Federal transfers and sub-national spending in India: an analysis of the stimulatory effect

This study empirically examines the stimulatory effect of federal transfers in India using a panel dataset of 21 states for the period 2005-06 to 2019-20. In mapping the stimulus effect, we test the validity of the 'extended flypaper effect', where lumpsum federal transfers tend to increase the state's public spending more than a corresponding increase in its own revenue and borrowing resources. The results suggest that the marginal effects of state own-source revenues and borrowing on India's sub-national non-capital expenditure outweigh those of federal transfers. Therefore, the existence of flypaper effects at the sub-national level in India cannot be ruled out. However, at the disaggregate level, 10 of 21 states report a stimulatory effect of lumpsum federal transfers on state spending. Of these, nine states are mapped to the capital expenditure account and one state to the revenue account. The empirical results also reveal the presence of fiscal illusion i.e., the systematic misperception of fiscal parameters. While the fiscal illusion produced by federal transfers is not a concern, the debt-driven fiscal illusion is worrisome in India as most states' non-development revenue expenditure is fuelled by borrowed money. Hence corrective action is needed to find a strategy of optimal mix of three stimulus factors for these states namely states' own revenue, federal transfers and state borrowing.