LOOKING FOR LEADERSHIP FROM THE 12th FINANCE COMMISSION

LOCAL FINANCES: LOOKING FOR LEADERSHIP FROM THE 12^th FINANCE COMMISSION

“The fiscal problems of cities will sooner or later occupy more of the attention of central government policymakers.” - Roy Bahl, Urban Public Finance in Developing Countries, OUP, 1992.

These words seemed prescient a few weeks back in Mumbai, when the Prime Minister committed to a national focus on urban infrastructure. Done correctly, this will be welcome news for our cities and towns. However, knee-jerk development could throw our urban centers into a fiscal tailspin. This is a time to respect institutional arrangements, and allow them to play leadership roles in charting the fiscal map for local governments. One such leadership candidate is the 12^th Finance Commission.

While the focus of the Commission’s outputs in December will be on Centre-State relations, a less-known subtext gives it an increasing role in local finances: Clause 4 (iii) requires it to “recommend measures to augment the Consolidated Fund of the States to supplement the resources of Panchayats and Municipalities on the basis of recommendations of the State Finance Commissions (SFCs).”

The SFCs have emerged as new entities on the public finance landscape to determine State-Local fiscal relationships. However, we are a long way from realizing the benefits of such a federalist scaffolding, largely because of alignment issues between the Central and the State Commissions. The 11^th Finance Commission looked to increase its elbow room in interpreting the local government clause. This trend seems to be continuing with the latest Commission. On more than one occasion, Dr Rangarajan has remarked, “‘Measures’ could be interpreted to include not only financial but also legislative and administrative.” At a recent discussion, he even suggested, “a radical departure under which a proportion of tax devolution from the central pool (be) set aside for local bodies.”

These are significant statements of intent, acknowledging the fiscal pressure being applied on local governments by vertical imbalance, with functions being devolved, without commensurate devolution of fiscal powers. There is an increasingly stronger case for local sharing of income tax, sales tax and motor vehicle taxes, as well as full or partial assignment of instruments like entertainment tax and stamp duty. In addition, it is clear that we are in the era of intelligently designed user charges focused on service outcomes and cross-subsidised pricing.

Of special interest – especially in light of the recent headline-grabbing news on infrastructure development – are two less traditional fiscal options, which merit a bit more analysis:

1. Monetising land: All of urban India comprises only 63,941 sq.km, implying that just 2% of the country’s area accounts for 60% of its GDP. Most urban local governments are asset-rich and cash-poor. A classic example is the Master Plan for New Delhi , where seed capital of Rs 12 crores was leveraged almost 2000 times, generating infrastructure of Rs 22,300 crores over 20 years.

However, there is need for careful fiscal and institutional design in the use of this option: state governments tend set up special purpose vehicles – as in the case of CIDCO and HUDA - which have minimal accountability to local governments, if at all. The substantial fiscal potential of this instrument needs to be harnessed within a democratic framework.

2. Accessing capital markets: There are two challenges in accessing the market: one, the lack of robust financial management systems; and two, the paucity of credible projects. The first requires some elaboration: switching to a modern system of financial management cannot be seen as just an accounting exercise, it demands business-process-reengineering of the entire local body. Without a full comprehension of this, what is under way in many cities will result in “phantom” parallel systems that are barely used by municipal staff.

As far as fulfilling its role under the decentralization clause, this Commission is constrained by four specific lacunae:

1. Poor quality data: There are substantial inconsistencies in determining the resource gaps in urban local bodies, leading the previous Commission to declare, “In the absence of any reliable budgetary/financial data, no realistic assessment of the needs of the panchayats and municipalities for basic civic and developmental functions can be made.” It allocated Rs 200 crores in 1999 to establish district-wide electronic databases.

Five years on, there has been little change. The Chairman remarked recently, “The absence of a rational determination of the gap between normative costs of service delivery and the normative capacity to raise resources … makes the task of recommending measures … hugely complex.”

The resource gap estimation for what are called Core Municipal Services (water supply, sanitation, education, healthcare, streetlights and roads) is central to the entire process of fiscal transfer, and equalisation formula. Astonishingly, the Zakaria Committee Report submitted in 1961 is still being used as a base, adjusted for CPI. Some fallouts of this:

• Per capita municipal expenditures for core services is estimated at Rs 355 p.a. (P K Chaubey)
• Taking Bangalore as an illustration, the cost to the Bangalore Water Supply and Sewerage Board (BWSSB) is Rs 20/kilolitre. At basic consumption levels of 100 lpcd, this works out to about Rs 750/person/year. Factoring unaccounted-for-water (50%), the actual annual per capita cost for water supply alone is around Rs 1500, four times the estimated cost for all core services.
• Adding the cost of sanitation, education, healthcare, street-lighting and municipal roads would push the total to several multiples of the estimate.

2. Exclusion of interest payments: The resource gap estimation is only for revenue expenditures, i.e. the maintenance cost of assets being created. However, this ignores interest payments on borrowings for asset creation. Various estimates place capital costs for urban infrastructure requirements at Rs 50,000 crores over 5 years. At 8% interest, this works out to Rs 4,000 crores annually, not factoring cost escalations. Ultimately, the annual interest burden on municipalities may add up to Rs 7,500 crores. The current buzz on building infrastructure could add to this debt trap, potentially placing local governments in the same fiscal mess as their federal cousins.

3. Quality of expenditures: In the submissions to the Commission, there is little mention of this issue, one which is damaging the credibility of local governments. In a recent example of corruption, the LokAyukta of Karnataka uncovering a scam of Rs 240 crores in 7 municipalities around Bangalore, a sum several times the combined annual budgets of these towns. One direct result of this is poor compliance from the tax-payer. The relationship between credibility and compliance is not a trivial one, and requires greater analysis.

4. Monitoring mechanism: This is one of the banes of any fiscal transfer mechanism. Rather than propose another set of institutional arrangements, a more sustainable answer may be in the creation of closed-loop accountability mechanisms with the citizens themselves. In the ultimate analysis, citizen participation can solve four critical issues facing fiscal decentralization: sustainability of reforms, equitable outcomes, optimal resource mobilization, and efficient deployment of funds.

While time is running out, all of the above issues could still be addressed by the Commission. The re-design of the decentralization index to capture mandated reform outcomes at the local government level, and recalibration of its weight in the transfer formula, is a powerful tool that the Commission possesses.

Important decisions are going to be made about the fiscal future of local governments in the next few months. We are witnessing a secular trend towards fiscal decentralization, with greater space for local governments. The time is right for the Finance Commission to chart a stable fiscal course for local governments, a map that could even help them weather the rough seas of unexpected national decisions on infrastructure

The writer is Campaign Coordinator of Janaagraha, a citizens’ platform for participatory democracy. He can be reached at ramesh@janaagraha.org