Municipal Finance: Taxes, Budgets, Fiscal Indicators, Debt and the Pricing of Services

Practice questions (20)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

1. After the 74th Constitutional Amendment, the taxing power of an Indian municipality is best described as

   1. unrestricted over any base inside its limits, because the Amendment placed municipal taxation on the same constitutional footing as the State legislature itself
   2. a fixed percentage of State revenue named in the Constitution itself, so that no commission is needed to review the sharing
   3. limited to the taxes, duties, tolls and fees that the State legislature authorises by law, with a State Finance Commission reviewing devolution
   4. confined to fees and user charges, because every tax has been reserved to Parliament under the legislative lists
   Show answer

   Answer: C — limited to the taxes, duties, tolls and fees that the State legislature authorises by law, with a State Finance Commission reviewing devolution

   Article 243X lets the State legislature authorise municipal taxes, duties, tolls and fees, and Article 243Y makes the State Finance Commission review municipal finances, so municipal taxes are creatures of State law. The tempting view of unrestricted power confuses constitutional status with a taxing power of the municipality’s own; the Constitution names no fixed share of State revenue.

2. Why do many cities find the annual rental value method a weak property-tax base where old rent-controlled tenancies are common?

   1. Assessed rents stay frozen far below market rents, so the base lags the market and similar properties are taxed unequally
   2. Rent control pushes the assessed rent above what the market would pay, so the tax exceeds the owner’s income and collection collapses
   3. The method ignores the use of the building, so residential and commercial premises are always taxed on exactly the same value
   4. The method needs a capital-value map of the whole city, and the cost of preparing that map outweighs the revenue it brings
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   Answer: A — Assessed rents stay frozen far below market rents, so the base lags the market and similar properties are taxed unequally

   Tax under this method is the rate times net ARV, and where rent control has frozen rents the ARV is low and differs between otherwise similar properties. Capital value and unit area value delink the base from rent. The distractor about a capital-value map describes the cost of a different method.

3. A city taxes built-up area multiplied by a zone-wise unit value and by multipliers for use, age and construction type, and then applies a rate. This is the

   1. annual rental value method
   2. capital value method
   3. land value tax on vacant plots
   4. unit area value method
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   Answer: D — unit area value method

   Unit area value is area × unit value of the zone × multipliers × rate. Annual rental value starts from rent and capital value from market value, neither from area and zone value.

4. A ULB raises a property-tax demand of ₹50 lakh and collects ₹38 lakh during the year. Under accrual accounting its property-tax income for the year is

   1. ₹38 lakh, because income is recognised only at the moment cash is received
   2. ₹50 lakh, with the ₹12 lakh not yet collected shown as a receivable
   3. ₹50 lakh, with no receivable because the uncollected tax is written off at year end
   4. ₹12 lakh, because only the amount still outstanding at year end is treated as income
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   Answer: B — ₹50 lakh, with the ₹12 lakh not yet collected shown as a receivable

   Accrual accounting recognises income when the right to it arises, which is when the demand is raised, so income is ₹50 lakh and ₹12 lakh sits on the balance sheet as a receivable. The tempting ₹38 lakh is the cash-basis figure.

5. A ULB has a current property-tax demand of ₹50 lakh and arrears of ₹20 lakh. It collects ₹38 lakh in all, of which ₹30 lakh is against the current demand. Its current collection efficiency is

   1. 76%
   2. 54%
   3. 43%
   4. 60%
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   Answer: D — 60%

   Current efficiency uses current collection over current demand only: 30 ÷ 50 = 60%. The figure 54% is the overall efficiency, 38 ÷ 70; 76% wrongly puts the arrears collected into the current numerator; 43% divides current collection by the total demand.

6. A ULB’s operating ratio, defined as operation-and-maintenance expenditure over revenue receipts, is 1.15. This means that

   1. running costs exceed revenue receipts, so there is an operating deficit and no surplus to service debt
   2. the ULB earns a 15% surplus over its running costs and can comfortably take on further debt
   3. own-source revenue is 115% of total receipts, which makes the ULB fully independent of transfers
   4. the debt service coverage ratio must also equal 1.15, since the two ratios are the same measure
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   Answer: A — running costs exceed revenue receipts, so there is an operating deficit and no surplus to service debt

   An operating ratio above 1 means O&M cost is more than income, so the revenue account shows a deficit. A surplus corresponds to a ratio below 1. The ratio is not the DSCR, which divides surplus by interest plus principal.

7. A ULB funds a new bulk-water scheme with a bond that is serviced only from that scheme’s tariff collections, held in an escrow account. The bond is best described as

   1. a general obligation bond
   2. a revenue bond
   3. a pooled-finance bond, because many users pay the tariff
   4. a zero-coupon bond, because no interest is paid in the term
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   Answer: B — a revenue bond

   A revenue bond is serviced from the net cash flow of the project it finances, usually through an escrow account, with limited recourse to the ULB’s other revenues. A general obligation bond would instead carry the ULB’s whole revenue base. Pooling concerns the number of issuers, not the number of tariff payers.

8. A credit rating assigned to a municipal bond primarily measures

   1. the price at which the bond will trade on its listing date and the return an investor should expect from holding it to maturity
   2. the engineering soundness and design quality of the project that the bond money will build
   3. the relative likelihood that the issuer will service that debt in full and on time, as an independent opinion
   4. the size of the city’s population and the rate of growth of its economy over the term
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   Answer: C — the relative likelihood that the issuer will service that debt in full and on time, as an independent opinion

   A rating is an independent, forward-looking opinion of ability and willingness to pay on time. It is not a price forecast, not advice to buy or sell, and not an appraisal of the project; population and growth are only inputs to it.

9. Five small ULBs, none of which could be rated above the lowest investment grade alone, jointly issue one pooled bond rated higher than any of them. Which feature most directly explains the higher rating?

   1. A pool-level reserve fund, a separate escrow for each member and State support, which together protect the investors’ claim
   2. The larger issue size, which by itself guarantees that investors are repaid whatever any one member does
   3. A common fund into which the members’ tax revenues are merged and from which each may draw freely in a shortfall without any condition
   4. The exemption of the bond interest from income tax, which makes each member’s revenues more dependable
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   Answer: A — A pool-level reserve fund, a separate escrow for each member and State support, which together protect the investors’ claim

   Ratings of pooled and structured issues reflect the structure: shared reserves, ring-fenced escrow for each member and credible State backing put investors’ claims ahead of weak members’ finances. Size lowers issue cost but guarantees nothing. A freely drawn common fund invites moral hazard and lowers the rating, and a tax exemption affects the coupon, not the repayment capacity.

10. A water utility has large fixed costs of pipes and treatment plants and a low cost of producing one extra kilolitre. If it charges every user exactly its marginal cost, then

    1. revenue exactly equals total cost, because marginal-cost pricing is defined as the break-even price
    2. revenue exceeds total cost, so the surplus can be used to cross-subsidise poor households
    3. revenue falls short of total cost, so the gap must be met by a subsidy or by a fixed charge in a two-part tariff
    4. consumption becomes inefficiently high, because users no longer face the true cost of the extra unit
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    Answer: C — revenue falls short of total cost, so the gap must be met by a subsidy or by a fixed charge in a two-part tariff

    Where fixed costs are heavy the marginal cost lies below the average cost, so pricing at marginal cost collects less than total cost and leaves a deficit. The claim that users no longer face the true cost of an extra unit is backwards: marginal-cost pricing is what makes users face the true cost of an extra unit.

11. A ULB must recover its water costs yet keep basic consumption affordable for poor households, and its large commercial users could drill their own wells. Which design fits best?

    1. A flat monthly charge for every connection, since it is cheap to collect and needs neither meters nor a billing system
    2. A very steep block tariff on commercial users alone, so that their payments cover the entire cost of every other class of consumer
    3. One volumetric rate at marginal cost for all classes, with the shortfall carried forward as arrears until grants allow its recovery
    4. A metered tariff with a small low-priced lifeline block, moderate upper blocks, and an explicit targeted subsidy for poor households
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    Answer: D — A metered tariff with a small low-priced lifeline block, moderate upper blocks, and an explicit targeted subsidy for poor households

    Metering with a lifeline block protects basic use and sends a price signal; keeping upper blocks moderate stops large users from bypassing the network, and an explicit subsidy reaches the poor directly. A flat charge gives no signal and invites waste, a punitive commercial tariff drives users to private wells, and marginal-cost pricing leaves an unfunded gap.

12. Which of the following are features of performance budgeting?

    1. Allocations are classified by programme and activity rather than only by input
    2. Each programme carries output targets and unit-cost norms against which actuals are reported
    3. Every activity must be justified from zero at the start of each budget cycle
    4. Money is linked to what is delivered, such as tonnes of waste collected or households served
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    Answer: A — Allocations are classified by programme and activity rather than only by input; B — Each programme carries output targets and unit-cost norms against which actuals are reported; D — Money is linked to what is delivered, such as tonnes of waste collected or households served

    Performance budgeting classifies by programme, sets targets and unit costs, and ties money to output. Justifying every activity afresh each cycle is zero-based budgeting, a different style.

13. Which of the following statements about municipal fiscal ratios are correct?

    1. A lower operating ratio indicates a healthier operating position
    2. A higher own-source revenue ratio indicates greater dependence on State transfers
    3. The debt service coverage ratio counts both interest and principal due in the year as the divisor
    4. Overall collection efficiency includes arrears in the amount demanded, while current efficiency does not
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    Answer: A — A lower operating ratio indicates a healthier operating position; C — The debt service coverage ratio counts both interest and principal due in the year as the divisor; D — Overall collection efficiency includes arrears in the amount demanded, while current efficiency does not

    Lower operating ratio is better, DSCR divides surplus by interest plus principal, and overall collection efficiency includes arrears. A higher own-source ratio signals less dependence on transfers, so the statement about dependence is reversed.

14. Which of the following are credit enhancements that can lift a municipal bond’s rating above the issuer’s stand-alone strength?

    1. A rise in the share of establishment expenditure within the ULB’s revenue expenditure
    2. An escrow account into which named revenues are paid before any other use
    3. A debt service reserve fund holding several months of debt service
    4. A longer moratorium on principal repayment with no change in the security
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    Answer: B — An escrow account into which named revenues are paid before any other use; C — A debt service reserve fund holding several months of debt service

    An escrow account and a reserve fund both protect debt service ahead of other claims, which lowers investor risk. A higher establishment share squeezes the surplus, and a longer moratorium only defers repayment without strengthening the security.

15. Which of the following are value-capture instruments that recover part of the cost of urban infrastructure from those who gain from land development?

    1. A betterment levy on owners whose land gains value from a public work
    2. An unconditional per-capita grant from the State Finance Commission
    3. Sale of premium floor area above the base permissible floor area ratio
    4. A metered water charge billed per kilolitre consumed
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    Answer: A — A betterment levy on owners whose land gains value from a public work; C — Sale of premium floor area above the base permissible floor area ratio

    A betterment levy and the sale of premium floor area both capture part of the land value that public investment creates. A per-capita grant is a transfer, not capture, and a metered water charge is a user charge tied to consumption, not to land value.

16. A building has a gross annual rental value of ₹2,40,000. The municipal law allows a 10% deduction from gross ARV for repairs, the general property-tax rate is 12% of net ARV, and a 5% rebate on the tax is given for payment in the first month. The tax, in rupees, payable by an owner who pays in time is ____.

    Numerical answer — type the value.

    Show answer

    Answer: 24624

    Net ARV = 2,40,000 × 0.90 = 2,16,000. Tax = 2,16,000 × 0.12 = 25,920. Rebate applies to the tax: 25,920 × 0.95 = 24,624. Check: rebate = 1,296 and 25,920 − 1,296 = 24,624. Applying the rebate to ARV first would give a different figure.

17. In a year a ULB has revenue receipts of ₹950 lakh. Its establishment and operation-and-maintenance expenditure together are ₹750 lakh (₹420 lakh and ₹330 lakh). It also pays interest of ₹60 lakh and repays principal of ₹90 lakh. Taking the surplus available for debt service as revenue receipts less establishment and O&M expenditure, its DSCR, to two decimal places, is ____.

    Numerical answer — type the value.

    Show answer

    Answer: 1.33

    Surplus available = 950 − 750 = 200. Debt service = interest + principal = 60 + 90 = 150. DSCR = 200 ÷ 150 = 1.33. Dividing by interest alone would give 3.33, which ignores the principal; the ratio is above 1, so the surplus just covers the debt service with a modest margin.

18. A ULB borrows ₹1,000 lakh at 10% a year, repayable in five equal annual instalments, the first due at the end of year 1. Taking 1.10⁵ = 1.61051, the principal still outstanding just after the first instalment is paid, in ₹ lakh to two decimal places, is ____.

    Numerical answer — type the value.

    Show answer

    Answer: 836.2

    Instalment A = 1,000 × 0.10 × 1.61051 ÷ (1.61051 − 1) = 161.051 ÷ 0.61051 = 263.80. Year-1 interest = 10% × 1,000 = 100, so principal repaid = 263.80 − 100 = 163.80 and balance = 1,000 − 163.80 = 836.20. The balance is not 800, which would result from repaying a fifth of the principal.

19. A ULB bond has face value ₹1,000, pays a coupon of 8% a year at the end of each year for three years and is redeemed at face value at the end of year 3. If the market yield is 10% a year, its price, in rupees to two decimal places, is ____.

    Numerical answer — type the value.

    Show answer

    Answer: 950.26

    Price = 80 ÷ 1.10 + 80 ÷ 1.10² + 1,080 ÷ 1.10³ = 72.727 + 66.116 + 811.420 = 950.26. The price is below face value because the market yield (10%) exceeds the coupon rate (8%); at an 8% yield it would equal 1,000.

20. A water utility must recover ₹5.4 crore a year. It produces 6 million kL a year, of which 25% is lost before billing, and it collects only 90% of the amount billed. The uniform tariff that exactly recovers the cost, in rupees per kL to two decimal places, is ____.

    Numerical answer — type the value.

    Show answer

    Answer: 13.33

    Billed volume = 6 × 0.75 = 4.5 million kL. Revenue that must be billed = 5.4 crore ÷ 0.90 = ₹6 crore. Tariff = 6 × 10⁷ ÷ 4.5 × 10⁶ = ₹13.33 per kL. Ignoring collection gives ₹12.00, and ignoring both loss and collection gives ₹9.00.