The Erosion of Fiscal Federalism


    Syllabus: GS 2/Centre -State Relations 

    In Context

    • The Kerala government has accused the Centre of pushing the State into a severe financial crisis by imposing a limit on its borrowings.

    Development of fiscal federalism in India

    • Fiscal functions are carried out by the different tiers of a government in a country. 
    • The number of tiers of government involved in the fiscal functions differ from one country to another depending upon the federal structure of the government.
      • For instance, the USA, India and Australia have a three-tier federal structure.
    • At the core of fiscal federalism in India lie fiscal transfers from the central government to subnational governments. 
    • Article 268 to 281 of the Indian Constitution deals with the distribution of revenue between the Union and the States.
    • Transfers are predominantly based on the recommendations of the Finance Commission and consist of tax devolution and grants. 
    Do you know ?
    – Article 280(1) of the Constitutions lays down that the modalities for setting up of a Finance Commission 
    – It is appointed after every five years or earlier to make recommendations to the President regarding the distribution of shared taxes, grants-in-aid and any other matter referred to the Commission.
    – Subsequent to the 73rd and 74th amendment of the Constitution and insertion of clause (3) to Article 280, the Commissions started giving additional grants for local bodies as a measure to augment the consolidated funds of the States to supplement the resources of local bodies.  

    Various issues regarding fiscal federalism in India

    • Centre’s ceiling rule: Kerala has moved the Supreme Court contending that the Centre’s imposition of a Net Borrowing Ceiling (NBC) on the State, which limits borrowings from all sources, violates Article 293 of the Constitution. 
      • According to Article 293(3) of the Constitution, the State has to obtain the consent of the Centre to raise ‘any loan’, if ‘any part of the previous loan’ extended by the Centre is outstanding.
      • Parliament does not have the power to legislate upon the ‘Public Debt of the State’ as this finds place in Entry 43 of the State List of the Constitution
    • Increasing dependency on Centre: The reliance of states on central government revenue has grown, witnessing a decrease in the share of revenue from independent sources from 55% in 2014-15 to 50.5% in 2020-21.
      • This trend is partly inherent in India’s fiscal structure, where states are significant spenders while the central government controls financial allocations.
      • The introduction of the GST has further compounded this situation, as most indirect taxes, except for a few like petroleum products, property tax, and alcohol excise, have been absorbed into the GST framework. This has diminished the states’ capacity to generate their own revenue.
    • Post GST: States no longer possess the authority to independently determine tax rates for subjects listed under the State List.
      • In the past, state governments had the flexibility to set tax rates based on factors such as their expenditure needs and revenue base. 
      • The current situation, where states cannot adjust tax rates according to their developmental needs, results in increased reliance on central government funds.
    • Cess and surcharges: Another emerging challenge is that cesses and surcharges are becoming a disproportionate proportion of the overall divisible revenue, withnon-tax revenues being kept outside the divisible pool.
    Net Borrowing Ceiling (NBC)
    – The NBC limits the borrowings of States from all sources including open market borrowings. 
    – The Centre has decided to deduct liabilities arising from the public account of the States to arrive at the NBC. 
    – In addition, borrowings by state-owned enterprises, where the principal and/or interest are serviced out of the Budget, or through assignment of taxes or cess or any other State revenue, are also deducted from the NBC.

    Suggestions and Way Forward 

    • Disputes between the Centre and States regarding economic policies have a long history in India.
      • However, in recent years the frequency and intensity of such disputes have increased and assumed the character of ‘persistent frictions’ in the federal system.
    • These issues needed urgent consideration to reinforce trust in fiscal federalism.
    • Therefore, there is need to give serious consideration for a consultative forum for credible policy dialogue between the Centre and the States
    • It is equally important to ensure all round efficiency in the deployment of public funds, in particular, investments in productive enterprises in the public sector.
    • There is a need for augmenting the resources both of the Centre and the States and the cake has to grow before the slices can become bigger. This requires faster growth of the economy and restructuring the expenditure of the Centre and the States.
    • The 15th Finance Commission has thus recommended a slew of fiscal reforms to increase the tax-to-GDP ratio, especially through an overhaul of the goods and services tax.
    • It is time that the major political parties develop a broad consensus at the centre and the states and blend good economics with politics.
    Mains Practice Question
     [Q] State in brief the principles of federal finance. How far do the Centre-State financial relations in India adhere to these?