Chapter-4: Reconciling Fiscal Federalism and Accountability: Is there a Low Equilibrium Trap?

In this chapter, Economic survey calls for fiscal federalism and accountability to avoid the so called “low equilibrium trap”. The key points from this chapter are as follows:

What is the so called “Low Equilibrium Trap”?

A poor person can lift himself out of poverty if he is able to save / invest part of what he earns. However, if that person is so poor that no part of his income can generate any saving or investment, then it’s quite obvious that he would always remain hand to mouth. There is equilibrium in his life that he earns→consumes→earns but such equilibrium is also a trap, which does not allow him to come out of his poverty. Such equilibrium was called a low equilibrium trap by Richard R Nelson.  Accordingly, at low levels of income, people are so poor to save and invest, resulting into low rate of growth of national income. The national income can rise only when people have income higher than some level which allows them to save and invest.

What are survey observations on so called Low Equilibrium Trap?

The survey uses this term not for individual poverty but the poverty of our third tier of governance i.e. the local bodies. We all know that local rural and urban bodies have very low collection of taxes and most of them depend upon the grants by central / state governments for their financial resources. This is true for local bodies in almost all states of India. The key survey observations on this front are as follows:

• In India, panchayats receive 95% of their revenues from the devolved funds from centre / state while generate only 5% of revenue from their own resources. This situation is very poor in some states like UP where almost all funds are based on devolution and panchayats not generating any revenue on their own.
• Most state governments have not devolved enough taxation powers to the Panchayats. Some states have given these powers but collection is low and despite of the powers to collect taxes, such panchayats are lazy enough to wait for devolved funds only.

The low level of tax collection by local bodies has put them into a low equilibrium trap and this is detrimental for fiscal federalism and accountability in the country.

Not only local bodies, the survey points that – such low equilibrium trap is with states also in  relation to the direct taxes.  In India, the states generate only 6% of their revenue from direct taxes while this figure stands 19% for provinces in Brazil and 44% in Germany. Only solacing point is that the urban local bodies are able to generate revenues for themselves equivalent to international standards. Quoting Rabindranath Tagore, survey points that fiscal decentralization captures the idea that spending and tax decisions must reflect local preferences as far as possible. Thus, future discussion on fiscal federalism should consider this hard reality of India.