Financial Challenges Facing Municipalities and Solutions from State Finance Commissions

Walk through almost any Indian city and you will notice the same pattern: overflowing drains during monsoon, potholed lanes that never quite get fixed, irregular water supply, and piles of uncollected garbage in the corners. Behind these everyday civic frustrations lies a quieter, more structural problem: our municipalities are broke. Despite being handed the responsibility of running our fastest-growing urban spaces, most Urban Local Bodies (ULBs) simply don’t have the money to do the job. This is where the State Finance Commission (SFC) is meant to step in, study the mess, and recommend a way out.

Why municipal finances matter more than ever 🔗

Cities are the engines of the economy, but they are running on fumes. Intergovernmental transfers to urban local bodies in India stand at roughly 0.5% of GDP, compared to 2-5% in many other developing countries. When you add the fact that after the rollout of the Goods and Services Tax, the tax revenue of ULBs (excluding property tax) shrank sharply, the picture becomes grim. A well-functioning municipal system is not a luxury; it decides whether a child gets clean drinking water, whether a street vendor has a functioning market, and whether an ambulance can reach a home in time. When money is short, every one of these services suffers.

The big financial problems municipalities face 🔗

The financial troubles of municipalities are not random. They follow a predictable pattern that the 74th Constitutional Amendment Act of 1992 tried – but largely failed – to fix. Let’s break down the core issues.

Revenue-expenditure imbalance 🔗

The single biggest problem is that what municipalities are expected to spend is far greater than what they earn. The 74th Amendment listed 18 functions in the Twelfth Schedule that states could devolve to ULBs – from urban planning and water supply to slum improvement and public health. But as a detailed assessment of municipal finance in India points out, less than half of these 18 functions have a corresponding financing source, creating a built-in vertical imbalance that is much larger in India than in most other countries. Municipalities are, in effect, asked to cook a feast with the budget for a snack.

Over-dependence on higher levels of government 🔗

Because own revenues are so thin, municipalities have to keep going back to the state and central government with a begging bowl. In terms of fiscal autonomy, Indian ULBs are among the weakest local governments anywhere in the world, with states controlling their powers to levy taxes, set rates, grant exemptions, borrow, and even decide the timing of transfers. The problem is not just financial; it is political. A mayor who cannot control her own budget cannot truly be held accountable for city services. And dependence breeds delay – grants often arrive late, or with strings attached that reduce flexibility.

Inadequate tax base and the property tax puzzle 🔗

After GST absorbed several local levies like octroi and entry tax, the municipal tax basket shrank dramatically. Property tax is now effectively the only major local tax left – and it is not performing well. Property tax revenue in India is roughly 0.2% of GDP, compared with 3-4% in countries like Canada and the United States. The reasons are depressingly familiar: outdated property registers, widespread undervaluation, generous exemptions, and poor collection machinery.

A recent analysis of Bengaluru’s BBMP suggests it may have only around 20 lakh properties on its tax rolls against an estimated 42 lakh total – a coverage ratio close to 49%. Even where properties are listed, collection efficiency has been falling; Ghaziabad’s collection rate reportedly dropped from 60% to 50% between 2015-16 and 2022-23. Smaller municipalities are worse off: they lack the staff, the technology, and often the political will to update tax rolls regularly.

Poor resource mobilisation from non-tax sources 🔗

Beyond taxes, ULBs can charge user fees for water, sanitation, parking, advertising rights, trade licences and rent from municipal assets. In practice, these charges are either too low to cover costs or too poorly collected to matter. Water tariffs rarely reflect the actual cost of supply; parking fees in most small towns are negligible; municipal land is often under-utilised or leased on outdated rates. The result is that a valuable portfolio of public assets sits there, producing very little revenue.

Parallel agencies that drain authority 🔗

Walk into any Indian city and you will find that water supply is handled by one parastatal, slum development by another, urban planning by a third – often with the ULB reduced to a bystander. The 13th Finance Commission observed that parallel agencies and bodies are weakening local governments both financially and operationally. When functions are fragmented, revenue streams are fragmented too, and the municipality ends up with the leftover responsibilities that nobody else wants – usually the most politically sensitive and financially unrewarding ones.

What State Finance Commissions are supposed to do 🔗

This is where the SFC enters the picture. SFCs are constitutional bodies established under Article 243-I, and the Governor is required to constitute one within a year of the 73rd Amendment coming into force and every five years thereafter. Their job is straightforward in theory: examine the financial position of panchayats and municipalities, and recommend how taxes, duties, tolls, fees and grants-in-aid should be shared between the state and its local bodies.

Chronic delays in constituting SFCs 🔗

Unfortunately, many states treat this constitutional mandate casually. A 2023 report tabled in Parliament noted that out of 26 states for which data was available, only nine had constituted their 6th State Finance Commission, and of those, only two were actually active. Some states are still operating under recommendations of their second or third SFC, which is the fiscal equivalent of using a city map from two decades ago.

Implementation is the bigger problem 🔗

Even when SFCs are set up and submit detailed recommendations, states often cherry-pick what they like and ignore the rest. Property tax contributes around 60% of municipal tax revenue, and yet states rarely implement SFC recommendations on new local taxes, fees, or penalties. The cycle repeats: a commission studies the problem, writes a report, and the report quietly gathers dust while cities keep drowning in their own sewage.

The Punjab experience: a case in point 🔗

Punjab offers a useful example of both the problems and the attempts at reform. The First Punjab Finance Commission, constituted in April 1994 for the period 1996-97 to 2000-01, identified the problems that panchayats and municipalities faced in generating adequate funds, and recommended augmenting resources through user charges for the services they provided and through the proper levy and collection of taxes under their purview. It also urged that octroi exemptions by the state be stopped – a politically difficult ask.

The Second Punjab SFC went further, pushing for tax restructuring, better tax administration and steps to plug evasion. But the story did not end happily. The recommendations of the first two Punjab State Finance Commissions remained largely unimplemented, particularly on imposition of local taxes and better fiscal management by PRIs and ULBs. The Punjab case demonstrates a pattern that repeats across states: sensible recommendations on financial discipline, new revenue-generating projects, and tighter control over expenditure get diluted once political costs show up.

Why Punjab’s problem is also a structural problem 🔗

Punjab’s fiscal stress is not limited to its municipalities; it is a state-wide crisis. The 16th Finance Commission’s decision to discontinue the Revenue Deficit Grant for Punjab is expected to cost the state around Rs 4,800 crore annually, or roughly Rs 24,000 crore over the five-year award period. When a state itself is drowning in debt and committed expenditure on salaries, pensions and subsidies, the natural casualty is what it transfers down to its municipalities. Urban local bodies are almost always last in the queue.

Solutions that SFCs typically recommend 🔗

Across states, the solutions suggested by State Finance Commissions follow a broadly similar script, because the problems are similar. Here are the main threads.

Broadening the tax base and rationalising rates 🔗

SFCs routinely recommend that ULBs be allowed to tap a wider set of revenues – taxes on vacant land, advertisement tax, entertainment tax, professional tax, and stronger user charges. Reforms generally need to update property tax laws, remove ineffective exemptions, complete property registers, adopt more effective valuation approaches, and strengthen tax administration – with a model municipal act to help build a more robust property tax system.

Technology-led tax administration 🔗

A recurring solution is the use of GIS mapping, digitised property registers and online payments. Pune’s GIS mapping exercise reportedly pushed its property roll growth from around 2% per year to 7% per year in 2016-17, and its amnesty scheme enabled nearly 1.2 lakh owners to clear dues, mobilising about Rs 225 crore. The Fifteenth Finance Commission went a step further by linking urban grants to property tax reforms and floor rates.

Better fiscal management and financial discipline 🔗

SFCs emphasise that more money without better management is a recipe for waste. Recommendations typically include time-bound budgeting, independent audits, computerised accounting, publication of performance indicators, and the creation of municipal cadres trained to handle finance and planning. The Punjab SFCs particularly stressed financial discipline and the launch of new revenue-generating projects as the route to stable municipal finances and sustainable growth.

New revenue-generating projects and innovative financing 🔗

Beyond traditional taxes, cities can raise money through municipal bonds, land value capture, public-private partnerships for parking, waste-to-energy projects, and commercial use of surplus municipal land. A handful of corporations – Pune, Ahmedabad, Hyderabad, Indore, Lucknow – have successfully issued municipal bonds, but the base remains narrow. SFCs often nudge states to build ULB capacity so that these instruments become usable by more than just a few big cities.

Empowering ULBs through legislative reform 🔗

Real change requires states to loosen their grip. States should set up SFCs regularly and accept their recommendations on time, empower ULBs through state municipal acts to introduce new taxes, fees and penalties, train elected representatives and permanent staff for financial responsibilities, and eventually allow ULBs to carry out all 18 functions listed in the 74th Amendment. Without this, every other reform remains cosmetic.

The road ahead 🔗

India is urbanising at breathtaking speed, and the cities of 2040 are being built – or failed – by the municipal budgets of today. The 16th Finance Commission, the SFCs of different states, researchers and civic groups are all converging on the same diagnosis: municipalities are under-funded, under-empowered and over-burdened. The cure requires a mix of bolder revenue mobilisation, stricter financial discipline, technology-led tax administration, and a genuine political decision to treat ULBs as governments rather than as glorified departments of the state. Until that happens, municipal finance will remain what it is today – a slow-motion fiscal crisis hiding behind every pothole and every overflowing drain.

What do you think? Should your municipality be given greater freedom to levy and set its own taxes, even if it means higher bills for property owners and users of civic services? And if State Finance Commission recommendations are so routinely ignored, what would actually make states take them seriously?

References

1. https://www.sanskritiias.com/current-affairs/16th-finance-commission-and-the-financial-position-of-urban-local-bodies
2. https://www.researchgate.net/publication/23777672_Municipal_Finance_in_IndiaAn_Assessment
3. https://accountabilityindia.in/blog/urbanisation-in-india-urban-local-bodies/
4. https://www.ideasforindia.in/topics/governance/tapping-the-revenue-potential-of-property-tax-in-india.html
5. https://thedailybrief.zerodha.com/p/behind-indias-poor-property-tax-collection
6. https://www.drishtiias.com/daily-updates/daily-news-analysis/state-finance-commission-2
7. https://india.mongabay.com/2023/03/state-finance-commissions-in-poor-shape/
8. https://competitiveness.in/state-of-municipal-finances/
9. https://nipfp.org.in/media/documents/wp05_nipfp_026.pdf
10. https://www.rozanaspokesman.com/news/punjab/020226/punjabs-fiscal-crisis-how-16th-finance-commission-recommendations.html
11. https://documents1.worldbank.org/curated/en/852151587668989296/pdf/Property-Taxation-in-India-Issues-Impacting-Revenue-Performance-and-Suggestions-for-Reform.pdf
12. https://cwas.org.in/resources/file_manager/Strengthening%20Municipal%20Property%20Tax.pdf