FISCAL FEDERALISM IN INDIA: THEORY AND PRACTICE
DRAFTNOT TO BE QUOTEDFISCAL FEDERALISM IN INDIA: THEORY AND PRACTICEM. G o v in d a RaoT a p a s K. S enMay, 1995NIPFP LibraryimuMiIH M R IilllJL42392336.1850954 R18F N5National Institute o f Public Finance and Policy18/2, Special Institutional Area, New Delhi 110 067
CONTENTSIN TR O D U CTIO N1A nalytical S ettingC hanging R ole o f the State and R eassessm ent o f FederalFiscal A rrangem entsP lan o f the Study14FISCA L DECENTRALISATION: T A X A NDEX PE N D IT U R E ASSIGNM ENTS11711Fiscal D ecentralisation: Som e T heoretical C onsiderationsT ax and E xpenditure A ssignm ents in India: Im portant Issues 1831E co n o m ic L iberalisation and Fiscal D ecentralisationFISC A L O V ER LAPPING IN INDIAN FED ER ALISM39IntroductionV ertical Fiscal D isharm ony: M ajor IssuesInter-jurisdictional T ax C om petition and A llo cativ eE fficiencyInter-S tate T ax D isharm ony in Indian F ederalismi. N ature and Im portance o f States' T axes in Indiaii. N ature and C onsequences o f S ales T ax C om petitionand T ax E xportationInter-S tate T ax Exportation: A S peculative E stim ateD istortionary E ffects o f other State T axesF iscal D isharm ony: Trends and C om parision w ith o therF ederationsS ub-national T ax System and Im pedim ents to Internal T rad eT axation o f Inter-S tate Trade: M ajor Issues394045H A R M O N ISA TIO N OF TA X SYSTEM S IN INDIA67IntroductionFiscal D isharm ony in Indian Federation:A S um m ary and a S tarting Pointi. V ertical overlap o f com m odity tax systemii. C ascading type com m odity taxesiii. N arrow tax baseiv. M ultiplicity o f tax ratesv. S ales tax incentives - its costs and efficacyvi. Inter-S tate sales taxation its consequences on efficiency and equityvii T ax atio n o f intra-State trade and allocative distortionsW hat is Fiscal H arm onisation?674848515558586365686868696970707172
d.e.f.g.C H A PT E R Va.b.c.d.C H A PT E R VIa.b.c.d.e.f.g.C H A PT E R VIIa.b.c.d.e.R EFE R E N C E ST ax H arm onisation: Som e G eneral PrinciplesV ertical Fiscal H arm onisationH orizontl T ax H arm onisationT ax H arm onisation: T ow ards a V alue A dded T axFISC A L IM BALANCES IN INDIAN FED ER ALISMIn troductionV ertical Fiscal Im balanceH orizontal Fiscal Im balanceE co n o m ic R eform s and Fiscal Im balanceIN T E R G O V E R N M E N TA L TRANSFERS IN INDIA:M A JO R ISSUESIn troductionIntergovernm ental T ransfers: E conom ic R ationaleT h e D esign o f Intergovernm ental T ransfersIntergovernm ental T ransfers in India1. T h e F inance C om m ission T ransfers2. P lan T ran sfers3. A ssistan ce for Central S ector andC entrally Sponsored Schem esC entral T ransfers to States and Inter-State E quityIn stitutional M echanism for Intergovernm entalT ransfersIntergovernm ental T ransfers in India:C o n cluding O bservationsR E STR U C T U R IN G INTER-G O VERN M EN TALFISC A L R ELATIO NS IN INDIA: M A JO R ISSU ESM otivation for the S tudyO bjectives, C onstraints and M easuresT h e Q uestion o f A ssignm entsT ax O verlap p in g and H arm onisationF iscal Im balances and Inter-governm ental T 8139144149157157159161163165170
CHAPTER IINTRODUCTIONa.Analytical SettingThere has been a resurgence of interest on fiscal federalism virtually in every part o f the worldin recent years. The renewal of interest is observed in the constitutionally declared federations as wellas unitary countries spanning across both advanced and developing countries.It extends to thetransitional economies and even the few countries that still have socialistic regime. The demonstratedmerits o f decentralisation has provided enough incentives t diffuse power among sub-Centralgovernmental units. The emergence o f the European Economic Union has clearly demonstrated theadvantages o f having a large common market while preserving the distinct regional identities. Theinternational experience also shows that overcentralisation was one o f the important reasons for thecollapse o f the erstwhile Soviet Union.The directed resource allocation could not build a strongeconomy and the concentration o f power did not entertain regional autonomy or identity.The analytical literature on fiscal federalism, right from the seminal paper by Charles Tiebout(1959) has emphasised the gains from fiscal decentralisation. Like the political concept o f democracy,fiscal federalism is considered to be an optimal institutional arrangement for the provision of publicservices. It combines the advantages o f decentralisation with the benefits from economies o f scale.In addition, inter-jurisdictional competition provides incentive for innovation and increase inproductivity in the provision o f public services.Further, the nation-wide market for factors andproducts helps in the determination of a set of efficient prices and thereby ensures more efficientresource allocation than a balkanised economy.The welfare gains from fiscal federalism accrue due to several reasons. As the decentralisationtheorem demonstrates, fiscal federalism ensures that public services are provided corresponding to thediversified demand conditions in a federation (Oates, 1972). The matching o f preference with thesupply of public services is enabled by the existence o f a large number of jurisdictions with differentmixes o f public services and tax rates. The consumer-voters exercise their preferences either by votingon foot (Tiebout, 1959) or by influencing public policies through a political mechanism. The largerthe number o f jurisdictions, the wider is the consumer choice. Also, the more diverse the demand for
public services in different jurisdictions, the greater are the welfare gains from fiscal decentralisation1.Welfare gains accrue from decentralised provision o f public services not only due to the existence ofa wider choice but also because the welfare costs arising from the ‘bundling’ o f public servicesprovided as a package on a ‘take it or leave it’ basis would be lower.In addition, as alreadymentioned, efficiency gains accrue also from inter-jurisdictional competition and the existence o f anation-wide market for factors and products.Fiscal federalism, however, represents the polar case where federal fiscal arrangements aredecided purely on economic principles. The existence or otherwise o f a federal constitution is not aconsideration, and the principles o f fiscal federalism apply to both unitary and federal countries2.What is relevant is the degree o f decentralisation and not whether a country is unitary or federal.Under fiscal federalism, everything - boundaries, tax and expenditure assignments, intergovernmentaland interjurisdictional interactions and intergovernmental transfer systems is determined purely oneconomic considerations. While such an analysis is clearly removed from reality, it certainly showseconomic solutions to federal fiscal problems in a multi-jurisdictional community and helps us to setbenchmark or ideal economic solutions to the problems o f federal finance.In shaping intergovernmental relationships in actual practice, historical, social, linguistic andpolitical factors have often played a far more important role than the considerations o f economicefficiency (Bird, 1986 p.206).In fact, the influence of non-economic factors on federal fiscalarrangements places a constraint on the efficacy o f pure economic solutions in solving federal fiscalproblems3. Although such a paradigm has obvious limitations, it is still helpful to understand andidentify the sources o f inefficiency and inequity. At the same time, it is necessary to be cautious aboutqualified application of economic solutions to the problems of different federations without consideringthe political and institutional constraints.Tiebout’s paper demonstrated that when the number o f jurisdictions are large, under some restrictive assumptions offootloose mobility and consumer voters deriving only dividend incomes, the mobility solution will lead to an efficientoutcome. Subsequently, a number o f scholars have examined the efficiency properties o f the Tiebout model whenthe assumptions are relaxed. For a detailed review' o f these studies, see Oates (1993). Another set of studies on fiscalfederalism have argued that efficiency gains arise from the ability o f the consumers to influence the policies throughthe political mechanism. It has been demonstrated that in a parliamentary democracy, majority voting will yieldmedian voter equilibrium. See, Mueller (1990) and also Oates (1977).As stated bystructure, butgovernments.many as fourLivingstone (1952 p.52), "The essence, o f federalism lies not in the institutional or constitutionalin the society itself’. Even in unitary systems there is a considerable degree o f hierarchial ordering ofAs noted by Breton (1989, p .l), in many unitary countries including France and Italy, there are aslevels o f elected governments.As stated by Breton (1981, p.253), ".Political scientists, who know better, have in their more generous momentstreated economists as poor souls with a model in need o f application".2
The influence of non-economic factors in shaping federal fiscal relationships necessitates theconsideration o f the practices and experiences of different federations in finding solutions to real worldfederal fiscal problems.Such experiences are useful in identifying the feasible options in anyrestructuring of federal fiscal arrangements.federations can provide a useful guidance.For this reason, comparative analysis o f differentAt the same time, the practices and experiences areparticular to each country - the products o f its own historical evolution and the stage o f politicaldevelopment, and therefore, it may not be possible to replicate them generally. Nevertheless, these,along with the principles of fiscal federalism, provide a useful analytical backdrop or frameworkagainst which the actual federal fiscal arrangements in a country can be analysed.The relationship between governmental units, be it vertical (inter-governmental) or horizontal(inter-jurisdictional) is a complex phenomenon. Although much o f the literature on federal financeemphasises the advantages o f ‘co-operative’ federalism4, it is necessary to note that the relationshipbetween governmental units is essentially competitive.Cooperation, in the extreme could meanconformity to a centralised policy regime and this could imply negation o f the concept o f federalismaltogether.Nor is competition among governmental units necessarily undesirable.Competitiverelationship among governmental units can be welfare improving, if it is harnessed and monitoredproperly. Like in the case o f firms in the market, governmental units compete with one another toprovide bundles o f public services at varying tax rates according to the preferences o f consumer-voters.At the same time, like in the market, it is necessary to satisfy certain pre-conditions to ensure thatcompetition among the jurisdictions leads to welfare gains. Inter alia- ensuring competitive equalityamong governmental units (like the prevalence of a large number of small firms in competitiveequilibrium), and cost-benefit appropriability in each o f the jurisdictions are the two importantnecessary conditions. (Breton, 1987).In this study, we have taken the view that governmental relationships are essentiallycompetitive.The efficient organisation or a federation will depend upon the way the competitiverelationships are harnessed productively. This, however, does not mean that there is no room for inter governmental or inter-jurisdictional cooperation. O f course, fiscal policy can be effective only whenthe policies o f different levels o f government are coordinated. Similarly, satisfactory resolution o f taxand expenditure overlapping and conflicts between different levels of government and jurisdictionswithin each o f the levels can be achieved only when there is a certain degree o f coordinated behaviourFor a review o f the literature on federal finance, see Scott (1964). A useful analysis o f cooperative federalism canbe found in Hicks (1955).3
among these governmental units. Also, the Coasian solution may not always be forthcoming; it maynot always be possible to resolve the problems arising from concurrency and overlapping functionsbetween different jurisdictions, much less different levels o f government through voluntary actionseven when the functions o f the governmental units are clearly specified. Therefore, it is important tohave an implementing agency or a monitor to oversee intergovernmental competition.Thus, competitive federalism, to be successful should have, (i) clearly enforceable propertyrights or the assignment o f functions and sources of finance; (ii) adherence to the set rules by eacho f the governmental units and effective machanisms to foster interactions based on mutual trust andunderstanding; and (iii) an independent and a just mechanism to conduct and monitor inter governmental relationships (Breton, 1987). The mechanism should ensure that no governmental unitis able to exploit, free ride and dominate other units so as to ensure competitive equality and costbenefit appropriability among governmental units.b.Changing Role of the State and Reassessment of Federal Fiscal ArrangementsIn this study, we reexamine federal fiscal arrangements in India in the light o f the economicliberalisation strategy initiated since 1991.The analytical backdrop for the study is given by theprinciples of fiscal federalism, but we also consider the experiences o f other federations in dealingwith issues o f federal fiscal relationships. The principles o f fiscal federalism, as mentioned earlier,help us to understand welfare maximising organisation o f governmental systems.It helps us toidentify the sources o f ineffiency and inequity in the federal fiscal arrangements in Indian federationand to get an idea o f the extent to which the actual deviates from the ideal.The analysis o f federal fiscal arrangements in India assumes particular importance in the wakeo f the economic liberalisation process initiated since 1991. With the reassessment o f the role o f theState, a review o f federal fiscal arrangements has in fact become necessary. Among other factors, theintergovernmental fiscal arrangements in India and institutional framework to conduct and monitorthem have evolved to suit the requirements o f the public sector dominated, heavy industry based,import substituting development planning strategy adopted in the four and a half decades sinceindependence.As the planning agency passes on the allocational role to the market, and as theeconomy is opened up to face international competition, intergovernmental fiscal arrangements andthe institutional framework to conduct them will have to adapt to the new role o f the State. At the4
political level too, as the ruling party at the Centre loses control over the States, it has becomenecessary to place intergovernmental fiscal relations on a clearer and firmer footing5.In India, the adoption o f economic planning strategy to accelerate economic growthnecessitated the concentration o f economic power in the hands o f the Central government. As statedby Chelliah (1991, p.7) ".Comprehensive central planning, involving as it does, centralised decisionmaking in relation to production activities and disposal of resources in the ‘national interest’ . is thenegation o f the principle of true federalism". In the Indian context, even though planning was carriedout in the ‘m ixed’ economy framework, it necessitated a high degree o f centralisation. The emphasison investment in heavy industries particularly in the public sector signalled significant transfer ofhousehold sector savings for public investment; this necessitated centralised control o f financial andbanking sectors.In order to channelise private sector investment according to plan priorities thegovernment had to resort to industrial licensing. To ensure that the market imperfection thus createddid not cause oligopolistic trade practices, a number o f other regulatory instruments had to beintroduced. The scarcity o f foreign exchange on the one hand, and a feeling o f export pessimism onthe other, led to the rationing o f the foreign exchange earnings through measures like the issue ofimport licences and exchange control, and in general, led to greater emphasis on import substitution.These, besides requiring a plethora o f centralised regulation and controls also led to altering the inter sectoral terms o f trade, which in turn had a centralising tendency.6Although many o f theseregulations and controls eventually did not serve the purpose for which they were introduced in thefirst instance, they certainly contributed to the concentration o f economic and political power with theCentral government.There were other economic reasons for centralisation as well. The general scarcity conditionsthat prevailed immediately after independence, particularly the inadequacy o f foodgrains output inrelation to the population, led to centralised food management. The national effort at augmenting theoutput of foodgrains led to Central intervention in an activity which essentially belonged to the domaino f the State governments. Similarly, the feeling that the State governments did not assign priority toThe national government (as opposed to regional governments) has different nomenclatures in different federations.In Canada and U.S.A. it is called ‘federal’; in Australia, it is called Commonwealth government. We have generallyfollowed the Indian nomenclature - ‘Central' government, but on occasions used these terms interchangeably.Similarly, the regional governments are termed as ‘States’, though, sometimes, they are also called ‘provinces’ as inCanada.Altering the terms o f trade in favour o f industry against agriculture to achieve speedy industrialisation, for example,reduced the role o f the State governments, as agriculture falls in their domain.5
certain nationally important activities like family planning and poverty alleviation in their expenditureallocations led to the encroachment o f the Central government in these activities.The economicrationale underlying Central intervention in the agricultural sector is the belief that these investmentshad benefit spillovers spanning more than a State (and hence, national benefits are greater than anindividual State’s benefits), or they required large scaleinvestments beyond theStates’ reach.O fcourse, both the reasons are questionable and even if the argument is valid, centralisation of theactivity is not necessarily the appropriate solution.Economic liberalisation measures introducedsince 1-991, however, have necessitatedrestructuring of intergovernmental fiscal relationships.Assigning greater role to the market indetermining prices and resource allocation and opening up the markets to domestic and foreigncompetition calls for redefining the governmental role. In the new situation, the governmental unitswill have to be reoriented to provide public services to cater to the diversified demand conditionsprevailing in different regions and to regulate and monitor the functioning o f the market. This hasshifted the focus o f governmental role from direct participation in production and distribution activitiesto one of strengthening the regulatory setup and o f protecting the property rights. Assigning greaterrole to the market in economic activity, therefore, has necessitated diffusion o f economic power of theCentral government and has necessitated relatively more active participation o f the sub-Centralgovernments in the regulatory setup.In the liberalised environment, although the governmental role in resource allocation in generalwould be smaller than in the past, the relative role o f the sub-Central governments is likely to increaserather than decline. As the emphasis shifts from direct participation o f th
Fiscal federalism, however, represents the polar case where federal fiscal arrangements are decided purely on economic principles. The existence or otherwise of a federal constitution is not a consideration, and the principles of fiscal federalism apply to both unitary and federal countries2.
Practice of Federalism as a Global Trend (America, Nigeria, Switzerland, and India/Uganda federalism as basis of critical analysis) Historical Antecedents of Federalism (Greek city States and the Leagues) Summary and Conclusion II. THEORY OF FEDERALISM Federalism is more of a political system than an .
This theme is concerned with the practice of fiscal federalism. Fiscal Federalism is concerned with economic decision making in federal system of government in which public sector decisions can be taken at various orders of government. The overriding issue in fiscal federalism is referred to as the assignment problem, that
Federalism 2.1 Explain how state power is constrained by federalism and by the national and state constitutions. n the United States, states and the national government share power un-der a unique structure called federalism. Federalism is a dual system of government. Tw
Fiscal Federalism in Practice There are now a number of empirical studies on the effects of fiscal federalism or decentralism of various kinds on government spending and debt and on economic growth. Indeed, one might be forgiven for believing the debate to be all but settled. The canonical works are Wibbels (2000), Rodden
FISCAL FEDERALISM (“THE CARROT”) Fiscal federalism is the model of spending, taxing, and providing grants in the federal government system. The national government’s primary means of influencing state governments is giving money to states in the form of grants-in-aid (or grants). Since World War II, states have come to rely heavily on federal money.
Fiscal Federalism, Governance and Internally Generated Revenue: Examining Weak Subnational Finances in Nigerian States Chukwuma Agu African Institute for Applied Economics,Enugu, Nigeria Abstract One of the most crucial challenges to Nigeria’s ailing fiscal federalism is the inability of states to raise, retain and manage revenue.
Fiscal federalism has to do with public finance arrangement and the division of governmental functions and financial relations among the tiers of government in a federation. As an approach to governance, fiscal federalism is seen to have guaranteed development and civilization across nations, especially in
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