Urban Growth, Fiscal Gaps: The Paradox in India’s Urban Governance
India’s cities generate the bulk of economic output — over 66% of GDP — and are rapidly urbanising. Yet municipal bodies control less than 1% of tax revenue. This structural mismatch between rising urban responsibilities and weak fiscal power has created a deep urban governance paradox that threatens sustainable city development.
Introduction
Urban India is the engine of growth: cities produce most of India’s GDP and are home to a rising share of population. But local governments — Urban Local Bodies (ULBs) — are underfunded, understaffed, and often lack the legal and fiscal authority to meet demands for services and infrastructure. The 74th Constitutional Amendment (1992) aimed to empower ULBs, yet the four Fs — Funds, Functions, Functionaries, and Functionality — remain inadequately resolved.
Context & Background
Rapid urbanisation (35% population in 2021, projected >40% by 2035) and rising infrastructure needs clash with constrained municipal finances. The World Bank (2025) estimates that urban infrastructure investment needs are roughly 2–4% of GDP annually, while India spends around 0.7% of GDP on urban infrastructure. Key legal provisions — Article 243P–ZG and the 12th Schedule — assign roles to ULBs, but practical devolution and revenue powers are limited. The introduction of GST (2017) further centralised many local taxes, shrinking municipal own revenues and increasing dependence on grants and tied schemes.
Key Points
- •74th Constitutional Amendment (1992): Provided constitutional recognition and a framework for ULBs, creating the 12th Schedule listing 18 municipal functions and mandating State Finance Commissions (SFCs) to recommend devolution.
- •Sources of Municipal Revenue: Own sources (property tax, user charges), assigned revenues (share of state taxes), intergovernmental transfers (CFC, SFC grants), and borrowings (bank loans, municipal bonds). For beginners: own revenue = what ULBs collect directly; transfers = money from state/centre.
- •Impact of GST: GST subsumed local taxes like octroi and entry tax, reducing municipal fiscal space. Promised compensation was often insufficient or non-transparent.
- •Property Tax Potential vs Reality: Many ULBs use outdated valuation systems and have low compliance. CAG shows municipal corporations collect only about 56% of property tax demand in many states.
- •High Dependence on Grants: ULB budgets are dominated by conditional central/state schemes such as Smart Cities and AMRUT, which limit local choice.
- •Weak Municipal Bond Market: Bonds are underutilised — only a few cities raised funds through bonds, often via private placements. Green bonds are nascent and expensive to issue.
- •Human Resource and Governance Gap: High vacancy rates (average ~37%), weak training, weak State Election Commissions delaying elections, and marginalised mayoral powers reduce accountability.
- •State Control over Key Functions: Important powers like land-use, planning, and large utilities are retained by state agencies and parastatals, limiting ULB autonomy.
- •RBI & World Bank Findings: RBI (2024) finds many municipal corporations lack financial autonomy, proper accounting, and sufficient capital expenditure capacity. World Bank (2025) highlights the large financing gap for urban infrastructure.
Constitutional Provisions & Practical Gap
| Provision / Schedule | What It Says | Practical Reality | Bookmark |
|---|---|---|---|
| Article 243P–243ZG | Defines structure, composition and powers of ULBs. | Many states have not fully devolved powers; functions often retained by state agencies. | |
| 12th Schedule | Lists 18 municipal functions (water, waste, roads, planning, etc.). | ULBs often lack funds or staff to discharge these functions effectively. | |
| Article 243X & 243Y | State can assign taxes; SFC to recommend devolution. | SFC recommendations are delayed or only partially implemented; transfers unpredictable. | |
| GST (2017) | Subsumed many local taxes into a central/state framework. | Municipal own-revenues shrank; inadequate compensation and limited formula-based sharing. |
Urban Revenue Composition — Typical ULB
| Revenue Source | Share / Issue | Bookmark |
|---|---|---|
| Property Tax | Major own-tax but collection inefficiencies (≈56% demand realized in many MCs) | |
| Grants & Schemes | Large share; often tied and conditional (Smart Cities, AMRUT) | |
| Fees & User Charges | Under-priced due to political resistance; collection shortfalls | |
| Borrowings | Rising but limited market access; municipal bonds underutilized |
Related Entities
Impact & Significance
- •Service Delivery Strain: Poorly financed ULBs cannot provide reliable water, sanitation, drainage, transport, and solid waste management — affecting public health and quality of life.
- •Infrastructure Bottleneck: Low capital expenditure and limited borrowing capacity slow investment in roads, public transport, water and sewerage, and climate-resilient infrastructure.
- •Policy & Planning Mismatch: Fragmented responsibilities between ULBs, parastatals and state departments create coordination failures in city planning and implementation.
- •Social Inequity: Weak local finance often leads to under-provision of services in poorer neighbourhoods — worsening urban poverty and slum conditions.
- •Economic Risk: Cities are engines of growth; fiscal weakness in ULBs undermines economic competitiveness, job creation, and investment climate.
- •Fiscal Fragility: Heavy dependence on unpredictable grants increases vulnerability to macro shocks and political changes.
- •Environmental & Resilience Costs: Inadequate investment in sewage, drainage and coastal protection increases disaster risk and climate vulnerability.
Challenges & Criticism
- •Inadequate Own-Revenues: Property tax systems are often outdated, undervalued, and administratively weak; user charges are politically sensitive and under-priced.
- •Conditional Grants & Project Mode: Central schemes are often vertical and project-focused, leaving little flexible funding for local priorities.
- •Weak Municipal Markets: Municipal bond market suffers from lack of standard credit practices, low investor appetite for small issuers, and procedural complexity.
- •Human Resource & Capacity Constraints: High vacancies, poor training, and weak financial skills hamper municipal functioning and project execution.
- •State Dominance & Parastatals: Key functions like land-use planning and utilities are often controlled by state agencies, fragmenting accountability.
- •Political Economy Issues: Mayors often lack executive power; politics and short electoral cycles push ULBs toward populist, short-term decisions instead of long-term planning.
- •Transparency & Accounting Gaps: Many ULBs do not follow standardized accounting (NMAM), reducing investor confidence and citizen oversight.
- •Equity Concerns: Financing models that rely on user-fees may exclude poor sections unless subsidised or designed progressively.
Future Outlook
- •Boost Own Revenues: Modernise property taxation (GIS mapping, periodic revaluation), digitise payment systems, and strengthen collection to unlock fiscal capacity.
- •Rationalise User Charges: Gradually move to cost-reflective pricing for water and sanitation with targeted subsidies to protect the poor.
- •Predictable, Formula-Based Transfers: Institutionalise inflation-indexed, predictable transfers from states to ULBs tied to transparent criteria and SFC recommendations.
- •Develop Municipal Bond Market: Promote pooled municipal financing, credit enhancement (state guarantees, pooled vehicles), and standardised disclosure to widen investor base.
- •Adopt NMAM & Improve Accounting: Enforce National Municipal Accounting Manual to improve transparency, linking state fiscal support to compliance.
- •Strengthen Institutional Capacity: Scale up training, create municipal finance cadres, and decentralise staffing decisions to ULBs for quicker hiring and retention.
- •Empower Mayors & Executive Mayoral System: Consider models where mayors have executive authority (with checks) for clearer accountability in megacities.
- •Green & Climate Financing: Tap climate funds, green bonds, and multilateral financing for resilient infrastructure (flood control, coastal protection, urban greening).
- •Innovative Financing: Use land value capture, development charges, public-private partnerships (PPPs) with safeguards, and user-fee backed bonds for capital projects.
- •Intergovernmental Coordination: Create city-level development authorities with clear roles or metropolitan governance structures for integrated planning and service delivery.
UPSC Relevance
UPSC
- • GS-2: Local governance, decentralisation, Constitutional provisions for municipalities (74th Amendment), intergovernmental fiscal relations.
- • GS-3: Public finance, infrastructure financing, urban planning, PPPs, climate resilience in cities.
- • Essay: Urbanisation and governance, decentralisation, sustainable cities and finance.
Sample Questions
Prelims
With reference to Urban Local Bodies (ULBs) in India, consider the following statements:
1. The 12th Schedule of the Constitution lists functions for ULBs.
2. The 74th Constitutional Amendment mandates State Finance Commissions (SFCs).
3. Introduction of GST increased municipal own-revenues by subsuming local taxes into a state pool.
Answer: Option 1, Option 2
Explanation: Statements 1 and 2 are correct. Statement 3 is incorrect — GST subsumed many local taxes and reduced municipal own-revenues.
Mains
India’s cities contribute disproportionately to GDP, but municipal bodies control a very small share of tax revenue. Examine the reasons for this fiscal paradox and suggest reforms to strengthen urban finances and governance.
Introduction: India’s rapid urbanisation has increased demands on cities, yet municipal fiscal autonomy remains weak — a paradox that undermines sustainable urban development.
Body:
• Reasons: GST centralisation, weak property taxation, dependence on tied grants, state control over key functions, poor accounting, weak municipal bond market, HR and capacity gaps.
• Effects: Poor service delivery, infrastructure shortfall, social inequity, fiscal fragility and investment bottlenecks.
• Reforms: Modernise property tax, predictable formula-based transfers, expand municipal bonds and pooled finance, NMAM adoption, capacity building, mayoral empowerment, green finance, and better state-ULB coordination.
Conclusion: Bridging the urban fiscal gap requires legal, institutional, and financial reforms that empower ULBs with adequate resources, autonomy, and capacity for accountable urban governance.