A Review of Indian Fiscal
M. Govinda Rao
National Institute of Public Finance and Policy
Why Study Indian Fiscal Federalism?
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
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
What does the theory say?
Traditional theories of fiscal federalism:
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).
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:
(i) Exploiting the fiscal commons: Dangers from decentralisation;
(ii) Political Economy Approach to Fiscal federalism.
Exploiting the fiscal commons: Need for hard budget constraints:
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
Application of industrial organisation theory and public choice
approach: Welfare maximisation assumption of the governments is
unrealistic; public agents maximize their own utility.
Principal –agent framework: Centre as principal and states as
agents; Voters as a principal and governments as agents.
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
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
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.
Are equalising transfers desirable? Tends to soften the subnational budget
constraint; alter the incentive for factor mobility and prevent normal trend
towards income convergence; 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
Proper design and implementation of transfer system in a political setting
is an issue of priority as well as a major challenge in fiscal federalism.
What do we learn from theories?
Theory deals with subnational governments as a whole. Need different approaches when we
deal with regional or local governments or urban or rural local governments depending on
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
Need to design transfers carefully. Perverse incentives should be avoided.
Market based reforms to minimise unintended distortions regional pattern of resource
allocation is necessary to ensure effectiveness of the transfer system.
Evolution of Indian Fiscal Federalism
Contribution from the provinces to the Union in the 1920s.
The Government of of India Act, 1919: The System of Diarchy.
The Constitution was erected on the foundation provided by Government
of India Act - 1935.
Planning and centralization
Single party domination impact on rules and institutions.
Problems of intergovernmental co-ordination in the new
The system: A quarter million governments
Rural Local Bodies (247033) Urban Local Bodies
(Municipal Corporations (96)
District (515) Municipalities (1494)
Nagar Panchayats (2092)
The Assignment Question
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
Expenditure Assignments: Political developments and
Assignment system: local governments (29 functions to
the rural local governments and 18 functions to urban
Revenue and expenditure shares. (Centre raises 63 percent
of revenues and States incur 58 percent of expenditures.
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 Per cent of Per cent of Per cent of
States' own States' revenue States' own States'
revenue receipts expenditure to revenues to expenditure to
total revenue total revenue States' revenue total
receipts expenditure Expenditure 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
Objectives of the transfer system
Multiple agencies and difficulty in pursuing the objectives:
Finance Commission; Planning Commission and Central Ministries;
Declining share of formula based transfers; discretion and asymmetry.
Direct transfers to autonomous bodies.
Problems with Finance Commission transfers;
Tax devolution and grants.
Tyranny of the base year
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
Transfers from State to local governments
Composition of Central Transfers to States
Transfers Plan Grants
Tax Grants State
Plan Periods Devoluti Total Plan Central Total Other
/ Years on Scheme Scheme Grants Total
Fourth Plan 54.4 10.3 64.6 12.9 11.6 24.4 11.1 100.0
(1974-79) 50.2 17.1 67.3 17.7 11.7 29.4 3.3 100.0
(1980-85) 57.0 5.1 62.1 17.7 16.6 34.3 3.6 100.0
(1985-90) 54.2 6.9 61.0 17.0 18.1 35.1 3.9 100.0
(1990-91) 52.2 10.5 62.7 17.4 16.8 34.2 3.1 100.0
(1992-97) 55.6 6.2 61.8 20.4 15.4 35.8 2.5 100.0
(1997-2001) 58.7 6.0 64.7 20.0 10.6 27.1 4.9 100.0
(2002-2007) 55.4 9.8 65.2 19.7 11.1 30.9 4.0 100.0
Criteria and Relative Weights for Tax
Criterion Weight Weight
(Per 12th FC
1. Population 10 25
2. Income (Distance Method)* 62.5 50
3. Area 7.5 10
4. Index of Infrastructure 7.5 -
5. Tax Effort** 5.0 7.5
6. Fiscal Discipline*** 7.5 7.5
Formula for Distributing State Plan
Variable Weight (Per cent)
Population (1971) 60.0
Per capita SDP, of which, 25.0
(i) Deviation from the average to the States below 20.0
average per capita SDP
(ii) „Distance „ from the highest per capita SDP for 5.0
all the general category States.
Fiscal Performance, of which, 7.5
(i) Tax effort 2.5
(ii) Fiscal management 2.5
(iii) National objectives
Special Problems 7.5
Equalizing Impact of Transfers
Transfers are not meant to equalise incomes:
Finance Commission Transfers – most equalizing
Even FC transfers do not entirely offset fiscal
Equalizing impact- declining over time
Specific purpose transfers – dis-equalizing
Growth differences and per capita incomes
Infrastructure levels and per capita Income.
Equalization in Fiscal Transfer System in India – 2005-06
(ln Per Capita Transfer = α + β ln Per Capita GSDP)
Finance Commission Plan Transfers Total
1. Major Tax Total State Centrall Total Plan
States Devolutio Transfers Plan y Transfers
n Schemes Sponsor
Intercept 12.2951* 12.1324* 4.9104* 3.9331 5.545* 11.1025*
(10.7236) (8.6215) (2.9939) (1.3682) (2.9613) (8.7866)
Coefficient -0.5535* -0.5303* 0.0197 0.0943 0.0177 -0.3973*
(-4.9123) (-3.8346) (0.1224) (0.3339) (0.0966) (-3.1991)
0.607 0.477 -0.07 -0.063 -0.07 0.381
Regional Policies and Invisible
Redistributive Impact of Centre‟s Own
Implicit transfers arising from controls on prices and
outputs. Administered price policy and invisible
Inter-State Tax Exportation
Subsidized Loans to States; loan waivers and invisible
Implicit resource transfers from financial repression;
rationing bank lending. (distribution of seigniorage,
subsidized lending to priority sectors etc.)
Distribution of Centre‟s Subsidies
Petroleum Food Fertilizer Agri. Central School and Total Per cent
Subsidy Subsidy Subsidy Marketing and Road Higher of GSDP
Insurance Fund Education
General Category States 450.25 170.11 243.47 11.52 12.83 25.65 913.84 3.90
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
Goa 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
Inter-State Distribution of Central
Figure 8 : Per-Capita Direct Central Spending in States: 2006-07
Central Spending Per-Capita (Rs.)
0 5000 10000 15000 20000 25000 30000 35000 40000 45000 50000
GSDP Per-Capita (Rs.)
Need for Role Clarity;
Tax and expenditure assignment system; Planning and Finance Commissions.
Reforms in the Transfer System:
General and specific purpose transfers and their design.
The role of three agencies; The methodology of transfers;
Need to continue market oriented reforms:
Phasing out subsidies
Ensuring hard budget constraint (avoid loan write off; financial repression;
phase out administered pricing); Destination based tax system.
Dealing with Challenges from Globalization.
Calibrating tax reform in co-ordination with tariff reform
Introduction of GST.
Finance and Planning Commissions;
Institution to resolve inter-state and Centre-State disputes.