Financial Relations Between Centre and States in India: Key Provisions, Challenges and Reforms – (Part 02)

The Indian Constitution provides a detailed framework for managing financial relations between the Central and State governments. This includes provisions for tax revenue distribution, grants-in-aid, borrowing powers, and addressing fiscal issues during emergencies. Key aspects involve statutory and discretionary grants, GST implementation, and the role of the Finance Commission in ensuring fair allocation of resources.

Financial Relations and Grants-in-Aid: An Overview of Fiscal Federalism in India

Grants-in-Aid to the States

• In addition to the distribution of taxes between the Central and State governments, the Constitution allows for grants-in-aid to States from Central resources.
• Types of Grants-in-Aid: These grants come in two forms: statutory grants and discretionary grants.

Statutory Grants (Article 275)

• Authority and Distribution of Statutory Grants: It grants authority to the Parliament to offer financial assistance to States in need.
  • Variation in Grant Allocation: These grants are not uniformly provided to every State, and varying amounts may be assigned to different States. 
  • Annual Charging of Grants: The funds from these grants are drawn from the Consolidated Fund of India on an annual basis.
• Specific Grants for Scheduled Tribes and Scheduled Areas: Beyond this general provision, the Constitution also mandates specific grants aimed at promoting the welfare of scheduled tribes within a State or elevating the standard of administration in scheduled areas, including the State of Assam.
• Role of the Finance Commission: The Finance Commission is responsible for recommending the allocation of statutory grants under Article 275, both the general and specific grants, to the States.

Discretionary Grants (Article 282)

• Grants for Any Public Purpose: It empowers both the Centre and the States to offer grants for any public purpose, regardless of whether it falls within their legislative jurisdiction.
• Nature of Central Grants: Within this framework, the Centre can provide grants to the States, and it is important to emphasise that such grants are not obligatory, the decision rests entirely on the discretion of the Centre.
• Prevalence of Discretionary Grants: It’s crucial to highlight that discretionary grants constitute the majority of Central grants to the States, surpassing statutory grants in terms of overall funding.

Additional Grants-in-aid

• Temporary Grants-in-Aid Provision: The Indian Constitution also provides for a third type of grants-in-aid, but for a temporary duration. 
• Grants in Lieu of Export Duties on Jute Products: This provision involves grants in lieu of export duties on jute and jute products to the States of Assam, Bihar, Orissa, and West Bengal. 
• Duration and Allocation of Grants: These grants were intended to be provided for a period of ten years from the commencement of the Constitution. 
• Charging and Allocation of Grants: The sums for these grants were charged to the Consolidated Fund of India and were allocated to the States based on the recommendations of the Finance Commission.

Goods and Services Tax Council

• Creation of the GST Council: The 101st Amendment Act of 2016 stipulated the creation of a Goods and Services Tax Council, known as the GST Council. 
• Authority for the GST Council: The constitutional authority to constitute the GST Council is vested in the President, as outlined in Article 279-A through an order. 
• Role and Responsibilities of the GST Council: The GST Council is a joint forum of the Centre and the States of India. 
  • It is responsible for overseeing the implementation of the Goods and Services Tax (GST) in the country.
• Composition of the GST Council: The GST Council consists of the following members:
• The Union Finance Minister as the Chairperson.
• The Union Minister of State in-charge of Revenue or Finance.
• The Minister in-charge of Finance or Taxation or any other Minister nominated by each State government.
• Supreme Court Ruling: The Supreme Court has ruled that the recommendations of the GST Council are not binding on either the Union or the State Governments.
  • This means that the States can reject decisions made by the GST Council and set different rates for goods and services in their jurisdiction.
• Significance of the Supreme Court’s Judgement:
  • The Supreme Court’s judgement has increased the bargaining power of the State governments.
  • It will prevent the union government from disregarding the interests of States.

Finance Commission

Function of the Finance Commission: The Finance Commission (FC) is a constitutional body (Article 280) in India that determines how tax revenue is distributed between the Centre and the States, as well as among the States themselves. 

• • Establishment and Tenure: The FC is established every five years by the President of India. 
    • The 15th Finance Commission was constituted in November 2017 and its recommendations cover a period of five years from 2021-22 to 2025-26.

Key Recommendations of the 15th Finance Commission:

• Vertical Devolution: The FC recommended maintaining the vertical devolution rate at 41%, which is the same as in its interim report for 2020-21.
• Horizontal Devolution: For horizontal devolution, the FC suggested using a formula that weighs 
• Demographic performance (12.5%), 
• Income (45%), 
• Population and area (15% each), 
• Forest and ecology (10%), and 
• Tax and fiscal efforts (2.5%).
• Revenue Deficit Grants to States: The FC recommended providing revenue deficit grants to States that are unable to meet their fiscal needs after considering their own tax and non-tax resources and tax devolution.
• Performance-Based Incentives and Grants to States: The FC recommended providing performance-based incentives and grants to States in four areas: social sector (health and education), rural economy (agriculture and rural roads), governance and administrative reforms (judiciary, statistics, and aspirational districts and blocks), and power sector (additional borrowing window).
• Fiscal Space for Center: The FC’s transfers account for about 34% of the Central government’s estimated Gross Revenue Receipts, leaving it with enough fiscal space to meet its resource requirements and spending obligations.
• Grants to Local Governments: The FC recommended providing grants to local governments for municipal services, local government bodies, incubation of new cities, and health.

Borrowing by the Centre and the States

• The Indian Constitution outlines the borrowing powers of the Central Government and the States as follows:

Intergovernmental Tax Immunities in the Indian Constitution

The Indian Constitution, like other federal constitutions, upholds the principle of ‘immunity from mutual taxation’ and outlines specific provisions in this regard:

• Exemption of Central Property from State Taxation: The property of the Centre is exempt from all taxes imposed by a State or any authority within a State, including municipalities, district boards, and panchayats. 
• Scope: This exemption applies to all forms of property, including lands, buildings, chattels, shares, debts, and any other asset with monetary value. 
• Uses of Central Property: The property may be used for either sovereign purposes (such as the armed forces) or commercial purposes.
• Authority to Lift Property Exemption: However, the Parliament has the authority to lift this exemption, allowing States to tax Centre’s property under certain circumstances.
• Exemption of State Property or Income from Central Taxation: The property and income of a State are exempt from Central taxation, regardless of whether they arise from sovereign or commercial activities. 
• Taxation of State Commercial Operations: However, if a State engages in commercial operations, the Centre can impose taxes on those operations, provided Parliament authorises it.
• Exemption of Local Authorities’: On the other hand, the Central Government cannot levy taxes on the property or income of local authorities within a State. 
• Taxation of State-Owned Corporations: Additionally, the Central Government can tax corporations and companies owned by a State.
• Supreme Court’s Advisory Opinion: In an advisory opinion issued in 1963, the Supreme Court clarified that the immunity granted to States regarding Central taxation does not extend to customs duties or excise duties. 
• This implies that the Central Government can impose customs duties on goods imported or exported by a State, and excise duties on goods produced or manufactured by a State.
• Key Points
  • System of Mutual Tax Immunity: The Indian Constitution establishes a system of mutual tax immunity between the Centre and the States.
  • Exemption of Central Property: The Central Government’s property is exempt from State taxation, but this exemption can be lifted by Parliament.
  • Exemption of State Property: State property and income are generally exempt from Central taxation, but commercial operations of a State can be taxed by the Central Government.

Effects of Emergencies on Centre-State Financial Relations

The distribution of financial resources between the Centre and the States in India is altered during periods of emergency. These changes are as follows:

• National Emergency: When a national emergency is declared under Article 352, the President has the authority to modify the constitutional allocation of revenues between the Centre and the States. 
• This implies that the President can either cut back on or completely eliminate the transfer of funds (both tax sharing and grants-in-aid) from the Centre to the States. 
• This change remains in effect until the end of the fiscal year in which the emergency is lifted.
• Financial Emergency: When a financial emergency is declared under Article 360, the Centre can instruct the States to:
• Adhere to the specified canons of financial propriety.
• Reduce the salaries and allowances of all classes of employees working in the State.
• Submit all money bills and other financial bills for the President’s consideration.
• Key Points: The President can alter the distribution of revenues between the Centre and the States during emergencies.
• • The Centre can issue directives to the States regarding financial matters during emergencies.
  • These measures are intended to ensure financial stability during times of crisis.

Challenges in Fiscal Federalism in India

Central Government’s Increasing Dominance: The principles of fiscal federalism in India have been undermined by a series of steps taken by the Central Government, leading to increasing dominance in fiscal policies. This has been evident in:

• Increasing State’s Share in Centrally Sponsored Schemes (CSS): The State Government’s share in CSS has been increasing, leaving States with a smaller proportion of funds for critical development programs.
• Demonetization without Adequate Consultation: The sudden implementation of demonetization in 2016 without proper consultation with States caused significant disruptions to the State economies.
• Outsourcing of Statutory Functions: The Central Government’s outsourcing of statutory functions under the Smart Cities Mission has raised concerns about States’ autonomy and control over their development initiatives.
• Declining States’ revenue from Petroleum products: The Union government’s share in the total contribution of the petroleum sector has risen to 68%, while States’ share has dwindled to 32%, affecting their revenue generation capacity.
• Taxation Issues: The expansion of the non-divisible pool of taxes through cesses and surcharges has limited States’ access to tax revenues, further diminishing their financial autonomy.
• GST Specific Issues: The Central Government’s repeated violations of compensation guarantees to States under the GST regime have exacerbated the financial strain on States during the pandemic. 
• The delay in extending the GST compensation period has added to their woes.
• Inadequate Funding: Cash-strapped States have been struggling to find alternative sources of funding to sustain their programs. 
• The suspension and transfer of MPLAD funds to the Consolidated Fund of India further exacerbated their financial challenges.
• Restrictions on Borrowing: Despite raising the borrowing limit under FRBM, the Central Government has imposed restrictive conditions, making it more difficult for States to borrow funds.

Positive Changes in Fiscal Federalism

Despite the challenges, there have been some positive developments in fiscal federalism:

• Replacement of Planning Commission by NITI Aayog: The establishment of NITI Aayog has fostered a more cooperative approach to planning, involving both the Central Government and States.
• Removal of Plan-Non Plan Expenditure Distinction: The elimination of the distinction between plan and non-plan expenditure has provided States with greater flexibility in utilising funds.
• Introduction of GST: The implementation of GST has simplified the taxation system and eliminated cascading taxes, potentially benefiting both the Central Government and States.
• Increased Devolution of Taxes: The 14th and 15th Finance Commissions have increased the devolution of taxes from 32% to 42% and 41%, respectively, providing States with a larger share of tax revenues.
• Outcome Based Budgeting: The introduction of outcome-based budgeting has linked resource allocation to specific outcomes, enhancing accountability and effectiveness of public spending.
• Access to Official Development Assistance (ODA): State entities have been allowed to borrow directly from ODA partners since 2017, expanding their access to external financing.
• Role of State Governments in External Relations: State governments have become more active in international relations, signing sister city agreements with cities in developed countries promoting cultural exchange and economic opportunities.

Conclusion

Despite some challenges, such as the dominance of the Central government and financial strain on States, positive reforms have emerged. 

• Changes like the introduction of GST, increased tax devolution, and the establishment of NITI Aayog have enhanced cooperation and financial management. 
• These measures aim to balance fiscal responsibilities and promote effective governance across all levels.

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