Major Issues in Fiscal federalism and Intergovernmental Transfers

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Major Issues in Fiscal federalism and Intergovernmental Transfers in India

Major Issues in Fiscal federalism and Intergovernmental Transfers in India

Presentation Scheme • Introduction. • What do we learn from theories of fiscal federalism?

Presentation Scheme • Introduction. • What do we learn from theories of fiscal federalism? • Evolution of Indian federalism. • The assignment question. • Fiscal imbalances in Indian federalism. • Intergovernmental transfers in India. • Equalizing impact of transfers. • Concluding remarks. 2

What is fiscal federalism? • Efficient fiscal organization of multilevel fiscal systems. Aligning fiscal

What is fiscal federalism? • Efficient fiscal organization of multilevel fiscal systems. Aligning fiscal responsibilities and fiscal instruments to carry them out to different levels. To gain from “magnitude and littleness of nations” (Alexis de Toqueville ). • The term federalism “for the economist is not to be understood in a narrow constitutional sense. In economic terms all governmental systems are more or less federal: even in a formally unitary system”(Oates, 1977) in contrast to Wheare’s view in which participating governments are coordinate and independent. • Breton’s concept of “extinguishability”. • Is India a federal country? 3

Why Study Indian Fiscal Federalism • Most populous and diverse democratic federal polity. •

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. 4

What makes an efficient fiscal federalism • Clarity in assignments; assignments according to com.

What makes an efficient fiscal federalism • Clarity in assignments; assignments according to com. advantage. • Systems and institutions to deal with overlapping assignments. • Finances should follow functions. “Wicksellian link” - 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. Residence based versus resource based taxes. • Intergovernmental transfers are inevitable even as they soften the budget constraint. Need to design them properly to avoid perverse incentives. • Ensuring a common market is at the heart of creating dynamism in fiscal federalism. Removal of impediments to mobility in factors and products and impediments to internal trade; Efficient factor (land, labour and capital) and product markets including credit and debt markets, institutional factors. Intergovernmental competition is important – avoid predatory competition. • 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. 5

Vertical Imbalance and Transfer System • Optimal assignment system and tax – expenditure asymmetry.

Vertical Imbalance and Transfer System • Optimal assignment system and tax – expenditure asymmetry. • Transfer dependency and soft budget constraint. • Need to strengthen the Wicksellian link • Vertical Imbalances • Pure vertical imbalance resolving transfers 6

Evolution of Indian Federalism • Historical factors: – Contribution from the provinces to the

Evolution of Indian Federalism • Historical factors: – Contribution from the provinces to the Union in the 1920 s. – The Government of India Act, 1919: The System of Diarchy. – The Constitution was erected on the foundation provided by 1935 Act. • Quasi-federal constitution; • Centralizing trends in the functioning; • 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. 7

Centralizing Features • • • Heavy reliance on 1935 Act Article 3 of the

Centralizing Features • • • Heavy reliance on 1935 Act Article 3 of the Constitution- Union govt can alter geographical boundaries of the State, change their names, carve out new ones from combining parts of one or more States after merely referring the Bill to the Legislature of the States concerned for expressing their views. Article 249 - Rajya Sabha can transfer any item contained in the State List of 7 th Schedule to the Union List with two-thirds of the members present and voting, if it is thought to be expedient in the national interest. Article 352 - the President can proclaim “Emergency” if he/she is satisfied that there is a grave danger for security of India or in any part of the country is threatened by external aggression or internal disturbance. Article 360 empowers the President to declare financial emergency if he/she is satisfied that financial stability is threatened. Although Article 301 guarantees the freedom of trade and commerce throughout the country, Articles 302 and 303 read together empower the Parliament to impose restrictions on internal trade if it is required in ‘public interest’ and is nondiscriminatory. Concurrent list contains “economic and social planning”. Residuary powers are assigned to the Union. Primacy of Union Laws in the event of a conflict in concurrent subject. Article 356. 8

The Assignment Question • Changing nature of economy, development strategy and technology calls for

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). 9

Fiscal Imbalances • Vertical Imbalance: Increasing revenues and yet increasing fiscal dependence. • States

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 NSDP in 2011 -12 varied from Rs. 23435 in Bihar to Rs. 108859 in Haryana; – Per capita development expenditure varied from Rs. 4902 (66% of average) in Bihar to Rs. 11705 (158%) 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. 10

States’ Share in Revenues and Expenditures Years Total Revenue Expendi (Centre ture +States) (Centre

States’ Share in Revenues and Expenditures Years Total Revenue Expendi (Centre ture +States) (Centre +States) States Share in Revenues Per cent Tax Rev Non-Tax of GDP Rev States' Share in expenditures Total Rev Current Exp Capital Exp Total Exp 2000 -01 16. 65 25. 82 38. 23 40. 82 39. 11 56. 03 56. 96 56. 50 2005 -06 18. 85 24. 93 37. 70 34. 68 36. 77 55. 17 59. 36 56. 73 2007 -08 20. 20 24. 40 31. 85 38. 51 32. 91 53. 48 53. 06 54. 67 2008 -09 18. 70 25. 71 33. 88 40. 48 34. 73 49. 30 64. 18 53. 84 2009 -10 18. 15 27. 19 37. 60 39. 64 37. 52 51. 15 61. 46 54. 30 2010 -11 19. 86 26. 35 37. 64 23. 78 35. 01 51. 33 53. 67 53. 10 2011 -12 18. 43 26. 83 38. 69 38. 27 34. 03 53. 67 60. 88 55. 77 2012 -13 19. 98 27. 32 38. 46 33. 98 36. 97 54. 67 53. 46 55. 58 11

Intergovernmental Transfers • Objectives of the transfer system • Multiple agencies and difficulty in

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 12 th Finance Commission. • Transfers from State to local governments 12

Composition of Union Transfers to States 2012 -13 2013 -14 2014 -15 States'Shate in

Composition of Union Transfers to States 2012 -13 2013 -14 2014 -15 States'Shate in Taxes 49. 9 50. 9 46. 5 Finance Commission Grants 9. 2 10. 6 9. 2 Finance Commission Transfers Plan Grants - State Plan; of which: Normal Central Assistance 59. 1 61. 5 55. 7 8. 3 4. 7 7. 8 6. 4 Centrally Sponsored Schemes 12. 0 37. 9 Direct Transfers 20. 5 18. 7 0. 0 32. 5 30. 7 37. 9 100. 0 Total 13

Criteria and Relative Weights for Tax Devolution 14

Criteria and Relative Weights for Tax Devolution 14

Formula for Distributing State Plan Assistance Variable Weight (Per cent) Population (1971) 60. 0

Formula for Distributing State Plan Assistance Variable Weight (Per cent) Population (1971) 60. 0 Per capita SDP, of which, (i) Deviation from the average to the States below average per capita SDP (ii) ‘Distance ‘ from the highest per capita SDP for all the general category States. 25. 0 20. 0 5. 0 Fiscal Performance, of which, (i) Tax effort (ii) Fiscal management (iii) National objectives Special Problems Total 7. 5 2. 5 7. 5 100. 0 15

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Equalizing Impact of Transfers • Finance Commission Transfers – most equalizing; but do not

Equalizing Impact of Transfers • Finance Commission Transfers – most equalizing; but do not offset fiscal disabilities fully; • Equalizing impact- declining over time • Specific purpose transfers – disequalizing • Growth differences and per capita incomes; • Trends during the last decade. . 17

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Regional Policies and Invisible Transfers • Redistributive Impact of Centre’s Own Expenditures; • Invisible

Regional Policies and Invisible Transfers • Redistributive Impact of Centre’s Own Expenditures; • Invisible Transfers: – Implicit transfers arising from controls on prices and outputs. – Inter-State Tax Exportation – Subsidized Loans to States – Implicit resource transfers from financial repression; rationing bank lending. (distribution of seigniorage, subsidized lending to priority sectors etc. ) 19

New Developments • Finance commission’s approach; • Abolition of Planning Commission and establishment of

New Developments • Finance commission’s approach; • Abolition of Planning Commission and establishment of NITI. • Experimentation with the Committee of Chief Ministers; 20

Concluding Remarks • Transfers have a progressive distribution, they have not offset fiscal disabilities.

Concluding Remarks • Transfers have a progressive distribution, they have not offset fiscal disabilities. • Multiple agencies giving transfers makes it difficult to achieve the objectives. • There are serious questions on equity and incentives in the distribution of transfers from the Finance Commission. • Specific transfers are discretionary and there are many problems of equity, incentives and accountability. • There are several invisible sources that nullify the progressivity of the explicit transfer system. • Need for role clarity in regard to Finance and Planning Commissions. 21