Chapter 3 INTERGOVERNMENTAL TRANSFERS IN THE INDIAN CONTEXT

Chapter 3 INTERGOVERNMENTAL TRANSFERS IN THE INDIAN CONTEXT 3.1 Introduction A federal system entailed assignment of functions and revenue sources between national and sub-national governments and each unit of government performing its assigned function of providing public goods. Evaluation of this system from the economics perspective of equity and efficiency criteria elicits three major sources of possible inefficiencies. First, vertical allocation of functions and powers between the national and sub-national governments, in practice, are rarely balanced, irrespective of what the traditional federal principle proposed 18 Usually it is considered preferable to put the central government in a more advantageous position for various economic and political reasons. This bias for vertical fiscal imbalance can be debilitating for efficient functioning of the fiscal system. Secondly, if the benefit of public good provided by one government spill over to other jurisdiction, then the supply of the good in question will fall short of the optimal amount, hence allocative inefficiency. Lastly, it is unlikely that each sub-national unit is equally placed in terms of fiscal capacity with the other due to reasons that are beyond the control of the sub-national government concerned. Inequality among citizens on the basis of residence itself goes against the spirit federalism. The most widely used, and hence most practical, fiscal instrument to address the issues of vertical fiscal imbalance, inter-jurisdictional spillovers and equity in a federation is the intergovernmental transfers. This chapter examined the system of Centre-State fiscal transfers in India in the light of normative theory of economic rationale, design of impact of intergovernmental transfers. The remaining portion of this chapter is arranged as follow: Section 3.2 and 3.3 reviews normative theory relating to the economic rationale for intergovernmental transfers and their design. Theoretical and empirical literature on the allocative impact of intergovernmental transfers are reviewed both from neoclassical and public choice 18 K.C. Whare (1953) proposed functional autonomy of each level of government in its assigned sphere with each level of government having its own independent revenue resources sufficient to perform its exclusive functions. 29

framework in sections 3.4. Section 3.5 to 3.7 we analyze the system of Centre-State transfers in India, the institutional arrangements, the quantum and trend as well as equity and efficiency aspects. A brief conclusion to the chapter is in section 3.8. 3.2 Economic justifications for intergovernmental transfers In general, the economic justifications for intergovernmental transfers in a federal system have been grounded on the objectives of achieving allocative effici~ncy (Breton, 1965), equity in distribution (Buchanan, 1950), fiscal balance (Musgrave, 1961), and competitive equality among governments (Breton, 1995). Apart from these, intergovernmental transfers have also been suggested to enable sub-national governments provide minimum standard of outlay for services considered to be merit goods by the national government (Musgrave, 1976). 3.2.1 Intergovernmental transfers to correct spillovers Public goods and services provided by a sub-national government may generate benefits for residents of other jurisdictions, i.e., positive externalities 19 When some proportion of the benefits of public services provided by a government spills over its jurisdiction, the outlays for such services tends to be non-optimal because the part of benefits accruing to non-residents escapes the marginal benefit and marginal cost calculations to determine the appropriate level of outlay. This allocative inefficiency due inter-jurisdictional spillovers could be prevented if there is perfect mapping that equates each territorial jurisdiction with the spread of benefits of the public good provided (Breton, 1965) or if there is jurisdictional separations for every public good with unique boundary so as to match the benefits with taxes, called the principle of fiscal equivalence (Olson, 1969). Since perfect mapping and fiscal equivalence is a difficult proposition, intergovernmental mechanism to correct the allocative inefficiency has been suggested. In principle, allocative inefficiency arising out of inter-jurisdictional spillover could be resolved in a Pareto optimal fashion through Coasian bargaining between the sub-national governments. The sub-national government which generates benefit 19 This is equally applicable for cases involving negative externalities. 30

spillovers could be bribed by other jurisdictions to provide the good in question up to the optimal level. This process entails intergovernmental transfers, but they are between subnational governments rather than from the central government to the sub-national governments. In practice, such efficiency transfers, however, are envisaged and implemented in terms of fiscal transfers from the central government or mediated by central government, compensating the sub-national government for the external benefits of its expenditure. The basis for transfers to correct spillovers, therefore, is to induce sub-national governments to internalized spillover benefits of their fiscal activities into their decisionmaking calculus (Oates, 1999). A system of specific matching grants based on the expenditures giving rise to the spillovers has been recommended to provide the optimum level of outlay. 3.2.2 Intergovernmental transfers to resolve fiscal imbalances There are two aspects of fiscal imbalances viz., vertical imbalance on account, usually, of centralization of revenue raising power and horizontal imbalance arising out of differential fiscal capacities of the sub-national units. It is obvious that assignment of greater taxing power to sub-national governments will reduce vertical fiscal imbalance or any type of fiscal transfer from the centre to sub-national governments will help in closing the gap. However, centralization of revenue with the objective of maintaining a more equitable and efficient overall tax system (Oates 1999) had to be handled with special arrangement. The most common way of handling vertical fiscal imbalance due to tax centralization is through the system of revenue sharing arrangement. Under such arrangement, the central government acts as tax collecting agent and distribute to subnational governments in the form of unconditional grant. Another form of fiscal imbalance in a federal system is the differential fiscal capacities of constituent units because of the unequal revenue base between rich and poor regions called horizontal imbalance. Such horizontal fiscal imbalance would not have been a problem in a world the perfect spatial mobility (Tiebout 1956) where citizens can move costlessly across jurisdictions to find governments which provide the mix of public services corresponding with their tastes and preferences. Thus, in a perfect spatial 31

mobility, horizontal equity is self policing. Mobility, however, is not perfect in the real world. Therefore, intergovernmental transfer is suggested to resolve the problem of inequality that arises due to horizontal fiscal imbalance. While there is unanimity on the type of fiscal transfer viz., unconditional grant, to remedy horizontal imbalance, there are two distinct approaches in respect of the underlying objective. The traditional approach goes in terms of inter-jurisdictional equity - or equalization of fiscal capacities of sub-national units (Musgrave, 1961, Maeszkowski and Musgrave, 1999) whereas the public choice approach advocates equalization of fiscal burden between individuals residing in different jurisdictions (Buchanan 1950). In this formulation, intergovernmental transfer to resolve horizontal equity is solely for equity equalization between individuals and the sub-national government acted merely as conduit to the fiscal transfer. However, in practice, these transfers are taken as equalization of fiscal capacities of sub-national governments with the objective of ensuring provision of comparable bundles of public services at comparable tax rates throughout the country (Broadway and Flatters, 1982). 3.2.3 Intergovernmental transfers for merit goods Propounded by Musgrave (1976), merit goods argument for intergovernmental transfer is based primarily on paternalistic view of the role that central government is considered to play. Obviously, this is not in line with the strict federal principles of sunnational autonomy. The central government, according to this argument, should provide grants to sub-national governments in order to ensure provision of minimum standards of services considered to be merit goods. Sub-national governments in this scheme play agency role for implementing programmes identified and formulated at the national level. Notwithstanding the lack of concrete theoretical justification in a federal set-up, these types of transfers, in reality, constitute significant part of intergovernmental transfers, especially in India. The type of transfers for this purpose will be tied, specific purpose with or without matching contributions by sub-national government. 32

3.3 Normative principles of transfers design Though a perfectly designed transfers system is hard to come by, economists like to insist that properly design transfers can achieve the purpose of getting prices right in the public sector in the sense of making governments fully accountable (Bird and Smart, 2001). The design of fiscal transfers is supposed to take care not only of the objectives of the transfers, but also the desired response of the recipient sub-national governments. Since unconditional transfers meant for bridging vertical and horizontal imbalances are highly disposed to creating adverse incentives, designing the right formula for these transfers posed immense challenge for efficient fiscal system. The normative principle stressed the importance of correct assessment of local differences in needs, costs and revenue raising capacities. These fiscal parameters being dynamic in nature makes the task even more daunting. Vertical fiscal gap that arises out of the initial asymmetric assignment can, over a period of time, get widened or narrowed down by own-revenue efforts or lack of it by the sub-national governments. Similarly, sub-national government policies can improve or worsened horizontal fiscal capacity relative to other governments of the same level. In view of these problems, to have an efficient fiscal system, the quantum of equalization transfers should, ideally, be minimized. Revenue sharing is the most common arrangement for correcting vertical fiscal imbalance. In designing these transfers shared taxes should be categorized and treated differently depending upon the incentives implications that different taxes carried for the sub-national governments. For example, formula for distribution of income tax and corporation taxes should give due recognition to the role that sub-national government policies played in the growth of these taxes in the form of retention of the increase at the margin as incentive mechanism. Secondly, different categories of sub-national governments should be treated differently, making equalization transfers available to disadvantage regions and allowing rich regions to retain significant portion of the growth in taxes from say, income tax and corporation tax. The incentive for growth in tax revenue build into the design of revenue sharing formula can achieve two goals, viz., improved fiscal balance and growth oriented policy of sub-national governments. The design of horizontal fiscal equalization transfer must focus on fiscal capacities and cost 33

disadvantages beyond the control of sub-national governments and should not give adverse incentives to tax effort and/or compensate for fiscal profligacy of the States. In general, transfers to offset spillovers should be specific purpose and openended with matching ratios varying for different services depending upon the degree of spillovers. Transfers to ensure minimum outlays on specified services should be specific purpose and closed-ended with matching provisions. The matching rate may decline as the level of expenditure rises and externalities diminishes or if the central preference is only for a basic or minimum national standard of service. The rate may also vary across jurisdictions depending upon the price elasticity of demand for the service in question. Further, there may be a case for introduction of equalizing element by varying matching rates inversely with fiscal capacities as reflected in income levels (Feldstein, 1975). 3. 4 Impact of intergovernmental transfers on the fiscal behavior The traditional literature on the allocative impact of intergovernmental transfers is based on consumer utility maximization models equating recipient government with individual consumer. The general conclusions drawn from the models constructed within the neoclassical framework are that lump-sum general purpose transfers being equivalent to the increase in income, expenditure will increase along the income consumption curve while matching transfers being similar to reduction in the relative price of aided service expenditure expansion will take place along the price consumption curve. Lump-sum transfers, whether general or specific purpose, are predicted to have similar effect on expenditure unless the specific aid is very large 20 (Wilde, 1971). While open-ended matching transfer is predicted to increase expenditure along the price consumption curve, closed-ended matching transfer may subdue price effect if the ceiling is set low. In general, open-ended specific purpose transfers are predicted to be having more stimulative effect on expenditure than lump-sum general purpose transfers. These general conclusions of the traditional theory based on equating decision makers with individual have also been found valid in a collective-choice setting and median voter model (Bradford and Oates, 1971; Romer and Rosenthal, 1980). 20 When the specific aid is large the state/local government may prefer to locate at the kink of the budget line rather than along the income consumption curve. Wilde (196&) used the term 'deflective effect' to describe such situation. 34

The traditional theory of grant impact which treats government as benevolent despots and grants as neutral instruments of fiscal adjustment has been demonstrated to institutionally naive and empirically ineffectual. In theoretical formulation, lump-sum intergovernmental transfer is equivalent to an increase in income of the residents of recipient government implying that should increase by an amount equal to the amount of increased income devoted to public goods and services. Empirical studies, however, have consistently found that lump-sum transfers have much greater impact on sub-national expenditure than changes in income (Gramlich and Galper, 1973). The anomaly is called the flypaper effect, grant money sticks where they land. The fly paper effect phenomenon has generated hypotheses such as budget maximizing bureaucrat (Niskanen, 1968; Breton and Wintrobe, 1975), fiscal illusion Oates (1979) et al which discards benevolent assumption about the government while emphasizing institutional issues. In-nutshell, the bureaucratic model assumed that the objective of bureaucrat is to maximize budget as a proxy for the power maximization. Budget maximizing bureaucrat provides public goods to the point where the average cost of providing a public good is equal to its price. The marginal cost exceeds price; hence, public goods are oversupplied. Grants reduce the price of public goods and induce bureaucrats to spend even more than before to maximize their budget. The fiscal illusion model basically suggests how the public authority presented lump-sum transfer as reduction in the average tax-price of public service rather than as increase in income. Since the voters base their decision on the average rather than the marginal tax-price they are willing to support a higher level of spending, basically because of the inaccurate assessment of the fiscal parameters. An important proposition arising out of the fiscal illusion hypothesis is the distortion or break in the link between the tax-price of public services and their benefits because of intergovernmental transfers. Intergovernmental transfers create the appearance that local public spending is funded by others or part of the cost is shifted onto other taxpayers. Local voters and politicl.ans receive fiscal or political benefits from grant financed programmes without internalizing their full cost. This goes against a condition necessary for fiscally responsible State/local budgetary choice which says that at the margin each government should finance its own expenditure (Oates, 1977). Institutional and public choice literatures on common pool problem and agency theory have contributed immensely to the way intergovernmental transfers and their allocative impact are viewed by giving emphasis to the incentive structure associated with 35

institutions and processes. Centralized provision of local public goods, according to- these literatures, creates common pool problem when the voters realize that the tax costs of public programmes spreads across all jurisdictions while they receive the concentrated benefits. This leads to inefficient and over-provision of local public goods and services 21 (Weingast, Shepsle and Johnsen 1981) and intergovernmental transfers being akin to centralized provision are predicted to affect sub-national incentives to provide public goods and also create soft budget constraint adversely affecting prudent fiscal choice. Centralization of resource allocation makes sub-national governments less sensitive the cost of their expenditure progarmmes and fiscal dependence in tum produced implementation of credible non-bailout commitment difficult for the central government. In such a situation sub-national governments are likely to resort to borrowings beyond sustainable level with the expectation that their costs can be shifted subsequently onto others through some bailout programme. The incentives issue associated with common pool problem can also have implication on the revenue raising efforts of sub-national governments when they do not derive the full benefit of extra resources in a revenue pooling system they have the incentives to reduce the tax burden on their citizens by increasing their reliance on transfers or even offload additional spending costs onto others (Hausmann and Purfield, 2004). Specific purpose fiscal transfers to sub-national governments whether for offsetting spillovers or for merit goods are susceptible to agency problems, especially that of moral hazard 22 These being a kind of contract between the central government (principal) and sub-national units (agents) moral hazard problem arise once the contract has been agreed to and the agent, realizing the informational advantage, does not meet the terms of the contract. The reason can either be straightforward opportunistic behaviour by sub-national government exploiting information advantage or because of the problem of multiple principals. While monitoring of financial and physical performance by central government would be an obvious step to reduce the incidence of such problems it is perceived that sub-national governments accountable to their constituents and are in competition with other jurisdictions of the same level are likely to performed better in 21 Common pool problem also can create under-provision of public goods when the set of tax payers is small relative to the set of beneficiaries. 22 Another agency problem of adverse selection relating to principal making unwise agency choice may be less relevant since the choice of agency is restricted by constitutional provisions, administrative procedures and political feasibility. 36

service delivery. To the extent that intergovernmental transfers weakens sub-national government's accountability to local electorates and dampened interjurisdictional competition, the efficacy of specific purpose grants in achieving national objectives may be curtailed. 3.5 The system of intergovernmental fiscal transfers in India 3.5.1 Institutions and types of intergovernmental transfers The system of intergovernmental transfers in India is characterized by multiplicity, whether in the type of transfers or in the institutions administering them. The Constitution of India has provided for sharing taxes between Central and States and also grants-in-aid to States from the Consolidated Fund oflndia for general as well as specific purposes. As per the Constitution, these transfers along with other issues relating to federal financial relation were to be mediated by the Finance Commission. The existence of multiple institutions and types of Centre-State transfers over and above the constitutional scheme is attributable to the centralized planning. Centralized planning entailed centralization of development policy formulation, resource allocation and it also requires creation of an apex planning body, the Planning Commission. While the Planning Commission can assess and allocate resources for development plans between the Centre and States, among States and sectors, it does not have the executive power to implement schemes and programmes. Hence, the Planning Commission administered the allocation of only the formula-based general purpose plan assistance to States while assistance for various specific schemes or programmes has to be implemented by the Central Ministries. On the basis of institutional channels administering fiscal transfers, intergovernmental transfers in India can be categorized into three, viz., (i) Finance Commission transfers, (ii) Planning Commission transfers and (iii) transfers administered by Central Ministries_ and Departments. Since planning gives rise to budget dichotomy into plan and non-plan, Central transfers have also came to be categorized into plan transfers and non-plan transfers depending roughly on which part of the States' budget the transfers are expended. Table 3.1 below gives summary of Centre-State transfers in India. 37

Institution/type of transfer A. Non-plan transfers A I. Finance Commission Al.l Share in Central taxes A 1.2 General purpose grants A 1.3 Specific purpose grants A2. Central Ministries A2.1 Specific purpose grants. B. Plan grants B I. Planning Commission a) Asst. for state plans Bl.l Block plan grants B 1.2 Specific purpose grants B2.Central Ministries b) Grants for CSS!CPs@ B2.1 Matching specific grants Table 3.1: Institutions and types of Centre-State transfers Method I. Formula-based revenue sharing in principle, distributed as equalization transfer. 2. Based on post-devolution non-plan revenue deficit 3. Discretionary grant for regulatory or specific sector. I. Discretionary grants for regulatory sector. I. Formula-based fund for development with end-use flexibility within plan budget. 2. Discretionary; for specific scheme. I. Discretionary. Rationale I. Vertical and horizontal fiscal equity. 2. Horizontal fiscal equity. 3. Merit goods I. Merit goods I. Reduce regional disparity in development. 2. Merit goods I. Merit goods and interjurisdictional spillover. B2.2 Non-matching specific grants. 2. Discretionary. 2. Merit goods @ CSS stands for Centrally Sponsored Schemes and CPS for Central Plan Schemes. 3.5.2 Finance Commission transfers The Finance Commission, against the backdrop India's centralized planning, is generally regarded as the institution responsible for upholding the Constitutional provisions relating to federal fiscal adjustment, albeit, without interfering into the development planning process. In general, the Finance Commissions confine their recommendations for fiscal transfers to sharing of Central taxes, revenue gap grant, grant for local bodies and specific purpose grants for regulatory sectors. Among these sharing of Central taxes constitute major chunk of the pool. Sharing of Central tax revenues involves determination of the vertical distribution between the Centre and the States and horizontal distribution of the respective-shares of the States. The vertical distribution recommended by the Finance Commissions saw increasing_ share of the States in Central taxes. In income tax the relative share of States increased from 55 percent in the First Finance Commission to 85 percent by the Ninth Commission while in Union excise the base has been increased from three commodities to the entire proceeds by the Third Commission. The schemes of revenue sharing adopted by the successive Finance Commissions can be seen from the ensuing tables. 38

Table 3.2: Income tax: Vertical and horizontal distribution Vertical Horizontal distribution distribution Finance Commission % share of % weight assigned States Population Collection Assessment First 55 80 20 Second 60 90 10 Third 66.66 80 20 Fourth 75 80 20 Fifth 75 90 10 Sixth 80 90 10 Seventh 85 90 10 Source: Report ofthe Finance Commission, 1st to 7th Commissions. In horizontal distribution formulae, the First Finance Commission up to the Seventh adopted separate approaches in respect of sharing of income tax and Union excise duties. In income tax, population and collection/assessment were used as the sole criteria (see table 3.2). The use of collection/assessment as a criterion can be traced back to the Joint Select Committee recommendation that Provinces should receive 3 pies in each rupee of the amount by which the assessed income of any year exceed that of 1920-21. The principle behind this system is that sub-national/provincial Governments are entitled to a share in increased tax revenue as a result of increased income within their jurisdiction. The inbuilt incentives mechanism for economic performance of Provinces contained in the original idea, however, seem to be lost in transition. Finance Commission First Second Third Fourth Fifth Sixth Seventh Table 3.3: Union excise: Vertical and horizontal distribution Vertical distribution %share of States 20 20 20 40 Population 100 90 unspecified 80 80 75 25 Horizontal distribution % weight assigned Other factors Discretionary adjustments: 10 Financial weakness & economic backwardness: weight unspecified Economic & social backwardness: 20 Income: 16.66; Index ofbackwardness: 16.66 Income distance: 25 Inverse income: 25; Poverty: 25; revenue equalization: 25 d: excise duties on tobacco, matches and vegetable products were made shareable. e: excise duties on tobacco, matches and vegetable products, sugar, tea, coffee, papers and vegetable noness.ential oils were made shareable. f: entire proceeds were made shareable. Source: Report of the Finance Commission, 1st to 7th Commissions. The Constitution, prior to the 80th amendment, has not made sharing of the proceeds of Union excise ducy mandatory but allowed sharing with the States to be K 39

decided by the Parliament. The Finance Commissions did not feel restricted by this provision as sharing with States were recommended first, in respect of selected duties then from the Third Commission onward the entire proceeds of Union excise duty were made sharable. Fiscal need of a State assessed on the basis of population and backwardness and capacity measured by income constitute the main criterion for determining inter se sharing of union excise duty (see table 3.3). From the Eight~ Finance Commission onward the unified formula for inter se distribution of income tax and Union excise duty began to be adopted. The vertical aspect of fixing separate percentage share of States in respect of income tax and excise duty continues, but the formula for horizontal sharing was applied to the total pool available for the States. Certain portions of the States' share in both the taxes, however, were set aside for distribution on the basis of collection in the case of income tax and for bridging assessed deficit in case of excise duty. The weight assigned to population has been cut down considerably to accommodate income criterion. Apart from population and income, various criteria such as poverty, backwardness, area, tax effort and infrastructure development index were introduced. The range of criteria introduced by these Commissions at times were reflective of the lack of clarity as to the objective of revenue sharing arrangement in a federal system (see table 3.4). Table 3.4: Income tax and Union excise: Vertical and horizontal distribution Vertical Horizontal distribution distribution Finance % share of %weight assigned Commission States - Popu- Income Inverse Poverty Index of Area Tax Infra. income tax lation distance income backward effort Dev. and excise Ness index du Eighth 85; 40 25 50 25 Ninth-1st 85; 45 25 50 12.5 12.5 Ninth- 2"d 85; 45 25 50 12.5 12.5 Tenth 77.5; 47.5 20 60 5.0 10.0 5 Source: Report of the Finance Commission, 8th to 1Oth Commissions. The 80th Amendment of the Constitution has made the net proceeds of all Central taxes sharable with the States. The amendment also abolished the separate identities of two tax rental arrangements viz., tax on railway passenger fares and additional tax in lieu of sales tax on specified commodities (cotton textiles, sugar and tobacco). This unified into one, the different set of revenue sharing that previous Finance Commissions had to 40

recommend upon and make one distribution formula applicable on the entire shareable pool of resource. The vertical sharing of revenue between the Central and State Governments and the criteria for horizontal distribution recommended by the 11th and 12th Finance Commissions is at table 3.5 below. Table 3.5: Revenue sharing: Vertical and horizontal distribution Relative Weight (Percent) Criterion Eleventh Finance Twelfth Finance Thirteenth Finance Vertical share of States I. Population ( 1971) 2. Distance (Income) 3. Fiscal capacity distance 23 Commission 29.5 io.o 62.5 Commission 30.5 25.0 50.0 3. Area 7.5 10.0 4. Index oflnfrastructure 7.5 5. Tax Effort 5.0 7.5 6. Fiscal Discipline 7.5 7.5 Source: Report ofthe Finance Commission, 11th, 12th and 13th Commissions. Commission 32.0 25.0 47.5 10.0 17.5 The weight assigned to population, income area and infrastructure are meant to capture fiscal need and fiscal capacity of the State while tax effort and fiscal discipline are considered incentive criteria to motivate State Governments in better fiscal management. The score of a State in these, so called, incentive criterion were determined on the basis of past performance and then built into its relative share worked out for the award period. Hence, by construction, it is only a reward or penalty for past performance rather than an incentive for future performance. Unified distribution formula has made life easier for the Finance Commission, but it ignore the different incentives structure embedded in different taxes. Of particular relevance to this issue are income tax and corporation tax. It needs to be recognized that the policy decisions of State Governments, to a large extent, contribute to the increase in these taxes and hence the proceeds rightfully belong to them. It might, probably, be with this understanding that the Joint Select Committee under GOI Act, 1919 had made income tax shareable with Provinces by incorporating collection as a criterion for inter se distribution. The practice continued till the Seventh Finance Commission. The Joint Select Committee report also provides useful guidance on how to construct incentive 23 The 13th Finance Commission introduced the Fiscal capacity distance criterion as equity component of the distribution formula in place of income distance adopted by previous commissions. The criterion represents the distance of potential per capita tax revenue of a State, computed from average per capita income to tax revenue ratio, from that ofharyana which has the second highest per capita tax revenue next to Goa. Notional entitlement ofrs.ioo per capita has been assigned to States with negative computed fiscal distance. 41

criterion in the distribution formula. Incentives should be in the form of making the States beneficent of the excess of collection within their jurisdictions over and above the projected amount in respect of income tax and corporation tax. In general, the Finance Commission determine allocation of grants-in-aid based on the assessed budgetary needs of States, standard of social services, special obligations of a State and programmes of national importance. Specific purpose grants are recommended for meeting specific needs like for pr~vision of standard level service in social sector, for improvement of the level of administration in tribal areas, for upkeep infrastructure relating to maintenance of law and order and for any special problem of a State. Over and above tax sharing and specific grants, the Finance Commission also gives general purpose grants to States, the quantum of which is determined on the basis of assessed deficit in the non-plan revenue account. After working out share in Central taxes and specific purpose grants-in-aid of States, the Finance Commission assess the non-plan budgetary balance of each State based, in principle, on normative assumptions, though in reality, they are projections from the base year actuals. Then general purpose grants-inaid are allocated to States which are still projected to be running deficit in their non-plan revenue budget. This is called 'gap-filling' approach. The methodology. gives Finance Commissions the satisfaction that, in their assessment, even the financially weakest States ends up with non-plan revenue balance or surplus by the end of the award period. The fact that actual budgetary balances rarely follow the Finance Commissions' projections is different issue altogether. 3.5.3 Assistance for the plans and the Planning Commission The flow of resources to the States in connection with the plans can be broadly categorized into Central assistance for State plans and centrally sponsored and central sector plan schemes. As the apex planning body, the Planning Commission is involve in the formulation of all the plan schemes of the Central Ministries and in the allocation of resources for these schemes. Apart from these, the Planning Commission has mediated Central assistance for schemes in the State plans. With this assistance, the Central Government provided support to the plans of State Governments either in the form of lump-sum plan assistance or in the form of assistance for specific programme formulated by. the Central Government and in few cases by. the State Governments. It is generally 42

understood that assistance for State plans. are for supporting developmental outlays in subjects assigned to the State Governments while assistance under Centrally sponsored and Central plan schemes are meant for subjects in the Concurrent or Union Lists. The allocation of budgetary resource for the plans of Central Ministries and the States and their channels may be seen from the following exhibit. Exhibit 3.1: Allocation of budgetary resources of the Centre for the plans Gross budgetary support for the plan plan schemes programmes Central assistance The quantum of gross budgetary support for the plan is determined annually taking into account the overall fiscal position of the Centre and the level of fiscal deficit agreed for the year. The gross budgetary support is divided into two parts: one for meeting the plan outlay of Central Ministries and the other for supporting the plans of State Governments. Central Ministries utilized a good part of their plan outlays for implementing various schemes through State Governments in the form of Centrally sponsored and Central sector schemes. The allocation under Central assistance for State plan is first preempted by various programmes and then the amount left after meeting these requirements constitute the normal Central assistance. 3.5.3.1 Central assistance for State plans The quantum and grant-loan mix of Central assistance for State plans determined on the basis ofthe nature of plan schemes the assessed resource gap was replaced in 1969 with distribution formula called the Gadgil Formula. Under this Formula, Central assistance for State plans was to be distributed among States on the basis of the agreed 43

criteria and given in a grant to loan ratio of 30:70 for general category States and 90:10 for special category States 24 Table 3.6: Gadgil Formula for distribution of normal Central assistance Criterion A. Special category states B. The remaining 70% distributed among Non-Special category States in: 1. Population (1971) 2. Ongoing major irrigation & power projects 3. Per capita income 2.1 Deviation method 2.2 Distance method 4. Performance 3.1 Tax effort 3.2 Fiscal management 3.3 National objectives 3.3.1 Population control 3.3.2 Elimination of female illiteracy 3.3.3 on-time completion of externally aided projects (EAP) 3.3.4 Success in land reforms 5. Special problems Total a States of Assam, J&K and Nagaland; Original Formula (1969) The requirements of 3 States" to be met out of the total pool 60.0 10.0 10.0 10.0 10.0 10.0 10.0 100.0 Modified Formula (1980) The requirements of 8 Statesb to be met out of the total pool 60.0 20.0 20.0 10.0 10.0 10.0 100.0 Revised Formula 1991 30%ofthe pool pre-empted by 11 States< 60.0 25.0 20.0 5.0 7.5 2.5 2.0 3.0 1.0 1.0 0.5 0.5 7.5 100.0 b States of Assam, Himachal Pradesh, J&K, Manipur, Meghalaya, Nagaland, Tripura and Sikkim; c Special category States of Arunachal Pradesh, Assam, Himachal Pradesh, J&K, Manipur, Meghalaya, Mizoram, Nagaland, Tripura, Sikkim and Uttaranchal. Source: Planning Commission. The Gadgil Formula reduces the discretionary power of the Planning Commission in allocating Central assistance among States and in fixing the grant:loan mix of plan assistance. For the State Governments, the Formula provides greater flexibility in the application of plan assistance. Originally, the formula was made applicable to the remaining pool of Central assistance after meeting the requirements of the special category States of Assam, Nagaland and Jammu & Kashmir. Subsequently, the number of special category States increased to 11 and the number of schemes funded in the form areas programmes and special and additional assistance pre-empting resource from the pool increased. Effectively, the share of resources available for distribution on the basis 24 On the recommendation of the Twelfth Finance Commission, the system of extending plan assistance to States in grant: loan mix has came to be discontinued from the year 2005-06. 44

of the Gad gil Formula reduces to less than 20 percent of the total Central assistance for State plans. Apart from normal Central Assistance, few area specific schemes like Hill and Border Areas Programmes were, earlier, given as additional/special Central assistance out of the total allocation of assistance for State plans. Later sectoral schemes like slum development, roads and bridges, power and irrigation were added into the list of additional Central assistance. Then the announcement of composite schemes like the Minimum Needs Programme (MNP), Basic Minimum Services (BMS), MPs' local area development program (MPLAD), Prime Ministers' Grameen Yojana (PMGY), flagship programmes under National Common Minimum Programme (NCMP) etc have added, over the years, to the list of additional Central assistance. Though these schemes are funded from the allocation under assistance for State plans, there is little difference between these schemes and Centrally sponsored ones as they are both implemented by Central Ministries. Inclusion of these Central schemes in assistance for State plans rather than under Centrally sponsored scheme helps in maintaining the relative share of State sectors in gross budgetary support regardless of actual increase in Central schemes and corresponding reduction in funds available for formula-based normal assistance. 3.5.3.2 Assistance for Centrally sponsored and Central plan schemes Centrally sponsored and Central plan schemes (CSS and CPS) are conceptually similar to special purpose grants for correcting inter-jurisdictional spillovers and public services considered merit by the national government. Central plan schemes (CPS) are roughly understood to confine to assistance to States for implementation Central schemes on subjects in the Union List or Concurrent List of the Constitution. Normally, full funding in the form of grants-in aid is the pattern employed in assistance for these schemes. Centrally sponsored schemes (CSS) are schemes of the Central ministries on subjects in the Concurrent List or State List. The schemes are formulated by Central ministries for implementation by the State Governments, mostly on cost sharing basis. Assistance for these schemes, till 2004-05, were given in a mix of grants and loans. With the discontinuation of plan loans by Central Government, assistance to States for CSS has been made fully grant, but cost sharing remained the pattern for most schemes. 45

Since Centrally sponsored schemes have remained a sore point in Centre-State financial relation from the mid-1960s because they are seen as Centre's intrusion into State subjects and for their discretionary nature. In 1968 the National Development Council (NDC) took the decision that the quantum of assistance should be restricted to 116th of Central assistance for State plans. Despite the decision, the number of schemes and quantum of assistance grew over the years. While the Central Government has shown willingness to consider the demands for transfer of CSS to States in the form of block normal Central assistance, progress in this direction has so far been limited. Main opposition for conversion of assistance for CSS into normal Central assistance came, predictably, from the Central ministries and the line departments of the State Governments. Both the types of additional assistance and Centrally sponsored schemes involve implementation of Centrally formulated schemes through State Governments as implementing agencies. While the need for these types of schemes from the perspective of national development goals is undeniable, from the allocative efficiency point of view these transfers may have little to contribute in enhancing accountability to local electorates. From the grantor perspective, these schemes are highly susceptible to agency problem which is reflected in the fact these schemes are perceived to be poorly targeted and monitored. The multiplicity of schemes with overlapping objective and thin spread of resources has been cited as classic example of a state overstretching itself 25 3.6 Volume and trend in Central transfers The volume of Central transfers to States has increased considerably from 1.16 percent ofgdp during the First Five-Year Plan to 4.14 percent by the Ninth Plan period (table 3. 7). There has be sustained increased up to the Seventh Plan period when Central transfers to GDP peaked at 4.93 percent, followed by successive decline during the Eight and Ninth Five-Year Plan periods. In general, statutory transfers through the Finance Commission are found to be less fluctuating than plan transfers. The discretionary nature of plan transfers, especially additional Central assistance, CSS and CPS is reflected in its fluctuation in relation to the revenue and the overall budgetary positions of the Central 25 See Planning Commission (2001), Approach Paper to the Tenth Five-Year Plan (2002-07), (p.47'-50}. 46

Government. The reasons for fluctuations in these type of plan grants are (i) the actual gross budgetary support for the plan depends upon Central overall budgetary position and in an event of a shortfall major part of the adjustment is borne usually by these schemes, (ii) the actual amount of grant depends upon the absorptive capacity of State Government by providing their share of the cost and fulfilling administrative requirements for release of further funds. When the economy experience higher growth rates, apart from revenue growth the Central government is in the position to accommodate larger fiscal deficits for plan spending whereas an economic downswing compressed the budgetary position which translated into cut in plan transfers. The decline in plan transfers from the mid 1990s is due, basically, to the cuts in CPS and CSS initiated during the Ninth Plan period. Besides, the decline is also attributable to the lower absorptive capacity of States due to their deteriorating fiscal balances during the decade. Table 3.7: Trend in Central transfers to States Five Year Plans First Second Third Fourth Fifth (As percent o[gdp) Sixth Seventh Eighth Ninth (1951-56) (1956-61) (1961-66) (1969-74) (1974-79} (1980-85) (1985-90) (1992"97) (1997-02) I. Finance Commission Transfers 0.68 1.17 1.35 2.08 2.39 2.67 3.01 2.86 2.86 1.1 Share in Central Taxes 0.63 0.90 1.04 1.78 1.79 2.46 2.67 2.55 2.50 1.2 Statutory grants 0.05 0.26 0.31 0.31 0.60 0.21 0.34 0.31 0.36 2. Plan grants 0.34 0.73 0.79 0.80 1.05 1.48 1.73 1.59 1.19 3. Other grants 0.14 O.Q7 0.03 0.39 0.13 0.18 0.19 0.09 0.09 4. Total Transfers 1.16 1.97 2.18 3.27 3.56 4.33 4.93 4.54 4.14 Source: Computed from the Eleventh and Twelfth Finance Commission Reports The importance of Central transfers in the fiscal operation of the States is revealed by the share in revenue expenditure. Central transfers constitute over 30 percent of States' total revenue expenditure and 37 percent of the total revenue receipts. A little less than 2/3rds of the total Central transfers to States are mediated by the Finance Commission of which 57 percent is accounted for by the share in Central taxes. Revenue transfers for State plan schemes and Centrally sponsored and Central plan schemes together accounted for 8.5 percent. The overall trend revealed over 10 percentage points decline in Central transfers as percentage of total revenue expenditure during the period 1980-81 to 2003-04. As percentage of States' total revenue receipts the decline is only 3 percentage points revealing the growing revenue deficit of State Governments (see table 3.8 below). 47

Table 3.8: Central transfers relative to States' total revenue expenditure (percent) 1980-81 1985-86 1990-91 1995-96 2000-01 2003-04 A. Non-plan transfers A. I Share in Central Taxes 25.6 22.2 19.9 20.0 17.4 17.4 (23.3) (21.7) (21.5) (21.2) (21.3) (21.2) A.2 Finance Commission grants 1.7 1.9 3.1 2.7 2.8 2.8 (1.6) (1.8) (3.4) (2.9) (3.4) (2.4) A.3 Other non-plan grants 2.4 2.6 1.5 1.4 1.7 1.7 (2.2) (2.6) (1.6) (1.5) (2.1) (2.1) Total A 29.7 26.7 24.4 24.2 21.9 21.9 (27.0) (26.1) (26.4) (25.6) (26.8) (25.7) B. Plan transfers B.l Grants for State plan schemes 7.7 8.5 6.7 5.6 5.6 5.6 (7.0) (8.3) (7.2) (5.9) (6.8) (8.1) B.2 CSS/CPS 5.9 6.3 6.4 4.7 2.9 2.9 (5.3) (6.2) {6:9) (5.0) (3.5) (3.6) Total B 13.6 14.8 13.1 10.4 8.5 8.5 (12.4) (14.5) (14.1) (11.0) (10.4) (11.7) TOTAL(A+B) 43.3 41.4 37.5 34.5 30.4 30.4 (39.4) (40.6) (40.5) (36.6) (37.2) (37.4) Note: Figures in parentheses gives transfers relative to total revenue receipt of States. Source: RBI - State finances- various issues. The degree of dependence of individual States on Central transfers differs widely. The share of Central transfers in the total revenue expenditure of the States given at table 3.9 revealed that while it is just 8.5 percent for Punjab it is 123 percent for Nagaland in 2003-04. In general, the share of Central transfers in revenue expenditure is lowest for high income States and highest for small special category States. For the States of Arunachal Pradesh, Jammu & Kashmir and Nagaland, Central transfers are in excess of their total revenue expenditure. This is because of the liberal plan assistance by earmarking 30 percent of the fund available for these States from the normal Central assistance and the easier grant to loan ratio of90:10 as against 30:70 for general category States. For the middle income States, the ratio is in the range of 19 to 32 percent whereas for low income States like Bihar and Orissa Central transfers accounted for over 45 percent of their revenue expenditure. 48

Table 3.9: Central transfers as percentage of revenue expenditure - State-wise (jn l!_ercentage) States 1980-81 1985-86 1990-91 1995-96 2000-01 2003-04 General category States I. Andhra Pradesh 39.6 34.0 34.9 39.1 26.8 31.7 2. Bihar 66.4 63.2 49.4 53.1 53.3 66.4 3. Chattisgarh 52.4 34.0 4.Goa 46.5 18.4 10.1 10.7 5. Gujarat 34.1 25.4 14.1 18.5 15.2 17.3 6. Haryana 26.6 23.5 17.2 12.3 11.5 12.6 7. Jharkhand 55.0 8. Kamataka 31.0 27.6 26.3 24.0 24.7 24.6 9. Kerala 30.5 34.5 30.2 25.8 18.5 18.8 10. Madhya Pradesh 47.6 41.1 41.0 36.8 42.1 32.1 11. Maharashtra 24.5 18.3 20.4 16.6 11.4 13.3 12. Orissa 65.7 52.6 59.4 45.5 45.7 46.4 13. Punjab 23.0 26.4 17.0 13.4 13.2 8.5 14. Rajasthan 47.2 42.4 46.3 31.7 36.0 32.4 15. Tamil Nadu 35.4 34.8 28.0 23.7 19.9 22.4 16. Uttar Pradesh 58.9 55.1 45.8 41.8 38.1 31.4 17. West Bengal 37.9 45.7 34.2 33.8 33.4 28.1 Special category States 18 Arunachal Pradesh 121.9 131.1 96.4 101.5 19. Assam 53.6 64.9 56.2 65.4 57.6 56.2 20. Himachal Pradesh 83.8 92.4 65.1 68.0 48.9 48.4 21. Jammu & Kashmir 52.2 70.4 76.4 111.8 66.4 106.1 22. Manipur 110.7 133.8 115.5 99.9 84.3 88.9 23. Meghalaya 105.5 116.0 96.0 94.9 85.9 83.1 24.Mizoram 94.1 106.8 101.9 15.1 99.3 25. Nagaland 96.8 120.4 88.3 85.9 92.9 123.0 26. Sikkim 99.2 96.8 94.8 33.3 66.5 58.9 27. Tripura 100.2 108.2 90.7 108.2 81.8 86.3 28. Uttaranchal 61.9 45.9 Source: RBI - State Finances, various issues. A declining trend in the share of Central transfers in States' revenue expenditure, especially for general category States, is observable. In case of special category States, there is an overall declining trend but large scale fluctuations are observable signifying high degree of dependence on Central transfers. Obviously, the declining share of Central transfers is compensated for by both States' own revenues and borrowings. By and large, the level of own source revenues remained the major determinant of the level of per capita revenue expenditure of major States which is evident from this strong correlation with the level of per capita incomes. (See Graph 3.1 below). 49