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Updated: May 3, 2011 13:32 IST

Practice of fiscal federalism in India

M. R. Sreenivasa Murthy
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The subject of Centre-State financial relations in India has received much less attention than it merits in academic research as well as in public discourse. This book by two renowned specialists meets a long-felt need of practitioners and students of federal finance. Rangarajan headed the Twelfth Finance Commission (TFC) and Srivastava was a member of the panel. The TFC made path-breaking recommendations, which not only ushered in an era of rule-based fiscal consolidation at the State level but also provided the basis for reforms in the management of public debt, both at the State and Central levels.

Imbalance

Federal Constitutions everywhere are characterised by an imbalance between the functional responsibilities and the financial powers at different levels of government. The Indian Constitution, while expressly vesting the Centre with greater powers of taxation, also provides for an institutional mechanism — the Finance Commission — to determine the share of the States in the Central tax revenues by way of correcting this imbalance. In deciding on the devolution of taxes and the provision of grants, the Finance Commission is required to address the vertical imbalance (between the Centre and the States) as also the horizontal imbalance, the one between the States with varying fiscal capacities but similar responsibilities in the provision of public services.

The Centre gets a little over 60 per cent of the total revenues. While the States are thus left with less than 40 per cent of the revenue, their share in revenue expenditure averaged about 57 per cent. At present, about 40 per cent of Central revenues (tax and non-tax) is transferred to the States, and this includes the grants they get from the Planning Commission and the Central Ministries.

Although the shareable pool has been enlarged (thanks to the 80th Constitution Amendment) to include all Central taxes, the relative revenue accruals of the Centre and the States have not seen any major change. As the authors note, “there has been a long-term stability in the shares of the Centre and the States in the combined tax revenues.”

Against this background of continuing resource asymmetry, most States achieved the statutorily envisaged fiscal consolidation by 2006 itself. They brought down the fiscal deficit to less than 3 per cent of the GDP and wiped out the revenue deficit as mandated. But the Centre has not complied with the FRBM mandate; it has not been able to control its revenue expenditure, particularly the outgo by way of subsidy.

What will be the impact of the proposed Goods and Services Tax (GST) on the vertical imbalance? Naturally, this would depend on the pattern and the rate of the GST that will be put in place. The authors clearly favour a dual rate, with the Central and State levies applying concurrently to all goods and services.

In their opinion,the GST rates should be determined “taking into account the present level of revenues of the two tiers from the concerned taxes” so as to ensure that the fiscal imbalance does not increase. It is in the matter of correcting the “horizontal imbalances” that several issues are contentious.

The fiscal capacities of the States as measured by the per capita income continue to vary widely even after six decades of federal financial devolution and economic planning. The disparity between the highest and the lowest is in the ratio of four-to-one. As a consequence, there is an uneven provision of public services across different States, including ‘merit goods' such as education and health services.

This inter-State inequality on account of differences in fiscal capacity is further compounded by two factors. The States with low income levels have a large population. It means they have to transfer huge additional resources if there has to be any impact at all. Further, some States have certain “cost disabilities” because of the vastness of the area or other geographical and climatic factors. An explicit equalisation methodology is yet to be developed to tackle this systemic problem.

The authors take the position that the Finance Commissions should, as a general principle, provide for more grants in the scheme of transfer of funds. (The 13th Finance Commission headed by Vijay Kelkar recommended only 15 per cent of the total devolution as grants) But this is contrary to what most of the States want — they “overwhelmingly prefer revenue-sharing.” Finding a suitable and optimal mix of these two modes of revenue transfer is indeed a ticklish problem, as acknowledged by the authors.

Fiscal deficits

The book contains a useful discussion on the dynamics of debt accumulation and fiscal deficits in India. The authors point out that, in the era of rising interest rates, the debt burden of the Central and State governments will become unsustainable unless the growth of GDP is maintained at a level higher than the interest rate.

The chapters offering a comparative analysis of the system of federal fiscal transfers in Canada and Australia with that prevailing in India go to enhance the value of the book.

Although the book is a collection of papers published over the years (with some revision), it reads like a single treatise with an integral framework, what with its analysis of the fundamental principles governing the financial relations between the Centre and the States. Those engaged in academic research and the practitioners of federal finance will find it particularly useful.

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