Fiscal Federalism in India

Fiscal Federalism refers to the division of responsibilities with regards to public expenditure and taxation between the different levels of the government. The Government of India Act 1919 and 1935 formalized the tenets of fiscal federalism and revenue sharing between the Centre and the states. It allows the government to optimize their costs on economies. The Constitution has provided provisions which enable the Union and the States to work in coordination and to levy and collect these taxes through systematic arrangements, provisions like-

Taxes levied and collected by the Centre but assigned to the States.
Taxes levied by the Centre but collected and kept by the States.

Sharing of proceeds of income from some taxes.

Grant-in-aid provided by the Centre to the States.
Grants provided for any public purpose.

Fiscal relations in India between the union and state governments have undergone significant changes in recent years. Three landmark changes in union-state fiscal relations since 2015-16 have been:

The abolition of the Planning Commission on January 2015 and the subsequent creation of the NITI Aayog.
Fundamental changes in the system of revenue transfers from the centre to the states by providing higher tax devolution to the states from the fiscal year 2015-16 onwards based on the recommendations of the Fourteenth Finance Commission (14th FC);
The Constitutional amendment to introduce the Goods and Services Tax (GST) and the establishment of the GST Council for the central and state governments to deliberate and jointly take decisions.

Need for Redefining Fiscal Federalism in India

Horizontal imbalances :

Replacing the Planning Commission with NITI Aayog has reduced the policy outreach of government by relying only on a single instrument of fiscal federalism i.e. Finance commission. This approach can lead to a serious problem of increasing regional and sub-regional inequities.The horizontal imbalances arise because of differing levels of attainment by the states due to differential growth rates and their developmental status in terms of the state of social or infrastructure capital.

Horizontal imbalances involve two types of imbalances:

Type I is to do with the adequate provision of basic public goods and services.
Type II is due to growth accelerating infrastructure or the transformational capital deficits.

Vertical imbalance:

Vertical imbalance arises due to the fiscal asymmetry in powers of taxation vested with the different levels of government in relation to their expenditure responsibilities prescribed by the constitution. In India’s fiscal federalism, the central government has a far greater domain of taxation Central Government collects around 60% of the total taxes, while its expenditure responsibility is only 40% of the total public expenditure. Such vertical imbalances are even sharper in the case of the third tier consisting of elected local bodies and panchayats. Vertical imbalances can adversely affect India’s urbanization, the quality of local public goods and thus further aggravating the negative externalities for the environment and climate change.

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Restructuring the Fiscal Federalism

India’s Fiscal Federalism needs to be restructured. By restructuring Finance Commission, NITI Aayog, GST and decentralization, it can eliminate the inadequacies of vertical and horizontal imbalances.

Finance Commission must be relieved from the dual task of dealing with the provision of basic public goods and services and capital deficits. It should be confined to focusing on removal of basic public goods imbalance (Type I).
NITI Aayog, for dealing in the realm of infrastructure and capital deficits (Type II).
It should be engaged with the allocation of capital in a way different than that used by the Finance Commission with different parameters for allocation. NITI Aayog should receive significant resources (1% to 2% of the GDP) to remove regional and sub-regional disparities among states by reducing development imbalances in the areas of infrastructure deficit. NITI Aayog should be mandated to create an independent evaluation office which will monitor and evaluate the efficacy of the utilization of revenue and capital grants. It should also be an integral part of the decision making processes as it can effectively negotiate between the states for the transfer of resources.
Decentralization can serve as the new fiscal federalism by strengthening local finances and state finance commission.

Local public finance: the creation of an urban local body or the Panchayati Raj institutions consolidated fund.
Centre and States should contribute an equal proportion of their Central GST(CGST)and State GST (SGST) collections and send the money to the consolidated fund of the third tier. One-sixth sharing of the CGST and SGST with the third tier can generate more than 1% of the GDP every year for the financing of public goods by urban-level bodies.
State FinanceCommissionsshould be accorded the same status as the Union Finance Commission and the 3Fs of democratic decentralization (funds, functions, and functionaries) should be implemented properly.

Goods and Services Tax should be simplified in its structure and by ensuring:

Single Rate GST: with suitable surcharges on sin goods, zero ratings of exports and reforming the Integrated Goods and Services Tax (IGST) and the e-way bill. GST is a comprehensive, multi-stage, destination-based tax that is levied on every value addition. GST is one indirect tax for the entire country. The GST council is the key decision-making body that will take all important decisions regarding the GST. The GST Council should undertake reforms in an informed and transparent manner, by creating its own secretariat and independent experts.

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Concern and issues in India

The Indian Constitution lays down the functions as well as taxing powers of the Centre and States.
It is against this background that the issues relating to vertical and horizontal imbalances are addressed by every Finance Commission.
Central transfers to States are not confined to the recommendations of the Finance Commissions.
There are other channels such as those through the Planning Commission until recently and the discretionary grants of the Central government.
In 2010-11, in the combined revenue receipts of the Centre and States, the share of the Centre was around 64%.
But after the transfer, the share came down to nearly 40%. Thus the shares of Centre and states got reversed after the transfers.
In 2016-17, the share of the Centre after transfers was around 33% and that of the States was 66%.
In comparison, in the case of total expenditures, the share of the Centre in 2014-15 was nearly 41% and that of the States was 58%.

Challenges of fiscal federalism

Fiscal federalism is the economic counterpart to political federalism.
It assigns functions to different levels of government and also offers appropriate fiscal instruments for carrying out these functions.
Determination of these specific fiscal instruments is a challenging task.
Building the principles into an actual scheme of assignment of taxes to different levels of government in a Constitution is difficult.
In India, income tax is levied only by the Central government though shared with the States.
Given the possibility of imbalance between resources and responsibilities, many countries have a system of inter-governmental transfers.
There is huge economic and cultural diversity among the various States. It is a terrible mistake to presume that all of India can be governed from Delhi.
Elected State governments and leaders cannot be made dummies without any fiscal powers for long.
This fiscal federalism tension between the Centre and States can erupt into something more dangerous and spread wide.

Public Administration Daily Answer Writing Challenge

15th Finance Commission of India

The Union Cabinet passed an amendment to widen the terms of reference of the 15th Finance Commission.
The Commission has now been asked to examine the possibility of setting up a mechanism for funding defence and internal security.
They may face resistance from states, especially when several of them are arguing for a greater share in tax revenues.
The Seventh Schedule of the Indian Constitution specifies the separate as well as concurrent responsibilities of the Centre and state governments, with defence falling in the Union list.The inability of the Centre to ramp up it’s spending on defence indicates the limited fiscal space available to it.
In large part, this is due to an increase in spending on items in the state and concurrent list, and a corresponding decline in spending on items in the Union list.In 2015-16 alone, the Centre spent 16 per cent of its revenue expenditure on items in the state list, and another 16.4 per cent on items in the concurrent list.

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Way ahead

Grant State governments the powers to levy income taxes. In large federal democracies such as the United States, State governments and even local governments have the right to levy income taxes.
State governments should be given powers to raise revenues and incur expenditure in accordance with each State’s needs and priorities.
Amend the Constitution to grant States the powers to levy income taxes as they deem fit.

Conclusion

Redefining the fiscal architecture of India can strengthen the fiscal federalism. Independent Finance commission, effective NITI Aayog, creating the new fiscal federal architecture based on the effective decentralisation and transparent GST regime can strengthen India’s unique cooperative federalism.