The poor state of India’s fiscal federalism

In his last speech to the Constituent Assembly in 1949, BR Ambedkar carefully notes About the entry into the life of the contradictions of the Republic of India. “In politics we will have equality and in social and economic life we ​​will have inequality. These struggles demanded attention: failing to do so, and those who refused would blow up the structure of political democracy”, he warned, although Jawaharlal Nehru actually believed that through his effort with the planning process Inequalities can be addressed. He felt that a degree of centralization in fiscal power was needed to address concerns of socio-economic and regional disparities. This was only accelerated and mutually strengthened, making the central government the extractive rather than the enabling one. While the states lost their ability to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime, Their expenditure pattern was also distorted by the infiltration of the Sangh, especially through its centrally sponsored schemes.

a political institution

Historically, India’s financial devolution worked through two pillars, i.e. the Planning Commission and the Finance Commission. But due to the lack of planning since the 1990s, and its abolition in 2014, the Finance Commission has become a major instrument of fiscal devolution as the Commission has since 2000 reduced its scope to share all taxes to only two taxes – income. extended from its original design. Taxes and Union Excise Duty. Today, the Finance Commission has become a political institution with arbitrariness and inherent bias towards the central government. The original intention to remove inequalities, a lofty idea, was, in fact, turned on its head as it morphed into one of the world’s most regressive taxation systems due to a centralized fiscal policy.

So, let’s see what has changed since 2014. The concerns of the Founding Fathers – addressing socio-economic inequalities – were forgotten in the process of ushering in the era of political centralization and cultural nationalism that drives fiscal policy today. To be sure, India was never truly federal – it was a ‘simultaneous federalism’ in contrast to ‘come-together federalism’, in which small independent entities come together to form a federation (as in the United States). in the United States). In fact, the Government of India Act 1935 was more federal in nature than the Constitution adopted on 26 January 1950, as for the first time more power was given to its provincial governments.

Anticipating this danger of centralisation, CN Annadurai asserted in the Tamil Nadu Legislative Assembly in 1967, ‘I want the Center to be strong enough to uphold the sovereignty and integrity of India… Do they have education and health departments? In what way does those who strengthen India’s sovereignty and independence?’ Subsequently, the Dravida Munnetra Kazhagam set up a committee under Justice PV Rajamannar in 1969, one of its kind by the state government, to look into centre-state financial relations and recommend greater transfer and taxation powers for regional governments. The first committee was It did not cut ice with the rest of India and centralisation, although partly contained due to alliances at the center in the 1990s and 2000s, reached its peak in 2014.

hollowing out fiscal capacity

The ability of states to finance current expenditure from their own revenue has declined from 69% in 1955-56 to less than 38% in 2019-20. While the expenditure of the states is increasing, their revenue has not increased. They still spend 60% of the country’s spending – 85% on education and 82% on health. Since states cannot raise tax revenue because of indirect tax entitlements subsumed in the GST, except for petroleum products, electricity and alcohol – revenues have remained stagnant at 6% of GDP over the past decade.

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Even as the share of transfer, proposed by the Fourteenth Finance Commission, was increased from 32% to 42%, the non-divisive cess and surcharge which go directly into the union kitty was removed. This non-divisible pool of Centre’s gross tax revenue increased from 9.43% in 2012 to 15.7% in 2020, shrinking the divisible pool of resources for devolution to states. In addition, the recent drastic cut in corporate tax, its adverse impact on the divisible pool and the abolition of GST compensation to states has had major consequences.

In addition to these, states are forced to pay different interest – around 10% against 7% – for market borrowings by the Union. It is not that the states are also suffering due to gross fiscal mismanagement – the surplus cash in the balance of the states has increased which is the money borrowed at higher interest rates – RBI, when there is a surplus in the treasury, So it usually invests in federally issued small Treasury bills at a lower interest rate. In short, the Union benefits at the expense of the states by taking advantage of these interest rate differentials.

By turning the states into mere implementing agencies of the plans of the Union, their autonomy has been curtailed. There are 131 centrally sponsored schemes, of which a few dozen account for 90% of the allocation, and states are required to share a portion of the cost. They spend about 25% to 40% in the form of similar grants at the expense of their priorities. Driven by a one-size-fits-all approach, these schemes are given precedence over state plans, which undermine the electoral mandated democratic politics of states.

In fact, it is the schemes conceived by the states which have proved beneficial to the people and which have contributed to the social development. Driven by democratic impulses, states have been successful in innovating schemes adopted at the national level, for example, employment guarantee in Maharashtra, lunch in Tamil Nadu, local governance in Karnataka and Kerala, and school education in Himachal Pradesh.

The conversion of a state’s own funds into centrally sponsored schemes, thereby depriving resources for its own schemes, is violative of the constitutional provision. Why should there be a centrally sponsored scheme on the item in the state list? Similarly, why should the state share the expenditure of a scheme in the Union List? For example, health is in the state list, so why should the union impose this scheme on the states; Even on better performers like Tamil Nadu and Kerala? It only prevents the states from adopting their own autonomous path of development.

deepening inequality

This political centralization has only deepened inequality. The World Inequality Report estimates that ‘the ratio of private wealth to national income has increased from 290% in 1980 to 555% in 2020, one of the fastest such growth in the world. The poorest half of the population owns less than 6% of the assets, while the top 10% own about two-thirds of the wealth. India has a poor record in taxing the rich. Its tax-GDP ratio has been one of the lowest in the world – of which 17% is well below the average ratio for emerging market economies and OECD countries, which are 21% and 34%, respectively.

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Pavitra Suryanarayan, a political scientist at the London School of Economics, demonstrated that the Indian elite historically reduced fiscal capacity because they felt threatened by the political equality offered by the one-man-one-vote system. The hollowing out of fiscal capacity continued for decades after independence, resulting in one of the world’s lowest tax bases on a regressive indirect taxation system. India has failed to tax its asset classes. If there was opposition to taxing farm income in the 1970s, when the sector prospered, the pro-business turn in the 1990s has led to corporate tax cuts by successive governments. There is also no property tax in India. Its income tax base has been very narrow. Indirect taxes still account for about 56% of the total taxes. Instead of strengthening direct taxation, the central government reduced corporate tax from 35% to 25% in 2019 and monetized its public sector assets to finance infrastructure.

In short, India’s fiscal federalism driven by political centralization has deepened socio-economic inequality, believing the dreams of the founding fathers who saw a cure for such inequalities in planning. It has not changed inter-state inequalities either. If there was anything that would reduce poverty, reduce inequality and improve people’s well-being, these were the time-tested schemes of state governments, but now they are in danger.

Kalaiyarasan A. Assistant Professor at the Madras Institute of Development Studies (MIDS), India and a Research Associate at the Institute of South Asia, Harvard University.