India’s Fiscal Federalism needs a rethink

India’s Fiscal Federalism needs a rethink

Context: Recently, an editorial was covered on the need to rethink emerging dynamics of India’s Fiscal Federalism.

What is Fiscal Federalism?
• Fiscal federalism in India refers to the division of responsibilities and resources between the central and state governments. It is based on the constitutional provisions that assign different subjects and taxation powers to the union and the states.
•  It also involves the mechanisms of revenue sharing and grants from the centre to the states to address the vertical and horizontal imbalances in the fiscal system.

Which are the different tools to achieve Fiscal Federalism?
• Tax devolution - This is the process of transferring a share of the central government’s tax revenues to the states based on the recommendations of the Finance Commission.
• Grants-in-aid - These are the transfers from the central government to the states for specific purposes, such as disaster relief, local bodies, health, education, etc.
• Goods and Service Tax - The GST is a comprehensive indirect tax that replaces multiple central and state taxes on goods and services. It's administered by a GST Council consisting of representatives from the central and state governments.

Why India’s Fiscal Federalism needs a rethink?
• The transition from a planned economy to a market-mediated economic system marked a shift from centralized decision-making to a more decentralized approach where market forces play a more significant role. This change has had implications on resource allocation, investment, and overall economic growth. It has also led to greater autonomy for states in economic decision-making.
• The 73rd and 74th Constitutional Amendments in India led to the establishment of Panchayats and Municipalities as local self-governing bodies. The amendments have not ensured adequate and predictable transfers of funds from the state governments to the local bodies. The state governments have often used their discretion to withhold or delay the grants-in-aid to the local bodies, thereby affecting their financial autonomy and accountability.
• Abolition of Planning Commission and Introduction of NITI Aayog - Unlike the Planning Commission, NITI Aayog has no say in centre-state transfers, which could motivate states to reform with plan grants.
• The implementation of Fiscal Responsibility and Budget Management (FRBM) Act, 2003 to foster a more responsible fiscal approach. However, its implementation has led to challenges in balancing growthoriented spending with fiscal prudence.
• GST and GST council - Some state finance ministers have alleged that the GST Council’s decisions are influenced by political considerations and not by economic rationality. They have also complained that their views are not accorded due weightage and that they are often outvoted by the majority.
• Several pieces of central legislation such as the Mahatma Gandhi National Rural Employment Guarantee Act 2005, the Right of Children to Free and Compulsory Education Act 2009, the National Food Security Act 2013 and many others impose an extra burden on the States.

How can India strengthen its Fiscal Federalism?
• Introduce performance-based grants that reward states for achieving certain developmental targets, such as improving health and education indicators.
• Revisit Articles 246 and the Seventh Schedule to redefine the division of powers and responsibilities between the central and state governments.
• Empower Local governments with adequate resources and autonomy.
• Provide states with more flexibility and control over taxation, enabling them to generate revenue according to their local economic conditions and priorities.
• Address the issue of off-budget borrowings by ensuring that all financial transactions are included in the budget. This prevents hidden liabilities and increases transparency in fiscal management.