CHAPTER- IV
Contemporary Practices and Challenges
The chapter attempts to present a comparative perspective on contemporary practices and challenges in two major federations of comparable nature. In the first case this chapter attempts to examine the institutions and mechanism and reviews various reviews the various institutional arrangements for fiscal transfers in India. It makes a comparative analysis of their approaches and analyses their relative significance in the scheme of transfers. It identifies certain critical indicators for analysing the comparative status of the States in economic and social sectors. From there, the chapter moves on to the analyses of the nature and extent of the vertical and the horizontal imbalances and interstate disparities. These indicators are the per capita State income and consumption expenditure, the human development index, the poverty ratio, infant mortality rate, literacy rate, school enrolment ratio, pupil-teacher ratio, unemployment rates and the availability of roads and of safe drinking water facilities. The relative disparity among the States is also compared in terms of the overall per capita expenditure on non-plan revenue accounts with specific analysis in respect of the education and health care sectors The chapter reviews (a) the approach adopted by the Finance Commissions in assessment of the revenue receipts and expenditure of the Central Government and the State Governments and (b) the principles for fiscal transfers laid down by the Finance Commission.
In the second comparative case, Canadian system of transfer of resources has also been examined. The Canadian system of fiscal transfers, which has been developed over a long period of time, has two central features: equalisation grants, which are constitutionally guaranteed, and the Canadian Health and Social Service Transfers (CHST). This chapter examines the relevance and applicability of the Canadian system of intergovernmental transfers in the Indian case. Equalisation grants are meant to ensure that provinces have sufficient revenues to provide reasonably comparable levels of services at reasonably comparable levels of taxation. An elaborate ‘Representative Tax System’ approach using individual revenue bases is used in Canada for determining the equalisation grants, although there has recently been a debate to use a more macro approach. The source by source approach is less practical in the Indian context for want of comparable and reliable information required for applying the method. A more practical alternative is the macro approach, which is adopted in India, but better indicators of fiscal capacity than those based on GSDP need to be used. In addition, the concept of ensuring that resources are available for maintaining the per capita expenditure of select basic services at certain levels among states, as attempted in Canada through the CHST transfers, is worth exploring, so explored in this chapter in details.
When we discuss about the contemporary practices and Challenges, necessarily we have to talk about the transfer of resources and distribution of expenditure functions and responsibilities between centre and states. Federalism is a unifying force. But at the same time the constituent units joining the federation also have a dream of better level of development and better standard of living for their people, which may not be possible with their own resources. Naturally the flow of fiscal transfers from centre to states in federal system like India assumes an important role, so far the solidarity and unity of federation is concerned. There are four main channels of federal transfers from the centre to the states in India and those are Finance Commission, Planning Commission, Central Ministries and Financial Institutions. The objective of the transfer of resources is reducing vertical and horizontal imbalance and the persisting inter-state disparities in India.
Mechanism and Institutions
The federal fiscal transfer mechanisms imply a design of transfer of resources between different tiers of government in a particular federation. The objective of the system of intergovernmental fiscal transfers is to correct vertical imbalances and horizontal inequalities in the distribution of federal resources. The vertical imbalance arises due to the asymmetric assignment of functional responsibilities and financial powers between different levels of governments and horizontal inequalities are the existing disparities in the revenue capacity across the constituent units of federation, which mainly arises due to the differences in their levels of income. The extent of these imbalances is different across federations and so the design of transfers. Under the Constitution, the Finance Commission is appointed by the President of India every five years mainly to decide on the distribution of resources, viz., tax sharing and grants from the Centre to the States[1]. This way the Constitution provides for the appointment of the Finance Commission by the President of India every five years to make an assessment of the fiscal resources and needs of the centre and individual States. Based on these, the commission is required to recommend the shares of personal income tax and union excise duty and grants-in-aid to the States. The scope of the Finance Commission becomes a major dispenser of funds to the state by way of both grants, and loans. The Finance Commission’s recommendations, once accepted by the Parliament become mandatory, so that the transfers of funds affected in pursuance of these recommendations could be said to have a statutory sanction behind them[2]these statutory transfers are unconditional transfers and the State governments according to their own expenditure priorities based on local needs use resources thus transferred through this channel.
However, given the system of transfers so evolved, over the years the transfer of resources have fallen largely outside the ambit of Finance Commission and it is the Planning Commission through which larger share of resources are getting transferred to the States. It is important in this context to remember that Planning Commission is an executive authority of the Central government rather than a constitutional body like Finance Commission. The Planning Commission transfers are non-statutory transfers in the form of plan grants, which has emerged as the single largest component of grants transferred to the States from the Centre. These non-statutory grants are decided on a year-to-year basis. At the same time as the States have to negotiate for these grants year after year, it creates a great deal of uncertainty about whether non-statutory grants will be available to States and if so in what amount and in what terms.[3] Apart from this, there are non-statutory discretionary transfers made to the States by various Central government ministries in the form of centrally sponsored schemes (CSS). By nature, CSS grants are conditional, specific purpose grants with or without matching requirements.
Vertical and horizontal imbalances are common features of most federations and India is no exception to this. The Constitution assigned taxes with a nation-wide base to the Union to make the country one common economic space unhindered by internal barriers to the extent possible. States being closer to people and more sensitive to the local needs have been assigned functional responsibilities involving expenditure disproportionate to their assigned sources of revenue resulting in vertical imbalances. Horizontal imbalances across States are on account of factors, which include historical backgrounds, differential endowment of resources, and capacity to raise resources. Unlike in most other federations, differences in the developmental levels in Indian States are very sharp. In an explicit recognition of vertical and horizontal imbalances, the Indian Constitution embodies the following enabling and mandatory provisions to address them through the transfer of resources from the Centre to the States.
(a)Levy of duties by the Centre but collected and retained by the States (Article268)
(b)Taxes and duties levied and collected by the Centre but assigned in whole to the States (Article 269).
(c)Statutory grants-in-aid of the revenues of States (Article 275)
(d)Grants for any public purpose (Article 282) See table 9
(e)Loans for any public purpose (Article 293) See table 10
(f)Sharing of the proceeds of all Union taxes between the Centre and the States under Article 270. (Effective from April 1, 1996, following the eightieth amendment to the Constitution replacing the earlier provisions relating to mandatory sharing of income tax under Article 270 and permissive sharing of Union excise duties under Article 272).See table 11
The Eleventh Finance Commission 2000(EFC)[4] noted that during the course of the last three decades, the central sector plan schemes / CSS have become an important vehicle for transfer of resources to the States, outside the State plans, and over and above the transfers following through the mechanism of Finance Commission. These were started primarily to provide funding for projects in areas / subjects considered to be of national importance and priority by the Central government. The details of the schemes are drawn up by the Centre and their implementation and funds for implementation are allocated to the State governments directly through District Rural Development Agencies or similar created organisation. There is little freedom left to the State governments to modify the schemes to local governments or to divert funds to other areas, which are considered of local priority. On the other hand the State budgets are burdened with additional revenue expenditure when the schemes are completed and their maintenance expenditure is pushed under the non-plan category. The EFC recommended that CSS need to be transferred to the States along with funds. Plans for transfer of CSS was contemplated and recommended by earlier Finance Commissions also to improve the flexibility of the State governments in deciding its own expenditure priorities and improve its financial position.
Apart from tax sharing and grants, another important instrument of resource transfer is loans and advances from the Central government. It is to be noted that the share of loan transfers to states as percentage of total resource transfer is declining over the years. However, if one looks at the structure of States outstanding debt, it becomes evident that the central loan is the single largest component of the stock of outstanding debt of the State governments. The system of federal transfer as discussed indicates the element of uncertainty and arbitrariness that non-statutory grants may create in the federal transfers which may adversely affect the goal of fiscal equalization.
Transfer of Resources
William Riker quoted in 2001, 'Federalism is the outcome of a constitutional bargain among politicians'. Fiscal relations in our country have evolved over time. These changes have taken place within the ambit of the provisions of the Constitution. Transfer of resources from Centre to federal units is a common phenomenon in all large countries having a federal constitution. This is so because there is always a mismatch between the responsibilities of the federating units and their ability to raise adequate resources. Certain resources are best raised only at the national level, both on grounds of equity and efficiency. This necessitates transfer of resources from the Centre to the states in order to correct what is very often described as vertical imbalance. Apart from this, the overall resources to be transferred to the states have to be distributed among them and the criteria for horizontal distribution are equally important.
Almost in the case of all the federations, centre enjoys larger revenue raising powers than the state governments, while the expenditure responsibilities remain largely with the latter. This gives rise to fiscal imbalance. There are, however, exceptions to this and in some of the advanced economies, the assignment of revenue powers and expenditure responsibilities are fairly evenly matched for both, the federal and the regional governments. When some imbalances do exist between the net revenue position of the Centre and the States taken together, as is the case with many federations including India, the situation is commonly called as one of vertical fiscal imbalance (VFI). In the situations of VFI, the central government is required to share its revenues with the sub-national governments. However, fiscal transfers are meant to go beyond mere revenue balancing and are expected to obtain optimum output from the operation of the fiscal system, ensure equitable provision of merit goods and promote national unity.
The prescription for intergovernmental fiscal transfers is not limited to vertical imbalances alone. In federal models of governance, fiscal imbalances could also occur horizontally, across the peer level of sub national units. The horizontal fiscal imbalance (HFI) happens particularly when the units despite having varying capacities to raise revenues, do not limit their expenditure needs to their revenue receipts. In other words, even the poorer States would try to match the expenditure patterns of the more affluent ones.[5] To an extent this situation occurs on account of legal factors, like the judicial dictum of equal pay for equal work, which forces even poorer States to pay salaries to their staff on the same scale as the richer States. In other cases, political expediency too contributes to the adverse fiscal balances among the States inter se. For instance, State governments go in for supply of free power or water to farmers, or waive off arrears of taxes, notify wage revision for staff etc., without due consideration of the impact of such measures on their respective fiscal balance. Fiscal transfers are, in such situations, expected to guard against inefficiency and populism while attempting to bring about horizontal equity by redistribution of federal resources among the States for mitigating inter-States disparities. See table 12. This is particularly important as the poorer States could prefer remaining poor and yet indulge in fiscal populism if their poverty continues to get rewarded by way of higher share in the fiscal transfers.
Fiscal transfers take place either through sharing of taxes and duties or through grants, or a combination of both. The relative merits of fiscal transfers by way of tax devolution and by way of grants have also been a matter of considerable discussion. The argument in favour of keeping the transfers largely in the nature of grants than tax sharing is two-fold. One is that the arrangement of tax sharing does not meet the equity criterion adequately even though it could be designed to achieve this goal to a limited extent. The other logic against tax sharing, particularly if it entails transfer of a significant share of the tax proceeds, is that it de motivates the Central government in improving the tax receipts and thus leads to sub-optimal operation of the taxation authority of the government. Grants, on the other hand, suffer from the stigma, and possible weakness, of being subjective to the wishes of the centre. It will pose centre as donor. Further, grants are more prone to coming with strings attached by the centre.
In a federation, such factors have the potential of leading to emotional discord in the society, to the detriment of peace and fraternity in the federation. Grants are also likely to lull the States into inaction on the presumption that the poverty of a State would be fully compensated by way of federal grants. To meet such objection, grants are often made conditional upon the Accepter State showing specified levels of improvement or by way of generating matching contributions.
Expenditure Functions
A strong traditional view has been that fiscal decentralisation in respect of public expenditure functions can entail substantial gains in terms of efficiency and welfare.[6] One of the major arguments advanced in favour of such decentralisation is that the preferences and the needs of citizens for public sector activities are better known to the local government functionaries than to those who represent the central or the state governments. The reason given is that contiguity provides more information while distance reduces the amount of information necessary to make good decisions. Further, people are closer to the state/local governments and can thus better control the activities of politicians and bureaucrats[7]
The conventional wisdom in the theory of public goods and public choice is that both the redistribution and stabilisation functions would be performed more effectively and efficiently by the central government as compared to the local governments because of the divergence between national benefits and local benefits, divergence between national costs and local costs and free-rider problems [8]These arguments are assumed to be strong enough to neutralize the advantages that economies of scale in the production of public goods and public services and in the generation of tax revenue may give to the arrangements that keep more power in the hands of central government. Critiques of this argument state that if accepted, it would imply that small countries should be more successful than large countries in satisfying the social needs of their populations. Thus, if the arguments for decentralisation were valid, there would be strong reasons for breaking up countries and weaker reasons for fiscal decentralisation[9]. However, studies have indeed shown that smaller federations do meet this test reasonably well, at least in some cases such as Switzerland.[10].