CHAPTER 5 TRANSFER OF RESOURCES FROM CENTRE TO STATES

CHAPTER 5 TRANSFER OF RESOURCES FROM CENTRE TO STATES An essential feature of Fiscal Federalism is the division of functions and resources between different layers of Government. However, when this division takes place on efficiency and other scientific considerations, the problem of noncorrespondence arises: the Centre has relatively more resources as compared to the functions to be performed by it. The States, on the other hand, face the problem of inadequacy of resources as against the various socio-economic functions expanding and expensive in nature to be performed by them. The problem is further aggravated by the disparity in the levels of development of various states that is partly caused by differences in the endowment of resources given by the nature and partly by manmade efforts in the process of development. In view of such a situation, it becomes necessary for the federal government to transfer resources to the states in a scale whereby the vertical fiscal imbalance is corrected on the one hand, and on the other hand devise such principles and mechanism whereby the disparities, as far as possible, amongst the various states are mitigated. In fact the task of removing horizontal fiscal imbalances in a federation is beset with a number of complexities in view of the vast disparities amongst the various states in a country like India (Bhargava, 2003; pp.113-114). Intergovernmental transfers have been employed in all federations to achieve a variety of political and economic objectives. In the political realm, transfers in many federal countries have performed a nation building role. In other words, they have been an important instrument for the central government to keep the country together, enable sub-central units to pursue their own goals, and yet influence their priorities through conditionalities. Often, the central government has employed intergovernmental transfers to influence the pattern of spending of sub-central governments or to implement its expenditure plans through sub-central governments, using them as agencies. In the economic sphere transfers have been employed as an effective instrument to resolve imbalances in the revenue and expenditure between different levels of government (vertical) and among different units within each of the

levels (horizontal) to establish fiscal equity among individuals or regions, or to offset inter-jurisdictional spillovers (Prasad, 2003;p.73). India is a large, heterogeneous developing country. For countries such as India, intergovernmental transfers can play an important role in nation building, by delivering public services corresponding to varied preferences of the people, enabling efficient and equitable allocation of resources, and promoting balanced regional development. At the same time, an ill designed system can create severe regional tensions and accentuate fissiparous tendencies. Political economy considerations such as regional demands may, in turn, pose serious constraints in achieving economic objectives in an attempt to design and implement the intergovernmental transfer system (Rao and Singh, 1998; p.2). The process of planned economic development in India initiated in 1951-52 with the first five-year plan has evolved on expanding role for the public sector in India. Since the development outlay in each five-year plan has been progressively stepped up, this has led to the need for raising an increasing volume of financial resources by the central and state governments to implement the plan outlay. But this has brought into sharp focus the incompatibility between the distribution of the revenue resources and the resource requirements of the development programmes of the central and state governments. This has, therefore, revealed that the Constitution had not envisaged the problem of enormous imbalance that may arise between the fiscal need and capacity of each layer of government in a developing economy. An analysis of the pattern of financing of the public sector outlay in each of the five-year plans abundantly illustrates the sharp and growing differences in the responses of the resource structure assigned to each layer of the government to the dynamics of development planning. Since the resource structure of the states has not adequately responded to their growing needs for development finance, the gap has tended to be bridged largely through central resource transfers who has led to the increasing financial dependence of the states on the centre and this has created enormous complications for inter-governmental financial relations (Tripathy, 1982; p.72). Against this background an attempt has been made in this chapter to study the transfers or resources from the centre to states in India from 1951-52 to 2008-09 (BE). 95

India is a unique but highly complicated case study in fiscal structure. Therefore, any study on transfer of resources from the centre to states of India needs to give an overview of the various institutional arrangements for such fiscal transfers. There are several unique aspects about the arrangements for fiscal transfer in Indian Federalism. The three major channels of transfer of resources are: 1) The devolution of resources from Centre to States as recommended by the Finance Commission (Statutory Transfers) 2) The Central Assistance to State Plans as allocated by the Planning Commission. 3) The transfer of resources from Centre to States for the centrally sponsored schemes and other non-plan assistance through the Ministries and Departments of Government of India (Discretionary Transfers) Apart from these transfers, resources also flow to the States indirectly through: 1. Establishment/Expansion of public sector enterprises. 2. Subsidised lending by banking and financial institutions. 3. Subsidised borrowing by the States from Central Government and the banking system. Finance Commission Transfers Finance Commission, in general, has to make recommendations relating to the following: a) Vertical Sharing: It relates to the distribution between the centre and states of the net proceeds of the taxes, which are to be or may be shared; b) Horizontal Sharing: It deals with the allocation between the states of the respective shares of such proceeds; c) Distribution of grants-in-aid: Principles that should govern the grants-in-aid of the revenues of the states out of the Consolidated Fund of India and the revenue sums to be paid to the states, which are in need of assistance by way of grants-in-aid under, Article 275 of the Constitution. 96

d) The Commission, may suggest changes to be made in the principles governing the distribution of (i) the net proceeds in any financial year of the additional duties of excise leviable under the Additional Duties of Excise (Goods of special importance) Act, 1957(Article 58); and (ii) the grants to be made available to the states in lieu of the tax under the repealed Railway Passenger Fares Tax Act 1957. (Arora, 2002;pp.103-104) Twelve Finance Commissions, so far have made recommendations to the central government and, with a few exceptions, these have been accepted. The Commissions have developed an elaborate methodology for dealing with horizontal and vertical fiscal imbalances. In particular, the formula for tax devolution is quite complicated, as a result of attempts to capture simultaneously disparate (and even contradictory) factors such as poverty, backwardness, tax efforts, fiscal discipline, and population control efforts. The result has been that the impact of Finance Commission Transfers on horizontal equity has been somewhat limited. Despite the ad hoc nature of tax-sharing formula, its persistence reflects the nature of precedent that has grown around the Finance Commission, even though it is not a permanent body, and lacks continuity in its staffing and its analysis. Grants recommended by the Finance Commission have typically been based on projected gaps between non-plan current expenditures and post tax devolution revenues. As with tax sharing, these grants have generally been unconditional, although some commissions have attempted to enhance outlays on specified services in the states by making closed ended specific purpose non-matching grants. In either case, the incentive problems with this gap filling approach are obvious. Some commissions did try to incorporate normative growth rates of revenues and expenditures in their calculations, but these attempts were selective and relatively unimportant (Singh, 2006; p.5). CRITERIA AND WEIGHTS USED FOR TAX DEVOLUTION THROUGH SUCCESSIVE FINANCE COMMISSIONS Finance Commissions have used a number of Criteria like Population, Contribution, Backwardness, Income Distance, Inverse per Capita Income, Poverty, Revenue Equalization, Non-Plan Deficit, Area, Index of Infrastructure, Fiscal Discipline and Tax effort for the horizontal distribution of financial transfers. In the 97

following section, we shall look into the evolution of some of the, more important of these Criteria over the course of the Twelve Finance Commissions. Population Population is the most important of the criteria adopted by the various commissions. While the weight assigned to it has varied, as between income tax and Union Excise duties and from commission to commission, it is one factor that figures in all the formulae adopted by all the Commissions. The strength of this criterion has been the perception that it is objective. Population has the advantage of being an undisputed factor without any statistical bias. Population is the basic indicator of need for public goods and services and as a criterion; it ensures equal per capita transfers across states (Vithal and Sastry, 2001; p. 104). Per Capita Income Distance After Population, per capita income has been the factor used, in one form or the other, by most commissions. The validity of population as an indicator of economic and financial needs arises out of the fact that each citizen is a unit of public needs and consumption that the state government has to meet. These needs are affected by the income distribution among the population. Among the criteria used for correcting differential fiscal capacities and for enabling poorer states to meet better the needs for public goods and services, per capita income distance appears to be the preferred indicator. It imparts progressivity in distribution. The Fifth Finance Commission, while using this criterion, recommended that a portion of the shareable Union excise duties be distributed among the states whose per capita income is below the average per capita income of all states in proportion to the shortfall of the states per capita income from all states average, multiplied by the population of the state. The Sixth Commission followed the distance method for all states with no cutoff point for eligibility. In this method, the distance of per capita income of each state from the per capita income of the state, which had the highest per capita income, was measured. This value was then multiplied by the population of each state. In this method, the distance in the case of the state with the highest per capita income would be zero, but various commissions have adopted a method by which this state is also 98

given a share on the basis of a notional distance between the per capita income of that state and that of next highest per capita income state. The eighth and ninth commissions have used this method. The tenth and eleventh finance commissions, while following this method, have used the average of the top three states with highest per capita incomes for measuring the distance. In all the cases, the Commissions had taken the average Gross State Domestic Product for three years in order to even out year-to-year variations. For determining the state- wise income distance index, Twelfth Finance Commission considered the average per capita comparable Gross State Domestic Product of each of the 28 States for the last three years, 1999-2000, 2000-01 and 2001-02 provided by the Central Statistical Organization. Following the tenth and the eleventh finance commissions, the average of the top three states with highest per capita income, namely Goa, Punjab and Maharashtra was taken to compute the income distance of each state. For the top three states, the notional distance was assigned by taking their distance with the per capita income of the fourth highest ranked state, namely Haryana (Government of India, 2005; pp. 130-131). Area The use of area of a state as a criterion for determining its share emanates from the additional administrative and other costs that a state with a larger area has to incur in order to deliver a comparable standard of service to its citizens. It should be noted that the use of area as a criterion in the formula could also be interpreted as inverse of population density multiplied by population. It should be recognized, however, that the costs of providing services may increase with the size of a state, but only at a decreasing rate. At the other end, even the smaller states may have to incur certain minimum costs in establishing the framework of governmental machinery. The Tenth Finance Commission provided for a floor level of 2 per cent and a ceiling of 10 per cent in the measurement of the area. The eleventh Finance Commission also followed the same procedure. Twelfth Finance Commission has also assigned a minimum 2 per cent share for states with their area share smaller than 2 per cent. But, it has not fixed an upper ceiling of 10 per cent, as there is only one state (Rajasthan), which marginally exceeds 10 per cent (Government of India, 2005; pp. 131-132). 99

Indices of Backwardness The Commissions have used indices of backwardness devised by them as a more precise criterion for distribution of devolved taxes than even Population. This criteria was used by Fourth, Fifth and Ninth Finance Commission. The Third Commission suggested the percentage of Scheduled Castes and Tribes and backward classes in the population, as a factor to be taken into account in determining the share to be allocated to the states. The Fourth Commission took the following factors into account but did not indicate how the share was worked out; (i) (ii) (iii) Per capita gross value of agricultural production; Per capita value added by manufacture; Percentage of workers to the total population; (iv) Percentage of enrolment in classes I to V, to the population in the age group 6-11; (v) (vi) (vii) Population per hospital bed; Percentage of rural population to total population; and Percentage of the population of Scheduled Castes and Tribes to total population. The fifth Commission took the following six factors: (i) (ii) (iii) (iv) (v) (vi) Scheduled population; Number of factory workers per lakh of population; Net irrigated area per cultivator; Length of railways and surfaced roads per 100 square kilometer; Shortfall in number of school going children as compared to those of school - going age; and Number of hospital beds per 1000 population. The Ninth Commission worked out a Composite index of backwardness combining two indices, that is, population of Scheduled Castes and Scheduled Tribes and the number of agricultural labourers in different states (Vithal and Sastry, 2001; pp 107-108). 100

Index of Infrastructure Another cost disability criterion used by the Tenth and Eleventh Finance Commission was the index of infrastructure, as an indicator of the relative availability of economic and social infrastructure in a state. This index was inversely related to the share. Twelfth Finance Commission find that the infrastructure index distance criterion is correlated with the income distance criterion and this index is better used in an ordinal way. For these reasons, Twelfth Finance Commission dropped the index of infrastructure as a criterion. Tax Efforts As observed by the Tenth Finance Commission, measurement of tax effort on a comparable basis among the states is not a straightforward exercise, because tax effort must be related to some notion of tax potential and there are differences in the nature and composition of tax bases among the states. Give the data constraints the Tenth Commission had used per capita Gross State Domestic Product as a proxy for the aggregate tax base. Tax effort was measured by the ratio of per capita own tax revenue of a state to its per capita income. The Commission felt that there was a need to provide for an adjustment for states with poorer tax bases. If the tax effort ratio as defined above is weighted by the inverse of per capita income, it would imply that if a poorer state exploits its tax base as much as a richer state, it gets an additional positive consideration in the formula. The Eleventh Finance Commission, while considering the tax effort index, reduced the weight of inverse of per capita income from 1 to 0.5. Twelfth Finance Commission adopted the same practice, but has raised the weight given to the tax effort criterion to 7.5 per cent, as the need for fiscal consolidation has become more urgent. Fiscal Discipline The Eleventh Finance Commission with a view to providing an incentive for better fiscal management proposed the index of fiscal discipline. The Eleventh Finance Commission adopted improvement in the ratio of own revenue receipts of a state to its total revenue expenditure, related to a smaller ratio for all states, as a criterion for measurement. The ratio so computed was used to measure the 101

improvement in the index of fiscal discipline in a reference period, in comparison to a base period. It may be noted that such an improvement can be brought about by higher own revenues or lower revenue expenditure or a combination of the two. The comparison of the performance of a state with the all-state performance reflects the consideration that, if the performance of the states is deteriorating in general, the state that accomplishes a relatively lower deterioration is rewarded. Similarly, if all revenue balance profiles are improving, the state where improvement is relatively more than average is rewarded relatively more (Government of India, 2005;pp.132-133). Table 5.1 and 5.2 show the criteria and relative weights used by different finance commissions for fixation of the shares of individual states. The criteria have differed between income tax and union excise duties. In case of income tax First to Seventh Finance Commissions have recognized 'Population' and 'Contribution' to be the relevant factors, though they have differed on the relative weightage to be accorded to these two factors. The weightage assigned to these two factors by First, Third and Fourth Finance Commissions was 80:20, while the Second, Fifth, Sixth and Seventh Finance Commissions changed the weightage to 90:10. The Eighth Finance Commission, after allocating 10 per cent weightage to assessment, gave the balance 90 per cent to the states by giving weightage of 25 per cent to population, 25 per cent to the inverse of per capita income multiplied by population and 50 per cent to the distance of per capita income from the highest per capita income multiplied by population. The Ninth Finance Commission (Second Report) recommended that the shareable proceeds of income tax be distributed among states by providing 10 per cent share on the basis of contribution, 45 per cent on the basis of distance, 22.5 per cent on the basis of population, 11.25 on the basis composite index of backwardness and 11.25 per cent on the basis of inverse of per capita income. The Tenth Finance Commission recommended the criteria for determining the inter se shares of states in the shareable proceeds of income tax on the basis of: 20 per cent on the basis of population of 1971, 60 per cent on the basis of distance of per capita income, 5 per cent on the basis of area adjusted, 5 per cent on the basis of index of infrastructure and 10 per cent on the basis of tax effort. As regards the criteria for determining the relative shares of states in union excise duties, the Finance Commissions did not adopt a uniform principle. The First 102

Finance Commission distributed the states' share on the basis of population. The Second Finance Commission recommended that the share of the states be 90 per cent on the basis of population and 10 per cent on the basis of certain adjustment. The Third, Fourth and Fifth Finance Commissions used criteria linked to specific characteristics of backwardness such as disparity in the level of development, percentage of scheduled castes/tribes and backward classes in the total population, per capita gross value of agricultural production; per capita value added by manufacturing; percentage of workers to total population, percentage of enrolment in primary schools, etc. The Sixth Finance Commission explicitly rejected the approach of using specific criteria for assessing economic backwardness in inter se transfers of union excise duties. It raised the weightage for backwardness from 20 per cent to 25 per cent and recommended that the remaining 75 per cent be distributed on the basis of population. The Commission recommended the distribution of 25 per cent on the basis of distance of states' per capita income from that of the state with highest per capita income. The Seventh Finance Commission drastically reduced the weight for population to 25 per cent. For the balance, it gave equal importance, namely 25 per cent to each (i) inverse of per capita State Domestic Product (ii) percentage of poor and (iii) revenue equalisation formula. The Eighth Finance Commission used a common formula for the distribution of income tax and union excise duties except that 10 per cent weight was retained for the contribution factor in respect of income tax. For excise revenue, it assigned 25 per cent for population, 25 per cent for the inverse of per capita income and 50 per cent for the distance criterion. The recommendation of the Ninth Finance Commission (Second Report) turns out to give a weight of 29.94 per cent to population, 40.12 per cent to distance, 14.97 per cent to inverse income and 14.97 to poverty / backwardness. The Tenth Finance Commission assigned 20 per cent for population, 60 per cent for the distance criterion, 5 per cent for the index of infrastructure to benefit states lower on the infrastructure scale and 10 per cent for tax effort of the states. This Commission also assigned 5 per cent for 'area adjusted' criterion. The Commission devised an adjustment procedure whereby no state gets a share higher than 10 per cent at the upper end, and no state gets a share less than 2 per cent at the lower end. The Commission used this formula for distribution of the entire divisible 103

pool of income tax and 40 per cent out of 47.5 per cent of union excise duties. The balance 7.5 per cent of union excise duties was earmarked for deficit states for filling their financing gaps. Thus, Tenth Finance Commission dispensed with the contribution factor in the distribution of income tax. The Eleventh Finance Commission recommended that the inter se share of the states in tax devolution be determined by the following criteria and relative weights be given as: 10 per cent on the basis of population, 62.5 per cent on the basis of income (distance method); 7.5 per cent on the basis of area; 7.5 per cent on the basis of index of infrastructure; 5 per cent on the basis of tax effort; and 7.5 per cent on the basis of fiscal discipline. Thus, the Eleventh Finance Commission reduced the weight of population from 20 per cent to 10 per cent and marginally increased the weight of income (distance method) from 60 per cent to 62.5 per cent (Om Parkash and Raikhy, 2003;pp.134-136). As per the formula used by the Twelfth Finance Commission, the share of each state in tax devolution was determined by the following criteria and relative weights: Population: 25 per cent Income Distance: 50 per cent Area: 10 per cent Tax Effort: 7.5 per cent Fiscal Discipline: 7.5 per cent (Government of India, 2005; p.133). Thus, criteria of population, distance and tax effort figure prominently in the allocation of tax shares to states by the Finance Commissions in India. Finally, it is imperative that the system of tax devolution encourages mobilization, efficiency, and cost-effectiveness in the application of the same in view of the emergence of a substantial resource crunch both in the union and the states (Om Parkash, 1994; p.114). 104

Table 5.1 Distribution of Income Tax to States as Recommended by various Finance Commissions First Finance Commission (1952) Second Finance Commission (1957)* Third Finance Commission (1961) Fourth Finance Commission (1965) Fifth Finance Commission (1969) Sixth Finance Commission (1973) Seventh Finance Commission (1978) Eighth Finance Commission (1984)** Ninth Finance Commission (1989) Coverage Net proceeds of taxes on income other than agricultural income Excluding proceeds attributable to Union Emoluments Advance tax collections included Percentage to be distributed among states 55 60 Basis of distribution 80% population; 20% collection 90% population; 10% collection 2/3 80% population; 66 20% collection 80% population; 75 20% collection 75 No change 80 No change 85 No change of assessment 85 85 90% population; 10% assessment 90% population 10% assessment 80% population; 20% assessment 10% on the basis of assessment; and 90% of divisible pool with following criteria (a) 25% on population basis; (b) 25% on basis of inverse of per capita income multiplied by population; and (c) 50% on the basis of distance of per capital income from the highest per capita income state multi-plied by population (i) 10% on basis of contribution; (ii) 45% on the distance of per capita income from highest per capita income state multiplied by population; (iii) 22.5% on the basis of population; (iv) 11.25% on the basis of composite index of backward; Contd 105

Table 5.1 Contd Tenth Finance Commission (1994) 77.5 (v) 11.25% on the basis of inverse of per capita income multiplied by the population of the state. 30% on the basis of population, 60% on the basis of distance, 5% on the basis of area adjusted, 5% on the basis of index of infrastructure, 10% on the basis of tax effects. * 100 population Goal ** In order that Punjab, which is the highest per capita income state, also gets a share under this formula, income distances of Punjab and Haryana are treated as equal. Source: Reports of successive Finance Commissions in India, Government of India, Ministry of Finance, New Delhi. 106

Table 5.2 Distribution of Union Excise Duties to States as Recommended by various Finance Commissions First Finance Commission (1952)* Second Finance Commission (1957) Third Finance Commission (1961)** Fourth Finance Commission (1965)*** Fifth Finance Commission (1969) Sixth Finance Commission (1973) Coverage Tobacco, matches and vegetable products Articles added: sugar, coffee, tea, paper and vegetable non-essential oils All commodities on which excise duties levied in 1960-61 except (i) those where yield is below Rs. 50 lakhs a year and (ii) motor spirit (treated differently) All excluding regulatory duties, special excises and earmarked cesses All excluding regulatory duties and earmarked cesses; special excises to be included from 1972-73 onwards All excluding auxiliary duties of excise for 1974-75 and 1975-76. However, from 1976-77 onwards auxiliary duties of excise but excluding cesses percentage to be distributed among states Basis of distribution 40 100% population 25 90% population; 10% for adjustments 20 20 20 20 Population major basis, but some adjustment was made on the basis of relative financial weakness, disparity in development, percentage of scheduled castes, tribes etc. 80% population and 20% relative economic and social backwardness; as measured by seven indicators 90% population; 20% economic and social backwardness, two-thirds of which distributed only among states with per capita income below average per capita income of all states 75% population; 25% relative economic and social backwardness, the distribution of this portion should be in relation to the distance of a state's per capita income from that of the state with the highest per capita income multiplied by the population of the state concerned. Seventh Finance Commission (1978) Entire net proceeds of union excise duty on generation of electricity to be paid to the states. Besides 40% of the net proceeds on all other ar-ticles excluding cesses 40 Percentage share in each state in the divisible pool determined by assigning 25% weight to each of the follow-ing factors: (a) population by 1971 census; (b) inverse of per capita state domestic product; (c) percentage of poor in total state population; (d) formula of revenue equalization as worked out by the Commission. Contd.. 107

Table 5.2 Contd.. Eighth Finance Commission (1984) Share increased from 40% of the net proceeds of the union excise duties excluding the excise duty on electricity which stands abolished from 1 October 1984 40 90% of divisible pool: (a) 25% on population basis; (b) 25% on basis of inverse of pre capita income multiplied by population; and (c) 50% on the basis of distance of per capital income from the highest per capita income state multi-plied by population Ninth Finance Commission (1989) Tenth Finance Commission (1994) 7.5% on the basis of deficit as assessed by Finance Commission 5 45 47.5 Exclusively for states showing deficits on revenue account after devolution of taxes and duties due to them. (i) 25% on basis of population; (ii) 12.5% on the basis of latp; (iii) 12.5% on the basis of index of backwardness; (iv) 33.5% on the basis of distance; (v) 16.5% among deficit states For 40% of the net proceeds the indices are: 20% on the basis of population of 1971, 60% on the basis of distance of per capita income, 5% on the basis of area adjusted, 5% on the basis of index of infrastructure and 10% on the basis of tax effort. * Selected excise on commodities of common and widespread consumption yielding a sizeable sum were included in order to ensure sizeable revenue and reasonable stability ** Wide coverage because of need for broader base and inter-relation with sales tax. *** Extension of same logic as by Third Finance Commission **** In order that Punjab, which is the highest per capita income state, also gets a share under this formula, income distance of Punjab and Haryana are treated as equal. A new principle of directly linking devolution to deficits rather than dealing with them only through grants-in-aid. Source: Reports of successive Finance Commissions in India, Government of India, Ministry of Finance, New Delhi. 108

Plan Transfers Plan Transfers are expected to meet the general plan needs of the States so that they are encouraged to undertake plan development at their own level in such a manner that objectives of economic planning like growth, balanced regional development etc. are easily achieved. The transfers made for centrally sponsored and central plan schemes are given in the overall development context of the nation. Plan assistance under Additionality is given for various purposes. This includes; (encouraging states to identify projects which may be financed by the outside agencies like World Bank etc. (ii) involving States to cooperate in projects preparation and their timely implementation; and (iii) insuring a regular and sufficient flow of financial assistance for identified projects (Arora, 2002;p.109). Criteria for Plan Transfers and Plan Outlays In the process of allocation of Plan funds and Plan Outlays, one has to examine the criteria, which governed these allocations. For this, the Plan era can be divided into two periods; the pre and post Fourth Plan periods. During the earlier period, there were no definite criteria governing either the Plan Outlay or the Plan assistance. During the second period the objective Gadgil formula to determine States Plan assistance was implemented. Prior to the Fourth Plan, Central assistance, it is believed, was being allocated after taking into account the States Plan Outlay and the States own resources determined during bilateral discussions. The States First Five Year Plan included projects/programmes, which were in progress before the commencement of planned economic development. A broad view was taken about the development efforts that were envisaged in the different states and after assessing the resources to be raised by the individual States, the quantum of Central assistance was fixed for each State for the entire plan period. During the second plan, the quantum of Central assistance was not predetermined. It continued to change from year to year in the light of the financial position of State and the Centre and the requirements of projects taken up in both the States as well as the Central sector. The National Development Council it may be mentioned did not specifically consider the principles for allocation of Central assistance to states either in the second or the third five-year plans (Shukla and Chowdhary, 1992; pp.153-155). 109

The criteria for determining the size and pattern of States Plan Outlay were too numerous, diverse and often contradictory to have any operational significance. In the process, the relative bargaining power, more than any rationale came to have dominance. For instance, the second plan is supposed to have taken into consideration the following factors in determining the Plan Outlays: 1. Population, 2. Commitments on account of the First Plan, 3. Expected achievement of development at the end of the First Plan, 4. Expected revenue contribution of the States and programmes for irrigation and power (Chatterji, 1971;p.38) The Third Plan seems to have taken into account a still larger number and variety of factors including needs, problems, past progress and lags in development, likely contribution to achievement of the major national targets, potential for growth and the contribution in resources which the States could make towards its development programmes. In assessing needs and problems, such factors as population, area, levels of income and expenditure, availability of certain service, for example roads, schools, hospitals extent of commitments carried over from the Second plan, commitments on account of large projects or special programmes and the State of technical and administrative service available were taken into account. Care was also taken to see that States whose resources were unavoidably small did not have to limit development to scale, which was altogether insufficient merely because of paucity of resources. At the same time, States which were able to make larger efforts in mobilizing their own resources could undertake development on an appropriate scale. (Planning Commission, 1960; p.60) How and why those criteria were selected, in what fashion they were combined and what weightage was given to each of them is anybody s guess including the Planning Commission s. One can only judge by the results that followed. 110

Patterns of Assistance There were no definite criteria for determining the grant-loan composition of the Central Plan transfers prior to the fourth plan. This proportion depended on the patterns of assistance of individual schemes included in the State Plans. Not all schemes in the State Plans were eligible for Central financing. Even for the eligible schemes, the grant-loan composition of central financing varied. The ultimate grantloan break-up therefore does have an element of mystery and was not known till the plan was completed. The patterns of assistance are made known not at the time of determining the State Plan outlays and the Plan Transfers. The loan and grant portions of the total Central assistance for a State Plan are arrived at by adding up the loan and grant components in the patterns of schemes included in the plan. If the sum total falls short of the total assistance assured to the state, the balance is made up through what is called a miscellaneous development loan. The patterns which had become a maze were both inefficient and inequitable. From the equity angle, the richer States with larger revenue resources could opt for schemes with a larger grant component than the poorer States. The grant component would be as large as 40 per cent or more in the case of developed States, which had resources; it would get 40 per cent as grants. On the other hand, an underdeveloped State that had no resources could get only 12 per cent as grants though the average was about 22 per cent. For these reasons, the States governments had demanded the abolition of patterns of assistance. Gadgil Formula replaced this uncertain and iniquitous pattern of Central assistance, during the Fourth Plan (Shukla and Chowdhary, 1992; pp.157-158). However, since 1969, plan assistance has been distributed on the basis of the Gadgil Formula approved by the National Development Council modified from time to time. Subsequent modifications and revision of the Gadgil formula is given in the following section: GADGIL FORMULA AND ITS VARIANTS 1. Original Gadgil Formula approved by National Development Council in September 1968 (1) The requirements of Assam, Jammu and Kashmir and Nagaland should first be met out of the total pool of Central assistance. 111

(2) The balance of the Central assistance should then be distributed among the remaining fourteen States on the basis of following criteria: (i) (ii) (iii) (iv) (v) 60 per cent on the basis of population-1965 mid year population estimates. 10 per cent on the basis of per capita State Domestic Product (SDP)-average of three years (1962-63 to 1964-65); assistance to go to those States only whose per capita State Domestic Products are below the national average. Deviation method is to be used in distribution. 10 per cent on the basis of tax efforts of States- State s own per capita tax receipts (1967-68) as percentage of per capita State Domestic Product (average of 1962-65). 10 per cent on the basis of spillover into the Fourth Plan, of major continuing irrigation and power projects, each costing more than Rs.20 crore and with expenditure of at least 10 per cent incurred. 10 per cent for special problems of individual States. 2. Updated Gadgil Formula: (1) Requirements of Assam, Himachal Pradesh, Jammu and Kashmir, Nagaland, Manipur, Meghalaya, Sikkim, and Tripura first to be met out of the total Central assistance. (2) Balance to be distributed as under: (i) 60 per cent on the basis of population-1971 population. (ii) 10 per cent on the basis of per capita State Domestic Product-average of 1970-73 to States below the average only. (iii) 10 per cent on the basis of tax efforts of States- State s own per capital tax receipts (1973-74) as percentage of per capita States Domestic Product (average of 1970-73). (iv) 10 per cent on the basis of continuing major irrigation and power projects. (v) 10 per cent on the basis of special problems of individual States. (Here, there is no change from the original Gadgil formula. Only the database has been updated.) 3. Modified Gadgil Formula (1) Lump sum amount to be set apart for eight Special Category States. 112

(2) Balance amount to be distributed among the remaining 14 states as under: (i) 60 per cent 1971 population (ii) 10 per cent- tax effort- 1978-79 tax receipts and 1973-76 per capita State Domestic Product. (iii) 20 per cent- average per capita State Domestic Product for 1973-76 to States below the average. (iv) 10 per cent- special problems of States. (Reserve Bank of India, 2007-08;p.64) 4. Revised Gadgil Formula The last modification in the formula was done in December 1991. According to this latest formula, at present 30 per cent of the funds available for distribution is kept apart for the special category states. Assistance to them is given on the basis of plan projects formulated by them and 90 per cent of the transfer is given by way of grants, with the remainder as loans. The 70 per cent of the funds available to the major states is distributed with 60 per cent weight assigned to population, 25 per cent to per capita State Domestic Product, 7.5 per cent to fiscal management and the remaining 7.5 per cent to special problems of states. Out of the 25 per cent weight assigned to per capita State Domestic Product, the major portion of the funds, 20 per cent is allocated only to the states with less than average per capita State Domestic Product on the basis of the inverse formula; the remaining 5 per cent of the funds are assigned to all the states according to the distance formula. For the major states, assistance is given by way of grants and loans in the ratio of 30:70(Rao and Singh, 1998; p.13). The Planning Commission works out five year plan investments for each sector of the economy and each state. Keeping this in the background, and based on the estimated resource availability, which includes the balance from current revenue, contributions of public enterprises, additional resource mobilization, plan grants and loans, market borrowings and other miscellaneous capital receipts, the states work out respective annual plans for each year, which are then approved by the Planning Commission. Thus, in the final analysis, given the quantum of central transfers to the states as determined by the Gadgil Formula, at the margin it is mainly the own resource position of the states that determine their plan sizes (Rao and Singh, 1998; p.13). Following Table shows the Gadgil Formula for distributing state plan assistance. 113

Table 5.3 Gadgil Formula for Distributing State Plan Assistance Criteria Share in Central Plan Assistance (per cent) Share of Grants and Loans Criteria for distribution in nonspecial category states A. Special Category States (10) 30 90:10 B. Non- Special Category States (15) 70 30:70 1. Population (1971) 60 2. Per Capita Income, of which 25 a) According to the' deviation' method covering only the states with per capita income below the national average. b) According to the 'Distance' method covering all the fifteen states 20 5 3. Fiscal Performance, of which 7.5 a) Tax Effort 2.5 b) Fiscal Management 2.5 c) National Objectives 2.5 4. Special Problems 7.5 Total 100 Note: 1) the formula as revised in December 1991. 2) Fiscal Management is assessed as the difference between states own total plan resources estimated at the time of finalizing annual plan and their actual performance considering latest five years. 3) Under the criterion of the performance in respect of certain programs of national priorities, the approved formula covers four objectives.a) population control, b) elimination of literacy, c) on-time completion of externally aided projects and d) success in land reforms. Source: State Finances: A Study of Budgets of 2008-09, Reserve Bank of India, Mumbai. 114

Central Ministry Transfers Central Ministries under Miscellaneous Financial Provisions of the Constitution assist States in financing their specific expenditures. The Ministries may undertake this financing, without necessarily consulting either the Planning Commission/or the Finance Commission (Arora, 2002; p.113). These transfers are neither based on the recommendations of the Finance Commission, nor determined by the Gadgil Formula, but are discretionary. Central government ministries initiate a number of National Programs, either by themselves, or at the request of the relevant Ministries at the State level. Central Sector Schemes assisted entirely by way of central grants and the states merely have the agency function of executing these programs. Centrally Sponsored Schemes are essentially cost sharing programs, and the share of central assistance is given by way of grants or loans decided for each of the programs. The rationale for introducing these programs is evidently to finance activities with a high degree of interstate spillovers, or is in the nature of merit goods (Rao and Singh, 1998; p.13). The relative share of the three channels of central transfers to states since the first five-year plan, as shown in Table 5.4,bring out some interesting features. Formula based transfers from Finance Commission and Planning Commission have shown large fluctuations from one plan period to another. During the first 18 years of planning, the share of statutory transfers was less than one-third of aggregate transfers. During the first, second and third plan periods, the role of statutory transfers was less than that of Plan transfers. During the Annual Plan period it was just equal. This is because of the reason that right from the first finance commission, all commissions reduced the scope of their enquires to consider only revenue grants, though capital grants were also within their powers under the constitution. From the second commission onwards they confined themselves further to consider only the non-plan revenue component of states budgets though it was well understood that the size of the non-plan revenue budgets is increasingly becoming a function of the plan expenditure made earlier. The third finance commission which tried to look into the revenue component of the State Plans met with a blunt rejection in the form of nonacceptance of its recommendations. The fear of non-acceptance of their recommendations possibly has made the commissions to tread carefully within the confines of the terms of reference imposed by the union government, though the importance of the finance commission has increased from the Annual plan (1966-69) onwards (Shukla and Chowdhary, 1992; pp.87-88). 115

Table 5.4 Plan-Wise Transfer of Resources from Centre to States through Various Channels (Rs. Crore) Year First Plan (1951-56) Second Plan (1956-61) Third Plan (1961-66) Annual Plans (1966-69) Fourth Plan (1969-74) Fifth Plan91974-79) Sixth Plan (1980-85) Seventh Plan (1985-90) Annual Plans (1991-92) Eight Plan (1992-97) Ninth Plan (1997-2002) Tenth Plan (2002-07) 2007-08(RE) 2008-09(BE) Finance Commission % age to total Resources transferred through Planning Commission % age to total Others Transfers % age to total Total 447 31.2 880 61.5 104 7.3 1431 918 32 1344 46.9 606 21.1 2868 1590 28.4 2738 48.9 1272 22.7 5600 1782 33.3 1917 35.9 1648 30.8 5347 5420 64.6 2050 24.43 930 11.08 8390 11090 67.33 4840 29.39 540 3.28 16470 25870 62.11 14280 34.29 1510 3.63 41650 55740 61.04 32030 35.08 3520 3.85 91310 20640 62.66 11250 34.15 1020 3.1 32940 146570 61.76 84840 35.75 5840 2.46 237310 249945.6 64.67 117601.2 30.43 18925.3 4.9 386472.1 476733.6 64.28 214181.3 28.88 50773 6.84 741687.8 165007 60.49 89557 32.83 18208 6.68 272772 189672 59.99 105721 33.44 20784 6.57 316177 Source: State Finances: A study of Budgets, various issues, Reserve Bank of India, Mumbai. 116

From Annual Plan (1966-69) onwards, resources transferred through finance commission as per cent of total have increased from 33.3 per cent to 64.28 per cent in tenth plan. The resources transferred through planning commission as a per cent of total, on the other hand, has gone down from 61.5 per cent in the first plan to 28.88 per cent in the tenth plan. From the three annual plan period (1966-69) onwards, the importance of central plan assistance in financing state plans has been steadily coming down, partly due to the large surpluses left by the Finance Commission on non-plan revenue account which added to the states own resources position. This shows that the grip of Finance Commission vis-à-vis the planning commission over the years has increased tremendously. Although resource transfers percentage in case of other transfers has shown a steep rise from 7.3 per cent in the first plan to 22.7 per cent in the third plan. Yet, in the subsequent plans it has come down to 4 to 5 per cent on an average, which again shows that both the Finance Commission as well as the Planning Commission in total increased their grip. The transfer of resources from centre to states can be analyzed by a study on proportion of sub-components of transfer of resources, which reveal about the contribution of sub-components in devolution of resources. For this analysis data of 58 years i.e. from 1951-52 to 2008-09 in subcomponents of devolution of resources which includes states share in central taxes, grants from the Centre to States and UT s, loans (gross) from the Centre to States and UT s, repayment of loans by States and UT s, gross transfers to States and net transfers to States has been considered. States share in central taxes is the devolution by centre to the states on the basis of recommendations made by Finance Commission relating to the distribution of net proceeds of taxes between the Union and the States and among the States as provided in the Constitution of India. The grants from the Centre are the total grants made by the Centre to the States. It consists of grants under State Plan Scheme, Central Plan Scheme, Centrally Sponsored Scheme, NEC/Special Plan Schemes and Non- Plan Schemes. Further Non- Plan Schemes also has three components as Statutory Grants, Grants for Natural Calamities and Non- Statutory Non- Plan Grants. Plan Loans and Non- Plan Loans from Centre to States together form Gross Loans from the Centre. States share in Central Taxes, Grants from the Centre and Gross Loans from the Centre when combined give Gross Transfer from Centre to States. Net Transfer of resources is transfer of resources adjusted for repayment and interest payment liabilities. 117

Table 5.5 Transfer of resources from Centre to States (Rs. Crores) Year Share of States in Central Taxes Grants from the Centre to States and UTs Loans (Gross) from the Centre to States Gross Transfers to States (1+2+3) Repayment of loans by States and UTs Net Transfers to States (4-5) 1 2 3 4 5 6 1951-52 53 34 60 147 12 135 1952-53 74 36 92 202 14 188 1953-54 72 45 124 241 13 228 1954-55 71 51 193 315 18 297 1955-56 74 48 250 372 25 347 1956-57 78 39 201 318 37 281 1957-58 121 114 276 511 60 451 1958-59 162 142 294 598 62 536 1959-60 170 182 275 627 82 545 1960-61 179 224 328 731 95 636 1961-62 179 215 452 846 134 712 1962-63 224 220 524 968 145 823 1963-64 259 234 624 1117 179 938 1964-65 258 286 680 1224 216 1008 1965-66 276 349 821 1446 276 1170 1966-67 372 406 931 1709 281 1428 1967-68 416 473 892 1781 378 1403 1968-69 491 536 915 1942 585 1357 1969-70 621 588 1056 2265 633 1632 1970-71 755 612 1028 2395 658 1737 1971-72 944 891 1209 3044 854 2190 1972-73 1067 947 1541 3555 655 2900 1973-74 1174 952 1576 3702 969 2733 1974-75 1224 1060 1093 3377 507 2870 1975-76 1599 1289 1296 4184 746 3438 1976-77 1690 1622 1481 4793 656 4137 1977-78 1798 1961 1956 5715 881 4834 1978-79 1957 2635 2769 7361 892 6469 1979-80 3406 2411 2762 8579 844 7735 1980-81 3792 2796 3146 9734 917 8817 1981-82 4274 2855 3460 10589 1264 9325 1982-83 4639 3635 4298 12572 1444 11128 1983-84 5246 4402 5059 14707 1941 12766 1984-85 5777 5220 6177 17174 2454 14720 Contd. 118