• India was never truly federal.
• It was a ‘holding together federalism’ in contrast to the ‘coming together federalism,’.
• Here, smaller independent entities come together to form a federation (as in the US).
• In 1949, B.R. Ambedkar in Constituent Assembly said “In politics we will have equality and in social and economic life we will have inequality. These conflicts demanded attention: fail to do so, and those denied will blow up the structure of political democracy”.
• He believed that a degree of centralisation in fiscal power was required to address the concerns of socio-economic and regional disparities.

Structure of India’s Fiscal Federalism

• Historically, India’s fiscal transfer worked through two pillars, i.e., the Planning Commission and the Finance Commission.
• The waning of planning since the 1990s, and its abolition in 2014, led to the introduction of Finance Commission.
• It broadened its scope of sharing all taxes since 2000 from its original design of two taxes — income tax and Union excise duties.
• Today, it became a politicised institution with inherent bias towards the Union government.

Challenges Pertaining to Fiscal Federalism

The asymmetric federalism, inherent to the Constitution, was reinforced with political centralisation since 2014:

• States lost their capacity to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime,
• State expenditure pattern was distorted through Union government’s centrally sponsored schemes.
• The recent drastic cut in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.

Fiscal Capacity of States

• The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20.
• While the expenditure of the States has been shooting up, their revenues did not.
• They still spend 60% of the expenditure in the country — 85% in education and 82% in health.

Increased Share of Devolution

• The increased share of devolution, mooted by 14^th Finance Commission, from 32% to 42%, was subverted by raising non-divisive cess and surcharges that go directly into the Union government.
• This non-divisive pool in the Centre’s gross tax revenues increased to 15.7% in 2020 from 9.43% in 2012, shrinking the divisible pool of resources for transfers to States.

Differential Interest

• States are forced to pay differential interest; about 10% against 7% by the Union for market borrowings.
• The Union gains at the expense of States by exploiting these interest rate differentials.

Diversion of a State’s funds to Centrally sponsored Schemes

• By turning States into mere implementing agencies of the Union’s schemes, their autonomy has been curbed.
• There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost.
• They spend about 25% to 40% as matching grants at the expense of their priorities.
• The diversion is thereby depleting resources for its own schemes, violates constitutional provision.

Deepening Inequality

• The political centralisation has only deepened inequality.
• Ratio of private wealth to national income increased from 290% in 1980 to 555% in 2020.
• India has a poor record on taxing its rich.
• Its tax-GDP ratio has been one of the lowest in the world.

Other Issues

• India has failed to tax its property classes.
• India does not have wealth tax either.
• Its income tax base has been very narrow.
• Indirect tax still accounts for about 56% of total taxes.
• India’s fiscal federalism driven by political centralisation has deepened socio-economic inequality.
• It has not altered inter-state disparities either.

Road ahead

• There is a need to look at Centre-State fiscal relations and recommend more transfers and taxation powers for regional governments.
• More schemes should be conceived to the states, as that have proved to be beneficial to the people and that have contributed to social development.
• For example: Employment guarantee in Maharashtra, the noon meals in Tamil Nadu, local governance in Kerala, and school education in Himachal Pradesh.
• Finance Commission should expand its mandate to undertake the resource allocation role of the erstwhile Planning Commission.
• There is a need to revive the Inter-State Council as an effective federal decision-making body.
• It can be restructured as a federal institution outside the home ministry.
• The Constitution must be amended again to provide for sharing of GST revenues amongst all the three levels of government.
• The Government of India must pay service charges to local governments in respect of properties owned by them, such as Railways.
• The Finance Commission should set up an Incentive Fund for municipalities to access the capital market and raise funds.

It is must for India to rethink the design and structure of a genuine fiscal partnership, which should be an attempt to move towards a vibrant Indian value chain that can catapult India’s growth rate closer to the quest for double-digit growth.