Fiscal Federalism in India- Significance and Challenges- Explained Pointwise

Recently, the Tamil Nadu Chief Minister M.K. Stalin alleged that the Union government was withholding funds for the State’s Metro rail completion and other vital projects. States of Southern India have also raised the issue of reduced fiscal devolution despite higher contribution in the Gross tax revenues. Several state governments have alleged that Central Government’s tax policies have reduced aggregate financial transfers to States, and has weakened cooperative fiscal federalism in India.

What is Fiscal Federalism? What are the constitutional provisions which provide for Fiscal Federalism in India?

Fiscal Federalism- Fiscal federalism refers to the division of financial powers and responsibilities between the central government and state governments in India.

Constitutional Provisions- The Indian Constitution defines the taxation and expenditure powers of the central and state governments through various provisions
a. Seventh Schedule- The Constitution assigns specific tax bases to the central and state governments, listed in the Union List and State List respectively.
b. Article 270- Article 270 of the Indian Constitution provides for the distribution of net tax proceeds collected by the Union government between the Centre and the States.
c. Article 280- The Finance Commission which is a constitutional body under Article 280, recommends the sharing of tax revenues and grants-in-aid to the states.
d. Article 275- It provides for the grants-in-aid system which involves discretionary transfers from the Centre to states for specific purposes.

Examples of Cooperative Fiscal Federalism

a. Introduction of GST- The introduction of Goods and Services Tax (GST) through the 101st Constitutional Amendment is a historic example of cooperative fiscal federalism in India. The GST act has transformed India’s indirect tax landscape, and fostered Centre-State cooperation.

b. Passage of FRBM Act- The Fiscal Responsibility and Budget Management (FRBM) Act 2003 aims to promote fiscal discipline at the central and state levels. 21 states enacted their own FRBM Acts, incentivized by debt and interest rate relief provided by the 12th Finance Commission. This is a historic example of centre-state cooperation in maintenance of Fiscal prudence.

c. Introduction of performance based grants- Performance-based grants are being used to incentivize states to achieve developmental targets. This has led to competitive and cooperative federalism between the Centre and States in the sphere of finances and public expenditure.

What are the Challenges to Fiscal Federalism in India?

1. Reduced Financial Transfers to the States- The share of states in the gross tax revenue (total tax revenue collected, which includes cess and surcharges) has decreased from 35% in 2015-16 to 30% in 2023-24.

2. Disproportionate Growth between Union Govt’s & State Govt’s Revenue- From 2015-16 to 2023-24, while the Union government’s tax revenue has increased by 2.3 times from ₹14.6 lakh crore to ₹33.6 lakh crore, the states’ share in the tax revenue has only doubled from ₹5.1 lakh crore to ₹10.2 lakh crore. This indicates a disproportionate growth between Union Govt’s and State Govt’s Revenues.

3. Decrease in Grants-in-Aid to the states- Direct financial support to states, in the form of grants-in-aid, has declined from ₹1.95 lakh crore in 2015-16 to ₹1.65 lakh crore in 2023-24.

4. Increase in the share of non-devolvable cess and surcharge- The share of collected cess and surcharge (which are not shared with states) has increased from Rs. 85,638 in 2015-16 (5.9% of the Union government’s tax revenue) to Rs. 3.63 lakh crore in 2023-24 (10.8% of the Union Govt’s tax revenue).

5. Centralisation of Public Expenditure- Out of the combined allocation of ₹19.4 lakh crore for Centrally Sponsored Schemes (CSS) and Central Sector Schemes (CSec Schemes) in 2023-24, only ₹4.25 lakh crore was devolved to States. These are tied grants and the states have no autonomy to plan their expenditure.

6. Interstate Inequality in public Finances through CSS schemes- The Union government compels the State to commit more or less an equivalent quantum of financial resources in the implementation of CSS schemes. Wealthy States can afford to commit equivalent finances and leverage Union finances inwards through the implementation of CSS. However, less wealthy States will have to commit their borrowed finances in these CSS, thus increasing their own liabilities. It has created inter-state inequality in public finances.

7. Increase in Conditional Transfers- Several grants to states are contingent on fulfilling certain conditions, including the insistence on specific labelling, which imposes Union government preferences over state priorities.

8. Erosion of State Taxation Autonomy on account of implementation of GST- The ability of states to set tax rates on their own revenue sources has been significantly diminished due to the implementation of GST. For ex- State VAT have been subsumed under GST.

9. Issues with GST- The compensation of revenue loss to states on account of GST implementation, have not been properly addressed. For ex- Discontinuation of GST compensation cess.

What is the Significance of Fiscal Federalism?

1. Addressing Diversity and Disparities- Fiscal federalism allows the central and state governments to address the regional imbalances through mechanisms like tax sharing, grants-in-aid, and performance-based incentives.

2. Promotes cooperation and consultation between states- Fiscal federalism encourages cooperation and coordination between the Centre and states, as they negotiate the sharing of resources and responsibilities. For ex- The GST Council brings together the Centre and states to jointly administer the Goods and Services Tax.

3. Ensuring Fiscal Discipline- Fiscal federalism frameworks like the Fiscal Responsibility and Budget Management (FRBM) Act promote fiscal discipline at both the central and state levels. This helps maintain macroeconomic stability and sustainability.

4. Enabling Decentralized Governance- Fiscal federalism supports decentralization by empowering state and local governments with financial autonomy and resources. This strengthens grassroots democracy and responsive governance closer to the people.

5. Undertaking Economic Reforms- Fiscal federalism helps to adapt to changes like the shift towards a market-oriented economy (1991 economic reforms), and undertake taxation reforms like the introduction of GST.

What are the finance commission recommendations for Fiscal federalism?

The Finance Commissions have made several important recommendations over the years to promote fiscal federalism in India-

a. Vertical Tax Devolution- The 14th Finance Commission radically increased the share of states in the central divisible pool of taxes from 32% to 42%, the biggest ever increase in vertical tax devolution. This enhances the fiscal autonomy and resources of state governments.

b. Horizontal Distribution Formula- The 15th FC used criteria like income distance (45%), population (2011) (15%), area (15%), demographic performance (12.5%), and forest and ecology (10%) to determine each state’s share. This helps equalize fiscal capacities and addresses horizontal imbalances between states.

c. Grants-in-Aid- The Finance Commissions provide grants-in-aid to specific states or sectors that are in need of assistance or reform. This promotes the spirit of competitive and cooperative fiscal federalism.

d. Fiscal Consolidation- The finance commissions have suggested maintenance of fiscal prudence by the states. The 12th FC recommended a multi-dimensional restructuring aimed at both qualitative and quantitative aspects of managing government finances

What should be the way Forward to strengthen Fiscal Federalism in India?

1. Enhanced devolution by the 16th Finance Commission- The 16th Finance Commission (FC) must look to enhance the state’s share in the net taxes from 41% (currently awarded by 15th FC). Further, the principles of Vertical and Horizontal devolution, must be relooked to ensure equitable distribution of taxes among the states.

2. Rationalisation of Public Expenditure by Central Govt- A mechanism must be instituted for thorough financial rationalisation of the Central Sector and Centrally Sponsored schemes, in collaboration with state governments.

3. Addressing the GST related Concerns- The anomalies in GST like the Integrated GST which favours the consuming states like UP and Bihar, rather than the producing states of TN, Gujarat must be corrected. Also, efforts must be undertaken to open more avenues for revenue generation by broadening the scope of GST to include petrol, diesel etc.

4. Revisiting Article 246 and the Seventh Schedule- The taxation powers listed in the seventh schedule must be relooked in the context of fiscal federalism.

5. List of Taxation for Third Tier of Govt- Specific taxation powers must be devolved to the local self governments to help them raise their own resources and reduce their dependence on grant-in-aids. This will help in achieving fiscal federalism in its true sense.

6. Reduction of Borrowing Constraints on States- The Union government should revisit the borrowing constraints placed on state investment funds, as suggested by Kerala.

7. Reduction in Cesses and Surcharges- The Union government should reduce the degree to which it uses cesses and duties to expand its share of tax collections.

8. Minimisation of the discretionary aspect of transfers to states- Some of these transfers can be made automatic. For other transfers, clear and non-discriminatory methods should be followed.