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Practices in Fiscal Federalism

Federalism and Fiscal Transfers in India by C Rangarajan and D K Srivastava (New Delhi: Oxford University Press), 2011; pp xxii + 257, Rs 695.

Practices in Fiscal Federalism

Sudipto Mundle

T
his new volume by Rangarajan and Srivastava is a seminal contribution to the small but growing literature on fiscal federalism in India. The India n federal system is very complex. It is also embedded in a democratic polity that is vibrant and energetic, but also noisy and pugnacious. Navigating one’s way through this complex political economic system in making recommendations that preserve the normative principles of fiscal federalism is a challenging task. The author s accomplished this as, respectively, chairman and member of the Twelfth Financ e Commission (TWFC). They have now translated that experience into a lucid and comprehensive treatise on the subject, a volume that is essential reading for all serious student s of fiscal federalism in India.

Asymmetry

Constitutional arrangements forged at the time of Independence, and reflecting the particular political pulls and pressures of that period, have resulted in an asymmetry in the assignment of resources and responsibility between the federal and subnational governments in India. The central government has a larger share of resources, while the state governments have a larger share of the responsibilities. Fiscal transfers from the central government to the states are the main instruments for addressing this asymmetry. Hence the normative principles governing vertical transfers from the centre to the states and their horizontal allocation among the states are central to the equitable allocation of resources among the different governments.

Chapter 1 deals with the theory and practices on these issues that have engaged successive finance commissions over the years. The authors then discuss the evolution of fiscal federalism in India in Chapter 2, focusing especially on the progression from sharing the revenue from only a few taxes to sharing most taxes, which eases the task of equalisation.

book review

Federalism and Fiscal Transfers in India by C Rangarajan and D K Srivastava (New Delhi: Oxford University Press), 2011; pp xxii + 257, Rs 695.

The next two chapters present a comparative discussion of the practice of fiscal federalism in India with that in Canada and Australia, two other countries where federalism is an important feature of their fiscal systems. The authors point out why the specific differences of the Indian system are more suited to our conditions.

Chapter 5 on the resolution of vertical and horizontal imbalances is, in my view, the key chapter that discusses the main thesis of the volume. The authors point out that the vertical sharing of total revenue s between the centre and states has been remarkably stable over the long term. This stability should be sustained, they feel, so long as there are no major changes in the existing assignment of responsibilities. However, sustaining this stability requires an upward adjustment of the share of states in the divisible pool of taxes when the buoyancy of central taxes is higher than state taxes. This was indeed one of the major recommendations of the TwFC.

On the question of equalisation to enable comparable standards of public and merit services across states with varying fiscal capacity, the authors call for a better measure of fiscal capacity than the gross state domestic product (GSDP), which is currently used. The TwFC formula for transfers, which they reiterate in the volume, consists of three parts: a basic vertical component of per capita transfers, common to all states including the highest income state, a second component to compensate those that have less than the defined benchmark of fiscal capacity, and a third residual component to cover special needs and ad hoc elements. The authors point out that with weights of 50%, 40%, and 10% for these three components, the TwEC was able to achieve 88% equalisation for finance commission transfers.

The quantum of debt servicing by the central government is an important determinant of the volume of resources available for sharing. Accordingly, the authors turn to macro questions such as public debt dynamics and the relationship between fiscal deficits and public debt in Chapters 6 and 7, arguing for strong fiscal prudence. They propose that compliance with legally mandated borrowing limits need to be monitored by an autonomous supervisory body like the Loan Council in Australia. This proposal is of course quite different from that of a public debt office located in the ministry of finance that is currently being contemplated.

Chapter 8 concludes with a discussion of key issues for the Thirteenth Finance Commission (THFC). While the volume as a whole is a seminal contribution, as noted earlier, this concluding chapter is somewhat awkward because of the timing of this publication. It deals with issues before the THFC that are somewhat dated since the volume was published long after the THFC submitted its recommendations, which have been widely discussed in the literature. It would have been more satisfying if in this concluding chapter the authors had commented on the recommendations of the THFC, based on the normative principles and practical considerations that they have discussed in earlier chapters. This is done only en passant in the preface. Perhaps the authors were reluctan t to say very much about the recommendation s of a finance commission that followed the one on which they had served.

Four issues arising out of this volume need to be highlighted for further discussion : the problem of multiple transfer channels, the need for a permanent secretariat for the finance commissions, the issue of coordination between centre and states on transfer issues, and the need for fiscal rules that are sensitive to busines s cycle.

The first issue has to do with multiple channels of resource transfer from the centre to the states. The finance commission transfers are mostly formula-driven

Economic & Political Weekly

EPW
june 25, 2011 vol xlvi nos 26 & 27

BOOK REVIEW

and based on some principles of equalisation. However, there is the large and growing volume of transfers under the Planning Commission, which is neither a constitutiona l body nor one established by an act of Parliament, through centrallysponsored schemes, and central schemes that are quite ad hoc. These awards are neither subject to finance commission approval nor do they require any coordination with the commission. It makes a mockery of principle of horizontal equity which successive finance commissions seek to implement so diligently. Though much debated, the matter remains unresolved.

Second, this volume is testimony to the enormous intellectual capital that is created on issues of fiscal federalism with each finance commission, only to be discarded once the life of the commission comes to an end following the submission of its recommendations, as required by the Constitution. The next commission starts virtually from scratch. In the interim a small division in the expenditure department of the ministry of finance monitors implementation of the recommendation of the last commission. This loss of institutional memory is unfortunate and quite avoidable. All it requires is the creation of a small permanent secretariat that will continue even though the life of each commission that it serves comes to an end with the submission of the commission’s recommendations.

Third, there is need for continuity of the dialogue between centre and the states on the question of transfers. For instance, currently there is coordination to introduce the goods and services tax (GST) through the vehicle of the Empowered Committee of State Finance Ministers that has been established for this purpose. That will end. However, post introduction of the new Direct Taxes Code (DTC) and GST, the entire architecture of taxation in India will have changed and the consequent recalibration will again require centre-state coordination. The continuing need for such coordination on revenue sharing and other mat

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ters would suggest that the empowered committee be established as a permanent platform for coordination on fiscal matters even beyond introduction of the GST. Coordination on fisca l matters in the interstates council does not seem to have the kind of political traction necessary to make such coordination successful.

Finally, at the macro level, there is a need for fiscal rules that adjust to the business cycle, much like automatic stabilisers, a matter also addressed by the THFC. In bringing down the level of the fiscal deficit, for instance, instead of a linear annual reduction the rules could specify a reducing average size of the deficit that is achieved over the business cycle. This would allow for counter-cyclical fiscal expansion or contraction as may be require d by the stage of the business cycle, while bringing down the average size of the deficit to some target level.

Sudipto Mundle (sudipto.mundle@gmail.com) is professor emeritus at the National Institute of Public Finance, New Delhi.

june 25, 2011 vol xlvi nos 26 & 27

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Economic & Political Weekly

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