Municipal Finance Test of State Governance-Srinath Sridharan
That citizens expect the government to spend on education, health, defence, infrastructure, subsidies, public order and general administration is obvious. That most of us citizens do not know or understand how government revenues and budgets are divided between the union, state and municipal levels is an understatement.
Most citizens assume that because they pay direct and indirect taxes of different kinds like income tax and GST, their local municipality would be wealthy and have enough resources to keep local areas running smoothly! Above all, that in order to spend enough, governments, including local government and municipalities, must have sufficient revenues, is not mentioned openly in the daily conversations of citizens.
In its latest published ‘State Finances 2021-22’ report, the Reserve Bank of India (RBI) noted that urban local bodies and municipal corporations have “come under severe pressure, forcing them to cut spending and mobilize funds from various sources. The report stresses that the diversion of funds from municipalities can have serious consequences on the financial viability of cities in the short and medium term. This has impacted their ability to deliver services to local communities as municipalities and gram panchayats have spent on Covid measures. The report also concludes that local governments have suffered from insufficient budgets, overreliance on funds from higher levels of government, lack of access to new sources of revenue and limited autonomy. .
Administration – an accountant
The administration in India operates at three levels, the central government of India, state governments and local municipal bodies. State governments and the central government raise funds for their development work through direct and indirect taxes.
The State Municipal Acts are legislation enacted by state governments to establish municipal governments, administer them, and provide a governance framework for cities in the state. Each state has its own municipal law, and some states have more than one municipal law, governing larger and smaller municipalities under different laws. Local governments – panchayats in rural areas and municipalities in urban areas – are closest to the people at the local level. They provide essential civic amenities such as roads, water and sanitation, primary education and health.
To have effective urban governance, the involvement of local organizations such as municipalities is essential. Capacity building at the municipal level, both in terms of talent and finance (for urban development) is a crucial component of urban governance. It is critical to ensure that civic government bodies have adequate capacity to ensure that physical and socio-cultural-economic planning processes are well-coordinated and in line with the spirit of local laws.
The responsibility now lies with the Urban Local Organizations (ULB) but it is not backed by adequate finance or planning and management capacity. State governments have an important role to play, not only in transferring functions, funds and civil servants, but also in creating an enabling environment through legislative and institutional reforms, while the Government of India is ensuring strategic leadership. Indian cities are not fully empowered within the federal framework to meet the challenges of rapidly growing urbanization.
In addition to the lack of financial decentralization, there is a lack of financial autonomy – both in mobilizing resources and in setting user fees to cover their costs. Property tax rates and exemptions are usually set by the state government. These are a major source of revenue for local government and show the gap in collaborative decision-making between urban local bodies and state governments.
Municipal financing options
Like any business adopting an effective financing mechanism, cities also need to be financed based on the revenues they generate today and so that their future services are met by predictable future revenues.
A careful combination of public debt issuance and institutional financing is needed. Effective city financing should have a mix of taxes and government borrowing that maximizes business profitability and the well-being of city residents. An effective way to finance the construction of urban infrastructure would be to structure the city’s revenues over the productive life of the assets and to use long-term infrastructure debt financing. It would be safe to assume that the taxes collected from the resulting improvement in the city’s land values would then have to be used to take care of the upkeep of the grounds as well as paying down debt.
It has been observed that cities in panic or politicization mode may misuse long-term debt to bridge the gap between current incomes and expenditures. It would be a flagrant abuse of his powers. But who questions them?
Municipal governments can easily generate funding locally, if their records on citizens, businesses, and use of municipal assets are up-to-date, traceable, and preferably digitized to allow for real-time updates. This would allow rapid application and efficient collection of local revenues such as property taxes, business taxes and user fees. Funding for city development will need to rely on unlocking land value through instruments such as the impact fee and by taxing incremental funding. Since the costs and benefits of infrastructure development are not equitably distributed across the region, cooperative financing arrangements will need to be devised within the federal framework with the active participation of cities and towns in the region.
In terms of financing capacities, the local communal bodies constitute the weakest layer of the administrative framework. In India, municipal corporations cannot manage a deficit budget, by legal mandate. Their revenues must exceed the revenue expenditures in their budgets. Municipal corporations can only borrow after formal approval from their respective state governments.
Using the municipal bond route, very few Indian municipalities have managed to raise debt so far, and a very small (almost negligible) proportion of their funds needs to do so. Pune, Hyderabad, Indore, Amravati, Bhopal, Visakhapatnam, Ahmedabad, Surat, Lucknow, Ghaziabad raised municipal bonds.
Municipal bonds are generally exempt from tax on interest, making them attractive products for investors. However, they are not necessarily without risk. While market sentiment views them favorably despite the lack of explicit money-back guarantees, it is an implicit safety net that state governments honor these commitments. Additionally, most municipal bonds are small in size and have low trading volumes, which makes the bonds illiquid.
There are two types of such bonds:
Revenue bonds ‒ used to finance specific projects. These are reimbursed by the income or taxes generated by these specific projects.
General Obligation Bonds ‒ used to finance general infrastructure purposes and are repaid from the common pool of government funds or municipal taxes.
Self-financing and the ability to generate public funding has been weak in Indian municipalities. Despite the few municipal bonds raised, the amount raised represents only a tiny proportion of overall budgets.
In the short term, increasing the financial autonomy and accountability of civic bodies, strengthening their governance models and making them financially independent units are essential for their effectiveness at the local level. Indeed, a faster way of delegating funds to municipal bodies in the Fifteenth Finance Commission can also catalyze effective grassroots governance. The speed with which state governments strengthen the local apparatus would be a test of their governance. After all, no one wants to be easily separated from their authority, financial and more!