Context:

India’s hard-won independence and unity needs to be preserved as there are threats from China and there may be threats from Afghanistan after the U.S. withdraws its troops. A transition to a more federal structure will allow the Centre to focus on external threats instead of internal dissensions.

Relevance:

GS-II: Polity and Governance (Centre-State Relations)

Mains Questions:

Will allowing the states to directly collect more tax make them less dependent on the Central government? To what extent will such a move solve the issues with fiscal federalism in India? (10 marks)

Dimensions of the Article:

  1. What is fiscal federalism?
  2. Structure of fiscal federalism in India:
  3. Recent development related to fiscal federalism?
  4. Understanding Revenue distribution
  5. Challenges to fiscal federalism in India:

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.

Understanding Revenue distribution

  • Direct taxes are income tax and corporate tax. In the U.S., both the federal and State governments collect such taxes from individuals and corporations. This is true in Switzerland and some other countries as well.
  • However, in India, direct taxes go entirely to the Central government. The Central government is supposed to distribute 41% of its gross tax revenues (reduced from 42% after the formation of new Union Territories in Jammu and Kashmir) to the State governments. In the U.S., the federal government distributes about 15% of its revenues.

Issue: Dependency of the States

  • State governments get funds from the Central government according to the Finance Commission’s recommendations.
  • Usually, the Central government does not meet the 41% target. We see various States either petitioning or coming into conflict with the Central government on this issue.
  • State governments also raise their own funds largely through taxes on liquor, property, road and vehicles. At an all-India level, the States get 26% of their total revenue from the Central government.
  • Some of the so-called poorer States get up to 50% of their total revenue from the Central government, making them even more dependent. This gives more economic power to the Central government and allows ruling parties at the Centre to use these funds to their advantage.

Issue: Regional disparity

  • Maharashtra, Delhi and Karnataka contribute the lion’s share of taxes to the government. These three regions along with Tamil Nadu and Gujarat contribute 72% of the tax revenue.
  • Uttar Pradesh, which has the largest population in India, contributes only 3.12% but gets over 17% of the revenue distributed by the Central government.
  • Revenue distribution is based on complex considerations including population and poverty levels. For every ₹100 contributed, southern States get about 51% from the Central government, whereas Bihar gets about 200%.
  • The population growth rates in the south have come down to near zero, whereas the population in central and north India continues to grow. The cross subsidy from the south to the north will therefore grow. Meanwhile, job seekers and those looking for higher quality education are flocking to the south.
  • On the other hand, political power is concentrated in the north because there are more Lok Sabha seats. The number of seats in each State will be revised in 2026 perhaps based on population and other factors. This has already created apprehension in the southern States that they will be further politically marginalised.

Challenges to fiscal federalism in India:

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.

Vertical Imbalances

  • 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.

Way forward

Treating the new fiscal federal architecture based on the effective decentralization, transparent GST regime, independent Finance commission and effective NITI Aayog can strengthen India’s unique cooperative federalism.

-Source: The Hindu

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