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Challenges to Indian Fiscal Federalism

T M Thomas Isaac ( is Minster for Finance, Government of Kerala and Honorary Fellow, Centre for Development Studies, Thiruvananthapuram. R Mohan ( is Senior Consultant, Gulati Institute of Finance and Taxation and Visiting Fellow, Centre for Development Studies, Thiruvananthapuram. Lekha Chakraborty ( is with the National Institute of Public Finance and Policy, New Delhi.

The state of cooperative federalism in India is analysed by focusing on the trends in vertical fiscal imbalances between the centre and the states, the impact of Fiscal Responsibility and Budget Management acts on the fiscal space of the states, the implications of the Terms of Reference of the Fifteenth Finance Commission, and the need for empowering local governments in the context of centre–state relations.

The functions of macroeconomic stabilisation and distribution are considered to be in the domain of the federal government and that of allocation in the realm of the tier of government closest to the beneficiaries (Musgrave 1959). In other words, allocation in the absence of externalities should be left to the tiers of government which can do it at least as efficiently as the federal government (Oates 1972). This is known as the subsidiarity principle. Under this division of powers, taxes with more redistributive impacts that are also incidentally more buoyant would be in the jurisdiction of the federation and the larger expenditure obligations, especially in the social sector, would fall in the fiscal territory of the provinces.

The natural consequence of this is the vertical fiscal imbalance between the federation and the provinces. In the Indian context, although this can be stated as a reason for substantial and buoyant sources of revenue remaining with the centre and major expenditure obligations with the states, one cannot overlook the colonial legacy of centralisation under the British. When the imperial government began facing a financial crisis, measures for discontinuing the assignment of expenditure and revenue functions to the provinces were also taken. It was in this situation that the provinces had to devolve a portion of their surplus to the imperial government to finance the deficits of the latter. The amounts were fixed through the Meston awards in the 1920s (Singh 1987).

A clear delineation of powers between the centre and the provinces was attempted through the Government of India Act, 1935. This had a substantial centralising tilt with discretionary powers for the governor general and governors, and the retaining of major revenue sources with the imperial government. The Government of India Act, 1935, was only partially implemented during 1937–39, when elected governments assumed office in the provinces. Later, when the Constitution was framed under extraordinary circumstances after partition, most of the fiscal provisions of the Government of India Act, 1935, found a place in it without any changes (Gulati and George 1988). This is the basic reason for the strong centralising trends in Indian polity, including in the fiscal division of powers and intergovernmental fiscal transfers.

This led to the states demanding more fiscal powers and share of all taxes collected by the centre from time to time. Under the initial constitutional scheme of things, personal income tax was shareable on the basis of the recommendations of the finance commissions (Article 270), and the central excise duty on the basis of law provided by Parliament (Article 272). Other taxes like corporation tax and customs duty were not shareable. But after the 80th Constitutional Amendment, on the basis of the recommendations of the Tenth Finance Commission, all taxes of the centre became part of the divisible pool shareable with the states since 2000–01, fulfilling a long-standing demand of the states.

But, surcharges and cesses rising in proportion to the gross tax revenue of the centre are not shareable with the states. With respect to the own tax revenue, states have substantially lost the power to vary tax rates of items de facto since 1 April 2005, when value added tax (VAT) was implemented on intra-state trade of goods, and de jure since 1 July 2017, when goods and services tax (GST) was introduced. On the expenditure side, there has been a rise in the share of conditional and tied grants that essentially deal with items in the state list of the seventh schedule of the Constitution. This restricts the freedom of the states in its spending priorities that takes into account the local specifications (GOI 2015a; Chakraborty and Chakraborty 2018). There are also constraints arising from Fiscal Responsibility and Budget Management (FRBM) acts, which lay down uniform targets across states ignoring the differing fiscal needs (GOI 2010). In short, the domain of the states, which should be unrestrained insofar as their constitutional assignment is concerned, is being constrained in more than one way.

This is happening in a scenario when cooperative federalism is accepted by the centre as the system most suited to the Indian context. Cooperative federalism is a system in which there is joint decision-making between several jurisdictions of government based on consensus (Inman and Rubinfeld 1997). The facts and circumstances, however, indicate that we are quite far from what cooperative federalism envisages. In this paper, we examine this hypothesis, by analysing the trends in central and state taxes, the issues in sharing taxes and distribution of grants, the vertical fiscal imbalances, the impact of FRBM legislations, the implications of the terms of reference (ToR) of the Fifteenth Finance Commission and empowering local governments (LGs), in the context of centre–state relations.

Trends in Tax Revenue

A look at the composition of central and states’ own taxes and expenditure reveal that the share of the own tax revenue and expenditure of the states is 38% and 58% respectively. This reflects the more than proportionate expenditure obligations of the states and also the lesser revenue raising powers vis-à-vis the centre. It is in this context that the distribution of resources from the centre to the states has been recognised in the Constitution by way of formation of finance commissions every quinquennium. Before proceeding to analyse the issues in intergovernmental fiscal transfers, the trends in tax revenue of the centre and the states are assessed.

The centre has buoyant sources of revenue like personal income tax, corporation tax, excise duty, customs duty and service tax (excise duty and service tax have been subsumed in the GST since 1 July 2017). However, the tax–gross domestic product (GDP) ratio of the centre has stagnated by 11% on an average, during the period 1970–71 to 2016–17.

As regards the structure of taxes, indirect taxes dominated the central tax revenue till the 2000s. During the 1980s, it comprised 80% of centre’s gross tax revenue. Gradually, the share of direct taxes in centre’s gross tax revenue increased to around 50% during 2016–17. If the state taxes are also taken, the share of the indirect taxes is markedly higher than that of direct taxes, though the share of the latter has been increasing since 2000–01 (Table 1). This points to the relatively regressive nature of the Indian taxation system.

The trend in the central tax–GDP ratio shows a rise in the 1980s followed by a decline during the 1990s. In the subsequent two periods, it showed an increase. During the 1990s, the rates of customs duty and income tax were reduced substantially and that was the most proximate reason for the decline in the tax–GDP ratio. During the early 2000s, economic growth picked up and corporation tax revenues were buoyant. Later, service tax collections also showed significant growth. During 2015–16 and 2016–17, the higher revenue from excise duty on petroleum products has been the major reason for the rise of tax–GDP ratio to more than 11%.

The question that needs to be answered is whether the tax–GDP ratio reflects the tax potential. Tax potential is not very easily amenable to accurate measurement. In the Indian context, the share of tax-evaded income as a proportion of GDP has been estimated by various studies. The National Institute of Public Finance and Policy (NIPFP 1986) estimated this at 21% of GDP, Schneider et al (2010) at 22.4%, NIFM (2012) at 35%–40% and Mohan et al (2017) at 27%. Although the estimates vary as a result of the different methodologies adopted, it can be stated that over a period of three-and-a-half decades, the size of the tax-evaded economy has been around a quarter of the GDP. This implies that in absolute size, the tax-evaded economy has been growing phenomenally despite the tax reforms in a technology-enabled environment. The increasing size of the tax-evaded economy has an adverse consequence not only for central finances, but also for the states. This has two aspects: first, the divisible pool of the taxes shareable with the states becomes smaller and second, the consequential evasion of state taxes. Given the higher expenditure obligations and limited revenue-raising powers of the states, it adversely impacts their intervention capacity more than that of the centre.

Trends in Transfer of Central Resources

The transfer of resources to states comprises taxes collected by the Union, statutory grants under Article 275 based on the recommendations of the finance commissions, grants given as central share in centrally sponsored schemes (CSS), other discretionary grants, and until 2015–16, formula-based grants for state plans under the Gadgil formula. All grants other than statutory grants recommended by the finance commissions are given by resorting to Article 282 of the Constitution under “Miscellaneous Financial Provisions.”

The transfer of central resources can be broadly classified into tied and flexible grants. The former is a conditional grant which comes with a scheme and has conditionalities. The state has no flexibility in deciding how to spend it. The CSS grants fall under this category. On the other hand, tax devolution and post-devolution revenue deficit grants given by the finance commissions fall in the flexible category as they have no conditionalities attached to them and the states can spend them according to their priorities. The share of the tied and flexible part of central transfers during the period from the Eleventh to theFourteenth Finance Commissions (2000–01 to 2016–17) is illustrated in Table 2.

The completely flexible part of central grants comprises the revenue deficit grants recommended by the finance commissions to the states, post-tax devolution. The share of these grants as a share of total central grants has been on an average 10.86% during the period of the Eleventh Finance Commission to the first two years of the Fourteenth Finance Commission, that is, from 2000–01 to 2016–17. Combined with tax devolution, this comprised 63.37% during the Eleventh Finance Commission (2000–05) and declined to 59.77% and 59.93% respectively during Twelfth and Thirteenth Finance Commissions. However, it rose to 67.05% during the first two years of the Fourteenth Finance Commission. Earlier, the finance commissions had also recommended sector-specific grants besides revenue deficit grants, but the Fourteenth Finance Commission recommendations did away with the sector-specific grants that are conditional in nature.

When the components of grants are examined, the share of statutory grants, given under Article 275 based on recommendations of the finance commissions, has been on an average 18.53% of the total central grants during the period 1999–2000 to 2016–17 (Table 3). The CSS comprised around 19.14% and central sector schemes (CSs) formed 2.84% during 1999–2000 to 2016–17. The state plan grants, that consist of grants for externally aided and specific projects, constituted 46.91% of the total central grants. But the normal central assistance (NCA), which was based on the Gadgil formula, as a component of central grants was only 13.25%. This has been declining continuously and has been stopped since 2015–16. This implies that only 24.11% (10.86% revenue deficit grants and 13.25% NCA) of the central grants was based on a norm and that the rest, 75.89%, was discretionary. The completely flexible component, that is, the revenue deficit grants was only 10.86% (Table 3).

Trends in Tax Devolution

Under Article 270 of the Constitution, the net proceeds of all taxes levied by the union, except surcharges and cesses are shareable with the states after the 80th Constitutional Amendment. The finance commissions since the Eleventh have been devolving the shares of all Union taxes to the states. The shares of net proceeds recommended to be devolved were 29.5%, 30.5%, 32% and 42% respectively, by the Eleventh to Fourteenth Finance Commissions.

Net proceeds are defined in Article 279 of the Constitution as gross tax revenue of the centre less surcharges and cesses, and cost of collection. However, the amount of net proceeds is not published in the budget documents of the union. But, the proportion of surcharges and cesses to gross tax revenue of the centre is rising, and this is neutralising the higher shares recommended by the successive finance commissions (Tables 4 and 5). The gap in devolution of taxes to the states between the share of the net proceeds and gross tax revenue has been increasing (Table 4). With higher share of net proceeds recommended by the finance commissions, the gap has risen. It has been substantially higher since 2015–16, when the Fourteenth finance commission raised the proportion of shareable taxes from 32% to 42% of the net proceeds. This trend in gap indicates shrinking of the divisible pool of taxes with the states, mainly through an increase in the share of surcharges and cesses.1

Surcharges and cesses are levied for the purpose of the union and are not shareable with the states, according to the provisions of Article 271 of the Constitution. But recently, surcharges and cesses have become a mode of shrinking the divisible pool of taxes and make reduction in basic tax rates revenue neutral for the centre. This is evident from the finance bills of the last two union budgets, when the tax rate of incomes up to ₹ 5 lakh was reduced from 10% to 5% and the revenue loss was sought to be compensated by levying a surcharge on incomes above ₹ 50 lakh. Similarly, in the 2018–19 budget, excise duty on petrol was reduced by ₹ 9 per litre and the road cess was increased by an equivalent amount. In short, when the share of taxes recommended to be devolved by the finance commission rises, the size of the divisible pool itself is made smaller (Table 5).

Besides this overt act, the lack of transparency in computation of net proceeds has also caused losses to the states. Hence, there is a sharp fall in net proceeds when it is extrapolated as 100% of the tax share, devolved based on finance commission recommendations, and when computed in accordance with the method laid down in Article 279. The shortfall during 2011–12 to 2018–19 budget estimate (BE) works out to ₹ 88,3170 crore (Table 6). This not only illustrates the extent of financial losses, but also the erosion of constitutional rights of the states through legislative and administrative actions of the centre. This substantiates the hypothesis that cooperative federalism is far from being a reality. The vertical fiscal imbalances between the centre and the states are being accentuated by these actions. Yet another, constraining factor for the states is the asymmetric burden imposed by the FRBM acts on the states vis-à-vis the centre.

FRBM Acts and Asymmetric Impacts

The FRBM acts were passed at the level of the centre and the states in the beginning of the 2000s. The large fiscal and revenue deficits of the centre and the states prepared the ground for setting numerical deficit ratios as a percentage of GDP/GSDP (gross state domestic product) and passing legislations stipulating the time period for achieving these targets. The reasons leading to larger deficits at the level of the states like higher interest rates, burden of implementation of the Fifth Pay Commission recommendations, etc, have been discussed in detail in several studies (Bagchi et al 1992; Rao 1992; Kurian 1999; Chaudhuri 2000; Vithal and Sastry 2001; Rao 2002; EPWRF 2004).

The FRBM acts and the finance commisions that became instrumental in incentivising the implementation of these acts by linking them to release of grants and debt rescheduling packages laid emphasis only on achieving targets. In the bargain, if revenues could not be raised, expenditure (even essential) would be cut. The logic advanced for restricting fiscal deficit as a fixed percentage of GDP/GSDP is that the household savings and sustainable current account deficit is at a certain percentage of the GDP. Both the government and the non-governmental sectors would have to borrow from this source. In order to not pre-empt the funds for the non-governmental sector, government borrowing in a year or the fiscal deficit needs to be contained as a percentage of the GDP. In the Indian context, the household saving is estimated at 7.6% and sustainable current account deficit at 2.3% of the GDP. This adds up to approximately 10% of the GDP. This was to be divided in the ratio of 60:40 between the government and the private sector. The total 6% of the government sector was divided equally among the centre and the states at 3% each of GDP and GSDP respectively.2 However, this is not equal as the GSDP is a narrower base than GDP as the former excluded the output of union territories; 3% of GSDP is approximately 2.54% of the GDP.

The FRBM review committee (2017) recommended that the proportion of borrowing in the savings pool of 10% of GDP should be divided equally among the government and the non-governmental sector instead of the earlier 60:40 ratio. Out of this, 2.5% was fixed for the centre and a lower limit of 1.7% was fixed for the states, stating that the negative balances in primary account, that is, borrowings excluding interest payments, of the states were more than that of the centre. The committee also recommended the debt to GDP ratio at 60% for both the centre and the states as the prime target (40% for the centre and 20% for the states). These targets have been recommended to be achieved by 2022–23. The centre has accepted the recommendations to be implemented from 2024–25. Before examining what these imply for the state finances, the theoretical and empirical basis for the recommendations of the FRBM review committee report can be considered:

(i) Why is household saving considered to remain static even when the economy continues to grow? A growing economy can have a larger pool of savings and consumption, fuelling further growth. So why is a static fiscal deficit and debt ratio prescribed over a time horizon?

(ii) Is there an empirical basis for apportioning the borrowing from the savings pool between the government and the non-governmental sector on an ongoing basis? When there is no credit offtake due to deficiency of demand, the crowding in effect of government borrowing is quite necessary. This condition has been kept with stringent restrictions in the FRBM review committee report.

(iii) What is the empirical basis for suggesting a 60% debt–GDP ratio in the Indian context? Reinhart and Rogoff (2010) mention a limit of 90% debt–GDP ratio for advanced countries and 60% for emerging market economies with substantial external debt. India does not have substantial external debt. External debt to total borrowings and liabilities has fallen from 18.91% in 1980–81 to 5.71% in 2016–17.

(iv) While imposing an asymmetric fiscal deficit target of 1.7% of GDP for the states as against 2.5% for the centre, the fact that almost the entire amount of borrowed sum of the states is spent on capital expenditure, as they have almost balanced their revenue accounts, has been overlooked. Would this not have adverse consequences for economic growth and impede the bridging of infrastructural deficits?

Examining the adherence to the FRBM acts, the states have been forced to limit their deficits due to sanctions by the finance commissions, whereas the centre is not bound by any such conditionalities. This can be seen from the performance of deficit indicators by the centre and the states in Table 7. The pressure in the recent two financial years on the states is due to borrowings for UjwalDiscom Assurance Yojana (UDAY) and the burden of implementing pay commission recommendations.

It can be seen that the revenue deficits have almost been eliminated by the states and fiscal deficits have been below 3% in the post-FRBM period. In such a scenario, imposing an asymmetric burden on the states, as suggested by the FRBM review committee (2017) that too when the centre has not adhered to FRBM targets is tantamount to hamstringing the much-needed spending space of the states, especially with regard to development expenditure. This is against the basic tenets of cooperative federalism. Besides, the FRBM review committee recommendations have been unilaterally accepted by the centre without consulting the states.

Inefficient Cash Management by States

If a state government has surplus cash in the treasury, it is invested by the RBI in 14-day intermediate treasury bills of the Government of India (GOI). Since revenue receipts are utilised for covering revenue expenditure, much of the cash surplus is from borrowed funds. It is a fact that the borrowing costs have come down from almost 9% during the 1990s to above 7% for the states. But when funds borrowed at 7% is invested in 14-day intermediate treasury bills which earn interest at 4.5%–5%, the states are in effect borrowing funds at a higher rate and lending back to the centre at a cheaper rate. The demand of the states to invest the cash surplus in dated GOI securities have not been accepted (RBI 2005). As on 31 March 2018, there was a cash surplus of ₹ 1,50,318 crore for all states (RBI 2018: 19). Although this is pronounced as inefficient cash management by the states, the causes of the prevalence of cash surplus are not looked into. Isaac and Ramakumar (2006) had analysed as to why the states do not spend. This trend continues even until now as can be seen from Table 8.

The states do not spend essentially due to the fear of the consequences of non-adherence to deficit targets, which are not only a legislative constraint but also a conditionality imposed by the finance commissions. The perversity of this is such that states are not only forced to adhere to deficit targets, but also to provide cheap financing to the centre, which has not adhered to deficit targets noted in the FRBM acts.

Post-GST Scenario

The implementation of the GST is being demonstrated as an example of the working of cooperative federalism. But how far does this conform to actual practice? Let us start from the voting rights in the GST Council as in the provisions of Article 279A of the Constitution. The states have two-thirds and the centre one-third voting rights. But to pass a resolution, three-fourths majority is required. This in effect confers a veto power for the centre, even when states jointly propose a change. The states should be able to adopt a change in their tax structure without the centre’s consent. The voting rights envisaged under Article 279A has made this impossible.

Another important aspect is the apportionment of the GST rates. The committee on revenue neutral rates (RNR) of the central government had suggested the apportionment between the states and the centre at 60:40 ratio, as almost 44% of states’ own tax revenue was subsumed under the GST as against 28% for the centre (GoI 2015b). It still retains the power to levy additional excise duty on tobacco products, even though it has been brought under the GST. States do not have such a right. The 50:50 apportionment of the GST rates between the centre and the states has resulted in a rate fall of 5.5% in the case of states, whereas the VAT rate was 14.5% for 75% of taxable commodities and it is 9% now (50% of the standard rate under the GST which is 18%). This would exacerbate the vertical fiscal imbalances between the centre and the states, even with the inclusion of services in the tax net of the states.

The centre also took a long time in implementing the anti-profiteering clause of the GST. The GST in India has not been a good example of cooperative federalism, in which equal stakeholders take decisions based on consensus. It is in this context that certain items of the ToR of the Fifteenth Finance Commission have become the cause for apprehension among the states for the adverse impacts it can have on state finances and federal polity.

ToR of the Fifteenth Finance Commission

In the post 1990s, the finance commissions have become a vehicle for incentivising or rather coercing the states to implement fiscal reforms as part of economic liberalisation (deficit targeting being the most important). The ToR of the Fifteenth Finance Commission has accelerated this process and if implemented along with the FRBM review committee recommendations, would reduce the states’ capacity to intervene in social and economic sectors. Certain examples of the ToR are illustrated to provide evidence:

ToR 5 The Commission shall review the current status of the finance, deficit, debt levels, cash balance and fiscal discipline efforts of the Union and the States, and recommend a fiscal consolidation roadmap for sound fiscal management, taking into account the responsibility of the Central Government and State Governments to adhere to appropriate levels of general and consolidated government debt and deficit levels, while fostering higher inclusive growth in the country, guided by the principles of equity, efficiency and transparency. The Commission may also examine whether revenue deficit grants be provided at all. (emphasis added)

Besides carrying forward the fiscal reform agenda, this ToR also suggests whether there should be revenue deficit grants at all. Till the Fourteenth Finance Commission, post-tax devolution grants under Article 275 were called non-plan deficit grants and were a very important source of the flexible part of the central devolution and a means for augmenting the revenue receipts of the states. The Fourteenth Finance Commission awarded revenue deficit grants taking a holistic view of plan and non-plan revenue expenditure. This ToR is a bolt from the blue with regard to the state finances that are already stressed by the impending pay commission award implementations, the obligation to bear the future interest burden from floating UDAY bonds and stagnation in the GST revenues. The ToR 5 in fact goes beyond the constitutional provisions of Article 280 (3) (b) which state that it shall be the duty of the finance commission to make recommendations on the principles which should govern the grants-in-aid of the revenues of the states out of the Consolidated Fund of India. The grants recommended by the finance commissions are charged to the Consolidated Fund of India under Article 275. The power of review, if literally construed, is much wider than a finance commission making a recommendation for no grants. The Constitution does not confer any power on the finance commission to review whether grants should be there or not. The ToR 5 is not only ruinous for state finances but also transcends the constitutional mandate of the finance commission.

TOR 6 (vi) Conditions that GOI may impose on States while providing consent under Article 293(3) of the Constitution (for market borrowings).

At present, all states have passed FRBM acts and borrowings are limited to 3% of the GSDP in a financial year. The necessity for imposing further conditions is not clear and is a move to narrow down the fiscal space for the states, much beyond what has been legislated. The proposed enlargement of restrictive conditions is a move towards fiscal centralisation and acts counter to cooperative federalism.

TOR 7 (viii) Control of lack of it on ‘populist’ measures

This is vague and is open to wide interpretations. With this ToR, the Fifteenth Finance Commission is being granted the authority to restrain democratically elected governments from implementing promises made to people in the election manifestoes such as provision of welfare pensions, food subsidy, etc. This strikes at the root of democratic polity. Moreover, it is highly discriminatory that while implementation of central flagship schemes are sought to be incentivised, the state schemes are sought to be controlled by dubbing them as populist. It has not been appreciated that the national schemes had their successfully implemented state-level predecessors. This discriminatory approach is not only against the federal spirit but also not in accordance with the Directive Principles of State Policy enshrined in the Constitution.

The ToR 7 also mandates the Fifteenth Finance Commission to assess and monitor performance of several aspects, including GST implementation, and other governance and achievement indicators. The finance commissions becoming a monitoring agency of states’ performance does not befit its constitutional role. Bodies like Inter-State Council (Article 263) can discuss and formulate guidelines in this regard.

The part of ToR 6 (iv) reads:

The impact of the fiscal situation of the Union Government of substantially enhanced tax devolution to the States following recommendation of the 14th Finance Commission, coupled with the coming imperative of national development programme including New India–2022.

In a framework of cooperative federalism, a higher devolution to the states and local governments (LGs) would empower them fiscally and this would be a more participatory way of achieving goals of New India–2022. The Union should not be apprehensive about this. All tiers should be fiscally empowered to achieve developmental goals, instead of adopting a top-down, one-size-fits-all approach. In fact, many of the goals in this initiative pertain to subjects in the State List. The apprehensive tone of this ToR is out of sync with the tenets of cooperative federalism.

In short, the basic principles of federalism will be adversely affected, if the fiscal space of the states is constrained by non-elected bodies in the name of sound finance. Making constitutional bodies like the finance commissions, a vehicle for implementing deficit targeting and expenditure cuts, started since the beginning of economic reforms, seems to have gathered momentum with the ToR of Fifteenth Finance Commission. States will have to effectively take a position on these issues in their memorandums to the Fifteenth Finance Commission, if they are to retain their rightful position in the federal polity, in spite of the difference of opinion they may have on formula for inter se sharing of taxes (Isaac and Ramakumar 2018). A group of state finance ministers had jointly submitted a memorandum to the President requesting the deletion of certain items of the ToR.

In this context, it needs to be mentioned that the delicate balancing of interests of the states at vastly different fiscal capacities has been impeded by the ToR 8 of the Fifteenth
Finance Commission, which mandates the use of population figures based on 2011 Census, than the hitherto adopted population based on 1971 Census, while making its recommendations. This would be to the disadvantage of states which have witnessed the decline of their population shares between 1971 and 2011 due to the successful implementation of the National Population Policy, 1977. It is essential that highly populous and low per capita income states should get a higher share in the interest of horizontal equity. They would still get higher shares even when the data on population based on the 1971 Census is used. If there is a need for augmenting their fiscal capacity further, it can be done through grants under Article 275, which the ToR mandates the finance commission to review. On the whole, unless reconsidered, the ToR of the Fifteenth Finance Commission that runs counter to the principle of cooperative federalism would weaken the foundations of fiscal federalism.

Empowering Local Governments

In a federal set-up with considerable unitary tendencies, democratic decentralisation is essential to preserve the existing federal features as well as to strengthen the democratic content. It is essential to de-bureaucratise the development functions and ensure peoples’ participation. E M S Namboodiripad, the first chief minister of Kerala, who had unsuccessfully attempted to legislate one of the most comprehensive and radical decentralisation initiatives ever, during 1957–59, had succinctly stated,

Democracy at the central and state levels but bureaucracy at lower levels. This is the essence of Indian polity as spelt out in the Constitution.3

Namboodiripad had criticised the 64th and 65th amendments for bypassing the states, envisaging direct connection of the centre and the panchayats (Isaac 1998). Some of the major points of criticism that were raised included direct funding from New Delhi, elections organised by the central election commission, administrative control through district collectors, and power of the governor to dissolve LGs. The bill, although passed by the Lok Sabha, failed to receive majority support in the Rajya Sabha and lapsed, when the former was dissolved in 1989, prior to fresh elections provoking some scholars to remark,

the Centre has thrown away an opportunity to develop a consensus on a matter of national concern and its credibility gap is increasing. The decentralisation process must begin with Centre shedding its powers to the States, to be followed thereafter from the State governments to the PRIs. (Chandrasekhar 1989)

Nevertheless, these criticisms need not detract from the other positive aspects of the draft bills, which by and large were carried forward to the 73rd and 74th Constitutional Amendments in 1993. The constitutional amendments brought about far-reaching changes in the federal structure of the country such as the creation of 2.5 lakh LGs of a uniform pattern throughout the nation to which 32 lakh representatives are elected at regular five year intervals, with affirmative reservation for women and Scheduled Castes/Scheduled Tribes. According to the 20th Anniversary Report of the Expert Committee on Leveraging Panchayats for Efficient Delivery of Public Goods and Services (2013),

This is an achievement in political empowerment that in scale and numbers is without precedent in history or parallel in the world. Yet, this historic achievement has made little impression on political circles, media perceptions, society as a whole, or even on the rural economy. (p 35)

The report also observed that,

the implementation of the operative core of Part IX relating to devolution of the 3 s—functions, finances and functionaries—has been far from in accord with the letter and spirit of the Constitution Amendments.

According to the report, the LGs in India are still a shadow of “institutions of self-government” envisaged in the Constitution. On the whole, there is an institutional sclerosis with
regard to the decentralisation process. A major impediment for substantial progress in decentralisation to LGs is the lack of any initiative to restructure centre–state relations in India. Although subjects in the state list have been suggested for transfer to LGs as per 11th and 12th schedules of the Constitution, the concurrent list has expanded and central inroads into the states’ expenditure domain are increasing through the CSS. In the CSS, there is no scope for any flexibility to take account of region-specific or location-specific factors. In fact, there should be tax devolution and unconditional grants enabling the states to carry out social and economic sector programmes with the empowered participation of the LGs. This would be the true translation of the subsidiarity principle into reality. On the contrary, the delivery of substantial resources through the CSS makes the states and the LGs mere agencies rather than equal partners in a federal set-up in which they can formulate and implement policies.

Yet another major obstacle is the vast differences in the decentralisation experience across the states, which is the consequence of the varying degrees of political will. One crucial determinant of this in the states would be the presence of mass political and social organisations which would build awareness and empowerment. This would build sustained pressure from below on the state governments to decentralise functions, functionaries and funds. The experience of Kerala, which has implemented decentralisation to LGs on a mission mode, is a classic example. In short, the empowering of LGs is not possible at the cost of constitutional powers of the states. A more meaningful decentralisation would require moving away from the asymmetric nature of centre–state relations.


Are we quite far from what cooperative federalism envisages? Assessing the trends in tax devolution, the experience with the FRBM acts in the light of the recommendations of the FRBM review committee, the structure of GST, the ToR of the Fifteenth Finance Commission, and the obstacles in the decentralisation process, the hypothesis cannot be rebutted.

As revealed by many studies, the performance of tax revenue in India is below its potential. This limits not only the spending capacity of the centre, but also the amount of taxes devolved to the states. Besides, what is constitutionally sought to be devolved to the states is not being done in its spirit by the centre, which imposes surcharges and cesses as a means of raising revenue, without the same being part of the divisible pool of taxes shareable with the states. There also exists non-transparency in the computation of net proceeds.

The FRBM acts have imposed an asymmetric burden on the state governments in the face of non-compliance to the targets by the central government. This is sought to be accentuated by the recommendations of the FRBM Review Committee, 2017. The rate apportionment and voting rights in the GST Council are not in accordance with the principles of cooperative federalism, in which decisions are to be taken by a consensus among equal stakeholders. The decentralisation of the LGs is impeded by the asymmetry in centre–state relations.

The ToR of the Fifteenth Finance Commission, which is the last in the chain of events, hastens the process of centralisation and if implemented, cooperative federalism would only exist in name, devoid of any content whatsoever. Fundamental changes are needed to make cooperative federalism a meaningful and functioning one.


1 Cost of collection of taxes has been declining and is less than 1%.

2 However, this is not equal as the GSDP is a narrower base than GDP as the former excluded the output of union territories, 3 % of GSDP is approximately 2.54% of GDP.

3 Note of Dissent to the GoI (1978). It is relevant here that decentralisation has to be democratic and should facilitate the combination of, and cooperation between, the official machinery of administration and the non-official leadership and control through the mechanism of LGs (Meenakshisundaram 1994).


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Updated On : 6th Mar, 2019


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