The way in which the terms of reference of successive finance commissions have been framed, including that of the Thirteenth Finance Commission, has diluted the basic constitutional rationale of having such a statutory commission. Various deficiencies in the transfer system require correction not through a heavy reliance on tied and conditional grants (as we have seen in recent years), but with an alternative approach which accommodates and protects the objectives of equity, efficiency and autonomy of the recipient state governments.
SPECIAL ARTICLEoctober 25, 2008 EPW Economic & Political Weekly86Intergovernmental Transfers: Disquieting Trends and the Thirteenth Finance CommissionT M Thomas Isaac, Pinaki ChakrabortyThe way in which the terms of reference of successive finance commissions have been framed, including that of the Thirteenth Finance Commission, has diluted the basic constitutional rationale of having such a statutory commission. Various deficiencies in the transfer system require correction not through a heavy reliance on tied and conditional grants (as we have seen in recent years), but with an alternative approach which accommodates and protects the objectives of equity, efficiency and autonomy of the recipient state governments.The provision for the periodic appointment of an independ-ent finance commission, with a semi judicial character to limit the scope of discretion of the centre in the matter of resource flows to the states was a key stone of the basic fiscal structure envisaged in the Constitution. However, this basic structure is being undermined due to proliferation of transfers through various other channels outside the statutory transfers recommended by the finance commissions. Many of these trans-fers are not only discretionary; they are directly going to district authorities and societies bypassing the state budgets. Multilateral and bilateral lending institutions are also entering in a big way in determining state level fiscal policy through various sectoral and structural adjustment lending linked to fiscal reforms. The reform era also has seen a big push for rule-based fiscal control at the state level at the instance of Twelfth Finance Com-mission (TWFC). These changes in intergovernmental fiscal trans-fers have made the system complex and states are increasingly finding it difficult to pursue an independent state level fiscal policy. The straitjacketed reform approach of the TWFC with its uniform deficit reduction targets ignored the fiscal capacity differentials and differences in public service delivery needs across states, which has the potential to accentuate spatial inequalityinthe provisioning of public services across states in the era of reforms. This period has also witnessed an increase in the share of condi-tional and tied transfers to the states. One of the most disturbing aspects of this phenomenon is the attempts to link even the finance commission’s transfers to fiscal performance. A few exam-ples in this context are the Monitorable Fiscal Reforms Programme of the Eleventh Finance Commission (EFC), the Fiscal Responsi-bility Acts (FRA) of TWFC and the terms of reference (TOR) of the Thirteenth Finance Commission (THFC), be it review of the Debt Consolidation and Relief Facility (DCRF) and thereby FRA, or issues like quality of public expenditure to achieve better output and out-come. It appears that the basic constitutional foundation of having a finance commission has been diluted by the way the TORs of suc-cessive finance commissions have been framed. It is true that our transfer system has various deficiencies, but that requires correc-tion not through heavy reliance on tied and conditional grants, but an alternative approach is a must, which accommodates and protects the objectives of equity, efficiency and autonomy of the recipient state governments.The TOR of the THFC is different in three major aspects when compared with that of the Eleventh and the Twelfth Finance Commissions. This paper was largely written during the second author’s stint at the Centre for Development Studies, Thiruvananthapuram.T M Thomas Isaac is finance minister, government of Kerala and honorary fellow, Centre for Development Studies, Thiruvananthapuram. Pinaki Chakraborty (pinaki@nipfp.org.in) is at the National Institute of Public Finance and Policy, New Delhi.
SPECIAL ARTICLEEconomic & Political Weekly EPW october 25, 200887(a) Unlike the last two commissions, the THFC, due to the im-proved fiscal balance of states in recent years, is not required to suggest another fiscal restructuring measure but needs to review “the state of finances keeping in view, in particular, the States’ Debt Consolidation and Relief Facility (DCRF) 2005-2010 intro-duced by the Central Government, on the basis of the recommen-dations of the Twelfth Finance Commis-sion…” As debt consolidation and relief were conditional upon the enactment of the fiscal responsibility legislation at the state level, the THFC will have to review the FRA and suggest measures to main-tain “a stable and sustainable fiscal environment consistent with equitable growth”.(b) The other significant departure is the inclusion of gross budgetary support (GBS) to the central and state plan as a committed expenditure of the central government, implying the finance com-mission’s transfers as residually deter-mined, especially when there is an overall cap on the aggregate resource transfers to the states1 and also on the levels of fiscal deficits due to the Fiscal Responsibility and Budget Management (FRBM) Act of the central government.(c) Examine the impact of the proposed goods and services tax to be introduced from April 1, 2010, including its impact on foreign trade.(d) Other than these three major issues, the THFC has also been asked to look into the issues related to the quality of public expenditure to achieve better output and outcome and also to give its views on the management of ecology, environment and climate change “consistent with sustainable development”. The previous commission, by making access to the DCRF conditional upon enactment and adherence to a FRA by the states, introduced rule-based fiscal control at the state level that fixed the permissible level of the fiscal deficit at 3 per cent of the respective state’s gross state domestic product (GSDP) by 2008-09. However, binding the states to a uniform deficit target only constrained their ability to spend. A fixed limit does not give due regard to differential needs and also ignores the basic fiscal principle that different states can have different levels of sustainable deficits. Also too many diverse tasks, especially, management of ecology and environment, poses the critically important question, whether the finance commission transfer mechanism is the appropriate one to deal with them? Entrusting too many diverse tasks to a finance commission may unnecessarily complicate the transfer system and risks weakening the primary objective of transfer, i e, bring about fiscal equalisation across states (see ‘Thirteenth Finance Commission’, editorial,Economic & Political Weekly, Decem-ber 29, 2007, p 5).In this context, we may also note the appointment of a new commission in April 2007 to “look into the issues of Centre-State relations keeping in view the sea-changes that have taken place in the polity and economy of India since the Sarkaria Commis-sion had last looked at the issue of Centre-State relations over two decades ago.” The scope of the commission’s work is much wider than fiscal relations. Nevertheless, the TOR of this commission demand among other things a review of the work-ing of the financial relations between the centre and the states, economic and so-cial planning, panchayati raj institutions and sharing of resources. The commis-sion has been asked to look into the role, responsibility and jurisdiction of the centre vis-à-vis states in linking central assistance of various kinds with the per-formance of the states. The commission has further been asked to look into the role, responsibility and jurisdiction of the centre vis-à-vis states in promoting the concept and practice of independent plan-ning and budgeting at the district level. The TOR of the commission as framed, with regard to centre-state fiscal rela-tions, call for examination of the issues of performance-linked transfers and inde-pendent planning and budgeting at the district level. If a balanced view is not taken of these issues, then it may institu-tionalise these centralising tendencies, curbing further the fiscal and functional domains of state governments. This paper makes an attempt to evaluate the evolving federal fiscal relationship in the context of the TOR of the THFC so as to enable us to highlight the major challenges that require urgent attention to strengthen the intergovernmental fiscal relationship. This paper is divided into five sections. In section 1, we discuss the level of vertical imbalance. Section 2 analyses the growing discretion in the system of transfers in recent years. Section 3 critically examines the tendencies to link finance commission transfers to state level fiscal performance. Section 4 discusses the approach of the last three finance commissions in devolving funds to the local self governments. Section 5 summarises the findings and draws conclusions. 1 WorseningVerticalImbalance The combined size of the revenue and expenditure of the central and state governments has increased more than threefold in re-lation to gross domestic product (GDP) between 1950-51 and 2006-07 (BE) (Table 1). The increase in the size of the state gov-ernment was faster than the centre. The beginning of the era of fiscal reforms has seen a decline in the combined government expenditure as a percentage ofGDP by 3.5 percentage points between 1990-91 and 1996-97, primarily due to the decline in central government expenditure. In the subsequent years, there was an improvement in the ratio and it reached 30.98 per cent of Table 1: Revenues and Expenditures of the Centre and States(As % of GDP) RevenuesExpenditures Combined Centre States Combined Centre States1950-51 7.914.9 3.3 9.895.134.751960-61 10.25 6.8 5.1 17.88 9.4 8.491970-71 12.84 8.915.8417.17 10.34 9.511980-81 16.58 11.32 7.82 24.44 14.87 13.491990-91 17.46 12.17 6.9626.83 17.74 14.31991-92 18.6212.697.42 26.316.5214.841992-93 18.112.66 7.0526.11 16.37 14.431993-94 17.14 11.39 7.2225.89 16.49 14.211994-95 17.58 11.45 7.6425.03 15.27 14.371995-96 17.44 11.72 7.3 24.214.66 13.781996-97 17.1111.796.9223.3814.1313.461997-98 16.95 11.45 6.9424.15 13.64 13.761998-99 15.63 10.74 6.4425.44 14.41 14.21999-00 16.8911.6 8.1426.5414.9415.112000-01 16.75 11.71 8.1226.07 14.98 14.682001-02 16.7 11.22 8.5926.62 15.26 15.022002-03 17.17 11.71 8.4226.65 14.91 14.692003.04 18.79 11.99 7.1830.98 17.07 15.582004-05 19.72 12.32 7.5829.77 15.94 15.422005-06 RE 20.75 12.49 7.68 29.36 14.4 16.092006-07 BE 21.45 13.14 7.84 29.05 14.48 16.19Source:Indian Public Finance Statistics, various issues.
Total Transfers Grants Tax Shares
SPECIAL ARTICLEEconomic & Political Weekly EPW october 25, 200889Table 3: Flow of Resources to States: Aggregate View 2006-07 (RE) 2007-08 (BE) 2006-07 (RE) 2007-08 (BE) (Rs crore) (Rs crore) (as % of GDP) (as % of GDP)States' share of taxes and duties 1,20,377 1,42,450 3.29 3.50Non plan grants 36,152 38,403 0.99 0.94Central assistance for states and UT plans 38,226 43,322 1.04 1.07Assistance for central and centrally sponsored schemes 15,232 21,705 0.42 0.53Total grants through state budgets 89,610 1,03,430 2.45 2.54Direct transfer of central plan assistance to state/district level autonomous bodies/implementing agencies 45,166 49,607 1.23 1.22Total grants 1,34,776 1,53,037 3.68 3.76Source: Union Government Budget Document 2007-08.Table 4: Ministry-wise Direct Transfer to States 2006-07 (RE) 2007-08 (BE) 2006-07 (RE) 2007-08 (BE) (Rs crore) (Rs crore) (as % of Total) (as % of Total)Ministry of agriculture and cooperation 1,712.65 2,372.82 3.79 4.78Ministry of environment and forests 225.65 304.55 0.50 0.61Ministry of health and family welfare 5,547.78 6,631 12.28 13.37Ministry of human resource development 11,518.8411,104.7425.5022.39 of which SSA 10,145.68 9,760.24 22.46 19.68Ministry of women and child development 3 10 0.01 0.02Ministry of new and renewable energy 155.85 188.1 0.35 0.38Ministry of rural development 25,452.66 28,395.51 56.35 57.24 of which NREGS 11,233.9 11,939.35 24.87 24.07Ministry of commerce and industry 550 600 1.22 1.21Grand total 45,166.43 49,606.72 100 100 Source: Union Government Budget Document 2007-08.issue of CSS in the next section. However, for the purpose of discussion here it is important to note that the CSS in 2007-08 is estimated to be 1.75 per cent ofGDP. If this is also factored in, it is readily evident that the vertical imbalance has tended to sharply widen in recent years.2 Discretionary Central Transfers through CSSAs per the 2007-08 budget estimates (BE), the aggregate resource flow from the centre to the states, constituted more than 7.26 per cent of GDP; resources that are going directly to districts and other imple-menting agencies amounted to 1.22 per cent of GDP. This is higher than any other component of grants transfers and constituted 37.5 and 34.8 per cent of tax devolution to the states in 2006-07 and 2007-08, respectively. It is important to examine what constitutes these flows. As evident from the Table 3, around 93 per cent of this flow is through three central ministries, viz, the ministry of rural development (57 per cent), ministry of human resource development (22 per cent) and ministry of health and family welfare (13 per cent). Out of this, transfers on account of Sarva Siksha Abhiyan (SSA) and NREGS together constituted almost half of the total (Table 4).If we look at the distribution of these transfers, they are largely progressive (Table 5, p 90) as per capita transfers to low income states have been several fold higher than the middle and high in-come states. Though these transfers have the inherent problem of central discretion both with regard to the allocation and quan-tum, the data reveals a positive discretion in favour of low in-come states. But the larger question is can these transfers be jus-tified on the ground of progressivity bypassing the authority of the state? If the authority of the states is bypassed on the func-tions that are in their domain, accountability will be lost. As mentioned by Rao (2007: 1253), this kind of transfers has been:undermining the role of systems and institutions in the transfer sys-tem. In fact, even under the transfers for state plans, normal assist-ance, which is given according to the Gadgil formula, constituted less than 48 per cent. Thus, we have a situation where the grants system has become predominantly purpose specific with a cobweb of condi-tionalities specified by various central ministries. Furthermore, quite a considerable proportion of grants which used to be given to the states now directly goes to autonomous agencies. This raises questions about the capacity to deliver public services by these autonomous agencies, mechanisms to augment the capacity and as the funds do not pass through states’ consolidated funds, of accountability.Regarding the allocation of these funds, an element of uncer-tainty continues and it is well-known that these transfers have been an impediment to achieving horizontal equity and prudent management of state finances. Since these tendencies have in-creased over time and states are also accepting without resist-ance these deviations from what the Constitution has envisaged, central intervention on state subjects would continue to grow. N C Saxena, as member of the National Advisory Council in an insightful paper onCSS, observed thatGoI has increased its control over the State sector in three ways, firstly through substantial funding of CSS, the budget for which is about 60 per cent of the Central Assistance; secondly much of it goes straight to the districts, thus bypassing the States and placing district bureau-cracy directly under the supervision of the GoI; and thirdly more than half of Central Assistance is given in the form of ACA, which is often not formula based but where the GoI Ministries have a great deal of control over the State allocations and releases.The most worrisome aspects of the TOR of the THFC that has the potential to further strengthen the proliferation of CSS is the inclusion of the gross budgetary support to the central and state plan as the committed expenditures of the central government and demand on resources of the centre for the first time in the TOR of a finance commission. As commented by Reddy (2007)by including the GBS in the needs of the centre, there is a danger that the finance commission transfers to the states would become residual, given the deficit reduction targets mandated under the Fiscal Respon-sibility and Budget Management (FRBM) legislation and the indicative amount of overall transfers to states to be fixed at 38 per cent of cen-tral gross revenue receipts as recommended by the Twelfth Finance Commission and accepted by the central government.As we know,GBS of the central government consists of central plan and central assistance to state andUT plans and the GBS to central plan comprises the central sector plan and CSS. This, in turn, means that consideration ofGBS as committed central ex-penditure is in a way an effort towards institutionalising this kind of centralising tendencies in the flow of resources through GBS. This becomes clear when we look at the Eleventh Plan document. The Eleventh Plan envisages a significant step up in the outlay, the resources of the central plan rising from 5.3 per cent of GDP during the 10th Plan to 7.99 per cent of GDP during the 11th Plan. The central assistance to states and union territories rises only by 0.21 percentage points from 0.99 per cent to 1.2 per cent during the two plan periods, respectively. In contrast, GBS for central plan is expected to rise by 1.2 percentage points from 2.77 to 3.97 per cent of GDP during the same period. The GBS for the central plan, which was 73.6 per cent of the total GBS during the 10th Plan, is expected to rise to 77 per cent in 11th
SPECIAL ARTICLEoctober 25, 2008 EPW Economic & Political Weekly90Table 5: Per Capita Transfers under Major Central Sector Schemes (in Rs) SSA NREGS PMGSYAndhra Pradesh 57 118 133Bihar 117 113 99Chhattisgarh 223246701Goa 4765Gujarat 271772Haryana 10814150Jharkhand 175 218 189Karnataka 953997Kerala 131041Madhya Pradesh 164 268 444Maharashtra 493966Orissa 112 221 464Punjab 4914101Rajasthan 120 122 498Tamil Nadu 55 24 78Uttar Pradesh 111 48 135West Bengal 72 55 154Source: Respective Ministry Web sites.Table 6: Real Per Capita Expenditure: Social and Economic Services(in Rs) 1999-2000 2006-07 Increase in Per Capita Expen- diture 1999-2000 to 2006-07 Social Economic Social Economic SocialEconomic Services Services Services Services ServicesServicesAndhra Pradesh 638 475 767 819 129 344Bihar 556 403 359 221 -197-182Goa 2,0412,2422,7953,3477551,105Gujarat 995 1,090 1,031 981 36-109Haryana 7607838168735690Karnataka 760 695 858 1,104 98409Kerala 795 529 914 591 119 62Madhya Pradesh 765 570 550 751 -215 181Maharashtra 808623 978 983 170 360Orissa 692 390 564 376 -127 -14Punjab 757 606 779 952 22346Rajasthan 735 385 866 594 131 209Tamil Nadu 863 495 1,030 611 166 116Uttar Pradesh 356 318 411 360 55 42West Bengal 675 303 569 338 -106 35Source: Reserve Bank of India,Study of State Finances.Plan. The consequence for the state plan has been summed up in the plan document as follows:The share of projected grant component of central assistance to States/UT plan in the total GBS for Eleventh plan has decreased slightly than what has been realised in the 10th Plan (from 26.4 per cent to 22.8 per cent) primarily because of much higher allocation has been made to centrally sponsored schemes. The allocation to centrally sponsored schemes has increased from 1.4 per cent of GDP for the 10th Plan to 2.35 per cent of GDP in the Eleventh Plan [Planning Commission 2008: 53].The projected central assistance to the states/UTs for the Elev-enth Plan under various schemes is Rs 3,24,851 crore. Of this allo-cation, normal plan assistance for states including special category states is just Rs 1,11,053 crore. In other words, CSS constitute Rs 2,13,798, i e, nearly double the allocation for the state develop-ment plan. The THFC needs to take a fresh look at this, especially estimates of GBS in the 11th Plan and use this opportunity to bring consolidation of CSS to a few pro-grammes of national importance where specific purpose transfers are necessary and divert the rest of the resources under GBS for CSS as part of the unconditional transfers to the states to ensure greater fiscal autonomy and effective utilisation of resources.3 Linking Transfers to State Level Fiscal Performance The other important concern in the context of evolving inter-governmental fiscal relations in India is linking transfers to fiscal per-formance of the states and the THFC needs to take a fresh look at this. It is true that the transfer system should not create an adverse incen-tive. However, as mentioned earlier, the approach of the transfer sys-tem should not be a reliance on tied and conditional grants, but an alternative, which accommodates and protects the objectives of equi-ty, efficiency and autonomy of the recipient state governments. This is critically important for furtherance of federalism. In this context, it needs to be highlighted that the EFC for the first time was given a crucial mandate to take a holistic view of the finances of both the centre and states to suggest “ways and means by which the govern-ments, collectively and severally, may bring about a restructuring of the public finances so as to restore budgetary balance and maintain macroeconomic stability”, although stabilisation is a central govern-ment function not that of the finance commission. The EFC had sug-gested a plan of restructuring of public finances to improve the fiscal situation including setting of numerical targets for yearly reduction in revenue and fiscal deficits. The, TWFC’s restructuring plan also pro-posed numerical targets of deficit reductions and it went one step further by linking state level debt relief and debt restructuring condi-tional upon the enactment of FRA legislation. To ensure that all state governments undertake fiscal reform programmes, the EFC recommended that a portion of the non-plan revenue deficit grants should be linked to progress in implementing the reform programmes. According to EFC, the ra-tionale for such tying of a revenue deficit grant as an incentive is inevitable as to quote EFC, “otherwise these States will not have any interest in it”. Although various states questioned the consti-tutional validity of such a TOR, and unanimity was not there within theEFC, the majority view in the EFC rationalised a moni-torable fiscal reform. The final report of theEFC “recommended that 15 per cent of the revenue deficit grants meant for 15 states during 2000-05 and a matching contribution by Central Govern-ment be credited into an Incentive Fund from which fiscal per-formance based grants should be made available to all 25 states.” TheTWFC in its approach went one step further by making enactment of the FRA mandatory for the states to avail of debt restructuring and debt relief from the central government. The FRA specifies that states should eliminate the revenue deficit by 2008-09 and bring down their fiscal deficits to 3 per cent of their respectiveGSDP by the same year. Now all the states have FRA legislation except West Bengal and Sikkim. Of these states, other than Karnataka, Kerala, Punjab and Uttar Pradesh, all other states have passed the FRA after the DCRF announced by the TWFC. The rush to pass the FRA was clearly driven by the debt relief and write-off proposed by the Commission. This is not to argue that fiscal discipline is not important. But fiscal discipline at the cost of fiscal autonomy could be detrimental. It needs to be emphasised that a straitjacketed approach of uniform deficit targets ignores differential needs and resource requirement in different states. It binds the states to adhere to a uniform target of deficits without having due regard to state specific levels of sustainable deficits. Though at the aggregate level, there is fiscal consolidation at the state level due to rule-based fiscal control with the revenue deficit coming close to zero and fiscal deficits below 3 per cent of GDP by the end of 2007-08, the outcome of such consolidation requires in-depth analysis of state finances. A quick analysis of the provisioning of expenditures across states reveals that real per capita expendi-ture in social and economic services declined sharply in low income states (Table 6) with fiscal consolidation induced by rule based fiscal control.
SPECIAL ARTICLEEconomic & Political Weekly EPW october 25, 200891It is true that until recently a burgeoning revenue deficit at the state level was a major problem and its reduction became the key for prudent management of state finances. In fact, states’ revenue deficit as a percentage ofGDP increased sharply from 0.81 per cent in 1991-92 to as much as 2.96 per cent in 1999-2000. During the same period, the revenue deficit of the centre also increased from 2.64 to 3.81 per cent. It is acknowledged by both the Elev-enth and Twelfth Finance Commissions that the major reasons for the increase in the revenue deficit of both the centre and the states are an increase in the committed liabilities of both levels of governments, viz, interest payments, salaries and allowances, subsidies and pension. Among all these components, interest payments were one of the fastest growing expenditures in the revenue accounts of all states. Between 1991-92 and 1998-99, in-terest payments grew at the trend growth rate of 18.23 per cent, which was much higher than the growth of total revenue expend-iture of 14.22 per cent. The share of interest payment in total revenue expenditures of states also increased from 13.80 to 17.76 per cent during the same period. One of the major reasons for the increase in the interest burden is the financial liberalisation and consequent deregulation of interest rates. This is purely a macro-economic policy change and states had to adjust themselves with the greater fiscal strains arising out of it. 4 Transfers to Local Self-GovernmentsFinally, we take up the issue of fiscal devolution to local self- government (LSG), which has entered the scope of the finance commission’s recommendations since the passage of the 73rd and 74th constitutional amendments. Despite the constitutional amend-ments, the local bodies in India are a far cry from the constitutional ideal of self-governing units. Generally, functions have been devolved without concomitant devolution of finance. According to the data collected by the TWFC, the expenditure ratios of LSGs are very low. In 2002-03, the expenditure – GNP ratio was only 1.71 and the expenditure ratio to combined expenditure of governments was 4.39. Comparable figures for a sample of Organisation for Econom-ic Cooperation and Development (OECD) countries are 12.75 per cent of GDP and 28 per cent of consolidated expenditures of gov-ernments. The ratios for developing countries other than for China are generally lower than those of the developed countries. The ratios for India are one of the lowest among developing countries [Isaac and Shaheena 2007; Shah and Shah 2006].Even though it was not a part of a mandate, it is to be appreci-ated, that the Tenth Finance Commission (TEFC) took up the issue of the devolution of the LSG, in view of the constitutional amend-ments. However, the TEFC adopted a conservative interpretation of the constitutional provisions of the fiscal devolution and the role of the finance commission. This is how theEFC has approv-ingly summarised the approach of to the TEFC. “(a) The need for augmentation of the Consolidated Funds of the States should first be ascertained and only thereafter the meas-ures for such augmentation be recommended. (b) Such measures need not necessarily involve transfer of resources from the centre.(c) Once the SFCs complete their task, the Finance Commission becomes duty bound to assess and build into the expenditure stream of the States the funding requirements for supplementing the resources of the panchayats and the municipalities. Measures needed for augmentation of the Consolidated Funds of the States may be determined accordingly. (d) The responsibility for sharing and assigning taxes and provid-ing grants to the local bodies rests with the States and does not stand transferred to the Centre.(e) The transfer of duties and functions listed in the Eleventh and Twelfth Schedules of the Constitution would also involve con-comitant transfer of staff and resources. Transfers of duties and functions to the local bodies should, therefore, not entail any extra financial burden.”The above line of thinking assumes (a) the present federal relationship between the central and state governments is more or less optimal, and (b) there is no case for any substantial trans-fer of functions and finance from the centre to the LSGs. Both these assumptions are fundamentally wrong. It is enough to have a cursory look at the spread of CSS to realise how much the cen-tral government has entered into the functional domain of LSGs. In other words, the finance commissions have so far adopted a very conservative approach to the devolution to LSGs. The ap-proach of the state finance commissions (SFCs) have been equally conservative so much so that the needs for “supplementing Con-solidated Fund of the state governments” were very limited. The EFC found that the report of theSFCs could not even form the basis of its recommendations for various reasons such as non-synchronisation, of the periods of the reports, lack of clarity and weakness of analysis, lukewarm attitude of the state government in implementing the recommendations and non-availability of the reports themselves. Therefore all the union finance commis-sions have made only ad hoc recommendations, which have proved to be too meagre to make a significant impact on the finances of the LSGs (Table 7). TheTEFC recommended a grant of Rs 100 per capita of rural population as per 1971 Census for the panchayats (Rs 5,380 crore in total). Rs 1,000 crore was the award for municipalities. The EFC had recommended Rs 8,000 crore and Rs 2,000 crore for panchayats and municipalities respectively. This works out to be only around 1.56 per cent of the total transfer to the states. Given the national commitment to the LSG and to counter the decelera-tion in the momentum of the decentralisation process in the recent years, a substantial enhancement of transfer toLSG was Table 7: Awards of the Finance Commissions and the Significance to LSG Finances Finance Year Devolution to Rural LSGs as a % of Devolution to Urban LSGs as a % ofCommission Amount OT Ex NSDP Amount OT Ex NSDP10th 1995-961076.191.310.450.28200.000.240.080.05 1996-971076.191.150.400.24200.000.210.070.04 1997-981076.191.120.320.21200.000.210.060.04 1998-991076.191.030.290.15200.000.190.050.03 1999-001076.190.840.270.13200.000.160.050.0211th 2000-011600.001.170.400.17400.000.290.100.04 2001-021600.001.200.360.14400.000.300.090.04 2002-031600.001.010.340.13400.000.250.080.03 2003-041600.000.860.320.11400.000.210.080.03 2004-051600.000.710.290.10400.000.180.070.0312th 2005-064000.001.460.790.231000.000.370.200.06OT – Own tax revenue of the central government, Ex- Expenditure of the central government, NSDP-Net state domestic product. Source: RBI,Study of State Finances (various years), GOI (1995, 2000, 2005).
SPECIAL ARTICLEoctober 25, 2008 EPW Economic & Political Weekly92expected fromTWFC. It devolved grant in aid of Rs 25,000 crore to the LSGs, of which, Rs 20,000 was to rural LSGs and Rs 5,000 crore to urban LSGs. There is an increase in the devolution to local bodies by the TWFC compared to the EFC (1.5 times the amount devolved by the EFC). Given the above situation, the THFC has to take a bold initiative to give up the incremental approach and adopt a target of a minimum level ofLSG expenditure ratio toGDP or either combined expenditure of the government to be attained as an outcome of its recommendations. Part of this devolution would have to come from the sharply enhanced devolution from the centre and a portion from the devolution from the states. 5 ConclusionsTo conclude, the major problems of the intergovernmental trans-fer system in India in recent years have been the increasing verti-cal imbalance, proliferation of conditional and tied grants Notes1 The Twelfth Finance Commission has recom-mended that the overall transfers from the centre to the states be fixed at 38 per cent of central revenues [TWFC Report: 129].2 The share of transfers in total revenues of a poor income state like Bihar is as high as 73 per cent when the all state average is only 36.50 per cent.ReferencesIsaac, Thomas T M and P Shaheena (2007): ‘Fiscal Devolution to Local Self-Governments and the Finance Commissions’, mimeo. Planning Commission (2008): ‘Towards Faster and More Inclusive Growth – An Approach to the 11th Five-Year Plan’, Planning Commission, New Delhi, Government of India.Rao, M G (2007): ‘Fiscal Adjustment: Rhetoric and Reality’, Economic & Political Weekly, Vol 42, No 14, April 7-13, pp 1252-57.Reddy, G R (2007): ‘Imbalance in Agenda of Finance Commission’,Economic & Political Weekly, Vol 42, No 51, pp 8-10.Report of the Twelfth Finance Commission (2004).Report of the Eleventh Finance Commission (2000).Report of the Tenth Finance Commission (1995).Saxena, Naresh C (nd): ‘Central Transfers to States & Centrally Sponsored Schemes’, http://nac.nic.in/concept%20papers/Central%20Transfers.pdfShah, Anwar and Sana Shah (2006): ‘The New Vision of Local Governance and the Evolving Role of Local Governments’ in Anwar Shah (ed),Public Sector Governance and Accountability Series – Lo-cal Governance in Developing Countries, World Bank, Washington DC.through various css, low level of fiscal decentralisation and plethora of authorities (not envisaged in the Constitution) including the multilateral lending institutions deciding the course of fiscal policy at the state level. The larger question is whether there is scope for intergovernmental fiscal relations to grow and mature in a manner that provides fiscal autonomy to the states within the basic framework of the Constitution. That would be possible, if and only if we are able to develop an incentive compatible trans-fer system without compromising on sub-national fiscal auto-nomy. We can only hope that the Commission on Centre-State Relations, which has a larger mandate, and also the Thirteenth Finance Commission will take into consideration the reality of evolving federal fiscal relations so that their recommendations provide a road map, which would help improve the fiscal auto-nomy of the states. Given the TORs of both the commissions, this may seem very optimistic.
SPECIAL ARTICLEoctober 25, 2008 EPW Economic & Political Weekly86Intergovernmental Transfers: Disquieting Trends and the Thirteenth Finance CommissionT M Thomas Isaac, Pinaki ChakrabortyThe way in which the terms of reference of successive finance commissions have been framed, including that of the Thirteenth Finance Commission, has diluted the basic constitutional rationale of having such a statutory commission. Various deficiencies in the transfer system require correction not through a heavy reliance on tied and conditional grants (as we have seen in recent years), but with an alternative approach which accommodates and protects the objectives of equity, efficiency and autonomy of the recipient state governments.The provision for the periodic appointment of an independ-ent finance commission, with a semi judicial character to limit the scope of discretion of the centre in the matter of resource flows to the states was a key stone of the basic fiscal structure envisaged in the Constitution. However, this basic structure is being undermined due to proliferation of transfers through various other channels outside the statutory transfers recommended by the finance commissions. Many of these trans-fers are not only discretionary; they are directly going to district authorities and societies bypassing the state budgets. Multilateral and bilateral lending institutions are also entering in a big way in determining state level fiscal policy through various sectoral and structural adjustment lending linked to fiscal reforms. The reform era also has seen a big push for rule-based fiscal control at the state level at the instance of Twelfth Finance Com-mission (TWFC). These changes in intergovernmental fiscal trans-fers have made the system complex and states are increasingly finding it difficult to pursue an independent state level fiscal policy. The straitjacketed reform approach of the TWFC with its uniform deficit reduction targets ignored the fiscal capacity differentials and differences in public service delivery needs across states, which has the potential to accentuate spatial inequalityinthe provisioning of public services across states in the era of reforms. This period has also witnessed an increase in the share of condi-tional and tied transfers to the states. One of the most disturbing aspects of this phenomenon is the attempts to link even the finance commission’s transfers to fiscal performance. A few exam-ples in this context are the Monitorable Fiscal Reforms Programme of the Eleventh Finance Commission (EFC), the Fiscal Responsi-bility Acts (FRA) of TWFC and the terms of reference (TOR) of the Thirteenth Finance Commission (THFC), be it review of the Debt Consolidation and Relief Facility (DCRF) and thereby FRA, or issues like quality of public expenditure to achieve better output and out-come. It appears that the basic constitutional foundation of having a finance commission has been diluted by the way the TORs of suc-cessive finance commissions have been framed. It is true that our transfer system has various deficiencies, but that requires correc-tion not through heavy reliance on tied and conditional grants, but an alternative approach is a must, which accommodates and protects the objectives of equity, efficiency and autonomy of the recipient state governments.The TOR of the THFC is different in three major aspects when compared with that of the Eleventh and the Twelfth Finance Commissions. This paper was largely written during the second author’s stint at the Centre for Development Studies, Thiruvananthapuram.T M Thomas Isaac is finance minister, government of Kerala and honorary fellow, Centre for Development Studies, Thiruvananthapuram. Pinaki Chakraborty (pinaki@nipfp.org.in) is at the National Institute of Public Finance and Policy, New Delhi.
SPECIAL ARTICLEEconomic & Political Weekly EPW october 25, 200887(a) Unlike the last two commissions, the THFC, due to the im-proved fiscal balance of states in recent years, is not required to suggest another fiscal restructuring measure but needs to review “the state of finances keeping in view, in particular, the States’ Debt Consolidation and Relief Facility (DCRF) 2005-2010 intro-duced by the Central Government, on the basis of the recommen-dations of the Twelfth Finance Commis-sion…” As debt consolidation and relief were conditional upon the enactment of the fiscal responsibility legislation at the state level, the THFC will have to review the FRA and suggest measures to main-tain “a stable and sustainable fiscal environment consistent with equitable growth”.(b) The other significant departure is the inclusion of gross budgetary support (GBS) to the central and state plan as a committed expenditure of the central government, implying the finance com-mission’s transfers as residually deter-mined, especially when there is an overall cap on the aggregate resource transfers to the states1 and also on the levels of fiscal deficits due to the Fiscal Responsibility and Budget Management (FRBM) Act of the central government.(c) Examine the impact of the proposed goods and services tax to be introduced from April 1, 2010, including its impact on foreign trade.(d) Other than these three major issues, the THFC has also been asked to look into the issues related to the quality of public expenditure to achieve better output and outcome and also to give its views on the management of ecology, environment and climate change “consistent with sustainable development”. The previous commission, by making access to the DCRF conditional upon enactment and adherence to a FRA by the states, introduced rule-based fiscal control at the state level that fixed the permissible level of the fiscal deficit at 3 per cent of the respective state’s gross state domestic product (GSDP) by 2008-09. However, binding the states to a uniform deficit target only constrained their ability to spend. A fixed limit does not give due regard to differential needs and also ignores the basic fiscal principle that different states can have different levels of sustainable deficits. Also too many diverse tasks, especially, management of ecology and environment, poses the critically important question, whether the finance commission transfer mechanism is the appropriate one to deal with them? Entrusting too many diverse tasks to a finance commission may unnecessarily complicate the transfer system and risks weakening the primary objective of transfer, i e, bring about fiscal equalisation across states (see ‘Thirteenth Finance Commission’, editorial,Economic & Political Weekly, Decem-ber 29, 2007, p 5).In this context, we may also note the appointment of a new commission in April 2007 to “look into the issues of Centre-State relations keeping in view the sea-changes that have taken place in the polity and economy of India since the Sarkaria Commis-sion had last looked at the issue of Centre-State relations over two decades ago.” The scope of the commission’s work is much wider than fiscal relations. Nevertheless, the TOR of this commission demand among other things a review of the work-ing of the financial relations between the centre and the states, economic and so-cial planning, panchayati raj institutions and sharing of resources. The commis-sion has been asked to look into the role, responsibility and jurisdiction of the centre vis-à-vis states in linking central assistance of various kinds with the per-formance of the states. The commission has further been asked to look into the role, responsibility and jurisdiction of the centre vis-à-vis states in promoting the concept and practice of independent plan-ning and budgeting at the district level. The TOR of the commission as framed, with regard to centre-state fiscal rela-tions, call for examination of the issues of performance-linked transfers and inde-pendent planning and budgeting at the district level. If a balanced view is not taken of these issues, then it may institu-tionalise these centralising tendencies, curbing further the fiscal and functional domains of state governments. This paper makes an attempt to evaluate the evolving federal fiscal relationship in the context of the TOR of the THFC so as to enable us to highlight the major challenges that require urgent attention to strengthen the intergovernmental fiscal relationship. This paper is divided into five sections. In section 1, we discuss the level of vertical imbalance. Section 2 analyses the growing discretion in the system of transfers in recent years. Section 3 critically examines the tendencies to link finance commission transfers to state level fiscal performance. Section 4 discusses the approach of the last three finance commissions in devolving funds to the local self governments. Section 5 summarises the findings and draws conclusions. 1 WorseningVerticalImbalance The combined size of the revenue and expenditure of the central and state governments has increased more than threefold in re-lation to gross domestic product (GDP) between 1950-51 and 2006-07 (BE) (Table 1). The increase in the size of the state gov-ernment was faster than the centre. The beginning of the era of fiscal reforms has seen a decline in the combined government expenditure as a percentage ofGDP by 3.5 percentage points between 1990-91 and 1996-97, primarily due to the decline in central government expenditure. In the subsequent years, there was an improvement in the ratio and it reached 30.98 per cent of Table 1: Revenues and Expenditures of the Centre and States(As % of GDP) RevenuesExpenditures Combined Centre States Combined Centre States1950-51 7.914.9 3.3 9.895.134.751960-61 10.25 6.8 5.1 17.88 9.4 8.491970-71 12.84 8.915.8417.17 10.34 9.511980-81 16.58 11.32 7.82 24.44 14.87 13.491990-91 17.46 12.17 6.9626.83 17.74 14.31991-92 18.6212.697.42 26.316.5214.841992-93 18.112.66 7.0526.11 16.37 14.431993-94 17.14 11.39 7.2225.89 16.49 14.211994-95 17.58 11.45 7.6425.03 15.27 14.371995-96 17.44 11.72 7.3 24.214.66 13.781996-97 17.1111.796.9223.3814.1313.461997-98 16.95 11.45 6.9424.15 13.64 13.761998-99 15.63 10.74 6.4425.44 14.41 14.21999-00 16.8911.6 8.1426.5414.9415.112000-01 16.75 11.71 8.1226.07 14.98 14.682001-02 16.7 11.22 8.5926.62 15.26 15.022002-03 17.17 11.71 8.4226.65 14.91 14.692003.04 18.79 11.99 7.1830.98 17.07 15.582004-05 19.72 12.32 7.5829.77 15.94 15.422005-06 RE 20.75 12.49 7.68 29.36 14.4 16.092006-07 BE 21.45 13.14 7.84 29.05 14.48 16.19Source:Indian Public Finance Statistics, various issues.
Total Transfers Grants Tax Shares 
SPECIAL ARTICLEEconomic & Political Weekly EPW october 25, 200889Table 3: Flow of Resources to States: Aggregate View 2006-07 (RE) 2007-08 (BE) 2006-07 (RE) 2007-08 (BE) (Rs crore) (Rs crore) (as % of GDP) (as % of GDP)States' share of taxes and duties 1,20,377 1,42,450 3.29 3.50Non plan grants 36,152 38,403 0.99 0.94Central assistance for states and UT plans 38,226 43,322 1.04 1.07Assistance for central and centrally sponsored schemes 15,232 21,705 0.42 0.53Total grants through state budgets 89,610 1,03,430 2.45 2.54Direct transfer of central plan assistance to state/district level autonomous bodies/implementing agencies 45,166 49,607 1.23 1.22Total grants 1,34,776 1,53,037 3.68 3.76Source: Union Government Budget Document 2007-08.Table 4: Ministry-wise Direct Transfer to States 2006-07 (RE) 2007-08 (BE) 2006-07 (RE) 2007-08 (BE) (Rs crore) (Rs crore) (as % of Total) (as % of Total)Ministry of agriculture and cooperation 1,712.65 2,372.82 3.79 4.78Ministry of environment and forests 225.65 304.55 0.50 0.61Ministry of health and family welfare 5,547.78 6,631 12.28 13.37Ministry of human resource development 11,518.8411,104.7425.5022.39 of which SSA 10,145.68 9,760.24 22.46 19.68Ministry of women and child development 3 10 0.01 0.02Ministry of new and renewable energy 155.85 188.1 0.35 0.38Ministry of rural development 25,452.66 28,395.51 56.35 57.24 of which NREGS 11,233.9 11,939.35 24.87 24.07Ministry of commerce and industry 550 600 1.22 1.21Grand total 45,166.43 49,606.72 100 100 Source: Union Government Budget Document 2007-08.issue of CSS in the next section. However, for the purpose of discussion here it is important to note that the CSS in 2007-08 is estimated to be 1.75 per cent ofGDP. If this is also factored in, it is readily evident that the vertical imbalance has tended to sharply widen in recent years.2 Discretionary Central Transfers through CSSAs per the 2007-08 budget estimates (BE), the aggregate resource flow from the centre to the states, constituted more than 7.26 per cent of GDP; resources that are going directly to districts and other imple-menting agencies amounted to 1.22 per cent of GDP. This is higher than any other component of grants transfers and constituted 37.5 and 34.8 per cent of tax devolution to the states in 2006-07 and 2007-08, respectively. It is important to examine what constitutes these flows. As evident from the Table 3, around 93 per cent of this flow is through three central ministries, viz, the ministry of rural development (57 per cent), ministry of human resource development (22 per cent) and ministry of health and family welfare (13 per cent). Out of this, transfers on account of Sarva Siksha Abhiyan (SSA) and NREGS together constituted almost half of the total (Table 4).If we look at the distribution of these transfers, they are largely progressive (Table 5, p 90) as per capita transfers to low income states have been several fold higher than the middle and high in-come states. Though these transfers have the inherent problem of central discretion both with regard to the allocation and quan-tum, the data reveals a positive discretion in favour of low in-come states. But the larger question is can these transfers be jus-tified on the ground of progressivity bypassing the authority of the state? If the authority of the states is bypassed on the func-tions that are in their domain, accountability will be lost. As mentioned by Rao (2007: 1253), this kind of transfers has been:undermining the role of systems and institutions in the transfer sys-tem. In fact, even under the transfers for state plans, normal assist-ance, which is given according to the Gadgil formula, constituted less than 48 per cent. Thus, we have a situation where the grants system has become predominantly purpose specific with a cobweb of condi-tionalities specified by various central ministries. Furthermore, quite a considerable proportion of grants which used to be given to the states now directly goes to autonomous agencies. This raises questions about the capacity to deliver public services by these autonomous agencies, mechanisms to augment the capacity and as the funds do not pass through states’ consolidated funds, of accountability.Regarding the allocation of these funds, an element of uncer-tainty continues and it is well-known that these transfers have been an impediment to achieving horizontal equity and prudent management of state finances. Since these tendencies have in-creased over time and states are also accepting without resist-ance these deviations from what the Constitution has envisaged, central intervention on state subjects would continue to grow. N C Saxena, as member of the National Advisory Council in an insightful paper onCSS, observed thatGoI has increased its control over the State sector in three ways, firstly through substantial funding of CSS, the budget for which is about 60 per cent of the Central Assistance; secondly much of it goes straight to the districts, thus bypassing the States and placing district bureau-cracy directly under the supervision of the GoI; and thirdly more than half of Central Assistance is given in the form of ACA, which is often not formula based but where the GoI Ministries have a great deal of control over the State allocations and releases.The most worrisome aspects of the TOR of the THFC that has the potential to further strengthen the proliferation of CSS is the inclusion of the gross budgetary support to the central and state plan as the committed expenditures of the central government and demand on resources of the centre for the first time in the TOR of a finance commission. As commented by Reddy (2007)by including the GBS in the needs of the centre, there is a danger that the finance commission transfers to the states would become residual, given the deficit reduction targets mandated under the Fiscal Respon-sibility and Budget Management (FRBM) legislation and the indicative amount of overall transfers to states to be fixed at 38 per cent of cen-tral gross revenue receipts as recommended by the Twelfth Finance Commission and accepted by the central government.As we know,GBS of the central government consists of central plan and central assistance to state andUT plans and the GBS to central plan comprises the central sector plan and CSS. This, in turn, means that consideration ofGBS as committed central ex-penditure is in a way an effort towards institutionalising this kind of centralising tendencies in the flow of resources through GBS. This becomes clear when we look at the Eleventh Plan document. The Eleventh Plan envisages a significant step up in the outlay, the resources of the central plan rising from 5.3 per cent of GDP during the 10th Plan to 7.99 per cent of GDP during the 11th Plan. The central assistance to states and union territories rises only by 0.21 percentage points from 0.99 per cent to 1.2 per cent during the two plan periods, respectively. In contrast, GBS for central plan is expected to rise by 1.2 percentage points from 2.77 to 3.97 per cent of GDP during the same period. The GBS for the central plan, which was 73.6 per cent of the total GBS during the 10th Plan, is expected to rise to 77 per cent in 11th 
SPECIAL ARTICLEoctober 25, 2008 EPW Economic & Political Weekly90Table 5: Per Capita Transfers under Major Central Sector Schemes (in Rs) SSA NREGS PMGSYAndhra Pradesh 57 118 133Bihar 117 113 99Chhattisgarh 223246701Goa 4765Gujarat 271772Haryana 10814150Jharkhand 175 218 189Karnataka 953997Kerala 131041Madhya Pradesh 164 268 444Maharashtra 493966Orissa 112 221 464Punjab 4914101Rajasthan 120 122 498Tamil Nadu 55 24 78Uttar Pradesh 111 48 135West Bengal 72 55 154Source: Respective Ministry Web sites.Table 6: Real Per Capita Expenditure: Social and Economic Services(in Rs) 1999-2000 2006-07 Increase in Per Capita Expen- diture 1999-2000 to 2006-07 Social Economic Social Economic SocialEconomic Services Services Services Services ServicesServicesAndhra Pradesh 638 475 767 819 129 344Bihar 556 403 359 221 -197-182Goa 2,0412,2422,7953,3477551,105Gujarat 995 1,090 1,031 981 36-109Haryana 7607838168735690Karnataka 760 695 858 1,104 98409Kerala 795 529 914 591 119 62Madhya Pradesh 765 570 550 751 -215 181Maharashtra 808623 978 983 170 360Orissa 692 390 564 376 -127 -14Punjab 757 606 779 952 22346Rajasthan 735 385 866 594 131 209Tamil Nadu 863 495 1,030 611 166 116Uttar Pradesh 356 318 411 360 55 42West Bengal 675 303 569 338 -106 35Source: Reserve Bank of India,Study of State Finances.Plan. The consequence for the state plan has been summed up in the plan document as follows:The share of projected grant component of central assistance to States/UT plan in the total GBS for Eleventh plan has decreased slightly than what has been realised in the 10th Plan (from 26.4 per cent to 22.8 per cent) primarily because of much higher allocation has been made to centrally sponsored schemes. The allocation to centrally sponsored schemes has increased from 1.4 per cent of GDP for the 10th Plan to 2.35 per cent of GDP in the Eleventh Plan [Planning Commission 2008: 53].The projected central assistance to the states/UTs for the Elev-enth Plan under various schemes is Rs 3,24,851 crore. Of this allo-cation, normal plan assistance for states including special category states is just Rs 1,11,053 crore. In other words, CSS constitute Rs 2,13,798, i e, nearly double the allocation for the state develop-ment plan. The THFC needs to take a fresh look at this, especially estimates of GBS in the 11th Plan and use this opportunity to bring consolidation of CSS to a few pro-grammes of national importance where specific purpose transfers are necessary and divert the rest of the resources under GBS for CSS as part of the unconditional transfers to the states to ensure greater fiscal autonomy and effective utilisation of resources.3 Linking Transfers to State Level Fiscal Performance The other important concern in the context of evolving inter-governmental fiscal relations in India is linking transfers to fiscal per-formance of the states and the THFC needs to take a fresh look at this. It is true that the transfer system should not create an adverse incen-tive. However, as mentioned earlier, the approach of the transfer sys-tem should not be a reliance on tied and conditional grants, but an alternative, which accommodates and protects the objectives of equi-ty, efficiency and autonomy of the recipient state governments. This is critically important for furtherance of federalism. In this context, it needs to be highlighted that the EFC for the first time was given a crucial mandate to take a holistic view of the finances of both the centre and states to suggest “ways and means by which the govern-ments, collectively and severally, may bring about a restructuring of the public finances so as to restore budgetary balance and maintain macroeconomic stability”, although stabilisation is a central govern-ment function not that of the finance commission. The EFC had sug-gested a plan of restructuring of public finances to improve the fiscal situation including setting of numerical targets for yearly reduction in revenue and fiscal deficits. The, TWFC’s restructuring plan also pro-posed numerical targets of deficit reductions and it went one step further by linking state level debt relief and debt restructuring condi-tional upon the enactment of FRA legislation. To ensure that all state governments undertake fiscal reform programmes, the EFC recommended that a portion of the non-plan revenue deficit grants should be linked to progress in implementing the reform programmes. According to EFC, the ra-tionale for such tying of a revenue deficit grant as an incentive is inevitable as to quote EFC, “otherwise these States will not have any interest in it”. Although various states questioned the consti-tutional validity of such a TOR, and unanimity was not there within theEFC, the majority view in the EFC rationalised a moni-torable fiscal reform. The final report of theEFC “recommended that 15 per cent of the revenue deficit grants meant for 15 states during 2000-05 and a matching contribution by Central Govern-ment be credited into an Incentive Fund from which fiscal per-formance based grants should be made available to all 25 states.” TheTWFC in its approach went one step further by making enactment of the FRA mandatory for the states to avail of debt restructuring and debt relief from the central government. The FRA specifies that states should eliminate the revenue deficit by 2008-09 and bring down their fiscal deficits to 3 per cent of their respectiveGSDP by the same year. Now all the states have FRA legislation except West Bengal and Sikkim. Of these states, other than Karnataka, Kerala, Punjab and Uttar Pradesh, all other states have passed the FRA after the DCRF announced by the TWFC. The rush to pass the FRA was clearly driven by the debt relief and write-off proposed by the Commission. This is not to argue that fiscal discipline is not important. But fiscal discipline at the cost of fiscal autonomy could be detrimental. It needs to be emphasised that a straitjacketed approach of uniform deficit targets ignores differential needs and resource requirement in different states. It binds the states to adhere to a uniform target of deficits without having due regard to state specific levels of sustainable deficits. Though at the aggregate level, there is fiscal consolidation at the state level due to rule-based fiscal control with the revenue deficit coming close to zero and fiscal deficits below 3 per cent of GDP by the end of 2007-08, the outcome of such consolidation requires in-depth analysis of state finances. A quick analysis of the provisioning of expenditures across states reveals that real per capita expendi-ture in social and economic services declined sharply in low income states (Table 6) with fiscal consolidation induced by rule based fiscal control.
SPECIAL ARTICLEEconomic & Political Weekly EPW october 25, 200891It is true that until recently a burgeoning revenue deficit at the state level was a major problem and its reduction became the key for prudent management of state finances. In fact, states’ revenue deficit as a percentage ofGDP increased sharply from 0.81 per cent in 1991-92 to as much as 2.96 per cent in 1999-2000. During the same period, the revenue deficit of the centre also increased from 2.64 to 3.81 per cent. It is acknowledged by both the Elev-enth and Twelfth Finance Commissions that the major reasons for the increase in the revenue deficit of both the centre and the states are an increase in the committed liabilities of both levels of governments, viz, interest payments, salaries and allowances, subsidies and pension. Among all these components, interest payments were one of the fastest growing expenditures in the revenue accounts of all states. Between 1991-92 and 1998-99, in-terest payments grew at the trend growth rate of 18.23 per cent, which was much higher than the growth of total revenue expend-iture of 14.22 per cent. The share of interest payment in total revenue expenditures of states also increased from 13.80 to 17.76 per cent during the same period. One of the major reasons for the increase in the interest burden is the financial liberalisation and consequent deregulation of interest rates. This is purely a macro-economic policy change and states had to adjust themselves with the greater fiscal strains arising out of it. 4 Transfers to Local Self-GovernmentsFinally, we take up the issue of fiscal devolution to local self- government (LSG), which has entered the scope of the finance commission’s recommendations since the passage of the 73rd and 74th constitutional amendments. Despite the constitutional amend-ments, the local bodies in India are a far cry from the constitutional ideal of self-governing units. Generally, functions have been devolved without concomitant devolution of finance. According to the data collected by the TWFC, the expenditure ratios of LSGs are very low. In 2002-03, the expenditure – GNP ratio was only 1.71 and the expenditure ratio to combined expenditure of governments was 4.39. Comparable figures for a sample of Organisation for Econom-ic Cooperation and Development (OECD) countries are 12.75 per cent of GDP and 28 per cent of consolidated expenditures of gov-ernments. The ratios for developing countries other than for China are generally lower than those of the developed countries. The ratios for India are one of the lowest among developing countries [Isaac and Shaheena 2007; Shah and Shah 2006].Even though it was not a part of a mandate, it is to be appreci-ated, that the Tenth Finance Commission (TEFC) took up the issue of the devolution of the LSG, in view of the constitutional amend-ments. However, the TEFC adopted a conservative interpretation of the constitutional provisions of the fiscal devolution and the role of the finance commission. This is how theEFC has approv-ingly summarised the approach of to the TEFC. “(a) The need for augmentation of the Consolidated Funds of the States should first be ascertained and only thereafter the meas-ures for such augmentation be recommended. (b) Such measures need not necessarily involve transfer of resources from the centre.(c) Once the SFCs complete their task, the Finance Commission becomes duty bound to assess and build into the expenditure stream of the States the funding requirements for supplementing the resources of the panchayats and the municipalities. Measures needed for augmentation of the Consolidated Funds of the States may be determined accordingly. (d) The responsibility for sharing and assigning taxes and provid-ing grants to the local bodies rests with the States and does not stand transferred to the Centre.(e) The transfer of duties and functions listed in the Eleventh and Twelfth Schedules of the Constitution would also involve con-comitant transfer of staff and resources. Transfers of duties and functions to the local bodies should, therefore, not entail any extra financial burden.”The above line of thinking assumes (a) the present federal relationship between the central and state governments is more or less optimal, and (b) there is no case for any substantial trans-fer of functions and finance from the centre to the LSGs. Both these assumptions are fundamentally wrong. It is enough to have a cursory look at the spread of CSS to realise how much the cen-tral government has entered into the functional domain of LSGs. In other words, the finance commissions have so far adopted a very conservative approach to the devolution to LSGs. The ap-proach of the state finance commissions (SFCs) have been equally conservative so much so that the needs for “supplementing Con-solidated Fund of the state governments” were very limited. The EFC found that the report of theSFCs could not even form the basis of its recommendations for various reasons such as non-synchronisation, of the periods of the reports, lack of clarity and weakness of analysis, lukewarm attitude of the state government in implementing the recommendations and non-availability of the reports themselves. Therefore all the union finance commis-sions have made only ad hoc recommendations, which have proved to be too meagre to make a significant impact on the finances of the LSGs (Table 7). TheTEFC recommended a grant of Rs 100 per capita of rural population as per 1971 Census for the panchayats (Rs 5,380 crore in total). Rs 1,000 crore was the award for municipalities. The EFC had recommended Rs 8,000 crore and Rs 2,000 crore for panchayats and municipalities respectively. This works out to be only around 1.56 per cent of the total transfer to the states. Given the national commitment to the LSG and to counter the decelera-tion in the momentum of the decentralisation process in the recent years, a substantial enhancement of transfer toLSG was Table 7: Awards of the Finance Commissions and the Significance to LSG Finances Finance Year Devolution to Rural LSGs as a % of Devolution to Urban LSGs as a % ofCommission Amount OT Ex NSDP Amount OT Ex NSDP10th 1995-961076.191.310.450.28200.000.240.080.05 1996-971076.191.150.400.24200.000.210.070.04 1997-981076.191.120.320.21200.000.210.060.04 1998-991076.191.030.290.15200.000.190.050.03 1999-001076.190.840.270.13200.000.160.050.0211th 2000-011600.001.170.400.17400.000.290.100.04 2001-021600.001.200.360.14400.000.300.090.04 2002-031600.001.010.340.13400.000.250.080.03 2003-041600.000.860.320.11400.000.210.080.03 2004-051600.000.710.290.10400.000.180.070.0312th 2005-064000.001.460.790.231000.000.370.200.06OT – Own tax revenue of the central government, Ex- Expenditure of the central government, NSDP-Net state domestic product. Source: RBI,Study of State Finances (various years), GOI (1995, 2000, 2005).
SPECIAL ARTICLEoctober 25, 2008 EPW Economic & Political Weekly92expected fromTWFC. It devolved grant in aid of Rs 25,000 crore to the LSGs, of which, Rs 20,000 was to rural LSGs and Rs 5,000 crore to urban LSGs. There is an increase in the devolution to local bodies by the TWFC compared to the EFC (1.5 times the amount devolved by the EFC). Given the above situation, the THFC has to take a bold initiative to give up the incremental approach and adopt a target of a minimum level ofLSG expenditure ratio toGDP or either combined expenditure of the government to be attained as an outcome of its recommendations. Part of this devolution would have to come from the sharply enhanced devolution from the centre and a portion from the devolution from the states. 5 ConclusionsTo conclude, the major problems of the intergovernmental trans-fer system in India in recent years have been the increasing verti-cal imbalance, proliferation of conditional and tied grants Notes1 The Twelfth Finance Commission has recom-mended that the overall transfers from the centre to the states be fixed at 38 per cent of central revenues [TWFC Report: 129].2 The share of transfers in total revenues of a poor income state like Bihar is as high as 73 per cent when the all state average is only 36.50 per cent.ReferencesIsaac, Thomas T M and P Shaheena (2007): ‘Fiscal Devolution to Local Self-Governments and the Finance Commissions’, mimeo. Planning Commission (2008): ‘Towards Faster and More Inclusive Growth – An Approach to the 11th Five-Year Plan’, Planning Commission, New Delhi, Government of India.Rao, M G (2007): ‘Fiscal Adjustment: Rhetoric and Reality’, Economic & Political Weekly, Vol 42, No 14, April 7-13, pp 1252-57.Reddy, G R (2007): ‘Imbalance in Agenda of Finance Commission’,Economic & Political Weekly, Vol 42, No 51, pp 8-10.Report of the Twelfth Finance Commission (2004).Report of the Eleventh Finance Commission (2000).Report of the Tenth Finance Commission (1995).Saxena, Naresh C (nd): ‘Central Transfers to States & Centrally Sponsored Schemes’, http://nac.nic.in/concept%20papers/Central%20Transfers.pdfShah, Anwar and Sana Shah (2006): ‘The New Vision of Local Governance and the Evolving Role of Local Governments’ in Anwar Shah (ed),Public Sector Governance and Accountability Series – Lo-cal Governance in Developing Countries, World Bank, Washington DC.through various css, low level of fiscal decentralisation and plethora of authorities (not envisaged in the Constitution) including the multilateral lending institutions deciding the course of fiscal policy at the state level. The larger question is whether there is scope for intergovernmental fiscal relations to grow and mature in a manner that provides fiscal autonomy to the states within the basic framework of the Constitution. That would be possible, if and only if we are able to develop an incentive compatible trans-fer system without compromising on sub-national fiscal auto-nomy. We can only hope that the Commission on Centre-State Relations, which has a larger mandate, and also the Thirteenth Finance Commission will take into consideration the reality of evolving federal fiscal relations so that their recommendations provide a road map, which would help improve the fiscal auto-nomy of the states. Given the TORs of both the commissions, this may seem very optimistic.
