The poor state of India’s fiscal federalism

Source: This post is based on the article “The poor state of India’s fiscal federalism” published in The Hindu on 28th July 2022.

Syllabus: GS 2 – Issues and challenges pertaining to the federal structure.

Relevance: About India’s fiscal federalism.

News: A degree of centralisation in fiscal power was required to address the concerns of socio-economic and regional disparities after the Independence. This asymmetric fiscal federalism was accelerated and mutually reinforced in recent times.

About India’s fiscal federalism

India 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).

B.R. Ambedkar in Constituent Assembly said “In politics we will have equality and in social and economic life we will have inequality. These conflicts demanded attention: fail to do so, and those denied will blow up the structure of political democracy.”

Anticipating this threat of centralisation, the Tamil Nadu government, constituted a committee under Justice P.V. Rajamannar in 1969, the first of its kind by a State government. The committee looked at Centre-State fiscal relations and recommended more transfers and taxation powers for regional governments.

What is the present structure of India’s fiscal federalism?

India’s fiscal transfer worked through two pillars, the Planning Commission and the Finance Commission. Ever since the abolition of the Planning Commission, the Finance Commission became the major means of fiscal transfer.

The finance commission broadened its scope of sharing all taxes since 2000 from its original design of just two taxes – income tax and Union excise duties.

What is the status of state’s revenues and expenditures?

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. They still spend 60% of the expenditure in the country — 85% on education and 82% on health.

The expenditure of the States has been increasing, but their revenues did not. States cannot raise tax revenue because of curtailed indirect tax rights (under GST). Their revenue has been stagnant at 6% of GDP in the past decade.

What are the recent instances that hamper fiscal federalism?

1) States lost their capacity to generate revenue by surrendering their rights after the Goods and Services Tax (GST) regime, 2) The Fourteenth Finance Commission increased share of devolution from 32% to 42%. But, the increasing non-divisive pool in the Centre’s gross tax revenues and reduction in the divisible pool of resources hampers the revenue, 3) States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings.

4) The issue of centrally sponsored schemes: State’s expenditure pattern was distorted by the Union’s intrusion, mainly through its centrally sponsored schemes(CSSs). This is because,

a) There are 131 centrally sponsored schemes. States are required to share a part of the cost. b) CSSs are driven by the one-size-fits-all approach and are given precedence over State schemes. Thus undermining the electorally mandated democratic politics of States, c) The schemes conceived by States have proved to be beneficial to the people and have contributed to social development, and d) Many  State schemes are adopted at the national level, For instance, the employment guarantee in Maharashtra, the noon meals in Tamil Nadu, local governance in Karnataka and Kerala, and school education in Himachal Pradesh.

What are the impacts of the centralisation of fiscal policy?

Heavy centralisation made India, one of the lowest tax bases built on a regressive indirect taxation system in the world. India has simply failed to tax the following,

a) Agriculture income, b) Reduced corporate tax to boost the economy, c) India does not have any wealth tax, d) Indirect tax still accounts for about 56% of total taxes.

Overall, India’s fiscal federalism driven by political centralisation has deepened socio-economic inequality and has not altered inter-state disparities either.