CHAPTER- IV

Contemporary Practices and Challenges

The chapter attempts to present a comparative perspective on contemporary practices

and challenges in two major federations of comparable nature. In the first case this

chapter attempts to examine the institutions and mechanism and reviews various

reviews the various institutional arrangements for fiscal transfers in India. It makes a

comparative analysis of their approaches and analyses their relative significance in the

scheme of transfers. It identifies certain critical indicators for analysing the

comparative status of the States in economic and social sectors. From there, the

chapter moves on to the analyses of the nature and extent of the vertical and the

horizontal imbalances and interstate disparities. These indicators are the per capita

State income and consumption expenditure, the human development index, the

poverty ratio, infant mortality rate, literacy rate, school enrolment ratio, pupil-teacher

ratio, unemployment rates and the availability of roads and of safe drinking water

facilities. The relative disparity among the States is also compared in terms of the

overall per capita expenditure on non-plan revenue accounts with specific analysis in

respect of the education and health care sectors The chapter reviews (a) the approach

adopted by the Finance Commissions in assessment of the revenue receipts and

expenditure of the Central Government and the State Governments and (b) the

principles for fiscal transfers laid down by the Finance Commission.

In the second comparative case, Canadian system of transfer of resources has also

been examined. The Canadian system of fiscal transfers, which has been developed

over a long period of time, has two central features: equalisation grants, which are

constitutionally guaranteed, and the Canadian Health and Social Service Transfers

(CHST). This chapter examines the relevance and applicability of the Canadian

system of intergovernmental transfers in the Indian case. Equalisation grants are

meant to ensure that provinces have sufficient revenues to provide reasonably

comparable levels of services at reasonably comparable levels of taxation. An

elaborate ‘Representative Tax System’ approach using individual revenue bases is

used in Canada for determining the equalisation grants, although there has recently

been a debate to use a more macro approach. The source by source approach is less

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practical in the Indian context for want of comparable and reliable information

required for applying the method. A more practical alternative is the macro approach,

which is adopted in India, but better indicators of fiscal capacity than those based on

GSDP need to be used. In addition, the concept of ensuring that resources are

available for maintaining the per capita expenditure of select basic services at certain

levels among states, as attempted in Canada through the CHST transfers, is worth

exploring, so explored in this chapter in details.

When we discuss about the contemporary practices and Challenges, necessarily we

have to talk about the transfer of resources and distribution of expenditure functions

and responsibilities between centre and states. Federalism is a unifying force. But at

the same time the constituent units joining the federation also have a dream of better

level of development and better standard of living for their people, which may not be

possible with their own resources. Naturally the flow of fiscal transfers from centre to

states in federal system like India assumes an important role, so far the solidarity and

unity of federation is concerned. There are four main channels of federal transfers

from the centre to the states in India and those are Finance Commission, Planning

Commission, Central Ministries and Financial Institutions. The objective of the

transfer of resources is reducing vertical and horizontal imbalance and the persisting

inter-state disparities in India.

Mechanism and Institutions

The federal fiscal transfer mechanisms imply a design of transfer of resources

between different tiers of government in a particular federation. The objective of the

system of intergovernmental fiscal transfers is to correct vertical imbalances and

horizontal inequalities in the distribution of federal resources. The vertical imbalance

arises due to the asymmetric assignment of functional responsibilities and financial

powers between different levels of governments and horizontal inequalities are the

existing disparities in the revenue capacity across the constituent units of federation,

which mainly arises due to the differences in their levels of income. The extent of

these imbalances is different across federations and so the design of transfers. Under

the Constitution, the Finance Commission is appointed by the President of India every

five years mainly to decide on the distribution of resources, viz., tax sharing and

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grants from the Centre to the States1. This way the Constitution provides for the

appointment of the Finance Commission by the President of India every five years to

make an assessment of the fiscal resources and needs of the centre and individual

States. Based on these, the commission is required to recommend the shares of

personal income tax and union excise duty and grants-in-aid to the States. The scope

of the Finance Commission becomes a major dispenser of funds to the state by way of

both grants, and loans. The Finance Commission’s recommendations, once accepted

by the Parliament become mandatory, so that the transfers of funds affected in

pursuance of these recommendations could be said to have a statutory sanction behind

them2 these statutory transfers are unconditional transfers and the State governments

according to their own expenditure priorities based on local needs use resources thus

transferred through this channel.

However, given the system of transfers so evolved, over the years the transfer of

resources have fallen largely outside the ambit of Finance Commission and it is the

Planning Commission through which larger share of resources are getting transferred

to the States. It is important in this context to remember that Planning Commission is

an executive authority of the Central government rather than a constitutional body like

Finance Commission. The Planning Commission transfers are non-statutory transfers

in the form of plan grants, which has emerged as the single largest component of

grants transferred to the States from the Centre. These non-statutory grants are

decided on a year-to-year basis. At the same time as the States have to negotiate for

these grants year after year, it creates a great deal of uncertainty about whether non-

statutory grants will be available to States and if so in what amount and in what

terms.3 Apart from this, there are non-statutory discretionary transfers made to the

States by various Central government ministries in the form of centrally sponsored

schemes (CSS). By nature, CSS grants are conditional, specific purpose grants with or

without matching requirements.

Vertical and horizontal imbalances are common features of most federations and India

is no exception to this. The Constitution assigned taxes with a nation-wide base to the

Union to make the country one common economic space unhindered by internal

barriers to the extent possible. States being closer to people and more sensitive to the

local needs have been assigned functional responsibilities involving expenditure

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disproportionate to their assigned sources of revenue resulting in vertical imbalances.

Horizontal imbalances across States are on account of factors, which include

historical backgrounds, differential endowment of resources, and capacity to raise

resources. Unlike in most other federations, differences in the developmental levels in

Indian States are very sharp. In an explicit recognition of vertical and horizontal

imbalances, the Indian Constitution embodies the following enabling and mandatory

provisions to address them through the transfer of resources from the Centre to the

States.

(a) Levy of duties by the Centre but collected and retained by the States (Article268)

(b) Taxes and duties levied and collected by the Centre but assigned in whole to

the States (Article 269).

(c) Statutory grants-in-aid of the revenues of States (Article 275)

(d) Grants for any public purpose (Article 282) See table 9

(e) Loans for any public purpose (Article 293) See table 10

(f) Sharing of the proceeds of all Union taxes between the Centre and the States

under Article 270. (Effective from April 1, 1996, following the eightieth 

amendment to the Constitution replacing the earlier provisions relating to

mandatory sharing of income tax under Article 270 and permissive sharing of

Union   excise duties under Article 272). See table 11

The Eleventh Finance Commission 2000 (EFC)4 noted that during the course of the

last three decades, the central sector plan schemes / CSS have become an important

vehicle for transfer of resources to the States, outside the State plans, and over and

above the transfers following through the mechanism of Finance Commission. These

were started primarily to provide funding for projects in areas / subjects considered to

be of national importance and priority by the Central government. The details of the

schemes are drawn up by the Centre and their implementation and funds for

implementation are allocated to the State governments directly through District Rural

Development Agencies or similar created organisation. There is little freedom left to

the State governments to modify the schemes to local governments or to divert funds

to other areas, which are considered of local priority. On the other hand the State

budgets are burdened with additional revenue expenditure when the schemes are

completed and their maintenance expenditure is pushed under the non-plan category.

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The EFC recommended that CSS need to be transferred to the States along with

funds. Plans for transfer of CSS was contemplated and recommended by earlier

Finance Commissions also to improve the flexibility of the State governments in

deciding its own expenditure priorities and improve its financial position.

Apart from tax sharing and grants, another important instrument of resource transfer

is loans and advances from the Central government. It is to be noted that the share of

loan transfers to states as percentage of total resource transfer is declining over the

years. However, if one looks at the structure of States outstanding debt, it becomes

evident that the central loan is the single largest component of the stock of

outstanding debt of the State governments. The system of federal transfer as discussed

indicates the element of uncertainty and arbitrariness that non-statutory grants may

create in the federal transfers which may adversely affect the goal of fiscal

equalization.

Transfer of Resources

William Riker quoted in 2001, 'Federalism is the outcome of a constitutional bargain

among politicians'. Fiscal relations in our country have evolved over time. These

changes have taken place within the ambit of the provisions of the Constitution.

Transfer of resources from Centre to federal units is a common phenomenon in all

large countries having a federal constitution. This is so because there is always a

mismatch between the responsibilities of the federating units and their ability to raise

adequate resources. Certain resources are best raised only at the national level, both

on grounds of equity and efficiency. This necessitates transfer of resources from the

Centre to the states in order to correct what is very often described as vertical

imbalance. Apart from this, the overall resources to be transferred to the states have to

be distributed among them and the criteria for horizontal distribution are equally

important.

Almost in the case of all the federations, centre enjoys larger revenue raising powers

than the state governments, while the expenditure responsibilities remain largely with

the latter. This gives rise to fiscal imbalance. There are, however, exceptions to this

and in some of the advanced economies, the assignment of revenue powers and

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expenditure responsibilities are fairly evenly matched for both, the federal and the

regional governments. When some imbalances do exist between the net revenue

position of the Centre and the States taken together, as is the case with many

federations including India, the situation is commonly called as one of vertical fiscal

imbalance (VFI). In the situations of VFI, the central government is required to share

its revenues with the sub-national governments. However, fiscal transfers are meant to

go beyond mere revenue balancing and are expected to obtain optimum output from

the operation of the fiscal system, ensure equitable provision of merit goods and

promote national unity.

The prescription for intergovernmental fiscal transfers is not limited to vertical

imbalances alone. In federal models of governance, fiscal imbalances could also occur

horizontally, across the peer level of sub national units. The horizontal fiscal

imbalance (HFI) happens particularly when the units despite having varying

capacities to raise revenues, do not limit their expenditure needs to their revenue

receipts. In other words, even the poorer States would try to match the expenditure

patterns of the more affluent ones.5 To an extent this situation occurs on account of

legal factors, like the judicial dictum of equal pay for equal work, which forces even

poorer States to pay salaries to their staff on the same scale as the richer States. In

other cases, political expediency too contributes to the adverse fiscal balances among

the States inter se. For instance, State governments go in for supply of free power or

water to farmers, or waive off arrears of taxes, notify wage revision for staff etc.,

without due consideration of the impact of such measures on their respective fiscal

balance. Fiscal transfers are, in such situations, expected to guard against inefficiency

and populism while attempting to bring about horizontal equity by redistribution of

federal resources among the States for mitigating inter-States disparities. See table 12.

This is particularly important as the poorer States could prefer remaining poor and yet

indulge in fiscal populism if their poverty continues to get rewarded by way of higher

share in the fiscal transfers.

Fiscal transfers take place either through sharing of taxes and duties or through grants,

or a combination of both. The relative merits of fiscal transfers by way of tax

devolution and by way of grants have also been a matter of considerable discussion.

The argument in favour of keeping the transfers largely in the nature of grants than

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tax sharing is two-fold. One is that the arrangement of tax sharing does not meet the

equity criterion adequately even though it could be designed to achieve this goal to a

limited extent. The other logic against tax sharing, particularly if it entails transfer of a

significant share of the tax proceeds, is that it de motivates the Central government in

improving the tax receipts and thus leads to sub-optimal operation of the taxation

authority of the government. Grants, on the other hand, suffer from the stigma, and

possible weakness, of being subjective to the wishes of the centre. It will pose centre

as donor. Further, grants are more prone to coming with strings attached by the centre.

In a federation, such factors have the potential of leading to emotional discord in the

society, to the detriment of peace and fraternity in the federation. Grants are also

likely to lull the States into inaction on the presumption that the poverty of a State

would be fully compensated by way of federal grants. To meet such objection, grants

are often made conditional upon the Accepter State showing specified levels of

improvement or by way of generating matching contributions.

Expenditure Functions

A strong traditional view has been that fiscal decentralisation in respect of public

expenditure functions can entail substantial gains in terms of efficiency and welfare.6

One of the major arguments advanced in favour of such decentralisation is that the

preferences and the needs of citizens for public sector activities are better known to

the local government functionaries than to those who represent the central or the state

governments. The reason given is that contiguity provides more information while

distance reduces the amount of information necessary to make good decisions.

Further, people are closer to the state/local governments and can thus better control

the activities of politicians and bureaucrats7

The conventional wisdom in the theory of public goods and public choice is that both

the redistribution and stabilisation functions would be performed more effectively and

efficiently by the central government as compared to the local governments because

of the divergence between national benefits and local benefits, divergence between

national costs and local costs and free-rider problems 8These arguments are assumed

to be strong enough to neutralize the advantages that economies of scale in the

production of public goods and public services and in the generation of tax revenue

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may give to the arrangements that keep more power in the hands of central

government. Critiques of this argument state that if accepted, it would imply that

small countries should be more successful than large countries in satisfying the social

needs of their populations. Thus, if the arguments for decentralisation were valid,

there would be strong reasons for breaking up countries and weaker reasons for fiscal

decentralisation9 . However, studies have indeed shown that smaller federations do

meet this test reasonably well, at least in some cases such as Switzerland.10.

In respect of public goods11, the conventional wisdom proposes that the central

government should provide national public goods whose spatial incidence of benefits

covers the entire country e.g. defence, foreign affairs, currency, infrastructure for

telecommunication and inter-regional transport etc. See table below for details. In this

table four types of functions are described as Regulatory functions, Developmental

and Welfare Functions, Commercial Functions, Financial Functions in respect of the

Union, States and concurrent matters.

Similarly, a state/ regional/ local government should provide local public goods

whose spatial incidence of benefits is limited to the state /region/ local area and

conform to a unique preference pattern, such as primary education, rural roads,

community centres, basic health care etc. Another criterion for assignment of an

expenditure function to a regional or a local level of government is the issue of

managerial convenience, one example being the primary education. In a large country,

the regional diversities in terms of language, customs and traditions would require

primary education to be assigned to sub-regional or local levels, while the broad

contours of course curriculum, textbook contents and teacher’s training arrangements

are organized at the regional or State levels with a view to maintaining standards of

quality and practices. It is possible to find some logic for assigning such functions to

the national government, such as quality, but in the overall analysis, such benefits

would not prove adequate to favour centralisation.

On the same line, the provision of public health care, the intricate inter-village road

network, housing, maintenance of law and order and a host of other services would

preferably fall in the ambit of the sub-national governments for efficient management

and effective delivery. Intervention of national government in such sectors of

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expenditure has been accepted by some analysts in cases where when the provision of

a local public goods enjoys substantial economies of scale and/or when the provision

and consumption of a local public good produces substantial externalities, the cause

of efficiency may be promoted if such goods is provided by central government rather

than by local (or regional) government12

It is possible to visualise that some States may be too poor to mobilise adequate

resources for bringing about a quick progress in the levels of attainment in the sector,

calling for financial support from the national government. Similarly, certain poorer

States may have large geographical areas with scattered population like the hilly or

the desert regions, wherein extension of public goods and services such as roads,

electricity, schooling and medical care may be too costly in terms of economies of

scale. It would be unfair to ignore the needs of such regions on the grounds of

financial non-viability. In fact, continued neglect of backward and remote regions not

only leads to social and economic imbalances, but could even make such regions the

breeding ground for social evils and crime, as the experience in various regions of

India, Pakistan, Sri Lanka and many other countries has shown. Yet, despite federal

supports, such services remain the primary responsibility of the sub-national

governments. Centralised expenditure management is often believed to be helpful in

mitigating regional disparities, particularly when the ability of the regional

governments to provide public goods and services to their residents vary widely

leading to uneven growth of, say, levels of educational attainments, public health etc.

However, while the central government could provide funding for such sectors, it

would normally find it impractical and costly to handle the management of the same.

Another argument against fiscal centralisation is that it gives rise to a series of ills in

public finance and administration, such as inefficiency, lack of transparency and

development of special interest groups who thrive on the federal funding, all of which

is detrimental to the public interest. These arguments assume that fiscal

decentralisation would, as opposed to centralisation, lead to reducing the influence of

special interests on political decisions, increasing the accountability of government at

all levels, and motivating a more rational assignment of responsibility for government

functions between the federal, state, and local levels of government.

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Revenue Collections

As far as revenue collection is concerned, the generally discussed theories are of three

hues, recommending, respectively, a centralised pattern assigning the dominant role to

the national government, a decentralised pattern advocating preponderance of the sub-

national governments and a middle approach. The centralised collection of revenues is

expected to promote efficiency in the government’s revenue functions resulting from

substantial economies of scale in tax administration, promoting uniform taxation

across the country and better access to information on the issues relating to tax

planning and administration. It believes that the regional and local governments tend

to get focused more on regulations than on the outcome.

In India, land taxes, popularly called the land revenue, offer an interesting example of

a sub national tax of this kind and fate. Land revenue is a direct tax that concerns the

largest share of the population. Similar is the case of the agricultural income tax and

of the non-agricultural property taxation such as the house tax that is assigned to the

local governments. It appears reasonable to assume that the factor of proximity to the

taxpayers leads to dilution of revenue mobilisation. Extension of this argument leads

to the proposition that sub-national governments get carried away by local

considerations that could seriously impede significant revenue mobilisation. It is also

argued that decentralisation leads to tax competition among the States, which is

eventually a zero-sum game, besides causing a de facto fragmentation of the national

market. Centralisation would avoid such situations. Another argument is that

decentralisation impedes redistribution, as people with higher income tend to avoid

taxes and move to other jurisdictions having lower taxation.13 Further, the tax

personnel of the local governments are likely to be less motivated than their federal

counterparts on account of the lower salaries, fewer prospects for advancement, far

too many regulations to handle, inadequate professional training and greater

proximity to the taxpaying citizens. Federal governments are expected to be more

methodical and modern in tax administration, including collection, analysis and

sharing of information relating to taxation as also in manning of the bureaucracy of

tax personnel.

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In countries having regional disparities in terms of income levels and availability of

economic resources, a fiscally strong Centre can do a better job of income

redistribution. It has also been argued that local governments, if given freedom to

raise debt from the market, may incur large debts and also go in for soft budgets while

they believe that the national government would eventually bail them out. On the

other hand, if budget constraints are hard and states cannot rely on a bail out from the

federal government, they would be forced to manage their budget more carefully.

Such hard budget constraints could also have other positive effects: the federal

subunits will have to be more careful when they grant subsidies to attract firms and

individuals. In general, the concept of market-preserving federalism seems to neglect

the role of a central authority as guardian of competition enforcing general rules and

having the power to establish hard budget constraints for the lower jurisdictions.

It is argued that the sub-national governments get carried away by local

considerations that could seriously impede any nation-wide economic reforms. This

statement is supported by the experience in regard to Value Added Taxation (VAT) in

India. The attempts to replace the State sales taxes with VAT had been getting

thwarted for almost ten years (1993-2003) largely owing to the traders’ lobbying

against it for inadequate economic or fiscal reasons, but for their proximity to the

State Government functionaries. Fiscal decentralisation is often advocated for

ethnically and geographically divided societies. Sceptics fear that this would lead to

increasing claims for more autonomy endangering the unity of the federal state. Apart

from that the division into lower jurisdictions is expected to produce new minority

problems. Thus, fiscal decentralisation is said to be not only inefficient but also even

dangerous.14

As for the arguments in favour of decentralised revenue collection, it is generally

believed to promote efficiency in the fiscal administration, accountability and

responsibility as well as real fiscal autonomy of lower tiers of governance 15 The more

ardent champions of fiscal decentralisation do not remain satisfied with the

arrangement where the central government is empowered to collect lion’s share of

taxes and then share the receipts with the States. Some of them would prescribe large-

scale decentralisation of the power to tax and linking it with reverse fiscal transfers16

(Lee, 1994)

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Another view is media approach. It recognizes the benefits of centralisation in terms

of factors such as economies of scale, better attainment of the stabilisation goals etc.,

but suggests that in order to yield optimal benefits, revenue collection should not be

excessively centralised. It recommends that revenue collection powers should be

shared between the different tiers of government in a manner that ensures that such

powers are closely aligned with expenditure functions.17 It has also been suggested

that privatisation would be a more effective alternative to transfer of functions from

the central government to the sub national governments in respect of several services

such as collecting garbage, providing electricity, transportation, water, health services,

education and even jails or cemeteries, which would include collection of the related

revenues such as the user charges or toll taxes. Some proponents of this theory have

gone to extent of recommending that in many instances, if an activity can be

decentralised, it can also be privatised (Tanzi, 2000). A comprehensive evaluation of

fiscal federalism should, in its extended version, take into account the status and

scope of privatisation issues as well, though this would remain outside the purview of

the present study.

In Canada, the ‘equalization’ payments have been mandated in the constitution since

1982, which commits the federal government to the “principle of making equalization

payments to ensure that provincial governments have sufficient revenues to provide

reasonably comparable levels of public services at reasonably comparable levels of

taxation”. The equalization transfer to a province in absolute amount is determined by

applying the average revenue effort to the difference between standard base and the

actual base for that province with respect to the various revenue sources. This

produces an estimate of revenue, which is higher than the actual revenue for provinces

that have ‘below-average’ capacity. In the Canadian system, there is no reference to

cost differentials and the states are free to use their equalized capacities in providing

any mix of public goods and merit goods. The equalization grants are supplemented

by health and social sector transfers that are equally important in volume and are also

of an equalizing nature.

The Australian system of equalization transfers18 goes into the question of cost

differentials relevant for comparison with some notion of equal efficiency in the

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provision of goods and services by the provincial authorities. The guiding principle of

horizontal transfers system is fiscal equalization, which is defined by the

Commonwealth Grants Commission (CGC-2004) as follows: “State governments

should receive funding from the pool of goods and services tax revenue and health

care grants such that, if each made the same effort to raise revenue from its own

sources and operated at the same level of efficiency, each would have the capacity to

provide services at the same standard”. The Australian equalization differs from the

Canadian equalization due to the reference to efficiency and standard of services. The

Canadian system makes reference only to equalization in fiscal capacity. In Australia,

fiscal equalization looks at both the revenue and expenditure sides.

The ground conditions in India are different from Canada or Australia in two critical

respects. First, the extent of difference in the resource bases is far larger than in

Australia or Canada. The second difference is that the population that resides in the

main ‘donor’ states as compared to main recipient states is much larger in Canada and

Australia. In India, it is the other way round. As a result, the amount of redistribution

implicit in the equalizing scheme is far larger when the recipients are more than

donors, making it extremely difficult to achieve full equalization. Thirdly, there are

large inter-state differences in cost conditions in India due to differences in density

and composition of population, nature of terrain etc. In India, the horizontal

imbalance is resolved through a combination of tax devolution and revenue-gap

grants. In Canada, this is done by grants. In Australia, this is done by sharing the

revenue under the Goods and Services Tax (GST) topped up by the Health Care

Grants. The Australian system has switched from grants to revenue sharing and back

from time to time. Some economists consider grants as the right means of transfers.

States themselves overwhelmingly prefer revenue sharing. The transfer system in

India has evolved in a manner that relies on both modes of transfers. Finding a

suitable combination is the relevant problem.

The rationale for specific purpose transfer is rooted in offsetting spill over. In the

absence of perfect measuring of the public services by sub-central governments, may

spill over the jurisdictions. To be cost-effective, specific purpose transfer made to the

States to ensure optimal provision of public service require matching contributions

from them, matching ratios should vary with the size of spill over. Subsidy is

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required to ‘set the price right’. Often , the general-purpose transfers fail to achieve

full equalization, and in such cases the response to a uniform matching rate would

be non-uniform in rich and poor localities and this may require varying matches

rates among the sub-central units19

The rationale for transfers with the strongest basis in the economic literature is that

local services may spill over to other jurisdictions. Although matching (or

conditional) transfers make local governments more susceptible to central influence

and control, they also have the important political advantage of introducing an

element of local involvement, commitment, accountability, and responsibility for the

aided activities. Such grants may be particularly important with respect to capital

investment projects. If a central government wishes to use its scarce budgetary

resources to attain given standards of expenditure on certain services provided by

local governments, it should pay only as much of the cost as is needed to induce each

local government to provide that level of service.

Another rationale for matching grants is to equalize differences in need or in

preferences. For example, the central government may wish to increase spending on

health. One way to do so is (as was done in Canada) to match local health care

expenditures, essentially on the grounds that those who choose to spend more on

health, are, by definition, more deserving of assistance.

In principle, the correct matching rate, or the proportion of the total cost paid by the

central government, should be determined by the size of the spill over (or,

alternatively, the strength of the preferences of the central government for the aided

activity). The rationale is to ensure that all local governments, regardless of their

fiscal capacity, provide a similar level of certain specified public services to their

residents. The basic idea is simply to set the price of the service to each local

government in such a way as to neutralize differences in capacity by varying the

matching rate. Such equalization differs from the general equalization argument

discussed earlier in three ways. First, specific services are designated -- either because

they are thought to entail spill over or because they are considered especially

meritorious. Education and health have been singled out in this way in a number of

countries. Second, the specific level of service to be provided is also established by

the donor government. Third, the payment of the grant is conditioned on that level of

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the specified services in fact being provided. With respect to India, “The vast numbers

of such schemes, their high administrative overhead costs, and rigid eligibility criteria,

have undermined effectiveness and distorted state priorities.” (Of course, the aim of

such transfers is precisely to “distort” state priorities!)20

Finance Commission

Need for some machinery for periodical adjustments and reallocations in resources by

way of transfers in the light of changing conditions was felt and the Indian

Constitution has designed the Finance Commission precisely to serve this purpose.

The Indian Constitution is unique in that way as no other federal constitution in the

world has provision for any such permanent machinery to serve such a purpose. The

Finance Commission constituted by the President of India pursuant to clause (1) of

article 280 of the Constitution is composed of four members, headed by the Chairman

The finance Commission is a constitutional body, set up every five years to make

recommendations relating to the distribution of the net proceeds of taxes between the

Union and the States, the principles which should govern the grants-in-aid of the

revenues of the States out of the Consolidated Fund of India and the measures needed

to augment the Consolidated Fund of a State to supplement the resources of the

Panchayats and the Municipalities. In addition, any other matter may be referred to

the Commission by the President in the interests of sound finance. While the planning

Commission gives a large proportion of financial assistance to States, the scope of the

Finance Commission has been restricted to meet non-plan current expenditure

requirements of the States. The approach of the Finance Commission to determine

transfers consists of

(a) Assessing the overall budgetary requirements of the Centre and States to

determine the volume of resources that can be transferred during the period of

their recommendation

(b) Forecasting States own current revenues and non-plan current expenditure

(c) Determining the States’ share in Central tax revenues and distributing them

between the States based on a formula

(d) Filling the post- devolution projected gaps between non-plan current expenditures

and revenues with the grants in aid. This is known as the “gap-filling” approach.

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Functions of the Finance Commission

While the Finance Commissions look after the current account needs of the States, the

Planning Commission is primarily concerned with the developmental needs of the

states, which comprise both current and capital account needs. In the context of fiscal

federalism, two important issues need to be addressed – the issue of regional

disparity, and macroeconomic stability with high quality growth.21

Article 280 of the Indian Constitution relates to the appointment, functioning and

duties of the Finance Commission. Article 280(3) states as follows: “It shall be the

duty of the Commission to make recommendations to the President as to

(a) 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 this Chapter and the

allocation between the States of the respective shares of such proceeds;

(b) Determination of principles and quantum of grants-in-aid to States which are in

need of such assistance.

(c) The measures needed to augment the consolidated fund of a State to supplement

the resources of Panchayats (rural local governments) in the State on the basis of

recommendation made by the State Finance Commission.

(d) The last function was added following the 73rd and 74th amendments to the

Constitution in 1992 conferring statutory status to the Panchayats and

Municipalities.

The imbalance between revenue sources and expenditure responsibilities between the

Centre and the States was part of the Constitutional design. While dividing the

taxation powers between the Union and the States, most major taxes were assigned to

the Centre. On the other hand, major expenditure responsibilities were assigned to the

States. To correct this imbalance, the Constitution provided for statutory fiscal

transfers from the Centre to the States through the instrumentality of the Finance

Commission.22

These Constitutionally mandated functions are the same for all the Finance

Commissions and mentioned as such in the Terms of Reference (TOR) of different

Finance Commissions. To enable the Finance Commission to discharge its

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responsibilities in an effective manner, the Constitution vests the Finance

Commission with power to determine its procedures. Under the Constitution, the

President shall cause every recommendation made by the Finance Commission

together with an explanatory memorandum as to the action taken thereon to be laid

before each House of Parliament. So far, twelve Finance Commissions have given

their reports. The Thirteenth Finance Commission has come with its report in

October, 2009. The Union government has always been accepting the

recommendations of the Finance Commissions, exception being the recommendations

of the Third Commission relating to Plan grants. There have been major changes in

the public finances of the Union and the States during the period of over 60 years

covered by the Finance Commissions. A number of new matters have been referred to

the Commissions in consonance with these developments. There are four categories of

recommendations made by the finance commission:

(a) Those to be implemented by an Order of the President (under Art.270 and Art.

275 of the Constitution)

(b) Those to be implemented by law of Parliament (under Art. 272)

(c) Those to be implemented by executive orders (grants for relief expenditure, up

gradation, debt relief and grant in lieu of tax on railway passenger fares.

(d) Those to be examined further.

Vertical Distribution by the Finance Commission

Initially, the Constitution provided for the sharing of only two Central taxes with

States. Article 270 permitted mandatory sharing of the net proceeds of income tax

levied and collected by the Union with the States. Such proceeds assigned to States

did not form part of the Consolidated Fund of India. Article 272 provided for sharing

of Union excise duties, if Parliament by law so provided. The shares of the States in

Union excise duties were to be paid from the Consolidated Fund of India. This

position continued till the 80th amendment of the Constitution in 2000 which

provided for sharing of the proceeds of all Union taxes and duties with the States,

except the Central sales tax, consignment taxes, surcharges on Central taxes and

earmarked cesses. This was done taking into account the recommendation of the

Tenth Finance Commission to enable the States to derive the advantage of sharing the

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buoyancy of all Central taxes, to ensure greater certainty in the resource flows to the

States and to facilitate increased flexibility in tax reforms.

As per the then Constitutional provisions, tax sharing recommended by the first ten

Finance Commissions was restricted to the proceeds of income tax and Union excise

duties. The share of States in the proceeds of income tax as recommended by the

Finance Commission witnessed a significant jump from 55 per cent (the First

Commission) to 85 per cent (the Ninth Commission). For the first time, the Tenth

Commission lowered the shares of States to 77.5 per cent on the ground that the

authority that levied and administered the tax should have a significant and tangible

interest in its yield. The higher share of States in income tax recommended by the

Commissions was partly due to historical reasons and partly on account of the

Constitution providing for compulsory sharing of income tax proceeds with States.

As far as the distribution of the proceeds of Union excise duties was concerned,

initially the share of States was restricted to certain specified commodities. From the

Fourth Commission onwards, States were being given a share in the proceeds of the

tax on all the commodities. The shares of States in the Union excise duties as

recommended by the First, Second and Third Finance Commissions were 40 per cent

of the proceeds of the tax on three commodities, 25 per cent of the proceeds of the tax

on eight commodities and 20 per cent of the proceeds of the tax on 35 commodities,

respectively. During the periods covered by the Fourth to Sixth Commissions, the

shares of States remained static at 20 per cent of the net proceeds of the tax on all

commodities.  The Seventh Commission made a major departure by recommending

an increase in the share of the States from 20 per cent to 40 per cent. That

Commission felt that the Union excise duties should have a predominant role in the

transfer of financial resources to States, considering the size of the proceeds. Another

factor that prompted the Commission to increase the share of the States was to effect

bulk of the transfers through tax devolution, reducing the grants to a residual on the

one hand and to leaving surpluses on revenue accounts with as large a number of

States as possible on the other hand.

The system of recommending shares of States in the proceeds of income tax and

Union excise duties gave way to recommending shares of States in the total net

proceeds of all taxes, heralding a new phase in tax devolution to States. This was

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facilitated by the eightieth amendment of the Constitution in 2000, which was done on

the recommendation of the Tenth Finance Commission. The Eleventh Finance

Commission was the first Commission to make recommendations on tax shares under

the new dispensation. The Eleventh Finance Commission recommended that the

States’ share in Central taxes be fixed at 29 per cent. Of this, 2 percent share was on

account of additional excise duties levied by the Centre on manmade textiles, tobacco

and sugar in lieu of sales tax by States under a tax rental agreement between the

Centre and the States. The Twelfth Commission increased the shares of the States to

30.5 per cent.

The Eleventh Finance Commission, for the first time, introduced the concept of

overall ceiling on total Central transfers to States from all channels on the revenue

account. The indicative ceiling recommended by the Commission was 37.5 per cent of

the gross revenue receipts of the Centre. This was raised to 38 per cent by the Twelfth

Finance Commission. This indicative ceiling was based on the then prevailing level of

transfers on the revenue account. The recommendation of the indicative ceiling seems

to have been prompted by considerations relating to macro-economic and fiscal

stability. This has prompted States to demand that the total revenue account transfers

might be fixed at 50 per cent of the gross revenue receipts of the Centre on the ground

that this was the level reached in the year 1999-2000.

Broadly, the needs of the States guided the recommendations of the first three

Commissions on vertical distribution of resources. The Fourth Commission, for the

first time, took the view that in determining the overall share of States, due regard was

to be given to the requirements of States on the one hand and the needs of the Union

on the other. This was partly because of the reason that no reference was made to the

resources of the Centre and the demands thereon in the Terms of References of the

first four Commissions. Appreciation of the need for applying more or less uniform

norms for assessing the resources and requirements of the Centre and the States and

their adoption started taking shape from the Sixth Commission onwards.

The shares of States in tax devolution had gone up from about 10 per cent of the total

tax receipts of the Centre in the 1950s to 30.5 per cent during the period of 2005-10

covered by the recommendations of the Twelfth Finance Commission. This was

mainly facilitated by the higher buoyancy of Central taxes as compared with the State

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taxes, reforms and broad basing of Central taxes and the levy of taxes on services by

the Centre from the year 1994. The tax devolution recommended by the successive

Finance Commissions was without much controversy. The States, however, have been

demanding the fixation of their share in Central taxes at a higher level.

Restrictions on the Scope of the Finance Commission

Planning Commission gaining predominance in allocation decisions, restrictions were

sought to be placed on the Finance Commission role through the presidential order

detailing the terms of reference. The Finance Commission role was restricted to the

examination of the non-plan current account of the states, particularly since the third

Finance Commission.

Restricting the scope of the Finance Commission to non-plan requirements has led to

several problems. First this has prevented the Commission from undertaking a

comprehensive overview of the finances of state governments. Second the plan and

non-plan sides of the budget are interdependent and this compartmentalization cannot

adequately take account of the requirements of the state. The maintenance

expenditures on completed plan projects are considered non plan and so are the

interest payments on the borrowings made of finance the plans. Sometimes some

important developmental projects are even undertaken outside the plan particularly if

such project involves interstate disputes. Although the terms of reference of the ninth

Finance Commission did not impose restriction on the scope the Commission could

not completely break the shackles imposed by history the convention developed over

the year of assessing the non plan side separately from the plan side was continued.

However, the Constitution does not place any such limitation on the scope of the

Commission. In fact the chairman of the fourth Finance Commission went so far as to

state. As the language of Article 275 stands there is nothing to exclude from its

purview grants for meeting revenue expenditures on plan schemes nor is there any

explicit bar against grants for capital purposes. Yet the Commission did not do so as it

would blur the entire division of functions between the Finance Commission and the

Planning Commission and therefore took upon a role much narrower than the

constitutionally assigned one. In this sense the hesitancy on the part of the

Commission is as much to blame as the terms of reference given to them.

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The Twelfth Finance Commission (TFC) submitted its Report [1] at the end of 2004

in the backdrop of a severe fiscal stress affecting government finances, particularly

states finances in India. The Report contained, apart from the recommendations

concerning the core tasks of the Finance Commission regarding tax devolution and

grants, a detailed roadmap for the restructuring of India’s public finances including an

incentive linked debt-relief scheme for the states. In spite of these achievements, the

fiscal transfers system in India requires further reforms concerning both its vertical

and horizontal dimensions. These concerns primarily revolve around the following

main questions:

Stability in Vertical Transfers: Vertical transfers should be stabilized around an

appropriate level. These should not be continuously changed in favour of one side or

the other. The question assumes importance also because of likely impact of the

proposed goods and services tax (GST) on vertical imbalance in India.

Composition of Transfers: The composition of transfers should be changed towards

grants as compared to tax devolution and within grants, larger emphasis should be on

grants on statutory basis as recommended by the Finance Commission (FC) rather

than grants at the discretion of the centre.

Gap-Filling Approach to Determine Transfers: In the case of horizontal transfers,

the long-term criticism of the Indian approach has been the so-called gap-filling

approach in the assessment of needs and resources by the Finance Commission

because of the implicit adverse incentives.

Measurement of Fiscal Capacity: In applying the equalization principle,

measurement of fiscal capacity of states is a key requirement. The measurement of

state level fiscal capacity in India is proxies by estimates of the gross state domestic

product (GSDP) at factor cost. This provides an incomplete indicator of fiscal

capacity although the Central Statistical Organization prepares comparable estimates

of GSDP. We need a more comprehensive indicator of fiscal capacity.

Determination of Relative Weights of Sharing Criteria: The revenue sharing

criteria used by the Finance Commission account by far the largest share of transfers.

However, the relative weights assigned to different criteria remains by and large ad

hoc. There is a need to develop a more objective framework for determining suitable

weights for the alternative revenue sharing criteria.

Bail-outs and Controls on Borrowing: In a system where states have been

borrowing heavily from the centre, there is a built-in expectation that centre will

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provide a bailout from time to time. This leads to strong adverse incentives for the

states to finance current expenditures through borrowing from the centre and other

sources and expect that either a gap-filling grant or a debt-service write off will bail

them out in future.

Growing Centralization of Expenditure on State Subjects: This is an issue

concerning the relative ambits of assignments of the two tiers of governments. There

is a clearly noticeable trend of central government getting involved in progressively

spending more and more on subjects that are clearly under the Concurrent or the State

List in the constitution, sometimes through the state governments and sometimes

bypassing them.

Thirteenth Finance Commission has submitted its report on 25 Feb 2010, for the

period from 01 April 2010 to 31 March 2015. The most important recommendation is

the creation of a new State Finances Division in the Ministry of Finance, which will

have the analytical capabilities to provide policy advice on matters pertaining to inter-

governmental fiscal arrangements and financial relations. “This division will serve

as a national think tank on inter-governmental fiscal matters, a service which, at

this point, is only provided by the Reserve Bank of India. It will also be pro-active in

monitoring the progress of state level fiscal reforms and implementation of

forward looking recommendations of the Finance Commission in letter as well as in

spirit. Another recommendation is the setting up of an ongoing research

program(independently managed by reputed national institutions) on issues of inter-

governmental fiscal federalism in India that could provide inputs to the Ministry of

Finance and also serve as a research resource for the work of future Finance

Commissions.”23

The economic scenario has changed, in the last few decades, with liberalization of

Governmental regulations and assignment of an increasingly larger role for the private

sector in not only production of goods but also provision of services which were

hitherto mainly in the domain of governments, local authorities and public sector

enterprises. The plan formulation and time phasing of investments have to be adjusted

to the changed scenery. “It is a matter of great potential concern that increases in

disparities in growth should not lead to demonstrable differences in access to

opportunities and public goods. This is not an issue which can be tackled using the

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limited instruments of inter-governmental public finance available to the Finance

Commission. It is a wider policy issue on which we feel the institutions charged with

designing the overall development policy framework of the country, particularly the

Planning Commission, should reflect on and address.”24

Apart from the terms of reference specially laid down in the constitution, the

Thirteenth Finance Commission reviewed the state of finances of the Union and the

State keeping in view the operation of the states’ Debt Consolidation and Relief

Facility 2005-2010 (DCRF) and suggested measures for maintaining a stable and

sustainable fiscal environment consistent with equitable growth. The Thirteenth

Finance Commission also reviewed 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.Other recommendation relates to assessment of the resources of the centre and

the states for the five year period, Taxation efforts and the potential of additional

revenue mobilization, demands on the resources of the Central Government, the

requirement of the states to meet the non-salary component of maintenance

expenditure on capital assets and plan schemes, the objective of not only balancing

receipts and expenditure but also generating surpluses, and the need to ensure

commercial viability of irrigation and power projects, departmental undertakings and

public sector enterprises through various means including levy of user charges and

adoption of measures to promote efficiency.

Planning Commission as the apex body for approval of the Five Year and the Annual

Plans of the States is another major source of flow of resources from the Centre to the

States in addition to the statutory tax-devolution and grants-in-aid recommended by

the Finance Commission. Plan grants and loans to the States for financing their

development programmes under the Five Year Plan and Annual Plans were initially

project based, but later according to an agreed formula known as the Gadgil

Formula25. Planning commission allocates resources to states by two methods

(a) Formulae based plan assistance

(b) discretionary plan assistance

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The first one known originally as Gadgil formulae, and modified26 subsequently

provides a mechanism for horizontal transfer only and not vertical. Allocation of

resources is guided by the category of states, special category states and non special

category states. The states in the second category receive 30 percent of the plan

assistance as grant and 70 percent as loan. Whereas the states in the first category

received 90 percent as grant and only 10 percent as loan. There is a need for re-

examination of the discretionary plan assistance to suit the requirement of the poorer

states.

Centrally Sponsored Schemes

There are also large numbers of development programmes known as Centrally

Sponsored Schemes (CSS), which are initiated by the Centre and implemented by the

States in various sectors. These schemes are largely financed through assistance from

Centre with some share from the States, which may vary from scheme to scheme.

These cover a variety of development oriented schemes ranging from poverty

alleviation, family planning and employment generating programmes in the rural

areas to a large number of small schemes in sector like agriculture, education and

health – subject which fall squarely within the State’s purview. Many of these

schemes have a large staffing component and the posts in a number of cases continued

across several plan period, the cost either being met fully or partly by the Centre.

Other sources of resource transfer

There are several other sources of resource transfer to states. However a relatively

smaller quantum of funds is made available through such sources. These include the

following:

(a) Externally aided schemes

(b) Special central assistance for hill areas, border areas, trivial sub plan and north

eastern council.

(c) Budgetary support to rural electrification.

(d) Calamity relief fund

(e) Loans under small savings collections

(f) Loans to cover gaps in resources

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(g) Helping the states to raise loans from the market or financial institutions like LIC,

GIC IDBI,HUDCO, UDI etc.

Other sources of funds are barrier subsidies items like fertilizers, crop insurance,

family welfare etc. Another available source has been receipts from investments of

national savings

Categories of Resources Transferred

A balance economic growth objective in a federation makes it essential that the

federal government should give differential aid to the poorer states to reduce this

inter-state disparity. A rational structure is desired which will serve to accelerate

development while preserving the budgetary freedom of the states. Due to

concentration of economic power in the hands of central government there has arisen

the need of fiscal transfers from the central government to states in India. The fiscal

transfer from the Centre to the States of India may be classified into three categories:

Shared taxes

Loans

Grants-in-aid

Three broad categories of fiscal transfers have been provided by the Indian

constitution are shared taxes, Loan and grants. There are two bodies to determine the

nature and extent of implementation. Shared taxes are the exclusive domain of the

Finance Commission and loans of the Planning Commission. Grants are a common

field, the Finance Commission deciding the non plan grant and the Planning

Commission the plans grants.

The Indian Constitution has provided that the revenues of certain Union taxes have to

be shared with states. There are taxes the net proceeds of which are compulsorily

shared with the states. The best example in this category is income tax. The Union has

the power to levy this tax to determine its rate and to collect it. But the Union must

share it with states and the share of the states has to be determines by the president

after considering the recommendation of the Finance Commission.

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Shared taxes as mentioned above consist of non corporate income tax and union

excise duty. The net proceeds from non-corporate income tax (excluding revenue

from certain items such as tax on emoluments of central government employees and

surcharges) must be shared between the centre and the states under Article 270 of the

Constitution. On the other hand revenue from Union excise duties may be shared

under Article 272 of the Constitution as decided by the Finance Commission, if

Parliament by law approves so.

Different state governments have limitations in absorbing the capital from the markets

in the form of loans. They tend to depend a large extent upon the Centre as a source

for their borrowings. Not all States have equal capacities to service loans. Hence in

the market only a few states will be able to succeed in obtaining a larger portion of

loans. Here again there are difficulties in equalizing the loan absorption of different

States as they are constituted. Borrowing is an important source of financing

infrastructure.  Until 1987-88, government savings at the State level did contribute to

financing of some capital expenditures.  Since then, however, with increasing non

savings at the state level, the borrowing is used not only to finance capital

expenditures, but also a significant part of current expenditures of the States.

The States’ liabilities consist of Central government loans, market borrowings, share

of small savings collections, and provident funds, deposit accounts etc.  The Central

loans constitute 60 per cent of the States’ indebtedness.    These loans were

accumulated mainly for financing the plans under the Gadgil formula under which, 70

per cent of plan assistance to non-special category states and 10 per cent of assistance

to special category states was given as loans.   However, conditionality can be

attached to loans. The system by which loans are advanced and mediated by the

centre to states are marked by features that have a deleterious effect on fiscal

discipline and need to be attended urgently. States are forced to observe fiscal

prudence as poorly performing states are punished by the market with higher cost of

borrowing or limited access to credit. Since 2005-06, based on the recommendation of

the TFC, the central government has discontinued the practice of advancing loans to

states for plan purposes.     Other Central loans consist of ways and means advances

and the share of small savings collections.27

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The importance of grants conditional and unconditional, including compensatory

sharing, differs from federation to federation. In the U.S.A., there is no tax sharing to

the unconditional grants, there are only conditional grants. In Canada, on the other

hand, unconditional grants are given on a large scale and these include compensation

for federal assumption of tax power. In India under the government of India on a large

scale and these include compensation for federal assumption of tax powers. In India

under the government of India Act, 1935 a special procedure had been laid down for

grants-is-aid which could only be prescribed by an order-in-council and increased

under a very specific procedure ,Section 150 permitted grants by the centre and

provinces for even purposes not in their legislative spheres .Conditional grants have

been made under this section. From 1944-45 onward grants were disbursed on a

substantial scale to assist “Grow More Food" campaign on the basis of additional food

production schemes. The post-war development schemes were on the basis of

Provinces like Orissa, Assam and Punjab the provincial share was much lower or nil.

Bengal was assisted to meet the cost of famine and reliabilities measures, and Assam

helped for meeting past excess expenditure over revenue in administration of tribal

areas and for approved schemes of development to raise the level of administration of

these areas. A new category of sizable grants relating to community projects were

started. But in 1948-49 and 1949-50 the tax sharing and unconditional grants were of

much greater significance.

Once again, with the beginning of planning in the country the "specific or conditional

grants under Article 282 by Union to the states, decided on the recommendation of

planning Commission, have assumed importance. Moreover, since no definite criteria

have been laid down by the Planning Commission with regard to the Union

Assistance to the States all sorts of devices were used by the state with a view to

obtaining large quantum of central assistance as possible. There has always been a

tendency to emphasis "Needs" aspects of the plan rather than its "resources" aspect.

The result is that size tended to be out of proportion to resources. Thus in turn has

fostered on element of unreality in the formation and implementation of the plans at

the state level Governments are exempted to exaggerate the requirements and ask for

increasing aid from the centre.28

This tendency is further aggravated by the absence of efficient planning machinery at

state level. In its absence no real planning at the stature level is possible especially if

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it is a backward one, feels greatly overawed and overwhelmed by the expertise and

knowledge of the central department and planning commission though the state

department prepare their own plans, in their turn they largely rely upon the opinions

and expertise of their counterparts in the central government, and co-ordination at the

horizontal level is relatively weak. 29 Therefore, the objective of the constitution,

conditional freedom the states to evolve policies suited to their local milieu and

introduction of a national bias in the state policies are not attained. The states have

adhered to the pattern expenditure as proposed by the planning commission every

when it was not suited to their needs when the assistance was not linked to a specified

pattern utilized it sometimes in a manner different from that proposed by the

commission.30

The increasing outlays on plans have necessarily meant substantial increasing outlays

on plans have necessarily meant substantial increase in plan grants. But as the

planning Commission has no constitutional base and the grants under Article 275 can

be made only by the Finance Commission the plan grants determined by the Planning

Commission are given under Article 282 which is actually not a substantive provision

intended for transfer of resources from the centre to the states but a miscellaneous

provision for grants in aid intended for validating expenditure outside the legislative

power of the centre. The assistance given under Article 282 was 48 percent of the

Total central assistance in 1952-53 and went up by as much as 80 percent for 1961-

62. It makes it clear how Article 282 has been overworked to a point where it has

overshadowed the Article 275.

Again the plan grants and non plan grants differ not only in respect of the authority

determining their quantum and the Article of the constitution justifying their existence

but in the basic fact that the non plan grants under Article 275 are virtually

unconditional whereas the plan grants are discretionary and conditional varying from

year to year and depending on the plan performance of the states. Plan grants it has

been considered have to be a flexible type, capable of revision according to

performance and securing particular objectives. The quantum and mode of this

assistance are determined by the Finance Commission which is appointed in terms of

the provisions of the constitution every five years.

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Three broad categories of fiscal transfers have been provided by the Indian

constitution are shared taxes (Art.270 and 272), Loan (Art.293) and grants(Art.282)31

The major objectives of grants-in-aid under Article 27(1) as recommended by the

Finance Commission or under Article 282 on the recommendation of Planning

Commission are to reduce the inter-state disparity in the level of economic

development. The relative backwardness of a state or region is a very important

consideration for the Planning Commission while formulating the strategy structure

and substance of development plan for the balanced regional development to the

country. Naturally, the plan expenditure reflects the efforts of levelling the inter-state

disparities but the Finance Commission while recommending statutory grants does not

consider this plan expenditure of the state. Therefore, what is needed in clearly

defined objectives and procedures of union grants-in-aid to state by single well

established sound but flexible institutional frame work? It would not only assure a

smooth union-state financial relationship but would also ensure the effective

implementation of the state schemes and projects with central assistance in the context

of the national economy. One of the main objectives of central assistance to states has

been to ensure that the states implement effectively those schemes and projects which

have a certain rationale in the overall consent of the national economy. In other

words, the pattern of assistance devised was designed to facilitate the use of central

funds in channels predetermined in the plan. 32

Article 282 of the constitution empowers the Union Government or the State

Government to make grants for any purpose even though that purpose may not be

within the legislative jurisdiction of the Parliament or the State legislature. Since

1951-52 the Union Government has used the powers derived under this article for

making plan grants to the states matter to the Finance Commission which have been

appointed. The grants have been made to be applied to Plan purposes. As such the

Union Government have been making them as recommended by the Planning

Commission. Whereas the specific grants recommended by the Finance Commission

under Article 275 (1) of the constitution are meant to area compensatory fiscal effects

i.e. in order to provide social and economic service in the various states, the

discretionary grants recommended by the planning commission under Article 282 of

the constitution have been made to enable the states to undertake certain development

functions or projects.

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In India currently there are twenty-eight State governments and seven Union territory

governments. The finances of Union territories are the direct responsibility of the

Central government. The twenty eight State governments are classified in two

categories, viz., special category States and Non-special category States. There are

eleven special category States and rest are non-special category States. The special

category States are given special central assistance in the form of 90:10 plan grants

and loan. The same ratio for the non-special category States is 30:70 33

Development projects/schemes running out of grants, made by the Union

Governments, under Article 282, state acts as implementing agencies. The former are

the projects/schemes which are suggested and initiated by the states, approved by the

planning Commission. Other project/schemes are suggested and initiated by the

Union Government with the consent of the Planning Commission. For the projects

/Schemes assisted by the Union Government, centre provides 25 percent of the cost of

the project in the form of discretionary grants as specific plan assistance, 50 percent

of the cost of the project is provided in the form of loan from the Union Government

to the State Government and State Government concerned is required to meet balance

of 25 percent of the cost of project from its own resources. Thus such

projects/schemes are finances to the extent of 75 percent of the cost, by the Union

Government.

The Union Government however attaches certain amount of condition if it wants the

projects/schemes to be located within its jurisdiction. Otherwise the state in question

would have to forego the projects/ schemes and the assistance from the Union

Government for its implementations. No state has ever declined to adhere to

conditions laid down by the Planning Commissions because loss of a projects/scheme

means deprivation from massive financial assistance from the Union Government.

In addition to these two forms of plan assistance, the Union Government, on its own

in co-operation with the state concerned, has been giving specific grants to the non-

governmental bodies (N.G.Os) for the promotion of the activities like social welfare,

village industries, development works of a community development project, public

health scientific research, University education, public administration etc.

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As already noted, in addition to transfers via the Finance and Planning Commissions,

States receive funds for Centrally Sponsored Schemes pertaining to subjects that are

under the State domain. Grants for CSS are meant to supplement the resources of the

state governments, who are responsible for the implementation of these schemes and

who are expected to pay a matching contribution. These schemes are designed by the

central Ministries, who then pass on the funds to the States from the central plan

budget that the Ministries control. The outlay and nature of the individual schemes is

determined by the provisions and guidelines attached to schemes, are relatively

inflexible, and cannot be altered by the States. Centrally Sponsored Schemes were

originally to be formulated only where an important national objective such as

poverty alleviation was to be addressed, or the program had a regional or inter-State

character or was in the nature of pace setter, or for the purpose of survey or research.

At the beginning of the Fourth Five Year plan (1969-74) there were only 45 CSS, but

their number rapidly increased during the IV and V plan periods and stood at 201 in

1979. Centre’s involvement with State subjects started increasing under Mrs. Indira

Gandhi’s regime with her focus on Garibi Hatao (poverty eradication). Several

subjects, such as education, population control, and forests were brought from the

State to the concurrent list through amendment in the Constitution. This enabled the

central Government to pass legislation in these sectors without obtaining States’

agreement. Many current Schemes like JRY34, NAREGA35, IAY36or PMGSY37 in

rural development, such as IRDP, creation of employment through public works, rural

housing, etc. were initiated as CSS. These transfers have been criticized as being

‘discretionary’ as they are designed by the central ministries where many non-

economic considerations enter into the distribution mechanism.

Vertical Fiscal Imbalance (VFI)

Vertical and horizontal imbalances are common features of most federations and India

is no exception to this. The Constitution assigned taxes with a nation-wide base to the

Union to make the country one common economic space unhindered by internal

barriers to the extent possible. States being closer to people and more sensitive to the

local needs have been assigned functional responsibilities involving expenditure

disproportionate to their assigned sources of revenue resulting in vertical imbalances.

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The consequences of constitutional assignments as well as fiscal developments over

the years has been to create a high degree of fiscal centralization and vertical

fiscal imbalance . From the revenue sources assigned to them, they could finance

only about 4.3 percent of their current expenditures, and had to depend upon

Central funds or borrowing to meet the rest. In India, the sates dependence on the

centre for the financing their expenditures was the highest among the federations

compared.

The Union Budget of India defines the financial projection by the Union Minister for

Finance for the forthcoming financial year and a financial review of the current fiscal

year, with a view to consummate economic stability for the Country. The authority to

ensure that economic stability has been rested upon the Bicameral Parliament by the

Constitution of India, although a major portion of the responsibility is shifted to the

Lok Sabha (House of the People), to overlook all financial matters. The imposition of

any Central Government taxes and distribution of Government expenditure from

public funds cannot be possible without an Act of the Parliament, which examines and

reviews all statements to ensure the proper dissemination of Government

expenditures. However, proposals for taxation and expenditures can be initiated solely

within the Council of Ministers, specifically by the Minister of Finance.

Under Article 112 of the Constitution of India, a statement of estimated receipts and

expenditure of the Government of India has to be laid before the Parliament in respect

to every financial year, which is announced by the Minster for Finance, usually by the

end of February every year. The statement, which is titled "Annual Financial

Statement", is the main Budget document. The Annual Financial Statement shows the

receipts and payments of the Government under the three parts, in which Government

accounts are kept - Consolidated Fund, Contingency Fund, and Public Account.

Distribution of Expenditure Liabilities

The Constitution also recognizes that the state tax powers are inadequate to meet their

expenditure needs and therefore, provides for the sharing of revenues from central

taxes. Prior to the Eightieth amendment to the Constitution, revenue from taxes on

non-agriculture incomes and union excise duties were shared with the state.

Considering the potential adverse incentives of sharing of taxes from individual

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source for the Central Government, based on the recommendation of the tenth

Finance Commission was amended to include proceeds from all central taxes in the

divisible pool. In addition to tax devolution, the Constitution provides for making

grants in aid to the states as well (Article 275). Both tax devolution and grant in aid

have to be determined by the Finance Commission, an independent body appointed by

the President every five year (Article 280)

The expenditure responsibilities assigned to the Union and the States have been

enumerated in the Lists I and II of the Seventh Schedule, while List III enlists the

concurrent jurisdiction of both Governments. The regulatory functions of the Centre

as also of the States entail considerable expenditure on staff salaries, office

maintenance, etc. Yet, between the two, the States have a larger net expenditure

liability than the Centre. The developmental and welfare functions are, by very nature,

expenditure intensive. Indeed, most of these expenditure functions involve revenue

receipts as well, by way of taxes or user/service charges.

The functions assigned to the States require far more expenditure than the Centre. The

commercial functions are net contributors to the exchequer. The revenue expenditure

from the exchequer in respect of these functions is negligible for both, the Centre and

the States. However, the Centre with the exclusive domain over the most payee items

of these, such as railways, shipping, airways, posts, broadcasting and communication,

banking, insurance, stock exchange, industries, mineral oils, petroleum products, etc.

enjoys more than the States. They have very few such items assigned to their domain,

which are also limited by the residuary powers of the Centre. The taxation functions

entail certain levels of expenditure too, for instance, towards salary etc. of the staff,

which is applicable in case of the Centre as well as the States. In both cases the cost of

tax administration is usually only a small fraction of the revenue collected. But the

overall comparison of tax authority indicates the higher revenue raising capacity of

the Centre.

Distribution of Taxation Authorities

Any fiscal system has to suit its policies and rules to the nature of the economy and

polity in which it functions. The theory of public finance, which provides the

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analytical framework to understand a fiscal system, has to consider the historical

contexts and the specificities and constraints of the economy. Since the days of

Ricardo, who began the tradition of treating public finance matters as those of the

political economy, economists, by and large, have stuck to this tradition. The state, or

rather the government, has a positive role in fiscal matters. The theory of taxation is

the centrepiece of fiscal economics. The power to tax is given to the governments by

the Constitution or by the people, in general.

Though taxes and expenditure are two sides of a coin, each has its own theories. But

economics, by and large, has a similar logic behind both taxes and expenditure. In

early years, there was not much borrowing by the governments. But borrowing also

means a transfer of command over resources and, hence, as the public domain has the

power to borrow, and such borrowing would affect the current and future generations.

However, India has a well-developed tax structure with clearly demarcated authority

between Central and State Governments and local bodies. Central Government levies

taxes on income (except tax on agricultural income, which the State Governments can

levy), customs duties, central excise and service tax. Value Added Tax (VAT), stamp

duty, State Excise, land revenue and tax on professions are levied by the State

Governments. Other State Taxes are-

(a) Stamp duty on transfer of assets, property

(b) Property Tax or Building tax levied by local bodies

(c) Agriculture income tax levied by State Governments on income from

plantations

(d) Luxury tax levied by certain State Government on specified goods

As regards taxation on goods, the locally manufactured goods, excluding the liquors

and agricultural produce, are placed by the Constitution in the exclusive domain of the

Centre. Taxation on all imports, i.e. customs, too is in the sole jurisdiction of the

Centre. Service tax, which was introduced in the year 1994-95 as an off-shoot of the

Central Excise and Salt Tax Act 1944, too came to the exclusive domain of the Centre

by virtue of being a residuary tax till January 2004 where after it was formally placed

in the Union List. The 80th Amendment to the Constitution (2000) had placed the

service tax in the list of sharable taxes, but the 88 th Amendment (January 2004) had

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changed the situation. Despite the excise and custom duties levied exclusively by the

Centre, States had been given authority to levy taxes on goods in the form of sales tax

and entry tax, which was practically a parallel levy to excise and customs.

In theory, States could levy as high rates of these taxes as they wished, and

compensate for the loss of revenue potential that seems inevitable in the

Constitutional division of the fields of taxation between the States and the Centre.

However, raising the rates of such taxes by the States suffered from two major

limitations. The theoretical limit come from the fact that secondary taxation would

invariably tend to yield less than the primary taxation. In other words, the same

goods, having suffered significantly either excise duties (if these were produced or

manufactured locally) or custom duties (if these were imported), cannot be expected

to yield still higher revenues from secondary taxation such as the sales tax or entry

tax. States had been repeatedly stating before the Finance Commissions that the cream

was skimmed off by way of primary taxation on goods levied by the Centre in the

form of excise/customs, leaving little scope of providing any more significant revenue

by way of State taxes like the sales taxes.

The inter-State tax competition added another dimension to this situation. To attract

industry and business, States were constantly under pressure to reduce the tax rates

rather than enhancing it. The limitations faced by the States in respect of taxation of

goods were further compounded by the provisions relating to the taxation on sales of

inter-State nature. Such transactions were excluded from the purview of the State List

and are governed by the Central legislation, namely, the Central Sales Tax Act, 1956.

Though the States had been empowered by the Parliament to collect and appropriate

the receipts from this levy, yet this law had imposed a ceiling on the rate of tax, which

was limited to 4 per cent. All these factors limited the capacity of the States in raising

significantly higher revenue from the taxes on goods and services. All the same,

States had reached a level of stagnation where they are unable to raise the tax rates

any more, for both, Sales taxes and the State Excise Duties. To overcome these

limitations, some States have tried to impose other levies like luxury tax on specific

goods such as cigarettes, but the courts have found these against the Constitution.

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Introduction of State level VAT is the most significant tax reform measure at State

level. The State level VAT implementation has replaced the erstwhile sales tax system

of the States. “Tax on sale or purchase of goods within a State”38 is a State subject.

The decision to implement State level VAT was taken in the meeting of the

Empowered Committee (EC) of State Finance Ministers held on June 18, 2004, where

a broad consensus was arrived at amongst the States to introduce VAT from April 1,

2005. Accordingly, VAT has been introduced by all States/UTs by now. Uttar

Pradesh is the latest State which has introduced VAT on January 1, 2008.

Since sales tax/VAT is a State subject, the Central Government is playing the role of a

facilitator for successful implementation of VAT. A compensation formula has also

been finalized in consultation with the States, for providing compensation to them,

during 2005-06, 2006-07 and 2007-08, for any loss on account of introduction of

VAT and compensation is being released according to that formula. Technical and

financial support has also been provided to the States for VAT computerization,

publicity and awareness and other related aspects. The through its deliberations over

the years, finalized a design of VAT to be adopted by the States, which seeks to retain

certain essential features commonly across States while, at the same time, providing a

measure of flexibility to the States to enable them to meet their local requirements.

The initial experience of implementation of VAT has been very encouraging. The

new system has been received well by all the stakeholders. The transition to the new

system has been quite smooth. The EC39 is constantly reviewing the progress of

implementation of VAT. The revenue performance of VAT implementing States/UTs

has been very encouraging so far. The rates of VAT on various commodities shall be

uniform for all the States/UTs. There are two basic rates of 4 per cent and 12.5 per

cent, besides an exempt category and a special rate of 1 per cent for a few selected

items. The items of basic necessities and goods of local importance (up to 10 items)

have been put in the 0 per cent or the exempted schedule. Gold, silver and precious

stones have been put in the 1 per cent schedule. The 4 per cent rate applies to other

essential items and industrial inputs. The 12.5 per cent rate is residual rate of VAT

applicable to commodities not covered by other schedules. There is also a category

with 20 per cent floor rate of tax, but the commodities listed in this schedule will not

be taxable under VAT. This category covers items like motor spirit (petrol, diesel and

aviation turbine fuel), liquor, etc.

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There is provision for eliminating the multiplicity of taxes. In fact, several State taxes

on purchase or sale of goods (excluding entry Tax in lieu of Octroi) have been

subsumed in VAT or made VAT able. Provision has been made for allowing “Input

Tax Credit (ITC)”. However, since the VAT being implemented is intra-State VAT

only and does not cover inter-State sale transactions, the ITC will not be available on

inter-State purchases. Exports will be zero-rated, and at the same time, credit will be

given for all taxes on inputs/ purchases, related to such exports. There are provisions

to make the system more business-friendly. These include provision for self-

assessment by the dealers, provision of a threshold limit for registration of dealers in

terms of annual turnover of Rs. 5 lakh, and provision for composition of tax liability

up to annual turnover limit of Rs. 50 lakh. States have been allowed to continue with

the existing industrial incentives, without breaking the VAT chain.

The taxes on properties are earmarked for the exclusive domain of the States.40 The

main taxes levied on properties are the land revenue, which is a tax on holdings of

agricultural lands but varies with the quality and yield of the land. The taxes on non-

agricultural lands and on buildings also come under this. States are at liberty to assign

any of the taxes of their domain to the local bodies. Most States have retained land

revenue under their direct administration (in Kerala it stands delegated to the

Panchayats), while the taxation on non-agricultural lands and buildings of all kinds

has been delegated to the local bodies. Land revenue is a direct tax that concerns the

largest share of the population. As regards the taxation on non-agricultural properties,

which has traditionally been assigned to the local bodies, the proceeds have remained

small and subject to rather ineffective administration. In most States, the tax rates

have not been revised periodically and there has been no standard mechanism for

determination of property tax rates and their revision41. It may also be noted that

article 285 of the Constitution exempts the properties of the Union from being taxed

by a State legislation.

The issue of surcharges and cesses on the Central taxes and duties also needs to be

taken note of. Until the 80th Amendment (2000) came about, article 270 had provided

for mandatory sharing of only the personal income tax proceeds, while article 272 had

provided for sharing of the proceeds of Union excise duties at the discretion of the

Parliament. The other central taxes and the cess and surcharges levied on any Union

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taxes, including the sharable taxes, were excluded from the purview of sharing (article

271). After the 80th Amendment, article 270 provides for mandatory sharing of the

net proceeds of all Union taxes and duties, except for the levies under articles 268 and

269 as also the surcharges and cess.

Sharing of Income Tax

In India, the most common basis of federal fiscal transfer derivation principle was

accepted in theory in the devolution of income tax proceeds. The major emphasis,

however, has been on equity. The success of a devolution scheme depends upon the

criteria and their measure adopted by various Finance Commissions in India.

Derivation found general acceptance in principle but there was no consensus about the

method of its application, among the various Finance Commissions. Besides this

principle, they gave importance to the principle of ‘need’ and adopted ‘Population’ as

a major criterion of need.

Sharing of Union Excise Duties

In the distribution of union excise duties population was accepted as the major

criterion, but the first two commissions gave marginal weight to consumption or

adjustment. The Third Commission totally rejected consumption and accept factors as

financial weakness, SC/ST population, backwardness, etc. The Fourth Finance

Commission did not accept the criterion of financial weakness; instead, they included

social backwardness of the states. The Fifth finance commission recommended, 80%

on the basis of population of respective states and out of the remaining 20%, 2/3 to be

distributed among states whose per capita income is below the average, 1/3 to be

distributed according to the integrated index of backwardness. The Sixth finance

commission rejected the factor of ‘contribution’, and gave importance to reduction in

regional disparities. In order to measure economic backwardness, instead of relying

on controversial physical indicators, the commission took per capita income as the

sole criterion in assessing the relative economic position of the states. Further, this

Commission introduced the ‘distance criterion.42

The Seventh Finance Commission adopted, population, inverse of the per capita State

domestic product, Percentage of the poor in each State and formula of revenue

equalization. They gave equal weight of 25% to each of these criteria. The Eighth

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finance commission accepted “backwardness” as one of the criteria which cannot be

discounted in the distribution formula, but did not accept the ‘poverty ratio’. This

commission rejected ‘revenue equalization’ and made special arrangements to help

the deficit states by setting aside 5% of the net proceeds of excise duties, for purposes

of distributing only among those states which had deficits on revenue account.

In addition to this, the Ninth finance commission introduced use of proportion of

people below poverty line as an additional criterion. This Commission added,

“Distribution should be done on the basis of the proportion of deficit of each state to

the total of all states deficit worked out by us.”43 The Tenth Finance commission

advocated for the conversation of the criteria for the devolution of income tax and

union excise duties.

The principle of equalization demands that the low income states should be given

higher per capita shares of Central resources. If equal per capita assistance is given to

all the states on the basis of population, the resultant distribution scheme will not be

guided by the ‘principle of equalization’. Though, population is not a true measure of

States need for resources to meet its expenditures need, the finance commissions have

used this measure extensively and high weight has been given to this criterion in their

schemes. The Finance Commissions have used population as a scale factor in other

two criteria, namely, I.A.T.P. and distance criteria; and this made the population to

continue to be predominant.

Thus the Twelfth Finance Commission (TFC) has recommended the distribution of

30.5 per cent of net proceeds of Central taxes. An important feature of tax devolution

recommended by the Finance Commissions is that, while the criteria adopted for

distribution are different from the principles of grants-in-aid, it is made clear that the

economic objectives of the two instruments are different44.  The tax devolution is

recommended mainly on the basis of general economic indicators and grants are given

to offset the residuary fiscal disadvantages of the States as quantified by the

Commissions.  Further, assigning weights to contradictory factors like `backwardness'

and ‘contribution’ has rendered the achievement of the overall objective of offsetting

revenue and cost disabilities difficult. Report of the Thirteen Finance Commission has

come on 26 February 2010. The share of states in net proceeds of shareable central

taxes shall be 32 percent in each of the financial years from 2010-11 to 2014-15.

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Under the Additional Duties (Goods of special Importance) Act, 1957, all goods were

exempted from payment of duty from 01 March 2006.45 Following this, the centre had

adjusted the basic duties of excise on sugar and tobacco products.

Challenges

Challenges faced by the Indian fiscal federalism are very general in nature as

demographic and topographic factors.

Horizontal Fiscal Imbalance or Regional Disparities

An important feature of Indian fiscal federalism is wide interstate differences in the

ability to raise revenues. There are 17 relatively more homogeneous general category

states, but even these have wide differences in revenue raising capacities, efforts,

expenditure levels and fiscal dependence on the centre. In addition, in terms of

economic characteristics and endowments, the 11 mountainous states of the north and

the north east differ markedly from the rest and therefore are considered special

categories states. Of the 28, three states have been recently carved out from 3 large

states.46 The Indian States have not been constituted from the point of view of

optimum regions with each region having equal resource-endowment and equal

resource development potentials nor have they been constituted from the point of

view of equal capacities for revenue rising. They do not have optimum capacities to

absorb resources from the point of view of their most productive deployments. The

size of different States varies enormously. Some are very large and some are very

small. The population densities are also very different. Even agricultural development

potentials are not common among different States. Some states are heavily drought

prone and because of scarcity of water they cannot derive the best benefits of ground

water. Some are excessively prone to floods and this causes considerable uncertainties

for long term investment in agricultural development.

Horizontal imbalances across States are on account of factors, which include

historical backgrounds, differential endowment of resources, and capacity to raise

resources. Unlike in most other federations, differences in the developmental levels in

Indian States are very sharp. In an explicit recognition of vertical and horizontal

imbalances, the Indian Constitution embodies the some enabling and mandatory

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provisions to address them through the transfer of resources from the Centre to the

States.

Demographic Factors

The demographic status of the States influences the revenue raising capacity. States

with larger area and population are, capable of producing more and consuming more.

Fertile and mineral rich lands and professionally qualified manpower are great

economic assets while barren lands and illiterate population are burden. As a

consequence, small countries like Hong Kong and Singapore have higher levels of per

capita income than most other countries having higher geographical area or

population. Within India, Goa and Punjab offer a similar example.

The heterogeneity among the Indian States is striking. In an even distribution

scenario, each State should have about 3.57 per cent of the country’s population and

geographical area. However, as per census 2001 their actual share in the country’s

population varies from as low as 0.05 per cent (Sikkim) to 16.16 per cent (Uttar

Pradesh). The share of each of the ten special category States (i.e. excepting Assam)

as also of Goa is less than 1 per cent, while that of five other States (Assam,

Chhattisgarh, Haryana, Jharkhand and Punjab) is less than 3 per cent. States like

Andhra Pradesh, Bihar, Maharashtra, Uttar Pradesh and West Bengal, have each more

than 7 per cent of the country’s total population. Further, seven geographically

smallest States put together have less than 3.5 per cent of the country’s area. In terms

of population, as many as 17 smallest States put together constitute less than 3.5 per

cent of the country’s total population.

Yet another indicator of inter-State disparity is the literacy rate. The All India average

being 64.8 per cent, many States, particularly those with largest population, have

much lower levels of literacy. The more notable in this regard are Bihar (47.0 per

cent), Jharkhand (53.6), and Uttar Pradesh (56.3). The general picture is that poorer

States have lower levels of literacy. The converse argument could be that lower levels

of literacy leads to poverty, which reduces the revenue potential of the State.

Topographic Factors

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The Topography or location of the States also affects their revenue potential. States,

which are located close to the centres of economic connectivity, such as seaports,

international airports, major junctions for the railways and the national highways, may

be able to attract higher levels of economic activities, which in turn becomes the

source for higher levels of revenues. The landlocked and poorly connected States such

as the north-eastern States, the hilly States of Himachal Pradesh, Jammu & Kashmir

and Uttaranchal, the landlocked States of Chhattisgarh and Jharkhand are examples of

States facing such disability though in varying degrees. Such State are on the natural

disadvantage in the development and growth of trade and commerce. The States

having much better commercial connectivity such as Maharashtra, Tamil Nadu,

Kerala, Karnataka, and West Bengal are more prosperous.

Variation in Revenue Capacities

States vary in their revenue capacities owing to a variety of factors, of which the more

significant ones are the per capita income, the levels of consumption expenditure, the

demographic factors and the economic location factor.

Variation in Expenditure Needs

States vary in their expenditure needs primarily owing to demographic factors and the

uneven availability of public infrastructure. The expenditure needs of the States vary

on account of the size of their population, its lifespan, age and gender profile, health

indicators such as infant mortality rate, life expectancy at birth, as well as the

availability of infrastructure such as schools and hospitals, roads, electricity etc., and

status of employment. The expenditure needs vary also on account of cost disabilities

emanating from the factors that are beyond the control of the respective States, such

as natural calamities, large geographical areas relative to the population, hilly or

desert terrains, excessive rainfall, proneness to drought, very small size of the State in

terms of area and/or population, and remoteness of its territories.

The demographic heterogeneity among the States is the factor which is responsible for

variations in expenditure needs. These factors influence the revenue raising capacity

as well as the expenditure responsibilities of the State. The pattern of heterogeneity in

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the share of the States in the geographical area is still more complex. It varies between

0.12 per cent (Goa) and 10.82 per cent (Rajasthan). Andhra Pradesh, Madhya

Pradesh, Maharashtra and Uttar Pradesh, these four states have more than 7 per cent

each, of the total geographical area of the country. Larger geographical area requires

the State to expend higher amounts on creation and maintenance of infrastructure such

as roads, drinking water supply, and electricity, and telecommunication, educational

and medical facilities. This variation in the status of the States gets further

complicated in terms of population density. The all India average is 325 persons per

square kilometres. Bihar, Kerala and West Bengal are above 800 persons per square

kilometres. Arunachal Pradesh with 2.65 per cent of the geographical area has only

0.11 per cent of the population. Rajasthan with 10.82 per cent of the geographical area

has only 5.49 per cent of the population, while West Bengal, with 2.81 per cent of the

geographical area, has 7.79 per cent of the population.

There does not seem to be a direct correlation between affluence and population

density of the States. Some of the high income States, like Haryana and Punjab, have

high population density, around 480 persons per sq. km., whereas another high

income State, Gujarat, has as low as 258. Similarly, some of the low income States

have very low population density, examples being Chhattisgarh (154), Madhya

Pradesh (196) and Orissa (236). On the other hand, some of the low income States

have among the highest densities, such as Uttar Pradesh (697), Bihar (881) and West

Bengal (903). However, despite such lack of correlation, the issue of variation in

population density remains significant for determination of cost disabilities for the

States. In hill and desert areas, for instance, people live in small habitations (called

vangram) of twenty to fifty households and yet the government is required to provide

to them school, health care, drinking water, power supply, road connectivity etc.

States lagging behind in literacy need to spend more on literacy programmes,

elementary education, health awareness and generally on creating awareness among

the masses about the various social and development issues. Further, dependence of

the people on the government for various services is higher if the people themselves

are poorer.

Variation in Per Capita Income and Consumption

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Income distribution data, according to received theory, would reveal that persons in

the upper income brackets form a small portion of aggregate workers in the economy.

The NSS47 data does not collect information on the basis of an a priori sample based

on distribution according to income size classes. Only a very tiny portion of the

income of top brackets gets reflected in the NSS results, though the relative

proportion of the income of the better-off classes is substantially higher than the

representation to them in the NSS. That is why there is so much underestimation of

the income accruing to the richer classes in generalisations of aggregate distribution,

income class-wise, for the economy. This is very important from the point of view of

fiscal and tax policies.

What has been the improvement over the post-independence decades in per capita real

incomes in different states? Growth in net real domestic products in different

states will not give an idea of the growth in real per capita products because the

population growth rates in different states have been different . Given equal extent

of growth in net state domestic products, state with a lower population growth rate,

would show a higher growth rate in per capita real income. This has been so in many

cases in the post – independence period. A state with a higher growth rate in real

product may yet have a high growth rate of population and thus get denied to itself

of higher growth rate per capita real incomes. It would be a fair assumption to

make that by and large there is excess population in most states and a high growth

rate in the later would accentuate the economic difficulties of the states.

The level of a State’s income, measured in terms of the per capita NSDP 48, also called

as the per capita income, is the most significant determinant of the State’s revenue

raising capacity. The higher is the level of the per capita income, the more resource

the State can be expected to generate by way of taxes. There are further refinements

possible to this concept, such as the spread of the wealth among the people, the nature

and composition of the NSDP, the efficiency of tax administration etc. However, as a

broad concept, the totality of per capita NSDP can be considered to be the first good

indicator of the State’s revenue raising capacity. In particular, the receipts from the

direct taxes can be correlated positively to the per capita income. Another useful

indicator would be the level of consumption expenditure, as the indirect taxes are

generated based on the same. The data for per capita income of the States is compiled

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by the Central Statistical Organisation, whereas for the consumption expenditure, by

the National Sample Survey Organisation through its periodic rounds of sample

surveys. The inter-State variation can be measured in various ways, such as the

standard deviation, coefficient of variation, ratio of the highest to the lowest and Gini

coefficient/ Gini index49.

Uneven Availability of Essential Public Services

Inequalities in expenditures on social and economic services cause inequalities in the

access to basic social and economic services.  Thus, the children in states with low

literacy rates have poor access to school education and people in states with low

health status have low levels of expenditures on medical and public health.  Similarly

the states with low infrastructure levels have low expenditures on infrastructure

facilities.   This pattern of spending accentuates unequal access to social and physical

infrastructure accentuating inequalities in levels of living and human development in

the states. Other indicators such as school enrolment, literacy rate, registered

factories, water supply, transport facilities, electrification and so on do indicate the

level of development.

The relative cost disability among the States arises also due to inadequate availability

of critical public infrastructure and services such as safe drinking water, educational

facilities particularly at the elementary levels, roads and medical care. A variety of

indicators are available to measure the level of availability of such services.

Availability of Drinking Water Sources

For the availability of safe drinking water, the Census (2010) data has been adopted.

For the country as a whole, 82 per cent of the households have access to sources of

safe drinking water (Census 2010). The high income States are, with the exception of

Goa (72 per cent), better placed than the average. While Punjab leads the group with

98 per cent, Andhra Pradesh, Tamil Nadu and Karnataka, too have higher than

average but Kerala (27 per cent) and Rajasthan (70 per cent) are well below the same.

Among the low income States, Bihar, Uttar Pradesh and West Bengal have fairly high

range of 92 to 95 per cent, while Jharkhand is having 46 per cent, Chhattisgarh is 74

240

per cent. Among the special category States, three, Arunachal Pradesh, Himachal

Pradesh and Uttarakhand, have 84 to 90 per cent of the households with access to safe

sources of water., while the remaining eight States have very low coverage, ranging

between 38-46 per cent on the one hand (Mizoram, Manipur, Meghalaya, and

Nagaland) and, on the other hand, little better, in the range of 55-65 per cent (Tripura,

Assam, Jammu & Kashmir). States with lower level of households with access to safe

sources of drinking water need to spend more of their budgetary resources not only

for providing safe drinking water but also on the health care as most of the mass

health problems occur on account of consuming water of poor quality. The sources

considered as safe are the water supplied through taps, bore wells and hand pumps,

while the remaining sources, namely, open wells, ponds, lakes, rivers and springs,

have not been considered safe as these are easily susceptible to pollution.

Elementary Education

In respect of the elementary education, up to class VIII, two indicators have been

selected. One is the ratio of children enrolled in the schools (Classes I to VIII) to the

child population (age group 6 to 14) and the other is the pupil-teacher ratio. The Gross

Enrolment Ratio (GER) for the children in the age group 6 to 14, who are expected to

be enrolled in classes I to VIII, gives a picture of large variation existing between the

high income and low income States. The GER for all the special category States is

above 90 per cent except for Jammu & Kashmir where it is 84 per cent. Among the

high income States, two have GER above 100 per cent (Gujarat and Maharashtra),

while the other three, i.e. Goa, Haryana and Punjab, have it between 66 and 73 per

cent. The GER for middle income States varies between 90 and 98 per cent. GER for

Andhra Pradesh is 82 per cent, Chhattisgarh 98 per cent, Uttar Pradesh 54 per cent,

with other larger States like Bihar (60 per cent) and Jharkhand (69 per cent) also

remaining way behind.

In terms of pupil-teacher ratio for the elementary classes (I to VIII), the gap among

the high income and low income States is not uniform, but it does exist. Some of the

high income States are relatively comfortably placed, such as Maharashtra (41) and

Gujarat (44), while some others have more adverse ratios, such as Goa (57), Punjab

(56) and Haryana (50). Similar variation is noticeable in respect of the middle income

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and low income States. However, some of the low income States have very high ratio,

such as West Bengal (81), Bihar (69) and Jharkhand (63). There is considerable

variation among the States in the access to elementary education, measured in terms

of gross enrolment ratio and the pupil-teacher ratio. The low income States are, by

and large, placed in adverse position and require higher investments in this sector.50

Road Network

For roads, the availability has been assessed in three ways. First two are quantitative

indicators, measured as the ratio of total length of roads of all kinds to the

geographical area and to the population of the State, respectively. The third criterion

is the quality of the road network. Availability of roads of all types taken together

was, for the country as whole, 776 km. per 1000 sq.km. of geographical area. Kerala

and Punjab with 3,882 and 2,613 were way ahead of the all India average, while

Jharkhand and Chhattisgarh, with 144 and 262, were the most deprived non special

category States. Similar large degree of variation exists among the special category

States too. Tripura, Nagaland and Assam have more than 1,000 km of roads per 1,000

sq km of area, whereas Arunachal Pradesh, Jammu & Kashmir and Mizoram have this

ratio as below 250. The inter- States variation in the availability of road network is

confirmed in terms of the ratio of road length to the population. While the ratio of the

length of roads of all types per one lakh population was 239 at the all India level, it

was as low as 43 for Jharkhand, 92 for Bihar, 115 for Madhya Pradesh, all three being

in the low income category. The high income States were, in general, much better

placed than the all India average, with Goa having 718, the sole exception being

Haryana (133).

A crucial indicator of the quality of roads is the ratio of surfaced roads in the total

road network. This ratio was 83 per cent for the high income States, 60 for the middle

income, 43 for the low income and 31 for the special category States. There were,

however, inter-State variations among the respective group of Sates too. The six

States placed highest in terms of this ratio were all the five high income States and

Tamil Nadu, where the ratio ranged between 71 (Punjab) and 93 (Haryana). The ratio

was the lowest in respect of the special category and low income States of Assam

(14), followed by Orissa (22), Jharkhand (25), Tripura (27), etc. Thus, the availability

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of road network, in terms of sheer length as well as of quality, varies very

significantly among the States.

Medical Facility

As for the availability of infrastructure for medical care, the ratio of hospital beds to

the population has been taken as the representative criterion. However, it will be

better to take availability of doctors per 1000 of population, but data are not

authenticated. The availability of medical care facility, in terms of population served

per hospital bed, the all India average being 995 (as on 1.1.2002), all the high income

States as well as the middle income States with the sole exception of Haryana and

Rajasthan, respectively, were having lower ratios whereas all the low income States

were at much higher levels. On the one end of the spectrum were States like Kerala

(290) and Goa (320), whereas the other end had the low income States like Madhya

Pradesh (2842), Bihar (1974) and Uttar Pradesh (1681). Similar inter-State variation

is seen in respect of the special category States too. On the whole, the high and middle

income States had much better ratio than the low income and the special category

States.

The data and analysis comparing the availability of four critical infrastructure and

services indicate a large degree of variation existing among the States. In general, the

low income States are deficient in these respects, though in respect of some of the

items, a few of the higher income States lag behind. Such variations have direct

adverse impact on the finances of the States as the deficient States require more funds

to improve the level of essential services. Such deficiencies also hit the State’s

finances indirectly as, for example, inadequate availability of safe drinking water

leads to higher incidences of water borne diseases which in turn inflates the

expenditure on public health and medical care. The net impact of such variations is

that poorer States need more resources to mitigate inter State inequality but have

fewer resources to achieve that goal. This is the fundamental reason for the

requirement of federal fiscal intervention.

Lapses in Indian Transfer System

243

A fundamental shortcoming of our transfer system pointed out by critics has been the

'gap filling' approach of the Finance Commissions whereby grants-in- aid are

recommended for states found to be in deficit in their revenue budget after taking

account of their share of central taxes under the FC's devolution formula. This creates

a problem like “Robbing peter, Paying Paul” and acts as an incentive for improvident

budgeting. States showing large deficits in their budget get rewarded while those that

manage their finances better suffer. For although the share of individual states in the

devolution of central taxes that constitutes the dominant component of transfers

ordained by the FC — the statutory transfers, as they are called — is determined by

formulae relying on parameters unrelated to the actual of their revenue and

expenditure, the manner in which the balance of the statutory transfers, that is the

grants-in-aid, are decided can act as a source of fiscal indiscipline.

Finance Commissions don’t go entirely by what the states project of their revenue and

expenditure. Projections are made by the FC, on the basis of growth rates or norms of

their own. But the starting point — the base year figures from which the projections

start — still rely heavily on history or past actual. The projections made by an FC are

thus of no consequence to its successor. They simply go waste. The Ninth FC made

an attempt to apply norms for estimating the base year figures based on scientifically

derived parameters. The Eleventh FC also has made an attempt to do so, but these

efforts have not gone very far. The belief that the absence of a full-fledged normative

approach may have weakened fiscal discipline finds some support also from findings

of research showing that increase in the grants from the centre to the states have

dampened the tax effort of states who benefit most from the 'gap filling' approach of

the FCs. It means, when a state is sure to get sufficient grant from centre, no need to

do the tax efforts. These states may be happy to become parasite with their

dependency syndrome, which results in steady decline in the proportion of revenue

receipts from own sources.

Substantial funds flow from the centre to the states also held responsible for creating

perverse incentives for fiscal discipline among the states in India. The Planning

Commission assists the states with funds in the form of grants and loans for the Plan

which in the case of general category states, the ratio is of 30:70, while for those in

the special category the ratio is 90:10. Since 1969, that is, when the Gadgil Formula

was adopted, plan assistance is allocated among the states out of the total amount set

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apart in the Union budget as gross budgetary support for the Plan. Population carries

the maximum weight in the formula followed by factors like relative position of a

state in terms of income levels. Some weight is attached also to factors like tax effort.

While this imparts a measure of transparency and an incentive for better tax effort, the

actual amount allocated to a state is decided through bilateral negotiation through the

Annual Plan discussions.

A practice observed in the scheme of devolution is the use of 1971 population data.

Though, Finance Commissions cannot be blamed for using 1971 population figure, as

it is in the form of directive in their terms of reference, but the rationale is lacking. To

this, Ninth Finance Commission in its first report replied, “we consider that

promoting family welfare measures, including Planned Parenthood and small family

norms, is a matter of paramount national importance. We are of the view that this

desirable national importance. We are of the view that this desirable national

objectives should be accorded due recognitions and encouragement. If we were to

take 1981 census figures instead of 1971 population data, the respective shares of the

states will change ( within the same overall quantum of devolution) to the detriment of

the States that have been more successful in implementing the family planning

programme. We are accordingly adopting the 1971 census figures in our devolution

package.”51

The plea that the purpose of taking 1971 population is to ensure a few States that they

do not lose on account of highly efficient implementation of Family Planning

Program does not sound logical. Similarly, the plea that by taking 1971 population

they would be discouraging States to increase their population also is questionable.

First of all, it may be true at the national level that total increase in population is due

to higher growth rate of birth (provided no immigration on an exceptionally large

scale had taken place from other countries). The same does not hold good at sub-

national level, where free inter-state migration is a common phenomenon. The States

with higher levels of development, better socio-economic infrastructure, good

administration and good law and order situation attract labour along with their

dependents from other states. This immigration results in increase in population.

Along with increase in population, demand for certain public sector services , such as

law and order, drinking water, housing , sanitary , drainage and so on also goes up ,

thus increase in public expenditure due to migrated population is totally ignored when

245

static population figure is taken to indicate the need of the State. Secondly ,

population may also increase in spite of low birth rate due to fall in the mortality rate ,

owing to better family welfare programmers , health care , environmental protection,

medical care and so on which require huge funds for implementation of these

programmes. Considering these realities, it is illogical to adopt a static population

figure and to call it a measure of need.

The above arrangements are just to counter the contention of the ninth finance

commission that by adopting 1971 census population, they are only helping the States

with better family planning performance. There is no theoretical ground to support the

above contention. However, a stronger argument against this approach of the finance

commissions is on the basis of the nature and genesis of shared taxes and duties.

Federal government should not try to impose its preferences for any policy measure

on the states in the scheme of devolution of taxes and duties. There is specific

provision in the constitution to make conditional or unconditional grants to the states.

If the intention of the central government is to help states with good family planning

measures, Centre may give special grant for this purpose. Thus , using population

figure alone to measure ‘need’ of a state, applying quarter century old data to

represent States need and to try to impose federal government will on the States

through revenue sharing is not at all acceptable and justified on any ground. However,

it does not mean that population should not appear at all in the distribution scheme.

Population is also one of the determinants of State level expenditure and hence some

relevance in assessing the programme needs of the states. There are certain items of

expenditure which are directly related to the number of people residing in a region,

e.g., housing , sanitation , drinking water, health facilities, number of public transport

vehicles, providing police protection and so on. Some consideration to population

factor is desirable but not this way.

Article 293 of the Constitution empowers the Union government to deny a state

access to borrowing so long as it has any debt or guarantee outstanding to the centre.

There are ways in which the states can bypass the constraint such as by borrowing

through enterprises set up by them, off-budget borrowings as they are called. The

practice of passing on to the states the bulk of the accretion to small savings on origin

basis provides another channel of states' borrowing over which Article 293 does not

apply. Of course, the centre could still exercise restraint over the states' borrowing by

246

limiting its own lending or lending by Financial Institutions to states that are already

heavily indebted. But the centre does not seem to have exercised the powers it can, on

the states borrowing available under Article 293. Otherwise, it is difficult to explain

how the borrowing of the states during the Ninth Plan could mount to over Rs.2,

00,000 crore when under the Plan the deficits in the balance from current revenue

were put at no more than Rs.20, 000 crore.52. Indian experience shows that economic

federalism with a strong centre running the country almost like a unitary state

provides no guarantee of prudent fiscal management. Transfer system is deficient in

providing the right incentives for good fiscal conduct on the part of the states; this

system is not addressing the horizontal imbalances.

Derivation and ‘need’ have been the most common criteria of federal fiscal transfers.

In India, derivation principle was accepted in theory in the devolution of income tax

proceeds. The major emphasis, however, has been on equity. The success of a

devolution scheme depends upon the criteria and their measurements. In spite of

laudable objectives pursued, the scheme can become regressive and subjective in the

absence of rational or basis of devolution. In India Finance Commission is not a

permanent body, it is formatted after every five year and recommendations are

advisory only, not binding on the centre. This is another problem that the major

portion of transfer of resources from union to the states is comprised of Discretionary

Grants (Articles 282) and ‘specific purposes Grants’ and on the recommendation of

planning commission and given directly by the union government respectively.

The flow of grants-in-aid form Centre to the States has also taken the shape of

'statutory grants' under Article 275(1) on the recommendations of Finance

Commission. This system of dual authorities for recommending union grant-in-aid to

the states has tended to overlap quite considerably. It has created considerable amount

of confusion in the criteria adopted in the determination of union grants-in-aid to the

states. For example, the Third Finance Commission's recommendation in respect of

communications and coverage of certain percentage of the revenue component of the

Third Five Year Plan was the specific purpose grants, the jurisdiction of the

commission over which was first disputed (the member-secretary dissented) and

finally denied by the Government of non-acceptance of the recommendation with the

observation that there would be no real advantage in the states receiving assistance for

their plans partly by way of statutory grants-in-aid by the Finance Commission and

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partly on the basis of annual reviews by the Planning Commission. The question

about the scope of coverage of grants-in-aid under Article 275(1) on the

recommendation of Finance Commission was also raised in the time of Fourth

Finance Commission. The legal position, therefore, is that there is nothing in the

constitution to prevent the Finance Commission to take into consideration both capital

and revenue requirements of the state in formulating a scheme of devolution and in

recommending grants under Article 275 of the constitution. 53

The existence of these dual authorities over flow of Union assistance has resolved in

some serious but interesting development.54 In the first place, the estimates submitted

by the state government to these two bodies are not consistent. In order to attract the

'revenue gap' grants from finance commission, the states figures when presented to

them under-estimate their resources; when pressed to increase their plan size and

show the necessary resources for them in their submission to the Planning

Commission, they consistently over estimate their resource raising potentialities and

capabilities at current rates of taxation and prices and under estimate their non-plan

expenditure liabilities, as the more they undertake to raise the more they are likely to

get. Considering that the process of plan formulation has not generally coincided with

deliberation of the various Finance Commissions (except in respect of the Fourth

Commission) it is not very difficult for the state government to give the two sets of

figure to these bodies.

Again, the functioning in isolation of these two commissions leads some relatively

more developed state to judge the figures. Since the statutory assistance under the

Finance Commission's awards is given to those states which have a gap in their non-

plan revenue account. These advanced states are either listless or indifferent to the

Finance Commission, or if they show any interest, they manoeuvre a gap in the

revenue account. The approach is reversed when they place the case before the

Planning Commission.

Chairman to the Fourth Finance Commission added therefore, “that the data which

one body considers as relevant is totally ignored by the other. Since it is the total

expenditure which is pertinent, it should be total assistance that must be the concern

of my commission charged with the allocation of central assistance.”55

248

In India , accepting economic planning as means of attaining economic growth with

an objectives to narrow the inter-state disparities in the level of development , if

finance commission is confined to recommend only a portion of the total central fiscal

devolution this work should form a part of the whole integrated system. Thus, there is

a need for a close co-ordination between the working of the two bodies of planning

commission and the finance commission. Overlap leads to vertical competition among

governments to capture voter power and dilution of accountability and thereby

wasteful enlargement of government expenditure.56 However, it should be the centre's

task to control externalities and spill over from the states’ tax and expenditure policies

firmly. The ideal solution would seem to be for constitutional amendment to make the

finance commission a permanent body with jurisdiction over the inter-state allocation

for development purpose also.

The design and implementation of central transfer to states suffer from a number of

shortcomings.  First, multiple agencies with overlapping jurisdictions have blurred the

overall objectives of transfers.  Second, accommodating different interests has unduly

complicated the transfer formula by Finance and Planning Commissions.  Third, the

transfer system is not well targeted to achieve equalization and to ensure minimum

service levels in the States.  Fourth, they have disincentive effects on the fiscal

management in the States.  The design and implementation of the centrally sponsored

schemes has served the objectives and has tended to multiply State level bureaucracy

and distort States’ own allocations.  Most importantly, segregation of state budgets

into plan and non-plan categories and compartmentalized view has contributed to the

complexity in expenditure decisions.  This has been further complicated by the

eagerness to enhance plan spending, often by raising resources through indiscriminate

means or by compressing more productive spending on social services and operation

and maintenance of assets.

Canadian context

The representative tax system now has 30 separate revenue sources, and the

assessment of revenue-raising capacity is done separately for each source. This is

done by defining a tax base for each tax that will be typical of the actual tax bases

used by those provinces levying the tax, and then estimating the revenue yield in each

province, by applying the average rate of provincial tax to that typical base. The

249

assessments for all 30 revenues sources are than added for each province to arrive at

its total fiscal capacity. The assessments of fiscal capacity among provinces therefore

reflects the real world of what provinces and their local governments collectively

choose to tax , rather than some top-down notion of what they ought to be taxing. The

total assessments of each province’s fiscal capacity is then put on a per-capita basis

and compared with a per-capita standard, with any province that is below that

standard having an equalization entitlement equal to its per-capita short fall multiplied

by its population. This calculation is done for each fiscal year and the payments are

made free of any conditions as to how the money is to be spent57.

The standard is a key element of the equalization Program, because it determines the

level of equalization and the extent to which measured disparities among provinces in

fiscal capacity will be narrowed , It is inherently a very subjective elements of the

equalization ‘formula’, but on which must be established with reference to the

constitutional mandate for equalization . The original equalization standard was based

upon the per capita revenue-raising capacity of the two richest provinces. As revenue

coverage was expanded , the standard was lowered – first to the average for all ten

provinces (known as the ‘national average’) in 1967 and then to five ‘middle –rich’

provinces in 1982 , excluding extremes consisting of rich , but volatile , Alberta and

the four relatively poor Atlantic provinces . Each excluded group has about 9 percent

of total provincial population.

Another key element of equalization in Canada is the provincial population, because

the equalization standard is always expressed in terms of per-capita fiscal capacity, so

that provinces of different size may be compared on a reasonable basis. Accurate

population estimates are therefore of great importance. They are determined by means

of a census conducted by statistics Canada every five years, and are estimated with

reference to census benchmarks adjusted for annual data on births, deaths and both

interprovincial and international migration .Census counts are now adjusted for

estimates of coverage error.

A program ceiling was added in 1982, which places an upper limit on total annual

entitlements as a percentage share of gross national product in the year for which

entitlements are being calculated. This, together with the change in the program

standard made in the same year , was added in response to federal government

250

concerns over sudden and large year-to-year increases in program entitlements,

which at the time were largely attributable to natural resources and , in particular , to

highly volatile and unpredictable oil and natural gas revenues. Some (relatively

minor) ‘floor provisions’ were added at the same time to protect individual provinces

([particularly the very poorest) in respect of any significant year-over-year reductions

in their total entitlements.

Provincial view

The fundamental issue is where the needs are and who has the money.

Such on imbalance is thought to exist in Canada because the provinces are responsible

for people oriented programs (health Education social services etc) with high inherent

growth rates, yet they rely for funding upon a set of taxes that cannot grow adequately

to fund expenses. The federal government on the other hand has at its disposal a set of

taxes expected to generate revenue that will grow faster than program spending

requirements. These are the conclusions of a series of studies by Ruggeri.58

According to the provincial point of view, Canada has lost its vertical fiscal balance,

which provincial territorial government struggle to meet their spending

responsibilities, particularly in health care and education areas with the fastest growth

rates among public expenditures but federal govt always having budgetary surplus

and projects continued fiscal strength. The Quebec govt has been the busiest of the

provinces in its study of fiscal imbalance. The Seguin commission March 2001 was

created by the Quebec. The situation can be summed up fairly easily the federal

government occupies too much tax room capered to its responsibilities. If the federal

government gives Quebec the GST, we solve the problem of health care financing59.

The concern about vertical fiscal imbalance is not a number game, but an issue that

strikes at the very heart of the Canadian federation.60 The need and they are

significant, are with the provinces, but the means, and they are significant, are in

Ottawa.61

The federal View

There can be no imbalance to the detriment of one order of government when it has

access to all revenue sources and even has a Monday on such major sources as

251

lotteries and natural resources royalties.62 Provinces have access to tax bases such as

resource royalties, gaming and liquor profits, and property taxes. To the federal

government, the fact that virtually all provinces have chosen to reduce taxes in recent

years, it seems to indicate that they have sufficient revenues to manage their spending

pressure. Canada is not the only country involved in the fiscal balance of the

federation. Federal governments in Australia, the United States, Switzerland and

Germany are all constantly being challenged by states, cantons and lender, concerning

the Division of fiscal authority and responsibility. The underlying roots of the crisis of

federalism die in differing concepts of community, in regional economic tensions and

in linguistic differences. “The Intergovernmental mechanism breaks down when

issues are posed in sharp regional terms, or when the institutional interests of

governments are directly involved. The greater failure is in the constitutional

negotiations, past and present, above both these forces combine and where it does not

seem possible to more without complete unanimity,”63

NOTE

252

1 In India currently there are twenty-eight State governments and seven Union territory governments. The finances of Union territories are the direct responsibility of the Central government. The twenty eight State governments are classified in two categories, viz., special category States and Non-special category States. There are eleven special category States and rest are non-special category States. The special category States are given special central assistance in the form of 90:10 plan grants and loan. The same ratio for the non-special category States is 30:70.

2 I.S. Gulati , Centre State Budgetary Transfers, New Delhi: Oxford University Press,1987

3 Ibid

4 The Eleventh Finance Commission had submitted its report in the year 2000, which delineates among other things, the norms of tax share and statuary grants from Centre to the States for the period between 2000-01 and 2004-05.

5 Rao and Chellaiah, Internal Migration-Centre State Grants and Economic of growth in the states of India,1996

6 Tiebout, Regional & Urban Economics,1961, Musgrave, Theory of Public Finance,1969, and Oates, Fiscal Federalism-The Optimal Assignment of Authorities,1972

7 Frey, Bruno S. and Bohnet, Iris, Democracy by Competition - Referenda and Federalism in Switzerland. Publius: The Journal of Federalism, 23, 1993, PP.71-81.

8 R. A Musgrave and P.B Musgrave, Public Finance in Theory and Practice, Tokyo: McGraw Hill, 1976, 2nd Ed.,

9 Tanzi, Vito, Pitfalls on the Road to Fiscal Decentralization, Washington D.C.: Carnegie Endowment Working Paper Nr.19, 2001

10 Adamovich, I.B., Fiscal Federalism for Emerging Economies: Lessons from Switzerland. Montevideo: Latin American and Caribbean Economic Association, 2001

11 Public goods are of three broad categories, namely, pure public goods, impure public goods and private goods. Private goods (publicly provided) are consumed individually and its consumption is contingent upon payment. Impure public goods are goods collectively consumed but their consumption is contingent upon payment while pure public goods are collectively consumed but consumption is not contingent upon payment (Musgrave and Musgrave, 1989)

12 R. A Musgrave and P.B Musgrave, Public Finance in Theory and Practice, Tokyo: McGraw Hill, 1976, 2nd Ed.,

13 Hans Warner Sinn, Environmental Economics,1990 and 1997, available on ideas.repec.org/e/psi146.html

14 Eichenberger, Hosp, Fiscal Federalism For Emerging Economics, 2001, this paper was presented in six th LACEA in Montevideo, 2001, available at www.unifr.ch/ 2001 /Adamovich Hosp2001

15 Miyume Tanzi, Community Resistance & Sustainability 1995; Gboyega, 1994, www.standardchartered.com/hereforgood

16Dwioght R. Lee, The Case for Fiscal Federalism, 1994, available at http://www.mmisi.org/IR/32_01/lee.pdf

17 Tanzi, V., Fiscal Federalism and Decentralization: A Review of some Efficiency and Macroeconomic Aspects. In: Bruno, M. and B. Pleskovic, (eds.) Annual Work Bank Conference of Development Economics, Washington D.C., World Bank, 1995, pp.317 – 322

18 Rangarajan and Srivastava, Regional Imbalance & Federal Structure, 2004, available at sciie.ucsc.edu/workingpaper/2006/rao_singh_aug2006.pdf

19 Martin Feldstein, Lecture Slides 1975; Rao and Das-Gupta, Tax Reforms in India, 1993

20 Dr. Mathew McCartne on Economic Blogger

21 Address by Shri K. C. Pant, Deputy Chairman, Planning Commission on the Occasion of Golden Jubilee Function of the Finance Commission on 9th April, 2003 at Vigyan Bhavan, New Delhi

22 Address by Shri K. C. Pant, Deputy Chairman, Planning Commission on the Occasion of Golden Jubilee Function of the Finance Commission on 9th April, 2003 at Vigyan Bhavan, New Delhi

23 Report of the 13th Finance Commission, Government of India, Chapter 13, Page-257-258

24 Report of the 13th Finance Commission, Government of India, Chapter 8, Page 122,

25 Vithal B.P.R. & Sastry M.L, The Gadgil Formula for Allocation of Central Assistance for State Plans. New Delhi: Manohar Publishers, Centre for Economic and Social Studies, Nizam Observatory Campus, Begumpet, Hyderabad-500016 , 2002

26 R. Ramalingam and K.N. Kurup , Plan transfer to states : revised gadgil formulae and analysis , Economic and political weekly , march 2-9,1991 based on planning commission’s woking papers)

27 M. Govinda Rao, Invisible Transfers in Indian Federalism, Vol.  No.  P. ,1997

28 A .R. C. Report on Financial Administration, 1986, p. 78

29 D. T. Lakdawala, Union State Financial Relation, pp.79-81

30 G.S. Lal, Financial Administration in India, p. 66, 1989

31 Aziz, Ghazala, Fiscal Federalism in India: An Analysis of Fiscal Transfers to States, Working Paper Series, Aligarh Muslim University, January 14, 2010

32 A .R. C. Report of the Study Team on Financial Administration, p. 79

33 Pinaki Chakraborty, Unequal fiscal capacities across India states: how corrective is the fiscal transfer mechanism?, 01 march 2003, page-4

34 Jawahar Lal Nehru Rojgaar Yojna

35 National Rural Employment Guarantee Act

36 Indira Gandhi Awas Yojna

37 Pradhan Mantri Grameen Sadak Yojna

38 Entry 54 of List II (State List) in the Seventh Schedule to the Constitution of India

39 Empowered Committee

40 List II, Entry 49,Seventh Schedule, Constitution of India

41 Eleventh Finance Commission, Government of India, Para 8.16

42 Distribution of this portion of union excise duties should be in relation to the distance “of a state’s per capita income multiplied by the population of the state concerned according to 1971 census.

43 Report of the 9th Finance Commission, Government of India

44 Rao and Sen, 1996, Ch.6

45 13 th Finance Commission, Summary of Recommendation, Chapter 1;pg-3

46 The three new states are Jharkhand (carved out of Bihar), Chhattisgarh (carved out of Madhya Pradesh) and Uttaranchal (Carved out of Uttar Pradesh. While the first two states have continued as general category states, the last one considered to be a special category state.

47 National Sample Survey

48 Net State Domestic Product

49 The Gini coefficient is a measure of inequality. It was developed by the Italian statistician Corrado Gini and published in his 1912 paper "Variabilità e mutabilità". It is usually used to measure income inequality, but can be used to measure any form of uneven distribution. The Gini coefficient is a number between 0 and 1, where 0 corresponds with perfect equality (where everyone has the same income) and 1 corresponds with perfect inequality (where one person has all the income, and everyone else has zero income). The Gini index is the Gini coefficient expressed in percentage form, and is equal to the Gini coefficient multiplied by 100. Retreived from www.wikipedia.org

50 Census Report of India, (2001)

51 Ninth Finance Commission, Government of India

52 Report of the Planning Commission, Government of India, 2001

53 P.V. Rajamannar, (Chairman) in the Minute submitted by him in report of the fourth finance commission pp. 88-89

54 A.R.C. Report on Centre State Financial Relations, pp. 363-65

55 P.V. Rajamannar, (Chairman) in the Minute submitted by him in report of the fourth finance commission pp. 88-89

56 William Niskanen in Buchanan and Musgrave, 1999

57Gagnon, Alain G. and Rafaele Iacovino, Federalism, Citizenship and Quebec: Debating Multinationalism, Toronto: University of Toronto Press, 2007

58 G.C Ruggeri, R. Howard Cr, K Robertson and D. Van wart, “Rebalancing Canada’s fiscal structure”. Policy options December 1993 P. 27-30

59 Yves Seguin, presidential of the commission on fiscal Imbalance, March 2002

60G. C Ruggeri, professors of economics, University of Brunswick, Dec.2001

61Stephane Dion, Federal Minister of inter govt. affairs, Oct 2002

62 Bernard Landry mire of Quebec, May 2001

63 Richard Simeon, Intergovernmental Relations and the Challenges to Canadian Federalism, Paper for the IPA Canada Winnipeg, Aug 79