Relevance: GS 2: Issues and challenges about the federal structure, devolution of powers and finances up to local levels and challenges therein.

Key Phrases: Linguistic pluralism, Federal structure, Fiscal federalism, Schedule VII of the Indian constitution, Finance Commission, Planning Commission/NITI Aayog, Goods and Services Tax (GST).

Context:

• Linguistic pluralism and a federal structure are two of the three pillars that have held the Indian republic together and allowed this diverse and complex country to do better than all its neighbours. The third of these pillars is fiscal federalism

What is Fiscal Federalism?

• The term “fiscal federalism” was introduced by the German-born, American economist Richard Musgrave in 1959.
• This concept applies to all forms of government: unitary, federal and confederal.
• 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.

What is Article 246 of the Indian Constitution?

• Article 246 of the Constitution deals with the division of power between the Union and the States. It demarcates the powers of the Union and the State by classifying their powers into 3 lists. They are
  • The Union List;
  • The State List and
  • The Concurrent List.

Fiscal Federalism in India:

• The Fiscal federalism is the economic counterpart of Political Federalism. Fiscal Federalism essentially consists of 2 aspects:
  • Assignment of functions to different levels of government is provided under the VII Schedule of the Indian Constitution by allocating the subjects into above mentioned three lists.
  • This allocation of subjects is based on the Principle of Subsidiarity i.e., the subjects are allocated to that level of government where it can be performed most efficiently. (For Example- Defence has been allocated to Union whereas agriculture has been allocated to State Government)
• Assignment of financial powers to different levels of Governments to enable them to perform their functions. It is done through the allocation of taxes to the Union and States based on the principle of subsidiarity. (For example- Income tax has been allocated to Union whereas property tax has been allocated to States)

Why is balancing equity, equality, and efficiency in a hyper-diverse federation complicated?

• Both the Union and States are political creations. Their boundaries need not necessarily enclose economically self-sustaining societies.
• Thus, a sub-continental federation allows the forces of comparative advantage to benefit everyone:
  • Each region can produce what it is better at and trade with others.
  • Yet, balancing equity, equality, and efficiency in a hyper-diverse federation is complicated.
• At the time the Constitution came into force, some regions were endowed with more human capital, infrastructure, and industrial capacity, others had abundant natural resources, and a few had very limited economies.

Why Indian States have Relatively Weak Fiscal Capabilities?

• Careless about upholding fiscal federalism:
  • While the linguistic reorganization of States helped address political aspirations, fiscal federalism was the crucial but invisible factor that permitted the political restructuring.
  • What we take for granted to this day is part of the ‘secret formula’ of India’s success.
  • Like other parts of the formula, we have been careless about upholding fiscal federalism.
• Central Planning and Nationalisation of Banks:
  • Central planning, “constrained both the market and State governments in allocation of resources” and the nationalization of banks further centralized resource allocations and aligned them to planning.
• Disbanding Planning Commission:
  • The disbanding of the Planning Commission in 2014 was an important corrective, but the vestiges of central planning remain, and the mindsets of the States’ political elite have yet to adapt to the loosening of central constraints.
• Introduction of GST:
  • Similarly, with the introduction of GST and the formation of the GST Council, states gained a powerful platform to negotiate their fiscal interests.
  • Despite its complexities and controversies, GST has brought fiscal federalism prominently into the public discourse, and that is a good thing.
  • With the end of the Planning Commission the same year and the adoption of GST two years later, India today is in uncharted waters.
• Union Government’s Role in Directing Expenditure:
  • On one hand, States enjoy a greater degree of fiscal autonomy than before, but on the other, the Union government has a larger role in directing expenditure through a large number of “centrally sponsored schemes” like those for education, and health and rural employment guarantee.

Importance of Fiscal Federalism:

• Balanced Regional Development.
• Decentralisation of powers, roles and responsibilities from the centre to the states.
• It acknowledges that "one-size-fits-all" policies cannot work in a country with huge diversity in terms of society, culture, geography, economy etc.
• Keeping the country united.
• Lower planning and administrative costs.
• Competition among local governments favours organisational and political innovations
• It creates a unified common market, which promotes greater economic activity.
• Helps governmental organizations to realize cost efficiency by economies of scale in providing public services.

Role of Finance Commission:

• Independent and non-partisan:
  • The Constitution created an independent, non-partisan Finance Commission to determine how fiscal resources ought to be shared among the Union and States.
  • The Planning Commission might well have strengthened New Delhi’s hand over that of States, but the Finance Commission’s quiet, transparent and professional functioning ensured the latter were not pushed over the edge.
  • Successive Finance Commissions' consultative and non-partisan character has meant that the Union and States accept its allocations as fair, even if they felt they deserved more.
• Unity of Country:
  • Finance Commission has a fundamental role in keeping the country united.
  • Many politically sensitive and border States receive disproportionately larger shares of funds.
• Devolution of More Funds to States:
  • A new era of fiscal federalism dawned in 2015 when the 14th Finance Commission (2015-2020) raised the States’ share of funds from 32% to 42%.
  • The 15th Finance Commission (2021-2026) retained the states’ share, and its methodology of assigning weights based on population is likely to be a factor in the politics of federalism.

The Reluctance of States:

• Setting up State finance committee:
  • Everyone wants decentralisation, but only up to his level.
  • While states have been zealous about their entitlements, they have been laggards in setting up state finance commissions to devolve funds to municipalities and panchayats.
• Raising their Revenues:
  • State governments and local bodies have also been reluctant to raise their revenues. Political considerations prevent taxing richer farmers and bureaucratic incapacities at the municipal level in the collection of property taxes.
  • As Arvind Subramanian observed, “the closer the government is to the people, the more unwilling it is to raise taxes”.

Need of the Hour:

• To Check Horizontal Imbalances:
  • The horizontal imbalances arise because of differing levels of attainment by the states due to differential growth rates and their developmental status in terms of the state of social or infrastructure capital.
• To Check Vertical Imbalance:
  • Vertical imbalance arises due to the fiscal asymmetry in powers of taxation vested with the different levels of government about their expenditure responsibilities prescribed by the constitution.
• Better Framing Of Fiscal Policy:
  • States have to learn how to frame fiscal policy. If they do not, the fiscal balance will tilt towards the centre.
• Permanent Secretariat for Finance Commission:
  • Institutionally, there is an ongoing debate on whether or not the Finance Commission should have a permanent secretariat.
• Inter-State Council:
  • The Inter-State Council must be upgraded into a national forum, chaired by the Prime Minister and comprising state chief ministers.

Conclusion:

• Linguistic pluralism, a federal structure and fiscal federalism have served us well and enabled us to succeed where others have failed.
• In these three columns, there is an attempt to draw attention to the structural pillars of India’s unity and success.
• We must not allow popular emotions and polarized discourse to weaken them any further.

Source: Live-Mint

Mains Question:

Q. How can a new era of fiscal federalism strengthen national unity? Discuss with suitable examples.