The new era of fiscal federalism could strengthen national unity
In previous columns, I have argued that linguistic pluralism and a federal structure are two of the three pillars that have held the Indian republic together and enabled this diverse and complex country to outperform all of its neighbours. The third of these pillars is fiscal federalism: because, as even high school kids know, how money is raised, shared, and spent by its members is crucial to a club’s survival and success.
The Union and the States are political creations. Their borders do not necessarily have to encompass economically autonomous societies. Thus, a sub-continental federation allows the forces of comparative advantage to benefit all: each region can produce what it does best and trade with the others. Yet balancing fairness, equality and efficiency in a hyper-diverse federation is complicated. At the time the Constitution came into force, some regions were endowed with more human capital, infrastructure and industrial capacities, others had abundant natural resources and a few had very limited economies. While the linguistic reorganization of states helped to meet political aspirations, fiscal federalism was the crucial but invisible factor that enabled political restructuring. What we take for granted to this day is actually part of India’s “secret formula” for success.
Like other parts of the formula, we have been negligent about maintaining fiscal federalism. The Constitution created an independent, nonpartisan finance commission to determine how fiscal resources should be shared between the Union and the states. However, as Mr. Govinda Rao points out in his new book, Studies in Indian Public Finance, the Planning Commission became an important arbiter of how funds were shared. Central planning, Rao argues, “constrained both the market and state governments in the allocation of resources” and the nationalization of banks further centralized resource allocations and aligned them with planning. This is one of the reasons Indian states have relatively weak fiscal capacities.
The dissolution of the Planning Commission in 2014 was therefore an important corrective, but the vestiges of central planning remain and the mindsets of state political elites have yet to adjust to the loosening of central constraints. Likewise, with the introduction of the GST and the formation of the GST Board, the states got a powerful platform to negotiate their tax interests. Despite its complexities and controversies, the GST has placed fiscal federalism high in the public discourse, and that’s a good thing.
The planning commission might well have strengthened New Delhi’s hand over that of the states, but the silent, transparent and professional functioning of the finance commission ensured that the latter were not pushed to the limit. During a discussion on national security, Vijay Kelkar once pulled me aside and underlined the fundamental role of the Finance Committee in keeping the country together. Many politically sensitive and border states receive disproportionate shares of funds. More importantly, the consultative and non-partisan nature of successive finance commissions meant that both the Union and the states accepted its allocations as fair, even if they felt they deserved better.
A new era of fiscal federalism began in 2015 when the 14th Finance Committee (2015-2020) raised the share of state funds from 32% to 42%. With the end of the Planning Commission in the same year and the adoption of the GST two years later, India today finds itself in uncharted waters.
On the one hand, the states enjoy greater budgetary autonomy than before, but on the other hand, the Union government plays a greater role in directing expenditure through a large number of of “centrally sponsored schemes”, such as those for education, health and rural employment guarantee. The 15th Finance Committee (2021-2026) retained the state share, and its methodology of assigning weights by population is likely to be a factor in the politics of federalism.
Moreover, as Rao writes in his book, “everyone wants decentralization, but only to their level”. While states have been zealous about their rights, they have been slow to set up public finance commissions to delegate funds to municipalities and panchayats. State governments and local agencies have also been reluctant to raise their own revenues. Political considerations prevent taxing the wealthiest farmers and bureaucratic inability at the municipal level to collect property taxes. As Arvind Subramanian observed, “the closer the government is to the people, the more reluctant it is”. it is to raise taxes”.
States must therefore learn to define fiscal policy. If they don’t, the budget balance will lean toward the center.
On the institutional level, a debate is underway on the question of whether or not the Finance Committee should have a permanent secretariat. Far more important, in my view, is that the Interstate Council should be transformed into a national forum, chaired by the Prime Minister and composed of the chief ministers of the states.
In these three columns, I have attempted to draw attention to the structural pillars of India’s unity and success. Linguistic pluralism, a federal structure and fiscal federalism have served us well and allowed us to succeed where others have failed. We must not let popular emotions and polarized rhetoric weaken them further.
Nitin Pai is co-founder and director of The Takshashila Institution, an independent center for public policy research and education