sIpF~- Public Disclosure Authorized PUBLIC AND PRIVATE FINANCE DIVISION PAPER NO. 12 Public Disclosure Authorized CENTRE-STATES FINANCIAL RELATIONS IN THE CONTEXT OF PLAMNED DEVELOPMENT by V. V. Bhatt Public Disclosure Authorized Public and Private Finance Division Public Disclosure Authorized Development Economics Department Development Policy Staff January 1976 CENTRE-STATES FINANCIAL RELATIONS IN THE CONTEXT OF PLANNED DEVELOPMENT In a federal form of government, the right to levy certain taxes by the Centre (Federal Government) and the States (State Governments) as well as the right to share the proceeds of certain central taxes are governed by the form of the Constitution adopted. However, even in the older federations like the United States, these inter-governmental financial problems are still live problems and are not settled once and for all.1/ More serious problems arise with regard to the rights of different governments to raise loans and the rights and duties i respect of planning and economic development. These problems did not arise when the older federations like the United States of America were formed as economic development was not then a national objective-2/ However, for the new federations like India, Nigeria and Brazil, the problem of planned economic development is vital and hence what Mrs. Hicks calls the 1/ See Walter W. Heller, New Dimensions of Political Economy, Harvard University Press, 1966. Mr. Heller argues for a new look at the Federal-State Fiscal Relationship in the United States and makes some specific suggestions for the allocation of federal tax revenue. 2/ In the older federations uncontrolled borrowing by the States gave rise to repeated trouble and led to the virtual bankruptcy of certain States. This was especially true in Australia. As a result of this experience, most of the older federations have now evolved orderly devices 'and practical methods of coordination. Australia has, for some decades, employed the services of an independent Loans Board on which both the Commonwealth and State Governments are represented. See Ursula K. Hicks, Development Finance, Oxford 1965, Chapter 6. -2- capital account problems,i/ require urgent solution in the light of the objectives of the planned process of development. Since the growth-responsive taxes can be largely levied only by the Centre and since the Centre has the dominant right to borrow in the domestic market as well as from abroad, a greater part of the financial resources accrues to the Centre. At the same time, a large segment of development plan has to be implemented by and through the States.2/ Adequate planning and implementation at the State level thus require strengthening of their financial position in a manner that would evoke a creative response by the States to the challenging problems of development, which largely arise at the State level. India has been a pioneer in federal and State planning since 1950, and her experience in this field would doubtless be useful to the other new federations. It is the purpose of this article to indicate the broad lines on which federal-States financial relations have evolved in India (Section I), to discuss briefly rational principles of allocation (Section II), to suggest a new institutional device for the rational use of borrowed resources by the I/ See Ursula K. Hicks, op cit. pp. 110-111. Mrs. Hicks writes, "But planning for economic development, and particularly the construction and finance of fixed capital formation, presents problems in federal finance that are essentially new. India has been a pioneer in federal and State planning since 1950. Other developing countries have all enthusiastically followed suit. ... In this field the older federations have much less experience to offer than in respect of borrowing policy and debt service, since they were already largely developed by the time that planning became feasible". 2/ Mr. Heller notes, "Or to put it bluntly, the Federal Government simply cannot carry out large segments of its responsibilities at all -- or at all efficiently -- without strengthening the States and localities. A very large part of what we do through government is done through State and local units. ... But the States and localities are still the most essential part of a mechanism for feeding ideas up the line and having them come back down with money attached". See Heller, op cit. pp. 121-124. 3- federal government and the States (Section III), and finally to indicate the broad principle according to which such problems need to be tackled in a country with a democratic framework of government (Section IV). Some of the suggestions may have some relevance to the problem of the older federa- tions also in the context of their search for "major new fiscal coordination devices".i I. Evolving Pattern of Centre-States Financial Relations The Indian Union comprises seventeen States of varying size and at different stages of socio-economic development and their relations with the Centre are governed by the Constitution of India! which came into force in 1950. The process of planned development was iritiated in 1951 with the formulation of the First Five-Year Plan (1951-52 to 1955-56; year: April to March). Since the major elastic sources of tax-revenue were put in charge of the Central (Federal) government, the Constitution of India did realize that the resources of the State Governments would prove inadequate for the discharge of their functions. Accordingly, it provided for the obligatory sharing of income-tax receipts (Article 270) and permissive sharing of excise duties (Article 272) between the Centre and the States and grants-in-aid of the revenue to the States (Article 275). Articles 268 and 269 mention items of taxes which are to be allocated completely to the States, whether collected by the Centre or the States. The Constitution, however, did not indicate either the total share of the States or the allocation principles with regard to income-tax, excise 1/ See Heller, op cit. p. 117 2/ Government of India, Law Ministry, The Constitution of India, Delhi, 1965. duty or grants-in-aid. These were to be decided by the Finance Commissionl/ to be appointed under Article 280. Thus, the total share of the States as well as its allocation among them has been governed by the periodical awards of the Finance Commissions. With regard to tax sharing, it is likely that the intention of the framers of the Constitution was to specify the share of each State on the basis of what it could have collected, had it been in a position to levy that tax. In actual practice, it has been Finance Commission Assistance difficult to apply this principle either to income-tax or excise duties. Under income-tax, it is not possible to determine the magnitude of income assessable to tax of local origin. Similarly in the case of excise duties, it has not been possible to base the share of each State on the basis of consumption of commodities on which excise duties are levied. As a result, income-tax has been shared 80 percent on the basis of population and only 20 percent on the basis of collection, while excise duties have been shared 80 percent on the basis of population and only 20 percent on the basis of relative backwardness in terms of the recommendations of the Fourth Finance Commission. 1/ For a critical study of the Federal-State Fiscal and Financial Relations in India, see D.T. Lakdawala, Union-State Financial Relations, Bombay, 1967. Mr. Lakdawala writes, "The role of the Indian Finance Commission is unique in many ways. It is one of the few Commissions provided in the Constitution. It has no parallel in established federal Constitutions. , The only close substitute is the Australian Commonwealth Grants Commission which examines the pleas of the claimant States for assistance. It has, however, no powers to suggest changes in tax-sharing nor the basis for distribution inter se". pp. 47-48. See also, Government of India, Adminis- trative Reforms Commission, Report of the Study Team on Financial Adminis- tration, Delhi, May 1967. Again, the total share of the States in each of the two taxes has been decided on a very ad hoc basis; the Fourth Finance Commission recommended 75 percent share in income-tax and 20 percent in the excise duties. With regard to grants-in-aid also, though the Finance Commission was expected by the Constitution to frame principles of allocation, no principles have been evolved and grants are recommended by and large on the basis of revenue deficits of the States. However, since then, the Fifth Finance Commission have submitted their report (July 1969).1 The Fifth Finance Commission have maintained the States' share at 75 percent and 20 percent respectively, with regard to income- tax and excise duties. They have, however, enlarged the divisible pool by including advance income-tax payments under divisible income-tax and special excise duties under divisible excise duties. The share of each State in income-tax on the basis of population is raised from 80 percent to 90 percent (the Second Finance Commission had recom- mended this weight to population), while the remaining 10 percent is based on assessments instead of collections. The criteria for the distribution of excise duties remain the same as given by the Fourth Finance Commission; however, social and economic backwardness is defined in more concrete terms than was done earlier. With regard to granta-in-aid, the Fifth Finance Commission have emphasized, as did the Second Finance Commission, broad fiscal needs as the governing criterion in place of just budgetary needs. Like the earlier Finance Commission, the Fifth Finance Commission have also examined in detail the projections with regard to the revenue and non-Plan expenditure items of the 1/ Report of the Fifth Finance Commission.