸ The CFO has several duties, including the requirement to provide a report to the local council if there is, or is likely to be unlawful expenditure or an unbalanced budget. This report must also be sent to the LG ’s external auditor and to the Secretary of State of the Interior Ministry (DCLG). Until the council has considered the report, Section 114 of the Local Government Finance Act of 1988 determines that the local authority is not allowed to make any new agreements incurring expenditure. By functioning in practice as a prohibition on any local spending, Section 114 gives strong powers to the local CFO. Section 114 notices were frequently issued in the 1990s, but following improvements in local financial management have been relatively scarce in the period since 2000.

The English system provides no formalized follow-up scheme for intergovernmental supervision once a Section 114 notice has been issued by the CFO. In case the LG is unable to re-balance its finances, central government can issue a financial directive, directing the LG to take certain measures. Since the introduction of the Local Government Act of 1999, the UK Government has the additional competence to intervene in a LG in order to re-establish the authority’s finances. ⁹ This decision is up to the discretion of the Secretary of State of the Interior Ministry (DCLG) and is normally taken after pre-agreement within cabinet. Directions and interventions have only seldom been used by central government, the first time being in the London borough of Hackney in 2001, after a critical report from the Audit Commission called for government intervention (Local Government Chronicle 2001). Although financial matters often call for central government intervention, non-performing local services, especially in the social welfare domain, constituted the main reason for the interventions that occurred in England between 2000 and 2013 (e.g., Doncaster, Kingston upon Hull, and—threatened with intervention—Walsall).

6 Conclusions and Policy Recommendations

The three regulatory regimes on LG finances investigated in this chapter are highly heterogeneous. The findings demonstrate that the design and enforcement of budget rules in local government is strongly influenced by the wider institutional context in which local authorities operate. Fiscal rules on LG finances are limited and have become more flexible in recent years. Despite the strong belief among credit markets in the quality of the regulatory frameworks, and hence indirectly the creditworthiness of LGs, the monitoring of LG finances in England, Germany/NRW, and the Netherlands shows flaws in practice. Different features reduce the contribution of the regulatory frameworks to enhance government financial sustainability .

The English regulatory system used to provide the most heavily regulated system of the three regulatory regimes in this chapter. The introduction of the Prudential Borrowing Framework (PBF), however, has transferred many treasury decisions that were previously subjected to intergovernmental inspection to the local level. The local level in NRW has also experienced a relaxation of intergovernmental regulations . Most notable has been the removal of the credit ceiling on short-term liquidity, which has increased the vulnerability of local finances in NRW to factors outside the control of government. In addition, through its debt-enhancing effect the extension of the requirement of setting a balanced budget from the 4th to the 10th year after the identification of an unbalanced budget is likely to reduce long-term spending flexibility of NRW LGs.

In the Dutch system, provincial supervision on LG finances has been reduced in favor of a larger scrutiny role for local politicians. The expected effects of the Dutch reforms regarding greater local control over LG finances have not materialized. The Dutch system also demonstrates substantial local leeway to temporarily escape from the balanced budget rule. The relaxation of the regulatory regime on local debt and deficit making in NRW by the NRW State authorities has been triggered by growing financial stress at the NRW local level, which, to a significant extent, has been caused by increasingly tight federal- and state-level funding for statutory services provided by NRW LGs (De Widt 2016). As both State authorities and LGs in Germany have limited possibilities to increase their own revenues, a relaxation of the regulatory regime on LG finances offers German government actors a readily available solution to alleviate local financial pressures. Further, in the Dutch and English systems, a relaxation of the regulatory regimes has enabled LGs to reduce immediate financial pressures through increased borrowing.

Inadequate performance by the regulatory regimes carries considerable risks for the sustainability of local and intergovernmental finances. The absence of LG bankruptcies in the recent history of the three systems analyzed in this chapter should not lead to the conclusion that the question of how sovereigns will respond in case of defaulting LGs is only of theoretical interest. The EU financial crisis has led to discussions about defaulting European states unimaginable in the European discourse before the crisis. Uncertainty about the responses of the regulatory regimes in situations of defaulting LGs may well have an immediate effect as well. This is most visible in NRW, where heavily indebted LGs and unclearly defined government liability structures can cause private sector loan providers to apply (slightly) higher interest rates to more indebted NRW LGs in case of a local financial default. ¹⁰

Clearly, a preference exists among intergovernmental actors in all three systems to enable LGs to profit from low local borrowing costs. The findings of this chapter demonstrate that the focus on short-term financial advantages in the form of low borrowing costs affects the thoroughness of intergovernmental monitoring, reduces its transparency to the outside world, and biases local budgeting behavior towards borrowing instead of exploring other financial options, such as reducing expenditure. This even applies to the most heavily indebted LGs, who do not face any penalty costs in the form of higher interest rates. As all three systems generate uncertainty regarding the responses of the regulatory regimes in the case of defaulting LGs, increased divergence in LG borrowing costs constitutes a relevant mechanism to improve local budgetary practices and, in that way, enhance the sustainability of LG finances. A reassessment of the regulatory regimes based upon a realistic evaluation of their regulatory performance, as well as the actual regulations in place, will most likely reduce the debt-enhancing effect of low borrowing costs, since LGs with problematic finances will be charged higher interest rates.

Notwithstanding its likely initial cost-increasing effect, divergence in borrowing costs may well have a positive financial effect in the long term as it will put pressure on LGs to improve their financial decision-making. Clearly, we need more knowledge on how regulatory regimes, in their broadest institutional sense, affect local financial decision-making and the financial sustainability of local authorities. Further studies on the relationship between fiscal rules and the financial health of local government , using both large-N and case study approaches, are likely to generate valuable insights for scholars and policymakers alike.

Notes

• 1. The province of South Holland speculated with almost 0.8 billion € (1.7 billion gulden) of loans to realize interest profits. After some initial lucrative years, the secret banking activities brought the province near financial collapse when one of its debtors, the trading house Ceteco, went bankrupt (Koelewijn and Meeus 1999).

• 2. NRW’s 1994 and currently operational Local Government Act formulates this as follows: ‘For the timely performance of their payments, the municipality may take up liquidity credits up to the ceiling amount as ascertained in its budgetary bill insofar as it has no other means available. The authorization is valid for the budget year and until the adoption of a new budgetary bill’. Original clause: ‘Zur rechtzeitigen Leistung ihrer Auszahlungen kann die Gemeinde Kredite zur Liquiditätssicherung bis zu dem in der Haushaltssatzung festgesetzten Höchstbetrag aufnehmen, soweit dafür keine anderen Mittel zur Verfügung stehen. Diese Ermächtigung gilt über das Haushaltsjahr hinaus bis zum Erlass der neuen Haushaltssatzung’ (Gemeindeordnung NRW Section 89, par. 2).

• 3. See for this so-called ‘Ausgleichsrücklage’, Gemeindeordnung NRW, Section 75, par. 2, sentence 3.

• 4. The system in NRW regulates capital borrowing through the municipal balance. Capital borrowing is allowed as long as a municipality does not become over-indebted. Over-indebtedness is defined as a municipality that has used all local assets on the municipal balance (Gemeindeordnung NRW, Section 75, par. 7).

• 5. Source: http://archive.audit-commission.gov.uk/auditcommission/inspection-assessment/corporate-governance/pages/default.aspx.html (visited 12 July, 2014).

• 6. Interviewees NL3 and NL18; part of a series of research interviews conducted amongst central and local government actors in the Netherlands in January 2014.

• 7. Only in the case the deficit exceeds 2% of the sum the municipality receives from the Dutch Municipal Fund, the municipality can be considered for Section 12 emergency support. In addition, an income threshold, or admission ticket, is in place that demands that the local property tax is at least 20% above the national average, and fees for savage and refuse collection need to cover all costs.

• 8. Case law Attorney General -v- De Winton (1906) established that the local treasurer is not merely a servant of the Council but also holds a fiduciary relationship to the local taxpayers.

• 9. Local Government Act 1999, Section 15, par. 5 states: ‘the Secretary of State may direct the authority to take any action which he considers necessary or expedient to secure its compliance with the requirements of this Part,’ and Local Government Act 1999, Section 15, par. 6a states ‘the Secretary of State may direct that a specified function of the authority shall be exercised by the Secretary of State or a person nominated by him [-],’ and Section 15, par. 6b: ‘the authority shall comply with any instructions of the Secretary of State or his nominee in relation to the exercise of that function and shall provide such assistance as the Secretary of State or his nominee may require for the purpose of exercising the function.’

• 10. A survey conducted by the German treasurers’ magazine Der Neue Kämmerer (2013) illustrated that whereas 6% of German treasurers had noticed inter-local interest rate differences in 2011, 17% did so in 2013.