What are the Current Problems in Fiscal Federalism?

Economy Aug 21, 2021

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Fiscal federalism refers to financial relationships that exist between the federal government and various divisions of government in the country.

There are three categories of powers and topics allocated by the Indian Constitution, Article 246 and the Seventh Schedule:

  1. List I: The Union is in charge of activities of national importance like communications, constitution, defense, elections, external affairs, and the organization of the Supreme Court and the High Courts.
  2. List II: States are responsible for affecting people's lives and wellbeing in various ways, such as public order, police force, agriculture, local governance, public health, water land, and so on.
  3. List III: There are several concurrent topics on the Concurrent list, including governance, economics, and social planning.

According to the lists, the Parliament has reserved exclusive rights to make legislation pertaining to everything on List I. The Legislature of any state, on the other hand, reserves the authority to enact laws for their individual states in connection to anything on List II.

But, for any subject falling under List III, both the Parliament and the State Legislature can establish laws; however, in the case of a disagreement, the legislation made by the Parliament will take precedence. The Union has no vested authority over the residuary functions specified in lists I or II.

Direct taxes, mostly income tax, are the Union's primary source of revenue. The State List contains land revenue, alcoholic liquor excise, estate duty, car tax, and other taxes. There is no taxing power on the Concurrent List. Various Articles of the Indian Constitution govern the division of income and the methods for calculating grants between the States and the Union.

Issues Affecting Fiscal Federalism in the Present Structure

Given the recent developments, India's present fiscal federalism framework urgently needs to be redefined. Horizontal and vertical instabilities in the structure have resurfaced.

  1. Horizontal imbalances

Finance commissions have fundamentally evolved since the 1990s to become a tool for coercing nations to adopt budgetary changes as part of economic liberalization. This has been worsened by the NITI Aayog's replacement of the Planning Commission. This change has limited the government's policy outreach because they now rely entirely on the finance commission, which has resulted in a significant problem of rising regional and sub-regional disparities.

Several factors have intensified this process, including the 15th FC's Terms of Reference (ToR), which if implemented together with recommendations from the Fiscal Responsibility and Budget Management Bill (FRBM) review committee may potentially hamper states' ability to intervene economically and socially.

  1. Vertical imbalances

Vertical imbalances are created as a result of fiscal asymmetry in taxing powers granted in various levels of government in proportion to their expenditure obligations as stipulated by the Indian Constitution. The central government is granted a significantly larger area of taxing, with a collection of 60% of total taxes, despite their expenditure obligation being just 40% of overall public expenditure.

These disparities are accentuated in the case of third tiers, which include elected local authorities and panchayats. Vertical imbalances can have a detrimental influence on India's urbanization and the quality of local public goods, exacerbating the negative externalities for climate change and the environment.

India has drifted from the vision of cooperative federalism. The distinction between direct and indirect taxes must be examined, particularly following the adoption of the GST. States must be able to keep the commitments they made when they were democratically elected.

This article has been written by Omer Khan for The Paradigm

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