Fiscal Federalism in India: Emerging Challenges

1. Fiscal Federalism in India: Emerging Challenges M. Govinda Rao National Institute of Public Finance and Policy

2. 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. • Fiscal Imbalance in India – Need for Coordinated Calibration of Policies. • 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.

3. 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

4. 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.

5. Political Economy Approaches to Fiscal Federalism • Public choice approach: Welfare maximisation assumption of the governments is unrealistic; public agents maximize their own utility. • 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.

6. 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. • Another reason: 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. • Design and operation of the transfer system in a political setting is an issue of the first priority in fiscal federalism.

7. What do we learn from theories? • Theory deals with local governments as a whole. One size does not fit all. • 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.

8. Evolution of Indian Fiscal Federalism • Historical factors: • Contribution from the provinces to the Union in the 1920s. • The Government of oa India Act, 1919: The System of Diarchy. • The Constitution was erected on the foundation provided by 1935 Act. • 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

9. 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)

10. 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.

11. 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.

13. 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

15. Criteria and Relative Weights for Tax Devolution

16. 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 7.5 2.5 2.5 2.5 Special Problems 7.5 Total 100.0 Fiscal Performance, of which, (i) Tax effort (ii) Fiscal management (iii) Nationalobjectives Formula for Distributing State Plan Assistance

18. Equalizing Impact of Transfers • 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.

19. Note: Estimated by employing the functional form: Ln G = a + b Ln Y+ e Where, G denotes different types of per capita transfers, Y represent per capita NSDP, a and b represent parameter estimates and e is the error term.

20. 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.)

21. Distribution of Centre’s Subsidies

22. Inter-State Distribution of Central Subsidies

23. Concluding Remarks • Reforms in Policies and Institutions Needed. • Need for Role Clarity; • 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; • 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.