Ecological Economics 68 (2009) 3052–3059

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Ecological Economics

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Analysis

Compensation for environmental services and intergovernmental fiscal transfers:The case of India

Surender Kumar a,⁎, Shunsuke Managi b

a Department of Policy Studies, TERI University, 10, Institutional Area, Vasant Kunj, New Delhi 110070, Indiab Yokohama National University, 79-4, Tokiwadai, Hodogaya-ku, Yokohama 240-8501, Japan

⁎ Corresponding author.E-mail addresses: surenderkumarbansal@hotmail.co

managi@ynu.ac.jp (S. Managi).1 Environmental services or “ecological public function

sustainable use of natural resources, living organism,These also include negative impacts of human activities oof environmental pollution such as emissions, waste anor destroyed landscapes among others (Ring, 2002).

2 It also can be the other way round. The benefits arethe regional or national level. In general there is a mequivalence.

0921-8009/$ – see front matter © 2009 Elsevier B.V. Adoi:10.1016/j.ecolecon.2009.07.009

a b s t r a c t

a r t i c l e i n f o

Article history:Received 23 January 2009Received in revised form 13 July 2009Accepted 14 July 2009Available online 3 August 2009

JEL classification:H77Q01

Keywords:Environmental servicesFiscal federalismSpatial externalitiesEnvironmental expenditureIndia

This paper studies mechanisms to compensate local government for the public provision of environmentalservices using the theory of optimal fiscal transfers in India. Especially, we analyzed the role of intergovernmentalfiscal transfers in achieving the environmental goal. Simply assigning the functions at appropriate levels does notensure optimal provision of environmental services. Optimality in resource allocation could be achieved bycombining the assignment system with an appropriate compensation mechanism. Intergovernmental fiscaltransfers would be a suitable mechanism for compensating the local governments and help in internalizing thespillover effects of providing environmental public goods. Illustrations are also provided for India.

© 2009 Elsevier B.V. All rights reserved.

1. Introduction

Provision of environmental services1 involves spatial externalities.The costs of provision are borne at the level of provision, but thebenefits are realized at larger scales.2 Mismatch between the decisionmaking responsibilities and costs and benefits has been considereda cause for the under-provision of the services. Perrings and Gadgil(2003) suggest a number of measures to patch up the local costs andglobal benefits of biodiversity conservation. This paper aims to explorethe role of intergovernmental fiscal transfers to encourage the optimalprovision of environmental public goods that yield benefits beyondthe jurisdiction of the body supplying these public goods.

m (S. Kumar),

s consist of the protection andecosystems and landscapes.”n the environment in the formd contaminated sites, impaired

local but the costs are borne atismatch if there is no fiscal

ll rights reserved.

Compensation for environmental services (CES)3 helps in inter-nalizing environmental externalities through the transfer of financialresources frombeneficiaries of certain environmental services to thosewho provide these services. Effectiveness of the CES systemis contingent on that the ecosystem managers — individuals andcommunities — have appropriate property rights and the benefits ofthe services remain confined to only those who pay for the services(Engel et al., 2008). For the natural resources such as forests, propertyrights do not remain confined to individuals and communities but alsovest with the local or regional governments, and there are positivespatial externalities in the conservation activities. As a result, theseregional governments spend less than required and the commodity inquestion remains underprovided. For example, in a study of federaland state spending under the Endangered Species Act in the U.S., Listet al. (2002) find that the states tend to spend less relative to thefederal government on those species that demand a large habitat areaand whose preservation cause conflicts with economic development.Similarly, Gray and Shadbegian (2004) find evidence of higher waterand air pollution when out-of-state residents get a larger share ofbenefits of pollution control. This necessitates the need to broaden the

3 For the definition of terms payment for environmental services (PES), CES, marketfor environmental services, and reward for environmental services and differencebetween them, see appendix of Wunder (2006). We use PES and CES interchangeably.

3053S. Kumar, S. Managi / Ecological Economics 68 (2009) 3052–3059

scope of CES mechanism, i.e., local/regional governments be compen-sated for the opportunity costs borne by them (above their benefits)for managing the natural resources. Intergovernmental fiscal transfersare an innovativewayof compensating the local and state public actorsfor their ecological public functions.

Intergovernmental fiscal transfers redistribute the public revenuefrom federal and regional governments to local governments. Tradi-tionally these transfers are used to compensate local governments forexpenditure incurred in providing public goods and services withspillover benefits to areas beyond their boundaries, for example forschools and hospitals. Environmental services performed by a sub-national government are the classic case of spatial externalities. Neg-lecting these services in the fiscal transfers causes two fold effects —inadequate incentives/compensation to those conserving naturalresources on the one hand, and lack of disincentives to those fritteringaway such precious resources on the other hand. Fiscal transfers canbe an inducement for local governments to support and maintain thequality of water and nature protection areas within their territories,but which can also provide wider environmental benefits beyondtheir boundaries. Fiscal transfers designed to encourage the optimalprovision of environmental services is expected to depend upon thelevel of associated externalities (Bird and Smart, 2002).

Indian states have been raising concerns related to divergence be-tween costs borne and benefits enjoyed by them for the conservationof natural resources.4 The 12th Finance Commission recognized themismatch and allocated 10 billions rupees for the preservation of forests(Government of India, 2004). The 13th Finance Commission has beengiven themandate tomake its recommendations that help inmanagingecology, environment and climate change, which is consistent withsustainable development (Government of India, 2007). The objective ofthe paper is to discuss mechanisms to compensate local governmentfor the public provision of environmental services using the theory ofoptimal fiscal transfers in the case of India.

India has a three-tier federal system of governance. The responsi-bilities of governance are shared between the federal government, thestate governments, and the local governments (i.e., rural and urbanlocal bodies). Assignment of responsibilities on all matters, includingenvironment between the different tiers of government is governedby the Indian Constitution. The assignment of functions related toenvironmental activities is fairly clear in India and tries tominimize thetransaction costs by giving much scope for the decentralized systemsof environmental governance.5 Environmental degradation cannot beavoided simply by assigning the task at appropriate level. For example,the task of managing and maintaining forests has been assigned tostate governments and despite the ban on green felling, the forestcover in the country has been declining. India lost about 1358 km2 offorest cover (canopy density more than 40%) in just two years, from2003 to 2005 (Forest Survey of India, 2005). Compensating the statesfor their efforts through intergovernmental fiscal transfers can helpthem in conserving natural resources and addressing poverty. Thepoverty distribution coincidently is linked to the distribution of eco-systems and their health in India (ESPASSA, 2008).

The paper is organized as follows: Section 2 makes an inquiryinto the theory of fiscal federalism and analyses the role of inter-governmental fiscal transfers in compensating the lower levels ofgovernments for providing environmental public goods. Section 3presents some international practices of compensating the publicsector actors for conservation activities. An empirical investigationof the environmental concerns in Indian intergovernmental fiscal

4 Recently, the chief minister of Himachal Pradesh, Mr. P. K. Dhumal raised theconcerns. He said that Himachal preserves and conserves its vast natural potential forthe benefit of the nation, but it has not been compensated. (Why can't Himachal getcarbon credits for keeping India green? The Indian Express, April 08, 2008).

5 For details on Environmental Federalism in India, see Gupta (2001) and Mandaland Rao (2005).

relations is carried out in Section 4. An illustration of how environ-mental indicators could be included into fiscal devolution mechanismis also provided in this section. Section 4 also explores the possibleoptions for integrating environmental functions into intergovern-mental fiscal transfers. Concluding remarks are discussed in Section 5.

2. Theory of fiscal federalism and the environment

2.1. Decentralization and the environment

Local public goods and services are provided more efficiently whenresource allocation decisions are limited to the lowest governmentallevel (Oates, 1972). Decentralization introduces intergovernmentalcompetition and checks and balances (Breton, 1996), and reduces co-ordination and transactions costs. Note that the decentralization rulein resource allocation is applicable in the absence of economies of scaleand externalities.

Following the decentralization rule, lower levels of governmentsare assigned the task of protecting the environment where appropriate.There are numerous studies realizing that decentralizationworks muchbetter in environmental protection than that of top-down mechanism(e. g, Chopra et al., 1990). Presence of spatial externalities in the pro-vision of environmental services calls for a differentiated approach inexecuting the decentralization rule. Appropriate solutions have to besought according to the specific characteristics of the various environ-mental problems. This is reflected in the debate “regarding the com-petencies of the national or even supranational governmental levelversus the state or local level in environmental standards setting” (Ring,2008a).

Highly mobile environmental services and pollutants easily crossadministrative boundaries and create far reaching spatial externalities;and require more centralized solutions (Ring, 2002). For example, theproblem of climate change requires centralized solutions if not globalpolicies. Similarly, public goods such as basic and applied research,including that concerning the development of environmental policyinstruments, but also the dissemination of information on harmfulenvironmental impacts or the development of pollution control tech-niques tend to be underprovided at decentralized levels (Oates, 2001).In contrast, an environmental policy associated with less mobile envi-ronmental services/pollution is better suited for assignment to decen-tralized levels of government (Oates, 2001).

Sigman (2005) estimates the environmental costs of water pollu-tion generated downstream due to free riding states when rivers crossstate boundaries in the United States and finds that free riding givesrise to a 4% degradation of water quality downstream of authorizedstates. Helland andWhitford (2003) find toxic chemical releases to behigher in border counties. Trans-boundary air and water pollution isassociated with negative externalities; priority areas for waterprotection can involve positive externalities. Water protection zonesare generally located in rural areas and villages bear the costs ofprotection, but provide water services far beyond their boundaries.Conservation and sustainable use of biodiversity is another exampleof spatial externalities (Perrings and Gadgil, 2003). Spatial scale andmobility are very important determinants of species protection. Listet al. (2002) find the phenomenon of free riding on the part of thestates under the Endangered Species Act in the U.S. These examplesreveal that the misallocation of resources cannot be avoided simply byassigning the task at appropriate level because these mechanisms donot provide adequate incentives for internalizing the externalities.Rewarding local governments according to their conservation effortsis necessary to reconcile both local and global public benefits of con-servation of natural resources (Perrings and Gadgil, 2003; MillenniumEcosystem Assessment, 2005; Ring, 2008a).

To summarize, intergovernmental fiscal transfers can help in achiev-ing environmental sustainability. This is because (1) economic andpolitical incentives to states and local bodies often favor the destruction

7 Though few studies (e.g., Horton et al., 2003) have tried to capture the value of

3054 S. Kumar, S. Managi / Ecological Economics 68 (2009) 3052–3059

of natural resources since the benefits from conservation and costs ofconservation are distributed asymmetrically across territorial units(Köllner et al., 2002)6; and (2) the ecologically rich regions often have tospend more on conservation measures than others and are in need ofmore resources given their fiscal capacity. For example, the Indian stateshousing larger forest cover have to spendmore on themaintenance anddevelopment of forestry and wildlife sectors. Correlation coefficientbetween the forest cover and expenditure on forestry and wildlifesectors for the year 2005 is positive (0.23).

2.2. Designing fiscal transfers for internalizing spatial externalities

Samuelson (1954) provides condition for the optimal provisionof a public good: themarginal cost of supplyof the commodity should beequal to the sum over all individuals of their individual willingness topay for the commodity. As the provision of environmental servicesinvolves externalities, irrespective of the distribution of property rights,each person has an incentive not to reveal his/her true willingnessto pay. Sub-optimality results and under-provision is severe for largerspillover effects (Dur and Staal, 2008). The solution to the problem ofexternalities and free riding rests either in internalizing of benefitsor costs. In the absence of true values of aggregate willingness to pay,intergovernmental fiscal transfers help in internalizing the problemfrom the cost side by compensating the provider for a part of theopportunity costs of the provision.

Dur and Staal (2008) and Dahlby (1996) show that conditioningof fiscal transfers from federal to regional governments on the sizeof spillover effects or the levels of public goods helps in mitigatingthe under-provision problem. Similarly, the fiscal transfers can effec-tively address the spillover effects arising from the expenditure onenvironmental activities by regional governments and help in achiev-ing national standards in environmental programs, like the socio-economic programs. A system of open-ended matching grants basedon expenditures giving rise to spillovers will provide the incentiveto increase expenditures (Shah, 2006).

Dahlby (1996) provides a formula for designing fiscal transfersin the provision of public goods provided by the local governments.Using the Atkinson and Stern (1974) condition of optimal provisionof public good by a local government, Dahlby sets the matching grantrate equal to:

mgi = σgi 1− ρgi

� �+ ρgi − ρi

gi

� �ð1Þ

where, mgi is the matching grant rate for public good gi to its providerstate i, σgi is the fraction of direct benefits that go to people who resideoutside i (positive externalities), ρi is the change in total revenue ofstate i per rupee spent on gi, and ρgii is the additional revenue to statei from an additional rupee spent on gi.

This formula has two components. The first term is the value ofdirect positive externalities that has to be financed through inter-governmental grants in the absence of net revenue spillovers. Thesecond term represents net revenue spillovers. If the expenditure onpublic good is financed through non-distortionary taxes, then thematching rate would be mgi=σgi. In the absence of spillover effects,but taxes are distortionary thematching ratewould be equal to secondterm. In practice, public goods are financed through distortionarytaxes and also create revenue spillovers; the matching rate would beequal to the sum of both of the terms.

6 In 1996, the government of Tamil Nadu went to the Supreme Court seeking arelaxation of the effluent standards for tanneries set by the Tamil Nadu PollutionControl Board (TPCB). Similarly in the same year a committee of the state legislaturetook the Karnataka Pollution Control Board (KPCB) to task for not enforcingenvironmental regulations stringently and in Orissa, the state pollution control boardexpressed its apprehension over the (state) government's inaction to the problem ofhigh fluoride pollution. For details on these examples see Gupta (2001).

Since the value of σgi is not known by the federal governments7

(here assuming that the provision of good i is revenue neutral), Durand Staal (2008) show that two types of transfers— earmarked andlump-sum — help in mitigating the under-provision problem andincreasing allocative efficiency of public good provision in the eco-nomy. The earmarked transfers are spent on these public goods onlyand lump-sum transfers are conditioned on the level of these goods.8

Given the logic of public good provision, only the direct costsaccruing for environmental services provide basis for matching grants.The grantor finances the fraction of recipient's expenditure thatexternally benefits other jurisdictions on the basis of Eq. (1)). Clean-up activities such as air and water pollution abatement and theirregulation, municipal solid waste management, reforestation, man-agement of public parks, development of renewable energy are goodcandidates for earmarked grants.

Note that local governments are generally less interested in theprotection of nature conservation and watershed protection activitiesgiven the mismatch between net benefits forgone by them and ex-ternally enjoyed benefits. Some nature conservation activities do notinvolve more direct public expenditure but affect the ability to de-velop productive activities and generate revenue in a number of ways,both for local governments and private land users. Therefore, it wouldbe rational to compensate the local governments for the foregoneopportunities. The compensations could be in the form of lump-sumfiscal transfers that are linked to the extent of conservation activitiesto be performed by the local governments that help in meeting thenational environmental standards.

3. International practices

It is common practice in the US and Europe to compensate thefarmers or private land users for nature conservation activities andrecently it has been getting currency to compensate individuals andcommunities for their conservation efforts through payments for en-vironmental services (PES) in developing countries also. The sameargument, however, applies for compensating the local governmentsfor environmental services provided within their boundaries. In mostof the countries, including India, environmental services are providedby the decentralized governments also. The potential benefits of in-troducing fiscal equalization principles into regional environmentalfunding have been recognized in some countries. Ring (2002) notesthat in Germany, ecological functions are incorporated into the inter-governmental fiscal relations at the local level through conditionalgrants. In Switzerland, Köllner et al. (2002) report that the fiscaltransfers for nature conservation are from the federal government tothe cantonal level and these grants are project-oriented. They developan index to base intergovernmental fiscal transfers on biodiversity.Similarly, Hajkowicz (2007) defines a needs index that forms the basisfor fiscal equalization across regions for environmental managementin Queensland, Australia, using multiple criteria analysis. Portugal hasset up a fiscal transfer scheme by explicitly rewarding local govern-ments (municipalities) for conservation activities (Ring, 2008b).

Another interesting case is of Brazil, which is an innovative exam-ple to learn from. During the early 1990s, the Brazilian state, Paraná,introduced ecological indicators alongside other indicators commonlyused for lump-sum fiscal disbursements. To base the fund allocation

spillover benefits of conservation, to get the true value of the spillover benefits is likelyimpossible. Barton et al. (2009) propose to use benefit transfer studies to evaluate thespillover benefits. Moreover, they find that the socio-ecological systems (SES)framework proposed by Ostrom (2007) can provide guidance on matches betweenexisting valuation studies and social–ecological context, building on multiple variablesand tiers covered by the framework.

8 Earmarked grants are given for specific purposes and are required to be spent forthese purposes only, whereas the conditional grants are conditioned on meetingcertain criteria but the local government can use this money the way it wishes.

10 “Distance Formula=(Yh−Yi)Pi /Σ(Yh−Yi)Pi, where, Yi and Yh represent per capitastate domestic product (SDP) of the ith and the richest state, Pi is the population of theith state, (Yh−Yi) for the ‘h’ state is to be equivalent to that of the second highest percapita SDP state” (Rao, 2000).11 Cost disabilities arise due to factors that are mainly beyond the control of the statelike large areas relative to population, hilly terrains, excessive rainfall, and pronenessto droughts (Government of India, 2004).12 Bharat Nirman is a rural development project initiated by the Government of Indiain partnership with State Governments and Panchayat Raj Institutions for the period2005–09. Under Bharat Nirman, actions are proposed in the areas of irrigation, road,rural housing, rural water supply, rural electrification and rural telecommunicationconnectivity.

Table 1Criteria for intergovernmental transfers adopted by the 12th Finance Commissions inIndia.

Criteria Relative weights (%)

Population 25Income (distance method) 50Area 10Tax effort (income weighted) 7.5Fiscal discipline 7.5Total 100

Source: The 12th Finance Commission Report (Government of India, 2004).

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on environmental indicators, an instrument known as value addedsales and services tax, (ICMS)-Ecológico, was introduced. Other statesfollowed Paraná and today 12 Brazilian states explicitly consider eco-logical indicators in intergovernmental fiscal transfers. According tothe Brazilian Constitution, 75% of the total amount of ICMS (a valueadded tax on goods and services) revenue has to be passed on tomunicipalities according to their contribution to state ICMS. The stategovernments decide on further indicators for allocating the remaining25%. Note that each state is independent about taking decisions onthe inclusion of indicators and assigning corresponding weights fordisbursing the 25% of ICMS revenues to the local level. The share ofICMS to be distributed for environmental indicators varies from 0.5%in Minas Gerais and São Paulo to 5% in Rondônia and Mato Grossodo Sul.9 The implementation mechanism of ICMS-Ecológico can beexplained in the following steps (Vogel, 1997):

i. collection and processing of data regarding areas of conservationfor each municipality,

ii. calculation of the indices for fiscal compensationwith reference towater-sheds and units of conservation,

iii. publication of the results, andiv. periodic evaluation of the process.

The Brazial case analysis reveals that it is an application of themix of regulatory and economic instruments — land use restrictionscombinedwithfiscal transfers— to internalize the spatial externalities ofconservation activities performed by local governments. As a result, thetotal area in conservation units across all governmental levels increasedby 165% during the period of 1992–2000 in Paraná and municipalitieswith larger shares of protected areas considerably benefit from theintergovernmentalfiscal transfers (Mayet al., 2002; Ring, 2008b, Bartonet al., 2009).

The Brazilian experience also highlights that the benefits from theinclusion of conservation units in intergovernmental fiscal transfersare contingent on a good information and communication strategy.In the state of Minas Gerais, the State Forest Institute helped in pub-licizing the new instruments coupled with the task of monitoring allinformation related to ICMS-Ecológico transfers based on conservationunits (Barton et al., 2009). Information and communication strategiesnot only help in informing the local and regional governments andeven citizens that part of their public revenues stems from ecologicalfiscal transfers, but also help in reducing local opposition to protectedareas and thereby eventually help in increasing the quantity andquality of environmental services provided by these jurisdictions.

4. Fiscal federalism and the environment in India

4.1. Fiscal federalism in India

Similar to the assignment system, fiscal federalism in India is char-acterized by constitutional demarcation of revenue and expenditurepowers among different levels of government. The finance commissionfacilitates the division of financial resources between different levels ofgovernments. Federal finance commission recommends the distribu-tion of the net proceeds of taxes and also grants-in-aid from federalgovernment to states as also among the states and the state financecommissions determine the revenues of local governments.

The main considerations before a federal finance commission are:(i) how is the proportion of central tax revenue to be shared be deter-mined; (ii) specify criteria for deciding shares of individual states; and(iii) determining the weights attached to different allocation criteria(Government of India, 2004; Hazra et al., 2008). The tax devolutioncriterion involves three sets of considerations: (i) population, tax efforts

9 For details on the Brazilian case, see May et al. (2002), and Ring (2008b).

and fiscal discipline to correct vertical imbalance; (ii) income distancemethod10 to correct horizontal imbalance; and (iii) area to accountfor cost disabilities11 (Rangarajan and Srivastava, 2008). As of now, interse, sharing of taxes between the Union and states, according to therecommendation of the 12th Finance Commission, is governed by thebroad criteria given in Table 1. These formula based disbursements thestate governments use in the way they wish. In addition to thesetransfers, there are grants-in-aid, which are given for specific purposesand some time they are partly in the form of matching grants.

Besides the Finance Commission, the Planning Commission is alsoa major distributor of funds in India. It provides grants and loans tothe states. The funds are distributed according to a formula evolvedand modified by the National Development Council (NDC) from timeto time. The criterion used by the Planning Commission considerspopulation (60% weight) and fiscal management efforts (7.5% weight)for addressing vertical imbalance and the distance in per capita in-come from the national average (25% weight) for dealing with hori-zontal imbalance. In addition to these two agencies, states and localbodies also receive purpose specific grants from various federal min-istries. Some of these grants are entirely funded by the federal gov-ernment and some are shared cost programs.

In their recommendations, consecutive Finance Commissions treadcautiously in balancing concerns of equity versus efficiency, and arrivingat a scheme of fiscal transfers that is predictable and stable from socio-economic aspect. However, the issues of fiscal spillovers in generaland environment externalities in particular had not found a place as itshould, of the financial devolution mechanism in the country.

4.2. Fiscal transfers and provision of environmental services in India

Before discussing the role of fiscal transfers in the provision ofenvironmental services, it is necessary to make some preliminaryremarks. In addition to the above mentioned fiscal transfers, the stategovernments and local bodies are familiar with a number of otherearmarked grants that include environmental functions. For example,the antipoverty programs such as Bharat Nirman12 in which the localbodies can take up projects that have bearings on environmentalconservation. Similarly, the Jawaharlal Nehru Urban Renewal Mis-sion13 ,a program for urban areas, includes projects related to provisionof water services, solid waste management etc. A comprehensive

13 Jawaharlal Nehru National Urban Renewal Mission is a massive city modernizationscheme launched by the Government of India. It envisages a total investment of over$20 billion over a period of 5–6 years.

Table 2Environment related grants-in-aid recommended by the 12th Finance Commission.

State Environment related activity Amount(rupees billions)

Haryana Water logging/salinity and declining water tables 1.00Kerala Inland waterways and canals 2.25

Coastal zone management 1.75Maharashtra Coastal and eco-tourism 2.50Manipur Loktak lake 0.115Meghalaya Zoological park 0.30

Botanical garden 0.05Mizoram Bamboo flowering 0.40Orissa Consolidation and strengthening eco-restoration

work in the Chilika Lake0.30

Sewerage system for Bhubaneswar 1.40Punjab Stagnant agriculture 0.96Rajasthan Indira Gandhi Nahar Pariyojana 3.00

Meeting drinking water scarcity in border and desertdistricts

1.50

Tamil Nadu Sea erosion and coastal area protection works 0.50West Bengal Arsenic contamination of ground water 6.00

Problems relating to erosion by Ganga-Padma river inMalda and Murshidabad districts

1.90

Development of Sundarbans regions 1.00Total 24.925

Source: The 12th Finance Commission Report (Government of India, 2004).

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analysis offiscal grants should also consider the additional policies andregulations in conjunction with fiscal equalization where the localjurisdiction can serve as applicant.14

4.2.1. Geographic area as an indirect criterion for fiscal transfersGeographic area of a state can be a starting point for considering

environmental services in intergovernmental fiscal transfers (Ring,2002). The provision of environmental services is directly linked toland uses. A state having less population density is supposed to dele-gatemore land to agriculture and forestry, and houses valuable habitatfor rare species. Similarly within a state the areas that are remote fromthe district centers have low population density and provide moreenvironmental services given the land use practices in these areas(Ring, 2002).

In India, federal finance commissions consider ‘area’ of a state asone of the criteria to account for cost disabilities in providing publicgoods in fiscal transfers. They define cost disabilities as the circum-stances, like excess rainfall, hilly terrain, and large and remote areaswith low density of population, that are beyond the control of a stateand lead to higher than average per capita costs for delivering thesame level of public services at an average level of efficiency. The use of‘area’ of a state as a criterion for determining its share stems fromthe additional administrative and other costs that a state with a largerarea has to incur in order to deliver a comparable standard of serviceto its citizens (Government of India, 2004). The Finance Commissionsrecognize that the costs of providing services increase with the size ofa state, but at a decreasing rate. Similarly, the State Finance Commis-sions use area and remoteness as criteria for financial devolution fromthe state governments to rural and urban local bodies.15 The considera-tion of ‘area’ as an indicator in fiscal transfers from the cost disabilitypoint of view recognizes economic functions; this criterion has alsorelevance for internalizing environmental externalities.

Though one can argue that indirectly the ecological functions arealready considered in the fiscal devolution in India, the existing regu-lations concerning area as an indicator in fiscal transfers at all levelspredominately concentrate on socio-economic functions. To accountfor ecological functions the weight attached to the ‘area’ criterionshould be adequately strengthened until an appropriate direct cri-terion of environmental sustainability is considered.

4.2.2. Provision of environmental services and grants-in-aidThe Finance Commissions recognize that the formula used for

allocation of tax proceeds among states is not able to take care of alldimensions of the fiscal needs of a state. Therefore, the lower levels ofgovernments receive certain grants-in-aid. Some of the grants-in-aidare common for all the states and some are specific to a particular stategiven its needs. These grants-in-aid are purpose specific earmarkedgrants.

In India, there is a total ban on the green felling. The state gov-ernments consider forests net liability rather than a source of revenueand appealed to the 12th Finance Commission for separate grants forthe maintenance of forests. The Commission recognized the problemand recommended for a grant of 10 billion rupees spread over theaward period 2005–2010 for maintenance and preservation of forests,and to be distributed among the states according to their forest area(Government of India, 2004).

The 12th Finance Commission also recommended for total statespecific earmarked grants-in-aid of the amount of 71 billions rupeesover its award period. Table 2 shows that about 35% of these grants-in-

14 The analysis of other policies and environmental regulations is beyond the scope ofpresent paper.15 For example the 2nd Uttaranchal Finance Commission used area and remoteness inaddition to population, tax efforts and deprivation index for devolution of finances tothe local bodies (Second Uttaranchal Finance Commission Report as accessed on June24, 2008 http://gov.ua.nic.in/sfc/Second.htm).

aid are allocated for environment related activities.16 Table 2 revealsthe following points. First, except the common pool of the earmarkedgrant-in-aid for the maintenance of forest areas, the ecological func-tions are not included directly in the fiscal transfers. However, beyondarea, the states get some earmarked grants for the provision of envi-ronmental services. Second, the fiscal equalization rules consider eco-logical functions by means of earmarked grants. Most of the fiscaltransfers are explicitly related to sewage disposal, water supply, wastedisposal, urban and agricultural development among others. Thirdly,there is wide spread tendency to support the end-of-pipe infrastruc-ture such as drinking water supply provision. Though a proportion oftotal earmarked grants-in-aid is implicitly kept aside for environmentalmanagement, it is by no means enough to internalize the externalitiesthat cause environmental degradation.

4.3. Integrating environmental indicators into fiscal transfers: an illustration

We provide a brief illustration how the transfer works. To integratethe environmental services in the fiscal transfers an indicator thatcould reflect both conservation efforts and the stock of natural re-source in a jurisdiction is required and this indicator should be basedon a set of measures that are appropriate to quantify gains. Encour-aging states and union territories the combination of forest, tree andmangrove cover could be considered as an additional criterion forthe allocation of fiscal transfers in the absence of an appropriateindicator. Forests help in maintaining biological variability, protectionagainst natural risks such as landslides, soil erosion and the climatechanges. Forests also play an important role in hydrological cycle,through the water flows originating in them. However, note thatforests cover certain environmental services and not all the environ-mental services, and the services delivered by the forests are highlyspecialized and are contingent on the space where they are located.The State of Forest Report 2005 (Forest Survey of India, 2005) providesnumbers for recorded forest areas in 2005, and also of actual forest,tree and mangrove covered areas for all states and union territories.

The Forest Survey of India (2005) reveals that the state of forest isin a devastated condition; over the interval of mere two years (2003–

16 For the definition of activities or what these activities involve see the 12th FinanceCommission Report Chapter 10 (Government of India, 2004).

17 The 11th Commission assigned 10% weights to population in devising the formulafor tax devolutions.

Table 3Illustrated allocations of 350 billion rupees according to the 12th Finance Commission (TFC) formula and suggested formula.

State Population(%)

Geographicarea (%)

Forest, tree andmangrove cover(%)

Per capita SDP(2002–03)(rupees)

Allocations followingTFC formula(billion rupees)

Allocations followingsuggested formula(billion rupees)

Difference(billion rupees)

Forest coverper thousandpopulation (km2)

General category statesGoa 0.13 0.11 0.32 60,787 0.44 0.57 0.13 1.82Maharashtra 9.42 9.36 7.32 26,858 32.90 31.32 −1.59 0.58Haryana 2.06 1.34 0.41 26,818 6.48 5.07 −1.41 0.15Punjab 2.37 1.53 0.44 26,395 7.45 5.79 −1.66 0.14Kerala 3.10 1.18 2.36 22,776 8.92 7.89 −1.03 0.57Gujarat 4.93 5.96 3.01 22,624 18.28 17.10 −1.18 0.46Tamil Nadu 6.07 3.96 3.71 21,740 19.12 16.83 −2.29 0.46Karnataka 5.14 5.83 5.27 19,576 18.68 18.95 0.27 0.77Andhra Pradesh 7.41 8.37 6.77 19,087 26.89 26.65 −0.24 0.69West Bengal 7.79 2.70 2.17 18,494 22.18 16.69 −5.49 0.21Uttaranchal 0.83 1.63 3.25 14,947 3.69 5.71 2.02 2.96Rajasthan 5.49 10.41 3.13 12,641 24.14 23.60 −0.54 0.43Chhattisgarh 2.03 4.11 7.81 12,369 9.18 14.03 4.86 2.90Madhya Pradesh 5.87 9.38 10.64 11,500 24.04 28.50 4.46 1.36Jharkhand 2.62 2.42 3.32 11,139 8.97 9.45 0.48 0.95Orissa 3.58 4.74 6.88 10,164 13.68 16.44 2.76 1.44Uttar Pradesh 16.16 7.33 2.89 9963 47.72 35.56 −12.16 0.13Bihar 8.07 2.86 1.05 5606 23.03 16.47 −6.57 0.10

Special category statesHimachal Pradesh 0.59 1.69 1.95 22,902 3.17 4.47 1.30 2.48Mizoram 0.09 0.64 2.43 22,207 0.86 2.76 1.90 21.15Nagaland 0.19 0.50 1.81 20,746 0.99 2.27 1.29 7.01Sikkim 0.05 0.22 0.43 20,013 0.35 0.67 0.32 6.08Tripura 0.31 0.32 1.07 18,550 1.10 1.67 0.57 2.59Arunachal Pradesh 0.11 2.55 8.82 16,916 2.81 9.96 7.15 62.13Meghalaya 0.23 0.68 2.25 16,803 1.25 2.88 1.63 7.50Jammu and Kashmir 0.99 6.76 3.48 14,507 9.23 12.54 3.31 2.65Manipur 0.22 0.68 2.23 12,878 1.24 2.85 1.62 7.51Assam 2.59 2.39 3.77 12,247 8.86 9.69 0.83 1.09

Union territoriesChandigarh 0.09 0.00 0.00 53,886 0.22 0.14 −0.08 0.03Delhi 1.35 0.05 0.04 45,579 3.41 2.10 −1.31 0.02Pondicherry 0.09 0.01 0.01 45,431 0.25 0.17 −0.08 0.09A and N Islands 0.03 0.25 0.95 28,340 0.34 1.08 0.74 20.56Dadra 0.02 0.01 0.03 NA 0.07 0.07 0.01 1.13Daman 0.02 0.00 0.00 NA 0.04 0.03 −0.01 0.11Lakshadweep 0.01 0.00 0.00 NA 0.02 0.01 0.00 0.48

Source: for population, per capita state domestic product: Economic Survey 2007–08, and for geographic area and forest cover (forest cover+mangrove cover+tree cover): State ofForest Report 2005.

3057S. Kumar, S. Managi / Ecological Economics 68 (2009) 3052–3059

2005) the forest cover (lands having tree cover with canopy densitymore than 40%) has declined by 1358 km2. Total forest cover is 20.6%of the geographic area of the country against the targeted figure of 33%despite that the Government of India has been concentrating onefforts to increase forest cover through reforestation. We observe thata positive correlation between the total forest cover (as measured asthe canopy density of more than 40%) and total state expendituretowards forestry and wildlife implies that the states having largerforest cover have to spend more resources for their conservation anddevelopment. We also observe a positive correlation (though veryweak) between the change in forest cover and change in the expen-diture, and a negative correlation between the total forest cover in astate and the per square kilometer expenditure. These correlationcoefficients imply that the states having larger forest stock need moreresources for conservation and development of these resources. Thisshows that linking forest cover in the financial disbursement canprovide more financial resources to forest rich states and helps inrealizing the national target.

For illustrative purposes, we assume that the total amount to bedisbursed among state and union territories is 1000 billion rupees.The 13th Finance Commission, following its predecessor, recom-mended allocation of 65% of the total amount on the basis of incomedistance, fiscal efforts, and fiscal discipline. The remaining 35% on thebasis of population, geographic area and forest cover. It assigns 15%

weight to population,17 12.5% to geographic area and a weight of 7.5%to forest cover.

Table 3 provides illustrated disbursements of the remaining350 billion rupees. It also shows the distribution of population, geo-graphic area, and forest cover area among states and union territories.In the proposed formula, the state and union territories with lesserforest cover area receive fewer lump-sum transfers, while the othersgain according to their forest cover area. This illustration shows thatinclusion of forest cover in the disbursement formula provides morefinancial resources for the maintenance of forests to those states thathouse more forest resources and thereby creates incentive for theconservation of forest resources, but also makes the allocations moreprogressive. Beneficiary states are either the places with relativelylarge amounts of forest cover (the hilly states, like Tripura, Sikkim,Mizoram, Meghalaya, Manipur, Arunachal Pradesh), or the places inwhich the composition of population below the poverty line is rela-tively higher (e.g. Madhya Pradesh, Jharkhand, Chhattisgarh, Orissa,Nagaland, Andaman and Nicobar). The hilly states with high forestcover also contribute substantially towards the population below thepoverty line (ESPASSA, 2008).

3058 S. Kumar, S. Managi / Ecological Economics 68 (2009) 3052–3059

There are also states that receive smaller amounts of transfersbecause of the lower weight to the population. These states aremostlythe states with higher per capita state domestic product (income)exceeding 20,000 rupees. However, Bihar and Uttar Pradesh wouldalso receive lesser amounts based on the proposed formula, and theper capita state domestic products in these states are less than 10,000rupees. Though large proportion of the states of Bihar and UttarPradesh is under the Indo-Gangetic plain and has fertile alluvial soiland tremendous irrigation potential, depends on natural irrigationand there has been very little investment in agriculture and irrigationin these states (Rao and Mandal, 2008). Similarly, Rajasthan is alsoconsidered a poor state and would be a loser. The losing states can becompensated through more grants-in-aid for clean-up activities andfor developing agriculture and irrigation projects.

4.4. Policy options for compensation for environmental services

The foregoing analysis shows that (a) local governments will under-provide the environmental public goods if not compensated, and (b)intergovernmental fiscal transfers are an appropriate mechanism forcompensating local governments since the provision of these goodsoffers benefits beyond the local jurisdictions. Note also that the un-certainties about the wider potential benefits/costs of local environ-mental public goodswill furtherworsen theproblemof under-provision.

Note that at the international level, the Global EnvironmentalFacility (GEF) allocates resources among countries on the basis on twoconsiderations: (1) a country's potential to generate global environ-mental benefits, and (2) a country's performance which is reflectedfrom the national policies and enabling environments that facilitatesuccessful implementation of GEF projects (GEF, 2005). At the nationallevel, the environmental indicators considered for resource allocationshould account for both, efforts of concerned governments and stock ofnatural resources in their territories. The inclusion of these indicatorsin intergovernmental fiscal transfers would not only compensate thestates for their environmental efforts, it would also help in reversingthe ‘race to the bottom’ approach followed by the state governmentsin the implementation of environmental regulations.18

The earmarked grants to states for environmental managementallow a greater degree of targeting and can be allocated by the FinanceCommission as a separate grant similar to the grants given for edu-cation or health. There is an advantage of this kind of grant. That is, itensures that funds are directly channeled into the provision of thetargeted good. Generally grants-in aid are allocated on the basis ofsocio-economic considerations; the 13th Finance Commission shouldexplicitly consider environmental services also while recommendingthese grants.

Another way to approach this is to base the transfers on the lines ofthe Fiscal Reform Facility19, wherein a particular environmental per-formance could be made conditional for the states and local bodiesto apply for grants to address specific environmental objectives. Anenvironmental fund can be designed to co-finance actions to helpimprove the environmental performance of states. The resources canalso be used to finance ways in which human resources and builtinfrastructure can be improved to build resilience to environmentaldegradation. Similar funds can be designed at the state levels tofinance environmental related activities of local bodies.

18 Per se, states in India cannot compete by lowering environmental standards, but itis possible that the states may get to ‘race to the bottom approach’ by using laxenforcement of standards (Gupta, 2001). In the absence of systematic studies noconclusive statement can be made, however the possibility of the presence of race tothe bottom cannot be completely ruled out.19 The Fiscal Reform Facility was envisaged by the 11th Finance Commission toaddress the problem of revenue deficit and to help states converge to a stable,sustainable debt path. However, the scheme was later discontinued primarily becauseit did not reward past fiscal performance and did not provide enough incentives for aprudent fiscal behavior in the future.

To bring accountability in the use of funds, the recipient statesand local bodies would be required to meet certain conditions. Theseconditions include a clear objective as what would be achieved alongwith a statement of how the funds would be spent to achieve the goalwith specified benchmarks to attain targets. Moreover, no state andlocal bodywould be allowed to get the funds unless theywere spent ona verifiable project with measurable benefits towards environmentalsustainability. That is, grants must be linked to physical outcomesmeasured by independent auditing and evaluation system assigned tooutside agencies.20

Note that the options explored above do not in any way underminethe role of existing regulatory functions performed by the respectiveinstitutions, environment related fiscal policies, and other earmarkedgrants received from different agencies by the states and local bodiesfor realizing their environmental goals, and can remain in continua-tion without any conflict.

5. Conclusions

We discuss mechanisms to compensate local government for thepublic provision of environmental services using the theory of optimalfiscal transfers in India. Simply assigning the functions at appropriatelevels does not ensure optimal provision of environmental services.Optimality in resource allocation could be achieved by combining theassignment system with an appropriate compensation mechanism.Intergovernmental fiscal transfers would be a suitable mechanism forcompensating the local governments and help in internalizing thespillover effects of providing environmental public goods. Thesetransfers could be both, lump-sum and matching (earmarked) grants.

The significance of socio-economic functions has a comparablylong tradition in federal systems, including India. The respective con-sideration of environmental services, however, is yet to be recognized.It is found that in India, though the assignment of responsibility forprotecting the environment is clear, the genesis of environmentaldegradation could be found in the incentive structure of governance.Though environmental functions are not directly considered in inter-governmental transfers, they find place through the grants-in-aidroute. About 35% of total grant-in-aid recommended by the 12thFinance Commission is allocated for the provision of environmentalservices. These grants are predominately for developing the end-of-pipe infrastructure. Consideration of ‘area’ as an indicator of ecologicalfunctions to a certain limited extent might be considered the inclusionof environmental services in the disbursement of fiscal transfers, butit is considered only for socio-economic considerations.

This study highlights the need for both, lump-sum and earmarkedgrants for internalizing the spillover effects. Earmarked grants arebetter suited for environmental clean-up activities and for financingways in which human resources and built infrastructure can be im-proved to build resilience to environmental degradation. Lump-sumtransfers are better suited for precautionary activities such as naturepreservation, and soil and water protection.

To understand the significance of intergovernmental fiscal trans-fers in internalizing environmental positive externalities, the studyprovided an illustration. The illustration demonstrated that the in-clusion of forest cover in the formula for lump-sum transfers benefitsthe states that house more natural resources and give incentives tothe states for conserving and developing these natural resources. Thestates that are poor and have degraded environment can be com-pensated through grants-in-aid for clean-up activities.

The financial acknowledgement of the environmental servicesprovided by the states and local bodies would raise environmentalawareness and provide incentives for the protection and enhancement

20 Grafton et al. (2004) developed such conditions for the use of funds available fromagencies such as Global Environmental Facility (GEF) that funds projects meetingenvironmental sustainability criteria.

3059S. Kumar, S. Managi / Ecological Economics 68 (2009) 3052–3059

of ecosystem services and meeting national standards. The compen-sation mechanism should be combined with a suitable informationand communication strategy. The inclusion of environmental servicesin the disbursement of fiscal transfers could also help in reducingpoverty and regional disparities because distribution of poverty andecosystems and their health is overlapping in the country.

Acknowledgements

We wish to thank the anonymous referees, Irene Ring andM. Govinda Rao for their valuable comments and suggestions on anearlier version of the paper. The usual disclaimer applies.

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