(Co-authored with Amandeep Kaur and Divy Rangan)
Climate change commitments require long term fiscal policy instruments, such as climate responsive budgeting and ecological fiscal transfers . In India we have Climate Action Plans at national and subnational government levels. However, a roadmap towards comprehensive climate responsive budgeting as a PFM (Public Financial Management) tool for accountability has not yet been fully developed. As such, the public expenditure towards climate change is highly fragmented and highly sectoral in India. On the monetary policy front, the European Central Bank has started integrating climate change into monetary policy reaction function. A few experts have even proposed ‘Carbon Central Banks’ (https://voxeu.org/article/climate-change-after-covid-19).
Apart from macro-fiscal and monetary policies, ecological fiscal transfers have also been designed to address the climate change commitments. With the advent of fiscal decentralisation, many countries have focused on the climate change commitments at the subnational government level. The “principle of subsidiarity” says that the responsibility for providing a particular service should be assigned to the jurisdiction “closest to people”. Such decentralized decisions in climate change commitments is getting attention worldwide ex-post to Paris accord on climate change. However, the interjurisdictional competition to attract the mobile capital by trading (lowering) environmental regulations lead to “race to bottom” and “pollution havens”. Empirical evidence reveals this continuous tension between 'principle of subsidiarity' and the “race to the bottom”.
In the intergovernmental fiscal framework, three functions of environmental quality have been developed (https://media.rff.org/archive/files/sharepoint/WorkImages/Download/RFF-DP-01-54.pdf). The first case considers environmental quality as a pure “international” public good for which a global solution is required, irrespective of its location. The second case considers environmental quality as a pure “local’ public good”. The 'principle of subsidiarity' is directly applicable to this second case. The third case, which is most common in practice, deals with the effects of interjurisdictional externalities, including water and air pollution. The governments have tried to "internalize these externalities” through legal negotiations and fiscal instruments.
In India, the idea of ecological fiscal transfers was discussed in the state negotiations by the 13th Finance Commission (FC), with several states including Tripura, Uttarakhand, Chhattisgarh, and Madhya Pradesh recommending for forest cover to be included with the weights of 5%, 10%, 10%, and 7.5% respectively, as one of the criteria of tax transfers. Arunachal Pradesh also recommended for the inclusion of environmental and forest conservation with the weight of 10%. Though 13th Finance Commission has incorporated “conditional” ecological fiscal transfers, there was no ecological criteria integrated in the tax transfer formula.
The 14th Finance Commission is the first ever Commission to integrate an ecological variable in the tax transfer formula in India. The 14th Finance Commission acknowledged the ecological benefits of forest cover and its “opportunity cost” with less area available for other economic activities, and assigned a weight of 7.5% to the “moderate forest cover” as a part of the tax transfers. Subsequently, 15th Finance Commission (interim report) also retained the criterion with increased weightage of 10 per cent, using the “dense forest cover” inter-state data.
The pertinent question is whether finance commissions of India used equalization as an instrument for increasing forest cover and ecological sustainability. The equalization transfers for climate change commitments in that sense is nil in India, as the finance commissions have used the ecological criteria in the intergovernmental fiscal transfers to mitigate the “cost disabilities”. As the ecological criterion is incorporated in the unconditional fiscal transfers, the prioritization of climate change in expenditure function of the state government is significant to have effectiveness of such transfers on ecology. Unlike thirteenth finance commission, the latest commissions have not designed any conditional fiscal transfers to climate change commitments. Empirically, it would be interesting to examine if there is any “flypaper effect” at the local level from such ecological fiscal transfers. The narrative of flypaper effect is “money sticks where it hits”. The flypaper effect in this context examines if exogenous ecological fiscal transfers leads to significantly higher local government spending on climate change commitments than an equivalent amount of citizen income. The channels in which the flypaper effects work can be either the fiscal illusion (the median voters are unable to differentiate between the heterogeneous sources of revenue) or the bureaucratic behavioral sets, for instance, if they prioritise the climate change commitments in their expenditure functions as an outcome of political institutions and the associated incentives of elected representatives.
The preliminary evidence on the relationship between the inter-State share of intergovernmental fiscal transfers and the ecological variables is positive. This reiterates the efficacy of ecological (rather “environmental”) fiscal transfers. The final report of the fifteenth finance commission will be tabled in the Parliament during Budget session in February 2021. It is pertinent to analyse the way the Commission has incorporated the ecological variable, if any, in their final report, which will set the tax transfer to subnational governments for the next five years. Equally important is how efficacious the forthcoming Union Budget 2021-22 in integrating the climate change commitments. This policy certainty towards SDG commitments is crucial for sustaining the recovery momentum of economic growth (https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/EBUL21012021_F5770050C073B4C99AD00DD0B520ABAAC.PDF) , in the time of covid 19.
Lekha Chakraborty is Professor, Amandeep Kaur is Economist, and Divy Rangan is Fellow at NIPFP, New Delhi.
The views expressed in the post are those of the authors only. No responsibility for them should be attributed to NIPFP.