Fiscal Federalism in india

47

3.

FISCAL FEDERALISM IN INDIA Like in other countries, the fiscal dimensions of federalism are a reflection

of the political federal structure in India. The traditional subjects of concern of fiscal federalism, such as the assignment of taxes and responsibilities as well as the correction of vertical and horizontal imbalances, continue to remain important in India. Devolution of taxes and duties still constitutes the most significant dimension of fiscal federalism in India (Krishna, 2004). Fiscal federalism in India unlike in many rich countries has to satisfy the competing demands to deliver a number of essential and basic socio-economic services. As a paramount objective, fiscal federalism is expected to enable the national and sub-national governments to operate in such a way that leads to efficiency in the use of resources - not only in terms of the quality of services  provided by the various levels of government but also in terms of creating the environment in which all economic agents use resources efficiently (Rangarajan, 2004). Political environment is important in determining contours of fiscal federalism. After Independence, there was a single and same party rule at the Centre and in almost all states for many decades. There are now telltale signs that India is moving away from an era of cooperative federalism towards competitive federalism, due to multi-party polity, and predominance of regional parties at the state level, and coalition governments at the centre. The existence of competition  brings-in the importance of transaction cost of coordinating policies and their implementation (a) vertically between different levels of government and (b) horizontally between different different units within within each of the levels. Many challenges, therefore, lie ahead for fiscal federalism in the country. Bulk of literature on federalism in India had focused on economic aspects of fiscal fiscal federalism. There is a little work done in the area of environmental environmental  policy and its influence on i ntergovernmental financial relations in India. Within the context of Indian Federalism, what remains important is to take into account the social diversity in a general sense and the diverse ways in which each member state is able to relate to the federal system as a whole and to other member states (Thornton, 1995). The existing cultural, economic, social, environmental and

48  political factors combining to produce asymmetrical variations in the country, if not handled properly, have the potential to affect harmony within the federal structure of the country. 3.1

EVOLUTION OF FISCAL FEDERALISM

The history of fiscal federalism in modern India goes back to the Government of India Acts Acts of 1919 and 1935. While the Act of 1919 provided for a separation of revenue heads between the Center and the provinces, the 1935 Act allowed for the sharing of Center’s revenues and for the provision of grants-in-aid to provinces. The salient features of Government of India Acts of 1919 and 1935 are provided as Box as Box –3.1 and Box – 3.2 respectively. Box 3.1 MAIN FEATURES OF THE GOVERNMENT OF INDIA ACT, 1919

(1) Relaxation of Central control over the Provinces: The Act of 1919 made a separation of the subjects of administration and sources of revenue into two categories-Central categories-Central and Provincial. The Provinces could run the administration with the aid of revenues they themselves raised. Provincial budgets were separated from the budget of the Government of India. (2) Diarchy in the Provinces: The Provincial subjects were divided into ‘transferred’ and ‘reserved’ subjects. Transferred subjects were to be administrated by the Governor with the aid of Ministers responsible to the Legislative Council in which the proportion of elected members was 70 percent. Reserved subjects were to be administrated by the Governor without any responsibility to the Legislature. (3) The Indian Legislature: It was made more responsible and bicameral, but on a communal and sectional basis. The diarchy was impracticable and devoid of any real substance. The Governor had all the po wers and the introduction of ministerial government over a part of the Provincial sphere was only an empty shell and was, as such, a failure. Even though subjects were divided, the Central Legislature retained the power of legislation for the whole of India. No popular responsibility was introduced at the Centre and the Governor General-in-council continued to remain responsible only to the British Parliament through the Secretary of State f or India. Source: GoI Act, 1919 Box 3.2 THE MAIN FEATURES OF THE GOVERNMENT OF INDIA ACT, 1935

(1) Federal Scheme: Under all the earlier Acts, the Government of India was unitary, while the Act of 1935 prescribed a federation, taking the Provinces and the Indian States as units. It was proposed to unite the Provinces and the India States into a federation under the Crown. This involved the breaking up of the unitary State into a number of autonomous Provinces which were to derive their authority directly

48  political factors combining to produce asymmetrical variations in the country, if not handled properly, have the potential to affect harmony within the federal structure of the country. 3.1

EVOLUTION OF FISCAL FEDERALISM

The history of fiscal federalism in modern India goes back to the Government of India Acts Acts of 1919 and 1935. While the Act of 1919 provided for a separation of revenue heads between the Center and the provinces, the 1935 Act allowed for the sharing of Center’s revenues and for the provision of grants-in-aid to provinces. The salient features of Government of India Acts of 1919 and 1935 are provided as Box as Box –3.1 and Box – 3.2 respectively. Box 3.1 MAIN FEATURES OF THE GOVERNMENT OF INDIA ACT, 1919

(1) Relaxation of Central control over the Provinces: The Act of 1919 made a separation of the subjects of administration and sources of revenue into two categories-Central categories-Central and Provincial. The Provinces could run the administration with the aid of revenues they themselves raised. Provincial budgets were separated from the budget of the Government of India. (2) Diarchy in the Provinces: The Provincial subjects were divided into ‘transferred’ and ‘reserved’ subjects. Transferred subjects were to be administrated by the Governor with the aid of Ministers responsible to the Legislative Council in which the proportion of elected members was 70 percent. Reserved subjects were to be administrated by the Governor without any responsibility to the Legislature. (3) The Indian Legislature: It was made more responsible and bicameral, but on a communal and sectional basis. The diarchy was impracticable and devoid of any real substance. The Governor had all the po wers and the introduction of ministerial government over a part of the Provincial sphere was only an empty shell and was, as such, a failure. Even though subjects were divided, the Central Legislature retained the power of legislation for the whole of India. No popular responsibility was introduced at the Centre and the Governor General-in-council continued to remain responsible only to the British Parliament through the Secretary of State f or India. Source: GoI Act, 1919 Box 3.2 THE MAIN FEATURES OF THE GOVERNMENT OF INDIA ACT, 1935

(1) Federal Scheme: Under all the earlier Acts, the Government of India was unitary, while the Act of 1935 prescribed a federation, taking the Provinces and the Indian States as units. It was proposed to unite the Provinces and the India States into a federation under the Crown. This involved the breaking up of the unitary State into a number of autonomous Provinces which were to derive their authority directly

49 from the Crown, and then building them up into a federal structure, in which both the federal and Provincial governments would get definitely demarcated powers by delegation from the Crown. The federal structure envisaged by this Act never came into being, because it was optional for the Indian States to join, and they never gave their consent. (2) Provincial Autonomy: Though the part relating to the federation never came into effect, the relating to Provincial autonomy was given effect to from April 1937. To this extent, the Government of India assumed the role of a federal government visà-vis the provincial government, although the Indian states did not come into the fold to complete the federal scheme. The Act of 1935 retained the control of the central government over the provinces in certain spheres requiring the Governor to act without ministerial advice and through him, of the Secretary of State. (3) Diarchy at the Centre:  The executive authority of the Centre was vested in the Governor General (on behalf of the Crown), whose functions were divided into: (a) reserved subjects- defence, external affairs, etc., left to the Governor General in his discretion; and (b) other than reserved subjects-in which the Governor General was to act on the advice of a ‘Council of Ministers’. In fact, no Council of Ministers came to be appointed; and the old Executive Council  provided by the Act of 1919 continued to advice the Governor General until the Indian Independence Act, 1947. The executive authority of the Act of 1935 was applied as between the Central government and the Provinces. This is of special interest in view of the fact that the States, proceeds largely on the same lines. A three-fold division was made in the Act of 1935: Federal List, Provincial List and Concurrent List. The allocation of residuary  powers of legislation i n the Act was unique u nique in t he sense that it was not vested in eith er the Central or Provincial Legislature, but empowered the Governor to authorize either the federal of the Provincial Legislature to enact a law with respect to any matter which was not enumerated in the Legislature Lists. (4) Non-sovereign character of the Legislature:   The legislature powers of both the Central and Provincial Legislatures were subject to various limitations and neither could be said to have possessed the features of a sovereign legislature. (5) Federal Court:  Consistent with the federal scheme, the Act set up, for the first time, a Federal Court for India. The Federal Court had an original jurisdiction to determine disputes between the units of the federation inter se and it was also the Appellate Court on constitutional questions, Appeal, however, lay from the decisions of the Federal Court to the Privy Council until such appeal was abolished  by the enactment of the Abolition of the Privy Council Jurisdiction Jurisdiction Act, 1949. Source: GoI Act, 1935

After independence, the Indian Constitution that came into existence in 1950 is widely known as basically ‘federal’ in nature, but with striking ‘unitary’ features, owing to the circumstances of the times when ‘unity and integrity’ of the country was of prime concern (Basu, 1980). Fiscal relations in India had evolved

50 over time through political, institutional and functional changes within the ambit of the provisions of Indian Constitution. The Finance Commission had played an important role in this evolving structure because resource sharing, based on constitutional division of functions and finances between the Centre and states, is a critical element in the Indian federal system (Rangarajan, 2004). The Indian Constitution has not only provided a frame work for social and  political development but also established the national ideals and, laid down the manner in which they were to be pursued. The members of the Constituent Assembly “skillfully selected and modified the provisions they borrowed” and “applied to their task two concepts – ‘accommodation’ and ‘consensus’. Accommodation was applied to the principles to be embodied in the Constitution. Consensus was the aim of the decision making process, the single most important source of the constituent Assembly effectiveness” (Granville, 1966). While the spirit of accommodation has been evident not only in the finalization of the  provisions of Constitution but also in the manner in which Indian union and the constituent states have discharged their responsibilities of serving an ever increasing population within the democratic framework of governance. The profile of Federal India has undergone significant changes over the last six decades, with the population increasing from 36.10 million 1951 to 1027 million in 2001, and with the number of states emerging in 1956 in a major way and at subsequent points of time in a minor way. What has been significant is the remarkable continuity even while political and institutional changes had taken  place in India. 3.1.1

Division of functions and resource asymmetry asymmetry

The Indian Constitution has, under Article 246 and Seventh Schedule, distributed powers and allotted subjects to the Union and the states with a threefold classification of subjects: (i) List I invests the Union with all functions of national importance such as defence, external affairs, communications, constitution, organization of the supreme court and the High courts, elections etc.

51 (ii) List II invests the states with a number of important functions touching on the life and welfare of the people such as public order, police, local government,  public health, agriculture, water land etc. (iii) List III is the Concurrent list, which includes administration of justice (excluding Supreme Court and High Courts), economic and social planning, trade and commerce, etc. It is of interest to note that higher education; forests and population control were all added to this list in 1977 during the emergency when it was felt that the states were not doing justice to these subjects of national importance. Accordingly, the Parliament has exclusive powers to make laws regarding matters enumerated in List I. On the other hand, the Legislature of any state has exclusive power to make laws for that state regarding any of the matters enumerated in List II, subject to other clauses of Article 246. With regard to List III, both the Parliament and State Legislature can make laws but in case of any conflict, the law made by Parliament will prevail (Article 254). The residuary functions, that is, those not included in either lists I or II, vest with the Union. The Union and State lists include the powers of taxation as well. The enumeration of taxation powers placed in the Union List includes: tax on income other than agricultural income, excise duties, customs and corporate tax. Recently service tax had been included in view of diminishing importance of customs. The State List contains land revenue, excise on alcoholic liquor, tax on agricultural income, estate duty, tax on sale or purchase of goods, tax on vehicles, tax on  professions, luxuries, entertainment, stamp duties etc. However, due to political reasons, none of the states had i mposed tax on agriculture income. The C oncurrent List does not include any tax power. The distribution of revenues between the Union and the States and approaches for determining grants as per various Articles of the Indian Constitution is given at Box - 3.3. Distribution of resources between the Centre and the states together with the perceived mismatch between the functional responsibilities and revenue raising powers assigned by the Constitution to the two layers of Governments i.e., Centre and states, has been the subject of considerable discussion and debate in the relevant literature. Two points have been made in this regard: (i) that there is mismatch between the functions allocated to the centre and to the states, their

52  powers of taxation and (ii) t hat the more buoyant tax areas have b een assigned t o the centre. But, it has also been pointed out that “the Constitution recognizes that the division of resources and functions between the Union and the states was such that there would be imbalance between them” and that “the Finance Commission  periodically corrects the imbalance bringing about an alignment between them” (Vithal and Sastry, 2001). A moot point is whether relative responsibilities of the Centre and states could be defined and worked out in financial terms. The Indian Constitution had given a workable solution that has been able to sustain the federal spirit and  provide the framework for many years to come. Many scholars are of the view that in the context of the changes in a growing economy, it is good that they did not freeze the financial relations in a tight frame; they rather chose to provide an institutional mechanism like the Finance Commission to be appointed every five years with powers to make recommendations for statutory devolution and grants (Srinivasan, 2002). 3.1.2

Vertical and horizontal imbalances

Adequacy and elasticity are the essential elements of federal finance. Adequacy

implies

sufficient

resources

for

discharging

constitutional

responsibilities and elasticity implies an expansion of resources in response to the growing needs of Government. The practical effect of the division of tax powers has been to deny both these characteristics in the case of states in India (Vithal and Sastry, 2001). A vertical imbalance between the Centre and states is built into the Constitution by the provisions relating to powers of taxation. This arises, not out of any consideration of making the centre stronger, but out of the desire to build a common economic space in the country and out of an apprehension that with more  powers the states may put up ‘barriers’ within this space. The vertical imbalance is further accentuated by the assignment of several responsibilities involving the public expenditure to the states on the grounds that tiers of government nearer to the people would be more sensitive to their needs and thus be better able to discharge such responsibilities. Since states differ in their resource endowments, levels of development and standards of delivery of  public services, there are sharp horizontal imbalances among the states in India.

53 3.1.3

Inter-governmental transfers

In order to correct built-in vertical and horizontal imbalances for an even and equitable development of the entire country, the main instrument for achieving this is fiscal transfers from the Centre to states through different channels and the mechanisms as provided in the Constitution ( Box 3.3). Fiscal transfers to the third tier of government through subsequent Constitutional rd

th

Amendments (73  and 74 ) had also been envisaged in India. Accordingly, there are both mandatory and enabling provisions facilitating a wide ranging transfer of resources from Union to states, arranged in a systematic manner as given in  Box – 3.3. Box 3.3 CONSTITUTIONAL PROVISIONS FOR DISTRIBUTION OF REVENUES BETWEEN THE UNION AND THE STATES IN INDIA Article 268: Duties levied by the Union but collected a nd appropriated by the States. Article 268 (A): Taxes on services shall be levied by the GoI and such tax can be th collected and appropriated by GoI and the States. (88 Amendment) Article 269: Taxes levied and collected by the Union b ut assigned to the States. Article 270: Taxes levied and collected by the Union and distributed between the Union and the States. Article 271: Surcharge on certain duties and taxes for purposes of the Union. Article 272: Taxes which are levied and collected by the Union and may be distributed  between the Union and the States. Article 275: Grants from the Union to certain States. Article 276: Taxes on professions, trades, callings and employments. APPROACHES FOR DETERMINING GRANTS Article 280 (3) (b): Finance Commission to make recommendations as to the “principles” which should govern such grants in aid. Article 275 (1): Specific “sums” to be paid to the states which are assessed to be in “need of assistance”. Source: The Constitution of India

The Indian Constitution, having provided for a certain division of the  powers of taxation between t he Union and states, also gives the states a share in the resources available to the Centre as contained in Articles in part XII of the Constitution. Any amendment to the List from which the Union and the states

54 derive their power of taxation is covered by the proviso to Article 368. This requires ratification by the Legislatures of not less than one-half of the states. On the other hand, if any of provisions of part XII are to be amended, this can be done under Article 268(2) which requires the approval of only half of the members of each house of Parliament. This means that the share of the Union resources that the states are entitled to, can be altered by Parliament by its powers of amendment. 3.1.4

Mechanism of Transfers

Over the last six decades, an overarching institutional framework had emerged to deal with Centre-state financial relations in India. The main pillars of this frame work are: (a) Finance Commission appointed periodically as per Article 280 of the Constitution of India, intended to address the vertical imbalance in financial resources between the centre and states and to address the horizontal distribution of resources among the states. (b) Planning Commission set up by a Resolution of the Government of India th

dated 15  March 1950 to make an assessment of the material, capital and human resources of the country, and to formulate a plan for effective and  balanced utilization of the country’s resources. (c)  National Development Council set up in August 1952 to strengthen and mobilize the effort and resources of the nation in support of the Five year  plans. The financial provisions of the Constitution are in accordance with what experts would consider acceptable principles for a federal constitution and a desirable attribute of inter-governmental tax power assignment (Bagchi, 2001). However, it is the actual working of the scheme that has revealed deficiencies that seriously detract from much of its supposed merits. Bagchi (2001) cites the under utilization of Article 269 by the Union Government, the abridgement of the scope of Article 275, and, consequently, the extensive use of Article 282 by the Union to make extensive grants to the states as examples of the original constitutional scheme being distorted in actual practice over the years.

55 It is the combination of all three agencies, namely, the Finance Commission, Planning Commission and the various Ministries of Government of India, that has taken, over several years, qualitatively si gnificant and quantitatively demanding decisions resulting in an increasing level of transfer of resources from the Centre to states. Federal transfers to the states in India, are made in three streams, as (1) Devolution of states share in Central Taxes (2) Grants from Central to the states (classified as statutory or non statutory; and plan as well as non-plan) covering (i)  Non-Plan grants, comprising – i.

Statutory grants recommended by the Finance Commission to cover gap in revenue;

ii.

Assistance for relief measures after natural calamities

(ii)  Non Statutory grants, comprising – i.

Plan grants(a) State plan schemes (b) Central plan schemes (c) Centrally sponsored schemes (d) Special schemes for North Eastern council etc

(3) Loans from Centre a.

Plan loans

 b.  Non Plan loans including Ways and Means Advance 3.1.5

Distribution among the states

In the approach to horizontal devolution, each of the previous Finance Commissions has come up with its own formula, with changes in criteria adopted and with the assignment of weights to different criteria for determining the share of individual states in the total share of Central resources. The choice of criteria and the weights assigned by each Commission for the distribution of income tax and union excise duties had regularly provoked not only reaction from the state

56 governments but also invoked critical comments from academics and public finance experts. Table 3.1 and Table 3.2 capture the criteria and weights assigned  by various finance commissions for distributing income tax and union excise duties respectively among states. In so far as the allocations made by the Finance Commissions are concerned, it has been claimed that these were made, often, on the considerations of ensuring equity with pursuing redistributive principles. It does appear that the transfer scheme, after taking into account pre-devolution and post-devolution financial position of the states, has helped the relatively poorer states (Srinivasan, 2002).

However, this approach has led to a criticism that the “gap filling

approach” of the successive Finance Commissions, had encouraged fiscal imprudence of some of the states. The relative importance to be attached to equity in distribution and efficiency in utilization of resources in determining the respective shares of various states in federal transfers has become a critical factor. Resolving the tension between equity and efficiency remains a fundamental challenge in public  policy (Bagchi, 2001). 3.2

Approach of Finance Commissions

All the Finance Commissions have in their reports so far, initially set out the general approach to the duty cast on them by the provisions of the Constitution and the tasks mandated to them under their specific terms of reference. Most Commissions had followed a broad and consistent frame work in whose context their recommendations could be placed and their logic appreciated. The First Finance Commission (I FC) felt that the transfer of resources from the Centre had to be such that it could bear without undue strain, taking into account of its own vital responsibilities. The persistence of this concern in the approach of all the commissions can be seen from the fact that the Fifth Commission felt that “the  pre-emptive character of the financial needs of the Union constitutes a limiting  factor in formulating the scheme of transfers to states”. Similarly, the Eight Commission stated that “the overriding consideration is the national interest taken as a whole. Ultimately, the solutions we have chosen have been judged on this touchstone”. The Tenth Commission also followed this approach when it stated

57 that the problems facing the country could be ‘tackled only by taking a holistic view of government finances and looking for an integrated solution’. 3.3

NORMS FOLLOWED BY FINANCE COMMISSIONS

3.3.1

First Finance Commission

The First Finance Commission (IFC) was not given any specific terms of reference. Therefore, it had spelt out its own functions in terms of the provisions of Article 280 of the Constitution. Being the first Commission, it reviewed the history of the evolution of Centre-state relations leading to the relevant provisions in the Constitution. The Commission stated that it had ‘no doubt about the imperative need for a substantial augmentation of the revenues now available to the states’. However, its report emphasized that ‘the prosperity of the states must rest on the solid foundation of a reasonably strong and financially stable Centre’ . While states have large and expanding responsibilities for the welfare and development of the people, the capacity of the Centre to make ad ditional resources available is conditioned both by the amount of revenue it can raise and by its own essential needs, which are the needs of the country as a whole (I FC, Chapter I,  para 19). The First Commission laid down two principles that had by and large,  been followed by succeeding Commissions that: (1) at the time of distribution of revenues between the states, the determination of grants-in-aid for them must be based on principles that are uniformly applied to all states; and (2) the scheme of distribution should attempt to lessen the inequalities  between the States. 3.3.2

Second Finance Commission

The Second Commission added an equally important third principle (3) that it was necessary to maintain ‘a balance between devolution by transfer of  shares of taxes and devolution by fixed grant-in-aid’   (II FC, para-199). It elaborated that ‘the gap between the ordinary revenue of a state and its normal inescapable expenditure should, as far as possible, be met by sharing of taxes. Grants-in-aid should be largely be a residuary type of assistance given in the form

58 of general and unconditional grants’   (II FC, Para 66). Such grants, it clarified, could be given for broad purposes. The Second Commission also set out another principle that the scheme of devolution it recommended was ‘an integrated scheme’ and that any modification of individual recommendations would ‘upset its balance’ (II FC, Para 199). 3.3.3

Third Finance Commission

The Third Commission (1961) took note of certain disturbing features that arose in the management of the finances of the states, namely ‘an allergy (on the  part of the states) to tap resour ces in the rural sector’ and a ‘disin clination to make up the lee-way’ in other sectors. According to the III FC, the states did not attach ‘importance to a proper and adequate control of expenditure in the matter of services and supplies’. It could not evolve any scheme that would recognize the effort made by the states in affecting economies in expenditure or in raising resources; and was compelled ‘to cover the annual budgetary gaps of all the stat es’ including ‘mounting interest charges’ and condone even ‘a measure of improvidence’. Another disturbing feature, as pointed out by III FC, was that ‘the unsound financial policies of a state affected neighboring states as well’ (III FC,  paras 88, 90, 93). The C ommission suggested a comprehensive examination ‘to access the tax potential of each state’. 3.3.4

Fourth Finance Commission

The Fourth Commission observed that the Constitution did not make any distinction between plan and non-plan expenditure, and that even capital expenditure need not necessarily be outside the scope of the Finance Commission. At the same time, it felt that there should be a division of responsibility between the two Commissions - Finance and Planning; and, for this reason, ‘it would not  be appropriate for the Finance Commission to take upon its elf the tas k of dealing with the states’ new pla n expenditure’ (IV FC, Para 1 6). Like the previous Commission, the Fourth also took the view that a Finance Commission could not ‘merely fill-up non-plan revenue deficits reported by the states’ (IV FC, Para 17). It, therefore, did not take the budgetary deficits as a criterion for distribution but reassessed the states’ estimates. It differed from the view of the Third Commission that ‘the relative financial weaknesses of the states’

59 should be the criterion for determining the shares of states in the divisible pool. Its approach was that the principles of tax sharing should be uniformly applied and if, as a result, some states have larger deficits, these should be covered by explicit grants under Article 275, rather than being disguised as shares of taxes. It advocated ‘a trade-off between the sharing of taxes and grants such that the total transfers were not affected’ (IV FC, Para 20). 3.3.5

Fifth Finance Commission

The Fifth Commission was of the view that in covering the revenue deficits of states due regard should be given to financial prudence and the efforts made by the states in raising resources. However, it could only ‘keep in view  broad considerations which can be applied to all t he states’ as it is difficult for an y outside authority ‘to judge the propriety’ of the policies of the states in regard to taxation, expenditure and investment within their own constitutional sphere (V FC, Para 2.22). The Commission did try to asses the tax performance of state and the quality of their expenditure. However, the problem it identified was that the existing levels of taxations both at the Centre and the states were ‘not adequately indicative of their potential resources’ and termed it as a real constraint on the magnitude of transfers (V FC, Para 2 7). 3.3.6

Sixth Finance Commission

The Sixth Commission that came twenty-five years after the First, felt that the provisions of the Constitution concerning Union-state financial relation had  been designed with great care and circumspection and ‘had demonstrated remarkable resilience in coping satisfactorily with the new demands made on it  from time to time’. However, ‘the strains and stresses’ in the national economy as also, perhaps, the spirit in which ‘the provisions of the constitution had sometimes  been worked, particularly by the Central Ministries, had given rise to some signs of dissatisfaction’ (VI FC, II.2). It pointed out that there could be significant improvement in the climate of Centre-State financial relations ‘if decisions that affect the revenues of the states were taken after the widest possible measure of consultations’ (VI FC, II.2.6).

60

Table 3.1 Criteria Adopted by Finance Commissions for Distribution of Income Tax

(percentage) Commission

 Per capita income  Poverty  Infrastructure  Area  Fiscal Tax ration  Index  Adjusted  Discipline  Effort Inverse Distance

Population

Contribution

First

80

20*

-

-

-

-

-

-

-

Second

90

10*

-

-

-

-

-

-

-

Third

80

20*

-

-

-

-

-

-

-

Fourth

80

20*

-

-

-

-

-

-

-

Fifth

90

10#

-

-

-

-

-

-

-

Sixth

90

10#

-

-

-

-

-

-

-

Seventh

90

10#

-

-

-

-

-

-

-

Eighth

22.5

10#

22.5

45

-

-

-

-

-

 Ninth (I)

22.5

10#

11.25

45

11.25

-

-

-

-

(II)

22.5

10#

11.25

45

-

11.25**

-

-

-

Tenth

20

-

-

60

-

5+

5

-

10

Eleventh

10

62.5

7.5

7.5

7.5

5

Twelfth

25

50

-

10

7.5

7.5

Thirteenth 25 47.5 10 17.5 * Collection # Assessment ** Index of Backwardness +Index of Infrastructure  Note: Under Eighth and Ninth Commissions, the formula was used for *90 percent of income tax and 'total of Union excise duties'. Under the Tenth Commission, the same formula was used for both the taxes (Source: Reports of various Finance Commissions as compiled by the Author)

61

Table 3.2 Criteria for Distribution of Union Excise Duties

Commission First Second Third

Population

Contribution

100 90

-

 Per capita income Inverse Distance -

 IATP -

(percentage)  Poverty  Revenue  Area Tax ration  Equalization  Adjusted  Effort -

Population major factor. Relative financial weakness of states, disparity in levels of development,  population of SCs and STs, etc were also taken into account 80 20* 80 6.66# 13.34** 75 25 25 25 25 25 25 25 50 25 50 12.5 12.5 25 12.5# 33.5 12.5 16.5 for deficit states 20 5+ 60 5

Fourth Fifth Sixth Seventh Eighth  Ninth (I) (II) Tenth Eleventh Twelfth Thirteenth (Source: Reports of various Finance Commissions as compiled by the Author) *Relative economic backwardness ** To states whose per capita income is below the all-states average # Index of backwardness

10

61

Table 3.2 Criteria for Distribution of Union Excise Duties

Commission First Second Third

Population

Contribution

100 90

-

 Per capita income Inverse Distance -

 IATP -

(percentage)  Poverty  Revenue  Area Tax ration  Equalization  Adjusted  Effort -

Population major factor. Relative financial weakness of states, disparity in levels of development,  population of SCs and STs, etc were also taken into account 80 20* 80 6.66# 13.34** 75 25 25 25 25 25 25 25 50 25 50 12.5 12.5 25 12.5# 33.5 12.5 16.5 for deficit states 20 5+ 60 5

Fourth Fifth Sixth Seventh Eighth  Ninth (I) (II) Tenth Eleventh Twelfth Thirteenth (Source: Reports of various Finance Commissions as compiled by the Author) *Relative economic backwardness ** To states whose per capita income is below the all-states average # Index of backwardness + Index of infrastructure

62

The VI Finance Commission also noted that with the advent of economic  planning the Planning Commission had acquired a voice ‘in the entire range of developmental activities, cutting across the Constitutional delimitation of powers  between them under t he Constitution’. The Commission’s scheme of devolution was based on the view that the resources belonged to the entire nation and they should be applied at points where they were most needed according to accepted  priorities. ‘While the emphasis is on social justice, there is no escape from a realignment of the resources in favor of states, because services and programs which are at the core of a more equitable social order come within the purview of the states under the Constitution’  (VI FC, II.16). The VI Finance Commission was also of the view that the question of allocation of resources between the Centre and the states should not be viewed in isolation from the allied issue of the relative share of each state in the pool of

10

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The VI Finance Commission also noted that with the advent of economic  planning the Planning Commission had acquired a voice ‘in the entire range of developmental activities, cutting across the Constitutional delimitation of powers  between them under t he Constitution’. The Commission’s scheme of devolution was based on the view that the resources belonged to the entire nation and they should be applied at points where they were most needed according to accepted  priorities. ‘While the emphasis is on social justice, there is no escape from a realignment of the resources in favor of states, because services and programs which are at the core of a more equitable social order come within the purview of the states under the Constitution’  (VI FC, II.16). The VI Finance Commission was also of the view that the question of allocation of resources between the Centre and the states should not be viewed in isolation from the allied issue of the relative share of each state in the pool of national resources. Such imbalances existed not only among different states but also between different areas within individual states themselves. As the people’s needs could be effectively attended to only by agencies close to them and in the functioning of which they are involved, it recommended that this idea could find ‘its full consummation only if the states also, in their turn, realize the imperative need to transfer resources and powers to local bodies’ (VI FC, II.19). 3.3.7

Seventh Finance Commission

The Seventh Commission dealt with the issue that its terms of reference were different from those of the previously applied to t he determination of grantsin-aid, were made applicable to the clause concerning the sharing of taxes also, and certain states had questioned this limitation placed on it. However, the Commission’s view was that the change in the terms of reference was, ‘a purely formal one’. These ‘were not constraints on the Commission in any way (and) the Commission’s freedom to take into account other factors is not inhibited’ (VII FC, Para 4). Like a few previous Commissions, the Seventh also considered that the exclusion of plan expenditure, ‘in no way limited the freedom of a Finance Commission’ and ‘whatever may have been the position in the past in the matter of the size of discretionary Central transfers’, these did not affect the freedom or discretion of a Finance Commission to do its duty under the Constitution. In

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regard to the grants-in-aid, the Commission’s approach was based on three  principles namely to: (1) fill fiscal gaps; (2) narrow disparities in the availability of various administrative and social services between the developed and less developed states; and (3) take into account the special burdens cast on a state because of its  peculiar circumstances or matters of national concern. VII FC also took the view that the grants-in-aid element in the transfers should, as far as possible, be a residual item. The Commission noted that ‘the  general concern over the widening disparities in the levels of development among the states is reflected in the criticism of the existing arrangements of the Centre state financial relations’ . It, however, felt that this could not be blamed on the Planning Commission or any particular arrangement. The transfers made by the Finance and Planning Commissions had to be viewed together as part of an overall process (VII FC, 9.17). Like the Sixth Commission, the Seventh also expressed disappointment that there were no reviews or studies of the finances and expenditures of local bodies and expressed the hope that the states would ‘pay increasing attention to the subject of l ocal body finances’ (VII FC, 9.16). 3.3.8

Eighth Finance Commission

The approach of the Eighth Commission in the matter, such as the share of taxes, grants-in-aid etc., was similar to that of the previous Commissions. One issue that it considered was the states’ contention that for some commodities  produced by the central public s ector, price increase were being effected instead of increasing excise duties, which were divisible with the states. The Commission’s view was that administered prices would be justified if the increase was due to an increase in the cost of production, but if the intention was to obtain revenue, then the appropriate course would b e to increase excise duties. 3.3.9

Ninth Finance Commission

The Ninth Commission submitted two reports and stated in its second report that the principles upon which financial transfers under the Constitution

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were affected ‘must be so as to ensure that the linking of revenue and expenditure decision and fiscal responsibility are not unduly weakened’ . It went full circle  back to the First Commission, stating that ‘the method of extending financial assistance should be such as to avoid any suggestion that the Central Government have taken upon themselves the responsibility for helping the States to balance their budgets from year to year’ (IX FC, Para 2.11). The Commission had set out three basic principles on which its approach was based. (1) a fair apportionment of revenue resources between the Centre and the states; (2)  preserving the fiscal autonomy of the states; and (3) ensuring inter-state equity while not penalizing  ‘fiscal prudence and the effort and growth impulses’  (IX FC, 2.2) IX FC observed that ‘the steadily deteriorating fiscal scenario in the country was due to the slow rate of growth of revenue receipts in the case of both the Centre and the states’ (IX FC, 2.3). This had resulted into ‘revenue deficits on a large scale year after year (implying) an infraction of one of the fundamental  principles of sound public finance in any economy’ (IX FC, 2.4). As the public debt and, as a result, the burden of interest payments was going up, the Commission felt that its first task had to be ‘to restore balance in the budget by  phasing out the revenue deficits’  (IX FC, 2.6, 2.7). The terms of references of the Ninth Commission had, for the first time stated that it should adopt ‘a normative approach’ . Many states protested against this formulation since this could have led to the Commission dictating expenditure norms, which were hitherto the prerogative of the state governments. The Commission later, clarified that its methodology implied ‘no interference with the right of the state government to raise resources and incur expenses at  such levels and in such a manner as desired by its people and its Legislature. The norms are relevant only in arriving at the relative entitlement to Central transfers and are so designed as to ensure inter-state enquiry in working out such entitlement ’ (IX FC, Para 2.17). It also cautioned that while the total transfers from the Centre to the states ‘should not be less than what they are as a  percentage of estimated Central revenues, the fiscal situation at the Centre being

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what it is they cannot be substantially higher’ (IX FC, 2.26). This Commission also took the plan expenditure of the states into account since its terms of reference referred to ‘revenue expenditure’. It, therefore, took a total view of transfers and grants-in-aid to the states, including assumed central assistance under the Gadgil Formula. In the process, it sought to correct what it considered a  basic flaw in the existing system of federal fiscal transfers (IX FC, 7.9). 3.3.10 Tenth Finance Commission

The Tenth Finance Commission stated that its approach had been ‘ guided by the paramount need to restore fiscal equilibrium in the economy’   as the economy had moved into ‘a state of continuous deficit on revenue account’. The rate of growth of expenditure exceeding that of revenues had led to a build-up of  public debt and interest burden. It noted that ‘the structure of expenditure has imparted downward rigidity and inflexibility to its level’ because of interest, wages and salaries becoming major components (X FC, 2.9). Like other Commissions it also confined its reassessment to the non-plan revenue account  because of ‘the practical difficulties of making acceptable projections of plan outlay’ (X FC, Para 2.27), while asserting its constitutional competence to deal with the entire revenue account. As almost all states have gone through deterioration in the revenue account balance, it observed that “all the states have had almost identical turning points seems to suggest that there are systemic  factors underlying the deterioration rather than state specific reasons.” (X FC, P.5). The Tenth Finance Commission’s basic approach was influenced by its view that all Central taxes should be pooled, as had been suggested in its alternative scheme of devolution; but its recommendations were based on the existing provisions of the Constitution. As regards the horizontal distribution among the states, its concern was to ‘blend equity with efficiency’ (X FC, 2.23). Grants-in-aid recommended by the Commission under Article 275 were based not only on the surplus or deficits at the end of the process of devolution but also took into account the special problems of states. Although the Seventy-third and Seventy-fourth amendments to the Constitution had not become operative  because the reports of St ate Finance Commissions were not availabl e, the Tenth Commission recommended grants for local bodies also, based on its own assessment.

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3.3.11 Eleventh Finance Commission

The Eleventh Finance Commission suggested that the amount involved  by the way of tax devolution - plan and non-plan grants - should not exceed 37.5% of Gross Revenue receipts of the Centre. The Union Finance Minister informed the Parliament in July 2000, that the Government of India has accepted this ceiling on total revenue account transfers, with a rider that “the acceptance does not imply the establishment of a principle of mandatory sharing of a fixed  percentage of Centre’s revenue, receipts with the states.” While the Tenth Finance Commission recommended a minimum of 29% of tax receipts for transfer to the states, the Eleventh Finance Commission approached the issue from the other end suggesting a cap of 37.5% of gross revenue receipts on the quantum of total transfer of resources, as a share of Centre’s revenue receipts. The issue is still open, either in terms of prescribing the share of the states as the floor or as a ceiling (Srinivasan, 2002). 3.3.12 Twelfth Finance Commission

The Twelfth Finance Commission suggested the measures on fiscal consolidation

by

the

Central

and

State

governments.

Following

this

recommendation, the Government of India had set up a Debt Consolidation and Relief Facility and enactment of Fiscal Responsibility and Budget Management (FRBM) legislation. In so far environmental aspects were concerned, the state governments inter alia pointed out before the Twelfth Finance Commission that the maintenance of the forest area as per the working plans had become a  problem due to financial constraints. Many stat es pleaded for separate grants for the maintenance of forests. The Finance Commission recognized the problem and recommended a grant of Rupees 1000 crores spread over the award period 20052010 for the maintenance and preservation of forests to be distributed among the states according to their respective forest area. This initiative by XII FC could be considered as the turning point in the Indian fiscal federalism for “recognizing area based approach for management of natural resources”. 3.3.13

Thirteenth Finance Commission

The Thirteenth Finance Commission had been constituted as per TOR at  Box - 3.4 and had given their report to the Government of India. The Thirteenth Finance Commission’s Terms of Reference provide for considerable continuity as

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well as some fresh ground to cover. For the first time in the history of Finance Commissions, issues of environment, ecology and climate change etc had been included as one of the terms of reference of this C ommission. Box 3. 4 TERMS OF REFERENCE OF THE THIRTEENTH FINANCE COMMISSION

The Commission shall make recommendations as to the following matters, namely:(i) the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them under Chapter I Part XII of the Constitution and the allocation between the States of the respective shares of such proceeds; (ii) the principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India and the sums to be paid to the States which are in need of assistance by way of grants-in-aid of their revenues under article 275 of the Constitution for purposes other than those specified in the provisos to clause (1) of that article; and (iii) the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State. 2. The Commission shall review the state of the finances of the Union and the States, keeping in view, in particular, the operation of the States’ Debt Consolidation and Relief Facility 2005-2010 introduced by the Central Government on the basis of the recommendations of the Twelfth Finance Commission, and suggest measures for maintaining a stable and sustainable fiscal environment consistent with equitable growth. 3. In making its recommendations, the Commission shall have regard, among other considerations, to – (i) the resources of the Central Government, for five years commencing on 1st April 2010, on the basis of levels of taxation and non-tax revenues likely to be reached at the end of 2008-09; (ii)

the demands on the resources of the Central Government, in particular, on account of the projected Gross Budgetary Support to the Central and State Plan, expenditure on civil administration, defence, internal and border security, debt-servicing and other committed expenditure and liabilities;

(iii)

the resources of the State Governments, for the five years commencing on 1st April 2010, on the basis of levels of taxation and non-tax revenues likely to be reached at the end of 2008-09;

(iv)

the objective of not only balancing the receipts and expenditure on revenue account of all the States and the Union, but also generating surpluses for capital investment;

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(v) the taxation efforts of the Central Government and each State Government and the  potential for additional resource mobilisation to improve the tax-Gross Domestic Product ratio in the case of the Union and tax-Gross State Domestic Product ratio in the case of the States; (vi) the impact of the proposed implementation of Goods and Services Tax with effect st from 1  April, 2010, including its impact on the country’s foreign trade; (vii) the need to improve the quality of public expenditure to obtain better outputs and outcomes; (viii) the need to manage ecology, environment and climate change consistent with sustainable development; (ix) the expenditure on the non-salary component of maintenance and upkeep of capital assets and the non-wage related maintenance expenditure on plan schemes to be completed by 31st March, 2010 and the norms on the basis of which specific amounts are recommended for the maintenance of the capital assets and the manner of monitoring such expenditure; (x) the need for ensuring the commercial viability of irrigation projects, power projects, departmental undertakings and public sector enterprises through various means, including levy of user charges and adoption of measures to promote efficiency. 4. In making its recommendations on various matters, the Commission shall take the  base of population figures as of 1971, in all such cases where population is a factor for determination of devolution of taxes and duti es and grants-in-aid. 5. The Commission may review the present arrangements as regards financing of Disaster Management with reference to the National Calamity Contingency Fund and the Calamity Relief Fund and the funds envisaged in the Disaster Management Act, 2005(53 of 2005), and make appropriate recommendations thereon. 6. The Commission shall indicate the basis on which it has arrived at its findings and make available the estimates of receipts and expenditure of the Union and each of the States. st

7. The Commission shall make its report available by the 31  day of October, 2009, covering the period of five years commencing on the 1st day of April, 2010. Source: The Gazette of India: Extr aordinary dated 13 November, 2007. Ministry of Finance, Department of Economic Affairs:

XIII FC had recommended reduction in the number of Centrally Sponsored Schemes (CSS) and to restore the predominance of formula based plan transfers (Para 4.56 XIII FC). In so far fiscal consolidation is concerned, it hoped that the revenue deficit of the Centre needs to be progressively reduced and eliminated latest by 2014-15 (Paras 9.18 and 9.31 of XIII FC). While addressing environmental concerns, XIII FC had proposed an amount of Rs. 5000 crores as forest grant (Para 12.46), an incentive grant of Rs. 5000 crores for grid-connected

69

renewable energy (Paras 12.52 and 12.53) and another Rs. 5000 crores as water sector management grant subject to setting up of a Water Regulatory Authority and achieving the normatively assessed state-specific recovery of water charges (Para 12.58). In addition, another Rs. 6,721 crore state specific grants had been made by the XIII FC for environmental purposes. XIII FC had also come out with “a grand bargain between the Centre and the states” to implement the Model Goods and Services Tax (GST). It had recommended a 32 percent share to states in net proceeds of shareable central taxes in each of the financial years covered under the recommendation of the Commission (Paras 8.17 and 8.18). 3.4

FINANCE COMMISSIONS IN INDIA: A REVIEW

After more than six decades of functioning, Finance Commissions of the  past, have in their approach to transfer of Central resources to the states have appraised the ‘quantitative’ and assessed the ‘qualitative’ aspects of public expenditure. Salient principles enunciated by various Finance Commissions are  presented in Table 3.3.  Having experienced thirteen Finance Commissions in India, it could be concluded that the mechanisms envisaged in the Constitution have proved adequate for dealing with the consequences of the asymmetry of resources between the Centre and the states. The Commissions did not feel constrained by the terms of reference given by the Centre, and derived authority from the constitutional provisions to go beyond these terms whenever they felt that an equal treatment between the Centre and the states required this. They excluded the plan expenditure from their purview, not because they accepted this as a constraint imposed by the Constitution or the terms of reference, but because they recognized the complementary role of the Planning Commission in the plan  process (Srinivasan, 2002). The broad approach of the Co mmissions has been to follow the principles of justice in what is called the vertical division of resources between the Centre and the states; while in the horizontal distribution of these

resources among the

states equity has to be taken into consideration in view of the disparate levels of development of different states. For this purpose, the two main instruments they resorted were: (a) progressive formulae for the distribution of the divisible pool and (b) grants-in-aid under Article 275. The Commissions and the states have  been in agreement that the more important instruments of transfer from the

70

Centre to the states should be the devolution of taxes, with the grants-in-aid  playing a residuary role. Table 3.4  presents total amount and relative share of various states as allocated by VII to XIII Finance Commissions. An examination of the recommendations of Finance Commissions over the period of time reveals that the total transfers, as also the share of each state (Table 3.4), do not follow a consistent pattern, owing to frequent change of criteria and weightage for inter-se allocation among the states. It is further evident from the Table 3.4 that quantum of total transfers to various states increased significantly during XI and XIII FCs. It would also be proper to mention that each Commission left its own stamp on its specific recommendations, based partly on the circumstances at that time and partly on its own emphasis on priorities within their general approach.  Nevertheless, it could be observed that there were three consistent strands that run through the recommendations of all the Commissions namely (1) satisfaction with the provisions of the Constitution; (2) a desire to do justice to both the Centre and the states; and (3) a concern to ensure equitable treatment among the states taking into account the special circumstances of each state (Srinivasan, 2002). An objective analysis also leaves one with the uncomfortable thought that some of the previous Finance Commissions, in trying to transfer higher level of resources to the states, to help them out of their financial distress, have unwittingly or otherwise, led the Central Government to meet a relentless series of revenue deficits and daunting gross fiscal deficits, from year to year. A study of public expenditure management by state Governments, carried out by the Indian Institute of Economics for the Planning Commission, concludes that “the most important contribution to fiscal imbalances in the states have been on the expenditure side”; it identifies other problem areas like the falling levels of  budgetary marksmanship, declining standards of public accountability, leakage and wastage of funds in programme implementation, tardy devolution of funds to local bodies and continuing intra-state disparities (Srinivasan , 2002). Like other facets of Indian federalism, various aspects of the Indian Constitution have been subjected to judicious scrutiny. However, there has not  been a systematic analysis of the issues involved in any other aspect of the Constitution to the extent there has been on financial relation due to periodic

71

constitution of Finance Commissions in India. In the next Sections, other institutional mechanisms dealing with fiscal federalism in India are discussed. 3.5

PLANNING COMMISSION FUNDS

It is appropriate to mention that in addition to the Finance Commission, the Planning Commission is also a major dispenser of funds in India. Planning Commission funds are distributed according to th e formula (Gadgil Formula from the IV Five Year Plan of 1969-74) further evolved and modified by the National Development Council (NDC) from time to time. The states are entitled to get the following types of Central Assistance for their Plans as mentioned subsequently: Table 3.3 Key Principles Enunciated by the various Finance Commissions Finance Commission First

Second

Third Fifth

Sixth

Seventh

 Ninth

Twelfth Thirteenth

Key Principle(s) The determination of grants in aid to states must be based on  principles that are uniformly applied to all states. (ii) The scheme of distribution should attempt to lessen the inequalities between the states. (iii) It is necessary to maintain the balance between devolution  by transfer of s hare of taxes and devolution by fixed grant in aid. (iv) The scheme of devolution is an integrated scheme and any modification of individual recommendations would upset the balance. (v) The unsound financial policies of a state also affect neighboring state. (vi) In the distribution of resources among the states, there is a need for equalization and large disparities have to be avoided. (vii) The people’s need could be effectively attended to by the agencies close to them. To achieve this, states should transfer resources and powers to local bodies. (vii) The transfers made by the Finance Commission and Planning Commission had to be viewed together as part of an overall process. (viii) Mandated to follow ‘the n ormative approach’, clarified that there will be no interference with the right of the State Government to raise resources and incur expenses at such levels and in such a manner as desired by its people and its Legislature. (ix) Recognition of area based approach for management of natural resources (x) The Grand Bargain

(i)

Source: Author based on the reports of various Finance Commissions

(a)  Normal Central Assistance, which is governed by the modified Gadgil Formula; (b) Additional Central Assistance, which is received for the implementation of externally assisted projects;

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(c) Other Assistance for schemes through various Ministries like the Jawaharlal Nehru National Urban Renewal Mission (JNNURM), Accelerated

Irrigation

Benefit

Program

(AIBP),

National

Rural

Employment Guarantee Assistance (NREGA) and Accelerated Power Development and Reform Programme (APDRP) etc. The details of allocation of Central Plan Assistance to states based on the yardsticks of population, tax efforts (performance), per capita income, ongoing irrigation and power projects, special problems and fiscal management are as given in  Annexure 3.1. Besides the Finance Commission and Planning Commission, various Central Ministries also make transfers to the states and, often, to local bodies directly, for specific purposes, under various Central Sponsored Schemes. Some of the specific-purpose transfer schemes are entirely funded by the Center and other are shared cost programs. In addition to these explicit transfers, there are implicit transfers as well. The important sources of implicit transfers are subsidized loans to the state governments by the Central government. Moreover, resource transfers (not necessarily through governments) occur also due to subsidized lending to priority sector by the financial and banking system and, more importantly, inter-state tax exportation. Also, state governments and local bodies depend upon loans from Central Government and other Public Financial Institutions. Depending on socioeconomic development and robustness of their policies and institutions, debt raising capacity widely varies from state to state. Barring a few well performing states and large local bodies, most of them find it difficult to raise resources from financial institutions. Subsidies provided and levies charged by Central government also indirectly affect the state governments.

3.6

THE QUANTUM OF FISCAL TRANSFERS

The Fiscal Transfers of Federal System, as they now stand to cover (a) State share of Central Taxes and duties (b) Non Plan grants and loans (c) Central assistance for State plans (d) Assistance for Central sector and Centrally

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Sponsored Schemes. The sum of the above transfers makes up to Gross Transfers. The Central Government recovers its loans and advances including interest, due from the states, which gives rise to Net Transfers. The details of the total transfer of financial resources from centre to states as percent of gross revenue receipts of the Centre in recent years are shown in the Table 3.5. It shows average transfers from Centre to states as percentage of gross revenue receipts of the Centre coinciding with various Finance Commissions. Total transfers through Finance Commission varies from 22.77 (VIII FC) to 26.20 percent (XII FC), while total transfers after taking into consideration other transfers varies from 35.27 (XI FC) to 40.33 percent (IX FC). Finance Commission transfers include share in Central Taxes as well as grants. Similarly, other transfers consist of grants through Planning

Commission

and

non-plan

grants

(Non-statutory).

Planning

Commission grants vary from 10.57 (X FC) to 14.49 percent (IX FC). As can be seen from Table 3.6 , the transfers recommended by successive FCs have increased enormously. The level of transfers, whether viewed in gross or net terms show that over the decades the transfers, from Central to the states have been increasing in absolute terms, but the states have a di fferent perception on this as they feel that it is not only the sums in all but also the manner of transfer, whether statutory or discretionary, and whether as a share of central revenues or of state expenditure. One major area of criticism of fiscal federalism in India is the downfall in the relative share of resources to states. Under the Eleventh Plan, a further reduction in the share of resources to states has been envisaged, with the central assistance coming down from 26 percent to 23 percent. With the untied funds being constantly reduced, the dependence of states on the Centre has been increasing. The increasing size of Centrally Sponsored Schemes amounts to almost completely taking away the flexibility of the state governments (Address of Chief th

Minister, Rajasthan in the 54   Meeting of National Development Council). Growing disparities in fiscal capacities and levels of services among states upset this stability as widening disparities require larger and more pr ogressive transfers. 3.7

THE CRITERIA FOR DEVOLUTION OF TAXES AND GRANTS

As regards the determination of the inter se shares of the states, the basic aim of the finance commission transfers in the past has been to (i) correct the differentials in revenue capacity and cost disability factors inherent in the

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economies of states and (ii) foster fiscal efficiency among the states. The criteria used in the past for these p urposes can be grouped under: (a) factors reflecting the needs, such as population and income, measured either as distance from the highest income or as inverse; (b) cost disability indicators such as area and infrastructure distance; and (c) fiscal efficiency indicators such as tax effort and fiscal discipline.

In so far as devolution of central taxes and grants are concerned,  population is the basic indicator of need for public goods and services and it ensures equal per capita transfers across states. However, the overall population criterion does not take into consideration effective family welfare measures adopted by various states. The result being the states those are tardy in controlling their population gets unduly rewarded. Among the criteria used for correcting differential fiscal capabilities for enabling poorer states to meet better the needs for public goods services, per capita income distance is t he preferred indicator.

The use of ‘geographical 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. Cost disabilities are defined as the circumstances, like excess / deficient rainfall, hilly terrain, and large and remote areas with low density of  population, that lead to higher than average per capita costs for delivering the same level of services at an average level of efficiency. 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. The Finance Commissions recognize that the costs of providing services increase with the size of a state, but only at a decreasing rate. Similarly, the State Finance Commissions use ‘area’ and ‘remoteness’ as criteria for financial devolution from the state governments to rural and urban local bodies.

75 Table 3.4: Total Transfer of Resources to States by Finance Commissions' Recommendations (Rs. in Crores) States/Territories VII FC VIII FC IX FC X FC XI FC XII FC XIII FC 1 Andhra Pradesh 1522.5 7.31 2897 7.34 7239 6.8 18081 7.98 31011 7.13 50353.26 6.66 114148.3 6.69 2 Arunachal Pradesh 835 0.8 1768 0.78 2315 0.53 3525.56 0.47 9103.8 0.53 3 Assam SC 518.65 2.49 1607 4.07 3956 3.7 8328 3.67 13281 3.05 24329.4 3.22 57832.7 3.39 4 Bihar 2212.9 10.62 4220 10.7 11176 10.5 24655 10.88 56728 13.04 75646.83 10.01 172944.1 10.13 5 Chattisgarh 18273.7 2.42 42000.7 2.46 6 Goa SC 509 0.5 622 0.27 821 0.1 1724.53 0.23 4374.0 0.26 7 Gujarat 963.87 4.63 1489 3.77 3713 3.5 8876 3.92 12000 2.76 25608.75 3.39 53789.9 3.15 8 Haryana 308.57 1.48 439.2 1.11 1195 1.1 2793 1.23 4206 0.97 8042.44 1.06 19470.3 1.14 9 Himachal SC 325.07 1.56 774.4 1.96 1860 1.8 4762 2.1 4760 1.72 14450.36 1.91 21691.6 1.27 10 Jammu & Kashmir 376.89 1.81 1120 2.84 3359 3.2 7322 3.23 16428 3.78 20880.28 2.76 40438.7 2.37 11 Jharkhand 23656.84 3.13 47878.6 2.81 12 Karnataka 1005 4.82 1728 4.38 4063 3.8 10521 4.64 19692 4.53 31416.28 4.16 74376.3 4.36 13 Kerala 770.34 3.7 1288 3.27 3448 3.3 7722 3.41 12317 2.83 19607.72 2.59 40325.8 2.36 14 Madhya Pradesh 1597.5 7.67 2958 7.5 7843 7.4 16094 7.1 34998 8.05 46321.96 6.13 116593.4 6.83 15 Maharashtra 1714.1 8.22 2635 6.68 6201 5.8 13709 6.05 19387 4.46 36194.25 4.79 91709.8 5.37 16 Manipur SC 194.03 0.93 469.1 1.19 1085 1 2137 0.94 3216 0.74 6870.2 0.91 13567.5 0.79 17 Meghalaya SC 134.15 0.64 581.9 0.97 822 0.8 1889 0.83 2961 0.68 4367.77 0.58 9842.4 0.58 18 Mizoram SC 1021 1 1802 0.08 2535 0.58 4660.91 0.62 8805.3 0.52 19 Nagaland SC 240.59 1.15 527.4 1.34 1244 1.2 2793 1.23 4450 1.02 7453.41 0.99 13744.2 0.81 20 Orissa 984.45 4.72 1910 4.84 5223 5.2 9706 4.28 20754 4.77 36942.77 4.89 78974.9 4.63 21 Punjab 419.53 2.01 646.2 1.64 1674 1.6 3589 1.58 5429 1.25 12884.59 1.7 25686.6 1.51 22 Rajasthan 902.81 4.33 1676 4.25 6526 6.2 11401 5.03 23589 5.42 39062.47 5.17 97842.0 5.73 23 Sikkim SC 36.85 0.18 104.5 0.27 252 0.2 699 0.31 1634 0.38 1829.14 0.24 4525.7 0.27 24 Tamilnadu 1503.6 7.21 2465 6.25 6198 5.8 13361 5.89 21601 4.97 36688.13 4.85 83437.3 4.89 25 Tripura 199.84 0.96 561.2 1.42 1434 1.4 2873 1.27 4361 1 8417 1.11 13127.6 0.77 26 Uttar Pradesh 3314.7 15.9 6105 15.47 17449 16.5 36159 15.95 78509 18.05 133471.5 17.66 312140.0 18.29 27 Uttaranchal 12194.34 1.61 20308.1 1.19 28 West Bengal 1597.1 7.66 3450 8.74 7409 7 14980 6.61 35220 8.1 50877.28 6.73 117997.2 6.91 Delhi (NCT) 0.00 Total: All States 20843 100 39452 100 1060036 100 434905 100 434905 100 755751.6 100 1706676.8 100.00

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In the past (up to Eleventh Finance Commission) ‘index of infrastructure’ was used as a cost disability criterion as an indicator of the relative availability of economic and social infrastructure in a state. This index was inversely related to the share. The Twelfth Finance Commission was of the view that the infrastructure index distance criterion is correlated with the income distance criterion and the fact that this index is better used in an ordinal way. For these reasons, Twelfth FC had dropped the index of infrastructure as a criterion. In so far as tax effort is concerned, 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 the composition of tax base among the states. Given the data constraints, the Tenth FC used per capita GSDP as a

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In the past (up to Eleventh Finance Commission) ‘index of infrastructure’ was used as a cost disability criterion as an indicator of the relative availability of economic and social infrastructure in a state. This index was inversely related to the share. The Twelfth Finance Commission was of the view that the infrastructure index distance criterion is correlated with the income distance criterion and the fact that this index is better used in an ordinal way. For these reasons, Twelfth FC had dropped the index of infrastructure as a criterion. In so far as tax effort is concerned, 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 the composition of tax base among the states. Given the data constraints, the Tenth FC used per capita GSDP 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. In order to provide for an adjustment for states with poorer tax bases, tax effort ratio as defined above was weighted by the inverse of per capita income – implying that if a poorer state exploits its tax-base as much as a richer state, its gets an additional positive consideration in the formula. The index of fiscal discipline was proposed by the Eleventh FC with a view to providing an incentive for better fiscal management and was defined as improvement in the ratio of own revenue receipts of a state to its total revenue expenditure in a reference period in comparison to a base period. This index had also  been accepted and followed by the subsequent Finance Commissions. 3.8

TRANSFER OF RESOURCES TO LOCAL BODIES

As per the constitutional scheme of things, local bodies constitute the third administrative and political structure of the Indian federation. In so far fiscal transfer of resources from state to local bodies is concerned, the State Finance Commissions (SFCs) play an important role. Article 243 I of the Indian Constitution prescribes that the Governor of a State shall, as soon as may be within one year from the commencement of the Constitution (Seventy-third Amendment) Act, 1992, and thereafter at the expiration of every fifth year, constitute a Finance Commission to

77

review the financial position of the Panchayats and to make recommendations to the Governor as to: A. The principles which should govern 1. The distribution between the State and the Panchayats of the net  proceeds of the taxes, duties, tolls and fees leviable by the state, which may be divided between them under this Part and the allocation between the Panchayats at all levels of their respective shares of such proceeds; 2. The determination of the taxes, duties, tolls and fees which may be assigned as, or appropriated by, the Panchayats; 3. The grants-in-aid to the Panchayats from the Consolidated Fund of the state; B. The measures needed to improve the financial position of the Panchayats; C. Any other matter referred to the Finance Commission by the Governor in the interests of sound finance of the Panchayats. Article 243 Y of the Constitution further provides that the Finance Commission constituted under Article 243 I shall make similar recommendation visà-vis municipalities. The Governor is required to cause every recommendation made  by the State Finance Commission together with an explanatory memorandum as to the action taken thereon to be laid before the Legislature of the state. When it comes to devolution of resources, Indian fiscal federalism has very interesting insights to offer. While the states clamor for greater financial devolution from centre, but when it comes to them in turn to devolve authority and resources to local bodies, most of them develop cold feet. States have often been not prompt enough to constitute the state finance commissions with the required regularity. In so far as transfers from centre to local bodies are concerned, XII FC had  provided a total grant of Rs 20,000 crore to panchayats and Rs. 5,000 crore to municipalities in its report. Index of decentralization, revenue effort and index of

78

deprivation are other important considerations in addition to population, geographical area and distance from highest per capita income for allocation of grants by the FC to local bodies. Table 3.7  provides shares of states for panchayats and municipalities for 2005-10 by the XII FC. XIII FC in its report had exclusively dealt with the issue of strengthening local bodies (both urban and rural) and had proposed a grant of Rs. 87,519 crore to urban and rural local bodies as per criterion given in Table 3.8 including general and specific areas - basic and performance grants covering the award period 2010-2015. 3.9

EFFICIENCY VERSUS ECONOMY DEBATE

It is not that the working of fiscal federalism in India had not attracted negative comments. There is criticism as well about the working of fiscal federalism in the country as at the core is the rob-Peter-to-pay-Paul approach that punishes  productivity,

diligence

and

thrift

(Ramachandran,

2005).

According

to

Ramachandran, India have too few Peter states that are wealthy enough to be robbed. The remaining states that are a little productive will choose to become poor instead of  being robbed. It is only when inter-state and intra-state disparities are reduced, that the federal system would become stable. The question, therefore, is a tightrope walking between equity versus efficiency concerns while providing economic, social and ecological services. While some amount of equity needs to be introduced into the process of distributing the devolved taxes among states, efficiency had also to be given due consideration in this process. The main instrument to help the poorer and the less developed states could be grants-in-aid under Article 275. The Tenth Finance Commission argued that equity and efficiency are not mutually exclusive and that is had given weight in its Report to efficiency on the revenue side, by recognizing tax effort. The Eleventh Finance Commission, considered both tax effort and fiscal discipline as criteria for determining the share in devolution.

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Table 3.5: Transfers from Centre to states as Percentage of Gross Revenue Receipts of the Centre (Finance Commission Period Averages) Finance Commission Transfers Finance Commission

1 VII FC VIII FC (1984-89) IX FC (1989-95) X FC (1995-2000) XI FC(2000-2005) XII FC (2005-10)

Share in Central taxes

Grants

2 22.39 20.25 21.37 22.22 20.59 21.75

3 1.96 2.52 3.42 2.34 3.88 4.45

Total Transfers through Finance Commission 4 24.35 22.77 24.79 23.56 24.47 26.20

Other Transfers Grants through Planning Commission

5

Non-Plan Grants (Nonstatutory)

Total Transfers

6 12.11 13.56 14.49 10.57 10.10 10.99

7 13.77 15.10 15.55 11.24 10.80 12.31

1.66 1.54 1.06 0.67 0.70 1.32

Total Transfers

8 38.12 37.86 40.33 35.79 35.27 38.51

Source: Union Government Finance Accounts and Revenue Receipts are from Central Government Receipts Budget (Various issues)

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Table 3.6: Finance Commission Transfers Devolution

I FC (52-57) II FC (57-62) III FC (62-66) IV FC (66-69) V FC (69-74) VI FC (74-79) VII FC (79-84) VIII FC(84-89) IX FC (89-90) 1990-95 X FC (95-00) XI FC (00-05)

362 852 1068 1323 4605 7099 19233 35683 11785 87882 206343 376318

Grants

50 197 244 422 711 2510 1610 3769 1877 18154 20300 58587

Total

412 1049 1312 1745 5316 9609 20843 39452 13662 106036 226643 434905

Increase over PFC %

120 25 33 205 70 117 89 303 89 92

(Rs. Crore) % of Total Transfer Devolution

Grant

88 81 81 76 87 74 92 90 83 91 87

12 19 19 24 13 26 8 10 17 9 13

80

Table 3.6: Finance Commission Transfers Devolution

I FC (52-57) II FC (57-62) III FC (62-66) IV FC (66-69) V FC (69-74) VI FC (74-79) VII FC (79-84) VIII FC(84-89) IX FC (89-90) 1990-95 X FC (95-00) XI FC (00-05) XII FC (05-10) XIII FC (10-15) Grand Total

362 852 1068 1323 4605 7099 19233 35683 11785 87882 206343 376318 613112 1448096 2813761

Grants

50 197 244 422 711 2510 1610 3769 1877 18154 20300 58587 142639 258581 509651

Total

Increase over PFC %

412 1049 1312 1745 5316 9609 20843 39452 13662 106036 226643 434905 755751 1706676 3323411

(Rs. Crore) % of Total Transfer Devolution

Grant

88 81 81 76 87 74 92 90 83 91 87 81 84 84.67

12 19 19 24 13 26 8 10 17 9 13 19 16 15.33

120 25 33 205 70 117 89 303 89 92 74 126 -

Source: Reports of XIII Finance Commission

At this stage it is appropriate to recognize significant conceptual differences  between ‘efficiency’ and ‘economy’ in practice though they are used synonymously. Efficiency refers to the process of gaining more outputs for a given quantity of inputs. Economy refers to using fewer inputs to gain a specified level of outputs. The scope for achieving either is largely dependent on two factors (a) a consideration given to these aspects in the initial design of a programme and (b) at a later stage the economy derived and efficiency secured through the exploitation of competitive  pressures in the procurement of materials and equipment and in the utilization of management

techniques

to

reduce

inventories,

overlapping

services

and

administrative overheads. It has also been realized that the pursuit of fiscal consolidation, mainly through expenditure reduction, has its snares, since government expenditure on consumption and investment constitute an important part of aggregate demand in the economy with its impact on the economic growth prospects.

Over a period of time,

there has been increasing emphasis on proper attention to the expenditure side of fiscal restructuring in India through ‘programmes for structural adjustment and fiscal stabilization’. Concomitant attention to expenditure reduction and to improvement in

81

quality of public spending is thus crucial to ensure economic growth with equitable distribution of benefits among various social classes and different regions of the country. Although references have been made in the Terms of References’ of various Finance Commissions, none of those Commissions did set out any specific criteria for assessing efficiency or make its observance a condition for release for Central funds. At this stage, it would be suffice to say that the federal transfer system needs to be retuned and the states made to assume greater responsibility for managing their fiscal situation and for achieving budgetary balance. The design of federal transfers should be so as to facilitate the processes of economic growth and public financial management intertwined with social and  political objectives of governance. The economic growth rate has to be assessed along with quality of expenditure and distributional equity. Reiterating this, in his address to the nation on June 25 th  2004, the Prime Minister Dr. Manmohan Singh observed that “Equity and efficiency are complementary, not contradictory, and we must move forward on both these. While some regions of the country seem to be on an accelerating growth path, there is a concern that other regions are not only lacking  but are also falling behind” and that “as a nation we cannot accept such disparities “. It would also be appropriate to mention that “stepping up the rate of growth and improving its quality calls for incentives to the performers forging ahead and intelligent guidance to those lagging behind” (Srinivasan, 2002). In the interest of improved federal fiscal framework, and of ensuring equal availability of quality  public services in all states, it is imperative that an attempt is made to utilize the federal transfers, as an instrument to prod the states into more efficient ways of utilizing their own revenue as well as the resources transferred by the Centre by careful planning and budgeting of expenditure and improved systems of monitoring. 3.10

MACRO POLITICAL ENVIRONMENT

The Constitution of India had ushered a Union of States, giving the nation a Federal character even while several features appeared to be those of a unitary state. The democratic framework sustained through regular elections to the Union

82

Parliament and State Assemblies has brought India credit in the comity of nations,  but the history of Federal Republic that came into existence in 1950 has not been without challenges. The spirit of federalism has however been kept alive, overcoming stress and strain inevitable in a nation marked by economic, social, political and cultural diversity. It would be prudent to say that the fiscal federalism in India has withstood many changes in the political environment. However, the political history of the past sixty plus years in the country is testimony to the fact that multi party coalitions are here to stay both at the centre and state levels. There are also increasing trends that the same party or coalition may not rule at the centre and the state. The differences in  political ideologies, is expected to lead to hard time for fiscal federalism in the country as charges of favoritism and neglect will be hurled frequently and with greater intensity. It is also important to put environmental issues sufficiently along with social and economic issues on the radar screen of political process in India. The  past experience of fiscal federalism brings testimony to the facts that ‘equity considerations’ had often preceded over ‘efficiency considerations’ in resource allocations over a period of time.

Sl.No

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

State

Andhra Pradesh Arunachal Pradesh Assam SC Bihar Chattisgarh Goa Gujarat Haryana Himachal Pradesh Jammu and Kashmir Jharkhand Karnataka Kerala Madhya Pradesh Maharashtra Manipur Meghalaya Mizoram Nagaland Orissa Punjab Rajasthan Sikkim Tamilnadu Tripura Uttar Pradesh Uttaranchal West Bengal

Table 3.7 : Shares of States in Allocation (2005-10) Panchayats Percent 7.935 0.340 2.630 8.120 3.075 0.090 4.655 1.940 0.735 1.405 2.410 4.440 4.925 8.315 9.915 0.230 0.250 0.100 0.200 4.015 1.620 6.150 0.065 4.350 0.285 14.640 0.810 6.355 100.00

(Rs Crore) 1587 68 526 1624 615 18 931 388 147 281 482 888 985 1663 1983 46 50 20 40 803 324 1230 13 870 57 2928 162 1271 20000

Municipalities Percent 7.480 0.060 1.100 2.840 1.760 0.240 8.280 1.820 0.160 0.760 1.960 6.460 2.980 7.220 15.820 0.180 0.160 0.200 0.120 2.080 3.420 4.400 0.020 11.440 0.160 10.340 0.680 7.860 100.00

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Table 3.8: Weights Allotted to Criteria for Grants to Local Bodies by XIII Finance Commission (2010-15) Weights Allotted (%) Criterion PRIs ULBs Population 50 50 Area 10 10 Distance from highest per capita sectoral income 10 20 Index of devolution 15 15 SC/ST proportion in the population 10 0 FC local body grants utilization index 5 5 100 100 Total Source: Report of the XIII Finance Commission

(Rs Crore) 374 3 55 142 88 12 414 91 8 38 98 323 149 361 791 9 8 10 6 104 171 220 1 572 8 517 34 393 5000

83

84

Table 3.8: Weights Allotted to Criteria for Grants to Local Bodies by XIII Finance Commission (2010-15) Weights Allotted (%) Criterion PRIs ULBs Population 50 50 Area 10 10 Distance from highest per capita sectoral income 10 20 Index of devolution 15 15 SC/ST proportion in the population 10 0 FC local body grants utilization index 5 5 100 100 Total Source: Report of the XIII Finance Commission

85 ANNEXURE- 3.1 ALLOCATION OF CENTRAL PLAN ASSISTANCE

The states are entitled to get three types of ‘plan assistance’ from the Planning Commission namely (a) Normal Central Assistance (NCA) which is governed by the modified Gadgil Formula; (b) Additional Central Assistance (ACA) which is received for implementation of externally assisted projects; and ( c) Special Central Assistance (SCA) for special schemes. The Normal Central assistance is given as per the Gadgil formula being adopted from the fourth F.Y.P. (1969-74). This formula has been revised from time to time as shown below:— Year Criteria

(1) Population

1969

1980

1990

60%

60%

55%

(2) Tax efforts (performance)

10%

10%

(3)Per Income

10%

20%

capita

(4)On going irrigation / 10% … Power Projects. (5)Special 10% 10% Problems* (6)Fiscal … … Management *Special problems includes, problems relating to chronically drought affected areas and tribal areas.

Dec. 1991

60%

7.5% (Tax efforts, management of economy, … implementation of nation  priorities) 25% (5% distance 25% criteria 20% deviation criteria) …

…

15%

7.5%

5%

…

metropolitan areas, floods,

In the NDC meeting held in January 1997 it was pointed out that the modified Gadgil/Mukharjee formula revised in December 1991 does not take into account the strain on the resources of a State where the extent of immigration is high. The Plan Panel suggested that the population criterion, which has a weightage of 60% in the modified Gadgil/Mukharjee formula, should be split into two elements - a weightage of 5% is given to net immigration into a State and 55% to the population of the state as per 1971 Census. 5% of the Central assistance should be distributed to the state

86 having net immigration, in proportion to the net cumulative immigration since 1971, including natural growth of immigration in the earlier decades. Similarly, per capita income of some states is overstated to the extent because the remittances to other states by labour coming into in search of better opportunities which result in an outflow of funds from such states and correspondingly, the per capita income of the recipient states is understated. Therefore, the gap between high  per capita income states and low per capita income states is also much wider than if the flow of funds because of remittances were to be taken into account. It had been argued that ‘allowance’ should therefore be made for these factors in determining Central assistance. ADDITIONAL PROJECTS:

CENTRAL

ASSISTANCE

FOR

EXTERNALLY

AIDED

The state Governments receive external aid for projects in various sectors from agencies such as the World Bank, USAID (United States Agency for International Development), EEC (European Economic Community), and JBIC (Japanese Bank for International Cooperation) etc. When the state proposes to pose a  project for external assistance, its primary responsibility is to make the provision of adequate funds to cover the cost of the project and to have competent technical staff for implementing the project. The assistance is either in the form of grant or loan, or  both, to cover the entire cost of the project or some percentage of project cost as per the agreement. Unless adequate outlay is provided in the Annual Plan/Five Year Plan, as per the year-wise schedule of requirement of funds, the projects are not accepted for external aid. The required outlay is, therefore, provided in the Annual Plan and additional central assistance (ACA) is claimed on the basis of the expenditure as per the agreement. Hence ACA is estimated while working out the resources for the Annual/F.Y.P. and treated as a part of resource of the annual plan size. The ACA is not paid directly to the State Government but routed through the Government of India that releases it to the concerned state on the basis of the expenditure incurred on the externally aided projects (EAP). The state Government has to pay back (now largely on back to back basis, with full exchange rate risk and repayment liability borne by the states) this additionality received by way of loan from the foreign donors in installments to the Government of India that in turn, pays back the loan with interest