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«Metropolitan City Finances in India: Options for A New Fiscal Architecture Roy Bahl International Center for Public Policy Working Paper 12-33 ...»

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For example, over half the population of Mumbai lives in slum settlements which have little by way of water or sanitation systems. A significant percent of families living in slums is not below the poverty line, but nearly all slum dwellers live in deplorable conditions because of lack of access to basic services. Most do not have access to health and education services. Rao (2009) and Bandyopadhyay and Rao (2009) cite statistics on access to services that underlines the magnitude of the problem: only 78 percent of slum dwellers use tap water; 37 percent used communal toilet facilities and 24 percent walked 0.2 to 0.5 km to latrine facilities;

there is a little by way of solid waste disposal; and only 84 percent of slums had approach roads that would service motor vehicles. The price tag on servicing these slums, even to minimum acceptable levels, is very large.


The revenue needs in urban areas in low and middle income countries are well beyond the level of resources that are typically raised from own sources. For Infrastructure alone, the annual needs for urban areas are placed in the range of 3-5 percent of GDP annually (Ingram, Liu and Brandt, forthcoming). Estate (2010) estimates that about 1 billion people lack clean water and perhaps 3 billion lack access to adequate sanitation facilities. The annual infrastructure expenditure required to meet this one local need is estimated at 2.0% of GDP in Sub-Saharan Africa and 1.7% in South Asia, with about 40% of these amounts required for new investment and the balance for operation and maintenance.

4 The extent of urban poverty may be understated because full account is not taken of the higher cost of essential consumption in larger cities (Hashim, 2009).

Metropolitan City Finances in India: Options For A New Fiscal Architecture 7 The level of own source revenues of subnational governments available to address this shortfall, to support current expenditure needs and to service debt, averages about 2.3 percent of GDP (Table 1) in low and middle income countries.

If this financing gap is to be reduced, it will need to be done with a heavy dose of new intergovernmental transfers or with a very significant enhancement to the revenue raising powers and efforts of urban governments, or both.

In its report on Indian urban infrastructure, the High Powered committee (2011) estimated that new investment needs are roughly equivalent to an annual amount equivalent to 1.1 percent of GDP by 2032. This estimated amount does not include maintenance. Mohanty, Misra, Goyal and Jeromi (2007) estimate annual infrastructure expenditure needs at 2 percent of GDP. The financing gap for recurrent expenditures is no less severe in large urban areas (Bandyopadhyay and Rao, 2009; and Mohanty, et. al., 2007). The problem is a longstanding one.

The results of the Rakesh Mohan committee for 2001 indicated shortfalls of similar magnitude (Mohan and Dasgupta, 2004).

Revenues generated by local governments fall well short of these levels in almost all metropolitan area governments, and there is a longstanding pattern of low buoyancy of local government revenues (Oommen, 2000). In general, state governments have not shown an inclination to emphasize investment in urban areas, in part because of their weak fiscal position and in part because of the competing needs in rural areas (Garg, 2007).

The major fiscal policy question to be addressed is how the additional revenues to cover the shortfall will be found. In fact, there are a number of options. One way to address the revenue shortfall in India is the inertia solution, which is the route that countries most often take. The idea is to make policy and administration changes around the edges but basically to continue on under the present fiscal structure. Two other approaches could involve more sweeping changes: increase the revenue mobilization powers and efforts of urban local governments, and/or increase the flow of transfers from higher level governments to the urban local governments. A much more radical approach is to enhance the revenue powers of local governments by rethinking the place of governance in large metropolitan

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areas in the federal system. To varying extents, all of these approaches are taken in various low and middle income countries.


The path of least resistance usually is to limit reform to those marginal adjustments that might make the present system work more effectively. The very great advantage of this approach is that it is likely to be the most politically acceptable, it does not require the homework that a comprehensive reform might require, and it avoids bumping up against serious legal constraints to reform. It also has the advantage of not requiring a retooling of the local administration and management as might be needed if the basic fiscal structure were to be changed.

Perhaps most important of all, a holding to the fiscal architecture that is laid down in the Constitution and in federal and state laws gives a stability to the fiscal system that subnational governments can count on in planning their budgets.

These advantages are so important that they have caused many low and middle income countries to back away from comprehensive changes in subnational government finance.

The muddling through approach has the great drawback of resigning large metropolitan areas to their present trajectory of fiscal balance. If the fiscal architecture was not designed to accommodate present day realities, its basic flaws will continue to stand in the way of fiscal sustainability. Without a revamping of local revenue raising powers, reassignment of expenditure responsibilities or increased transfers, metropolitan finances will continue to be supported by the revenues that can be generated from economic growth, and by increased revenue effort on present sources.

Some countries have taken the path of greater resistance and have changed the intergovernmental fiscal architecture of the country. South Africa, for example, moved to a unitary system, and set up a new revenue mobilization scheme with differential revenue raising powers in the hands of the metropolitan cities. The revision called for constitutional changes as well as a redrawing of the boundaries of metropolitan areas. These changes were possible because of a “moment in time”, the end of apartheid and the formation of a new government. Similarly, Metropolitan City Finances in India: Options For A New Fiscal Architecture 9 Indonesia’s “big bang” decentralization was a moment in time, the aftermath of an economic shock and the move to democratic elections. Another example of “a moment in time” that allowed a fundamental change in the fiscal architecture was the Chinese re-centralization in 1994.The question on the table here is whether Indian urbanization might also be thought of as a moment in time that can justify sweeping reform. India is an advanced democracy where political compromise solutions in the area of reforming intergovernmental fiscal relations are more likely than “big bangs”.

Though some large and important reforms have been made, these have not yet led to a major change in the fiscal architecture that has put metropolitan finance on a sustainable path. The 74th amendment to the Constitution empowered urban local governments by recognizing their legal status and providing for their expenditure powers. This had the makings of a major structural reform.

However, while expenditure responsibilities grew, no comparable revenue expansion occurred, leaving urban local governments with a growing gap between expenditure needs and resources available. Mohanty, et. al., using normative estimates of expenditure needs, found the average level of underspending to be about 75 percent. Despite the constitutional amendment, local public services remained weak and devolution has progressed unevenly (Mathur, 2006, Garg, 2007).

The elimination of octroi in most Indian states could have opened the door for a revamping of local government revenue systems, but still no satisfactory revenue productive replacement for this revenue source has been offered. Nor have other structural reforms gone in the right direction. Some states imposed entry taxes, which are a similar levy to octroi, and two states have abolished the property tax.

The Central Finance Commission in India is admirable for the stability and thoughtful reform it brings to intergovernmental fiscal relations but its success is in part because its proposals usually do not call for big changes in direction.

While the Thirteenth Finance Commission acknowledged the problems with local government finance, it followed the constitution and left the solutions to the states. The institution of State Finance commissions would seem to have opened

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the door for regular review of intergovernmental fiscal structure in each state, but this has not led to much by way of reform that would improve the position of urban local bodies.

The introduction of JNNURM is a major change in intergovernmental transfers in that it provides for an increased flow of funds to urban local bodies, and attempts to use the funds as a carrot to draw out needed structural reforms. On two counts, the JNNURM has the potential to be a major restructuring. First, it bypasses the states in channeling more funds to the large urban governments. In a sense it puts metropolitan finance directly in the policy agenda. Second, it aims at inducing policy changes that will enhance the operational efficiency of urban service delivery and stimulate revenue mobilization. On neither count has the program been successful. Urban local governments in some states have been slow to buy in, and the policy changes have not materialized in the way that was hoped for (Bandyopadhyay and Rao, 2009).


Most students of devolution argue that the low level of revenues raised by subnational governments in developing countries is a failing of the intergovernmental fiscal system (Bahl, Linn and Wetzel, forthcoming). The result of heavy reliance on intergovernmental transfers is a reduced ability of local governments to shape their expenditure budgets, less accountability of local politicians to their constituent voters, and perhaps an inability to ratchet up the size of government to address new needs. To the extent that local governments do not have the expenditure discretion that comes with raising their own money, the “lighthouse effects” from local innovations in service delivery are lost.

International Practice

Many factors stand in the way of increased revenue mobilization by local governments. Subnational governments often have only limited legal taxing power, but it is also the case that they often underuse the taxing power that they do have. Central (state) governments are loathe to give up their control over the most productive part of the tax base for fear that their own revenue mobilization Metropolitan City Finances in India: Options For A New Fiscal Architecture 11 efforts will be harmed by the competition, and elected local government leaders are not always anxious to have the accountability that comes with increased taxing powers.

There also is a more pure political dimension. Increased local taxing power may enhance the success and hence visibility of local politicians, who may be present or future political rivals. On top of this is the limited assignment of expenditure responsibilities given to subnational governments in many developing countries, and the ensuing argument that finance should follow function and so increased local taxing power is not warranted. The result is that subnational government taxes in developing countries account for an average of about 2.4 percent of GDP, compared to 6.4 percent in industrialized countries (Table 1).5 There are important exceptions. Some low and middle income countries have made significant improvements in the rate of revenue mobilization of large urban governments. In Argentina, for example, the City of Buenos Aires finances over 80 percent of expenditures from own sources and the revenues of provincial and local governments are equivalent to over 5 percent of GDP. Urban local governments in Colombia raise revenues equivalent to 2.4 percent of national GDP, mostly in the larger cities. In the cases of both Argentina and Colombia, the mainstay of the local revenue system is a gross receipts tax. Sao Paulo and Rio de Janeiro levy a gross receipts tax on services, while Cape town, Johannesburg and Jakarta impose a surcharge on electricity consumption. The major source of own revenue in Mexico City is a payroll tax.

None of this is meant to say that the practice of local taxation in low and middle income countries is free of problems. Martinez (forthcoming) gives a good summing up of the current state of the practice: “The good news is that examples of best practice are not scarce; the bad news is that there is still an extended failure in applying those best practices in the vast majority of urban governments around the world.” 5 Note that these shares include state (provincial) governments as well as local governments. Good, comparable data on local government finance in developing countries are available for only a limited sample and only for certain countries.

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Problems and Options for India India is not one of the countries that has made significant strides in bringing large urban governments into the revenue mobilization mix. The Indian system is still characterized by a sizeable vertical imbalance at the subnational government level that is transmitted by state governments to urban local governments. State and local governments account for a larger percent of government spending than revenue collections, with the gap filled by intergovernmental transfers (Rao, 2009). State and local government tax revenues are equivalent to about 15 percent of GDP which is well below the international average for developing countries. Municipal government spending accounts for less than one percent of GDP, and for only about 2.3 percent of total government spending (Mohanty, et.

al., 2007).

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