Essay on Tax System of Local Government (India)

The status and powers of local government in India ebbed and rose throughout the colonial period. The Government of India Act of 1919 marked the first serious devolution to the local level, with chairmen of district boards (previously provincial officials) becoming elected officials, and municipalities and district and local boards increasing the scale of their activities, though still with relatively narrow expenditure assignments.

However, local governments were reluctant to tax, or enforce collections, and revenues came primarily from provincial transfers. While municipalities used (a local entry tax on goods) and personal income taxes, rural boards depended on land revenue surcharges, supplemented by professions and vehicle taxes.

Land revenue still represented the major source of provincial revenue, and served as a substitute for an agricultural income tax.

The 1935 Act did not have much impact on local government structures. Typical local responsibilities, such as health and education, received little attention. World War II increased centralization of government, and it was only Mahatma Gandhi who continued to press for decentralization to the local government level.

Gandhi’s perspective received some acknowledgement in the Constitution’s Directive Principles, but little more until the 1980s, when a few states shifted the emphasis in formulating and implementing economic plans from bureaucratic to political control, and generally strengthened rural local government.

In 1988, a central committee recommended that Panchayati Raj bodies should be given constitutional status. In 1991, two separate constitutional amendment bills were introduced, covering panchayats and municipalities respectively. These were brought into force as the 73rd and 74th amendments to the Constitution of India in 1993.

A key change brought about by the amendments was a reduction of state government discretion concerning elections to rural local government bodies. Direct elections to local bodies must be held every five years. Hence “voice” replaces “hierarchy” as the primary accountability mechanism.

This is a positive step to the extent that it provides more refined incentives, subject to the caveat of effective monitoring and transparency being achievable. Local government reform also has changed the nature of tax and expenditure assignments to local governments, and instituted a system of formal state-local transfers modeled on the component of the existing center-state system that is governed by the Finance Commission. While there are some serious issues with the new assignments, including problems of local capacity and efficiency of raising and spending money, we focus here on the new transfer system.

One view has been that formal transfers from the center and states to local governments have the potential to accentuate fiscal deficit problems. Alternatively, a formal, rule-governed system will make existing problems more transparent. In fact, the evidence suggests that this is the case.

It is now apparent that local government finances, particularly for urban bodies, steadily worsened over the period before local government reform, under a system of hierarchical control and supposedly strict monitoring by state governments.

The new State Finance Commissions (SFCs) have struggled to formulate the principles for sharing or assigning state taxes, tolls, and fees and for making grants-in-aid. There remains considerable variation in the quality of analysis, methodologies used, and implementation of transfers across the different states.

Lack of political wills at the state level and the states’ own fiscal problems have both restricted progress in this dimension. On the other hand the current situation with respect to local governments seems no worse than the previous one of ad hoc and discretionary transfers and control of local bodies by state governments, the new constitutional structures create a space within which local governments may become effective over time.

After the May 2004 election the new government at the center proposed transferring money directly to local governments. In the past, the states have received unconditional Finance Commission transfers earmarked for local governments, but have retained control of these monies.

They have also controlled Planning Commission and central ministry conditional transfers that have ostensibly been targeted at district or block level rural government authorities. With local governments now enjoying constitutional status, the states are reluctant to permit new transfers direct to rural local governments, and they have opposed the center’s proposals, fearing that they will lead to reductions in their own transfer receipts.

One way out of this impasse may be for states to give local governments greater effective taxing powers, and to improve their collection capabilities.