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Restricted and Unrestricted Fiscal Grants and Tax Effort of Panchayats in India
The impact of restricted and unrestricted fiscal grants on tax effort of panchayats is examined using nationally representative panel data on finances. Three pathways are proposed through which these impacts accrue: wages, profits, and incentives. In order to deal with the simultaneities of grants received and taxation, a system of equations is estimated simultaneously, where the first stage equations predict the grants. The results show that a wage impact on taxation exists, but is very small and the productivity impact of grants on taxes is negligible. This means that incentive effects associated with the specifics of the intergovernmental fiscal system in the states are the main determinant of village taxation. Several policy conclusions are advanced.
This paper was part of the IDRC–NCAER research programme on “Building Policy Research Capacity for Rural Governance and Growth in India” and was previously published in the NCAER–IDRC Working Paper Series on “Decentralisation and Rural Governance in India.” The authors acknowledge the support of the late Hans P Binswanger-Mkhize on an earlier version of this paper, as well as the contributions from Kailash Pradhan and Niranjana Prasad. The usual caveat applies.
Ever since Musgrave (1959), a large literature has argued that provision costs of public goods will be lowered if public goods are paid for by a benefits tax (or user fee). This fee is the household’s marginal utility from the public good. Furthermore, an elected local body (like the village panchayat) is more likely to reflect local preferences and effectively match the provision of public goods and services to such preferences. A local government will be administratively more responsible if at least part of its budget is financed by its own revenues, that is, through local taxation. This incentive is missing if the local government merely spends money handed down to it through vertical transfers.
In the context of Indian panchayats there is evidence that taxpayers are willing to pay local taxes provided the benefits are evident. This willingness also reveals improved governance.1 Yet fiscal (particularly revenue) devolution is lower in developing countries like India (where only 10% of panchayat expenditure are financed by local revenue) than in developed countries (Gardenne and Singhal 2014). Given this and the above-mentioned importance of local tax collection, it becomes imperative to examine the impact of such transfers on local tax collection, an issue that has been relatively neglected in the literature. This paper examines this issue at the level of panchayats in rural India.2 Our analysis shows that the type of grants from higher level governments matters. We argue that, at the margin, it is welfare enhancing to reduce employment generating grants and increase the block grants.
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