Municipal Finances: Test of States’ Governance

That citizens expect the government to spend on education, health, defence, infrastructure, subsidies, law and order, and general administration, is a given. That most of us, the citizens, do not know or understand how the government’s revenues and budgets are segregated across 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 rich and have sufficient resources to keep the local areas smoothly functioning! And importantly, that to spend enough, governments, including the local government and municipalities, must have sufficient revenues, is not spoken of openly in the daily citizenry conversations. 

In its last released ‘State Finances 2021-22 report’ the Reserve Bank of India (RBI) noted that the urban local bodies and municipal corporations have "come under severe strain, forcing them to cut down expenditures and mobilise funding from various sources". The report pushes across the observation that the diversion of municipal corporation funds may have severe consequences for the financial sustainability of cities in the short to medium term. This has impacted their ability to provide services to local communities, as municipalities and gram panchayats have spent on Covid fighting measures. The report also concludes that the local governments suffered from insufficient budgets, overreliance on funds from upper tiers of government, lack of access to new sources of revenue and limited autonomy. 

Administration ‒ a reckoner 

The administration in India operates at three levels, the Central Government of India, the state governments, and the local municipal bodies. The state and central governments raise funds for their developmental works through direct and indirect taxes.

The State Municipal Acts are legislations enacted by the state governments to establish municipal governments, administer them, and provide a framework of governance for cities within the state. Every state has its own municipal Act and some states have more than one municipal Act, governing larger and smaller municipalities under different acts. Local governments ‒ panchayats in rural areas and municipalities in urban areas ‒ are the closest to the people at the grassroots level. They provide critical civic amenities such as roads, water and sanitation, and primary education and health. 

To effectively have Urban Governance, the involvement of local bodies like municipalities is critical. Creating capacities at the municipal level, both in terms of talent as well as finances (for urban development) is a crucial component of urban governance. It is vital to ensure that across governmental civic bodies, adequate capacity is built to ensure that physical and socio-cultural-economic planning processes are well-coordinated and within the spirit of the local laws. 

The accountability now rests with the Urban Local Bodies (ULB) but it is not backed by either adequate finances or the capacity for planning and management. State governments have an important role to play, not only in transferring functions, funds, and functionaries but also in providing an enabling environment through legislative and institutional reform, whereas the Government of India provides the strategic leadership. Indian cities are not fully empowered within the federal framework to take on the challenges of urbanisation with rapid growth.

In addition to the lack of financial devolution, there is a lack of financial autonomy ‒ both in mobilising resources and in setting user charges to cover their costs. Property tax rates and exemptions are typically set by the state government. These are a major source of revenue for the local government, and showcase the gap in collaborative decision-making between the urban local bodies and the state governments. 

Municipal Financing options 

Just like any company adopting efficient financing mechanism, cities too need to be funded on the basis of the revenues they generate today and so that their future services are met by predictable future revenues.  

A prudent mix of public debt issuance and institutional funding is required. Efficient city financing should have the mix of taxes and public borrowing that maximises the profitability of firms and the welfare of city residents. An efficient way to finance the construction of city infrastructure would be to structure the city revenues over the productive life of the assets and to use long-term infrastructure debt financing. It would be prudent to assume that the taxes collected on the resultant improved value of city land should then be used to take care of land maintenance as well as to repay the debt. 

It has been observed that cities in a panic or politicising mode, could misuse long-term debt to take care of the gap between present revenues and spending. This would be blatant abuse of its powers. But who questions these?

City governments can easily generate finance locally, if their records on citizenry, businesses, municipal asset usage are updated, traceable and preferably digitised to enable real-time updates. This would allow for timely demand of and efficient collection of local revenues like property taxes, business taxes and user fees. Financing for town development will have to rely on unlocking land value through instruments such as impact fee and by taxing increment financing. Since the costs and benefits of infrastructure development are not equally distributed within the region, cooperative financing arrangements will have to be devised within the federal framework with active engagement of the cities and towns in the region.

Municipal bonds

In terms of financing capabilities, the local municipal bodies form the weakest layer in the administrative framework. In India, municipal corporations cannot run a deficit budget, by legal mandate. Their revenue receipts must exceed revenue expenditure in their budgets. The municipal corporations can borrow, only after formal approval from their respective state governments. 

Using the Municipal Bonds route, very few Indian municipalities have successfully raised debt so far, and a very small proportion (almost negligible) of their fund requirement at that. Pune, Hyderabad, Indore, Amravati, Bhopal, Visakhapatnam, Ahmedabad, Surat,  Lucknow, Ghaziabad have raised municipal bonds.

Municipal bonds are usually tax-exempt on the interest, making them attractive products for investors. However, they are not necessarily risk-free. While the market sentiment looks favourably on these despite no explicit repayment guarantees, it is an implicit backstop that the state governments honour these commitments. Also most municipal bonds are small in issue size and have low trade volumes which make the bonds illiquid. 

There are two types of such bonds: 

Revenue Bonds ‒ used to finance specific projects. These are repaid through the revenues or taxes generated from these specific projects. 

General Obligation Bonds ‒ used to finance general infrastructural purposes and are repaid from the common pool of government funds or municipal level taxes.

Way forward 

Self-financing and the ability to generate public financing has been shallow in the Indian municipalities. Notwithstanding the few municipal bonds raised, the amount raised are a tiny proportion of the overall budgets. 

In the short-term ahead, increasing the financial autonomy and accountability of civic bodies, strengthening their governance templates and making them financially-independent units are critical for their effectiveness at the grassroot level. In effect, a speedier way that can devolve funds to municipal bodies from the Fifteenth Finance Commission can also catalyse effective governance at the grassroots. How quickly the state governments strengthen the local machinery would be a test of their governance. After all, none want to part with their authority easily,  a financial one at that!