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EDITORIAL ANALYSIS: The poor state of India’s fiscal federalism

Prelims: Finance Commission, features of federalism, GST etc.

Mains GS Paper II: Issues and challenges pertaining to the federal structure.

ARTICLE HIGHLIGHTS

The article discusses the centralisation of India’s fiscal federalism and its consequences on India’s fiscal federalism.

Direction: For GS2 as well as GS3, it is a very important topic, plz keep handy notes of issues involved (3-4 points in each heading) and some data points supporting your arguments.

INSIGHTS ON THE ISSUE

Fiscal federalism: It refers to how federal, state, and local governments share funding and administrative responsibilities within our federal system.

Background of centralisation of fiscal powers.

  • GOI, 1935: Government of India Act 1935 was more federal in nature than the Constitution adopted on January 26, 1950, as the first offered more power to its provincial governments.
  • 1949: In his last speech to the Constituent Assembly, R. Ambedkar said “In politics, we will have equality and in social and economic life we will have inequality.” Thereby there was a greater need for a balance of power between central and state governments.
  • The 1950s: India was never truly federal: As it was a ‘holding together federalism’ in contrast to the ‘coming together federalism,’ in which smaller independent entities come together to form a federation (as in the United States of America).
  • Jawaharlal Nehru believed that inequities could be addressed through his tryst with the planning process.
    • He felt that a degree of centralisation in fiscal power was required to address the concerns of socio-economic and regional disparities.
  • Rajamannar Committee (1969): A committee for Centre-State fiscal relations, it recommended more transfers and taxation powers for regional governments.
  • Planning commission and Fiscal Commission have been two pillars of fiscal transfers:
    • But after 2014, FC remains the sole authority to safeguard the interests of states.
  • Politicisation of finance commission: There are allegations that Finance Commission has become a politicised institution with arbitrariness and inherent bias toward the Union government.

Decline in fiscal capacities of state

  • Decline in revenue: The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20.
  • Increased expenditure: the expenditure of the States has been shooting up, their revenues did not.
  • Stagnant revenue: Since States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol —
    • the revenue has been stagnant at 6% of GDP in the past decade.

Recent instances that hamper fiscal federalism in India

  • GST: Because of GST, States have lost the autonomy to decide the tax rates of subjects that fall within the State List.
    • The inability of states to fix tax rates to match their development requirements implies greater dependence on the centre for funds.
  • Non-divisive cess and surcharges: Even the increased share of devolution, mooted by the Fourteenth Finance Commission, from 32% to 42%, was subverted by raising non-divisive cess and surcharges that go directly into the Union kitty.
    • This non-divisive pool in the Centre’s gross tax revenues shot up to 15.7% in 2020 from 9.43% in 2012, shrinking the divisible pool of resources for transfers to States.
  • Reduction in Corporate tax:
    • Instead of strengthening direct taxation, the Union government slashed corporate tax from 35% to 25% in 2019 and went on to monetise its public sector assets to finance infrastructure.
  • Issue of differential interest: States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings.
    • The Centre has been setting the limits on the market borrowings of States under Article 293 of the constitution. This goes against their autonomy.
  • Suspension of MPLAD: The central government suspended the MPLAD scheme and diverted that money to the Consolidated Fund of India leading to the centralization of the country’s financial resources
  • Issue of centrally sponsored schemes: There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost.
    • They spend about 25% to 40% as matching grants at the expense of their priorities.
    • These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes.

 

Fig: Issues with central revenue from States

Impact of centralisation of fiscal measures

  • Deepened inequality:
    • The poorest half of the population has less than 6% of the wealth while the top 10% nearly grab two-third of it’ (World Inequality Report)
  • Autonomy of states being curbed: By turning States into mere implementing agencies of the Union’s schemes, their autonomy has been curbed. It also undermines the electorally mandated democratic politics of States.
  • Depletion of state’s resources: The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates a constitutional provision.
    • It only impedes States from charting their own autonomous path of development.
  • Lower tax to GDP ratio: India has a poor record of taxing its rich. Its tax-GDP ratio has been one of the lowest in the world — 17% which is well below the average ratios of emerging market economies and OECD countries’ about 21% and 34%, respectively.
  • Biasedness towards Indian elites: Pavithra Suryanarayan, a political scientist at the London School of Economics, demonstrates that the Indian elites historically undermined fiscal capacity as they felt threatened by the political equality offered by the one person-one vote system.
  • Regressive indirect tax: The hollowing out of fiscal capacity continued for decades after Independence, resulting in one of the lowest tax bases built on a regressive indirect taxation system in the world.
  • Not adequate financial powers with states lead to
    • Vertical Fiscal Imbalance: State’s capacity to augment its revenue is estimated to be just 37.5% (average).
    • Horizontal Fiscal Imbalance:  Inequality in Fiscal health of states e.g. Bihar can generate revenue for just 37.6% of their expenditure while Haryana can do so for 82.6%.
    • Imbalances after Liberalization:  Market-based reform generated more inequality due to unequal capacity among states for infrastructure development.

 

Steps that need to be taken:

  • 15th FC recommended:
    • Financial Rationalization of CSS and Central outlays in consultation with the state government.
    • GST Council and the Finance Commission working need to be coordinated to optimize revenue targets
    • Giving Permanent status to Finance Commission
    • Relook at the 7th schedule: Re-examination of entries of List I and List III as per changes in the polity, technology, and aspirations of society.
    • Effective devolution of funds to local bodies through measures like more taxation powers, reforming the functioning of state finance commissions
  • 14th  Finance  Commission:The  transfers  from  the  Union  to  the  States (outside  the recommendations of the Finance Commission), should be ideally under the aegis of the Inter-State Council
  • Recommendations of Punchi Commission (2007) for better Centre-State fiscal relations
    • Minimizing discretionary transfers, particularly those channelled through CSS.
    • Expenditure liabilities on States for implementation of Central legislation should be fully borne by the Central Government.
    • Ceiling  on  professional  tax  should  be  completely  done  away
    • State-specific targets of fiscal deficit in the FRBM legislation of States.
  • Reviving institutions like the Inter-State Council after the abolition of the planning commission- will rebuild institutional capital. Also, increasing political capital through institutions like the Chief Minister’s conference will help bridge the trust deficit.
  • The TOR can be made a joint exercise rather than a top-down exercise by the union government.

 

Conclusion:

In sum, India’s fiscal federalism driven by political centralisation has deepened socio-economic inequality, belying the dreams of the founding fathers who saw a cure for such inequities in planning.

Thus only a buoyant tax system by increasing tax compliance and reviewing GST continuously can ease the battle for resources in our federal system. Also, mechanisms like the GST council will help nudge from competition to coordination over control of resources between union and states and minimize the mistrust that has grown in recent years.