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Talking back to the Centre

As regional parties demand radical changes for greater fiscal decentralisation

Written by Bhaskar Dutta |
April 9, 2013 12:20:52 am

As regional parties demand radical changes for greater fiscal decentralisation

Nitish Kumar,Bihar’s chief minister,is much sought after. And he knows it. In a giant rally in New Delhi,held recently,Kumar made it clear that his party would side with whichever political combination supported the granting of “special status” to Bihar. Not so long ago,the West Bengal chief minister had also asked for a special package for her state. But her demand received short shrift,possibly because she has proved to be an unreliable political ally. In view of the Congress’s recent overtures to Kumar,political expediency may well ensure that Kumar’s demand is satisfied. Now Orissa’s chief minister,Naveen Patnaik,has pressed the Centre again for special status for his state.

But what light can economic principles shed on this issue? The special status category has typically been granted to those states that are geographically handicapped — the hill states of Uttarakhand,Himachal Pradesh as well as states in the Northeast. These states have a substantial part of their development plans funded by the Central government. Although Bihar is among the poorest states in India,it cannot claim that its misfortunes are due to any locational disadvantage. While Kumar himself has been instrumental in turning around the fortunes of the state,his predecessors have been guilty of gross misgovernance. This has been the principal reason for Bihar’s backwardness.

Of course,this does not tell the full story. Bihar can,with some justification,claim that Central government policies have not treated the state fairly. First,the earlier,much misguided freight equalisation policy discriminated against the mineral-rich eastern region by subsidising the cost of transporting minerals to western India. So entrepreneurs found it profitable to set up factories in regions that were closer to ports or had better infrastructure,instead of locating their plants closer to the source of raw materials. Second,and perhaps more seriously,Bihar continues to receive less than the national average Central assistance on a per capita basis. This is despite the fact that Centre-state transfers are supposed to be biased in favour of the poorer states.

Although we have a federal structure,most of the lucrative tax instruments fall under the jurisdiction of the Central government. So states are heavily dependent on Central government largesse in order to finance their development plans. This would not be a problem if Centre-state transfers followed well-defined principles. Unfortunately,our system gives the Central government a lot of discretion in such transfers. There is also considerable evidence that politics does play a significant role in these transfers. More specifically,the ruling party at the Centre is typically biased in favour of states controlled by its own party.

Regional parties have started flexing their political muscles to protest the perceived inequities in the system. Their increasing political clout has resulted in substantial increases in the states’ share of Central tax revenues over time. But,regional parties continue to demand more radical changes. The clamour for change has become so loud that we will soon have to take a closer look at the appropriate degree of fiscal decentralisation in our country.

What are some of the benefits of fiscal decentralisation? Several economic arguments have been made in favour of it. For instance,it is often said that local governments are more aware of and responsive to the preferences of local inhabitants. Also,decentralisation implies that local politicians have both more power (and hence perks?) and greater accountability. The former makes public office more attractive,while the latter increases the chance of being booted out of office in the event of non-performance. Hence,the argument goes,they are induced to perform more responsibly.

There is a compelling political argument in favour of decentralisation if a country is very heterogeneous in terms of ethnic,linguistic or religious divides and if these divisive characteristics are regionally distributed. This is perhaps the main rationale for the high degree of decentralisation witnessed in Belgium,which is divided into the French and Flemish speaking regions,or in Canada,where French-speaking Quebec has a great deal of fiscal autonomy. Similarly,Russia and Ethiopia are examples of countries that have opted for decentralisation because of ethnic divisions. Essentially,decentralisation means that each region is in charge of its own future,and so cannot accuse other regions of foul play. There is a widespread feeling that only decentralisation holds such countries together.

Centralisation also has its advocates,who will advance at least three separate reasons for a moderate or high degree of centralisation. First,consider a country with wide regional disparities. Apart from the usual responsibilities of defence and foreign policy,it is imperative that the central government play a redistributive role,transferring resources from the richer to poorer states. The latter cannot be left to fend for themselves. Second,many public goods generate benefits that are spread across regions — ports,railways,power plants,large irrigation projects being just a few examples. Only the Central government can conduct a dispassionate and “neutral” cost benefit analysis of such projects. Equally,it would be impossible for different states or regions to agree on how to distribute the huge cost of such investments. Third,another important task that can be performed only by the Central government is the implementation of counter-cyclical fiscal policies. For instance,the UPA government did have to pursue expansionary fiscal policies in order to stimulate the domestic economy during the recent global recession.

So,there is a variety of tasks that must be allocated to the Centre. This inevitably implies that the Centre must have adequate revenue at its disposal. In an ideal world,perhaps almost all tax instruments would be entrusted to a benevolent Centre,which would,in Solomon-like manner,weigh the interests of all regions before deciding on its pattern of expenditure. Since the world is not Utopian,various constraints must be imposed on the Centre so as to ensure that its spending decisions are not unfairly biased in favour of some specific regions or groups. In the Indian context,this is perhaps best achieved by increasing the proportion of Central revenues mandatorily transferred to the states through the recommendations of successive Finance Commissions.

The writer is professor,Department of Economics,University of Warwick,UK

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