16th Finance Commission pushes urbanisation agenda while tightening fiscal discipline for local bodies

The 16th Finance Commission report, tabled in Parliament by Union Finance Minister Nirmala Sitharaman on February 1, 2026, clearly stated that grants will be provided to Urban Local Bodies. It has deliberately not used the term “urban areas”, but instead referred specifically to “Urban Local Bodies”. That, in my view, creates a major practical problem.

I would have been happy if the Finance Commission had used the term “local governments” instead of “local bodies,” which is a colonial-era term with a different connotation.

When it comes to distributing the grant, difficulties are likely to arise as urban local bodies may receive larger allocations but may not have the capacity to spend them effectively. If the Commission had used the term “urban areas”, panchayats located in newly urbanising regions could also have been eligible. By restricting the language to Urban Local Bodies, the scope has been narrowed considerably.

Take Kerala as an example. The state has been allocated a substantial amount for urban areas. However, while Kerala has several census towns classified as urban under the Census definition, they are not municipalities. The state has only around 86 or 87 statutory urban local bodies — roughly 81 municipalities and six corporations.

If eligibility is confined to Urban Local Bodies, only these institutions will qualify. They may struggle to absorb such a large allocation. Some adjustment may therefore be required in Kerala’s case; otherwise, this could become a serious issue. That said, the overall allocation for Kerala is reasonably good.

Urbanisation not inherently good

The second concern is the Commission’s apparent assumption that urbanisation is inherently positive and that states should actively move in that direction. My personal view is that while urban amenities are essential, urbanisation itself is not necessarily desirable.

The report suggested that if more people migrate to urban areas, rural areas will generate more employment. This is not entirely accurate. A more balanced strategy would be to develop peri-urban and rural areas in a way that reduces the pressure on cities, rather than encouraging further concentration in them.

With the emergence of new forms of employment, work can now be located almost anywhere in the country. It does not have to be confined to large urban centres — although reliable electricity, water and connectivity remain essential.

India’s long-term strategy should align more closely with what the late former president of India APJ Abdul Kalam proposed: providing urban amenities in rural areas. Instead, the report indicated that panchayats should be expanded or converted into municipalities.

Such suggestions overlook the Constitutional position. Under the Constitution, it is the prerogative of state governments to determine what constitutes an urban or rural area, and which institutions will function as urban or rural local bodies.

These are the principal concerns I see. Otherwise, this set of recommendations is an improvement on the previous one. The grant size is not exceptionally large, but it is reasonable and offers a fair degree of flexibility.

What to look forward to in the recommendations

Over the years, the tendency of central and state governments to impose additional conditionalities on how local governments spend Finance Commission grants has increased. This has been expressly forbidden by the Commission — a welcome decision.

For the first time, the Commission has emphasised the importance of a learning management system. This opens the door for structured capacity-building programmes to strengthen both urban and rural local institutions. The focus on enhancing own source revenue is also an important and welcome step. In many northern states, own source revenues have steadily declined over the years.

Previously, states could afford to overlook this issue, but that will no longer be possible. To access the grants, local bodies will now be required to increase their own source revenue annually. This is a positive reform.

The provision of 60 per cent untied grants in the report is substantial. More importantly, the Commission has stipulated that no more than 20 per cent of the untied grant may be spent on roads. This is perhaps the most consequential decision. It will compel panchayats to shift their focus towards health, agriculture and other developmental sectors. In the past, nearly 95 per cent of available funds were often spent on cement-concrete roads. That pattern is unlikely to continue.

There is also adequate allocation for water management and related activities. Water management needs to be properly understood to include stream and river rejuvenation, ponds, wells, other waterbodies, rainwater harvesting, and watershed management — rather than being narrowly limited to water supply.

The Commission has also made it mandatory for states to transfer at least 20 per cent of their Finance Commission grants as devolution to local governments. This will certainly enhance the resource availability of local governments, especially panchayats.

The Commission has set a condition that local bodies should raise Rs 1,200 per household in own source revenue over time. This is a significant benchmark. Once panchayats reach that level, they are likely to strengthen their revenue base further.

In practical terms, this means that if states wish to access these funds, they will need to revive property taxation. Alternative taxation options are limited. Many states effectively abolished or weakened property tax over the past 15 to 20 years. They will now have to reconsider that approach. In several states, legislation does not even explicitly empower panchayats to levy taxes, although Urban Local Bodies generally retain this authority.

States will therefore have to rethink their fiscal strategy — or risk forfeiting these funds.

SM Vijayanand is former secretary, Union Ministry of Panchayati Raj.

Views expressed are the author’s own and don’t necessarily reflect those of Down To Earth