The poor state of India’s fiscal federalism

The concerns of the founding fathers — addressing socio-economic inequities — are being forgotten in today’s fiscal policy

Updated - July 29, 2022 11:22 am IST

Published - July 28, 2022 12:16 am IST

‘The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates constitutional provision’

‘The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates constitutional provision’ | Photo Credit: Getty Images/iStockphoto

In his last speech, in 1949, to the Constituent Assembly, B.R. Ambedkar sounded a note of caution about the Indian republic entering a life of contradictions. “In politics we will have equality and in social and economic life we will have inequality. These conflicts demanded attention: fail to do so, and those denied will blow up the structure of political democracy”, he warned, though Jawaharlal Nehru truly believed that inequities could be addressed through his tryst with the planning process. A degree of centralisation in fiscal power was required to address the concerns of socio-economic and regional disparities, he felt. This asymmetric federalism, inherent to the Constitution, was only accelerated and mutually reinforced with political centralisation since 2014, making the Union Government extractive rather than enabling. While States lost their capacity to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime, their expenditure pattern too was distorted by the Union’s intrusion, particularly through its centrally sponsored schemes .

A politicised institution

Historically, India’s fiscal transfer worked through two pillars, i.e., the Planning Commission and the Finance Commission. But the waning of planning since the 1990s, and its abolition in 2014, led to the Finance Commission becoming a major means of fiscal transfer as the commission itself broadened its scope of sharing all taxes since 2000 from its original design of just two taxes — income tax and Union excise duties. Today, the Finance Commission became a politicised institution with arbitrariness and inherent bias towards the Union government. The original intention of addressing inequities, a lofty idea, indeed, was turned on its head as it metamorphosed into one of the world’s most regressive taxation systems due to a centralised fiscal policy.

So, let us see what has changed since 2014. The concerns of the founding fathers — addressing socio-economic inequities — were forgotten in the process of ushering in an era of political centralisation and cultural nationalism that drive today’s fiscal policy. To be sure, India was never truly federal — it was a ‘holding together federalism’ in contrast to the ‘coming together federalism,’ in which smaller independent entities come together to form a federation (as in the United States of America). In fact, the Government of India Act 1935 was more federal in nature than the Constitution adopted on January 26, 1950 as the first offered more power to its provincial governments.

Anticipating this threat of centralisation, C.N. Annadurai asserted in the Tamil Nadu Assembly in 1967, ‘I want the centre to be strong enough to maintain the sovereignty and integrity of India…should they have education and health department here... in what way does that strengthen the sovereignty and independence of India?’ Subsequently, the Dravida Munnetra Kazhagam constituted a committee under Justice P.V. Rajamannar in 1969, the first of its kind by a State government, to look at Centre-State fiscal relations and recommend more transfers and taxation powers for regional governments. It did not cut ice with the rest of India and centralisation, though partly contained in the 1990s and 2000s due to the coalition at the Centre, touched its apogee in 2014.

Hollowing out fiscal capacity

The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20. While the expenditure of the States has been shooting up, their revenues did not. They still spend 60% of the expenditure in the country — 85% in education and 82% in health. Since States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol — the revenue has been stagnant at 6% of GDP in the past decade.

Also read | Fiscal federalism crucial to development: Rangarajan

Even the increased share of devolution, mooted by the Fourteenth Finance Commission, from 32% to 42%, was subverted by raising non-divisive cess and surcharges that go directly into the Union kitty. This non-divisive pool in the Centre’s gross tax revenues shot up to 15.7% in 2020 from 9.43% in 2012, shrinking the divisible pool of resources for transfers to States. In addition, the recent drastic cut in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.

Besides these, States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings. It is not just that States are also losing due to gross fiscal mismanagement — increased surplus cash in balance of States that is money borrowed at higher interest rates — the Reserve Bank of India, when there is a surplus in the treasury, typically invests it in short treasury bills issued by the Union at lower interest rate. In sum, the Union gains at the expense of States by exploiting these interest rate differentials.

By turning States into mere implementing agencies of the Union’s schemes, their autonomy has been curbed. There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost. They spend about 25% to 40% as matching grants at the expense of their priorities. These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States.

In fact, it is the schemes conceived by States that have proved to be beneficial to the people and that have contributed to social development. Driven by democratic impulses, States have been successful in innovating schemes that were adopted at the national level, for example, employment guarantee in Maharashtra, the noon meals in Tamil Nadu, local governance in Karnataka and Kerala, and school education in Himachal Pradesh.

The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates constitutional provision. Why should there be a centrally sponsored scheme on an item that is in the State list? Similarly, why should the State share the expenditure of a scheme on the Union list? For instance, health is on the State list, so why should the Union thrust this scheme onto States; even on those that are better performing such as Tamil Nadu and Kerala? It only impedes States from charting their own autonomous path of development.

Deepening inequality

This political centralisation has only deepened inequality. The World Inequality Report estimates ‘that the ratio of private wealth to national income increased from 290% in 1980 to 555% in 2020, one of the fastest such increases in the world. The poorest half of the population has less than 6% of the wealth while the top 10% nearly grab two-third of it’. India has a poor record on taxing its rich. Its tax-GDP ratio has been one of the lowest in the world — 17% of which is well below the average ratios of emerging market economies and OECD countries’ about 21% and 34%, respectively.

Also read | Centre eroding financial rights of States: Balagopal

Pavithra Suryanarayan, a political scientist at London School of Economics, demonstrates that the Indian elites historically undermined fiscal capacity as they felt threatened by the political equality offered by the one person-one vote system. That hollowing out of fiscal capacity continued for decades after Independence, resulting in one of the lowest tax bases built on a regressive indirect taxation system in the world. India has simply failed to tax its property classes. If taxing on agriculture income was resisted in the 1970s when the sector prospered, corporate tax has been slashed by successive governments thanks to a pro-business turn in the 1990s. India does not have wealth tax either. Its income tax base has been very narrow. Indirect tax still accounts for about 56% of total taxes. Instead of strengthening direct taxation, the Union government slashed corporate tax from 35% to 25% in 2019 and went on to monetise its public sector assets to finance infrastructure.

In sum, India’s fiscal federalism driven by political centralisation has deepened socio-economic inequality, belying the dreams of the founding fathers who saw a cure for such inequities in planning. It has not altered inter-state disparities either. If there was anything that alleviated poverty, reduced inequality and improved the well-being of people, these were the time-tested schemes of State governments, but they are now under threat.

Kalaiyarasan A. is an Assistant Professor at the Madras Institute of Development Studies (MIDS), India and a Research Affiliate at South Asia Institute, Harvard University

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