Metropolitan City Finances in India: Options for A New Fiscal

International Center for Public Policy

Working Paper 12-33

December 2012

Metropolitan City Finances in India: Options for

A New Fiscal Architecture

Roy Bahl

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International Center for Public Policy

Working Paper 12-33

Metropolitan City Finances in India: Options

for A New Fiscal Architecture

Roy Bahl

December 2012

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Metropolitan City Finances in India: Options

for A New Fiscal Architecture

Roy Bahl

Andrew Young School of Policy studies, Georgia State University

Roy Bahl is Regents Professor of Economics, Emeritus, The Andrew Young School of Policy studies, Georgia State

University, Atlanta Georgia, USA. ([email protected]).

2 International Center for Public Policy Working Paper Series

INTRODUCTION

India will face great problems in finding a way to finance public services in its

large cities in the next two decades. Backlogs in service levels and infrastructure

are already great, and migration to urban areas will put even more pressure on

state and local government budgets. Metropolitan cities have an economic base

of significant size, but have not been empowered to tap this revenue potential.

State governments have more ability to reach a buoyant tax base, and to borrow,

but must also use these resources to provide statewide services and to tend to

the servicing needs of poorer local governments. The Indian Constitution poses

significant constraints on the financing options, and neither the Central Finance

Commission nor the State Finance Commissions have shown the way out of this

problem. One could correctly say that India has not successfully implemented a

strategy to address the fiscal problems of metropolitan areas.

The goal in this paper is to describe and evaluate some of the alternative

approaches to developing such a strategy. While most studies of urban finance in

India consider good reforms that might be politically possible, and that might lie

within the present legal framework (Rao and Bird, 2011: Mohanty, et. al., 2007;

High Powered Committee, 2011), this analysis focuses on the largest metropolitan

cities and considers the option of state government status for large metropolitan

areas.

We begin with a discussion of the factors driving the budgetary needs that will

face big cities in the next twenty years and then turn to a review of the options

for covering the growing resource gap that will emerge. Three of these reform

choices are the usual suspects: muddling through with the present approach,

giving urban local governments access to more revenue raising powers, and

increasing the rate of intergovernmental transfers from both the central and the

state governments. The fourth, less often discussed reform path is to give state

government status to the largest metropolitan cities. Throughout the paper we

draw on the recent experiences in middle and low income countries. While every

country is unique, there are lessons for India to learn from the international

experience in financing urban governments.

Metropolitan City Finances in India: Options For A New Fiscal Architecture 3

DETERMINANTS OF THE URBAN FINANCING PROBLEM

Urbanization and the public financing and governance adjustments that it will call

out are a world-wide issue (Bahl, 2010). The expectation is that the demand for

new infrastructure and maintenance and for enhanced public services will grow

dramatically. Ingram, Liu and Brandt (forthcoming) estimate that annual urban

infrastructure needs will be equivalent to about 3 percent of GDP for new

construction and 2 percent for maintenance. The sources of this increased

demand include migration to urban areas, growing per capita incomes, business

demand for enhanced public services, and the need to upgrade slum

neighborhoods. On top of this are the needs to address the negative externalities

that come with urbanization, such as pollution (solid waste collection) and

congestion (transportation).

Population Growth.

The workers and families that will move to cities from smaller places and from

rural areas will pressure the budgets of urban local governments. The rate of

urbanization in developing countries is now projected to reach the 50 percent

mark in the next decade (United Nations, 2008). According to current estimates

the world population will likely grow from approximately 7 billion in 2012 to over

9 billion

by 2050 and virtually all of the population increment will be absorbed by

urban areas in developing countries.

The number of megacities (population greater than 10 million) is projected to

increase from 19 now to 27 in 2025, when about 10 percent of the world’s urban

population will reside in these cities. Of the projected 27 mega-cities, 21 will be

in less developed countries. By 2025, there will be 48 cities with populations

between 5 and 10 million, and three-fourths of these will be in developing

countries (United Nations, 2008). The rate of population growth in the largest

metros may be slower than that in other urban areas, but the size of the

populations to be serviced will be larger than anything seen before.

For a detailed discussion of these determinants, see Bahl, Linn and Wetzel (forthcoming).

US Census Bureau Website (last accessed 21 July 2012)

http://www.census.gov/population/international/data/idb/worldpopgraph.php

4 International Center for Public Policy Working Paper Series

The distribution of population in India will follow these international trends.

Between 2001 and 2031, the urban share of total population is projected to

double, though India’s rate of urbanization will still lag that in the rest of the

world. The number of cities with populations greater than one million will

increase from 35 to 87 (High Powered Committee, 2011). The United Nations

(2008) projects that by 2025, Mumbai (26 million) and Delhi (23 million) will be

the second and third largest urban agglomerations in the world. About half of the

increase in urban population over the decade of the 1990s was due to natural

growth, but this share will fall as urban job opportunities will bid in more

migrants.

Competitiveness.

Urban economic growth (and national economic growth) is fueled by a strong

competitive position of businesses operating within the metropolitan area.

“Competitiveness” means production at lowest costs consistent with the quality

necessary to sell in international markets, but it also means an ability of urban

enterprises to absorb new technologies, take advantage of agglomeration

economies, and to attract foreign direct investment and a high quality labor force.

Maintaining competitiveness requires a setting in which innovation can take

place, e.g., technology parks, linkages with universities, and incentives for

incubation and small business development (OECD, 2006).

The competitiveness of a city’s businesses in international markets is enabled by

the infrastructure and public services offered. Transportation services have long

been recognized as a key to urban economic development. This has led to heavy

investment in mass transit and freeways that have reduced congestion, and in

seaports and airports that have facilitated trade (Yusuf, forthcoming). A

communications network that allows an efficient transfer of information is key to

all of this (Glaeser and Gottlieb, 2009). Another part of the strategy to maintain

competitiveness is to make cities more attractive to high quality labor. This leads

to public investments in improving amenities, such as provision of modern health

facilities, education curricula that support the new economy, recreational and

cultural activities, and security.

Metropolitan City Finances in India: Options For A New Fiscal Architecture 5

The Indian economy is increasingly driven by its urban sector. Projections are

that the urban share of GDP will reach 75 percent by 2030. The industry and

service sectors are the primary contributors to urban economic growth,

particularly IT, telecoms, banking and “smart” manufacturing such as engineered

goods and pharmaceuticals (High Powered Committee, 2011). It is estimated that

between now and 2030, 70 percent of net new employment will be generated in

cities (McKinsey Global Institute, 2010).

As in other countries, the competitive challenge in India will be to capture the

agglomeration benefits of urbanization without being overwhelmed by

congestion costs. This will call out a strategy of investing in basic infrastructure to

allow the communication among firms that is necessary to capture the benefits of

proximity, and to attract a skilled labor force. At the same time, virtually all cities

must invest heavily in transportation to reduce congestion and air pollution. The

pressure will be on to get the government institutions arranged so that good

decisions can be made, and to mobilize the resources needed.

Poverty and Slum upgrading

Many large metropolitan areas in low and middle income countries face the

problem of addressing the special needs of a heavy concentration of poor and

badly housed families, often in sprawling slums which call for major infrastructure

investments by metropolitan governments. The magnitude of the slum problem

is staggering. One estimate is that about $60 billion per year will need to be

spent on slum improvement and prevention during the next 15 years (Freire,

forthcoming).

While the problem of urban poverty has been a focus of policy action in low and

middle income countries during the past two decades, it is also the center of

much debate. Two fundamental issues are how poverty should be measured, and

what are the relative sizes of the poor population in metropolitan cities, other

urban areas and rural areas. Another is which policy instruments are likely to

yield the greatest returns in terms of poverty reduction (Linn, 2010). This same

debate takes place about poverty in India.

6 International Center for Public Policy Working Paper Series

How will migration to urban areas in India affect the rate of poverty? About one-

fourth of the Indian population now lives below the poverty line, though the

share is considerably lower in urban areas.

Moreover, the evidence suggests

that new migrants are no more likely than non-migrants to have incomes below

the poverty line (Singh, 2009)

The Indian problem in cities is probably better described as “shelter poverty”.

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 SHORTFALL

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.

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

8 International Center for Public Policy Working Paper Series

areas in the federal system. To varying extents, all of these approaches are taken

in various low and middle income countries.

MUDDLING THROUGH

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

10 International Center for Public Policy Working Paper Series

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).

OWN REVENUE MOBILIZATION

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).

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.”

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.

12 International Center for Public Policy Working Paper Series

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).

Comparable data for individual urban local governments are not readily available,

but special surveys and case studies for individual cities have shown a weakening

balance between own revenue capacity and expenditure needs. In a survey of the

finances of 34 cities for 2004, Mohanty, et. al. (2007) found that nearly all faced

annual revenue shortfalls. When revenue inflows were compared to expenditure

needs based on a normative approach to identifying minimum requirements for

service levels, the finding was that the revenue gap could not be covered with the

current revenue structure. This study finds that on average, large cities finance

about 45 percent of their expenditure from own sources, which is not a low

number by international standards, but this statistic masks the problems that

stem from the currently low level of spending.

Revenue effort. There are two routes to increasing metropolitan government

capabilities to finance budgets from own sources: raising the revenue effort that

is made by local governments, and strengthening the revenue raising powers of

local governments. Both routes can be taken in India. There is considerable

room for increased revenue effort, but vertical balance for large urban

governments almost certainly will require enhanced revenue-raising powers.

The goal of raising the revenue effort by local governments in metropolitan cities

might be addressed in a number of ways. User charges are rarely levied at cost

Metropolitan City Finances in India: Options For A New Fiscal Architecture 13

recovery levels (Rao and Bird, 2011). With increased rates and stronger

enforcement, revenues could be augmented significantly. Mohanty, et.al. (2007)

studied 25 municipal corporations for 2004 and found that 16 recovered less than

20 percent of costs from charges and only 2 recovered as much as 75 percent.

The High Powered committee (2011, page 140) reports later data to show that

only 8 of the 63 JNNURM cities recovered water and sewerage O&M costs, and

only 6 recovered O&M costs for solid waste management services. The main

bottlenecks to full cost recovery with user charges are political resistance, dis-

satisfaction with the level of services provided, and the complications that arise

because tariff increases for urban services require state government approval.

There also is room to increase local tax effort in India. The mainstay of local

government revenue systems is the property tax, but this remains underutilized

with an effective rate against GDP at about one half the international average for

developing countries (Mathur, et. al., 2009).

Measured by almost any yardstick, the Indian property tax is badly administered.

A survey of the property tax practice in the 36 largest urban local governments,

carried out by Mathur, Thakur and Rajadhyaksha (2009), revealed that 44 percent

of all parcels are excluded from the tax net, properties are assessed at about 30

percent of market value, and the average collection rate is about 40 percent.

They show that simply raising the coverage rate and the collection rate to 85

percent will increase the urban property tax in India to a level above the

international average for low and middle income countries, though the average

effective rate would still be lower than one percent of GDP.

In some metropolitan areas, the problem is legal or structural, suggesting that a

different type of reform is needed. One example is the case of Mumbai where

rent control legislation has eroded the tax base. To try and get around the

problems of valuation and revaluation, and legal constraints on tax base growth

such as rent control, some large cities have moved to a form of area based

valuation, sometimes with success (Rao, 2008). In other cases the problem is an

unwillingness to reform the property tax, arguably because it is so unpopular with

voters. Two Indian states have abolished the property tax.

14 International Center for Public Policy Working Paper Series

Revenue structure. Improved revenue effort on the existing tax base is not likely

to be enough to establish vertical balance in the Indian system. In a study of

urban local governments, Bandyopadhyay and Rao (2009) find evidence of a

revenue gap that would exist even if these governments realized their full

revenue potential. This problem can be addressed by assigning a broad-based

revenue source to metropolitan local governments. From the international

practice, we can observe that cities in low and middle income countries that have

succeeded with developing a significant role for local revenues have done so with

a broad-based tax as a mainstay of the revenue structure. A package of

narrower based levies such as is common for local governments in developing

countries – professions tax, entertainment tax, licenses, and the like – will not

allow cities of 10 million plus populations to efficiently address their financing

problems.

The fiscal instrument of choice in most countries seems to be a turnover tax. It

has a broad base, high buoyancy and a relatively simple administration. The

problem is that it is distortive because of its cascading feature, and it can give a

great advantage to headquarters locations. Some cities – Buenos Aires and the

Brazilian cities, for example – have attempted to address these disadvantages by

including value added features, but others (Bogota, for example) seem willing to

live with the flaws because of the revenue benefits and wait for the time when

subnational government value added taxes become more feasible. The South

African metropolitan cities relied heavily on a combination payroll-turnover tax,

but this was abolished in 2010 and has not been replaced.

In the case of Indian metropolitan cities, the Octroi has been revenue

productive, but its distortive features and its all-but-impossible administrative

arrangements have led to its elimination in most places. This has significantly

weakened the rate at which large cities finance services from own revenue

sources. In Mumbai where it still is levied, octroi accounts for 45 percent of

revenues, compared to about 25 percent for the property tax (Pethe,

forthcoming).

Metropolitan City Finances in India: Options For A New Fiscal Architecture 15

There is no doubt that octroi is a highly distortive levy that imposes sizeable

welfare costs on society, and on economic efficiency grounds its elimination is

welcome. Complaints from the business community have heightened the calls for

its complete elimination. But how will the lost revenues be replaced? To date,

there has not been much progress on this front. Replacement with a turnover tax

could restore lost revenues, but the distortive features would be retained. A

derivation- based sharing of the VAT with large urban governments (with a higher

local sur-rate in those cities) would be a better approach, even though it would

have some distortive features and would create some incentives for protecting

local producers. Rao and Bird (2011, p28) estimate that a one percent surcharge

on the GST base could yield an amount equivalent to 0.34 percent of GDP.

Note

that if a metropolitan city had state government status (see below), it would

automatically receive a share of the envisioned central-state value added tax.

Arguably a better option for a broad-based local tax – at least from a point of

view of economic efficiency -- would be a payroll tax. To the extent that workers

in formal sector employment are also residents in the city, the benefits test is

passed. Such a tax can be easily collected on a place of work basis, and can be

revenue productive though much less so than in the case of a turnover tax. It

might also be levied as a surcharge on the federal income tax, so as to avoid

additional administrative costs. The problems are the informal sector, which is

not reached by such a levy, the imposition of a tax on labor in metropolitan areas

where unemployment is at very high levels, and the situation in some cities

where people are working in one jurisdiction but living in another. The ways

around the latter problem are either a piggyback arrangement on the individual

income tax, with a higher local sur-rate, and with distribution on a derivation

basis, or the levy by a large metropolitan government rather than by a city whose

taxing jurisdiction does not cover the entire area. Another major drawback to be

resolved is the headquarters problem, which exists when a firm that operates

nationally files a single return making it hard to sort out payroll amounts for

specific local areas.

They also caution that movement away from a uniform rate structure would complicate the administration of the

system.

16 International Center for Public Policy Working Paper Series

There are other forms of taxation that could significantly increase revenue

mobilization in large metropolitan cities. A better use of motor vehicle taxes

could be greatly revenue productive. Licenses, parking, tolls, and even motor

fuels are viable tax bases that can more of less pass the benefits test for local

taxation if they are correctly levied (Bahl and Linn, 1992). The base of all of these

taxes is growing. The High Powered Committee (2010, p56) pointed out that the

motor vehicle population in India increased by 100 times between 1951 and 2004.

Moreover, taxes on motor vehicles, properly structured, might be justified as

congestion charges. The problem is that this would be unpopular with certain

voter groups, would probably raise transportation costs, and it would draw some

revenues away from the state government.

Finally, there is the great potential of benefit charges, particularly those levied on

land. In addition to the annual property tax, cities could be empowered to levy

the transfer tax on real property and perhaps bring both under a uniform (or

consistent) valuation approach. Various forms of betterment charges and impact

fees could also contribute markedly to the revenue base.

A problem with all of these revenue options for metropolitan areas is the

fragmentation of the local government structure. When there are multiple local

governments operating in the same metropolitan area, the place where

consumption or employment takes place may be different from the place of

residence, and a mismatch occurs. In such cases, the property tax and benefit

charges can work effectively but broad based taxes lead to significant inter-

jurisdictional inefficiencies (Bahl, forthcoming).

INTERGOVERNMENTAL TRANSFERS

The financing gap for urban local governments can be reduced by an increased

flow of grants from higher to lower level governments. The justification for grant

financing of local governments is usually to redress an imbalance between

assigned expenditures and assigned taxing powers, to equalize, to correct for

some external effect, or to encourage spending in some high priority area. There

also are political reasons. Some elected local leaders see grants as a less risky

political strategy than local taxation, and some elected state and central leaders

Metropolitan City Finances in India: Options For A New Fiscal Architecture 17

see grants as a way to preserve their near-monopoly on broad based taxes and

their degree of control over how the revenues are spent. Whatever the reason,

intergovernmental transfers usually play a large role in the financing of

subnational governments in most low and middle income countries. (Bird, 2006,

Boadway and Shah, 2009).

International Practice

Countries vary widely in terms of how they structure their grant systems, and how

they treat large urban governments. Consider the following examples drawn from

the unitary countries. The Chinese emphasize economic development and the

main transfer instrument is shared taxes that are allocated on a derivation basis.

The provincial and local governments have no independent taxing powers. South

Africa, on the other hand, allocates its transfers by an equalization formula and

the largest metropolitan local governments receive little in grant revenues. Both

Indonesia and the Philippines share a substantial portion of national taxes with

local governments, with the allocation being by an objective formula that seems

to favor local governments where expenditure needs are greater. Colombia

operates a system of conditional grants to local governments, where the central

government strictly controls the use of the funds.

There is also a lot of variation in the practice among federal countries. Pakistan

and Argentina channel grants through one large program with a formula that

emphasizes population. The grants are made directly to the provincial

governments. Mexico’s grant system has a conditional and an unconditional

sector, of about equal size.

What these few examples show is that countries structure their grant systems

according to what they intend for these transfers to accomplish. In some

countries, the metropolitan governments receive a significant share of the

transfers (e.g., China), but in others the metropolitan governments raise most of

the revenues from their own sources (South Africa and Argentina).

Indian Practice

18 International Center for Public Policy Working Paper Series

Transfers to state governments in India are made through three channels: Finance

Commission grants, Development grants, and centrally sponsored schemes. The

Finance Commission has recommended heavier allocations to local governments,

but the decision is left to the state governments, with advice from their planning

commissions, to decide whether to do this and if so, how it should be done. In all

of this, there would not appear to be an urban strategy.

The JNNURM is a program of direct federal aid to large cities. This program does

appear to be a strategy to address the infrastructure needs of urban areas, and

also to provide local governments with incentives to undertake needed structural

reforms. The amounts of assistance involved under this program are significant,

and the policy reforms sought are important. But in its first iteration, the

program suffered from design flaws. Most importantly, the proposed policy

reforms did into materialize in many cases, and there was no conditionality built

into the grant flow. Disbursement of the funds was slow, in part because of the

matching requirement and in part because of the limited capacity of the local

governments to implement the projects and the policy reforms.

Reform options

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 Practice

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

See Bahl, Linn and Wetzel, forthcoming

20 International Center for Public Policy Working Paper Series

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.

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.

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.

22 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 city-

states. 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

reason, elected local officials might be divided in their support for

this change to the fiscal architecture.

 Those who live and invest in Mumbai probably be subject to higher

taxes than those who live and do business in other urban areas. This

seems an advantage because it would force those living in larger

urban areas to pay the marginal servicing cost that they impose on

their governments.

 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

24 International Center for Public Policy Working Paper Series

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.

 A particularly difficult issue will be how to stem the tide of demands

for city-state status, e.g., Kolkata, Chennai, Hyderabad, Bangalore,

and others. Most large urban areas in India probably feel

discriminated against and many would see this new governmental

arrangement as a way to reduce the flow of money from their tax

base to support services provided elsewhere. Others may argue for a

change in their governance status in order to capture rents. In

countries where the fiscal architecture has been changed

dramatically, subnational governments have succeeded in changing

their status in order to gain some advantages from the

intergovernmental transfer system. Indonesia is an example.

(Hofman and Kaiser, 2003)

26 International Center for Public Policy Working Paper Series

 The cost of government might increase with the creation of state

level cities, at least in the initial period. For example, a “residual

“state of Maharashtra would be smaller and with less expenditure

responsibility, so it should be able to reduce government

employment and overhead. But such costs are sticky downward. On

the other hand, a new city- state might increase its spending

dramatically to address a backlog of unmet needs, but the cost

increases might be held back by the requirement of more self-

financing.

CONCLUSIONS

While revenues do not match expenditure needs at any level of Indian

government, a particularly critical problem has emerged in the case of large cities

where infrastructure is inadequate and promises to grow more so with expected

high rates of migration. In recent years, the federal government has recognized

the urban government finance problem with programmatic assistance and policy

advice, but state governments have been slow to follow this lead. It would be fair

to say that a coherent strategy for metropolitan finances has not been

implemented. The approach continues to be one of muddling through with

various policies that have independent effects at the margin, rather than with a

comprehensive strategy that involves a fundamental change in the fiscal

architecture.

The implementation of a comprehensive metropolitan fiscal strategy is a

possibility for India, but it would be politically difficult and would involve some

costs that might be unacceptable on social as well as economic grounds. Such a

strategy would have the objective of making the metropolitan cities more

financially self-sufficient, and giving them more control over their budgets. It

might have three legs: redrawing metropolitan government boundaries, assigning

more revenue raising powers to metropolitan governments than to other local

governments, and limiting transfers to metropolitan governments to those that

are designed to address externalities and equity concerns.

Metropolitan City Finances in India: Options For A New Fiscal Architecture 27

In many respects, India operates as a traditional federalism with state

governments controlling the fiscal powers of third tier local governments. While

municipalities have been empowered in terms of their expenditure

responsibilities, there has been little movement by state governments to

implement a strategy that would give them more budgetary self-sufficiency.

Some large metropolitan areas could be converted to city-states, i.e., be given

state government status. This would create a taxing district that is roughly

coterminous with the labor market area, and the metropolitan government would

have access to all state government tax bases and user charge bases. Revenue

raising powers would be extended to include all present state government taxes.

Independence in revenue raising powers would be extended to motor vehicle

taxes and various forms of development charges, and the metropolitan local

government would have freedom to raise user charges to whatever rate they

chose. The revised JNNURM would grow in size and be the major

intergovernmental transfer in the revenue system.

28 International Center for Public Policy Working Paper Series

Table1.1 Fiscal Decentralization: International Comparisons for the 2000s

Subnational Government

Expenditures

Subnational Government Taxes

Region

Percent of Total

Government

Expenditures

Percent of GDP

Percent of Total

Taxes

Percent of GDP

Developing

countries

18.8

(16)

5.1

(20)

11.4

(16)

2.3

(20)

Industrial

countries

27.8

(26)

13.9

(26)

22.7

(24)

6.4

(25)

Source: Bahl, Linn and Wetzel (forthcoming) drawn from IMF (various years) and estimates

drawn from the case studies by Roy Bahl.

Note: Data reported are unweighted averages for the 2000s for years in which data are

reported.

a. The number in parenthesis shows the number of countries included in the comparison.

Metropolitan City Finances in India: Options For A New Fiscal Architecture 29

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