Fiscal Federalism

31 Aug 2022 Fiscal Federalism

GS Paper 2:Issues and Challenges Pertaining to the Federal Structure.

GS Paper 3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development, and Employment.

Essential features of Indian Fiscal federalism:

• Constitutional base for the division of resources between governments is mentioned in the 7th schedule. 
• Since India is a union of states there is a unitary tilt in Indian federalism. 
• Finance Commission plays an important role in fiscal devolution.

Importance of  Fiscal Federalism: 

• Through the Fiscal Federalism mechanism government optimize its costs on economies of scale.
• By optimizing costs people get their preferred public service without any unnecessary expenditure.
• In terms of economic view point federalized structure helps in creating a unified market.

Evolution of Fiscal federalism in India, pre-Independence:

• Contribution from the provinces to the Union in the 1920s.
• GoI Act 1919 (Montague-Chelmsford reforms) provided for a separation of revenue heads between Centre & State.
• GoI Act 1935 established the basic structure of fiscal federalism in India, allowing for sharing of the Centre’s revenue and the provision of grants in aid to provinces.

Evolution of Fiscal federalism in India, post-Independence:

• Post-independence center assumed greater importance.
• Single party domination impacts on rules and institutions.
• Problems of intergovernmental co-ordination in the new political environment.

Recent issues in India’s fiscal federalism:

• Incongruence of Article 282 of the Constitution with the letter and spirit of the Seventh Schedule. Article 282 of the Constitution states that “The Union or a State may make any grants for any public purpose, notwithstanding that the purpose is not one with respect to which Parliament or the Legislature of the State, as the case may be, may make laws”. Residuary power granted under Article 282 used excessively by  central government through  implementation of  Centrally sponsored schemes.
• Fiscal incongruity due to Fiscal Responsibility and Budget Management (FRBM) Act.
• Politicization of institutions such as the Finance Commission: Finance Commission is a major means of fiscal transfer but it  became a politicized institution having  arbitrariness and inherent bias towards the Union government.
• Expenditure of the States has been shooting up, their revenues did not: State still spends 60% of the expenditure in the country 85% in education and 82% in health. But, its ability to finance current expenditures from their own revenues has declined.
• Stagnant Revenue of States: Since States tax revenue curtailed as most of the indirect tax rights got  subsumed in GST.
• Increase in non-divisive cess and surcharges that go directly into the Union kitty: 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.
• Recent drastic cuts in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.
• Exploitation of interest rate differentials by the Union government: States are forced to pay differential interest about 10% against 7% by the Union for market borrowings. That increased surplus cash in the balance of States that money borrowed at higher interest rates invested by Reserve Bank of India(RBI), in short treasury bills issued by the Union at lower interest rate.
• Implementation of central schemes: Autonomy of the states were curbed by turning them into mere implementing agencies of the Union’s 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. 
• Conceptions of Central schemes, are  driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States.
• Violation of constitutional provision due to Diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes. Implementation of centrally sponsored schemes on an item that is in the State list.
• Conflict over issues related to Goods and Services Tax (GST) such as the rate structure, inclusion and exclusion of commodities, revenue sharing from GST and associated compensation.
• Deepening socio-economic inequality due to political centralization: The poorest half of the population has less than 6% of the wealth while the top 10% nearly grab two-third of it. India has a poor record on taxing its rich. Its tax-GDP ratio has been one of the lowest in the world — 17% of which is well below the average ratios of emerging market economies and OECD countries’ about 21% and 34%, respectively.
• Reliance on Indirect taxation for raising revenue: Indirect tax still accounts for about 56% of total taxes. Instead of strengthening direct taxation, the Union government slashed corporate tax from 35% to 25% in 2019 and went on to monetize its public sector assets to finance infrastructure.
• Inter-state disparities: There are inter-state disparities due to inequities in planning.
• New era of political centralization and cultural nationalism drives today’s fiscal policy neglecting  concerns of socio-economic inequities.

 Mechanisms to resolve issues related to fiscal federalism:

• Issues related to GST have a forum for discussions as they are usually the agenda for GST council meetings. 
• Other matters are generally flagged by the Finance Ministry based upon reports and studies done by the Reserve Bank of India (RBI) and the Comptroller and Auditor General of India. 

Way Forward:

• Restructure Seventh Schedule i.e. the allocation of centre-state responsibilities while keeping in mind development of Indian value chain and national priorities and notable policy initiatives like Swachh Bharat, the New Education Policy, Ayushman Bharat and Swachh Jal through Jal Jeevan Mission that transcend boundaries.
• Rationalization of centrally sponsored schemes and central outlays through central entities that took overview of  number and forms of centrally-sponsored schemes.
• Clearly define the role of the National Institution for Transforming India (NITI Aayog), which is primarily a think tank institution and not a financial body, in the financial sphere. 
• Continuous reforms in public finance management (PFM) systems that will help us to rethink the design and structure of a genuine fiscal partnership.
• Rebuilding Institutional Capacity by reviving institutions like Inter-State Council after abolition of Planning Commission.
• More effective devolution of funds to local bodies by giving them more taxation powers.

Sources: The Hindu, OECD Library.

Source Link:

1. The Hindu:- https://bit.ly/3DcCTwz ; https://bit.ly/3DaC2fA
2. OECD Library:- https://bit.ly/3eE8lcz

• Yojna IAS Daily current affairs eng med 31th August

khushhal chauhan