Fiscal Federalism in India

Syllabus: GS2/ Polity, GS3/ Economy

Context

• Recent debates over tax devolution and State fiscal autonomy have renewed concerns about the balance between Union resources and state responsibilities.

About Fiscal Federalism

• Fiscal federalism is an economic framework for understanding the relationship among Union, state, and local governments, focusing on the division of spending and taxing powers among these governments.
  • It deals with the division of responsibilities among different types of governments.
  • It also deals with the division of revenue-raising powers among various governments, often referred to as “tax assignment.” 
• The traditional theory of fiscal federalism argues that taxes on highly mobile entities should be assigned to the central government and taxes on less mobile entities to state or local governments.
  • Grants-in-aid and intergovernmental transfers become necessary when a government’s expenditure responsibilities exceed its own revenue-raising capacity.

What is Fiscal Imbalance?

• The Constitution distributes taxation powers and expenditure responsibilities between the Union and States through the Seventh Schedule.
  • However, the division is not perfectly symmetrical and creates imbalance.
• Vertical Fiscal Imbalance: It refers to the mismatch between the revenue-raising capacity and expenditure responsibilities of different levels of government.
  • The Finance Commission under Article 280 recommends the distribution of the divisible pool between the Union and the States and the allocation of the States’ share among individual States.
• Horizontal Fiscal Imbalance: It refers to differences in revenue-raising capacity and expenditure needs among governments at the same level, such as between different states or between different local governments.

GST as a Mechanism for Cooperative Fiscal Federalism

• The introduction of the Goods and Services Tax (GST) represented a major transformation of India’s indirect tax system.
• GST subsumed several Union and State indirect taxes into a common framework and introduced a destination-based taxation system.
  • The input tax credit mechanism also reduced the cascading effect of taxation.
• The GST Council under Article 279A is particularly significant because it provides an institutional mechanism through which the Union and States jointly participate in important GST-related decisions.

Fiscal Responsibility and Public Debt

• The sustainability of fiscal federalism also depends on responsible borrowing.
• Government borrowing can support development when it finances productive investments that generate long-term economic returns.
  • However, persistent fiscal deficits can increase debt-servicing obligations and reduce the resources available for essential public expenditure.
• The Fiscal Responsibility and Budget Management framework 2003  seeks to promote fiscal discipline at the Union and State levels.

What are the Concerns?

• India’s vertical fiscal imbalance remains a structural challenge because states have extensive expenditure responsibilities but relatively limited access to broad-based and buoyant sources of taxation.
• Horizontal disparities between States remain significant because States differ substantially in their income levels, tax bases, demographic structures and costs of providing public services.
• The increasing use of tied or conditional transfers can sometimes reduce the flexibility of states to allocate resources according to their specific priorities.
• The fiscal position of local governments remains weak because their own-source revenues are limited and their dependence on higher levels of government remains substantial.
• Off-budget borrowings, government guarantees and other contingent liabilities can make it difficult to assess the true fiscal position of governments.
• Poor expenditure outcomes reduce the developmental impact of public spending even when governments allocate substantial financial resources.

Way Ahead

• States should strengthen tax administration, improve compliance and expand their revenue base without imposing excessive compliance costs on citizens and businesses.
• Governments should increasingly adopt outcome-based budgeting and evaluate whether public expenditure produces measurable improvements in health, education, infrastructure and livelihoods.
• Future fiscal transfers should increasingly account for differences in climate vulnerability, demographic transition, geographical constraints and the cost of delivering essential public services.

Source: HT