No money to govern rural India

In India, gram panchayats (GPs) were given constitutional legitimacy following the passage of the 73rd Constitutional Amendment Act, which was meant to decentralise power and responsibility to them to improve local public service delivery and governance. Following this, all State governments passed their own enabling Acts, detailing the specific functions and financing powers of panchayats in their jurisdiction, apart from outlining the financing mechanisms available to them, and mandating the provision of public infrastructure services such as water supply, sanitation, housing and roads.

It is almost two decades since these Acts have come into force in all Indian States, but the promise held out by decentralisation, including financing local development efforts, remains unfulfilled.

State of Infrastructure

The state of infrastructure in India’s villages is appalling: 10 per cent of rural population has no access to drinking water; public water supply, where available, largely suffers from bacterial and chemical contamination; in 90 per cent of the villages, there are no sanitation facilities; over 50 per cent are not connected to the power grid; and the average distance to an all-weather road is 2 km. These stark statistics not only point to sharp deficiencies in rural infrastructure, but also highlight the inability of gram panchayats to deliver on their statutory duties.

Why is public service delivery by the panchayats so poor? To answer this, it is essential to analyse funding sources and financial mechanisms available to them. Their finances come from two sources: (i) funds devolved by State governments under the guidance of State Finance Commissions (SFCs), set up every five years and (ii) ‘own’ revenues generated locally from levies of house tax, professional tax and water charges.

Gram panchayats are in a sub-optimal revenue situation by being dependent on fund devolutions from higher-level governments without tapping the potential of their own revenue flows: 75-90 per cent of total revenues are from State government devolutions (grants), and only the rest is generated through local levies. This points to the need for the panchayats to boost their own revenue sources and explore other financing mechanisms rather than depend on State-devolved funds.

Two fundamental issues explain low own revenue generation by gram panchayats: (i) they are reluctant to set tax rates at levels that meaningfully reflect the cost of service provision; they set very low rates and are also reluctant to revise them periodically. Consequently, these levies generate much lower revenues than potentially possible and (ii) the collection efficiencies are substantially low.

Therefore, the panchayats are stuck in a low-level equilibrium, where revenues are compromised by low tax and fee rate regimes and under-collections. Setting reasonable tax and fee rates, improving collection efficiencies and expanding financing mechanisms are central to ensuring buoyancy of GP revenues overtime.

State governments can play a catalytic role in incentivising these outcomes. For instance, SFCs can recommend tax slabs (bands) for local taxes, within which each panchayat can set its rates. As each new SFC recommends tax bands, GPs will be required to calibrate their tax rates every five years. This will ensure viable tax rate regimes with periodic resets. Further, state governments can insist that citizens produce tax and fee payment receipts for the last three years to access state-level schemes. This will not only incentivise citizens to pay local levies, it will also ensure that they demand more accountability from GPs.

Accessing Commercial Debt

While many State government Acts empower GPs to access loans for public infrastructure and service delivery, GPs have not borrowed from financial institutions. Access to debt capital markets can be a valuable source of financing for GPs, providing them the scope for planned infrastructure development.

In the absence of debt, GPs are forced to use current revenues for current needs and unable to plan effectively for the long-term. Incorporating debt in funding mix enables GPs to plan for long-term needs, borrow upfront to invest for these planned needs and repay overtime on the basis of a predictable, regular revenue stream.

The inability of GPs to ensure predictable, regular stream of revenues prevents financial institutions from providing debt finance to them. Unless this fundamental credit risk issue is resolved by GPs, debt financing will remain unviable, irrespective of state governments allowing them debt access.

Apart from enhancing own revenue generation capabilities, GPs need to substantially improve their overall administrative and technical capacities to access debt, particularly long-term bonds. They will require credit rating, which has to be high investment-grade to access low-cost funds from bond issues. Ratings are determined by the quality of administration — skilled manpower, use of appropriate technology, robust processes and quality of financial management.

Considering current GP capacities, considerable improvements are required on these fronts before bond access for rural infrastructure becomes a reality. The government can play an enabling role by developing bond-bank type structures that enable pooling of projects from multiple GPs and issue bonds backed by the cash flows of these projects.

Another mechanism that can be used to finance rural infrastructure is Special Purpose Vehicles (SPVs) created by local communities. If there is an infrastructure need and the community is willing to pay for it, then the community can form an SPV that can be used to float tenders for the requisite project(s) and route funds. Overall, if the core issue of local revenue generation is addressed, a number of financing mechanisms for rural infrastructure development become feasible.

This article first appeared in The Hindu Business Line.