NSE takes the first step towards functional municipal finance

Municipal spending is a mere 1% of GDP in India. The corresponding figures for Brazil and South Africa are 7.4% and 6%, respectively, according to an RBI report. This is not just because of the relatively lower level of urbanisation in India (the World Bank pegs it at 35% of the population – though the delayed census means this a guesstimate – compared to 87% in Brazil and 68% in South Africa), but also because of the relatively low importance given to urban local government in India.

We constantly hear of mayors of large cities going on to become the heads of governments of their countries: Joko Widodo of Indonesia and Recep Tayyip Erdogan of Turkey are prominent examples (and Boris Johnson a sorrier one). In India, the chief minister of Tamil Nadu, MK Stalin, has served as the mayor of Chennai but that is probably more of an exception, as he is the son of a former chief minister who had total dynastic control of his political party. By and large, heads of city governments in India almost never advance to higher levels of office.

This is both a reflection of the relatively low level of administrative responsibility given to urban local bodies and a cause of stunted urban governance. While the 74th Constitutional Amendment prescribed devolution of 18 functions to urban local bodies, it did not assign additional fiscal capacity to the third tier of government below the Centre and the state government.

As a result, the largest and fastest-growing share of urban government revenue comes from devolutions from higher levels of government rather than own tax or non-tax revenue. Without adequate fiscal capacity, how are municipalities and corporations supposed to service the bonds they issue? And without clear revenue streams for the bond-issuing urban body, why would any investor buy those bonds?

Successful municipal bond issuances in India run to a couple of hundred crores of rupees. The Indore municipality made a splash by successfully issuing bonds worth ₹228 crore. But the outstanding municipal bonds in the US amount to $4 trillion, or about 17% the nation’s GDP. According to Oxford Economics, India is home to 17 of the 20 cities expected to grow at the fastest rate globally. Clearly, India has plenty of work to do on reforming its urban finances.

Property taxes are the mainstay of urban local government revenue. Few places in the world use this source as well as it could be. It could be augmented with what is known in public finance jargon as ‘value-capturing finance’ — levies such as a betterment tax, development charges and vacant land tax, which capture for the local body a portion of the increase in private property value that accrues from urban government expenditure on, say, widening roads or covering up open drains.

Property taxes are best collected locally. However, most other taxes are more efficiently collected at a higher level and then shared with lower levels of government. Tax on corporate incomes would be collected in major cities where corporate headquarters tend to be. But that income, on which the tax is collected, would be generated from sales across the country. It would be unfair for the local body or the state where the bulk of the tax is collected to lay claim to a large share of it simply on account of its location.

This applies to import duty as well. Though is collected in states with ports, the imports are due to generalised demand across the country. Such taxes should, therefore, be collected centrally and shared with lower levels of government.

The same logic applies to the Goods and Services Tax (GST), which should ideally subsume all indirect taxes. It should be collected at state and central levels and shared across levels of government. In principle, municipal bodies are supposed to receive funds from the state government exchequer as per the recommendations of a state-level finance commission, just as states receive devolved funds from the Centre on the recommendations of a central finance commission, appointed every five years.

Ideally, governance functions should be assigned to different levels of the government depending on each level’s ability to discharge a particular function. This is called the principle of subsidiarity. Filling potholes is best done at the local level. Controlling air pollution and managing water sources and drainage are best done at the level of the airshed and watershed involved, and these could span regions, states and even countries. Health and education require distribution at different levels, with coordination from above. Fiscal needs and sources should be identified for each level and the remaining fiscal requirement must be met through devolution from a higher level.

This might entail reworking parts of the Constitution and calls for political consensus that might be difficult to achieve. While work on this progresses, the least the states can do is to appoint state finance commissions as scheduled, and faithfully implement their recommendations on devolutions to local governments without dragging their feet, as has been the practice so far.

There has been some progress on developing a National Municipal Accounting Manual. Municipalities and other local governments must keep their books in a uniform fashion that makes sense to would-be investors in their bonds. The central government could help with software and cloud-based storage and access for the accounts.

Greater clarity on the road ahead will only come with each additional mile covered.