Revenue and Taxation Reforms- New paradigms for Local governments

Mohanish Verma, Former PCCIT- IRS

The importance of local governments and municipal bodies particularly in developing economies is increasingly being recognized with rising aspirations of citizens. The nature of social and economic activity has also undergone a huge change in the past few years. The importance of reforms for tax and revenue sources by local governments like municipal bodies, counties and cantons has become critical also in the context of addressing focused sectors which have been emerging in recent years, to also consider issues of green taxation and to capture the prosperous activities which will remain out of the existing tax regimes if not fairly analyzed.

Rethinking on existing legislations and designs, implementing mechanisms and proactive engagement by the stakeholders will provide better results. Fair taxes and objectivity in functioning of local bodies is being recognized across the globe. Such reforms will cater to local aspirations and also strongly support the priorities of sustainability in the medium and long run. These financial tools like taxation, fees, user charges, levies can be used for generating superior local resources and also act as policy tools for promoting activities for social purposes like employment, reducing poverty, using green technology etc. at local level, much more effectively.

Own Source Revenue (OSR) Components in LSGs

In most developed and developing economies, property tax remains amongst the most important source of local revenues for the Urban Local Bodies (ULBs). In developed nations like in US and EU, they are designed and implemented in a more efficient manner and help in taxation with equity. They are strongly supported with legislation, data and technology. Significant scope exists for increasing revenues from property taxes, especially in developing countries. Total property taxes in Sub-Saharan Africa and Emerging Asia barely raised 0.1 percent of GDP in 2021, versus an average of 1 percent in Europe, 3 percent for the US, and 1.4 percent in the OECD[1]. Expanding coverage, better data management, improving tax administration will facilitate efficiency in property tax collections. In India property taxes contributed to 60 percent of own tax revenues of local bodies in 2023-24 as per RBI Report. The other important sources of local tax revenue have been local business and trade licenses, parking charges, lease rents, waste collection, other permits and license fees and local advertisement charges.

Other taxes have also been defended at the local level particularly in European economies, even though they are generally less effective at satisfying the criteria for a good local tax. These include an income tax on individuals, some type of consumption based tax that could include a general sales tax, a hotel and motel occupancy tax, an automobile fuel tax, and a local automobile registration tax. The only local tax currently used, by itself, in place of the property tax is a local income tax[2].

Global Trends

Considering the general principles of fair taxation the sensitive expectation of tax reciprocity by the tax payer attaches increased importance to local taxes and revenue levies. Closer visibility to outcomes and access to tax collectors in proximity are factors catering to increased awareness at the local level. As per UNDP, the crucial recommendations of the Council of Europe on local taxes are very important for decentralization and local financial autonomy because (a) Higher local taxes will increase the autonomy of local authorities.(b)  Strengthening of the local tax capacity will improve the allocative efficiency.(c )Emphasis on local tax will make the local politicians more accountable for their decisions.(d)  Local taxation as a municipal income source may strengthen local democracy.(e)  Local government own taxes tend to make local governments more responsive to citizens needs and preferences, thus improving resource allocation, and they tend to improve budget management efficiency as citizens became directly aware of the costs of publicly funded activities.

Own taxes of the local bodies also promote democratic accountability, since those who benefit from public services decide on taxation levels and finally pay the bill[3].

While the most important role in raising resources lies with the Federal Governments in most countries, it is worth considering and providing a more important role to the local governments, Municipalities, Counties, Panchayats for enhancing their coffers with better localized version of taxation suiting their characteristics and generating greater acceptability. Own source revenue[4] (OSR) has been identified as a significant part of funds for local governments. They have been considered to be highly efficient in terms of their identity with local residents. Local accountability and its role in the democratic process have been recognized.

International Growth Centre, London, (2016) has also emphasized^[5] that a. Sub-national governments need to generate more revenue at the local level. b. Sub-national governments must be in charge of their budgets and c. Sub-national governments need strong support to raise and impose taxation in an independent manner.

Global thinking clearly has recognized the role of strengthening the financial potential of local bodies and governments and in most economies including India the legislative framework is also already in existence.

Indian Context.

Municipal Corporation Act, 1959 and Municipality Act, 1916 empowers ULBs in the State to tap various sources of own revenue (CAG Report 2022). CAG and RBI have been regularly emphasizing the potential as well as the crucial need for local governments like Urban Local Bodies as well as Panchayats and others to improve their capabilities to raise own revenues. Keeping in view, both the legislative powers available and also huge possibilities to improve capacities and efficiencies at the local level, it is imperative for most emerging economies like India to tap this area and raise resources with better designing and analysis as well as improving administrative efficiency of local governments.

As per RBI Report on Municipal Finances, 2024, own tax revenue, inclusive of property tax, water tax, electricity tax, education tax, and other local taxes, constituted 30.0 per cent of total revenue during 2023-24 (BE), with significant variations across States.  The ratio was the highest in Karnataka (53.8 per cent), followed by Telangana (50.3 per cent), Tamil Nadu (44.3 per cent) and Jharkhand (44.0 per cent). Property taxes are a major source of own tax revenue of the MCs in India, constituting more than 16 per cent of revenue receipts and more than 60 per cent of their own tax revenue.

Table-6.1: Details of revenue of ULBs during the period 2015-16 to 2020-21[6] (` in crore)

Source: Information furnished by Directorate, UDD for 91 ULBs

The above data clearly indicates that the own revenue source of local bodies is extremely low and mostly below 15 percent of their total revenue. Their dependence on grants and support is much higher than desirable. Secondly the share of such revenue has remained static even in absolute terms between 120 to 135 crores. Even though this is only a limited study, it indicates lack of any innovative actions and ideas despite drastic changes in technology, economic activity and global changes around any region across the world. The overdependence on grants and financial support has kept the Urban Local bodies very weak and probably they are also suffering from poor administration and obsolete laws and regulations. There is definitely a case for deeper analysis and efforts to enhance resource generation at the local level. This will reduce the burden on hierarchy above as well as raise resources from the deserving activities and sectors.

There is scope for fresh policy thinking as well. Issue relating to taxing polluting activities, wastage of water, use of chemicals even at the local level can be much more effective. At the same time promoting other activities like green technology, green agriculture, generating employment, other socially useful activities can be designed to be implemented by the local bodies in an innovative and effective way. Generating data and capturing the statistics in every local body can have tremendous impact for fair taxation, designing effective economic and social policies and eventually integrating the overall economy of any nation.

As per RBI report (2022)[7] following observations highlight the current status of Local bodies

Urban Local Bodies (ULBs) and the Panchayati Raj Institutions (PRIs) constitute Local governments in India. Information on their fiscal position is scanty. Most municipalities in India do not have balance sheets in public domain and many of them continue to follow cash accounting system. Municipal laws do not prescribe any uniform accounting standard to be followed, rendering municipal accounts largely incomparable across States and even within a State.

It has also been specifically observed “In many countries, the decentralisation of responsibilities from the national and subnational governments to Local governments has not been accompanied by a commensurate decentralisation of financial power (Bird, 2001). In most countries, taxation power lies with upper tiers of the government, with only a few exceptions like the Nordic countries where Local governments have substantial access to large and elastic tax bases such as the income tax (Bird and Vaillancourt, 1998).”

The share of local and Municipal revenues in India have stagnated at very low levels of 1 percent of GDP over past several years which is much lower than  7.4 per cent of GDP in Brazil and 6 per cent of GDP in South Africa[8].

The issue of giving more powers and financial delegation to local bodies is a sensitive one. There are issues of political sensitivity and at the same time the challenges to ensure a the capacity to effectively and efficiently manage the local bodies minimizing conflicts and checking issues of corruption as well as transitioning to a technology and data driven transparent regime.

Some Specific Challenges for Local Bodies 

Some of the key constraints for Own Source Revenues (OSR) for local governments in various regions of the developing world are: (a) Very poor share of OSR in total revenues of the local bodies. (b) Domination of State and Federal laws without specific focus on the local factors (c) Inadequate effort for enhancing management and administration of the local bodies (d) High content of informal business activity. (e) Low fiscal discipline (f) Lower tax reciprocity perception by citizens (g) Political challenges to reform tax and OSR at local level due to resistance of citizens in proximity. (h) Dependence on few traditional heads like obsolete property taxes, rents and royalty, licenses and registration fees. (i) Poor administrative capacities and obsolete laws and regulations.

The tax gaps in local municipal bodies are potentially very high and difficult to estimate at present. Some case studies have been undertaken to provide an idea. A study of Kenya’s county governments[9]  indicates that the actual tax collection gaps are between 35 and 94 per cent for different county revenue sources (and the study suggests that improved tax administration may result in a fivefold increase in county revenues. Similarly, some assessments for the Democratic Republic of the Congo put the loss from leakages in tax collection at 55 per cent of potential budget revenue (Englebert and Mungongo, 2016)[10].

Unlocking the Indian Potential.

India is one of the most dynamic and proactive economies with drastic reforms in multiple sectors and regions. It has a large physical area and also large numbers of local government bodies including Urban Local bodies and Panchayats in the rural areas. There are total 283976 local government bodies in India out of which 4852 are Urban Local Bodies, 262996 are Rural Local Bodies and 16128 are Traditional Local Bodies[11]. By considering paradigms for local revenue and tax generation in a modest manner, it will unlock huge resources and also ensure superior policy outcomes.

Some specific steps which can boost such efforts can be initiated along following lines:

A. Developing standard models for having efficient management of these local bodies with a mix of professionals and political representatives.

B. Improving local data bases through technology for identifying economic and social activities, natural resources, skills and education available as well as infrastructure in each area.

C. Analyzing the revenue and tax generation as well as future potential and possibilities for reforms.

D. Consider the local policies in synergy with national policies relating to environment, employment, poverty reduction, by also engaging local residents and all stakeholders.

E. Develop capacity building through training and research centers and learning from each other and across the world.

F. Maintaining transparency and efficiency along with specific motivation or incentives to the employees of these local bodies.

There are possibilities to bring about reforms on a real time basis, but it is more important to have a time bound initiative. In India, the emphasis on the Panchayati Raj System has existed for some time but in recent times, more importance is being given to it. More delegation of powers by the Central and State Governments with guidance and monitoring will enhance overall outcomes by generating resources in a fair manner. There is already a positive recognition by citizens for being ready to participate by paying taxes as part of their duty. With a more transparent and efficient mechanism with local governments, India moving towards a developed nation and overall welfare of all citizens will become easier.

Planning Ahead

Local Urban and also rural government bodies in most emerging economies have not undergone much change in their structures, designs, data bases and also regulatory formats. The economic and social advancements as well as increased local aspirations of citizens calls for strongly energizing the local bodies to rise to the occasion and push reforms to tap fair sources of revenue and also design financial tools to promote or discourage various activities. Generating data and closer proximity to citizens will also ensure more accountability and transparency. The challenges for getting more powers delegated by the Central and State Governments might gradually reduce. However the real challenge will be the issue relating to effectively and efficiently manage these local bodies for which a dedicated and committed team will be essential.  Despite multiple challenges, it cannot be denied that more emphasis for resource generation as well as policy implementation at the local level will have to be considered on priority by most emerging economies including India.

( The author is a former Principal Chief Commissioner of Income Tax, Indian Revenue Service. The views are personal. He has multiple publications on topical taxation, financial and public policy issues)

Notes:-

[1] How to Design and Implement Property Tax Reforms: Martin Grote and Jean-François Wen September 2024. IMF.

[2] LOCAL TAXATION IN SELECTED COUNTRIES: A COMPARATIVE EXAMINATION1 By Harry Kitchen Department of Economics Trent University.(2004)

[3] https://www.undp.org/sites/g/files/zskgke326/files/migration/md/finante-locale-eng.pdf (Last visited 28th Jan. 2025)

[4] http://www.eficon.co.ug/, Local Government Own Source Revenue Mobilisation Strategy. Jan. 2020  (Last Visited 25/1/25.

[5] https://www.theigc.org/sites/default/files/2017/05/Gadenne-2016-Final-report.pdf (Last visited 27th Jan. 2025)

[6] https://cag.gov.in/uploads/download_audit_report/2022/10-Chapter-6-064199054cbade3.14694339.pdf (Last visited 27th Jan. 2025)

[7] https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=21360 (Last visited 27^th Jan. 2025)

[8] https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=21360 (Last visited 27^th Jan. 2025)

[9] Adam Smith International, 2018

[10]https://www.researchgate.net/publication/358643691_Building_an_Enabling_Environment_for_Local_Own_Source_Revenue_Political_Economy_Considerations.  (Last visited 27^th Jan. 2025)

[11] https://localbodydata.com/ (Last visited 29^th Jan. 2025)