Fiscal federalism and governance challenges

The age of centralisation is receding fast. There is a distinct swing of the pendulum towards democratic decentralisation. Liberal democracy has failed to provide the poor and the weak, voice and choice in decision making. In a multi-cultural and multi-lingual federal polity like India democratic decentralisation commands a natural appeal. Prima facie, it has tremendous potential to reduce transaction and coordination costs, besides enhancing equity. Fiscal decentralisation which is an integral subset of decentralisation assumes significance because without its proper functioning decentralisation becomes inoperative and meaningless. It has particular significance in the context of a multi-level system of governance with fiscal responsibilities vested in the centre, state and local governments. In the literature on multi-level public finance this is broadly referred to as ‘fiscal federalism’ or decentralised fiscal system. Fiscal decentralization is often embraced as not just a desirable economic but also as a political and philosophical principle, as Tagore envisaged. This is captured in the idea that spending and tax decisions must reflect local preferences as far as possible. To what extent is this principle followed? That is, what is the share of own revenues (compared to devolved sources) in total revenues at lower levels of government, and what is the relative contribution of direct taxes?

At the second tier, all countries are broadly comparable in their reliance on devolved resources, but India stands out as a country where the second tier (states) generate a very low share of its revenue from direct taxes: about 6 percent in India compared to 19 percent in Brazil in 2016 and a hefty 44 percent in Germany.
At the third tier, India’s rural local governments (RLGs) stand out on both counts. RLGs’ reliance on own resources is just 6 percent compared to 40 percent for third-tier governments in Brazil and Germany. And panchayats raise about 4 percent of their overall resource envelope in the form of direct taxes, compared with about 19 and 26 percent in Brazil and Germany respectively.
India’s urban local governments (ULGs), meanwhile, are much closer to international norms. Their own revenues as a share of total revenues are actually higher than Brazil and Germany, while their direct tax share (about 18 percent of total revenues) is only marginally lower than Brazil (19 percent) and somewhat lower than Germany (26 percent). This is evidence that ULGs have emerged more fiscally empowered than RLGs so far in India.
Economic Survey inputs: Especially with the formation of the Fifteenth Finance Commission, which will re-assess issues related to fiscal federalism, it is perhaps time to pose a different—and complementary—question about the functioning of second and third tier institutions. Why is their own revenue collection, especially from direct taxes, so poor? Recall that RLGs collect less than 10 percent of their total resources from own revenues and ULGs around 45 percent. A common answer is that higher levels especially the states have not devolved enough taxation powers to the Panchayats. For example, the permissible taxes for panchayats include property and entertainment taxes but not land taxes or tolls on roads (except local panchayat roads). Property taxes are the principal sources of direct tax revenue at the third tier of government, apart from professional taxes. The collections from these potentially buoyant sources of revenue are generally stacked at very low levels because of archaic base values—far below market values—applied to properties, low rates of taxes levied, and lack of powers to local bodies in some states like Odisha and Rajasthan.
The 73rd and 74th amendments to the constitution in the early 1990s were watershed developments in India’s federal structure, its governance and accountability. But twenty years on, it is necessary to realistically evaluate their performance. To do this, better data and evidence on the performance of these institutions is imperative. In comparison with their counterparts in some other federal countries, they rely much more on devolved resources and much less on their own tax resources, and they collect less direct taxes. And the reason does not seem to be so much that they don’t have enough taxation power. Rather, the bigger problem is that they are not fully utilizing the taxation powers they already possess. But why would that be? Is under-collection a matter of capacity and resources, perhaps even related to expenditure? After all, there is little reason to collect more taxes if they cannot be spent efficiently. Or, is the problem a potential unwillingness to tax by the State, stemming possibly from the very proximity between state and citizens upon which decentralization is premised? Or, perhaps taxpayers/citizens are able but unwilling to pay more, because they are dissatisfied with the quality of services they are receiving?
There is another possibility. The status quo can be an equilibrium desired by all actors with higher tiers (both Centre and states) using their devolution powers to control and influence lower levels; and the latter, unable and unwilling to tax their proximate citizens, need outside resources even if they are not always untied. But this is a low-equilibrium, perhaps even a trap.
Answers to these questions must inform future discussions of devolution and decentralization. For unless the underlying problems are identified and solved, local governments could remain stuck in a low equilibrium trap. That is, the fiscal model of the states and third tier institutions could forever be based on outside resources which—like foreign aid and natural resources or other forms of ‘redistributive resource transfers’ (Economic Survey 2016-17 Volume I, Chapter 13)—come with weak accountability mechanisms and weak own-resource generation capacity.
In the context of growing decentralization of economic and political power, how to break this equilibrium could well be one of the more pressing issues confronting fiscal federalism going forward. Indian policy makers can perhaps no longer avoid this question: should vertical and horizontal resource devolution to second and third tier fiscal institutions be credibly linked to their performance in increasing reliance on own taxes, especially direct taxes?
Perhaps there is a broader challenge—afflicting all tiers of government—in the limited ability to collect direct taxes. Given the quality of public service delivery, such taxes are often viewed as a "tribute" to a state rather than a contribution to and acknowledgement of the state in raising the quality of life (Aiyar and Pritchett, 2015). One consequence is middle-class exit to more privately-provided services (safety, health, and education) that only serves to exacerbate the problem. Breaking that self-reinforcing cycle of inadequate delivery-low direct taxes-weak accountability-inadequate delivery is perhaps the heart of the fiscal governance challenge in India.

By: Abhishek Sharma