By Anand Sahasranaman & Vishnu Prasad, IFMR Finance Foundation

A version of this article was first published in the September 2014 edition of the monthly journal Yojana. This post first appeared on IFMR blog.

Municipal finances in India are characterised by the constant tension between the funds and functions of local governments. Cities in India have insufficient revenue tools to meet their expenditure requirements. While the 74th Constitutional Amendment Act (CAA) devolved a great deal of functional autonomy to local governments, a commensurate devolution of financial autonomy was absent. Out of the 18 functions to be performed by municipal bodies under the 74th CAA, less than half have a corresponding financing source. Furthermore, most local governments cannot set tax rates or change the bases of collection without the explicit concurrence of state governments. However, not all problems of municipal financing in India are attributable to the upper tiers of governments. Local governments have failed to utilize adequately even those tax and fee powers that they have been vested with, in particular by failing to put forth an adequate collection effort. The very low levels of own revenue generation in Indian cities have, thus, precluded them from providing even the most basic public services to their citizens.

While the thrust of urban policy in India has been on the metropolitan centres, the current state of public infrastructure and service delivery in India’s small and medium cities is, if anything, even more alarming than that in the larger ones. The central question that therefore confronts us, in the context of cities both big and small, is this: How can cities sustainably finance the development of public infrastructure to ensure service delivery that conforms to the laid-out benchmarks for all citizens in the next fifteen years? This article argues that in order to meet this challenge, Indian cities will need to increasingly generate higher levels of own source revenue and efficiently use market based financing mechanisms to ensure minimum levels of service delivery.

To read the full article please click here.

This post first appeared on IFMR Blog.

The investment requirement of urban infrastructure over the next 20 years is estimated by the Isher Ahluwalia Committee to be in the region of Rs. 40 lakh crore. The issue of how this investment will be financed is central to the provision of urban services. Any discussion of the financing options available to a municipality will have to begin with an understanding of the finances that it generates internally since , at a fundamental level, the internal revenue generation of a municipality is a reflection of the quality of its governance, and the transparency and accountability of its administration.

Internal revenue sources like the property tax and user charges are, perhaps, the most critical funding levers available to a municipality because without effective, predictable generation of internal revenues, it will be a tremendous challenge to attract new, external sources of funding. External sources, whether in the form of bank loans, bonds or other capital market instruments, will be available to municipalities only on the basis of the internal revenues they generate now and are expected to generate in the future. There is also a corresponding need to create a stable and predictable flow of grant funding to cities from upper tiers of government. In the absence of such sustainable financing models for municipal infrastructure, the agenda for inclusive, equitable cities in India could be seriously jeopardised.

In the below talk, delivered at the Conference on Financing Metropolitan Governments in Developing Countries, ICRIER, Anand Sahasranaman of IFMR Finance Foundation highlights the need to understand how the various levers of funding available to cities can be fully leveraged in the task of infrastructure provision and service delivery.

Watch the video below:

By Anand Sahasranaman, IFMR Finance Foundation

The recently released volume on urbanisation titled “Urbanisation in India” edited by Dr. Isher Ahluwalia, Dr. Ravi Kanbur and Dr. P. K. Mohanty, contains a chapter authored by Vikram Kapur, Commissioner of Chennai, and me, dealing with the practice of Public Private Partnerships (PPPs) in urban infrastructure in India. In this paper, we undertake an assessment of private participation in the provision of public infrastructure and services – participation in the form of financing as well as in developing, managing and operating public services. This post provides a synopsis of the chapter.

The environment for urban infrastructure provision has undergone a sea change in the last two decades. Prior to 1991, the government (along with government-linked institutions such as para-statals and public sector institutions under direction from the government) was the financier, developer and operator of all urban infrastructure and services. While this created some much needed infrastructure in cities, the absence of accountability in this top-down, centralised approach led to the development of infrastructure of poor quality, without concern for the needs of citizens.

However, since 1991 there has been a substantial re-think on the mechanisms for the development and financing of urban infrastructure. The passage of the 74th constitutional amendment gave statutory basis for ULBs and placed the third tier of government in India on a firm pedestal. All states created enabling legislation to transfer responsibilities of local infrastructure and service delivery to this tier of government. This development was followed by the emergence of new models of financing, developing and operating public services in India.

In view of the high deficits of central and state governments, new mechanisms to leverage private capital were required. The emergence of municipal and pooled bond markets have provided municipalities, large and small, with avenues to access private commercial funding to finance public infrastructure. While these markets have seen some hiccups, they have the potential to provide access to substantial financing for urban infrastructure. However, the policy environment must actively support the deployment of debt capital for public infrastructure creation. In this context, the flagship JNNURM program must incentivise the leverage of government grants with funds raised from the capital markets, as well as other reforms that deepen private sector participation in urban infrastructure and services. Additionally, the role of HUDCO must be revamped and it must refocus on its core mission of enabling financial resources generation for urban development. Instead of acting as a subsidised lender, HUDCO could become a market maker through the provision of guarantees and investing in subordinate tranches of municipal bonds or directly providing subordinate debt to projects to supplement private capital.

There has also been a sea change in the philosophy of models of public service delivery and consequently the role of the private sector in the development, management and operation of public assets. While the private sector has been recognised as being able to bring in management and technical capabilities as well as increased efficiencies, the historical experience of PPPs in India has been decidedly mixed. India has seen success in projects that are technically simple with small gestation periods; and with lesser uncertainties in demand estimation. Projects with greater management and technical complexity, long gestation periods and difficulties in estimating demand have faced problems. However, there is some evidence that newer projects are absorbing the learning’s from earlier failures and structuring risks in a way that reduce the probability of disruptions due to unexpected events in the course of a project’s life. Over the past decade there has also been increasing policy focus on PPPs with the Ministry of Finance’s model laws and guidelines, setting up of state PPP cells and legislation by some states to enable PPPs. While these are important measures, they will need to be supported by fundamental reforms in governance, institutional structures, laws and regulation to create an environment that is conducive for the creation of critical public infrastructure through the design and implementation of complex PPPs in India.

To read the full paper please click here.

By Vishnu Prasad, IFMR Finance Foundation

According to the 2011 Population Census data, urban India grew by 90 million people in the previous decade. During this period, 2774 new towns were born with over 90% of the new towns belonging to the category of census towns. Census towns are defined¹ as places that satisfy the following three criteria:

1. a minimum population of 5,000
2. at least 75% of the male main working population engaged in non-agricultural pursuits, and
3. a density of population of at least 400 per sq. km.

An estimated one-third of these new towns are located in close proximity to India’s large cities (in a 50 km neighbourhood of million-plus cities). These suburbs occupying just 1% of India’s land area provide about 18% of the country’s employment. These statistics provide staggering evidence of India’s rapid suburbanization in the previous decade. Places situated on the edge of India’s cities like Sriperambudur near Chennai, Noida and Gurgaon near Delhi, and Raigarh near Mumbai have witnessed rapid growth.

A World Bank report titled ‘Urbanization beyond Municipal Boundaries’ investigates the cause of this phenomenon characterising India’s urbanisation. The report presents evidence of the stagnation of India’s metropolitan cores. As the figure below shows, the metropolitan cores² of India’s seven largest cities³ saw a decline in employment over 1998-2005 while the peripheral towns and villages witnessed rapid growth in high-technology manufacturing, real estate and other manufacturing sectors. While suburbanisation is a common phenomenon in most urbanising countries, what makes India’s predicament particularly worrying is that it is occurring at a relatively early stage of India’s urban development.

The report outlines two fundamental causes for this development:

1. Weak institutional foundations for land valuation and transactions

The report argues that “India lacks many of the necessary institutions, such as a transparent system to convert land use, a clear definition of property rights, a robust system of land and property valuation, and a strong judicial system for addressing public concerns to facilitate land markets, land transactions, and land use changes.” For example, India does not have a robust system to independently and reliably arrive at land valuations. Historically high stamp duties have created incentives to under-report the value of land and property.

Rapid urbanisation in recent years has created increased pressure on land in urban cores and combined with a weak institutional framework governing the valuation, transaction and acquisition of land, this has resulted in a distortion of the pace and shape of urban expansion.

2. Stringent regulation on land use

Indian cities have placed stringent caps on the density of cities through low FSI (Floor Space Index) regulations. The report argues that such regulations drive urban expansion towards the periphery of existing urban areas and encourages sprawl. For example, it is estimated that “FSI-induced sprawl” in Bangalore creates welfare losses of 2-4 per cent through increased commuting costs. Further, Indian cities impose blanket FSI norms across the city as opposed to international practices in cities like New York, Singapore that favour granularity or local variation in FSI norms.

The suburbanisation of Indian cities is creating new challenges for Indian cities. The report notes two challenges in particular:

1. Wide spatial disparity in access to basic services

The report reveals that there are wide core-periphery differentials in accessing services. For example, in India’s seven largest cities, 93% of households living in core metropolitan areas have access to drainage. This proportion falls to 70% at a distance of 5km from the core. In cities like Bangalore, other utilities like access to piped water are largely concentrated in the urban core.

2. Transportation and movement of freight

Rapid growth of individual modes of transport, low ridership of public transport services, high costs of public transport (refer figure below) and slow commuting speeds have combined to create an exigent transportation challenge in Indian cities. Further, there is evidence that businesses located in peripheries are finding it increasingly difficult to access local and regional markets. Freight rates between metropolitan cores and peripheries in India are Rs. 5.2 per ton-km, twice the national average and five times the cost in United States.

Urban Reform

The report outlines three priority areas that warrant immediate attention. First, there is an urgent need to reform the land valuation process in India. As the report argues, “land valuation is an integral part of land transactions and local revenue generation, because land values form the basis of property taxes, land sales, and leases.” We have written previously on the importance of land as a tool for urban infrastructure financing. India requires robust institutional mechanism to govern land use conversion and land valuation. Second, the efforts to leverage the potential of land markets as a financing tool needs to be complemented by an integrated urban planning process. The report notes how cities like Sao Paulo have used FSI limits as an effective urban planning/density management and infrastructure financing mechanism (For a detailed look at how Latin American cities have effectively used land as a tool for financing and urban planning, see our post here). Indian cities also need to improve connectivity between metropolitan cores and peripheries to ensure ease of mobility for individuals and business. Third and perhaps most importantly, India needs to resolve the question of who is responsible for urban planning and reforms in a federal system where the multiple jurisdictions of national, state and urban local bodies overlap. As noted previously in this blog, the lack of financial autonomy of India’s ULBs, and their over-reliance on upper tiers of governments are stifling our cities from unlocking their true potential.

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By Anand Sahasranaman, IFMR Finance Foundation

Given the magnitude of investments¹ and expertise needed for sustainable development of urban infrastructure in India, it is essential that there be substantial private sector involvement. This post explores how there has been a greater thrust towards private funding models post-1990 and what how policy can incentivize cities to move further in this direction.

Evolution of urban infrastructure financing in India

Prior to 1990, urban infrastructure in Indian cities was financed largely through government grants and Plan funds of central and state governments. Decisions on local infrastructure investments were made by state and central governments. Because of the disconnect between local needs and infrastructure plans drawn up at higher levels of government, these infrastructure investments made were without any clear understanding of local demand. In the absence of inputs on both the nature and extent of local demands, the infrastructure that was built ended up being inadequate, of poor quality and often unrelated to people’s needs.

In addition to these direct government levers of grants and Plan funds, cities were also allowed to access debt from the Housing and Urban Development Corporation (HUDCO), which was directed by the central government to lend to cities². These borrowings from HUDCO were guaranteed by state governments, thereby de-risking the investment for HUDCO by ensuring that the lender was exposed to the state government’s risk and not the particular project’s risk. By design, such an arrangement ensured that the credit discipline that is associated with prudent, commercial lending programs was missing here. The incentives of the lender were completely skewed by disconnecting the lending from the project risk, and the incentive of the city to structure a viable project was also skewed by the knowledge that the ultimate risk of default lay with the state government. This financing structure fundamentally lent itself to the design of sub-optimal, unsustainable projects.

It is interesting to note that most countries, including the now developed ones, started subsidised lending to municipalities through specialized Municipal Banks or Municipal Development Funds. In Europe, specialised municipal banks were set up to provide capital and, in addition, a range of services to complement their lending, such as assistance in preparation of municipal budgets, designing and appraising investment projects, and even managing the municipalities’ financial accounts. The support services and subsidized credit provision were important in the early years of the municipalities’ tryst with credit markets and were made possible because of central government policies of subsidising municipal banks by giving them preferential access to low-cost, long-term savings or to accord them partial protection from competition. This ensured that once the state directed low cost funding taps dried up, these municipalities had the requisite capacity to approach the debt markets on their own. Unfortunately in India, while HUDCO has performed the job of providing subsidised debt to municipalities, it has not directed attention to developing municipal capacities for the long-term, thereby only spawning a culture of dependence and lack of accountability.

Post-1990, there has been a greater thrust towards exploring alternative funding models for urban infrastructure. The impetus for this came from three sources:

• Passage of the 74th constitutional amendment has given constitutional status to urban local bodies (ULBs) and has devolved funds, functions and functionaries to the ULB level
• Economic liberalisation and increased competition has forced more efficient allocation of capital by financial institutions and therefore a move away from inefficient financing mechanisms
• State government finances have been under pressure and they have been unable to continue with a programme for subsidising municipal debt

Analysing the municipal financing environment in India, it is apparent that the last 15 years have seen a substantial evolution from a grant and soft-loan based infrastructure creation program to increasing usage of market based mechanisms that bring in private capital. In our earlier posts, we have discussed how cities like Ahmedabad and Bangalore have accessed municipal bonds. Smaller municipalities, especially in Tamil Nadu and Karnataka have accessed capital markets through the issue of pooled bonds. Since 1997, 25 municipal bond issues have taken place in India, which have included taxable and tax-free bonds and pooled financing issues, mobilizing funds to the tune of nearly Rs. 1, 400 crore³.

Despite these developments, the critical lever for accessing private debt finance, the city’s internal revenue generation- especially through property tax and user charges- remains under-utilised. The Thirteenth Finance Commission estimates that property taxes collected constitute between 0.16% and 0.24% of the GDP, while revenues generated from user charges are also abysmally low in India, at 0.13% of the GDP⁴. To add to this gloomy picture, states in India have also slacked in terms of setting up State Finance Commissions, accepting their recommendations and implementing the same. The quantum and predictability of inter-governmental transfers are crucial in maintaining the stability of a city’s finances and thus, ensuring access to debt markets.

Way Forward

A major hurdle in the development of the municipal bond market is that the policy environment is currently dis-incentivising the use of market mechanisms to raise financing for public projects. One of the criticisms of the JNNURM has been that despite the large quantum of funds it is directing into urban infrastructure, very little, if any, of it has been used to leverage commercial capital. This has sparked concerns regarding the ‘crowding out’ of bond markets by government funds. Cognisant of the reality of the Indian scenario, where central and state governments run huge deficits and capital is very scarce, it is essential that all efforts to promote infrastructure development and service delivery need to incorporate mechanisms to leverage scarce grant funds with debt from the capital markets. Therefore, while all the JNNURM funds may not be suitable for leverage, a substantial portion must certainly be leveraged with commercial debt capital, as this will allow sparse central and state government funds to be spread efficiently across many more critical projects.

A related issue is the need for market makers of municipal debt, with HUDCO being a case in point. Set up to finance housing and infrastructure, HUDCO has shifted its focus to financing larger power and gas projects. As the HPEC (2011) Ahluwalia Committee report points out, its financing for urban infrastructure (to the extent that it does) is subsidised by its profitable lending to larger infrastructure projects. The focus of HUDCO needs to be re-oriented towards urban infrastructure financing, but away from being a subsidised lender. HUDCO could become a market-making institution for municipal debt, thus helping catalyse the municipal debt market. On this role, HUDCO could perform the role of a credit enhancer by activities such as providing guarantees or investing in lower rated tranches of municipal issues so as to enable commercial market investors to participate in low-risk, highly rated municipal investments. The essence of HUDCO’s market making nature should be determined by its arm’s length distance from the municipalities it works with, i.e. the provision of guarantees must be based on HUDCO’s own assessment of the credit risk associated with the municipalities, backed up by a credit rating. HUDCO can thus, one the one hand, expose the municipalities’ true creditworthiness to the market, providing for transparency and incentivising municipalities to address their governance and service delivery issues and on the other hand, help attract commercial funds into investing in credit enhanced municipal debt. This will be critical in view of the extent of investments required for urban public infrastructure development in India.
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By Vishnu Prasad, IFMR Finance Foundation

In a recent report titled “Implementing Value Capture in Latin America- Policies and Tools for Urban Development“, Martim O Smolka of the Lincoln Institute of Land Policy discusses a wide suite of land financing instruments that have been used in Latin America. The report focuses on instruments of value capture, which are based on the principle of recovery by the public of land value increments (unearned income) created by actions other than the landowner’s direct investments. Although all such increments constitute unearned income, value capture instruments focus primarily on the increment created by public investments and administrative actions.

The tremendous opportunity of using value capture to fund urban infrastructure is evident from the case of Barra da Tijuca, Rio de Janeiro. Barra da Tijuca, an extension area of the city’s high income zone covering 82 km², was earmarked for development in 1967. By 1974, the creation of expensive public transit lines including an elevated expressway and direct access through tunnels led to skyrocketing land prices (the appreciation is estimated to be nearly 1900% between 1972 and 1976). However, the absence of plans to capture this appreciation in prices led to the control of 30% of the area by only three owners and presented a substantial loss to the city. The rest of the post focuses on examples of successful implementation of value capture policies from the report. The post concludes by looking at land financing tools used in India.

Betterment contributions

A betterment contribution is a charge or fee imposed on owners of selected properties to defray the cost of a public improvement or service from which they specifically benefit. As noted in the previous post, Bogota, Columbia is a prime example of a city using a system of betterment levies- almost a quarter of Bogota’s revenues consists of betterment contributions. A lesser known example is that of the municipality of Cuenca, Ecuador, which over the last decade issued 1,800 contracts for public works projects and collected close to US$200 per capita, much higher than Bogota’s US$150 in the same period. 90% of households in Cuenca made their contributions in less than four years, with 95% of the projects collecting 60% in betterment contributions.

Betterment levies are considered anti-poor by many critics, who argue that the well-serviced parts of a city are occupied by high-income residents, who were not charged when the services were provided. They advocate that it is unfair to charge people who receive these amenities later. However, evidence from Lima, Peru suggests that low-income households are often willing to pay against a guarantee of service. The city introduced a successful program featuring 30 projects that used a contributory tool to finance public works in the early 1990s. Ironically, it was the high-income households that failed to pay the contributions.

Exactions and other regulatory charges

Exactions are the most common value capture tool used in Latin America. Landowners are obliged to make cash or in-kind contributions to obtain special approvals to develop or build on their land. In-kind exactions may require the land developers to set apart some of the land for public facilities, including streets, schools, parks, or environmental conservation areas. The most common example in the region entails the land owner releasing between 15 and 35% of the area for public uses.

Gautemala uses an innovative instrument known as Impacto Vial, whereby the responsibility for road improvements is shifted to private developers. When a large private development project requests for a license, the municipality undertakes a road traffic study to gauge its impact on the community. An infrastructure plan is then designed to mitigate any negative impacts, together with a calculation of the share of the cost the developer should cover. The work is then executed by the developer under municipal supervision. If the cost of the work is higher than the developer’s estimated share, the value of the license is used to make up for the difference

Building Rights

This instrument of land financing is predicated on the separation of building rights from land ownership rights, which allows the public to recover the land value increment resulting from development rights over and above an established baseline. For instance, building rights in Brazil (known as Outorga Onerosa do Direito de Construir, OODC) is based on a basic FAR cap on the landowner’s building rights. The landowner is charged a fee for the right to build above this basic FAR on her land. Between 2002 and 2004, the city of Sao Paulo reduced FAR coefficients in most parts of the city to 1 and in 2012; the city generated about US$ 175 million in OODC payments. OODC payments are deposited in the Urban Development Fund (FUNDURB), which implements special plans and projects in urban and environmental areas. Projects created using OODC payments include bus terminals, transportation corridors, parks and green areas, slum regularization, historical preservation, and drainage.

Given the numerous difficulties in valuing a change in building rights, cities in Brazil estimate the willingness to pay of developers under market conditions by issuing Certificates of Additional Potential Construction Bonds (CEPACs). The idea is that new development potential, such as for different types of uses and additional buildings, created by rezoning and public investments in a well-defined area should not be available for free, but auctioned to developers interested in taking advantage of the economic benefits resulting from the public interventions. Municipalities in Brazil issue CEPAC bonds corresponding to specific building rights for purchase by competing developers through public electronic auctions. The total number of CEPACS issued is a function of the total additional development that an area can support. Between 2004 and 2010, Sao Paulo sold close to 640,000 CEPACS valued at around US$720 million.

Privatizing Public Land for Redevelopment

In 1989, the city of Buenos Aires proposed to redevelop 160 acres of the old port area of Puerto Madero. A corporation was created to spearhead the project with a mandate to promote economic growth and job recovery in the area. Over the last 2 decades, about 1.5 million m2 of floor space has been developed in this area. The state contributed the port land, which generated more than US$2.26 billion in private investments. By 2011 the corporation sold around US$230 million worth of land and the proceeds have funded public works worth US$113 million. Till date, the project has contributed 4 major waterways covering 39 hectares and 28 hectares of green space for the city, making Puerto Madero a leading tourist destination of Buenos Aires.

Use of land financing instruments in India¹

Development impact fee is a onetime fee imposed by ULBs on new developments to fund a portion of the cost of infrastructure facilities necessitated by that development. In India, development charges are usually based upon the area of the land and the buildings, rather than on the actual demand for infrastructure generated by a new development. For instance, under the Karnataka Town and Country Planning Act of 1961, charges development fees that range from Rs. 20 to Rs. 75 per square metre of land area, and Rs. 2 to Rs.10 per square metre of building area. The state government is now in the process of revising the fee to 18 per cent and shifting the basis for charging the fees from area to value.

Lease or sale of landholdings is a common tool used by ULBs in India. For instance, the Mumbai Metropolitan Regional Development Authority (MMRDA) has garnered substantial funds by selling land in the Bandra Kurla Complex. The funds are being used to finance infrastructure investments in other parts of the city. MMRDA has also used the sale of additional FSI to raise funds. A major owner of land in India is the Ministry of Defence which is estimated to hold close to 2 lakh acres of cantonment land. Cantonments were initially set up outside city limits, but as cities expanded over the years, they have come within urban agglomeration. If cantonments can be resettled to outside the city area, large parcels of land would be freed, helping bring down the escalating prices of real estate in urban areas.

Land Pooling and Readjustment (LPR) is a process whereby a local government consolidates small parcels of land, without paying compensation to the land owners and undertakes collective planning of their land. The authority designs and sub-divides the consolidated lands for urban use and retains a portion of this land for creation of public infrastructure like roads, parks, gardens etc. Some portion of this land is then set aside for public sale to ensure the recovery of development costs and the remaining land is returned to the original owners. The owners gain from the increase in the overall value of their land. In India, cities in Gujarat are using these instruments (called Town Planning schemes) for city expansion. For instance, Surat and Ahmedabad have completed more than 100 such schemes each. In Surat, these schemes have covered 137 sq. km and appropriated 32 sq. km of that for public use. Surat has additionally constructed 617 km of roads and 10,000 houses for the poor.

Despite examples of use of land based financing tools listed above, Indian cities are yet to unlock the full potential of these instruments for financing infrastructure. Indian cities can learn from the experiences of their Latin American counterparts to better prepare our cities for the future.

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1 – The section is based on Report on Indian Urban Infrastructure and Services (2011)

By Aditi Balachander and Anand Sahasranaman, IFMR Finance Foundation

At a fundamental level, it can be argued that internal revenue sources are the most critical funding levers available to a municipality because without effective, predictable generation of internal revenues, it will be impossible to attract new, external sources of funding. External sources, whether in the form of bank loans, bonds or other capital market instruments, will be available to municipalities only on the basis of the internal revenues they generate now and are expected to generate in the future. Additionally, the internal revenue generation of a municipality is but a reflection of the quality of its governance, and the transparency and accountability of its administration. Any assessment of the internal financing capability of a municipality is, therefore, a judgment on its governance standards. A better governed municipality implies better information availability, better assessment capability and better collection efficiencies that are then reflected in the quantum of revenues generated through internal funding levers. Therefore, any attempt to substantially improve the infrastructure provision scenario in India will need to begin by giving a significant thrust to improving the assessment, enforcement and collection of internal revenue levers.

While the generation of internal revenue is critical for a city, the use of land as a source of financing urban infrastructure can be a very useful supplementary mechanism. Traditionally, urban infrastructure has been financed by savings of local government, grants from higher levels of government and capital borrowings. However, at a time when government budgets are hard pressed and large-scale borrowings are hard to come by, land-based financing presents an important option for local infrastructure finance. By leveraging the sensitivity of land values to urban economic growth and the principle that benefits of infrastructure are capitalized into land values, land-based financing instruments have come to play a key role in complementing other sources of capital finance.

Land-based financing introduces significant advantages to infrastructure financing decisions, reducing dependence on debt and its associated fiscal risks. It has the advantage of generating revenues upfront, sometimes before the infrastructure is undertaken, making it easier to finance infrastructure projects that call for massive investments. The scale of land-based financing is also much larger in magnitude when compared to other sources of urban capital finance. Further, mobilizing finance from land transactions strengthens efficiency of urban land markets and rationalizes the pattern of urban development by sending out price signals to the market.

While land-based financing holds the potential for closing the infrastructure financing gap and supporting the sustainable development of cities, its role is restricted as an instrument of capital finance. It is not a permanent and recurring source of revenue as land sales cannot continue indefinitely. Thus, revenues from land financing should ideally not be used to finance operating expenses and must be directed only to the capital budget. Further, we need to keep in mind that the volatility inherent in land markets could simply reflect an asset bubble and world-wide economic conditions. Thus, extrapolating past trends to prepare future investment plans could be risky. Also, the magnitude of revenues raised from land financing breeds the risks of favoritism, corruption and abuse of government power if land-based transactions lack transparency and accountability.

Land financing has been widely used to finance urban transportation projects or the infrastructure required to service new urban developments. It has been less frequently employed to finance investment in existing basic infrastructure services such as repair or upgrading of water supply, waste-water collection, or solid waste removal. The fact that water supply and other basic services agencies do not own excess land that can be sold or developed explains the lack of land-based financing in these areas. A possible solution would be to establish a consolidated capital budget that could automatically allocate part of the land finance proceeds for the delivery of basic services. Also, when governments are responsible for providing the entire range of infrastructure services, employing land financing to pay for particular investment projects frees up funds for investment in basic services. This calls for special measures to be taken to make land-based financing support investment in existing infrastructure services.

Categorising land-based financing instruments

Land-based financing instruments can be broadly classified under three categories: developer exactions (including impact fees), value capture (betterment levies, land sales) and land asset management (including private investment in public infrastructure). The following table discusses the working of land financing instruments and recounts select cases of their employment.

By Vishnu Prasad, IFMR Finance Foundation

Continuing our focus on Municipal Finance, we look at the financial statements of Srirangapatna TMC in Karnataka in this post. We are currently working with the town of Srirangapatna as a part of IFMR Finance Foundation’s Financial Access for Small Cities initiative. In this post, we examine the town’s finances over the past ten years and find similarities to national trends.

The financial books of Srirangapatna Town Municipal Council (TMC) comprise three accounts- revenue receipts/payments, capital receipts/payments and extra-ordinary receipts/payments. Table 1 presents an overview of heads that are classified under each account.

The key findings from our analysis are summarized below²:

i. Dramatic Increase in Total Income and Expenditure: The finances of Srirangapatna TMC have witnessed dramatic growth over the past decade. For instance, total Income has increased from Rs. 4.22 million in FY 2000-01 to Rs. 141 million in FY 2010-11 (see Figure 1). The city ran a surplus budget for most of the previous decade, except FYs 2007-08 and 2009-10 when the city ran a deficit budget³. This seems to be part of a wider trend in Karnataka, where 90% of the TMCs have surplus budgets⁴.

The last FY (2010-11) saw a large increase in both total Income and total expenditure; total Income doubled over the previous FY. This large spike is explained by two items in the city’s accounts. First, the city’s capital receipts account shows a deferred income of Rs, 39.5 million received under the head of public works. Second, the city received a development grant of Rs. 33.3 million under extra-ordinary receipts.

On average, the city’s income has exceeded its expenditure by a factor of 1.23. According to the Third Karnataka State Finance Commission (SFC), on average a TMC’s income exceeds its expenditure by a factor of 1.78. (For a deeper analysis of Kanataka’s third SFC, refer to our blog post on Funds devolution from state governments to ULBs)

ii. Increasing share of devolved revenue: Table 2 shows how the share of own and devolved revenue has changed over the past five years. In FY 2010-11, devolved revenue formed 74% of total revenue. The table shows that the proportion of devolved revenue saw a rapid increase in FY 2006-07; it rose from 35% in FY 2005-06 to 70% in FY 2006-07. This rise can be attributed to an untied SFC grant of Rs. 10 million that the TMC received in FY 2006-07.

Since 2006-07, the TMC has received an average of Rs. 15.61 million as untied SFC grants each year, which explains the increasing share of devolved revenue. This is similar to the trend seen across smaller ULBs in Karnataka. For instance, on average devolved revenue forms 71% of a TMC’s total income in Karnataka. This trend is also seen nationally where the share of own revenue in the income of ULBs has declined from 63.48% in 2002-03 to 54.94% in 2007-08⁵. (For a detailed discussion on national level trends, refer to our blog post on Municipal Finance-Funds)

iii. Declining revenue from property tax: Table 3 shows the mean composition of own revenue over the past five years. Property Tax, Water Charges and Fees collected form 76% of own revenue. As the third SFC notes, property taxes form the largest source of own revenue for TMCs in Karnataka, forming 12% of total revenue (as of 2007). However, over the past five years, the share of property taxes in Srirangapatna’s total revenue has reduced to 7.5% in 2010-11 from 11% in 2005-06. The own revenue of the city is heavily reliant of a variety of fees that are collected; in 2010-11 total fees collected formed a third of own revenue.

iv. Administrative expenses forms 35% of total expenditure: Administrative expenses make up a large portion of the TMC’s total expenditure. Salaries, Allowances and collection of taxes form 41.69% of total expenditure of TMCs in Karnataka. This true of larger ULBs as well, for instance, Mohanty (2007)⁶ finds that establishment and administrative expenditure make up 36% of total expenditure in a study of 35 Municipal Corporations.

Public work expenses form about 41% (see Table 4) and hence, the largest expenditure item for the TMC. Public works comprises work undertaken on roads, pavements, footpaths, drains and street lights. Although their mean shares are small, expenditure on sanitation, water supply and urban poverty alleviation have increased. For instance, the TMC spent 17%, 16% and 10% of the total budget on sanitation, water supply and urban poverty alleviation respectively in 2010-11.

v. Sound fiscal health and High level of under-spending: The TMC seems to have been in sound fiscal health over the past decade. Even in years where the city’s budget ran a deficit, it had closing balances of Rs. 27.14 million (2007-08) and Rs. 44.17 million (2009-10). In FY 2010-11, the city had a surplus of Rs. 49.1 million, resulting in a closing balance of about Rs. 95.73 million.

As we found in our State of Srirangapatna report 2012⁷, the city has many areas of opportunity that require spending from the TMC. For instance, the city has a serious sanitation issue- 39% of the households surveyed reported that they defecated in the open. 50% cited the lack of availability of public toilets as the reason for defecating in the open. As Table 4 shows, the city spends only 7.5% of its budget on sanitation and solid waste management combined.

This reflects a broader trend that is seen across ULBs in India. For example, Mohanty (2007) finds that municipal corporations in India are characterized by sound fiscal health and high levels of under-spending. The study finds that the level of under-spending on core services (as compared to the norms set by the Zakaria Committee) is 76%. Heavy dependence on upper tier of government (as seen by the over-whelming share of devolved revenue) and inability to raise revenues on their own hamper delivery of basic services.

Note: Budget Statements of the last three years are available on the TMC’s official website: http://www.srirangapatnatown.gov.in/
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1. Total fees comprises fees charged under the head of planning and regulation; these include building regulation fees, town planning fees, jatra/urs fees, development charges, parking fees and fees collected from grounds rented out for civic purposes
2. Data for FY 2008-09 is missing from the analysis
3. The city had a deficit of Rs. 3.14 lacs in 2007-08 and Rs. 25.09 lacs in 2009-10.
4. Source: Report of the Third State Finance Commission, Government of Karnataka. Available at: http://www.finance.kar.nic.in/others/TSFC%20Report-English-Full.pdf
5. Report of the Thirteenth Finance Commission (2010-2015). Finance Commission, India. December 2009
6. Mohanty, P.K et al. Municipal Finance in India: An Assessment. Development Research Group, Reserve Bank of India. December 2007
7. A summary is available here: http://financingcities.ifmr.co.in/SOS_Summary.pdf

By Vishnu Prasad, IFMR Finance Foundation

As a part of our series on Municipal Finance, we present a summary of Anand Sahasranaman’s paper on Pragmatic Municipal Finance Reforms in India, published in the November 2012 edition of Environment and Urbanisation Asia. The paper draws out the lessons that the South African and Brazilian experiences in property tax reform, institutional reform for effective service delivery, market making institutions for municipal debt and participatory budgeting hold for India. A working paper version may be accessed here.

South African Policy and relevance for India

In South Africa, the Municipal Systems Act (2000) requires each local government to prepare a holistic development plan, which is a long term (8-10 year) plan for provision of social and infrastructure services to the municipality. Financial planning forms a critical part of this plan as the municipality’s proposed infrastructure program must be supported by a sustainable financing structure. The Act also envisages the participation of the community as an equal partner in local government by requiring participatory and transparent budget practices, participatory decision making in pursuing municipal service partnerships and a public process of policy development in setting municipal tax rates and tariffs. In this section, we look at relevant features of South African policy.

1. Property Tax reform

Property taxes and user charges form the bulk of a municipality’s own sources of revenue and understanding the significance of uniform property taxes policy, South Africa passed the Municipal Property Rates Act in 2004. The act allows municipalities to set their own tax rates and requires them to conduct an annual review of the rates. The act specifies that valuations of property must be based on market value and done once every five years. As a note of caution, the act also mentions ‘constitutionally impermissible rates’, which it defines as rates that would unduly bias national economic policies, and free national movement of capital labour, goods and services

2. Definition of Minimum Service Levels

Under the Free Basic Services policy, water supply, electricity, sanitation and waste removal services of a stipulated minimum quality and quantity are to be provided by local governments to all households free of cost. A minimum level of service is also explicitly defined. For example, it is stipulated that each household should have access to 50 kwH of electricity per month, which is the amount of energy necessary for a month of basic lighting, small black and white TV, small radio, basic ironing and basic water boiling through an electric kettle

3. Corporatisation for efficient service delivery

Corporatisation refers to the separation of service delivery from policy and regulation, with the objective of providing for greater accountability and countering overt political interference in the day-to-day provision of services. It allows the municipality to set policy and service standards and hold the entity accountable for meeting these standards. It also offers greater autonomy and flexibility to the management of the corporatized entity to introduce commercial management practices.

Johannesburg Water (JW) was formed in 2002 as a corporate entity, wholly owned by the City of Johannesburg, and was mandated the responsibility of providing water and sanitation to the three million residents of the City of Johannesburg. In the subsequent years, JW introduced a slew of projects including repairing and upgrading water networks, installing prepaid meters to ensure more efficient use of water and carrying out capital works. The important thing to note is that JW has been able to provide affordable, clean water to Johannesburg while remaining a financially sustainable entity.

4. Creating a market maker for debt capital access

Activity in the South African municipal debt market ceased after the government stopped providing guarantees. Currently, the Municipal Finance Management Act (2003) shapes and directs the basis for municipal borrowing. There are two important players in the municipal debt market: Development Bank of Southern Africa (DBSA) which has moved away from being a lender to the larger municipalities to supporting market development through lending to smaller municipalities and introducing new financial instruments (such as partial credit guarantees); and the Infrastructure Finance Corporation (INCA), a private sector player, which has become a source of funding to many municipalities by swapping the municipal investment portfolios of insurance companies and pension funds for INCA bonds

5. Incentivising cities to compete on service provision

Once the minimum service levels have been met by cities, they must be incentivised to provide higher level services, while not compromising on fiscal discipline. One such incentive for performance can be competition between cities on better quality and level of services through an annual benchmarking exercise, where the service provision status of different cities is compared. In South Africa, this has resulted in a situation where cities such as Johannesburg and Durban compete with each other to provide better services.

Brazilian Policy and Relevance for India

After the financial crisis in the early 1990’s, Brazil pushed through a process of fiscal reform, holding local governments accountable for their revenue transfers. This resulted in much better outcomes in local government service delivery, especially in education and health, where service delivery showed a marked improvement once their funding was tied to achievement of service levels. Further, the Fiscal Responsibility Law (2000) aimed at creating greater stability, sustainability and transparency in municipal financing. The important tenets of the law included limitations on payroll expenditures and ability of the central government to block automatic transfers if a state spent itself into a deficit. Relevant features of Brazilian policy are outlined below.

1. Participatory Budgets

The Participatory Budget (PB) is a process of consultation and debate between citizens, civil society groups (labour unions, community organisations), technocrats and local government officials to decide on the priorities, plans and actions that need to be undertaken by local government to improve infrastructure and service delivery. Porto Allegre was the first city in Brazil to experiment with the concept of PBs. A World Bank case study indicates that after introduction of PBs, coverage of water supply and sewerage connections went up from 75% in 1988 to 98% in 1997, number of schools quadrupled with enrolments doubling, and health and education budgets increased from 13% to 40%. Citizens are also increasingly involved in decision making, participation going up from a mere 1000 in 1990 to about 40,000 at the end of the millennium

2. Property Taxes

Property taxes and tax on services constitute the bulk of the municipality’s own source revenues, about 60% (17% of total revenues). Municipalities in Brazil use the Capital Value method to assess the value of all land and buildings in urban areas. The tax is administered by each municipality and like in South Africa, all municipalities enjoy the freedom to set the tax rate and collect the tax. Property tax rates in Brazilian municipalities vary between 0.2% and 1.5% and valuations are adjusted each year for inflation.

Recommendations for Policy Reform in India

Based on lessons from South African and Brazilian policies, the paper lays out four sets of policy reform for India.

I. Constitutional Reforms

1. Municipalities should be empowered to set tax rates and levy user charges within reasonable limits so that they can plan effectively for infrastructure service provision. However, like in the case of South African policy, there must be restrictions on misuse of these. This can be achieved by requiring the State Finance Commissions to provide the limits within which the municipality can fix tax rates and charges every 5 years.

2. A uniform Property Taxation code should mandate a move towards a uniform method of property valuation across the country. The paper suggests that an Area based system can be adopted initially across the country as this tends to be an improvement over the current ARV system in terms equity as well as an increase in the property tax base.

3. Minimum service quality and quantity levels for basic infrastructure services need to be enumerated. While the enumeration of benchmarks will be an essential step forward, we need to ensure that ULBs are appropriately incentivised to meet these targets. This can be achieved by tying the achievement of minimum service delivery targets to accessing funds from central infrastructure grant programs.

II. Innovative Service Delivery

4. As the Johannesburg Water example showed, corporatisation of water supply or electricity supply entities as service providers under the ownership of the city with a clear mandate on providing quality and affordable services, can serve large cities well. While the corporatised entity remains focused on service delivery, all equity concerns are handled by the ULB on its own balance sheet. A direct link between the service provider and citizens can be designed through the sale of a stake in the corporatised entity to citizens of the ULB.

III. Vibrant Municipal Debt Market

5. In India, HUDCO could play the role of market maker rather than subsidised lender. The municipal debt market can be expanded if HUDCO took on the role of a market development through providing financial guarantees, rather than being the sole financier backed by state government guarantees The municipal debt market can also be a source of citizen participation in governance and the demand for accountability.

IV. Citizen Participation and Activism

6. Ward Committees and Area Sabhas need to be invigorated to become vehicles of participatory democracy, as envisioned by 74th CAA. This could be achieved through choosing a few cities that have a history of citizen activism and actively pushing the formation and functioning of these committees. The positive outcomes from these initial cities could be publicised widely to incentivise other municipalities to follow suit and make participatory democracy a reality.

7. Information dissemination can be used effectively as a tool of citizen participation. When information is available publicly, citizens can hold local governments responsible for delivery of services For example, the national government in Brazil launched an anti-corruption drive in 2003 which involved the random audit of municipal government budgets by an independent public agency and releasing these results to the public. This disclosure of information led to a significant reduction the re-election rates of mayors found to be corrupt.

By Krushna Ranaware, Intern, IFMR Finance Foundation

This post follows our earlier post on US Municipal Securities Market.

The evolution of US Municipal Securities Market can be divided into three distinct phases¹–

i. 1800s-1950
ii. 1950-1975 and
iii. 1985-present.

i. 1800s-1950

The idea of using public financing for infrastructure works emerged in the early 1800s. The financing of Port of New Orleans in the 1800s was the first instance of an authority using public financing. Until then (and for a few decades after) the dominant form of financing transport, canals and railroad was corporate debt. Following this, the issuance of Erie Canal bonds issued between 1812 and 1825 were guaranteed by New York State. The Port Authority of New York and New Jersey were among the first conduit bonds issued by state for a specific public purpose which overlay multiple municipal boundaries and whose debt was paid not from taxes but from operating revenues.

As the United States moved into the new century, city governments were granted “home rule” by state legislatures. This broadened their ability to borrow and spend. This period also witnessed an expanded Federal agenda of public work programmes. Post-World War I, the rate of increase in outlays for public works by states tended to exceed the proportional expansion of tax revenues. Moreover, outlays constituted an increasing proportion of total governmental cost payments during this period. Thus, the states experienced a growing need for borrowing to finance public works. By 1925, municipal revenue bonds became an established method.

The Federal Government had a major impact on local governments accessing public financing for public works projects through its regulatory standard setting powers. For example, the Flood Control Act of 1917 and 1928 was passed to control of floods on three rivers. Local interests protected because of flood control were to contribute not less than one-half of the cost of construction. The Hill Burton Act of 1946 was designed to provide federal grants and guaranteed loans to improve the nation’s hospital system. The federal money was only provided in cases where the state and local municipality were willing and able to match the federal grant or loan, so that the federal portion only accounted for one third of the total construction or renovation cost. The Housing Act of 1946 required municipalities with populations over 50,000 to finance one-third of the cost of redevelopment activities to match the two-thirds federal share.

ii. 1950-1975

The post- World War II period saw an increase in individuals’ taxable incomes as well as an increase in average effective tax rate for insurance companies. It also saw the emergence of a range of environment protection legislations. In addition, pent-up housing demand, the changing character of transportation and a shift in structures for manufacturing facilities, all combined to produce a huge demand for additional public and private facilities. In response to that demand, the level of state and local government debt rapidly increased. So while the total outstanding debt in 1960 was only $66 billion, by 1981 the amount was over $361 billion.

This period also saw an increase in the total outstanding amount of short term borrowing. In the early 70s, the annual dollar amount of short term debts issued equalled or exceeded the amount long-term debt issued. Also, revenue bonds began to constitute over half of new issues in the late 1970s. During this period, there were four purposes for which short term borrowing was put to use:

• Over one-third was for public housing or urban renewal purposes
• Synchronizing flow of current disbursements with current tax receipts
• Reducing financing costs associated with capital projects, in order to avoid borrowing the amount required to finance an entire capital project before all of the funds are needed
• Financing expected and unexpected operating deficits.

Some of the important federal legislations in this period that influenced the kind of debt issued in this period are:

• The Veterans’ Adjustment Act of 1952 included benefits like low-cost mortgages, loans to start a business or farm, cash payments of tuition and living expenses to attend college, high school or vocational education, as well as one year of unemployment compensation for World War II veterans. They could receive state and federal benefits, the federal benefits beginning once state benefits were exhausted.
• The Air Pollution Control Act of 1955 left states principally in charge of prevention and control of air pollution at the source. Under the Clean Water Act of 1972, the Congress created a major public works financing program for municipal sewage treatment. In the initial program the federal portion of each grant was up to 75 per cent of a facility’s capital cost, with the remainder financed by the state. In subsequent amendments Congress reduced the federal proportion of the grants and in the 1987 Water Quality Act, it transitioned to a revolving loan program. The environmental legislations permitted companies to borrow through state and local agencies for pollution control purposes, allowing them to enjoy lower interest rates because of the tax exempt status of interest on state and local debt.
• The Elementary and Secondary Education Act of 1965 is one of the most far reaching federal legislation affecting education ever passed by the Congress. Under this act, federal funds would not serve as replacements for local funds but rather they would serve as ancillary resources.
• The Housing and Urban Development Act or New Communities Assistance Program of 1970 was established to guarantee bonds, debentures, and other financing of private and public community developers and to provide other development assistance through interest loans and grants, public service grants, and planning assistance.

iii. 1985-present

As of 2010-2011, the municipal securities market had close to 44,000 state and local issuers, and with a total face amount of $ 3.7 trillion. Figure 1 below shows that while the amount issued per year has not fluctuated much, the number of issues has seen great fluctuation since 1986. Each dip in the number of securities issued roughly corresponds with periods of recession in the American economy².

Figure 1 Summary of debt issued (1986-2010)

As Figure 2 shows, retail investors or individual investors have been the largest owners of municipal debt for more than the last decade and half. These investors usually buy and hold securities till the end of the maturity period. As of 2010-2011, approximately 50 per cent of the outstanding total outstanding debt was held directly by individuals and up to 25 per cent was held on behalf of individuals by mutual, money market, closed end and exchange traded funds.

Figure 2 Ownership of debt (1996-2010)

As shown in Figure 3, most of the total outstanding debt, despite many fluctuations, is issued for general purpose. General purpose debt is issued for long range capital needs issuing agencies as well as to support construction of public work facilities and their upkeep improvements especially when there is a shortfall of federal funds. General purpose is followed by education as the purpose with the second largest issue.

Figure 3 Purpose of debt as percentage of total outstanding debt (1986-2010)

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1-This analysis is incomplete due to unavailability of data for some individual years between 1959-1962, 1962-1967 and 1974-1984
2-The sudden leap in the total outstanding amount from 2004 to 2005 is a result of revision in the Federal Reserve’s figures on municipal securities and loans due to a change in data sources. New data indicate that municipal securities and loans outstanding in 2004:Q1 is $740 billion greater than previously estimated in the flow of funds accounts. The estimate of household holdings of municipal securities and loans is revised up by about $840 billion, on average, from 2004 forward.