CHAPTER – 4

Theories of urbanization and urban finance

4.1 Provision of public goods by government

4.2 Theories of urbanization, urban local government and provision of

public goods

4.3 Fiscal federalism models

4.4 Fiscal structure of urban local government

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 CHAPTER 4

Theories of Urbanization and Urban Finance

The urban finance faces numerous issues in the rapidly urbanizing regions

of the world. These regions have important impact on the growth and

development of the economy. The financial crisis of urban local

government reflects the changes taking place at the grass root level

requiring rapid action.

This chapter highlights the fundamental theories related to urbanization and

urban finance of these regions. The introductory part of this chapter throws

light on the characteristics of public goods. It is due to these characteristics

of public goods market cannot provide public goods and services. So, the

interference of government is necessary. Government is also required to

choose necessary public goods and services.

The second part of this chapter further highlights the theories related to

urbanization and urban finance. Certain goods and services of local nature

are required to be provided by the urban local government rather than

regional or central government.

The models related to fiscal federalism with special emphasis on urban

local government is presented in the third part of this chapter.

The last part of this chapter highlights functional division between various

layers of governments. Here the structure of the income and expenditure of

urban local government is discussed.

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4.1 Provision of Public Goods by Government
The trade or exchange is not possible easily in case of few goods and

services even though there is demand for it. Market fails to provide certain

goods and services due to their special characteristics and hence they are

known as public goods. The public goods can be termed as “Collective

consumption good”. Public goods can be define as a good enjoyed in

common, each individual’s consumption of such a good leads to no

subtraction from any other individual’s consumption of that good and no

one can be excluded from its consumption.

Characteristics of Public Goods

Market fails to provide certain goods and services due to its special

characteristics. They are:

Non- Excludability: Public goods and services are non-excludable, the

benefit received by an individual ‘X’ from public goods does not reduce its

availability to individual ‘Y’ and hence it is inappropriate to use exclusion

principle in case of public goods and it may also leads to higher cost.

Private entity fails to provide goods in case of which benefit and price

cannot be determined on an individual basis.

Non-Rivalry: According to Samuelson (Samuelson 1954) “if an individual’s

consumption of a good leads to no subtraction from any other individual’s

consumption of that good, it is called non-rival consumption.” As

consumers cannot be excluded, the cost of non-rival goods and services

cannot be recovered unless consumer voluntarily makes payment. Thus

non- excludability and non-rivalry in consumption creates the problem of

‘Free rider’

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Free Rider Problem
Free rider means consumers are getting benefit of a specific good and

service without making any payment or pay less than the full cost of these

goods and services. Free riders are burden on society.

Zero Marginal Cost

If marginal cost of additional unit of consumption is zero, price of the goods

or services must be zero (since marginal cost is zero). Hence, it should be

provided free of charge as additional individual can consume the good

without any increase in the cost of production. Private profit would be

impossible with zero prices. Therefore, the government is required to

provide such public goods.

Externalities
One of the most important reasons of market failure is existence of

externalities. Many economic activities lead to “external economic effects”

on the society as pointed out by Musgrave (2000). There are two types of

externalities or spill over – positive and negative. It is difficult to share cost

or benefit in case of negative or positive externalities. Musgrave (2000)

argued that this “tragedy of commons” could be solved if a few private

entities jointly carry out activities having positive or negative externalities.

However in such case also, government is required in deciding the rules of

bargaining process to determine rewards for external benefits and charges

for external cost (Buchanan and Musgrave, 2000).

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Common Pool Goods
These goods are non-excludable but have rival characteristics. In case of

common pool goods such as essential goods and services, the supply does

not change with change in demand or price.

Musgrave (Musgrave and Buchanan, 2000) had cleared the fog between

public provision and public production. He clearly mentions that only public

entities are suitable for provision of public goods, but are not necessarily

required to be produced by them.

Market Failure and Provision of Public Goods

Market mechanism is well suited only for provision of private goods. As in

market mechanism an individual reveals his preference by paying suitable

price for it. Market mechanism is like big bidder market where the highest

bidder will receive the goods and services by offering highest price and

others will be excluded as stand by Musgrave and Musgrave (1973). The

peculiar characteristics of public goods and services as well as the nature

of their exchange make it difficult for market to provide such goods. These

particular characteristic also reveal the important of government for the

provision of public goods as market fails to provide them.

Theory of public Choice

Public Choice Theory is directed towards the study of politics based on

economic principles. James Buchanan, and Gordon Tullock are the primary

developers of public theory (Felkin. http://perspicuity.net/sd/pub-

choice.html). It involves the interaction of the voting public, the politicians,

the bureaucracy and political action committees.

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One must not assume that public goods are unlimited or free of cost. As

this theory clearly puts emphasis on the very basic issue of economics that

is human begins have to make a choice in how to fulfill the unlimited wants

out of limited resources. On similar ground, government also has to make

choice. However, it is assumed that private sectors are governed by profit

motive while government sector by welfare motive. Hence, public entity or

government is well suited for the provision of public goods and services.

But in theory of public choice, individuals, interested groups, bureaucrats,

and politicians are assumed to seek their own self interest as in the market

place. When an individual votes for a representative group called political

parties. He tried to maximize his own benefits by voting for a suitable policy

measure opted by a political party.

4.2 Theories of Urbanization, Urban Local Government and Provision

of Public Goods
Urbanization is a world phenomenon. Urban region has always remained

the centre for production, innovation, commerce, art and science, social

and political revolution. It is the urban region, which brings new ideas and

creates new economic activities. The existence of a city cannot be

assumed without its government i.e. urban local government. Hence, urban

local government is an essential part of an economy. As economy moves

from agrarian to industrial and service oriented economy the important and

role of urban local government changes drastically.

Theories of Urbanization
Urbanization is an irreversible process. Urban region or city had first been

noted in the Indus valley civilization in the middle of the 3rd millennium BC

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in India (Bhattacharya, 1979). Hence one can say that there are several

urban theories and some of which go back to the time of initial civilization.

Most urban theories are derived ones some of which are:

1. Suburbanization

2. The dependency theory

3. Theory of spatial disparities

4. Migration theories – some of the migration theories are as:

a. Buffer’s theory of migration

b. Stouffer’s law of intervening opportunities

c. Migration theory of neo-classical economists

d. Push and pull theories of migration

e. Urban bias theory

5. Lewis two sector model

6. Concentric zone theory

7. Bid rent theory

8. Modern theory of urbanization

9. Theory of evolutionary ladder of development

10. Writh’s essay on “Urbanization: A typology of Changes”

1. Suburbanization
Suburbanization means “beyond the city” thus it refers to peripheral areas

of large cities around the world (Fishman, 2002). As cities grow, it expands

towards outskirt areas and thus peripheral or suburban areas develop and

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grow. Cities expand towards peripheral area due to high density, increasing

urban land price and pollution (Fava, 1962) well developed transport and

communication facilities. It is the responsibility of urban government to

provide basic amenities in these areas (Fava, 1962) as these suburban

areas may not necessarily have a separate political unit (Fishman, 2002).

2. Dependency Theory
The dependency (theory) school argues that urban regions could establish

expand and develop only if agriculture is well developed. The developing

countries are sources of input for developed Countries (Tetty, 2005). Hence

developing countries receive larger foreign investment in agriculture as well

as non-agricultural sectors. Developed agriculture pushed rural farmer and

labourer while developing industries attract labourer due to large

employment scope in urban areas,

3. Theory of spatial disparities

Spatial disparities theory states that disparities are created due to variation

in geographically advantaged and disadvantaged regions, political

importance of a city, economically favorable policies etc. Spatial forms

divided the society. The problem of spatial disparities further leads to

migration which creates pressure on urban amenities.

4. Migration Theories
Migration can be both a problem and a solution for various urban regions.

There are several migration theories, some of them are discussed below.

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a) Buffer Theory of Migration
Buffer theory of migration stated (Beets and Willekens, 2009) that “the

workers who are imported on temporary base due to creation of short fall of

labourer will return” However, it is not appropriate to make such

assumption that labourer will go back. Migration cannot applicable always

as adjustment mechanism. Hence, the Buffer’s migration law is not

practical.

b) Stouffer’s law of intervening opportunities states that

(http://www.civil.iitb.ac.in/~dhingra/ce751/module3.pdf) “The number of

persons going a given distance is directly proportional to the number of

opportunities at that distance and inversely proportional to the number of

intervening opportunities”. Stouffer explained that between the final

destination and departure place if there are good opportunities them the

migrant will settle down in between rather than their planned final

destination. Stouffer argues that the volume of migration had less to do with

distance and population than with the availability of opportunities in each

location.

c) Neo- Classical economist argues that the main reason for labour

migration is wage difference between two geographic locations. These

wage difference are usually due to labour demand and supply in specific

geography.

d) Push and pull factors theory

The push and pull theory is based no various push and pull factors. Push

factors are those things/ factors which are unfavorable about the specific

area that one lives in and hence push them to move away from that

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particular area. Pull factors are those things that attract one to another area

due to various reasons. (Dorigo and Tobler,

http://geog.ucsb.edu/~tobler/publications/pdf_docs/movement/migration/

PushPull.pdf) push factors can be less of employment opportunities,

natural disaster, war, pollution, poor, housing etc. and pull factors can be

better employment opportunities, better living conditions, healthy

environment etc. However, it is difficult to say whether migrants are pushed

by rural poverty or pulled by positive reasons city offered (Fava, 1962)

e) Urban bias theory is emphasizing on political perspective of urban

regions. This theory argues that government policies favour the urban

regions. While the amenities are provided on a larger scale in urban areas

but the larger proportion of the population is found in rural areas of a

country. Hence, there is migration from rural to urban areas (Tetty 2005)

5. Lewis Two Sector Model

Industrialization with the support of specialization supports urbanization

process. Lewis presents two sector model of development with high

productivity of modern urban industrial sectors. Lewis assumes that

abundant labourer in agriculture can be absorbed in labour scarce

industrial units. However agricultural migrants cannot always support and

help these industries to grow.

Hence the major limitation of Lewis model is the assumption that rural and

agricultural labourer are having skills and ability to get employment in urban

industries.

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6. Concentric zone Theory
Ernest Burgess with Chicago Sociologist Robert Park (of Chicago School)

put forward concentric zone theory of urbanization which (Hoyt, 1968)

assumes various concentric rings in urban regions. The zones identified

are

1) Central Business District

2) Transitional zone (Recent immigrant group)

3) Working class zone

4) Residential zone (Single family has yards an garages)

5) Commuter Zone (Suburbs)

Zone I is Central Business District (CBD). It is at the centre of the city.

Hence, centre is wealthy and has powerful economy compared to its

suburban. There is high concentration of population in this most inner part

of the city.

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Zone II is transit zone. This zone is surrounding the central business district

area for residential purpose and business district. Hence, it is called transit

zone or zone in transaction (Hoyt, 1968).

Zone III is working class zones. It is the zone of independent workingmen’s

homes. The resident in this zone are the one who desire to live near but not

too close to their work place.

Zone IV is the zone of better residences. Here lives small businessperson,

professional people, clerks and salesmen.

Zone V is the commuters’ zone, consists of small cities, towns, and

hamlets. There are also suburbs because majority of men residing in this

zone spends the day at work in the CBD returning only for the night.

Concentric zone theory has been criticized by Chicago Leangles School of

urbanization as it only indicates economic patter of one region or city urban

region of Chicago only.

7. The Bid Rent Theory

The Bid Rent Theory (BRT) theory is theory of geographical economy. It is

based on geographical location rather than productivity of land. It refers to

price and demand for real estate. The BRT explained that different land

users would compete with one another for land close to the city centre. This

theory is based upon the reasoning that the more is the accessible area

(i.e., the greater the concentration of customers) It is higher the chance of

earning more profit. Hence, to have land in inner city or central business

district land users are willing to pay high price. This price of land paid by

various users is known as “Bid Rent”

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The above graph clearly indicates that commercial sectors are ready to pay

higher rent so that they can establish near central business district as it is

more accessible to larger population. Industry prefers next outer ring where

rent is comparably low and still easily connected with commercial sector

and with market. Residents and residential areas can be away from central

business district. They can be in the outer most ring or peripheral areas.

Bid Rent and Concentric theory assumed that inner city is wealthy and

peripheral area is poorer. However, many cities around the world indicate

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the trend which is otherwise. (http://www.ssc.wisc.edu/cde/cdewp/72-

28.pdf)

8. Modern Theory of Urbanization

Modern theory was developed in the mid 20th century. It presented an idea

that economic development is possible only if industries develop and

expand by the introduction and use of advanced methods of production and

use of modern technologies. According to modern school, the view which is

shared by the classical economist, there cannot be urbanization without

industrialization (Dutt. 2001)

9. Theory of Evolutionary ladder of Development

To understand stages of urbanization, Walter Rostow’s evolutionary ladder

of development and warren Thomas demographic transaction can be

combined and presented as:

1. Traditional Society (pre-modern)

2. Pre-take off (industrialization /transitional)

3. Take off stage (mature industrial / industrial)

4. Stage of maturity (Post industrial)

5. High mass consumption

In the first and second stage, society is a traditional one. Larger proportion

of population lives in rural areas.

Third stage is ‘take off’ stage modern and new technologies are employed

by industries to increase production. Manufacturing becomes important.

This changes and growth however is concentrated in few regions only

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(Tetty, 2005). Demographically, in this stage the death rate falls and birth

rate still remains high. In terms of urbanization, a large proportion of

population migrates to areas where manufacturing activities are

concentrated for employment (Tetty, 2005)

The fourth stage ‘drive to maturity’ in this stage there is spread of

technology into all parts of the economy. The demographic transition

associated with the stage sees declined death rates while birth rates drop

at a faster than death rates. Urbanization at this point continues to progress

since more and more people move to urban centers for jobs.

The final stage is know as ‘high mass consumption’ and is characterized by

the economy forcing on durable consumer goods like car instead of

production of heavy industries like heavy machines (Tetty, 2005) with high

personal incomes. Focus is no- durable economic activities rate than basic

need. The final stage of demography indicates negative or zero population

growth. At this point, urbanization begins to level off because at this stage

countries experience development that has reached 80 percent urban

population mark. (Terry 2005)

10. Writh’s essay on Urbanism as a way of life

Louis Writh’s in his essay “Urbanism as a way of life” emphasis as that

urbanism is a matter of physical residence and urbanization is a social

phenomenon. Moreover, Writh also questions the most common indicator

adopted for the measurement of urbanization around the world i.e.

Population numbers.

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11. Reissman’s Urbanization: A typology of Change
Leonanard Reissman indicates four ways of urban society a)

demographically urban b) economically urban (industrialization ) c)

politically urban (nationalism) d) Having an urban class structure

(emergence of middle class) Today various combinations of these

indicators are used in defining urbanization.

Adam Smith’s principle of ‘division of labour’ is in favour of urbanization.

Cities provide larger market, which further promotes division of labour and

can provide better employment opportunities. The division of labour is less

to mass production, mass employment. Hence, it provides economies of

scale and productivity growth. It further leads to increase in wages/income

which can sustain mass consumption. This is known as “Fordism’ (Painter,

2002). The graph one indicates how city evolve, grow and establish. The

city initially was surrounded by villages and rural area. City used to be

either centre of commerce or capital or provisional capital. Some cities in a

economy develop more rapidly while others lag behind, the spatial theory

indicates as city expands towards its periphery, suburban areas and

theories related to suburban areas developed. These developments attract

migrants as explained by migration theories. However important question is

“is there any limit to a city?” Aristotle in his politics (Fava, 1962) advocates

that there should be certain limit to a city. Plato also believed that the ideal

city must not contain more that 5000 (Fava, 1962) There is no certainty

whether there is some absolute limit beyond which cities cannot grow. It

may seem that big city around the world has already crossed these limits.

Concentric zone mode, bid rent and many such models try to help to

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manage various economic activities as well as income earning class into

different zones. However they are obsolete today.

Urban Local Government

The institution of self – government is as old as the civilization itself. They

were assumed autonomous units responsible for their internal

administration and socio-economic development - both urban and rural.

Urban Local Government in Ancient Time

Urbanization of Indus valley may not be as widespread and rapid as of

today, however well established towns with well –served amenities

indicated urban government. Indus city builder were the first to introduce

the method of strict discipline in the form of town planning. They even

planned the street as noted by Bhattacharya (1979). Hence, there had to

be effective and efficient city government or municipal government for the

provision and maintenance of such urban amenities.

Egyptian civilization was highly centralized. However in some cases the

local government enjoyed little power. Romans were found to use

“provincial” and “local governments” to govern conquered territories without

having to rule them directly. The local governments had certain degree of

freedom to manage their own affair depending on the communities status

of city Kautilya was the first author to write a book on economics, he

advocated for the devolution of power to the grass root level of Janapadas

(there by decentralization) (Kashyap, 2010). It is amazing to find micro

planning of city in his book of Arthashastra (Bhattacharay 1979). However,

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the functions and forms of urban local government during ancient times

were different than that of modern times.

Urban Government Layers and Activities

The local government especially in growing urban cities is having greater

responsibilities to bridge the gap between the haves and the have not.

Traditionally theories of fiscal federalism assumed that policy objectives of

local government are only to maximize social welfare. However, second

generation theory of fiscal federalism assumes that it is the agent of

government who prefer to maximize their own welfare function (Rao, Bird

2010). In recent years, four alternative models of metropolitan governance

developed by Bird and Slack as cited by Rao and Birds (2010) are:

(i) On – tier model

(ii) Two – tier model

(iii) Voluntary co-operation

(iv) Special purpose districts (Rao and Bird, 2010)

In one tier model taxing and expenditure decisions are made at one level

only even though there can be various stages and division for

implementation. The structure of two tiers can be less transparent yet

creates confusion among citizen. “However, it would be cost effective as it

leads to economies of scale in provision of public goods and services” (Rao

and Bird 2010). “The voluntary corporation models can be developed with

the coordination of two or more municipalities formally or informally to

provide urban amenities to citizen” (Rao and Bird, 2010). The services –

specially having positive or negative externalities can be provided under

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this model as it not only reduces the cost but also increase the efficiency.

Specialized agencies can provide municipal services to more than one

municipality which reduce the unit cost and can be more efficient. However,

specialized agencies type local government or municipalities system is

possible only among homogeneous local government otherwise it creates

administrative issues (Rao and Bird, 2010). Urban local bodies can also be

classified into three major categories.

1) Urban local bodies which carry out commercial industrial types of

activities and their by make profit. They are competing with private entity.

2) Urban local bodies as facilitators for private entity: In such case,

urban local bodies facilitate for private firm and earn profit. Urban local

government is providing market place or shopping mall to private firm to

compete and maximize their profit. These local bodies earn rent from

private entity.

3) Public goods and services such as water, drainage, solid waste etc

are provided only by urban local bodies. Hence in case of public goods and

services, urban local government is having monopoly.

Provision of public goods by urban local government

The social goods having local nature should be provided by local

government. Due to various factors, certain public goods should be

provided by local government rather than government of higher level. The

reason for certain public goods to be provided by local government are:

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Public Goods and Spatial Benefit Area
“Social goods are defined as ‘being available to all’ does not literally means

all as national or even state population” (Musgrave, Musgrave, 1973)

Public goods have spatial benefits areas and thus are provided locally to

the resident of specific local area. For example national defense have

nationwide benefit while street light have local benefits. Certain public

goods are of local nature so local government is well suited for its

provision. This suggests that the nature of social goods has some

interesting bearing on the issue of fiscal federalism --- centralized and

decentralized as noted by Rao and Chellia, (1990)

Decentralized Fiscal Federalism

The local governments have limited tax power with expenditure

responsibilities of local level. However, central government has the

supreme constitutional power (Hicks 1948) Oates’s (1972) ideal case of

‘Perfect correspondence’ also favours decentralization. The optimal form of

Federal government providing public goods and services at each layers

required simultaneous government entity at each layer. It is important to

note that preferences and taste of local resident can be satisfied easily by

local government rather than central government.

However, it is important to understand that “the essence of federalism lies

not in the institutional or constitutional structure but in the society itself”

(Rao and Chellia, 1990) Oates (1972) advocates decentralization based

on:

1. Taste and preferences of different regions can be easily understood

by local government.

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2. Provision of mixed output according to the preference of individuals

is reflecting economic efficiency.

3. Local government may provide innovative ways and means in the

production and provision of public goods.

4. Decentralization provides opportunities for efficient utilization of

resources due to income constraint to satisfy the preferences of local

residents.

5. Decentralization provides market like solution to the problem of

production as well as efficient provision of output for some public goods.

In brief the decentralize theorem maintains that if there is not much cost

difference it would be more efficient for central or state government to hand

over responsibilities to local governments for the provision of public goods

and services. These will reflect the consumers/ votes choice more

perfectly. Decentralization theorem clearly indicates “the importance of

local government in the provision of public / Social goods and services as

well as managing local areas more efficiently than any higher level of

government” (Rao and Chellia, 1990)

Mix Goods
An argument of mix goods stated that certain goods have the both

characteristic public and private goods (Brown and Jackson, 1993). Public

goods with the characteristic of mixed goods are also a reason why it

should be provided by local government. Mixed goods are required to be

charged optimum amount owing to their mixed characteristic. Hence local

government is required to determine the size of population for provision of

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mixed goods and also augment the resources from such group or

residents.

4.3 Fiscal Federalism Models

Fiscal federalism concerns with the division of public sector functions and

finances among different tiers of government. Hence the models of fiscal

federation will help urban local government to develop suitable policy

according to rapidly changing urban regions. The models of fiscal

federalism are

1. Oates model of local government countercyclical policy

2. The Tiebout’s Hypothesis of “Voting with your feet”

3. Welfare gains from multi fiscal units: The decentralization Theorem

1. Local Government Countercyclical Policy: Oates

Oates (1972) tries to investigate the potential of fiscal policy at the local

government level and sets forth a simple income and payment model of

local economy.

Oates made simple model with the assumption of

1. Each locality is small and highly open and is price taker

2. Financial Capital is highly mobile hence; rate of interest has to be

same.

3. Real income is perfectly elastic at given price level.

4. Government expenditure is divided between imports and commodity

produced within community.

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5. The level of income and output, Y, is assumed to be perfectly elastic

at given price level.

The model can be summarized as:

Commodity market: C(Yd, Io, A) + Go + Xo – I (Yd, Io, A, Go) – Y = 0 -------

--(1)

Financial assets market: L (Yd, Io, A) – A = 0 --------- (2)

Trade Balance: Xo – I (Yd, Io, A, Go) = 0 --------- (3)

Where;

Y = real income

Yd = disposable income

Io = Rate of interest (exogenously determined)

Xo= Flow of exports (exogenously determined)

A= real value of the net financial assets holding of the private sector

Go= local government expenditure (exogenously determined)

I= flow of import

The demand of both the commodity and financial assets market is

assumed to be dependent on disposable income. Financial assets market

is indicating combined Bond and money market. They are exogenously

determined. “If equation one and three equations are satisfied, it follows

from Walras” law that the financial assets market must be in equilibrium”

Oates (1972)

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With injection of A, there will be positive wealth effect i.e. it leads to

increase in income till the point that it consumes the excess supply of

financial assets from the economy. Hence, with injection, there will be

temporary rise in income in responding to a deficit in the balance of trade.

This does not surprise as A and Y are dependent variables in the system.

Assuming the model to be stable, a change in either of these variables sets

work force that restore the initial equilibrium solution.

For local Governments Fiscal Policy balanced budget is assumed to be nil.

Further the impact of balanced budget spending in the local income model.

Consider now a balance increased (dG = dT) in local government spending

(MPC = 1 for government and MPC > 1 for private sector). This increases

both expenditure and imports. It will create deficit balance of trade and

outflow of financial assets from the local economy which will decrease

spending and income until the balance of trade return to zero. Since export

remain unchanged level of imports, must remain unchanged only then

outflow of financial assets will cease.

I    c  --------- (4)
y d  y d 

I  --------- (5)
g

I    c  --------- (6)
A  A 

Where 0<<1

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I   I
 y d

 y  I
 d A 
A  I  
g
0 --------- (7)

Substituting equation (4) and (6) into (7)

I    c
 y d

   c A  c
 A  --------- (8)


=   c
 y  c

 yd  d 
A
A


  g

c  g    c  g   0

c  g --------- (9)

Government spends equally on imports and home made goods, but not to

influence community’s equilibrium level of income through balanced budget

spending government will spends more on domestic commodities. However

it violates the condition in equation 5. Hence G o drop out and Yd and A are

determined independent of Go Hence, in this limiting case as put forward by

Oates, the balanced budget multiplier is unity; the equilibrium level of

income rises by the amount of the increase in public expenditure so as to

maintain Yd at its previous equilibrium level. In less extreme case, where

public expenditure involves some import but relatively less than in private

sector multiplier to be positive but less than unity. Hence, in such case

government spending has an import substitution effect.

2. The Tiebout Hypothesis: ‘Voting with Your Feet’

Tiebout argued that individuals select the local community whose provision

of local public goods and tax-prices best satisfy their preferences.

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However, in a local community context individuals would reveal their

preferences, by moving to the locality that is best reflected in their tastes

and offered the preferred tax –benefit mix (if mobility was relatively

costless) for examples, those who like expenditure on sports complexes

can reside with others of the same preference. Those with a preference for

other forms of goods and services will join their respective local ‘club’

elsewhere.

The Tiebout Mechanism Assumes

1. Full knowledge of all the communities’ characteristics

2. Costless motilities

3. Economies of scale

4. Positive externalities

The Tiebout effect increases the welfare gains from decentralization as

indicated in figure-1 below.

Holcombe (1983) illustrates the Tiebout equilibrium using a diagram similar

to Fig. 1.1 in part (b) of the figure the vertical sum of three individuals with

different demand curves (D1 D2 and D3) for a local public good G is E

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(SIGMA). With a marginal cost of provision of G equal to O-T and equal tax

shares, the equilibrium quantity (either on a X> MC or a median voter

argument) is O-q2. For this outcome for individual 1 whose demand curve

is D1 there is a welfare loss from over-provision Of triangle 1-4-5. For

individual 3 the welfare loss from under-provision is triangle – 1 -2-3 if there

are competing local jurisdictions. Individual 1 can exit to a community of

like minded individuals, and similarly for individual 3. I an ideal outcome,

there would be three communities with equilibrium as in parts (a), (b) and

(c) of the figure. If in each community there are (three) identical individuals

(each enjoying a situation where their demand equals O-P1) there are no

welfare loss triangles. In each community, there is a different level of

provision of local public goods O –q1, O – q2 and O – q3 Given fiscal

migration, welfare losses from allocatively different outcomes from some

individuals equilibrium quantities can be avoided. Individual 3 has

expressed preferences for a greater provision of the local public good by

moving to a jurisdiction that offer greater provision of the local public good,

voting with their feet, both individual 1 and individual 3 no longer

experience the welfare loss of consuming a level of provision of a local

public good which is different to that which they would prefer. In this way,

the ‘Tiebout hypothesis’ is obviously of considerable theoretical importance.

This might be one of the reasons of migration towards bigger cities.

3. Welfare gains from multiple fiscal units: the decentralization

theorem
Oates (1973), advocates decentralization, He stated, “The welfare gains

from decentralization are often considered with reference to the deadweight

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losses that result from centralization (Oates 1972).” Assume that the

population of a particular nation state is divided into two distinct localities. A

local public good is to be provided in each locality and it is assumed that

there are no inter- jurisdictional spillovers. The cost is to shared equally by

residents, in fig. 2 we illustrate the demand for the local public good of two

‘representative’ individuals, one from each locality, DA represents the

demand of individuals in locality A and DB represents the demand of

individuals in B. The marginal costs of providing this particular local public

good G are assumed to be constant. The price each individual is asked to

pay is shown as P = MC in the diagram (this would be each individual’s

share of the overall marginal costs.)

In this diagram, if a centralized regime provided a single uniform level of

the good, the level of output provided could be shown as a compromise

between the demand of the individuals in each locality, i.e. a level of q.

such a quantity is lower than the amount that would be demanded by the

representative individual A but more than would be demanded by the

representative individual B inevitably, each of these two individuals

experiences welfare losses. The losses are shown as triangles 1-2-3 and 1-

4-5. Triangle 1-2-3 indicated the loss that arises because individual A does

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not consume as much as a would choose if there were no need to

compromise. The individual would gladly pay ^-2-3-^ for the additional units

q-<f, but these would cost only ql-3^ to be made available. Triangle 1-4-5

indicates the welfare losses that are experienced by individual B because B

is consuming more than he would otherwise choose. B pays qh-5-1-q for

the additional units qb-q but B values them at only qb-5-4-q.

If each area could provide itself with just the quantity of the good that it

requires, these deadweight losses could be avoided. Decentralization

permits each locality to provide itself with the quantity of the good it prefers.

4.4 Fiscal Structure of Urban Local Government

In a rapidly urbanizing economy, it is important to understand the functions,

fiscal power, and responsibilities or urban local governments to mange the

rapidly urbanizing region of the world.

Functions for Various Layer of Government: The functional division

among various layers of government helps to avoids overlapping and also

helps to clear the fiscal power and expenditure responsibilities of each level

of government. There are three main Musgravian branches of economic

functions for which help to understand functional responsibilities of each

layer of government like (Musgrave, 1959) Allocation, Stabilization and

distribution of income in the economy. Theories of federal decentralization

clearly indicate the superiorities of central government to carry out

redistribution and stabilization functions. Local government is best suited

for allocation function.

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Allocation Function
The allocation branch is concerned with production of goods and services

for which competitive private markets fail to operate efficiently. Grass- root

level governments are best suited for allocation function. As these layers of

governments are aware of the taste and preferences of local residents they

are expected to make allocation more efficiently (Brown and Jackson 1993)

Moreover, it can be scrutinized and necessary changes can be made if

required.

Stabilization Function
The stabilization function is the best suited for central government. The

major stabilization policies are monetary policy and fiscal policy. The

impact of central stabilization policy may be different in different region. Yet

it is important for the different policies of different urban regions to suit with

the national policy (Rangarajan and Srivastava, 2011). Now, if each local

monetary policy means a country can have number of exchange rates in

the distance of every 15 kilometers.

In a similar fashion, if each local government has its own fiscal policy, the

migration rate increase and will create burden on few urban governments,

which provides better amenities (Musgrave and Musgrave, 1973). Hence,

central government is best-suited for shaping macro level stabilization

policy which has an interwoven micro policy of different local levels.

Distribution Function
Distribution policy also required macro framework rather than micro

framework hence it should also be taken care by the central authority.

Local redistribution policy leads to many possibilities. It is difficult and

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inefficient to determine specific criteria for such a micro unit. Moreover,

administrative cost will increase if same criteria and pattern of distribution is

applied for an urban area having population of seven lakhs and seven

thousand. Musgrave (Musgrave and Buchanan, 2000) argue that the

central government is in the ideal position to provide public goods with wide

economic reach. If all local bodies together determine a single policy that

each local government will agree to operate on then again it is as good as

a single uniform policy just like the central government policy (King, 1984)

Expenditure of Urban Local Government

Oates (1972) pointed out that the establishment of urban local government

itself incurs the cost viz cost of establishment and maintenance. However,

more layers of government is the result of decentralization, however, if

benefits incurred due to decentralized. Aiyer (1967) talks about two types of

expenditure.

1) Beneficial Expenditure: The expenditure, which brings back some

return in the form of public services such as water, solid-waste, drainage

etc.

2) Onerous Expenditure: Benefit is general and indirect such as

education and health services.

It is important to note that onerous expenditure not only increase

productivity but also avoids negative externalities. The central authorities

(Musgrave and Musgrave, 1973) must provide important and pure public

goods i.e. National Defense. However the issue of free rider arises to a

greater extent in the consumption of such public good.

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On the other hand, public goods such a highway - requires the co–

ordination and efficient functioning of all three layers of government.

Hence, this particular public good demand “Perfect integrated co-ordination

of various layers of government” (Musgrave and Musgrave, 1973)

Education has externalities i.e. external benefit. It is a merit good. The

benefit is much beyond the limits of city or state (even if provided to

resident of that city only) Hence, central government rather that urban

government should provide this particular service. However , Musgrave

(Musgrave and Buchanan, 2000) advocates that local bodies can provide

the public goods and service having special benefits such as education

with central assistance such as education.

Public goods such as Streetlight Public Park with spatial characters should

be provided by urban local government. The benefit of such public goods

incur to only the resident of specific area where it is made available.

Wagner had already assumed high-density living, congestion and

externalities which urban regions are facing today; hence public sector

requires interfering and managing (Brown and Jackson 1993) Peacock –

Wiseman indicate (Brown and Jackson, 1993) that expenditure should

match with tax income and tax income must not be underutilized due to

poor management or inefficiency. Martin and Humes (1961) in his book

quoted Kalidas advocating principle of efficiency for public expenditure in

his ‘Raghuvamsa’ “tax collected from the subjects must go back to them a

thousand fold just as water vapour taken from the sea comes back to earth

in the form of rain as fertilizer shower”. Hence when one rupee collected as

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tax revenue is spent on public goods and services; it should provide

thousand fold benefits to tax payers in general.

Income of Urban Local Bodies

It is the tax power of urban government which is important as it helps urban

local government to spend on development activities and the growth of

urban region. The major sources of income for urban local government are

local tax revenue, grants, local generated non – tax revenue and

borrowing.

Local Taxes
There are many Indian ancient literatures, which talk about tax power –

ways and means to collect it. The augmentation of revenue depends on

two factors namely; expenditure pattern and income of a citizen. The tax

and non-tax revenue has been raised as price to be paid to local

government for provision of public goods.

The development and growth of urban regions clearly reflect efficient

utilization of tax revenue in limited geographical unit. Moreover, locally paid

tax can easily be scrutinized, in case of local government, the tax can be

levied on non-movable things such as property. However, (Rao and Bird,

2010) local government should be allowed to levy tax on mobile base up o

a specific limit. The local finance is different from central finance hence. It is

important to know special characteristics of local tax. Hicks (1948) noted

that local tax should be;

a) Tax yield should be reasonable stable in good and bad times.

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b) Tax base should be localized to make it more effective and efficient

for local government. Local government can enjoy autonomy in such cases.

It is expected to have effective control over their budget.

c) It is mot desirable to have a local tax, which does not exaggerate

local disparities in wealth.

d) The local tax should be reserved for local use.

In some cases, local tax creates issue of inequality due to variation in

wealth and need of different locality. The most important tax for urban

government is property tax.

Property Tax: Property tax can be levied on land, personal property –

rented or own and tangible or intangible properties. The base of property

tax is immobile hence more suitable for local level. Moreover, the benefit

principle justifies (use of street light, refuse collection) the wide spread use

of property tax. (Kamer, 1983) Property tax is on current income hence it

reduces the consumption and promote saving. Property tax is the most

important tax for urban government in terms of yield as well as equity

principle, yet policy makers and government rarely reforms the entire

property tax system.

Water tax: is another important tax for urban government. The supply of

potable water and the sanitary collection and disposal of residential and

industrial wastewater are among the most essential local services (Bhal

and Linn, 1992) for which the tax has been paid. The packed drinking water

bottles are perfect indicators of the fact the water is now an economic good

which was termed as free goods by traditional economic theory. Water

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expenditure includes both potable and disposal of waste water. The

sewerage system development cost depends on density of development

and population, pattern of land usage. Sewerage is an essential service for

urban regions.

Solid waste Management: is another important service carried out by

urban local government. Solid waste management is a part of public health

and sanitation. This is non exclusive, non-rivaled, negative externalities

generating essential service. Hence, the local bodies should provide these

services. Moreover this activity is of local nature; hence local bodies are

expected to provide it. User charges can be levied based on the use of

these services such as residential, commercial, industrial and medical

uses. The by – product of solid waste such as fertilizers can also be

utilized. Thus, it not only can earn revenue but also can reduce negative

externalities

Mass transit: is another important service provided by urban local

government. Mass transit used to be the responsibility of state government

(GOG, 2007). However, it is important to note that, larger urban areas with

sound finance are able to provide such services. Moreover, public transport

also helps to reduce the conjunction, air pollution and other traffic issues in

rapidly urbanizing cities. The user charges can be levied to carry out this

services in urban regions. The use of public transport is possible not only

by providing it at lower cost but also by increasing the tax on private

vehicle.

Non-Tax revenue includes fee, rent, interest, user charges and sale of

government property. Fee and rent are prices paid by residents for the use

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of services. It is more direct and visible payment unlike taxes hence

preferred by user. User charges also come under this category.

Economists favour user charges as it raises additional revenue and leads

to more efficient allocation of resource (Kamer, 1993)

Intergovernmental Transfer
Local governments do not have strong financial base to carry out their

allocated functions efficiently. With rapid urbanization the responsibilities of

urban government has also increased tremendously. The cost to carry out

functions such provision of public goods always outweighs the revenue

funds. Hence, higher level of government is required to support team

through transfer funds or grants. The four principles of fiscal devolution

identified by IMF (2000) are:

1) Lower level government should be held responsible for all funds

including intergovernmental transfer. Even Earmarking for grants as

indicated by Buchachan is also a good solution (Buchanan and Jollison,

1972)

2) Subsidiaries – To help preserve smaller social groups from the more

encompassing institutions of government, which deals efficiently with

regional differences.

3) Equality – horizontal and vertical, to address regional disparity

4) Fiscal autonomy – lower levels of government should be

autonomous in their decision making and executive power.

Earmarking Grant is conditional grant. It is provided for a specific project or

purpose. The benefit of such grant is the allocated amount can be utilized

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for specific purpose. In such case lower level government have to utilize

grants for specific development purpose marked for. The expenditure on

goods and services having externalities or spill – over effect will lead to

under allocation of resource (Kamer 1993) However, it is possible to have

joint program of few urban government for services having positive spill

over. According to A.C. Pigou (Oates, 1972) subsidies should be provided

for public goods and services having positive externalities and it should be

equal to the value of benefit. Subsides is not direct monetary support hence

more appropriate tool. However, external cost is also required equally else

it creates free rider.

Horizontal equity or intergovernmental equity is an important aspect of

federal finance. This ensures equity criteria. It is a fact that region with

adequate revenue will provide better services and will have strong fiscal

position and vice versa. Hence horizontal imbalance is difficult to equalize.

Hence to equalize such regions, grants from higher level government is

required. In such case, migration can be reduced to a certain level. Hicks

favours grants based on need of Locality to achieve horizontal balance.

However, like perfect competition, horizontal equity is just an ideal case.

Buchanan advocates equity both in terms of tax and benefits. Hence, he

provides term “equity in fiscal residium” which is taxes minus benefits (Rao

and Chellia, 1990)

Vertical transfer is essential due to shared taxes. The regional or central

government levies taxes some of which are collected by local government

and are handed over to the respective government. Moreover, grants from

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higher level also support the public goods, which have external benefit

such as program related to higher or education sector at local level.

However it is important to note that dependency on intergovernmental grant

may reduce the autonomy. It may also raise the question on the ability of

local government. A local government receiving greater amount of grant

may not remain careful in the collection of their local taxes. A welfare

optimum is requiring for both allocation efficiency and an equitable

distribution of income.

Debt of Urban Local Government

The financing through debt by central and local government is entirely

different. As for the urban local government debts are external which is not

the case always with central government is not always. Oates (1972)

argues that local debt could support in provision of local public goods by

local government with respect to local need and preferences. However,

traditional view favours local government debt for financing capital project

only. As these are long term investment programs which not only benefit

present but also future generation. Ahmedabad Municipal Corporation was

the first urban local government in Asia to issue city bond without state

government’s guarantee. They were tax- free bonds. The trend has later

been followed by other Indian cities such as Banglore, Ludhiyana, Nasik,

Kanpur, Madurai. Hence, urban government can opt for debt financing as

one of the options to carry out responsibilities of provision of public goods

and development expenditures.

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