FISCAL FEDERALISM

Q. What do you understand by fiscal federalism? Why is it needed in India? What are the
challenges we face in realizing this objective? (250 Words)

Answer: Fiscal federalism, financial relations between units of governments in a

federal government system. It is part of the broader public finance discipline.

Two things can be made out of the constitutional assignment between the centre
and states.

 Firstly, national public goods have been assigned to the central government while local
public goods as well as items with regional tastes and preferences have been assigned to
the state governments.
 Secondly, the central government has been assigned larger tax base compared to the state
governments, while later is required to make most of the expenditures. In practice, the
centre collects nearly two-third of taxes while incurs one-third of total government
expenditure.
 Case is the opposite of the expenditure and revenue shares of the state governments. This
centralization of revenue collection and decentralization of expenditure inherently leads
to vertical imbalance. Indian federal system is also marked by huge regional income
disparities, which automatically leads to horizontal fiscal imbalances as well.
 The Indian Constitution has all specification of financial powers and functional
responsibilities of the Centre and the States and the institutions needed for a federal
structure and a well-defined mechanism for intergovernmental transfers to address
vertical and horizontal imbalances.
 Recognizing the inbuilt vertical and horizontal imbalances, Constitution framers made
explicit provisions for intergovernmental fiscal transfers like Finance Commission, Grant
in Aid, etc.

Challenges-

1. Horizontal imbalances and rising regional inequalities: Replacing the

Planning Commission with NITI Aayog has reduced the policy outreach of government
by relying only on a 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 inequities.

2. Vertical imbalance- 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 defense, etc.) is only 40% of the total
public expenditure.

3. There are a number of Central legislations, the compliance and

enforcement cost of which are entirely borne by the States. Central legislations, such
 as the Environment Protection Act, etc. At present, States are not compensated for the
cost of compliance and the revenue loss on account of compliance.

4. The periodic pay revision by the Central Government gives rise to demand on
the part of State government employees for a similar pay hike. For the States, it is a
demand which is difficult to resist.

5. The main grievances of the States are that the provision of revision of royalty
rates is not being adhered to and that there are undue delays in the revision of these rates
at periodic intervals depriving the States of potential revenue.

6. With the increased exploitation of offshore oil and gas reserves, the non-tax
revenues of the Centre are likely to improve considerably through higher royalty
collections. Under the present Constitutional arrangements, offshore royalty accrues
entirely to the Centre.

Recommendation by Punchi commission are as follows-

 The Commission recommends a comprehensive review of all transfers to States with a

view to minimizing the component of discretionary transfers, particularly those channeled
through CSS.
 As the resources at the command of the States are limited, we recommend higher Central
transfers to backward States to enable them to improve their physical and human
infrastructure.
 All future Central legislations involving States’ involvement should provide for cost-
sharing as in the case of the RTE Act.
 The ToR of future Finance Commissions should be formulated in such a way that the
additional commitments of States on account of pay revision are fully taken into account.
 The royalty rates on major minerals should be revised at least every three years without
any delay. States should be properly compensated for any delay in the revision of royalty
beyond three years.
 A part of the sale proceeds of the spectrum should be devolved to States for expenditure
on infrastructure projects.
 This ‘one-size fits all’ approach to fiscal consolidation has constrained fiscally strong
States to raise more resources. Therefore, State-specific targets of fiscal deficit in the
FRBM legislation of States. The fiscal correction path may factor in the variations in the
initial fiscal situation across States and be made State-specific.