June 6, 2022The Intersectionliberal democracyeconomics

How fiscal federalism has kept the Indian republic united

Indian states must up their game to take advantage of the new era of fiscal federalism

Mint This is from The Intersection column that appears every other Monday in Mint.

In previous columns, I had argued that linguistic pluralism and a federal structure are two of the three pillars that have held the Indian republic together, and allowed this diverse and complex country to do better than all its neighbours. The third of these pillars is fiscal federalism: for, as even high-schoolers know, how money is raised, shared and spent by its members is crucial to the survival and success of a club.

Both the Union and states are political creations. Their boundaries need not necessarily enclose economically self-sustaining societies. Thus, a sub-continental federation allows the forces of comparative advantage to benefit everyone: each region can produce what it is better at and trade with others. Yet, balancing equity, equality and efficiency in a hyper-diverse federation is complicated. At the time the Constitution came into force, some regions were endowed with more human capital, infrastructure and industrial capacity, others had abundant natural resources, and a few had very limited economies. While the linguistic reorganization of states helped address political aspirations, fiscal federalism was the crucial but invisible factor that permitted the political restructuring. What we take for granted to this day is actually part of the secret formula’ of India’s success.

Like other parts of the formula, we have been careless about upholding fiscal federalism. The Constitution created an independent, non-partisan Finance Commission to determine how fiscal resources ought to be shared among the Union and states. However, as M. Govinda Rao points out in his new book, Studies in Indian Public Finance, the Planning Commission became an important arbiter of how funds were shared. Central planning, Rao argues, constrained both the market and State governments in allocation of resources” and the nationalization of banks further centralized resource allocations and aligned them to planning. This is one reason why India’s states have relatively weak fiscal capabilities.

The disbanding of the Planning Commission in 2014 was thus an important corrective, but the vestiges of central planning remain and mindsets of the states’ political elite have yet to adapt to the loosening of central constraints. Similarly, with the introduction of GST and the formation of the GST Council, states gained a powerful platform to negotiate their fiscal interests. Despite its complexities and controversies, GST has brought fiscal federalism prominently into the public discourse, and that is a good thing.

The Planning Commission might well have strengthened New Delhi’s hand over that of states, but the Finance Commission’s quiet, transparent and professional functioning ensured the latter were not pushed over the edge. In a discussion on national security, Vijay Kelkar once pulled me aside and pointed out the Finance Commission’s fundamental role in keeping the country united. Many politically sensitive and border states receive disproportionately larger shares of funds. More importantly, the consultative and non-partisan character of successive Finance Commissions has meant that the Union and states accept its allocations as fair, even if they felt they deserved more.

A new era of fiscal federalism dawned in 2015 when the 14th Finance Commission (2015-2020) raised the states’ share of funds from 32% to 42%. With the end of the Planning Commission the same year and adoption of GST two years later, India today is in uncharted waters.

On one hand, states enjoy a greater degree of fiscal autonomy than before, but on the other, the Union government has a larger role in directing expenditure through a large number of centrally sponsored schemes” like those for education, health and rural employment guarantee. The 15th Finance Commission (2021-2026) retained the states’ share, and its methodology of assigning weights based on population is likely to be a factor in the politics of federalism.

Also, as Rao writes in his book everyone wants decentralisation, but only up to his level”. While states have been zealous about their entitlements, they have been laggards in setting up state finance commissions to devolve funds to municipalities and panchayats. State governments and local bodies have also been reluctant to raise their own revenues. Political considerations prevent taxing richer farmers and bureaucratic incapacities at the municipal level the collection of property taxes. As Arvind Subramanian observed, the closer the government is to the people, the more unwilling it is to raise taxes”.

States, therefore, have to learn how to frame fiscal policy. If they do not, the fiscal balance will tilt towards the Centre.

Institutionally, there is an ongoing debate on whether or not the Finance Commission should have a permanent secretariat. Far more important, in my view, is that the Inter-State Council must be upgraded into a national forum, chaired by the Prime Minister and comprising state chief ministers.

In these three columns, I have attempted to draw attention to the structural pillars of India’s unity and success. Linguistic pluralism, a federal structure and fiscal federalism have served us well and enabled us to succeed where others have failed. We must not allow popular emotions and polarized discourse to weaken them any further.

There are many more The Intersection columns here

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