Recent Evolution of India’s Fiscal Federalism

Fiscal union is nothing but Federalism by another name. It has become a huge area of interest for this blog. The idea is to understand the Indian federal system and figure how the union works. So expect a lot of posts on the matter going ahead.

In this regard, I found this superb speech by Dr Vijay Kelkar. Who better than Dr Kelkar who headed the 13th Finance Commission.  The speech is full of insights:

While describing federalism, people have described it in many ways. For instance, some scholars have described federalism as administrative federalism;” some have argued for “market preserving federalism” and some others have described it as “coming together federalism” vs. “holding together federalism”. Countries like USA are supposed to be examples of “coming together” federalism while India is supposed to be an example of “holding together” federalism.

In my view, the important feature of Indian federalism is what in India we call the “cooperative federalism” feature with formal and informal rules for maintaining the political system as well as for the peaceful change management. This is the feature that gives the “flexibility” to our Federation.

I think that it is this “flexibility” which helped the country to maintain unity while strengthening the democracy and I do believe that the democracy is one of the deep determinants of India’s growth performance. The U.S. constitution, over its 200 years or more of existence, has been amended only 27 times while in India, we have amended the Constitution 94 times in the first sixty years. In my view, this is the strength and not weakness of our system.

Amazing!!

He explains the fiscal and horizontal imbalances. FinCom exists to ease these imbalances:

Since 1982, in the Canadian constitution, there is a clear mandate for horizontal “equalization”. Section 36(2) of the Canadian Constitution commits the federal government to the “principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonable levels of public services at reasonably competitive levels of taxation” and this exercise is done annually. In India, the Constitution does not give such clear instructions.

To meet these fiscal challenges of vertical and horizontal imbalances, our Constitution has created an institution called the Finance Commission, which is an independent Constitutional body, appointed every five years and which reports to the President of India.

Unlike the Constitutions of Canada or Australia, Indian Constitution does not give any precise guidance to the Finance Commission as to how horizontal equalization is to be achieved. In the absence of such guidance, each Finance Commission works out its own approach, devising a formula for sharing of the taxes, i.e. for vertical sharing and horizontal distribution. The recommendations are usually based on the Commission’s overall judgement for vertical devolution which takes into account the resource availability and needs of the Union government for fulfilling its own functions such as defence, internal security, debt repayment etc.

 How changes in FinCom assessment helped in 1991 reforms. Before 1991, basically the sharing formula was specified for indiv taxes like income tax, corporate tax etc. This created problems when economy was opening up:

Over time, India’s fiscal federalism has been flexible enough to change its structure. For instance, till 15 years ago, the Constitution envisaged sharing of revenues tax-wise; in other words, share could be at different rates for corporate tax, personal income tax or manufacturing taxes or import duties. This feature created a perverse incentive structure for India’s tax policy. For instance, this gave no incentive for central government to reduce import duties as constitutionally, it could retain all earnings from such import tariffs. When India embarked on its new economic policy in 1991, the Tenth Finance Commission recommended the pooling of all these taxes and have a common sharing formula in order to rationalize the fiscal system. In my view, this paved the way for India’s tariff reforms which saw one of the most dramatic reduction in tariffs when they came down from 150 per cent to 10 per cent. Similarly, the support to the third tier through Finance Commission grants has also given momentum to effective decentralization programme in India.

He then mentions how GST will help address the vertical imbalances..

Superb primer..Though lots to follow and read

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