Fiscal Federalism and Fiscal Relations Across Levels of Government

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Fiscal Federalism and Fiscal Relations across Levels of Government – The Indian Experience

-Manu Abbi

Economics (H)

Roll No. – 601

Section II

Introduction

Fiscal federalism is concerned with "understanding which functions and instruments are best

centralized and which are best placed in the sphere of decentralized levels of government". Inother words, it is the study of how competencies (expenditure side) and fiscal instruments

(revenue side) are allocated across different (vertical) layers of the administration. An

important part of its subject matter is the system of transfer payments or grants by which a

central government shares its revenues with lower levels of government including but not

limited to State Government, Municipalities and sometimes Autonomous Federations as in the

case of Scotland and Hong Kong.

Federal governments use this power to enforce national rules and standards. There are two primary types

of transfers:

1) Conditional Transfer - A conditional transfer from a federal body to a province, or other territory,

involves a certain set of conditions. If the lower level of government is to receive this type of

transfer, it must agree to the spending instructions of the federal government. An example of this

would be the Canada Health Transfer scheme under which funds must be used by provinces and

territories for the purposes of "maintaining the national criteria" for publicly provided health care in

Canada (as set out in the Canada Health Act).

2) Unconditional Transfer - An unconditional grant is usually a cash or tax point transfer, with no

spending instructions. An example of this would be a federal equalization transfer in which cash

payments made in some federal systems of government from the federal government to

subnational governments with the objective of offsetting differences in available revenue or in the

cost of providing services.

This may be noted that the concept of fiscal federalism is relevant for all kinds of government: unitary,

federal and confederal. The concept of fiscal federalism is not to be associated with fiscal decentralization

in officially declared federations only; it is applicable even to non-federal states (having no formal federal

constitutional arrangement) in the sense that they encompass different levels of government which have

defacto decision making authority.



This, however, does not mean that all forms of governments are 'fiscally' federal, only that 'fiscal

federalism' is a set of principles that can be applied to all countries attempting 'fiscal decentralization'. In

fact, fiscal federalism is a general normative framework for assignment of functions to the different levels

of government and appropriate fiscal instruments for carrying out these functions.

Fiscal Instruments in a Federal System

To carry out their functions, the various levels of government require specific fiscal instruments. On the

revenue side, governments will typically have access to tax and debt instruments. But in a federal system

there is a further method for allocating funds among the different levels of the public sector:

intergovernmental grants. One level of government may generate tax revenues in excess of its

expenditures and then transfer the surplus to another level of government to finance part of the latter’s

budget.

Taxation in a Federal System

The determination of the vertical structure of taxes is known in the literature as the "tax-

assignment problem" (Charles McLure 1983). And the basic issue here is the normative

question: Which taxes are best suited for use at the different levels of government? The

question is typically posed in a setting in which there exists a nation state with a central

government, where there is little or no mobility across national borders; at decentralized levels,

in contrast, economic agents, goods, and resources have significant mobility across

jurisdictional boundaries with the extent of this mobility increasing at successively lower levels

of government. "Local" government, for analytical purposes, may sometimes be characterized

as operating in a setting in which economic units can move costlessly among jurisdictions.

The difference in the mobility of taxed units at the central and decentralized levels has

important implications for the design of the vertical structure of taxation. Taxes, as we know,

can be the source of distortions in resource allocation, as buyers shift their purchases away

from taxed goods. In a spatial setting, such distortions take the form of locational inefficiencies,

as taxed units (or owners of taxed items) seek out jurisdictions where they can obtain relatively

favorable tax treatment. High excise taxes in one jurisdiction, for example, may lead purchasers

to bear unproductive travel costs in order to purchase the taxed items in jurisdictions with

lower tax rates. Such examples can suggest the conclusion that decentralized levels of

government should avoid the taxation of highly mobile economic units (be they households,

capital, or final goods). But this in itself is not correct. The real implication is that decentralized

levels of government should avoid non-benefit taxes on mobile units. Or, more accurately, the

analysis shows that on efficiency grounds decentralized governments should tax mobile

economic units with benefit levies (Oates and Robert Schwab 1991; Oates 1996b). Such

economic units, in short, should pay for the benefits that they receive from the public services

that local governments provide to them.



Intergovernmental Grants and Revenue Sharing

Intergovernmental grants constitute a distinctive and important policy instrument in fiscal

federalism that can serve a number of different functions. The literature emphasizes three

potential roles for such grants: the internalization of spillover benefits to other jurisdictions,fiscal equalization across jurisdictions, and an improved overall tax system.

As discussed before, grants can either be conditional or unconditional. The theory prescribes

that conditional grants in the form of matching grants (under which the grantor finances a

specified share of the recipient's expenditure) be employed where the provision of local

services generates benefits for residents of other jurisdictions. The rationale here is simply the

usual Pigouvian one for subsidies that induce individuals (in this case policy-makers or the

electorate) to incorporate spillover benefits into their decision-making calculus.

Fiscal equalization is a contentious issue from an efficiency perspective. Some observers seesuch grants as playing an important role in allowing poorer jurisdictions to compete effectively

with fiscally stronger ones. This view holds that, in the absence of such grants, fiscally favored

jurisdictions can exploit their position to promote continued economic growth, some of which

comes at the expense of poorer ones. Fiscal equalization, from this perspective, helps to create

a more level playing field for inter-jurisdictional competition.

The third potential role for intergovernmental grants is to sustain a more equitable and

efficient overall tax system. Centrally administered, non-benefit taxes with a single rate

applying to the national tax base will not generate the sorts of locational inefficiencies

associated with varying rates across decentralized jurisdictions. Moreover, central taxes can be

more progressive, again without establishing fiscal incentives for relocation. There is, in fact,

considerable evidence to indicate that state and local systems of taxes are typically more

regressive than central taxation (e.g., Howard Chernick 1992). There is thus some force in an

argument for "revenue sharing" under which the central government effectively serves as a tax-

collecting agent for decentralized levels of government, the central government then transfers

funds, in a presumably unconditional form, to provinces, states, and/or localities. It is certainly

possible, where the polity wishes, to build equalizing elements into these transfers. While there

is here a real case for the use of intergovernmental grants, a most important qualification is

that such a system of grants must not be too large in the sense of undermining fiscal discipline

at lower levels of government.

The prescriptive theory of intergovernmental grants thus leads to a vision of a system in which

there exists a set of open-ended matching grants, where the matching rates reflect the extent

of benefit spillovers across jurisdictional boundaries, and a set of unconditional grants for

revenue sharing and, perhaps, equalization purposes. Such a conception has, however, only



modest explanatory power. We do, in fact, find federal matching programs that have supported

a number of state and local activities with spillover effects, including, for example, grants for

interstate highway construction. However, on closer examination, important anomalies appear.

These grants are often closed, rather than open, ended. They thus do not provide incentives for

expansion at the margin. Moreover, the federal matching shares are typically much larger than justifiable by any plausible level of spillover benefits. More generally, in a careful study of the

intergovernmental grant system, Inman (1988) concludes that the economic theory of

intergovernmental grants does not provide a very satisfactory explanation of the structure of

U.S. grant programs; he finds that a political model can do a much better job of explaining U.S.

grant programs.

Much of the early empirical work on the expenditure response to intergovernmental grants

studied the period from the 1950's through the 1970's, when these grants exhibited a

continuing path of expansion. As a result, much of the interest focused on the budgetary

response to increases in grants. However, in more recent times, efforts at fiscal retrenchment

and devolution have led to large cuts in a wide range of federal grant programs. And this has

raised the interesting and important question of whether the response to cuts in grants is

similar in sign and magnitude to the response to increases in these grants. Gramlich (1987), for

example, observed that during this period of retrenchment, state and local governments

responded to the cutbacks in grants by picking up much of the slack: they increased their own

taxes and replaced in large part the lost grant funds so as to maintain levels of existing

programs. If Gramlich is right, then we should observe a basic asymmetry in response: the

spending of recipients should be more responsive to increases in grant monies than to

decreases in these revenues.



Fiscal Federalism in India

Evolution of Indian Federalism

India is a federation with constitutional demarcation of functions and sources of finance

between Union, State and local governments. However, statutory introduction of the third tier

is a recent phenomenon – after the 73rd and 74th amendments of the Constitution in 1992

gave the rural and urban local governments the constitutional status. Until this development,

India had evolved as a two-tiered federal structure with the powers and functions demarcated

between the Union and the States. Of course, informally some degree of decentralization

below the state level existed for a long time.

The centripetal bias in fiscal matters was seen mainly in the assignment and vesting of residuary

powers with the center. The most important factor that concentrated economic powers withthe union government, however, was entry 22 in the concurrent list – "Economic and Social

Planning" and the consequent experiment on social engineering attempted through centralized

planning in a mixed economy framework. What is however significant is the fact that the

development over the years concentrated the financial powers with the Union government.

The most important event that concentrated the financial powers of the Union government

was the nationalization of major financial including banking and insurance institutions.

Formally, Indian federalism was evolved as a two-tier structure until 1992. Nevertheless, local

government units existed both in urban and rural areas, which basically acted as agencies of the

State government. In rural areas historically, Panchayat Raj (PR) institutions in villages provided

basic community services and dispensed justice. The committee was appointed by the

Government of India to review the functioning of these local government agencies India,

(1957). The Committee recommended that: (i) these local governments should be constituted

through democratic electoral process, (ii) the elected members should represent the local

interest and should ensure proper selection and supervision of various projects to conform to

the preferences of the residents and (iii) the local governmental units should be vested with

adequate financial powers.

Subsequent to the recommendations of the Committee, most State governments introducedthe third level of government in rural areas. In many of the States, a three-tier structure of

local government unit was evolved with Panchayats established at village, Taluk (block) and

District levels. Similarly, in urban areas, the State governments instituted municipal

corporations, municipalities and notified area committees and devolved some revenue and

expenditure powers to provide urban services.



Structure of Multilevel Government in India

Federalism in India is characterized by constitutional demarcation of revenue and expenditure

powers among the three levels of government. The institutional structure of multilevel

provision of public services is shown in the figure. Thus, one billion people in the country are

spread over twenty five States and seven centrally administered territories. The Seventh

schedule to the Constitution specifies the legislative, executive, judicial and fiscal domains of

Union and State governments in terms of Union, State and concurrent lists. The Constitution

also requires the President to appoint a Finance Commission every five years or earlier to

review the finances of the Union and States and recommend devolution of taxes and grants-in

aid of revenues to them for the ensuing five years. In addition to these transfers, the PlanningCommission also gives assistance to the States based on a formula determined by the National

Development Council and specific purpose transfers for various central schemes implemented

by different ministries of the Union government.

Centre

States (28)

Urban Area Bodies (Municipal

Corporations, Municipalities, Notifie

Area Councils)

Rural Local Bodies

District

Taluk/Block

Villa e



Issues

Indian State finances are a source of growing concern. According to the Twelfth Finance

Commission Report, “…the six years from 1997-1998 to 2002-2003, have been the worst in the

history of state finances.” During this period, the ratio of state debt-to-GDP increased from 21

percent to 35 percent. The literature abounds with references to the combined fiscal deficit of

the center and the states, currently at over 10 percent of GDP. In addition to the growing debt

burdens of the states, the composition of state expenditures is also cause for serious concern.

State expenditures on interest, pensions, and wages were approximately 76 percent of the total

revenue receipts of the States in fiscal year (FY) 2003-04 (Revised Estimates), and investment in

power, irrigation, transportation, and urban infrastructure has stagnated in recent years. This

threatens India’s ability to sustain robust economic growth.

The lack of state fiscal discipline is due in large part to a flawed intergovernmental transfersystem that fosters fiscal profligacy at the state level. Specifically, the States are highly

dependent on transfers from the Union Government, which breaks the Wicksellian link

between costs and benefits. The high transfer dependency of the states has weakened

accountability and fiscal discipline. The transfer system is very complex and lacks coordination

and transparency among the three current institutions in charge of implementing transfers,

which together produce a cycle of distorting incentives. The transfer formulae are also complex

and lack clearly defined objectives. If the fiscal behavior of the States reflects the incentives

created by the intergovernmental transfer system, then, absent a structural reform of the

intergovernmental fiscal system that addresses the perverse incentives of the current system,the fiscal trends described above are likely to persist. Although the Twelfth Finance Commission

(TFC) has made an attempt to address some of the issues identified in the intergovernmental

fiscal system, there is still an urgent need to tackle other issues in the system that create

perverse incentives and soften budget constraints This emphasizes the need for the State and

Union Governments of India to strengthen and accelerate the reform of India’s

intergovernmental system.



The Fiscal Condition of State Finances

During the ten year period beginning in the mid-1980s, there was a slow but steady

deterioration in the revenue deficits of the States. Starting in 1997-98, however, this steadydecline turned into a sharp deterioration. State revenue deficits averaged 0.8 percent of gross

domestic product (GDP) between 1987-88 and 1996-97, and 2.8 percent of GDP from 1997-98

to 2000-01. Then, in both 2001-02 and 2002-03, the States made some progress in reducing

their revenue deficits. However, he revised estimates for 2003-04 show another sharp

deterioration in state fiscal balances. The States are financing these deficits through

borrowings. Consequently, the total debt of the States has increased from the already high level

of 20.7 percent of GDP in 1987-88 to 35 percent of GDP in 2004-05 (Budget Estimates) (RBI,

2004). The growth in state revenue deficits is attributable to the failure of revenue receipts to

keep pace with the growth in revenue expenditures. Absent a matching increase in revenuereceipts, the fiscal shock represented by the large wage and pension increases by the States in

1997-98 has led the way to large and persistent revenue deficits and growing state debt

burdens as a share of GDP.

20

25

30

35

Debt/GDP Ratio

Debt/GDP Ratio

0

24

6

8

10

12

Primary Deficit

Fiscal Deficit

Revenue Deficit



Generally speaking, intergovernmental fiscal transfers are used to correct for vertical and

horizontal imbalances, inter-jurisdictional spillovers, and promote national objectives. Most

federal countries, the U.S. appears to be the lone exception, use equalization grants to address

horizontal fiscal disparities among jurisdictions. All countries, the U.S. included, use special

purpose grants of one type or another to promote national priorities and address inter- jurisdictional spillovers. Equalization grants, special purpose transfers, and often different forms

of revenue sharing in themselves a type of transfer, are used to help reduce vertical imbalances

or the mismatch between expenditure responsibilities and own sources of revenues for sub-

national governments. However, the only fail proof way to address vertical imbalances is to

provide sub-national governments with an adequate level of revenue autonomy. While a

system of transfers is needed for many good reasons, it can easily be misused, and they should

not be considered as a substitute for a healthy degree of tax autonomy, and this seems to be

case of the states of India. The large vertical imbalance of the states arises from the fact that

the central government has a greater taxing power while states have been entrusted with

larger responsibilities.

In India, the high transfer dependency of the States has weakened accountability and fiscal

discipline. Transfers from the central government represent a significant part of state finances.

Shared taxes and grants from the Center to the States represent over 4 per cent of GDP. We

can see from the table that the share of transfers in state total revenues is nearly 38 percent

which is about the same since the 1990’s. The share of transfers in state total expenditures

represents about 31 percent, which is a decrease f rom the high 30’s in the 1990’s. Certainly,

this decline in the share of transfers in state expenditures is attributable to state expenditures

increasing at a much faster rate than state revenues. The Center also transfers close to 1 per

cent of GDP in the form of loans to the states. These resources constitute over one-third of the

aggregate fiscal resources available to the states.

“Central Transfers to the States”

2530

35

40

45

50

55

As a % of Central Tax Revenues

As a % of State Total Revenues

As a % of State Total

Expenditures



Additionally, there is a lack of coordination among the three current institutions in charge of

implementing transfers. The development grants implemented by the Planning Commission

create future non-plan expenditure liabilities for the states (i.e., debt service liabilities,

infrastructure maintenance costs, and personnel costs). It is implicit in the gap filling of the

grants-in-aid (GIA) approach that larger plan outlays financed by larger borrowing create largerstate liabilities, which, in turn, generate larger claims for additional fiscal transfer from the

Finance Commissions. Furthermore, the Planning Commission often receives pressure from the

Center and the states to accept that the states will be able to generate additional resources.

Based on such arguments, the Planning Commission then authorizes the states to borrow

additional amounts (Rao and Singh, 1998). Thus, there is a cycle of distorting incentives due to

the fact that the decision process is fragmented, without any single institution being

responsible for looking at the system of transfers as a whole. Additionally, the Center has not

fully exercised hierarchical control over state borrowing. The states have been able to avert the

Center’s constitutional debt controls through off -budget borrowings and guarantees. Market

borrowings of the states do not reflect creditworthiness, which contribute to the lack of fiscal

discipline among the states. There are different types of transfers taking place depending in

the agency: a) The Finance Commission Transfers

A bulk of the central transfers to the States consists of general revenue sharing of

proceeds of certain centrally levied taxes. The horizontal distribution is decided by the

Finance Commission. In addition, the Finance Commission provides for grants-in-aid

which are popularly known as “gap-filling” transfers as they are designed to cover for

the deficit between projected expenditures and revenues after tax devolution with

grants (Rao and Singh, 1998).

The transfer methodology adopted by the Finance Commissions has numerous

weaknesses. First, the formula used for tax devolution lacks a clear purpose. For

instance, the Eleventh Finance Commission (EFC) (2000-2005) mixed variables

pertaining to fiscal capacity and expenditure needs, but it did not differentiate in a

transparent way between these two fundamental means of equalization. The criteria of

population, land area, and infrastructure index measure expenditure needs. But there is

more to the measurement of expenditure need that is not covered by these indices, in

particular the poverty rate, the unemployment rate, age structure, and the like. The

only criterion for fiscal capacity, although with a weight of 62.5 per cent, is income

disparity. A more direct method to measure fiscal capacity would be the size of tax

bases and their potential yield, and the Twelfth Finance Commission (TFC) is actually

moving in this direction.



b) The Planning Commission Transfers

The Planning Commission (PC) in India is charged with the responsibility of enhancing

productive public investments in the country by working out plan investments for each

sector of the economy and each state based on the estimated resource availability.

States work out their respective annual plans for each year and then the PlanningCommission approves them. However, the plan transfers suffer from a number of

shortcomings (Bahl et al, 2005). First, under pressure from the Center and States, it

promotes increasing public investments even though they may be fiscally unsustainable.

As a result, the PC pitches for higher 'Gross Budgetary Support' for plan, irrespective of

the level of national or state indebtedness. The inability of the states to rein in revenue

expenditure and an increasingly higher proportion of revenue expenditure component

of their plans has contributed to the states running very high and persistent revenue

deficits. This is aggravated by the selection of plan schemes for states by the Planning

Commission. Increasingly, most of the schemes financed from the central assistancerecommended by the Planning Commission are revenue expenditure schemes. A stage

has come where most of the borrowings undertaken by the states for plan are going for

funding the non-plan or revenue component of the plan schemes.

Second, the central assistance released through the Planning Commission is also in loan

and grant form. The Gadgil formula 70-30 (10-90 in the case of special category states)

loan-grant transfers create incentives for the states to assume debt in order to get the

grant even though they otherwise may not have borrowed the funds because of their

very high debt levels and for other reasons. The Planning

Commission’s development projects create budgetary obligations on the sta tes (debtservice, maintenance and operation costs, and personnel costs) that are many times

now shifted to the non-plan side as the states in their misconceived interest continue to

treat these as plan expenditure, which prevents the Finance Commission from taking

these into account when they make their recommendations.

c) Other Transfers – Centrally Sponsored Transfers

Assistance provided to the states through central sector and centrally sponsored

schemes (CSSs) are an important source of revenue for the States of India, and in some

respects they are the most controversial form of transfers due mainly to its arbitrarinessand discretion. They are justified on the same bases as conditional grants are in other

countries: addressing externalities/spillovers, pursuing national objectives, and so on,

but it is generally recognized that there are too many schemes in India (Rao and Singh,

1998; Rao, 2000). In other countries, the problems associated with the proliferation of

conditional grants generally has led to calls for (or effective) simplification and

consolidation into a much smaller number of block grants.



In India, in contrast, the trend has been in the opposite direction with a continued

growth in the number of schemes. Additionally, these schemes provide a backdoor for

the federal government to micro-manage decisions that are ostensibly the responsibility

of the states. Thus, CSSs burden the administrative capacity of the states and distort

state decision-making and priorities. Furthermore, these schemes blur the lines of responsibility, particularly in the minds of voters.

d) The Problem of Soft Budget Constraint

Soft budget constrains typically arise when there is a high vertical gap, low sub-national

revenue autonomy, high sub-national borrowing autonomy, and a history of debt

forgiveness by the central government. In India, soft budget constraint has been

institutionalized by the Center providing autonomous borrowing through plan loans,

lending by the Center to the states, lending by the GoI owned institutions to the states

without insistence on debt servicing capacity, ways and means advances from theReserve Bank of India, the Ministry of Finance and the like. Neither the Center, nor the

states, passed any law placing limits on their borrowing as envisaged in the Constitution

of India. GoI has been providing substantial loan funding knowing fully well that the

states are using the same for funding their revenue deficits. GoI in 2003 decided to

adopt a fiscal responsibility law. Some states have also done so. Now, the TFC has

recommended a fiscal responsibility law that places statutory limits on both revenue

deficits and fiscal deficits. The financing framework of the states now needs to be

brought within a regime of hard budget constraints.

The no bailout policy lacks credibility. In the past, the central government hasrescheduled state debt and granted waivers of interest and principle, usually on the

basis of recommendations of the Finance Commissions. The TFC has again

recommended major debt-rescheduling with a lower rate of interest and

a debt-waiver scheme. However, this has been linked to states adopting fiscal

responsibility legislation and also to eliminating revenue deficits over a five year period.

Nevertheless, such waivers may create expectations that the Center will bailout the

states in the event of a future fiscal crisis. In which case, the states lack incentives to

behave in a fiscally prudent manner. Many states also use off-budget borrowings and

accumulation of arrears. Various orders have been issued by the GoI and the Reserve

Bank of India (RBI), which would, if implemented, bring off-budget borrowing to an end.



Record of India's Federalism in Redistribution

Does redistribution constitute a basic function of government? The question has assumed

relevance in the context of increasing disillusionment with the limited success attained by

redistributive measures to correct economic disparities and remove poverty and the focusshifting to efficiency in recent years. Transfers recommended by the Eleventh Finance

Commission came under particularly sharp attack because of what was seen as an undue tilt

towards equity to the neglect of efficiency; some critics have raised doubts even about the

constitutionality of attaching weights to inequality indices in the formula for allocating the

share of the central taxes among the states (Godbole,2001).

Public expenditure theories designed to show how resources are optimally allocated between

the public and the private sector by equalizing the social costs and benefits at the margin,

proceed on the assumption of a given state of distribution. However, Wicksell who first

indicated how the public sector can be optimally organized, applying marginal analysis, also

postulated that for the tax-expenditure arrangements to be efficient as well as just, the

underlying distribution of income must be fair. In order to close the model, a tax-transfer

budget is required to establish a just state of distribution. What is 'just' in this context involves

a value judgment raising issues in ethics. As Musgrave (1999), pointed out in the course of a

recent debate on Public Finance and Public Choice, ultimately, the mandate for fairness or

equity in the distribution of income and consumption in the community is derived from ethical

precepts that are accepted by civil societies as a matter of categorical imperative. Starting from

this premise, it is argued, in a federal system distribution has to be a concern of the centre

mainly for the reason that redistributive policies are difficult to pursue at the state level.

Redistributive tax – transfer policies in any one state tend to drive away the rich and bring in

the poor. Thus while the states can have distributive concerns of their own, redistribution

across the country has to be the concern of the center.

Regional disparities – converging or diverging?

Literature on growth theory tells us that the level of development among nations tends to

coverage as poorer nations catch up with higher growth. Studies undertaken by scholars throw

some light on whether the hypothesis of convergence holds for states in India as well. While theresults are not unanimous, some broad conclusions have emerged. A study carried out by

researchers at IMF based on data for 20 states spanning the period 1961-91 finds some

evidence of absolute convergence whereby different entities move towards the same steady

state (Cashin & Sahay, 1996) Others have questioned the findings pointing to methodological

flaws. Most of the other studies find evidence either pointing to divergence or at best

'conditional convergence', that is, where the entities in question (states in this case) converge



to possibly different steady states. A study by Rao, Shand and Kalirajan (RSK, 1999) covering 14

major states over the years 1965-95 finds no evidence of either absolute or conditional

convergence; on the contrary the evidence, according to them, points to divergence. The study

suggests that the speed of divergence had accelerated in the half decade, 1990-95.

A notable conclusion of the RSK study is that private investment (PI) plays an important role in

explaining growth differences across states flowing disproportionately more to high-income

states as well as to states with higher per capita public expenditure. They also argue that

explicit centre-state transfers have had only moderate impact on inter-state disparities, and

that their influence has been overshadowed by implicit transfers via subsidized lending (public

and private) and interstate tax exportation.

A more recent study by M.S. Ahluwalia (2000), also concludes that interstate disparities have

accentuated after the economic reforms of the 1990s as some of the richer states, recorded

faster growth in the nineties than in the eighties and the dispersion in growth rates amongstates, increased significantly. The widening trend in the disparities that was discernible even in

the late eighties became more pronounced in the nineties. D.K. Srivastava, (2001), finds that

the Gini-coefficient of inequality in real per capita GDP among 23 out of 25 states has increased

over the period 1980-81 to 1996-97, with the rising trend setting in during the latter half of the

eighties.

Overall, the transfer system no doubt had a moderating influence on the disparities in the level

of revenue expenditure across states but marked inequalities persist. One reason is that while

transfers designed by FCs lay considerable stress on equity, funds flowing through other

channels do not always move in the same direction. Transfers through the PC under the Gadgil

formula are not as equalising as the statutory transfers. Assistance under CSSs and externally

aided projects are believed to be even regressive. Substantial amounts are spent by central

ministries on various programmes that benefit the states which are not routed through the

state budgets. In the budget for 2000-01 for instance, a provision of Rs. 17,000 crore was made

for various welfare schemes to be spent by central ministries directly or thorough district

development agencies against Rs. 9700 crore under CSSs. The distribution of these amounts

among the states is not known. While the basic weakness of the poorer states stems from their

weak economies and accompanying revenue bases, the transfer system has not helped to

reduce them to the extent required to bring about a measure of equality in their revenue

capacity.

Economic federalism of the first three decades was perhaps instrumental in containing the

growth of disparities somewhat while liberalization and change in the character of federalism

thereafter took the lid off market forces and led to their accentuation. However, economic

federalism did little to tackle the sources of the disparities, that is, factors that constricted the



Reform Recommendations

Following are the broad set of reforms that need to be undertaken:

i. The scheme of assignment of functions and powers to different tiers of government as

contemplated in the constitution should be respected in letter and spirit, with only such

modifications as may appear needed to correct the deficiencies and the negative

externalities that have surfaced over the years in their operation. The center should

disengage from functions that are better performed at the lower levels of government.

The tendency on the part of the center to micro-manage the economy should cease.

The CSS’s should be compressed to only a few that represent truly national interests

that the states may not be in apposition to look after. With constitutional recognition of

local governments, more powers and responsibilities should be assigned to panchayats

and municipalities. The key to accountability in delivery of public services lies ultimately

in this. Results achieved in some states with decentralization are most encouraging.

ii. Assignment of tax powers needs a fresh look. For SNGs to be accountable and fiscally

prudent it is desirable that as far as possible they can meet their expenditures out of

revenues they can raise on their own at least at the margin. This is particularly

important in the context of the constitutional recognition of the third tier of

governments, as most of them lack any substantial revenue sources of their own.

Generally accepted principles of tax assignment in a federal polity suggest that in the

interests of autonomy and efficiency, SNGs should have the power to levy taxes that

provide little scope for tax exportation and do not interfere unduly with internal or

international commerce. Residence-based taxes like proportional individual income tax

and destination based value added tax on consumption come within this category. Taxes

may be assigned concurrently to more than one jurisdiction: There is no particular virtue

in assigning a tax exclusively to one jurisdiction. Compliance and administration are both

helped if there is some uniformity in the tax bases but the power to fix the rates should

rest with the states. That would enable the states to control the level of their revenue at

the margin to finance expenditures desired by their people. One way of enlarging the

tax powers of subnational governments while avoiding the distortions, inequities, and

administration and compliance problems associated with independent taxation at lower

levels is to allow them to levy surcharges on tax bases defined at higher levels.

Subnational surcharges have been recommended as the most appropriate form of tax

assignment for developing countries (McLure, 2000). The feasibility of assigning the

power to levy surcharges to subnational governments particularly at the local levels

(panchayats and municipalities) should be explored to a much greater extent than is the



case now. Feasibility of assigning new taxes like the 'business value tax' proposed by

Bird for local governments may also be explored to reduce their dependence on higher

level governments for funds (Bird and Mintz, 2000).

iii. In expenditure responsibilities, the concurrent list is much too wide providing scope foroverlap. While there may be a case for central intervention in many matters, the scope

for overlap needs to be reduced. Overlap leads to vertical competition among

governments to capture voter power and dilution of accountability and thereby

wasteful enlargement of government expenditure (William Niskanen in Buchanan and

Musgrave, 1999). However, it should be the center’s task to control externalities and

spillovers from the states’ tax and expenditure policies firmly. This is particularly

important for the smooth functioning of the internal market in the economy. While

with delicensing a major hurdle to the states' autonomy in industrial location policy and

the working of free enterprise in the economy has now gone, some of the other barriers

remain, as evidenced by the reservation for small industries, continuing controls over

the movement of several commodities like foodgrains, and cotton, origin based sales

taxation of inter-state trade and the jungle of taxes and regulations at various levels of

government. The reported exodus of intending foreign investors owes not a little to the

mess created by regulations of various kinds, that are still in operation. The center

would be well within its rights to see that the Part XIII of the constitution that assures

free flow of trade and commerce within the country remains effective. What is more,

there is an urgent need to rethink the role of planning. With liberalization and

dismantling of the regime of controls that constituted its support system, planning has

lost its rationale. The states should be encouraged to draw up their own schemes of

development and implement them with resources available from their own budget and

borrowing from the market.

iv. The Planning Commission should give up its system of 'approving' the five- year and

annual plans of the states. The states which are doing well should be allowed to draw up

and implement their plans as they think best, the PC may help them with advice. The PC

should focus its attention on the backward states by formulating special development

programmes for them in consultation with them (Chelliah, 2000b). The programme

should be implemented largely by the centre in association with the state governments.

This is the only way in which the backward states and those coming within the special

category can be helped to develop their revenue base and come out of their

dependency syndrome. There should be no objection from the 'have' states to the

centre concentrating on the backward states as the growth of the better off states is

propelled largely by the flow of private investment. 'Industrial entrepreneur



memoranda' drawn up in the last ten years (1991-2001) show that over 50 percent of

the investments proposed are accounted for by only four states. That should

compensate for the centre's attention being focused more on the poorer states.

v. The transfer system also needs some radical reform. To cure the weaknesses of thesystem, the multiplicity of transfer channels should go. All revenue transfers from the

centre barring only those for meeting special situation, should come within the purview

of the FC. However, the design of the FC's transfer needs to change. Revenue transfers

should be based strictly on the basis of a normative assessment of the revenue capacity

and cost disabilities of the states. That is the only way to neutralize the disincentive

effects on fiscal discipline that is inherent from transfers. One important reason for the

inability of the FCs to assess the revenue needs of the states normatively, which is

believed to be a prime source of fiscal indiscipline in the states, is inadequate technical

input in their deliberations. Determination of norms – or the application of techniques

like the Representative Tax System as followed in Canada and Australia call for building

up research expertise within the government. The need for establishing a permanent

secretariat for the FCs to undertake research on a continuing basis has been emphasized

by many. This requirement needs to be met. Another problem with the FCs' transfers

has been the segmentation of transfers recommended by them into tax devolution and

grants-in-aid. With tax devolution accounting for nearly 90 percent of the revenue

transfers ordained by the FC, the grants-in-aid have lost their teeth as an equalising and

disciplining instrument. For transfers to be based on rational principles, the focus

should be only on equalisation of revenue capacity to meet normatively assessed

expenditure needs. That requires integration of all components of revenue transfer into

one. Given the constitutional mandate for tax sharing it may not be easy to reduce the

weight of tax devolution drastically in one stroke. A beginning can perhaps be made by

gradually moving in that direction.

vi. Conditionalities can however be attached to loans. The system by which loans are

advanced and mediated by the centre to states at present are marked by features that

have a deleterious effect on fiscal discipline and need to be attended to urgently.

Experience across the world shows that fiscal discipline among SNGs is promoted not so

much by hierarchical controls as by the market – the capital markets, land markets and

owners of mobile factors like workers and investors (Rodden et.al, forthcoming). States

are forced to observe fiscal prudence as poorly performing states are punished by the

market with higher cost of borrowing or limited access to credit. Societal norms and

public awareness also matter (Shah, 1998). However, for markets to be efficacious in

enforcing discipline, there should be a developed and well regulated capital market.



That in turn presupposes that lending institutions are allowed to function autonomously

guided purely by prudential norms. Few among the developing countries can meet

these requirements. In fact only in USA and Canada, SNGs have to rely only on the

market for credit. But even in these countries market based discipline took time to be

established and the countries had to go through a prolonged period of pain in theprocess – some states/provinces remained in default for long periods. Hence, some

hierarchical, federal control exercised preferably through a loan council as in Australia

will be needed before market based discipline can work. But such control should be

rules-based. Rules have the merit of transparency and even-handedness and may be

framed to lay down limits to the absolute level of aggregate SNG borrowing (including

those contracted outside their budget). Lending institutions should be guided by these

norms. However, if market discipline is to come into full play, 'it is important not to

backstop state and local debt and not to allow ownership of the banks by any level of

government' (Shah, 1998). Enforcement of fiscal discipline on the states is thus

contingent on inter alia divestment of government ownership or control of the financial

institutions.



Conclusion

Empirical analysis shows that there has been an increasing trend in structural deficits and both

Center and States are guilty of fiscal profligacy. The deficits are not the result of higher

transfers. The States on their part have not bothered to observe fiscal discipline and havefound several ways to soften their budget constraints at the cost of macroeconomic stability.

The transfer system from the Center to the states has inherent moral hazard problems. Despite

this, the problem has continued. Multiple agencies have been making transfers, makes it

difficult to target the transfer system to meet the objectives of transfers. The gap-filling role

adopted by the Finance Commissions has only contributed to fiscal indiscipline. Despite

weaknesses, the central transfers are generally equalizing. The major contributor to

equalization is Finance Commission transfer. The Planning Commission transfer and assistance

given to Centrally Sponsored Schemes are not equalizing. Despite the overall equalizing impact,

per capita expenditure of States is positively related to taxable capacity.

In spite of constitutional recognition to the third tier, the local governments seem to play a very

limited role both in raising revenues and in spending. It would be correct to characterize

decentralization at the third level as mostly top-down. It is also seen that initiative for

decentralization at the third level has come from the Center and not the States. In raising

revenues, their role is negligible. Nor have the States given enough transfers to enable them to

play a meaningful role even in implementation. The only way they could play a meaningful role

is to resort to heavy borrowings as seems to have happened in urban local bodies in Andhra

Pradesh and Maharashtra. But this has significantly added to their deficits. The transfers at

local level do not follow any clear pattern. Of course, the level of development of the States

does seem to be a factor contributing to the success of decentralization in terms raising

revenues. However, in absolute terms the local role is not substantial. From this, it will not be

an exaggeration to say that the institutional environment does not seem conducive to the

success of decentralization at local level in India. It is necessary to understand the policies and

institutions necessary for the success to make the local fiscal governance successful.

Fiscal Federalism and Fiscal Relations Across Levels of Government

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