Why Finance Commission Grants to Cities Remain Limited

The Finance Commission (FC) is a constitutional body established under Article 280 of the Indian Constitution to recommend the distribution of financial resources between the Union and the States, as well as grants-in-aid to local governments. In recent decades, Finance Commissions have increasingly recognised the importance of Urban Local Bodies (ULBs) as engines of economic growth and service delivery. Cities generate a significant share of India’s economic output—around 67% of GDP and nearly 90% of government revenue—yet they depend heavily on transfers from higher levels of government for funding infrastructure and services.

The financial data from recent Finance Commissions highlights a structural imbalance. Under the 15th Finance Commission, urban local bodies received roughly ₹1.2–1.3 lakh crore over five years. Despite the large absolute figure, this allocation represented only about 0.12–0.13% of India’s GDP. The 16th Finance Commission proposes around ₹3.56 lakh crore for urban local bodies between 2026 and 2031, translating to approximately ₹75,000 crore per year. However, as India’s GDP is projected to grow to around ₹400 lakh crore during that period, the proportion of transfers remains nearly unchanged.

Another dimension is population growth. India’s urban population was approximately 470 million in 2020 and is expected to exceed 600 million by 2030. When these funds are distributed across a rapidly growing urban population, the per capita fiscal capacity of cities does not increase significantly. In fact, in real terms, it may stagnate or decline.

This situation suggests that while Finance Commissions recognise the importance of cities, the scale of financial devolution remains limited relative to urban needs. As India continues to urbanise rapidly, strengthening the fiscal autonomy and financial capacity of ULBs will be crucial for delivering sustainable urban infrastructure and public services.

Urban fiscal autonomy refers to the ability of city governments to raise and manage their own financial resources through taxes, fees, and user charges without excessive dependence on higher levels of government. In India, most urban local bodies rely heavily on transfers from the Centre and State governments because their own source revenue (OSR) remains limited. This financial dependence constrains their ability to plan long-term infrastructure projects or respond effectively to local development needs.

One major challenge is that urban infrastructure demands are rapidly increasing due to urbanisation, population growth, and economic expansion. Cities require large investments in transport systems, water supply, sanitation, housing, waste management, and climate resilience infrastructure. If urban local bodies lack fiscal autonomy, they may struggle to mobilize resources quickly or prioritize projects based on local needs. As a result, urban governance can become inefficient and overly dependent on centralised funding schemes.

The 16th Finance Commission attempts to address this issue by encouraging cities to expand their OSR, particularly through property taxes and user charges. For instance, the Commission proposes that cities raise approximately ₹1,200 per household through such revenues. While this approach can strengthen fiscal discipline and encourage local accountability, it also presents challenges because property tax systems in many Indian cities remain underdeveloped and politically sensitive.

Therefore, improving urban fiscal autonomy requires both institutional reforms and capacity building. Cities must modernise property tax administration, improve financial transparency, and adopt innovative financing mechanisms such as municipal bonds. By strengthening their own revenue base, urban local bodies can reduce dependence on transfers and play a more proactive role in shaping India’s urban development trajectory.

Tied grants are funds provided by higher levels of government that must be spent on specific sectors or purposes, such as water supply, sanitation, or wastewater management. While such grants ensure that critical services receive adequate funding, they also limit the flexibility of local governments to allocate resources according to their own priorities. In the context of Indian cities, tied grants have become a significant component of Finance Commission transfers.

The 16th Finance Commission places even greater emphasis on conditional funding mechanisms. Apart from sector-specific tied grants, it proposes performance-based grants, where a portion of funds is released only if certain governance benchmarks are achieved. These benchmarks include improving fiscal discipline, conducting regular local body elections, publishing audited financial statements, and establishing State Finance Commissions.

While these conditions aim to improve accountability and transparency, they also create challenges for cities with limited administrative capacity. For example, if a city fails to meet performance conditions, it may lose access to a significant portion of the allocated funds. In the case of the 16th Finance Commission, around 20% of the grants are linked to additional performance conditions, meaning cities that cannot meet these requirements may face financial constraints.

The key policy challenge lies in balancing accountability with flexibility. Conditional grants can promote better governance standards, but excessive conditionality may undermine local autonomy. Therefore, policymakers must ensure that performance benchmarks are realistic and accompanied by institutional support so that urban local bodies can effectively meet these expectations.

Urban finance in India faces several structural challenges that limit the ability of cities to provide adequate infrastructure and public services. One of the most significant issues is the gap between the economic importance of cities and the financial resources available to them. Although urban areas generate the majority of national income and tax revenues, the share of fiscal transfers they receive from Finance Commissions remains relatively small compared to their development needs.

Another challenge is the low utilisation of available funds. For instance, under the 15th Finance Commission, total grants to local bodies amounted to around ₹4.36 lakh crore, yet approximately ₹90,000–95,000 crore remained unspent or pending utilisation. This indicates institutional and administrative constraints within local governments, such as weak planning capacity, delays in project approvals, and limited technical expertise.

Additionally, the growing urban population intensifies fiscal pressures. As India’s urban population expands toward 600 million, the demand for urban infrastructure will increase dramatically. However, if fiscal transfers remain constant as a share of GDP, the per capita financial resources available to cities will stagnate or decline.

Finally, the article points out the growing significance of cess revenues collected by the Union government. These revenues, amounting to about 2.2% of GDP, remain outside the divisible pool and therefore are not shared with States or local governments. Since much of this revenue originates from urban economic activity, the exclusion of cess collections from fiscal devolution raises important questions about equitable resource distribution in India’s fiscal federalism framework.

The recommendations of the 16th Finance Commission regarding urban governance raise several important questions related to India’s federal structure. According to the Constitution, urban development falls under the jurisdiction of State governments, as listed in the State List. However, certain proposals by the Commission appear to influence urban planning decisions in ways that may indirectly encroach upon State authority.

One example is the proposed financial incentive for the merger of peri-urban villages with nearby cities. The Commission has allocated around ₹10,000 crore as a one-time incentive to encourage such mergers for urban areas with populations exceeding one lakh. While this initiative may help expand municipal boundaries and improve revenue collection, critics argue that it could lead to unintended administrative and governance challenges.

For instance, in states like Kerala, rural local governments function effectively and deliver high-quality public services. Forced or financially incentivised urban expansion could disrupt existing administrative arrangements and reduce the effectiveness of rural governance structures. Furthermore, the primary motivation for such mergers may become revenue generation rather than sustainable urban planning.

From a federal perspective, this raises concerns about whether central financial incentives should influence decisions that constitutionally fall within the authority of State governments. While improving urban fiscal capacity is important, reforms must respect the principles of cooperative federalism and ensure that states retain the autonomy to determine their own urban development strategies.

Case Study Scenario: Imagine a rapidly growing metropolitan city experiencing severe infrastructure stress due to population growth and economic expansion. The city receives grants from the Finance Commission but still struggles to finance projects related to transport, sanitation, housing, and climate resilience. This situation reflects the broader challenge faced by many Indian cities where fiscal transfers alone are insufficient to meet development needs.

In such a scenario, the first policy response should focus on strengthening own source revenues. Cities can modernise property tax systems by updating property valuation methods, digitising land records, and improving tax compliance. Many global cities rely heavily on property taxation as a stable and predictable revenue source. In India, however, property taxes remain underutilised due to outdated assessment methods and weak enforcement mechanisms.

Second, cities should explore innovative financing mechanisms such as municipal bonds, land value capture financing, and public-private partnerships. For example, cities like Pune and Ahmedabad have successfully issued municipal bonds to finance infrastructure projects. These mechanisms enable cities to raise funds directly from capital markets while improving financial transparency.

Third, strengthening institutional capacity is essential. Urban local bodies must improve financial management practices, adopt transparent budgeting systems, and enhance technical expertise for project planning and implementation. When cities demonstrate strong governance and financial discipline, they are more likely to attract private investment and external financing.

Ultimately, improving urban fiscal sustainability requires a combination of enhanced local revenue generation, innovative financing tools, and institutional reforms. Such measures would empower cities to become self-reliant engines of economic growth while reducing excessive dependence on higher-level government transfers.