Central Fiscal Transfers and States' Spending In India: An Analysis of Incentive Effect

The paper examines the incentive effects of federal fiscal transfers on states' spending in India. To this end, a panel data set for 22 states for the period 1980-81 to 2004-05 is used; and fixed and random effect panel regression models are employed. Per capita resource transfers in channel specific and in aggregate terms from the Centre are found to be significant and positively associated with states' aggregate expenditure, revenue expenditure and capital disbursements in per capita terms. The ratio of revenue expenditure to own revenue receipts of states in percent is also significant and positively related to per capita resource transfer. Further, the results validate fly paper effect in Indian context. The findings suggest that central transfers not only have stimulatory effect on states' spending but also they have disincentives on expenditure economy of states. The paper calls for reexamining the design of transfers and the ratio of lump-sum transfers to specific purpose transfers in order to address the adverse incentives.