The poor state of India’s fiscal federalism 

  • IASbaba
  • July 29, 2022
  • 0
Indian Polity & Constitution
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Context: The concerns of the founding fathers — addressing socio-economic inequities — are being forgotten in today’s fiscal policy.

  • In his last speech, in 1949, to the Constituent Assembly, R. Ambedkar sounded a note of caution about the Indian republic entering a life of contradictions.

“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”.

  • Initially a degree of centralisation in fiscal power was required to address the concerns of socio-economic and regional disparities.
  • But this asymmetric federalism, inherent to the Constitution, is recently accelerated and mutually reinforced with political centralisation making the Union Government extractive rather than enabling.

What’s happening?

A politicised institution

  • The concerns of the founding fathers — addressing socio-economic inequities — were forgotten in the process of ushering in an era of political centralisation and cultural nationalism that drive today’s fiscal policy.
  • Historically, India’s fiscal transfer worked through two pillars, i.e., the Planning Commission and the Finance Commission.
  • But the waning of planning since the 1990s, and its abolition in 2014, led to the Finance Commission becoming a major means of fiscal transfer as the commission itself broadened its scope of sharing all taxes since 2000 from its original design of just two taxes — income tax and Union excise duties.
  • Today, the Finance Commission became a politicised institution with arbitrariness and inherent bias towards the Union government.

Hollowing out fiscal capacity

Stagnant Revenue

  • 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
  • States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol — the revenue has been stagnant at 6% of GDP.


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

Differential Interest

  • The States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings.
  • It is not just that States are also losing due to gross fiscal mismanagement — increased surplus cash in balance of States that is money borrowed at higher interest rates — the Reserve Bank of India, when there is a surplus in the treasury, typically invests it in short treasury bills issued by the Union at lower interest rate.
  • In sum, the Union gains at the expense of States by exploiting these interest rate differentials.

Centrally sponsored schemes

  • 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.
  • These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States.
  • Driven by democratic impulses, States have been successful in innovating schemes that were adopted at the national level, for example, employment guarantee in Maharashtra, the noon meals in Tamil Nadu, local governance in Karnataka and Kerala, and school education in Himachal Pradesh.

Deepening inequality

This political centralisation has only deepened inequality.


  • The World Inequality Report estimates ‘that the ratio of private wealth to national income increased from 290% in 1980 to 555% in 2020, one of the fastest such increases in the world.
  • The poorest half of the population has less than 6% of the wealth while the top 10% nearly grab two-third of it.
  • India has a poor record on taxing its rich.
  • Its tax-GDP ratio has been one of the lowest in the world — 17% of which is well below the average ratios of emerging market economies and OECD countries’ about 21% and 34%, respectively.


  • Hollowing out of fiscal capacity continued for decades after Independence, resulting in one of the lowest tax bases built on a regressive indirect taxation system in the world.
  • India has simply failed to tax its property classes.
  • If taxing on agriculture income was resisted in the 1970s when the sector prospered.
  • 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.
  • Instead of strengthening direct taxation, the Union government slashed corporate tax from 35% to 25% in 2019 and went on to monetise its public sector assets to finance infrastructure.

Way Forward

India’s Fiscal Federalism needs to be restructured in order to eliminate the above mentioned inadequacies.

  • Finance Commission: The role of finance should be redefined. Commission should frame a devolution framework by considering the concerns of all the stakeholders.
  • NITI Aayog should strive to remove regional and subregional disparities among states by reducing development imbalances.
  • Decentralization can serve as the third pillar of the new fiscal federalism by strengthening local finances and state finance commission.
  • Goods and Services Tax should be simplified in its structure by ensuring Single Rate GST and Transparency.
  • A Reformed Approach toward States – the Centre could strive to be more conciliatory towards States’ concerns and fiscal dilemmas.

Source: The Hindu

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