Transcript Fiscal Federalism in India: Emerging Challenges

Fiscal Federalism in India:
Emerging Challenges
M. Govinda Rao
National Institute of Public Finance and Policy
Why Study Indian Fiscal Federalism?
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Most populous and diverse democratic federal polity
Transition from plan to market: Need for reforms in policies and institutions
(implicit transfers, common market principles, regional equity)
Globalization and fiscal federalism. Need to reorient the system to create a
competitive environment.
Changing political environment; emergence of coalition government at
Centre, regional parties in States, latter becoming pivotal members in
Central coalition government, changing priorities and time horizons of
political parties.
Fiscal Imbalance in India – Need for Coordinated Calibration of Policies.
Notable Feature: Holding the country together for 60 years: Constitution
with fundamental rights guaranteed; Independent judiciary; free press and
steel frame bureaucracy.
Dissatisfaction: Has not reaped gains from “magnitude and littleness”;
Highly centralised system; impediments to common market; Regional
aspirations and demand for statehood; absence of satisfactory institutional
mechanism to resolve with Centre-State and inter-State disputes.
What does the theory say?
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Traditional theories of fiscal federalism:
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Decentralization theorem: If there are no cost advantages from
centralised provision, there will be significant welfare gains from
decentralisation in service delivery as it caters to diversified
preferences. Gains vary with magnitude of variation in demand and
inversely with price elasticity of demand. Trade off between welfare
gains from decentralisation and scale economies from centralisation
(supply cost includes, production cost, organisational cost,
information cost and transaction cost).
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Assumptions: Benevolent government and centralised provision results
in uniform output levels (information cost).
Tiebout model: Footloose mobility; welfare maximisation
through Tiebout sorting out process. Imperfect mobility and
welfare maximisation through capitalisation of property
values. May not fully take account of “local” circumstances
Theoretical Insights - Continued
New Theoretical perspectives:
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(i)
(ii)
Exploiting the fiscal commons: Dangers from decentralisation;
Political Economy Approach to Fiscal federalism.
Exploiting the fiscal commons: Need for hard budget constraints:
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Soft budget constraint and exploiting the fiscal commons. Game theoretic
approach: Structural sources of soft budget constraint: ill defined
responsibilities to units and functionaries; federal transfers, borrowing and
bail outs; absence of a strong system of private markets (land, capital),
history and precedents.
Market preserving federalism: Five preconditions.
(i) hierarchy of governments and clear assignments; (ii) subnational
autonomy to provide and regulate; (iii) national government should have
policies to ensure a common market; (iv) subnational governments should
have hard budget constraints; and (v) institutionalisation of political
authority to ensure that one level of government does not abridge or
extinguish the powers of others.
Political Economy Approaches to
Fiscal Federalism
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Public choice approach: Welfare maximisation assumption of
the governments is unrealistic; public agents maximize their
own utility.
Centralisation allows for better coordination; while
decentralisation can be more effective in matching
preferences and increased accountability. Accountability
requires matching decisions on public services with taxes at
the margin. Gains from coordination versus greater marching
of preferences and accountability.
Yardstick competition or competitive governments by Breton.
‘Salmon’ mechanism: efficiency and accountability.
Role of Intergovernmental Transfers
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Rationale for transfers: Traditional theory: Local public goods and private
goods: User charges and taxes.
Public goods with externalities: Specific purpose matching transfers
depend on the degree of spillovers. Actual grants do not resemble this
anywhere.
Grants to offset fiscal disabilities to enable comparable level of public
services at comparable tax rates. Controversial. ‘Transfer dependency’
undermines sound fiscal behaviour. Need to design it well.
Another reason: Massive inter-regional transfers in Italy have blunted the
incentives for factor mobility that would normally result in income
convergence.
However, it is a part of the fiscal federalism architecture: Need to have (i)
a solid system of local taxation should underlie an effective system of
transfers; (ii) System of transfers must be transparent and predictable; (iii)
the transfer system should be designed to offset fiscal disabilities without
perverse incentives.
Design and operation of the transfer system in a political setting is an
issue of the first priority in fiscal federalism.
What do we learn from theories?
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Theory deals with local governments as a whole. One size does not fit all.
Clarity in assignments and assignments according to comparative advantage is
critical. One size does not fit all.
Assigning responsibilities to different functionaries – Need to make the elected
executive responsible for decision making. Importance of governance systems.
Finances should follow functions. “Wicksellian link” - Matching revenue –
expenditure decisions. Local governments should have productive tax handles.
Accountability requires that local services should be paid for locally and services
with spillovers should receive matching transfers.
Ensuring a common market is at the heart of creating dynamism in fiscal
federalism. Removal of impediments to mobility in factors and products and trade
impediments to trade; Abolition of laws restricting markets (land, housing,
capital), institutional factors.
Hard budget constraint is critical for efficiency and accountability; This requires
clarity in assignments, avoidance of bail outs, avoidance of transfer dependency;
development of markets; transparency in decision making.
Promotion of intergovernmental competition to ensure efficiency. Prevention of
unstable competition.
Need to design transfers carefully. Perverse incentives should be avoided.
Evolution of Indian Fiscal Federalism
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Historical factors:
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Contribution from the provinces to the Union in the 1920s.
The Government of oa India Act, 1919: The System of Diarchy.
The Constitution was erected on the foundation provided by 1935 Act.
Quasi-federal constitution
Planning and centralization
Single party domination impact on rules and institutions.
Problems of intergovernmental co-ordination in the new
political environment.
Sub-state decentralisation.
The system: A quarter million governments
Chart I
Centre
States (28)
Rural Local Bodies (247033)
District (515)
Taluk/Block (5930)
Village (240588)
Urban Local Bodies
(Municipal Corporations (96)
Municipalities (1494)
Nagar Panchayats (2092)
The Assignment Question
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Changing nature of economy, development strategy and
technology calls for changing assignment system.
Tax Assignments: Problems with the principle of
exclusivity. Lack of coordinated reforms; poor tax
harmonisation;
Expenditure Assignments: Political developments and
intrusion.
Assignment system: local governments (29 functions to
the rural local governments and 18 functions to urban
local governments).
Revenue and expenditure shares. (Centre raises 63 percent
of revenues and States incur 58 percent of expenditures.
Fiscal Imbalances
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Vertical Imbalance: Increasing revenues and yet
increasing fiscal dependence.
States raise 37 per cent of revenues, but incur 58 per
cent of expenditures;
Increasing horizontal imbalance. (Per capita GSDP in
2006-07 varied from Rs. 10286 in Bihar to Rs. 48213
in Haryana; Per capita development expenditure varied
from Rs. 2105 in Bihar to Rs. 5718 in Haryana).
Fiscal Adjustment in the states – deficits not related to
per capita GSDP, but per capita development
expenditures in poorer states are significantly lower.
Vertical Fiscal Imbalance in India
Year
Per cent of
States' own
revenue
receipts total
revenue
receipts
Per cent of
States' revenue
expenditure to
total revenue
expenditure
Per cent of
States' own
revenue
receipts to
States' revenue
Expenditure
Per cent of
States'
expenditure to
total
expenditure
1955-56
41.2
59.0
68.9
61.7
1960-61
36.6
59.9
63.9
56.8
1970-71
35.5
60.2
60.6
53.9
1980-81
35.6
59.6
60.1
56.0
1990-91
35.2
54.6
53.1
51.7
1995-96
39.2
57.0
58.6
55.8
1999-00
38.6
56.4
49.8
56.0
2000-01
37.8
56.0
48.6
56.1
2001-02
40.2
56.9
50.0
56.3
2002-03
38.3
54.3
56.0
55.1
2003-04
37.5
56.3
53.8
57.7
2004-05
38.1
56.3
60.1
56.6
2005-06 (RE)
37.1
56.6
56.1
58.1
Intergovernmental Transfers
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Objectives of the transfer system
Multiple agencies and difficulty in pursuing the objectives:
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Finance Commission; Planning Commission and Central Ministries;
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Declining share of formula based transfers; discretion and asymmetry.
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Direct transfers to autonomous bodies.
Problems with Finance Commission transfers;
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Tax devolution and grants.
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Tyranny of the base year
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Fiscal dentistry.
Problems with plan transfers.
Central sector and centrally sponsored schemes.
Increasing discretionary element in transfers.
Regional policies and invisible transfers
Financing infrastructure: Loans – Fiscal Restructuring by 12th Finance
Commission.
Transfers from State to local governments
Table .5
Composition of Central Transfers to States
Rs. Billion
Plan Periods
/ Years
Fourth Plan
Fifth Plan
(1974-79)
Sixth Plan
(1980-85)
Seventh Plan
(1985-90)
Annual Plan
(1990-91)
Eighth Plan
(1992-97)
Ninth Plan
(1997-2001)
Tenth Plan
(2002-2007)
Finance commission
Transfers
Tax
Grants
Devoluti
Total
on
54.4
10.3
64.6
Plan Grants
State
Plan Central
Scheme Scheme
12.9
11.6
Total
24.4
Other
Grants
11.1
Total
100.0
50.2
17.1
67.3
17.7
11.7
29.4
3.3
100.0
57.0
5.1
62.1
17.7
16.6
34.3
3.6
100.0
54.2
6.9
61.0
17.0
18.1
35.1
3.9
100.0
52.2
10.5
62.7
17.4
16.8
34.2
3.1
100.0
55.6
6.2
61.8
20.4
15.4
35.8
2.5
100.0
58.7
6.0
64.7
20.0
10.6
27.1
4.9
100.0
55.4
9.8
65.2
19.7
11.1
30.9
4.0
100.0
Criteria and Relative Weights for Tax
Devolution
Criterion
Weight
(Per
cent)
12th FC 13th FC
11th FC
1. Population
10
25
25
2. Income (Distance Method)*/Fiscal
62.5
50
47.5
Capacity Distance
3. Area
7.5
10
10
4. Index of Infrastructure
7.5
5. Tax Effort**
5.0
7.5
6. Fiscal Discipline***
7.5
7.5
17.5
Formula for Distributing State Plan
Assistance
Variable
Weight (Per cent)
Population (1971)
60.0
Per capita SDP, of which,
(i) Deviation from the average to the States below
average per capita SDP
(ii) ‘Distance ‘ from the highest per capita SDP for
all the general category States.
Fiscal Performance, of which,
(i) Tax effort
(ii) Fiscal management
(iii) National objectives
25.0
20.0
5.0
7.5
2.5
2.5
2.5
Special Problems
Total
7.5
100.0
Equalizing Impact of Transfers
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Finance Commission Transfers – most
equalizing
Even FC transfers do not entirely offset fiscal
disabilities;
Equalizing impact- declining over time
Specific purpose transfers – dis-equalizing
Growth differences and per capita incomes
Infrastructure levels and per capita Income.
Note: Estimated by employing the functional form: Ln G = a + b Ln Y+ e
Where, G denotes different types of per capita transfers, Y represent per capita NSDP, a and b represent parameter estimates and e is the error term.
_Table 8
Equalisation in Fiscal Transfer System in - 1998-99
State
Finance
Commission
Planning Commission
Total Current Transfers
State Plan
Schemes
Centrally
Sponsored
Total
1. Major States
Intercept
8.383
5.859
-2.819
3.848
8.124
T value
8.943
3.527
-0.760
2.011
9.180
Coefficient
-0.260
-0.171
0.736
0.115
-0.194
T value
-2.638
-0.978
1.891
0.573
-2.087
R2
0.349
0.068
0.216
0.025
0.251
Regional Policies and Invisible
Transfers
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Redistributive Impact of Centre’s Own
Expenditures;
Invisible Transfers:
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Implicit transfers arising from controls on prices and
outputs.
Inter-State Tax Exportation
Subsidized Loans to States
Implicit resource transfers from financial repression;
rationing bank lending. (distribution of seigniorage,
subsidized lending to priority sectors etc.)
Distribution of Centre’s Subsidies
Petroleum
Subsidy
Food
Subsidy
Fertilizer
Subsidy
Agri.
Marketing and
Insurance
Central
Road
Fund
School and
Higher
Education
Total
General Category States
450.25
170.11
243.47
11.52
12.83
25.65
913.84
Andhra Pradesh
489.01
276.17
361.93
25.13
5.80
24.34
1182.37
4.00
Bihar
226.82
68.22
149.45
8.32
2.50
10.18
465.49
4.94
Chattisgarh
335.58
291.00
245.87
0.38
9.97
14.81
897.62
3.64
1646.55
52.20
60.69
0.00
0.00
50.28
1809.72
2.42
Gujarat
632.93
79.08
294.58
16.32
17.41
13.09
1053.42
3.19
Haryana
867.49
59.02
610.53
52.70
24.00
26.14
1639.88
3.90
Jharkhand
320.80
145.23
55.11
17.97
3.47
14.56
557.13
3.41
Karnataka
550.83
248.73
297.86
2.35
19.21
16.94
1135.91
3.81
Kerala
520.09
199.83
69.85
0.55
9.16
27.18
826.67
2.55
Madhya Pradesh
334.12
141.45
211.54
4.66
12.11
36.41
740.28
4.79
Maharashtra
623.71
141.82
243.92
2.13
20.33
21.93
1053.84
2.92
Orissa
339.81
288.18
129.31
0.61
12.90
22.82
793.63
4.48
Punjab
842.46
18.38
791.04
0.54
23.09
39.45
1714.97
4.67
Rajasthan
429.15
61.71
177.21
73.46
21.31
21.81
784.66
4.33
Tamil Nadu
624.63
396.61
194.25
7.60
19.67
31.64
1274.40
4.13
Uttar Pradesh
317.99
149.26
245.96
1.34
10.42
37.46
762.44
5.73
West Bengal
350.84
185.78
183.13
3.82
7.80
28.67
760.04
3.10
Goa
Per cent
of GSDP
3.90
Inter-State Distribution of Central
Subsidies
Central Spending Per-Capita (Rs.)
Figure 8 : Per-Capita Direct Central Spending in States: 2006-07
2000
1500
1000
500
0
0
5000
10000
15000
20000
25000
30000
GSDP Per-Capita (Rs.)
35000
40000
45000
50000
Concluding Remarks
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Reforms in Policies and Institutions Needed.
Need for Role Clarity;
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Assignment system;
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Planning and Finance Commissions.
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Local governments.
Reforms in the Transfer System:
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General and specific purpose transfers and their design.
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The role of three agencies.
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The methodology of transfers;
Dealing with Challenges from Globalization.
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Calibrating tax reform in co-ordination with tariff reform
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Introduction of GST.
Institutional Reforms:
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Finance and Planning Commissions;
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Institution to resolve inter-state and Centre-State disputes.