Urban local bodies: Fixing finances and functioning

Two roads diverged in a wood, and I-
I took the one less travelled by,
And that has made all the difference.
Robert Frost

The Fifteenth Finance Commission (FFC) will shortly be submitting its final report for the five-year period, 2021-26. Inter alia, it will consist of recommendations for urban local bodies (ULBs) as mandated under Article 280(3)(c) of the Constitution. There are expectations at this stage that firstly the FFC may opt to continue with the approach and pattern of the grant-in-aid that it laid out for ULBs in its 2020-21 report, and secondly it may spell out an agenda, possibly a dedicated one, for making local bodies self-governing (pp 53, 2020-21 report).

The rationale behind such expectations is simple: The nature of recommendations that the FFC has proposed for ULBs in its 2020-21 report, such as providing a grant-in-aid for pollution abatement, using urban agglomerations as spatial units for implementing some of its recommendations and requiring states to establish floor rates for property taxation and keep them aligned with GSDP growth rates, demand a much longer time frame to produce results. A one-year time frame for such recommendations would seem wasteful.

Likewise, the FFC appears to hold that making local bodies self-governing is necessary for enhancing revenue mobilisation and accountability; it may even contribute to the larger goals that underlie the Constitution (seventy-fourth) Amendment Act. These are new and seminal initiatives and it is fair to acknowledge the FFC having stepped onto a road less travelled by; the next step for the FFC is to pitch for a road that would make a difference.

The big questions here are: What should be the structure and make-up of such a road? Are there lessons from the approaches employed by the previous Finance Commissions (FCs) that can help lay out the structure of such a road?
These are compelling questions. Let me elaborate.

The FCs, beginning with the 10th FC, have been engaged with the finances and functioning of ULBs for 26 long years during which they have, in aggregate, dispensed a basic grant-in-aid of Rs 1,22,076 crore for ULBs, supplemented it with a performance grant amounting to Rs 25,428 crore, and capped it with a slew of recommendations for bringing about improvements in ULB finances and functioning. Annual average grant-in-aid for ULBs has risen from Rs 250 crore in 1996 to Rs 29,250 crore in 2020.

Property Tax Boards have been established in a few states. Several states have introduced changes in the accounting system of local bodies. Outside of the FCs framework, too, initiatives have been taken to refurbish the finances of ULBs—listing of municipal debt securities in the stock market being one such recent initiative. Prima facie, these appear to have a large spread.

A review of these initiatives undertaken to assess their impact on ULB finances and functioning shows that while there is a change in the composition of the revenue of ULBs, their overall fiscal status, i.e. revenues and expenditures measured in terms of a percentage of gross domestic product (GDP), has changed little over the past two decades (see table). ULB revenues are stuck at an incredibly low level of about 1% of GDP compared with levels ranging 4-7% in several emerging economies.

Transfers from the higher governmental tiers including grant-in-aid from the FCs have risen; in the process, however, transfers seem to have undercut local revenue-raising efforts. Tax share of ULBs has dipped to a historic low of 1.8% from a high of 4.2% in the early 1990s. In other spheres too, such as creation of a comparable local finance data base, sought by every FC, or restoring to ULBs the functional space that stands occupied by parastatals, there is no evidence of any headway.

With this record of performance, the FFC can hardly afford to be status quoist and continue on the path laid out by its predecessors; a strategic shift in how to make Article 280(3)(c) effective—the only instrument available to it for bringing about a change—is necessary. Five suggestions focused on how to make grant-in-aid work better, revive local revenue raising, and widen ULBs functional and fiscal space are presented here:

1. Bring in a hard budget constraint for ULBs: There is enough global evidence to suggest that transfers do not function under conditions of a soft budget where local governments operate sub-optimally in matters of resource raising and service delivery. Setting benchmarks for local revenue raising—a kind of fiscal responsibility—is a prerequisite for a transfer-grant system to become effective;

2. Use an index of local revenue effort with a substantial weightage as a key criterion in the interstate allocation of the recommended grant-in-aid: It should work as an incentive for states to provide ULBs autonomy in making choices about tax bases, tax rates, tax exemption, fixing surcharges on state taxes that have a strong local orientation, etc. It will be a major step towards self-governing ULBs;

3. Provide a dedicated grant-in-aid window for ULBs to implement those 12th Schedule functions that are drawn from the Concurrent List of the Constitution, such as planning for economic and social development, urban forestry and protection of environment;

4. Pull in the Reserve Bank of India (RBI) in the standardisation and publication of a volume on municipal finances, complementary to that on state finances. It is an essential step to assessing the fiscal health of ULBs;

5. Initiate a process of amending Article 280(3)(c): In its existing format, this Article is discriminatory to local bodies in that it denies them access to the ‘divisible pool of resources’, and consequently a place in the country’s intergovernmental fiscal framework. Under the existing arrangement, local governments are at best grantee institutions. Article 280(3)(c) is also an unusual and cumbersome provision that requires the FCs to make use of the reports of the state finance commission (SFCs) for assessing the requirements of ULBs. No FC has been able to do it, with the result that determination of the grant-in-aid recommended by the FCs has thus far been an ad hoc exercise. Even after 26 years, a methodology that will allow the FCs to systematically assess the requirements of ULBs has not emerged.

A long-term improvement in the finances and functioning requires a more scientific method in place of the current one as laid down in Article 280(3)(c) of the Constitution. In an interview (IE, September 30), the chairman of the FFC referred to the need to revisit the constitutional framework defining the federal structure, especially the 7th Schedule; Article 280(3)(c) deserves to be one of the candidates for such a revisit.

The author is senior fellow, Global Cities Institute, University of Toronto, and former IDFC Chair, NIPFP