Problems of Federal Fiscal Transfers (With Suggestions)

The following points highlight the three main problems of federal fiscal transfers from Union to States. The problems are: 1. Method of Devolution 2. Criteria for Fiscal Devolution-Shared Taxes 3. Criteria for the Distribution of Statutory Grant.

Problem # 1. Method of Devolution:

The working of the Finance Commissions also presents dismal picture in certain respects. On the basis of the recommendations of the last three commissions, some rich states (viz., Punjab, Haryana and Maharashtra) ended up with sizable surpluses in their non-plan revenue account.

This tendency on the part of finance commission, far from mitigating the inequality in the public services provides between the states, is likely to aggravate it.

Problem # 2. Criteria for Fiscal Devolution-Shared Taxes:

For distributing the income tax share among the states, population and collection or assessment have been taken as the main criteria. Population was considered to be a broad measure of needs. Similarly, in the case of Union excise duties, population was accepted as the most important criterion.

Population is at best a neutral criterion. But assigning weight to collection or assessment has consistently favoured by the rich urban states as this criteria goes in favour of the rich urban states. About the distribution of union excise duties, population has been assigned predominant weightage.

The Third, Fourth, Fifth, Sixth, Seventh, Eighth and Ninth Finance Commissions also gave weightage to some criteria of social, economic and financial backwardness of the States to compensate for their financial needs. This provides only a patch work and does not consider the needs of the states comprehensively.

Problem # 3. Criteria for the Distribution of Statutory Grant:

The Finance Commissions recommended revenue gap filling approach to the distribution of statutory grants and this cannot be said to be equitable either. The devolutions made on the basis of the forecasts (revenue and expenditure of the states) made by assuming price stability have been consistently found eroded in real terms due to the continuous rise in the price level.

Further, the major weakness of the criteria for distribution of statutory grants arises from the fact that the budgetary gap has been taken to be the bedrock of statutory grants. Other exceptionable principles such as ‘tax effort’ and ‘expenditure economy’ and ‘standard of social services provided’ though approved by the successive Finance Commissions, have not been put into practice by these Commissions satisfactorily.

There was nothing in the constitution that called upon the Finance Commissions to recommend grant to cover budgetary gaps. Rather than covering the excess of fiscal needs of the states over their own revenue capacities objectively, the commissions assumed the role of ‘mere mechanical gap fillers.

Thus as the Finance Commissions made their recommendations on grant-in-aid just to fill the gap between the predicted revenues and expenditure of the states, there is likely to be serious disincentive for the states to raise revenue and economise on expenditure.

Besides, the states may also succeed in obtaining sizeable grants by under-estimating their revenues, exaggerating their expenditure and thus manipulating a huge gap in their non-plan revenue accounts. This system of allocating statutory grants to the poor states like Assam and Orissa will never push forward an impetus for achieving self-reliance in financing both non-plan and plan expenditure.

But the type of criticism may not hold good in respect of the awards of the Seventh and Eighth Finance Commissions.

The Seventh Finance Commission was probably the First Finance Commission which was deeply concerned with the equitable system of federal transfers and, therefore, the devolution awarded by the Eighth Finance Commission that its award was not a ‘gap filling’ one, but it attempted to attain a more equal and rational relationship between the centre and the states and inter-state equity.

This while the first six Finance Commissions relied heavily on grants-in-aid to cover their revenue deficits, the Seventh and Eighth Finance Commissions put much stress on raising the divisible pool of shared taxes (viz. income tax from 80 to 85 per cent and excise duty from 20 to 45 per cent).

But again considering the huge revenue deficit of the Central Government during the last four years resulting mostly from massive devolutions of revenue recommended by the Eighth Finance Commission, the Ninth Finance Commission (NFC) has reversed this trend. The NFC had a close look at the central revenues, enforce economy and force out surpluses.

Moreover, the NFC cautioned the states against raising non-revenue expenditure and asked the states to be very cautious in incurring additional debt, especially for financing revenue expenditure. The NFC was also very strict in writing-off loans and rescheduling. In respect of inter­state transfer, the NFC tried to attain horizontal equity much more than what the previous finance commissions did.

Accordingly, after the devolutions of taxes, duties and grants from the Centre to the States, the extent of difference in per capita surplus between the maximum and minimum surplus states which was as high as 69 times in the Sixth Finance Commission, 18 times in the Seventh Finance Commission and 31 times in the Eighth Finance Commission, but it declined to only 11 times in the Ninth Finance Commission.

NFC also laid stress on phasing to phase out revenue deficits of the centre and the states by 1995.

Suggestions:

Considering the present position, some steps should be taken to wipe out this disincentive effect of federal transfer upon the states and for achieving self-reliance on financial stream of the poor states.

To prevent the disincentive effect of federal transfers on the states’ tax revenues and expenditure, it is necessary that the ‘tax rates’ and’ Unit Cost’ of providing public output of the states should not enter into the formula adopted by the Finance Commission.

The states should determine the fiscal gap by estimating the relative fiscal capacities and needs of the states, which are determined on the basis of predetermined norms of tax rates and service levels.

Thus the future Finance Commissions should comprehensively assess ‘fiscal capacities’ and ‘needs’ of the states and make that the basis of federal transfers, which would not only remove the disincentive effect, but also raise of public services in the backward states by removing the constraints on them.

Thus the poor states like Bihar, Assam, Orissa, etc. can gain effectively in case of federal transfer if the fiscal capacities and needs of the States will receive much importance from the future commissions, which will be able to reduce the financial constraints and to achieve self reliance gradually on the financial stream.

In the mean time, some of the recommendations made by the Ninth and Tenth Finance Commissions have achieved certain result in this regard and more is expected from the award of the Eleventh Finance Commission.