An Analysis of Explicit and Implicit Intergovernmental Transfers in India

In this paper, we provide a critical overview of central-state transfers in India. In addition to examining explicit transfers through the Finance Commission, Planning Commission and central ministries, we also analyze implicit transfers that operate through inter-state tax exportation and subsidized lending to the states. We quantify equity impacts of these transfers, finding that formula-based transfers have been equalizing, helping to overcome lack of fiscal capacity in poorer states, but that implicit transfers tend to go disproportionately to richer states, canceling out much of the equity impact of explicit transfers. We also highlight some of the institutional weaknesses of the current methods of intergovernmental transfers in India. We therefore make a case for reforms that would include: channeling transfers through a single, permanent, professional agency; a rule-based system of transfers rather than expanding central discretion; a transfer system with appropriate fiscal incentives for the center and the states, and minimizing implicit transfers arising from undesirable policies such as inter-state sales taxes, or badly targeted policies such as subsidized credit. * This paper is part of a larger, ongoing study of Indian federalism. The second author would like to gratefully acknowledge the hospitality and support of the Research School of Pacific and Asian Studies at the Australian National University (Summer 1997), and the Center for Research on Economic Development and Policy Reform at Stanford University (Fall 1998), where his stays as Visiting Fellow have provided congenial environments for the research reported here. We are also grateful for financial support from our respective institutions, ANU and UCSC. Finally, we benefited greatly from the detailed comments of Nick Hope, though he is blameless for remaining shortcomings. + Respective affiliations: Rao Australia South Asia Research Centre, Research School of Pacific and Asian Studies, Australian National University, and (from Dec. 22) Director, Institute for Social and Economic Change, Bangalore, India; Singh Department of Economics, University of California at Santa Cruz, and Visiting Fellow, Center for Research on Economic Development and Policy Reform, Stanford University.