Challenges to Indian Fiscal Federalism

Relevance: Mains: G.S paper III: Indian Economy

Context

The state of cooperative federalism in India is analysed by focusing on the trends in vertical fiscal imbalances between the centre and the states, the impact of Fiscal Responsibility and Budget Management acts on the fiscal space of the states, the implications of the Terms of Reference of the Fifteenth Finance Commission, and the need for empowering local governments in the context of centre–state relations.

Structure of taxation

  • The functions of macroeconomic stabilisation and distribution are considered to be in the domain of the federal government.
  • Allocation in the absence of externalities should be left to the tiers of government which can do it at least as efficiently as the federal government. This is known as the subsidiarity principle.
  • Under this division of powers, taxes with more redistributive impacts would be in the jurisdiction of the federation and the larger expenditure obligations, especially in the social sector, would fall in the fiscal territory of the provinces.
  • The natural consequence of this is the vertical fiscal imbalance between the federation and the provinces.

Fiscal Federalism during British India

  • In the Indian context, although fiscal imbalance between the federation and the provinces can be stated as a reason for substantial sources of revenue remaining with the centre and major expenditure obligations with the states, one cannot overlook the colonial legacy of centralisation under the British.
  • When the imperial government began facing a financial crisis, measures were taken for discontinuing the assignment of expenditure and revenue functions to the provinces.
  • It was in this situation that the provinces had to devolve a portion of their surplus to the imperial government to finance the deficits of the imperial government.
  • A clear delineation of powers between the centre and the provinces was attempted through the Government of India Act, 1935. This had a substantial centralising tilt with discretionary powers for the governor general and governors, and the retaining of major revenue sources with the imperial government.
    • The Government of India Act, 1935, was only partially implemented during 1937–39, when elected governments assumed office in the provinces.
  • Later, when the Constitution was framed under extraordinary circumstances after partition, most of the fiscal provisions of the Government of India Act, 1935, found a place in it without any changes
  • This is the basic reason for the strong centralising trends in Indian polity, including in the fiscal division of powers and intergovernmental fiscal transfers.

Fiscal Federalism post-independence

  • The states started demanding more fiscal powers and share of all taxes collected by the centre from time to time.
  • Under the initial constitutional scheme of things, personal income tax was shareable on the basis of the recommendations of the finance commissions (Article 270), and the central excise duty on the basis of law provided by Parliament.
  • Other taxes like corporation tax and customs duty were not shareable.
  • But after the 80th Constitutional Amendment, on the basis of the recommendations of the Tenth Finance Commission, all taxes of the centre became part of the divisible pool shareable with the states since 2000–01, fulfilling a long-standing demand of the states.
  • With respect to the own tax revenue, states have substantially lost the power to vary tax rates of items de facto since 1 April 2005, when Value Added Tax (VAT) was implemented on intra-state trade of goods, and de juresince 1 July 2017, when goods and services tax (GST) was introduced.
    • On the expenditure side, there has been a rise in the share of conditional and tied grants. This restricts the freedom of the states in its spending priorities that takes into account the local specifications.
  • There are also constraints arising from Fiscal Responsibility and Budget Management (FRBM) acts, which lay down uniform targets across states ignoring the differing fiscal needs.
  • This is happening in a scenario when cooperative federalism is accepted by the centre as the system most suited to the Indian context. Cooperative federalism is a system in which there is joint decision-making between several jurisdictions of government based on consensus.
  • The facts and circumstances, however, indicate that we are quite far from what cooperative federalism envisages.

Trends in Tax Revenue

  • A look at the composition of central and states’ own taxes and expenditure reveal that the share of the own tax revenue and expenditure of the states is 38% and 58% respectively.
  • This reflects the more than proportionate expenditure obligations of the states and also the lesser revenue raising powers vis-à-vis the centre.
  • It is in this context that the distribution of resources from the centre to the states has been recognised in the Constitution by way of formation of finance commissions every 5 years.
  • The centre has buoyant sources of revenue like personal income tax, corporation tax, excise duty, customs duty and service tax (excise duty and service tax have been subsumed in the GST since 1 July 2017).
    • As regards the structure of taxes, indirect taxes dominated the central tax revenue till the 2000s.
    • During the 1980s, it comprised 80% of centre’s gross tax revenue. Gradually, the share of direct taxes in centre’s gross tax revenue increased to around 50% during 2016–17.
    • The trend in the central tax–GDP ratio shows a rise in the 1980s followed by a decline during the 1990s. In the subsequent two periods, it showed an increase. During the 1990s, the rates of customs duty and income tax were reduced substantially and that was the most proximate reason for the decline in the tax–GDP ratio.
  • The question that needs to be answered is whether the tax–GDP ratio reflects the tax potential. Tax potential is not very easily amenable to accurate measurement.
  • In Indian context it can be stated that over a period of three-and-a-half decades, the size of the tax-evaded economy has been around a quarter of the GDP.
  • This implies that in absolute size, the tax-evaded economy has been growing phenomenally despite the tax reforms in a technology-enabled environment. The increasing size of the tax-evaded economy has an adverse consequence not only for central finances, but also for the states.

Trends in Transfer of Central Resources

  • The transfer of resources to states comprises taxes collected by the Union, statutory grants under Article 275 based on the recommendations of the finance commissions, grants given as central share in centrally sponsored schemes (CSS), other discretionary grants, and until 2015–16, formula-based grants for state plans under the Gadgil formula.
  • All grants other than statutory grants recommended by the finance commissions are given by resorting to Article 282 of the Constitution under “Miscellaneous Financial Provisions.”
  • The transfer of central resources can be broadly classified into tied and flexible grants.
    • The former is a conditional grant which comes with a scheme and has conditionality. The state has no flexibility in deciding how to spend it. The CSS grants fall under this category.
  • On the other hand, tax devolution and post-devolution revenue deficit grants given by the finance commission fall in the flexible category as they have no conditionality attached to them and the states can spend them according to their priorities.
    • The completely flexible part of central grants comprises the revenue deficit grants recommended by the finance commissions to the states, post-tax devolution.

Stats

  • When the components of grants are examined, the share of statutory grants, given under Article 275 based on recommendations of the finance commissions, has been on an average 18.53% of the total central grants during the period 1999–2000 to 2016–17
  • The CSS comprised around 19.14% and central sector schemes (CSs) formed 2.84% during 1999–2000 to 2016–17.
  • The state plan grants, that consist of grants for externally aided and specific projects, constituted 46.91% of the total central grants
  • But the Normal Central Assistance (NCA), which was based on the Gadgil formula, as a component of central grants was only 13.25%. This has been declining continuously and has been stopped since 2015–16.
  • This implies that only 24.11% (10.86% revenue deficit grants and 13.25% NCA) of the central grants was based on a norm and that the rest, 75.89%, was discretionary. The completely flexible component, that is, the revenue deficit grants was only 10.86%

Trends in Tax Devolution

  • Under Article 270 of the Constitution, the net proceeds of all taxes levied by the union, except surcharges and cesses are shareable with the states after the 80th Constitutional Amendment. The finance commissions since the Eleventh have been devolving the shares of all Union taxes to the states.
  • Net proceeds are defined in Article 279 of the Constitution as gross tax revenue of the centre less surcharges and cesses, and cost of collection. However, the amount of net proceeds is not published in the budget documents of the union.
    • Surcharges and cesses are levied for the purpose of the union and are not shareable with the states
  • When the share of taxes recommended to be devolved by the finance commission rises, the size of the divisible pool itself is made smaller. Besides this overt act, the lack of transparency in computation of net proceeds has also caused losses to the states.
  • This not only illustrates the extent of financial losses, but also the erosion of constitutional rights of the states through legislative and administrative actions of the centre.

FRBM Acts and Asymmetric Impacts

  • The FRBM acts were passed at the level of the centre and the states in the beginning of the 2000s.
  • The large fiscal and revenue deficits of the centre and the states prepared the ground for setting numerical deficit ratios as a percentage of GDP/GSDP (gross state domestic product) and passing legislations stipulating the time period for achieving these targets.
  • Examining the adherence to the FRBM acts, the states have been forced to limit their deficits due to sanctions by the finance commissions, whereas the centre is not bound by any such conditionality.
  • It can be seen that the revenue deficits have almost been eliminated by the states and fiscal deficits have been below 3% in the post-FRBM period.

Post-GST Scenario

  • The implementation of the GST is being demonstrated as an example of the working of cooperative federalism.
  • Let us examine from the voting rights in the GST Council as in the provisions of Article 279A of the Constitution. The states have two-thirds and the centre one-third voting rights. But to pass a resolution, three-fourths majority is required.
  • This in effect 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.
  • Another important aspect is the apportionment of the GST rates. The committee on Revenue Neutral Rates (RNR) of the central government had suggested the apportionment between the states and the centre at 60:40 ratio, as almost 44% of states’ own tax revenue was subsumed under the GST as against 28% for the centre.
    • The centre also took a long time in implementing the anti-profiteering clause of the GST.
    • The GST in India has not been a good example of cooperative federalism, in which equal stakeholders take decisions based on consensus.

Empowering Local Governments

  • In a federal set-up with considerable unitary tendencies, democratic decentralisation is essential to preserve the existing federal features as well as to strengthen the democratic content.
    • It is essential to de-bureaucratise the development functions and ensure peoples’ participation.
  • According to the report, the Local governments in India are still a shadow of “institutions of self-government” envisaged in the Constitution. On the whole, there is an institutional sclerosis with regard to the decentralisation process.
    • A major impediment for substantial progress in decentralisation to Local governments is the lack of any initiative to restructure centre–state relations in India.
    • In fact, there should be tax devolution and unconditional grants enabling the states to carry out social and economic sector programmes with the empowered participation of the Local governments.
  • On the contrary, the delivery of substantial resources through the CSS makes the states and the Local governments as mere agencies rather than equal partners in a federal set-up in which they can formulate and implement policies.
  • In short, the empowering of Local governments is not possible at the cost of constitutional powers of the states. A more meaningful decentralisation would require moving away from the asymmetric nature of centre–state relations.

Conclusion

  • Assessing the trends in tax devolution, the experience with the FRBM acts in the light of the recommendations of the FRBM review committee, the structure of GST, we are quite far from what cooperative federalism envisages
  • As revealed by many studies, the performance of tax revenue in India is below its potential. This limits not only the spending capacity of the centre, but also the amount of taxes devolved to the states.
  • Besides, what is constitutionally sought to be devolved to the states is not being done in its spirit by the centre, which imposes surcharges and cesses as a means of raising revenue, without the same being part of the divisible pool of taxes shareable with the states. There also exists non-transparency in the computation of net proceeds.
  • The FRBM acts have imposed an asymmetric burden on the state governments in the face of non-compliance to the targets by the central government. This is sought to be accentuated by the recommendations of the FRBM Review Committee, 2017.
  • The rate apportionment and voting rights in the GST Council are not in accordance with the principles of cooperative federalism, in which decisions are to be taken by a consensus among equal stakeholders.
  • The decentralisation of the Local governments is impeded by the asymmetry in centre–state relations.

 

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