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A stimulating alliance: On addressing fiscal worries of States


The Centre will release over ₹95,000 crore in one stroke to States this month, Finance Minister Nirmala Sitharaman announced after meeting with Chief Ministers and State Finance Ministers to discuss the state of the economy and to sustain the recovery from the COVID-19 pandemic.


GS-II: Polity and Constitution (Constitutional Provisions, Basic structure of the Constitution, Federal Structure), GS-III: Indian Economy

Dimensions of the Article:

  1. Implication of the announcement to release over ₹95,000 crores to states
  1. What is fiscal federalism?
  2. Recent development related to fiscal federalism?
  3. Challenges to fiscal federalism in India

Implication of the announcement to release over ₹95,000 crores to states

  • The Government set aside the spate of recent confrontations with States over
    • Revenue
    • GST compensation concerns
    • Fear by States about ‘encroachment’ on their powers,
  • The measure shows that government has taken steps to initiate an economy-focused dialogue independent of Budget consultations and GST Council machinations.
  • Its ready acceptance of States’ request to expedite the sharing of taxable revenues is a token of faith to reinforce federalism.
  • While most States have positive cash balances, access now to double the funds than usual will help them ramp up capital expenditure.
  • The cash flow could also help several States catch up on their capex targets, on which hinges an additional borrowing limit of 0.5% of their Gross State Domestic Product.
  • The Finance Ministry’s clarification that the excise duty cuts on petrol and diesel shall not dent the tax pool shared with States has also soothed frayed nerves.
  • The meeting with CMs yielded several ideas and policy proposals, including a simple demand that the Centre share leads about prospective investors and come out with a clear policy on green clearances.

What is fiscal federalism?

Fiscal federalism is financial relationship between centre and states, it deals with the division of governmental functions and financial relations among levels of government.

Structure of fiscal federalism in India:

The Seventh Schedule to the constitution of India  defines and specifies allocation of powers and functions between Union & States. It contains three lists; i.e. 1) Union List, 2) State List and 3) Concurrent List.

  • Union list: The Union Government or Parliament of India has exclusive power to legislate on matters relating to these items.
  • State list: The respective state governments have exclusive power to legislate on matters relating to these items.
  • Concurrent list: This includes items which are under joint domain of the Union as well as the respective States
  • Article 268 to 293 in Part XII deal with the financial relations.

Recent development related to fiscal federalism?

Three landmark changes in union-state fiscal relations since 2015-16 have been:

  1. The abolition of the Planning Commission in January 2015 and the subsequent creation of the NITI Aayog.
  2. Fundamental changes in the system of revenue transfers from the centre to the states by providing higher tax devolution to the states from the fiscal year 2015-16 onwards based on the recommendations of the Fourteenth Finance Commission (14th FC).
  3. The Constitutional amendment to introduce the Goods and Services Tax (GST) and the establishment of the GST Council for the central and state governments to deliberate and jointly take decisions.

Finance commission of India: The Finance Commission is a Constitutionally mandated body that is at the centre of fiscal federalism. Set up under Article 280 of the Constitution, its core responsibility is to evaluate the state of finances of the Union and State Governments, recommend the sharing of taxes between them, lay down the principles determining the distribution of these taxes among States.

Goods and Services Tax: GST is a single tax that has subsumed several indirect taxes that were previously levied on the sale of goods and services. It is applicable to the manufacture, sale, and consumption of all goods and services in India.

Challenges to fiscal federalism in India

  1. Horizontal imbalances: The horizontal imbalances arise because of differing levels of attainment by the states due to differential growth rates and their developmental status in terms of the state of social or infrastructure capital. However Replacing the Planning Commission  with NITI Aayog has reduced the policy outreach of government by relying only on single instrument of fiscal federalism i.e Finance commission. This approach if not reviewed can lead to a serious problem of increasing regional and sub regional inequalities.
  2. Vertical imbalance arises due to the fiscal asymmetry in powers of taxation vested with the different levels of government in relation to their expenditure responsibilities prescribed by the constitution.
    • Central Government collects around 60% of the total taxes, while its expenditure responsibility (for carrying out its constitutionally mandated responsibility such as defence, etc.) is only 40% of the total public expenditure.
    • Such vertical imbalances are even sharper in the case of the third tier consisting of elected local bodies and panchayats.
    • Vertical imbalances can adversely affect India’s urbanization, the quality of local public goods and thus further aggravating the negative externalities for the environment and climate change.
  3. Restructuring the fiscal federalism: India’s Fiscal Federalism needs to be restructured around the four pillars namely Finance Commission, NITI Aayog, GST and decentralization in order to eliminate the inadequacies of vertical and horizontal imbalances.
    • Finance commission: it should be relieved from the dual task of dealing with provision of basic public goods and services and capital deficits. It should be confined to focussing on removal of basic public goods imbalance
    • NITI Aayog: it should deal with infrastructure and capital deficit.
    • Decentralisation can serve as the third pillars of the new fiscal federalism by strengthening local finances and state finance commission.
    • GST should be simplified in its structure and can serve as the fourth pillar of our fiscal federalism, by ensuring.
December 2023