How does the intergovernmental transfer system operate in India? How appropriate are the various socio-economic criteria? What features are desirable for the Indian transfer system? This paper by the National Institute of Public Finance and Policy, New Delhi, examines the transfer system in India from the perspective of the Finance Commission. It finds that an overarching consideration is that of incentives built into the system: the safest being one that bases transfers on variables completely outside the control of recipient governments.
The design of intergovernmental transfers is an important issue in federal countries not only because sub-national governments often depend on them to maintain their supply of public services, but also because elements of the determination of transfers may have incentive effects for sub-national governments. These may not be taken fully into account when designing transfers and hence have unintended effects. The six major reasons for intergovernmental grants are: ameliorating vertical imbalance, reducing horizontal imbalance, correcting for inter-jurisdictional spill-overs, ensuring minimum standards of basic services, paying for agency functions undertaken by sub-national governments and returning revenues to lower level governments as part of a tax-rental arrangement.
In the Indian system of statutory transfers, criteria-based transfers apply to tax sharing only. Desirable features of the transfer system include adequacy, regularity, transparency and feasibility. Factors that must be taken into account when examining the system in India include:
- Vertical and horizontal imbalance should be treated separately. A formula-driven system of transfers does not necessarily cover the entire normative deficit and appropriateness depends on the transfer instrument and objectives.
- Evolution of the Indian transfer system. This has been characterised by ambivalence but the overall trend has been toward tax devolution as compared to grants.
- Equalising fiscal capacity. The criteria of fiscal performance and fiscal discipline aim to foster fiscal discipline of state governments.
- The population, area, infrastructure and backwardness criteria all have a use, at times limited, in the transfer formula but poverty is not a good criterion to use.
- Tax effort criteria. It is likely that a high price is paid to motivate states to raise higher taxes which may not come about in practice and may not always be desirable.
- Collection/ assessment criterion. Returning tax revenues to originating jurisdictions may have a small use as a compensatory measure.
If the primary concerns of the transfer system are to eliminate vertical imbalances and enable states to minimise horizontal imbalances, then it is necessary to conceptually separate them out. However, it is difficult to assess any element of a transfer system in isolation, since the elements usually complement each other. Policy considerations include:
- The trade off between the best system of equalisation conceptually, that of a full-blown normative assessment, and simplicity. Various criteria are used as an approximation.
- Criteria like infrastructure index are best avoided, primarily due to incentive problems. Rather, needs-based variables ought to be used. Population data has been used but with declining weight.
- Fiscal performance indicators are bad criteria to determine transfers. They should be justified only in temporary situations.
- In terms of revenue capacity, only variants of the income criterion have been used.
- In terms of expenditure needs, several variables have been used.
- Any significant transfers based on the origin of tax revenues is not logically maintainable. However, there is a case for a small amount to be transferred on this basis.
