CENTER FOR RESEARCH ON ECONOMIC DEVELOPMENT AND POLICY REFORM

Working Paper No. 140

Dynamics of Indian Federalism

by

M. Govinda Rao*

July 2002

Stanford University 579 Serra Mall @ Galvez, Landau Economics Building, Room 153

Stanford, CA 94305-6015

* Director, Institute for Social and Economic Change, Bangalore

DYNAMICS OF INDIAN FEDERALISM

M. Govinda Rao

Institute for Social and Economic Change,Nagarabhavi, Bangalore.

Stanford India Conference on Indian Economic Reforms, Center for Research on EconomicDevelopment and Policy Reform, Stanford University, USA. (June 3-4, 2002)

2

DYNAMICS OF INDIAN FEDERALISM

M. Govinda Rao

I. Introduction:

Until the economy embarked on market based reforms in 1991, intergovernmental

policies and institutions in India were structured to meet the requirements of public sector

dominated, heavy industry based, import substituting industrialization strategy. In fact,

centralized planning is the negation of federalism and, sub national governments had very

little role in formulating and implementing the development strategy. In addition,

regulations and controls introduced to meet the requirements of a shortage economy have

segmented the market. Transition from plan to market based development since 1991

has envisaged greater role for sub national governments in providing physical and social

infrastructure and creating accommodating investment climate. Therefore, it is important

to examine whether the federal policies and institutions evolved over the years have been

flexible enough to adjust to the changing requirements.

In a multilevel fiscal system, governmental units enjoy competitive relationships.

Intergovernmental competition, when it is stable and efficient can result in efficiency

gains and help to accelerate the growth process. ‘Dynamics’ denotes movement from one

circular flow to another in which intergovernmental units engage themselves in

Shumpeterian type ‘entrepreneurial competition’ (Breton, 1995, p.32). For inter-

governmental competition to be efficient, however, there are important preconditions.

Competitive equality and cost-benefit appropriability ensure that no governmental unit

can dominate, coerce and exploit another (Breton, 1987). Most importantly, violation to

“market preserving federalism” by creating impediments to free mobility of factors and

products across the country can have an adverse impact on growth and equity. It is also

important that sub national units should be faced with hard budget constraints (Bahl,

2002). The Central government has to monitor intergovernmental competition.

Since reforms were initiated, Indian economy has seen significant acceleration in

economic growth. The growth of GDP (factor cost) accelerated from 5.8 per cent during

3

1981-90 to 6.3 per cent during 1992-2001. However two important facts about economic

growth should be noted. First, even during the 1990s, the performance has been below

the potential and since 1996-97 the growth rate has actually tended to decelerate

(Acharya, 2002). Second, the growth acceleration has been generally taken place in

relatively affluent States and therefore, during the 1990s, inter-state income disparity has

accentuated. (Ahluwalia, 2001, Rao, Shand and Kalirajan, 2000). By and large, more

affluent States have better infrastructure, governance and investment climate and

therefore, have been able to take advantage of liberalized investment opportunities better

(Figure 1). Exception to this has been the deceleration in economic growth in the two

agriculturally predominant States of Punjab and Haryana. The States that could take

advantage of market liberalization fared better.

Figure 1: Relationship Between Levels of Income and Growth Rates

r = 0.5731 r = 0.8741

This paper attempts to examine the extent to which intergovernmental fiscal

policies and institutions have helped or hindered efficiency and growth during the last

decade. The second section summarizes the salient features of Indian fiscal federalism. In

the third section, macroeconomic stability aspects of sub national finances and their

contribution to overall fiscal imbalances in the country are analyzed. The fourth section

examines the causes of fiscal imbalances at sub national level. The fifth section analyzes

the efficiency implications of sub national fiscal operation in Indian federalism. The last

section summarizes the major conclusions.

0

1

2

3

4

5

6

7

8

2000 4000 6000 8000 10000 12000

Per Capita SDP -1991-92 (Rupees)Ann

ualG

row

thR

ate

ofP

erC

apit

aG

SDP

-199

1-98

(%)

14 Major StatesRelationship Between Level of Income and

Growth Rate(Excluding Punjab and Haryana)

0

1

2

3

4

5

6

7

8

2000 4000 6000 8000 10000 12000

1991-92 Rupees

Ann

ualG

row

thR

ate

ofP

erC

apit

aG

SDP

(%)

4

II. Indian Fiscal Federalism: Salient Features

II. 1. Indian federalism: Evolution and Structure.

India represents a classical federation with Constitutional demarcation of

functions and finances between the Union and the States. The billion people in the

federation are spread over 28 States and 7 Union territories (2 with their own elected

governments). Separate legislative, executive and judicial arms of government are

constituted at both Central and State levels. The seventh schedule to the Constitution

specifies the legislative domains of the Central and State governments in terms of Union,

State and Concurrent lists. The Constitution also requires the President of India to

appoint a Finance Commission every five years (or earlier) to review the finances of the

Center and the States and recommend devolution of taxes and grant in aid for the ensuing

five years. With the 73rd and 74th Constitutional amendments in 1993 over a quarter

million local government units have been created in urban and rural areas to provide an

enabling environment for decentralized provision of public services.

Historical factors have played a crucial role adopting a federal constitution with

strong unitary features in India (Rao and Singh, 2002a). The centralization inherent in

constitutional assignment was further strengthened by the adoption of a planned

development strategy. This not only caused the concentration of economic power but

also led to the introduction of several controls and regulations with attendant distortions

on relative prices and economic incentives. Rationing, price controls and regulations

introduced to manage the shortage economy contributed to market segmentation further

and even when the economy transited into surpluses, strong distributional coalitions

created by the system have resisted reforms to meet changing requirements.

II.2 Assignment between Center and States:

The functions related to money supply, external borrowing, international

relations, defense, atomic energy, space, national highways, airways, international

waterways, and those having significant scale economies are assigned exclusively to the

center. The functions involving benefits spanning across States and matters with

significant developmental potential are undertaken concurrently with the States. These

5

include economic planning, energy, education, health and family welfare. The functions

with statewide implications are assigned to the States. Most progressive tax handles have

been assigned to the Center. The taxes assigned to the States include land revenue, taxes

on agricultural incomes and wealth, stamp duties and registration fees, tax on sales and

purchase of goods, excise duties on the sale of alcoholic products and tax on motor

vehicles and tax on goods and passengers transported through roads and inland

waterways. From the viewpoint of revenue productivity, sales tax is the most important

tax handle. The residual functions and tax powers vest with the Center.

Notably, the tax powers are assigned on the basis of the principle of separation -

assigned exclusively either to the Center or the States. Thus, the Center can levy taxes on

production whereas, the tax on sale or purchase of goods is levied by the States. This can

lead to uncoordinated development of the tax system for, the separation is only in the

legal and not economic sense. Similarly, only the States can levy the taxes on agricultural

incomes and the power to levy tax on non-agricultural income vests with the Center. The

States have found taxing agricultural incomes politically infeasible. This base has opened

up avenues of avoidance and evasion of personal income tax.

The most anomalous part of the assignment, however, is the distinction between

'goods' and 'services' for tax purposes. Entry 54 in the State list empowers the States to

levy “taxes on the sale and purchase of goods other than newspapers”. Taxation of

services does not find a specific mention in any of the lists. The Central government has

been levying the tax on selected services on the basis of residuary power. The

compartmentalized tax treatment of goods and services has violated neutrality in taxation,

rendered the levy of coordinated system of consumption tax difficult, and has led to

significant evasion and avoidance of the sales tax (NIPFP, 1994).

The Constitution assigns borrowing power to both Union and State governments.

However, when a State is indebted to the Center, it has to obtain the latter’s permission.

Thus, in actual practice, the Union Ministry of Finance, the Reserve Bank of India and

the Planning Commission essentially determine States’ borrowings. The States can also

borrow from Public Accounts - mainly loans from small savings and the public provident

fund. Thus, in principle, the Center has power to exercise overall control over borrowing.

But, in practice, the States have found several ways to soften their budget constraint.

6

The Constitution also provides for the appointment of the Finance Commission to

transfer funds from the Union to the State governments by way of tax devolution and

grants every five years. The functions of the Commission include: (i) distribution of the

proceeds of sharable taxes, (ii) giving grants in aid to the States in need of assistance, (iii)

recommending measures to augment resources of the States to supplement the resources

of the Panchayats and Municipalities, and (iv) addressing any other matter referred to the

Commission in the interest of sound finance. Since the adoption of Indian Constitution,

Eleven Finance Commissions have submitted their reports.

Over the years, Planning Commission too has been giving substantial assistance

to the States to finance developmental plans. The assistance is given both as grant and

loan in the ratio 30:70 for the non-special category States and 90:10 for the special

category States. In addition to Finance and Planning Commissions, Central Ministries

give assistance to the States to implement Central schemes. The Central sector schemes

are entirely funded by the Central government and the States are merely implementing

agencies. The centrally sponsored schemes are shared cost programs requiring the states

to make matching contributions, the matching ratio differing with projects.

II.3 Assignment between State and local governments:

With the constitutional amendments in 1992, roles and responsibilities of rural

and urban local governments have been specified. Accordingly, in separate schedules, a

list of 29 items to rural local bodies and another list of 18 items to urban local bodies

have been specified. However, revenue and expenditure assignments in the lists are

concurrent with the States’ responsibilities. Actual devolution of specific revenue sources

and expenditure functions to local governments depends on the willingness of the State

government to devolve functions and powers to the local governments.

The rural local governments have very limited own sources of revenues. Only the

village panchayats have some independent revenues. The transfers to the local bodies are

required to be determined by the State Finance Commissions. The responsibilities of

these Commissions include (i) distribution of States’ revenues between States and local

bodies and determining inter se allocation of the latter, (ii) assignment of tax and non tax

powers to village panchayats and urban local bodies; and (iii) determination of the grants

in aid to the local governments from the consolidated fund of the State.

7

In addition to their own lump sum transfers, States pass on the transfers received

from the Central Finance Commissions. Besides, there are almost a hundred central

sector and Centrally sponsored schemes. The important schemes are for water supply,

poverty alleviation, rural roads, education and health and for the social justice. Analysis

shows that local governments have very little flexibility in the use of funds.

Analysis, however, shows that despite giving constitutional status to quarter

million local governments, their role in raising revenues and delivering public services is

negligible. Table 1 shows that fiscal decentralization in Indian federalism is only up to

the state level. In 1997-98, the local bodies together raise just about 0.6 per cent of GDP

or 3 per cent of total revenues and the revenue raised by rural local governments was

abysmal at 0.04 per cent of GDP. After receiving transfers they had control over

resources of just 1.4 per cent of GDP. Thus, their share in total expenditures was less

than 5 per cent. Thus, local governments in India do not raise significant revenues. As

State governments themselves are faced with several resource constraints, they are unable

to devolve adequate resources to provide a meaningful role to them.

Table 1Fiscal Decentralization in India - 1997-98

RevenueCollection

Revenue Accrual Total Expenditure

Center 11.4 6.8 12.0States 6.3 10.9 13.6Local Bodies 0.6 2.1 2.2Urban Local Bodies* 0.5 0.8 0.8Rural Local Bodies* 0.04 1.4 1.4District Panchayats* n 0.6 0.6Taluk Panchayats* n 0.3 0.4Village Panchayats* 0.04 0.4 0.4

Total 18.3 19.8 27.8Center 62.45 34.43 43.2States 34.56 55.03 48.9Local Bodies 2.99 10.53 7.9Urban Local Bodies 2.74 4.07 2.9Rural Local Bodies 0.24 6.46 5.0

District Panchayats 0.03 3.21 2.2Taluk Panchayats 0.01 1.44 1.4Village panchayats 0.21 1.82 1.4

Total 100.00 100.00 100.00Note: n - negligible. * Revenue accrual estimates are taken as proxi for expenditures.Source: Public Finance Statistics 1999-2000, Ministry of Finance, Government of India, 2000.Report of the 11th Finance Commission, Ministry of Finance, Government of India. 2000.

8

III. Fiscal Adjustment in Indian Federalism

III.1 Trends in fiscal imbalances:

Table 2 details the trend in States’ fiscal imbalances. It is seen that fiscal

adjustment during the early 1990s helped reduce States’ revenue deficit from about 1 per

cent in 1990-91 to 0.4 per cent in 1993-94. The States tried to contain their deficits until

the pay revision made the situation uncontrollable in 1997-98. Thus, revenue deficit

increased to 2.5 per cent in 1998-99 and is estimated at about 3 per cent in 2000-01.

Similarly, States were able to contain their fiscal deficit until 1997-98 at 3 per cent, but

thereafter it increased sharply to 4.2 per cent in 1998-99 and further to 4.6 per cent in

1999-2000 on account of pay revision.

Table 2Trend in States’ Fiscal Imbalances

Year Per Centof

RevenueDeficit to

GDP

Per Centof FiscalDeficit to

GDP

Per Centof Rev.Def to

Fiscal Def.

Per Centof Primary

Def. ToFiscal Def

Per cent ofStates’

Rev Def toTotal Rev

Def

Per cent ofStates’ Fis.

Def toTotal Fis.

Def

States’Capital

Exp. As %of Total

State Exp.

Per cent ofStates’CapitalExp. toGDP

1980-81 -1.0 2.6 -38.5 65.4 -250.0 34.7 26.0 3.61985-86 -0.2 2.7 -7.4 59.3 -10.5 33.8 20.0 2.91990-91 0.9 3.3 27.3 54.5 21.4 35.1 15.8 2.41995-96 0.7 2.6 26.9 30.8 21.9 40.0 14.0 2.01996-97 1.2 2.7 44.4 33.3 33.3 42.2 11.4 1.61997-98 1.1 2.9 37.9 31.0 26.8 39.7 13.3 1.81998-99 2.5 4.2 59.5 52.4 39.7 47.2 12.6 1.81999-00 2.7 4.6 58.7 50.0 43.5 48.9 12.6 1.92000-01

(RE)2.4 4.3 55.8 44.2 40.7 47.3 13.1 1.8

Source: Public Finance Statistics, Ministry of Finance, Government of India.

Figure 2 shows that both revenue and fiscal deficits of the States follow patterns

similar to those of the Centre. States’ revenue deficit constituted just about 21 per cent of

total revenue deficit in 190-91, but increased to 41 per cent in 1999-2000. Similarly,

states share of fiscal deficit increased from 35 per cent to 47 per cent during the period.

This is not to place the problem of fiscal imbalances in the country at the doorstep of the

States. Indeed, the major reasons for increasing fiscal imbalance at the State level has to

be found in declining share of transfers in States’ revenues and more importantly, the

impact of pay revision triggered by central pay revision.

9

In a competitive federalism, “Salmon” mechanism activates entrepreneurial

competition by comparing the performances of other governments. In Indian federation,

in contrast, the competition is not in terms of achieving the performance of benchmark

governments. Institutional factors have contrived to constrain intergovernmental

competition in terms of standardizing salary levels and following populist policies.

Figure 2 : Fiscal Imbalance in Indian Federalism

Surely, fiscal adjustment has not been effective; but to the extent adjustment was

achieved, it has led to sharp deterioration in the quality of deficits. By 1990-91, a little

over a quarter of borrowed funds were used to finance current expenditures, but by 2000-

01, this increased to 60 per cent. The share of capital expenditure in GDP declined from

3.6 per cent in the early 1980s to 1.8 percent in 2000-01. Thus, States’ fiscal

deterioration has made their fiscal operations increasingly unsustainable, contributed to

macroeconomic instability and constrained their ability to provide quality infrastructure.

The persistence of large and growing fiscal deficits in the States has led to steady

accumulation of debt over the years. Outstanding debt as a ratio of GDP fell from 19.4

per cent in 1990-91 to 17.8 percent in 1996-97 but increased thereafter to 23.1 per cent in

2000-01. In fact, since 1995-96, the debt stock increased at the compound annual rate of

17.9 per cent whereas, the revenue receipts increased only at 11.2 per cent.

Consequently, the share of interest payment in total expenditure increased from 13 per

cent in 1990-91 to 21.6 per cent in 2000-01 to crowd out productive expenditures.

Revenue Deficit

0

1

2

3

4

5

6

7

8

Centre

States

Total

States

0

2

4

6

8

10

12

Years

Pe

rc

en

to

fG

DP

Centr

Total

Fiscal Deficits

10

Fiscal deterioration in the States is a general phenomenon. In terms of both

revenue and fiscal deficits, and spending on creation and maintenance of infrastructure,

there has been a significant deterioration in each of the States (Rao, 2002). In 1999-2000,

among the non-special category States five states had revenue deficits surpassing 5 per

cent of Net State Domestic Product (NSDP), with West Bengal showing the worst

performance (6.7 per cent). In terms of fiscal deficit, Bihar, Orissa and west Bengal were

the worst performers with deficits exceeding 9 per cent of NSDP.

By and large, fiscal imbalances is more acute in poorer than in richer States with

the exception of Punjab. The State has the highest per capita SDP, and also very high

revenue and fiscal deficits. The correlation coefficient of Per capita SDP with revenue

deficit is -0.319 for 14 non-special category States and -0.438 when Punjab is excluded

from the sample. The correlation coefficient of per capita SDP with fiscal deficit is -

0.331 for non-special category States and -0.446 when Punjab is excluded. Thus, in

general severity of fiscal crunch is felt more by the poorer than by richer States.

III.3 Hidden imbalances and softening budget constraints:

An important implementation rule for efficient fiscal decentralization is that sub

national governments should have hard budget constraints (Bahl, 2002). Although in

principle, the States have hard budgets, in practice, they can soften the constraint in a

variety of ways (Lahiri, 2000; Anand, Bagchi and Sen, 2002). The practice of collecting

taxes in advance and keeping contractors’ bills pending is well known. The States can

also increase their liabilities in Public Account, particularly through small savings loans.

Another method used is by creating special purpose vehicles for investments in activities

such as irrigation. They also resort to borrowing from public enterprises. In recent years,

the States have been borrowing heavily from financial institutions such as NABARD,

LIC, HUDCO, and IDFC to finance infrastructure. We have already referred to

borrowing from multilateral lending agencies. All these are in addition to the ways and

means advances and overdrafts from the RBI.

Thus, the fiscal position discussed above does not reveal fiscal imbalances of the

States in its entirety. There are significant contingent liabilities arising from the State

11

government guarantees and indemnities given to urban local bodies, public enterprises

and autonomous institutions. Available information shows that recorded contingent

liabilities in 1999-2000 were Rs. 1248 billion or almost 6.4 per cent of GDP.

A major source of imbalance not reflected in the budgets is losses incurred by

public enterprises, notably, SEBs. In 2000-01, estimated losses of SEBs were over Rs.

260 billion of which only Rs. 60 billion subsidy was included in the budgets. The losses

of SEBs accounted for 1.2 per cent of GDP. The performance of SEBs has had adverse

repercussions on Central finances as well. As on 28th February 2001, dues payable by

SEBs to central enterprises were Rs. 415 billion (2 per cent of GDP) comprising of Rs.

257 billion principal and the remaining, interest.

IV. Causes of Fiscal Imbalances in States

IV.1 Imbalance in the growth of revenues and expenditures:

Fiscal imbalance in the States is structural; on average, States’ expenditures grew

faster than revenues during the 1990s (Table 3). An important reason for this is that

Central transfer was the slowest growing item (10 per cent). The increases in States’ own

revenues (both tax and non-tax) did not keep pace with expenditures. It must also be

noted that growth rates of both States’ own revenues and Central transfers significantly

decelerated in 1990s over 1980s. Although resource constraint led to deceleration in

annual expenditure growth to 14.8 per cent in the 1990s, expenditure growth during the

1990s was higher than the revenue growth by 2.2 percentage points.

An important cause of fiscal imbalances is the secular decline in the tax ratio

(Table 4). This is seen not only in the aggregate but also in respect of each of the

individual states except Kerala (Annexure Table 2). Since the mid 1990s, revenue-GDP

ratio declined by 1.5 points. Of this, about 0.6-point decline was in Central transfers, 0.5-

point was in States’ non-tax revenues and 0.4-point was in States’ tax revenues. Thus,

States’ revenue-GDP ratio from each of the major sources has shown a declining trend

during the 1990s and the decline has accelerated since the mid 1990s.

12

Table 3Average Annual Growth Rates of States’ Revenues and Expenditures

Percent14 Non-Special Category

States25 States

1980-81 to1989-90

1990-91 to1998-99

1980-81 to1989-90

1990-91 to1999-00

Own Tax Revenue 15.82 14.09 15.92 14.08Own Non Tax Revenue 13.13 11.51 12.54 12.38Total Transfers 14.58 10.99 15.84 11.50Total Revenues 14.91 12.62 15.30 12.83Revenue Expenditure 16.69 14.82 17.07 14.94Capital Expenditure 8.80 11.39 9.69 11.13Total Expenditure 15.07 14.38 15.53 14.43Source: Public Finance Statistics, Ministry of Finance, Government of India.

The hardening resources position and increasing pressure of interest payments and

salaries have crowded out capital expenditures (Table 4). The latter declined from 2.4

per cent in 1990-91 to 1.8 per cent in 1999-2000. Further, within revenue expenditures,

spending on economic services declined from 3.7 per cent to 2.9 per cent during the

period. Expenditure on social services declined from 4.9 per cent in 1990-91 to 4.6 per

cent in 1998-99, but later increased to 5 per cent because of salary revision. Expenditure

on administrative services steadily increased throughout the two decades.

Table 4Per Cent of States’ Revenues and Expenditures to GDP

1980-81 1985-86 1990-91 1995-96 1998-99 1999-00 REA. States’ RevenuesOwn Tax Revenue 4.60 5.23 5.34 5.20 4.89 5.21Own Non Tax Revenue 2.27 1.90 1.62 1.92 1.36 1.49Own Revenues 6.87 7.14 6.96 7.12 6.25 6.70Total Transfers 4.46 4.89 4.73 4.20 3.58 4.04Total Revenues 11.33 12.02 11.69 11.32 9.83 10.74B. States’ ExpendituresRevenue Expenditure 10.30 11.79 12.62 12.05 12.36 13.68General Services * 3.49 4.03 4.63 4.97 5.68Interest Payments 0.85 1.06 1.52 1.84 2.02 2.30Social Services * 4.81 4.92 4.43 4.56 5.09Economic Services * 3.49 3.67 2.99 2.82 2.91Capital Expenditure 3.62 2.94 2.37 1.87 1.67 1.81Total Expenditure 13.92 14.73 14.99 13.92 14.02 15.50

Note: Due to differences in budgetary classification, the figures are not estimated. Source: PublicFinance Statistics (Relevant years), Ministry of Finance, Government of India.

13

IV.2 Causes of slow growth of revenues:

There are a number of reasons for the slow and decelerating growth of revenues.

Low revenue productivity of taxes on land and agricultural incomes has been a much-

debated issue. From the viewpoint of horizontal equity and revenue productivity, levying

a tax on agricultural incomes is necessary. Yet, the architecture of the tax has remained

only on paper for want of political willingness. In fact, States have not been able to levy

the tax even on agricultural income declared in the tax returns submitted to the Central

income tax department. The fragmented nature of income tax has provided an easy

avenue for evasion and avoidance of personal income tax.

The principal reason for the deceleration in the growth rate of sales taxes has to be

found in the inability to extend the tax base to the services sector. During the last decade,

the services sector grew at 7.8 per cent per year, much higher than both the primary

(2.8%) and secondary (5.7%) sectors, and since the mid 1990s, over 70 per cent of the

growth of the economy may be attributed to this sector (Acharya, 2001). As the States

are allowed to levy taxes on only goods, the production and consumption of services

remains mostly outside the tax net. In the medium term, revenue productivity of States’

tax system can be increased only when the States are enabled to extend sales taxes to

services (Rao, 2001). This would also help to evolve a comprehensive destination based

value added tax at the State level. This is the problem of assignment and the solution lies

placing the power to tax services in the concurrent list.

The bases of State taxes are rendered narrow also because of large-scale

exemptions, evasion and avoidance of taxes. In the case of sales tax for example, besides

wide ranging exemptions, there are generous schemes of incentives in terms of tax

exemption and deferment. While the efficacy of such fiscal incentives in promoting

industrialization is limited, revenue foregone is significant. These incentives do not

enhance the availability of capital in the country, but merely redistribute the existing

capital in distortionary ways.

The problem is similar with other taxes as well. Levying stamp duty and

registration fees on transfer of immovable property at high and differentiated rates has led

14

to widespread evasion of the tax by undervaluing the value of the property transacted.

Along with Urban Ceiling and Rent Control Acts, the structure of property tax has

prevented the development of organized market for immovable properties in the country.

Lack of proper information system and administrative machinery to implement

taxes is a general shortcoming in all the States. Much remains to be done to simplify the

tax system and strengthen administration and enforcement of the tax. There is hardly any

co-operation between one tax department of a State and another, much less between

Central and State tax departments. Complications in the tax system add to complexity in

administration and most States are ill equipped to administer the taxes designed to fulfil

multiple objectives, thus adding to compliance cost and reducing revenue productivity.

Inability to recover reasonable returns from the large investments has been a

major reason for the low and declining growth in non-tax revenues. By march 31, 1999,

States’ outstanding investments in statutory corporations were Rs. 750 billion and about

Rs. 420 billion were invested in the government companies. Together, they yielded

hardly any return. In most cases, public enterprises do not recover even a fraction of the

capital cost and depreciation, leave alone generating any return on investments

(Government of India, 2000).

Almost 85 per cent of the investment in State level public enterprises is on electric

utilities. Poor financial performance of SEBs has been a major cause of drain in States’

exchequers. The Electricity (Supply) Act, 1948 stipulates that State Electricity Boards

(SEBs) should yield 3 per cent return on their net fixed assets. In actual practice,

however, they generated a commercial loss of Rs. 230 billion or 33.8 per cent of the

value of fixed assets in 1999-2000 (Government of India, 2001). The losses excluding

the State government subsidy amounted to Rs. 182 billion.

Restoring fiscal balance is inextricably linked to the improvement in the SEBs

and State Road Transport Corporations (SRTCs). In fact, SEBs losses add to the deficit

by an additional Rs. 260 billion or about 1.3 per cent of GDP. With this revenue deficit

is estimated at close to 3 per cent of GDP. Similarly, losses of SRTCs in 1997-98

amounted to Rs. 13 billion and their finances have shown a steady deterioration over the

15

years. The situation is similar with other State enterprises as well. The Accountant

Generals’ reports reveal that accumulated loses exceed the value of fixed assets in respect

of a number of State level enterprises.

Poor fiscal condition of the States should also be attributed to poor cost recovery

from public services. The NIPFP study for 1996-97 showed that cost recovery in social

services was as low as 8.4 per cent of the cost of providing services and in the case of

economic services it was 16.6 per cent. The studies show that the malice of poor cost

recovery does not lie merely in uneconomic pricing of services; often, the problem is one

of poor efficiency in their provision. In such cases, increasing the prices will simply pass

on the burden of inefficiency to the consumers. As mentioned earlier, instead of

“Salmon” mechanism leading to healthy intergovernmental competition, the pork barrel

electoral politics in Indian federalism has led to “competitive populism”.

IV. 3 Causes of expanding expenditures

Despite attempts to contain the growth of expenditures during the decade 1991-

2000, the States’ revenue expenditure - GDP ratio increased by 0.9 point. This has

contributed to the severity of fiscal imbalance at the State level broadly by the same

magnitude as the reduction in the revenue-GDP ratio. As mentioned earlier,

intergovernmental competition has not been to adopt the supply efficiency of the

benchmark governments either at the Central (of other countries) or State level. The

sociology of fiscal politics in India has dictated expenditure decisions. In the event,

expenditure growth has been determined by competitive populism and redistribution of

expenditures in favor of “distributional coalitions”.

A substantial proportion of increase in revenue expenditures is due to interest

payments. Both the volume of liabilities and average rate of interest have increased

significantly. As increasing share of States’ loans are used for revenue expenditures, the

vicious cycle of higher interest payments increasing expenditures feed back into larger

borrowings. The problem is exacerbated by low productivity of capital expenditures.

The proliferation of projects spread the resources thinly and inadequate financial

allocation causes severe cost and time over-runs.

16

Nowhere is intergovernmental competition as pronounced as in implementing pay

revisions. The impact of pay revision has been much more severe on the States than the

Center because the share of salary expenditure in States is higher, revisions had to be

extended to aided institutions and local bodies besides government administration. Thus,

administrative expenditure excluding interest payment increased by almost one

percentage point during the decade reflecting the increases in pay and pension payments.

Almost 0.7 point increase was just in two years beginning 1998-99 (Table 5). Overall,

much of the 1.3 point increase in non-interest revenue expenditure seen in the last two

years was due to pay revisions. In absolute terms, compensation to employees (pay and

pensions) in States increased from Rs. 734 billion in 1996-97 to Rs. 1119 billion in 1998-

99. Thus the increase of Rs. 160 billion in 1997-78 was followed by a further increase of

Rs. 220 billion in 1998-99 (Acharya, 2001, p. 48).

Despite significant increase in the salary component of social services

expenditures, expenditure-GDP ratio remained more or less constant at about 5 per cent

of GDP. Constancy in social services expenditure-GDP ratio in the wake of increasing

salary cost implies reduction in non-salary inputs with adverse impact on their quality.

Table 5:Trends in State ExpenditurePercentages of States’expenditure to GDP

Growth rate (percentper annum)

1990-91 1999-00 1985-95 1990-2000Total Revenue Expenditure 12.62 13.68 15.16 13.92

1. General Services 4.03 5.68 17.85 16.84Of which - Interest Payment 1.52 2.30 19.99 17.392. Social Services 4.92 5.09 13.30 13.82

Education 2.73 2.91 14.44 14.09Health and Family Welfare 0.81 0.75 12.58 12.71

3. Economic Services 3.67 2.91 14.41 9.75Agriculture and Allied Activities 1.10 0.88 13.33 9.83Rural development 0.88 0.69 13.20 9.35Irrigation 0.60 0.48 11.99 11.53Power 0.17 0.29 29.33 14.59Industry and Minerals 0.21 0.12 11.40 8.12Transport and Communications 0.41 0.29 13.95 9.77

Capital Expenditure 2.37 1.81 9.48 10.55Total Expenditure 14.62 15.50 14.24 13.48

17

The impact of declining revenue-GDP ratio and inevitability of meeting

increasing commitments on pay and pension revisions and interest payments has been to

crowd out capital expenditure-GDP ratio from 2.4 per cent in 1990-91 to 1.8 per cent in

1999-2000. Within revenue expenditures, sharp decline in economic services signifies

the inability of the States to make adequate provision for maintenance of infrastructure.

The effect has been to displace both the availability and quality of physical infrastructure.

An important structural cause of expenditure proliferation is the artificial and

often, meaningless distinction made between plan and non-plan expenditures. Implicit in

this is the assumption that plan expenditures are productive and non-plan expenditures

are not. This is incorrect, for, a number of projects classified as “plan” in the revenue

account are merely salary payments that are not productive. Similarly, completed plan

schemes are classified as “non-plan”. Maintenance expenditures on roads, irrigation

works and buildings are certainly productive and inadequate provision for these to

contain non-plan expenditures has been a major shortcoming in expenditure management

in States. Often, for convenience and strategic reasons various developmental projects are

initiated in the non-plan side. The classification itself is unscientific, and this has led to

inadequate expenditure allocation to maintenance of assets. Emphasis on increasing the

plan size in every successive plan irrespective of resources position has caused

proliferation of plan schemes even when they cannot be justified on economic

considerations. As already mentioned, emphasis on increasing the plan size has also had

the effect of allocating expenditures to large number of projects resulting in the thin

spread of resources causing time and cost over-runs.

IV. 4 Inequity and disincentives from central transfers:

Incentives and equity in the transfer system is an important determinant of both

efficiency and equity in fiscal operations of donor as well as recipients. The critical

issues to be discussed are whether the general purpose transfer system has been designed

to offset the fiscal disabilities and what are its effects on incentives. Similarly it is

important to analyze whether specific purpose transfers have been designed to ensure

minimum standards of designated services or fulfil categorical equity goods. The issue

18

assumes importance considering the increase in inter-state inequalities in per capita

incomes and the declining ability of the Center to undertake inter-regional redistribution.

The problems associated with Central transfers are well known and has been

analyzed by several studies. Although the transfer system as whole has an equalizing

impact (Figure 3), it has a number of shortcomings. Political economy of the transfer

system is manifest in the multiple agencies dispensing transfers and naturally, this has

constrained targeting them to offset fiscal disabilities satisfactorily (Rao, 1992, Rao and

Singh, 2002b). The income elasticity of transfers for 14 major States declined from -0.35

in 1990-91 to -0.20 in 1998-99 (Table 6). It would also be appropriate to make all

current transfers through the instrumentality of the Finance Commission and all the loan

assistance through Planning Commission. The Planning should be confined to

infrastructure projects and plan non-plan distinction in the revenue budget should be done

away with. The Finance Commission grant has serious design problems, and the ‘fiscal

dentistry’ is alleged to have had the consequence of widening ‘budgetary cavities’.

Figure 3: Equalizing Impact of Intergovernmental Transfers.

The influence of political factors in the transfer system is nowhere as prominent

as in dispensing funds for central sector and centrally sponsored schemes. There has

been a proliferation of these schemes, often for political reasons and at present they

number more than 210. Besides spreading the resources thinly, these programs distort

400

500

600

700

800

0 5000 10000 15000 20000 25000

Percapita SDP (Rs.)

Perc

apita

Tra

nsfe

rs(R

s.)

19

States’ choices in expenditure allocation, multiply bureaucracy and cause thin spread of

resources across several schemes (Saxena, 2002). As centrally sponsored schemes also

require matching contributions from the States, the extent of distortion in resource

allocation higher and expenditure centralization is much larger than what is indicated by

the expenditure shares of the States. Often, poorer States are unable to provide

counterpart funds and are unable to receive even the allocations made to them. Thus, the

actual dispensation of the transfers deviates from its design.

Table 6.Per capita Current Transfers to States from Center 1998-99

State FinanceCommission

Planning Commission TotalCurrentTransfers

State PlanSchemes

CentrallySponsored

Total

Intercept 8.383 5.859 -2.819 3.848 8.124T value 8.943 3.527 -0.760 2.011 9.180Coefficient -0.260 -0.171 0.736 0.115 -0.194T value -2.638 -0.978 1.891 0.573 -2.087R 2 0.349 0.068 0.216 0.025 0.251

Note: The equations pertain to only the non-special category States.

In addition to the explicit transfers discussed above, in planned economies where

prices and outputs are determined by government fiat rather than market forces, there can

be several sources of implicit transfers. Some of the important sources of implicit inter-

regional transfers in Indian federation include inter-state tax exportation, subsidized

lending to States either from the central government or from the government controlled

financial sector. Analysis of subsidized lending to states shows that these implicit

transfers can be significant; they can also significantly offset the progresivity of explicit

transfer system (Rao, 1997).

Based on the recommendations of the 11th Finance Commission, it is proposed to

earmark 15 per cent of the deficit grants with an equal contribution from the Center to be

distributed to the States according to their fiscal performance. Each state will be given a

share in excess or short of its initial eligibility (population share) depending on its fiscal

performance. The States will be required to put out their Medium Term Fiscal Reforms

Programme (MTFRP) and performance will be will be measured on the basis of a single

20

monitorable fiscal objective, improvement in the revenue deficit by at least 5 per cent of

its revenues. If a State fails to fulfill the condition, the fund will be rolled over to the

next year. If the withheld portion is not claimed by 2005-06, the fund will lapse. 12 of

the 28 States have already signed the Memorandum of Understanding (MOU) with the

Center and the rest are expected to follow. The problem with the scheme is that the funds

earmarked may not be large enough to incentivize transfers. Further, the scheme is only

incremental and does not consider the size of the deficit.

IV. 5 Inter-State disparities in Infrastructure Availability:

The worsening fiscal situation has adversely impacted on infrastructure

availability more in poorer than more affluent States. Figure 4 shows a positive

relationship between infrastructure index and per capita NSDP. Poor quality of

infrastructure in less developed States has constrained them from exploiting their growth

potential, even when these States are resource rich. Of course, it may not be proper to

attribute low incomes or their slow growth rates to infrastructure constraints alone.

Often, these are consequences of in policies, their implementation and institutions.

Figure 4: Relationship Between Per capita NSDP and Infrastructure Index.

0

50

100

150

200

0 5000 10000 15000 20000 25000

Percapita NSDP

Infr

astr

uctu

reIn

dex

Source: 1. Infrastructure Index: Report of the Finance Commission, Ministry of Finance,Government of India. 2000.

V. Efficiency Implications of Sub-national Fiscal Operations.

V.1 Efficiency aspects of sub national tax and regulatory system:

The advantage of federalism over a centralized fiscal system is its ability to

provide wider choice of bundles of public services while preserving the advantages of a

unified common market. Therefore, the system has to be judged from efficiency gains

21

netted for costs of administration, intergovernmental coordination, signaling and

mobility. These costs depend on a variety of factors including the state of technology,

efficiency of information flow and educational levels of electorate.

Dynamic efficiency, however, depends on the existence of “market preserving

federalism”. The latter requires the fulfillment of a number of important preconditions

such as (i) existence of a hierarchy of governments, (ii) primary authority of sub national

governments over the economy under their jurisdictions, (iii) the powers of national

authority to police the common market, (iv) limited revenue sharing and existence of hard

budget constraint, (v) institutionalized degree of durability of assignments. Of these,

monitoring role assigned to the central government to preserve the common market is a

critical element of market preserving federalism.

In Indian context, efficiency implications of tax policy in terms of distortions in

the tax system and violation of common market principles have not received much

attention. This can partly be explained by the fact that in a closed economy,

inefficiencies of tax and expenditure systems are neither transparent nor important. It is

therefore, not surprising that emphasis has been to raise revenues to finance large public

sector plans without concerning about allocative distortions.

The sales tax - the most important source of states’ own tax revenue is also the

most important source of distortion. Administrative considerations have led to the levy

of the tax predominantly at the first point of sale. All pre-retail sales taxes cause

cascading. The tax is levied also on inputs and capital goods and this exacerbates the

problem. Pursuit of multiple objectives has caused minute differences in tax rates. Inter-

state competition in sales tax to attract trade and investments has complicated the tax

structure further. In this “race to the bottom” the Union Territories have played a

destabilizing role. The competition has led the States to adopt the self-defeating schemes

of fiscal incentives in terms of sales tax holiday and deferment. In addition, to meet

exigencies of revenue, the States have levied turnover taxes, additional sales taxes and

entry taxes. All these have contributed to complicated, cascading and opaque tax

systems. The tax on tax, mark up on tax and tax on mark ups have altered relative prices

22

in unintended ways. The complicated tax systems and wide discretions to officials have

resulted in negotiated tax payments and high compliance costs. In addition, the Central

sales tax levied by the exporting state has distorted relative prices and segmented the

market. This has also been a major source of inequitable inter-State tax exportation.

Like in other federations, the Constitution seeks to ensure free inter-state trade

and commerce across the country. Article 301 of the Constitution in India declares,

“Subject to the other provisions in this part, trade, commence and intercourse throughout

the territory of India shall be free”. However, the parliament has powers to impose

restrictions if it is required in “public interest” (Article 302) so long as the restrictions are

not discriminatory (Article 303). Similarly State legislature can impose restrictions in

“public interest” without discrimination, but with the prior sanction of the President of

India (Article 304).

Despite the Constitutional provision to have a common market, fiscal and

regulatory system in India imposes a number of impediments to internal trade. The

impediments arise from the nature of assignments, competition to ‘free-ride’ by exporting

the tax burden to non-residents, asymmetric arrangements in the federal system, autarchic

nature of developmental strategy and the legacy of micro-management of a scarcity hit

economy. These are besides the impediments caused by the lack of development of the

market itself and the impact of social, political and linguistic diversities.

As important source of impediment to internal trade in India is the assignment of

tax powers. Despite the pronouncement in the constitution that the internal trade should

be kept free, the center is allowed levy tax under Entry 92A of the Union list, and it has

allowed the states to levy the tax on inter-state sale of goods by the exporting state

subject to a ceiling rate of 4 per cent. In a system in which the sales tax is predominantly

a first point levy, and there are taxes on inputs and capital goods, and in some states,

turnover taxes in addition to sales taxes, the levy of inter-state sales tax can cause

significant inter-state tax exportation.

Despite widespread awareness of the distortions caused by Octori, the States of

Gujarat, Maharashtra, Orissa and Punjab have assigned their urban local bodies the power

23

to levy Octroi, the tax on the entry of goods into local areas for consumption, use or sale.

In these States, this levy is major source of market segmentation; it impedes internal

trade, and causes allocative distortions. In addition, as this is a check-post based levy, it

enlarges scope for rent seeking. In spite of the awareness of the ills of the levy, it has

continued to be levied by urban local bodies in these states. Some other States have

allowed the local bodies to levy an account based levy, “entry tax”. In all other respects

this levy has effects similar to Octori except that this is an account based levy whereas

Octroi is a check post based tax.

The taxes on the transfer of property, as they are levied at present, have hindered

the development of the organized market for immovable properties in the country. The

levy of high and differentiated rates of stamp duty and registration fees has led to

widespread under valuation of immovable properties and evasion of the tax. There is no

incentive for honest reporting of the value of transactions and this prevents the

development of a transparent market for immovable properties. The levy has hindered the

very development of a transparent organized market for immovable properties.

In addition to the tax policies, there are a number of regulatory instruments

impeding free mobility of factors and products. To give examples of only a few, until

recently, the “freight equalization” scheme sought to subsidize transportation cost for

items such as steel and coal denying forward and backward linkages of large public

sector investments in the less developed states of Bihar, Madhya Pradesh and Orissa.

Similarly, under Essential Commodities Act, basic food items cannot be moved from one

state to another. Besides these, there are market impediments caused by planned

economic regime and labor immobility caused by linguistic barriers.

V.2 Political economy of sub national borrowing:

Political factors play an important role in the determination of the transfer system

as well as sub national borrowing. The issue assumes significance when the there is a

coalition government at the Center and regional parties in power in some of the States

24

have a pivotal role in determining the stability of the coalition. Political favoritism may

find a means to soften the budget constraints to the State governments ruled by these

parties or their allies. More importantly, favorable treatment to States ruled by coalition

partners can be done through discretionary transfers. This can also be done through

dispensing loans. This is aided by the fact that allocation of market borrowing is not

done in a transparent manner. Thus, there is considerable scope for political factors

determining the quantum of inter-regional resource flows. In addition, as market based

reforms are introduced into the system of determining loans, States with better credit

rating will receive more favorable treatment. This may accentuate inter-State disparities.

While, introduction of market-based reforms is inevitable, it is important to ensure that

the intergovernmental transfer system is targeted to offset fiscal disabilities and invisible

transfers arising from inter-state tax exportation and other resource flows are minimized.

An additional dimension to States’ finances in recent years has been is the lending

by multilateral lending institutions (World Bank and ADB) to States. Although the loans

are made conditional on the States undertaking effective fiscal reforms, there will be a

tendency to dilute the conditions as eventually, the repayment liability for loans lies with

the Center. Loan pushing by these lending institutions can result in excessive borrowing

by the States. Besides the usual problems associated with loans, these loans carry the

additional foreign exchange risk as well. It is extremely important that effective fiscal

reforms program should be put in place in order to avoid serious problems arising from

excessive borrowing.

The record of fiscal conditionality at the State level has not been very enthusing.

A number of States with poor fiscal performances have had to seek repeated refuge with

the Ministry of Finance for bailouts from overdraft regulations after signing MOUs, the

contents of which were not made public. Despite this, it was found necessary to give

directive to the Finance commission to link transfers with monitorable program of

reducing revenue deficits. This implies the irrelevance of those MOUs. In terms of both

the size of the transfers linked to fiscal performance and its design, it is very much

doubtful whether the new MOUs will inculcate greater fiscal discipline among the States.

25

Of course, there have been increasing awareness of the need to undertake fiscal

reforms. In order to get a comprehensive picture on the state of their finances, most non-

special category States have decided to publish their contingent liabilities. Some of the

States notably, Andhra Pradesh, Karnataka, Kerala, Maharashtra, Tamil Nadu and Uttar

Pradesh have, in recent years, brought out White Papers to increase public awareness of

their problems. Some of the States have also prepared a medium term fiscal plan for

policy institutional reforms to restore fiscal balance in the medium term of five years.

Initiatives have also been taken to undertake in depth analysis and to make detailed

recommendations on tax reforms and administrative restructuring by appointing tax

reforms Commission and Administrative Reforms Commission in States such as

Karnataka. Some of the States are also in the process of initiating measures to legislate

on the fiscal responsibility to provide legislative control over fiscal imbalances.

However, these measure have merely cosmetic and have not been able to arrest

declining revenues and increasing revenue expenditures. In this environment providing

quality infrastructure by sub national governments is a major challenge. The challenge is

particularly formidable in poorer States and unless this issue is addressed, this could pose

serious problem for the stability of Indian federation.

VI. Concluding Remarks

This paper has attempted to analyze the extent to which federalism in India has

facilitated or constrained the market environment during the last decade. The paper has

also attempted to identify policy and institutional reforms required to impart greater

dynamism to Indian federalism.

An important advantage of federalism over unitary system is that it provides a

large common market while providing a wider choice of fiscal packages. Equally

important are the gains from intergovernmental competition. The forces of

entrepreneurial competition, both horizontal and vertical, can bring in dynamism not just

to the provision of public services but also in creating enabling environment for the

market to function. The dynamism of competitive federalism is aided by the “Salmon

26

mechanism” in which, people compare and vote for the performance of a governmental

unit based on the benchmark performances seen in other governmental units.

However, in India, economic reforms initiated in 1991 have not gone far enough

in dismantling the policies and institutions and remnants of the regime have continued to

hinder the development of the market based institutions. The system is yet to unleash the

potential from beneficent intergovernmental competition. In addition, regulations and

controls introduced to meet the compulsions of a scarcity-ridden economy have

segmented the market in unintended ways. The advantage of a large common market is

frittered away due to several fiscal and regulatory impediments to internal trade. These

impediments, besides segmenting the market have also caused severe allocative

distortions. This has, to a large extent negated the gains from potentially a large common

market in the country. In an open economy, segmenting the market will pose severe

disadvantages to Indian industry.

Indian federalism is faced with a dilemma. The liberalized market environment

since 1991 has provided greater opportunities for the States to impart dynamism to the

economy. However, the experience of the last decade shows that the States with a large

manufacturing base with market friendly environment have been able to forge ahead.

This has tended to accentuate inter-regional disparities. Decline in the central transfers

and reduced progressivity in these transfers has only added to the problems. Moreover,

the inequitable invisible transfers have also contributed to accentuation in regional

disparities.

In Indian context, intergovernmental competition too has not been beneficent to

the desired extent. In many ways, the “Salmon mechanism” has worked to benchmark

adoption of retrograde policies such as implementation of pay scales and adoption of

populist policies on subsidies and transfers resulting in fiscal profligacy. These implicit

and explicit subsidies not only create fiscal imbalances and distortions but also perpetuate

a culture of free riding.

To unleash the dynamism of competitive federalism, it is important to initiate

systemic reforms in both policies and institutions. These include, inter alia, competitive

27

equality of jurisdictions, cost-benefit appropriability, ensuring hard budget constraint at

both national and even more important, sub-national levels. Reform in the assignment

system should avoid anomalies and enable evolution of efficient tax system. An

important precondition for the competitive market environment is the removal of all

fiscal and regulatory impediments to internal trade. More importantly, benefits of

competitive federalism will accrue only when the States compete to provide efficient

public services rather than higher salary payments or subsidies to special interest groups.

References

1. Acharya, Shankar (2001), India’s Macroeconomic Management in the Nineties,Indian Council of Research in International Economic Relations, New Delhi

2. Ahluwalia, Montek (2000), “Economic Performance of States in Post-ReformsPeriod”, Economic and Political Weekly, May 6, pp 1637-1648.

3. Anand, Mukesh, Amaresh Bagchi and Tapas K. Sen (2002), “Fiscal Discipline atthe State level: Perverse Incentives and Paths to Reform”, Working Paper No. 1,(January).

4. Bahl, Roy, W (2002), “Implementation Rules for Fiscal Decentralisation”, inGovinda Rao (Ed), Poverty, Development and Fiscal Policy, Esays in Honour of RajaChelliah, New Delhi: Oxford University Press (Forthcoming).

5. Bird, Richard, M and F. Vaillancourt, (1998), Fiscal Decentralisation inDeveloping Countries, Cambridge University Press, Cambridge.

6. Breton , Albert (1995), Competitive Governments, Cambridge University Press,New York.

7. ______, (1987), “Towards a Theory of Competitive federalism”, EuropeanJournal of Political Economy, Vol. 3, No.1-2, pp. 263-329.

8. Chelliah, R. J. (1991), Towards a Decentralised Polity, Fourth L. K. Jha MemorialLecture, Fiscal Research Foundation, New Delhi.

9. Feldstein Martin, S. (1975), “Wealth Neutrality and Local Choice in PublicEducation”, American Economic Review, Vol. 65, pp. 75-89.

10. Government of India (2000), Report of the Finance Commission, Ministry ofFinance, Government of India.

11. Government of India (2001), Approach to tenth Five Year Plan, PlanningCommission, New Delhi.

12. Kurian, N. J. (1999), State Government Finances, Economic and PoliticalWeekly, May 8, pp. 1115-1125.

28

13. Lahiri, Ashok (2000), Subnational Public Finance in India, Economic andPolitical Weekly, April, 29. pp. 1539-1549.

14. Parikh, Sunita and Barry R. Weingast (1997), A Comparative Theory ofFederalism: India, Virginia Law Review, Vol. 83. No. 7. pp. 1593-1615.

15. Rao, M. Govinda (2001), “Taxing Services: Issues and Strategy”, Economic andPolitical Weekly, October 20, pp.3999-4006.

16. ______ (2002), “Fiscal Decentralization in Indian Federalism”, in EhtishamAhmad and Vito Tanzi (Eds), Fiscal Decentralization in Developing Countries,Routledge, London, (Forthcoming)

17. ______ (1997), “Invisible Transfers in Indian Federalism”, PublicFinance/Finances Publiques, Vol. 52, No. 2, pp. 299-316.

18. _________ K. P. Kalirajan and Ric Shand (1999), “Convergence of Incomes inIndian States - A Divergent View”, Economic and Political Weekly, March 27- April 2.pp. 76-778.

19. ________ and Nirvikar Singh (2002a), “Fiscal Transfers in a Developing Country- The Case of India”, Paper presented in the Seminar in Comparative Federalism,University of Birmingham, January 18-19.

20. ______and ______ (2001), “Federalism in India: Political Economy and Reform”,Conference on “India: Ten Years of Economic Reform” William Davidson Institute,University of Michigan, September.

21. ______and _______ (2000), The Political Economy of Centre-State FiscalTransfers in India", Paper presented at the Columbia University - World BankConference on Institutional Elements of Tax Design and Reform, February 18-19.

22. ______ and ______ (1999), "How to Think About Local Government Reform inIndia, Paper presented at the conference on second-generation Indian economic reforms,Madras School of Economics, Chennai, December 8-10.

23. Rodden, Jonathan R and Susan Rose-Ackerman, “Does Federalism PreserveMarkets? Virginia Law Review, Vol. 83 pp. 1521-1570.

24. Salmon , Pierre (1987), Decentralization as an Incentive Scheme, Oxford Reviewof Economic Policy, Vo. 3, No. 2, pp. 24-43.

25. Saxena, N. C (2002), “Improving Efectiveness of Government Programmes - AnAgenda of Reform for the !0th Plan", Planning Commission, Government of India, NewDelhi.

29

Annexure Table 1State-wise Fiscal Imbalances

(Percent of NSDP)

1990-91 1995-96 1999-00RevenueDeficit

FiscalDeficit

RevenueDeficit

FiscalDeficit

RevenueDeficit

FiscalDeficit

Andhra Pradesh 0.46 2.79 1.03 3.36 2.34 5.16Bihar 2.17 6.11 2.81 4.09 5.45 9.37Gujarat 2.51 6.42 0.34 2.71 2.75 6.01Haryana 0.16 3.04 1.35 3.84 3.02 5.76Karnataka 0.33 2.30 -0.12 2.76 1.71 3.29Kerala 2.67 5.06 1.15 3.71 3.88 5.49Madhya Pradesh 0.62 3.17 0.83 2.85 2.93 4.45Maharashtra 0.09 2.65 0.43 2.93 4.11 6.03Orissa 0.19 5.98 3.38 5.85 6.24 9.35Punjab 3.36 7.67 1.31 3.98 5.74 7.93Rajasthan -0.76 2.45 1.67 6.13 5.92 8.85Tamil Nadu 1.74 3.55 0.44 1.79 3.09 4.16Uttar Pradesh 2.16 5.39 2.29 4.28 4.68 7.24West Bengal 3.03 4.85 1.86 4.02 6.71 9.06Major States 1.33 4.18 1.17 3.50 4.06 6.34Special categoryStates

-0.40 8.04 -2.53 4.65 3.70 10.69

All States 0.93 3.30 0.73 2.60 2.94 4.75Notes: All States is sum of 25 States

For States, Major States and Special States it is ratio to NSDP newSeries. For All States it is ratio to GDP new Series.

30

Annexure II Average Annual Growth Rates of States’ Revenues and Expenditures Percent1980-81 to 1989-90 1990-91 to 1999-00Own TaxRevenue

Ownrevenues

RevenueExpenditure

InterestPayments

CapitalExpenditure

Own TaxRevenue

Ownrevenues

RevenueExpenditure

InterestPayments

CapitalExpenditure

Andhra Pradesh 17.15 16.57 17.13 22.28 11.15 14.30 13.76 15.54 20.99 7.84Bihar 14.28 19.57 16.36 21.31 10.63 11.78 10.18 10.89 11.29 6.78Gujarat 16.05 16.34 17.90 24.70 8.13 14.92 15.51 16.56 18.51 14.77Haryana 15.79 15.87 17.19 21.58 6.94 13.33 14.86 17.66 19.38 9.79Karnataka 16.43 14.78 16.49 22.55 6.78 14.61 14.20 15.09 18.43 10.99Kerala 15.97 13.33 15.68 23.77 8.92 16.98 16.61 16.62 18.53 14.44Madhya Pradesh 16.20 14.40 16.89 23.62 6.48 14.03 12.95 14.65 17.44 4.30Maharashtra 15.77 15.44 16.67 24.31 9.13 14.16 13.13 15.45 18.87 13.66Orissa 16.60 12.93 14.73 22.66 12.67 12.47 12.36 15.20 18.52 7.30Punjab 14.22 13.42 16.47 16.21 15.86 12.44 14.68 15.78 27.54 3.15Rajasthan 17.05 14.39 17.71 20.53 7.62 15.72 13.35 15.63 20.92 12.87Tamil Nadu 14.61 13.54 16.27 17.53 2.90 15.24 14.38 13.28 20.78 22.48Uttar Pradesh 15.43 14.87 17.84 24.20 7.53 13.14 11.64 13.54 19.53 7.18West Bengal 16.26 14.24 14.78 19.77 9.90 11.23 11.25 15.44 21.45 21.18Major States 15.82 15.10 16.69 22.00 8.80 14.09 13.50 14.82 19.26 11.39Special States 19.36 12.99 21.14 28.06 17.00 13.79 17.30 16.12 16.03 9.42All States 15.92 14.95 17.07 22.50 9.69 14.08 13.68 14.94 18.99 11.13

Note: Growth rates have been estimated by fitting semi-log trend lines.