Working Paper No. 140 DYNAMICS OF INDIAN FEDERALISM. by M. Govinda Rao. July 2002

Transcription

1 Working Paper No. 140 DYNAMICS OF INDIAN FEDERALISM by M. Govinda Rao July 2002 Stanford University John A. and Cynthia Fry Gunn Building 366 Galvez Street Stanford, CA Stanford India Conference on Indian Economic Reforms, Center for Research on Economic Development and Policy Reform, Stanford University, USA. (June 3-4, 2002)

2 DYNAMICS OF INDIAN FEDERALISM M. Govinda Rao I. Introduction: Until the economy embarked on market based reforms in 1991, intergovernmental policies and institutions in India were structured to meet the requirements of public sector dominated, heavy industry based, import substituting industrialization strategy. In fact, centralized planning is the negation of federalism and, sub national governments had very little role in formulating and implementing the development strategy. In addition, regulations and controls introduced to meet the requirements of a shortage economy have segmented the market. Transition from plan to market based development since 1991 has envisaged greater role for sub national governments in providing physical and social infrastructure and creating accommodating investment climate. Therefore, it is important to examine whether the federal policies and institutions evolved over the years have been flexible enough to adjust to the changing requirements. In a multilevel fiscal system, governmental units enjoy competitive relationships. Intergovernmental competition, when it is stable and efficient can result in efficiency gains and help to accelerate the growth process. Dynamics denotes movement from one circular flow to another in which intergovernmental units engage themselves in Shumpeterian type entrepreneurial competition (Breton, 1995, p.32). For intergovernmental competition to be efficient, however, there are important preconditions. Competitive equality and cost-benefit appropriability ensure that no governmental unit can dominate, coerce and exploit another (Breton, 1987). Most importantly, violation to market preserving federalism by creating impediments to free mobility of factors and products across the country can have an adverse impact on growth and equity. It is also important that sub national units should be faced with hard budget constraints (Bahl, 2002). The Central government has to monitor intergovernmental competition. Since reforms were initiated, Indian economy has seen significant acceleration in economic growth. The growth of GDP (factor cost) accelerated from 5.8 per cent during 2

3 to 6.3 per cent during However two important facts about economic growth should be noted. First, even during the 1990s, the performance has been below the potential and since the growth rate has actually tended to decelerate (Acharya, 2002). Second, the growth acceleration has been generally taken place in relatively affluent States and therefore, during the 1990s, inter-state income disparity has accentuated. (Ahluwalia, 2001, Rao, Shand and Kalirajan, 2000). By and large, more affluent States have better infrastructure, governance and investment climate and therefore, have been able to take advantage of liberalized investment opportunities better (Figure 1). Exception to this has been the deceleration in economic growth in the two agriculturally predominant States of Punjab and Haryana. The States that could take advantage of market liberalization fared better. Figure 1: Relationship Between Levels of Income and Growth Rates Annual Growth Rate of Per Capita GSDP (%) Major States Per Capita SDP (Rupees) Annual Growth Rate of Per Capita GSDP (%) Relationship Between Level of Income and Growth Rate (Excluding Punjab and Haryana) Rupees r = r = This paper attempts to examine the extent to which intergovernmental fiscal policies and institutions have helped or hindered efficiency and growth during the last decade. The second section summarizes the salient features of Indian fiscal federalism. In the third section, macroeconomic stability aspects of sub national finances and their contribution to overall fiscal imbalances in the country are analyzed. The fourth section examines the causes of fiscal imbalances at sub national level. The fifth section analyzes the efficiency implications of sub national fiscal operation in Indian federalism. The last section summarizes the major conclusions. 3

4 II. Indian Fiscal Federalism: Salient Features II. 1. Indian federalism: Evolution and Structure. India represents a classical federation with Constitutional demarcation of functions and finances between the Union and the States. The billion people in the federation are spread over 28 States and 7 Union territories (2 with their own elected governments). Separate legislative, executive and judicial arms of government are constituted at both Central and State levels. The seventh schedule to the Constitution specifies the legislative domains of the Central and State governments in terms of Union, State and Concurrent lists. The Constitution also requires the President of India to appoint a Finance Commission every five years (or earlier) to review the finances of the Center and the States and recommend devolution of taxes and grant in aid for the ensuing five years. With the 73rd and 74th Constitutional amendments in 1993 over a quarter million local government units have been created in urban and rural areas to provide an enabling environment for decentralized provision of public services. Historical factors have played a crucial role adopting a federal constitution with strong unitary features in India (Rao and Singh, 2002a). The centralization inherent in constitutional assignment was further strengthened by the adoption of a planned development strategy. This not only caused the concentration of economic power but also led to the introduction of several controls and regulations with attendant distortions on relative prices and economic incentives. Rationing, price controls and regulations introduced to manage the shortage economy contributed to market segmentation further and even when the economy transited into surpluses, strong distributional coalitions created by the system have resisted reforms to meet changing requirements. II.2 Assignment between Center and States: The functions related to money supply, external borrowing, international relations, defense, atomic energy, space, national highways, airways, international waterways, and those having significant scale economies are assigned exclusively to the center. The functions involving benefits spanning across States and matters with significant developmental potential are undertaken concurrently with the States. These 4

5 include economic planning, energy, education, health and family welfare. The functions with statewide implications are assigned to the States. Most progressive tax handles have been assigned to the Center. The taxes assigned to the States include land revenue, taxes on agricultural incomes and wealth, stamp duties and registration fees, tax on sales and purchase of goods, excise duties on the sale of alcoholic products and tax on motor vehicles and tax on goods and passengers transported through roads and inland waterways. From the viewpoint of revenue productivity, sales tax is the most important tax handle. The residual functions and tax powers vest with the Center. Notably, the tax powers are assigned on the basis of the principle of separation - assigned exclusively either to the Center or the States. Thus, the Center can levy taxes on production whereas, the tax on sale or purchase of goods is levied by the States. This can lead to uncoordinated development of the tax system for, the separation is only in the legal and not economic sense. Similarly, only the States can levy the taxes on agricultural incomes and the power to levy tax on non-agricultural income vests with the Center. The States have found taxing agricultural incomes politically infeasible. This base has opened up avenues of avoidance and evasion of personal income tax. The most anomalous part of the assignment, however, is the distinction between 'goods' and 'services' for tax purposes. Entry 54 in the State list empowers the States to levy taxes on the sale and purchase of goods other than newspapers. Taxation of services does not find a specific mention in any of the lists. The Central government has been levying the tax on selected services on the basis of residuary power. The compartmentalized tax treatment of goods and services has violated neutrality in taxation, rendered the levy of coordinated system of consumption tax difficult, and has led to significant evasion and avoidance of the sales tax (NIPFP, 1994). The Constitution assigns borrowing power to both Union and State governments. However, when a State is indebted to the Center, it has to obtain the latter s permission. Thus, in actual practice, the Union Ministry of Finance, the Reserve Bank of India and the Planning Commission essentially determine States borrowings. The States can also borrow from Public Accounts - mainly loans from small savings and the public provident fund. Thus, in principle, the Center has power to exercise overall control over borrowing. But, in practice, the States have found several ways to soften their budget constraint. 5

6 The Constitution also provides for the appointment of the Finance Commission to transfer funds from the Union to the State governments by way of tax devolution and grants every five years. The functions of the Commission include: (i) distribution of the proceeds of sharable taxes, (ii) giving grants in aid to the States in need of assistance, (iii) recommending measures to augment resources of the States to supplement the resources of the Panchayats and Municipalities, and (iv) addressing any other matter referred to the Commission in the interest of sound finance. Since the adoption of Indian Constitution, Eleven Finance Commissions have submitted their reports. Over the years, Planning Commission too has been giving substantial assistance to the States to finance developmental plans. The assistance is given both as grant and loan in the ratio 30:70 for the non-special category States and 90:10 for the special category States. In addition to Finance and Planning Commissions, Central Ministries give assistance to the States to implement Central schemes. The Central sector schemes are entirely funded by the Central government and the States are merely implementing agencies. The centrally sponsored schemes are shared cost programs requiring the states to make matching contributions, the matching ratio differing with projects. II.3 Assignment between State and local governments: With the constitutional amendments in 1992, roles and responsibilities of rural and urban local governments have been specified. Accordingly, in separate schedules, a list of 29 items to rural local bodies and another list of 18 items to urban local bodies have been specified. However, revenue and expenditure assignments in the lists are concurrent with the States responsibilities. Actual devolution of specific revenue sources and expenditure functions to local governments depends on the willingness of the State government to devolve functions and powers to the local governments. The rural local governments have very limited own sources of revenues. Only the village panchayats have some independent revenues. The transfers to the local bodies are required to be determined by the State Finance Commissions. The responsibilities of these Commissions include (i) distribution of States revenues between States and local bodies and determining inter se allocation of the latter, (ii) assignment of tax and non tax powers to village panchayats and urban local bodies; and (iii) determination of the grants in aid to the local governments from the consolidated fund of the State. 6

7 In addition to their own lump sum transfers, States pass on the transfers received from the Central Finance Commissions. Besides, there are almost a hundred central sector and Centrally sponsored schemes. The important schemes are for water supply, poverty alleviation, rural roads, education and health and for the social justice. Analysis shows that local governments have very little flexibility in the use of funds. Analysis, however, shows that despite giving constitutional status to quarter million local governments, their role in raising revenues and delivering public services is negligible. Table 1 shows that fiscal decentralization in Indian federalism is only up to the state level. In , the local bodies together raise just about 0.6 per cent of GDP or 3 per cent of total revenues and the revenue raised by rural local governments was abysmal at 0.04 per cent of GDP. After receiving transfers they had control over resources of just 1.4 per cent of GDP. Thus, their share in total expenditures was less than 5 per cent. Thus, local governments in India do not raise significant revenues. As State governments themselves are faced with several resource constraints, they are unable to devolve adequate resources to provide a meaningful role to them. Table 1 Fiscal Decentralization in India Revenue Revenue Accrual Total Expenditure Collection Center States Local Bodies Urban Local Bodies* Rural Local Bodies* District Panchayats* n Taluk Panchayats* n Village Panchayats* Total Center States Local Bodies Urban Local Bodies Rural Local Bodies District Panchayats Taluk Panchayats Village panchayats Total Note: n - negligible. * Revenue accrual estimates are taken as proxi for expenditures. Source: Public Finance Statistics , Ministry of Finance, Government of India, Report of the 11th Finance Commission, Ministry of Finance, Government of India

8 III. III.1 Fiscal Adjustment in Indian Federalism Trends in fiscal imbalances: Table 2 details the trend in States fiscal imbalances. It is seen that fiscal adjustment during the early 1990s helped reduce States revenue deficit from about 1 per cent in to 0.4 per cent in The States tried to contain their deficits until the pay revision made the situation uncontrollable in Thus, revenue deficit increased to 2.5 per cent in and is estimated at about 3 per cent in Similarly, States were able to contain their fiscal deficit until at 3 per cent, but thereafter it increased sharply to 4.2 per cent in and further to 4.6 per cent in on account of pay revision. Year Per Cent of Revenue Deficit to GDP Table 2 Trend in States Fiscal Imbalances Per Cent Per Cent Per cent of Per cent of of Rev. of Primary States States Fis. Def to Def. To Rev Def to Def to Fiscal Def. Fiscal Def Total Rev Total Fis. Per Cent of Fiscal Deficit to GDP States Capital Exp. As % of Total State Exp. Per cent of States Capital Exp. to GDP Def Def (RE) Source: Public Finance Statistics, Ministry of Finance, Government of India. Figure 2 shows that both revenue and fiscal deficits of the States follow patterns similar to those of the Centre. States revenue deficit constituted just about 21 per cent of total revenue deficit in , but increased to 41 per cent in Similarly, states share of fiscal deficit increased from 35 per cent to 47 per cent during the period. This is not to place the problem of fiscal imbalances in the country at the doorstep of the States. Indeed, the major reasons for increasing fiscal imbalance at the State level has to be found in declining share of transfers in States revenues and more importantly, the impact of pay revision triggered by central pay revision. 8

9 In a competitive federalism, Salmon mechanism activates entrepreneurial competition by comparing the performances of other governments. In Indian federation, in contrast, the competition is not in terms of achieving the performance of benchmark governments. Institutional factors have contrived to constrain intergovernmental competition in terms of standardizing salary levels and following populist policies. Figure 2 : Fiscal Imbalance in Indian Federalism Revenue Deficit Fiscal Deficits Total Centre States PercentofGDP Total Centr States Years Surely, fiscal adjustment has not been effective; but to the extent adjustment was achieved, it has led to sharp deterioration in the quality of deficits. By , a little over a quarter of borrowed funds were used to finance current expenditures, but by , this increased to 60 per cent. The share of capital expenditure in GDP declined from 3.6 per cent in the early 1980s to 1.8 percent in Thus, States fiscal deterioration has made their fiscal operations increasingly unsustainable, contributed to macroeconomic instability and constrained their ability to provide quality infrastructure. The persistence of large and growing fiscal deficits in the States has led to steady accumulation of debt over the years. Outstanding debt as a ratio of GDP fell from 19.4 per cent in to 17.8 percent in but increased thereafter to 23.1 per cent in In fact, since , the debt stock increased at the compound annual rate of 17.9 per cent whereas, the revenue receipts increased only at 11.2 per cent. Consequently, the share of interest payment in total expenditure increased from 13 per cent in to 21.6 per cent in to crowd out productive expenditures. 9

10 Fiscal deterioration in the States is a general phenomenon. In terms of both revenue and fiscal deficits, and spending on creation and maintenance of infrastructure, there has been a significant deterioration in each of the States (Rao, 2002). In , among the non-special category States five states had revenue deficits surpassing 5 per cent of Net State Domestic Product (NSDP), with West Bengal showing the worst performance (6.7 per cent). In terms of fiscal deficit, Bihar, Orissa and west Bengal were the worst performers with deficits exceeding 9 per cent of NSDP. By and large, fiscal imbalances is more acute in poorer than in richer States with the exception of Punjab. The State has the highest per capita SDP, and also very high revenue and fiscal deficits. The correlation coefficient of Per capita SDP with revenue deficit is for 14 non-special category States and when Punjab is excluded from the sample. The correlation coefficient of per capita SDP with fiscal deficit is for non-special category States and when Punjab is excluded. Thus, in general severity of fiscal crunch is felt more by the poorer than by richer States. III.3 Hidden imbalances and softening budget constraints: An important implementation rule for efficient fiscal decentralization is that sub national governments should have hard budget constraints (Bahl, 2002). Although in principle, the States have hard budgets, in practice, they can soften the constraint in a variety of ways (Lahiri, 2000; Anand, Bagchi and Sen, 2002). The practice of collecting taxes in advance and keeping contractors bills pending is well known. The States can also increase their liabilities in Public Account, particularly through small savings loans. Another method used is by creating special purpose vehicles for investments in activities such as irrigation. They also resort to borrowing from public enterprises. In recent years, the States have been borrowing heavily from financial institutions such as NABARD, LIC, HUDCO, and IDFC to finance infrastructure. We have already referred to borrowing from multilateral lending agencies. All these are in addition to the ways and means advances and overdrafts from the RBI. Thus, the fiscal position discussed above does not reveal fiscal imbalances of the States in its entirety. There are significant contingent liabilities arising from the State 10

11 government guarantees and indemnities given to urban local bodies, public enterprises and autonomous institutions. Available information shows that recorded contingent liabilities in were Rs billion or almost 6.4 per cent of GDP. A major source of imbalance not reflected in the budgets is losses incurred by public enterprises, notably, SEBs. In , estimated losses of SEBs were over Rs. 260 billion of which only Rs. 60 billion subsidy was included in the budgets. The losses of SEBs accounted for 1.2 per cent of GDP. The performance of SEBs has had adverse repercussions on Central finances as well. As on 28th February 2001, dues payable by SEBs to central enterprises were Rs. 415 billion (2 per cent of GDP) comprising of Rs. 257 billion principal and the remaining, interest. IV. IV.1 Causes of Fiscal Imbalances in States Imbalance in the growth of revenues and expenditures: Fiscal imbalance in the States is structural; on average, States expenditures grew faster than revenues during the 1990s (Table 3). An important reason for this is that Central transfer was the slowest growing item (10 per cent). The increases in States own revenues (both tax and non-tax) did not keep pace with expenditures. It must also be noted that growth rates of both States own revenues and Central transfers significantly decelerated in 1990s over 1980s. Although resource constraint led to deceleration in annual expenditure growth to 14.8 per cent in the 1990s, expenditure growth during the 1990s was higher than the revenue growth by 2.2 percentage points. An important cause of fiscal imbalances is the secular decline in the tax ratio (Table 4). This is seen not only in the aggregate but also in respect of each of the individual states except Kerala (Annexure Table 2). Since the mid 1990s, revenue-gdp ratio declined by 1.5 points. Of this, about 0.6-point decline was in Central transfers, 0.5- point was in States non-tax revenues and 0.4-point was in States tax revenues. Thus, States revenue-gdp ratio from each of the major sources has shown a declining trend during the 1990s and the decline has accelerated since the mid 1990s. 11

12 Table 3 Average Annual Growth Rates of States Revenues and Expenditures Percent 14 Non-Special Category 25 States States to to to to Own Tax Revenue Own Non Tax Revenue Total Transfers Total Revenues Revenue Expenditure Capital Expenditure Total Expenditure Source: Public Finance Statistics, Ministry of Finance, Government of India. The hardening resources position and increasing pressure of interest payments and salaries have crowded out capital expenditures (Table 4). The latter declined from 2.4 per cent in to 1.8 per cent in Further, within revenue expenditures, spending on economic services declined from 3.7 per cent to 2.9 per cent during the period. Expenditure on social services declined from 4.9 per cent in to 4.6 per cent in , but later increased to 5 per cent because of salary revision. Expenditure on administrative services steadily increased throughout the two decades. Table 4 Per Cent of States Revenues and Expenditures to GDP RE A. States Revenues Own Tax Revenue Own Non Tax Revenue Own Revenues Total Transfers Total Revenues B. States Expenditures Revenue Expenditure General Services * Interest Payments Social Services * Economic Services * Capital Expenditure Total Expenditure Note: Due to differences in budgetary classification, the figures are not estimated. Source: Public Finance Statistics (Relevant years), Ministry of Finance, Government of India. 12

13 IV.2 Causes of slow growth of revenues: There are a number of reasons for the slow and decelerating growth of revenues. Low revenue productivity of taxes on land and agricultural incomes has been a muchdebated issue. From the viewpoint of horizontal equity and revenue productivity, levying a tax on agricultural incomes is necessary. Yet, the architecture of the tax has remained only on paper for want of political willingness. In fact, States have not been able to levy the tax even on agricultural income declared in the tax returns submitted to the Central income tax department. The fragmented nature of income tax has provided an easy avenue for evasion and avoidance of personal income tax. The principal reason for the deceleration in the growth rate of sales taxes has to be found in the inability to extend the tax base to the services sector. During the last decade, the services sector grew at 7.8 per cent per year, much higher than both the primary (2.8%) and secondary (5.7%) sectors, and since the mid 1990s, over 70 per cent of the growth of the economy may be attributed to this sector (Acharya, 2001). As the States are allowed to levy taxes on only goods, the production and consumption of services remains mostly outside the tax net. In the medium term, revenue productivity of States tax system can be increased only when the States are enabled to extend sales taxes to services (Rao, 2001). This would also help to evolve a comprehensive destination based value added tax at the State level. This is the problem of assignment and the solution lies placing the power to tax services in the concurrent list. The bases of State taxes are rendered narrow also because of large-scale exemptions, evasion and avoidance of taxes. In the case of sales tax for example, besides wide ranging exemptions, there are generous schemes of incentives in terms of tax exemption and deferment. While the efficacy of such fiscal incentives in promoting industrialization is limited, revenue foregone is significant. These incentives do not enhance the availability of capital in the country, but merely redistribute the existing capital in distortionary ways. The problem is similar with other taxes as well. Levying stamp duty and registration fees on transfer of immovable property at high and differentiated rates has led 13

14 to widespread evasion of the tax by undervaluing the value of the property transacted. Along with Urban Ceiling and Rent Control Acts, the structure of property tax has prevented the development of organized market for immovable properties in the country. Lack of proper information system and administrative machinery to implement taxes is a general shortcoming in all the States. Much remains to be done to simplify the tax system and strengthen administration and enforcement of the tax. There is hardly any co-operation between one tax department of a State and another, much less between Central and State tax departments. Complications in the tax system add to complexity in administration and most States are ill equipped to administer the taxes designed to fulfil multiple objectives, thus adding to compliance cost and reducing revenue productivity. Inability to recover reasonable returns from the large investments has been a major reason for the low and declining growth in non-tax revenues. By march 31, 1999, States outstanding investments in statutory corporations were Rs. 750 billion and about Rs. 420 billion were invested in the government companies. Together, they yielded hardly any return. In most cases, public enterprises do not recover even a fraction of the capital cost and depreciation, leave alone generating any return on investments (Government of India, 2000). Almost 85 per cent of the investment in State level public enterprises is on electric utilities. Poor financial performance of SEBs has been a major cause of drain in States exchequers. The Electricity (Supply) Act, 1948 stipulates that State Electricity Boards (SEBs) should yield 3 per cent return on their net fixed assets. In actual practice, however, they generated a commercial loss of Rs. 230 billion or 33.8 per cent of the value of fixed assets in (Government of India, 2001). The losses excluding the State government subsidy amounted to Rs. 182 billion. Restoring fiscal balance is inextricably linked to the improvement in the SEBs and State Road Transport Corporations (SRTCs). In fact, SEBs losses add to the deficit by an additional Rs. 260 billion or about 1.3 per cent of GDP. With this revenue deficit is estimated at close to 3 per cent of GDP. Similarly, losses of SRTCs in amounted to Rs. 13 billion and their finances have shown a steady deterioration over the 14

15 years. The situation is similar with other State enterprises as well. The Accountant Generals reports reveal that accumulated loses exceed the value of fixed assets in respect of a number of State level enterprises. Poor fiscal condition of the States should also be attributed to poor cost recovery from public services. The NIPFP study for showed that cost recovery in social services was as low as 8.4 per cent of the cost of providing services and in the case of economic services it was 16.6 per cent. The studies show that the malice of poor cost recovery does not lie merely in uneconomic pricing of services; often, the problem is one of poor efficiency in their provision. In such cases, increasing the prices will simply pass on the burden of inefficiency to the consumers. As mentioned earlier, instead of Salmon mechanism leading to healthy intergovernmental competition, the pork barrel electoral politics in Indian federalism has led to competitive populism. IV. 3 Causes of expanding expenditures Despite attempts to contain the growth of expenditures during the decade , the States revenue expenditure - GDP ratio increased by 0.9 point. This has contributed to the severity of fiscal imbalance at the State level broadly by the same magnitude as the reduction in the revenue-gdp ratio. As mentioned earlier, intergovernmental competition has not been to adopt the supply efficiency of the benchmark governments either at the Central (of other countries) or State level. The sociology of fiscal politics in India has dictated expenditure decisions. In the event, expenditure growth has been determined by competitive populism and redistribution of expenditures in favor of distributional coalitions. A substantial proportion of increase in revenue expenditures is due to interest payments. Both the volume of liabilities and average rate of interest have increased significantly. As increasing share of States loans are used for revenue expenditures, the vicious cycle of higher interest payments increasing expenditures feed back into larger borrowings. The problem is exacerbated by low productivity of capital expenditures. The proliferation of projects spread the resources thinly and inadequate financial allocation causes severe cost and time over-runs. 15

16 Nowhere is intergovernmental competition as pronounced as in implementing pay revisions. The impact of pay revision has been much more severe on the States than the Center because the share of salary expenditure in States is higher, revisions had to be extended to aided institutions and local bodies besides government administration. Thus, administrative expenditure excluding interest payment increased by almost one percentage point during the decade reflecting the increases in pay and pension payments. Almost 0.7 point increase was just in two years beginning (Table 5). Overall, much of the 1.3 point increase in non-interest revenue expenditure seen in the last two years was due to pay revisions. In absolute terms, compensation to employees (pay and pensions) in States increased from Rs. 734 billion in to Rs billion in Thus the increase of Rs. 160 billion in was followed by a further increase of Rs. 220 billion in (Acharya, 2001, p. 48). Despite significant increase in the salary component of social services expenditures, expenditure-gdp ratio remained more or less constant at about 5 per cent of GDP. Constancy in social services expenditure-gdp ratio in the wake of increasing salary cost implies reduction in non-salary inputs with adverse impact on their quality. Table 5:Trends in State Expenditure Percentages of States expenditure to GDP Growth rate (percent per annum) Total Revenue Expenditure General Services Of which - Interest Payment Social Services Education Health and Family Welfare Economic Services Agriculture and Allied Activities Rural development Irrigation Power Industry and Minerals Transport and Communications Capital Expenditure Total Expenditure

17 The impact of declining revenue-gdp ratio and inevitability of meeting increasing commitments on pay and pension revisions and interest payments has been to crowd out capital expenditure-gdp ratio from 2.4 per cent in to 1.8 per cent in Within revenue expenditures, sharp decline in economic services signifies the inability of the States to make adequate provision for maintenance of infrastructure. The effect has been to displace both the availability and quality of physical infrastructure. An important structural cause of expenditure proliferation is the artificial and often, meaningless distinction made between plan and non-plan expenditures. Implicit in this is the assumption that plan expenditures are productive and non-plan expenditures are not. This is incorrect, for, a number of projects classified as plan in the revenue account are merely salary payments that are not productive. Similarly, completed plan schemes are classified as non-plan. Maintenance expenditures on roads, irrigation works and buildings are certainly productive and inadequate provision for these to contain non-plan expenditures has been a major shortcoming in expenditure management in States. Often, for convenience and strategic reasons various developmental projects are initiated in the non-plan side. The classification itself is unscientific, and this has led to inadequate expenditure allocation to maintenance of assets. Emphasis on increasing the plan size in every successive plan irrespective of resources position has caused proliferation of plan schemes even when they cannot be justified on economic considerations. As already mentioned, emphasis on increasing the plan size has also had the effect of allocating expenditures to large number of projects resulting in the thin spread of resources causing time and cost over-runs. IV. 4 Inequity and disincentives from central transfers: Incentives and equity in the transfer system is an important determinant of both efficiency and equity in fiscal operations of donor as well as recipients. The critical issues to be discussed are whether the general purpose transfer system has been designed to offset the fiscal disabilities and what are its effects on incentives. Similarly it is important to analyze whether specific purpose transfers have been designed to ensure minimum standards of designated services or fulfil categorical equity goods. The issue 17

18 assumes importance considering the increase in inter-state inequalities in per capita incomes and the declining ability of the Center to undertake inter-regional redistribution. The problems associated with Central transfers are well known and has been analyzed by several studies. Although the transfer system as whole has an equalizing impact (Figure 3), it has a number of shortcomings. Political economy of the transfer system is manifest in the multiple agencies dispensing transfers and naturally, this has constrained targeting them to offset fiscal disabilities satisfactorily (Rao, 1992, Rao and Singh, 2002b). The income elasticity of transfers for 14 major States declined from in to in (Table 6). It would also be appropriate to make all current transfers through the instrumentality of the Finance Commission and all the loan assistance through Planning Commission. The Planning should be confined to infrastructure projects and plan non-plan distinction in the revenue budget should be done away with. The Finance Commission grant has serious design problems, and the fiscal dentistry is alleged to have had the consequence of widening budgetary cavities. Figure 3: Equalizing Impact of Intergovernmental Transfers. 800 Percapita Transfers (Rs.) Percapita SDP (Rs.) The influence of political factors in the transfer system is nowhere as prominent as in dispensing funds for central sector and centrally sponsored schemes. There has been a proliferation of these schemes, often for political reasons and at present they number more than 210. Besides spreading the resources thinly, these programs distort 18

19 States choices in expenditure allocation, multiply bureaucracy and cause thin spread of resources across several schemes (Saxena, 2002). As centrally sponsored schemes also require matching contributions from the States, the extent of distortion in resource allocation higher and expenditure centralization is much larger than what is indicated by the expenditure shares of the States. Often, poorer States are unable to provide counterpart funds and are unable to receive even the allocations made to them. Thus, the actual dispensation of the transfers deviates from its design. Table 6. Per capita Current Transfers to States from Center State Finance Commission Planning Commission Total Current Transfers State Plan Centrally Total Schemes Sponsored Intercept T value Coefficient T value R Note: The equations pertain to only the non-special category States. In addition to the explicit transfers discussed above, in planned economies where prices and outputs are determined by government fiat rather than market forces, there can be several sources of implicit transfers. Some of the important sources of implicit interregional transfers in Indian federation include inter-state tax exportation, subsidized lending to States either from the central government or from the government controlled financial sector. Analysis of subsidized lending to states shows that these implicit transfers can be significant; they can also significantly offset the progresivity of explicit transfer system (Rao, 1997). Based on the recommendations of the 11 th Finance Commission, it is proposed to earmark 15 per cent of the deficit grants with an equal contribution from the Center to be distributed to the States according to their fiscal performance. Each state will be given a share in excess or short of its initial eligibility (population share) depending on its fiscal performance. The States will be required to put out their Medium Term Fiscal Reforms Programme (MTFRP) and performance will be will be measured on the basis of a single 19

20 monitorable fiscal objective, improvement in the revenue deficit by at least 5 per cent of its revenues. If a State fails to fulfill the condition, the fund will be rolled over to the next year. If the withheld portion is not claimed by , the fund will lapse. 12 of the 28 States have already signed the Memorandum of Understanding (MOU) with the Center and the rest are expected to follow. The problem with the scheme is that the funds earmarked may not be large enough to incentivize transfers. Further, the scheme is only incremental and does not consider the size of the deficit. IV. 5 Inter-State disparities in Infrastructure Availability: The worsening fiscal situation has adversely impacted on infrastructure availability more in poorer than more affluent States. Figure 4 shows a positive relationship between infrastructure index and per capita NSDP. Poor quality of infrastructure in less developed States has constrained them from exploiting their growth potential, even when these States are resource rich. Of course, it may not be proper to attribute low incomes or their slow growth rates to infrastructure constraints alone. Often, these are consequences of in policies, their implementation and institutions. Figure 4: Relationship Between Per capita NSDP and Infrastructure Index. 200 Infrastructure Index Percapita NSDP Source: 1. Infrastructure Index: Report of the Finance Commission, Ministry of Finance, Government of India V. Efficiency Implications of Sub-national Fiscal Operations. V.1 Efficiency aspects of sub national tax and regulatory system: The advantage of federalism over a centralized fiscal system is its ability to provide wider choice of bundles of public services while preserving the advantages of a unified common market. Therefore, the system has to be judged from efficiency gains 20

21 netted for costs of administration, intergovernmental coordination, signaling and mobility. These costs depend on a variety of factors including the state of technology, efficiency of information flow and educational levels of electorate. Dynamic efficiency, however, depends on the existence of market preserving federalism. The latter requires the fulfillment of a number of important preconditions such as (i) existence of a hierarchy of governments, (ii) primary authority of sub national governments over the economy under their jurisdictions, (iii) the powers of national authority to police the common market, (iv) limited revenue sharing and existence of hard budget constraint, (v) institutionalized degree of durability of assignments. Of these, monitoring role assigned to the central government to preserve the common market is a critical element of market preserving federalism. In Indian context, efficiency implications of tax policy in terms of distortions in the tax system and violation of common market principles have not received much attention. This can partly be explained by the fact that in a closed economy, inefficiencies of tax and expenditure systems are neither transparent nor important. It is therefore, not surprising that emphasis has been to raise revenues to finance large public sector plans without concerning about allocative distortions. The sales tax - the most important source of states own tax revenue is also the most important source of distortion. Administrative considerations have led to the levy of the tax predominantly at the first point of sale. All pre-retail sales taxes cause cascading. The tax is levied also on inputs and capital goods and this exacerbates the problem. Pursuit of multiple objectives has caused minute differences in tax rates. Interstate competition in sales tax to attract trade and investments has complicated the tax structure further. In this race to the bottom the Union Territories have played a destabilizing role. The competition has led the States to adopt the self-defeating schemes of fiscal incentives in terms of sales tax holiday and deferment. In addition, to meet exigencies of revenue, the States have levied turnover taxes, additional sales taxes and entry taxes. All these have contributed to complicated, cascading and opaque tax systems. The tax on tax, mark up on tax and tax on mark ups have altered relative prices 21

22 in unintended ways. The complicated tax systems and wide discretions to officials have resulted in negotiated tax payments and high compliance costs. In addition, the Central sales tax levied by the exporting state has distorted relative prices and segmented the market. This has also been a major source of inequitable inter-state tax exportation. Like in other federations, the Constitution seeks to ensure free inter-state trade and commerce across the country. Article 301 of the Constitution in India declares, Subject to the other provisions in this part, trade, commence and intercourse throughout the territory of India shall be free. However, the parliament has powers to impose restrictions if it is required in public interest (Article 302) so long as the restrictions are not discriminatory (Article 303). Similarly State legislature can impose restrictions in public interest without discrimination, but with the prior sanction of the President of India (Article 304). Despite the Constitutional provision to have a common market, fiscal and regulatory system in India imposes a number of impediments to internal trade. The impediments arise from the nature of assignments, competition to free-ride by exporting the tax burden to non-residents, asymmetric arrangements in the federal system, autarchic nature of developmental strategy and the legacy of micro-management of a scarcity hit economy. These are besides the impediments caused by the lack of development of the market itself and the impact of social, political and linguistic diversities. As important source of impediment to internal trade in India is the assignment of tax powers. Despite the pronouncement in the constitution that the internal trade should be kept free, the center is allowed levy tax under Entry 92A of the Union list, and it has allowed the states to levy the tax on inter-state sale of goods by the exporting state subject to a ceiling rate of 4 per cent. In a system in which the sales tax is predominantly a first point levy, and there are taxes on inputs and capital goods, and in some states, turnover taxes in addition to sales taxes, the levy of inter-state sales tax can cause significant inter-state tax exportation. Despite widespread awareness of the distortions caused by Octori, the States of Gujarat, Maharashtra, Orissa and Punjab have assigned their urban local bodies the power 22

23 to levy Octroi, the tax on the entry of goods into local areas for consumption, use or sale. In these States, this levy is major source of market segmentation; it impedes internal trade, and causes allocative distortions. In addition, as this is a check-post based levy, it enlarges scope for rent seeking. In spite of the awareness of the ills of the levy, it has continued to be levied by urban local bodies in these states. Some other States have allowed the local bodies to levy an account based levy, entry tax. In all other respects this levy has effects similar to Octori except that this is an account based levy whereas Octroi is a check post based tax. The taxes on the transfer of property, as they are levied at present, have hindered the development of the organized market for immovable properties in the country. The levy of high and differentiated rates of stamp duty and registration fees has led to widespread under valuation of immovable properties and evasion of the tax. There is no incentive for honest reporting of the value of transactions and this prevents the development of a transparent market for immovable properties. The levy has hindered the very development of a transparent organized market for immovable properties. In addition to the tax policies, there are a number of regulatory instruments impeding free mobility of factors and products. To give examples of only a few, until recently, the freight equalization scheme sought to subsidize transportation cost for items such as steel and coal denying forward and backward linkages of large public sector investments in the less developed states of Bihar, Madhya Pradesh and Orissa. Similarly, under Essential Commodities Act, basic food items cannot be moved from one state to another. Besides these, there are market impediments caused by planned economic regime and labor immobility caused by linguistic barriers. V.2 Political economy of sub national borrowing: Political factors play an important role in the determination of the transfer system as well as sub national borrowing. The issue assumes significance when the there is a coalition government at the Center and regional parties in power in some of the States 23

24 have a pivotal role in determining the stability of the coalition. Political favoritism may find a means to soften the budget constraints to the State governments ruled by these parties or their allies. More importantly, favorable treatment to States ruled by coalition partners can be done through discretionary transfers. This can also be done through dispensing loans. This is aided by the fact that allocation of market borrowing is not done in a transparent manner. Thus, there is considerable scope for political factors determining the quantum of inter-regional resource flows. In addition, as market based reforms are introduced into the system of determining loans, States with better credit rating will receive more favorable treatment. This may accentuate inter-state disparities. While, introduction of market-based reforms is inevitable, it is important to ensure that the intergovernmental transfer system is targeted to offset fiscal disabilities and invisible transfers arising from inter-state tax exportation and other resource flows are minimized. An additional dimension to States finances in recent years has been is the lending by multilateral lending institutions (World Bank and ADB) to States. Although the loans are made conditional on the States undertaking effective fiscal reforms, there will be a tendency to dilute the conditions as eventually, the repayment liability for loans lies with the Center. Loan pushing by these lending institutions can result in excessive borrowing by the States. Besides the usual problems associated with loans, these loans carry the additional foreign exchange risk as well. It is extremely important that effective fiscal reforms program should be put in place in order to avoid serious problems arising from excessive borrowing. The record of fiscal conditionality at the State level has not been very enthusing. A number of States with poor fiscal performances have had to seek repeated refuge with the Ministry of Finance for bailouts from overdraft regulations after signing MOUs, the contents of which were not made public. Despite this, it was found necessary to give directive to the Finance commission to link transfers with monitorable program of reducing revenue deficits. This implies the irrelevance of those MOUs. In terms of both the size of the transfers linked to fiscal performance and its design, it is very much doubtful whether the new MOUs will inculcate greater fiscal discipline among the States. 24