Pressures To Pool

The finance ministry has circulated a discussion paper on the Alternative Scheme of Devolution recommended by the Tenth Finance Commission (TFC) to encourage a debate before a decision is taken. It examines, somewhat narrowly, the issue of pooling all the central taxes and assigning 29 per cent to the states.

The idea of pooling all central taxes and devolving a percentage to the states is not new. In 1991, the Chelliah Committee on tax had observed: At present, tax devolution to the states constitutes around 24 per cent of gross central government tax revenues. With the consent and co-operation of the states, the relevant constitutional provisions could be amended to the effect that 25 per cent of the Centres aggregate tax revenues shall be shared with the states. The TFC went beyond this suggestion and presented a full-fledged alternative devolution scheme.

 

In 1989, the Sarkaria Commission had also considered this issue. It didnt favour bringing all tax receipts into the divisible pool. If its report is taken as the last available authoritative document in this field, then it would have to conceded that in many ways its recommendations, which have not been implemented, dont go far enough in the current situation. Much has happened after 1989. Two of the most important developments with far-reaching implications on the relative roles of the Centre and the states are the change in the economic regime and the strengthening of the third tier of the federal system by the 73rd and 74th Constitutional amendments.

The discussion paper is basically sympathetic to the idea of pooling. This is not surprising in view of the fact that the UF government is structurally bound to be federal in its approach it is, after all, a coalition of state-level parties. But the paper misses two important points: the reasons for a change are systemic and should not be seen in terms of the Centre vs states. Second, pooling is not simply a scheme to enlarge the divisible pool in favour of the states. This article deals with the first issue.

The need for a basic change in Centre-state financial relations arises due to various factors: First, of course, is redressing the constitutionally congenital imbalance. The Constitution recognises that the functions and finances of the states are not in line with each other. Hence, the different mechanisms of resource transfers. While the existing system of resource sharing has served its purpose, there is a feeling among states, shared by many fiscal experts, that the extent of the devolution of central taxes is not consistent with the respective responsibilities of the Centre and the states.

This old issue has gained new relevance and urgency. The economy is now heading for the second stage of reform. In this phase, the thrust will be on improving the efficiency and optimal utilisation of economic resources. For this, an adequate level of social and economic infrastructure and cost-effective provision of public services is critical. Thus, two basic areas for governmental action are the improvement of physical infrastructure and development of social services. This is in addition to the prime responsibility of governments to provide an administrative and legal framework for the market to operate efficiently.

These areas are within the constitutionally delineated sphere of activity of the state governments whose overwhelming importance in these areas is obvious even from the existing structure of government expenditure. The states collectively incur more than 70 per cent of the total developmental expenditure. More importantly, this is concentrated in the areas of infrastructure (about 87 per cent), social service (about 85 per cent), and agricultural development (about 80 per cent). The requirements of liberalisation will result in an increase in these expenditure responsibilities of the states. And this will increasingly fall within the revenue budget. At the same time, the resources available for this component of the Budget may not expand, even after tax reform, at the reguired growth rate.

Finally, the state finance commissions set up under the 73rd and 74th amendment are bound to have a major impact on the vertical flow of funds. Many revenue sources like stamps and registration, motor vehicle tax, electricity duty will have to be either transferred to the local bodies or at least earmarked for them. Some expenditure responsibilities primary education and health will also have to be shifted to the third tier. This will lead to a mismatch between the functions and finances of local bodies. As a result, the state finance commissions will recommend grant-in-aid from states to them. This has already been done in states which have set up state finance commissions. In the light of the fundamental changes in the Constitution and the economy, it would be unrealistic not to change the existing system of revenue sharing.

The accompanying chart shows that there are two basic types of budgetary transfers from the Centre to the states. On the revenue side, there are statutory transfers under Article 270 and 272 . Under these, two central taxes income tax and excise duty are shareable with the states. Taxes that are not shareable are corporation tax and customs duties. The second form of resource link is in the form of a tax rental agreement between the Centre and the states. An example of this is the additional excise duty devolved to the states in lieu of sales tax.

On the expenditure side also there are two types of links statutory and non-statutory expenditure allocations. Under Article 275, grants-in-aid are given to states which need assistance. Being a grant, it is not related to any particular source of revenue. In addition, the Centre has been making use of Article 280 to give grants, like plan grants, to the states.

Article 275 grants are linked to deficits. This has fostered the tendency among state governments to rely on the Centre to foot their expenditure. At the same time, the development pattern of fiscal federalism has been to increase discretionary control of resources by the Centre. The increase in discretionary transfers to states implies the Centres control over the expenditure of the states. Over time, in most cases, this amounts to underwriting the expenditure of the state governments.

The critical difference between revenue sharing and expenditure allocation is that in the former there is an element of entitlement. The latter, even if it is statutory, is discretionary depending on the goodwill of the party at the Centre. This is a fundamental distinction and needs to be the basis of restructuring federal fiscal relations. It might be better for the Centre to focus on devolving resources to the states through the revenue side, so that the need for assistance and allocation on the expenditure side is completely eliminated.

Thus the direction of restructuring federal transfers has to be from expenditure allocation to revenue devolution. If this is not initiated, the dependence of the states on the Centre will increase over time and lead to the complete breakdown of the federal fiscal setup.

The concluding part of this article will be published on January 15.