Discuss the constitutional underpinnings and major challenges to fiscal federalism in India. Analyze the impact of its erosion on cooperative federalism.

Why?

Kerala has moved the Supreme Court contending that the Centre’s imposition of a Net Borrowing Ceiling (NBC) on the State, which limits borrowings from all sources, violates Article 293 of the Constitution.

Approach:

• Introduce your answer by defining fiscal federalism and its significance for cooperative federalism.
• In the main body, list the Constitutional provisions like the Seventh Schedule, Articles 268-281, and the role of the Finance Commission. Next discuss the challenges to fiscal federalism like GST implications, cesses and surcharges, borrowing restrictions, and centrally sponsored schemes. Next write about the impact of eroding fiscal federalism on cooperative federalism like strained relations, reduced autonomy, policy misalignments, etc.
• Conclude by underscoring the need for a balanced fiscal federal structure.

Answer:

Fiscal federalism encompasses the allocation of financial powers and responsibilities between the Union and state governments, ensuring efficient and equitable fiscal arrangements. The interplay between fiscal federalism and cooperative federalism is crucial, as the former provides the financial foundation that supports the collaborative governance and policy-making essential for the latter, fostering a harmonious relationship to achieve common national objectives.

Constitutional Underpinnings of Fiscal Federalism in India:

• Division of Powers: The Constitution delineates financial powers between the Centre and the States, ensuring a clear demarcation to avoid overlaps and conflicts (VII Schedule).
• Transfers from the Centre to the States: The VII Schedule creates a vertical fiscal imbalance, granting the Union more revenue powers and states more expenditure duties, thus necessitating transfers.
• Distribution of Revenue: Articles 268 to 281 specify the distribution of revenues, aiming for a logical and thorough division.
  • Revenue from cesses and surcharges levied by the Union Government are not shared with the states.
• Finance Commission: Article 280 mandates the periodic appointment of a Finance Commission to recommend the distribution of revenues and grants, ensuring periodic review and adjustment of financial relations.
• Grants-in-Aid:
  • Statutory: Article 275 addresses financial disparities among states by providing for grants-in-aid, signifying federalism’s role as a leveling force.
  • Discretionary: Article 282 empowers the Union Government to make grants for a public purpose even on subjects in State’s list.
• Borrowing: Articles 292 and 293 permit borrowing by the Union and states, subject to constraints, especially for states indebted to the Union.

Major Challenges to Fiscal Federalism in India:

• Reduction in taxation powers of the States with the introduction of GST: making them more dependent on Centre to meet their financial obligations.
  • Discontinuation of GST Compensation in 2022.
• Increasing share of Cesses and Surcharges: in the gross tax revenue of the Centre reduces the states’ share in central taxes.
  • Though the States’ share in the Central taxes is 41%, as recommended by the Fifteenth Finance Commission, they only get a 29.6%.
• Borrowing Restrictions: The Net Borrowing Ceiling (NBC) limits the borrowings of States, affecting their ability to finance projects and meet expenditure needs.
  • The NBC includes open market borrowings, liabilities on the public account of the States and borrowings by state-owned enterprises that are serviced by the State.
• Treatment of Off-Budget Borrowings as State’s Borrowing: from 2021-22 onwards and adjusting them against borrowing limits under FRBM is against established norms.
  • Treating off-budget borrowings retrospectively is unjustified.
• Proliferation of Centrally Sponsored Schemes (CSS): Despite recommendations to curtail the number of CSS, the Union government has only grouped them under broad umbrella heads.
  • The Chairman of the Fifteenth Finance Commission argued that the provision under Article 282 was not meant to be an overarching route for effecting transfers, but an extraordinary one and to be sparingly used.
• Imposition of Unfunded Mandates on States: to implement certain programs or policies, but without providing them with the necessary financial resources.

Impact of Eroding Fiscal Federalism on Cooperative Federalism:

• Strained Union-State Relations: centralized control over finances strains relations and undermines trust essential for cooperative federalism.
• Reduced Fiscal Autonomy: Centralized fiscal policies limit state governments’ ability to finance local initiatives, challenging the principle of autonomy in cooperative federalism.
• Dependency on Central Transfers: Increased reliance on the Union for financial resources reduces states’ bargaining power, affecting their participation in cooperative decision-making.
• Disparities in Development: Centralized resource allocation exacerbates regional disparities, underinvestment in critical areas, jeopardizing national goals and cooperative efforts for balanced and equitable development.
• Policy Misalignment: Union-imposed fiscal policies may not align with state priorities, creating conflicts and inefficiencies, counter to cooperative federalism’s aim for harmonized policy-making.

Autonomy of the States, as envisaged by the Constitution, can be meaningfully enjoyed only with the availability of adequate financial resources. Ensuring this balance is crucial for the effective functioning of India’s federal structure, where both the Union and the States can fulfill their constitutional mandates and work collaboratively towards national development.

‘+1’ Value Addition:

• The cess and surcharge collection in 2015-16 was 5.9% of the gross tax revenue of the Union government, and this ratio increased to 10.8% in 2023-24.
• Between 2015-16 and 2023-24, the allocation for CSS increased from 2.04 lakh crore to 4.76 lakh crore through 59 CSS.