Date : 26/08/2023

Relevance:

• GS Paper 2 -Polity- Fiscal Federalism
• GS Paper 3- Economy- Inclusive growth

Keywords: Fiscal federalism dynamics, Equity-centric transfers, Division of powers, Subsidiarity principle, Off-budget borrowing

Context-

• India's constitutional framework, a 'holding together federation' with unitary tendencies, has stood the test of time for over seven decades.
• However, the evolving landscape of India's fiscal federalism demands a reevaluation. As India transitioned from a planned economy to a market-oriented system and experienced changes like multi-tier fiscal systems and the Goods and Services Tax (GST), the interplay between fiscal policies and federalism requires a fresh perspective.

Equity-Centric Intergovernmental Transfers

• India's intergovernmental transfer system should evolve to be more equitable. While market-mediated growth processes often favor the propertied class,
• India's experience has been strikingly different. Research by Chancel and Piketty reveals that the top 1% earners in India claimed less than 21% of total income in the 1930s, which drastically plummeted to 6% in the early 1980s, only to surge to 22% during the liberalization phase.
• The current scenario, characterized by tax exemptions and concessions disproportionately benefiting the wealthy, has shrunk the divisible pool's size.

The Quest for Equity

• A study analyzing the convergence trajectory of per capita income across major Indian states underscores an increasingly divergent trend. The standard deviation of log per capita income has risen from 0.186 in 1991-92 to 0.231 in 2020-21, signifying a compound annual growth rate (CAGR) of 0.72%. Simultaneously, adopting the Human Development Index (HDI) approach, another research demonstrates that HDI values across 15 states show convergence in the post-reform era.
• The standard deviation of HDI dropped from 0.611 in 1991 to 0.268 in 2018. Notably, the period since 2005, coinciding with Fiscal Responsibility and Budget Management (FRBM) legislation, witnessed a diminishing convergence rate with a CAGR of -2.85%. In this light, promoting equity emerges as a crucial concern, and HDI could be a strong contender for horizontal tax devolution.

Revisiting Division of Powers

• The time has come to reconsider the distribution of powers, functions, and responsibilities among the various tiers of government. India's political landscape has transformed from a post-independence one-party governance to a vibrant multi-party system.
• Additionally, central legislation like the National Rural Employment Guarantee Act, Right to Education Act, and National Food Security Act have burdened states. Rethinking the division of powers, functions, and responsibilities is essential, especially as the nature of governance, society, and technology have evolved.

Subsidiarity Principle and Functional Allocation

• Revisiting the Government of India Act 1935, the basis for India's constitution-making, should involve applying the subsidiarity principle, which advocates that activities should be performed at the most suitable level of government.
• The 73rd and 74th Constitutional Amendments offered an opportunity for such a reevaluation, yet operational clarity remained elusive. The introduction of Schedule XI and Schedule XII without detailed breakdowns undermined their effectiveness. Establishing a new local list outlining functional and financial responsibilities for local governments is imperative.

Empowering the Third Tier

• Empowering the third tier of government – panchayat raj institutions and municipalities – merits serious attention. The absence of a uniform financial reporting system across all levels of government creates a critical gap.
• Despite referring to them as "institutions of self-government," policymakers often term them as "local bodies," failing to provide the necessary support.
• Addressing this gap and ensuring uniform financial reporting systems can fortify the foundation of local democracy.

Curbing Off-Budget Borrowing

• A critical facet of fiscal federalism pertains to reining in off-budget borrowing practices. Off-budget borrowings, unscrutinized and unreported, pose transparency challenges.
• Both the Union and States indulge in such practices, with central public sector undertakings and special purpose vehicles raising resources, burdening governments with repayment liabilities.
• While States adhere to fiscal discipline through Article 293(3) and the FRBM Act, the Union sometimes evades such controls. Transparent reporting mechanisms must encompass all levels of government.

Conclusion

As India's fiscal federalism continues to evolve, the 16th Finance Commission should lead a comprehensive rethinking process. The shift from planned to market economies, combined with changing fiscal paradigms and diverse economic shifts, requires recalibrating India's fiscal federalism approach. Ensuring equity, revisiting powers and functions allocation, strengthening the third tier, and curbing unregulated borrowing practices are essential facets that demand urgent attention. By reassessing these dynamics, India can better align its fiscal policies with the principles of inclusivity and balanced development.

Source - The Hindu