An Analysis of Fiscal Federalism in India

The Author, Roshni Bagai, is a 4th-year, LLB student at City University of Hong Kong. She is currently interning with LatestLaws.com.

Introduction

Fiscal federalism refers to the financial relations between the country’s federal government system and other units of government. It is the study of how expenditure and revenue are allocated across different vertical layers of the government administration. Article 246 and Seventh Schedule of the Indian Constitution distributes powers and allots subjects to the Union and the states with a threefold classification type:

1. List I: The Union is responsible for functions of national importance, including but not limited to communications, constitution, defence, elections, external affairs and organisation of the Supreme Court and the High Courts.
2. List II: States are responsible for touching on the life and welfare of the people, for instance, through public order, police force, agriculture, local government, public health, water land, etc.
3. List III: The Concurrent list includes the administration of justice, economic and social planning, and more.

In accordance with the lists, the Parliament has reserved exclusive powers to create laws with regards to anything from List I. Contrarily, the Legislature of any state reserves the power to make laws for their respective states in relation to anything from List II. However, for any subject matter that falls within List III both, the Parliament and State Legislature can create laws, however, in the event of any conflict, the law made by the Parliament will prevail. Residuary functions listed in neither lists I or II are vested in the Union.

The Union and State lists also include the powers of taxation. The main source of income for the Union are direct taxes, mainly income tax. However, they are also entitled to collect various other taxes such as customs and corporate tax. States normally derive their income from indirect taxes, most commonly from sales tax. Besides this, State List also includes land revenue, excise on alcoholic liquor, estate duty, tax on vehicles and more. The Concurrent List does not comprise any tax power. The distribution of revenues and approaches for determining grants between the States and Union are legislated by various Articles of the Indian Constitution.

Recent Changes to the Indian Fiscal Federalism Structure

In recent years, fiscal relations between the union and state governments have undergone significant changes. Since 2015-2016, three landmark changes include:

1. The abolition of the Planning Commission in January 2015 and the subsequent creation of the NITI Aayog;
2. Fundamental changes in the system of revenue transfers from the centre to the states through the provision of higher tax devolution to the states based on the recommendations of the Fourteenth Finance Commission (henceforth, “14th FC”); and
3. The Constitutional amendment to introduce the Goods and Services Tax (henceforth, GST) and the establishment of the GST Council for the central and state governments to deliberate and jointly take decisions.

These changes and implementations have far-reaching consequences for the provision of public services and the union-state fiscal relations. In light of constitution of the Fifteenth Finance Commission (henceforth, “15th FC”) and the formulation of its Terms of Reference (henceforth, “TOR”), there have been rising concerns centralling around the following:

1. The Finance Commission’s role in providing conditional and unconditional transfers to the states;
2. The use of the transfer system to achieve development and policy outcomes; and
3. The future framework of state government borrowing.

Issues Under the Current Fiscal Federalism Structure

Given the recent changes, there is a serious need for redefining India’s current fiscal federalism structure. There has been a resurgence of horizontal and vertical imbalances in the structure, which will be further discussed below.

1. Horizontal Imbalances

Finance commissions, post 1990s, have essentially grown to become a vehicle for coercing states to implement fiscal reforms as part of economic liberalisation. This has been exacerbated by the replacement of the Planning Commission with the NITI Aayog. This move has reduced the policy outreach of the government as they now solely rely on the finance commission, which in turn, leads to a serious problem of increasing regional and sub-regional inequities. It has caused an unfortunate surge in horizontal imbalances because of the differing levels of attainment by the states, resulting from the differential growth rates and their developmental status in terms of the state of social or infrastructure capital. The Terms of Reference (henceforth, “ToR”) of the 15th FC has exacerbated this process which, if implemented along with the Fiscal Responsibility and Budget Management Bill (henceforth, “FRBM”) review committee recommendations, may potentially reduce the states’ capacity to intervene in economic and social sectors.

A “fragmented” transfer system is a prime feature of the Indian fiscal federal arrangements between the union and the states.  The transfer of financial resources from the union to the states flow through various streams which fall in either of the following categories:

1. General purpose transfers (i.e. states can spend these resources on their respective priorities which can be drawn up by them; or
2. Conditional transfers (i.e. the centre only transfers resources upon the condition that the states must use it for particular programs and schemes drawn up by the centre)

The Twelfth Financial Commission (henceforth, “12th FC”) had placed emphasis on the fact that to achieve equalisation among states, grants provided for a more effective mechanism as compared to tax devolution. Therefore, there was a higher degree of importance given to transfers through grants, thereby, increasing the share of grants in total transfers. These were known as conditional grants. In the Thirteenth Financial Commission, the opposite movement took place, where the share of tax devolution rose again, and further increased in the 14th FC. However, this has changed to some extent in the 15th FC.

Momentarily, approximately 40% of the total transfers are still linked to conditional transfers, which are largely linked to the Centrally Sponsored Schemes (henceforth, “CSS”). However, transfers made under the CSS are, in actuality, outside the Finance Commission’s purview. These transfers are used by the central government to improve development outcomes in specific sectors, primarily economic and social services.

In light of this institutional reality, the Finance Commission’s role in relation to conditional transfers if the related transfers are not in their ambit is questionable. On one hand, it could be accurate to interpret “measurable performance-based incentives” as an effort to introduce conditionality-driven transfers through the Finance Commission. However, this brings forth two issues, namely, the availability of fiscal space with the Finance Commission for making conditional grants after tax devolution, and the desirability of such grants as well as their effectiveness. This requires a serious review of the conditional transfers provided by the Finance Commissions, their relative importance in total transfers, the design of conditional transfers and their impact on spending as well as the outcomes in delivery of services by the states. In all likelihood, if a large share of Finance Commission transfers are set aside for conditional transfers, it will fundamentally change the way resources flow to the states. Additionally, the transfer of resources by the mechanism of grants would also affect the freedom and maneuverability of the states with regards to setting priorities.

The volume of conditional grants provided by the Finance Commission may eventually alter the states’ spending behaviour. This would have a detrimental effect because it suggests that the Finance Commission has been granted the authority to restrain democratically elected governments from implementing promises made to people in the election manifestos, for instance, the provision of welfare pensions, food, subsidies, etc.. this, in turn, strikes the root of democratic polity. Besides, it has proliferated discriminatory practices. This is denoted by the fact that the implementation of central flagship schemes is incentivised, whereas the state schemes are being controlled by classifying them as populist, as evidenced by paragraph 7(viii) of the ToR. This approach goes against the federal spirit and fails to abide by the Directive Principles of State Policy enshrined by the Indian Constitution. Moreover, the 7th provision of the ToR also mandates the 15th FC to assess and monitor the performance of GST implementation and various other governance indicators. The added functionality of the Finance Commission as a monitoring agency of the states’ performance goes against its constitutional role.

2. Vertical Imbalances

The creation of vertical imbalances is a result of the fiscal asymmetry in powers of taxation vested with the different levels of government in relation to their expenditure responsibilities prescribed by the Indian Constitution. The central government is given a much greater domain of taxation, with a collection of 60% of the total taxes, despite their expenditure responsibility only amounting to 40% of the total public expenditure. These imbalances are further exacerbated in cases of third tiers, comprising elected local bodies and panchayats. Vertical imbalances can have a hostile impact on India’s urbanisation, the quality of local public goods, which thereby, would further aggravate the negative externalities for climate change and the environment.

The introduction of the GST is a demonstrative example of the working of cooperative federalism. However, it is questionable as to how far this conforms to actual practice. Under article 279A of the Indian Constitution, two-thirds of the voting rights belong to the states while the centre has one-third voting rights at the GST Council. Nonetheless, passing a resolution required three fourths majority. In effect, this confers a veto power for the centre, even when states jointly propose a change. The states should be able to adopt a change in their tax structure without the centre’s consent, given that each state is governed differently based on local legislations.

Furthermore, the GST’s apportionment has raised some concerns. The suggested apportionment between the states and the centre by the committee on revenue neutral rates of the central government was a 60:40 ratio, as almost 44% of the states’ own tax revenue was subsumed under the GST as compared to 28% for the centre. The centre still retains their power to levy additional excise duty on, for instance, tobacco products, even though it has been brought under the GST. States, on the other hand, have no such right. This deprives the state of their main source of income, being indirect taxes, thereby slowly causing the state government to fail in upholding their end of the bargain in relation to their responsibilities. The following case study showcases the importance of providing state governments with fiscal freedom in order to better the governance of state governments and to enhance the economic and social wellbeing of states.

In 1982, the Chief Minister of Tamil Nadu wanted to expand the midday meal scheme to 70 lakh children across government schools, with the primary purpose of improving the enrollment of students. Due to the lack of funds, the state government decided to levy an additional sales tax on goods sold in Tamil Nadu. This program was further expanded by the political party. Shortly after the scheme was successfully implemented, they achieved a literacy rate of 83% as compared to 54% prior to the scheme.

Recommendations

In a framework of cooperative federalism, it is important to have provisions for a higher devolution to the state governments in order to fiscally empower them to achieve the goals of the national development programme of New India-2022, which expresses goals that pertain to the subjects in the State List. In fact, all tiers should be fiscally empowered to achieve state-specific targets of fiscal deficit, rather than adopting a top-down approach. Future legislations issued by the Central Government in relation to states should enact more provisions for cost-sharing to aid them in fulfilling their duties. 

Conclusion

In light of the recent changes, it appears that India has deviated rather far from what cooperative federalism envisages. One can only hope that these changes bring forward the absence of a framework for non-Finance Commission grants. Given the replacement of the Planning Commission, there is more clarity necessitated in relation to the treatment of grants outside the Commission's purview. States need to be able to fulfill their promises upon which they were democratically elected, otherwise this can have detrimental effects not just on the fiscal federalism principles, but on the social and economic state by and large. For this, the division of direct and indirect taxes needs to be considered, especially after the implementation of the GST.