Fiscal Federalism needs a look-in by the 16th FC

Syllabus: GS1/ Constitutional Bodies

In Context

• The Sixteenth Finance Commission (16th FC) is likely to be appointed soon & The commission may have to face some challenging issues of fiscal federalism.

About Fiscal Federalism

• About:
  • It deals with the division of financial powers as well as the functions between multiple levels of the federal government. 
    • It has within its ambit the imposition of taxes as well as the division of different taxes between the Centre and the constituent units. 
    • Similarly, in the case of joint collection of taxes, an objective criterion is determined for the fair division of funds between the entities. 
  • Usually, there is a constitutional authority (like Finance Commission in India) for the purpose to ensure fairness in the division.
• Significance of fiscal federalism:
  • Fiscal federalism broadly considers the vertical structure of the public sector, fiscal policy institutions and their interdependence.
  • Fiscal federalism is significant broadly due to following reasons:
    • To determine at which level of government to assign different expenditure responsibilities. 
    • To determine the strategy to finance a given level of public goods and services. 
    • To adopt strategies to cap excessive spending and borrowing at each level of government. 

Challenging issues of fiscal federalism in India

• Intersecting domains:
  • There is the intersecting domain of the Finance Commission and Goods and Services Tax (GST) Council. 
    • The latter’s decisions impact the own tax revenue flows of states and, more importantly, the size of the central tax revenue pool which is to be shared among the central and state governments as per the recommendations of Finance Commissions. 
  • Finance Commission projections of state and central tax revenues, and recommendations based on them will be impacted by decisions taken by the GST Council. 
• Demands for centralization of expenditure:
  • Recent demands for greater centralization of expenditure assignment is another issue. 
  • India has a quasi-federal system. 
    • For purposes of legislation, regulation and administration, Schedule 7 of the Constitution assigns 97 subjects to the Union List.
    • If there is any conflict between Union and State legislation, Union laws prevail. 
  • Even for State subjects, the Union government can and does intervene through centrally sponsored schemes in which it incentivizes states to take up the Centre’s chosen schemes by financing a part of the cost of these programmes.
  • Equity considerations may require greater centralization to enable the provision of comparable levels of public or merit services for all citizens in a country.
• Third tier of government:
  • Though the Constitution referred to the importance of local governments and Panchayati Raj institutions, it left it to the state legislatures to decide which functions, funds and functionaries should be assigned to PRIs and ULBs.
  • Capacity building:
    • State governments have pointed out that it is difficult to transfer functions to PRIs and ULBs, which typically have very low capacity. 
    • However, the capacity of these institutions cannot be strengthened unless they are provided the resources to build such capacity. 
      • To help break this conundrum, the 13th, 14th and 15th FCs have all attempted in different ways to ensure substantial fund flows to PRIs and ULBs.
  • No reforms for PRIs:
    • Chairman of the 13th FC, suggested that consolidated funds should be created for PRIs and ULBs, funded by earmarking a share of the central GST and state GST for them. 
    • So far, except in one or two states, there have been no serious reforms to empower the third tier of government. 

Way ahead

• Recommendations of PV Rajamannar committee of 1971 needs to be considered which suggested that the Finance commission be made a permanent body.
• The Union government needs to invest resources towards facilitating effective consultation with States as a part of the lawmaking process.