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Equalising Transfers through the Finance Commission

This article discusses the issues that the Thirteenth Finance Commission has to address to enable it to design a scheme of transfers that is just and fair to all states. A significant fiscal correction took place in most states over the last four years. The most important trend that has emerged is the differing significance of transfers to the rich and poor states. It is imperative that the thFC accepts the concept of equalisation as the guiding principle in deciding transfers. Another issue it may have to address is the mix of tax share and grants.

PERSPECTIVEEconomic & Political Weekly EPW july 19, 200837Equalising Transfers through the Finance Commissionn j kurianThis article discusses the issues that the Thirteenth Finance Commission has to address to enable it to design a scheme of transfers that is just and fair to all states. A significant fiscal correction took place in most states over the last four years. The most important trend that has emerged is the differing significance of transfers to the rich and poor states. It is imperative that thethFC accepts the concept of equalisation as the guiding principle in deciding transfers. Another issue it may have to address is the mix of tax share and grants.According to Oates (1972), the efficiency of a federal set-up lies in assigning important revenue raising powers to the government and allocating major expenditure responsibili-ties to the lower levels of government and equipping them to spend by transferring resources from the centre. Indeed, most of the federations across the world have been following this fiscal efficiency criterion for a long time. The founding fathers of the Indian Constitution also followed this criterion, perhaps, not necessarily for fiscal efficiency alone. While most of the important and buoyant revenue sources are assigned to the union government, major expenditure responsibilities in social and economic sectors are assigned to the state governments. The Constitu-tion has assigned the responsibility of correction of this fiscal imbalance to the finance commissions. A second federal principle, which is universally accepted is the equalisation of basic services across the federal units. There may be vast differences between fiscal capacity and fiscal needs across states. This may arise due to historical/geographical reasons or due to a variety of other reasons. In the Indian context, the level of social and economic development across the states differed considerably. Mandates of ConstitutionOne of the important mandates of the finance commissions is to ensure equita-ble distribution of the share of central taxes as under Article 270 of the Consti-tution. A second mandate is to assign grants-in-aid to the states, which are in need of assistance under Article 275 of the Constitution.Soon after the constitutional scheme came into existence, the government of India started the five-year plans for the socio-economic development of the country. One of the important objectives of the five-year plans has been to reduce the regional imbalances in social and economic development. To achieve this objective, the centre has been providing financial assistance to state governments for development projects, besides making direct investments in major infrastruc-tural and industrial projects in backward regions. In the wake of the economic reforms, which resulted in the deregula-tion of economic activities, the effective-ness of the planning process was diluted. The private sector has become the principal engine of economic growth. This has resulted in an aggravation of regional inequalities. For example, the per capita income of the richest state (Haryana) in 2005-06 was about five times higher than that of the poorest state (Bihar). In contrast, the difference in per capita income between the richest (Punjab) and poorest (Bihar) states in 1990-91 was just about three times. This increasing economic disparity has implications for the fiscal capacity of the states, which in turn makes the job of the Finance Commis-sion (fc) more difficult.From early 1990s onwards, state finances have been under severe strain on account of a variety of reasons. Financial sector reforms initiated as part of economic reforms implied that the state governments will have to pay market-related interest rates on loans from the banking system and the centre. This resulted in a significant increase in the interest burden of the state governments. As compared to less than 15 per cent of revenue expenditure in the early 1990s, the interest payment soared to more than 30 per cent of revenue expenditure of all the states together a decade later. In the post-reform period, states started provid-ing fiscal incentives including tax holidays and reduced rates of taxes to attract private investment. As a result, those states, which succeeded in attracting private investment found that their tax revenues were growing at a rate that was much slower than their economies. Further, the more buoyant service sector of the economy could not be taxed by the state governments as per the constitutional This is a revised version of a paper presented in a seminar organised by the Foundation for Public Economics and Policy Research in Delhi on “Challenges Before the Thirteenth Finance Commission” on May 17, 2008. The author has benefited from the comments of D N Rao who was the discussant of the paper and other participants of the seminar. The usual disclaimer applies. Research assistance by Jaya Lekshmi Nair is gratefully acknowledged. N J Kurian (njkurian@yahoo.com) is at the Council for Social Development, New Delhi.

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PERSPECTIVEEconomic & Political Weekly EPW july 19, 200839Fund and loans from this fund did not form part of central loans. The TWFC recommended termination of the loan component of State Plan Assistance from the centre, which resulted in a steep decline since 2005-06.As a result of the changes discussed above, there have been some significant changes in the structural composition of GDT over the past 18 years. Throughout the period, the share in central taxes constituted the largest component of GDT, varying from the lowest level of 34.9 per cent in 1990-91 to 52.6 per cent in 2005-06. Grants-in-aid varied from the lowest share of 23 per cent in 1998-99 to the peak level of 45 per cent in 2006-07. Loans from the centre were at their peak of importance in 1998-99 with a share of 38.5 per cent. After that, the loan share has been more or less steadily declining to reach below 5 per cent in 2005-06. Overall,the share of central taxes and grants-in-aid improved and that of loans declined.Central transfers during the regimes of differentFCs are presented in Table 2. GDT increased more than fourfold in nominal terms between the Ninth and Twelfth FCs. As a percentage ofGDP, however, there was a significant decline of GDT from 6.8 during NFC to 5.5 during the first three Table 2: Central Transfers during Regimes of Different Finance CommissionsItem Ninth FC Tenth FC Eleventh FC Twelth FC 1 2 3 4 5GDT (Rs crore) 51,765 88,314 1,31,829 2,25,394GDT as per cent of GDP 6.8 5.7 5.2 5.5GDT as per cent of aggregate receipts of states 42.3 38.7 30.2 33.0Net devolution and transfers (Rs crore) 39,798 62,965 84,515 2,04,058NDT as per cent of GDP 5.2 4.1 3.3 4.9NDT as per cent of aggregate receipts of states 32.5 27.8 19.3 29.8Share in central taxes (Rs crore) 19,710 37,608 61,047 1,15,315SCT as per cent of GDT 38.0 42.6 46.2 51.3SCT as per cent of GDP 2.6 2.4 2.4 2.8Grants-in-aid 17,34324,26746,44399,008GIA as per cent of GDT 33.4 27.7 35.2 43.9GIA as per cent of GDP 2.3 1.6 1.8 2.4Gross loans from centre (Rs crore) 14,632 26,440 24,337 11,071GLFC as per cent of GDT 28.6 29.6 18.6 4.8GLFC as per cent of GDP 1.9 1.7 1.0 0.3Figures are annual averages. Figures for the Twelveth FC are averages for three years, viz, 2005-06, 2006-07 and 2007-08 only.GDT and NDT are gross and net devolution and transfers; SCT is states’ share in central taxes; GIA is grants-in-aid and GLFC is gross loans from the centre.Source: RBI (2007).Table 1: Composition of Gross Devolution and TransfersYear Share in Central Taxes Grants-in-Aid Loans from Centre Total Share in Central Taxes Grants-in -Aid Loans from Centre Total Rupees(crore) %ofTotal 1 2 3 4 5 6 7 8 91990-91 14,242 12,643 13,974 40,859 34.9 30.9 34.2100.01991-92 16,848 15,226 13,069 45,113 37.3 33.7 29.0100.01992-93 20,580 17,759 13,100 51,439 40.0 34.5 25.5100.01993-94 22,395 21,176 14,277 57,848 38.7 36.6 24.7100.01994-95 24,885 19,911 18,742 63,538 39.2 31.3 29.5100.01995-96 29,048 20,873 18,804 68,725 42.3 30.4 27.4100.01996-97 35,038 22,949 22,931 80,918 43.3 28.4 28.3100.01997-98 40,411 23,853 29,744 94,009 43.0 25.4 31.6100.01998-99 39,421 23,480 39,3671,02,268 38.5 23.0 38.5100.01999-2000 44,121 30,177 21,354 95,652 46.1 31.5 22.3 100.02000-01 50,734 37,289 18,7071,06,730 47.5 34.9 17.5 100.02001-02 52,215 42,601 24,3961,19,213 43.8 35.7 20.5100.02002-03 56,655 45,170 26,8311,28,657 44.0 35.1 20.9100.02003-04 67,080 50,834 25,8711,43,785 46.7 35.4 18.0100.02004-05 78,550 56,322 25,878 1,60,750 48.9 35.0 16.1 100.02005-06 94,024 76,750 8,097 1,78,871 52.6 42.9 4.5 100.02006-07(RE)1,15,737 1,02,955 10,197 2,28,889 50.6 45.0 4.5 100.02007-08(BE) 36,184 1,17,320 14,918 2,68,422 50.7 43.7 5.6 100.0Source: RBI (2007).years of TWFC. The principal reason for this steep decline, as noted earlier, is the reduction of loans from the centre follow-ing the TWFC recommendation to do away with central loans to state plans.3 TheGDT as a share of GDP was even lower at 5.2 per cent during the regime of EleventhFC (EFC). This was mainly on account of the declining importance of the loan compo-nent in the central transfers following the bilateral memorandum of understandings between the union finance ministry and state governments regarding reduction of state deficits.GDT as a share of aggregate receipts of the state governments also showed a similar downward trend over the period of the last fourFCs.The annual average net devolution and transfers (NDT) has increased more than fivefold over the fourFC periods, i e, even faster than that ofGDT. NDT as a share of GDT has increased from 77 per cent during NFC to 91 per cent during TWFC after hitting lower levels of 71 per cent and 64 per cent during the regimes of TFC and EFC respectively. This rather puzzling trend is on account of the accelerated repayment of high cost central loans during the regimes of the TFC andEFC and the resulting reduced repayment liability during the regime ofTWFC.NDT as a percentage ofGDP declined from 5.2 duringNFC to 4.1 during TFC and further to 3.3 during EFC. However, as a result of reduced repayment liability to the centre during the span ofTWFC, the NDT share inGDP increased to 4.9 per cent. The NDT as a percentage of aggregate receipts of the states showed a similar declining trend from 32.5 duringNFC to 19.3 duringEFC and then increasing to 29.8 during the TWFC.The rest of Table 2 presents the differ-ent components ofGDT during the regimes of the fourFCs. Each component is also expressed as a percentage of GDT and GDP during each of theFC regimes. The weight of the share of central taxes (SCT) inGDT has been steadily increasing over the FC periods from 38 per cent during NFC to 51 per cent duringTWFC. A more or less similar upward trend is shown by grants-in-aid as a percentage of GDT. Gross loans from the centre as a share of GDT has, however, shown a steady decline from the level of 30 per cent during TFC to
PERSPECTIVEjuly 19, 2008 EPW Economic & Political Weekly40just under 5 per cent during the TWFC, the reasons for which have already been noted.State-wiseGDT are presented in Table 3. For each of the 17 major states, the annual average GDT andGDT as percentage of GSDP during each of the four recent FC regimes are given in the table. Certain broad trends of GDT as a percentage of GSDP over time and across the states are discernable. The importance ofGDT in relation to state income has been coming down in the case of economically developed states like Gujarat, Haryana, Kerala, Maharashtra, Punjab and Tamil Nadu. However, the importance of GDT in relation to GSDP has been on the increasein the case of economically backward states. As a result, the diffe-rencebetweenthe percentages across the statesincreased significantly over the FC regimes – while the lowest percentage of Haryana decreased from 3.8 to 2.2, the highest percentage of Bihar increased from 15.3 to 26.4. The relative importance of GDT in Bihar compared to Haryana increased from four times to 12 times during this period.Column 10 of Table 3 presents the per capita average annualGDT across the states during 2005-08. Here, the interstate variation is much less – the lowest amount being Rs 1,104 for Haryana and the highest amount being Rs 3,505 for Assam. The absolute amount for Bihar is not even double that for Haryana.Table 4 presents the state-wiseSCT in relation to total revenue receipts of the states and in relation to total tax receipts of the states. Columns 2 to 5 give the average annualSCT as a percentage of total revenue receipts. During the NFC regime, it varied from 8.8 for Haryana to 38.8 for Bihar. The dependence of Bihar on SCT further increased to 58 per cent by the time of EFC and slightly reduced to 56.1 per cent by the time of TWFC. In case of Haryana, however, the share came down to 6.3 per cent during EFC period and then went up to about 8 per cent. Other states which depend heavily on SCT to boost their revenue receipts are Jharkhand, Orissa and Uttar Pradesh. On the other hand, Gujarat, Haryana, Maharashtra and Punjab have least dependence on SCT to augment their revenue receipts.SCT as a share of total tax revenues of the states during the regimes of different FCs are presented in columns 6 to 9 of Table 4. Four states, viz, Assam, Bihar, Jharkhand and Orissa have been drawing more than 50 per cent of their tax revenues fromSCT during the regimes of all the four FCs. While the dependence of Bihar on central taxes has been steadily increasing from 59 per cent to 74 per cent over the period, the other three states have more or less maintained their dependence at about 50 per cent throughout the period. On the other hand, the share of SCT in total tax revenues has remained consistently low at below 20 per cent in the case of richer states like Gujarat, Haryana, Maharashtra and Punjab. An interesting fact, however, is the increase in the share ofSCT in their tax revenues during the regime of the TWFC as compared to the period ofEFC. This appears to be mainly on account of the higher tax buoyancy experienced by the centre as compared to the states.A few important fiscal indicators are presented, state-wise, in Table 5 (p 41). Outstanding liabilities at the end of March 2007 as given in column 2 indicate that Andhra Pradesh, Maharashtra, Uttar Pradesh and West Bengal have liabilities in excess of Rs1 lakh crore each. States with less than Rs 50,000 crore liability are Table 3: State-wise Gross Devolution and Transfers (GDT)Major States GDT (Rs crore) GDT as % of GSDP Per Capita GDT 1990-95 1995-2000 2000-05 2005-08 1990-951995-2000 2000-05 2005-08 (2005-08) 1 2 3 4 5 6 7 8 9 10Andhra Pradesh 3,720 6,794 10,142 15,048 7.4 6.8 6 5.6 1,886Assam 2,098 3,487 5,186 9,918 15.314.9 13.819.33,505Bihar 4,4287,27410,55217,91212.712.11926.42,008Chhattisgarh --2,264 4,984 --6.7 10.0 2,245Gujarat 2,016 4,006 5,819 8,238 4.6 4.3 4.2 3.4 1,526Haryana 758 1,531 1,429 2,528 3.8 4.0 2.1 2.2 1,104Jharkhand --4,293 5,323 --11.3 9.8 1,842Karnataka 2,199 3,867 6,502 11,3596.0 5.2 5.3 5.8 2,043Kerala 1,707 2,529 3,798 6,782 7.3 5.1 4.6 4.9 2,049Madhya Pradesh 3,222 5,574 7,628 12,436 7.7 6.7 8.7 10.0 1,907Maharashtra 3,754 6,362 5,948 14,067 4.0 3.3 2.02.8 1,360Orissa 2,2333,6796,36410,56713.811.513.414.62,745Punjab 1,800 2,393 1,964 4,482 7.1 4.8 2.6 3.8 1,737Rajasthan 2,826 4,8487,036 11,2059.1 7.6 7.5 8.0 1,837Tamil Nadu 3,218 4,671 6,191 10,227 6.5 4.6 3.9 4.2 1,581Uttar Pradesh 7,983 12,481 17,541 31,808 10.2 8.5 8.7 10.4 1,768West Bengal 3,527 6,853 9,229 14,378 7.2 7.0 5.5 6.0 1,704Source: RBI (2007). Table 4: State-wise Share in Central Taxes (SCT) in Relation to Total Revenues, Receipts and Total Tax RevenuesMajor States SCT as % of Revenue Receipts SCT as % of Tax Receipts 1990-951995-2000 2000-05 2005-08 1990-95 1995-2000 2000-05 2005-08 1 2 3 4 5 6 7 8 9Andhra Pradesh 21.2 23.6 18.6 18.4 30.5 32.6 25.3 24.7Assam 22.226.110.415.654.158.350.950.2Bihar 38.846.758.056.159.362.270.874.4Chhattisgarh --26.2 26.1 --37.8 36.6Gujarat 11.012.99.713.215.217.614.217.5Haryana 8.8 8.3 6.3 7.9 14.815.28.8 10.6Jharkhand --32.5 35.4 --50.2 52.0Karnataka 16.617.816.414.221.722.620.818.3Kerala 19.719.117.417.025.223.120.621.0Madhya Pradesh 24.1 26.4 29.7 30.5 38.8 38.4 40.7 41.9Maharashtra 12.010.88.710.2 16.6 14.210.813.1Orissa 33.334.035.534.954.952.750.950.6Punjab 10.59.4 6.6 7.8 10.9 11.512.513.1Rajasthan 21.121.923.526.737.334.133.736.9Tamil Nadu 19.1 17.7 15.0 15.8 24.3 21.0 18.0 18.6Uttar Pradesh 28.8 35.9 39.5 37.9 44.7 46.8 47.8 48.7West Bengal 26.7 29.7 30.9 30.8 34.1 36.5 39.6 40.3Source: RBI (2007).
PERSPECTIVEEconomic & Political Weekly EPW july 19, 200841Assam, Bihar, Chhattisgarh, Haryana, Jharkhand and Orissa. The remaining seven states have outstanding liabilities between Rs 50,000 and Rs 1 lakh crore. Debt as a percentage ofGSDP presented in column 3 of Table 5, however, gives a more realistic picture of the debt sustain-ability of different states. While Assam, Chhattisgarh, Gujarat, Haryana, Karnataka, Maharashtra and Tamil Nadu with debt-GSDP ratio of less than 40 per cent are in the comfortable zone, states with such ratio higher than 50 per cent, viz, Bihar, Orissa, Rajasthan and Uttar Pradesh have to worry about their debt sustainability. The remaining six states having debt-GSDP ratio between 40 and 50 per cent are also, from the debt-sustainability point of view, in uncomfortable zones. Of course, their individual debt sustainability position will depend on specific factors like growth rate and interest burden.Column 4 of Table 5 indicates the com-mitted expenditure liability as a percent-age of the state’s own revenues. One of thenoteworthy features is the immense variation in the ability of the major states in financing their committed expenditure liabilities from their own revenues. Bihar and West Bengal are true outliers in the sense that their committed expenditure far exceeds their own revenues. Keeping in mind the fact that committed expendi-ture here includes just interest and pen-sion liability and essential administrative services, the fiscal situation of these two states can be characterised as, indeed, grim. Only those states, which have com-mitted expenditure less than 50 per cent of their own revenues can be characterised as fiscally comfortable. Five states are in this category, viz, Chhattisgarh, Haryana, Karnataka, Maharashtra and Tamil Nadu. The remaining 10 states have a committed expenditure liability between 50 and 100 per cent of their own revenue receipts varying from just 50 per cent for Gujarat to 89 per cent for Orissa.Own tax revenues as a percentage of GSDP are given in columns 5 and 6 of Table 5. Column 5 gives the three-year average ratios for 2003-04 and 2005-06 whereas column 6 gives the revised estimates figures for 2006-07. The first important point to be highlighted is the across the board increase in the tax-GSDP ratio from the triennium 2003-06 to the annual figure for 2006-07. This appears to be partly the effect of introduction of VAT and partly on account of the better performance of the state economies and better revenue efforts. Jharkhand is the only exception where the tax-GSDP ratio remained unchanged. Uttar Pradesh, which has not adopted VAT, however, has shown a respectable increase in the tax ratio. The more surprising but worrying fact is the significant interstate variation in the tax ratio. The tax-GSDP ratio in 2006-07 varied from 12.3 per cent in Karnataka to 4.8 per cent in West Bengal. These two states have more or less the same level of per capita income. But the tax ratio in West Bengal is just a little over one-third of that in Karnataka. This is truly intriguing and the reasons need closer examination, which cannot be attempted here. Unlike the small states which are characterised as “special category” states, all the 17 states taken up in our study are major states which are considered to be fiscally viable. The gap between the tax potential and the Table 5: Few Important Fiscal IndicatorsMajor States Outstanding Liabilities Debt as % Committed Exp of Own Tax Revenue at the End of March GSDP State Governments as % of GSDP 2007 (Rs Crore) (2006-07) as % of State’s Own 2003-04 2006-07 Revenue (2006-07) to 2005-06 (RE) 1 2 3 4 5 6Andhra Pradesh 1,11,279 42.1 52.1 7.9 9.6Assam 19,352 38.081.56.1 7.0Bihar 48,51473.3195.3 6.0 6.8Chhattisgarh 14,282 28.7 36.58.0 10.7Gujarat 89,21736.450.07.17.5Haryana 28,45124.535.48.99.1Jharkhand 21,36640.072.55.85.8Karnataka 53,40727.534.410.512.3Kerala 54,56840.271.78.78.8Madhya Pradesh 53,830 43.8 56.7 7.6 8.3Maharashtra 1,61,11332.442.87.98.1Orissa 41,77858.288.67.08.0Punjab 55,39247.752.28.08.4Rajasthan 71,09050.864.97.48.1Tamil Nadu 68,434 28.4 43.0 10.2 11.6Uttar Pradesh 1,71,404 55.9 77.2 6.8 8.0West Bengal 1,22,895 47.2 134.9 4.7 4.8Committed expenditure of state governments in column 4 includes interest payments, pension and administrative services.Source: RBI (2007).Table 6: Decomposition of Gross Fiscal Deficit(in %)Major States 2000-01 (Accounts) 2005-06 (Accounts) Revenue Deficit Capital Outlay Net Lending Revenue Deficit Capital Outlay Net Lending 1 2 3 4 5 6 7Andhra Pradesh 49.2 37.3 13.5 0.8 92.3 6.9Assam 50.636.512.9-424.3505.119.1Bihar 60.623.216.2-2.256.345.9Chhattisgarh ----325 348.8 75.2Gujarat 78.937.5-16.4 6.4111-17.2Haryana 26.863.89.4-424.8564.4-39.6Jharkhand ---31.6 45.2 23.2Karnataka 44.146.19.7 -62.7157.94.8Kerala 81.214.9474.819.55.6Madhya Pradesh 48.6 40.9 10.4 -0.7 144.9 -44.1Maharashtra 87.3 49.7 -37 21.8 57.2 21Orissa 57.925.216.8-174375.5-101.4Punjab 59.835.74.546.857.1-3.9Rajasthan 61.132.16.9 12.883.43.8Tamil Nadu 67.7 30.5 1.8 -86.7 180.2 6.5Uttar Pradesh 61.8 32.1 6.1 12.6 86.4 1West Bengal 69.4 12.1 18.5 77 17.2 5.8All states 59.8 34.8 5.4 7.8 86.1 6.1Source: RBI (2007).
PERSPECTIVEjuly 19, 2008 EPW Economic & Political Weekly42actual tax revenue raised is an important issue in the context of GDT, which is to be addressed by the FCs.The decomposed fiscal deficit for 2000-01 and 2005-06 are presented, state-wise, for major states in Table 6 (p 41). The reference years happen to be the first year of the Eleventh and TwelvethFCs respec-tively. The most important change, over the five-year period, is the impressive improvement in the share of capital outlay in all states. The overall improvement is from about 35 per cent of the gross fiscal deficit (GFD) to 86 per cent of GFD. This has been brought about by a correspond-ing reduction in revenue deficit from about 60 per cent to just about 8 per cent for all states. There was no significant change in the share of net lending out of the GFD. Thus, at the aggregate level, while out of every Rs 100 borrowed, Rs 60 was used up for meeting the revenue gap in 2000-01, this has come down to just Rs 8 by 2005-06. As a result, the share of capital outlay out of Rs 100 borrowed improved from Rs 35 to Rs 86.Not only that there was a huge reduc-tion of revenue deficit at the aggregate level, there are a number of states, which moved from a revenue deficit regime to a revenue surplus regime. While no major state had revenue surplus in 2000-01, there were eight out of 17 major states with revenue surplus by 2005-06. Apart from the overall improvement in revenue receipts of the states on account of improved tax-GSDP ratios of individual states and increase in central transfers, another factor which contributed to reduc-tion in revenue deficit was the fiscal self-discipline imposed by the states through theFRBM acts. As noted earlier, except two states, viz, Sikkim and West Bengal, all others have passedFRBM acts with more or less the same target dates for elimina-tion of revenue deficits.One concern in this context, however, is regarding significant improvement in revenue deficit in some of the fiscally weak, states like Assam, Bihar and Orissa. It appears that these states may have achieved revenue surplus at the expense of essential social services.4 These states are known for poor human development indicators on account of low levels of social expenditure, especially in education and health. One has to probe further to determine whether achieving fiscal targets was actually at the cost of essential social services. A related policy issue is whether all states should be treated at par as far as fiscal correction is concerned, irrespective of their fiscal health. In this context, it needs to be mentioned that theTWFC recommendation, which formed the basis for stringent fiscal correction by the states was critiqued for treating all states at par irrespective of their fiscal health.According to column 6 of Table 6, Kerala and West Bengal are the two states with the lowest percentage share ofGFD devoted to capital outlay. While not overlooking the fact that both states have a relatively high level of committed expenditure (as indicated in Table 5), one cannot exclude the possibility of misclas-sification of capital outlay as revenue expenditure. This is especially true in the context of Kerala where one-third of the state plan outlay is being passed on to the elected bodies at the local level as plan grants. Though the entire amount is treated as revenue expenditure in state budgetary classification, a significant share of such funds are used for capital formation.5The projected state plan outlays for the Tenth and Eleventh Plans along with actual expenditure during the Tenth Plan are presented state-wise in Table 7. A cursory look at columns 4 and 6 indicate that the per capita plan outlays projected by richer states are significantly higher than those by the poorer states during both the Tenth Plan as well as the Eleventh Plan.Stateplan outlays are essentially to build up capacity for economic, social and human development. Higher outlays by states which have already achieved higher development and lower outlays by states, which are lagging behind imply that the gap in development potential among the states will further widen at the end of each five-year plan.At the time of formulation of five-year plans, most states including the economi-cally weaker ones, project ambitious plan outlays. The experience at the end of every plan is that several states fail to mobilise sufficient resources to fulfil the projected plan, while some states perform better than projected. More often, states which failed to reach the target are the poorer ones and states, which did fulfil or even exceed the target are the richer ones. Column 4 of Table 7 shows that better off states like Andhra Pradesh, Gujarat, Haryana and Karnataka more than fulfilled their Tenth Plan projected outlays. On the other hand, poorer states like Bihar, Orissa, Uttar Pradesh and West Bengal lagged behind. From the inception of the economic reform process in the beginning of 1990s, one of the factors, which enabled the economically and administratively better off states to fulfil the plan outlay targets has been their ability to attract external Table 7: Projected Plan Outlays and ExpenditureMajor States Projected 10th Projected 10th Plan Per Actual Per Capita Projected 11th Plan Projected 11th Plan Outlay Capita Outlay at 10th Plan Exp at Outlay Plan Per Capita (Rs Crore) Base Year Prices Current Prices (Rs Crore) Ourlay (Rs) 1 2 3 4 5 6Andhra Pradesh 46,614 6,155 8,460 1,47,395 18,468Assam 8,315 3,122 4,307 23,9548,461Bihar 21,0002,5332,53560,6316,800Chhattisgarh 11,000 5,289 7,923 53,73024,160Gujarat 40,0077,9078,7151,06,91819,806Haryana 10,2854,8785,74333,37414,556Jharkhand 14,6335,438 6,90440,24013,933Karnataka 43,5588,26010,9411,01,66418,299Kerala 24,0007,5387,12441,94012,683Madhya Pradesh 26,190 4,337 5,693 70,329 10,788Maharashtra 66,632 6,887 5,331 1,27,53812,337Orissa 19,0005,1763,85532,2258,377Punjab 18,6577,6815,29428,92311,232Rajasthan 27,3184,837 5,944 71,73211,752Tamil Nadu 40,000 6,440 6,895 85,344 13,187Uttar Pradesh 59,708 3,596 3,238 1,81,094 10,067West Bengal 28,641 3,570 2,932 63,779 7,561Source: Government of India (2007).
PERSPECTIVEEconomic & Political Weekly EPW july 19, 200843aid from bilateral and multilateral donors. Often, such external aid to some of the major states significantly exceeded the central assistance for state plans. More importantly, the external aid mostly received as sovereign loans by the central government was being passed on to the states on the same terms and conditions as central assistance to the state plans.Another factor, which has been contri-buting to the differing development per-formance across the states has been the role of private investment. An aspect of economic liberalisation has been the free-dom of private sector to choose the loca-tion to set up industries of their choice. This has led to a lot of competition among the states to attract private investment. By and large, states with bettersocialand economic infrastructure and efficient ad-ministrative culture succeeded in attract-ing more private investment. However, various concessions and incentives offered by the states in a competitive manner also helped the private sector in choosing among the better off the states. On the whole, after private investment has become the principal engine of economic growth following economic liberalisation, the gap between the richer and poorer states in terms of almost all aspects of development has been widening.ConclusionsThe foregoing discussions clearly indicate certain trends, which have emerged over the last two decades. The most important among them is the differing significance of central transfers to the rich and to the poor states now. For example,GDT consti-tutes just 2 per cent of state income in Haryana whereas it is more than 25 per cent of state income in Bihar. Similarly, central taxes account for about 75 per cent of the tax receipts in Bihar as compared to just about 10 per cent in Haryana. Commit-ted expenditure as a share of own revenues varies from 35 per cent in Haryana to 195 per cent in Bihar.Differing fiscal needs and fiscal capaci-ties of federal units are the hallmarks of any federal country and in this matter India is not an exception. In the past, every FC had accepted the concept of equalisa-tion as the guiding principle. But in the past, the FCs have not succeeded in fulfilling this objective.6 More often the revenue gaps as reported by the state governments formed the basis for gap-filling grants. To be fair to every state, equalisation transfers have to be workedouton the basis of fiscal capaci-ties, cost conditions and expenditure efficiency. There have been a number of instances in the past when the gap-filling approach, without taking into account fiscal capacities and expenditure norms, led to undeserving states getting benefits at the cost of deserving states.Another issue which the THFC may have to address will be the mix of tax share and grants-in-aid. Grants are more effective in state-specific and purpose-specific target-ing. Apparently, following this criterion, theTWFC had increased the importance of grants-in-aid by specifically assigning grants-in-aid for education, healthcare and asset maintenance. However, the tax share cannot be brought down to pursue this objective further. Again, the formula for tax sharing cannot be made too skewed to achieve the objective of equity. Already large states like Bihar and Uttar Pradesh, which contribute comparatively smaller shares to the central tax kitty receive significantly higher shares as devolution. In contrast, states like Gujarat and Mahar-ashtra, which account for a very high proportion of central tax revenues receive only a very small share by way of devolu-tion. In the wake of the report of the EFC, this issue came the forefront. One way out of this sensitive predicament may be to raise the implicit ceiling of central trans-fers from the present 38 per cent of the total tax revenue of the centre to, say 45 per cent. With the present buoyancy of central taxes, this is not an impossible proposition. Maybe with the proposed introduction of the general sales tax and a fair sharing of its proceeds between the centre and states, these problems may be automatically solved.Another perennial problem, which eludes solution is the existing multi- channel central transfers to the states, viz, FC, Planning Commission and central ministries. Also, the disconnect between the award period of the FCs and the five-year plans creates further complications. In this context, a handicap of the FCs is worth mentioning. While the Planning Commission and ministries are continuing institutions with institutional memories, the situation is totally different in the case of the FCs. They suffer from an acute absence of institutional memory. A typical FC gets two years from the date of its constitution to the submission of the report. Out of this, the first six months are spent on setting up and settling down. Visiting 28 states and interacting with all the concerned parties will take the better part of the next year. Truly, the FC will actually get a maximum period of six months to do its job. Some thought has to be given to the idea of making the commis-sion a continuing constitutional body. Pending this, there should be some serious thinking about a full-fledged permanent secretariat for FCs. Notes 1 The tax-GDP ratio in 2003-04 was 9.2 per cent, which rose to 12.5 per cent by 2007-08. More importantly, the 80th amendment to the Consti-tution in 2000 based on the recommendation of Tenth Finance Commission enabled the states to share the highly buoyant corporation tax.2 Major states are defined as all states with a population of 20 million or more. The 17 states included in this group together account for 95 per cent of the population of the country. The remain-ing 11 states have been left out from detailed analysis mainly for data manageability. This in no way reflects any lesser importance assigned to the smaller states in this study. 3 The central intermediation in the debt market to arrange loans for the states from the banking sector had been an anachronism for quite sometime. More importantly, the state govern-ments did not have the option not to take loans from the centre. The grant component of central assistance to state plan was invariably accompa-nied by the loan component. 4 If these states have, indeed, further rolled back the meager public expenditure in social services to achieve revenue surplus they may even loose their legitimate equalisation grants from the THFC. 5 According to the present budgetary classification, any grant is classified as revenue expenditure even if the entire amount is used by the grantee for capital formation. One of the reasons for the very slow process of financial devolution to local self-governments in most states appears to be this irrational budget classification. It is high time that the Comptroller and Auditor General, Reserve Bank of India, finance ministry and Planning Commission together sort out these problems. 6 The late Amaresh Bagchi used to passionately argue for equalising fiscal transfers. See for example ‘A Note of Observations’ by him attached to the report of the EFC, of which he was a member.ReferencesGovernment of India (2007):Eleventh Five-Year Plan (2007-12): Volume-II, Planning Commission.Oates, W E (1972): Fiscal Federalism, Harcourt Brace Jovanovich, New York.Reserve Bank of India (2007): ‘State Finances – A Study of Budgets of 2007-08’.

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