Fiscal Federalism | Economics Optional Notes for UPSC PDF Download

Introduction

Fiscal federalism refers to the distribution of financial powers and responsibilities among various levels of government within a country. It encompasses considerations about which functions and services should be managed by the central government or state governments, the methods for generating and distributing revenues among them, and the allocation of transfers or grants to ensure efficiency and equity.

What are Some Tools to Achieve Fiscal Federalism?

Constitutional Assignment of Taxation and Expenditure Powers: In the context of India, the Constitution delineates the powers and functions of taxation and expenditure for different government levels, establishing a clear division between the central government and state governments.

• Finance Commission: Established as a constitutional body under Article 280, the Finance Commission plays a crucial role in recommending the distribution of tax revenues between the central government and state governments. Additionally, it proposes strategies to enhance the financial resources of states, foster fiscal discipline, and ensure stability in fiscal matters.
• Goods and Services Tax (GST): Serving as a comprehensive indirect tax, the GST replaces numerous central and state taxes on goods and services. Its administration falls under the purview of a GST Council composed of representatives from both central and state governments.
• Grants-in-Aid System: Governed by Article 275, the grants-in-aid system involves the discretionary transfer of funds from the central government to state governments for specific purposes or schemes. This mechanism aims to supplement state resources, addressing regional disparities and developmental gaps.

Why a Reassessment of India's Fiscal Federalism is Necessary?

• Transition from Planned Economy to Market-Mediated System: The shift from a planned economy to a market-mediated economic system signaled a move from centralized decision-making to a more decentralized approach, with market forces playing a prominent role. This transformation has implications for resource allocation, investment, and overall economic growth, granting states greater autonomy in economic decision-making.
• 73rd and 74th Constitutional Amendments: The implementation of the 73rd and 74th Constitutional Amendments in India led to the establishment of Panchayats and Municipalities as local self-governing bodies, aiming to enhance local governance and empower grassroots institutions. However, these amendments have not ensured consistent and predictable fund transfers from state governments to local bodies. State governments have, at times, exercised discretion in withholding or delaying grants-in-aid to local bodies, impacting their financial autonomy and accountability.
• Abolition of Planning Commission and Introduction of NITI Aayog: The replacement of the Planning Commission with the National Institution for Transforming India (NITI Aayog) in 2015 marked a shift from a top-down planning approach to a collaborative policy-making process. NITI Aayog provides strategic and technical advice but lacks influence in center-state transfers. This shift could motivate states to reform with plan grants.
• Fiscal Responsibility and Budget Management (FRBM) Act, 2003: Introduced to ensure fiscal discipline, the FRBM Act, applicable to both central and state governments, aims to reduce fiscal deficits and manage public debt. However, challenges arise in balancing growth-oriented spending with fiscal prudence during its implementation.
• Goods and Services Tax (GST) Act and GST Council: The introduction of the GST Act in 2017 replaced multiple indirect taxes with a unified structure, reducing tax cascading. However, it also diminished the tax collection powers of states. Allegations have been made that the GST Council's decisions are influenced more by political considerations than economic rationality, with complaints about inadequate representation of state views.
• Use of Cess and Surcharges: The common practice of using cess and surcharges to raise revenue for specific purposes can impact the size of the divisible pool, affecting funds available for distribution to states. For example, controversies surrounding inadequate and untimely payments related to the GST compensation cess have arisen.
• Central Legislations: Various central legislations, such as the Mahatma Gandhi National Rural Employment Guarantee Act 2005, the Right of Children to Free and Compulsory Education Act 2009, and the National Food Security Act 2013, impose an additional burden on states.
• Evolved Political Discourse: India's shift from one-party governance to a multi-party system has altered the political landscape, introducing new fiscal dimensions. Changes in polity, society, technology, demographic structure, and the development paradigm have made India's political arena more competitive and dynamic.

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How India Could Enhance its Fiscal Federalism?

• Equity-Oriented Intergovernmental Transfers: Design intergovernmental transfers, such as funds from the central government to states, with a focus on promoting equity.
• Horizontal and Vertical Fiscal Imbalances: It is crucial to address both horizontal imbalances (disparities among states) and vertical imbalances (between the central and state governments). Devolution formulas should account for both imbalances, ensuring fair resource allocation.
• Use of Performance-Based Grants: Introduce performance-based grants that reward states for achieving specific developmental targets, such as improvements in health and education indicators. This approach incentivizes effective governance and tangible results.
• Constitutional Reforms: Reevaluate Articles 246 and the Seventh Schedule to redefine the division of powers and responsibilities between the central and state governments. This clarification can reduce confusion and enhance efficiency by specifying the functions allocated to each level.
• Empowering Local Governments: Strengthen the third tier of government by providing adequate resources, functions, and autonomy. Establish a clear framework for responsibilities and finances to empower local bodies to make decisions that directly impact their communities.
• Uniform Financial Reporting System: Implement a standardized financial reporting system encompassing all government levels to ensure transparency, accountability, and efficient fiscal management.
• Review Off-Budget Borrowing: Address off-budget borrowings by ensuring that all financial transactions are included in the budget. This prevents hidden liabilities and enhances transparency in fiscal management.
• Convergence of Development Indicators: Utilize a combination of economic and social indicators, such as per capita income and the Human Development Index (HDI), for fund allocation. This approach ensures states focus not only on economic development but also on improving the overall well-being of their citizens.
• Fiscal Responsibility and Budget Management (FRBM) Act: Align the provisions of the FRBM Act for both central and state governments to maintain fiscal discipline while accommodating their unique fiscal situations.
• Devolving Tax Powers: Grant states more flexibility and control over taxation to enable them to generate revenue based on their local economic conditions and priorities.
• Cooperative Federalism: Foster a spirit of cooperative federalism where the central and state governments collaborate to design and implement policies for the overall benefit of the nation.
• Regular Review and Dialogue: Establish mechanisms for regular review and dialogue between the central and state governments to discuss fiscal issues, policy challenges, and potential improvements to the fiscal federalism framework.