What is on the agenda for the 16th Finance Commission?

Context

The 16th Finance Commission (FC) has commenced its work, operating under the authority of Article 280 of the Indian Constitution. This commission’s primary responsibility is to recommend the distribution of the consolidated fund of India among the Union and State governments.

With the 73rd and 74th Constitutional Amendments, local bodies like panchayats and municipalities gained significant recognition and support within India’s federal structure.
These amendments introduced sub-clauses 280(3)(bb) and (c), which direct the Finance Commission to propose measures for augmenting the resources of State consolidated funds to support panchayats and municipalities.
This foundational context sets the stage for understanding the broader implications and challenges of the 16th Finance Commission’s mandate, particularly in relation to urban development and fiscal devolution.

Relevance:

GS-03 (Economy)

Dimensions of the Article:

Key Highlights of the Finance Commission
Importance of Cities in Economic Growth
About the Taxation System
Significance

Key Highlights of the Finance Commission:

The 16th Finance Commission’s work is crucial as it deals with the allocation of funds to various tiers of government, ensuring fiscal federalism and equitable distribution of resources.
This commission is especially significant because it operates in the wake of India’s rapid urbanization, which has brought to the forefront the fiscal needs of urban local bodies (ULBs).

Importance of Cities in Economic Growth:

The mid-1980s saw the National Commission on Urbanisation describing cities as “engines of growth.” Although this perspective might be somewhat limited, it underscores a critical reality: cities are vital to India’s economic landscape, contributing approximately 66% of the GDP and about 90% of total government revenues.
Cities are essential for the country’s development, yet they face severe financial challenges. The World Bank estimates that India needs $840 billion for basic urban infrastructure over the next decade to meet rising demands.
Despite efforts by five Finance Commissions since the 11th Finance Commission, financial devolution to cities remains insufficient. The fiscal health of municipalities is poor, impacting both their productivity and the quality of life for residents. Rapid urbanization without corresponding fiscal measures has adverse effects on development.
Intergovernmental transfers (IGTs) to ULBs in India are about 0.5% of GDP, significantly lower than the 2-5% typical of other developing countries. For instance, South Africa allocates 2.6%, Mexico 1.6%, the Philippines 2.5%, and Brazil 5.1% of their GDPs to their cities.
IGTs constitute about 40% of ULBs’ total revenue, but issues persist regarding their predictability, earmarking for vulnerable groups, and horizontal equity. Given the financial state of ULBs, stable support through IGTs is essential until they can improve their revenue generation capabilities.

About the Taxation System:

The introduction of the Goods and Services Tax (GST) significantly impacted ULBs’ tax revenue. Before GST, ULBs’ tax revenue (excluding property tax) was about 23% in 2012-13, but it dropped to around 9% by 2017-18. This decline in tax revenue has made ULBs more dependent on IGTs from State governments. However, these transfers are minimal, with State Finance Commissions recommending only about 7% of States’ own revenue in 2018-19.
Increasing the quantum of IGTs as a percentage of GDP is crucial for strengthening the financial position of ULBs. Despite the 74th Constitutional Amendment’s objective to financially empower ULBs, progress over the past three decades has been inadequate.
The 13th Finance Commission observed that “parallel agencies and bodies are emasculating local governments both financially and operationally.” Local governments need support from Union and State governments in the form of funds, functionaries, and technical assistance. However, the proliferation of parallel agencies has distorted the roles of local governments. Programs like the Member of Parliament Local Area Development Scheme (MPLADS) and the Member of Legislative Assembly Local Area Development Scheme (MLALADS) exacerbate this issue by distorting the federal structure.

Significance:

The significance of strengthening the fiscal capabilities of ULBs cannot be overstated. Urban areas are crucial for India’s economic growth and development. However, the inadequate fiscal health of municipalities hampers their ability to provide essential services and infrastructure. Ensuring robust financial support for ULBs through increased IGTs and effective local taxation mechanisms is essential for sustainable urban development.
Moreover, the absence of the 2021 Census data poses a challenge for evidence-based fiscal devolution. India has approximately 4,000 statutory towns and an equal number of Census towns, along with an estimated 23,000 villages that are effectively urban. These figures must be accurately captured by the 16th Finance Commission to reflect the true extent of urbanization and migration to Tier-2 and Tier-3 cities.
The 15th Finance Commission’s nine guiding principles require a revisit, particularly those related to enhancing property tax collection in tandem with the State’s GST, maintaining accounts, allocating resources for mitigating pollution, and focusing on primary healthcare, solid waste management, and drinking water. The 16th Finance Commission must consider the dynamic nature of India’s urbanization and ensure that IGTs to urban areas are at least doubled. According to a McKinsey Global Institute report, if India continues investing in urban infrastructure at the current rate, it will face severe shortfalls in water supply and untreated sewage.

Way Forward

Increase Intergovernmental Transfers (IGTs): The quantum of IGTs to ULBs needs to be significantly increased to match the levels seen in other developing countries. This increase will provide stable financial support to ULBs until they can improve their own revenue generation.
Strengthen Local Taxation Mechanisms: Enhancing local taxation mechanisms, particularly property tax, is essential for improving the financial health of ULBs. Ensuring efficient collection and linking it with State GST can provide a more stable revenue source.
Address Parallel Agencies: Reducing the influence of parallel agencies and programs that distort local governance is crucial. Strengthening the roles and capabilities of local governments should be prioritized.
Utilize Updated Census Data: Accurate and up-to-date Census data is vital for evidence-based fiscal devolution. The 16th Finance Commission must consider the latest data on urbanization and migration patterns to ensure fair distribution of resources.
Focus on Sustainable Urban Development: Emphasizing sustainable urban development through investments in basic infrastructure, healthcare, waste management, and water supply is crucial. The Commission should ensure that urban areas receive adequate financial support to address these needs.
Promote Horizontal Equity: Ensuring horizontal equity in the distribution of IGTs is essential. Allocations should be based on the specific needs and capacities of different urban areas to ensure fair and effective distribution of resources.
Foster Collaboration Between Union and State Governments: Strengthening collaboration between Union and State governments is essential for effective fiscal federalism. Providing technical assistance and capacity-building support to ULBs can enhance their ability to utilize funds efficiently.
Encourage Public Participation and Accountability: Promoting public participation and accountability in local governance can improve the efficiency and effectiveness of fiscal devolution. Encouraging transparency and citizen engagement can lead to better management of resources.

Conclusion:

The 16th Finance Commission’s mandate is critical for ensuring equitable and effective fiscal federalism in India. By increasing IGTs, strengthening local taxation mechanisms, addressing parallel agencies, utilizing updated Census data, focusing on sustainable urban development, promoting horizontal equity, fostering collaboration between Union and State governments, and encouraging public participation and accountability, the Commission can ensure that urban local bodies receive the necessary financial support to drive India’s economic growth and development.