Finance Commission Grants to Urban Local Bodies

Context

• Cities generate 90% of total government revenue and nearly 67% of India’s GDP, yet Urban Local Bodies (ULBs) receive disproportionately limited fiscal devolution from Finance Commissions.
• The 16th Finance Commission allocated ₹3.56 lakh crore to ULBs for 2026-31, but structural limitations continue to constrain genuine urban fiscal autonomy.

Issues with Finance Commission Grants

• 15th FC urban grants: ₹1.2-1.3 lakh crore over five years, which is approximately 0.12-0.13% of GDP (when India’s GDP hovered around ₹200-210 lakh crore).
• 16th FC urban grants: ₹3.56 lakh crore (₹75,000 crore per year), yet India’s projected GDP of ₹400 lakh crore means the ratio remains virtually unchanged at 0.13% of GDP.
• Urban population crossed 470 million in 2020 and is projected to approach 600 million during 2026-31, meaning per capita transfers stagnate or even decline in real terms.
• Under the 15th FC, ₹90,000-95,000 crore of total local body grants remained unspent, including ₹30,000-35,000 crore meant specifically for ULBs thus raising serious absorption capacity concerns.
• Problem of Tied Grants
  • Tied grants earmark funds for specific sectors i.e. water supply, sanitation, and wastewater management, thus severely restricting cities’ fiscal autonomy and planning flexibility.
  • The 16th FC approach is even more restrictive, introducing performance-based grant conditions that withhold funds until specific criteria are met.
  • Performance conditions include improving fiscal discipline, conducting regular local body elections, publishing audited accounts publicly, and constituting State Finance Commissions.
  • Critically, 20% of funds are linked to additional conditions, thus primarily raising Own Source Revenue (OSR) of ₹1,200 per household through property taxes and user charges, failing which cities lose that share entirely.

Federal Concerns

• ₹10,000 crore kept as one-time incentive for peri-urban merger of urban villages with population exceeding one lakh thus raising serious federal concerns.
• Urban development is constitutionally a State subject under the 12th Schedule; Central incentives inducing administrative mergers represent dangerous federal overreach.
• In states like Kerala, where rural local governments function robustly, merging rural areas into urban agglomerations risks creating administrative and civic complications.
• Merging peripheries of only 10% of urban towns may translate into lopsided urban integration driven primarily by revenue generation objectives rather than genuine development needs.
• Critical Gaps in the 16th FC Approach
  • 16th FC remains largely silent on climate change, a growing urban governance challenge requiring dedicated financial attention.
  • Cess revenues collected by the Centre amount to approximately 2.2% of GDP thus roughly ₹8.8 lakh crore, yet remain entirely outside the divisible pool.
  • Much of this cess revenue is generated from cities themselves, yet does not appear in OSR calculations, thus creating a fundamental fiscal asymmetry.
  • Cities are being asked to increase their own revenues while the Centre retains large cess collections generated primarily from urban economic activity.

Way Forward

• Include cess and surcharge revenues in the divisible pool to correct the structural fiscal asymmetry between the Centre and urban bodies.
• Increase urban grants to at least 1% of GDP to match the scale of urban population growth and infrastructure demands.
• Reduce the tied grant proportion and expand untied funds, allowing cities to plan expenditure based on locally identified priorities.
• Strengthen State Finance Commissions and ensure the timely constitution and implementation of their recommendations for genuine fiscal federalism.
• Adopt a “cities plan their own futures” framework where the Centre acts as an enabler rather than a conditioner of urban fiscal decisions.