2.1 Approach to Review This chapter reviews the literature
relating to the role, functions, working and finances of Urban Local Bodies (ULBs).
The review is sequenced under the following heads: fiscal decentralization, structure
of local bodies, resources of local bodies, imbalances in revenues and responsibiliti
fiscal transfers, role in economic development, etc. The international
studies, are reviewed initially followed by the studies done in the Indian context.
In the last section, an attempt has been made to bring out the major observations
emerging from the review of literature. 2.2 International Studies
2.2.1 Fiscal Decentralization - Theoretical Aspects
The importance and significance of municipal finances arises in the context
of fiscal decentralization (and also urbanization). Therefore, it is pertinent
to start with examining the theoretical aspects of fiscal decentralization so
that the role and relevance of the municipal finances can be established on a
sound footing. The ‘Decentralization Theorem’, formulated by Oates
(1972) states: “For a public good – the consumption of
which is defined over geographical subsets of the total population, and for which
the costs of providing each level of output of the good in each jurisdiction are
the same for the central or for the respective local government – it will
always be more efficient (or at least as efficient) for local governments to provide
the Pareto-efficient levels of output for their respective jurisdictions than
for the central government to provide any specified and uniform level of output
across all jurisdictions”. The theorem suggests that a public
good should be provided by that geographical jurisdiction which internalises its
provision and should include precisely the set of individuals that consumes it:
“each public service should be provided by the jurisdiction having
control over the minimum geographic area that would internalise benefits and costs
of such provision”. Oates (1972). The above principle, known
as ‘subsidiarity’ in the theory of fiscal federalism rests on the
foundation that efficient allocation of public resources to match public preferences
for services is facilitated by factors such as access to local knowledge, alignment
of resources to services, local financial autonomy in planning and delivering
services, scope for achieving cost-effectiveness in service delivery and performance
accountability in service provision. The theory contends that welfare would be
maximized if each local government provides the Pareto-efficient output for its
constituency. Two major factors in favour of decentralisation are enumerated
in literature as follow: i) The central government, while remaining more
concerned with the functions like economic stabilization, income distribution
and resource allocation that have macro implications, often neglects the activities
relating to provision of basic services. Most central governments are primarily
concerned with managing macroeconomic policies and maintaining national political
stability. They are often less concerned with the provision of civic services,
except to the extent that these involve large-scale capital-intensive investments
(Rondinelli, 1990). ii) Decentralisation of political, financial and
administrative authority to the lower levels of government increases the efficiency
in provision of various services due to the lesser jurisdiction and focused attention
of the lower levels of government. The following three forms of decentralization
are distinguished in literature [e.g. Davey (1996) and Rondinelli and Cheema (2002)]:
i) Deconcentration of authority to field offices, lower echelons, etc.,
i.e., to officials within same organisational hierarchy; ii)
Delegation to separate legal persons, but ultimately under the same political
direction; and iii) Devolution to a representative body, such as a provincial
government or local authority, i.e., with independent political accountability.
In this background, it may be noted that fiscal decentralization is a subset
of decentralization. Fiscal decentralisation can be defined as “the devolution
of taxing and spending powers to lower levels of government” [Fukasaku and
de Mello Jr. (1999)]. More specifically, fiscal decentralisation refers to the
principles and practices concerning functional or expenditure responsibilities,
revenue assignment and rectification of vertical and horizontal imbalances. In
a broader sense, fiscal decentralisation is the fiscal empowerment of lower tiers
of the government. The theoretical literature on fiscal decentralization
has tried to answer the basic question - ‘who should do what’ to ensure
the most efficient and equitable allocation and distribution of resources consistent
with the preferences of the people [see Oates (1972), King (1984), Bird (2000),
Shah (1994), Litvack et al (1998) and Bahl and Linn (1992)]. These fiscal balance
questions have particular significance in a vast country like India with significant
regional disparities in resource endowment, level of income, stage of development,
fiscal disabilities and even social deprivation. As pointed out earlier,
traditionally the theory of public finance [Musgrave (1959) and Musgrave and Musgrave
(1989)] identifies the following three functions for the public sector:
i) macroeconomic stabilization; ii) income redistribution; and iii) resource allocation. As
per the theory, while the stabilization and redistribution functions are to be
performed by the national government, the sub-national governments have a significant
role in resource allocation. The basic argument provided by the theory of fiscal
federalism [Oates (1972)] is that in a democracy, decentralization will result
in a better match of supply and demand for local public goods. Being closer to
the people, local bodies can more easily identify people’s needs and thus
supply the appropriate form and level of public services [Rondinelli (1989)].
The above demarcation is by and large true although there may be considerable
overlapping and inter-governmental coordination required in regard to all these
functions. To ensure the effective redistribution of income and alleviation of
poverty, the national government has a dominant role [Hirsch (1970), Oates (1999)]
although the local governments have to play important role for effective implementation.
Sometimes a range of rewards and disincentives may have to be built into inter-governmental
fiscal relations by the central government in order to achieve certain national
goals and egalitarian objectives. Again, if more expenditure and resources are
left to the control of local bodies, the stabilization function cannot be handled
effectively by the national government alone. Ensuring some degree of correspondence
between the benefits obtained from public services in a particular jurisdiction
with the revenue potential is important because it also promotes accountability
[(Litvack et al (1998), Bird (2000)]. Regarding expenditure,
literature suggests that watertight assignment of several services and functions
would be difficult. This is particularly so, when the relevant policy and regulatory
framework and much of the financing come from higher levels of government with
the actual service delivery being done at a lower institutional level (Bird, 2000).
The need for clarity in expenditure assignment brings home the equally important
question of matching functions and finances and the channels of accountability.
Bird (2000) outlines three major rules in the context of accountability for local
public expenditures: i) Sub-national governments should, whenever possible,
charge for the services they provide; ii) Where charging is impracticable,
sub-national governments should finance such services from taxes borne by local
residents, except to the extent that the central government is, for whatever reasons,
willing to pay for them through transfers and iii) Where the central
government does pay, sub-national governments should be accountable to the central
government, at least to some extent. This is one way to ensure accountability.
But in the context of decentralised democratic governance, it may be noted
that, the concept means much more than ‘answerability.’ Actually,
democratic decentralisation is expected to correct not only the distortions caused
by the abuse of power of public agencies (the answerability aspect), but also
to make them more responsive, participative and transparent. Transparency facilitates
participation, and participation makes a public agency really responsive to people’s
needs. 2.2.2 Structure of Local Bodies Cross-country
experience reveals that in most of the countries, governments are characterized
by multiple structures. Apart from the government at the national level, countries,
in general, have governments at two sub-national levels, i.e. provincial
(or regional) and local. Fjeldstad (2001) provides the structure of sub-national
governments in selected countries which is produced in Table 6. 2.2.3
Resources of Local Bodies A basic question in fiscal decentralisation,
with regard to resources, is ‘who should tax, where and what’ (Musgrave,
1983). Several authors have advanced principles underlying revenue assignment.
They range from broad principles to the rationale of specific taxes [See Oates
(1972), Musgrave (1983), Mc Lure Jr. (1983), Bird and Wallich (1993), Stein (1998),
Oates (1999), Bird (2000) and Bahl (2001)]. There is a broad consensus among the
authors that the taxes dealing with redistribution or stabilization, taxes on
Table
6: Structure of Sub-national Governments in Selected Countries |
Country | Intermediate
level | Local
level | | | |
Argentina | 23
provinces | 1617 minicipios |
Brazil | 27
states | 4974 municipios |
Colombia | 32
departments | 1068 municipalities |
Ethiopia | 9
region, plus 2 city administration, | 550
woredas | | 66
zones | | France
| 22 regions, 96 departments | 36772
communes | India | 25
states, | 3586 urban local bodies, 234078 |
| 7
union territories | rural local bodies |
Italy | 22
regions, 93 provinces | 8100 municipalities |
Kenya | 39
country councils | 52 municipal, |
| | town
and urban councils | Malaysia
| 13 states | 143
city, municipal and district councils | Mozambique
| 10 provinces | 33
municipalities | Philippines
| 76 provinces | 850
local authorities | Tanzania
| 21 regions (incl. Zanzibar) | 92
district councils, | | | 18
municipal and town councils, | | | 1
city council (Dar es Salaam) | Uganda
| 45 districts | 950
sub-counties | | 13
municipalities | 39 municipal divisions |
| | 52
town councils | United Kingdom
| Counties | 540
rural districts, metropolitan | | | districts
and London boroughs. | United
States | 50 states | 39000
counties and municipalities | | | 44000
special-purpose local authorities | | | |
Source: Fjeldstad
(2001). | | mobile
factors, and taxes requiring national level information and involving significant
economies of scale in tax administration should be levied by the federal government.
The revenue instruments assigned to a tier of government should match, as far
as possible, the expenditure requirements to induce “fiscal responsibility”
[Ter-Minassian (1997)]. However, in reality, the mismatch in functions and finance
is the major issue in fiscal decentralisation. The literature on public
finance addresses the issue of the suitability of types of taxes for various levels
of government. Though there is no ideal assignment of taxes between central and
lower levels of government, one can find a set of tax-assignment rules in the
traditional theory of fiscal federalism. These principles are in accordance with
the respective responsibilities of central and lower tiers of governments. Thus,
taxes on international transactions (customs duties) and a considerable share
of income and excise taxes should be assigned to central government. To perform
the function of income redistribution, it is appropriate for the central government
to collect corporate income and wealth taxes. Local bodies require relatively
stable sources of revenues. Following Musgrave (1983), the six principles
of tax assignment in a federation are: i) Taxes suitable for economic
stabilization should be levied by the central government; ii) Progressive
re-distributional taxes should be assigned to central government; iii) Personal
taxes with progressive rates should be levied by the jurisdictions most capable
of implementing a tax on a global base; iv) Lower-level governments should
tax revenue bases with low mobility between jurisdictions; v) Tax bases distributed
highly unequally between jurisdictions should be centralized and vi) Benefit
taxes and user charges may be appropriately used at all levels. Broadway
et al (2000) examines the suitability of various taxes and levies which
can be collected by various tiers of government as set out in Table 7.
Research suggests that the urban local bodies need to have a good number of local
taxes so as to become financially sound and match the range of assigned functions
effectively. A local tax is one where the local authority (a) determines the tax
revenue by setting the tax rate and/or defining the tax base and (b) retains the
revenue collected for its own purposes [Bailey (1999) and Bird (2000)]. Oates
(1972) suggests the following basic guidelines for the design of local taxation
systems:
Table
7: Tax Assignment: Who should tax what? | Tax
type | Determination
of | Collection
and | Comments |
| Tax
base | Tax
rate | Administration | |
Customs | N | N | N | International
trade taxes | Corporate
income | N | N | N | Mobile
factor | Personal
Income | N | N,
P, L | N | Redistributive,
mobility, | | | | | stabilization |
Wealth taxes (incl. | | | | |
capital, inheritances) | N | N,
P | N | Redistributive |
Payroll | N,
P | N, P | N,
P | Social programme |
Value Added Tax | N | N | N | Admin,Costs,Stabilization |
Resource Taxes: | | | | |
Rent (profit) tax | N | N | N | Unequally
distributed | Royalties/fees | P,
L | P, L | P,
L | Environmental
preservation | Alcohol,
tobacco | N,
P | N, P | N,
P | Health care
shares | Gambling,
betting | P,
L | P, L | P,
L | Province
and local responsibility | Lotteries | P,
L | P, L | P,
L | Province
and local responsibility | Taxation
of ‘bads’: | | | | |
Carbon | N | N | N | Global/national
pollution | Motor
Fuels | N, P,
L | N, P, L | N,
P, L | Tolls
on road use | Congestion
tolls | N, P,
L | N, P, L | N,
P, L | Tolls
on road use | Parking
fees | L | L | L | Local
congestion | Motor
Vehicles: | | | | |
Registration | P | P | P | Provincial
revenue source | Driver’s
license | P | P | P | Provincial
revenue source | Business
taxes | P | P | P | Benefit
tax | Excises | P | P | P | Immobile
tax base | Property
tax | P | P | P | Benefit
tax, immobile tax base | Land
tax | P | P | P | Benefit
tax, immobile tax base | User
charges | N,
P, L | N, P,
L | N, P, L | Payment
for services | N=National
(or, Central); P=Provincial (or, State); L=Local | |
Source:
Boadway, e t al (2000). | •
Local taxes should be as neutral as possible in terms of their effects on economic
behaviour; • The benefits and costs
of local taxes should be clear to those to whom services are to be provided;
• The pattern of incidence of local taxes
should meet the basic equity standards; and •
Administration and compliance costs should be minimized by avoiding the assignment
of complex taxes to local governments. Bird (1994) compares the major taxes
in terms of the above criteria for qualifying as suitable local taxes (Table 8).
Table
8: Criteria for Choice of a Local Tax | Characteristics | Property
Tax | Property
Tax | Sales
Tax | Business
Tax | Immobility | + | - | - | - |
Adequacy | - | + | + | ? |
Buoyancy | - | + | + | + |
Stability | + | - | - | - |
Non-Exportability | +/- | +/- | + | - |
Visibility | + | + | + | - |
Fairness | + | + | ? | - |
Acceptability | - | - | ? | + |
Administrative Ease | ? | + | ? | + |
| | | | |
Note :
‘+’ means that the tax is good, ‘-’ means
it is bad, and ‘ ?’ means it is indeterminate. ‘+/-’
means that the tax is good to the extent it falls on residents and bad to the
extent it falls on non-residents. It may be noted that the table may not fully
apply to all situations in all developing countries. Source :
Bird (1994). | Though the basic principles of
local taxation are derived from the general principles of taxation in public finance,
the following criteria are particularly relevant for making choice among local
taxes: Equity: The notions of vertical and horizontal
equity should apply as far as possible. Efficiency:
Local taxes should promote allocative efficiency. This requires local voters to
pay local taxes so that the use of service reflects the willingness to pay.
Transparency: The accountability of service providers to
tax payers depends on voters knowing exactly how much they are paying in taxes.
Local autonomy: Local governments and their voters are free
to determine the rates at which local rates are set. Economy:
Local taxes should be collected with least expenses. Adequacy:
The tax yield should be, as far as possible, adequate to finance the levels of
services for which people vote. The local tax should, therefore, have an easily
adjustable and/or an elastic tax base, expanding as fast as expenditure. Revenue
stability: There should not be undue fluctuations in the flow of local
revenue. Immobile tax base: Local taxes may do well
to confine to immobile tax bases such as land, buildings, etc., besides
levying user charges wherever relevant. This does not rule out imposing fees or
other levies on business, trade, and taxes on profession and so on. Several
researchers regard land-based taxes as the most appropriate sources of local body
finances where the local authorities, as in India, are required to provide the
basic civic infrastructure facilities. A key argument is that local government
spending translates into rising land values and the land-owners benefit proportionately
more than what they pay as taxes due to urbanization and infrastructure development
leading to agglomeration economies. The literature recognises ‘users
pay’, ‘beneficiaries pay’ and ‘polluters pay’ as
desirable principles of financing local infrastructure and services like water
supply, sewerage, drainage, roads etc. When beneficiaries are identifiable
and benefits can be measured, user charges are regarded as the ‘first best’
instruments of financing public services. They promote efficiency by providing
information on demand to the providers of public service and also ensure that
what the public sector supplies is valued (at the margin) by citizens. They act
as instruments to ensure the accountability of public functionaries. The theory
of local public finance suggests the following guiding principles for levying
user charges and benefit taxes: (i) Wherever possible, user charges may
be levied for the services provided as the first resort; (ii) For achieving
efficiency, user charges should be levied on the direct recipients of benefits;
(iii) The poor may be subsidised directly, if needed, rather than through
reduced prices and distortions in the entire market for services; (iv)
Where charging is impracticable, specific benefit taxes should be levied on local
residents; and (v) Inter-governmental transfers may be used to finance services
only if user charges and benefit taxes are not adequate. User pricing
has been adopted in land development in certain countries as described below:
In Colombia road improvements, water supply and other public services have
been financed by “valorisation” under which the cost of public works
is allocated to the affected properties in proportion to the estimated benefits
conferred on them by those works. The success of the scheme is seen to depend
on (i) careful planning and execution, (ii) active involvement of beneficiaries,
(iii) effective revenue collection system, and (iv) significant initial funding
of the ‘valorisation fund’ by higher levels of government.
In Korea and some other countries, large land parcels have been developed by local
governments. After development, a part of the property is returned to the original
owner in proportion to his original occupation. The balance is sold at market
prices to recover the development costs. The scheme requires fairly sophisticated
procedures for success. In India, town planning laws of some States like Gujarat
provide for town planning schemes which are similar to land readjustment. However,
such schemes have not been used extensively in India. Development charges,
impact fees and lot levies are popular in North American countries. They are levied
with a view to accommodating population expansion in new development areas. Levies
are imposed on would-be property developers in proportion to the estimated costs
of the needed infrastructure. Both off-site and on-site impacts are taken into
account while calculating the fees. In the case of ‘collective’
services where beneficiaries are not identifiable or services are not measurable
and levying user charges is not possible, researchers regard benefit taxes as
the appropriate instruments of financing local expenditures. It is argued that
when clear linkages exist between the taxes levied and the expenditures financed,
earmarked benefit taxes constitute indirect user charges or surrogate prices for
services. Earmarking then facilitates the rational choice by tax payers.
Nobel laureate James Buchanan (1963) and a number other researchers regard ‘earmarking’
as a ‘first best’ operational way of dealing with the fundamental
normative problem of public economics: how to provide public services that match
peoples’ preferences. They contend that earmarking aims at the introduction
of market prices into the budgetary process. The strongest economic case for earmarking
exists where there are clear benefit linkages between the taxes or charges levied
and the expenditures financed so that earmarked taxes act as indirect forms of
user charges or prices for services. Through the linking of user charges and specific
benefit taxes to certain public services, earmarking facilitates the rational
choice by taxpayers. The effectiveness of earmarking depends on the following
three conditions: • Expenditure specificity,
i.e. the expenditures to be financed by earmarked revenues are well-defined
and specific in the sense that taxpayers can identify their obvious benefits.
• Tight earmarking, i.e. the
linkage between earmarked revenues and expenditures is tight at the margin. When
the amount earmarked is substantially less than the amount spent on the designated
functions, earmarking will have no effect on the margin and will be meaningless.
• Strong benefit linkage, i.e.
revenues are in the form of direct user charges such as payments for use and indirect
user charges such as specific benefit taxes. Local public finance provides
broad guidance for matching revenues with expenditure responsibilities. Bahl and
Linn (1992) suggests the following general principles for identifying the revenue
sources appropriate to financing particular types of local expenditures:
i) Where the benefits of public services are measurable and accrue to readily
identified individuals in a jurisdiction, user charges are the appropriate financing
instruments; ii) Local public services such as administration, traffic
control, street lighting and security, which are services to the general public
in the sense that identification of beneficiaries and measurement of benefits
and costs to individuals are difficult, are most appropriately financed by taxes
on local residents; iii) The cost of services for which significant spillovers
to neighbouring jurisdictions occur (e.g., health, education and welfare), should
be financed substantially by state or national inter-governmental transfers and
iv) Borrowing is an appropriate source to finance capital outlays on infrastructure
services, particularly, public utilities and roads. 2.2.4 Imbalance
of Revenues and Responsibilities Notably, the nature of functions
and finances in a federal setup across a wide range of countries is similar. National
governments assign more expenditure functions to the sub-national governments
than the sources of revenues. The same is true of provincial governments which
assign more responsibilities to their local governments as compared to revenues.
The result is the mismatch between functions and finances - often referred to
as ‘vertical imbalance’. Hence, sub-national/local governments are
generally dependent upon transfers from higher levels of government. The extent
of vertical imbalance in resources of sub -national governments in different countries
is given in Table 9. It is clear from the table that the resources raised by the
sub-national governments are not sufficient to match the expenditure responsibilities,
thus leading to what is called as the fiscal gap. The basic rationale for the
system of inter-governmental fiscal
Table
9: Vertical Imbalances in Selected Countries | Country | Share
of sub-national government (per cent) | |
| In
total public expenditure | In
total tax revenue | |
| 1990 | 1997 | 1990 | 1997 |
| | | | |
Argentina | 46.3 | 43.9 | 38.2 | 41.1 |
Brazil | 35.3 | 36.5 | 30.9 | 31.3 |
Ethiopia | 1.5 | .. | 1.6 | .. |
France | 18.7 | 18.6 | 9.7 | 10.8 |
India | 51.1 | 53.3 | 33.8 | 36.1 |
Italy | 22.8 | 25.4 | 3.6 | 6.5 |
Kenya | 4.4 | 3.5 | 2.2 | 1.9 |
Malaysia | 20.2 | 19.1 | 3.7 | 2.4 |
Philippines | 6.5 | .. | 4.0 | .. |
South Africa | 20.7 | 49.8 | 5.5 | 5.3 |
United Kingdom | 29.0 | 27.0 | 5.9 | 3.6 |
United States | 42.0 | 46.4 | 33.8 | 32.9 |
Source: Fjeldstad
(2001). | transfers, from higher levels of government,
is the existence of fiscal gap at the local government level. It may
be noted that the term ‘sub-national’ includes both provincial and
local governments. Some countries (e.g. India, United States) have two-tier sub-national
governments while others have just one tier, that is, local government (e.g. United
Kingdom). 2.2.5 Inter-Governmental Fiscal Transfers
The need for inter-governmental transfers arises largely out of vertical
mismatches between functions and finance as well as out of the compulsions necessitated
by horizontal disparities between different jurisdictions. Inter-jurisdictional
spillovers of costs and benefits also justify transfers. A higher-level
government may also wish to compensate local governments on considerations
of fiscal disabilities like poor taxable capacity. It may also
be because the national government may impose its preferences on the sub-national
governments in the national interest (e.g. eradicating poverty,
ensuring a national minimum of public services of standard quality such
as health and education, reducing regional disparities etc.).
Often programmes sponsored and funded by the central government are required to
be implemented by local governments. There is a broad typology of grants
based on the prevailing practices in countries. Grants are broadly grouped into
conditional or specific and unconditional or general. The conditional categories
are divided into matching and non-matching, the latter further into close-ended
or open-ended. There are also equalisation grants largely governed by the considerations
of horizontal equity. Which of these or what combination of them is to be adopted
is a policy decision largely governed by the objectives to be served by the concerned
governments [Bahl and Linn (1992)]. The design of transfers is critical because
whether a transfer is good or bad depends on the objectives to be served and the
manner in which it is designed. Inter-governmental grants, other things
being equal, stimulate the provision of local government services, increase private
sector demand and may even lead to the reduction of taxation. In theory,
grant works by increasing the real income of the local citizens (the so called
income effects) and/or by reducing the relative price of the services in question
(substitution effects). The local residents’ response to grants depends
upon their respective income and price elasticities of demand. In all cases where
the income effect is higher than the substitution effect, there is potential for
stimulating more demand for goods as well as services. Grants also open the option
for reducing local taxation. Whether grants will stimulate more positive impact
or reduce local taxation or produce other effects is an empirical question.
While matching grants, particularly of the open-ended variety, have greater
stimulating effect on grant-receiving institutions because of both income and
substitution effects, there are empirical studies indicating that closed ended
grants stimulate greater expenditure than open-ended ones [Gramlich (1977), Shah
(1979) and Shah (1989)]. The chief weakness of this type of grants is that it
may distort local priorities besides widening spatial disparities as richer governments
can attract more resources especially in an open-ended grant programme. This has
very serious implications for countries like India where reducing spatial disparities
has been an avowed development objective of the Government. Successful
fiscal decentralisation depends, to a great
extent, on designing inter-governmental transfers in a rational, equitable and
accountable way. Given the wide institutional set-up and socioeconomic factors
governing countries, the transfer system has to be country-specific subjected
to constant review depending on the changing demands of time. India is a country
that has made constitutional provision for periodically evaluating and recommending
inter-governmental transfers with separate arrangements for union-state as well
as state-local transfers. From the vast literature on inter-governmental
transfers, a few principles, considered to be relevant for a federal system like
that of India, are listed below: i) Sub-national governments must be
made an integral part of the revenue mobilization as much as it has shared responsibilities;
ii) Objectivity, transparency and predictability may be built into sub-national
budgeting; iii) Transfers should not perform a “gap filling”
function as far as possible. (Any transfer from a higher to a lower government
will help to close the fiscal gap and the objectives to be served therefore assume
importance here). Needs, rights and incentives are key criteria of inter-governmental
transfers. A simple distributive formula that gives due weights to needs, rights
to minimum basic services, incentives to performance, inter-jurisdictional equity
etc. is important; iv) Medium-term expenditure and revenue framework
may be put in place; v) Efficiency and inter-jurisdictional equity have
to be ensured. Efficiency requires that those responsible for any service
should have adequate resources (assuming the best own revenue effort) and sufficient
flexibility to make decisions, while being held accountable for results. Unless
increased transfers are matched by a local contribution, however small that contribution
may be in the poorest communities, the full efficiency benefits of decentralisation
are unlikely to be realized; vi) Transfers should not bail out the incompetent
and the irresponsible. Hard budget constraints should be the rule and soft options
need to be avoided; vii) Fiscal autonomy cannot be built in a regime
of grants, but the sub-national governments will have to progressively rely on
tax effort and innovative revenue mobilisation including project–tied loans,
public donation and the like and viii) Sub-national governments should
have defined responsibility including expenditure and performance conditionality
and accountability. 2.2.6 Municipal Finance and Economic Development
Municipal finance can affect the nature and location of development. In some
cases, municipal financial tools work in tandem with planning tools, but in other
cases the two have opposite effects. In general, the effect of municipal financial
tools in the nature, type and location of development is less understood. Slack
(2002) analysed the impact of municipal taxes in Canada and found that they, in
general, encourage low-density development, which is not advisable. The author
suggested that a combination of user fees, based on marginal cost pricing, and
development charges, levied on a development-by-development basis, could encourage
efficient land and infrastructure use and result in developments located closer
to existing services. Further, the user charges should be based on the marginal
cost of additional units of services from the infrastructure, and development
charges on the marginal cost of extending infrastructure to new developments.
The study suggested that municipal financial tools should not work against planning
objectives and tools. Martinez-Vazquez and McNab (2001) reviews the impact
of fiscal decentralization on economic growth. The authors state that though one
of the stated primary objectives of fiscal decentralization is to foster economic
growth, academic interest in fiscal decentralization as an engine of growth has
not developed. At the theoretical level, the overall impact of fiscal decentralization
on economic growth is uncertain. In terms of a direct impact, one can expect higher
growth associated with decentralization. Further, there can be potentially a multiplicity
of indirect effects of decentralization on growth including those through consumer
efficiency, producer efficiency, geographical distribution of resources, macroeconomic
stability, etc. Mohan (2006), while analyzing the urbanization
in Asia, has examined the financing needs of Asian urbanization over the next
thirty years. The author noted that financial markets in Asia have not been sophisticated
enough to allow for borrowing from the credit or bond markets as in case of Europe
or North America. Financing of urban infrastructure in Asia usually comes from
higher tier of governments who raise resources from taxes, or from banks and financial
institutions that have been typically government owned or sponsored (hence it
has some element of moral hazard). Ideally, cities have to develop self-sustaining
local taxation and user charge systems so that they can tap national and international
financial markets for their financing needs. The author has brought out an interesting
international dimension to urban infrastructure financing. Historically, regions
undergoing intensive urbanization had to mobilize external savings. Hence, urbanization
of Asia in the coming years will put pressure on international resource mobilization
and it will in turn get reflected in higher interest rates in the years to come,
which is of relevance to central banks. 2.3 International Experience
The documentation of international experience is sparse on functions and
finances of urban local bodies. One notable exception is Bahl & Linn (1992).
Among the developing countries, few have seriously addressed fiscal federalism
from the state to local level. There are not many relevant models from developing
countries from which India could derive useful lessons. The practice of local
government finance in countries as documented in government publications reveals
varying degrees of adherence to or departure from principles of public finance.
Revenue assignment remains the most conspicuous problem. The Centre for
Tax Policy and Administration in OECD periodically publishes statistical data
and analytical papers on intergovernmental finances of OECD and non-OECD countries.
Studies relating to OECD countries (see Appendix 2) reveal that property tax is
the dominant local tax in Australia, Canada, Ireland, New Zealand, United Kingdom
and the United States. These countries have either less important local governments
(e.g., Ireland, Australia) or local governments that are more dependent on inter-governmental
transfers (e.g., Canada, U.K.). Income tax is the most important local tax in
Austria, Belgium, Luxembourg, Switzerland, Norway, Sweden, Denmark, Finland and
Japan. A small number of countries have a balanced local tax structure. These
include France, Spain, Portugal, Italy and Turkey. Countries influenced by the
Anglo-Saxon tradition appear to depend heavily on property taxes and inter-governmental
transfers. Property taxes seldom accounted for more than 20% of local current
revenues in majority of developed countries. However, in many developing countries
including India, the dependence of the municipal authorities on property taxes
and inter-governmental transfers is inordinately heavy, reflecting their narrow
revenue base. There is a visible trend in the OECD countries towards
more effective utilisation of user charges and benefit taxes by local governments.
This is attributed partly to citizens’ preference for user charges over
general taxes. In contrast, user charges in India remain a grossly under-exploited
source till today. The structure and system of local government finance
in selected countries are presented below: United Kingdom
The finance regimes of local authorities in England include:
(i) a system of non-domestic rates, being a property tax levied on industrial
and commercial property - set by the Secretary of State for Environment for England
and Wales, collected into the national pool and then distributed among the local
jurisdictions based on adult population, (ii) a system of exchequer grants to
local authorities, principally the Revenue Support Grant (RSG) designed to compensate
local authorities for differences in the cost of providing municipal services,
(iii) a capital finance system (grants and loans) within which the local authorities
are also able to participate in partnerships with the private sector under the
Private Finance Initiative and (iv) a system of local domestic taxation, known
as the Council Tax. In 1995-96 the Government grants constituted about 52 per
cent of the total revenue expenditures by local authorities in England. The share
of non-domestic rates was 25 per cent and that of Council Tax was 21 per cent
[DETR (1997)]. For the purposes of the Council Tax, each dwelling is
assigned to one of eight bands: A to H according to its value on the open market
as on 1st April, 1991. The Council Tax, which replaced the Community Charge in
1993, is a revision of the old property rating system. However, in stead of a
notional annual letting value, for which market evidence was deficient, it is
based on the capital value of property. All households in the same band pay the
same amount of tax, but the tax increases upwards from A to H, the tax for H being
treble that of band A. There is 50 per cent discount for unoccupied dwellings
and second homes. Tax-exempt people include students, student nurses, apprentices,
youth trainees, those on income support and the severely mentally handicapped.
United States The United States
which has a loose and flexible structure of fiscal federalism. The hallmark of
the US local government finance system is the absence of too many specifications.
State governments assign local governments taxes and their maximum rates. Rules
are clear on whether local governments may seek voter referenda on fiscal decisions
such as tax rates, new borrowings and so on. They can formulate their own user
charges. On the whole, local government revenues finance about of 40 to 70 per
cent of the expenditures. The result of relative openness in tax assignment rules
and rates has been a relatively flexible, smoothly functioning system, while there
has also been significant inter-state and inter-country competition for attracting
industry. This could be one reason why overall tax levels in USA are low by standards
of developed countries. The main sources of local public finance in the United
States include the following: Property Tax Property
tax amounts to 70-75 per cent of all local tax revenues in USA. The tax is based
on capital value of property (often at a rate exceeding 1 per cent). It is unpopular
because of high visibility, linkage to unrealised gains, lumpsum nature of collection
and uncertainty of assessment. However, it gives a stable source of local funds,
is difficult to evade, and generates revenues to finance services which enhance
property values. It also provides a degree of independence to the local bodies
from the state and federal governments. Being a general benefit tax, it is assessed
at a considerably higher rate on non-residential property compared to residential
property. Local Option Income Tax States like Alabama,
Arkansas, Delaware, Georgia, Kentucky, Indiana, Maryland, Michigan, Missouri,
New York and Pennsylvania authorise their municipal authorities to levy local
income tax. Some states like Georgia mandate a local choice of either an income
tax or a general sales tax. While local jurisdictions usually collect the local
option income tax themselves, some states like Indiana and Maryland collect it
on behalf of their local governments by piggy-backing onto state income taxes.
This is on consideration of lowering the administrative costs. It is argued that
local option income tax adversely affects business and residence location decisions.
However, it provides a buoyant source of local revenues, although a slump in the
economy can lower the tax collections. General Sales
Tax This tax is generally popular among taxpayers because it is
collected in small amounts with many transactions. Local rates of this tax ranged
from 0.25% to 6% in the United States in 1993. However, local plus state rates
exceeded 6%. General sales tax, like income tax, is subject to the effects of
cyclical changes such as boom and recession. Excise Taxes
Excise taxes are sales taxes imposed on specific goods and services and are
most commonly assessed on lodging, alcoholic beverages and tobacco products, utilities
and motor fuel (local option gasoline tax). Some local jurisdictions levy an excise
tax on new construction. Impact Taxes These taxes,
notably levied in California, aim at generating resources from new developments
to finance their infrastructure requirements. These taxes are imposed under the
‘tax’ powers of local authorities and not under their ‘police’
powers. These are comparable to excise taxes. Special Assessments
Special assessments are levied on real property to fund improvements that
benefit particular properties rather than the society at large. The charge to
any specific property is a portion of the increase in the property value. Local
jurisdictions normally advance construction funds from general revenues and collect
onetime or multi-instalment special assessments as reimbursement. Sometimes special
districts are set up as separate, limited-purpose units of government to provide
specific services to areas. These special districts are authorised by concerned
state governments to levy taxes, issue debt and contract for services.
User Charges & Fees User fees and fees pay for the cost
of operating and maintaining public facilities and services, as well as repay
outstanding debts. Road tolls, park admission fees and water and sewer charges
are representative user fees in the United States. Development Exactions
Exactions are in-kind contributions (i.e. land or facilities) or
in-lieu payments (fees) by developers, dedicated to provide specific infrastructure
facilities for new development. They are negotiated on a project-by-project basis.
Debt Financing Borrowing enables local authorities to raise
large amounts of capital in a short period of time while spreading repayment over
a long period. Forms of debt financing available to local governments in the United
States include tax-free bonds (general obligation and revenue), taxable bonds,
lease-purchase contracts, revolving loan funds and bond banks. General
Obligation Bonds General obligation bonds are the most secure form
of debt a local authority can issue and do not require a debt service reserve.
They are limited by set debt ceilings and require the approval of voters. Unlimited-tax
varieties of general obligation bonds pledge future tax collections to repay principal
and interest. Limited-tax general obligation bonds are pledged against a fixed
tax rate levied on taxable property. General obligation bonds are usually exempt
from federal taxation. Revenue Bonds Revenue bonds
are designed to finance revenue-generating facilities, backed by a stream of revenues
pledged from user charges for services like water supply, sewerage, drainage,
toll roads etc. In most cases, interest rates on revenue bonds are higher
than those on general obligation bonds. This is mainly because revenue bonds are
backed by variable revenues rather than by stable taxes. Revenue bonds are generally
tax-exempt and do not require voter approval. Taxable Bonds
These bonds are similar to commercial bonds and allow more leeway in the
types of projects funded. To attract investors, a higher rate of interest is required
than on tax-exempt bonds. Tax Increment Financing Tax
increment financing (TIF) is similar to special assessment in that it defines
a particular geographic area for special treatment. Property owners in the TIF
area are assessed at the same tax rate as all other owners in the local jurisdiction.
However, property within the TIF area is assessed at both pre- and post-development
values. Taxes on pre-development values are deposited with other general funds.
The difference between the pre- and post-assessed values is used to service TIF
bonds or loans secured to finance infrastructure in the TIF area. Lease-Purchase
Contracts These contracts allow local authorities to purchase equipment
or property on an instalment basis while using the purchased items. Financing
is arranged typically through a financial institution or manufacturer and the
contracts generally carry higher rates of interest than outright purchases.
Revolving Loan Funds These funds are established with a
specific amount of federal and/or state money for clearly desired purposes. They
function as permanent lines of credit for local governments which are often too
small and not able to access the bond market. Bond Banks
Bond banks are created by state statutes to purchase small bond issues of participating
local governments and in turn issue bonds large enough to float on the national
market. Interest rates are typically lower than the local governments could obtain
on their own. Impact Fees Impact fees are ‘one-time’
charges levied by local governments to pay for public infrastructure required
by new developments. They are imposed as a condition for approval to proceed with
development. The facilities financed out of impact fees may include on-site and
off-site infrastructure such as roads, water supply, sewerage, storm water drainage,
flood control measures, open space, solid waster management, fire protection,
libraries, schools, police services, public buildings and administration. Impact
fees are assessed under the broad ‘police’ powers of local authorities
(as distinct from ‘tax’ powers) to regulate the use and development
of land. These powers have their root in the legal “nuisance” doctrine
which dealt with the elimination of potential negative impacts of new development
on the community. The fees differ from exactions, which are “negotiated”
requirements mandating developers either to dedicate land or infrastructure for
public use or to contribute cash for provision of facilities needed to serve a
proposed development. Impact fees have a demonstrated potential for raising revenues
to support new development. US Department of Housing and Urban Development
(1993) reported that the local governments in all 50 States in USA imposed impact
fees in some form or other. The average level of impact fee assessment on a 2000
square feet single-family home based on a study of 206 representative local governments
in the United States in 1991 was $ 9,425. State and federal courts and the US
Supreme Court have generally ruled that the assessment of impact fees is within
the legal powers of local governments to finance all types of public facilities
as long as state statutes permit such levy and the “rational nexus”
criterion is met. The local government imposing impact fees must show the nexus
or link among the new development’s need for public facilities (needs test),
the benefits to the assessed development (benefits test) and the proportionality
of the fee (proportionality test). Proportionality refers to the portion of the
cost of public facility improvements which reasonably relates to the needs of
and benefits accruing to new development. A study of State legislations
in the Untied States to enable the local authorities to levy impact fees suggests
some desirable criteria for drafting an impact fee legislation. The same are presented
in Box 1. Canada The main
sources of municipal finance in Canada include: property tax, business tax, special
taxes to raise revenue to pay for a specific service or purpose and local improvement
taxes. Special service taxes in the province of Alberta, for example, include
one or more of the following: (a) waterworks tax; (b) sewer tax; (c) boulevard
tax; (d) dust treatment tax; (e) paving tax; (f) tax to cover the cost of repair
and maintenance of roads, boulevards, sewer facilities and water facilities; (g)
ambulance service tax; (h) tax to enable the Municipality to provide incentives
to health professionals to reside and practice their profession in the Municipality;
(i) fire protection area tax; (j) drainage ditch tax; (k) tax to provide water
supply for the residents of a hamlet; and (l) recreational services tax. Box
1 : Lessons from Impact Fee Legislations in USA
• Clearly state the jurisdictions authorised
to levy impact fees; • Identify the
specific types of developments/buildings brought under the net of impact fees
and clearly specify the basis for that assessment (e.g. square footage, per unit
etc.); • Stipulate all types
of facilities and expenditures (benefiting new development) that are eligible
for funding by impact fees; • Require
the definition of service area of facility improvement to ensure that the impact
fees are calculated, assessed, collected and spent only in the area served by
improvement; • Prescribe the application
of rational nexus test among the new development’s needs for facilities,
the amount of fee charged to develop the facilities and the benefits accruing
to new development from the facilities; •
Stipulate that impact fees finance only those eligible facilities projected for
development in an existing Capital Improvement Plan (CIP); •
Require that the level of services provided by facilities funded by impact fees
do not exceed that provided by existing infrastructure to the community as a whole.
Otherwise remedy would be needed to meet the deficiency from sources other than
impact fees; • Include a system of
credits for developer-donated in-kind contribution and revenue payments including
taxes and fees; • Allow jurisdictions
to establish a system of exemptions for specified types of development with foregone
fees paid from general revenues; •
Specify the time of fee payment. Since timing has consequences for land seller,
builder and buyers, the fees may be assessed early in development process and
collected late; • Require the establishment
of separate interest-bearing accounts for the deposit of impact fees so that they
are not co-mingled with funds for other purposes; •
Require the adoption of a plan to refund fees not spent on the needed public facilities
within a reasonable time period; •
Specify criteria to be taken into account while devising a formula to determine
impact fee assessment and • Include
provision to guide inter-governmental agreements, citizen advisory committee requirements,
public hearings, fee appeal process and procedures for fee fixation. Local
improvement taxes in Canada are generally in the form of betterment levies linked
to benefits accruing to specific local areas due to the provision of infrastructure
as a result of implementation of local improvement plans. Australia
The Australian experience may be contrasted with
that of the US in some important aspects. Australia remains a highly centralized
federalist developed country with the central government collecting about 80 per
cent of total tax revenue, while state and local governments remain responsible
for most of the expenditure items. It delegates little tax raising power at the
local level. This results in extreme vertical imbalance, with the states having
to depend on central grants for 50 per cent of their expenditures and local governments
collecting an insignificant amount on their own. Brazil
Brazil’s experience is of particular relevance to India
since it is unique in the sense that municipalities are granted full autonomy,
while these are, at least legally, under state tutelage in most countries. In
Brazil, consumption and production taxes are assigned to all three levels of government.
Selected excises on manufacturing with a set-off mechanism are assigned to the
Centre, while a broad-based, harmonized value added tax is assigned to the states.
Local governments are assigned a tax on selected services. Urban property is taxed
by municipalities, while that on rural property is a central tax. The
main municipal taxes in Brazil are those on services (ISS) and urban property
(IPTU). ISS rates are set by the municipalities, subject to ceilings introduced
by the federal government. IPTU is levied on the capital value of land and buildings.
Based on Constitutionally mandated revenue sharing, the municipalities are entitled
to (a) 25 per cent of the revenue from state Value Added Tax (ICMS), (b) 50 per
cent of revenue from the state tax on motor vehicles registration (IPVA), (c)
22.5 per cent from the federal Value Added Tax (IPI) and Income Tax (IR), (d)
all revenue from the income tax held at source (IRPF) and paid by the municipalities
or by their decentralized agencies, (e) 70 per cent of revenue from the federal
financial-transactions tax levied on transactions with gold (IOF-Quro) and (f)
50 per cent of revenue from the federal rural-property tax (ITR). Municipalities
also receive compensatory transfers and transfers related to healthcare and investment
programmes. In 2002, total revenue of all municipalities in Brazil was 7.9 per
cent of GDP of the country – own sources, 1.5 per cent; shared revenue,
3.2 per cent; specific grants and compensatory transfers, 2.2 per cent, and other
revenues, 1.0 per cent [de Mello (2007)]. The Brazilian experience, however,
indicates that local governments have been poor tax collectors. Tax on selected
services basically remains an ignored tax. Even urban property tax has been implemented
only by very few large cities, such as Sao Paulo. Many local governments ignore
their taxing powers and responsibilities altogether. In some of the poorer municipalities,
own tax revenues are meager, while transfers received per capita exceed those
for state capitals and bigger cities reflecting the constitutional changes. Such
low level of ‘own’ tax revenues indicates that assumptions for raising
local tax efforts through purely legal provisions may be insufficient. As in the
case of the US, certain basic parametric assumptions must be fulfilled before
devolution can become successful. Similarly, for mobilizing resources through
issuing municipal bonds, local bodies should have explicitly defined borrowing
powers as in the case of the US. China
China’s fiscal system is highly decentralized among the 31 provincial,
331 prefecture, 2,109 county and 44,741 township-level units. Nearly 70 percent
of total public expenditure in China takes place at the sub-national (i.e.
provincial, prefecture, county, and township) level, of which more than 55 percent
takes place at sub-provincial levels. Key sub-national expenditure responsibilities
in China include sub-national administration, local capital construction, basic
local services, maintenance, repair and operation of urban infrastructure, primary
and secondary schooling, health and hospitals, support for agricultural production,
price subsidies, poverty alleviation, cultural and heritage protection, environmental
conservation, local and regional development and physical planning. The
Budget Law of China confers substantial autonomy – each level of Government
should have an independent Budget that must be approved by the People’s
Congress at that level. The Chinese decentralization policy, implemented in the
early 1980s, gave buoyant taxes to local governments, which made contractual commitments
to transfer revenues up to the centre. The 1994 ‘Tax Assignment System Reform’,
however, introduced certain strong measures to increase tax collection by and
resource flows to the centre. The revenue assignment between Central
and Sub-national Governments after 1994 reforms stands as follows. Central revenues
in China comprise import tariffs, consumption taxes, income taxes, import-related
consumption taxes and VATs, taxes imposed on banks, non-bank financial institutions
and insurance companies (including business taxes, income taxes, and the urban
maintenance and development tax) and taxes on railroads. Sub-national revenues
consist of business taxes (excepting taxes imposed on banks, non-bank financial
institutions, insurance companies and railroads), company income tax (excluding
local banks, foreign banks and non-bank financial companies), personal income
tax, urban land use tax, urban maintenance and development tax (excluding banks,
non-bank financial institutions, insurance companies and railroads), fixed asset
capital gains tax, house property taxes, stamp taxes, agriculture and related
taxes, tax on contracts and land-value increment taxes. Shared revenues include
VATs (75 per cent central and 25 percent, sub-national governments), stamp taxes
on security exchange (50: 50 sharing) and resource taxes. As seen from
the comparison of local government finance systems in United Kingdom, United States,
Canada, Australia, Brazil and China, the patterns of local revenues vary widely
across countries depending upon their diverse historical and political factors,
stage of development and urbanisation and organisation of government, including
constitutional provisions, institutional arrangements and intergovernmental fiscal
relations. Political, economic and social contexts and the range of assigned expenditure
responsibilities are critical for determining whether a particular model of revenue
mix is appropriate for a country at a given point of time or not. It is not possible
to make universally applicable recommendations for reforming the structure of
local government finance without going into country-specific situations.
2.4 Indian Studies In the backdrop of a review of the
theories of multi-level finance, Rao and Chelliah (1991) provides a brief survey
of literature on fiscal federalism in India and raises several issues pertaining
to fiscal decentralization. The study, undertaken prior to the enactment of the
73rd and 74th Constitutional Amendment Acts, highlighted the “glaring”
absence of a reasonably developed independent institutional structure to provide
local public services in India. The Expert Group on the Commercialisation
of Infrastructure (GOI, 1996), also known as Rakesh Mohan Committee, inter
alia, recommended for private sector participation in urban infrastructure
development. It emphasized the need for accessing capital market, including the
issuance of municipal bonds. The Committee also made projections of investment
requirements in urban infrastructure. NIPFP (1995) studied 293 municipalities
in India spread over seven States: Andhra Pradesh (54), Assam (21), Gujarat (63),
Kerala (57), Maharashtra (33), Punjab (33) and West Bengal (32). The study documents
the problems of vertical imbalance, horizontal imbalance, inadequate exploitation
of existing resources by local authorities, high cost of administration and collection
of local taxes and arbitrary system of fiscal transfers from State Governments
to ULBs as the common features of the municipal finance system in the country:.
Kundu, Bagchi and Kundu (1999) find that the levels of inequity in the provision
of basic services across the States and size categories of urban centres are extremely
high. Given the resource crunch in State Governments and urban local bodies, the
authors recommend privatization, public-private partnerships and promotion of
community-based projects as options for undertaking investments to create civic
amenities. However, the aspects of equity are required to be addressed through
specific measures. The authors observe that in the case of private sector or joint
sector projects, the poor are likely to get priced out due to various reasons.
In the case of infrastructure projects taken up with borrowed funds, the finances
generated from the common people are likely to get escrowed as a security for
projects that are likely to benefit the better-off sections of population or elite
colonies. Bagchi (2000) examines whether the decentralisation initiative
has succeeded in empowering the city governments, if there has been any empowerment
of such entities and how such empowerment has been reflected in the resource generation
capacity of the urban local bodies. The impact of decentralisation was studied
on the basis of a decentralisation index constructed for the purpose. The author
finds that though the decentralisation initiative has made some headway towards
improving the tax generating capacity of city governments, it has, to a large
extent, remained confined to the municipal corporations. However, the possibility
of improvement in this count, for the lower tiers of urban local bodies, could
not be ruled out in the long run, keeping the existing trend in view. The author
observes that the decentralisation initiative has almost remained ineffective
in improving the resource generation out of the non-tax sources for the ULBs.
The growing literature on rural decentralization, both official and non-official,
emphasizes the need for ushering in a more efficient, equitable and accountable
system of local governance in India. Jha (2002) examined the issue of fiscal decentralization
in rural areas following the 73rd Constitutional Amendment. Based on field studies
and the State Finance Commission reports of seven states, the author concludes
that the progress made has been extremely uneven and tardy. The lack of progress
along with the absence of administrative and technical capacity in the Panchayati
Raj Institutions (PRIs) has weakened the process of fiscal decentralization in
many cases. The basic dictum of devolution that functions, finance and functionaries
should be devolved down in totality is observed in its breach, Kerala being a
prominent exception. Although a formula-based devolution is welcomed by most State
Finance Commissions, the criteria chosen by them are deficient in that they relate
largely to population and area. Rao (2001) analyses fiscal decentralization
in Indian federalism within the three-tier framework for governance and addressed
the issues of inter-governmental transfers and macro-economic stability. The author
found that the aggregate fiscal deficit in 1997-98 worked out to almost 15 per
cent of GDP, of which 7 per cent is due to the local governments. This finding,
however, is questionable. Bagchi (2001) analyses the nitty-gritty of alternative/
unconventional modes of financing urban infrastructure. The author notes that
it is due to the inherent characteristics of infrastructure in general and urban
basic services in particular – externality, non-excludability, inelastic
price demand, huge capital investments with long gestation period – that
these are to a large extent provided by the public sector. The study makes the
following observations: (i) An alternate approach to the traditional
mode of financing is public-private partnership (PPP). However, presently, the
objective of public-private partnership relates much to attracting capital and
curtailing public sector employment rather than increasing the efficiency and
effectiveness of service delivery. The basic reason for the failure of PPP model
is the lack of customer approach in it and the extensive focus on technical and
commercial aspects of infrastructure. (ii) Just two sources, namely,
Octroi and property tax, have been the major sources of revenue. Basically, Octroi
is the only tax within the jurisdiction of city governments that has the potential
to grow over time with the growth of economic activities. However, Octroi is on
the verge of being abolished. Therefore, there is an urgent need for the State
Governments to devolve some major tax sources to the municipalities which have
their growth potential derived from the economic growth in cities. (iii)
Municipalities have not succeeded in realising the potential of the property tax,
though property values are on rise. A major problem with the property tax system
in India lies in the process of tax computation. The linking of the property tax
– based on annual rental value (ARV) - with the rent control law has hindered
the growth of collection. (iv) For accessing capital market funds, municipalities
need financial, structural, institutional and administrative changes. These include:
i) placing certain buoyant revenue sources at their disposal, ii) transforming
the urban governance system with limited control by the state, iii) changing the
capital market structure and iv) recovering the cost of services to make infrastructure
projects commercially viable. Vaidya and Johnson (2001) gives a vivid
account of how the Ahmedabad Municipal Corporation (AMC) issued municipal bonds
worth Rs.1,000 million in early 1998, the first such instrument issued in India
without a State guarantee and it marked the first step towards a market-based
system of local government finance. Before the issue of the bonds, AMC introduced
reforms to improve revenue collection so as to make up for the loss it had been
incurring. Other preparatory steps taken by the AMC included preparing a five-year
capital investment or corporate plan and credit rating by the CRISIL. For debt
servicing, revenues from 10 Octroi collection centres were placed in an escrow
account-structured debt obligation (SDO). Other credit enhancing measures adopted
by the AMC were fixing minimum average debt service coverage ratio of 1.5 and
having a sinking fund for repayment of principal and mortgage equal to 1.2 times
the par value of the bonds. The authors suggested that the technical framework
developed for the AMC bonds can act as a blueprint for future development initiatives
in this area. Pethe and Ghodke (2002) examine the status of Indian infrastructure,
including urban infrastructure, and argue for accessing capital market funds to
bridge the resource gap, in view of the changing role of Governments. The paper
argued for newer financial instruments like ‘Municipal bonds’ for
financing urban infrastructure. To impart liquidity and create an incentive for
individual agents to invest in the bonds, a thick and efficient secondary market
for debt instruments is needed. Mathur and Ray (2003) provides a framework
for municipalities to assess their creditworthiness for tapping the nascent but
expanding capital market for financing urban infrastructure. The paper discusses
the changes needed in the legal framework for municipal borrowing based on an
analysis of finances of four municipal corporations (Agra, Allahabad, Bangalore
and Vadodara). Mathur and Thakur (2004) examined the fiscal performance
of municipalities and assessed the load on state finances on account of the implementation
of the State Finance Commission recommendations. The study found that the size
of the municipal sector, in terms of revenues, was only 3.07 per cent of publicly
raised resources (by municipalities, States and Central Government taken together).
The study further found that the expenditure levels on services provided by municipalities
across states were low when compared to the norms established by the Zakaria Committee.
Another finding of the study was that per capita expenditure-revenue gap declined
over the period of 1997-98 to 2001-02. Fiscal transfers to municipalities formed
3.85 per cent of the combined own resources of states. Bagchi and Chattopadhyay
(2004) analyses the impact of decentralization on the mechanism for financing
urban basic services in India. The study finds that developed states and larger
cities/towns are the major destinations for domestic institutional funds and external
assistance. The emphasis made on full cost recovery and imposition of strict financial
discipline on state governments by the Reserve Bank of India are likely to result
in further concentration of funds in developed states or regions. Chattopadhyay
(2004) further examined the impact of decentralization – both revenue and
expenditure – on the financial health of urban local bodies through an empirical
study of the aggregates of three states in the post-74th Constitutional Amendment
Act era. The study observes that decentralization improved the revenue structure
of the municipal corporations and positively affected their tax and non-tax revenue
generation. However, the large urban local bodies benefited most from the decentralisation
initiatives. India Infrastructure Report 2004 (3i Network, 2004), inter
alia, discusses the issues relating to creating local financial systems for
infrastructure development, accessing capital markets by ULBs and reforming the
property tax. In this Report, Jha (2004) lists a range of options and models available
to developing countries on how to finance infrastructure projects locally. These
options include i) specialized banks for municipal lending, ii) municipal bond
markets, and iii) specialized municipal funds. The paper reviews the initiatives
for issue of municipal bonds and the experience of Tamil Nadu Urban Development
Fund. For strengthening the creditworthiness of local bodies, the paper suggests
that they should be given autonomous authority to set realistic tax-rates and
user-charges for the basic services provided by them and also for pursuing hiring-firing
policies. Measures needed for strengthening Municipal Bond issuance, such as bond
insurance facility, facilitating the listing of bonds on domestic stock exchanges,
etc. are also discussed in the paper. Ghodke (2004) examines
the issues relating to capital market access by ULBs. The study documents that
till 2004 the ULBs raised about Rs.700 crores from the domestic capital market
by issue of municipal bonds. In view of their increasing resource gap, the paper
makes a strong case for facilitating the access of ULBs to the capital market
for debt financing, either through loans or bonds. It suggests ‘pooled financing’
as a promising method for financing urban infrastructure. Under the ‘pooled
financing’ framework, small local bodies can pool their strength and jointly
access the capital market. The paper points out that there are typically two models
of municipal credit market followed in countries - the bank lending model used
in Western Europe and the municipal bond model used in North America.
Oommen (2005) provides a critique of the approach and recommendations of the Twelfth
Finance Commission with reference to the rural and urban local bodies. The author
states that during 2002-03, the total tax revenues and expenditures of local bodies
as a percentage of the combined taxes and expenditure of Union, States and local
bodies was only 1.6 per cent and 4.7 per cent, respectively, indicating marginal
presence of local finance in the fiscal structure of India. In advanced countries,
local bodies normally account for 20-35 per cent of the total government expenditure
(UNDP, 1993). The author reveals that the Tenth Finance Commission (TFC) did not
follow the principle of horizontal equity while allocating grants-in-aids to states
(local bodies). The TFC, the author argues, was wrong in abandoning the decentralization
index for deciding the grants-in-aid. It is noted that the local bodies are yet
to be put prominently on the public finance map of India, which is needed to facilitate
an inclusive and equitable economic growth and to secure better horizontal equity.
The author suggested that the Reserve Bank of India may consider developing a
reliable database of the finances of local bodies similar to the database of the
finances of State Governments. Mathur (2006) provides a comparative picture
on the particulars of municipal bonds issued by urban local bodies in India to
raise resources as shown in Table 10. Pethe and Lalvani (2006) examined
the finances of ULBs in Maharashtra and drew attention to the significance of
sub-national governments accessing the financial markets in general, and debt
market in particular. The paper finds that the powers of ULBs in Maharashtra are
highly restricted with respect to both tax and non-tax sources of revenues, as
there has been no sufficient devolution of taxation powers. The paper noted that
the growth of revenue of the ULBs has been constrained by inherent structural
bottlenecks like
Table
10: Details of Bonds Issued by Municipal Corporations |
City | Amount | Interest | Escrow | Purpose | Credit |
| (Rs
million) | % | Arrangement | | Rating |
Ahmedabad | 1000 | 14 | Octroi
from 10 Octroi | Water supply
& | AA-(SO) |
| | | collection
points | sewerage project | |
Bangalore | 1250 | 13 | State
Government | City roads/street | A-(SO) |
| | | grants
and property tax | drains | |
Ludhiana | 100 | 13.5
to 14 | Water and sewerage | Water
supply & | LAA-(SO) |
| | | taxes
and charges | sewerage project | |
Nagpur | 500 | 13 | Property
tax and | Water supply & | LAA-(SO) |
| | | water
charges | sewerage project | |
Nashik | 1000 | 14.75 | Octroi
from 4 Octroi | Water supply
& | AA-(SO) |
| | | collection
points | sewerage project | |
Indore | 100 | | NA | Improvement
of | A(SO) |
| | | | city
roads | |
Madurai | 300 | 12.25 | Toll
tax collection | City road
project | LA+(SO) |
Ahmedabad | 1000 | 9 | Property
taxes of 2 | Water supply
& | AA(SO) |
(Tax Free) | | | zones | sewerage
project | |
Hyderabad | 825 | 8.5 | Non-residential
property | Road construction | LAA+(SO) |
(Tax Free) | | | tax,
advertisement. tax, | and
widening | AA+(SO) |
| | | professional
tax, etc. | | |
Tamil Nadu | 110 | 9.20 | Monthly
payments | Water supply & | LAA(SO) |
(Pooled Financing | | | equal
to one-ninth of | sewerage
project | |
| | | their
annual payments | in 14 MCs | |
Source: Mathur
(2006) | limited autonomy regarding taxation,
small bandwidth for non-tax revenues and the unpredictable nature of funds flowing
from the State. For accessing the capital market, the paper extended the concept
of ‘pooled funds’ and classified the ULBs in the State into three
categories, namely, ‘Cherries’ (financially better off), ‘Salvageables’
(potentially better off) and ‘Duds’ (financially very poor). While
the self-help group amongst the Cherries and Salvageables will be able to access
the capital markets, infrastructure needs of Duds have to be taken care of by
the State directly. The paper made two other suggestions. First, the existing
infrastructure fund could be used to facilitate under-writing of the projects
to be undertaken by coalition of ULBs coming together as virtual entities. Second,
banks should look at the coalition formation of ULBs and encourage them by making
more exposure a matter of policy mandate or guided by their profit motives.
India Infrastructure Report 2006 (3i Network, 2006), inter alia,
discusses the trends and patterns of urbanization and urban public finance in
states. It highlights the colossal needs of urban infrastructure investments in
keeping with the projected urban trends and suggests measures for municipal reforms
needed to access capital markets. Chattopadhyay (2006) documented the
problems and prospects of the municipal bond market in India. The paper finds
that several policies and legal frameworks to facilitate the access of ULBs to
capital market are already in place. These include: preparation of a Model Municipal
Law (MML) to assist ULBs in the areas of accounting reforms, resource mobilization
and the entry of private sector partnerships, tax exemptions in the case of bonds
issued by ULBs and other local authorities, trading of municipal bonds in the
National Stock Exchange, measures taken by RBI to deepen secondary market activities,
etc. The paper notes that without the financial empowerment, it is difficult
to make the municipalities more market-oriented and capable of mobilizing resources
from the capital market. The paper concludes that local capacity building, financial
empowerment, rationalization of the state-local fiscal relationship and further
legislative changes are critical in developing a viable and vibrant municipal
bond system in the country. Lall and Deichmann (2006) report that while
reforms in property tax administration have taken off and become quite popular,
associated reform efforts focused on assessment and valuation are less evident.
In most ULBs, property rental values are used as the base for assessing property
taxes. However, in the face of rent control laws, this approach is limiting the
growth of revenues. Based on their study of the assessment systems in Bangalore
and Pune, the authors find that structural reforms that link tax assessments to
market rental or capital values have the potential to significantly increase aggregate
tax revenues. They found that in Pune Municipal Corporation, the use of market
values also played a redistributive role by reducing the tax burden in areas with
poor services and amenities. In case of Bangalore, a one-time move from the previously
used rental value-based assessment to an area-based system increased revenues
by around 62 per cent. The authors opine that a capital value system which requires
the valuation of individual properties is difficult to implement in the present
Indian context, especially because property records are in shambles and most local
governments do not have a cadre of trained assessors to evaluate property values
and update them regularly. Hence, they suggest that while the introduction of
true capital value assessment system should be a longer term objective, local
governments must implement other simpler and less costly reforms. Srinivasan
(2006) examined the equity, accountability and environmental concerns in Solid
Waste Management (SWM) practices of a public body, a private body and non-profit
organization in Chennai city. The study finds that private sector and civil society
participation pose several challenges in terms of equity and accountability. The
study shows that while a crucial role exists for the private sector, the intervention
of the state and public policy is imperative to safeguard ecological and equity
interests and to enable greater accountability on part of both the public and
private actors. Mathur (2006) finds that the finances of municipalities
in India are in a grossly unsatisfactory state. The spending levels of municipalities
are about 130 per cent lower compared with norms and standards. Own revenues of
municipalities are insufficient to meet even the revenue account expenditure.
The revenue-expenditure gap is particularly high in states like Madhya Pradesh,
Rajasthan, Uttar Pradesh and West Bengal. Oommen (2006) analyses the
trends in fiscal decentralization in India focusing on the 15 non-special category
states, based on the data given in the report of the Twelfth Finance Commission.
The author finds that total expenditure of local government as a proportion of
the combined expenditure of Union, States and Local Governments declined from
6.4 per cent in 1998-99 to 5.1 per cent in 2002-03. Thus, the extent of fiscal
decentralization, which was already very low, has shown a pronounced decline in
recent years. The author reiterates that in advanced countries, local governments
normally account for about 20-35 per cent of total government expenditure. The
average rate of growth in the tax revenues of Panchayati Raj Institutions (PRIs)
and Urban Local Bodies (ULBs) in most of the States had been negative or declining.
Another finding by the author is that the transfers to local governments as a
percentage of State Domestic Product have declined in the country as a whole.
Based on empirical analysis, the author concludes that the record of fiscal decentralization
to sub-state level governments through the mechanism of inter-governmental transfers
has been very poor. An obvious shortcoming in the literature of local
public finance in India is the inability to locate a suitable alternative to Octroi.
Traditionally Octroi has been the most important source of municipal taxes in
the country. Being regarded as an obnoxious tax, Octori has been on its way out
and all but a limited number of States like Maharashtra and Gujarat have already
abolished Octroi. However, the States which abolished Octroi have not been able
to find an alternative for their ULBs as buoyant as Octroi. Several States have
gone for experiments. Karnataka levied entry tax. Tamil Nadu permitted a surcharge
on sales tax for the Chennai Municipal Corporation. States like Uttar Pradesh
and Andhra Pradesh have not attempted instituting any major tax in the place of
Octroi. The compensations to Municipalities in lieu of Octroi have been kept at
abysmally low levels in the States that abolished it. Although in the interest
of economic growth and free trade within the country there can be no case for
Octroi, the need for assigning a substitute ‘own’ tax to ULBs as buoyant
as Octroi continues to be strong. The Report of the Committee on Octroi
(1985), constituted by the then Ministry of Urban Development, Government of India,
had made the following recommendations: (a) Octroi might be retained
in Municipal Corporations covering a population of three lakhs or more; the tax
could be abolished in the smaller local bodies. (b) Octroi should be
replaced with taxes the incidence of which would be on the transport sector. The
alternatives in the case of smaller Municipalities include surcharge on sales
tax, entry tax, terminal tax, road tax, tax on motor vehicles, etc. If
the revenue realised on account of these taxes was inadequate, augmentation measures
through property tax, entertainment tax, professional tax, etc. might
be considered. If the revenue still remains inadequate even after the imposition
of these taxes, only then special grants-in-aid should be provided. Grants-in-aid
should not be considered in isolation without augmentation of the tax base of
the local bodies as this would take away their initiative and autonomy.
(c) The procedure for payment of grants to the Municipalities should be revised
in so far as it related to the loss of Octroi revenue. They should be paid
as a direct advance to the Municipalities by the Planning Commission at the time
of plan allocation and should be adjusted against the revenues due to the State
Governments. (d) The alternative sources of revenue to the local bodies
in lieu of Octroi should not only yield revenue equivalent to the amount lost
as a result of its abolition, but should be elastic enough to ensure future revenue
for the local bodies. Due regard should be paid to the potential of Octroi revenue
while deciding the quantum of compensation. The Eleventh Finance Commission
also noted the following: “Besides the property/ house tax,
Octroi has been the major source of revenue for the municipalities, and in some
states, even for the Panchayats. Many states have, however, abolished Octroi with
a view to remove impediments to the physical movement of goods, though several
other new barriers have been created. Some states have introduced a levy in lieu
of Octroi, usually the entry tax, the net proceeds of which are transferred to
the local bodies in the form of grant. During our interaction with representatives
of the local bodies, we were told that through the grant in lieu of Octroi given
to the local bodies was raised by certain percentage from year to year, it does
not have as much buoyancy as the Octroi had. There have also been numerous complaints
of delay in release of the compensatory grants. While we do not advocate re-introduction
of Octroi, we do feel that there is a need for replacing it with a suitable tax
that is buoyant and can be collected by the local bodies. Taxes, such as entertainment
tax, which has shown a very good growth, are potential source of increasing the
revenue for the local bodies, given that they are linked to the consumption characteristic
of good and hence also buoyant.” 2.5 Summary Observations
2.5.1 International Literature The rationale for
fiscal decentralization is well-grounded in theory and it is gaining momentum
in many countries. The identified role of local bodies, in the public finance
literature, is resource allocation, though they can also contribute to the two
other objectives of public finance, namely, macroeconomic stabilization and income
distribution. Literature has identified the suitable expenditure responsibilities
and revenue sources of local bodies. However, in general, countries assign more
expenditure responsibilities than resources to their local bodies, thereby leading
to constitutionally-built vertical imbalance in functions and finances. This vertical
imbalance, as prominently reflected in the resource gap of local governments,
is the basis of inter-governmental fiscal transfers from national and provincial
governments. In the urban context the vertical imbalance is getting more pronounced
due to population concentration in cities and the inability of city governments
to tap economic growth as a source of revenue. Urbanization of Asia in the coming
years is likely to put pressure on international resource mobilization and it
will in turn get reflected in higher interest rates in the years to come, which
is of relevance to central banks. These considerations call for reforms in the
structure of local government finance in India. 2.5.2 Indian
Literature Studies in Indian context have traced the progress
of fiscal decentralization since the 73rd and 74th Constitutional Amendments.
The record of fiscal decentralization to the sub-state level governments through
revenue assignment and transfers has been poor. Fiscal decentralization has not
made any significant progress in terms of revenues raised and expenditures incurred
by a large numbers of local bodies. The dictum that functions, finance and functionaries
should be devolved down is observed almost in breach. Decentralisation has resulted
in improving the tax generating capacity of some urban local bodies, mainly corporations.
However, there has not been much impact on non-tax revenues. The size of the municipal
fiscal sector is small compared to any conceivable standard, whether in terms
of international comparison or normative considerations. It is evident that the
fiscal domain of urban local bodies in India is far narrower than that in most
developed countries and several developing countries, mandated to discharge similar
responsibilities. In case of property tax, the introduction of capital
value assessment system should be a longer term objective. However, the system
is difficult and costly to implement. Area-based property tax system, based on
a self-assessment scheme, holds promise. A suitable alternative to Octroi has
not yet been found out. Given the resource crunch at State and ULB levels, privatisation,
central-state-local and public-private partnerships and promotion of community-based
projects are alternate options for creating civic amenities. However, sometimes,
the poor are likely to be at a disadvantage in the case of these arrangements.
While there is a crucial role for the private sector, the intervention of the
state and public policy is imperative to safeguard equity and ecological interests
of the society and to enable greater accountability of both public and private
actors. The 74th Amendment has envisaged poverty alleviation and slum development
as legitimate functions of urban local bodies. This has shifted some redistribution
functions of the public sector to the urban local bodies unlike the case in developed
countries. Thus, the urban local bodies in India are connected with two major
planks of public sector responsibility: allocation and redistribution. However,
the revenue assignment required by these institutions woefully falls short of
the expenditure assignment. 2.5.3 Some Issues for ULBs in India
While the national expectations from the ULBs are too high, however laudable
they may be, the fiscal arrangements for meeting these expectations are highly
unsatisfactory. The expenditure levels on services provided by municipalities
across the country, especially on infrastructure and poverty alleviation, are
low when compared to the norms established by the Zakaria Committee. The devolution
of funds to ULBs through the State and Central Finance Commissions has been on
an ad hoc basis in the absence of normative estimates of their resource
gap. In the above circumstances the local authorities are in need of major ‘own’
tax and non-tax sources, proceeds of which should grow along with the growth of
the cities concerned and their economies. Urbanising states and larger
municipal corporations are seen to be the major destinations of institutional
funds channelised for public infrastructure. The first step towards a market-based
system of local government finance in India was the issue of municipal bonds by
Ahmedabad Municipal Corporation, which undertook several preparatory tasks to
improve finance as well as financial management. For accessing capital market
funds for the creation of infrastructure, urban local bodies are required to undertake
financial, structural, institutional and administrative reforms. For strengthening
the creditworthiness of urban local bodies, it is suggested that they should be
given autonomous authority to set realistic tax-rates and user charges for the
services provided by them and also for pursuing hiring-firing policies. The system
of intergovernmental transfers to urban local bodies also needs a drastic overhaul.
While municipal revenue reforms need to be pursued, banks should look at coalition
formation by ULBs and encourage them by making more exposure to credit a matter
of policy mandate or guided by their profit motives. Lastly, wasteful municipal
expenditures need to be curtailed and steps must be taken to ensure that the cities
are professionally managed. A vibrant Urban India of the 21st Century,
acting as an engine of inclusive growth, needs drastic reforms in the municipal
finance system of the country so as to broaden and deepen the resource base required
to match the growing needs of infrastructure and civic services to the urban population,
especially the poor. |