The Political Economy of Center-State Fiscal Transfers in India

India’s federal system is distinguished by tax and expenditure assignments that result in large vertical fiscal imbalances, and consequent transfers from the central government to the state governments. Several channels are used for these transfers: the Finance Commission, the Planning Commission, and central government ministries. The transfers include statutory tax sharing as well as various categorical and block grants. While predetermined formulas are used for some transfers, there is considerable discretion in allocating other classes of transfers. In this paper, we use panel data on center-state transfers to examine two broad classes of hypotheses: (i) the economic importance of the states, measured by the state domestic product, influences the level and the composition of per capita transfers to the states; (ii) the political importance of the states, measured by their importance in the ruling coalition, and by whether the ruling party at the central and state levels is the same, influences the level and the composition of per capita transfers to the states. We control for variables such as population and per capita income in the panel regressions, and for state fixed effects, although population can also be considered a measure of political importance. We do find evidence supporting the bargaining view of federalism, as manifested in the result that states with indications of greater bargaining power seem to receive larger per capita transfers.