Fiscal federalism

Concerns over distribution must not be allowed to fester

In what is becoming a regular ritual during the Budget season, the governments of some states in South India have objected to their share of taxes and thus to the Union government’s implementation of fiscal federalism in general. Their complaint is not new, but has taken on additional political implications in recent years. Naturally, non-National Democratic Alliance-ruled states are more likely to raise this complaint. It can be recalled that Gujarat also raised concerns about fiscal federalism during the years in which the United Progressive Alliance was in power in New Delhi. But there are concerns beyond pure politics that should be scrutinised in this case. The divisions between what is paid into the exchequer and what is received by some states are indeed reaching levels that will lead to unwelcome political attention.

The Union government must recognise that it cannot arrogate to itself the first call on the nation’s resources — especially when many developmental tasks have to be carried out primarily by state governments. One of the institutional mechanisms that has served India well is the respect given to the tax-division formula recommended by successive Finance Commissions. While it is up to the Union to accept or refuse this formula, the Commissions’ awards have always been honoured. However, on occasion, the Union government has breached the devolution formula in spirit, if not in the letter of the law. In recent years, the sharp growth of cesses and duties — which are not part of the divisible pool of taxes — has expanded the resources available to the Union at the expense of those that can be accessed by the states. Naturally, this will lead to a breakdown in trust between New Delhi and state capitals. It is a practice that should be sharply curtailed. The Union has also begun, reportedly, to attach conditions to transfers on account of developmental schemes.

The Union government cannot naturally address, given India’s current structure, the basic complaint of southern states that they are taxed too much compared to poorer and more populous states. That is a political question that must be addressed through skilful coalition building, as it has been in the past. But it can certainly observe this problem and act with caution. It should revisit the borrowing constraints placed on state investment funds, as Kerala has suggested. It should also reduce the degree to which it uses cesses and duties to expand its share of tax collections. There are also good reasons now to minimise the discretionary aspect of transfers to states under various developmental schemes. Some of these can be made automatic, alongside the digitisation of the government’s expenditure management system.

For other transfers, clear and non-discriminatory methods should be followed. Technocratic solutions to conditionalities are one way out. But the larger problem of stresses on fiscal federalism can be addressed only through political give and take. The Prime Minister, as a former chief minister who had expressed concerns about devolution and central control, is well placed to take the lead on this issue. Given India’s developmental needs, it is important that relations between the Centre and states are cordial. The bigger policy challenge, however, is to use fiscal resources effectively in states that have been left behind to increase growth and generate more revenue.