Local-body finances: the third tier

Detail

1. What "third tier" means

• India has three tiers of government:
• the Union (Centre)
• the states

• local bodies: panchayats in villages and municipalities in towns and cities.

• Fiscal federalism is the way taxing powers, spending duties and money transfers are divided between these tiers.

• Local bodies deliver the most basic services, such as water, drains, garbage collection and street lights. But they have very little money of their own. This gap between their duties and their money is the core problem of the third tier.

2. Constitutional scheme: 73rd and 74th Amendments (1992)

Subject	Panchayats (Part IX)	Municipalities (Part IXA)
Powers and functions	Art. 243G, 11th Schedule (29 subjects)	Art. 243W, 12th Schedule (18 subjects)
Taxation	Art. 243H: only what the state legislature allows by law	Art. 243X: same
State Finance Commission	Art. 243I: set up every five years	Art. 243Y: the SFC under 243I also reviews municipal finances

• Powers are "devolved", not guaranteed.
• The 11th and 12th Schedules only list subjects. The state law decides how many of them are actually handed over.

• Result: the funds, functions and staff given to local bodies differ a lot from state to state.

• No tax power of their own.

• Local bodies cannot create a tax by themselves. They can levy only the taxes, duties, tolls and fees that the state legislature allows (Arts. 243H and 243X).

• Property tax is the most common example. Its rates and how it is calculated are usually set or limited by state law.

• State Finance Commission (SFC): a body set up by the Governor every five years (Art. 243I). It recommends:

• how the state's taxes should be shared between the state and its local bodies
• which taxes and fees local bodies may collect themselves

• what grants-in-aid (money given by a higher government) the state should pay them.

• The link to the Union FC: Art. 280(3)(bb) and (c)

• The Union Finance Commission recommends steps to increase the Consolidated Fund of a State (the state government's main account), so that the state can pass more money to its panchayats (bb) and municipalities (c).
• The Union FC must base this on the SFC's recommendations.
• Chain: SFC report → Union FC → Centre gives grants to states → states pass them to local bodies.

3. The reality: weak finances

• Own-source revenue (OSR) is the money a local body raises itself, from taxes (property tax, advertisement tax) and non-tax sources (water charges, building-permit fees, rent).
• Formula: OSR share = (own tax + own non-tax revenue) ÷ total revenue receipts × 100.

• Worked example: a city collects ₹300 crore in property tax and ₹100 crore in user charges, and receives ₹600 crore in grants. OSR share = 400 ÷ 1,000 × 100 = 40%. The other 60% depends on transfers from above.

• Revenue is tiny compared with the economy. Municipal revenues are about 0.6% of GDP, and property tax is only a small part of that (NCERT scaffold, citing the RBI Report on Municipal Finances, 2024; verify current).

• RBI Report on Municipal Finances (released 13 November 2024):
• It studied 232 municipal corporations (MCs), more than 90% of all MCs in India [4][5].
• It covered 2019-20 to 2023-24 (Budget Estimates). Its theme was "Own Sources of Revenue Generation in Municipal Corporations: Opportunities and Challenges" [5].
• The revenue account of MCs stayed in surplus, but they still rely heavily on transfers and grants from the Centre and states [4].
• For most MCs, own-source revenue is not enough to meet revenue expenditure (day-to-day spending such as salaries and upkeep). This weakens their functional and financial autonomy (freedom to decide and pay for their own work) [4].
• Revenue is concentrated: the top 10 MCs earn over 58% of all municipal revenue receipts [5].
• Property tax is the largest part of municipal tax revenue [5].

• Suggested reforms for property tax [4]:

  • GIS mapping (digital maps that show every property, so none is missed)
  • digital payments
  • dynamic valuation (updating property values regularly)
  • better checks on leakage (tax that is due but never collected).

• SFCs often fail in practice. Many states set them up late, and their reports are often ignored or not acted on. This is why the 16th FC made a timely SFC a condition for grants (see §5).

• Cities have been weak for a long time. The High Powered Expert Committee (HPEC, 2011) on urban infrastructure found that Indian cities are among the weakest in the world, both in raising money and in financial freedom [7].
• HPEC said urban infrastructure needed ₹97,500 crore to ₹1,95,000 crore a year. Urban schemes were investing only about ₹32,500 crore a year (as of 2017) [7].

4. Municipal bonds: borrowing from the market

• A municipal bond is a debt paper that a city body sells to investors. The city gets money now and repays it with interest later.
• Regulation: the SEBI (Issue and Listing of Municipal Debt Securities) Regulations, 2015 [6]:
• A public issue (bonds sold to the general public) may only be of revenue bonds. These are repaid from the income of the project or from a set revenue stream [6].

• The money raised can be used only for the projects named in the offer document, and those projects must have the required approvals [6].

• Credit ratings come first. By March 2017, 94 cities had credit ratings, and 55 of them were investment grade (considered safe enough for investors) [7].

• Pune (2017) restarted the market. It raised ₹200 crore for water-supply projects [7]. Other cities followed.
• AMRUT incentive: the Centre gives an incentive to cities that issue bonds. Under SEBI's framework, the issuer must keep it in an escrow account (a locked account controlled by a third party) as fixed deposits, and may not use it for anything else [6].
• According to RBI (2024), municipal bond financing has recovered somewhat in recent years [5].
• Limit: only big, well-run cities with good accounts can borrow this way. Smaller bodies cannot.

5. Local body grants from Finance Commissions

• Local body grants are Finance Commission grants to panchayats and municipalities. Part of the money is tied (it must be spent on set purposes such as sanitation and water). The goal is to strengthen third-tier finances.
• Tied grant: can be spent only on specified purposes.
• Untied grant: the local body decides how to spend it, except on salaries and other set costs.

FC	Total local-body grants
14th (2015-20)	₹2.87 lakh crore
15th (2021-26)	₹4.36 lakh crore (rural basic grants: 40% untied, 60% tied to sanitation and drinking water)
16th (2026-31)	₹7,91,493 crore ≈ ₹7.91 lakh crore (rural ₹4,35,236 crore, urban ₹3,56,257 crore) [2]

• The 16th FC (Chair: Dr. Arvind Panagariya) report was tabled on 1 February 2026 for 2026-27 to 2030-31 [2].
• Its total grants were ₹9,47,409 crore. Local bodies got ₹7,91,493 crore, or about 84% of all grants. The rest was ₹1,55,916 crore for disaster management [2].
• It stopped three kinds of 15th FC grants: revenue deficit grants, sector-specific grants and state-specific grants [2]. So local body grants are now the main FC grant.

6. 16th FC design (2026-31)

• Split: basic grants 80%, performance grants 20% (for both rural and urban bodies) [2][3].
• Basic grants: 50% untied, 50% tied to (i) sanitation and solid waste management and/or (ii) water management [2].
• This gives more freedom than the 15th FC, which was 40% untied and 60% tied.

Worked example: rural local bodies (₹ crore) [2] | Component | Amount | Check | |---|---|---| | Basic grant | 3,48,188 | 80% of 4,35,236 | | – Untied (50%) | 1,74,094 | 3,48,188 ÷ 2 | | – Tied (50%) | 1,74,094 | 3,48,188 ÷ 2 | | Performance grant | 87,048 | 20% of 4,35,236 | | – RLB performance | 43,524 | half | | – State performance | 43,524 | half | | Total | 4,35,236 | |

Urban local bodies (₹ crore) [2] | Component | Amount | |---|---| | Basic grant | 2,32,125 | | Performance grant (ULB 29,016 + State 29,016) | 58,032 | | Special Infrastructure Component | 56,100 | | Urbanisation Premium | 10,000 | | Total | 3,56,257 |

• The 80:20 rule applies to the core grant: 2,32,125 ÷ (2,32,125 + 58,032) = 80%. The two extras sit on top.
• Uttar Pradesh gets the largest rural basic grant (₹66,608 crore). Maharashtra gets the largest urban basic grant (₹37,442 crore) [2].

Entry conditions (all three must be met before any grant is released) [2]:

• Local bodies must be duly constituted (properly elected and set up) under the Constitution.
• Provisional and audited accounts must be published for the public.
• The state must set up its SFC on time.

Performance grants: two parts [2]:

• State performance grant: paid when the state meets a minimum benchmark for transfers to local bodies from its own resources.

• This rewards states that share their own money, not only the money that comes from the FC.

• Local body performance grant: linked to meeting minimum targets for own-source revenue growth.

• This pushes cities and panchayats to collect more property tax and user charges.

Urban extras [2]:

• Special Infrastructure Component, ₹56,100 crore over five years:
• It is tied to building a full wastewater management system.

• It covers 22 cities with a population of 10-40 lakh (Census 2011), for example Pune, Jaipur, Lucknow, Indore, Patna, Coimbatore and Raipur.

• Urbanisation Premium, ₹10,000 crore, a one-time grant to states that:

• merge peri-urban villages (villages on the edge of a city) into the city's urban local body, and
• adopt a Rural-to-Urban Transition Policy.

Prelims Hooks

• The 11th Schedule has 29 subjects (panchayats, Art. 243G). The 12th Schedule has 18 subjects (municipalities, Art. 243W).
• State Finance Commission: Art. 243I, set up by the Governor every five years. Municipalities are covered through Art. 243Y.
• Art. 280(3)(bb)/(c): the Union FC recommends steps to increase a state's Consolidated Fund for local bodies, based on SFC recommendations.
• Local bodies have no tax power of their own. They levy only what the state legislature allows (Arts. 243H, 243X).
• 16th FC local body grants: ₹7,91,493 crore (2026-31). Rural ₹4.35 lakh crore, urban ₹3.56 lakh crore. Basic:performance = 80:20. Basic grant untied:tied = 50:50 (15th FC rural basic: 40:60).
• Three entry conditions: duly constituted bodies, published provisional and audited accounts, and a timely SFC.
• Special Infrastructure Component (₹56,100 crore): wastewater systems in 22 cities of 10-40 lakh population (Census 2011). Urbanisation Premium (₹10,000 crore): merging peri-urban villages plus a rural-to-urban transition policy.
• SEBI ILMDS Regulations, 2015: a public issue of municipal debt may only be of revenue bonds. Pune (2017) raised ₹200 crore and restarted the market.
• RBI Report on Municipal Finances (Nov 2024): 232 MCs, and the top 10 MCs earn over 58% of total municipal revenue.
• Trap: the 16th FC dropped revenue deficit, sector-specific and state-specific grants. Local body grants and disaster grants remain.

Mains Points

• Funds, functions, functionaries gap:
• Arts. 243G/243W hand over duties, but Arts. 243H/243X keep the power to tax with the states.
• So local bodies depend on transfers. OSR does not cover even their revenue expenditure (RBI, 2024).

• This weakens the local democracy that the 73rd and 74th Amendments set out to build.

• FC grants as a reform lever:

• The 16th FC ties money to conditions: published audited accounts, a timely SFC, OSR growth, and the state's own transfers to local bodies.
• This uses grants to push both states and local bodies to reform.

• Trade-off: states or bodies with weak capacity may miss the conditions and lose money exactly where it is needed most.

• Freedom vs national priorities:

• Moving from a 40:60 to a 50:50 untied:tied basic grant gives local bodies more choice.
• Tied money still ensures spending on sanitation and water (SDG 6, Swachh Bharat).

• The wastewater and urbanisation-premium grants point FC money towards planned urbanisation.

• Property tax and bonds as the path to self-reliance:

• GIS mapping, regular revaluation and digital collection can raise OSR.
• Better OSR brings better credit ratings. Better ratings let cities borrow through municipal bonds (SEBI 2015 rules, AMRUT incentive).
• This matters because urban infrastructure needs far more money than grants provide (the HPEC 2011 gap).