In dire financial straits
Will local governments go under en masse?
By Chung Hee-hyung
Seongnam city, the 10th largest city in Korea, earned the dubious honor of becoming the country’s first municipality to declare a moratorium on debt payments in June 2010.
“The city was scheduled to pay 520 billion won of debt it owes to the central government by this December, but the current fiscal state of the city does not allow it to make such a large lump sum payment within such a short period of time,” said Mayor Lee Jae-myung at a press conference at the time.
“The city is therefore obliged to declare a moratorium. It will make payment of its debts in gradual installments in the next four years.”
Technically, the declaration did not amount to a default, because under moratorium a debtor merely asks for a delay or suspension of payment, instead of announcing outright that it is simply unable to pay back its debt.
But Mayor Lee’s announcement still caused enough of a shockwave throughout the country to look for a possible cause of the city’s critical financial state. If a city considered the most financially stable in Gyeonggi Province was unable to pay its debt on schedule, what about other local governments?
Korea has a relatively short history of local self-government. It was not until 1995 that local municipalities elected their own governors and legislators, and up until then they were little more than administrative units of the central government. They were accorded no independent sovereignty, and in practical terms this meant that they had little, if any control, over their budgets. They were neither able to collect their own revenues nor therefore spend on local needs. Instead, they had to receive and spend what money was allocated to them in a manner prescribed by the central government.
The introduction of local self-governance in 1995 changed much of that situation. Now, municipalities collect local revenue themselves and have broad discretionary powers about how to spend it too. Unfortunately, local governments have failed to show financial restraint commensurate with the broad powers of fiscal discretion they were suddenly granted.
“Governors and mayors made a lot of rosy promises while they were running for elections without ever considering their long-term financial consequences,” said Lee Sae-ku, a senior research fellow at Seoul Development Institute.
“Almost no local governments have mechanisms to review and check if the projects are ever feasible at the planning stage. Nor do they have institutional devices to make sure that the projects have been carried out within the original budgetary estimate. As a result, in lots of cases local governments spent too much and their deficit spiraled out of control.”
It is not difficult to find observers who echo Lee’s remarks.
“The reckless construction projects played a very significant role in pushing local governments toward financial destruction,” said Kang hyung-ki, professor of Public Administration at National Chungbuk University.
“They failed to foresee that economic cycles could turn for the worst at any moment. Local governments went ahead with their projects based on overly optimistic estimations. Experts had constantly warned about the dire consequences for such inaccurate assessments, but most of these warnings fell on deaf ears.”
Moreover, some experts point out that the central government is at least partially responsible for the municipalities’ financial debacle.
“The former administration handed over too much budgetary control to local governments in the name of decentralization,“ said Jung Chang-soo of the Center for Good Budget, a non-profit watchdog.
“The current administration, on its part, encouraged local governments to cut taxes to stimulate the economy. It also let them issue municipal bonds to raise capital for large-scale projects. The net result is a large budgetary hole that local governments are belatedly trying to fill up.”
Pork barrel projects
The reason for such deficits, however, may run deeper than mere budgetary indiscretions. The case of Seongnam city shows the extent to which outright corruption can eat away at the balance sheets of local governments and put them into financial ruin.
All three mayors of the city before the incumbent Lee Jae-myung were arrested on charges of embezzlement and bribery.
Lee Dae-yup, the last to depart and go to jail, was accused of forging false documents which purportedly showed that the city spent 250 million won ($230,000) for procurement. However, the money actually ended up in Lee’s pocket. The 79 year-old former mayor was also charged with accepting bribes worth 180 million won from a real estate developer in exchange for granting a favorable contract for building the new city hall.
The local district court sentenced him to 10 years in prison, holding that “Lee had betrayed the trust of his fellow citizens by using the city’s budget for personal purposes,” although the appellate court commuted the sentence to four years, citing Lee’s “health conditions.”
The city hall epitomized the city’s inefficiency and corruption. Due in part to favorable contracts granted to developers, the construction cost of the city hall bloated to one-fifth of the city’s 2010 budget. Lee Dae-yup had to divert 320 billion won from the city’s special account and funnel it toward the construction project, although this action was against the law.
Watchers point out that the example of Seongnam is the most salient example of corruption and inefficiency, but they say that the trend permeates almost every level of local government.
The causes of such mismanagement are legion, but the unusually strong influence that heads of local government wield over their personnel may provide a partial explanation at least.
“Currently, heads of local governments have almost total discretion in appointing and promoting civil servants working under them. And for these civil servants, nothing matters more than climbing up the organizational ladder,” said Song Jae-bong of Chungbuk Citizens’ Autonomous Association. “In such cases, it is almost inevitable that they will compete against each other to prove their loyalty, and this situation makes for fertile grounds for corruption. It also breeds inefficiency, since promotion based on personal connections leaves little room for meritocracy. ”
Small income, large expenditures
The global financial crisis and the following brutal recession battered local finances particularly hard, resulting in a steep decline in their revenue. Every level of government was badly hit, but municipal finances came out in a much worse shape.
However, the deficit is less cyclical than institutional. First, greater demand for social welfare has put a severe financial strain on local governments. When the Seoul Metropolitan Council passed a bill last year authorizing the city government to subsidize free lunch meals for its school children, the city estimated that the cost of this single program would amount to 1.2 percent of its entire education budget.
In general, social welfare expenditure by the country’s local governments has increased by an average 22 percent in the past five years. This figure is more than two times the comparable increase in general expenditure, according to a 2011 report by the Ministry of Public Affairs and Security (MOPAS).
In some cases, social welfare programs are carried out under the initiative of the central government, but it is the local governments which bear the brunt of the cost. “It is irresponsible for the central government to start a social welfare program and pass over the actual cost of implementing it to local municipalities,” professor Kang said.
“When the government initiates a new welfare program, it should create a matching fund that would foot the necessary cost. Otherwise, the financial shape of local governments would get even worse. They just cannot raise enough money on their own to cover all of the expenditure.”
Kang’s reference to inadequate funding points to another structural flaw: inadequate revenues accounts as much for overreached spending as local governments’ deficit.
“Increase in spending has been much steeper than increase in revenues,” said Lim Sang-su, analyst at Korea Institute at Local Finance (KILF). Lim pointed out that total spending of local governments grew at an annual rate of 8.4 percent from 2002 to 2008 while revenues rose only 5.3 percent during the same period.
“Worse, the lion’s share of such revenues comes from grants and subsidies by the central government, and few municipalities are financially self sufficient,” said Lim. “Without such monetary pipeline from above, most local governments would plunge into a state of financial coma.”
Money furnished by the central government comes in two forms. One is state subsidies. They are geared toward specific purposes, such as subsidizing projects that are too big for local governments to handle on their own. Local municipalities are not permitted to switch the subsidized amount from its intended use to another, and the special account created to raise capital for the Pangyo development project is a case in point.
Local share tax, on the other hand, is essentially a budget allotment sliced off at a statutory rate of 20 percent from the national tax collected by the central government. The allotment is then handed out by the government to municipalities. It gives them more financial stability than state subsidies, because the central government is obligated to hand out a fixed rate of local share tax every year.
More importantly, the municipality receiving the sliced off portion of the tax is free to use the money for whatever purpose it seems fit, given it greater leeway in spending. Unfortunately, the growth rate of local share tax from 2002 to 2010 has been 2 percent below than that of state subsidies.
But Lim said that the problem was not simply about which form of state assistance was better than the other. “It might be even more desirable if local governments would rely less on money from the top, be it state subsidy or budget allotment. In the end, local revenues should come from local government themselves, not doled out by the central government.”
Currently, local governments are able to furnish only half of their overall revenue on their own, mostly through collecting local income and consumption tax.
Lim said this was clearly not enough, and urged the central government to raise the local tax rate. “It is important for municipalities to establish financial independence. Otherwise, we cannot say that local governments that are supposed to be autonomous are really autonomous.”