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Decentralising income tax revenue could turn India’s 250,000 local councils into growth engines—delivering equity, efficiency, and resilience
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Conventional economic theory identifies four primary inputs that drive growth— land, labour, physical capital, and human capital—each functioning within institutional frameworks that ensure fair competition and foster innovation. While these inputs are often analysed in abstract terms, they are manifested in physical spaces—on land owned and inhabited by people whose social networks, lived experiences, and interests shape how economic development unfolds locally.
However, while economic activities benefit society at large—generating wealth for citizens and tax revenue for the state—they often impose significant costs at the local level. These costs may include environmental impact, infrastructural strain, and the institutional burden on local governance systems. Such negative externalities frequently result in a lack of enthusiasm or outright resistance from local governments and citizens, especially without compensatory mechanisms.
While economic activities benefit society at large—generating wealth for citizens and tax revenue for the state—they often impose significant costs at the local level.
Central or state governments aiming to catalyse sustainable economic growth must ensure that local governments—and, by extension, the citizens they represent—derive tangible benefits from supporting business development, irrespective of political, cultural, or religious affiliations. A practical and effective strategy to motivate local councils to champion economic development is fiscal empowerment: specifically, sharing a portion of centrally collected taxes, such as Personal Income Tax (PIT) and Corporate Income Tax (CIT), with the municipalities where the taxes originate. Allowing local authorities to levy commercial and industrial property tax would further strengthen local fiscal autonomy.
This approach creates a robust incentive structure. The more economically vibrant a municipality, the greater the PIT and CIT revenues accruing to its budget. This motivates local authorities to improve the business climate through better infrastructure, efficient public services, and enhanced quality of life. Since municipalities cannot compete by altering the tax rate (as the shared state tax is uniformly applied), they are compelled to engage in a ‘race to the top’—competing through the quality of services and infrastructure rather than tax concessions. As the example of the Nordic Countries indicates, such competition for the best local public services turns the public sector into an important driver of innovation.
Empirical validation remains scarce, with few rigorous econometric studies examining the impact of local fiscal incentives on economic development.
Decades ago, political economist Barry Weingast underscored the importance of incentivising local governments to nurture their local economies. Despite its conceptual strength, the argument has received limited attention in mainstream economic research. Empirical validation remains scarce, with few rigorous econometric studies examining the impact of local fiscal incentives on economic development. However, global patterns suggest a strong correlation between robust municipal tax bases and sustained economic prosperity. While not a necessary condition for growth, some high-income countries thrive without significant municipal taxation, and all countries where municipalities have substantial local tax revenues are either already prosperous or on a clear path to economic convergence.
In Europe, this pattern holds across both established and emerging economies. Countries including the Nordic states, Germany, Austria, Luxembourg, Ireland, and Switzerland, where local governments receive a substantial share of tax revenue, consistently outperform others in long-term growth. In contrast, countries such as Greece, Italy, Spain, Portugal, and the United Kingdom (UK) show relatively weaker growth trajectories, where local fiscal empowerment is limited.
Among newer European Union (EU) member states, countries with significant fiscal decentralisation (the Baltic countries, Poland, Romania) outperform those with limited local fiscal authority (Bulgaria, Slovakia, Czech Republic). Similarly, within Asia, Japan and South Korea—now high-income, innovation-driven economies—operate under fiscal systems that allocate a share of PIT and CIT to local governments.
Countries such as Greece, Italy, Spain, Portugal, and the United Kingdom (UK) show relatively weaker growth trajectories, where local fiscal empowerment is limited.
China offers a contrasting case. Its rapid transformation was partly driven by local governments’ share in the state enterprise tax. However, Chinese local governments are not autonomous. They are accountable to the central government, not local constituents. Thus, the incentive to maximise local revenue has often led to unsustainable growth strategies, prioritising short-term gains over long-term well-being and environmental preservation.
India, by contrast, possesses a well-established framework of local self-governance. With approximately 250,000 local councils and an estimated 3.1 million elected representatives, India hosts the world’s most extensive local democratic apparatus. If properly incentivised, these councils can be activated as powerful engines of economic development.
Social skills, motivation, and common sense often outweigh formal educational credentials in ensuring effective governance.
Sceptics might argue that many local bodies lack the technical expertise to design and implement sophisticated infrastructure and services. However, the challenge of local governance is not equivalent to advanced scientific research. It is about managing communities' basic needs and aspirations through consensus, pragmatism, and commitment. Social skills, motivation, and common sense often outweigh formal educational credentials in ensuring effective governance.
Italy is a good example: the two Autonomous Provinces of Trento and Bolzano (South Tyrol), which have some of the highest-quality regional and local government, also have the lowest level of formal staff education. However, these two provinces are the only ones where 90 percent of PIT and CIT remain in local budgets.
India’s federal government could allocate a modest share of PIT and CIT to local governments. The share need not be significant; the key is that the resulting revenue must be sufficient to incentivise local action. In exchange, local governments could take responsibility for funding services currently financed through federal transfers, subject to a robust equalisation mechanism. This would ensure that municipalities in economically weaker regions can still provide essential services such as education and healthcare. An effective equalisation fund must balance equity with efficiency: poorer councils must be supported, but successful ones must retain enough surplus to reward their proactive development efforts.
When local citizens and businesses fund their councils directly through taxes, the demand for transparency, accountability, and performance naturally increases.
Critics often cite the potential for local corruption as a reason to withhold fiscal authority. Yet, when local citizens and businesses fund their councils directly through taxes, the demand for transparency, accountability, and performance naturally increases. Citizens are far less tolerant of inefficiency, especially when their own money is at stake. Concurrently, local governments are incentivised to improve services to expand their tax base and support local enterprises. This mutually reinforcing dynamic facilitates both better governance and faster economic growth.
Finally, such a fiscal reform would generate significant political dividends. It would create a cooperative alliance between the central government and local councils, bolstering India's democratic fabric and stability. Ukraine’s decentralisation reform offers a powerful example. In 2015, Ukraine granted municipalities a 60 percent share of PIT. This allowed local economic growth, a tax compliance increase, and a strong sense of local ownership, which played a crucial role in the population's resilience and organisational capacity during the 2022 Russia-Ukraine War. It may be time for India to rethink its fiscal structure and opt for tax sharing with its local councils. The ultimate causal evidence may still be lacking, but even without it, there is good reason to anticipate that such a reform could become a significant game-changer. India could become South Asia’s Nordic country, leading in happiness, health, education, innovation, and overall quality of life.
Disclaimer: The views expressed are purely those of the authors and may not in any circumstances be
regarded as stating an official position of the European Commission.
Benedikt Herrmann is a Research Officer at the European Commission, Joint Research Centre, Ispra, Italy.
Soumya Bhowmick is a Fellow and Lead, World Economies and Sustainability at the Centre for New Economic Diplomacy (CNED) at the Observer Research Foundation.
The views expressed above belong to the author(s). ORF research and analyses now available on Telegram! Click here to access our curated content — blogs, longforms and interviews.
After graduating with a master's degree in molecular biology from the University of Bayreuth in Germany, Benedikt worked for several years as a programme director ...
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Dr. Soumya Bhowmick is a Fellow and Lead for World Economies and Sustainability at the Centre for New Economic Diplomacy (CNED) at the Observer Research ...
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