Fiscal Federalism In India: Current Status, Challenges and Way Forward

Context:  

This article is based on the news “Why is fiscal consolidation so important? | Explained” which was published in the Hindu. The states of Karnataka and Kerala are bringing their protest against the Centre’s alleged biased fiscal policies to the national capital, Delhi.

Kerala Chief Minister to Lead Protest Against Centre’s Financial Embargo

• Protest by Kerala: The Kerala Chief Minister has decided to lead a protest in New Delhi against the Centre for placing Kerala on a financial embargo.
  • According to the Kerala government, there has been a fall of Rs 57,400 crore in state’s receipts from the Centre, a shortfall of Rs 12,000 crore in GST compensation, another cut of Rs 8,400 crore in this year’s revenue deficit grant, and a fall in Kerala’s eligible borrowing limit to Rs 28,830 crore from the Rs 39,626 crore it expected.
  • It has accused the Centre of pushing the State into a severe financial crisis by imposing a limit on its borrowings.
• Karnataka’s Protest: Karnataka Chief Minister has put the losses suffered by the state exchequer due to factors such as reduction of Karnataka’s share in the divisible pool of taxes and faulty implementation of GST at around Rs 1.87 lakh crore.

About Fiscal Federalism

• Fiscal Federalism: It entails the division of responsibilities and resources between the central and state governments, with the Finance Commission playing a key role in recommending tax proceeds distribution. 

• • Equitable intergovernmental transfers, involving fund transfers from the central to state governments, are vital for balanced regional development, reducing fiscal imbalances, and promoting cooperative federalism.
  • Federalism: It is a mode of government that combines a general government with regional governments in a single political system, dividing the powers between the two.
• Constitution provides for a significantly centralized federal structure, with the bulk of revenue-raising powers residing with the Union government. As a result, Union government transfers to the States are vital for the latter’s fiscal space.
  • The Union government’s fiscal transfers to States are made through two mechanisms viz. the Finance Commission and a variety of Central government schemes. 
• Finance Commission (FC): The Constitution envisages the Finance commission as the balancing wheel of fiscal federalism in India. 
  • Article 280 of the Constitution of India provides for a Finance Commission as a quasi judicial body. It is constituted by the President of India every fifth year or at such an earlier time as he considers necessary.
  • The Finance commission was formed to define the financial relations between the central government of India and the individual state governments.
  • It makes recommendations on three areas:
    • The share of the divisible pool of the Union government’s taxes that is to be devolved to the States.
    • Grants made by the Union government to the States to meet their revenue deficits. 
    • Certain other grants to States and local governments. 

India’s Fiscal Federalism and Associated Challenges

• Tax Devolution

  • The share of devolution for the less populous and fiscally stronger southern states tends to be lower, while few northern states, which are weaker on these metrics, get a larger share of central taxes.
  • According to the Reserve Bank of India’s (RBI) of State Finances: A Study of Budgets of 2023-24 report, due to increase in cesses and surcharges, the divisible pool has shrunk from 88.6 percent of gross tax revenue in 2011-12 to 78.9 percent in 2021-22 despite the 10-percentage point increase in tax devolution recommended by the 15th finance panel.

• Issues With the Seventh Schedule

  • The 7th Schedule of the Indian Constitution broadly divides governance functions into three lists: the central, state, and concurrent lists. Over time, the Concurrent List has expanded its scope, surpassing its designated boundaries and encroaching upon the domains of subnational governments. 
  • For example, the 42nd Amendment of the Constitution (1975) shifted the subjects of forest and education from the State List to the Concurrent List. 
  • The Mahatma Gandhi National Rural Employment Guarantee Act of 2005, the Right of Children to Free and Compulsory Education Act of 2009 and the National Food Security Act of 2013, and many others impose an extra burden on the States.
  • The report of the 15th Finance Commission notes that in 2018-19, the states had only 37.3 per cent of the resources but were responsible for 62.4 per cent of the expenditure that was incurred.

• Incongruence of Article 282 with the Letter and Spirit of 7th Schedule

  • Article 282 enables the Union (as well as the states) to make discretionary grants, even beyond their respective legislative competences, for any ‘public purpose’. 
  • Originally, it was an extraordinary provision that was to be used very sparingly. 
    • Based on an exercise by the 15th FC, there are around 211 schemes/sub-schemes under the umbrella of 29 core schemes with the total outlay of the central government on these centrally sponsored schemes is around INR 3.32 trillion in 2019-20. 

• Issues with GST

  • Goods and Services Tax (GST) subsumes the majority of the indirect taxes viz. excise, services tax, sales tax, octroi etc. and the GST Council decides the central and state GST rates. 
  • However, states have lost the autonomy to decide the tax rates of subjects that fall within the State List and the inability of states to fix tax rates to match their development requirements implies greater dependence on the centre for funds.

• Issues in Finances of the Third Tier of Government

• • The persistent failure to place the third tier properly on the fiscal federal map of India is a serious issue. 
  • For example, the 73rd and 74th Constitutional Amendments introduced  XIth and XIIth Schedule, which, respectively, list out the subject matter for the panchayat raj institutions and municipalities by simply lifting items from the State list and Concurrent list lack operational meaning. 

• Limits State’s Borrowings

  • The Net Borrowing Ceiling (NBC) limits the borrowings of States from all sources including open market borrowings. 
  • For example, Kerala has moved the Supreme Court contending that the Centre’s imposition of a NBC on the State, violates Article 293 (borrowing by states) of the Constitution. 

• Determining State Finances

  • According to Article 293 of the Constitution, the State has to obtain the consent of the Centre to raise any loan, if any part of the previous loan extended by the Centre is outstanding. 
  • Parliament does not have the power to legislate upon the ‘Public Debt of the State’ as this finds place in the State List of the Constitution.

Way Forward to India’s Fiscal Federalism

• 16th Finance Commission Directive: The directives could be given to the 16th FC to enhance devolutions effectively, including:
  • Review Tax-Sharing Principles: In line with India’s evolving fiscal federalism, its mandate could center on consolidating the indirect tax base between the Union and states.
  • Revamp Statutory Sharing of Indirect Taxes: The evolving landscape requires a reevaluation and redesign of the statutory sharing of indirect taxes, both vertically and horizontally.
  • Vertical Devolution: Aligning the vertical sharing principle with the new system necessitates redefining the divisible pool. For instance, the commission should outline the procedures for incorporating Integrated GST (IGST) entirely into the pool, including unsettled IGST with input tax credit.
  • Horizontal Devolution: Revisit the criteria for distributing the divisible pool among states, especially regarding equalizing grants, to accommodate the shift from a production-based to a consumption-based tax system.
• Revisiting Article 246 and the Seventh Schedule: Article 246 deals with the division of power between the Union and the States, since India is no longer one-party governance and has become a multi-party system, there is a need to revisit and reform this division of power to ensure cooperative federalism. 
• Rationalise Central Spending: There’s a necessity for a more credible approach to rationalize Central Sector Schemes (CSS) and Central outlays. It’s imperative to establish a mechanism for thorough financial rationalization of these schemes, ideally in collaboration with state governments.
  • Given that NITI Aayog serves primarily as a Think Tank rather than a financial authority, there currently isn’t a central entity responsible for overseeing CSS and exploring their integration with central sector outlays. 
• News List for Third Tier: A new local list that maps out the functional and financial responsibilities of the panchayat raj institutions and municipalities is need of the hour, with moving of the irrelevant item in the State list to this new local list. 
• Expanding Scope of GST to Boost Revenue: The main point of contention between the Center and States regarding GST Compensation Cess stemmed from revenue shortages. Currently, GST does not encompass electricity, petrol, diesel, real estate, and agriculture. Broadening the scope of GST could establish a broader taxation base in the long term.

DOWNLOAD PDF