Fiscal Federalism refers to the division of responsibilities with regards to public expenditure and taxation between the different levels of the government. The Government of India Act 1919 and 1935 formalized the tenets of fiscal federalism and revenue sharing between the Centre and the states. It allows the government to optimize their costs on economies. The Constitution has provided provisions which enable the Union and the States to work in coordination and to levy and collect these taxes through systematic arrangements, provisions like-
- Taxes levied and collected by the Centre but assigned to the States.
- Taxes levied by the Centre but collected and kept by the States.
Like in other countries, the fiscal dimensions of federalism are a reflection of the political federal structure in India. The traditional subjects of concern of fiscal federalism, such as the assignment of taxes and responsibilities as well as the correction of vertical and horizontal imbalances, continue to remain important in India. Devolution of taxes and duties still constitutes the most significant dimension of fiscal federalism in India (Krishna, 2004). Fiscal federalism in India unlike in many rich countries has to satisfy the competing demands to deliver a number of essential and basic socio-economic services. As a paramount objective, fiscal federalism is expected to enable the national and sub-national governments to operate in such a way that leads to efficiency in the use of resources – not only in terms of the quality of services provided by the various levels of government but also in terms of creating the environment in which all economic agents use resources efficiently. Political environment is important in determining contours of fiscal federalism. After Independence, there was a single and same party rule at the Centre and in almost all states for many decades. There are now telltale signs that India is moving away from an era of cooperative federalism towards competitive federalism, due to multi-party polity, and predominance of regional parties at the state level, and coalition governments at the centre. The existence of competition brings-in the importance of transaction cost of coordinating policies and their implementation
(a) vertically between different levels of government and (b) horizontally between different units within each of the levels.
Many challenges, therefore, lie ahead for fiscal federalism in the country. Bulk of literature on federalism in India had focused on economic aspects of fiscal federalism. There is a little work done in the area of environmental policy and its influence on intergovernmental financial relations in India. Within the context of Indian Federalism, what remains important is to take into account the social diversity in a general sense and the diverse ways in which each member state is able to relate to the federal system as a whole and to other member states (Thornton, 1995). The existing cultural, economic, social, environmental and political factors combining to produce asymmetrical variations in the country, if not handled properly, have the potential to affect harmony within the federal structure of the country.
EVOLUTION OF FISCAL FEDERALISM
The history of fiscal federalism in modern India goes back to the government of India Acts of 1919 and 1935. While the Act of 1919 provided for a separation of revenue heads between the Center and the provinces, the 1935 Act allowed for the sharing of Center’s revenues and for the provision of grants-in-aid to provinces. The salient features of Government of India Acts of 1919 and 1935.
After independence, the Indian Constitution that came into existence in 1950 is widely known as basically ‘federal’ in nature, but with striking ‘unitary’ features, owing to the circumstances of the times when ‘unity and integrity’ of the country was of prime concern (Basu, 1980). Fiscal relations in India had evolved over time through political, institutional and functional changes within the ambit of the provisions of Indian Constitution. The Finance Commission had played an important role in this evolving structure because resource sharing, based on constitutional division of functions and finances between the Centre and states, is a critical element in the Indian federal system (Rangarajan, 2004). The Indian Constitution has not only provided a frame work for social and political development but also established the national ideals and, laid down the manner in which they were to be pursued. The members of the Constituent Assembly “skillfully selected and modified the provisions they borrowed” and “applied to their task two concepts – ‘accommodation’ and ‘consensus’. Accommodation was applied to the principles to be embodied in the Constitution. Consensus was the aim of the decision making process, the single most important source of the constituent Assembly effectiveness” (Granville, 1966). While the spirit of accommodation has been evident not only in the finalization of the provisions of Constitution but also in the manner in which Indian union and the constituent states have discharged their responsibilities of serving an ever increasing population within the democratic framework of governance. The profile of Federal India has undergone significant changes over the last six decades, with the population increasing from 36.10 million 1951 to 1027 million in 2001, and with the number of states emerging in 1956 in a major way and at subsequent points of time in a minor way. What has been significant is the remarkable continuity even while political and institutional changes had taken place in India.
Division of functions and resource asymmetry The Indian Constitution has, under Article 246 and Seventh Schedule, distributed powers and allotted subjects to the Union and the states with a threefold classification of subjects: (i) List I invests the Union with all functions of national importance such as defence, external affairs, communications, constitution, organization of the supreme court and the High courts, elections etc
(ii) List II invests the states with a number of important functions touching on the life and welfare of the people such as public order, police, local government, public health, agriculture, water land etc.
(iii) List III is the Concurrent list, which includes administration of justice (excluding Supreme Court and High Courts), economic and social planning, trade and commerce, etc. It is of interest to note that higher education; forests and population control were all added to this list in 1977 during the emergency when it was felt that the states were not doing justice to these subjects of national importance. Accordingly, the Parliament has exclusive powers to make laws regarding matters enumerated in List I. On the other hand, the Legislature of any state has exclusive power to make laws for that state regarding any of the matters enumerated in List II, subject to other clauses of Article 246. With regard to List III, both the Parliament and State Legislature can make laws but in case of any conflict, the law made by Parliament will prevail (Article 254). The residuary functions, that is, those not included in either lists I or II, vest with the Union. The Union and State lists include the powers of taxation as well. The enumeration of taxation powers placed in the Union List includes: tax on income other than agricultural income, excise duties, customs and corporate tax. Recently service tax had been included in view of diminishing importance of customs. The State List contains land revenue, excise on alcoholic liquor, tax on agricultural income, estate duty, tax on sale or purchase of goods, tax on vehicles, tax on professions, luxuries, entertainment, stamp duties etc. However, due to political reasons, none of the states had imposed tax on agriculture income. The Concurrent List does not include any tax power. The distribution of revenues between the Union and the States and approaches for determining grants as per various Articles of the Indian Constitution is given at Box – 3.3. Distribution of resources between the Centre and the states together with the perceived mismatch between the functional responsibilities and revenue raising powers assigned by the Constitution to the two layers of Governments i.e., Centre and states, has been the subject of considerable discussion and debate in the relevant literature. Two points have been made in this regard: (i) that there is mismatch between the functions allocated to the centre and to the states, their powers of taxation and (ii) that the more buoyant tax areas have been assigned to the centre. But, it has also been pointed out that “the Constitution recognizes that the division of resources and functions between the Union and the states was such that there would be imbalance between them” and that “the Finance Commission periodically corrects the imbalance bringing about an alignment between them” A moot point is whether relative responsibilities of the Centre and states could be defined and worked out in financial terms. The Indian Constitution had given a workable solution that has been able to sustain the federal spirit and provide the framework for many years to come. Many scholars are of the view that in the context of the changes in a growing economy, it is good that they did not freeze the financial relations in a tight frame; they rather chose to provide an institutional mechanism like the Finance Commission to be appointed every five years with powers to make recommendations for statutory devolution and grants.
Vertical and horizontal imbalances
Adequacy and elasticity are the essential elements of federal finance. Adequacy implies sufficient resources for discharging constitutional responsibilities and elasticity implies an expansion of resources in response to the growing needs of Government. The practical effect of the division of tax powers has been to deny both these characteristics in the case of states in India . A vertical imbalance between the Centre and states is built into the Constitution by the provisions relating to powers of taxation. This arises, not out of any consideration of making the centre stronger, but out of the desire to build a common economic space in the country and out of an apprehension that with more powers the states may put up ‘barriers’ within this space. The vertical imbalance is further accentuated by the assignment of several responsibilities involving the public expenditure to the states on the grounds that tiers of government nearer to the people would be more sensitive to their needs and thus be better able to discharge such responsibilities. Since states differ in their resource endowments, levels of development and standards of delivery of public services, there are sharp horizontal imbalances among the states in India.
Inter-governmental transfers
In order to correct built-in vertical and horizontal imbalances for an even and equitable development of the entire country, the main instrument for achieving this is fiscal transfers from the Centre to states through different channels and the mechanisms as provided in the Constitution). Fiscal transfers to the third tier of government through subsequent Constitutional Amendments (73rd and 74th) had also been envisaged in India. Accordingly, there are both mandatory and enabling provisions facilitating a wide ranging transfer of resources from Union to states, arranged in a systematic manner as given in.
CONSTITUTIONAL PROVISIONS FOR DISTRIBUTION OF REVENUES BETWEEN THE UNION AND THE STATES IN INDIA
Article 268: Duties levied by the Union but collected and appropriated by the States.
Article 268 (A): Taxes on services shall be levied by the GoI and such tax can be
collected and appropriated by GoI and the States. (88th Amendment) Article 269: Taxes levied and collected by the Union but assigned to the States. Article 270: Taxes levied and collected by the Union and distributed between the Union and the States.
Article 271: Surcharge on certain duties and taxes for purposes of the Union.
Article 272: Taxes which are levied and collected by the Union and may be distributed between the Union and the States.
Article 275: Grants from the Union to certain States. Article 276: Taxes on professions, trades, callings and employments.
APPROACHES FOR DETERMINING GRANTS
Article 280 (3) (b): Finance Commission to make recommendations as to the “principles” which should govern such grants in aid.
Article 275 (1): Specific “sums” to be paid to the states which are assessed to be in “need of assistance”.
The Indian Constitution, having provided for a certain division of the powers of taxation between the Union and states, also gives the states a share in the resources available to the Centre as contained in Articles in part XII of the Constitution. Any amendment to the List from which the Union and the states erive their power of taxation is covered by the proviso to Article 368. This requires ratification by the Legislatures of not less than one-half of the states. On the other hand, if any of provisions of part XII are to be amended, this can be done under Article 268(2) which requires the approval of only half of the members of each house of Parliament. This means that the share of the Union resources that the states are entitled to, can be altered by Parliament by its powers of amendment.
Mechanism of Transfers
Over the last six decades, an overarching institutional framework had emerged to deal with Centre-state financial relations in India. The main pillars of this frame work are:
(a) Finance Commission appointed periodically as per Article 280 of the Constitution of India, intended to address the vertical imbalance in financial resources between the centre and states and to address the horizontal distribution of resources among the states.
(b) Planning Commission set up by a Resolution of the Government of India dated 15th March 1950 to make an assessment of the material, capital and human resources of the country, and to formulate a plan for effective and balanced utilization of the country’s resources.
(c) National Development Council set up in August 1952 to strengthen and mobilize the effort and resources of the nation in support of the Five year plans. The financial provisions of the Constitution are in accordance with what experts would consider acceptable principles for a federal constitution and a desirable attribute of inter-governmental tax power assignment (Bagchi, 2001). However, it is the actual working of the scheme that has revealed deficiencies that seriously detract from much of its supposed merits. Bagchi (2001) cites the under utilization of Article 269 by the Union Government, the abridgement of the scope of Article 275, and, consequently, the extensive use of Article 282 by the Union to make extensive grants to the states as examples of the original constitutional scheme being distorted in actual practice over the years. It is the combination of all three agencies, namely, the Finance Commission, Planning Commission and the various Ministries of Government of India, that has taken, over several years, qualitatively significant and quantitatively demanding decisions resulting in an increasing level of transfer of resources from the Centre to states. Federal transfers to the states in India, are made in three streams, as (1) Devolution of states share in Central Taxes (2) Grants from Central to the states (classified as statutory or non statutory; and plan as well as non-plan) covering (i) Non-Plan grants, comprising – i. Statutory grants recommended by the Finance Commission to cover gap in revenue; ii. Assistance for relief measures after natural calamities (ii) Non Statutory grants, comprising – i. Plan grants- (a) State plan schemes
(b) Central plan schemes (c) Centrally sponsored schemes (d) Special schemes for North Eastern council etc (3) Loans from Centre a. Plan loans b. Non Plan loans including Ways and Means Advance.
So that was it about fiscal federalism.
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