Fiscal Fedralism

According to author the dynamics of the emerging fiscal federalism of India entails significant rethinking especially in the context of the 16th Finance Commission. One Fundamental aspect of our Governance is the fiscal federalism which provides the autonomy of the states to raise revenue and undertake expenditure according to their priorities and needs. Such form of fiscal federalism has been formulated keeping in mind the diverse needs and aspirations of the states across India and hence considered critical for balanced and holistic development of the entire country.

Before going into details of the report which shall be extremely important from the perspective of Mains examination, Let us first understand the need for any such body at the first place? Specially given that states and centre both have been enabled to levy and collect taxes in their domains. 

Now finance commission is body to facilitate fiscal balance in the Indian federal structure and hence enabling Fiscal federalism. 

What is a Fiscal imbalance?

  • Fiscal imbalance occurs when the revenues of a are not appropriate to carry out the responsibilities allocated to it. 

Now there are two kinds of imbalances that can occur in Indian Federalism: 

  • vertical imbalance (between state and centre)
  • horizontal imbalance (among the states)

Finance Commissions – A Historical Perspective

Reason for vertical distribution of resources from centre to state

Vertical and horizontal imbalances are common features of most federations and India is no exception to this.

So why does vertical imbalance (between state and centre) occur? 

  • Because there is a mismatch of responsibilities and revenue sources between the Union and the States? 
  • Now why is that?: mainly because of two reasons
    1. Constitution assigned taxes with a nation-wide base to the Union (which earn higher revenues)
      • Why was this done? 
        • This was done to make the country one common economic space unhindered by internal barriers to the extent possible. 
    2. Constitution assigned functional responsibilities involving high expenditure disproportionate to their assigned sources of revenue
      • Since the expenditures are incurred mainly in the executive branch, let us see the constitutional scheme for the same: 
Legislative responsibility  Executive responsibility  
LIST IUnion Union 
LIST IIState State 
LIST IIIBoth State 
  • So you can see that states take care of both List 1 and List II
  • Why was this done? 
    • States being closer to people and more sensitive to the local needs have been assigned 
  • These two factors have resulted in vertical imbalances.

So why does horizontal imbalance (among the states) occur? 

  • Unlike in most other federations, differences in the developmental levels in Indian States are very sharp. 
  • Horizontal imbalances across States are on account of factors, which include historical backgrounds, differential endowment of resources, and capacity to raise resources. 

So you can say that the creation of Finance commission is the recognition of the imbalance which exists in the federalism and hence mechanisms under article 280 and 281 have been created to ensure that these imbalances are minimized. 

Hence let us have a look at the constitutional provisions related to the finance commission as far as constitution of India is concerned:

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So as you read in article 280, the report of the Finance Commission has to be submitted for every five years and you also know that the report of the last FC (14th) was applicable for 2015-2020 period, then why did FC 15 not submit the final report for the period 2020-2025? 

  • At the formation of the 15th FC, It was required to submit the report by October 30, 2019 for five years for the period 2020-21 to 2024-25. 
  • However, due to various political and fiscal developments, its term was extended. 

So what are the reasons behind the extensions? 

  • Speak: the basic reason is that the reports of the FC are based on the projections of various parameters related to taxation, GDP and deficits. the current state of Indian economy makes it difficult for any panel to successfully do a projection. 

So why making medium-term projections in the current scenario would mean serious risks? 

  • Changes in the federal units 
    • the abolition of Statehood to Jammu and Kashmir required the Commission to make an estimation excluding the Union Territory
  • Historically low Nominal growth rate 
    • the deceleration in growth and low inflation has substantially slowed down the nominal GDP growth which is the main tax base proxy; making projections of tax revenues and expenditures based on this for the medium term could have posed serious risks. 
  • Issues related to Tax revenues 
    • Poor revenue performance of tax collection more particularly Goods and Services Tax 
    • Also the compensation agreement to the loss of revenue to the States is applicable only till 2022(which means  it will cover only two years of the period covered by the Commission’s recommendations hence posing uncertainties)

So these are the factors which have compelled the extension of the term of 15th FC as well as its submission of interim report. 

Let us now discuss the highlighting features of the report: 

14th FC15 FCRemarks
Vertical distribution 4241the Fifteenth Finance Commission continued with the recommendation of the previous Commission relating to vertical division of taxes, and adjusted the States’ share to 41% to exclude the share of Jammu and Kashmir.
Horizontal Distribution 
Population1971 (17.5%)


Income Distance50.0%45.0%
Forest cover7.50%10.0%
it has used two additional factors — demographic performance and tax effort.
Demographic PerformanceNA12.5%the inverse of fertility rate hence showing sensitivity to the concerns of these States.
Tax Efforts NA2.5%

However, in recent years, the fiscal federalism has become skewed towards the Centre in certain aspects and the same has been opposed by number of states. In this regard, let us understand some important issues which have arisen in the Centre State Fiscal Relations.

Higher Share of Cess and surcharge: Cess and surcharge imposed and collected by the Centre do not form part of Central Divisible pool of taxes. They are not distributable among the States and hence continue to remain with the centre. Over a period, the Centre has been imposing large number of surcharge and Cess to mobilise revenue. A Case in point is the recent introduction of the Agri Infrastructure Cess in the Union Budget 2021-22.

The share of Cess and Surcharge as a percentage of Gross Tax Revenue (GTR) of the centre has increased sharply from 2.3% in 1980-81 to 15% in 2019-20. The States see this as an illegitimate way of depriving resources that are rightfully due to them. 

GST compensation: States agreed to give up the power to impose indirect taxes and adopt GST based on a guaranteed 14 per cent growth in GST revenues per annum. The Centre committed to pay the states for the shortfall in their GST revenue through the imposition of GST Compensation Cess for a period of 5 years.

However, on account of CoVID-19 pandemic, there was GST shortfall of almost around Rs 3 lakh crores. However, money collected under GST compensation Fund was hardly around Rs 65,000 crores. Hence, there was an obligation on the Centre to pay compensation amount of almost Rs 2.35 lakh crores. Initially, the Centre asked the States to borrow this amount from the market. Later on, due to strong opposition, the Centre decided to borrow on behalf of the states and compensate them. This recent issue over GST compensation has led to erosion of trust in the fiscal federalism.

Centrally Sponsored Schemes (CSS): The Centrally Sponsored schemes are the schemes which are financed by both Centre and States in a defined proportion (70:30 or 60:40 or 50:50 etc), but implemented by the respective State Governments. Some of these schemes include MGNREGA, Ayushman Bharat, National Education Mission etc.

The Centre lays down elaborate rules and guidelines with respect to implementation of these schemes. It also lays down purposes for which the funds can be utilised for. The State governments claim that such rules and guidelines do not provide them with enough financial and operational autonomy in executing the schemes.

These Centrally sponsored schemes have also faced political controversy. For instance, some of the States such as West Bengal, Telangana etc. have decided not to implement Ayushman Bharat Scheme. These states claim that their own health insurance schemes are better than centre’s Ayushman Bharat Scheme.

Borrowing powers of the States: Under Article 293, the States are allowed to raise loans from the Centre or market. However, a State cannot raise a public loan without the consent of the Centre if there is still outstanding any part of a loan. Since all the State Governments have been and continue to be indebted to the Centre, the Centre effectively controls the amount of public debt raised by State Governments. 

In recent times, particularly in the aftermath of CoVID-19 pandemic, frictions have risen over the Centre’s attempt to perpetually control borrowings by the States. The recent 50-year interest free loan announced by the Centre for the states is a case in point. Any State which avails this facility will need to take Centre’s permission for all future borrowing at least for the next 50 years.

Policies: Several other policies initiated by the Union government in the recent past have also led to the weakening of States’ autonomy. These include the farm laws; the Government of National Capital Territory Amendment Act, 2021; the Dam Safety Bill, 2019; the National Education Policy of 2020 etc. 

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