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India: Fiscal Federalism and Approach to Equalization Indian States: Some Basic Features Institutions Finance Commission Planning Commission Inter-State Council Inter-state council National Development Council State Finance Commission Main Issues Main Issues (continued) Vertical Imbalance Finance Commission: Approach to Determining Transfers Finance Commission: Tax Revenue Sharing Determining Grants:Gap-filling Approach Gap-filling approach (continued) Equalization Approach Equalization in Canada Equalization in Australia Inverse-income criterion Main Recommendations of TFC TFC Recommendations (continued) TFC Recommendations (continued) Challenges to Equalization Distribution of Plan Assistance Reforming the Fiscal transfer System: The Way Forward Reforming the Fiscal Transfer System: The Way Forward(continued) India: Fiscal Federalism and Approach to EqualizationD.K. SrivastavaNational Institute of Public Finance and Policy, New DelhiIndian States: Some Basic Features•28 States; Number growing with increasing fragmentation•Heterogeneity in terms of size of population, income (per capita GSDP), area, distance from centers of economic activities, nature of terrain, cost conditionsInstitutions•Finance Commission•Planning Commission•Inter-State Council•National Development Council•State Finance CommissionsFinance Commission•Constitutionally provided for•Set up every five years under normal circumstances•12 Finance Commissions have given recommendations so far•Core duties defined constitutionally but additional tasks and ‘considerations’given in the Presidential terms of referencePlanning Commission•Created by an administrative order•A permanent body•Main task originally envisaged development and planning•10 Five Year Plans have so far been prepared: 10th Plan to continue until 2006-07•The 5-year periods for FC and the Plans remain unsynchronisedInter-State Council•Established in 1990 under article 263 of the constitution•Prime Minister, Chief Ministers of states, Chief Ministers of UTswith legislatures, Administrators of other UTs, Six Ministers of Union Cabinet nominated by the PM,two Ministers of the Union cabinet nominated as permanent invitees Inter-state council•Basic mandate: to deal with all centre-state and inter-state matters (administrative, political, judicial, financial)•Meets infrequently•Standing committee deals with for continuous consultations and processing of mattersNational Development Council•Apex body for all development related policies and issues•Prime Minister, Deputy Chairman, Planning Commission, Selected cabinet ministers,all chief ministers•The body that finally approves the Five year PlansState Finance Commission•Provided for in the constitutional amendments (73rd and 74th) dealing with rural and urban local bodies•Each state has to appoint and give terms of reference once in 5 years•Two rounds of Such SFCshave been appointed•Deal with revenue sharing and grants from states to local bodiesMain Issues•Vertical Imbalance: relative claims of the centre and states•Horizontal imbalance: increasing disparities•Gap-filling approach and the alternative of equalization transfers•Fiscal needs of the special category states•Multiplicity of channels of transfersMain Issues (continued)•The challenge of Information lags•The challenge of hidden transfers•Pace and content of decentralizationVertical Imbalance•Vertical imbalance by design•Vertical imbalance is the outcome of revenue centralization and expenditure decentralization•This is common in all federal arrangements but degrees differ•Large vertical imbalance is needed when there are large horizontal inequalitiesFinance Commission: Approach to Determining Transfers•Three main channels of transfers•Criteria-based sharing of central tax revenues•General Purpose Grants: Determined on the basis of assessment of needs and resources•Conditional specific-purpose grantsFinance Commission: Tax Revenue Sharing•Evolution of criteria•Population•Distance•Inverse income•Tax effort•Fiscal discipline•Area •Index of InfrastructureDetermining Grants:Gap-filling Approach•Adverse incentives since higher the historical levels of expenditures, and lower the historical levels of revenues, the larger the projected gap•hence, it is in the interest of the states to spend as much as possible and raise as little as possibleGap-filling approach (continued)•States cannot create a history of expenditure unless they finance additional expenditure by borrowing: in other words, the presence of a hard budget constraint is critical to minimize the adverse impact of gap-fillingEqualization Approach•Basic Principle•Fiscal capacity equalization•Capacity equalization with allowance for cost differentialsEqualization in Canada•Provided for in the constitution•“…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”Equalization in Australia•CGC: “State governments should receive funding …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.”Inverse-income criterion•Share of a state is given by•bi=Ni.(1/yi)/[ΣNi.(1/yi]•[ΣNi.(1/yi]=Z is constant for all states•Per capita share of a state can be written as•b*i=Z/yiMain Recommendations of TFC•Over all transfers 38 per cent of centre’sgross revenue receipts•Complete overhaul of on-lending; states to borrow directly subject to limits imposed by a loan council•Consolidation of outstanding loans at 7.5 per cent interest rateTFC Recommendations (continued)•FRBMA requirements for centre and states•Outlook for reducing fiscal deficit and revenue deficit and improving sustained growth prospects•New grants for maintenance of roads and bridges, government buildings, forestsTFC Recommendations (continued)•Raising the share of states to 30.5 per cent•Raising the share of grants in devolution•Special equalizing grant for health and education•CSSsto be devolved to the states•Monitoring mechanism for all conditional grantsChallenges to Equalization•Multiple Channels and Interface with Finance Commission•Issues of Information Lag•Disparities and Extent of Required Redistribution•Claims of Special category statesDistribution of Plan Assistance•StatesGrantsLoansTotal•Special27330•General214970•Total4852100Reforming the Fiscal transfer System: The Way Forward•Re-look at the Role of Planning•Abolishing Plan-non-Plan distinctions in expenditure•Focusing Governments’attention on public and merit goods•Hard-budget constraint on centre and states through fiscal responsibility legislationsReforming the Fiscal Transfer System: The Way Forward(continued)•Controlling Revenue and Fiscal Deficit•Effective Decentralization•Encouraging migration to urban areas•Norm-based equalization Approach to transfers•Redesigning centrally sponsored schemes