Firm steps to ease the fiscal federalism tension

The Centre should not confuse uniformity for unity and must grant States the powers to levy direct taxes

October 23, 2019 12:02 am | Updated 12:02 am IST

A “camel’s nose” is a metaphor from an old Arabian tale, to describe a situation where one permits a small entry to an outsider into one’s territory, only to be soon pushed out entirely. The fiscal relationship between the Centre and the States is fast turning into a “camel’s nose” syndrome for the States. After a seemingly innocuous entry through the Goods and Services Tax (GST) by the Centre into the territory of taxation powers of States, it is now arming itself to elbow the States out entirely of its fiscal powers. This is a dangerous development, especially coming at a time when the nation is at its divisive worst.

India is a union of States. Citizens of every State elect their government independently. The primary responsibility of such an elected government is efficient governance and accountability to its voters. An elected government is typically granted the powers to be able to raise revenues through taxation of its citizens and incur appropriate expenditure for their benefit.

Over the past five years, democratically elected State governments have been stripped of almost all powers of taxation; there is an attempt to palm off the Centre’s expenditure obligation to the States and there is now talk of even limiting expenditure powers of the States.

The meal scheme lesson

In 1982, the newly elected Chief Minister of Tamil Nadu, MG Ramachandran (MGR) wanted to expand the midday meal programme to all 70 lakh children across 52,000 government schools to improve student enrolment. This entailed an additional expenditure of ₹150 crore, which the government did not have. MGR decided to levy an additional sales tax on goods sold in Tamil Nadu to cough up the amount needed. The programme was then further expanded by successive governments under the Dravida Munnetra Kazhagam, which then catapulted Tamil Nadu’s literacy rate from 54% in 1981 to 83% in 2011. In just three decades, Tamil Nadu was counted as one of India’s most literate States.

MGR and other Chief Ministers of Tamil Nadu did not have to rush to New Delhi to make the decision to implement a midday meal programme and impose additional sales taxes to fund it. It was decided and approved in Chennai. But in today’s India, MGR would have had to dash to Delhi and seek approval.

Typically, more than 80% of government’s revenues come from taxes, primarily from income tax (direct tax) and sales taxes (indirect tax). State governments in India do not have powers to levy income taxes. With GST, the Centre stuck its nose into the metaphorical indirect taxes tent of State governments. States lost their sole powers to levy indirect taxes. Instead, they depend on a GST Council to determine tax rates and revenues, in the mischievous disguise of cooperative federalism. So, a democratically elected State government in India can neither levy income tax nor sales tax. Representation without taxation, as the Americans might say.

Planned steps

With its nose in the tent, the Centre is now stretching its arms and legs to capture more. It has now proposed that there should be a permanent expenditure fund created for defence spending out of the total tax revenue pool. The Centre keeps 52% of the total tax revenue pool and distributes 48% to all the States and Union Territories. Instead of using its 52% share to spend on defence, the present government wants to palm off this expenditure to all the States. This will likely further reduce the tax revenues distributed to States for their own expenditure. Just as how in the garb of cooperative federalism the Centre intruded into States’ taxation powers, under the garb of nationalism, it wants to further dilute the overall tax revenue pool of the States.

If this was not enough, there is now talk, supported by the Prime Minister’s economic team, of constituting an Expenditure Council, similar to the GST Council. Not only did States lose their taxation powers but with this idea, they will lose its sole spending powers too. An elected Chief Minister of a State with no discretionary powers to earn or spend for the people of the State can virtually hand over the reins of governance to Delhi. This is not very different from how it was for provincial governments in India during the imperialistic reign.

Powers to levy income tax

While it may seem like there is a political monopoly in India today, let us not forget the huge economic and cultural diversity among the various States. It is a terrible mistake to presume that all of India can be governed from Delhi. Elected State governments and leaders cannot be made dummies without any fiscal powers for long. This fiscal federalism tension between the Centre and States can erupt into something more dangerous and spread wide.

The one tangible solution to restore this balance is to grant State governments the powers to levy income taxes. Since the birth of the republic, State governments have not had the powers to levy income taxes on citizens, except for agriculture taxes which are very small. In large federal democracies such as the United States, State governments and even local governments have the right to levy income taxes. In an India that is now increasingly diverging, it is imperative that democratically elected State governments are given powers to raise revenues and incur expenditure in accordance with each State’s needs and priorities. It is foolhardy to think that a council in Delhi can determine all revenues and the expenditure of each State. There is a new report of the direct tax code that has been submitted to the Finance Minister recently. The time is now appropriate to amend the Constitution to grant States the powers to levy income taxes as they deem fit.

Among the present governmet’s various intellectual misgivings, the biggest of them is perhaps its inability to make a distinction between unity and uniformity. Uniformity is not an essential condition for unity. On the contrary, a celebration of plurality may foster greater unity in a nation such as ours. The days of imperialistic London are over. It is the era of Gandhinagar, Chennai, Lucknow and Kolkata.

Praveen Chakravarty is a political economist and a senior office-bearer of the Congress party

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