Finally, various ministries give grants to their counterparts in the states for specified projects, either wholly funded by the center (central sector projects) or requiring the states to share a proportion of the cost (centrally sponsored schemes). Both these categories are reported together as central schemes.

The ostensible rationale for these programs is financing activities with a high degree of inter-state spillovers, or which are merit goods (e.g., poverty alleviation and family planning), but they are often driven by pork-barrel objectives.

These projects are supposed to be monitored by the Planning Commission, and coordinated with the overall state plans but both monitoring and coordination are relatively ineffective.

There are over 100 such schemes, and several attempts in the past to consolidate them into broad sectoral programs have not been successful. These programs have provided the central government with an instrument to actively influence states’ spending, replacing the pre-1969 plan transfers in this role.


The proliferation of schemes may also have increased the size and control of the bureaucracy. While the NDC recently appointed an investigative committee that recommended scaling down and consolidating centrally sponsored schemes, implementation of this objective was weak.

While the specific purposes and matching requirements of central and centrally sponsored schemes make them potentially an important channel for dealing with spillovers, as noted, the implementation of these schemes has been problematic, with the issues including lack of transparency, poor selection of projects, and ineffective monitoring.

Nevertheless, the discretionary aspect of these intergovernmental transfers has made them attractive to central ministries, and, their relative importance in overall transfers has increased.

Loans and Guarantees


In addition to explicit transfers, intergovernmental loans, to the extent that they are subsidized, also constitute implicit transfers to sub national governments. Ideally, borrowing should be to finance investment, but state governments have increasingly used borrowing to meet current expenditure needs (now approaching 50 percent).

State governments can only borrow from the market with central government approval if they are indebted to the center, and this constraint binds for all the states.

Central loans now constitute about 60 percent of the states’ indebtedness, with another 22 percent being market borrowing, and the remainder made up of pension funds, shares of rural small savings, and required holdings of state government bonds by commercial banks (Rao and Singh, 2002; Srinivasan, 2002). While these captive sources of finance are limited, the states have been able to soften their budget constraints further by off-budget borrowing or nonpayment by their public sector enterprises (PSEs). For example, the State Electricity Boards (SEBs) have been tardy in paying the National Thermal Power Corporation, a central PSE (Srinivasan, 2002).

Other sources of softness in state government budget constraints include central government guarantees of loans made to state government PSEs by external agencies, and central forgiveness of past loans made to state governments, presumably to gain political advantage.


Even in the case of attempts to impose conditions on state borrowing that would encourage fiscal reforms, the center has not been able to harden budget constraints. In particular, in 1999-2000, eleven states signed Memorandum of Understanding (MOUs) with the center, promising fiscal reforms in exchange for ways and means advances (essentially, overdrafts) on tax devolution and grants due to them.

In some cases, however, the center has had to convert these advances into three-year loans. The Reserve Bank of India (RBI) reports stopping Dayments to three states (Reserve Bank of India, 2001), but the political difficulty of not bailing out states that are both poor and populous is obvious.

In the 1990s, India has struggled with high fiscal deficits and the states have contributed significantly to this problem after 1997-98. Several states have also followed the center’s lead in passing Fiscal Responsibility and Budget Management Acts to set targets for deficit reduction, and recently the Ministry of Finance has released a report outlining a roadmap for achieving deficit reduction targets.

In addition to reforms in tax and transfer systems as ways of reducing sub national fiscal deficits, an important area of reform relates to the process of borrowing by the states, which has hitherto been ad hoc and opaque. Improvements in financial information, budgeting practices, regulatory norms and monitoring are all required here, as well as changes in the institutional rules.


These reforms parallel many of those required for the financial sector as a whole: state governments just happen to be among the most powerful among those taking advantage of poorly functioning credit markets to run up unpaid debts. Some reform is already taking place, including statutory or administrative borrowing ceilings, guarantee redemption funds, explicit restructuring and write-offs, and market-based borrowing mechanisms such as auctions conducted by the RBI.

Another approach to the states’ indebtedness and continued high fiscal deficits has been to tie some portion of intergovernmental transfers to state-level fiscal reforms.

The Eleventh Finance Commission worked out a scheme by pooling 15 per cent of revenue deficit grants and adding an equal amount to it to create an incentive fund to be allocated among the states based on fulfillment of targets of growth of tax and non-tax revenues and expenditures on salaries, interest payments and subsidies, as set in the fiscal restructuring plan detailed by the Commission.

The incentive fund has been allocated to the states according to their population shares. A state will get its full amount if it fulfils the specified targets of the monitor able measure (revenue deficit as a percentage of total revenue receipts of the states) evolved for the purpose, with graduated rewards for partial fulfillment. However, the potential problems with this scheme include the relatively small size of the incentive fund, biases in the monitor able measure against smaller and poorer states, conflicts with other fiscal incentive programs, and opportunities for moving deficits off budget to manipulate the program outcomes. One might also simply argue that India’s intergovernmental transfer system is already complex and overburdened with multiple objectives: this theme is reprised in the next section.