The scale of municipal finances is insufficient

Fiscal deficits, constraints in broadening the tax base and weakening institutional mechanisms are challenges

Fiscal deficits, constraints in broadening the tax base and weakening institutional mechanisms are challenges

The health of municipal finances is a critical component of municipal governance that will determine whether India realizes its economic and development promise. The 74th Constitutional Amendment Act was passed in 1992, mandating the creation and delegation of powers to Urban Local Bodies (ULBs) as the lowest unit of governance in towns and villages. Constitutional provisions have been made for the tax independence of ULBs. However, three decades later, growing budget deficits, constraints on expanding the tax base and weakening institutional mechanisms that enable resource mobilization remain challenges. Revenue losses after the introduction of the Goods and Services Tax (GST) and the pandemic have exacerbated the situation.

Comprehensive municipal finance datasets are important for understanding and addressing these challenges, but few exist at the city level. Recently, the Indian Institute for Human Settlements (IIHS) analyzed data from 80 ULBs in 24 states between 2012-13 and 2016-17 to understand ULB finances and spending, and found some key trends.

Share of own revenue

The first is that ULB’s own sources of revenue represented less than half of their total revenue, with significant untapped potential. The main sources of income for ULBs are taxes, fees, fines and royalties, as well as transfers from central and state governments, known as intergovernmental transfers (IGTs). The share of own-source revenue (including revenue from property taxes and advertising, and non-tax revenue from user charges and fees on building permits and business licenses) in total revenue is an important indicator of the fiscal health and autonomy of the ULB. This ratio reflects the ability of ULBs to use the sources they have the right to exploit and their dependence on IGTs. Cities with a higher share of own revenue are more financially self-sufficient.

Our study revealed that the ULB’s own revenues amounted to 47% of their total revenues. Of this amount, tax revenue was the largest component: about 29% of the total. There was a 7% increase in own revenues from 2012-2013 to 2016-2017, but the ULBs still lacked dynamism, as their share in GDP of own revenues was only 0.5% for the period of five years.

Composition of receipts of receipts for the year 2016-2017, based on estimates based on data from the 80 ULBs studied.  Source: IIHS, 2022

Composition of receipts of receipts for the year 2016-2017, based on estimates based on data from the 80 ULBs studied. Source: IIHS, 2022

Share in total revenue for the years 2012-13 to 2016-17, based on estimates based on data from the 80 ULBs studied.  Source: IIHS, 2022

Share in total revenue for the years 2012-13 to 2016-17, based on estimates based on data from the 80 ULBs studied. Source: IIHS, 2022

Graph illustrating the comparison between self-revision and total revenues for the years 2012-13 to 2016-17, based on estimates from the 80 ULBs.  Source: IIHS 2022

Graph illustrating the comparison between self-revision and total revenues for the years 2012-13 to 2016-17, based on estimates from the 80 ULBs. Source: IIHS 2022

Property tax, the main contributor to ULB’s own revenue, represented only around 0.15% of GDP. The corresponding figures for developing and developed countries were significantly higher (around 0.6% and 1%, respectively), indicating that this potential is not being tapped in India. Estimates suggest that Indian ULBs can reach these levels. It is essential that ULBs leverage their own revenue-raising powers to be financially viable and self-sufficient and to have better equipment and better quality of service delivery.

Dependent on IGTs

Second, many ULBs were highly dependent on IGTs. Transfers from central government are as stipulated by central finance commissions and through grants for specific reforms, while transfers from state government are in the form of grants and decentralization of local tax collection by the state. Most ULBs relied heavily on external grants — between 2012-13 and 2016-17, IGTs accounted for around 40% of total ULB revenues.

Graph showing the comparison of revenue by intergovernmental transfers vs own revenue, based on data analyzed from 80 ULB.  Source: IIHS, 2022

Graph showing the comparison of revenue by intergovernmental transfers vs own revenue, based on data analyzed from 80 ULB. Source: IIHS, 2022

Stable and predictable IGTs are all the more important as the collection of ULB’s own revenue is insufficient. While reliance on IGTs has declined over the years due to a modest increase in own-source revenue, the magnitude of IGTs in India has remained at around 0.5% of GDP, which is much lower. to the international average of 2 to 5% of GDP.

This can be improved by increasing revenues earmarked for ULBs by state governments and allocating a share of the proceeds of the State and Center GST to ULBs. This will cushion the balance sheets of ULBs as they mobilize their own revenues and explore market-based instruments. IGTs can also encourage ULBs to provide better quality of service and maintain budgetary discipline.

Third, tax revenue is the main source of income for large cities, while small cities are more dependent on subsidies. There are considerable differences in the composition of revenue sources between cities of different sizes. Class IA cities (population over 50 lakh) mainly depend on their own tax revenue, while class IB cities and class IC cities (population 10 lakh-50 lakh and 1 lakh-10 lakh, respectively ) are more dependent on IGTs.

Trends in sources of income in city classes, based on estimates of data from 80 ULB.  Source: IIHS, 2022

Trends in sources of income in city classes, based on estimates of data from 80 ULB. Source: IIHS, 2022

Own revenue mobilization in Class IA cities has increased significantly. It is mainly due to the increase in non-tax revenue. Over the five-year period studied, tax revenue in Class IA cities increased by approximately 11%, while non-tax revenue increased by approximately 30%. The reliance on external revenue for these major cities has been gradually reduced over time, from around 27% in 2012-13 to around 15% in 2016-17. The own revenues of Class IB and Class IC cities, on the other hand, have stagnated even as these cities have grown in size.

Operations and maintenance

Fourth, operating and maintenance (O&M) expenses are increasing but remain insufficient. O&M expenditures are crucial for maintaining infrastructure and maintaining the quality of service delivery. The share of O&M expenses in total ULB revenues increased from around 30% in 2012-13 to around 35% in 2016-17. While spending was on the rise, studies (such as ICRIER, 2019 and Bandyopadhyay, 2014) indicate that it remained insufficient. For example, operation and maintenance expenditures incurred in 2016-2017 covered only about one-fifth of the needs forecast by the high-level expert committee to estimate investment needs for urban infrastructure services.

Comparison over the years on operating and maintenance expenditure variances based on data from 80 ULBs in India.  Source: IIHS 2022

Comparison over the years on operating and maintenance expenditure variances based on data from 80 ULBs in India. Source: IIHS 2022

O&M expenditures should ideally be covered by user charges, but total non-tax revenues, of which user charges are a part, are insufficient to cover current O&M expenditures. Cost recovery for services such as water supply, solid waste management, transportation and wastewater management is therefore clearly insufficient.

Non-tax revenues were about 20% less than O&M expenditures, and this shortfall contributed to the increase in ULB’s revenue shortfall. Increasing levels of cost recovery through improved user charge regimes would not only improve services, but also contribute to the financial vitality of UWBs.

The scale of municipal finance in India is undoubtedly insufficient. The realized own resources of a ULB are well below the estimated potential. Drawing on land taxes, other land resources and user fees are all means of improving the income of a ULB. IGTs play an important role in the budget composition of ULBs, and stable support from central and state governments is crucial until ULBs improve their own revenues. Measures must be taken to also cover the operating and maintenance expenses of a ULB for better infrastructure and better service.

Amir Bazaz is Principal Director and Associate Dean of the School of Environment and Sustainability and Madhumitha Srinivasan is Research Assistant, both at the IIHS. Manish Dubey, head of the practice program at the IIHS, contributed to the article

Melissa C. Keyes