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Local Government Functions and Finances

The relative importance of local government in country is usually judged by the share of its expenditure in total government expendi ture; the accepted norm in the developed countries ranges between 20 per cent and 29 per cent (Marshall, 1969). India is well below the norm, with local government accounting for only 8.6 per cent of total government expenditure in 1976-77 and 6.4 per cent in 1986-87 (Table 4.2), even though during the same period its share in GNP rose from 1.6 per cent to 2.1 per cent. minimum target of 15 per cent of total expenditure for local government is desirable and achievable if the proposed 1989 bills are passed, allowing for the federal nature of the Indian polity. The desired increase in the ratio of local government expenditure to GNP should be at the expense of the central government rather than that of the states.

Functions

Functional delegation of powers to local governments is made in terms of the English doctrine of ultra-vires -- meaning that the local authorities are to operate strictly within the scope of delegated functions. Most municipal legislations, however, contain general clause to cover local welfare and well-being, and this residual functional delegation could approach the continental doctrine of "general competence". Nevertheless, state governments are not averse to undertaking parallel local functions without amending local government legislations. Another peculiar aspect is process of division of labor between state and local government functions in terms of development and maintenance, whereby local authorities are supposed to take over state-financed projects for operation and maintenance using their own resources. This is fairly common in metropolitan and district development, creating undue financial strain on the fragile revenue base of local governments and distorting local expenditure priorities.

The narrow range of functional jurisdictions of local authorities, as distinct from their permissible functional domain, is more evident in the PRIs than in the MAs, due to: (1) parallel local service provision by state agencies, (2) the role specification of the local authorities mainly for maintenance tasks, and (3) inadequate arrangements for financing their assigned services. In any scheme of reform, therefore, the function-finance nexus needs to be considered in wholistic manner.

An analysis of the functional domain of local governments (in Appendix 4.1) shows that the exclusive functions for rural authorities are only five, with another six being concurrent with the states; for the urban authorities the exclusive functions are 14, with another 16 being state-concurrent. All of these are civic services, and some of them are of regulatory nature, especially the urban services. Although the rural authorities are also supposed to undertake social, welfare and agricultural services, these are largely provided by the states, sometimes through the agency of the rural governments at the area and district levels, despite the long list of functions allotted to the various categories of rural authorities (Table 4.3).

Expenditures

Local functions are usually divided into obligatory and discretionaiy categories, but such distinction is only notional in the absence of any quantitative specifications. Urban authorities are reported to be equally dividing their expenditures on these two categories (NIUA, 1989).

Available data on local government expenditures (Table 4.4) show similar functional coverage by urban and rural authorities, despite their differences in functional competence. Such similarities also appear in expenditures on civic and social services, although their relative importance varies. Rural authorities spend relatively more on social services due to the greater availability of function-specific grants for education, health, and welfare. Urban authorities, being finan cially self-reliant, spend more on community semces like public health and sanitation. With increased financial strain resulting from rising staff salaries, urban authorities are cutting down their expendi ture on social services and concentrating more on community services and on their core or obligatory services to cope with financial strain. Among rural authorities, the village and area-level authorities are more effective in providing local services than those at the districtlevel.

The search for economy and effectiveness in local government expenditures seems to lie in the direction of obtaining "value for money" through (1) cheaper technology, (2) greater productivity, (3) increased competition, and (4) promotion of joint services. In such effoits, local government manpower issues have critical significance which sometimes takes on political overtones. Yet there are isolated success stories from various local e.-.J.horities in this regard, which need to be collected and widely disseminated for replication elsewhere.

Revenues and Taxation

The dissimilar nature of rural and urban governments is apparent from their differing revenue structures: in the former about 89 per cent of revenues are derived from the states, while in the latter about 81 per cent of revenues are internally generated, with local taxation claiming about 55 per cent and nontax revenues about 27 per cent in 1976-77 (Table 4.4). By 1986-87 the dependence of urban local govern ments on external assistance had increased from 19 per cent to 23 per cent. This was related to the declining share of nontax revenues trend which is likely to continue. On the other hand, substantial reduction of external dependence in the revenue structure of rural governments must await radical restructuring of their tax compe tence, mainly through the assignment of land revenues. Until this happens, rural local government will not develop its own personality, while urban local governments will continue to be marginalised in generally unified Soviet-type fiscal arrangement.

A state-wise breakdown of local government revenues indicates that three states (Maharashtra, Gujarat, and West Bengal) account for about two-thirds of rural government revenue, while among urban authorities the situation is more variegated, with only one state (Maharashtra) claiming disproportionate share of 39 per cent (Table 4.5). This is mainly due to the importance of octroi in internal reve nue (Maharashtra and Uttar Pradesh) and larger external assistance (Maharashtra, Madhya Pradesh, and West Bengal). In Madhya Pradesh the urban authorities claim more external assistance (43 per cent) due to their share of compensation for the state entry tax. Maharashtra's dominant reliance on internal revenue for both tax and nontax sources (86 per cent both rural and urban) also is striking. The internal revenue mobilization picture of local authorities is diverse: among rural governments the best performers are Kerala and Uttar Pradesh (61 per cent each), followed by Himachal Pradesh (53 per cent), while among urban governments the highest ratings belong to Haiyana (99 per cent), Karnataka (95 per cent), and Punjab (92 percent). The worst states in terms of rural government revenue mobilization are West Bengal and Orissa (3 per cent each), followed by Bihar (8 per cent); in urban government the worst state is again Bihar (less than 40 per cent), while others are way above (Table 4.5).

Per-capita revenues of the various tiers of rural government and types of urban government show their relative fiscal resilience: the village and area authorities are more effective in rural government, while the municipal corporations and councils are effective in urban government. The town and notified authorities are a shade better than the village councils in terms of revenue performance (Table 4.6). On an overall basis, there seems to be a need to enhance minimum revenues of rural authorities substantially (at least five-fold), while the urban authorities need minimum of half of this level of reve nues. This would imply increased tax devolution to the rural authori ties and increased assistance for the urban authorities (Table 4.7). A detailed look at the revenue competence of rural authorities shows the need for strengthening their compulsory taxation capabilities through assignment of land revenue and devolution of land cess (Table 4.8).

Local government tax powers include 27 state taxes for rural governments (20 exclusive and 7 concurrent) and 20 state taxes for urban governments (9 exclusive and 11 concurrent), as detailed in Table 4.9. Only minor state taxes have been allocated to rural governments, while urban governments have access to 9 major taxes (including the central terminal tax). Only two taxes, octroi (exclusive) and property taxes (concurrent) account for about 90 per cent of municipal tax revenues -- 70 per cent under octroi and 20% under property taxes (NIUA, 1989).

Apart from limited tax powers, urban local governments are experiencing increasing state intrusions into their tax domains, covering virtually all the important taxes devolved to them. Earlier, under the Government of India Act, 1919, there was a separate "local tax list" for exclusive utilization by local governments; this was abolished with the introduction of provincial autonomy under the Government of India Act, 1935, reaffirmed in the Constitution of 1951. Various commissions and committees have suggested revival of the local tax list through a consensus or under a constitutional amendment. Under the 1989 bills this is left to the judgment of the mandatoiy state finance commission for each state.

The productivity of local taxes is low. In rural governments, this is partly due to the absence of a compulsory list of taxes and a prescribed minimum rate of levy; in urban governments, there is reluctance to levy high rates of compulsory direct taxes (property and service taxes). The tax collection performance of local governments is also low (around 30 per cent for rural governments and 50 per cent for urban governments). In the non-octroi states in the eastern and north-eastern areas, the tax collection performance of the urban governments is relatively unsatisfactory (NIUA, 1989). The remedy seems to lie in variety of directions. On the internal side, innovative management and a system of incentives and penalties are important (Delhi Municipal Corporation achieved a 96 per cent improvement in 1986/87); on the external side, local tax performance could be included as a factor in determining the level of general or incentive grants to local government (as in Gujarat).

Considering the small share of local taxes in the total taxes levied in India (5 per cent), it is unlikely that greater utilization of these taxes would materially affect total tax incidence. In any case, the per capita tax incidence of octroi is negligible and the incidence of property tax may be mildly progressive (NCAER, 1980). The buoyancy of local taxes also compares well with similar state and central taxes.

Among possible tax-related reforms, there is a case for imposition of poll tax to defray the cost of providing a package of local commu nity services that emphasizes local voter-accountability. Such a tax has replaced domestic rating in the UK and is being levied in Nigeria and Papua-New Guinea. In the Indian context, a poll tax would have considerable merit in the PRIs and in the smaller MAs where either the land rate or the property tax is difficult to operate. Its extension to larger MAs would, however, be difficult in the absence of requisite information on assessable adults "resident" in a local area. This is apart from the requirement of large exemptions to unemployables and acceptance of the tax in cash or in labour. Once poll tax succeeds in the smaller MAs, its extension to the larger MAs could be considered to partly relieve the burden of property tax.

The local taxes on professions, trades, callings and employment are being increasingly taken over by the states, and, in spite of the recent increase in their taxable limit to Rs. 2,500 from the earlier Rs. 250, they are rarely utilized to their full potential. There is a need to raise the taxable limit of the professions tax to the full extent of income exempted from income-tax (now Rs. 18,000) and utilise this as a lower level income-tax (LLIT), as is done in many countries in southern Africa. Municipal corporations at least should be allowed to use the professions tax as an assigned tax, leaving the rest for sharing with other local authorities on derivative principles. This would widen the local tax base and the own income of the local authorities in a situation when the other two major local taxes (octroi and property tax) are faltering.

The issue of abolition of local octroi came up almost simultaneously with the introduction of local government in the country. During the colonial era the central government pressed for its abolition, while the provincial governments steadily extended its scope (Tinker, 1967). The debate continued after independence, and a few state governments are now actively considering its abolition, mainly due to the pressure of the transport lobby. Octroi was replaced by state wide entiy tax in Madhya Pradesh (1977) and Karnataka (1979); by a terminal toll in Jammu & Kashmir (1990); and by a surcharge on the state sales tax in Uttar Pradesh (1991). Abolition of octroi has been advocated because of several problems associated with it: (1) hindrance to trade, (2) corruption at the checkposts, (3) high cost of collection, and (4) wastage of time and fuel. The present emphasis is on: (1) the adverse effect of local trade barriers on the national economy and (2) avoidance of the cascading effect of the tax due to its coverage of raw materials and intermediate goods. Despite these shortcomings, octroi continues to be levied in 8 out of the 25 states in the countiy (Table 4.10). It is interesting to note that while some of the major octroi-states are now thinking of its abolition (Gujarat, Maharashtra and Rajasthan), some other non-octroi states have either opted for it (Manipur, Meghalaya, and Orissa), or imposed trans-local octroi or entiy tax to mobilize additional local revenue (West Bengal and Assam).

The experience with the working of the state gentry tax in Madhya Pradesh shows several shortcomings, including (1) its limited nature, (2) its coverage of intermediate goods, (3) its partial revenue retention by the state, the compensation being based on a fixed percentage of revenue growth, (4) its adverse effect on the liquidity of local finances, and (5) its erosion of local fiscal autonomy. The other two basic objections against the entiy tax are that (1) it is of doubtful constitutional validity, since octroi is a local tax whereas entiy tax is not, and (2) the replacement of check-post collection by return-based collection does not remove the adverse economic consequences of internal trade restrictions. Substitution of octroi by terminal toll is a retrograde step since the latter is imposed not only on goods but also on passengers carried by road. A surcharge on sales tax makes the impost too heavy on the existing dutiable goods already subjected to the state sales tax. 

Replacement of octroi by a new tax is contingent on the following condit^ns: (1) the replacement should be return-based, (2) it should be revenue neutral, (3) it should not be more regressive, (4) it should ensure free flow of internal trade, and (5) it should be a local levy. So far the search for a viable local tax substitute for octroi has proved elusive, as all of the possible alternatives -- with the exception of a business property tax -- entail overlapping tax jurisdictions (Nath and Sen, 1989). The business property tax cannot be counted upon due to the lack of evidence of market value for property use or transfer. A local surcharge on sales tax could be allowed to the metropolitan cities, unless terminal taxes are imposed therein; for the other local authorities, a state surcharge seems to be a practical replacement. Both these may eventually entail the transformation of state indirect taxes into a retail value-added tax, shared between the states and a local governments under a fixed formula, as in France.  

Overall Situation

The surplus syndrome in local government budgets is a familiar phenomenon (Table 4.4), despite the veiy low physical level of various local services. Partly it is a legal fiction, since local authorities are required to present a surplus budget to meet contingent liabilities and actual shortfalls in revenues. However, there is evidence that these surpluses could be quite large, and there is no discernible cycle of their accumulation and utilization. The reasons could be that (1) local revenue expenditures are pegged at a lower level due to uncertainties in external assistance and (2) there is a desire on the part of urban authorities to finance part of their capital expenditure from revenue surpluses (Datta, 1990a).

Financing of local government services is linked with the issue of a normative level of local expenditures. Attempts have been made to define such norms for urban services in terms of assumed physical standards by a committee of state ministers headed by Rafiq Zakaria (India, 1963b), although local resource availability (both internal and external) and shifts in local expenditure priorities (toward personal rather than property-related services) would make nonsense of such assumed standards. On the basis of Zakaria norms, the MAs would require at least Rs.5,363 million of grants annually during 1990-91 to 1994-95 on the assumptions of constant (1986-87) prices, stable population growth (1971-81 rate), and municipal fiscal stability (at 1986-87 levels). This requirement may increase or decrease depending on the choice of methods adopted to bridge municipal fiscal gaps (NIUA, 1989). No such commitment to underwrite municipal fiscal gaps has been made by the states.