A Review of Indian Fiscal Federalism

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A Review of Indian Fiscal Federalism

• M. Govinda Rao
• National Institute of Public Finance and Policy

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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.

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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

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Theoretical Insights - Continued

• New Theoretical perspectives
• Exploiting the fiscal commons Dangers from
  decentralisation
• 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.

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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.

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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.

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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.

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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

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Chart I
Centre
States (28)
Rural Local Bodies (247033)
Urban Local Bodies (Municipal Corporations
(96) Municipalities (1494) Nagar Panchayats (2092)
District (515)
Taluk/Block (5930)
Village (240588)
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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.

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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.

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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

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Criteria and Relative Weights for Tax Devolution
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Formula for Distributing State Plan Assistance
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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.

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Regional Policies and Invisible Transfers

• Redistributive Impact of Centres 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.)

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Distribution of Centres Subsidies
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Inter-State Distribution of Central Subsidies
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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.