Sp issue on 16th Fin Commission-(wl-8286)-Discipline and Efficiency in State Finances: Arguments for Using Fiscal Space by Finance Commissions

This paper is concerned with the sharing of tax revenues between the central and state governments. We point out deficiencies in the current approach to the sharing of revenues and propose an alternative that will introduce discipline and accountability to the expenditures undertaken by state governments. The present system of fiscal transfers does not adequately address the important objectives of improving the tax efforts of state governments and making a minimum level of public goods and services in all the states of India. Further, the availability of grants to bridge the gap between the fiscal resources of the states and their expenditures on the revenue (current) account of their budget creates moral hazard problems. We propose an alternative to evaluate the performance of state governments using the measure of fiscal space. Our approach focuses on the ability of state governments to meet their development expenditures out of their own revenues, that is, before receiving any federal transfers. This allows us to determine the quantum of devolutions required to bridge any gaps in meeting the development expenditures. The amount of devolutions left over after meeting shortfalls in development expenditures has to be horizontally distributed among the states. We propose that this horizontal devolution should take into account the performance of states in providing public goods/services via their revenue (current) account development expenditure. In addition, states' efficiency in collecting their own tax and non-tax revenues should also be considered.