Where did we go right with the grants for the cities?

Indian cities need higher amount of intergovernmental transfers in order to increase the public spending.

The year 2015 will be remembered for the launch of Smart Cities Mission, when finally the centre recognised the value of Indian cities. Along with allotting Rs. 48000 crore amongst 100 cities, Rs 50,000 crores were sanctioned for the Atal Mission for Rejuvenation and Urban Transformation of 500 cities. In addition to these conditional transfers, central government also announced unconditional Rs 100 crore transfer for the cities every year for five years. The move towards unconditional lump-sum transfers is a move in the right direction. As per public finance theory, the general lump-sum intergovernmental grant are more beneficial for assuring public services than the local revenue sources. This concept of public finance is backed by the flypaper effect.

The flypaper effect is generally know as an anomaly in the public finance theory. Bradford and Oates (1972) used the economic concepts to explain how general lump sum intergovernmental transfer should have the same effect on spending as does the increase in individual income. In other words, increase in individual income increases the taxes and thereby the spending capacity of the local authorities. Similarly, increase in intergovernmental transfers also increases the income and thereby the spending capacity of the local bodies. Hence, it is implicit that the equivalent increase in income from either of the sources would have the same impact.

However, Bradford and Oates paper was followed by various papers by economists such as, Edward Gramlich, William Stine, Shama Gamkhar and Wallace Oates used empirical evidence to disqualify the theory. The papers that followed noticed that the empirical evidence on the topic showed a higher increase in the public service provision as a result of intergovernmental transfer than by increasing income of the local authorities. Although various theoretical explanations have been given for this anomaly, a definite answer is yet to found.

One of the well know explanation for flypaper effect is fiscal illusion. The concept of fiscal illusion exists due to biases of the local population. The local population assumes that the increase in the revenue needs be used to increase investment on public services instead of reducing the tax burden. Thereby, the increase in the public finance remains in the public sector itself, or in other words, money sticks where it hits like a flypaper. This further creates the long term conditions in which any decrease in the grant leads to an increase in the local taxes.

Other theoretical explanation include deadweight loss, whereby, the high transaction cost of raising additional income depletes the net spending from the revenue earned. As per Tovmo and Falch’s (2001), the flypaper effect exists as the political leadership is weak in highly fragmented urban local level. In addition to this Baber and Sen (1986) point out that the local authorities need to appeal to both the interest groups, the ones that receive local public services and the ones that supply local resources. Therefore they seek ways to increase spending without increasing taxes. This is further explained by Brennan and Pincus (1996) where they show that a flypaper effect may arise if there are constraints on the tax mix decided at the local level. Hence, the population will be dependant on unconditional income from the central fund for additional expenses required for expanding local services.

Both Brennan and Pincus, and Tovmo and Falch have explained the significance of flypaper effect within a heterogeneous and fragmented local council in their papers. Karnik and Lalwani (2005) have further signified the existence of the flypaper effect within urban local bodies in India. Their paper also brings to lights that the urban local bodies in India reduce local expenditure in case of grant cuts. This outcome indicates that either spending by urban local governments is excessive or the revenue provided is inadequate, or both.

Therefore, keeping these explanations in mind it is imperative that the the urban local bodies in India are provided appropriate amount of intergovernmental lump sum grants. However in case of India cities, the low existent revenue amongst cities makes the reason behind the increase in public services ambiguous, as it may happen purely due to the increase in income instead of the flypaper effect.

Devika Kher is a Research Associate at Takshashila Institution. Her twitter handle is @DevikaKher.

Image source: Philip Duffy, ‘The Resilience of Local Government Budgets and the Flypaper Effect’ http://www.romeconomics.com/wp-content/uploads/2013/10/Flypaper-Effect.png?50ff81