Nuts and bolts of fiscal federalism

The subject of federalism and fiscal transfers may not stir up passion among the youth as would a World Cup semi-final cricket match between India and Pakistan. But the principles that have guided the determination of fiscal transfers from the Centre to the States and the distribution of these transfers amongst the States over the last 60 years merit closer examination from citizenry.   

Providing us with an incisive analysis of the principles of fiscal transfers followed by the Finance Commissions till date is the book Federalism and Fiscal Transfers in India ( Oxford University Press ).

This book has been co-authored by Dr C. Rangarajan, Chairman to the Prime Minister's Economic Advisory Council and Mr D.K. Srivastava, Director, Madras School of Economics. Both the authors were part of the Twelfth Finance Commission with Dr Rangarajan as its Chairman and Mr Srivastava as a Member.  

For the uninitiated, fiscal transfers involve sharing of Central taxes and grants with the States. In India, the key institutional arrangement that has guided fiscal federalism has been the Finance Commission. Federalism is an old concept and its origin is primarily political. Particularly in large countries, it was felt that sub-national Governments are required and that only a federal structure can effectively meet the requirements of people from different regions.

There is barely an area in Indian economic policy making that does not have Dr Rangarajan's imprint. This volume has brought together eight articles written by the authors since 2003 on the subject of fiscal federalism in India.

The focus of the book is on the principles that have guided the determination of fiscal transfers from the Centre to the States and the distribution among States, given the large differences in fiscal capacities and service standards across States in India.  Transfer of resources from the Centre to the federating units is a common phenomenon in all large countries.

This is so because there is always a mismatch between the responsibilities of federating units and their ability to raise adequate resources. Second, resources are best raised only at Central level, both on grounds of efficiency and equity. This necessitates transfer of resources from the Centre to the States in order to correct what is known as vertical imbalances.

Correcting imbalances

Apart from this, overall resources have to be distributed among the States and the criteria for horizontal distribution would also be equally important. The book has examined the critical issues involved in correcting vertical and horizontal imbalances. As far as vertical dimension, the book has noted that there has been stability for a long time in the share of Centre and States in the combined tax revenue of the system after tax devolution.

It may be considered desirable to maintain this stability as long as there are no basic changes in the division of responsibility between the Centre and the States, Dr Rangarajan has suggested.

In one of the essays, it has been shown that maintaining this stability requires an upward adjustment in share of States in the divisible pool of taxes in period where the expected buoyancy of the Centre is higher than that of the States.  In fact, the 13th Finance Commission has made specific reference in its report to this particular conclusion of the authors.

In more than one chapter, the authors have traced the evolution of system of fiscal transfers in India both with respect to vertical and horizontal dimensions.

Equalisation

Some of the well-established federations such as Australia and Canada follow the system of fiscal transfers which is guided by the principle of equalisation. There are chapters describing the system in Australia and Canada.

Equalisation is considered a desirable principle as it empowers and ensures both equity and efficiency.  Equalisation here means equalisation of fiscal capacity. In this book, the authors have shown that over time the Indian system has also evolved in a manner which is consistent with the principle of equalisation.

The difference is that in India, a macro approach rather than tax-by-tax approach is followed. Taking the transfers done by the 12th and 13th Finance commissions, it has also been shown that on certain assumptions 88-90 per cent of the equalisation of fiscal capacity was achieved in the scheme of fiscal transfers.

Fiscal deficit

This book has also looked at impact of fiscal deficit on savings, investments and growth. The authors have also examined the dynamics of debt accumulation — for the Centre and combined Central and State governments.

The role of primary deficit, growth rate and interest rate in the evolution of the Central debt relating to GDP has also been brought out.

But what were sorely missed were more insights or analysis of the proposed goods and services tax (GST) system and its implications on the revenue profiles of the Central and State Governments.

Hopefully, both Dr Rangarajan and Prof Srivastava will soon come together to throw more light on the proposed GST architecture and its implications on revenue resources for the States.

Many States apprehend that in the Centre's anxiety to usher in a common market with uniform rates and removal of multiple points of taxation, their own (States) tax base may get eroded. A highly rewarding read for students, scholars and practitioners of Indian fiscal federalism!

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