Power to the States: Is the Indian Model of Fiscal Federalism Taking Shape?

The fiscal relationship between the Central and State governments in India has just been radically transformed. As far as intergovernmental transfers are concerned, the 14^th Finance Commission report will have wide-ranging implications for India and lessons for other large federal countries around the world. Here’s why:

India’s Finance Commission provides recommendations on how the Central government should share its revenue – nearly 10 percent of the country’s GDP or about $200 billion per year – with the 29 State governments. The recommendations are based on consultations with every State government and are submitted to Parliament at the end of the Commission’ two-year term. And, in a unique tradition, the Central government has accepted the recommendations in full without modifications.

The latest report recommends a 10 percent increase in fiscal devolution, reduced fragmentation of fiscal transfers, and enhanced fiscal space at the sub-national level so States can plan and spend based on their own priorities. There are three reasons why these recommendations are a game-changer.

First, the share of States in tax revenue has significantly increased from 31.54 percent to 42 percent. A ten-point increase in tax devolution is practically unheard of in any large fiscally decentralized country where such changes typically take place over decades. This means States will now have significantly larger fiscal space (around $20 billion) to make their own resource allocation decisions. This will have implications for many sectors, including health (see our work on fiscal transfers for health here and here), education, water and sanitation, and food security.

Second, the report doesn’t provide any specific-purpose grants to equalize per capita expenditure in health and education. This is a good thing. My forthcoming research with Victoria Fan and colleagues at Accountability Initiative, New Delhi, suggests equalization grants mandated by the past two Finance Commissions for health were an exercise in futility. The transfers were neither substantial enough to make an impact on health expenditure especially for the poorer states nor were they designed efficiently to pay for performance (see related blog post here). The new strategy of providing unconditional transfers to augment fiscal space at the State level, therefore, is a better approach as it puts the onus of increasing expenditure and improving performance on State governments. This replaces bureaucratic obfuscation with political accountability—something the Indian voter has been demanding for quite some time.

Finally, greater transfers to the States means the Center’s fiscal power has been reduced significantly. Its discretion in determining transfers through what came to be known as ‘centrally sponsored schemes’ is now down from nearly one-third of the divisible resources to less than one-sixth. In the context of other major institutional reforms, such as the restructuring of the Planning Commission, the leverage that the Center had with the States in directing development policy will give way to a much broader array of policy choices driven by States’ needs and priorities. The Center will do well to seize this opportunity to foster the new paradigm of ‘cooperative federalism’, playing the role of a facilitator to improve growth and reduce inequality. Countries like Brazil, Mexico, South Africa and Indonesia, where there have been calls for greater State fiscal autonomy, will be keeping a keen eye on how the new fiscal world unfolds in India.

Thanks to this landmark report, things are looking good and moving in the right direction. However, a lot will depend on how States seize this opportunity and spend effectively to achieve better outcomes. I’ll be following the developments closely, so stay tuned!