Relevance: GS-2: Functions and responsibilities of the Union and the States, issues, and challenges pertaining to the federal structure, devolution of powers and finances up to local levels, and challenges therein.

Key Phrases: fiscal federalism, Goods and Services Tax (GST) regime, centrally sponsored schemes, Finance Commission, Shrinking the divisible pool of resources, inequality, politicized institution, political centralization.

Why in News?

• The States lost their capacity to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime, their expenditure pattern too was distorted by the Union’s intrusion, particularly through its centrally sponsored schemes.

A politicized institution:

• 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 politicized institution with arbitrariness and inherent bias toward the Union government.
• The concerns of the founding fathers — addressing socio-economic inequities — were forgotten in the process of ushering in an era of political centralization

Reasons for declining fiscal capacity of states:

• Declining revenue and increasing expenditure:
  • 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% on education and 82% on health.
• GST implementation:
  • Since 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 in the past decade.
• Shrinking the divisible pool of resources:
  • Even the increased share of devolution, mooted by the Fourteenth 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 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 rates:
  • Besides these, 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 the 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 the lower interest rate.
  • In sum, the Union gains at the expense of States by exploiting these interest rate differentials.
• 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.
  • These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States.
  • In fact, it is the schemes conceived by States that have proved to be beneficial to the people and that have contributed to social development.
  • 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.
  • The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates a constitutional provision.
  • Implementing the centrally sponsored schemes on state subjects even by states which are better performing in those subjects impedes States from charting their own autonomous path of development.

Deepening 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-thirds of it.
• India has a poor record of taxing its rich and its tax-GDP ratio has been one of the lowest in the world — 17% which is well below the average ratios of emerging market economies and OECD countries about 21% and 34%, respectively.
• The Indian elites historically undermined fiscal capacity as they felt threatened by the political equality offered by the one person-one vote system.
• India has simply failed to tax its property classes, it does not have a wealth tax either, its income tax base has been very narrow, and 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 monetize its public sector assets to finance infrastructure.

Conclusion:

• In sum, India’s fiscal federalism driven by political centralization has deepened socio-economic inequality, much against the dreams of the founding fathers who saw a cure for such inequities in planning.
• It has not altered inter-state disparities either and if there was anything that alleviated poverty, reduced inequality, and improved the well-being of people, these were the time-tested schemes of State governments, but they are now under threat.

Source: The Hindu

Mains Question:

Q. How has political centralization-driven fiscal federalism in India exacerbated socioeconomic inequality? Discuss.