A Review of Indian Fiscal Federalism by zgu84696

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									A Review of Indian Fiscal
      Federalism
                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
     political parties.
    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?
   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
             Fiscal Federalism
   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
    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.
   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
    perverse incentives.
   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
    institutional capacity.
   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.
   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
   Historical factors:
       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.
   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)             Urban Local Bodies
                                        (Municipal Corporations (96)
       District (515)                   Municipalities (1494)
                                        Nagar Panchayats (2092)
     Taluk/Block (5930)

       Village (240588)
           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
    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
   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
             Intergovernmental Transfers
   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
       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
                  Finance commission
                        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
Fifth Plan
(1974-79)       50.2     17.1      67.3     17.7      11.7       29.4     3.3        100.0
Sixth Plan
(1980-85)       57.0      5.1      62.1     17.7      16.6       34.3     3.6        100.0
Seventh Plan
(1985-90)       54.2      6.9      61.0     17.0      18.1       35.1     3.9        100.0
Annual Plan
(1990-91)       52.2     10.5      62.7     17.4      16.8       34.2     3.1        100.0
Eighth Plan
(1992-97)       55.6      6.2      61.8     20.4      15.4       35.8     2.5        100.0
Ninth Plan
(1997-2001)     58.7      6.0      64.7     20.0      10.6       27.1     4.9        100.0
Tenth Plan
(2002-2007)      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    Weight
                                (Per      12th FC
                                cent)
                                11th 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
            Assistance
                    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
                                                              2.5
Special Problems                                              7.5

Total                                                        100.0
     Equalizing Impact of Transfers
   Transfers are not meant to equalise incomes:
   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.
              Equalization in Fiscal Transfer System in India – 2005-06
                (ln Per Capita Transfer = α + β ln Per Capita GSDP)
                Finance Commission                  Plan Transfers             Total
                                                                             Transfers


1. Major         Tax          Total       State       Centrall Total Plan
States         Devolutio    Transfers      Plan          y     Transfers
                  n                      Schemes      Sponsor
                                                         ed
                                                      Schemes
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)
      R2
                   0.607         0.477      -0.07       -0.063       -0.07       0.381
        Regional Policies and Invisible
                  Transfers
   Redistributive Impact of Centre‟s Own
    Expenditures;
   Invisible Transfers:
       Implicit transfers arising from controls on prices and
        outputs. Administered price policy and invisible
        transfers.
       Inter-State Tax Exportation
       Subsidized Loans to States; loan waivers and invisible
        transfers
       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
             Subsidies
                                                 Figure 8 : Per-Capita Direct Central Spending in States: 2006-07


                                    2000
Central Spending Per-Capita (Rs.)




                                    1500


                                    1000


                                    500


                                       0
                                           0   5000    10000    15000     20000    25000     30000    35000     40000   45000   50000

                                                                          GSDP Per-Capita (Rs.)
                       Concluding Remarks
   Need for Role Clarity;
       Tax and expenditure assignment system; Planning and Finance Commissions.
       Local governments.
   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.
   Institutional Reforms:
        Finance and Planning Commissions;
        Institution to resolve inter-state and Centre-State disputes.

								
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