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Fiscal Federalism in India: An Analysis of Fiscal Transfers to States

Article  in  SSRN Electronic Journal · January 2010

DOI: 10.2139/ssrn.1536324

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1.1: INTRODUCTION
India is a federation where functions of Union and States’ governments are well
defined in the Constitution. Such division of responsibilities is aimed at achieving
political, economic and administrative efficiency. Government of India Act, 1919 could
be said to be the beginning of modern federalism as it provided for the clear cut
separation of revenue heads between the Center and the Provincial governments. The
next major step towards constituting a fiscal federalism was the Government of India Act,
1935 when besides the jurisdictional distribution of revenue between Union and States
there was provision for revenue sharing and transfer.

Since these federal arrangements were effected under the colonial rule the bias
towards strong Centre with certain amount of flexibility to maneuver was essential. When
independent India adopted its Constitution on 26th January, 1950, it retained these
features. The challenges before it were not only keeping States that have cultural, lingual,
ethnic, economic and geographic heterogeneity (probably without parallel in the world)
together but to ensure rapid economic development with social justice as well as balanced
regional development.

The Seventh Schedule of the Constitution of India, Article 246, provides for three
lists: these are the Union List, the State List, and the Concurrent List. In the Union list, or
under the exclusive domain of the Center are all matters relating to currency, banking and
finance, defense, foreign affairs, including economic relations with foreign countries,
matters affecting the country as a whole, and those relating to inter-State relations. Under
the State List are matters closely connected with the life and welfare of the population,
such as law and order, local government, public health, infrastructure, land, agriculture,
and water management? Finally, on the Concurrent List are matters relating to law,
marriage, succession, personal law, transfer of property other than agricultural land,
economic and social planning, trade unions, social security, education, electricity, and
production or/and trade in, products of any industry deemed by the Parliament as best
controlled by the Center. By and large, the Center ultimately prevails in several important
areas where Central control or intervention is considered to be expedient in the public
interest by the Parliament.

Electronic copy available at: http://ssrn.com/abstract=1536324

 This Indian federation worked as two tier structure until-1993 when through 73rd
and 74th amendments to constitution, other institutions of rural and urban Local
governments were created. This tier of government is yet to attain the maturity level. The
responsibilities assigned to it could not be properly institutionalised in spite of the fact
that being closer to the people local governments could be the ideal for the provision of
local public goods. So far as financial resources of such governments are concerned such
institutions are largely dependent on the devolutions from State government. However
local governments, for certain schemes, do receive financial grants directly from Central
government also. To recommend the amount to be devolved to the Local governments,
Finance Commission was created at State level.

1.2: CONSTITUTIONAL PROVISION FOR FISCAL FEDERALISM

To carryout their functions the various levels of governments require specific

fiscal arrangements. The fiscal federal arrangements that are provided in the Constitution
adopted by independent India in 1950 were largely the logical extensions of the
Government of India Act, of 1935. Jurisdictions over tax revenue were assigned
according to the following scheme where five categories of taxes were provided;

1. Taxes, which are levied, collected and retained by the Central government.

2. Taxes, which are levied and collected by the Central government but wholly,
assigned to the States.

3. Taxes which are levied and collected by the Union government but the net proceed
is shared with the States. This category of taxes is also known as divisible pool.1

4. Taxes, which are levied by the Union but, collected and retained by the States.

5. Those taxes, which are collected, levied and retained by the States.

In a major restructuring of the above scheme the 80th amendment to the

Constitution in 2000 all the Central taxes were made shareable.

1
Tax on personal income other than the one derived from agriculture and Union Excise duty were the notable in this divisible
pool.

Electronic copy available at: http://ssrn.com/abstract=1536324

 Assignments of revenue sources to respective layers of government and their
Constitutional responsibilities do not seem to have any correspondence. Amongst the tax
sources, where the State governments have the exclusive jurisdiction (from designing the
rate structure and administration to utilisation) only the tax on sale of goods yield revenue
of worth mentioning magnitude. Therefore the tax sharing constitutes the significant
position of State government’s revenue receipts. Besides the shareable pool, the tax
mentioned under category 2 and 4 can also be the instruments, which intervene, in the
fiscal matters of the States.

In addition to transfers of resources from Union to the States by means of shared

tax, Article, 275 of the constitution provides for the Grants-in-aid to the State
governments in whose case gap between expenditure and revenue is estimated to persist
even after the devolution in the form of tax sharing.

In order to determine the quantum of States’ share from the sharable pool and to
determine the principle that should govern the distribution of such share amongst the
States the Constitution under Article, 280 provided for the Finance Commission. The
Commission is appointed every five year by the President of India to assess the States’
and Union government’s revenue and expenditure projection for the next five years and
make recommendations on the above mentioned issues and on any other matter which the
President may ask for in the ‘terms of reference’ for each Finance Commissions.

Another channel of federal transfer is through Planning Commission. Whereas the

Finance Commission decides on tax shares and grants the Planning Commission2
facilitates the loans and grants, in the ratio of 70:30 for non-special category States3, for
implementing development plans. In fact the institution of Planning Commission is used
to transfer the resources provided in Article, 282 of the constitution.4

Yet another source of federal transfers is the Central Ministries that provide
finance to their State counterparts in the form of the grants. Such grants are meant for
financing the specified projects. These projects may be wholly financed by such grants or

2
A non-statutory body created and through resolution of the cabinet.
3
For special category states the corresponding figure is 10:90.
4
The Article provides for the grants and lending by the Union government to states for financing their expenditure on socio-
economic development projects.
may require the States government to share a proportion of cost. The projects that are
normally covered under such grants are those that have a considerable amount of inter-
state spillover, as also for the provision of merit goods like poverty alleviation program,
immunization drives etc. These programs are often guided by the specific local objectives
like employment generation etc.

Thus there are, in general, three channels through which federal transfers flow to
the States.

(a) Finance Commission

(b) Planning Commission

(c) Central Ministries

Besides maintaining vertical balance between different layers of the

governments, getting the States make their expenditure consistent with the national
priorities are the major objectives of fiscal transfers. These objectives obviously entail
transferring more resources to the States with less fiscal capacity for their development.
As a logical corollary relatively richer States will get less because they can take care of
their expenditure from their own revenues.

In fact ‘equity approach’ calls for balanced regional development which in turn
requires greater devolution to the poor States by locating the Central projects in backward
regions. Strong votary of equity approach J.M. Buchanan argued that the fiscal pressure
in poor States would provide an incentive for highly skilled professional and potential
entrepreneur to migrate to richer States, as they are tax conscious. Therefore if the poor
States are offset for their backwardness this out migration can be checked.5 The
alternative approach advocates efficiency considerations, with Scott being its chief
proponent, it favors the deployment of factors of production where they can produce
more. The very fact that in poor region output per unit of input is lower, keeping them in
backward region will tantamount to sacrificing a portion of national output.6

5
J.M.Buchanan (1949): The pure theory of Government finance: A Suggested Approach, JPE Vol. LVII, Dec.1949.PP 496-505.
6
A.D.Scott (1950): Federal Grants and Resource Allocation JPE 1950- PP-534-538.
 There are other arguments and counter-arguments for and against these
approaches, which may not be appropriate to be discussed here, but they simply produce
one conclusion that efficiency and equity are the conflicting objectives, which can be
achieved only at the cost of one another. Federal transfers through various agencies in
India need to be examined in this context too. That is, to what extent a delicate balance
could be maintained.

2.3: FINANCE COMMISSION TRANSFERS

. Independent Indian Republic adopted its constitution on Jan. 26, 1950. Article,
280 of the Constitution provided for an Independent Finance Commission to be appointed
periodically. Out of many sources of federal transfers at least tax sharing and
unconditional grants were to be explicitly facilitated by the Finance Commission. Income
tax under Article 2707 and the union excise duty under Article 272 were the tax and
duties sharable with the States before all the Central taxes were made shareable through
80th amendment of the constitution. Grants under Article 2828 were outside the preview
of Finance Commission. Besides sharing of tax and duty the State also receive grants-in-
aid of their revenue under Article 275. The Finance Commission also recommends
quantum of such grants.

Therefore Finance Commission, which is the unique feature of Indian federalism,

has to recommend the percentage of proceeds to be shared with the States, and the
principle and criteria that should become basis for distribution of such proceeds among
the States.

1.3.1: Revenue Sharing

Fist finance commission was appointed in Nov.1951 whose report was submitted
in Dec.1952. Since then Twelfth Finance Commissions have submitted their reports.
Devolutions in the form of tax sharing and grants-in-aid up to March 31, 2010 will be
governed by the recommendations of Twelfth Finance Commission. Thirteenth has
already been constituted to make the recommendations of transfers after March 2010.

7
This tax was on personal income other then agriculture income. Tax on companies profit know as corporate tax was in exclusive
domain of centre and not sharable. So was surcharge on income tax.
8
Specific purpose grants provided through Central Ministries or Planning Commission.
Awards to the States recommended by successive Finance Commission are summarize in
the table 3.1

Table 3.1 suggests that to begin with, Center was assigned the greater share
from the divisible pool. It was thus maintaining a dominant position. States in such
circumstance were naturally dependent on the Center for the resources not only to carry
out the expenditure for socio economic development but also to discharge their statutory
functions. States were given only 55 per cent of the net proceeds9 from ‘income tax’ and
40 per cent of ‘union excise duty’ collected from only three items.

But every successive Finance Commission increased the share of States. Second
Finance Commission increased the States’ share of income tax from 55 per cent to 60 per
cent. As far as share in ‘union excise duty’ is concerned number of articles duty from
which was to distributed were raised to eight, however share itself was reduced to 25 per
cent from the 40 per cent as recommended by the First Finance Commission. The Third
and Fourth Finance Commissions further raised States’ share in ‘income tax’ to 66.7 per
cent, and 75 per cent respectively. Share of States in ‘union excise duty’ was lowered to
20 per cent by the Third Finance Commission from 25 per cent by its predecessor. But at
the same time the articles to be covered for this purpose were raised from eight (Second
Finance Commission) to thirtyfive by the Third Finance Commission. The Fourth
Finance Commission brought all the articles under the sharable pool, ‘union excise duty’
from which was to be shared with the States.

Fifth Finance Commission maintained the status quo, keeping the States share
of ‘income tax’ and ‘union excise duty’ to be at 75 per cents and 20 per cents
respectively, as was the award of the Fourth Finance Commission. Sixth Finance
Commission increased the States share’ marginally by raising the share from ‘income
tax’ from 75 per cent to 80 per cent while that from ‘union excise duty’ was kept at the
same level of 20 per cent.

Thus between First and Sixth Finance Commission States’ share had increased
in many respect. But devolutions have always been one of the sources of uneasiness for
Centre - State relations. Two items that have been frequently mentioned as the irritants

9
After deducting the cost of collection and the amount earmarked for Union territories directly governed by the Centre.
for the financial relations between Center and States were the surcharge on ‘personal
income tax’ and ‘corporate income tax’. These items did not constitute the shareable pool
(before Eightieth amendment) but certainly affect the ‘income tax’ proceeds, which is
shareable, because the ‘corporate tax’, which is levied on the profit of the companies
reduces the amount of dividend of the shareholders, resulting in lesser amount of ‘income
tax’ collection. Surcharge on ‘income tax’ therefore used to be resented by the States.
Argument was that if the tax tolerance exists, the same may be used for ‘income tax’.
Devolution in the form of Grants-in-aid of revenue under Article 275 was used to cover
the deficit in the revenue account of the States.10 Other grants and loans for socio
economic development and for specific purposes (provided under Article 282,293) were
devolved to the States through other agencies.

Seventh Finance Commission provided a quantum jump as far as States’ share

was concerned. It, not only double the States’ share in the ‘union excise duty’ from 20
per cent to 40 per cent but also raised the share in ‘income tax’ from 75 per cent, in Sixth
Finance Commission award, to 80 per cent. Thus the total devolution recommended was
substantially enhanced by Seventh Finance Commission. The relief to the States’ finances
was substantial as “It has for the first time left significant surpluses with all States”.11

Eighth Finance Commission further raised the States share in ‘union excise duty
to 45 per cent while leaving the ‘income tax’ share intact. Ninth Finance Commission did
not recommend any change in so far as tax sharing is concerned, while Tenth Finance
Commission made slight changes in both ‘income tax’ shares to be reduced from 85 per
cent to 77.5 per cent while at the same time increasing the share in ‘union excise duty’
from 45 per cent to 47.5 per cent.

The next major structural change for revenue sharing came through the
Eightieth amendment of Indian constitution. It made all the Central taxes to be shareable
with the States. Therefore one of the irritant in Center-State financial relations could be
removed as surcharge on ‘income tax’ and a tax on corporate income would no longer put
the States to some kind of disadvantage as now the States became eligible to share the

10
The practice is sarcastically termed as “fiscal dentistry”.
11
Note of dissent given by Prof. Raj Krishna (as a member) to the report of the Seventh Finance Commission, reproduced in
Readings in Indian Public Finance Edited by D.N.Dwivedi (1981).
aggregate buoyancy of Central taxes. The amendment came when Eleventh Finance
Commission was all set to finalise its recommendations. States’ share was thus revised
and fixed at 29.5 per cent, which was raised to 30.5 per cent by Twelfth Finance
Commission. One and very clear conclusion that can be drawn from the above data,
summarised in table 3.1, is that the trend in devolution through ‘revenue sharing’ has
been consistently moving in favors of States. The Center’s monopoly over more elastic
sources of revenue has been diluted considerably. Therefore the award of Seventh
Finance Commission and Eightieth Constitutional amendment could be termed as
landmarks. The saying goes; there is hardly any thing in Public finance, which is not
influenced by the political economic factors. So is true here. The growing assertiveness
of States succeeded in getting things changed to their favour only when they were
politically well placed. Seventh Finance Commission recommendations came when many
States were not only ruled by the non Congress parties, their leaders were having a
considerable say at the Central level as it was ruled by Janata Party which was
amalgamation of many parties who’s leaders were very strong in their respective States.

As regards the other change (Central tax becoming shareable), there was first
stable coalition government at the helm in Centre. In this coalition many regional parties
were having decisive say.

1.3.2: Distribution of States’ Share

The intricate issue is the horizontal sharing or how the States’ share to be
distributed amongst them. It becomes complicated because of the fact that States are
heterogeneous in terms of GSDP, population, poverty, and infrastructure etc. And as a
result of this they vastly differ in terms of fiscal capacity. In view of equity objective
poor States have to be accorded priority but as discussed earlier this militates against the
objective of efficiency. The criteria evolved through successive Finance Commissions are
presented in table 3.2.

The table 3.2 suggests that the criteria and weights used for tax devolution by
the Finance Commissions tend to move towards equity approach. For the distribution of
proceed from income tax ‘Population’ has been the dominating criteria up to Seventh
Finance Commission with first, third and fourth giving 80 per cent and second, fifth,
sixth and seventh giving it 90 per cent weight, the rest 20 per cent or 10 per cent was to
be distributed on the basis of contribution of respective States in the ‘income tax’
collection.

As for ‘union excise’ population was given 100 per cent weight by First Finance
Commission which declined to 90 per cent in second, further declined to 80 per cent,
remained so in fifth as well. Third Finance Commission did not specify as to how the
excise duty to be distributed. Sixth Finance Commission further reduced this weight to 75
per cent.

States backwardness started receiving attention since Fourth Finance

Commission when it was accorded 20 per cent weight. It was reduced to 6.66 per cent but
simultaneously a criterion of income distance was added with 13.34 per cent weight,
which was raised to 25 per cent by the Sixth Finance Commission.

For ‘union excise duty’ criteria was diversified for the first time by the Seventh
Finance Commission which, besides population, added ‘inverse of per capita income’,
poverty and ‘revenue equalisation’ with each assigned 25 per cent weight.

Eighth Finance Commission onwards ‘income distance’ became the principal

determinant. It remained with 45 per cent weight for ‘income tax’ distribution under
Eighth and Ninth Finance Commission. Tenth Finance Commission raised it to 60 per
cent. As for as ‘union excise duty is concerned ‘income distance’ has been the principal
determinant with 45 per cent weight each under Eighth, Ninth Finance Commission.

Population that was the dominant criterion for ‘income tax’ distribution at least up
to Seventh Finance Commission and for ‘union excise’ up to Sixth Finance Commission
had lost that primacy in case of ‘union excise’ and ‘income tax’ respectively from
Seventh and Eighth Finance Commissions onward. The reason for dilution of population
as weight was a clear-cut shift in favor of equity. Though revenue equalisation was
assigned 25 per cent weight for the distribution of ‘union excise’ any Finance
Commission thereafter did not use it in any significant measure. While Tenth and
Eleventh Finance Commissions evolved other criteria like area, index of infrastructure
and fiscal discipline, income distance continued to be the dominant criterion.
 Twelfth Finance Commission while reducing the weight of income distance from
62.5 per cent under Eleventh Finance Commission, to 50 per cent while at the same time
increased the weight assigned to population from 10 per cent under Eleventh Finance
Commission to 25 per cent. It also added, for the first time, a new element in the criteria
namely the ‘tax efforts’. Thus in general, equity principle dominated in case of Twelfth
Finance Commission award too. In short “we have tried to evolve a formula that balances
equity with fiscal efficiency. Equity considerations however dominate, as they should, in
any scheme of federal transfers trying to implement the equalisation principle”.12
1.3.3: Grants-in-aid

Vertical imbalance caused by the assignments of responsibilities and revenue

sources continued to persist till today. In the year 2000-01 States could finance only
about 43 per cent of the expenditure from their own revenue sources13. Inadequacy of this
magnitude is not made up even after the devolution of tax share. Therefore constitution
provided for various kinds of grants. The most important amongst the grants is the one
that come under article 275, and to be given only on the recommendation of the Finance
Commission. The purpose of article 275 is to give grants-in-aid of revenue to such States
that are adjudged to be in need of assistance. A practice of the successive Finance
Commissions has been that such grants have been assigned the resolving role under the
scheme of fiscal devolution. That means such grants are given to those States whose
resources are inadequate even after the tax devolution.

The First Finance Commission said:

“In assessing the needs of the States and formulating our

recommendations in regards to the sum to be paid as grants-in-aid,
we have considered the budgetary position of the States and the
probable amount which would accrue to them under our plan for
the devolution of income tax and union excise”.14

12
Report of Twelfth Finance Commission (2004), p-133.

13
Rao M Govinda: “Changing Contours in Federal Fiscal Arrangement in India” in Amaresh Bagchi
(Ed) Readings in Public Finance 2005.
14
Report of the First Finance Commission, 1952.
 Thus, grants (article 275) have been used, generally, to cover the non-plan
revenue gap of the states. Significance of the grants can be gauged from the fact that it
constituted 18.87 of the Finance Commission recommended devolution under the
Twelfth Finance Commission which was higher by 5.4 percentage point from such
devolution under Eleventh Finance Commission.

3.4: PLANNING COMMISSION TRANSFERS

While the Finance Commission decides on tax shares and grants (statutory one), a
separate body, the Planning Commission, makes grants and loans for implementing
development plans. It recommends only 30 per cent of the Central assistance for State
plans in the form of grants. Seventy percent of the plan assistance is provided in the form
of loans, which creates the burden of annual reverse flow of resources from the State
governments to the Central government in the form of interest amount and repayment
installments. Historically, as development planning gained emphasis, the Planning
Commission became a major dispenser of such funds to the States.

Constitution of India under Article 282 provides that the Union or the States may
provide grants for any public purpose, notwithstanding that the purpose is not one with
respect to which Parliament or the legislature of the State, as the case may be, make laws.
This Miscellaneous Financial Provision of the constitution is used to make devolution,
for socio-economic planning, through the Planning Commission (a non-statutory body).
Thus the funds are transferred to the States by the Planning Commission under two non-
statutory routs. One; via supports to State plans called the Central plan assistance and
two; via Centrally Sponsored Scheme of the Central Ministries known as specific purpose
grants.

States’ own revenue plus Finance Commission devolutions are not adequate to
find sufficient balance to finance their plans. They depend greatly on resources provided
to them by the Planning Commission. Each year Planning Commission finalise the
amount for State plans. Such transfers that are routed through Planning Commission are
in the form of loans and grants in the ratio of 70:30 for the general category States. For
special category States15 such ratio are 90 per cent grant and 10 per cent loan. These
States do require greater amount of support because they are having a strategic location in
the border with neighboring countries, hilly terrain, inadequate economic and social
infrastructure, predominantly larger tribal population, weak resource base compared to
development needs. Special Category States’ fiscal indicators remain normally in an
unenviable state despite the favorable treatment in terms of Central devolutions. Almost
all the special category States are presently having post tax, non-plan revenue deficit with
Assam being the sole exception. For general category States almost every State with the
exception of Punjab has such account in surplus. Punjab is having such deficit not
because of the inadequacy of revenue but the fiscal profligacy it often ventures into.

The Planning Commission works out five year plan investments for each sector of
the economy and each State. With this as background, the States work out their respective
annual plans for each year, based on estimated resource availability, which potentially
includes the balance from current revenue (including Finance Commission transfers),
contributions of public enterprises, additional resource mobilisation, plan grants and
loans, market borrowings, and other miscellaneous capital receipts. At this stage, a
certain amount of bargaining for resources goes on through the NDC16 as well as in
State-by-State discussions, to determine plan loans and grants. At the end of this process,
the Planning Commission approves the State plans. Thus, at the margin, it is mainly the
own resource position of the States that determines their plan sizes.

Before 1969 plan transfers used to be project based, thereafter a formula known as
Gadgil formula17 became the basis for such transfers. Since then the formula has been
revised twice. The formula currently in use is known as Revised Gadgil Formula, which
is as under.

(i) 60 per cent – 1971 population.

15
Special category states are-Assam, Arunachal Pradesh, Himachal Pradesh, J&K, Manipur, Mizoram,
Nagaland, Sikkam, Tripur and Uttaranchal.
16
The National Development Council (NDC) in 1969 thus took a decision that central assistance to states
plan should be by and large in the form of block/unconditional assistance and limit the CSS amount to
1/6th of the block assistance.
17
Gadgil formula is adopted by the NDC, the authority for the approval of Planning Commission in
1968.
 (ii) 25 per cent – per capita SDP

(a) 20 per cent for States below the average per capita SDP - Deviation Method.

(b) 5 per cent for all States - Distance Method.

(iii) 7.5 per cent for performance - In tax effort, fiscal management, population control,
female literacy, on time completion of externally aided projects and land reforms.

(iv) 7.5 per cent - Special problems of individual States.

Planning Commission transfers are conditional in nature. They are meant for the
specific purposes (to finance the State plan expenditure). Maintaining harmony between
the States plans and the over all objectives of the National Five Year Plans is always a
difficult task. Therefore Planning Commission transfers constitute a very significant
portion of Central transfers that include Finance Commission transfers and Central
Ministry transfers.

Table 3.3 presents the figure for the statutory and non-statutory transfers. It is
amply clear from the table that during Ninth and Tenth Finance Commissions total
finance commission transfers (tax share and grants taken together) were little less than
double the amount transferred through non-statutory source (bulk of which is are the
Planning Commission transfers). Eleventh Finance Commissions total transfers were just
the double the other transfers. If these non-statutory transfers are compared with the
statutory grants the latter appears to be meager.

Under Twelfth Finance Commission the ratio of Planning Commission transfers

as ratio to Finance Commission transfers declined as the former constituted only little
less than one third of the latter. Thus Planning Commission transfers represent a
significant portion of the total Central devolution to the States. But there is a down side
of this channel of devolution as 70 per cent of such transfers are in the form of loans (for
general category States). Servicing of such loans entails the additional revenue
expenditure in the form of ‘interest payment’ and therefore such loans are one of the
several causes of the imbalance in the revenue budget of States.
3.5: CENTRAL MINISTRY TRANSFERS

Besides support to States’ plan, grants are also routed through Central Ministries
to the States for specific projects known as Centrally Sponsored Schemes(CSS). Such
CSS are not meant to bridge vertical gap, but to provide the States with additional
resources for expenditure, which the Central Government considers to be of national /
regional priority, although the implementation of these programs is normally in the
domain of the State governments. Central Ministries design the CSS and pass the funds to
the States from the Central plan budget that the Ministries control. However, approval
and clearance of the schemes by the Planning Commission is required, after which the
Central Ministries make the State-wise allocations. The outlay and nature of the
individual schemes is determined by the provisions and guidelines attached to schemes,
which cannot be altered by the States. In its originality, CSS were to be formulated only
where an important national objective such as poverty alleviation was to be addressed, or
the program had a regional or inter-State character or was in the nature of pace setter, or
for the purpose of survey or research. However, the number of CSS proliferated by
including considerable areas of activity performed by the States.

The important reasons for increased involvement of Centre on State subjects are;
inability of the States to provide adequate resources for socially relevant programs, lack
of a clear strategy to implement social sector programs by the States and inadequate
commitment of resources on priority programs. The most important contributory factor,
however, is the availability of external funding for social programs, a State subject, which
was earlier available only for economic activities of the government. The external
funding on social sector, provided as soft loan by the external agencies, requires the
conditionality of ensuring accountability and close monitoring and evaluation of the
programs for smooth flow of funds.

Specific purpose grants and loans in the form of specific purpose schemes, which
was termed as CSS in 1969, have been a discord between the Centre and the States.
States have maintained that if the Centre had additional resources the same could be
transferred to States as untied or block assistance, and not as conditional assistance as in
CSS. The National Development Council (NDC) in 1969 thus took a decision that
Central assistance to State plans should be by and large in the form of block /
unconditional assistance and limit the CSS amount to 1/6th of the block assistance.
However, CSS has grown enormously both in terms of number and amount of assistance.

There are two types of CSS in the Central Plan. The first category (Category I) of
CSS includes those schemes for which outlays are explicitly recognised as CSS schemes
in the Union budget, and is routed through the State budgets. Category II CSS are not
recognised as transfers to the States in the Union budget and include those schemes,
which are budgeted with a separate programmatic minor / sub-minor head under the
specific functional head of the department. Category II CCS are either fully or partially
routed through the State budgets or bypass the State budgets and go to the State / district
agencies directly.

Even though the Centre mostly funds CSS as grants, the States are also required
to make matching contributions. In the 1980’s, it was generally a matching contribution
of 50 percent by the States, but was reduced to 25 per cent in the 1990’s in view of the
difficult fiscal situation faced by the States. In view of this required contribution by the
States, it has been observed that relatively better off States benefit more from the CSS, as
they have better matching resources and better implementation capability. Some of the
schemes started in the current decade such as the Pradhan Mantri Gram Sadak Yojana
(PMGSY) and Rastriya Sam Vikas Yojana (RSVY), Sarva Shiksha Abhiyan (SSA), Mid
Day Meals (MDM) and National Rural Employment Guarantee (NREG) are operated
through 100 per cent grants from the Centre.

A few issues relating to CSS have been raised in the academic literature. It has
been often stated that proliferation of CSSs creates administrative problems for the State
and Local bodies. Further, with ever increasing CSS, the fiscal transfer to the States
becomes more discretionary rather than formulae based, which may not be desirable in
the interest of fiscal federalism. A problem associated with CSSs is that the Central
Government designs the parameters within which the schemes operate and this often
deprives State governments of the flexibility that may be needed to take account of local
conditions. Another problem is the releases of Central assistance which are linked to
timely submission of utilisation certificates, a discipline imposed to ensure that transfers
lead to actual expenditures. It has been stated that the practice of requiring utlisation
certificates before releasing subsequent trenches of assistance can harm implementation,
especially when certain types of works can only be done in certain months of the year.

3.6: FEDERAL TRANSFERS AND VERTICAL IMBALANCE

As has been discussed earlier that the resource transfer from Center to States is based
not only on the needs of the States – reflected in the revenue gap in the State’s finances –
but is affected by Centre’s revenue and expenditure position. Since State’s have been
assigned greater constitutional responsibilities their expenditure level too should have
been higher but in case if India, Centre’s expenditure has been higher than the combined
expenditure of all the States. Though the expenditure of Centre as well as States have
grown considerably since 1950-51 when they were 5.13 and 4.75 percent of GDP
respectively it was the latter that grew faster.

Beginning of fiscal reforms caused a decline in the growth of government

expenditure of both Centre as well as States but the relative decline was faster in Centres’
expenditure. After declining till 1996-97 it started increasing again and went as high as
30.98 per cent. By the end of nineties the expenditure commitments of both the tier of
government have become almost equal because of the relatively faster growth of States’
expenditure.

Such a faster growth in States’ expenditure commitments called for a greater

devolution of resources from Centre but it could not be materialised because of the
Central fiscal reform. Table 3.5 reveals this fact along with the pre and post devolution
gap.

Between 1990-91 and 1999-2000 transfers as a percentage of GDP declined from

4.73 to 3.79 per cent. This decline was mainly in the grant component of the transfers.
Such decline affected poorer State more as their dependence on the transfer was
relatively greater.

The increasing vertical imbalance which is reflected in the pre-devolution

resource gap can be defined as the difference between States’ own revenue and the
States’ expenditure. The gap which was merely 1.45 per cent of GDP increased to 7.34 in
1990-91, thereafter registering a small decline initially it started rising again and in 2005-
06(RE) it stood as 8.41 per cent of gross domestic product.

Table 3.5 also contains the post devolution gap, i.e. the gap that remains even
after the devolution. This gap remained in the range of 2.25 – 2.5 per cent of GDP and
occasionally going as high as 4.03 per cent. Situation after the decade of late nineties also
remained serious as for most part it was greater than 3 per cent. This gap is basically
responsible for the States’ indebtedness, which was addressed separately by the Eleventh
and Twelfth Finance Commissions. But in doing so the Commission applied a uniform
yardstick in its offer of debt relief irrespective of the fiscal capacity of the States.

3.7: ATTEMPTED CORRECTIONS IN THE SYSTEM OF FEDERAL

TRANSFERS

Making recommendations regarding the statutory transfers and determining the

principles for distributing them among the States is a responsibility of Finance
Commission which is explicitly mentioned in the Constitution of India. Besides, the
Commission is obliged to give recommendations on any other matter referred to it by the
President of India in the interest of sound financial management of the economy. Such
matters are indebtedness of the States to Center and the possibilities and mechanism for
debt relief, financing of other relief expenditures of States, financing of schemes for
upgrading the administrative services etc. Of these, debt issue is the one that kept several
Finance Commissions engaged. It is because of debt that the interest payment absorbs the
greater portion of revenue receipts of the States. Problem becomes perpetual when States
run into deficit on their revenue account which, in turn is filled by the capital receipts
(principal among them is borrowings themselves). Thus the inadequacy of revenue
receipts is not only the cause of indebtedness but is caused by it too in a great measure.
Servicing the debt by incurring further debt is the easiest way for the States as the
considerable amount of loan flow to them automatically. This phenomenon particularly
brings to the fore the whole issue of debt sustainability.

Second Finance Commission was the first one to be asked on the issue of States’
debt. It was required to make recommendation on the rate of interest and terms of
repayment of Central loans advanced to States after independence and up to March 31,
1956. Thereafter, a review of the States’ debt has been a term of reference from the Sixth
Commission onwards. Till the Eighth Commission, the terms of reference (TOR) of
Finance Commissions required them to make an estimation of the non-plan capital gap of
the States and to undertake a review of the debt position with particular reference to the
Central loans to States. These commissions were asked to suggest debt relief measures
having regard to the overall non-plan capital gap and the purposes for which loans had
been utilized as well as the requirements of the Centre. From the Ninth Finance
Commission onwards, finance commissions were mandated to review the debt position of
the States as a whole and suggest corrective measures. The Ninth Commission was
required to suggest corrective measures with particular reference to investments made in
infrastructure projects and to link them to improvements in financial and managerial
efficiency. Whereas the Tenth Finance Commission had the mandate to suggest
corrective measures while at the same time keeping in view the financial requirements of
the Centre, the Eleventh Finance Commission, which was required to consider the long-
term sustainability of debt for both the Centre and the States observed, “the incremental
revenue recites should meet the incremental interest burden and incremental primary
expenditure”.18

Twelfth Finance Commission, in its terms of reference, was required to assess the
debt position of States as on March 31, 2004 and to suggest corrective measures
consistent with macro-economic stability and debt sustainability. Discharging this
mandatory duty Twelfth Finance Commission, not only captured one of the major causes
of States indebtedness, structurally inherent in the system of federal transfers, but also
came out with a comprehensive scheme for debt relief. Finance Commission’s contention
was that the transfers through Planning Commission, to the extent they are in the form of
loans, make the process of borrowing automatic. States become entitled to the loans and
the landing agencies (Planning Commission) do not have to bother with the credit
worthiness of the borrowing States. States too on their part do not have to worry much as
far as the soundness of their finances are concerned as the steady flow of loans are
assured in the system it self.
18
Eleventh Finance Commission as coated in the Report of Twelfth Finance Commission P-224.
 Twelfth Finance Commission, however, recommended that this automatic
entitlement should be dispensed with and instead, States to be asked to approach market
where they will have to impress the creditor with the soundness of their finances to
services the debt. Market will also charge the risk premium on their lending to the States,
which, in its judgment, are risky client. Taking advantage of the declining interest rates
commission offered debt relief package which, though provides a big relief to the States,
would bind them to certain legislative commitments. Default on these commitment would
prove to be costlier not only in the governance but in securing the loans from the market
at reasonable interest rate. Twelfth Finance Commission, while agreeing with the
observation of its predecessor Commission that the additional debt that should be
serviced out of the additional revenue, commented, “…prerequisite to this is the
achievement of revenue balance by instituting measures for augmenting revenue receipts
and compressing expenditure”.

The relief package offered by Twelfth Finance Commission, in order to pull out
the states from the quagmire of debt, is known as Debt Consolidation and Relief Facility
(DCRF). The scheme seems to have captured the genesis of the problem and seeks to
provide the long-term solution by forcing the states to fiscal prudence. The DCRF has
two components – (i) a general scheme of debt relief applicable to all States, and (ii) debt
write-off scheme linked to fiscal performance with a view to providing an incentive for
achievement of revenue balance by 2008-09. Availing the benefit of DCRF was subject
to the enactment of Fiscal Responsibility Act only. For debt write-off the quantum of
reduction in revenue deficit in each successive year and the containment of GFD at the
level of 2004-05 were to be attained. Twenty-four State Governments benefited out of
debt consolidation till August 30, 2007. Further, fourteen State Governments benefited
out of debt write-off and twenty-one State Governments received interest relief so far.
The total amount of consolidated loans of the State Governments stands at Rs.1, 09,977
crore, debt write-off stands at Rs.8, 474 crore and interest relief stands at Rs.8, 387 crore
as on August 30, 2007.19

19
RBI: States Finances, A study of Budgets 2007-08.
 It can be safely concluded from the above facts that the imbalance, both vertical
and horizontal, which exists on account of constitutional assignments and fiscal capacity
of States respectively are, to a considerable extent, corrected by the system itself. In order
to overcome the vertical imbalance greater assignments to States may not be the solution
as it would, while solving one problem may create many more. While assigning the
revenue resources to various level of government the other objectives of the economy are
also taken into account. As the theory suggests that the primary responsibility for macro
economic stabilisation policies and for the redistribution of income and wealth must rest
with the Central government.20 The sub national governments in the aggregate have
lesser impact on total demand or the distribution of income. Sub national governments do
not have monetary controls at their disposal, which is one of the handles for stabilisation
policies. Therefore certain amount of assignments that too are of elastic sources of
revenue has been inevitably remaining with the Centre.

As it is seen that there could be defects in the system, but then there exist a
correcting mechanism as well. States’ budgeted revenue surpluses at the consolidated
level would vouch for such inference. It is since 1986-87 that the deficit appeared in the
consolidated revenue account of the State governments, which kept on increasing till
1998-90. A downturn began thereafter and there is strong likelihood the revenue deficit
of States may disappear as stipulated in the fiscal responsibility legislation which has
been enacted by most of the States. Significant role played by Finance Commission in
this regard has to be acknowledged. One major correcting step in this direction has been
the discontinuity of Planning Commission transfers since 1st April, 2005.

Fault with the system of federal finance cannot be found in the assignments of
revenue sources and responsibilities the various levels of governments are entrusted with,
though such distribution is often regarded as one of the causes of vertical imbalances. For
the reason discussed above such distribution is desirable as the fiscal instruments are also
used for achieving other macro economic objectives like efficient allocation of
economy’s productive resources, macro economic stabilisation and redistribution of
income. The realisation of these objectives depends, a great deal on as to how effectively

20
Musgrave. RA (1958); Public Finance.
the fiscal instruments are employed and weather they are ably supported by the monetary
measures. Since States do not control monetary measures entrusting the Centre with
greater amount of fiscal role becomes necessary. Central government if, for reasons of
political expediency, indulges itself in some kind of fiscal profligacy, it has the monetary
handles to balance it so as to minimise the ill effects of such fiscal imprudence.

Probably this might be the reason for the resources and functional distribution
between Central and the States governments along the similar pattern in other major
federal country like Canada, Australia and USA. Following table provides the
comparative assessment of the working of the federal finance system in these countries.

Like India in these countries too functions relating to law and order, education
and health are given to the States. Defence, foreign affairs and communication are
assigned to Centre. As far as tax powers are concerned the elastic taxes are under the
jurisdiction of Central government. Even the provision of overriding powers, as in India,
rest with the Centre in Australia. There are no such arrangements in Canada and USA.
But unlike in India, in these countries Central government can levy all taxes. Indian
federalism has clarity too, that is the absence of any significant overlapping in matter of
tax powers. The inevitable consequences of such constitutional arrangements are the
vertical as well as horizontal imbalances.

Conclusion:

Indian experience points to the culpability of constitutional arrangement to be

influenced by the political economic factors. Flexibility inherent in the system can be
used, both Centre as well as States, to get larger share depending upon the respective
political strength these governments enjoy. The history of federal transfers in India amply
demonstrate that the States have succeeded in getting larger share when they were
politically more assertive as was the case at the time of the Seventh Finance Commission
award. Another example of their assertiveness was in evidence when 80th amendment of
the Indian constitution was effected.

Some kind of tussle, over the share of resources between the Centre and the States are
bound to prevail in any federal system. But the same federal system should also act as a
cohesion that keeps the federation going. Flexibility provided in the system should not be
stretched to the limits in either direction. India’s federal financial system has certainly
contributed to the financial harmony of federalism. Evidence does not suggest that States
ever faced imbalances in their finances because of the working of the federal system and
the transfers.

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