Fiscal Challenges of Indian Municipalities

Syllabus: GS2/ Governance

Context

• Urban India drives nearly two-thirds of the national GDP but remains financially weak, with municipalities controlling less than one per cent of tax revenue.

Concerns over Fiscal Architecture of Municipalities

• The 74th Constitutional Amendment Act (1992) empowered Urban Local Bodies (ULBs) to perform 18 functions listed in the 12th Schedule, including water supply, waste management, and public health.
  • However, the corresponding financial devolution has been weak and inconsistent across States, resulting in a situation where responsibility is decentralised but revenue is not.
• Dependency on Higher-Level Transfers: Cities increasingly rely on tied and scheme-based grants, such as under the Smart Cities Mission or AMRUT, limiting local flexibility and innovation.
• Weak Own-Revenue Base: Property tax, user fees, and local cesses form the backbone of ULB revenues but together constitute only 20–25% of potential municipal income.
  • Inefficient valuation, political resistance to rate revisions, and low collection efficiency further erode fiscal capacity.
• Impact of GST: Before GST, cities collected revenue through octroi, entry tax, advertisement tax, and local surcharges, which together formed about 19% of total municipal income.
  • GST subsumed these taxes, depriving municipalities of independent revenue sources.

Municipal Bonds: The New Frontier of Local Finance

• Municipal bonds are debt instruments issued by Urban Local Bodies (ULBs) such as municipal corporations or councils to raise money from investors. However, their success depends on deeper structural reforms.
• Current Challenges:
  • Flawed Credit Rating System: When agencies rate a city’s financial health, they often ignore regular grants and transfers from the State or Centre. This makes cities appear weaker than they actually are, reducing their ability to attract investors.
  • Low Credibility of Cities: Many cities don’t have strong financial records or proper audits. Investors hesitate to buy bonds because they fear the city may not be able to repay the money on time.

Way Ahead

• Adopt Global Best Practices: In countries like Denmark, Sweden, and Norway, municipalities have the authority to levy local income tax, ensuring direct accountability between citizens and local governments.
• Recognise Transfers as Legitimate Income: Grants and shared taxes must be treated as part of city income to build credible balance sheets.
• Reform Credit Ratings: City ratings should factor in governance quality, transparency, and citizen participation, not just narrow financial metrics.
• Enable Fiscal Innovation: Municipalities should be allowed to earmark a portion of GST compensation or their State tax share as collateral for bond issuance.

Source: TH