16th Finance Commission: Urban Local Bodies, Fiscal Transfers and Own Source Revenue

The 16th Finance Commission recommends that cities strengthen own-source revenues and broaden the tax base, as transfers to urban local bodies remain relatively limited.

• India’s urban population crossed 470 million around 2020 and is projected to approach or exceed 600 million during the 2026-30 FC cycle. 
• A sum of ₹10,000 crore is kept for the one-time incentive for peri-urban merger of urban villages with a population of more than one lakh.

About Tied Grants

• Tied grants for cities refer to funds earmarked for specific sectors such as water supply, sanitation, and wastewater management, etc. 
  • Tied grants hamper fiscal autonomy because States  and cities  are required to spend the funds only on these specified categories. 

Approach of the Sixteenth Finance Commission of India

• The Sixteenth Finance Commission of India has adopted a more stringent framework, leaving less flexibility for cities. 
  • Apart from tied grants, it has introduced performance-based grants, which will be released only when specific governance and fiscal conditions are met.

• Key Performance Conditions: Cities must meet several institutional and financial benchmarks, including:
  • Improving fiscal discipline in urban finances.
  • Regular constitution of local bodies through elections.
  • Publishing provisional and audited accounts in the public domain.
  • Constituting State Finance Commissions (SFCs) to strengthen fiscal federalism.
• Conditional Allocation of Funds: About 20% of the total grants are linked to additional conditions. If cities fail to meet these requirements, they will not receive this portion of funds, further tightening fiscal space
• Emphasis on Own Source Revenue (OSR): A major condition is increasing Own Source Revenue (OSR) through property taxes and user charges. 
  • The Finance Commission has set a benchmark of raising around ₹1,200 per household annually from such sources, pushing cities to strengthen their local revenue mobilisation capacity.
• Merger of peri-urban villages: The Sixteenth Finance Commission of India has proposed ₹10,000 crore as a one-time incentive to encourage the merger of peri-urban villages (population above one lakh) with urban areas. 

Challanges

• Declining Real Per Capita Transfers: India’s urban population crossed 470 million around 2020 and is projected to approach or exceed 600 million during the 2026-30 FC cycle. 
  • When urban grants are distributed across this expanded demographic base, per capita transfers stagnate and may even decline in real terms.
• Pending utilization of Funds: Under the 15th FC, total grants to local bodies amounted to around ₹4.36 lakh crore. 
  • Yet a substantial portion remained unspent or pending utilisation, estimated at roughly ₹90,000-95,000 crore, including about ₹30,000-35,000 crore meant for urban local bodies.
• Challenge in Defining ‘Urban’ Population: Another challenge is defining the ‘urban’, as different data sources project India’s urban population to reach around 41% by 2031, implying that per capita fiscal devolution to cities may not increase significantly despite higher allocations.
• Neglecting Climate Change: The 16th FC also remains largely silent on climate change and pays little attention to the growing pool of cess revenues collected by the Centre and kept outside the divisible pool.

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Way Forward

• Strengthen Own Source Revenue (OSR): Urban local bodies must expand their revenue base through improved property tax administration, rational user charges, and better tax collection systems.
• Promote Planned Urban Expansion: The proposed merger of peri-urban villages with cities should be accompanied by integrated urban planning, infrastructure development, and institutional restructuring.
• Integrate Climate Resilience in Urban Financing: Future fiscal frameworks should incorporate climate adaptation and urban resilience funding.

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