The Urban Finance Paradox: Centralised Taxes, Local Responsibilities

The article has criticised the imperfect municipal finance system in India, discussed the opportunities of municipal bonds, and affirmed the value of a decentralised tax system to enable urban governance.

The issue of urban governance in India is experiencing a critical shift, but its mode of fiscal structure is not structurally prepared to address the requirements of a high rate of urbanisation and decentralised service provisions. The third tier of the government is municipalities, which have constitutionally mandated varied responsibilities, yet have limited financial capacity. The reduction of fiscal space in which local bodies operate has also been reduced by the over-centralisation of tax collection, which is most evident in the Goods and Services Tax (GST), and which has forced it to rely on unpredictable grants and be at the mercy of state-level discretion. This lack of engagement between functional duties and financial empowerment has resulted in chronic underinvestment, inadequate infrastructure, and low levels of innovation in urban governance.In this respect, municipal bonds have become a new field of financing urban infrastructure that may provide an alternative to market-based financing of urban infrastructure, as an alternative to traditional grants and loans. Their adoption is, however, still not high because of the existence of regulatory bottlenecks, low credit ratings, and governance issues.

This article is a critical analysis of the faults of the municipal fiscal structure in India, an evaluation of whether municipal bonds are a viable instrument of sustainable financing, and an interrogation of the systematic consequences of excessive centralisation of the taxation system.

Weaknesses in Municipal Fiscal Architecture

The group of areas represented by the municipal fiscal architecture in India is afflicted by structural underlying barriers that affect the financial sustainability and independence of Urban Local Bodies (ULBs), even when there is an increment in their developmental mandate.

Revenue-Responsibility Mismatch
The core weakness of the municipal fiscal system of India is that there is an over-imbalanced allocation of tasks and the financial resources that must be used to fulfil the tasks assigned to the municipalities. The 74th Constitutional Amendment enabled municipalities to execute 18 functions enumerated in the Twelfth Schedule, such as water supply, sanitation, and urban planning. Nevertheless, the fiscal devolution has been inconsistent and insufficient. The municipalities produce almost two-thirds of the GDP of India, but only 1 percent of the total collection is controlled by them, which creates a critical fiscal insufficiency. This imbalance compels ULBs to be very dependent on state and central transfers, which tend to be delayed, conditional, and politicized.

The Revenue Erosion
Previously, local taxes like octroi, entry tax, and advertisement tax were also collected by municipalities. The introduction of GST incorporated a lot of these revenue streams into the centralised tax regime and made a major cut on the fiscal independence of the local bodies. Failureinthe increase or decrease of property taxation rates, which in most cases are caused by political obstacles, also limits revenue collection. Because of this, most of the municipal budgets of large cities are mainly financed using external transfers and non-personal income. Such a loss of self-generated revenues restricts the ability of municipalities to plan, innovate, or effectively act in response to local demands.

Institutional Capacity and Financial Management
Municipalities often do not have institutions that are professionally able to handle finances. Lack of transparency and efficiency is caused by poor accounting practices, a lack of bookkeeping capabilities, and minimal use of online financial systems. The majority of ULBs lack the preparation of audited financial statements or asset registers, and, therefore, it is hard to estimate fiscal well-being or encourage the inflow of private investment. Their access to market-based instruments, such as municipal bonds, which should be backed with solid financial disclosures and creditworthiness, is also impacted by this institutional weakness.

Dispersed Intergovernmental Transfers
The fiscal transfers system by the upper levels of government is disjointed and unpredictable. There is no option of using grants to spend wisely because they are usually attached to a certain scheme. Additionally, performance-based grants offered by the Finance Commission are not fully exploited because of the lack of good compliance and reporting systems. Such a disjointed system of transfers helps to strengthen the dependency factor and does not provide much foresight in terms of fiscal planning to the municipal government.

The Bright and Dark sides of Municipal Bonds

Municipal bonds have developed as a good tool for funding urban infrastructure in India, and their use is still not widespread because of structural, regulatory, and institutional issues.

Market-based finance
The City financing Municipal bonds provides an alternative strategy to historical sources of financing (grants) through allowing Urban Local Bodies (ULBs) to source capital within the market. These bonds are normally issued in order to finance long-term infrastructure like water supply, sanitation, roads, and housing. Their potential attractiveness is that they can note the opening of private investment, decreasing the dependence on higher tires of government, and developing fiscal responsibility. Recent policy moves, such as credit enhancement mechanisms and pooled financial mechanisms, have tried to make municipal bonds possible even for small cities. Smart Cities Mission and AMRUT by the Government of India have also promoted the issue of bond issuance as one of the solutions to the urban renewal policy.

Creditworthiness and Regulatory Barriers
The municipal bond market in India is underdeveloped. There are quite a few cities that have managed to issue bonds successfully; they are Pune, Ahmedabad, and Indore. One of the challenges is a lack of creditworthiness among most municipalities due to poor financial disclosures, poor revenues, and a poor accounting system. Credit rating agencies tend to give low ratings to the ULBs, and investors’interest. In addition, the regulatory framework implies adherence to SEBI standards, such as audited financial reports, project-related disclosures that are difficult to ensure in many municipalities.

Governance and transparency
The governance standards are more or less related to investor confidence in municipal bonds. The ineffective institutional capacity, absence of transparency, and political interference in the operation of the municipalities reduce the viability of bond issuances.The lack of solid project planning, citizen involvement, and performance monitoring spells delays and excessive costs of bond-funded projects. Moreover, in the lack of a second market for municipal bonds, there is limited liquidity, and long-term investment is discouraged. To develop trust and increase bond-based financing, strengthening governance systems and going digital with financial management systems is necessary.

Scalable Bond Ecosystem
India needs to invest in capacity building, fiscal reforms, and institution strengthening in order to achieve the maximum potential of the municipal bonds. This involves giving a mandate to the municipalities to mobilise own-source revenue, strengthening the standard of financial reporting, and incentivizing bond issuance that is performance-based. The ULBs could be offered technical and financial assistance by the national-level municipal bond development fund. Finally, the municipal bonds have to be integrated into a larger approach of urban fiscal empowerment and participatory governance.

Systemic Bottlenecks

Excessive concentration of taxation in India has become a structural bottleneck that undermines the fiscal autonomy of the municipalities, regardless of their increased involvement in urban governance and service delivery.

Fiscal Federalism
The cities in India contribute close to two-thirds of the GDP, although municipalities gain less than 1 percent of the total tax income. This virtual unequal portrayal is the product of a more endemic shortcoming of India's fiscal federalism, in which the central and state governments still enjoy inordinate control over the power of taxation. With the vision of empowered Urban Local Bodies (ULBs) in the 74th Constitutional Amendment, the failure to introduce the same with the fiscal devolution has made the municipalities financially reliant and institutionally a feeble structure.

GST and Local Tax Erosion
With the introduction of Goods and Services Tax (GST) in 2017, there was a great change in the environment of local taxation. The major sources of municipal revenue, like octroi, entry tax, and advertisement tax, were merged in the GST, which effectively centralized its tax collection and abolished most of the essential own-source revenues to ULBs. Although GST has brought about efficiency in national taxation, it has unknowingly led to the undercutting of the fiscal stability of the municipalities, as they have to depend on grants and transfers usually conditional and politically interfered with.

Reliance on the Transfers and Grants
More than 75 percent of the annual budgets in municipalities have become reliant on the state and central transfers. These transfers are often associated with definite schemes, with not much room to spend on discretion or local innovation. Also, the uncertainty and discontinuity of these transfers make it difficult to plan the fiscal situation in the long term. Finance Commission performance-related grants are yet underutilised as a result of poor compliance and reporting structures, which continue to strengthen fiscal dependency.

Revisiting Decentralised Taxation
To help solve this systemic bottleneck, a redesign of the fiscal architecture in India is necessary. The municipalities should be enabled to mobilise their own-source revenues via property tax restructuring, user charges, and local levies. There should also be a GST or compensatory directive amount to be given to the urban local bodies to replenish the fiscal balance. The institutional capacity must be fortified, the financial transparency enhanced, and the encouragement given to local generation of revenues in order to renew urban governance and curb over-centralisation.

Towards Sustainable Urban Finance

The urban finance regime in India requires a paradigm shift agenda in terms of enumerating institutional weaknesses and fragility idiosyncratic to the problem of perennial underfunding alongside the escalating level of infrastructure shortfall in the cities, which are witnessing an upsurge in demographic and economic transformations.

Making Own-Source Revenue Mechanisms Stronger
The basic reform agenda is to increase the capacity of Urban Local Bodies (ULBs) to harness own-source revenues. The biggest municipal tax, which is property tax, is underutilised because of the old methods of valuation, political opposition, and inefficient collection mechanisms. Cost recovery and fiscal sustainability can also be enhanced through rationalisation of the user charges on services such as water, waste management, and parking. Municipalities need to be empowered to adjust their rates and diversify their tax base to help them become less dependent on transfers from higher levels.

Financial Governance and Institutional Capacity
The cities should embrace modern financial management systems to enhance transparency, accountability, and confidence of investors. This involves the use of double-entry accounting, preparation of an audited financial statement, and maintenance of asset registers. Urban finance can be professionalised with capacity building, i.e., training, digital tools, and even technical support. The National Urban Policy Framework (NUPF) argues the importance of having a strong urban information system and data-driven governance to help in having evidence-based planning and budgeting.

Making use of Market-Based Instruments
The widening of access to municipal bonds and public-private partnerships (PPPs) is important in financing large-scale infrastructure. Urban Challenge Fund (UCF), which was announced in Budget 2025-26, is to jointly finance innovative city projects with the condition that at least half of the financing should be through bond financing using bonds, bank loans, or PPPs. This will promote financial restraint and promote the ability of municipalities to come up with bankable projects. Smaller cities that have low creditworthiness can be assisted by credit enhancement mechanisms and pooled financing models.

Redesigning Intergovernmental Transfers
Fiscal transfers need to be restructured and aimed at predictability, performance, and equity. Funds obtained through the Finance Commission should be linkedto observable results like the delivery of services, financial reporting, and involvement of citizens. The untied grants should be raised to offer freedom to municipalities when it comes to meeting local priorities. Also, the compensatory mechanisms of the lost revenue to GST centralisation should be institutionalised to regain fiscal balance.

Conclusion

The Indian urban fiscal system is at a critical crossroad, and the structural reform has ceased to be an option, but an absolute necessity. This never-ending imbalance between the local duties of the Municipalities and their financial autonomy, coupled with the excessive centralization of taxes, has left Urban Local Bodies in a weak financial position and limited their operation. Although municipal bonds are a promising way to finance the infrastructure, their expansion requires the governance that is strong enough, creditworthiness, and institutional capacity. These problems have necessitated a multidimensional reform agenda, such as strengthening own-source revenues, modernising financial management, and recalibrating intergovernmental transfers. The redirection of fiscal federalism, giving powers to the municipality, is compulsory not only to Sustainable urban development, but also to further decentralisation of democracy. This is why the financial structure of city centres in India needs to change, as the urban centres can turn into the product of economic advancement and social change, and their core role in the state development agenda needs to be reflected.