Fiscal Challenges and Reforms in Urban India

Urban India contributes nearly two-thirds of the national GDP. Yet, its municipalities control less than one per cent of the country’s tax revenue. The fiscal system has left cities dependent on State and Central government grants. This has created a paradox where cities bear responsibility without financial power. Recent developments show the urgent need for reform in urban fiscal governance.

Loss of Municipal Revenue Sources

The introduction of the Goods and Services Tax (GST) in India led to loss of local revenue for cities. Traditional municipal taxes like octroi, entry tax, and local surcharges were absorbed into the GST framework. This change reduced cities’ own revenue by nearly 19%. Compensatory mechanisms promised by the government largely bypass municipal bodies. As a result, cities lack predictable and autonomous revenue streams.

Dependence on Intergovernmental Transfers

Municipal finance relies heavily on grants, loans, and schemes from State and Central governments. These transfers are often irregular and tied to specific projects. This dependence weakens fiscal autonomy and accountability at the local level. It creates a situation where power is centralised but responsibilities are decentralised, making city governance inefficient and underfunded.

Challenges with Municipal Bonds

Municipal bonds are promoted as a solution to urban finance issues. However, Indian cities struggle to issue credible bonds. Credit rating agencies focus narrowly on a city’s own revenue, ignoring regular government grants. This misjudges cities’ financial health and perpetuates the myth that cities depend on charity. Proper recognition of grants as legitimate income is essential to improve bond credibility.

Limitations of Property Tax and User Fees

Property tax reforms are important but insufficient. Property tax accounts for only 20-25% of a city’s revenue potential and faces political and administrative hurdles. Heavy reliance on user fees shifts the financial burden to residents, especially in poorer areas. Essential urban services like water, sanitation, and public lighting should be collective entitlements, not market commodities.

International Models of Fiscal Decentralisation

Countries like Denmark, Sweden, and Norway offer successful models of fiscal decentralisation. Their municipalities have the right to levy and collect income taxes directly. This encourages transparency, accountability, and long-term planning. Transfers from higher governments are part of a shared fiscal system rather than discretionary grants. Such models combine efficiency with equity.

Path Forward for India

India needs to democratise its fiscal federalism. Municipalities require predictable, adequate, and untied revenues from both own sources and constitutionally mandated transfers. Municipal bonds should recognise grants and shared taxes as valid income. Credit ratings must include governance quality, transparency, and citizen participation. Cities should be allowed to use a portion of their GST compensation as collateral for borrowing. These reforms can restore cooperative federalism and strengthen urban governance.

Questions for UPSC:

1. Critically discuss the challenges of fiscal federalism in India and examine how decentralised taxation can improve urban governance.
2. Analyse the impact of the Goods and Services Tax (GST) on local government finances and point out the implications for municipal autonomy.
3. Estimate the role of municipal bonds in urban infrastructure financing and discuss the factors affecting their credibility in India.
4. What are the principles of fiscal decentralisation in Scandinavian countries? How can these principles be adapted to enhance India’s urban fiscal framework?

Answer Hints:

1. Critically discuss the challenges of fiscal federalism in India and examine how decentralised taxation can improve urban governance.

1. Urban municipalities generate two-thirds of GDP but control less than 1% of tax revenue, showing fiscal imbalance.
2. Centralisation of taxation powers limits municipal fiscal autonomy, making cities dependent on State and Central transfers.
3. Intergovernmental transfers are irregular, tied to projects, and often bypass municipalities, weakening accountability.
4. Decentralised taxation empowers cities to generate predictable revenue, improving planning and service delivery.
5. Fiscal decentralisation aligns responsibility with resources, enhancing transparency and citizen trust in local governance.
6. Reforms enabling municipalities to levy taxes (e.g., income tax) can reduce dependence on higher government and promote fiscal justice.

2. Analyse the impact of the Goods and Services Tax (GST) on local government finances and point out the implications for municipal autonomy.

1. GST subsumed traditional municipal taxes like octroi, entry tax, and local surcharges, reducing cities’ own revenues by nearly 19%.
2. Promised compensatory mechanisms largely bypass municipalities, deepening dependence on State and Central grants.
3. Loss of direct tax sources restricts municipal fiscal autonomy and predictability of revenue streams.
4. Municipalities face a paradox – decentralised responsibilities without adequate financial power.
5. Reduced fiscal independence limits cities’ ability to innovate and invest in local infrastructure and services.
6. To restore autonomy, cities need a share in GST compensation or direct taxation rights to ensure sustainable finances.

3. Estimate the role of municipal bonds in urban infrastructure financing and discuss the factors affecting their credibility in India.

1. Municipal bonds are promoted as a tool for cities to raise capital for infrastructure projects.
2. Indian municipal bonds have low credibility due to narrow assessment based only on own revenue (property taxes, user fees).
3. Regular government grants and transfers are ignored by credit rating agencies, misrepresenting cities’ true income.
4. Recognition of grants as legitimate, recurring income is essential to improve bond ratings and investor confidence.
5. Governance factors like transparency, audit compliance, and citizen participation should be incorporated in credit evaluations.
6. Allowing cities to use GST compensation or State shares as collateral can enhance borrowing capacity and bond credibility.

4. What are the principles of fiscal decentralisation in Scandinavian countries? How can these principles be adapted to enhance India’s urban fiscal framework?

1. Scandinavian municipalities have the constitutional right to levy and collect income taxes directly, ensuring fiscal autonomy.
2. Local taxation forms the foundation of their welfare states, enabling transparent and accountable governance.
3. Transfers from higher governments are predictable, adequate, and part of a shared fiscal ecosystem, not discretionary grants.
4. Decentralised fiscal systems promote efficiency, equity, and long-term urban planning flexibility.
5. India can adapt these by granting municipalities predictable, untied revenues from own sources and constitutionally mandated transfers.
6. Reforming credit rating frameworks and enabling use of GST compensation as borrowing collateral can replicate Scandinavian fiscal health.