The Hindu Business Line : The state of fiscal devolution

Increasingly the Central Government tries to pass the responsibility for economic and social outcomes on to State governments. But does the current state of fiscal federalism justify this? In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh examine this question.

It is often said that “India lives in its States”. This is obviously true, but it is also increasingly becoming a means of passing on governmental responsibility from Central to State levels. Under the Constitution, State governments have always had very significant responsibilities (for law and order, infrastructure development, health, education, agriculture — to name just a few). However, at the same time they have not had commensurate powers either to raise resources or to influence broader trends that create the context or enabling conditions for fulfilling these responsibilities.

The assigning of responsibility to States, particularly for economic outcomes, is now becoming even more pronounced in the Central Government. Thus, in the past week Ministers in the Central Government Cabinet have argued that the recent rise in the rate of inflation is the problem of State governments and must be dealt with by them.

Yet inflation is so clearly a macroeconomic process that it is obviously determined by aggregate national forces and policies. These include not only fiscal and monetary policies, which are the sole preserve of the Central Government, but also trade policies and other features that State governments cannot determine but must only respond to.

A wide range of other actions — for example, enactment and enforcement of a Right to Education Bill for the entire country — are being held up or undermined on spurious concerns about federalism. At the same time, it is now common to hear Central Government spokesmen argue that “the States are now flush with funds” because of the increase in sales taxes and therefore do not require further transfer of financial resources from the Centre.

The basic difference between Centre and States — that State governments necessarily face a hard budget constraint unlike the Central Government — is forgotten in this context. Also, since the State governments cannot impose service taxes, and therefore must exclude the fastest growing segment of the economy from their resource raising efforts, means that they are at a significant disadvantage compared to the Central Government in this regard.

Finance Commissions

The basic means of financial transfer is through the successive Finance Commissions, which are supposed to ensure a fair and equitable devolution of fiscal resources from the Centre to the States. However, the terms of reference of recent Finance Commissions have gone beyond the simple allocation of tax revenues between the Centre and different States according to a given formula, to allowing and even proposing conditional transfers, even if this goes against the basic principle of federal devolution. Thus, the Eleventh Finance Commission proposed a system of debt relief to States which required them to first pass fiscal responsibility legislation according to parameters laid down by the Centre.

For all the talk of decentralisation, this actually amounts to a greater centralisation of government finances. Direct central allocations to States are increasingly covered by conditionalities, even if they are egregious or unsuitable to the State in question.

A case in point is the transfer of funds under the Jawaharlal Nehru National Urban Renewal Mission (JNNURM), which requires problematic measures such as the elimination of stamp duty by recipient State governments. Or they are so rigid as to make it difficult to adjust the funding to local requirements, as in the case of the Sarva Shiksha Abhiyan (SSA) where exactly the same norms for expenditure are laid down for all States regardless of differing contexts.

Another attempt to undermine federalism and the authority of elected State governments comes in the arguments for fiscal provisions by the Centre directly to panchayats at district level. With norms for expenditure determined by the Centre, as well as “capacity building” of panchayat members by the Centre, this amounts to an extremely centralised notion of decentralisation, where the real decisions are made at the very top of national government rather than being delegated to States and then to panchayats.

In this context, what is the current situation with respect to the fiscal health of States and financial devolution? Chart 1 describes the pattern of deficit among all State governments taken together. It is evident that the severe fiscal crisis of the States that was so marked in the early years of this decade is no longer as pervasive.

Since 2004 all the major deficit indicators have been declining, and the revenue and primary deficits are now close to zero for the States as a whole. Even the fiscal deficit total is under 3 per cent of GDP.

It is generally supposed that this improved fiscal health is the result of the Eleventh Finance Commission’s award, which is perceived to have substantially increased grants to States and also allowed some debt write-off to those States that agreed to pass the controversial fiscal responsibility legislation.

However, Chart 2 indicates that such a conclusion is not justified.

In fact, the significant increase has been in tax receipts of the State governments themselves, which in 2006-07 accounted for more than 55 per cent of their total fiscal resources.

The share in central taxes has remained small and shown hardly any increase as a proportion of total receipts. Even all non-tax receipts (which include grants from the Centre as the biggest chunk) have not increased very much and remain at less than a quarter of total receipts. It is worth noting that the share of capital receipts has declined very sharply in recent years.

The relatively low and even declining share of central taxes is confirmed by the evidence on the States’ share of central taxes as a proportion of the total central tax collection.

Chart 3 shows that this has been declining since the most recent peak of 2001-02, and that the average of the last three years (2004-05 to 2006-07) is well below the average of the three-year period of a decade earlier.

All the State government taken together currently receive just around one quarter of central tax revenues, even though they are directly responsible for most of the public service delivery that directly affects the lives of people.

Financial devolution

What of the total financial devolution, that is, including grants and all other mechanisms? In current nominal terms that has certainly been rising, as indicated by Chart 4 which show the nominal rate of growth on the right hand scale.

However, as share of GDP of States they have been mostly stagnant in the recent period, and indicate some evidence of medium-term decline compared to the early 1990s.

It was noted earlier that capital receipts had been declining as a percentage of total State governments’ receipts, and stood at only 21 per cent in 2006-07. Within this, however, the share of market borrowings increased, as evident from Chart 5 which examines the nature of financing the fiscal deficit for all States. In the last three years described here there has also been a sharp increase in use of small savings (the NSSF or National Small Savings Fund) which reflects the shift in personal savings away from bank deposits to small savings because of interest rate differentials.

This of course means that State governments have had to pay relatively higher rates of interest on borrowing even in the period of lower interest rates on average, but at least they automatically receive most of these funds. Evidence from 2007-08 suggests that this was not forthcoming last year. Meanwhile, loans from the Central Government have declined to the point of irrelevance.

It is sometimes believed that grant funds, which are non-interest bearing and supposedly untied, allow a greater degree of comfort and flexibility to States, and indeed the Eleventh Finance Commission put more emphasis on grants for those reasons, as well as because of the perceived decline in aggregate tax-GDP ratios.

Central schemes

However, a substantial proportion of the grants provided to the States come in the form of Central Schemes and Centrally Sponsored Schemes.

Chart 6 shows that not only are these significant, but they have also been increasing as a proportion of total grants in the recent period. Strictly speaking, transfers for Central Schemes should not be included in such grants at all or counted as part of devolved resources, since they reflect Central Government expenditure that is simply administered by States.

Centrally Sponsored Schemes are also problematic since they typically require matching expenditure by States (of varying proportions according to the Scheme) and are in any case completely determined by the Centre, in terms of content, structure, format and process.

So they cannot really be described as devolved funds at all. This is especially the case given the significant increase in different forms of conditionality that now accompany most, if not all, Centrally Sponsored Schemes. However, it is apparent from Chart 6 that more than one-fourth of all grants to States come in these centralised forms.

All this suggests that fiscal federalism still remains somewhat of an empty promise in India, despite all the protestations to the contrary.

If this is indeed the case, and the Central Government continues to control the bulk of public finances in India, then surely it should also take more responsibility for the economic and social outcomes that are determined by public spending.