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Fiscal Fedaralism In India Intergovernmental Transfers Explored Economics Essay

As diverse as one could imagine, for the Indian state adoption of a federal structure was a natural option. Based on a quasi federal system, fiscal arrangements in India were designed in a way to meet the requirements of centralized planning in a mixed economy framework. In this paper we attempt to analyse the Intergovernmental transfers in the Indian context. We would go through the rationale, framework and major issues and concerns regarding Intergovernmental transfers in India.


A distinctive and crucial policy instrument, intergovernmental transfers can serve a number of functions. The economic rationale for these transfers rests on three potential roles it can play. They are

Offsetting fiscal imbalances or closing fiscal gaps,

Establishing horizontal equity across the federation, and

Offsetting inter jurisdictional cost and benefit spillovers or for merit good reasons.

Most important reason for transfers arises out of fiscal mismatch between revenues and expenditures of different governmental units. Fiscal imbalances can be of two types, vertical or horizontal. ‘Vertical fiscal imbalance refers to the difference between expenditures and revenues at different levels of government, while horizontal federalism refers to the differences between revenue and expenditure levels within a particular level of government.'(Rao, Singh, 2005)

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Implicit in the division of power into multiple levels of government, it is vertical imbalance that mandates sharing of revenues raised by the centre. This arises because central government has a comparative advantage in raising revenues as there are economies of scale in collecting taxes. But at the same time sub national governments can better supply public goods whose quantity and quality vary according to the requirements and preferences of residents. [1] Vertical fiscal imbalances can arise also out of factors such as intergovernmental tax competition or differential fiscal performances .In the Indian scenario the vertical imbalance is well pronounced. In 2002-3, state governments on an average raised about 38 per cent of total revenues but accounted for 58 per cent of expenditures, this in contrast to 1955-6 when the shares were around 41 per cent and 59 respectively. While it is crystal clear that there is a considerable degree of vertical imbalance in Indian fiscal system, this in itself cannot be a vindication for providing transfers. ‘In fact a vertical fiscal imbalance rationale for such transfers is tautological, because growth of the vertical fiscal imbalance itself could be due to

Increases in revenue capacity at the state level not keeping pace with growing expenditure needs and

Slackening fiscal management at the state level resulting in lower tax effort and increased fiscal profligacy.’ [2]

Horizontal fiscal imbalances are the results of revenue and expenditure differences between the states. Differences in revenue arise mainly due to difference in fiscal capacity or effort. On a similar note expenditure differences could be due to difference in quantity or quality of public goods offered or differences in unit cost. While these disparities could arise out of state policies it could very well be a result of factors beyond states’ control. The per capita net state domestic product (NSDP) in the richest state (Haryana) in 2007-08 was over 5.4 times that of the poorest state (Bihar) even when only the large states are considered. Of course, the state with the highest per capita GSDP is the small state of Goa and if this is considered, the difference between the lowest and highest per capita GSDP state is 9.5 times. [3] If we are to divide state into special category states and non special category the disparity is even wider.

Interjurisdictional spillover is a problem that results from decentralisation policy in fiscal federalism. Local government might be in a better position to provide better quality public goods, but the problem that remains is that the benefits of these goods might not be limited to a particular geographical area. Local government who provide these goods often lacks the incentive to consider how this would affect the neighbouring states. Thus the amount supplied would be inefficient from a national perspective. Central government can step in such cases to ensure an efficient allocation.


In India fiscal transfers are made from centre to state under article 270 of the constitution as well as grants under article 275 and 282.Intergovernmental transfers in India takes place mainly through three main channels. First there is a finance commission appointed every five years by president of India to devolve tax shares and give grants. Secondly, we have a planning commission which dispenses funds by the way of grants and finally there are ministerial allocations which funds central sector and centrally sponsored schemes taken up in states.

Formed under article 280 of Indian constitution, finance commission’s primary responsibility is to determine states share in tax revenue sharing. ‘The approach of finance commission to transfers consists of

Assessment of overall budgetary requirement of the center and states to determine the volume of resources that can be transferred during the period of their recommendation.

Foreseeing states own current revenues and non plan current expenditures.

Determining the states’ share in central tax revenues and distributing between the states of these shareable proceeds

Filling the post-devolution projected gaps between non plan current expenditures and revenues with the grants in aid.’ [4]

Known as gap filling approach, finance commission uses a fixed formula based on economic indicators to decide the tax devolution for each state. This formula is based on population, area, distance, infrastructure, fiscal discipline and tax effort. The two core criteria in the scheme of sharing of central taxes are: population and distance. While distance formula is used as a tool for fiscal capacity equalization, the population criterion is a tool for vertical transfers as it provides equal per capita transfers to all states independent of their fiscal capacities. Grants recommended by the finance commission, on the other hand are determined on the basis of projected gaps between non plan current expenditures and post tax devolution revenues. The Finance Commission grants is provided to meet the assessed revenue gap of the states (on non-plan or total revenue account) and also some other purposes including special needs and up gradation of standards. The share of grants in total transfers has varied in the range from the lowest share of 7.7 percent (Seventh Finance Commission) to the highest share of 26.9 percent for the Third Finance Commission with reference to actual transfers. (Rao, Singh; 2005)

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Planning commission, the second channel of transfers assists states through grants and loans. Often considered as a centralizing force in fiscal federalism, role of planning commission in Indian fiscal system has increased in the recent past. Prior to 1969, these transfers were mostly project based and hence highly discretionary. From 1969 the plan assistance is based on Gadgill formula. This was introduced with an aim to eliminate preferential allocation and discretionary nature of plan assistance provided. ‘According to this, at present 30 per cent of the funds available for distribution are kept apart for the special category states. Assistance to them is given on the basis of the plan projects formulate by them and 90 per cent of the transfer is given by the way of grants and the remaining as loans. The 70 per cent of funds available to major states is distributed with 6o per cent weight assigned to population, 25 per cent to per capita SDP, 7.5 per cent to fiscal management, and the remaining 7.5 per cent to special problems of the states. Of the 25 per cent weight assigned to per capita SDP, 20 percentage points worth is allocated only to states with less than average per capita SDP on the basis of ‘inverse’ formula and the remaining is assigned to all states according to the distance formula.’ [5]

Assistance to the central sector and centrally sponsored schemes is the third channels of transfers in India. This is neither based on the recommendations of the finance commission nor is determined by any formula. Grants for the central sector schemes are given to the states to execute central projects and are entirely funded by it. Centrally sponsored schemes, on the other hand, are shared cost programs which stipulate matching requirements from the state government. The economic rationale offered for these programs is that certain finance activities have a high degree of interstate spillovers or are in nature of merit goods. Though many of them are well designed, these transfers have attracted sharpest criticism due to the conditionality’s and discretion implicit in them. ‘These programs have provided the central government an instrument to interfere with the states allocation. [6] ‘ The volume and quantum of these transfers have increased considerably especially post 1969 adoption of Gadgill formula for plan assistance. They accounted for about 4o per cent of the total plan assistance and about 14 percent of total current transfers were given to these schemes in 2000-01.

What we have seen till now are explicit modes of fiscal transfers. In addition to these the state makes use of a number of implicit and invisible ways to further mainly its political interests. This happens primarily in through following ways.

Interstate tax exportation.

Subsidized lending by banking and financial institutions to the private sector.

Subsidized borrowing by the states from the central government and the banking system.

Implicit transfer arising out of control of prices and outputs


System of intergovernmental transfers in India faces multiple and varied challenges. The challenges faced by Indian transfer system stems out of its very basic character, Presence of multiple agencies whose functions overlap with each other. Though revamped many times certain issues still persist in the Indian system of fiscal federalism. Most importantly there has been a rise in discretionary element of transfers. Often cited as a tool to override constitutional and formula based transfers this is employed to achieve political goals. Bulk of the discretionary transfers is constituted by ministerial allocations. ‘The share of these transfers increased steadily from less than 12 percent in the fourth and fifth plan periods to about 20 per cent by the end of 1990’s’ (Rao, Singh;2005).Most of them require a matching contribution from the states. Thus it could be a potential tool for centre to make preferential allocations. Central government has increasingly used discretionary loans, often with interest subsidies or ex-post conversion of loans into grants as a component of political influence.

Though this problem was prelevant for a long time, recently many central schemes are bypassing states and makes direct transfers to the implementing agencies. ‘Although, the central intrusion into states’ domain by introducing a large number of central sector and centrally sponsored schemes has been in vogue for a long time, the recent political developments have resulted in the centre bypassing the states and making direct transfers to the implementing agencies with adverse consequences on both accountability and efficient.’. [7] This has happened at a time when coalition politics and role of regional parties has attained unprecedented dimensions. Thus at a time health of state finance was already taking a hit, central governments activities especially discretionary transfers added oil to the fire further worsening the fiscal health of Indian states.

There are serious concerns raised regarding finance commission also. The biggest problem faced by finance commission is the attempts to restrict its scope. This has taken matters to the level of conflict of domains between finance commission and planning commission. As the role played by planning commission in charting out the road map for countries development increased exponentially, finance commissions role gets restricted. ‘the increased domination of planning commission in allocative decisions and its empowerment to dispense assistance to states to finance their developmental activities substantially curtailed the role of finance commission in making intergovernmental transfers.’ Now finance commission makes only non plan transfers required to meet the needs of the state. This had multiple impacts on finance commission. First its ability to effect redistribution was constrained. Second, it resulted in failure to undertake a comprehensive periodic review and precluded it from taking a holistic view of state finances. More over it has been pointed out that the division between plan and non-plan, created a craze for large sized plans leading to proliferation of expenditure and inadequate provision for maintenance of existing assets. (Rao, Singh; 2005)

Another major issue that has been pointed out is regarding the gap filling approach followed by fiancé commission. The critics argue that the methodology followed by finance commission could create a moral hazard problem and can cause fiscal laxity. In the present context states with larger deficits gets rewarded while others suffer. This would not have been the case had the budget gaps of the states been assessed on the basis of objective norms independently of actual. ‘Projections are made by the FC, on the basis of growth rates or norms of their own. But the starting point the base year figures from which the projections start still rely heavily on history or past actuals.'(Bagchi, 2001) Proliferation of grants from centre to state is another concern as it could result in reduced tax effort from states end. Studies show that higher the ratio of central grants in total expenditures of a state government, the lower is its tax effort (Jha, et.al. 1999). According to the revised estimates of 2009-10, States’ tax receipts declined over the budget estimates of that year, reflecting a perceptible fall in States’ share in Central taxes and a marginal decline in States’ own tax revenue (OTR). [8] The tendency is more persistent in special category states suggesting the presence of a dependency syndrome.

The tax devolution formula used by finance commission in itself has attracted many criticisms. First as mentioned elsewhere tax devolution is determined on basis of general economic indicators and is not based on fiscal disadvantages per se. ‘Assigning weights to contradictory factors like ‘backwardness’ and contribution in the same formula has rendered the achievement of the overall objective of offsetting revenue and cost disabilities difficult.’ [9] Rao and Singh (2005) points out that in spite of higher weights to backwardness in the formula, the methodology is inherently biased against the poorer states. Projection made by commission is firmly based on existing revenues and non plan expenditures. This has caused the prevailing tax levels and standards of service to implicitly become the most important determinant. Further the practice of using general economic indicators has helped the states with greater means to have larger plan investments.

As noted earlier, plan transfers which comprise of grants and loans is enjoying increased prominence these days. It should be noted that an undeniable reasons for irregularities in the Indian fiscal system arises out of planning commission too. Major issue is lack of co-ordination with finance commission which we have already looked into. It has been noted that plan assistance often lacks proper relationship with the investment requirement of the state. The transfers are not directly related to the shortfall in states’ resources. ‘the plan assistance given to the states, as also its grant-loan components are not related to the required plan investments, their sectoral composition, resources available with the states or their fiscal performances. ‘ [10] The grant component of central assistance has remained constant over the years. This inherently results in bias against states with strategies for development through human capital formation, as against those with emphasis on physical capital formation. Another area of concern is planning commission’s role in state borrowings. It is suspected that while approving or mediating state borrowings or grants debt sustainability of the state concerned is largely ignored.

Most controversial of all transfers problems of central sector and centrally sponsored schemes have been partially explored earlier. These national programs initiated by either by central government or at request of ministries at state level are largely discretionary in nature. Most of them designed at the central level, fails to take into account the idiosyncrasies of the areas in which they are applied. This results in huge wastage of public finance at almost all levels of implementation. The objectivity and transparency of these schemes are also at doubt as these have been widely used for attainment of political gains. Huge increase in quantum and volume of these schemes in recent times and multiple agencies giving transfers in an uncoordinated manner also attracts sharp criticism. ‘Choosing the programs on political considerations and spreading the resources thinly across multiple schemes without proper monitoring mechanism may serve the political objective of dispensing political patronage to groups and parties ,but does not help to fulfill the economic objectives of such transfer.’ [11] In spite of various efforts to cut down the duplication of programs, the result in this direction has been far from satisfactory.

In spite of many weakness and draw backs fiscal federalism and decentralisation has come a long way in India. But certain issues persist. There are anomalies in assignments both between Center and States and States and local bodies. There is considerable need to rationalize the assignment system to enable the decentralized governments to raise revenues and incur expenditures according to the preferences of their citizens. Federalism in India as everywhere else has to face the challenges of changing times. Maintaining an appropriate balance in the relationship between the centre and the constituent units in a federation is the key to future. The federal structure needs perpetually to be altered and mended to cope with changing environment and emerging challenges. However, the one cardinal reality that should never be lost sight of is that federalism is the only possible form of government for a polyglot country like India.

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