Funds for Smaller Cities
- connect2783
- Aug 6
- 9 min read
Updated: Sep 15
Article 280 of Indian Constitution mandates the President to establish a Finance Commission (FC) every five years for advising on revenue sharing between centre, states and cities. Smaller cities under one million population rely heavily on FC grants due to limited revenue and weak infrastructure. Performance-linked funding for these cities rose from nil in earlier FCs to 60% under the XV FC. However, past FCs have not appropriately estimated the needs and capacities of smaller cities which have been a hurdle in meeting the grant entry conditions. The upcoming 16th FC offers a chance to rethink grant structures, provide context-sensitive support, and strengthen autonomy for smaller cities.
What does the Finance Commission mean to smaller cities?
Article 280 of the Constitution of India states the constitution of the Finance Commission (hereinafter FCs) and its functions. While detailed constitutional procedures and norms are laid out under Article 280, this commentary focuses on what the FC means for smaller Indian cities.
Unlike Million-plus cities (population > 1 million) who may rely on alternative revenue, smaller cities in India are significantly more dependent on FC allocations and grants. Most of the smaller cities in India have limited internal revenue and weaker infrastructure which makes them heavily dependent on the structure and conditionality of FC grants to effectively access funding.
How are smaller cities featured in the Finance Commission?
XVI FC is currently in its operational phase under the chairmanship of Dr. Arvind Panagariya, with its recommendations set to cover the period 2026-2031 and expected to be submitted by end of fiscal year 2025-26. While smaller cities haven’t explicitly featured as a category in the previous recommendations, urban systems and cities have evolved in the FC recommendations over the last two decades.
This commentary highlights how smaller cities have been represented on various FCs, and how their representation has grown over time. We focus specifically on the evolution of cities in terms of the monies that have been made available to them and what it has meant for them.
How has the representation of Smaller Cities evolved over years?
Over the three latest iterations, the representation of smaller cities in central grants has transitioned incrementally, from no structured performance‑grant model in the earlier finance commissions, to partial-performance-linked funding in the XIV FC, and finally to a 60% performance‑based grant model in the XV FC.
From limited conditionality to substantial accountability
Over the last three cycles, smaller cities have transitioned from receiving unconditional funds to being required to meet multiple performance and reform benchmarks. Currently, under XV FC, the total grants to smaller Municipal Governments (hereinafter MGs) which are below 1 million population, are divided into 40% untied (basic) grants and 60% tied (performance‑based) grants.
Categorisation of grants into broader sections
These tied funds are equally divided into two components: While 30% is earmarked for drinking water, rainwater harvesting, and water recycling services, another 30% is earmarked for sanitation and solid waste management, including achieving sanitation star ratings.
To access these grants, the cities below 1 million population must meet rigorous entry conditions such as:
Publish provisional and audited financial statements online, a baseline mandatorily tracked via central platforms.
Notify minimum floor rates for property tax, with mandatory annual revenue growth aligned to state GSDP.
Ensure State Finance Commissions (hereinafter SFCs) are constituted and their recommendations implemented by March 2024. 84% of grants are tied to this requirement.
Expansion in the Scope of Resources Available
XV FC had expanded the financial support for ULBs through larger allocations, performance-based grants, and challenge funds. It allocated around ₹1.21 lakh crore to ULBs, a significant rise from the ₹87,144 crore, i.e., 38.86% rise, given by the XIV FC. This showed the government’s stronger focus on improving urban governance and infrastructure.
The introduction of performance-based grants, especially for smaller cities, aimed to promote transparency and better financial reporting by setting clear conditions. These stricter rules encouraged ULBs to significantly improve their tax systems, leading to better property tax collection.
Also, applying the same rules across all cities made grant disbursement more predictable. It helped cities that met the conditions build credibility, making it easier for them to raise funds through municipal bonds in the future.
Performance as the “ Central Criterion”
The XV FC has fundamentally restructured how urban grants are given by making performance the main factor. For smaller cities, it introduced a more balanced model, still keeping a large share of the funding tied to performance, but not as heavily as in bigger cities. This shows a clear move towards transparent, results-based governance.
Earlier, smaller cities had very little funding linked to performance. The XV FC changed that by giving them a more structured mix of basic and performance-based grants.
Reality Check for performance conditionalities: Limited Capacity of Smaller Cities
The performance-based funding system under the XV Finance Commission posed major challenges, especially for smaller municipalities that have limited resources. This shows the need for more flexibility, fairer formulas, and clearer procedures in the upcoming XVI FC cycle.
While there’s limited data on how much conditional funding reached ULBs, state-level trends show big problems in using these funds. A study by the National Institute of Public Finance and Policy (NIPFP), found that in some areas, only about 50% of the FC grants were actually used. For example, nationally, only 44.76% of health grants under the XV FC were spent. Water-related grants did even worse, many states used just 25%, and some didn’t use any at all.
These trends could point towards the fact that smaller ULBs, which often lack enough staff or technical support, likely found it even harder to access these funds. For example, Nagpur was supposed to get ₹600.97 crore under the XV FC collectively for improving air quality, water, and sanitation. Before its municipal body was dissolved, ₹331.04 crore had already been released. But after elections were delayed and there was no elected body, Nagpur couldn’t meet key requirements, like increasing property tax collections by 15% each year. Because of this, the remaining ₹270.93 crore were not disbursed, which slowed down important local projects.
This is an example of how one ULBs received much less of the conditional grant money than they were supposed to, mainly because they couldn’t meet certain requirements (sometimes due to administrative failures as highlighted in Nagpur case), like having audited accounts, meeting service standards, or showing growth in their own income.
While this in itself is not an issue, the real problem is failing to recognize that smaller ULBs need extra support and shouldn’t be held to the same strict norms as larger or better-resourced ULBs.
Focus on Outcomes but not on the underlying Processes
The XV Finance Commission made a significant oversight when it came to sanitation. While it focused on star-ratings for sanitation performance, it didn’t give due weightage to faecal sludge and septage management (FSSM), from its performance-based grants. As a result, cities didn’t get financial incentives to build the actual systems needed to manage waste properly.
This is a major issue, especially for smaller and fast-growing cities that urgently need FSSM infrastructure. Without it, these cities can’t realistically improve their sanitation, but the Commission’s grant rules don’t encourage investment in these critical facilities.
Also, the grant conditions didn’t consider the basic safety needs of sanitation workers. Most smaller cities, including some state capitals like Bhopal, don’t provide proper personal protective equipment (PPE). Even when PPE is given, it’s often not usable, and cities don’t have enough funds to replace it.
SFC Delays
According to Article 280 of the Indian Constitution, the FCs must consider the recommendations made by SFCs while deciding grants for municipalities and panchayats.
However, many states either delay setting up SFCs or ignore their recommendations. This is partly because the central FC continue to directly allocate grants, reducing the incentive for states to empower local bodies.
Even when SFCs are formed, they often don’t have reliable data to understand and present the real needs of ULBs. SFCs face several challenges. They lack access to up-to-date, detailed financial records of ULBs. There is no standard accounting system across ULBs. Important data on services like waste, water, and transport is either missing or outdated. Additionally, real-time tracking of fund usage is poor. Lastly, they often don’t have the technical skills or resources needed to carry out thorough analysis.
This lack of reliable data makes it hard for SFCs to properly assess municipal finances. Their reports often become more opinion-based than fact-based, which weakens their recommendations and delays funding decisions.
For example, in November 2022, the Reserve Bank of India (RBI) published its first “Report on Municipal Finances”. It pointed out that municipal data is hard to find or compile due to the lack of standard accounting practices at the ULB level.
A 2019 study by the National Institute of Public Finance and Policy (NIPFP), covering 25 states, found similar issues: poor data systems and delays in submitting SFC reports.
One specific example is Karnataka. Even though the SFC recommended ₹44,691 crore be transferred to ULBs between 2014-15 and 2018-19, only ₹17,119 crore was actually released. This shows how SFC recommendations often fall short in addressing real infrastructure and service delivery needs, especially in smaller cities.
Lack of Autonomy
Many small and medium-sized ULBs are still financially weak because they don’t have their own sources of revenue or enough control over funds, even though the FC allocates them sufficient grants. In addition, they lack decision-making power; mayors and councils still need state government approval for major spending, which often leads to delays or their recommendations being ignored.
Feedback from states during consultations for the XV FC was not incorporated into its final recommendations.
Several southern states, like Tamil Nadu, Telangana, Kerala, Andhra Pradesh, and Puducherry, raised concerns during the XV FC consultations about using 2011 Census data to decide funding based on population. They felt this approach unfairly punished states that had successfully reduced their fertility rates. However, the XV FC did not accept this suggestion. As a result, many cities in these states received lower funding that didn’t match their actual infrastructure needs.
Similarly, states like Karnataka and Maharashtra asked the Commission to reduce the 45% weight given to the income-distance formula, i.e., the idea that poorer states should get more funds than richer ones, and instead give more importance to fiscal efforts and contributions. These inputs were also ignored. Because of this, smaller cities in financially stronger states ended up underfunded. This weakened ongoing governance reforms at the city level, especially in these smaller cities, as the focus remained mainly on state-level performance.
What States have demanded from the XVI FC and what it may hold for smaller cities?
It’s important to understand how the way funds were categorized under the XV FC affected how things were implemented and what outcomes were achieved.
The XV FC mainly focused on how much money was being given, rather than what the ULBs actually needed on the ground. By making 60% of the grants performance-based and tied to specific areas, it became very limiting.
The commission didn’t consider that many ULBs lacked basic infrastructure, like proper drinking water systems or waste management. The strict categories also meant that cities couldn’t use the funds for other urgent needs, like roads, primary healthcare, or street lighting.
Every city has its own development priorities, but because there were no tied grants for other important reforms, those areas were often ignored or delayed.
Conclusion
In order to meet this gap between the expectations and priorities, independent and consistent funding for smaller cities may need to be encouraged. The XVI FC will have to focus on boosting the financial independence of municipal governments by allocating additional revenue sources and minimizing the non-necessary requirements for state authorization on local spending and imposing pragmatic and feasible conditionalities instead of one size fits all conditions which may be too rigorous or unattainable for a large number of smaller cities.
While the commission carries the weight of multiple larger expectations including debates over tax devolution percentages, treatment of cesses and surcharges, and addressing regional disparities, some of the most important expectations are that smaller cities will revolve around enhanced and feasible urban financing mechanisms to address the infrastructure funding gap worth billions.
With climate change induced disasters becoming a reality for more and more cities, there is an urgent need for tailored disaster management funding given their vulnerability to natural calamities and limited fiscal capacity.
These smaller urban centers will look at the commission to recommend innovative financing solutions and transfers that can support their specific urbanization challenges while ensuring sustainable development without overwhelming their limited revenue bases.
The XVI FC should facilitate a steady and reliable distribution of grants, allocating need-based grants, adopting different models for different cities, re-shaping the general approach of FCs and offering prior notification of any deficiencies so that smaller cities can strategically plan their local investments more efficiently.
The current efforts of the XVI FC are crucial in tackling these issues by reevaluating the principles of fiscal devolution, refreshing methodologies to reflect the present trends in urbanization, and suggesting significant rises in intergovernmental transfers to cities.
Do you believe using the 2011 census data to calculate population-based grants is a fair criterion?
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Disagree
Not sure
Tell us in the comments below:
What do you think should the 16th FC consider while budgeting for smaller cities?
Research Team: Riya Bhardwaj, Prashant Srivastava and Praisy David.
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