Introduction

The last few decades saw widespread fiscal decentralization across the world. Although in most cases decentralization would be partial, which means that although the local governments are given large responsibility, powers related to revenue collection were vested with the central government. Policy autonomy of local governments is greatly reduced by this type of decentralization. Studies have shown that partial decentralization have many flaws ranging from reduced accountability and incentives to pursue sound economic policies, increased rent-seeking and corruption, soft-budget constraints, to clientelism in the allocation of transfers.

Panchayats in India raise very little revenue of their own and depend mainly on transfers from above, which come in the form of block grants and a multitude of earmarked grants for specific purposes. The overall question addressed in this chapter is: how can the very low levels of own revenue-raising of panchayats be increased via changes in devolution of functions and resources, from higher levels and in the autonomy given to use the panchayats over the use of the funds?

Devolution of functions, the level of transfers, and autonomy over the use of transfers will provide positive or negative incentives to raise taxes, the incentives effect of transfers. They can either crowd out own revenue-raising, or make it more attractive in order to complement the transfers. For example, a transfer for education may crowd out revenueraising for local schools, or unrestricted block grants may provide incentives to do even more, as the public expenditure pattern can now conform more closely to the preferences of the village community.

However, the transfers can also affect the tax base and therefore revenues. This chapter uses profits per capita from farm and non-farm enterprises as the tax base. If grants are for public works or employment generation programmes, they will generate employment and, therefore, tend to increase village wages and depress profits and impact the tax revenue directly. This is called this the wage effect of transfers. In addition, the expenditures from grants can directly affect profits by the impact the public goods and services have on productivity, which is called the productivity effects of transfers.