fiscal federalism             (Mains GS paper II : Indian Polity) 

Context:

India is a federal country wherein the states are considered to be sovereign in the sphere of the functions, roles and responsibilities which have been allocated to them under the Indian Constitution. One Fundamental aspect of our Governance is the fiscal federalism which provides the autonomy of the states to raise revenue and undertake expenditure according to their priorities and needs. It also provides for the transfer of taxes from the Union to the states.  Such form of fiscal federalism has been formulated keeping in mind the diverse needs and aspirations of the states across India and hence considered critical for balanced and holistic development of the entire country.

However, over a period of time, the fiscal federalism has become skewed towards the centre since the centre has encroached upon some of the taxation powers of the states. The two recent proposals of the central Government on setting up of Defence expenditure fund and Expenditure council would further erode the financial autonomy of the states.

In this regard, let us understand as to how the financial autonomy of the states has come under threat and what steps should be taken in order to reverse this trend.

Understanding Fiscal Federalism

The Fiscal federalism is economic counterpart of Political Federalism. The Fiscal Federalism essentially consists of 2 aspects:

1. Assignment of functions to different levels of Governments. It is provided under the VII Schedule of the Indian Constitution by allocating the subjects- Union List, State List and Concurrent List. This allocation of subjects is based on the Principle of Subsidiarye. the subjects are allocated to that level of government where it can be performed in the most efficient manner. ( For Example- Defence has been allocated to Union whereas agriculture has been allocated to State Government)
2. Assignment of financial powers to different levels of Governments in order to enable them to perform their functions. It is done through the allocation of taxes to Union and States based on the principle of subsidiary. (For example- Income tax has been allocated to Union whereas property tax has been allocated to States)

Importance of Fiscal Federalism

Balanced Regional Development: Different states in India are at different levels of development. Further, different states have varied needs and aspirations. Hence, it is the fiscal federalism that would ensure financial autonomy of the states to raise revenue and undertake expenditure as per their requirements.

Promotes Decentralisation: The Fiscal Federalism ensures higher level of decentralisation i.e. transfer of powers, roles and responsibilities from the centre to the states. This ensures that the States have the necessary financial resources in order to meet their expenditure needs. In absence of fiscal federalism, the states would be reduced to mere implementation agencies of the centre.

Does away with "One-Size-fits-all" approach: The fiscal federalism acknowledges that "one-size-fits-all" policies cannot work in a country with huge diversity in terms of society, culture, geography, economy etc. It recognises that it is the state governments who are best positioned to understand the ground realities and undertake policies for bringing about development.

How has the centre encroached over the financial powers of the states?

Setting up of the GST Council: Undoubtedly, the ushering in of GST has been a landmark event in our polity to foster fiscal federalism. However, it has led to decrease in the financial autonomy of the states. Earlier, the state governments had complete autonomy with respect to raising indirect taxes such as Sales Tax as per their requirements and needs. However, after setting up of the GST Council, the states can no longer raise such indirect taxes on their own. A case in point was the recent demand of the Kerala Government to raise revenue to meet its disaster related expenditure for undertaking relief and rehabilitation.  The Kerala Government was allowed to impose the GST cess only after it was approved by GST Council.

Hence, it can stated that the states would now have to be dependant on the GST council decisions for raising their revenue.

Defence Expenditure Fund: The Union Government has asked the 15th Finance Commission to examine whether a separate fund for meeting its  defence and internal security expenditure can be set up in India. This issue is presently examined by the 15th finance commission which is required to submit its report by November 30, 2019.

Now, as to why creation of such a fund would adversely affect the finances of the states? Firstly, the Finance Commission recommends for the transfer of the taxes from the centre to the states based upon the total money available in the Central Divisible Pool ( which basically consist of all the major Union Taxes). If the Defence expenditure fund is set up by the centre, then the total money available in the central divisible pool would be lower. This would in turn lead to decrease in the transfer of taxes from the centre to the states. Considerably, the fact that the 14th Finance Commission had recommended for 42% transfer of taxes to the states, setting up of such a fund would mean that 42% of the burden of the defence expenditure fund would fall on states.

Secondly, Defence is part of Union list under the Indian Constitution and hence it is the Centre that has to meet its defence related expenditure on its own without adversely affecting the finances of the states. This means that the Defence expenditure fund would have to be set up from the 58% of the centre share after transferring the 42% share to the states as per the 14th finance commission.

Proposal of Expenditure Council: Recently, the Prime Minister Economic Advisory Council (PMEAC) has recommended the need to set up Expenditure Council on the lines of the GST council to promote Cooperative Federalism. The rationale behind the Expenditure Council is to rationalise and prioritise spending by the centre and states. However, states have raised concerns that setting up of such an Expenditure council would take away the autonomy of the states to undertake expenditure as per their priorities.

 Way Forward

As discussed before, Fiscal Federalism plays a multi-dimensional role of promoting decentralisation and enabling balanced regional development. Hence, there is a need to strengthen fiscal federalism by reversing the recent trends which have led to skewed fiscal federalism towards the Centre.

In large federal countries such as USA, the state governments have been given the right to levy income taxes. On similar lines, there is a need to emulate such a model and empower the states to levy and collect Income tax. It is to be noted that presently, the states are allowed to impose the income tax only on agricultural income and hence vesting the states with higher taxation powers will lead to strengthening of Fiscal Federalism in India.