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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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Intergovernmental fiscal transfers will play an important role in filling the financing gap for metropolitan governments in India. Two streams of transfers might be considered. First, a reformed JNNURM, adequately funded and with conditionality on the policy reforms, and with provision for capacity development, could be a cornerstone of the financing program for metropolitan cities. Second, state governments could finally take seriously the mandate of forming competent State finance Commissions and relying on their recommendations. The Central Finance commission recommendation, that a share of state revenues be allocated to urban local bodies, would be a welcome addition to a national urban strategy.

Under other strategies, the level of intergovernmental transfers to metropolitan cities might be of a lesser magnitude. One scenario, proposed by the High Powered Commission (2011) would have urban local services financed by a combination of higher own source revenues and an upgraded JNNURM. Under a scenario where some metropolitan cities gain state government status (see Metropolitan City Finances in India: Options For A New Fiscal Architecture 19 below), the city- state would receive a share of all forms of intergovernmental transfer.

CITY-STATES Another approach to addressing the urban fiscal problem is to move large cities to state government status. At once this takes away some of the roadblocks to increased revenue raising powers, it resolves much of the government fragmentation problem, and it restores fiscal autonomy to local governments.

The International Practice7

Historically, city-states have been among the most successful jurisdictions in producing rapid economic growth and effective urban growth. Medieval Venice and the cities of the Hanseatic League in Northern Europe are early examples.

Hong Kong and Singapore are the contemporary counterparts. An interesting question is whether there are lessons to be learned for metropolitan governance and finance from the experience of the city-states and whether there is a way to pattern metropolitan governance at least partially after that model.

In larger countries, this could take the form of provincial cities, where the metropolitan area local government has both provincial and local status. For example in China, the four largest cities are treated as provinces and have the powers of both provincial government and local government. The same is true in the case of Jakarta and Mexico City. In many (most) countries, the capital city is treated as a special case and its financing structure is different from other local governments. Delhi, Islamabad and Washington DC are examples. In yet other cases, the metropolitan cities are singled out as a category and given special treatment, including perhaps more taxing and borrowing powers and less access to intergovernmental transfers. The South African metropolitan cities, the largest Colombian cities and Buenos Aires are examples.

There are some clear advantages to this approach. It allows for area wide governance that can internalize potential external effects, but also allows for 7 See Bahl, Linn and Wetzel, forthcoming

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significant autonomy in making budgetary decisions. The metropolitan government becomes much like a state in a federation, but usually with more manageable boundaries and without the understructure of local governments to deal with. A further advantage is that its boundaries can be large enough to allow regional taxation, and perhaps to adopt a broad based tax. Finally, its borrowing powers can be enhanced because it can oversee and regulate larger public enterprises and because its revenue base can support debt better than if it were a city government within a metropolitan area or subject to provincial oversight.

There also are disadvantages. For one, the metropolitan area may have already spread across jurisdiction boundaries so that the city-province status is assigned to the core city. In this case, the area wide governance advantage is lost. This is the case of Buenos Aires. Another disadvantage is the hinterland problem, e.g., the creation of a set of “special cities” in China led to harming the fiscal position of the “residual province by removing its most important revenue generator. A third disadvantage is that City-states are an ad hoc arrangement, created as special cases by the central government. How does one draw the line for deciding if there will be more, and how will the provincial city be made to fit within the existing local government code or budget law? Finally, a city state may be politically strong, with a governor or mayor, who might be considered a rival by the central government and the Legislature. This can lead to some degree of discrimination against the metropolitan area in terms of its treatment within the metropolitan area.

The Practice Applied to India

The city-state approach could be adopted in India. Under such a scheme, a designated set of large cities would be given state government status. The general argument is that the large metropolitan areas are very different from the rest of their states, and governance might be more efficient if they were given sate government status. Certainly the list would include Mumbai, and likely there would be other candidates.

Metropolitan City Finances in India: Options For A New Fiscal Architecture 21 To illustrate the city-state approach, we take the example of metropolitan

Mumbai. The state of Maharashtra would be divided into two states:

metropolitan Mumbai and the remainder of Maharashtra. There would be no hierarchical relationship between the two. Both states would be represented in the national Parliament, following the normal rules. The new city-states would have the same constitutional fiscal powers as any other state. This means that these cities would be empowered to levy VAT, property tax, automobile –related taxes, etc. In short, their taxing powers and access to revenues could be dramatically increased. So would their expenditure responsibilities, as Maharashtra state level programs within these cities (including parastatals) would be turned over to the new Mumbai state. Those presently responsible for administering state level activities within Mumbai would be shifted to the new state. Properly planned, this transition could be accomplished without major service level disruptions.8 An interesting case of such a transfer of powers is Indonesia where most government services were transferred from deconcentrated central departments to local governments, without a major disruption in service levels (Hofman and Kaiser, 2004). In all, about 2 million employees were transferred from central government to local government control.

The “residual state” of Maharashtra would continue on with the remainder of their urban and rural local bodies, just as under the present regime. However, it would no longer could collect taxes within the Mumbai metropolitan area, nor would it share taxes, make grants, be responsible for service delivery, or have the power to make regulatory decisions. Both of the states would be represented in the national congress but Maharashtra’s representation would be reduced because of the loss of metropolitan Mumbai from its jurisdiction. Both the residual Maharashtra and Mumbai would have a representative state legislative body and independent elections.

8 This is not to say that the transition would be without problems or that it would be costless. And, at a later period, the new city- state would want to exercise an option of deciding how many employees to retain and how to establish their seniority.

2122 International Center for Public Policy Working Paper Series

The Central Finance Commission would treat the new state just as it would any other state, though, admittedly, the formula allocations and equalization provisions might require some new thinking. Maharashtra would continue on with a state finance commission, and it would have the same responsibilities, i.e., to recommend the structure of the intergovernmental fiscal system within the state. In the case of Mumbai, the state finance commission would focus more on the relationship between the new state and its underlying deconcentrated units or wards.

Impacts: Advantages

There is much to be gained from a new fiscal architecture that includes citystates. It would be part of a long run solution rather than a patchwork solution to the very real problem of service level provision, infrastructure financing and slum upgrading. A number of specific gains might be highlighted.

 Local voters would have a greater influence on the level and mix of public services provided within the urban area (state). In theory, this will allow the local government in Mumbai to better take advantage of local knowledge in deciding on the package of services to be delivered. The result should be more voter satisfaction with services, and more willingness to pay for services.

 Revenue mobilization in the city- state could increase. This is because the city would have access to all the formerly state taxes, and could levy these on an area-wide basis, and because the demand for local services would be high because of all of the functions that had been absorbed. Local voters would have a greater influence on the level and mix of public services provided within the urban area (state). This could lead to increased local revenue effort.

 Local government officials would become more accountable to their local constituents for the quality of services delivered, because they would impose taxes and user charges on their constituents. For this Metropolitan City Finances in India: Options For A New Fiscal Architecture 23

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 Mumbai would now have a dedicated revenue stream that would allow them to show repayment potential for loans.

 Because Maharashtra state would no longer be required to deal with metropolitan Mumbai, it may have more degrees of freedom in designing the transfer system to be more equalizing. The mega cities are different enough from the rest of the state that fitting it into the intergovernmental fiscal system is an ongoing challenge.

Impacts: Disadvantages and Challenges

There also are major disadvantages to creating provincial cities. Most important, it is a radical change in the fiscal architecture, and would be resisted on grounds that big changes disrupt a longstanding state of affairs. Some would argue that the stability of the intergovernmental fiscal system in India has served it well. On the other hand, there are precedents for this in recent Indian history when three new states were created in the 1980s.

 The major problem would be the changed fiscal situation of the “residual” state of Maharashtra. It would lose the tax base in its major city, hence would suffer a huge revenue loss with respect to shared taxes and VAT. This would be offset to some extent by reduced expenditure responsibility for service provision in the largest city, and probably by larger transfers from the CFC awards. There

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might also be a contingency transfer to protect services in the residual state for a transition period. Still, “residual Maharashtra” would be weaker economically and would have less political force than it does now.

 The creation of state-level cities would be politically difficult. It would disturb many existing arrangements and power structures. In particular, state politicians and bureaucrats in the residual states would lose power. They would be working with a smaller budget and less resources to improve services to their constituent districts. State level bureaucrats would find their staff reduced as many line ministry officials will have been devolved to the new state. There also would be a threat to elected local officials in Mumbai and to former members of the state parliament from the former Mumbai districts.

Local politicians would be put in a position to make unpopular taxing decisions, and some might prefer the present arrangement where they rely heavily on transfers to finance their budgets.

 The net fiscal effect on the residual state would likely be negative.

This would leave the state in a position of being less able to fund vertical programs and to equalize. To the extent there is now an urban-rural transfer, this would be markedly lessened if Mumbai were removed from Maharashtra. Rural local governments could be a net fiscal loser under this policy reform. There would be increased pressure on the state government to increase its effective tax rate.

 There is also some risk with respect to establishing fiscal management and structure of the new state. The present deconcentrated state apparatus for service delivery may not function as well under a city administration as a state administration, at least during the transition period. Moreover, the vertical fiscal balance in a new Mumbai State might be weakened, at least initially, by the goal of making it more self-sufficient in terms of financing. Local Metropolitan City Finances in India: Options For A New Fiscal Architecture 25 voters might rebel against the necessary higher level of taxes and user charges.

The creation of a city-state would be a Federal government matter, and the policies and implementation would be set at the central government level. A particularly difficult issue will be the method used to draw the boundaries of the new city-state. The most likely choice would be based on the concept of a labor market area, as was done in South Africa. An alternative is that the new city state could follow the existing boundaries of incorporated municipalities in which case it would be analogous to annexation or consolidation.

 There may be some disruptions in federal revenue sharing arrangements. The CFC awards might require rethinking, as well as development assistance and central schemes. Depending on the outcomes, fiscal disparities between Mumbai state and the rest of the nation may need to be addressed.

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