India's framework of fiscal federalism presents interesting paradoxes and raises questions. Ajay Chibber draws attention to some very important statistics.
The very high share of sub-national devolution to states co-exists with very low share of transfers to local bodies.
India’s share of sub-national (state plus local) spending at 60 per cent of total spend is quite high at its level of development. The 14th Finance Commission shifted about 10 per cent of the divisible pool share of resources to the state level, resulting in a total share of 42 per cent... As a result, sub-national spending, which was about 50 per cent in 2013-14, jumped to about 60 per cent of the total government spending. Other large federal states spend less. Brazil spends around 50 per cent at the sub-national level, Germany 46 per cent, the United States around 40 per cent, and Indonesia around 35 per cent. Only Canada and China spend more than 70 per cent at the sub-national level. India’s share of sub-national spending when looked across the world is high...
India’s local government spend is less than 4 per cent of total government spending. This share is much smaller than in most advanced economies, but also much lower than in centralised authoritarian governments like China, where local government spending exceeds 50 per cent of total spending by government. China is an outlier in this, but in most advanced economies, the share is much higher than in India. The 28 countries in the EU spend 23.2 per cent at the local level, Canada 21 per cent, the US 29 per cent. In Latin America, local government spending is around 12.7 per cent and most analysts feel it should be much higher. If India is to map its way towards becoming an advanced economy by 2047, it must prepare a road map for greater devolution from state-level spending to local governments, and raise more local government revenues.
The fiscal problems of local bodies are compounded by their very low property tax collections
India has a very low property tax rate, accounting for around 0.5 per cent of its total tax revenue and only a little over 0.1 per cent of GDP. The OECD countries on average collect about 5.6 per cent of total tax revenue in property taxes (about 1.9 per cent of GDP) with Korea at 15.1 per cent and the US, UK and Canada at over 11-12 per cent at the highest levels. Among BRICS countries, China collects around 10 per cent of its revenue through property taxes, and Russia and South Africa between 4 and 5 per cent.
First, China remains, by quantitative measures, among the most decentralized political systems in the world. Local governments — starting at the provincial level and working down to prefectural, county, township, and village governments — account for 50 percent of government revenue and almost 85 percent of expenditures. In Organisation for Economic Co-operation and Development countries, the averages are 20 and 33 percent, respectively. China’s central government commands just 15 percent of total government expenditure, compared to the Organisation for Economic Co-operation and Development average of 66 percent. Second, China continues to rely almost entirely on business taxes, collected through a value-added tax on business-to-business transfers and a corporate income tax. Since 1990, these business taxes have made up between 60 and 75 percent of tax revenue. Consumption taxes (7 percent) and individual income taxes (6.3 percent of total revenue in 2021) are relatively unimportant. The remaining 15 percent of government revenue comes from central and local fees.
Some observations:
1. I believe that the most important snippet here is the low level of fiscal decentralisation. India's local governments are a paradox - it is at the cutting edge of public service delivery and is the face of government, but is chronically under-resourced and with very weak capacity.
An important reason for the low share of government spending in India by local governments is due to the limited share of untied funds available for state and central governments after accounting for salaries and pensions, interest service, and state and national programs. This is a consequence of India's low tax-to-GDP ratio. Another reason is that, despite being one of the most debated public policy matters and the logical case for devolution being unexceptionable, both the politicians and bureaucrats are loath to devolve funds. Even the well intentioned among them worry about loss of control and leakages from such decentralisation. To the extent that funds (and functionaries) are what confers power and patronage, it's impossible that this devolution will happen on its own. And unfortunately there appears to be no political demand for such devolution.
2. Whether centrally sponsored programs should be pruned down and the share of untied funds devolved increased has long been a matter of intense debate. But there are strong political economy factors which militate against it happening in the foreseeable future. For a start, the central government has adopted a development model which delivers individual benefits through flagship programs like pensions (NSAP), housing (PMAY), health insurance (PMJAY), crop insurance (PMFBY), direct transfers to farmers (PM-KISAN), household electricity and water connections, Ujjwala etc. This establishes a strong direct connect with the electorate, one which no government will want to give up.
3. There are two factors which could test this status quo. One, there is the trend of state governments supplementing the central share in programs such that the central share becomes much smaller than the 60% CSS share. This is especially so with pensions, health insurance, farmer transfers, and housing. In each of these, there are states where the state government shares dwarf the central government share. So much so that certain states have even started opting out of these programs. This also means that they can avoid having to share the electoral credits with the central government.
Two, the forthcoming delimitation exercise offers intriguing possibilities. There will be intense political bargaining at all levels, and fiscal devolutions will be an important part of the exercise. The Sixteenth Finance Commission will have its task cut out. There could be grand bargains which open up the possibility of reining in CSS and increasing the share of untied funds in devolution. For example, some programs like electricity and water connections will get phased out, though some others like higher education scholarships and unemployment insurance are politically tempting options.
4. The very low property tax collections should be one of the top policy priorities before central and state governments. To the extent that cities are engines of economic growth, have massive infrastructure investment needs, and their major share of revenues have to come from property taxes, there is an urgent need to significantly increase property tax revenues. The low 0.1% of GDP property tax realisation is itself misleading in so far as the vast majority of this would be from a handful of the largest cities. The smaller cities and towns are chronically under-resourced and dependent on state governments.
There is need to adopt a medium-term fiscal framework for improving property tax revenues. For example, a five to ten year plan to increase property tax revenues as a share of GDP from its current abysmal 0.1% to 2% in 5 years and 4% in 10 years. For a start, it's important to shift from the rental value method to capital value method for calculation of property tax, so that it is meaningfully linked to property values and indexed to its changes. This should be complemented with concerted attempts to capture under-assessments, improve collection efficiencies, and ensure governments pay their taxes on their properties.
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