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canadian tax journal / revue fiscale canadienne (2018) 66:3, 511  -  47

Interregional Fiscal Flows and Horizontal


Fiscal Equalization in India, 2001-2015
Deepak Sethia*

NOTICE OF AMENDMENT
Please note that the online version of this article differs from the printed version in the
following respects: (1) the correction of the title of table 1 to indicate the year 2015 rather than
2011; and (2) the use of unrounded decimal figures in the second full paragraph on page 544.

P r é ci s
Il existe une abondante littérature sur le calcul des flux interrégionaux des recettes
fiscales au moyen de la politique budgétaire fédérale dans les contextes européen et
nord-américain. Les pays à régime fédéral qui sont en voie de développement n’ont
toutefois pas reçu la même attention. Cet article fournit les premières estimations
publiées des flux interrégionaux des recettes fiscales en Inde pour la période de 2001 à
2015. Les estimations montrent que près de 40 pour cent de la population indienne vit
dans des États « donateurs » ou contributeurs nets, qui fournissent les ressources
fiscales au reste du pays. Étant donné les grandes disparités régionales et la petite base
de donateurs, la redistribution budgétaire ne réussit pas à éliminer les inégalités de
revenu régionales. Cependant, la redistribution budgétaire joue un rôle important dans
la réduction de 60 pour cent des inégalités fiscales régionales initiales. Contrairement à
ce que l’on trouve dans la littérature existante sur les pays développés, il est observé
dans cette étude que c’est par l’imposition plutôt que la dépense que se fait
principalement la redistribution budgétaire interrégionale en Inde. En ce qui a trait au
calcul, l’auteur de l’article préconise l’utilisation des soldes budgétaires primaires dans
une démarche d’équilibre budgétaire pour éviter la double comptabilisation et pour
contrôler le déficit budgétaire.

* Of the Indian Institute of Management, Indore, Madhya Pradesh, India (e-mail: sethiad@
iimidr.ac.in). This article is based on an extension of the data set prepared as part of my
doctoral thesis submitted to the Indian Institute of Management, Ahmedabad. I express sincere
thanks to my thesis adviser, Professor Ravindra H. Dholakia, for his feedback on an earlier
version of this article. I also thank the editor of this journal and two anonymous reviewers for
valuable comments that widened the scope of the study and greatly improved the manuscript.
Any errors or omissions are my own responsibility.
I confirm that I have no financial arrangements that might give rise to conflicts of interest
with respect to the research reported in this article.
Supporting tabular data for the findings reported in this article are available on request;
interested readers may contact me at the e-mail address provided above.

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A b s t r act
There is a large body of literature measuring interregional fiscal flows through federal
fiscal policy in the European and North American contexts. However, federal countries in
the developing world have not received similar attention. This article provides the first
published estimates of interregional fiscal flows in India for the period 2001-2015. The
estimates show that nearly 40 percent of the Indian population lives in “donor” or net
contributing states, which provide fiscal resources to the rest of the country. In the
presence of wide regional disparities and a small donor base, fiscal redistribution does
not succeed as a tool for eliminating regional income inequalities. However, fiscal
redistribution does serve an important purpose in reducing initial regional fiscal
inequalities by 60 percent. Contrary to the existing literature on developed countries, in
this study it is observed that taxation rather than expenditure emerges as the main
channel of interregional fiscal redistribution in India. With respect to measurement, the
author of the article argues for utilizing primary fiscal balances under a balanced budget
approach to avoid double-counting and to control for fiscal deficit.
Keywords: Federalism n fiscal policy n equity n regional n redistribution n India

C ontent s
Introduction 512
India’s Federal Structure and Fiscal Redistribution System 517
Measurement Issues and Data Sources 522
Disbursement 523
Local Goods and Transfers 523
National Public Goods 525
Central Revenues 526
Direct Taxes 526
Indirect Taxes 527
Non-Tax Revenues 527
Interest Payment on Public Debt and the Fiscal Deficit/Surplus 528
Results and Analysis 530
Broad Trends 530
Equalization 537
Income Equalization 537
Fiscal Capacity Equalization 542
Scope, Limitations, and Policy Implications 544
Conclusion 546

I nt r od u ction
India can be considered the most heterogeneous of the world’s federal countries,
given its regional diversity in terms of language and culture. In contrast to Euro-
pean nations, which have traditionally been formed on a relatively narrow linguistic
base, India has recognized 22 official languages with over a thousand dialects.1

1 Even China, the only comparable nation in terms of the size of its population, is largely
homogenous, with relatively little regional variation in culture and language.
interregional fiscal flows and horizontal fiscal equalization in india  n  513

Indian federalism is also marked with wide regional disparities, which automatically
lead to horizontal fiscal disparities where poorer states have a lower tax base to
finance government services relative to their richer counterparts (see table 1).
India’s constitution and the country’s economic planners have recognized the need
for horizontal fiscal equalization in the short run and balanced regional develop-
ment in the long run. These needs are being addressed through interregional fiscal
flows from the richer to the poorer regions. As in most federal countries, federal tax
rates are uniform across India, translating into a regional contribution of federal
tax revenue that is roughly proportional to the region’s income. However, in terms
of transfers and government expenditures, the federal government deliberately
provides higher per capita transfers to the poorer regions to offset regional dis-
parities in income or provision of government services. Hence, the regions with a
lower income systematically receive net fiscal transfers from the rest of the country.
It is important to distinguish between two related concepts of fiscal federalism,
namely, intergovernmental transfers and interregional fiscal flows. Intergovernmental
transfers are flows of resources from the federal (or central) government to the
provincial (or state) governments.2 Interregional fiscal flows take into consideration
these transfers and also taxation and direct expenditure by the federal government.
Net fiscal flows, sometimes referred to as “federal fiscal balances,” are calculated by
deducting federal transfers and direct expenditure from the federal taxes collected
at the regional level. The literature has explored cross-country comparative analysis
of tax-expenditure assignments among the different tiers of government, issues of
vertical and horizontal imbalances, and institutional mechanisms that regulate inter­
governmental transfers to address these imbalances.3 In addition, studies of many
developed countries (including, for example, Canada, Spain, and Italy) extend the
scope of federal fiscal activities through the inclusion of taxation and direct expendi-
ture, thus analyzing interregional fiscal flows through the lens of federal fiscal
policy.4 However, to my knowledge, such studies do not exist in the context of

2 The terms “federal,” “union,” and “central” government refer to India’s counterpart to
Canada’s federal government. In this article, these terms are used interchangeably. Similarly,
the terms “provincial” and “state” government are used interchangeably in reference to
subnational governments.
3 See, for example, Teresa Ter-Minassian, Fiscal Federalism in Theory and Practice (Washington,
DC: International Monetary Fund, 1997); and Richard M. Bird and Andrey V. Tarasvo,
“Closing the Gap: Fiscal Imbalances and Intergovernmental Transfers in Developed
Federations” (2004) 22:1 Environment and Planning C: Politics and Space 77-102.
4 François Vaillancourt and Richard M. Bird, “The Interregional Incidence of Central Budgets
in Federations: Some Evidence from Canada” (2007) 27:1 Public Budgeting & Finance 1-19;
Maria Flavia Ambrosanio, Massimo Bordignon, and Floriana Cerniglia, “Constitutional
Reforms, Fiscal Decentralization and Regional Fiscal Flows in Italy,” in Núria Bosch, Marta
Espasa, and Albert Solé Ollé, eds., The Political Economy of Inter-Regional Fiscal Flows:
Measurement, Determinants and Effects on Country Stability (Cheltenham, UK: Edward Elgar,
2010), 75-107; and Marta Espasa and Núria Bosch, “Interregional Fiscal Flows:
Methodologies, Results, and Their Determinant Factors for Spain,” ibid., 150-72.
Table 1  Comparison of Per Capita Income in the Richest and Poorest States/Provinces, Selected Countries, 2015
United States Canada Australia Germany China Brazil India

PCI . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,091 44,647 46,527 47,811 15,159 15,718 5,692


Richest state/province . . . . . . . . . . . . New York Alberta Western Hamburg Jiangsu São Paulo Haryana
Australia
PCI (1) . . . . . . . . . . . . . . . . . . . . . . . . 73,577 63,590 72,886 79,694 25,276 23,419 9,631
Percent of population . . . . . . . . . . . . . 6.17 11.68 10.76 2.17 5.82 21.72 2.11
Poorest state/province . . . . . . . . . . . . Mississippi Nova Scotia Tasmania Mecklenburg- Gansu Maranhão Bihar
Vorpommern
PCI (2) . . . . . . . . . . . . . . . . . . . . . . . . 35,577 34,564 36,017 32,124  7,509  6,092 1,819
Percent of population . . . . . . . . . . . . . 0.93 2.60 2.20 1.97 1.90 6.90 8.74
Ratio: PCI (1)/PCI (2) . . . . . . . . . . . . 2.07 1.84 2.02 2.48 3.37 3.84 5.29

Notes:
PCI: Per capita income in purchasing power parity (PPP) dollars.
“Percent of population” denotes the population of the state or province as a percentage of the total population of the country.
High-income city-states/provinces have been excluded.
Source: Author’s calculations based on data from official statistical agencies of the respective countries. PPP exchange rate: OECD Statistics
514  n  canadian tax journal / revue fiscale canadienne

(Organisation for Economic Co-operation and Development, Paris).


(2018) 66:3
interregional fiscal flows and horizontal fiscal equalization in india  n  515

developing countries. This article aims to address this gap in the literature by esti-
mating, for the first time, interregional fiscal flows in India. These estimates are used
to assess the impact of federal fiscal redistribution efforts on regional inequalities.
India’s federal system is marked by wide regional income disparities. Table 1
shows that the ratio of per capita income between the richest and the poorest sub-
national regions (state/province) in Canada, Australia, and the United States ranges
from 1.84 to 2.07, whereas the ratio for India is 5.29—considerably higher than the
levels observed in other large developing federal economies such as Brazil and
China. In most developed countries as well as in China and Brazil, lower-income
subnational jurisdictions are much smaller in terms of population compared to large
donor regions. However, the opposite is the case in India, where the poorer states
are also the most populous. Clearly, this imbalance poses a severe challenge, and
it arguably imposes a responsibility on the central government to engage in a
large interregional transfer of fiscal resources in order to achieve horizontal fiscal
equalization.
While the intergovernmental fiscal transfers in the Indian federal system have
been widely studied,5 the associated interregional fiscal flows have not received
much attention. There are two good reasons for this research gap: India’s political
economy, and incomplete data.
From the political economy perspective, countries with a tradition of estimating
interregional fiscal flows, such as Canada, Spain, Italy, Belgium, and the United
Kingdom, also have a history of secessionist threats that arise primarily from cul-
tural differences. In such a political environment, dissatisfaction about the sharing
of fiscal resources among provinces or regions tends to be aggravated. While India
has also experienced secessionist threats in the states of Punjab, Nagaland, and
Manipur, as well as continuous threats in Jammu and Kashmir, generally the focus
of the secessionist forces has been recognition of the cultural differences that dis-
tinguish these states from the rest of the country, rather than inequity in the sharing
of fiscal resources.6 Further, the fact that India was ruled by a single party both at
the centre and in most of the states for much of the three decades immediately fol-
lowing independence in 1947, could have helped to minimize centre-state friction
on the distribution of fiscal resources. Not surprisingly, in the last three decades,
with a coalition government at the centre and power wielded by regional parties at
the state level, tensions have arisen regarding centre-state fiscal relations.7

5 B.P.R. Vithal and M.L. Sastry, Fiscal Federalism in India (New Delhi: Oxford University Press,
2001); and M. Govinda Rao and Nirvikar Singh, Political Economy of Federalism in India (New
Delhi: Oxford University Press, 2005).
6 In Punjab, the sharing of river water—a crucial economic resource for the state—was also an
issue during the 1970s and 1980s, but only an additional one rather than the primary focus of
secessionists.
7 For example, southern states in India are currently objecting to the recent change in the
population base year, from 1971 to 2011, in the terms of reference of the 15th Finance
Commission. The southern states fear that their history of implementing successful population
516  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

As to the issue of available data, gaps in the statistical record on central expenditure
and taxation at the regional level may have acted as a major deterrent to attempts to
estimate interregional fiscal flows. Given this limitation, researchers and policy
makers have focused mainly on intergovernmental transfers rather than compre-
hensive interregional fiscal flows.
This article provides the first estimates (to my knowledge) of interregional fiscal
flows in India. For this, the state-level estimates of central transfers, expenditure,
and taxation have been prepared for the financial years 2000-1 through 2014-15.8
There are some justifications for the time period chosen. First, in 2000-1, there was
a reorganization of the Indian states that resulted in an increase in the total number
of states from 25 to 28. In 2014-15, another reorganization (bifurcation of one state)
took place, which increased the total number of states to 29. Hence, the chosen
time period provides uniformity in state composition. Second, this period coincides
with the era of stable coalition governments at the federal level, and thus makes
the estimates more interesting for those who may wish to use them to analyze the
political economy of centre-state fiscal relations. Finally, this period covers the high-
growth phase of the Indian economy. Hence, researchers concerned with analyzing
growth-redistribution linkages are likely to find the estimates both relevant and
interesting. In terms of cross-country comparisons, the study provides insights on
interregional fiscal flows and the associated fiscal equalization in a developing country
where wide regional disparities exist.
It should be stressed at the outset that this article does not envisage any ideal
level of interregional fiscal flows grounded in normative science. The magnitude
and directions of interregional fiscal flows are a result of political, economic, and
institutional characteristics of the economy in question. The estimates, however,
could certainly be useful for positive science by aiding the analysis of regional
growth and development dynamics.
The rest of the article is organized as follows. The next section provides a brief
contextual description of India’s fiscal redistribution system. To provide a comparative
benchmark for readers familiar with the world’s developed economies, the tax-
expenditure arrangement in India is compared with Canadian federalism. The
article then outlines a number of methodological challenges and identifies the data
sources used in this study for calculating federal fiscal balances. The “Results and
Analysis” section applies the new estimates in analyzing the broad trends in India’s
interregional fiscal flows and assesses the role of those fiscal flows in reducing
regional inequalities. The article ends with a brief concluding section.

control measures, in contrast to the response of northern states on this issue, would haunt
them in terms of their being allocated a lower share in the interstate distribution of Finance
Commission transfers. See Sneha Mary Koshy, “Southern States Oppose New Yardstick in
15th Finance Commission,” NDTV, March 23, 2018 (www.ndtv.com/india-news/southern
-states-oppose-new-yardstick-in-15th-finance-commission-1827809).
8 The financial year of India’s federal and state governments runs from April 1 to March 31.
interregional fiscal flows and horizontal fiscal equalization in india  n  517

I ndia’ s F ede r a l St r u ct u r e and F i s ca l


Redi s t r i b u tion S y s tem
India’s federal structure currently comprises 29 states and 7 union territories. (For
the purposes of this article, references to India’s states should be understood as
including the 28 states existing in the period 2001-2015 and the union territory of
Delhi [the nation’s capital]. These 29 states are listed in table 3.) The seventh sched-
ule of the Indian constitution provides details on the jurisdiction of central and state
governments in three lists, namely, the union list, the state list, and the concurrent
list.9 In the spirit of classical literature on fiscal federalism,10 the constitution
assigned most of the expenditure responsibilities to the state governments while the
central government has the power to collect most of the taxes.
Table 2 provides a comparative breakdown of federal and state/provincial
finances in India and Canada.11 India’s tax system is much more centralized than
Canada’s and reflects a greater separation of powers between the two tiers of gov-
ernment. The central government of India raises nearly two-thirds of the combined
revenues compared to less than 50 percent for Canada’s federal government
(items 3.1 and 3.3 in table 2).12 In Canada, both tiers of government have concur-
rent jurisdiction over major sources of taxes, with the exception of customs taxes,
which fall under the jurisdiction of the federal government. In India, personal
income tax, corporate income tax, and customs, excise (except in respect of potable
alcohol), and service taxes fall exclusively under the jurisdiction of the federal
government.13 For Indian states, the major sources of own-tax revenue are value-

9 Subjects included in the first two lists fall under the jurisdiction of central and state
governments, respectively, while the concurrent list provides details on the shared powers, with
the overriding authority being assigned to the central government. See article 246 of the
Constitution of India, 1950.
10 James M. Buchanan, “Federalism and Fiscal Equity” (1950) 40:4 American Economic Review
583-99; and Wallace E. Oates, “The Theory of Public Finance in a Federal System” (1968)
1:1 Canadian Journal of Economics 37-54.
11 In addition to the central and state governments, there is a third level of government in India,
namely, the urban and rural local bodies. In contrast to Canada, where local governments raise
significant resources on their own through property taxes, Indian local governments are largely
dependent on funding from the central and state governments for their operations. Hence, in
the analysis of interstate fiscal flows described in this study, the resources of local governments
are largely taken into account in the data for central and state government resources.
12 The share of the Canadian federal government relative to the Indian federal government
would be even lower if the combined revenue figures included revenues collected by local
governments. See supra note 11.
13 In July 2017, India introduced a dual goods and services tax (GST). A central GST replaced
the excise and service tax at the federal level. A destination-based state GST subsumed the
origin-based value-added tax (VAT) and interstate taxes at the state level. For the entire
duration of this study (2001-2015), the Indian federal indirect taxes (excise and service tax) are
comparable to the Canadian federal GST/harmonized sales tax (HST), while the Indian state
VAT corresponds to the provincial sales tax or the provincial component of HST in Canada.
518  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

Table 2  C
 omparison of Federal and State/Provincial Finances in India (2011-2015)
and Canada (2015)
Item s. no. India Canada

percent
1 Federal revenues (100)
1.1 Corporate income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.9 14.4
1.2 Personal income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17.4 49.4
1.3 Excise and service tax (India) /goods and services tax 25.3 15.5
(GST) and federal component of harmonized sales tax
(HST) (Canada) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.4 Customs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.4 1.7
1.5 Other taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.96 2.3
1.6 Employment insurance premium revenues . . . . . . . . . . . . . . na 8.2
1.7 Non-tax revenuea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.1 8.6
2 Federal disbursement (100)
2.1 Transfers to state/provincial governments . . . . . . . . . . . . . . 29.6 23.1
2.1.1 Finance Commission (India) / fiscal arrangements 20.4 6.0
(Canada) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.1.2 Planning Commission and central ministries (India)/ 9.2 17.2
support for health and social programs along with
gas tax fund and other minor transfers (Canada) . . . . . . . .
2.2 Direct expenditures (bypassing state/provincial 70.4 76.9
budgets) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2.1 Major transfers to persons . . . . . . . . . . . . . . . . . . . . . . . . . . . na 28.0
2.2.2 Other transfer payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . na 12.9
2.2.3 National defence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.0 8.7
2.2.4 All other departments and agencies . . . . . . . . . . . . . . . . . . . . 38.2 17.6
2.2.4.1 Other public goodsb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.7
2.2.4.2 Local goodsc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27.5
2.2.5 Public debt charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.2 9.7
3 Federal and state/provincial governments
(as % of gross domestic product [GDP])
3.1 Federal revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.3 13.8
3.2 Federal transfers and expenditures . . . . . . . . . . . . . . . . . . . . . 16.9 13.7
3.3 Own-revenues (states/provinces) . . . . . . . . . . . . . . . . . . . . . . 7.8 15.0
3.4 Total expenditure (states/provinces) . . . . . . . . . . . . . . . . . . . 12.9 19.0

(Table 2 is concluded on the next page.)

added tax (vat) and excise tax on potable alcohol. In contrast to Canada, where
personal income tax is the largest revenue source for the federal government, India’s
federal government depends heavily on revenues from the corporate income tax and
indirect taxes (excise, customs, and service taxes). In Canada, the provinces derive
their tax revenues from a mix of direct and indirect taxes (around 60:40, respect-
ively), whereas the Indian constitution explicitly bars states from taxing corporate
or personal income.14 Hence, the states’ own-tax revenues are raised entirely from

14 States can tax agricultural income, which the central government is not permitted to tax.
However, for political reasons, the states do not collect this tax, and thus effectively exempt
agricultural income from income tax.
interregional fiscal flows and horizontal fiscal equalization in india  n  519

Table 2  Concluded

Note: Total federal and state/provincial government expenditures can be calculated by adding
total expenditures (items 3.2 and 3.4) and netting out intergovernmental transfers shown in
item 2.1.
a Only net revenues/expenditures are used for Crown corporations in Canada and for
departmental commercial enterprises in India.
b Other public goods include general administration, foreign affairs, home affairs, etc., where
benefits are in the nature of a national public good.
c Local goods refer to direct expenditure by the federal government on agriculture, rural
development programs, food and energy subsidies, health, education, infrastructure, etc.
The beneficiaries of expenditures on these items are largely the residents of the region
where the money is spent.
Sources: Author’s compilation based on data from the following sources. For Canada,
federal government, Canada, Department of Finance, Annual Financial Report of the
Government of Canada, 2015-16 (Ottawa: Department of Finance, 2016); provincial
governments, Department of Finance, Fiscal Reference Tables, 2016 (Ottawa: Department of
Finance, 2016); GDP, Statistics Canada, table 36-10-0222-01. For India, federal
government, India, Ministry of Finance, Union Budgets 2012 to 2017); state governments,
Reserve Bank of India, State Finances: A Study of Budgets of 2016-17 (Mumbai: Reserve Bank
of India, 2017) and earlier issues; GDP, Central Statistical Organization, National Accounts
Statistics 2016, and earlier issues.

indirect taxes. As a result, indirect taxes dominate fiscal affairs in India and consti-
tute nearly two-thirds of the total taxes collected in the country.
Considering the expenditure side of the ledger, we see that not only is the
amount of federal government spending larger in India compared to Canada
(item 3.2), but India’s central government also accounts for a relatively larger share
of the combined federal and state expenditures, because of the relatively smaller
size of the state governments in India (item 3.4). Given the multiple channels of
federal transfers and expenditures involved, it is helpful to introduce two terms
defining the scope of activities covered: “direct expenditure,” which refers to all
spending by the central government, excluding transfers made to the state govern-
ments; and “disbursement,” which refers to direct expenditure plus transfers to the
state governments.
Transfers routed through the Indian state budgets account for approximately
30 percent of the total central disbursements. The transfers are routed through
three channels:

1. The Finance Commission (which is appointed once in five years) recom-


mends the share of central taxes to be allocated to the states, along with some
grants-in-aid. These transfers are explicitly meant to address interstate fiscal
disparities. Except for a small component designated as a specific purpose
grant (around 10 to 15 percent of the total allocation by the Finance Com-
mission), these are untied transfers and can be broadly compared with
Canada’s fiscal arrangements (equalization grants and territorial transfers).
However, in contrast to Canada, where the equalization grants are given
only to the “have not” provinces, in India the Finance Commission transfers
are made to all states.
520  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

2. Until recently,15 the Planning Commission provided grants to the state gov-
ernments in accordance with the economic and social priorities set at the
national level. Though the formula-based allocation accounted for a small
proportion of the Planning Commission grants (roughly 30 percent of the
total), the remaining discretionary funds were also allocated with great con-
sideration for reducing regional disparities.
3. The central ministries provide additional discretionary grants to the state
governments for the various central sector and centrally sponsored programs.

Unlike Canada’s health transfers and social transfers, which are block grants and
given on per capita basis, in India, the specific purpose grants provided by the
Planning Commission and central ministries are largely discretionary. Further,
these grants come with many strings attached with respect to their utilization, and
they also require matching contributions on the states’ part. Despite the abolish-
ment of the Planning Commission in 2014 and subsequent pruning of many
centrally sponsored schemes, the discretionary transfers remain among the most
contentious issues in Indian centre-state fiscal relations.
Excluding debt servicing, spending on pure public goods (national defence, for-
eign affairs, central banking, etc.), and intergovernmental transfers, major
expenditures by the Canadian federal government are made in the form of transfers
to individuals through programs for seniors’ income support, employment insur-
ance, and family benefits. In contrast, the central government in India has substantial
involvement in agriculture, rural development, health, education, energy, and infra-
structure. Direct spending on these items by the central government has implications
for regional welfare. Hence, they can be referred to collectively as “local goods.” An
item called “economic and social planning” in the concurrent list has been used to
justify the central government’s role across all sectors. For example, the state list
assigns the functional domain of health and agriculture to the states, and these items
do not find a place in the union or the concurrent list. However, the central govern-
ment is heavily involved in these domains, by invoking the need for economic and
social planning. Compared to Canada, India has a greater separation of powers with
respect to taxation but less on the expenditure side.
The kind of broad-based, federally operated, social security and insurance pro-
grams that are maintained in Canada and the United States do not exist in India.
Instead, the federal government provides a defined-benefit or defined-contribution

15 The Planning Commission was an extraconstitutional body created in 1950 to guide the
planning process and allocate resources at both the central and the state levels. The current
central government, elected in 2014, replaced the Planning Commission with a new institution
named the National Institution for Transforming India (NITI) Aayog, formed on January 1,
2015. Unlike the Planning Commission, the NITI Aayog works only as an advisory body,
without any financial powers for final allocation of the funds.
interregional fiscal flows and horizontal fiscal equalization in india  n  521

pension to its employees,16 who constitute around 1 percent of the total workforce
in the country. Considered to be a deferred liability of the government, this expendi-
ture is covered under either local goods or public goods, depending on the
functional role played by the particular employee (for example, for employees in
the defence forces, the cost of the pension is allocated to public goods, whereas for
employees working in health or education, the cost is added into local goods). Most
of the direct federal expenditure under the local goods provision operates through
food and energy subsidies, rural employment and development programs, agricul-
tural support, etc. While different from the social security and employment
insurance programs in Canada and the United States, these direct expenditures by
India’s federal government essentially aim to provide support to poorer members of
the population.
Previous studies of fiscal federalism in India have focused mainly on central
transfers that are routed through state budgets.17 Chakraborty, Mukherjee, and
Nath expanded the scope of resource flows by including local goods (item 2.2.4.2 in
table 2), and in this respect their research is closest to the present study.18 However,
even their study did not cover public goods and taxation. The authors observed that
the various channels of central transfers and expenditure follow different patterns
of interstate distribution. Specifically, the central transfers routed through the state
budgets provide higher resources to the poorer states, but the richer states get a
larger share of the direct central expenditure. Notably, the federal Ministry of
Finance’s annual economic survey for the 2016-17 fiscal year included a chapter on
the impact of federal fiscal flows on the developmental outcomes of the recipient
states.19 However, given the unavailability of state-level estimates on direct federal
spending, the survey limited the scope of the federal disbursement channel to trans-
fers through the state budgets (item 2.1 in table 2). Moreover, in the absence of
estimates of states’ contributions to central taxes, the survey used the share of states
in the nation’s gross domestic product (gdp) as a proxy for their contribution.
Compared to the existing literature, there are two improvements or extensions
made in the present study. First, there is room for improvement in the indicators
used for interstate allocation of federal spending on local goods. These indicators are
discussed in the next section. Second, varying regional incidence of the central

16 Since 2004, new government employees have been covered under the defined contribution
system, for which both fund management and annuity payments are operated by private entities.
In contrast to the social security system in the United States, the accounts of employees are
maintained at the individual level and involve no interpersonal or interregional transfers.
17 Vithal and Sastry, supra note 5; and Rao and Singh, supra note 5.
18 Pinaki Chakraborty, Anit N. Mukherjee, and H.K. Amar Nath, Interstate Distribution of Central
Expenditure and Subsidies, Working Paper no. 2010-66 (New Delhi: National Institute of Public
Finance and Policy, February 2010).
19 India, Ministry of Finance, “The ‘Other Indias’: Two Analytical Narratives (Redistributive and
Natural Resources) on States’ Development,” in Economic Survey 2016-17 (New Delhi:
Ministry of Finance, 2017).
522  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

taxes forms an important channel of fiscal flows through the central government’s
fiscal policy. This aspect is absolutely unexplored in the Indian context. The present
study is novel in incorporating public goods and taxation in the measurement of
interregional fiscal flows for India’s states.

M ea s u r ement I s s u e s and D ata So u r ce s


There are two conceptual issues for the top-down allocation of federal fiscal
activities:

1. choosing the approach to be used for the regional allocation of those activ-
ities; and
2. deciding on the scope of the activities to be covered.

The second issue is the more crucial of the two, but both of them must be
addressed, while maintaining consistency with the purpose of the allocation.
With respect to the first issue, two approaches—the cash flow approach and the
incidence/benefit approach—have often been used in prior studies. Under the cash
flow approach, the federal expenditure and the revenue contribution are linked to
the location of the expenditure or revenue collection. For example, the expenditure
on national defence would be allocated to the regions where the defence forces are
located. Similarly, it can be assumed that corporate income taxes are contributed by
the states where these taxes are collected, mainly those with large metropolitan
centres housing corporate head offices. Customs duty would also be attributed to
the states with ports engaged in the international shipping trade. Clearly, this admin-
istrative approach lacks an economic rationale. Most national statistical agencies,
such as Statistics Canada (in preparing its provincial economic accounts) and Italy’s
Department of Development Politics (for its project Conti Pubblici Territoriali),
use this approach. There is little connection between the regional incidences of the
burden and the benefits where the allocation is made under the cash flow approach.
In contrast, the incidence/benefit approach—as the name suggests—focuses on the
location where individuals deriving the benefits or bearing the burden of the federal
fiscal activity reside. Clearly, this approach is more suitable when one is concerned
about issues such as the effect of federal fiscal activities on economic and fiscal dis-
parities at the regional level.20
With respect to the second issue—the scope of the activities to be covered—
there are several key challenges. These challenges relate to national public goods,
the payment of interest on the federal public debt, and the federal fiscal surplus/
deficit. In the discussion that follows, three principles are applied in defining the
scope for regional allocation of the benefits and burden of federal fiscal policy:

20 See Vaillancourt and Bird, supra note 4, at 4; and Giuseppe C. Ruggeri, Regional Fiscal Flows:
Measurement Tools, IEB Working Paper 2009/4 (Barcelona: Institut d’Economia de Barcelona,
2009), at 4.
interregional fiscal flows and horizontal fiscal equalization in india  n  523

1. The benefits and burden must either be in the current year or, if they belong
to the past or future, be clearly identifiable as connected to a particular
region.
2. The quantum of the benefits and the burden at the national level should be
equal, so that the sum total of net federal fiscal balances of all regions is zero.
This can be done by identifying the intertemporal benefit/burden of the fiscal
surplus/deficit. The balancing of the aggregate expenditure and revenues is
necessary to avoid a possible scenario where all regions may appear to
receive net fiscal inflows if the federal government is running a large fiscal
deficit.
3. There must be no double-counting. Although this is a basic principle of
accounting practice, it is not fully appreciated in the existing literature on
fiscal flows.

Disbursement
The central government’s disbursement can be classified into the following
components: (1) transfers/grants routed through the state budgets, and (2) direct
expenditure. The first component would undoubtedly be part of any calculation of
India’s federal fiscal balances. The state-level data for these transfers have been
taken from the study on state finances published by the Reserve Bank of India
(rbi).21 The second component poses greater challenges both conceptually and in
respect of the data requirement for estimation. The discussion that follows expands
on these challenges in relation to direct expenditure on local goods and transfers
and on national public goods. The estimation issues relating to direct expenditure on
interest on the public debt are discussed in a later section, in conjunction with the
fiscal deficit /surplus (under the heading “Interest Payment on Public Debt and the
Fiscal Deficit/Surplus”).

Local Goods and Transfers


Major items included in direct expenditure on local goods and transfers are product
subsidies (for food, fertilizers, and petroleum products) and spending on agricul-
ture, rural development, health, education, and infrastructure. The usual practice in
allocating India’s food subsidy is based on the distribution of subsidized food grains
to consumers in recipient states.22 However, this approach ignores the fact that in
India (as in most developed countries), the food subsidy has twin objectives: to
provide higher procurement prices to farmers, and to serve poor consumers by
selling food grains below procurement prices. The food subsidy is the difference
between the procurement and selling prices, along with the subsidization of
transport and distribution costs. Accordingly, the food subsidy is allocated in three

21 See Reserve Bank of India, State Finances: A Study of Budgets of 2016-17 (Mumbai: Reserve
Bank of India, 2017), and earlier issues of this publication.
22 Chakraborty et al., supra note 18, at 26.
524  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

stages. In the first stage, the difference between the procurement price and the
production cost is considered as a producer subsidy to farmers. The Commission on
Agricultural Cost and Prices provides annual estimates of the production cost of the
various food grains. In the second stage, the difference between the production
cost and the issue price to consumers is considered as a subsidy to consumers. The
remaining subsidy is essentially for procurement and distribution incidentals.
The respective shares of producers and consumers in the procurement and distri-
bution cost would depend on the relative elasticity of demand and supply of food
grains. Although demand and supply for food grains would be expected to be
inelastic, no reliable estimates of elasticities are available. The best choice in this
case is an assumption of equal elasticities and equal incidence on both sides. Accord-
ingly, incidentals are equally divided between consumers and producers.
The issues that arise for the allocation of the food subsidy also apply to the
fertilizer subsidy. Chakraborty et al. allocated the fertilizer subsidy among states
on the basis of the consumption of fertilizers by agricultural producers.23 However,
subsidizing fertilizers helps in reducing farmers’ production costs, and this in turn
results in lower food prices.24 Thus, consumers of farm products also benefit from
the fertilizer subsidy. Keeping in mind the unavailability of elasticity estimates, the
fertilizer subsidy is allocated equally between producers and consumers. For
producers, fertilizer/nutrient consumption was taken as the indicator. For con-
sumers, the consumption of rice and wheat was considered, while also taking into
account the intensity of fertilizer use in producing the two crops. The petroleum
subsidy is largely meant for kerosene and liquefied petroleum gas for cooking pur-
poses. The individual subsidy for both items and the state-level consumption data
from the federal Ministry of Petroleum and Natural Gas were employed for the
allocation of the petroleum subsidy.25
The remaining items of the central expenditure on agriculture, rural develop-
ment, education, health, transport, and communication were allocated on the basis
of data relating to specific programs or schemes contained in various reports of the
relevant central ministries or departments. The answers to questions raised in Parlia-
ment constituted an important data source for this purpose. Some of the data on
infrastructure expenditure by the central government were taken from regional
accounts of the states. This data set was supplied by the Central Statistical Organ-
ization on request.

23 Ibid.
24 Ashok Gulati and Sudha Narayanan, The Subsidy Syndrome in Indian Agriculture (New Delhi:
Oxford University Press, 2003).
25 India, Ministry of Petroleum and Natural Gas, “Indian Statistics on Petroleum and Natural
Gas,” various years.
interregional fiscal flows and horizontal fiscal equalization in india  n  525

National Public Goods


Regional allocation of the expenditure on national public goods, such as national
defence, external affairs, and general administration, can invite marked differences
in opinion. If the purpose of allocation is only to understand the implications of central
expenditure for regional welfare, it is desirable to ignore the allocation of national
public goods. Hence, Chakraborty et al. rightly avoided allocation of these goods.26
However, a study focusing on fiscal flows must take into account national public
goods because the benefits of public goods and the associated burden of financing
them could have varying regional incidence. While the provision of national public
goods is meant for residents across the nation, the benefits derived would depend
on the individual’s utility function. The prevalent practice in the literature is to
allocate these expenditures on a per capita basis or on the basis of some concept of
income.27 The per capita approach presumes that expenditure on public goods is
based on the vertical addition of uniform demand curves irrespective of income
level; accordingly, the size of each state’s population can be taken as an indicator for
interstate allocation. Another possible assumption is of homothetic preferences with
an income elasticity of demand for public goods as unity; in this case, state income
can be taken as an indicator for interstate allocation. This approach seems more
suitable, since there is a genuine case of positive income elasticity for the demand
for public goods.
Another interesting factor in favour of linking the expenditure on national public
goods with state income is the association of the expenditure with the revenue
capacity of the states, and the consequent stability of the estimates of net fiscal flows
under varying assumptions. Central tax revenues are estimated to be largely propor-
tional to state income (shown in table 3 and discussed below), a trend observed in
the studies carried out in other countries as well.28 Accordingly, allocating national
public goods in proportion to state income further implies the allocation of these
goods roughly in proportion to the revenue contribution of each state. Hence, if
one decided not to allocate national public goods to any state, both central revenues
and expenditure at the state level would change by a similar magnitude, thus main-
taining stability of the estimates of net fiscal flows (presuming that adjustments were
made for fiscal surplus/deficits in order to obtain equality of total federal spending
and revenues). Effectively, the estimates of net fiscal flows would be similar for the
allocation of national public goods under three assumptions: (1) not allocating these
expenditures, (2) allocating them in proportion to income, and (3) allocating them
in proportion to revenue contribution.

26 Chakraborty et al., supra note 18.


27 Ruggeri, supra note 20, at 14; and François Vaillancourt, “Inter-Regional Fiscal Flows:
Interpretation Issues,” in The Political Economy of Inter-Regional Fiscal Flows, supra note 4, 39-58,
at 44.
28 For example, Ambrosanio et al., supra note 4, at 96, for Italy; and Espasa and Bosch, supra
note 4, at 155, for Spain.
526  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

Central Revenues
Central tax collection, ceteris paribus, reduces the disposable income/purchasing
power of taxpayers. The state-level burden of the central taxes would depend on the
tax base and the progressivity of the tax system.

Direct Taxes
Personal Income Tax
The accepted practice in the literature for allocating personal income tax is on the
basis of residence; thus, it is assumed that the person who pays the tax also bears its
burden.29 Even in the case of the shifting of tax incidence, the burden is likely to
remain within the same region.30 The same approach is followed in this study by
using state-level data on personal income tax collection from the reports of the
comptroller and auditor general of India.31

Corporate Income Tax


The estimation of the regional incidence of taxes on corporate profits requires
certain assumptions. Empirical studies show that capital is usually mobile within a
nation but immobile at the international level.32 The corporate tax rate is applied
uniformly across the nation; hence, the entire burden must be borne by the owner
of capital (recipients of interest and profits) in the context of a closed economy,
where the supply of capital can be considered inelastic. However, factors such as
market power, non-tax barriers, and tax preferences at the regional level may enable
corporations to pass on some of the burden to the labour force.33
A compromise approach can be followed by allocating corporate taxes to both
capital and labour and assigning equal weights to each. In this study, separate indices
were constructed to estimate states’ shares in labour and capital for bearing the
burden of corporate taxes. For labour, only the private organized sector was con-
sidered. Although many public sector enterprises (pses) pay corporate income tax,

29 Ruggeri, supra note 20, at 6.


30 Ibid.
31 Comptroller and Auditor General of India, Reports of Union Audit for Direct Taxes (New Delhi:
Government of India, various years).
32 Martin Feldstein and Charles Horioka, “Domestic Saving and International Capital Flows”
(1980) 90:358 Economic Journal 314-29; Alun H. Thomas, Saving, Investment, and the Regional
Current Account: An Analysis of Canadian, British, and German Regions, International Monetary
Fund Working Paper 93/62 (Washington, DC: IMF, August 1993); and Yasushi Iwamoto and
Eric Van Wincoop, “Do Borders Matter? Evidence from Japanese Regional Net Capital
Flows” (2000) 41:1 International Economic Review 241-90.
33 Núria Bosch, “Counting Monies: Measurement and Practice of Inter-Regional Fiscal Flows:
Comment I,” in The Political Economy of Inter-Regional Fiscal Flows, supra note 4, 59-63; and
Giuseppe C. Ruggeri, “Inter-Regional Fiscal Flows: Canada,” in The Political Economy of
Inter-Regional Fiscal Flows, ibid., 125-45.
interregional fiscal flows and horizontal fiscal equalization in india  n  527

the wages in pses are not linked to the profitability of the organization. Instead,
they are linked to the wages of employees in government administration as recom-
mended by the Central Pay Commission. For the private organized sector, the
study used employment data compiled by the Ministry of Labour and Employment.
To capture the relative wage differential among states, data from the Annual Survey
of Industries were used. The Indian financial system is dominated by the banking
and insurance sectors, which channel household savings into corporate debt and
equity markets. Hence, the ownership of household financial assets in the banking
and insurance sectors in the various states can be used for allocating the burden of
the corporate income tax on capital. Accordingly, an index of state-level ownership
of household financial assets covering the banking and insurance sectors was con-
structed using the data from the rbi and the Insurance Regulatory and Development
Authority. The sum of state-level contributions of personal and corporate income
taxes was used to allocate the remaining direct tax collection of the central govern-
ment. Corporate income tax paid by pses is levied on profits that result from prices
higher than the production cost. Hence, these can be considered as indirect taxes,
which are allocated to states along with other indirect taxes.

Indirect Taxes
The usual approach for allocating indirect taxes is based on the state share in final
consumption expenditure, which is termed the destination-based approach. This
approach is also used by the national statistical agencies in Canada and Australia for
allocating federal indirect taxes among provinces or states, to convert gross regional
product at basic prices to market prices. China, in contrast, uses the origin-based
approach for allocating indirect taxes among the provinces for estimating regional
product at market prices. However, the destination-based approach assumes that
either the elasticity of demand for all goods and services in all states is zero or
the elasticity of supply of all goods and services is infinite. The reverse is true for the
origin-based approach. Considering these as extreme assumptions, in a prior study
I allocated the central indirect taxes for India on the basis of both production and
consumption, assigning equal weights to each.34 I have adopted the same approach
in the present study for allocating all central indirect taxes.

Non-Tax Revenues
The central government receives non-tax revenues mainly in the form of (1) divi-
dends from pses, including seigniorage from monetary operations; (2) royalties (for
example, from the exploitation of natural resources); and (3) sales of goods and
services. The last item refers to user charges and fees (tickets for public museums
and monuments, education fees, etc.). The prices charged for government services
are usually lower than the cost of production, with the difference being financed by

34 Deepak Sethia, “Regional Accounts of India: Methods, New Estimates, and Their Uses” (2016)
62:1 Review of Income and Wealth 92-119.
528  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

the fiscal resources allocated as described above (see “Disbursement”). There is no


need to allocate user charges, since the benefits and burden are incurred in the same
region and thus involve no interregional fiscal flows. Hence, only the first two
items, which together account for about 8 percent of the total central revenue
receipts, qualify for regional allocation. Royalty receipts include spectrum, licence,
and other fees associated with the telecom sector. These have been allocated on the
basis of the states’ collection of these charges along with data taken from answers to
questions in Parliament. The central government’s dividend receipts can be con-
sidered as a return on capital, which has first been raised from taxpayers, while the
royalty receipts are essentially rents on natural resources, with respect to which
higher product prices are similar to indirect taxes. Accordingly, the entire amount
has been allocated in proration to a state’s total tax contribution.

Interest Payment on Public Debt and the Fiscal Deficit/Surplus


There are two prevalent approaches in the literature for the treatment of interest
payments on public debt. Under the first approach, the interest payments are
included in the scope of federal fiscal activities in order to maintain equality
between total disbursement and revenues at the aggregate level.35 Under the second
approach, this expenditure is excluded from the calculations, and offsetting reduc-
tions are made on the revenue side.36 The first approach is a clear violation of the
principle of allocating expenditure only if it is linked to the provision of benefits in
the current year. At best, an attempt can be made to allocate interest payments to
the regions that benefited from the fiscal deficit in the past. The second approach
also poses conceptual problems by understating the burden borne by taxpaying
regions.
Studies not allocating interest payments have recognized that although such pay-
ments constitute a current expenditure in the accounting sense, the corresponding
benefits are delivered in prior years through deficit financing. Hence, one possible
approach is to allocate interest expenditure to regions that benefited from deficit
financing in the past.37 This approach requires a regional allocation profile of
central disbursement for a long time series, thereby limiting its practical utility.
Interestingly, this or any other approach for the allocation of interest payments
poses a conceptual problem in the sense that one first allocates central disburse-
ment to regions at its full cost in the year when it was financed by borrowing, and

35 Robert Mansell and Ronald Schlenker, “The Provincial Distribution of Federal Balances”
(1995) 3 Canadian Business Economics 3-19; and G.C. Ruggeri and Weiqiu Yu, “The
Measurement of Interregional Redistribution” (2003) 31:4 Public Finance Review 392-412.
36 Michael C. McCracken, The Distribution of Federal Spending and Revenue by Province: Implications
for Ontario and Other Provinces (Toronto: Ontario Ministry of Intergovernmental Affairs, 1993);
Ambrosanio et al., supra note 4, at 90-91; and Paul Vann Rompuy, “Measurement and Practice
of Fiscal Flows: The Case of Belgium,” in The Political Economy of Inter-Regional Fiscal Flows,
supra note 4, 108-24, at 119.
37 Ambrosanio et al., supra note 4, at 90; and Rompuy, supra note 36, at 119.
interregional fiscal flows and horizontal fiscal equalization in india  n  529

subsequently adds the interest expenditure in future. The regional allocation of the
goods and services provided through deficit financing should be attempted only in
the year of borrowing, essentially representing the net present value of all future
repayments. Clearly, if one allocates all disbursement with implications for welfare
(national public goods, local goods, and transfers), the allocation of interest pay-
ments would be a case of double-counting.
The treatment of the federal fiscal deficit/surplus is also an unsettled issue in
estimating federal fiscal balances. The existing literature suggests two alternative
approaches in the case of fiscal deficit (surplus): (1) increase (decrease) the total rev-
enue collected to match the total disbursement; or (2) decrease (increase) the total
disbursement to match the total revenue collected. Both of these approaches have
different implications for the size of fiscal balances at the regional level. By increas-
ing (decreasing) revenue to match the total disbursement in the case of fiscal deficit
(surplus), the first approach will give higher (lower) estimates of the fiscal balances
than the second approach. Both approaches appear to be arbitrary and can be chosen
to provide estimates favouring particular political positions.
Vaillancourt and Bird have provided an interesting theoretical basis on which to
choose between the two alternatives, and which can very well be applied in the
Indian context.38 Over the last five decades, the central government has been
running fiscal deficits (consistently) and primary deficits (mostly). This suggests
that it is difficult to cut spending, and the government prefers to create future
revenue-repayment obligations by borrowing. If it is assumed that regional dis-
parities are likely to remain reasonably stable over the next 15 years (the weighted
average maturity period of central borrowings was around 14 years during the last
decade), the regional contribution of taxes will also likely remain stable. With this
reasoning, it is possible to consider public borrowings as deferred liabilities for
taxpayers in proportion to their current contribution. Accordingly, the contribution
of states should be raised upward to match the total disbursement.
With the decision to allocate public debt and not to allocate interest payments
on the public debt, this study avoids the pitfall of double-counting. Several prior
studies have failed to appreciate this point. They unnecessarily calculate several sets
of federal fiscal balances, such as basic balances, primary budget balances, balanced
budget estimates with disbursement adjustments, and balanced budget estimates
with revenue adjustments.39 In this study, I argue that calculating primary balances

38 Vaillancourt and Bird, supra note 4.


39 Mansell and Schlenker, supra note 35; and G.C. Ruggeri and Weiqiu Yu, “Federal Fiscal
Balances and Redistribution in Canada, 1992-1997” (2000) 48:3 Canadian Tax Journal 626-55.
“Basic balances” refers to the allocation of all federal expenditures (including interest payments
on public debt) and revenues on an actual basis. Hence, the sum of the fiscal balances for all
states may not be equal to zero if there is a fiscal deficit or surplus. “Primary balances” exclude
the allocation of interest expenditure, with other features being similar to those of basic
balances. Hence, the sum of the fiscal balances for all states will again not be zero if there is a
primary fiscal deficit or surplus. The balanced budget is prepared from basic balances by
530  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

(excluding interest payments) through adjustment on the revenue side for fiscal
surplus or deficits is the best approach for calculating federal fiscal balances, espe-
cially if regional inequalities are expected to remain stable during the maturity
profile of federal debt. The allocation of both interest payments and the fiscal deficit
is a clear case of double-counting.

Re s u lt s and A na ly s i s
This section serves three main purposes. First, it identifies the broad trends emerg-
ing from the estimates of India’s federal fiscal balances derived from this study.
Second, it examines the impact of federal fiscal activities on regional income and fiscal
inequalities. Third, it acknowledges the limitations of the new estimates and suggests
their policy implications.

Broad Trends
Indian states are usually classified into major and minor states according to the size
of their population. Approximately 95 percent of the Indian population lives in
17 major states; the remaining 5 percent lives in 11 minor states and seven union
territories. Table 3 presents a brief overview of the estimates prepared for major and
minor states along with the union territory of Delhi. The time frame of 2001-
2015 is divided into three five-year periods, coinciding with periods covered by the
recommendations of three different commissions. Table 3 sets out the estimated
central disbursement, revenue, and fiscal flow for each state, in each case presented
as a percentage of state income.40 The estimates are an average value for the rel-
evant variables (based on the calculation of annual percentages) in each five-year
period. To put these estimates in perspective, the share of states in the national
population and their per capita income relative to the national average (assumed to
be 100) are also presented. The per capita income variable is identified as “state
income relative” (sir). The approach of presenting fiscal aggregates as a percentage
of state income and per capita state income as a percentage of national income con-
trols for intertemporal changes in the absolute numbers associated with economic
growth and inflation.

eliminating the fiscal deficit, through the adjustment of expenditures to revenues or vice versa.
Hence, the sum of the fiscal balances for all states will be zero. The balanced primary budget
can also be prepared through the elimination of the primary fiscal deficit, by adjusting
expenditures to revenues or vice versa.
40 In India, state income is estimated through the income-originating approach (domestic
product), which is conceptually comparable to GDP at the national level. Estimates of state
income using the income-accruing approach, which is conceptually comparable to gross
national product (GNP), are not available. In the discussion that follows, in reference to states,
the terms “state income” and “GDP” are used interchangeably, as is the practice in Indian
regional accounts.
Table 3  Federal Fiscal Activities in Regional Accounts, India, 2001-2015
Average 2000-1 to 2004-5 Average 2005-6 to 2009-10 Average 2010-11 to 2014-15

Popu­ Disburse- Fiscal Popu­ Disburse- Fiscal Popula- Disburse- Fiscal


State/variable SIR lation ment Revenue flow SIR lation ment Revenue flow SIR tion ment Revenue flow

Panel 1: Major states


 1 Bihar 37 8.2 26.0 14.9 11.1 32 8.4 35.4 15.5 20.0 37 8.7 29.2 11.9 17.3
 2 Uttar Pradesh 60 16.3 17.5 14.6 3.0 55 16.4 22.6 15.2 7.4 52 16.6 21.4 13.4 7.9
 3 Jharkhand 71 2.6 16.0 15.6 0.3 68 2.7 20.5 18.8 1.7 63 2.7 19.7 16.2 3.5
 4 Assam 78 2.6 22.1 14.6 7.5 66 2.6 28.3 17.9 10.4 61 2.6 27.9 15.3 12.6
 5 Madhya Pradesh 73 5.9 16.7 13.3 3.4 65 6.0 22.2 14.1 8.1 68 6.0 20.9 12.0 8.9
 6 Orissa 71 3.6 20.5 12.1 8.4 81 3.5 21.5 12.3 9.2 80 3.5 20.3 11.2 9.2
 7 Chhattisgarh 78 2.0 17.6 12.9 4.7 86 2.1 20.8 11.8 9.1 85 2.1 19.4 9.9 9.4
 8 Rajasthan 83 5.5 15.6 14.0 1.6 81 5.6 18.1 14.3 3.7 90 5.7 14.9 11.7 3.2
 9 West Bengal 103 7.8 13.4 13.9 −0.5 91 7.7 14.9 16.0 −1.1 90 7.5 14.9 14.7 0.1
10 Andhra Pradesh 110 7.4 14.4 13.0 1.4 116 7.2 15.5 14.1 1.4 121 7.0 13.6 12.7 0.9
11 Karnataka 114 5.1 13.5 16.8 −3.3 120 5.1 14.1 21.2 −7.2 117 5.1 12.9 20.0 −7.1
12 Tamil Nadu 128 6.1 12.2 14.8 −2.5 136 6.0 13.2 15.0 −1.8 141 6.0 11.6 13.2 −1.6
13 Kerala 138 3.0 11.3 15.2 −3.9 146 2.8 11.3 15.4 −4.1 144 2.7 11.0 13.8 −2.8
14 Gujarat 137 4.9 10.8 14.7 −3.9 152 5.0 10.8 15.1 −4.2 150 5.0 9.6 13.8 −4.2
15 Punjab 166 2.4 16.7 13.3 3.4 148 2.3 17.7 14.5 3.1 139 2.3 15.2 13.2 2.1
16 Maharashtra 153 9.4 10.1 18.0 −7.8 164 9.4 10.9 21.9 −10.9 160 9.3 10.1 22.3 −12.2
17 Haryana 166 2.1 13.0 12.4 0.6 172 2.1 12.4 13.4 −1.1 181 2.1 10.8 12.1 −1.3

(Table 3 is continued on the next page.)


interregional fiscal flows and horizontal fiscal equalization in india  n  531
Table 3  Continued
Average 2000-1 to 2004-5 Average 2005-6 to 2009-10 Average 2010-11 to 2014-15

Popu­ Disburse- Fiscal Popu­ Disburse- Fiscal Popula- Disburse- Fiscal


State/variable SIR lation ment Revenue flow SIR lation ment Revenue flow SIR tion ment Revenue flow

Panel 2: Minor states


 1 Manipur 82 0.2 45.4 11.6 33.8 72 0.2 58.9 11.6 47.3 61 0.2 64.2 9.8 54.5
 2 Jammu & Kashmir 96 1.0 40.3 14.4 26.0 86 1.0 39.6 14.7 24.8 82 1.0 36.5 12.0 24.4
 3 Tripura 104 0.3 35.2 11.6 23.6 92 0.3 40.4 12.2 28.1 85 0.3 45.9 11.4 34.5
 4 Meghalaya 100 0.2 33.3 13.3 20.0 95 0.2 31.7 14.1 17.6 86 0.2 38.4 12.3 26.1
 5 Arunachal Pradesh 99 0.1 63.6 11.4 52.2 104 0.1 67.5 11.6 56.0 115 0.1 63.8 9.6 54.2
 6 Mizoram 114 0.1 64.6 13.5 51.1 102 0.1 69.9 14.1 55.9 105 0.1 62.6 10.8 51.8
 7 Nagaland 110 0.2 45.8 14.5 31.3 111 0.2 46.1 13.8 32.3 109 0.2 51.2 10.7 40.6
 8 Uttarakhand 104 0.8 24.4 14.8 9.6 128 0.8 20.3 13.7 6.6 145 0.8 16.4 11.6 4.8
 9 Himachal Pradesh 150 0.6 23.1 12.7 10.4 143 0.6 24.3 14.7 9.6 145 0.6 21.9 13.3 8.6
10 Sikkim 116 0.1 64.2 14.6 49.7 139 0.1 54.6 15.4 39.2 235 0.0 40.0 9.3 30.6
11 Delhi 255 1.4 14.6 24.7 −10.1 270 1.4 13.6 25.0 −11.4 270 1.4 11.2 25.0 −13.8
12 Goa 309 0.1 10.0 15.3 −5.3 382 0.1 9.0 16.2 −7.2 413 0.1 9.2 15.3 −6.2

(Table 3 is concluded on the next page.)


532  n  canadian tax journal / revue fiscale canadienne
(2018) 66:3
interregional fiscal flows and horizontal fiscal equalization in india  n  533

Table 3  Concluded
Notes:
SIR: Per capita state income relative to the national average (which is assumed to be 100).
Population: Percentage share of state in total national population.
Disbursement: Total central transfers and expenditure as a percentage of state income.
Revenue: Central revenue collection from the state as a percentage of state income.
Fiscal flow: Net federal fiscal flows [inflow (+)/outflow (−)] as a percentage of state income;
calculated as the difference between disbursement and revenue.
The states are arranged in ascending order based on their per capita income (SIR average for all
years).
Sources: Basic data for state income from the State Income Series published by the Central
Statistical Organization, India; basic population data from the Census of India, 2001 and
2011, with interpolation (2002-2009) and extrapolation (2012-2015) for other years. SIR
averages and figures shown for disbursement, revenue, and fiscal flow are based on author’s
calculations.

The estimates suggest the following broad trends in federal fiscal activities at the
regional level:

1. Central revenue collection as a share of state income is reasonably stable


across states, except that Maharashtra, Karnataka, and Delhi all bear a
higher burden of central taxes. This can be explained by the higher share of
the organized sector in these states. Maharashtra is an advanced state in
terms of both service sector and industrial development, while Karnataka
leads the country in information technology. Delhi, the national capital, has
a large service sector and accounts for a substantial share of federal govern-
ment employment. Hence, all three states are expected to contribute more
direct taxes, which are largely linked to organized sectors of the economy.
Among the poorer states, the estimates for Jharkhand and Assam are also
influenced by the contribution of the organized sector, though the focus of
these states’ economies is on natural resources.
The higher revenue burden for the states with a larger organized sector
should be seen in the context of the Indian labour market, where nearly
90 percent of the workforce is engaged in the informal sector, thus contrib-
uting little to personal income taxes. It is difficult to collect taxes from the
informal sector and the self-employed workforce, whereas the system of tax
deducted at source (tds) makes personal income tax evasion difficult in the
formal sector. Although India had a population of 1.3 billion in 2015, only
36.5 million individuals filed personal income tax returns in that year.41 It is

41 India, Ministry of Finance, Income Tax Department, Income Tax Return Statistics Assessment Year
2014-15 (New Delhi: Ministry of Finance, 2016). Even there, half of the tax returns declared
zero taxable income. In India, the exemption limits are also very high for its income level, since
personal income tax kicks in at an income level nearly 2.5 times per capita income. Hence, the
formal sector, which pays higher wages and is amenable to TDS, bears a relatively greater
burden of personal income tax.
534  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

of little surprise that the more formal economies of Karnataka and Maharash-
tra—which together account for around 14.5 percent of the national
population and 21 percent of the national income—contribute nearly 45 per-
cent of the personal income tax collection.42 In contrast, other states at
comparable per capita income levels (Andhra Pradesh, Tamil Nadu, Kerala,
Gujarat, Punjab, and Haryana) account for around 25 percent of the nation-
al population and 35 percent of the national income, but contribute only
23 percent of the personal income tax collected. With its large formal sector,
Delhi accounts for 3.6 percent of the national gdp and contributes nearly
12 percent of total personal income taxes. Among the poorer states,
Jharkhand and Assam have a huge share of the mining and plantation activ-
ities that are carried out in the formal sector, which translates into a
relatively higher tax burden for these states. On the corporate tax front, the
states’ share in the formal sector wage bill and financial capital are considered
as indicators for their share of labour and capital, respectively. The labour
share is driven by the same factors as personal income tax, while the formal
channels of financial savings (used as an index of capital) are also used rela-
tively more by those employed in the formal sector. Overall, the direct taxes
driven by formal sector explain the larger tax burden borne by some states in
comparison with others, despite similar income levels.
2. In contrast to the relatively uniform central tax rates across states, there is
high interstate variation in the disbursement rate as a share of state income.
This trend has been observed in other federal economies also.43 Among the
richer states, Punjab receives net fiscal inflows largely because of the histor-
ical legacy associated with agricultural subsidies. Among the middle-income
states, Andhra Pradesh receives fiscal inflows. This is probably because of its
political economy, since the ruling party in the state has been consistently
part of the coalition ruling at the federal level. Among the minor states, the
generous transfers to special category states (scss)44 are reflected in the esti-
mates of net fiscal inflows for these states, with several instances of net fiscal

42 These figures are my estimates and are not shown in a separate table.
43 See, for example, Ambrosanio et al., supra note 4, at 86 and 96, for Italy; and Espasa and Bosch,
supra note 4, at 155-60, for Spain.
44 The distinction of general states and SCSs was introduced in 1969 to provide higher transfers
to the states with special needs and non-viable public finances. All minor states except Goa and
Delhi are categorized as SCSs. Among the major states, Assam belongs in this category. Hence,
11 states are characterized as SCSs. These states have a hilly terrain and are located on
international boundaries. Given the fiscal disabilities faced by these states, more generous
transfers are provided to them. To some extent, political economy considerations influence
these transfers, since many of these states have faced secessionist movements relating to
differences in the ethnic and linguistic composition of their populations. Hence, generous
transfers can be seen as an effort to secure the political support of these states. Further, SCSs
have proportionately greater representation in the Indian Parliament than their population
interregional fiscal flows and horizontal fiscal equalization in india  n  535

flows exceeding 50 percent of state income (see panel 2 of table 3). This


special treatment is provided by the transfers routed through state budgets.
Ten scss (all minor states except Goa and Delhi) account for 3.6 percent of
the national population and 3.9 percent of the national income and popula-
tion. However, they receive 15.4 percent of the transfers routed through
state budgets. In contrast, their share in local goods is 3.9 percent, which is
comparable to their share in national income. The generous transfers to scss
are comparable to the generous territorial formula financing provided to the
three territories in Canada. These three territories face similar fiscal disabil-
ities because of a large number of small and isolated communities in difficult
geography.
3. Table 4 gives a summary of the data for the states divided into two categories:
“donor” states, which have a net fiscal outflow; and “recipient” states, which
have a net inflow of fiscal resources through central fiscal policy. At an aggre-
gate level, the seven major and two minor donor states (identified in the table
note) account for roughly 40 percent of the Indian population, while the
remaining 60 percent of the population lives in the recipient states. This is
interesting and in contrast to the pattern observed in the developed federal
economies. For example, in the case of Canada, 60 percent of the population
lives in the “donor” provinces, and the remaining 40 percent lives in the
“recipient” provinces.45 Clearly, the reduction of regional inequalities
through fiscal redistribution would be more challenging in India than in
Canada or other developed economies. This is particularly so owing to the
relatively greater regional disparities in India, a point made earlier in table 1.
4. The size of interregional fiscal flows as a share of state income has increased
over the years. More precisely, the net contribution by the nine donor states
rose from 4.31 percent to 6.09 percent of their aggregate state income
between 2001-2005 and 2011-2015. Correspondingly, the net fiscal inflows
in the remaining 20 states increased from 5.12 percent to 7.59 percent of
their aggregate state income in the same period. These estimates are com-
parable with the numbers reported for Spain, which are around 5 percent for
both recipient and donor regions.46 In the case of Italy, the donor provinces
contribute roughly 6 percent of their income, while the recipients gain

share. In certain federalism-related matters, such as the work of the GST council and the
constitutional amendment for items under article 368 of the Constitution of India, 1950, each
state has an equal vote. Hence, the central government can prefer to secure the support of
these states, given the lower cost. Assam has a relatively larger population, which makes
generous transfers comparable to the transfers to the other 10 SCSs fiscally difficult. Further,
fiscal disabilities faced by Assam are lower given its relatively flatter terrain and greater
population density.
45 Ruggeri, supra note 33, at 139.
46 Espasa and Bosch, supra note 4, at 164-65.
536  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

Table 4  S
 ummary Data for “Donor” and “Recipient” Groups of States, India,
2001-2015
Indicator 2001-2005 2006-2010 2011-2015

Group population (%)


Recipient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60.1 60.5 60.8
Donor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39.9 39.5 39.2
Group income share (%)
Recipient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45.7 44.0 44.5
Donor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54.3 56.0 55.5
Flow: in (+)/out (−) as % of group income
Recipient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.12 7.53 7.59
Donor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −4.31 −5.92 −6.09

Note: Data are averages for each five-year period. Donor states are West Bengal, Karnataka,
Tamil Nadu, Kerala, Gujarat, Maharashtra, Haryana, Delhi, and Goa (in ascending order of
per capita income). Remaining states have been characterized as recipient states.
Source: Author’s calculations.

12 percent of their income.47 The Indian economy grew at a rapid pace dur-
ing the study period, providing greater tax revenues to the central government
for redistribution. The existence of regional disparities with increasing tax
revenues for the central government creates the need, as well as providing an
opportunity, to increase the quantum of regional redistribution.
5. Given the unavailability of direct data on states’ contributions to central
taxes, it was necessary to resort to an indicator-based approach for corporate
income tax and indirect taxes. These taxes account for nearly 32 percent and
40 percent, respectively, of total federal revenues. To estimate the contri-
butions by donor and recipient states, the demand and supply side
indicators were used with the assumption of equal elasticity. Clearly, the
size of revenues allocated on the basis of the elasticity assumptions is quite
large. The estimates of states’ contributions to central revenues and the cor-
responding estimates of fiscal flows might differ under alternative assumptions
of elasticities. To check the stability of estimates at alternative elasticity
assumptions, the state-level revenue burden and fiscal flows were re-estimated
at varying proportions for the indicators used. (Detailed tables are not shown
here.) The analysis suggests that a 10 percent rise in the share of capital for
allocating corporate tax and in the share of production for allocating indirect
tax results in a change of −0.03 to 0.02 percent in the fiscal flows of group
income for the donor states (− reflects fiscal outflows, + reflects fiscal inflows).
Correspondingly, the change for recipient states ranges from 0.04 to
−0.03 percent of their group income across the study period. The estimates
of flows remain relatively stable even under extreme assumptions. For

47 Ambrosanio et al., supra note 4, at 79 and 98.


interregional fiscal flows and horizontal fiscal equalization in india  n  537

example, under the assumption of 100:0 weights (reflecting the allocation of


corporate income taxes based solely on capital and indirect taxes based
solely on production), the contribution of the donor group for the first
five-year period increases from the currently estimated 4.31 percent (shown
in table 4) to 4.48 percent of their group income. In the case of another
extreme assumption of 0:100 weights, there is a decline in the contribution
of the donor group from 4.31 percent to 4.14 percent of their state income.
Correspondingly, the estimates for the recipient states remain stable under
both of these assumed alternative weights.

Equalization
Income Equalization
The discussion clearly shows that substantial fiscal redistribution is carried out in
relation to the size of India’s national and regional gdp. Following a 1995 study by
Bayoumi and Masson,48 there have been several studies of other jurisdictions that
examine the impact of federal fiscal redistribution on the reduction of regional
disparities.49 Mélitz and Zumer 50 have argued that redistribution through federal tax
transfers can be analyzed with respect to the impact on both personal income and
gdp. However, the choice of federal tax-transfer package that may be considered for
reducing inequalities depends on the choice of independent variable. For an analysis
of the redistributive impact on personal income, the tax-transfer channels related to
personal income should be taken into account. However, for an analysis of the
redistributive impact on the regional gdp, all federal tax transfers, including those
related to corporate income and lower levels of government, should be taken into
account. The regional income data in India are available only in terms of gdp.
Therefore, in this study, the analysis is carried out for the broadest possible scope
of federal fiscal activities, taking into account all federal revenue and disbursement.
The basic approach followed in the literature for measuring the redistributive
impact of federal fiscal flows is to estimate per capita income before and after the
federal fiscal activities. Since redistribution is a long-term phenomenon, Bayoumi
and Masson have argued that, instead of annual data, one should use the data aver-
aged over time that can abstract from the short-term cyclical factors. This approach
can be operationalized through cross-section regression, as shown in equation 1:

48 Tamim Bayoumi and Paul R. Masson, “Fiscal Flows in the United States and Canada: Lessons
for Monetary Union in Europe” (1995) 39:2 European Economic Review 253-74.
49 Mansell and Schlenker, supra note 35; Jacques Mélitz and Frédéric Zumer, “Regional
Redistribution and Stabilization by the Center in Canada, France, the UK and the US: A
Reassessment and New Tests” (2002) 86:2 Journal of Public Economics 263-86; and Ralf Hepp
and Jürgen von Hagen, “Fiscal Federalism in Germany: Stabilization and Redistribution Before
and After Unification” (2012) 42:2 Publius: The Journal of Federalism 234-59.
50 Mélitz and Zumer, supra note 49.
538  n  canadian tax journal / revue fiscale canadienne (2018) 66:3
​(Y - TAX + DISB)​  it​​
1 n ​​​​​ _____________ 1 n ___ ​Y​  it​​
​​ __
n ​​ *​​  ∑   
​   ​​ = α + β ​​ _
n ​​ *​​∑ ​​​  ​  ​Y​  t ​​​  + ​ε​  i ​​​, (1)
t= 1 ​(Y - TAX + DISB)​  t​​ t=1

where
y is per capita state income before central taxes and disbursement;
tax and disb are per capita central taxes and disbursement, respectively;
subscript i refers to individual states while variables without subscript i refer to the
national average; and
subscript t refers to the year, which ranges from 1 to n.

To calculate the variables used in equation 1, the state-specific annual observa-


tions are first converted to state-relative form (with the all-state average acting as a
denominator for each year). These annual observations are averaged over the time
period n. Under the balanced budget approach, used here, the sum total of fiscal
balances for all states is equal to zero. Hence, (Y - TAX + DISB)t and Yt (referring to
the national average) in the denominator are equal for all 29 states for a particular
year, though they would vary over time. The difference between unity and the β
coefficient represents the size of the offset to initial income disparities caused by
fiscal flows. For example, a coefficient of 0.8 indicates that 80 percent of the initial
difference in relative income remains even after the federal fiscal redistribution,
with a 20 percent offset in initial regional income inequalities. Regressions were
carried out separately for each of the three five-year periods to reveal intertemporal
trends. To account for substantial interstate variation in the population of the states,
regressions were weighted by population.
Table 5 provides regression results using equation 1. It is possible to estimate the
marginal impact of each channel of interregional fiscal flows on the reduction in
regional income inequalities. This can be measured by a step-wise adjustment to the
state income through each fiscal channel.51 Hence, four regressions were run for
each five-year period with the same independent variable, but the dependent vari-
ables were calculated with a four-step adjustment to the state income in the
numerator. The “Impact” column in table 5 shows the marginal contribution of
each fiscal channel in reducing income disparities, which is calculated as the rise in
(1  −  β) coefficient against the previous row. In the first five-year period (2001-
2005), federal taxation could offset 19.0 percent of initial income disparities. The
1 − β coefficient for central taxes combined with transfers through the state budget
turned out to be 0.203, thus suggesting an additional 1.3 percent reduction in
income inequalities through the second channel. However, the role of local goods
and public goods provision by the central government seems to be in the reverse
direction, with an overall reduction in income inequalities of only 10.0 percent
during 2001-2005. Component level trends are similar for the other two five-year

51 Bayoumi and Masson, supra note 48.


interregional fiscal flows and horizontal fiscal equalization in india  n  539

Table 5  Regression Results for Reduction in Income Inequalities, India, 2001-2015


2001-2005 2006-2010 2011-2015

Adjustment to tax base 1 − β Impact R 2 1 − β Impact R 2 1 − β Impact R2

Central taxes . . . . . . . . 0.190 0.190 0.99 0.208 0.208 0.99 0.205 0.205 0.99
(0.027) (0.026) (0.031)
+ Transfer through
state budget . . . . . . . 0.203 0.013 0.97 0.220 0.012 0.97 0.218 0.014 0.97
(0.032) (0.030) (0.035)
+ Local goods . . . . . . . 0.157 −0.046 0.97 0.189 −0.031 0.97 0.192 −0.026 0.97
(0.029) (0.030) (0.035)
+ Public goods . . . . . . 0.100 −0.057 0.97 0.139 −0.050 0.97 0.146 −0.046 0.97
(0.029) (0.030) (0.035)
Total . . . . . . . . . . . . . .   0.100     0.139     0.146  

Notes:
Values in parenthesis denote standard error.
Impact columns may not add to totals because of rounding.

periods, though the reduction in income inequalities improves to 14.6 percent in


the third period.
In comparison with the above estimates, the literature from developed countries
provides evidence for a relatively higher offset in the initial inequalities in those
countries. Bayoumi and Masson estimated the offset in regional inequalities of per-
sonal income to be 22 percent and 40 percent for the United States and Canada,
respectively. They also measured the impact of federal fiscal redistribution on
inequalities in gdp for the Canadian provinces at a lower level (30 percent) than the
impact on personal income. They justified this finding on the ground that fiscal
policy is expected to equalize personal income rather than other components of the
gdp such as corporate income.52 Mélitz and Zumer measured the reduction in
regional inequalities for the United States and Canada and found it to be 21.3 and
30 percent, respectively, for personal income, and 13.6 and 22.6 percent, respect-
ively, for gdp.53 This supports the argument that the overall tendency of a reduction
in inequalities through fiscal redistribution is greater for personal income than for
gdp.
A reduction in income inequalities comparable to that in North American coun-
tries has also been found in the European context. Mélitz and Zumer have
estimated the reduction in personal income inequalities to be 38 percent for France

52 For their analysis of the impact on personal income inequalities, Bayoumi and Masson focused
on tax-transfer channels related to personal income along with grants to subnational
governments. For the analysis of inequality reduction in provincial GDP, corporate income tax
was taken into account, but direct expenditure was not considered. Ibid.
53 Mélitz and Zumer, supra note 49, at 280-82.
540  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

and 26 percent for the United Kingdom. Other studies have found the reduction in
regional inequalities in gdp to be 32 percent for Spain54 and 40 percent for Ger-
many.55 Interestingly, researchers across the developed world have consistently
found the expenditure side rather than taxation to be the main channel of redistri-
bution. For example, taxes and social insurance contributed to nearly 35 percent of
the total reduction in inequalities for Canada and the United States.56 The remain-
ing 65 percent reduction in inequalities was achieved through transfers and grants.
However, table 5 suggests that the regional redistribution in India is largely driven
by taxes, with a small contribution by transfers/grants to the state governments.
The contribution of direct federal spending to the cause of redistribution, if any, is
negative.
The results showing the taxation side rather than the expenditure side as the
main channel reducing regional inequalities in India need to be seen in the context
of the country’s wide regional disparities. As shown in table 1, regional disparities in
India are far greater than those in most developed countries. While in the developed
countries, the contribution of provinces to federal taxes generally varies on the basis
of provincial income, this variation would be less in comparison with India. In the
Indian scenario, even at a proportional rate, an average resident of Maharashtra
pays five times more taxes than an average resident of Bihar. We can presume a
baseline scenario, where federal disbursements are made on an equal per capita basis
while being funded by proportional taxes. In terms of regression analytics, an equal
amount would be added on the expenditure side of all states, which would yield a
zero coefficient with respect to initial income level (the entire impact would be
absorbed by the constant). However, on the taxation side, unequal amounts would
be deducted, where a much greater reduction would take place for the higher-
income states, thereby yielding a negative coefficient with respect to initial income
level. Relative income gaps will decrease more owing to unequal (though propor-
tional) taxes rather than owing to equal expenditures.
The above argument, along with figure 1, can be used to explain the differences
in sources of reduction in regional inequalities for India compared to the developed
countries. In figure 1, the 17 major Indian states are arranged on the horizontal axis
in ascending order of per capita income (measured as the average of state income
relatives over the 15-year period of the study). The state relatives’ levels for all four
channels of central fiscal redistribution are measured on the vertical axis, where the
per capita national average for each of the variables is 100. Per capita taxation
increases with income, with Maharashtra contributing the highest level of taxes.

54 Ramón Barberán, Núria Bosch, Antoni Castells, and Marta Espasa, The Redistributive Power of
the Central Government Budget, IEB Working Paper 2000/6 (Barcelona: Institut d’Economia de
Barcelona, 2000).
55 Hepp and Hagen, supra note 49, at 234.
56 Bayoumi and Masson, supra note 48, at 260; and Mélitz and Zumer, supra note 49, at 280-82.
interregional fiscal flows and horizontal fiscal equalization in india  n  541

FIGURE 1 Pattern of Central Transfers, Expenditure, and Taxation


for Major Indian States, State Relative Average for 2001-2015
270
State relatives to national average

240

210

180

150

120

90

60

30
r a l a du ala rat jab tra na
ha esh nd am esh ss arh an ga esh ak
Bi rad rkha Ass rad Ori ishg jasth Ben rad rnat il Na Ker uja Pun rash arya
P a P t a
R est ra P G a
tar Jh hy
a ha Ka Tam ah H
Ut ad Ch W ndh M
M A
Through state budget Local goods Public goods Central taxes

Note: The horizontal axis shows the states in ascending order of per capita income. The vertical axis
shows per capita value of the relevant variable as the state relative to the national average (national
average = 100 for the particular variable).
Only major states, accounting for 95 percent of the Indian population, are shown here.

Progressivity is also visible for transfers through the state budgets, with Assam (an
scs) getting the highest per capita transfers. In the regression analysis, the impact
of both the taxation and transfers through the state budgets would have a negative
coefficient with respect to initial income.57 However, the magnitude of the coeffi-
cient would be greater for taxation than for transfers. This is because of two factors.
First, the larger absolute size of central taxes compared to transfers through the
state budgets enables the former to make more of a dent in inequalities. Second, this
opportunity is materialized as well because the taxation side on its own is more
progressive than the transfers. The ratio of per capita taxes for Maharashtra and
Bihar is 6.6:1 compared to only 1.8:1 for transfers through the state budgets. In
addition to the initial income differential, the greater share of the formal sector
in Maharashtra and Karnataka plays a crucial role in improving the progressivity of
the taxation side.
The distribution of central expenditure on public goods and local goods is
regressive, such that Punjab and Haryana get a high share in local goods, mainly

57 Taxes are positively correlated with income level, but they need to be deducted from the initial
income.
542  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

through subsidies. Hence, the contribution of public and local goods to the β coef-
ficient with respect to initial income can be expected to be positive (of a regressive
nature). In the case of Canada and other developed countries, smaller regional
income inequalities lead to lower variation in taxation. Further, regionally relevant
expenditures by the federal government in these countries operate through trans-
fers to provinces and individuals, which are explicitly progressive (for example,
targeting unemployed individuals and seniors). With the combination of wide
regional income inequalities, proportional or somewhat progressive taxation, and
regressive expenditure, the taxation side emerges as the main channel of regional
fiscal redistribution in India.
The regressive nature of the interstate allocation of public goods is an outcome
of the approach described above for allocating this component among states. The
allocation of public goods in proportion to state income is bound to give a higher
share to richer states. The impact of public goods on the β coefficient would essen-
tially reflect the size of public goods as a share of gdp. Had public goods been
allocated on the basis of population, the β coefficient for local goods and public
goods in table 5 would have been exactly the same. This is so because the equal
per capita benefit of public goods would have zero correlation with per capita
income. Hence, its impact on regression would be accumulated into a higher con-
stant. Having noted the redistributive implications of the two approaches for the
allocation of public goods, readers have a choice between the two coefficients (the
step 3 regression covering central taxes, transfers through state budgets, and local
goods in the dependent variable versus the step 4 regression for which the depend-
ent variable also includes public goods allocated on the basis of per capita income).
Those preferring to allocate public goods on a per capita basis can take the former
as the overall reduction in income inequalities.
The above discussion suggests that, despite the contribution by donor states at
levels comparable with those in the developed European countries, federal fiscal
redistribution in India fails to make any significant dent on the disparities in region-
al income. The failure to reduce income inequalities through federal fiscal
redistribution can be explained by two factors. First, roughly 60 percent of the
Indian population lives in the recipient states; thus, there are few donors and many
recipients. Second, there are wide disparities in income levels, with the average
per capita income of the donor states being twice the average of the recipient states.
The net fiscal contribution of about 6 percent of gdp by the donor states is too
meagre to make a dent in such large income inequalities. This entire discussion
suggests that federal redistribution cannot be used in India for reducing regional
income inequalities. The only way to address the regional imbalances is to improve
productivity and growth performance in the poorer regions.

Fiscal Capacity Equalization


The most important purpose of the federal fiscal redistribution is to ensure hori-
zontal fiscal equity. By replacing income with relevant fiscal indicators, equation 1
interregional fiscal flows and horizontal fiscal equalization in india  n  543

can be modified to estimate the extent of the reduction in horizontal fiscal inequal-
ities that is achieved through fiscal redistribution. This is shown in equation 2:

n ​Fiscal  position​  ​​
1 n ____________ ​Fiscal  capacity​  it​​
​​  n1 ​​  *​​  ∑ ​​​  ____________
_ ​  it
= a + b ​ _
 ​  n ​  *​  ∑ ​​​  ​  ​Fiscal  capacity​   ​​​  
+ ​e​ i ​​, (2)​
t=1 t ​Fiscal  position​  ​​
t=1 t

where
fiscal capacity is per capita own-tax revenues collected by the state at the represent-
ative tax rate (the effective own-tax rate for all states taken together)58 plus per
capita revenues collected from the state by the centre;
fiscal position is fiscal capacity plus per capita net federal fiscal flows (inflow +/
outflow −), which also equals the state’s own taxes plus all central disbursement to
the state, both on a per capita basis;
subscript i refers to individual states while the variables without subscript i refer to
the national average; and
subscript t refers to the year, which ranges from 1 to n.

In the base scenario with no federal fiscal redistribution, fiscal capacity can be
taken as an indicator of resource availability for the regional governments by assum-
ing that taxes at present collected by the centre could potentially be collected by the
states. However, the total government expenditure departs from the base scenario
because of federal fiscal redistribution. The poorer states receiving net fiscal inflows

58 The variable fiscal capacity for a state (the independent variable in equation 2) can be constructed
as either of two concepts: (1) the sum of the state’s own-tax collection plus taxes raised from the
state by the centre, or (2) the sum of the state’s own taxes that it would raise at the representative
tax rate plus taxes raised from the state by the centre. The former suffers from the bias that
may arise because of the lower or higher own-tax effort by certain states. Here, the state’s laxity
in own-tax effort would result in lower assessed fiscal capacity, thus requiring compensation
through the central transfers for fiscal equalization. To avoid such biases, Bird suggested the
use of a representative tax rate for measuring the state’s own revenue resources while analyzing
the issue of horizontal fiscal capacity equalization: Richard M. Bird, “Threading the Fiscal
Labyrinth: Some Issues in Fiscal Decentralization” (1993) 46:2 National Tax Journal 207-27.
The same approach has been used by Bird and Tarasvo, supra note 3, in a cross-country
analysis, and by Rangarajan and Srivastava for the Indian context: C. Rangarajan and D.K.
Srivastava, “Reforming India’s Fiscal Transfer System: Resolving Vertical and Horizontal
Imbalances” (2008) 43:23 Economic and Political Weekly 47-60. This approach is also consistent
with the prescription by Buchanan, supra note 10, for enabling states to equalize the “fiscal
residuum” for comparable residents across the nation. This requires equalization of capacity at
a representative tax rate rather than equalization of the actual revenues of subnational
governments, thus enabling the provision of comparable public services at a comparable tax
rate. Following these recommendations, in the present article own-tax revenues of the states
are measured at a representative tax rate rather than the actual tax rate levied by the state. The
effective own-tax rate for all states taken together is used as the representative tax rate.
544  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

can have a higher consolidated government expenditure (combined expenditure by


central and state governments) than the limits set by their own fiscal capacity. The
reverse is true for the richer states. The β coefficient continues to have a similar
interpretation—that is, the percentage of initial regional fiscal inequalities present
even after federal redistribution. The step-wise regressions were carried out in a
manner similar to that used for regressions for income inequalities (table 5). Four
regressions for each of the three five-year periods were carried out with adjustments
in the numerator of the dependent variable.
The results are reported in table 6. Central taxes again dominate, reducing
76-77 percent of the existing horizontal fiscal inequalities in all three periods.
Transfers routed through the state budgets make a further dent of 5-6 percent in
fiscal inequalities. The distribution of central expenditure on local goods and public
goods partially erases the gains made in the reduction of fiscal inequalities. The
logic for taxation rather than disbursement emerging as the main channel for redis-
tribution is the same as discussed in the case of income inequalities.
As discussed above, a population-based allocation of public goods will lead to
exactly the same β coefficient for the step 3 and step 4 regressions. Here, the reduc-
tion in fiscal inequalities will be estimated at a higher level. For example, if
population is used for the allocation of public goods, a β coefficient of 0.354 for the
first five-year period will suggest a reduction of fiscal inequalities by 64.6 percent
(step 3). However, a β coefficient of 0.559 will suggest a 44.1 percent reduction
in fiscal inequalities if income is used for the allocation of public goods. As expected,
an income-based approach for allocating public goods provides conservative estimates
of the reduction in inequalities. Even under conservative estimates, the reduction in
fiscal inequalities is estimated to be 44.1 percent in the first period, increasing to
59.4 percent by the third period. Clearly, central fiscal policy is playing an import-
ant role in reducing interstate fiscal disparities.

Scope, Limitations, and Policy Implications


At this juncture, it is pertinent to give some space to the scope, limitations, and policy
implications of the estimates. In this article, the terms “benefits” and “burden” are
used interchangeably with “expenditure” and “taxation” on the basis of their link-
ages through regional incidence. While this is an accepted practice in the available
literature, there are limitations to finding perfect linkages between incidence and
expenditure/taxation. Moreover, the incidence approach can capture the regional
dimensions of the benefits/burden only in a static sense. In the long run, interstate
migration, intergenerational transfers, and regional terms of trade can be substan-
tially influenced by federal fiscal activities. In such a scenario, the richer regions also
benefit from government expenditure made in the poorer regions, while net fiscal
benefits, estimated as federal fiscal balances, may potentially harm the poorer
regions.59

59 Klaus Desmet, “A Simple Dynamic Model of Uneven Development and Overtaking” (2002)
112:482 Economic Journal 894-918.
interregional fiscal flows and horizontal fiscal equalization in india  n  545

Table 6  Regression Results for Reduction in Fiscal Inequalities, India, 2001-2015


2001-2005 2006-2010 2011-2015

Adjustment to tax base 1 − β Impact R 2 1 − β Impact R 2 1 − β Impact R2

Central taxes . . . . . . . . 0.756 0.756 0.93 0.772 0.772 0.92 0.763 0.763 0.89
(0.027) (0.020) (0.025)
+ Transfer through
state budget . . . . . . . 0.820 0.064 0.17 0.827 0.055 0.25 0.824 0.062 0.27
(0.043) (0.034) (0.037)
+ Local goods . . . . . . . 0.646 −0.174 0.36 0.720 −0.107 0.36 0.741 −0.084 0.34
(0.071) (0.064) (0.059)
+ Public goods . . . . . . 0.441 −0.205  0.56 0.554 −0.167 0.57 0.594 −0.147 0.52
(0.076) (0.071) (0.070)
Total . . . . . . . . . . . . . .   0.441     0.554     0.594  

Note: The values in parentheses denote standard error.

Despite expenditures on local goods taking place in a particular region, there can
be substantial interregional spillover of the benefits from government expenditure,
especially in an open federal economy. For example, the construction of roads in the
poorer states also benefits the richer regions by providing them access to markets.
Similarly, the provision of health and education in the poorer regions benefits the
richer regions through the flow of human capital from poorer to richer regions.
These human capital flows can be crucial in developing an industrial and service
base in the richer regions, which provide taxes to the government. One can clearly
see evidence of such spillovers in the form of a globally competitive information
technology sector in Indian cities such as Bangalore, Hyderabad, and Gurugram.
These cities house a highly educated workforce coming from the entire nation.
Such spillovers are diffuse and complex, and require substantial research for meas-
urement at both the conceptual and the empirical levels. Recalling the debates on
the “brain drain” in the international context, the flows can be even more substan-
tial in an open federal system. The estimates of fiscal flows measured in this study
will help researchers in examining the static and dynamic impacts of federal fiscal
redistribution.
A word on the scope of the study is in order. Virtually anything done by a federal
government could have some redistributive consequences. However, federal fiscal
balances are concerned solely with the fiscal side of the central government. Other
federal government domains, such as regulation, trade policy, industrial policy, and
natural resource policy, also have implications for interregional resource flows.60

60 For example, many poorer states in India have abundant mineral resources, which are mainly
used in the richer states at prices lower than those in international markets. Control by the
central government of natural resources and their pricing allows it to engage in interregional
resource flows by favouring high-income states. Similarly, trade policy on the agriculture and
fertilizer industry can be used to levy implicit taxes or subsidies on farmers and industry,
respectively (Gulati and Narayanan, supra note 24).
546  n  canadian tax journal / revue fiscale canadienne (2018) 66:3

This is particularly so in developing countries, where the public sector orientation


could be heavily focused on development through pses rather than redistribution
through the tax-transfer system. The study period of 2001-2015 belongs to the
post-liberalization phase in the development of India’s economy, which witnessed a
reduction in government involvement in the provision of private goods and services.
However, pses, particularly those operating in the natural resources, transportation,
and banking sectors, still engage in regional cross-subsidization. This article covers the
fiscal support given by the central government to these pses. Cross-subsidization is
considered an internal subject of pses, and is certainly important as a matter of
public policy, but is beyond the scope of this article.
A brief comment is required on the concept of fiscal equalization. It should be
noted that the data on federal taxes and transfers are presented as absolute nominal
amounts rather than in real terms. It is widely accepted that price levels are usually
lower in the poorer regions. Hence, the fiscal equalization achieved in real terms
should be higher than the nominal equalization of 60 percent as estimated in
table 6. The actual extent cannot be measured without having data on the purchas-
ing power of the Indian rupee across states. Further, an argument can be made
regarding the real cost of providing government services. Theoretically, the real
cost per unit of providing government services should be lower in the poorer states
if one allows for the famous Baumol’s cost disease.61 Wages constitute roughly
65 percent of the government final consumption expenditure in India, which should
be linked to productivity and wages in the non-government sectors of the economy.
Given the lower productivity and wages in the non-government sectors of the
poorer regions, the real wages in the government sector should also be lower than
those observed in high-productivity regions. However, this theoretical argument
for having lower nominal and even real wages for the government sector in the
poorer regions largely does not hold in practice for political reasons. The way in
which fiscal flows are being used in the recipient states is as important as the quantum
of flows itself. Fiscal flows certainly enable the poorer states to provide a larger size
of government in terms of nominal expenditure. Policy makers need to translate this
into a larger size of real government—that is, more government services in terms of
quantity.

Conc l u s ion
The primary focus of this article has been the measurement of interregional fiscal
flows in India. To avoid double-counting and to control for the fiscal deficit, the
primary federal fiscal balances are calculated with a balanced budget approach. The
estimates offer interesting insights on the magnitude and directions of fiscal flows.
The size of interregional fiscal flows accounts for approximately 6 percent of the

61 William J. Baumol and William G. Bowen, Performing Arts: The Economic Dilemma: A Study of
Problems Common to Theatre, Opera, Music and Dance (New York: Twentieth Century Fund,
1966).
interregional fiscal flows and horizontal fiscal equalization in india  n  547

income of the donor states, which is comparable to the numbers observed in developed
federal countries in Europe. In spite of this, the flows do not translate into compar-
able reductions in regional income inequalities. Roughly, 40 percent of the Indian
population lives in the donor states, providing fiscal resources to the rest of the
country. Further, the Indian federal system is marked by substantial regional dis-
parities, with the average per capita income in the donor states being twice the
average for the recipient states. With a small donor base and wide regional disparities,
it is difficult for fiscal redistribution to succeed in reducing regional income
inequalities. However, fiscal flows are successful in making a substantial dent in
interstate fiscal disparities, to the extent of addressing 60 percent of the gap. Inter-
estingly, in contrast to the literature on the developed countries, federal taxation
rather than expenditure emerges as the main channel of interregional fiscal redistri-
bution in India. This finding is an outcome of the combination of wide regional
income inequalities, proportional/somewhat progressive taxation, and regressive
interstate distribution of federal expenditure.