THE EFFECT OF CENTRAL FINANCIAL TRANSFERS ON TAX EFFORTS OF STATES IN INDIA: A PANEL DATA ANALYSIS

Abstract

Central government financial transfers and states’ own tax revenue is interlinked as the transfer policies may encourage or discourage the own tax effort of the states. This paper analyses the effects of central transfers on states’ own own tax revenue, using panel data for l5 major states from 1980-81 to 2019-20 applying panel fixed effects and random effects regression methods. The estimated results show a negative relationship between central transfers and grants and the own tax efforts of the states, indicating revenue substitution by states. More central government assistance means less dependence on own tax revenue dampening the states’ revenue mobilisation efforts. The existence of a strong positive relationship between NSDP per capita and state tax revenue shows the high tax potential of the states. The incentive criterion for tax effort as used both in the finance commissions devolutions and in the Gadgil formula used by the planning commission is not reflected in the federal system of India. The central transfers adversely affect the incentives to states to mobilise their own resources and fail to induce a desired positive revenue generation in states.