ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846
-A A +A

Deepening Federal Fiscal Asymmetry

Anita Rath (anita@tiss.edu) teaches at the Centre for Study of Developing Economies, School of Development Studies, Tata Institute of Social Sciences, Mumbai.

Indian Fiscal Federalism by Y V Reddy and G R Reddy, New Delhi: Oxford University Press, 2018; pp xxviii + 273, 695.

Challenges to Indian Fiscal Federalism by L Chakraborty, R Mohan and T M Thomas Isaac, New Delhi: LeftWord, 2019; pp 176, 295.

Indian federalism, with an accepted centripetal tilt, has been an enduring one. Nonetheless, issues and concerns have emerged from time to time threatening the federal balance. A host of unprecedented developments, at this juncture, are expected to affect the fiscal federal order. A different era of fiscal federalism has already ushered in with two major changes. First, the abolition of the Planning Commission in 2014 that marked the removal of a major platform, where the federal units interacted with each other to shape their development course and received resources for the same. Plan components were more than 30% of the total expenditure of the states in the final years. Ergo, changes in the nature and composition of intergovernmental transfers, the lifeline of federalism, are imminent. Second, the emergence of a common market for the nation has happened with the introduction of the goods and services tax (GST) in 2017. Apart from other repercussions for federal India, there is a concern that the GST may erode the control that states had on their own source of taxes. These two developments were not sudden or unexpected but were in the offing for a while. Apart from these two developments, there are subtle changes underway, which have the potential for altering the federal equation appreciably.

At this critical juncture, two books on Indian fiscal federalism have been published: Indian Fiscal Federalism by Y V Reddy and G R Reddy (Reddy and Reddy, hereafter), and Challenges to Indian Fiscal Federalism by L Chakraborty, R Mohan and T M Thomas Isaac (Chakraborty et al, hereafter). These books, under review here, provide useful insights into the historical context of federalism and offer an elaborate analysis of its emerging tendencies. Authors of these books are eminent policymakers and scholars, having both the insiders’ perspectives, by virtue of being at the helm of the affairs manoeuvring the federal machine from vital positions, and the intellectuals’ reserve to assess the problems from afar.

The review here is structured around two interrelated themes on emerging tendencies, which received detailed treatment in these books. These are, first, a host of factors leading to/having implications for a tightening of fiscal grip on subnational governments; and second, the nature and magnitude of shifts in the institutional structure in progress, which have a bearing on the course of fiscal federalism in India.

Grip over State Governments

Federal asymmetry has been inherent to Indian federalism since its inception. Both the books bring home this point by revisiting the origin and evolution of Indian federalism. Chakraborty et al’s book reiterates that “the colonial past” and “the emotional context of India’s partition” were the reasons for the strong centripetal character of India’s federal structure. Reddy and Reddy detail the context and exchanges that shaped Indian federalism. As cited by the authors, a different stand on federalism was adopted given “the changed circumstances (that is, the Partition)” in the Second Report of the Union Powers Committee, 1947, which was presided over by Jawaharlal Nehru. The section reproduced from the report, by Reddy and Reddy, suggests the unanimous view on this matter:

it would be injurious to the interests of the country to provide for a weak Central authority which would be incapable of ensuring peace, of coordinating vital matters of common concern and of speaking effectively for the whole country in the international sphere. (pp 8–9)

These books narrate, with illustrations, the deep-rooted asymmetries that have manifested subsequently, with the union government having overriding powers in different spheres—legislations, international treaties, administration and financial matters. As per Article 249, the centre can legislate on subjects in the State List. It gives directions to the states as per Articles 256, 257, and 355. As mentioned by Chakraborty et al, in the matters of international treaties the centre makes amendments without consulting the states even on such matters that have a huge bearing on the interests of the states. Asymmetric federal relations are not just apparent in the vertical sphere, its controversial presence is even felt in the horizontal sphere. A chapter in Reddy and Reddy is devoted to “Asymmetric Federalism” which details mainly the issues related to special category states (Chapter 11). The recent controversy surrounding the demand for a special status for Andhra Pradesh finds special mention here. Overall, as the write-ups suggest, efficiency reasons are not enough to explain the variety of asymmetry found in Indian federalism. Political economy concerns are paramount.

The federal fiscal structure is undergoing transition currently and there is further consolidation of centripetal forces. The books under review echo these concerns. The fiscal space of the states is under considerable duress inter alia due to the following reasons. First, states had limited revenue options and the GST regime has brought in almost all the own tax sources of the states under the purview of collective decisions, which can be problematic. Second, “a marketisation of borrowing by states” (to quote Reddy and Reddy) with several other constraints pose problem in the states’ access to borrowing on reasonable terms. Third, the fiscal responsibility laws have meant an unequal burden on the states. The fastidiousness with deficit management, under resource uncertainty, has led to inefficient allocations by the states. Fourth, under such circumstances, the transfers become crucial for the fiscal autonomy of states.

However, there are several issues here. Higher tax shares assigned to states by the recent finance commissions never get materialised as the shareable pool is shrinking due to the ever-increasing non-shareable components like cess and surcharges. Again, the complexities of the transfer formula, which have become vehicles to coax or coerce the states to follow certain national objectives or fiscal norms, have rendered uncertainties in transfers. The last straw has been the terms of reference (ToR) of the Fifteenth Finance Commission, which has some controversial clauses. A representation made by the state finance ministers to the President of India has warned that “it will impact the finances of the state governments as well as the fabric of our federal polity.” The expenditure scrutiny of the states has also been a ToR causing concern. These aspects are discussed in detail here.

Challenges to State Coffers

States rely exclusively on indirect taxes. Direct taxes used to be 30%–40% of the state-level taxes during the 1950s and 1960s. However, since the 1970s there has been a drastic fall in the share of direct taxes and a near elimination of this source of revenue, subsequently. States rely on four major indirect taxes: general sales tax, state excise duty, taxes on vehicles, goods and passengers, and stamp duty and registration fees. These taxes provide more than 90% of the total state-level taxes with some variation across the states. Now, a significant part of the states’ revenue sources has come under the purview of the GST.

This has implications as various aspects of the GST will now be subject to collective decision-making in the GST Council. Given the council’s profile, quorum and functioning, the centre would enjoy a kind of veto power by default. Chakraborty et al mention, in the context of tax rate, that the issue of uniformity of sales tax rate—which was happening in practice in case of the value added tax (VAT)—now becomes a de jure provision with the GST. In the coming years, the GST Council’s functioning, the revenue yield of GST and the (positive) impact of GST on the economy, at large, would determine the federal tension regarding this issue. Ultimately, the cost to fiscal auto­nomy confronting the subnational governments should not outweigh the benefits from a common national market under the GST regime.

Again, the centre and states are not on equal footing, constitutionally, to access debt. States, indebted to the centre, must obtain the latter’s approval for borrowings. In addition to this, the Fiscal Responsibility Legislation’s (FRL) requirements include a virtual limit on the state borrowings. In recent years, composition of sovereign borrowing has changed in favour of market borrowings. This has happened, in the case of the states, due to a series of deliberate steps taken mainly after the Twelfth Finance Commission’s recommendation to stop the intermediation of the union government in the states’ access to borrowing. Hence, the states now approach the market directly.

In this context, Reddy and Reddy write,

The current system has two implications. First, the ceiling on the access to borrowings is predominantly determined by the gross state domestic product (GSDP). Second, the terms and conditions under which public borrowings can be raised in the market tend to be favourable to the richer states. (p 229)

The Fiscal Responsibility and Budget Management (FRBM) Review Committee (N K Singh Committee, report submitted in January 2017) has recommended a new Debt and Fiscal Responsibility Act. Chakraborty et al raise a number of issues with this report and particularly, the arbitrary nature of the fixation of deficit ceilings. Reddy and Reddy mention that these provisions can alter the relative shares of the union and the states in their access to public debt and the future fiscal reform path can digress from the Fourteenth Finance Commission’s recommendations.

Fiscal responsibility requirements have put a constraint on state finances. States have achieved their targets in advance, whereas the union government has been the defaulter. Here, two issues come up. As Reddy and Reddy mention,

Assessments of the Centre and States have different effects. It is difficult to punish the Centre for its poor tax effort and profligacy in spending whereas the States can be taken to task even when uniform yardsticks are adopted. (pp 142–43)

Hence, an unequal treatment is meted out to the states in the case of non-adherence to fiscal targets. There is a tendency to underspend the available resources by states.

Gimmicks

Given the problem with own sources of revenue and borrowings, intergovernmental transfers have become crucial to the decentralised governance in a federal system. Several issues are highlighted by these books on this matter. As reiterated by Chakraborty et al, the discretionary channels of intergovernmental transfers have become more and more prominent over time and simultaneously, Finance Commission transfers, which are statutory, have come down to 60% up until the Fourteenth Finance Commission. An important issue, in this connection, has been the shrinking of the divisible pool as there is an ever-increasing share of cess and surcharges in central taxes which are non-shareable components. This has neutralised the higher devolutions committed by the recent Finance Commissions. This transfer gimmick has been exposed by both the books.

Reddy and Reddy write:

Despite the increase in tax devolution recommended by successive Finance Commissions, the share of the tax devolution in the gross tax revenue of the Centre remained between 26 and 28 per cent until 2014–15. (p 240)

And, they add:

The relative stability is almost wholly because of the levy of cesses and surcharges, which are outside the divisible pool of the Central taxes. These neutralized the increase in tax devolution recommended by the successive Finance Commissions.

The figures cited by Reddy and Reddy suggest that cess and surcharges were only 2.3% of the centre’s gross tax revenue in 1980–81. Their share is around 15% in 2016–17. As a consequence, states have been continuously demanding the inclusion of proceeds from cess and surcharges in the divisible pool.

However, contrary to the expectations that cess and surcharges will be removed in the GST regime, new cess on imports have been introduced to compensate for the cess subsumed under GST! Chakraborty et al also have strongly articulated their concerns about cess and surcharges. They quote Punchhi Commission’s observation on this matter:

The Finance Commissions’ recommendations are based on the assessment of the resource position of the Centre and the States and their needs. Extension of cesses and surcharges amount to dilution of the recommendations of the Finance Commissions and deprives the States of their due share in central tax revenue. (p 63)

A related issue brought up by Chakraborty et al is the opaque nature of computation of net proceeds. Due to this, a large cumulative loss to states is indicated by the Comptroller and Auditor General (CAG). To quote Chakraborty et al,

During the certification of “net proceeds” by the CAG, based on the recommendations of the successive Finance Commissions, it was noticed that during the period 1996–97 to 2014–15 an aggregate amount of `81647.70 crore was short devolved to States. (p 64)

Another issue related to transfers has been the complexity of the Finance Commission formula for inter se tax sharing. Chakraborty et al narrate how statutory grants, like Finance Commission transfers, are used for forcing the states to adhere to some of the conditions like FRL. This trend began with the Eleventh Finance Commission, which recommended the intergovernmental transfers as conditional upon fiscal performance. Numerical targets for revenue and fiscal deficits were set by the Eleventh Finance Commission. Apart from the emphasis on numerical targets for the reduction of deficits, linking the debt relief and debt restructuring to FRBM/FRL implementation has been the feature of the Twelfth Finance Commission. The Thirteenth Finance Commission went on to set time limits for fiscal targets. The Fourteenth Finance Commission gave some reprieve and provided for extra borrowing possibilities for those states which fulfilled the reduction of deficit requirements.

There are apprehensions now with the release of FRBM Review Committee’s report and the ToR of Fifteenth Finance Commission, which insinuate at further tightening of the fiscal grip over the states. Chakraborty et al question the theoretical premise of fiscal conservatism and sacrosanctity of fiscal rules. As pointed out by Reddy and Reddy, there could be problems with either of the
extremes:

States like Punjab, Kerala and particularly, West Bengal have gone about borrowing profusely, leaving a huge interest burden. In contrast, States like Odisha have been austere, and that does not help them to gain more from the transfers. (p 142)

Expenditure scrutiny has been a new proposal. The ToR of the Fifteenth Finance Commission has a clause which warrants that the latest Finance Commission should make observations about the populist policies of the states. It has become a matter of contention. At one level, populist policies are not exclusive to subnational governments and can be pursued in varying degrees by all levels of government. Hence, exclusive attention on the states and their policies is a display of consolidation of central authority.

Again, the moot question is how to identify a policy as populist. Barry Eichengreen in his book The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era (2018) writes about this problem: “The awkward fact is that there is no agreed definition. Populism is a multidimensional phenomenon, with multiple perspectives on each dimension” (p 1). Eichengreen’s own definition is that, “Populism is a political movement with anti-elite, authoritarian, and nativist tendencies” (p 1). Thus, the nebulous character of the problem can be exploited to label any policy as populist. It can render unstinted power in the hands of the centre to control the already limited policy space of the states. Hence, it is a dangerous arena to navigate without prior brainstorming on the nature and extent of the problem in the right platform, and if such scrutiny is warranted at all.

Institutional Structure

These developments have necessitated and/or have been made effective through the dismantling of the old institutions and establishment of new ones. Important changes like the establishment of the National Institute for Transforming India (NITI Aayog), the new avatar of Finance Commission as the sole dispenser of shared taxes and transfers, the setting up of the GST Council, and finally, the evolution of rule-based fiscal policy will determine the course of fiscal federalism. Much depends on how robust and supportive the new institutions will be of the federal culture.

The Planning Commission was a long-standing institution in federal India. Reddy and Reddy give an elaborate historical account of the functioning of the Planning Commission. There are conflicting views on the Planning Commission that surface from time to time despite a general consensus regarding its political nature and its role in boosting the discretionary transfers. Some amount of discretionary transfers may be necessary for laboratory federalism, a term used by Bryce as cited in Oates (1999). It narrates a typical advantage of a federal system in which policy innovations can be implemented in smaller jurisdictions effectively before scaling it up to the whole nation. Discretionary transfers can be used as the central support/credit for federal innovation. There are many other requirements in the federal context which cannot be accommodated in an objective formula. Moreover, there can be pressing political compulsions which cannot be ignored. From these points of view, the Planning Commission served an important purpose—its merit lied in its flexibility. It was the safety valve which diffused the federal political tensions.

Reddy and Reddy make an important point in this regard:

With the abolition of the Planning Commission and its replacement by NITI Aayog, the tale of two commissions has apparently ended. The abolition of the distinction between plan and non-plan has further diluted the debate. The normal central assistance to State plans has been discontinued. Yet, the issue remains, namely, of the relative roles of the Finance Commission, which makes recommendations once in five years, providing assurance and stability in Union-State fiscal relations, and of an institution (Planning Commission) that recommends transfers outside the mechanism of the Finance Commission, providing continuous flexibility to meet unforeseen circumstances and also scope for much-needed political bargaining. It can be argued that in the absence of the latter, there is a danger of the Finance Commission being politicized. (p 48)

Should we see the Fifteenth Finance Commission’s ToR, which has slipped into unprecedented controversy, in this light?

It is important to also pay attention to Reddy and Reddy’s comment on the Planning Commission in the immediate next page,

The most critical event that affected the scope and effectiveness of FCs was the establishment of Planning Commission. Inevitably, the de facto functions of the commission were constrained by this development. (p 49)

Above-mentioned statements, despite sounding contradictory, are equally true of the Planning Commission. It did encroach upon the statutory channels of fiscal engagement, but at that same time contained their political capture. One is reminded of Riker’s view here—federalism as a constitutional bargain among politicians. The challenge, therefore, is to maintain the federal balance with some necessary flexibility. The question is whether there is such provision in the new institutional structure.

The setting up of the NITI Aayog in place of the Planning Commission has also been another shift. Despite some attributes similar to the Planning Commission, such as a governing council similar to the National Development Council (NDC), it is just an advisory body with no financial resource. There is an apprehension about its role in managing the federal interests. Its future could be similar to the Inter-State Council (ISC), which was set up in 1990 as per the recommendation of the Sarkaria Commission. Reddy and Reddy write about the ISC that

the ISC has met only eleven times so far and has remained ineffective in providing a forum to the States to sort out issues with the Union. More importantly, as it was made a part of the Home Ministry, it has not been seen as a neutral institution but as a part of the Union Government. (pp 16–17)

Given the history of institutions, it seems, that with money the NITI Aayog may gradually metamorphose into the erstwhile Planning Commission in all practical sense, while without money, it will become irrelevant in the fiscal federal dealings.

The GST Council is seen as an ideal institution epitomising the value of cooperative federalism. As Reddy and Reddy write,

The two innovations that are noteworthy in the GST are its design and its new institutional arrangement, as the GST council. This, perhaps, is the best compromise between fiscal autonomy of the States and tax harmonization. (p 25)

The GST Council has uphill tasks ahead. Its competency has to be exhibited through the resolution of serious conflicts on the indirect tax front. Moreover, its jurisdiction is limited to only one aspect of fiscal federalism, though a momentous one at that. Again, given its profile and protocols, the centre’s dominance in this forum cannot be ruled out.

Finally, the rule based fiscal policies will circumscribe the states’ fiscal space and their potential. A broader outlook on this front is needed going beyond the nonchalant guarding of numerical and procedural rules.

Final Observations

Reddy and Reddy’s book has 16 chapters and Chakraborty et al’s book has nine. At times, while looking for the larger picture, there is a possibility of one getting lost in the short essays and quick transition of topics. However, these books are lucid and accessible for getting an extensive understanding of the issues. These books have followed broadly an empirical approach. Theoretical deliberations are either absent or are glossed over. Situating India’s journey in the context of the larger debate on the evolution and progress of federalism and the factors affecting the same would have been an added advantage.

Overall, these books contain elaborate discussion on federalism. Fiscal issues of the third tier of the government have also received fair treatment in both the books. Chakraborty et al’s book has a clear focus on the contemporary issues. It articulates effectively the perspectives of the states on many contentious issues. Reddy and Reddy’s book is a very useful addition to the already existing series of books (Vithal and Shastry 2001; Rao and Singh 2005; Rangarajan and Srivastava 2011) available on Indian fiscal federalism. It maintains the continuity, in terms of time period and coverage of topics, and offers a ceaseless account of the subject to scholars interested in this field.

These books are indispensable for anyone interested in having a comprehensive picture of Indian fiscal federal structure, in general, and its contemporary dynamics, in particular. Exhaustive and a well-rounded account of the emerging tendencies of federalism, at the current juncture, shall remain the special appeal of these contributions.

References

Eichengreen, Barry (2018): The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era, New York: Oxford University Press.

Oates, W E (1999): “An Essay on Fiscal Federalism,” Journal of Economic Literature, Vol 37, No 3, pp 1120–49.

Rangarajan, C and D K Srivastava (2011): Federalism and Fiscal Transfers in India, New Delhi: Oxford University Press.

Rao, M Govinda and N Singh (2005): The Political Economy of Federalism in India, New Delhi: Oxford University Press.

Vithal, B P R and M L Sastry (2001): Fiscal Federalism in India, New Delhi: Oxford University Press.

Updated On : 13th Sep, 2019

Comments

(-) Hide

EPW looks forward to your comments. Please note that comments are moderated as per our comments policy. They may take some time to appear. A comment, if suitable, may be selected for publication in the Letters pages of EPW.

Back to Top