FINANCIAL FEDERALISM AND DECENTRALISATION OF FINANCES TO LOCAL

GOVERNMENT BODIES

INTRODUCTION

a. Backdrop
To manage itself, India is nested in numerous tiers of systems due to its enormous size
and diversified demography1. The central executive, led by the President, sits at the top of
the chain, while municipalities (in urban areas) and panchayats (in rural areas) (together
known to as 'Local Governmental Bodies') sit at the bottom. All these levels are
acknowledged in the Constitution2. The purpose of doing so is to improve administrative
efficiency. A highly centralized system – whether at the Union or State/Provincial level –
would inevitably make it impossible for residents to "navigate the system for timely and
quality delivery of services," which would be counter to the Constitution's vision of good
governance. From the central government to the Local Government Bodies, welfare
schemes and government services trickle down to the lowest levels. As a result,
decentralization becomes a necessity, and governance is brought closer to the people3.

b. Statement of Problem

Local Governance Bodies, like any other administrative unit, require funds to function.
Bringing governance closer to the people becomes a useless activity without them. Public
welfare programmers and other initiatives would not be implemented, and good
governance would become a theoretical concept with no practical application. As a result,
LGBs must be viewed as "institutions of self-government and ‘delivery mechanisms.' In
light of this administrative necessity, the 15th Finance Commission has made a number of
recommendations relating to devolution of finances and grants to Local Governance
Bodies in its Report for 2021-2026, which has raised various topics for discussion.

1
Balmiki Prasad Singh, Union Home Secretary of India (1997-99), Panel Discussion at the Frontiers of
Innovation Conference: The Challenge of Good Governance in India: Need for Innovative Approaches p. 13
2
See, INDIA CONST., Part V, Chap. 1 (The Union Executive), Part VI, Chap. 2 (The State Executives), and Part IX
(Panchayats)
3
United Nations Development Programme, Discussion Paper on Decentralisation in India: Challenges &
Opportunities.
 c. Research Question

Whether the current process for distribution of finances to Local Government Bodies is
adequately practical, or perhaps improvable?

d. Research Objective

The research aim of this paper is to examine the recommendations of the FC's Report
considering how funds have historically been allocated to Local Government Bodies, the
considerations that underpin their recommendations, and to suggest a path ahead in light
of the flaws in India's devolution of funds system.

e. Research Methodology

Researcher has followed the Doctrinal method of research by analyzing primary and
secondary sources of Information. whereby hypotheses are created from qualitative
assessments based on archival and textual data.

LITERATURE REVIEW

A. Working a Democratic Constitution by Austin4

Granville Austin is regarded as one of the foremost authorities on Indian constitutional

history, having studied the country's growth from the beginning.

According to him, the Finance Commission's centralising tendency operates (potentially)

against a Constitution's basic instincts in two ways: 

(i) it tends to centralize economic decision-making by making one body – albeit full
of experts – the arbiter of how funds should be distributed to States with varying
needs; and
(ii) national development agendas are forcibly implemented homogeneous, even
though this may not be the case.

Austin did, however, highlight the crucial role of the Planning Commission and Zonal
Councils under the State Reorganization Act of 1956, which encouraged horizontal and
vertical economic collaboration. However, with the introduction of the National Institute of
Transforming India, or NITI Aayog, as a replacement for the Planning Commission, and with
the introduction of more centralized tax collection systems like the Goods and Services Tax
4
GRANVILLE AUSTIN, WORKING A DEMOCRATIC CONSTITUTION (Oxford University Press, 1999).
("GST"), state economic autonomy is potentially jeopardized; and its effects would
undoubtedly trickle down to the third tier, where Local Government Bodies exist.

B. Fiscal Federalism in India by Ursula Hicks5

As previously stated, the Indian federal structure was founded on the principles of national
unity and integrity. The framers of the Constitution were forced to make the revenue
distribution system more centralised due to the disasters of successionist impulses. The same
may be seen in how monies are devolved based on the recommendations of the FC — a
central body chosen by the President. Furthermore, under Article 243-I of the Constitution,
State Finance Commissions were not constituted until 1992.

In this context, Ursula Hicks stated that the idea of centralizing funds, as it did in British
India, hasn't gone away. This leaves the states with very little room to make financial
decisions based on their own needs and desires. While the FC has always consulted States
before issuing recommendations, they have recently encountered some difficulties.

According to Ursula Hicks, this creates two issues:

(1) the need for slow change, as FC only provide one report every five years and work in a
very centralized manner, typically in line with the Centre's goals: and

(2) deprives States of the ability to promote economic changes on their own.

C. Panchayat Finances and the Need for Devolutions from the State Government by
Anand Sahasranam6

Anand Sahasranaman examined how three LGBs in Pallavapuram, Pandiyapuram, and

Cholapuram used the fiscal resources they received from the State and Central Governments
in a rare effort to review panchayat finances in light of fiscal federalism. The following is a
list of the author's main findings:

(i)  Local Governmental Bodies in India, both rural and urban, appear to be operating
at "sub-optimal" revenue levels, and are heavily reliant on devolution from State
Governments or the Centre. According to the author, the low revenue generation
is due to LGBs' reluctance to increase taxes on the services they give to citizens.

5
Ursula Hicks, Fiscal Federalism in India, 34.H(2) FinanzArchiv/Public Finance Analysis 358 (1976)
6
Anand Sahasranaman, Panchayat Finances and the Need for Devolutions from the State Government, 47(4)
ECONOMIC AND POLITICAL WEEKLY 73
 (ii) Furthermore, because to limited revenue production, Local Governmental Bodies
s have a tendency to spend disproportionately large amounts of money on policy
expenditures in the hope that the State Government will bail them out later.
Another result of over-dependence on states is this.
(iii) Local Government Bodies are hesitant to pursue "politically unpalatable" ideas
and programmes, even though they could be lucrative. Rather of focusing on
revenue generation strategies that benefit individuals, LGBs tend to view surplus
expenditures as "soft budget limitations" that will be addressed by higher
government entities later (like the Union or State Governments).

While these findings are nuanced, they highlight two key points: LGBs' lack of accountability
and their lack of autonomy/independence. This goal appears to be slipping away about 30
years from now. Local Government Bodies appear to be unduly reliant on financial aid from
state and federal governments in the lack of defined incentives – or (fiscal) punishments in
situations of wrongdoing. In the next section, we'll look at the issues raised here.

Whether The Current Mechanism for Devolution of Finances To The Local government
bodies Is Sufficiently Feasible, Or Potentially Improvable?

Article 1 of the Constitution refers to India as a "Union of States," 7 hinting that a federal
structure is intended – even though the term "federal" is not used anywhere in the document.
Despite widespread opposition to the term "union," Dr. Ambedkar defended it in the
Constituent Assembly. For him, a 'Union of States' signified national integrity, with the
Constitution serving as a solemn guarantee of indestructible national unification rather than a
matter of ratification by the Indian states8. As a result, India was not constructed as a
'federation of states,' but rather as a 'centralised federation,' with the Central Government
(also known as the 'Union Government') wielding extensive powers9.

The Central Government has the authority to make key economic decisions affecting all
levels of government in the country, but States, admittedly, have some economic autonomy.
The Central Government is required by the Constitution to distribute its revenue with the

7
INDIA CONST., art. 1.
8
VII Constituent Assembly Debates
9
Ambar Kumar Ghose, The Paradox of ‘Centralised Federalism’: An Analysis of the Challenges to India’s Federal
Design
States in the form of grants and tax devolutions 10. However, the way in which these funds are
provided is governed by the FC's report, which is appointed every five years in accordance
with Article 280 of the Constitution11. The FC's recommendations are based on the President's
terms of reference, which include four items that must be addressed: distribution of "net
proceeds from taxes" between the Centre and the States; "principles" governing the Centre's
"grants-in-aid" to the States; measures to "augment" resources to Panchayats via the State's
Consolidation Funds; and measures to "augment" resources to Municipalities via the State's
Consolidation.

As a result, authority runs in two directions: first, from the federal level, where monies are
distributed to states, and then from the states, which distribute it to the LGBs. Because of
fiscal decentralisation and the lack of tight federal oversight, this tiered division of
responsibility reflects the 'Plurality Theory' of Fiscal Federalism, in which tasks are assumed
by different levels of government based on their own needs and interests.

Analysis of 15th Finance Commission Report

The grants to LGBs were for the following purposes, according to the TOR, which was
submitted to the FC by the President: (1) "the measures needed to augment the Consolidated
Fund of a State to supplement the resources of" LGBs; (2) improving basic services such as
human resource quality and service provision; and (3) progress in social development and
sanitation. Furthermore, the FC offered explicit suggestions for the first time in relation to
States that are specifically designated as excluded territories in the Constitution (such as
Nagaland, Tripura, Meghalaya etc.). Furthermore, improvements in funds for "internet and
telephone expenses" to increase connectivity in rural regions were highlighted in accordance
with the opinions of the Union Government's Ministry of Panchayati Raj12.

The Finance Commission also outlined nine principles under which devolved funds would be
distributed among Local Governing Bodies, two of which were "notifying minimum floor on
property tax rates by States in order to increase the buoyancy of revenue of urban local
bodies," as well as a focus on "strengthening primary health care" and "water sanitation and
waste management."13

10
INDIA CONST., art. 270, 278
11
See, INDIA CONST., art. 280.
12
15th FC Report
13
Id at 12
While these progressive ideas are admirable, the FC faced significant obstacles in
formulating broad proposals for financial devolution. These issues, as we will see, are similar
to the flaws that were noted by several authors in the previous section.

Key problems as shown the 15th Finance Commission Report

 States are required by Article 243-I to have their own FCs in order to assess the
finances in their jurisdiction, and these FCs must be reconstituted every five years
following the first appointment. Given that this rule was enacted in 1992, all states
should have received roughly 5 SFCs. However, the situation is not ideal.
 This clearly demonstrates a lack of interest on the part of states in taking fiscal and
economic matters seriously, as many of them are still using outmoded SFCs. This is
certainly against their Constitutional mission, and it also smacks of an unwillingness
to follow good governance norms. SFCs have also been flagged for failing to submit
their reports to the concerned State's Governor and the Legislature on time.
 States have been disincentivised and sluggish in managing finances domestically in a
centralised system of fiscal distribution of funds, which has been exacerbated by the
adoption of the Goods and Services Tax regime. The status quo persists because
economic decisions are not a contributing factor in people holding (those in power in
the State) accountable.
 The 15th FC eventually removed the SFCs from its report, requesting that the Central
Government, through the MoPR, maintain conformity with constitutional provisions,
establish SFCs in a timely manner, and submit a memorandum outlining the steps
done by March 2024.

This obviously demonstrates a lack of coordination between the Centre and States in
developing the TOR for an FC that will not only determine how monies are delivered to the
States but will also affect the States' ability to transfer cash to LGBs. Although the FC
consults with States before formulating its findings and recommendations, they are compelled
to work within the confines of the TOR. As a result, a constitutional obligation for states to
consult before constituting the TOR is required.

SUGGESTION

Following are some recommendations considering recent discussions on various areas of

fiscal devolution to Local Governing Bodies.
  The Constitution's Article 243-J should be changed to require Local Governing
Bodies to keep detailed records of all their economic activities. States shall also create
auditing organisations under the supervision of the CAG and the FC to ensure that
Local Governing Bodies economic/financial records are audited annually, and the
results are published on an internet database available to all governmental agencies,
including the FC.
 Article 280(3) of the Constitution should be amended to require the President to
consult State Ministers and Governors before constituting. Article 280 of the
Constitution could be amended to do this. States must confer with representatives of
local entities before meeting with the President, as is customary.
 States must appoint SFCs in accordance with Article 243-I of the Constitution. The
Governor of the State, or the FC, may conduct a check in this regard to verify
requisite compliance.
 Grants and tax money should primarily be conditional on Local Governing Bodies
generating revenue; otherwise, they will follow the general paradigm of
overdependence on government funding. This would encourage them to create
revenue and eliminate their traditional budget deficits. A model like this would also
make it easier for them to undertake public welfare programmes, as FCs have
repeatedly stated.

CONCLUSION

Many analysts claimed that when local governing units were first constitutionally recognised
under the Constitution in 1992, the then Narsimha Rao government was attempting to bypass
state governments and gain the trust of the rural population. Nearly 30 years later, those
objectives appear to be mostly unimportant. In India, adult franchise in the election of local
representatives has become a crucial democratic practise, and governance has come closer to
the people than it has ever been. In a system that is purportedly centralised, this makes
adequate finances for LGBs more important.

This is where fiscal and cooperative federalism find a home. In a country as large and
complex as India, the Union Government cannot make unilateral choices that have an uneven
impact on economic circumstances throughout the country. States' participation in Union
decision-making, as well as LGBs at the state level, are so essential. Without it, the principles
of good government, accountability, and openness — whose horns have been blown
repeatedly by political and constitutional philosophers – would be in jeopardy.