West Bengal:

Fiscal Decentralization to Rural Governments:

ANALYSIS AND REFORM OPTIONS

MAIN REPORT

February 28, 2007

Table of Contents

1.INTRODUCTION

2.THE SETTING FOR LOCAL GOVERNMENT FINANCE IN WEST BENGAL

Local Government Structure

Fiscal Autonomy

State Finance Commissions.

3.III. RURAL LOCAL GOVERNMENT FINANCES

Budget Shares

Expenditure Structure

Concentration by Population Size

Composition of Expenditures by Population Size Class

4.REVENUE STRUCTURE

Own Source Revenues

Grants and Transfers

Centrally Sponsored Schemes

Grants and Transfers: State Government

5.Analysis of the disparities in gram panchayat Finances

Expenditure Disparities

Explaining Expenditure Variations

Own Source Revenues

Explaining the Distribution Impact of Intergovernmental Transfers

6.FINANCIAL CONDITION

Do Many Gram Panchayats Have a Negative Recurrent Revenue Gap?

Do the Results For Surplus GPs Indicate an Inability to Absorb the Funds?

To What Extent Do “Deficit” Gram Panchayats Draw On Their Cash Balance Reserves to Cover the Cost of Delivering Services?

Do the Closing Balances Change Over Time, and How Do We Explain This? Are These Closing Balances “Too Large”?

What Determines Financial Condition?

7.THE FISCAL POSITION OF BLOCK AND DISTRICT LEVEL GOVERNMENTS

Expenditures

Own-Source Revenues

Intergovernmental Transfers

Financial Condition

Summary

8.State Government and FISCAL DECENTRALIZATION

State Taxation

Redirection of Existing Funds

The Granting of More Fiscal Discretion

9.Reform Options and Evaluation

Decide on an Optimal Tier for Local Self Government

Expenditure Assignment

Increased Own Source Revenue

Increased State Grants: Determining the Vertical Share

A Formula Approach.

Increased, Untied Grants: A Formula Distribution

10.FINANCING THE FISCAL DECENTRALIZATION PROGRAM

REFERENCES

1.INTRODUCTION

  1. This report is about the fiscal performance of rural local governments in the state of West Bengal. Specifically, our goal is to develop a comprehensive fiscal information system for all rural local governments, and to use these data to evaluate the intergovernmental finance structure in the state. The work is of significant policy importance, given the need to develop programs to respond to the constitutional amendments mandating fiscal decentralization[1], and to support central and state government initiatives to use the PRI system as an important part of its poverty alleviation strategy. A more immediate need in West Bengal (and other states as well) is to support the work of the State Finance Commissions to better integrate rural local governments into the intergovernmental fiscal framework.
  1. Many observers of fiscal federalism in India have pointed out that fiscal decentralization to the third tier has not progressed very far since the constitutional amendments of the early 1990’s. State governments have held on to budgetary control and State Finance Commission recommendations to strengthen local government finances have in large part been ignored. Underlying this state of affairs is the fact that neither the central nor state governments have data that allow them to accurately evaluate and monitor the fiscal performance of the Panchayat Raj Institutions (PRIs).
  1. At present, there is no accurate, official record of the fiscal activities of PRI in West Bengal. The existing data base is not comparable across local government units, is not readily available in one place or in electronic form, is incomplete, and is not linked to amenity or demographic databases. Every time the Department of Rural Development in West Bengal (or the State Finance Commission) carries out an analysis of gram panchayat finances, it must resort to doing a special survey[2]. The results presented in this report, based on primary data for nearly all PRIs in West Bengal, give arguably the first-ever look at the overall picture of rural local government finances in the state. The situation as regards socio-economic data is somewhat better in that there is a 2001 census. But even here, census data are missing for a substantial number of gram panchayats and the so-called “amenity data” have not been aggregated into a usable data base[3]. This is because the base measurement unit of the census is the sub-village level and aggregation to the gram panchayat level has not been done properly in every case.
  1. In this report, we use data from a newly developed fiscal information system to study the fiscal performance of PRIs in West Bengal. The general outline of the data base upon which this report is built, and the methodology used in collecting and organizing these data areincluded in Annex A.
  1. The first three sections of this report describe the structure of rural local government finance in West Bengal. More specifically, we describe the expenditure responsibilities and financing powers of local governments, and carry out an empirical study of how they use these responsibilities and powers. In Section IV, we focus on own source revenue and grants and transfers to PRIs from the central and state level governments. In Section V, we study fiscal disparities among gram panchayats in West Bengal and model an explanation of these variations. The concern in Section VI is with fiscal balance among the gram panchayats, i.e., with the extent to which they run deficits on current account and the extent to which they carry significant balances. A parallel analysis for block and district level governments is the subject in Section VII. In Section VIII, we examine the pivotal role of the state government in determining whether fiscal decentralization will take place. In the final two sections of this report, we evaluate some options for reform and the cost implications of these reform packages. While this work does profile the fiscal activity of all three levels of PRI, the focus is on gram panchayats. This is because of the view in West Bengal (and in many other quarters) that gram panchayats are the best candidate for local self-government.
  1. This study can be a significant compliment to the work of the Third State Finance Commission in West Bengal, which is due to report in 2007. An added benefit from this study, hopefully, is that it may lift the level of the discussion about PRI finances among political leaders, technical experts, private sector leaders and voters in the state. It might also be useful as a model for similar work being carried out in other states.

2.THE SETTING FOR LOCAL GOVERNMENT FINANCE IN WEST BENGAL

  1. In terms of budget responsibilities and resources, each of the three levels of local government within the rural sector is assigned a set of expenditure responsibilities, revenue raising powers, and entitlements from the grant system. These assignments are made by the State government under the guidance of the Constitution and the Panchayat Act. The expenditure responsibilities of rural local governments are spelled out in some detail in Government of West Bengal (2005). PRI finances also are impacted by the recommendations of the State Finance Commission concerning the distribution of fiscal resources between the state government and the local governments[4]. Finally, there are direct, conditional transfers from the central government to the PRIs and these constitute the major revenue flow to the local bodies. The impact of these three influences is described below.

Local Government Structure

  1. The PRI system in West Bengal consists of 18 districts (zilla), 341 blocks (panchayat samatis) and 3,324 gram panchayats, as described in Figure 1. The urban stream of local governments, which includes municipalities and city corporations, is separate from the rural stream. The rural and urban local governments operate under different enabling legislation, and each is allocated a specified share of the state government revenue sharing pool.
  1. Perhaps as befits a state with more than 80 million people, the structure of rural local government is a hierarchical one. Local officials report up to the next highest level. Moreover, the flow of most intergovernmental transfers passes through the district and block levels before reaching the gram panchayats. Budget approval by PRIs, however, does not have to be sought from a higher tier of local government.

Fiscal Autonomy

  1. The data presented in this report describe the pattern of spending and financing by rural local governments. But, data alone cannot reveal the degree of autonomy that local governments have in making fiscal decisions. There are elected local governments in West Bengal and each has the power to approve their budget. In fact, however, the degree of fiscal discretion that is underneath the making of these budgets is limited by expenditure mandates and by constraints on revenue-raising powers.
  1. Local governments are given no powers to exceed their assigned complement of employees, nor do they have any power to determine the rate of pay of their employees. So, the wage bill of local governments is fixed from above.[5] In addition, there are expenditure mandates, e.g., the central schemes are conditional grants with narrowly prescribed expenditure targets.
  1. The gram panchayats (GPs) are thought by some to be more like autonomous local governments than are districts or blocks. For decades, the idea of village government with some degree of autonomy has been discussed in India. Gandhi’s vision of village swaraj has influenced subsequent discussions of the need for local self-governance (Alok, p. 207). Moreover, there is provision for this in Article 40 of the Constitution. With the passage of the 73rd constitutional amendment, local governments were again recognized, and more explicit provision was made for planning and service delivery responsibility and for revenue raising powers. In most states, the gram panchayats have been given more fiscal autonomy than districts and blocks, including some independent power to levy certain taxes[6]. However, in West Bengal, this has led to only about 6 percent of GP expenditures being financed from local sources. On the side of expenditure composition, GPs play a role in project selection; hence to some extent they can be responsive to special needs in various locations within the gram panchayat. Otherwise,most of their expenditure budget is driven by mandates from higher level governments.
  1. The blocks and districts have less fiscal discretion on the revenue side than do the gram panchayats, even though they sit higher in the local government hierarchy. They may raise revenues from fees and charges, and have the authority to set the rate for some of these charges, but they have no taxing power. They rely primarily on grants and transfers for their general purpose finances (only about 3 percent of their revenues are raised from own sources). Therefore, the size of the block and district budget is mostly determined by higher-level governments.
  1. On the expenditure side, districts and blocks face the same restraints on their budget choices as do gram panchayats. The expenditure discretion that they do exercise is in the capital budget, and it relates mostly to project selection and implementation with respect to centrally sponsored schemes. With respect to State grants, only a small proportion is unconditional (untied). Most state grants and transfers in West Bengal are conditional and give local governments little room to rearrange the priorities laid down by the state government. Though governed by elected councils, the districts and blocks appear to function largely as spending agents of the state and central governments.

State Finance Commissions.

  1. The State of West Bengal has received reports from two State Finance Commissions (SFC)[7]. The first SFC was constituted in 1994 and reported in 1995. The “period of recommendation” was 1996-2001. The second SFC was constituted in 2000 and made an interim report in 2001, with a period of recommendation of 2001-2006. The third SFC is now sitting with a report expected in 2007.
  1. According to the West Bengal Panchayat Act and The Constitution, the charge of the SFC is far-reaching. Its report is to contain recommendations:

“…on the principles that should govern the distribution of state revenue between the state and the Panchayats and the allocation between the Panchayats, at all levels, of their respective shares of such proceeds. The Commission was also required to recommend the principle that should govern the distribution of the revenue resources between the state and the Municipalities and the allocation between the Municipalities of their respective shares. The Commission would also determine the taxes, duties, tolls and fees which could be raised by the Panchayats and the Municipalities. The Commission would also recommend measures needed to improve the financial position of the Panchayats and the Municipalities.”

  1. In effect, the SFC is empowered to recommend a complete overhaul of the system of state and local government finance. Though there were numerous recommendations made by both West BengalCommissions as regards intergovernmental finance, the focus has been heavily, if not exclusively, on the revenue side. This is similar to the approach that has been taken by State Finance Commissions in other states (Subrahmanyam, 2004), and it is consistent with the charge given to the SFCs in the constitutional amendments. Still, if the focus of the SFC is to be on ensuring adequate financing, a strongly implied responsibility is to determine optimal expenditure assignments. Otherwise, how could adequacy in “revenues” be determined?
  1. Arguably, the most important proposal of the first two State Finance Commissions was for a vertical share of 16 percent of state taxes as a grant entitlement of local governments. Acceptance of this proposal would have led to a very significant increase in fiscal decentralization. It was also proposed that these grants be “untied”, i.e., that the recipient local governments be given the discretion to spend this money in any way they choose.
  1. This primary recommendation of the Second SFC was not accepted by the state government[8]. Instead, they decided on a program where a fixed allocation would be made to a PRI revenue sharing pool each year, depending on the financial condition of the state. In fact, even this approach was not acted on by the State government in 2004 and 2005. In these two years, the State government did not distribute finance commission grants to the local bodies. In 2006, the vertical share was set at Rs 278 crore, which is about one-half the amount recommended. The sharing of this pool of funds among local governments, however, is done by formula, and in this regard, the recommendations of the SFC have been followed.
  1. Other important recommendations of the State Finance Commission were in the area of own-source revenues of PRIs, where the need for a revenue increase and the need for more autonomy were seen to be important. The First SFC proposed to devolve entertainment tax revenues fully to local governments and to give rate setting powers to the local bodies. The Second SFC called for full devolution of entertainment tax revenues to local governments, but not for rate-setting powers. The State Government has chosen to hold the power to set rates but to transfer 90 percent of the revenues raised to local governments. Both State Finance Commissions argued for devolving the powers to set for the level of various charges. State government has not moved very far in this direction.
  1. One could make the argument that the West Bengal State Finance Commissions have not been very successful[9]. Their major recommendation, that a general revenue sharing program with a 16 percent vertical share be established for local governments, was not accepted. There are many reasons for this, with the precarious fiscal position of the state government being the most common explanation. There were, perhaps, other shortcomings. A reasonable critique of the principal recommendation is that the 16 percent share was not justified by a hard analysis of the expenditure needs of the local governments. To date, neither of the SFCs nor the State Government has based their recommendations for a vertical share on expenditure needs. Oommen (2006) studied the outputs of five other State Finance Commissions and found that none estimated the vertical gap based on a hard analysis of expenditure needs. Correcting this problem is arguably the next important step that the SFCs should take to improve the acceptability of their recommendations.
  1. Another critique of the SFC work in West Bengal (though this problem was out of their control) was that neither commission had access to a reliable data base of PRI finances, as has been developed here. The extent to which the absence of fiscal information constrained the work is well-described by the following quote from “Recommendations of the Second State Finance Commission” (p. 26):

“Data regarding resources of the different tiers of the Panchayats were not available at the State level. In view of this we circulated a questionnaire to all the Panchayats. Responses to this questionnaire were not uniform. Seven hundred and nineteen (719) out of 3362 gram panchayat sent replies but the data in respect of only 170 gram panchayat could be used. We also received information from 142 PSs out of a total of 341 while 10 out of 17 ZPs responded to our questionnaire. In spite of better administrative infrastructure available at the ZP level, it is difficult to understand why larger number of ZPs could not respond. We are aware of the inadequacy of the data and the problems of generalization from the same. While in respect of PSs and ZPs, the data could be taken to be fairly representative, in respect of gram panchayat this would at best give an indication of their state of finance.”