Dynamics of Fiscal Federalism

Reference

From the transition from a planned economy to a market-mediated economic system to the formation of the NITI Aayog and the implementation of the Goods and Services Tax (GST) Act, there are many issues that have different impacts on India's fiscal federalism. Therefore, there is a need to reconsider the emerging dynamics of India's fiscal federalism.

Fiscal federalism of India

• From a fiscal point of view, the Indian federal system has three important components:
  • Article 1 of the Constitution: It states that India shall be a union of states.
  • Seventh Schedule of the Constitution: It allocates different functions with overlapping functions to the Union and the States under different lists.
  • Article 280 of the Constitution: It provides for the formation of a Finance Commission every five years to recommend vertical and horizontal redistribution of net Union taxes and various other grants.
• Fiscal federalism is defined as the financial relations between units of government in a federal government system.
• Fiscal federalism is part of the broader public finance discipline. It includes:
  • This may include the levy of taxes as well as the division of various taxes between the Centre and the constituent units.
  • Determination of criteria for fair division of funds between constituent units in case of joint collection of taxes.
  • Establishment of Finance Commission as a constitutional authority for the purpose of ensuring fairness in the division of taxes in India.

The Emerging Dynamics of India's Fiscal Federalism

• The shift from a planned economy to a market-mediated economic system is clearly visible in India's fiscal policy.
• The 73rd and 74th Constitutional Amendments have transformed the two-tier federal system into a multi-tier fiscal system.
• The Planning Commission was abolished and replaced by the NITI Aayog.
• The Fiscal Responsibility and Budget Management (FRBM) Act was passed to ensure fiscal discipline and accountability in both the Central and State governments.
• The GST Act and the establishment of the GST Council as a controlling authority have brought about significant changes in the tax structure and revenue sharing between the Centre and the States.
• Extensive use of cesses and surcharges which affect the size of the divisible pool of funds available for distribution between the Central and State governments.

Issues of Fiscal Federalism in India

• Disproportionate approvals: Tax waivers, tax concessions and other revenue waivers are reducing the size of the divisible fiscal pool while disproportionately benefiting the wealthy.
  • Based on Economic and Political Weekly Research Foundation data, the per capita income of 16 major states from 1970-71 to 2020-21 has recorded a compound annual growth rate (CAGR) of only 0.72%.
• Additional burden on states: Schemes implemented through central laws increase the financial burden on the states. For example:
  • Mahatma Gandhi National Rural Employment Guarantee Act, 2005
  • Right of Children to Free and Compulsory Education Act, 2009
  • National Food Security Act, 2013
• Confusion and Disorder: After the inclusion of Schedule XI and Schedule XII in the Constitution, more confusion and disorder has arisen regarding the division of functions and finances.
  • Taking subjects from the State List and the Concurrent List, the subjects for Panchayati Raj Institutions and Municipalities have been listed in both the schedules respectively.
  • Until these subjects are defined properly, a situation of chaos will continue.
• Lack of a uniform financial reporting system: The lack of proper place for the third tier in India's fiscal federal system is a serious issue. A uniform financial reporting system should be implemented at all levels of government. Such as -
  • Introduction of standard budget rules for all levels.
  • Introduction of the long-recommended accrual-based accounting system.
• Irregular Borrowings Off-Budget: Off-Budget borrowings refer to all borrowings for which provision has not been made in the Budget but whose repayment liabilities fall on the Budget.
  • Off-budget borrowing practices are followed by both the Central and State Governments.
  • Though the State Governments are controlled through Article 293(3) of the Constitution and the FRBM Act, such borrowings are neither subject to proper scrutiny nor reporting by the Centre.
  • The substantial use of the National Small Savings Fund to finance Central Public Sector Undertakings through loans is not included in the Union fiscal deficit.
• Fiscal federalism issues related to GST:
  • GST has made the country's indirect tax system more unitary, thereby reducing the financial autonomy of the states.
  • States were promised compensation if revenue growth fell below 14% but the Centre's failure to make timely payments has led to conflicts.
  • States face a shortfall in their own GST revenues, creating fiscal challenges and affecting fiscal federalism.

Suggestions for the future

• Reforming fiscal transfers: India’s fiscal transfer system must prioritise equity. For this, the upcoming 16th Finance Commission should focus on equity in tax transfers.
• Rethinking Article 246 and the Seventh Schedule: Changes in politics, society, technology, demography and development approach have brought about significant changes in the governance landscape.
  • There is therefore a need to revisit Article 246 and the Seventh Schedule of the Indian Constitution which outlines the distribution of legislative powers between the Centre and the States.
• Empowering the third tier: Recognising the role of local governments, the upcoming Central Finance Commission should focus on empowering the third tier.
  • Also, a new local list detailing the responsibilities and powers of local governments needs to be prepared.
• Review of off-budget borrowing: There is a need to review the off-budget borrowing practices of both the Centre and the states. Transparency is important and all income and expenditure transactions must be accounted for within the budget.