Economic Survey Volume 1 Chapter 4 (Latest)

ECONOMIC SURVEY   

VOLUME I

CHAPTER -4

RECONCILING FISCAL FEDERALISM AND ACCOUNTABILITY: IS THERE A LOW EQUILIBRIUM TRAP

 

THEME

The chapter discussed issues related to fiscal federalism, taxation and accountability. It draws important conclusions about direct taxes and own resources generated by different tiers of the government. It draws conclusions that fiscal models based on outside resources come with weak accountability mechanisms and weak own resource generation capacity.

 

INTRODUCTION

  • Taxation is not just a vehicle for raising state revenue but critically important for economic and political development.
  • There is a social contract between citizens and the state.
  • Role of state– to create conditions for prosperity for all by providing essential services and protecting the less well-off via redistribution.
  • Role of citizens– to hold the state accountable when it fails to honor the contract.
  • But citizens stake diminishes if he does not pay in a direct and visible way for the services:
  • Free rider – use the service without paying
  • Exiting – not using the service at all, thus, losing interest.
  • Taxation is the economic glue that binds citizens to the state in a necessary two-way relationship between citizens and state.

  • Relying on non-tax sources of government revenues makes economic and institutional development stunted as illustrated by the “aid” and “natural resource” curses

DIRECT TAXATION AND DEVELOPMENT: GENERAL GOVERNMENT

  • Economic and political development has been associated with a rising share of direct taxes in total taxes.
  • Advanced countries collect a substantially higher proportion of their taxes as direct taxes than do emerging markets. This proportion has also risen over time. (Today direct taxes account for about 70% of total taxes in Europe).
  • Apart from China (a non-democratic country), India has the lowest share of direct taxes in total taxes.
  • India not an outlier: its direct tax share is similar to other countries at a comparable stage of development.
  • But reliance on direct tax seems to be declining, which can be intensified if GST proves to be a buoyant source of revenue.

DIRECT TAXATION AND DEVELOPMENT: SUB-FEDERAL LEVELS

  • Data on own resources and direct taxes reveal that :
    • Own direct tax collections by Indian states and local governments are significantly lower than those of their counterparts in other federal countries.
    • India’s urban local governments (ULGs), meanwhile, are much closer to international norms. Their own revenue as a share of total revenue is higher (in comparison to Brazil and Germany).There is evidence that ULGs have emerged more fiscally empowered than RLGs so far in India.

Sharp Contrast is the case of GST:  it is clearly more “shared” because decisions and tax administration are done by both.

As per the Economic Survey, resources from the divisible pool to the states have a strong whiff of devolution.

 

LOCAL GOVERNMENTS: WHAT DO WE KNOW?

  • Over the past two decades, local governments have gained prominence as institutions with substantial ‘say’ in grassroots development issues, albeit with significant spatial variations, and spaces of intense political contestability. However, the tied nature of a considerable part of resource flow constrains spending autonomy in RLGs.
  • Expenditure patterns of different tiers of government:
    • The central and state governments spend on an average 15-20 times more per capita than do RLGs while ULGs spend about 3 times more.
    • This gap has persisted over time despite per capita spending by RLGs increasing almost four-fold since 2010-11.
  • Overwhelming reliance on devolved funds:
    • ULGs are different: ULGs generate about 44% of their total revenue from own sources while RLGs rely overwhelmingly (about 95%) on devolution. Per capita own revenue collected by ULGs is about 3% of the urban per capita income while the corresponding figure is only 0.1% for RLGs.
    • Variation across states: vast differences between RLGs within each state. Broadly there are two categories- RLGs of those States that collect some direct taxes and own tax revenue (e.g. Kerala, Andhra Pradesh and Karnataka) in contrast to RLGs of states like Uttar Pradesh that almost entirely depend on transfers. This variation is much starker in case of RLGs than ULGs.
    • Spending on purely local public goods not a priority: as devolved funds to a large extent are tied to sectors and schemes, Gram Panchayats spend the bulk of such funds on earmarked areas like roads, sanitation and community assets.
  • Other issues:
    • Inadequate tax and expenditure devolution: In many states RLGs and ULGs have not been devolved enough taxation powers. Successive Devolution Reports of Ministry of Panchayati Raj (MoPR) show that the share of revenues assigned to local governments in many states are much less vis-à-vis expenditure assignments.
    • Recommendations of State Finance Commissions: Few states have accepted recommendations of SFCs in full or even to a significant extent (as low as 11% in Karnataka to above 50% in WB, Andhra Pradesh and Rajasthan to full acceptance in Kerala).

STATE AND LOCAL GOVERNMENTS: POSING AN ENTIRELY DIFFERENT QUESTION

  • Own revenue collection in third tier is so poor because 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)
  • Given the power to tax, there is under collection of direct taxes relative to the potential. 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.

CONCLUSION: A LOW EQUILIBRIUM TRAP

  • The status quo is an equilibrium- where Center and states are 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 low equilibrium – a trap.
  • In context of growing decentralization of economic and political power, breaking this equilibrium, by answering the question: should vertical and horizontal devolution be credibly linked to performance in increasing reliance on own taxes.
  • But the broader challenge (afflicting all tiers of Governments) –limited ability to collect direct taxes. Given the quality of service delivery, taxes are often viewed as a “tribute” rather than a contribution and middle-class exit to more privately provided services exacerbates the problem.

  • Breaking that self-reinforcing cycle of inadequate delivery-low direct taxes-weak accountability-inadequate delivery is perhaps the heart of the governance challenge in India.