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Financing cities - the path to rapid growth

Rapid urbanisation is key to India's economic growth and for that, infrastructure financing and land acquisition need to be reimagined

Financing cities - the path to rapid growth

The urban population in India has grown by 32 per cent between 2001 and 2011 as compared to 18 per cent growth in the total population of the country. As per census 2011, 31 per cent of the country's population (377 million people) lives in cities and contributes to 63 per cent of the country's GDP. The urban population is projected to grow to 600 million by 2031 and to 814 million in 2050, with 806 million still residing in rural India (UN estimates). A report suggests that by 2030, 75 per cent of India's GDP will derive from urban areas.

Two takeaways from these statistics are (1) urban agglomerations are the drivers of growth. For economic activities, both scale and location matter. With their externalities arising out of size, backward and forward linkages, and knowledge spill-overs, cities offer growth opportunities and increasing returns at firm, industry and government levels. If economic growth is the target, the 'location of growth' has to be a matter of policy concern and that is cities.

(b) Unless the pace of urbanisation in India picks up dramatically from the 4-5 per cent per decade that we currently project, India will continue to have almost half its population residing in rural areas. Governmental revenues largely derive from cities. Without rapid urbanisation, a policy of redistribution of income to rural India will not sustain as revenue capability of cities reaches its limits.

Municipal revenues - no buoyancy
City development depends on the ability of municipalities to develop and finance infrastructure. Unfortunately, the municipalities in India suffer from low revenues and few tax options to generate their 'own income'. With GST subsuming most taxes that were the source of municipal revenues - entertainment tax, entry tax, etc. - municipal taxes have little natural buoyancy. Property tax and user charges remain the mainstay of municipal revenues.

User charges are rarely properly computed or collected and come elections, are often the target of political patronage - the ruling party will offer to waive them as an incentive to the populace to vote for it. Municipal revenues are largely dependent on devolutions from the state government. This takes decision-making powers away from the local bodies and vests it with the state - despite evidence that decisions affecting the daily lives of residents are best made closest to the residents. This also means that decisions regarding the priority of projects to be implemented are taken at the state and central levels, especially since the central funding support comes in the form of programmes of the central government, such as Smart City Mission, AMRUT, HRIDAY and PMAY-U. Such programmes require funding support from the State as well as have borrowing requirements. Discretionary funds for projects that are selected bottom-up cannot be garnered. In this context of limited revenue options, a less-utilised aspect of municipal financing in India is that of value-capture financing, 'VCF'.

Value-capture financing
Infrastructure enhances 'accessibility' and leads to 'location rents'. Accessibility adds convenience and reduces time to reach a destination and this translates into a price premium for properties located within the value-creation area of infrastructure projects. Land owners benefit disproportionately from this development without having contributed to this value creation.

Value capture is a method to capture this premium and use a part of it to finance infrastructure projects by requiring the beneficiaries to contribute towards the cost. A properly envisaged infrastructure project will result in a rise in land values in the project-served areas. If the cost-benefit analysis shows viability, it is expected that this rise in land values will exceed the project cost. Therefore, project cost can be recovered by reclaiming a part of the uplift in land values, leaving the rest to landowners as net windfall gains.

Eminent domain and excess condemnation
Infrastructure projects need to acquire rights over large tracts of land. 'Eminent domain' is the right by which governments may take property from individuals for the use of the community. This right comes with a caveat that the property owner has been adequately compensated.

'Excess condemnation' is the name applied to the practice under the power of eminent domain which permits a municipality to acquire more property that is actually needed for the given project. The additional property can be taken for important uses that are incidental to the main object. For example, inter-city highways require land for food-courts, toilet facilities, trauma centres, etc.

Both adequate compensation and fairness of extra land acquisition are questions that are usually challenged in court and lead to significant delays in project implementation. Those that have to give up land invariably resent losing out on the uplift in land prices that occurs once the project is complete. Land-acquisition costs are a major portion of project costs and need to be funded upfront.

Innovative solutions are needed to be structured to enhance fairness in land acquisition and to reduce the impact of upfront compensation payments. One such structure can be 'land pooling' within a designated project area where land holdings are pro-rata reduced from all holders to compensate those whose land is acquired for the project.

The compensation for the portion lost can be paid in the form of a zero-coupon tax-free bond that can be redeemed after, say, 10 years. When it comes up for payment, it can be expected that the project would have added value to the land adjoining the project and a value-capture tax can be imposed to allow for bond redemption. Some of the additional land that was acquired can also now be sold or leased to pay off part or all of the debt contracted for the project.

Variants of this mechanism can make infrastructure development self-financing. A proper framework of legal statutes needs to be created that are vetted by courts before this can be replicated widely. If done, this can reduce project risks and costs, making infrastructure development more viable and rapid and increasing India's growth rate. Focused urban development has the potential to raise India's growth rate into double digits - and create the kind of higher-value jobs that can take the pressure of population off the land and agriculture.

Anand Tandon is an independent analyst.