A new federalism

Transition to a new Centre-state framework could be one of this government’s most significant legacies

Published:May 30, 2015 12:00 am
Fiscal framework, Tax revenue, VAT, Goods tax, Service tax, GST, stake holders, federalist trends, india fiscal policy, iecolumnist, Subir Gokarn, indian Express The new federalist trends — centralised taxes and decentralised spending — while representing a huge improvement in an end state, pose significant transition risks.

By Subir Gokarn

India’s fiscal framework is going through a dramatic transformation. On the revenue side, the transition to the goods and services tax (GST) offers enormous potential gains in both revenue collections and productivity. It will encourage compliance, as has been visible in the state-level value-added tax (VAT) initiatives, and it will induce businesses to locate in the most efficient geographies, with the assurance that the entire national market for their goods and services is equally accessible. A nationwide GST with a uniform rate is actually a centralisation of the indirect tax system, because it takes away the autonomy of states to tax at rates that they determine. However, it is a positive centralisation because of the gains that it offers.

On the other hand, the positive movement on expenditure is towards decentralisation. Common sense and years of experience and evidence suggest, generally, that money is best spent by people who have the best knowledge of the needs of the ultimate stakeholders and the nature of local conditions. The recommendations of the 14th Finance Commission give substance to this proposition. States will now be provided with more resources than ever before from the national tax pool, with the autonomy — and responsibility — to spend them in the best interests of their citizens, both in terms of higher incomes and greater welfare.

Realistically speaking, however, these new federalist trends — centralised taxes and decentralised spending — while representing a huge improvement in an end state, pose significant transition risks. Here, I want to focus on the risks on the expenditure side.

Three significant risks need to be recognised in designing an effective transition strategy, First, there is a misalignment risk. States are, of course, free to prioritise different welfare measures and public services. However, one of the great competitive strengths of the Indian economy is its labour mobility. For people to be incentivised to move freely in search of better-paying jobs, there needs to be some assurance of baseline standards of public services — access to schools, for example. If there are significant differences across states in terms of their prioritisation, not to mention quality standards, mobility will decline; in fact, the pressure on the more effective states will probably increase.

Second, there is an asymmetric capacity risk. Assuming that welfare and public service delivery priorities remain the same as under the old arrangement, some states may not have the capabilities needed to sustain even the existing levels of effectiveness. This will obviously result in some citizens’ welfare being reduced in the transition. In some critical domains, like health and education, even temporary setbacks to access and quality can have lasting effects.

Third, somewhat related to the second but distinct in itself is what I would call the knowledge gap risk. For states that are about to initiate new schemes and programmes, there can be no better source of experiential knowledge than states that have done this before. There are, of course, institutional mechanisms to transfer this knowledge across states, but these deal largely in “disembodied” knowledge — written reports, presentations and the like. Far more valuable in this context is “embodied” knowledge — people who have worked on specific programmes in a state being available full time and hands-on to states that are just starting down the same road.

Putting the second and third risks side by side, one would argue that the objective of effective delivery might be compromised by both inadequate local institutional and organisational capacity as well as the inability to deploy the best human resources, because they are not available to a state.

First, the Central government needs to persuade states that, during a transition period, existing programmes should be preserved. To the extent that Central funding has diminished, states should compensate for that from their newly expanded resource base. In effect, the schemes remain in place but the funding pattern changes. The transition period may vary across schemes, but that is a matter of detail to be worked out; the essential objective is to ensure that citizens do not suffer during the transition. As states work out their priorities and put the resources required to deliver on them in place, this transitional arrangement can be unwound. Just as with the GST on the revenue side, this is going to require a significant effort in persuasion and handholding.

But the costs of not doing it could be enormous in terms of declining welfare levels and citizen resentment.

Second, during this transition period, states should put whatever knowledge is available, both inside and outside the country, to set up delivery mechanisms that are likely to be efficient and can function within the economic, social and political context of the state, or even within smaller regions. This is a unique opportunity to reconfigure the entire apparatus of the state in line with the demands on it and the resources available. This is really what fiscal autonomy is all about; locally accountable politicians and government employees having the resources to deliver on expectations.

Third, realising the full potential of embodied knowledge requires a restructuring of the civil service framework, which is currently a restricted hub-and-spoke system. An IAS officer spends most of his or her career alternating between a specific state and the Centre. In the new federalist arrangement, the skills and experience of this person, or for that matter any government official, should be freely available to any state government. Of course, incentives and career trajectories will need to be designed to make this work, but even as these are being worked out, volunteers could be sought for some pilots.

In sum, the transition to the new federalism could well be one of the most significant legacies of this government, and the first anniversary is an appropriate occasion to start thinking about how it is going to nurture it. An effective transition strategy that will help mitigate the three risks is going to be a critical component of the process. The three measures suggested may help accomplish this.

This article is part of the Brookings India blog Indiagov@365. The writer is director  of research, Brookings India, and former deputy governor of the Reserve Bank of India. Views are personal Series concluded

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