Fiscal Federalism

Syllabus: GS-II, Subject: Indian Polity and Constitution, Topic: Federalism

Why in news: Agitations by states like Karnataka in Delhi and petition in Supreme Court by Kerala on imposed borrowing limits.

 What is fiscal federalism?

Fiscal federalism is the framework that examines how central, state, and local governments share the responsibilities of raising revenue (through taxes and fees) and spending that revenue on public goods and services.

Key aspects of fiscal federalism:

  • Division of responsibilities: Different levels of government are assigned different responsibilities, such as national defense at the central level and education at the state and local levels.
  • Taxing authority: Each level of government has the authority to raise its own revenue through various taxes and fees.
  • Intergovernmental transfers: The union government may transfer funds to state and local governments through grants, loans, and other programs.

Constitutional provisions:

  1. Seventh Schedule (Union, State, and Concurrent Lists): This schedule divides legislative powers between the central (Union) and state governments. It specifies which level of government can levy taxes on specific items.
  2. Finance Commission (Article 280) a crucial body in fiscal federalism, recommends on devolution.
  3. Article 270: Deals with the distribution of taxes levied by the Union government A significant portion is collected by the Union but shared with the states based on recommendations by the Finance Commission .
  4. Grants-in-Aid System -Statutory grants(Article 275) and Discretionary grants(Article 282).
  5. Goods and Services Tax -administered by a GST Council consisting of representatives from the central and state governments.

Issues in Fiscal Federalism:

  1. Vertical Imbalance: The Central government collects a larger share of taxes compared to the states. This can leave states with insufficient resources to fund essential public services, particularly in poorer regions.
  2. Tax Devolution: While the Finance Commission recommends revenue sharing, there are concerns about the formula used for distribution.
  3. Grants: Additionally, the increasing use of discretionary grants by the central government can be seen as undermining the recommendations of the Finance Commission.
  4. Goods and Services Tax (GST): States argue it has reduced their tax collection autonomy and made them overly reliant on central government transfers.
  5. GST Compensation: Concerns exist over timely compensation for revenue losses due to GST implementation.
  6. Use of Cesses and Surcharges: The central government’s frequent use of cess and surcharges to raise funds for specific purposes can affect the size of the divisible pool of taxes available for distribution to states.
  7. Article 293 and Fiscal Responsibility and Budget Management (FRBM) Act: While aiming for fiscal discipline, the FRBM Act might impose stricter borrowing limits on states compared to the central government. This can restrict states’ ability to invest in infrastructure and social programs, hindering development.
  8. Rise in Tied Transfers: States are receiving more funds tied to specific central schemes, restricting their ability to allocate resources based on local needs.

Measures to address the issues in fiscal federalism in India:

Addressing Vertical Imbalance:

  • Reviewing the Finance Commission’s formula: A re-evaluation of the criteria used by the Finance Commission for distributing tax revenue
  • Increasing tax devolution: Gradually increasing the share of tax revenue that goes directly to states could enhance their fiscal autonomy and allow them to invest in their priorities.

Enhancing Transparency and Predictability:

  • Reducing reliance on discretionary grants: Limiting the use of discretionary grants by the central government and making resource allocation more transparent and predictable for states.
  • Timely GST compensation: Ensuring timely and complete compensation for revenue losses due to GST implementation is crucial to avoid financial strain on states.

Strengthening State Finances:

  • Relaxing FRBM Act limitations for states: Revisit the borrowing limits imposed on states under the FRBM Act, allowing them more flexibility for crucial infrastructure projects and social programs while maintaining fiscal responsibility.
  • Expanding tax base of states: Exploring ways for states to broaden their tax base, potentially through new taxes or surcharges with clear guidelines to minimize overlap with central taxes.

Promoting Cooperative Federalism:

  • Strengthening the role of NITI Ayog: with a focus on collaborative development strategies that consider state-specific needs and priorities.
  • Encouraging inter-state cooperation: Facilitating collaboration between states for resource sharing and joint infrastructure projects could address regional disparities.

Improving Institutional Mechanisms:

  • Strengthening State Finance Commissions: Providing adequate resources and technical expertise to State Finance Commissions can enhance their effectiveness in analyzing and addressing financial needs of local governments.
  • Enhancing fiscal transparency: Implementing robust financial reporting systems across all levels of government can improve accountability and facilitate better financial management.

Overall, finding a workable and adaptable system of fiscal federalism remains an ongoing challenge for India.  It requires ongoing dialogue, potential reforms, and a collaborative approach between the central government and the states to ensure a fair and equitable distribution of resources that fosters balanced development across the nation.

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