Federal fiscal transfers: an integrated approach for India

Abstract

Devising optimal criteria for federal fiscal transfers to reduce fiscal imbalances across the States has always been a demanding job in India. In particular, two aspects that have become perennial sources of controversy are; (i) the disintegrated approach, and (ii) the near-subjective assignment of weights to factors determining the shares of States. With regard to the fiiist aspect, the recommendation of the Tenth Finance Commission (TFC) infavour of integrating the system of tax devolution and enlarging the divisible pool to include all Union taxes should be welcomed. However, with regard to the second and perhaps, more important aspect of objective determination of weights for revenue shares, not much attention has been paid. This study explores an objective approach for the purpose. Given the reduction of horizontal fiscal inequity as an important objective of the federal transfers, the study suggests that the identification of factors as well as derivation of weights for deciding the revenue shares, could be accomplished from their observed degree of association with the fiscal balance of States. The approach is illustrated by estimating a fiscal behavioural model using panel data, in the Indian context. The resultant State-wise shares are compared with those recommended by the past Finance Commissions.