Challenges to Indian Fiscal Federalism

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).