The Indian Constitution can be conceptualized as a “holding together federation” with a slight inclination toward unity. Its inception was a response to the divisive forces at play in the nation before gaining independence. Over the course of the last 73 years, it has demonstrated remarkable resilience and adaptability. Nonetheless, in the contemporary landscape, it becomes imperative to reassess the mechanisms governing the allocation of funds and resources between the central government and the individual states. This is necessitated by the evolving economic dynamics and changing requirements of the country.

Why in News?

• A holding together federation with unitary orientation, the Indian Constitution has journeyed over 73 years with remarkable resilience.
• However, the emerging dynamics of India’s fiscal federalism, which refers to the financial relations between Union and the state governments, needs some rethinking.

What is Fiscal Federalism?

Fiscal federalism is a term that describes how the financial powers and responsibilities are divided between different levels of government in a country. It involves questions such as which functions and services should be provided by the central government or the state governments, how the revenues should be raised and shared among them, and how the transfers or grants should be allocated to ensure efficiency and equity.

About Fiscal Federalism:

• It is defined as the division of financial powers as well as the functions between multiple levels of the federal government.
• It has within its ambit the imposition of taxes as well as the division of different taxes between the Centre and the constituent units.
• Similarly, in the case of joint collection of taxes, an objective criterion is determined for the fair division of funds between the entities.
• Usually, there is a constitutional authority like Finance Commission in India for the purpose to ensure fairness in the division.

Reason Why India’s Fiscal Federalism Needs Rethinking

Altered Fiscal Landscape

• There have been some decisions, policies of the central government that have altered the Fiscal landscape. Some of these include:
  • The paradigm shift from a planned economy to a market-mediated economic system.
  • The transformation of a two-tier federation into a multi-tier fiscal system following the 73rd and 74th Constitutional Amendments.
  • The abolition of the Planning Commission and its replacement with NITI Aayog.
  • The passing of the Fiscal Responsibility and Budget Management (FRBM) Act.
  • The Goods and Services (GST) Act with the GST Council holding the controlling lever.
  • The extensive use of cess and surcharges which affect the size of the divisible pool.
  • This complexity has its roots in several factors, including substantial ethnic, social, and economic disparities among regions.
  • The long-standing vertical imbalance between the expenditure and revenue-raising responsibilities of the state governments is another problem.
  • This imbalance is in part covered by revenue-sharing arrangements. States also receive a variety of grants from the centre, but even then, states run deficits.
  • For these reasons, and because of the clear trends toward structural transformation of the economy away from central planning and increased claims of the states for fiscal autonomy, a comprehensive rethinking is needed.

Complex System of Intergovernmental Fiscal Relations

• This complexity has its roots in several factors, including substantial ethnic, social, and economic disparities among regions.
• The long-standing vertical imbalance between the expenditure and revenue-raising responsibilities of the state governments is another problem.
• This imbalance is in part covered by revenue-sharing arrangements. States also receive a variety of grants from the centre, but even then, states run deficits.
• For these reasons, and because of the clear trends toward structural transformation of the economy away from central planning and increased claims of the states for fiscal autonomy, a comprehensive rethinking is needed.

Issues /Challenges

• Hollowing out fiscal capacity
  • The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20.
  • States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol — the revenue has been stagnant at 6% of GDP in the past decade.
• Differential interest 
  • States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings. 
    • the Union gains at the expense of States by exploiting these interest rate differentials.
• Curbing autonomy and diversion of a State’s own funds
  • There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost.
    • States autonomy has been curbed by turning them into mere implementing agencies of the Union’s schemes
• These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States.
• The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates constitutional provision. 
• Deepening inequality
  • The political centralisation has only deepened inequality.
    • The poorest half of the population has less than 6% of the wealth while the top 10% nearly grab two-third of it’.

Conclusion

As India’s fiscal federalism continues to evolve, the 16th Finance Commission should lead a comprehensive rethinking process. The shift from planned to market economies, combined with changing fiscal paradigms and diverse economic shifts, requires recalibrating India’s fiscal federalism approach. Ensuring equity, revisiting powers and functions allocation, strengthening the third tier, and curbing unregulated borrowing practices are essential facets that demand urgent attention. By reassessing these dynamics, India can better align its fiscal policies with the principles of inclusivity and balanced development.

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