Ashima Goyal

Stress points in Centre-State finances

Ashima Goyal | Updated on August 08, 2012


Resource transfers to States should also be tied to incentives, as suggested by recent Finance Commissions, to improve their performance. Unconditional transfers, or debt write-offs as urged by West Bengal, are best avoided.

The most critical policy initiatives in India require the best of coordination efforts between the Centre and the States.

Failures in agriculture, health, education, policing, and in making India one market are all reflections of this basic coordination failure with regard to subjects falling under the Concurrent List of the Constitution. The same applies to the Goods and Services Tax (GST) or the National Counter Terrorism Centre, which are being held up only for lack of support from the States.

It is in this context that one must also look at the recent pressures mounted by West Bengal on the Centre to make concessions on its accumulated debts. It raises new questions: First, can the Centre extend these? Second, should it, and if so, what is the best way to do it?


India has a well-functioning fiscal union on paper, with the Constitution clearly demarcating taxation powers between the Centre and the States and laying down revenue sharing criteria that are revisited by periodic Finance Commissions.

These criteria favour equity, by mandating higher awards to weaker States, so as to enable the provision of uniform public services throughout the country. They are, in a sense, an essential component to making India one country.

But since such transfers can perversely motivate States to remain weak, recent Finance Commissions have also provided incentives to States to improve their finances. They have also provided for special grants that are conditional upon States improving the quality of their expenditures. States that have enacted Fiscal Responsibility and Budget Management (FRBM) legislations have also been given special debt forgiveness.

The above initiatives, together with buoyancy in the Centre's own revenues that are shareable, have led to significant improvement in State finances over the last few years. The erstwhile Left Front Government in West Bengal refused to sign the FRBM, largely on ideological grounds. Today, it happens to be one of the three most indebted States. The Constitution also allows for additional transfers to States under Article 282. These have, in fact, become quite dominant, accounting for as much as one third of State spending. The plethora of centrally sponsored schemes, administered through the Planning Commission, has also undermined the authority of the Finance Commissions.


History tells us that the macroeconomic outcomes have tended to be very poor in those fiscal unions, where the States or provinces were unconditionally bailed out by the Centre.

In these cases, the sub-national debt added on to national debt, in the absence of corresponding tax revenues, was serviced by printing money. It typically resulted in hyperinflation. If the debt was foreign, it ended in default, as was the experience of Argentina and Brazil.

In the US, too, the Centre bailed out the States for debts incurred during the War of Independence. Since States assumed the federal backing, they borrowed heavily to even finance infrastructure without any clear sources of revenue. But the Congress refused to bail them out, saying that the earlier case was specific to war expenditures. It forced the States, then, to balance their budgets, even though the Centre did later mandate transfers for their health and education programmes.

Canada, on its part, made bailouts available only on stringent conditions. As a result, the province of Alberta chose to default on its market debt rather than accept a bailout. As the risk premia rose for provinces with high debts, market discipline worked. Today, both the Canadian federal government as well as the provinces have good finances.

A viable fiscal union, in other words, requires a combination of both transfers and discipline. The Euro Zone countries are in trouble now because they are not a fiscal union and there is no mechanism for transfers.

Discipline alone cannot work. In this case, the markets simply assumed a bailout would occur; so they lent to the likes of Portugal, Ireland and Greece at the same rates as they were lending to Germany.

The results were predictable. Greece initially was able to over-borrow at low rates and built up unsustainable debts. But until the crisis broke, spreads were flat for countries across the Euro Zone.

As it became clear that a bailout was not going to happen and the countries with huge debts would not be able to print their own money – leave alone devalue their currencies that no longer existed to service them, the spreads shot up.


The scope for market borrowings by Indian States is limited, just as it is with market discipline, as the Centre absorbs much of the risks here. This should change gradually and States with higher debt should pay higher rates. West Bengal's suggestion, on the other hand, that high debt States should pay nothing sets a dangerous precedent. If accepted, other high debt States, too, would demand similar concessions. Also, they would be motivated to spend more in the assumption of rescue package following from the Centre.

Fairness is most important in any fiscal union. Consistent with this principle is a conditional rescue that does not create perverse incentives. West Bengal should, therefore, be asked to sign the FRBM, with debt relief being conditional upon that.

This could lead to a sustainable improvement in the State's finances. Mamata Banerjee should well be willing to go against the decision of the previous government.

The Centre is also free to design special transfer packages under Article 282 for West Bengal. But even these should not be unconditional.

All these concerns should be clearly articulated with the States in a spirit of dialogue that complements incentives. There should be regular meetings to evolve new policy initiatives, and not just communicate a unilateral policy decision.

The worst combination is one where the Centre's arrogance meets States' intransigence, resulting in policy paralysis. The best would be of cross-party involvement, where everyone shares blame and credit. That would be lesson for Sushil Kumar Modi and others from Opposition-ruled States. If these leaders take some initiative, they may well share the credit for GST's implementation. Delaying it would discredit them equally as the Centre.

(The author is Professor of Economics, Indira Gandhi Institute of Development Research. >

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Published on May 09, 2012
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