January 1, 2010

More states, not satrapies

On average, smaller states in India have better governance indicators like infrastructure, law and order, and anti-poverty programmes—according to research done by Bibek Debroy and Laveesh Bhandari. The finding in itself is not surprising. Andhra Pradesh, from which a new Telangana state is to be carved out, has a population greater than that of the United Kingdom (and the UK itself consists of 4 countries, multiple regions, and hundreds of districts). Uttar Pradesh—even after the state of Uttaranchal was spun off—has a population greater than that of the UK, France and Spain combined. Setting aside the political shenanigans around the creation of new states, it is reasonable to argue that India would do better with more states, even if we do not know the optimal number or average size at which to stop.

The real benefit of new states, however, would be achieved if they are allowed to be fiscally autonomous. The more the number of states, and the freer they are to set their own taxation and spending policies, the more policy innovation and efficiency we will have. This would in turn force the laggard states to shape up, as the revenue base erodes due to the migration of taxpayers and industries. According to M Govinda Rao, director of the National Institute of Public Finance and Policy, a thorough review of fiscal federalism for today’s market economy is urgently needed. He notes that the “fiscal arrangements in India have evolved in a quasi-federal system to meet the requirements of centralised planning in a mixed economy framework.” And, while fiscal centralisation—that is, redistribution from richer to poorer states through the Union government—has had an “equalising impact, it has [created] disincentives for fiscal management.”

That is why the Union government should not generously fund states. It could fund occasional capital investments like infrastructure in poorer states to “jump-start” them, and then let migration across states equalise incomes. To the extent that it does redistribute wealth across states, New Delhi should rely more on block grants with a carte blanche regarding policy innovation. It could also supplement this with limited, national means-tested welfare plans (in cash or in kind) to bypass the state governments completely. Means-tested plans would automatically help the poorer regions more but will not create disincentives for fiscal prudence on the part of the states.

Unfortunately, the debate on state size stops with economic viability and state capacity, before considering fiscal autonomy. This is revealing of the top-down mentality of governance in India. States, however, are not meant to be just effective implementers of policies that are de facto, if not de jure, fashioned in New Delhi. Yet, they are hardly free to formulate their own policies, and definitely not so when these policies are radically different from the central policies on the same issue (despite all constitutional pretensions of federalism). Why? Because he who pays the piper calls the tune. One look at the budgets of state governments, and one can see New Delhi’s imprint all over.

On the revenue side for states, we have consumption taxes, whose rates are significantly affected through New Delhi’s fiscal carrots and political sticks. Even the remaining independence to set rates will completely go if and when the uniform-rate-throughout-India version of the Goods and Services Tax (GST) comes into force. Other internal revenue sources are distortionary levies and octroi which are being gradually withdrawn, and the states cannot tax income or profits. Therefore, they end up relying on block grants from the Union government based on their size and per-capita income or policy-specific matching grants. While block grants are the most efficient federal transfers, but they still induce dependance on the Union government.

But such matching grants contribute to the expenditure side also, as the state must increasingly spend on the New Delhi’s welfare programs. If they do not, they either stand to lose substantial matching grants (as in the Sarva Shiksha Abhiyaan education scheme, where 50 to 85 percent of the funding comes from the Union government) or end up paying fines and mandated benefits (for example, not implementing the National Rural Employment Guarantee Scheme means losing central grants, even if the mandated wage is above the local market wage). Such matching grants should be used by New Delhi only to remove existing distortionary policies (like they were used to repeal rent control laws), otherwise they create incentives for states to spend on locally unsuitable policies. Other state expenditures include salaries of state officials which must be raised in tune with those of Union government officials. In any case, why should state leaders indulge in real fiscal austerity when they effectively cannot cut sales tax rates to get some political cover?

If a state is actually allowed to set its own policies, it must perforce be economically viable and administratively efficient. If it has a deficit, it must raise taxes or reduce spending or both. States, unlike the Union, cannot print money, so state bonds would be effective only in rolling over limited debt.

However, many civil servants and intellectuals still intone about how best to help the “masses” in far-away poor states. They do not remember that centralised policies are what kept many states poor by preventing them from exploiting their comparative advantage. For example, it is amusing to hear many Communists complain, without a hint of irony, that New Delhi’s “freight equalisation” policies—the effective nationalisation of the transportation of mineral resources—led to the de-industrialisation of West Bengal.

For governance to improve in India, and for deficits to be controlled, it is necessary to limit the Union government and empower local governments—especially the state governments. With fiscal autonomy comes responsibility, and this combined with a greater number of states, results in more competition and efficiency. That is why we need more states and more autonomy. Rather than adopting more technocratic and centralised solutions, India must have a debate about the first principles of Indian federalism and then translate them into policy reality.

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