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Equalization Transfers Policy Based on Expenditure Needs and Own Revenue Capacity of Indian State Governments

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India’s Contemporary Macroeconomic Themes

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Abstract

This study addresses an important policy issue pertaining to the determination of equalization transfers to Indian States. It measures the revenue expenditure needs and own revenue fiscal capacity of States normatively and determines the equalization transfers in four alternative scenarios. The estimated amounts of equalization transfers for all 29 States range from ₹ 3,73,956 crore to ₹ 14,77,282 crore. These findings will be useful to policymakers and other researchers to design more effectively the transfers policy besides general-purpose transfers to address the resource gap such that the Indian States can provide a standard level of public services.

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Notes

  1. 1.

    Boadway et al. (1993) argue that the equalization transfers that reduce net fiscal benefit differentials create one of those rare instances in economics when equity and efficiency considerations coincide. Other considerations used for equalization transfers include the prevention of secessionist tendencies in countries with relatively high regional tension (Martinez-Vazquez and Searle, 2007; Spahn, 2007).

  2. 2.

    Source: 15th Finance Commission Report, Vol. IV The States, 2020.

  3. 3.

    While the approach pursued by the Finance Commission has an equalizing content, none of the Commission so far has formulated an explicit methodology on normative basis to derive the equalization transfers. The partial gap filling approach also creates an adverse incentive among States. Further, this approach is partially equalizing the cost conditions. Thus, the aim of achieving the horizontal equalization is not yet fulfilled in India.

  4. 4.

    The literature argues that people will choose jurisdictions where they can optimize their net fiscal benefits. This will lead to inefficient allocation of labor across jurisdictions. If people with the same income level will not migrate despite differences in net fiscal benefits, there will be horizontal inequality. In such a case, the transfers will ensure efficiency in labor allocation and horizontal equity (Shanmugam & Shanmugam, 2022a).

  5. 5.

    The U.S. Advisory Commission on intergovernmental relations developed this approach. See Akin (1973) for a review. This approach involves two steps. The first step quantifies the tax base for each tax levied by the sub national Government. The second step applies the average effective tax rates of all States (the ratio between total tax revenue and total value of tax base) on the tax bases of individual States and derives the taxable capacity. Finally, the taxable capacities of individual taxes add up to get the aggregate taxable capacity of a State.

  6. 6.

    Studies such as Allers et al. (2001) and Solé-Ollé (2006) considered political economy factors. Some other studies included natural, social, and demographic factors as determinants of local revenues. For instance, regions enriched with a large volume of natural resources may collect larger revenues in the form of royalties from mining, etc. Regions with greater non-farm economic activities may be able to collect more fees and tax revenues.

  7. 7.

    Capital expenditure is investment nature; as per FRBM act, States are meeting capital expenses using public debt and so we consider only revenue expenditure.

  8. 8.

    Initially, this study considered various functional forms like log-linear, log-log, etc. However, the linear form was chosen due to its suitability for the data. Past studies by Lalvani (2002) and Panda (2017) also employed the linear model.

  9. 9.

    It is noted that the Central transfers variable is included as an independent variable in (1). This may create a potential endogeneity problem. In the preliminary investigation, it is found that the results do not change even after excluding this variable. This means that there is no endogeneity issue and even if there exists endogeneity, the bias may be negligible.

  10. 10.

    One may argue that many political economy variables may play a role in determining State expenditures; one can capture their effects by including dummies for election year, ruling party, etc. Since the term λi in (1) can also capture these individual-specific factors, this study does not include the political factors directly in order to avoid perfect multi-collinearity problem.

  11. 11.

    It is noted that while all other SCSs are smaller and hilly States, Goa is small but not hilly. The GCSs are major Indian States.

  12. 12.

    Results for only the latest year 2018–19 are reported due to space constraint. We find that results using Tables 7.2 and 7.3 are also almost the same as these results.

  13. 13.

    Evidences indicate that India’s tax GDP ratio is low. As India is moving toward achieving the status of developed nations, there is a need to raise our tax-GDP ratio such that the Centre can equalize the transfers.

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Authors and Affiliations

  1. Madras School of Economics, Chennai, India

    K. R. Shanmugam

  2. Government of Tamil Nadu, Chennai, India

    K. Shanmugam

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  1. Ernst & Young India, New Delhi, Delhi, India

    D. K. Srivastava

  2. Madras School of Economics, Chennai, Tamil Nadu, India

    K. R. Shanmugam

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Shanmugam, K.R., Shanmugam, K. (2023). Equalization Transfers Policy Based on Expenditure Needs and Own Revenue Capacity of Indian State Governments. In: Srivastava, D.K., Shanmugam, K.R. (eds) India’s Contemporary Macroeconomic Themes. India Studies in Business and Economics. Springer, Singapore. https://doi.org/10.1007/978-981-99-5728-6_7

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