Fiscal Federalism, Constitutional provisions, Challenges, Finance Commission's recommendations

Fiscal federalism refers to the financial relationship between the Union and states, aiming to balance state autonomy and national coherence. Constitutional provisions, including Articles 270, 275, 280, 282, and 293, govern fiscal distribution, grants, and borrowing. Challenges include declining state revenue shares, dependence on Centrally Sponsored Schemes (CSS), borrowing restrictions, and GST-related issues. 

The Finance Commission promotes fiscal federalism by recommending equitable tax devolution, targeted grants, and fiscal consolidation. For the future, reforms should focus on increasing states' revenue share, restructuring CSS, addressing GST issues, and empowering local governments.

What is Fiscal Federalism?

Fiscal federalism refers to the financial relationship and allocation of resources between different levels of government in a federal structure. It encompasses the distribution of fiscal powers and responsibilities, including taxation, expenditure, and the transfer of funds between the central and state governments. The term “fiscal federalism” was introduced by the German-born, American economist Richard Musgrave in 1959. 

In the context of India, fiscal federalism aims to balance the financial autonomy of states with the need for national coherence, allowing for regional development and public welfare.

Fiscal Federalism Constitutional Provisions 

Constitutional provisions for fiscal federalism in India include Article 270 for tax distribution, Article 275 for grants-in-aid, Article 280 for establishing the Finance Commission, Article 282 for Central fund allocations, Article 293 regulating state borrowing, and the Seventh Schedule defining taxation authority between the Centre and states.

• Article 270: Stipulates the distribution of taxes levied by the Centre among states, reinforcing the role of the Finance Commission in determining revenue shares.
• Article 275: Empowers the Centre to provide grants-in-aid to states, particularly those with special needs, ensuring a minimum level of public services.
• Article 280: Establishes the Finance Commission, tasked with recommending the distribution of tax revenues between the Centre and the states every five years. It assesses the financial needs of states based on criteria such as population and area.
• Article 282: Allows the Centre to allocate funds for projects that may benefit states or regions, promoting cooperative federalism and collaborative governance.
• Article 293: Article 293 governs state borrowing powers, requiring states to seek the Centre's consent for new loans if they have outstanding central loans, significantly impacting state fiscal autonomy.
• Seventh Schedule: Defines the distribution of subjects between the Centre and states, allowing both levels of government to impose taxes and manage finances within their respective domains.

Fiscal Federalism Challenges

The challenges to fiscal federalism include declining state revenue shares, increased dependence on CSS, borrowing limits, GST-related complications, political bias in fund allocation, reduced financial transfers, rising non-devolvable cesses, centralisation of expenditure, conditional grants, and erosion of state taxation autonomy.

• Decline in Revenue Shares: The 15th Finance Commission has reported a significant drop in revenue shares for states like Karnataka (4.71% to 3.65%) and Kerala (2.5% to 1.92%). This decline restricts their capacity to fund welfare schemes and adversely affects social expenditure.
• Increased Dependence on Centrally Sponsored Schemes (CSS): States have increasingly relied on CSS for welfare spending, with expenditures surging from ₹5.21 lakh crore in 2015-16 to ₹14.68 lakh crore in 2023-24. This shift reduces state autonomy, as the funding ratio has changed from 40:60 to 50:50.
• Borrowing Restrictions: The central government enforces a borrowing cap of around 3% of the State Domestic Product (SDP). This limitation hampers states' ability to raise funds, especially during financial crises. 
• For instance, Kerala faced a deprivation of ₹57,400 crore in transfers and loan approvals in 2023-24.
• Implications of Goods and Services Tax (GST): The implementation of GST has complicated fiscal federalism, leading to revenue shortfalls for states estimated between 19% and 33%. Delays in compensation payments have further exacerbated cash flow issues.
• Political Manipulation of Fiscal Resources: The central government’s emphasis on rewarding states aligned with the ruling party hampers equitable development. Opposition-ruled states face challenges accessing central funds, prompting protests against perceived discrimination.
• Reduced Financial Transfers: States' share in gross tax revenue has fallen from 35% in 2015-16 to 30% in 2023-24. Additionally, grants-in-aid have declined from ₹1.95 lakh crore to ₹1.65 lakh crore during the same period.
• Increase in Non-Devolvable Cess and Surcharge: The share of cess and surcharges, which are not shared with states, has grown from ₹85,638 crore (5.9% of the Union government’s tax revenue) in 2015-16 to ₹3.63 lakh crore (10.8%) in 2023-24.
• Centralisation of Public Expenditure: In the 2023-24 budget, out of the combined allocation of ₹19.4 lakh crore for CSS and Central Sector Schemes, only ₹4.25 lakh crore was devolved to states. These funds are tied grants, limiting states' autonomy in expenditure planning.
• Increase in Conditional Transfers: Several grants to states are contingent on fulfilling specific conditions, often aligning state priorities with Union government preferences, thereby imposing additional constraints on state autonomy.
• Erosion of State Taxation Autonomy: The implementation of GST has significantly diminished states' ability to set tax rates on their revenue sources, as State VAT has been subsumed under GST.

Fiscal Federalism Recent Development 

The Finance Commission's recommendations boost state autonomy through tax devolution, equitable resource allocation, and targeted grants. It also emphasizes fiscal consolidation, cooperative federalism, revenue deficit grants for weaker states, alignment with the FRBM Act, and improved transparency in resource management.

• Vertical Tax Devolution: The 14th Finance Commission raised states' share in the central divisible pool of taxes from 32% to 42%, boosting their fiscal autonomy and providing more resources for managing their budgets.
• Horizontal Distribution Formula: The 15th Finance Commission allocated tax shares among states based on criteria like income distance, population, area, and demographic performance, aiming to reduce disparities and ensure fair resource distribution.
• Grants-in-Aid: The Finance Commission provides targeted grants to states for specific sectors or reforms, promoting competitive and cooperative fiscal federalism and focusing on key areas like healthcare, education, and infrastructure.
• Fiscal Consolidation Recommendations: The Finance Commission advises states to manage finances prudently, control deficits, and maintain sustainable debt levels.
• Promotion of Cooperative Federalism: The Finance Commission fosters collaboration between the Centre and states through fiscal transfers, aligning national and state policy objectives for inclusive governance.
• Regular Review Cycle: The Finance Commission is appointed every five years to review and recommend fiscal arrangements between the Union and states, ensuring timely adjustments to evolving economic conditions and challenges.
• Addressing Fiscal Disparities: The Commission provides revenue deficit grants to economically weaker states, aiming to bridge fiscal gaps. This support helps these states meet their budgetary needs and promotes equitable regional development.
• Alignment with Fiscal Responsibility: The Commission emphasizes aligning state borrowing and spending with the Fiscal Responsibility and Budget Management (FRBM) Act. This alignment encourages sustainable public finances and prevents excessive debt accumulation.

Fiscal Federalism Way Forward 

To strengthen fiscal federalism, key actions include increasing states' tax share, revising the CSS funding structure, addressing GST-related issues, easing borrowing caps, revisiting taxation powers, empowering local governments, and reducing dependence on cesses and surcharges for more equitable tax distribution.

• Enhanced State Revenue Share: The 16th Finance Commission should increase states' tax share beyond the current 41%, addressing declines in revenue for states like Karnataka and Kerala, and ensuring adequate funds for welfare schemes.
• Revise CSS and Public Expenditure: The funding structure of Centrally Sponsored Schemes (CSS) should be restructured to restore state autonomy, with a collaborative mechanism for financial rationalization of the Central Sector and CSS.
• Address GST-Related Issues: GST anomalies should be corrected, particularly IGST favouring consuming states while expanding GST to include petroleum products and ensuring timely compensation for revenue shortfalls.
• Relax Borrowing Restrictions: The Union government should ease borrowing caps on states, particularly during financial crises, to enable greater fiscal flexibility. This is crucial for states like Kerala, which face constraints in transfers and loan approvals.
• Revisit Taxation Powers: Article 246 and the Seventh Schedule should be revisited to strengthen fiscal federalism. Revising the taxation powers will empower states by restoring their autonomy over local revenue sources post-GST.
• Empower Local Governments: Specific taxation powers must be devolved to local self-governments, reducing their reliance on grants and fostering genuine fiscal federalism by allowing them to raise their resources.
• Reduce Cess and Surcharge Dependence: The Union government should reduce the reliance on cesses and surcharges, which are not shared with states, to ensure a more equitable and transparent distribution of tax revenues.

Fiscal Federalism FAQs

Q1. What is the fiscal federalism?

Ans. Fiscal federalism refers to the financial relations and distribution of resources between the central and state governments, aimed at ensuring equitable resource allocation and addressing regional disparities. 

Q2. What are the principles of fiscal federation?

Ans. The three major principles are: Centre and States should maintain financial autonomy without undue dependence on each other; both must secure adequate funds for legitimate expenses, revenues should increase in line with growing expenditure needs.

Q3. What is the first generation theory of fiscal federalism?

Ans. The first-generation theory of fiscal federalism focuses on the allocation of responsibilities and resources between central and local governments, advocating for decentralized governance to enhance public service delivery.

Q4. What is the Article 275?

Ans. Article 275 of the Indian Constitution provides for grants-in-aid to states from the Consolidated Fund of India, aimed at addressing financial imbalances and supporting development initiatives.

Q5. What is vertical and horizontal fiscal federalism?

Ans. Vertical fiscal federalism pertains to the financial relations between different levels of government (central vs. state), while horizontal fiscal federalism addresses the distribution of resources among states at the same level.