Fiscal Federalism in India

Fiscal federalism in India represents the financial relations between units of government in the Indian federal system. The Constitution of India establishes a dual polity consisting of the Union at the center and the states at the periphery, each endowed with sovereign powers to be exercised in the field assigned to them respectively by the Constitution. Read here to learn more.

The Union government has been cutting back on financial transfers to States ever since the commencement of the Fourteenth Finance Commission award term (2015-16).

This is especially odd considering that the suggestion of the Fourteenth Finance Commission, which is a clear 10 percentage points higher than that of the Thirteenth Finance Commission, was to transfer 42% of Union tax income to the States.

Except for the devolution to Jammu and Kashmir (J&K) and Ladakh, which were reclassified as Union Territories, the Fifteenth Finance Commission kept its 41% proposal. It should be 42% if the contributions of J&K and Ladakh are taken into account. To raise its discretionary spending, the Union administration boosted overall revenue while simultaneously decreasing budgetary transfers to the States.

Since the Union government’s discretionary spending is not going via the state budgets, it may have varying effects on the various states.

Fiscal federalism in India

Fiscal federalism in India is designed to ensure the division of fiscal responsibilities and revenue sources between the central and state governments, enabling both to perform their functions effectively.

This framework encompasses mechanisms for revenue collection, allocation, and expenditure responsibilities, aiming to achieve economic efficiency, equity, and macroeconomic stability.

• Division of Powers and Responsibilities: The Constitution divides the legislative, administrative, and fiscal powers between the Centre and the States. List I (Union List), List II (State List), and List III (Concurrent List) in the Seventh Schedule of the Indian Constitution delineate these divisions.
• Revenue Sources: Taxes are divided between the central and state governments. While the Centre has the authority to levy taxes such as income tax (except on agricultural income), customs duties, and central excise (outside GST), states have the power to collect taxes on sales (within GST), state excise on liquor, stamps on property transactions, and agricultural income.
• Goods and Services Tax (GST): Introduced in July 2017, GST represents a significant step towards a unified national market, eliminating a cascading tax system and integrating state economies. GST is administered through the GST Council, where both the Centre and the States have representation, showcasing cooperative federalism.
• Financial Distribution Mechanisms: The Constitution provides for the distribution of financial resources between the Centre and states through mechanisms like the Finance Commission, which makes recommendations on the distribution of the union taxes to the states, principles governing grants-in-aid to states, and measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities.
• Planning and Development: Though the Planning Commission has been replaced by the NITI Aayog, the latter plays a crucial role in fostering cooperative federalism through a bottom-up approach to planning and development, focusing on the involvement of States in the economic policy-making process.
• Borrowings: Both the Centre and the States can borrow within the limits set by the Fiscal Responsibility and Budget Management (FRBM) Act, aimed at maintaining fiscal discipline. The Centre can make loans to the States or give guarantees on their behalf, with conditions for borrowing being laid down by the Centre.
• Grants and Loans: The Central Government provides grants and loans to States for various purposes, including disaster relief, and development projects, and to compensate for a reduction in revenue due to policy implementations like GST.

Centralization of Fiscal federalism

The Finance Commissions recommend a state portion of the Union government’s net tax revenue.

• The tax money to be allocated to Union territories, collection expenses, cess, and surcharges are all included in the difference between the gross and net tax revenue.
• The proportion of gross tax income was only 35% in 2015-16 and 30% in 2023-24, even though the Fourteenth and Fifteenth Finance Commissions proposed that the States receive 42% and 41%, respectively, of the net tax revenue (Budget Estimate).
• The States’ portion of Union tax revenue climbed from ₹5.1 lakh crore to ₹10.2 lakh crore over these two years, even though the Union government’s gross tax collection increased from ₹14.6 lakh crore in 2015-16 to ₹33.6 lakh crore in 2023-24.
• The rants-in-aid to States declined in absolute amount from Rs 1.95 lakh crore in 2015-16 to Rs 1.65 lakh crore in 2023-24.

Cess and surcharge

• The fact that the net tax income is calculated after subtracting the money collected under the cess and surcharge, the revenue collected from the Union Territories, and the expense of tax administration is one of the reasons why the States’ share of gross revenue decreased during this time.

Direct financial transfers

There are two more avenues by which the Union government can directly transfer funds to the States: Central Sector Schemes (CS) and Centrally Sponsored Schemes (CSS).

• Through CSS, wherein the Union government provides half the money and the States are responsible for the remaining portion, the government affects the priorities of the States.
• Put another way, it suggests the plans, and the States carry them out while contributing financial resources.
• The allocation for CSS grew via 59 CSS from Rs 2.04 lakh crore to Rs 4.76 lakh crore between 2015-16 and 2023-24.
• One significant feature of CSS shared schemes is the availability of matching grants to States able to provide matching funds from their state budgets. Regarding interstate equality in public budgets, this has two distinct impacts.

Challenges

• Vertical Imbalance: The division of fiscal powers often leads to a mismatch between the revenue-generating capacities of the states and their expenditure responsibilities, leading to vertical imbalances that require intergovernmental transfers to correct.
• Horizontal Imbalance: Differences in fiscal capacities and needs among states necessitate mechanisms for redistributing resources to ensure equity and balanced development across regions.
• GST Implementation Issues: While GST has streamlined tax administration and broadened the tax base, it has also faced challenges related to revenue allocation, compliance, and technological glitches.
• Fiscal Autonomy vs. Central Oversight: Balancing fiscal autonomy for states with the need for central oversight to maintain macroeconomic stability remains a delicate task.

Conclusion

Fiscal federalism in India is a dynamic and evolving system, reflecting the country’s socio-economic diversity and political complexities. While it has facilitated economic unity and contributed to the nation’s development, ongoing reforms, and adjustments are necessary to address emerging challenges, promote state equity, and ensure efficient and effective governance at all levels.

Related articles:

• Centre-state relations
• Indian federalism
• Issues and challenges pertaining to the federal structure
• States Borrowing Power

-Article by Swathi Satish