Explain Importance of Fiscal Federalism in India | UPSC

Introduction

• Recently, Tamil Nadu Chief Minister M.K. Stalin accused the Union government of withholding funds for the State’s Metro rail completion and other crucial projects. 
• Additionally, states in Southern India have expressed concerns about a reduction in fiscal devolution despite their significant contributions to Gross Tax Revenues. 
• Several state governments argue that the Central Government’s tax policies have led to diminished financial transfers to States, weakening cooperative fiscal federalism in India.

Understanding Fiscal Federalism

• Fiscal Federalism refers to the division of financial powers and responsibilities between the central and state governments in India, ensuring a balanced and cooperative financial relationship.

Constitutional Provisions for Fiscal Federalism

Seventh Schedule:

• • • Divides taxation powers between the central and state governments through the Union List and State List.

Article 270:

• • • Governs the distribution of net tax proceeds collected by the Union government between the Centre and the States.

Article 280:

• • • Establishes the Finance Commission, which recommends the sharing of tax revenues and grants-in-aid to the states.

Article 275:

• • • Provides for grants-in-aid from the Centre to the states for specific purposes.

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Examples of Cooperative Fiscal Federalism

Introduction of GST:

• • • The 101st Constitutional Amendment introduced GST, transforming India’s indirect tax system and fostering Centre-State cooperation.
    • Example: GST Council, comprising central and state finance ministers, collaboratively administers GST, ensuring uniformity in tax rates and seamless interstate trade​. 

Passage of FRBM Act:

• • • The Fiscal Responsibility and Budget Management (FRBM) Act 2003 promotes fiscal discipline.
    • Example: 21 states enacted their own FRBM Acts, incentivized by debt and interest rate relief from the 12th Finance Commission, reflecting a shared commitment to fiscal prudence​. 

Performance-Based Grants:

• • • Used to incentivize states to achieve developmental targets, fostering competitive and cooperative federalism.
    • Example: The Finance Commission’s recommendation of performance-based grants to states for improving governance and infrastructure.

Swachh Bharat Mission:

• • • A national campaign aimed at cleaning up the streets, roads, and infrastructure of India.
    • Example: Centre and states work together, with states receiving funds based on their performance in improving sanitation and hygiene​​.

National Health Mission:

• • • Aims to improve healthcare delivery across rural and urban areas.
    • Example: Joint funding and administrative collaboration between the Centre and states to achieve health targets​ .

Smart Cities Mission:

• • • Initiative to promote cities that provide core infrastructure and a decent quality of life to its citizens.
    • Example: Centre and states collaborate in funding and planning smart city projects, with states playing a key role in implementation​​.

Pradhan Mantri Awas Yojana (Urban and Rural):

• • • Housing scheme aimed at providing affordable housing to the urban and rural poor.
    • Example: Centre provides financial assistance, while states identify beneficiaries and implement the construction of houses​.

Ayushman Bharat Scheme:

• • • A health insurance scheme to provide coverage to the economically disadvantaged.
    • Example: Collaboration between Centre and states in implementing health insurance coverage and hospital empanelment​.

National Skill Development Mission:

• • • Aims to provide skills training to youth across the country.
    • Example: Centre sets targets and provides funding, while states customize training programs to local needs and implement them​.

Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA):

• • • Provides legal guarantee for 100 days of employment in every financial year to adult members of any rural household.
    • Example: Centre funds the program, while states are responsible for implementation and monitoring​.

Challenges to Fiscal Federalism in India

Reduced Financial Transfers to States:

• • • The share of states in gross tax revenue has decreased from 35% in 2015-16 to 30% in 2023-24.
    • Example: Tamil Nadu has raised concerns over reduced financial allocations, impacting projects such as the Chennai Metro Rail Phase II, where the Centre did not fully meet the state’s funding requirements​​.

Disproportionate Revenue Growth:

• • • Union government’s tax revenue increased by 2.3 times from 2015-16 to 2023-24, whereas states’ share only doubled.
    • Example: Andhra Pradesh and Telangana have significantly increased their borrowing to fund capital expenditure due to insufficient growth in revenue transfers from the Centre​ ​.

Decrease in Grants-in-Aid:

• • • Direct financial support to states declined from ₹1.95 lakh crore in 2015-16 to ₹1.65 lakh crore in 2023-24.
    • Example: States like Kerala have had to cut back on capital expenditure due to the reduction in grants-in-aid from the Centre, impacting their fiscal health​ .

Increase in Non-Devolvable Cess and Surcharge:

• • • The share of cess and surcharge not shared with states increased from ₹85,638 crore in 2015-16 to ₹3.63 lakh crore in 2023-24.
    • Example: The increase in cess on petroleum products and education, which are not shared with states, has significantly reduced the fiscal capacity of states like Karnataka​.

Centralisation of Public Expenditure:

• • • States received only ₹4.25 lakh crore out of the ₹19.4 lakh crore allocated for Centrally Sponsored Schemes (CSS) and Central Sector Schemes in 2023-24.
    • Example: Bihar and Uttar Pradesh have expressed concerns over limited autonomy in utilizing funds allocated for CSS, affecting their ability to plan and execute state-specific projects​ .

Interstate Inequality in Public Finances:

• • • Wealthier states leverage Union finances better due to their ability to match funds for CSS, while less wealthy states face increased liabilities.
    • Example: Wealthier states like Karnataka and Tamil Nadu can better leverage Union funds, while states like Bihar struggle to match funds, leading to disparities in public service delivery​.

Increase in Conditional Transfers:

• • • Grants to states often come with conditions that impose Union preferences over state priorities.
    • Example: Conditional grants for education and health often require states like Madhya Pradesh and Chhattisgarh to adhere to Union guidelines, limiting their policy innovation​.

Erosion of State Taxation Autonomy:

• • • Implementation of GST has reduced states’ ability to set tax rates independently.
    • Example: States like Gujarat and Tamil Nadu have raised concerns over their diminished authority to levy taxes on goods and services previously under state control​.

Issues with GST:

• • • Compensation for revenue loss due to GST implementation has not been properly addressed, such as discontinuation of GST compensation cess.
    • Example: Punjab and Haryana have reported revenue shortfalls due to delays and discontinuation in GST compensation payments, affecting state budgets​.

Borrowing Constraints on States:

• • • The Union government imposes borrowing limits on states, restricting their ability to raise funds independently.
    • Example: States like Kerala and Telangana have sought relaxation in borrowing limits to fund critical infrastructure projects but have faced restrictions​.

Non-Alignment of Fiscal Policies:

• • • Differences in fiscal policies between the Centre and states lead to inefficiencies and conflicts.
    • Example: Divergent policies on agricultural subsidies and loan waivers have caused friction between the Centre and states like Punjab and Maharashtra​.

Significance of Fiscal Federalism

Addressing Diversity and Disparities:

• • • Mechanisms like tax sharing, grants-in-aid, and performance-based incentives help address regional imbalances. This allows for the redistribution of resources to ensure that less wealthy states can fund essential services and infrastructure, thereby reducing economic disparities across regions.

Promoting Cooperation and Consultation:

• • • Fiscal federalism encourages Centre-State coordination in resource and responsibility sharing.
    • Example: GST Council meetings are a prime example of this cooperation, where both the Centre and states work together to decide GST rates and policies, fostering collaborative decision-making and ensuring uniformity in tax implementation across the country​. 

Ensuring Fiscal Discipline:

• • • Frameworks like the Fiscal Responsibility and Budget Management (FRBM) Act promote fiscal discipline, ensuring macroeconomic stability by controlling the fiscal deficit and managing public debt.
    • Example: The N.K. Singh committee’s recommendations for fiscal deficit targets and debt-to-GDP ratios aim to maintain fiscal prudence, which is crucial for economic stability and growth​. 

Enabling Decentralized Governance:

• • • Fiscal federalism empowers state and local governments with financial autonomy, strengthening grassroots democracy and enabling responsive governance.
    • Example: States have the autonomy to plan and implement policies that cater to their specific needs, such as local infrastructure projects and social welfare schemes, thereby improving public service delivery and governance at the local level.

Facilitating Economic Reforms:

• • • Fiscal federalism facilitates the adaptation to changes like market-oriented economy reforms and taxation reforms.
    • Example: The shift towards the Goods and Services Tax (GST) streamlined the taxation system, reducing the complexity of indirect taxes and promoting ease

Finance Commission Recommendations for Fiscal Federalism

Vertical Tax Devolution:

• • • The 14th Finance Commission significantly increased states’ share in central taxes from 32% to 42%, enhancing their fiscal autonomy and resources.
    • Example: This increase helped states like Kerala and Andhra Pradesh fund their development projects more effectively​. 

Horizontal Distribution Formula: 

• • • The 15th Finance Commission used criteria such as income distance, population, and area to ensure equitable distribution of resources among states.
    • Example: This formula ensures that states with lower income levels receive more funds to help bridge the economic disparity between richer and poorer states​.

Grants-in-Aid:

• • • Finance Commissions provide grants to specific states or sectors that need assistance, promoting competitive and cooperative fiscal federalism.

Fiscal Consolidation:

• • • Recommendations for fiscal prudence and multi-dimensional restructuring of government finances help maintain economic stability.

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Way Forward to Strengthen Fiscal Federalism

Enhanced Devolution by the 16th Finance Commission

• • • Increase States’ Share in Net Taxes: The 16th Finance Commission should aim to enhance the state’s share in the net tax revenue from the current 41% to a higher percentage to ensure equitable distribution of resources.
    • Example: The 15th Finance Commission allocated a significant share to states like Uttar Pradesh and Bihar to balance development and revenue disparities among states​. 

Rationalisation of Public Expenditure by Central Govt

• • • Collaborate with State Governments: Implement a thorough financial rationalisation of Central Sector and Centrally Sponsored Schemes (CSS) in collaboration with state governments to ensure efficient use of resources.

Addressing GST-Related Concerns

• • • Correct Anomalies: Address issues like the GST favoring consuming states over producing states and broaden the GST scope to include items like petrol and diesel.

Revisiting Article 246 and the Seventh Schedule

• • • Reevaluate Taxation Powers: The taxation powers listed in the Seventh Schedule should be reexamined to enhance fiscal federalism by providing states with greater control over their resources.

Taxation Powers for Local Governments

• • • Devolve Specific Taxation Powers: Empower local governments with specific taxation powers to reduce their dependence on grants-in-aid from higher governments.
    • Example: Augmenting the state consolidated fund to supplement resources for panchayats and municipalities can enhance local governance and development​. 

Reduction of Borrowing Constraints on States

• • • Revisit Borrowing Constraints: The Union government should relax borrowing limits on state investment funds, allowing states more financial autonomy to invest in critical infrastructure projects.
    • Example: States like Kerala and Telangana have highlighted the need for relaxation in borrowing limits to address their infrastructure needs​ . 

Reduction in Cesses and Surcharges

• • • Reduce Use of Cesses and Surcharges: Minimize the Centre’s reliance on cesses and surcharges, which are not shared with states, to ensure a fairer distribution of tax revenue.

Minimising Discretionary Transfers

• • • Implement Clear Methods for Transfers: Establish automatic or clear, non-discriminatory methods for transferring funds to states to reduce uncertainty and enhance fiscal stability.