Headline : Another look at fiscal transfers Editorial 25th Mar’19 TheHindu
Significance of federalism:
- The origin of the concept of federalism is mainly political.
- It is well known that the efficiency of a government depends on, among other factors, its structure.
- In large countries, it has been felt that only a federal structure can efficiently meet the requirements of people from different regions, as preferences vary across regions.
Federalism in India with much centralisation:
- In India, during the independence struggle, provincial autonomy was regarded as an integral part of the freedom movement.
- However, after Independence, various compulsions like defence and internal security led to a scheme of federalism in which the Centre assumed greater importance.
- Also in the initial decades following Independence, when the Centre and all States were ruled by the same party and when many of the powerful provincial leaders migrated to the Centre, the process of centralisation gathered further momentum.
- Economic planning at a nation-wide level helped this centralising process.
Central government held responsible for all subjects:
- Due to centralised planning for most of the period after independence, the performance of the Central government came to be judged not only on the basis of actions taken which fall strictly in its jurisdiction (Union list) but also on initiatives undertaken in the areas which fall in the Concurrent and even State lists.
- Also, through Centrally sponsored schemes, the Centre has often ‘encroached’ on the territory of States.
- Today, the Central government is held responsible for everything that happens, including, for example, agrarian distress (though Agriculture is a state subject).
- Fiscal federalism is the economic counterpart to political federalism.
- Fiscal federalism refers to the assignment of functions to different levels of government along with appropriate fiscal instruments for carrying out these functions.
Distribution of functions to various levels:
- It is generally believed that the Central government must provide national public goods that render services to the entire population. A typical example cited is defence.
- Sub-national governments are expected to provide goods and services whose consumption is limited to their own jurisdictions.
Distribution of fiscal powers:
- Fiscal federalism also requires determination of the specific fiscal instruments that would enable the different levels of government to carry out their functions.
- This is the ‘tax-assignment problem’ – determining the taxes that are best suited for use at different levels of government.
- How to decide?
- One basic consideration is in relation to the mobility of economic agents, goods and resources.
- It is generally argued that the de-centralised levels of government should avoid non-benefit taxes and taxes on mobile units.
- This implies that the Central government should have the responsibility to levy non-benefit taxes and taxes on mobile units or resources.
Various models on this:
- Building these principles into an actual scheme of assignment of taxes to different levels of government in a Constitution is indeed very difficult.
- Different Constitutions interpret differently what is mobile and what is purely a benefit tax.
- US: For example, in the United States and Canada, both Federal and State governments have concurrent powers to levy income tax.
- India: On the contrary, in India, income tax is levied only by the Central government though shared with the States.
- Recognising the possibility of imbalance between resources and responsibilities, many countries have a system of inter-governmental transfers.
Finance Commission recommendations and other modes of revenue sharing:
- The Indian Constitution lays down the functions as well as taxing powers of the Centre and States.
- Unconditional Transfers: Correction of vertical (Centre vs States) and horizontal (State vs State) imbalances have been addressed by every Finance Commission, taking into account the prevailing set of circumstances.
- Conditional/Discretionary transfers: However, Central transfers to States are not confined to the recommendations of the Finance Commissions.
- There are other channels such as those through the Planning Commission until recently as well the discretionary grants of the Central government.
Revenue sharing between Centre and States moving towards greater share for States:
- In 2010-11, in the combined revenue receipts of the Centre and States, the share of the Centre was 64.68%.
- After transfer, the share came down to 40.20%.
- In the case of the States, their share before transfers was 35.32%. After the receipts of transfers the share of States went up to 59.80%.
- Thus the shares got reversed.
- In 2016-17, the share of the Centre after transfers was 33.37% and that of the States was 66.63%.
- In the case of total expenditures, the share of the Centre in 2014-15 was 41.14% and that of the States was 58.86%.
Modes of revenue sharing
- While the current position on revenue sharing appears reasonable, the question remains on the mode of transfers.
Finance Commission now in control of unconditional transfers with Planning Commission disbanded:
- Finance Commissions prior to the Fourteenth recognised that some transfers were being made by the Planning Commission; this was kept in mind while deciding on tax devolution.
- But the Planning Commission was replaced by the NITI Aayog in 2014, with no powers of resource allocation.
- Now all the unconditional transfers are being done by the Finance Commission alone, and the 14th FC greatly increased this devolution to the states.
- 14th FC:
- The Fourteenth Finance Commission has broken new ground in terms of allocation of resources.
- One of its major recommendations has been to increase the share of tax devolution to 42% of the divisible pool.
- This is a substantial increase by almost 10 percentage points.
- The commission has argued that this does not necessarily affect the overall transfers but only enhances the share of unconditional transfers.
What happens if a future government brings back centralized planning?
- The moot question is about what happens if any future government revives the Planning Commission with financial powers.
- This will put the Central government in a fix.
Ways to ensure States’ revenues are not too dependent on the government at the centre:
- Fixing the proportion of shareable taxes:
- One way to achieve this is for the Constitution to be amended and to fix the proportion of shareable taxes that should go to the States.
- The shareable tax pool must also include cesses and surcharges as these have sharply increased in recent years.
- Fixing the ratio at 42% of shareable taxes, including cesses and surcharges, seems appropriate.
- Powers to States to tax income:
- Another possible route is to follow the practice in the U.S. and Canada: of allowing the States to levy tax on personal income, with some limitations.
- Since one of the concerns is that resources do not match functions, this may be a way out.
- But States’ powers must be limited:
- But, as in the U.S., the scheme should be simple and ride on federal income tax, that is, just a levy on the income assessed by federal authorities.
- The freedom given to the States must be limited.
- It is important to note that the levy by the Centre and States together should be reasonable.
- Tax sharing also needs to be adjusted:
- Also once this power is given to the States, the transfers from the Centre need adjustment.
Option 1 more feasible:
- As far as India is concerned, this is an area which needs a fuller study.
- Adoption of any one of these alternatives will avoid friction between the Centre and the States.
- Perhaps the first alternative of constitutionally fixing the ratio is the easiest.
Horizontal distribution also needs balanced criteria without taking too much from the richer states:
- There are issues relating to horizontal distribution.
- Equity considerations have rightly dominated the allocations. However, the ability of bringing about equalisation across States in India has limitations.
- Even the relatively richer States have their own problems and they feel ‘cheated’ because of the overuse of the equity criterion.
- An appropriate balancing of criteria is needed particularly in the context of the rise in unconditional transfers, and Finance Commissions will need to achieve that.
GS Paper II: Polity