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Characteristics of Federal Economy and its Problem

Characteristics of Federal Economy and its Problem

 Federal Economy
o India's political structure is federal, so, its financial system is also
federal in character.
o The essence of the federal form of government is that each government
(Central, Union Territories and State governments) and local self-
government is independent of each other with constitutionally
demarcated functions.
o Generally, in a typical federation along with the distribution of
legislative and administrative powers, the financial resources of the
country are also so distributed to ensure the financial independence of
the units.
o However, the Indian Constitution does not make a clear cut distribution
of the financial resources and leaves much to be decided by the Central
Government from time to time.
o The financial resources which have been placed at the disposal of the
state are so meagre that they have to look up to the Union Government
for subsidies and contributions

Constitutional Provisions – Financial relations

Article Provision
246 Subject Matter of Union and States to make laws on Taxation
265 Taxes not to be imposed save by authority of law
266 Consolidated Funds and public accounts of India and of the States
267 Contingency Fund of India
268 Duties levied by the Union but collected and appropriated by the State
269 Taxes levied and collected by the Union but assigned to the States
269 (A) Position in GST Regime
269(A) Parliament will make laws on the Inter-state trade and commerce
(5)
270 Taxes levied and distributed between the Union and the States
271 Surcharge on certain duties and taxes for purposes of the Union
273 Grants in lieu of export duty on jute and jute products
274 Prior recommendation of President required to Bills affecting taxation

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 in which States are interested
275 Statutory grants
276 Taxes on professions, trades, callings and employments
277 Saving of pre-constitutional laws
279 Calculation of net proceeds
279 A GST Council
280 Finance Commission to recommend distributing financial resources
between the central and state governments
281 the process of how the recommendations of the Finance committee will
be introduced in parliament
282 Discretionary grants to state and local governments for specific
purposes

Principles of Federal Finance (or Adarkar’s Principles)

 Following are the principles to be followed with respect to federal finance:
o Principle of Independence
o Principle of Equity
o Principle of Uniformity
o Principle of Adequacy
o Principle of Elasticity
o Principle of Integration and Coordination
o Principle of Efficiency
o Principle of Administrative Economy
o Principle of Accountability

Problems with Federal economy

 Increasing Centralisation of Fiscal Powers
o Over time, the proportion of non-shareable revenue accruing to the
central government, such as surcharges and cesses, has risen.
o Consequently, states are advocating for greater fiscal autonomy and a
larger share of all taxes collected by the centre.

 Erosion of State Tax Autonomy

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 o The ability of states to set tax rates on their own revenue sources has
significantly diminished. This erosion occurred following the
implementation of value-added tax (VAT) for intra-state trade of goods.
o As a result, states have experienced a loss of autonomy in determining
tax policies and revenue generation strategies.

 Constraints on State Expenditure Flexibility

o States face constraints on their expenditure flexibility due to the
increasing prominence of conditional and tied grants.
o These grants, which target items listed in the state list, limit states'
discretion in allocating funds according to their unique priorities and
local needs.

 Uniform Fiscal Targets Neglecting State Variations

o Challenges stemming from the Fiscal Responsibility and Budget
Management (FRBM) Act, 2003 exacerbate the situation by imposing
uniform fiscal targets across states.
o These targets fail to account for the diverse fiscal needs and economic
conditions of individual states, further limiting their ability to manage
their finances effectively.

 Declining Share in Gross Tax Revenue

o Though the 14th and 15th FCs recommended 42% and 41%,
respectively, of the net tax revenue to be the shares of States, the share
of the gross tax revenue has reduced from 35% in 2015-16 to 30% in
2023-24 (Budget Estimates)

 Increasing Tax Collection Under Cess and Surcharge Categories

o One of the reasons for the States’ share in gross revenue declining
during this period is that the net tax revenue is arrived at after deducting
the revenue collections under cess and surcharge, revenue collections
from Union Territories, and tax administration expenditure.
o Among the three factors, revenue collection through cess and surcharge
is the highest and increasing.

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 o This calculation is excluding the GST cess that is collected to
compensate for the revenue loss of the States due to implementation of
GST till June 2022.

 Reduction in Grants-in-Aid to States

o The grants-in-aid to States declined in absolute amount from Rs 1.95
lakh crore in 2015-16 to Rs 1.65 lakh crore in 2023-24. Thus, the
combined share of the statutory financial transfers in the gross tax
revenue of the Union government declined from 48.2% to 35.32%

 Implementation of Goods and Service Tax (GST)

o The 101st Constitutional Amendment of 2016 giving the Union and
states concurrent powers of indirect taxation has been the most far-
reaching change from a fiscal standpoint, since the setting up of the 1 st
FC in 1951.
o The collection of indirect taxes in the state where goods or services are
consumed, and not in the state where they are produced, changes both
the vertical as well as the horizontal dynamics of federalism.
o The tax burden has been shifted from rich and manufacturing states to
consuming states, leading to horizontal imbalances.
o The Integrated GST, for instance, charged during the inter-state supply
of goods or services has been transferred to the destination state. This
move from the principle of origin to the principle of destination is
reconfiguring the balance of power amongst states

 Financial Centralisation Concerns

o The Union government has two other routes of direct financial transfers
to States, i.e., Centrally Sponsored Schemes (CSS) and Central Sector
Schemes (CS).
o The government influences the priorities of the States through CSS
wherein the Union government provides partial funding and another
part is to be committed by States. In other words, it proposes the
schemes and States implement them, committing the latter’s financial
resources as well.
o Between 2015-16 and 2023-24, the allocation for CSS increased from
Rs 2.04 lakh crore to Rs 4.76 lakh crore through 59 CSS.

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 o Thus, the Union government compels the State to commit more or less
an equivalent quantum of financial resources.

 Issues Surrounding Wealthy vs Less Wealthy States

o An important aspect of CSS shared schemes is that the States that can
afford to commit matching finances from the State budgets alone can
avail of the matching grants. This creates two different effects in terms
of inter-State equity in public finances.
o Wealthy States can afford to commit equivalent finances and leverage
Union finances inwards through the implementation of CSS.
o Less wealthy States will have to commit their borrowed finances in
these CSS, thus increasing their own liabilities. These differential
trajectories of the public finances of States accentuate inter-State
inequality in public finances, the major reason being CSS.

 Larger Financial Powers of Union Govt with Limited Expenditure

Responsibilities
o Together with statutory grants, the total financial transfers as a
proportion to gross tax revenue were only 47.9% in 2023-24.
o In addition to retaining more than 50% of gross tax revenue, the Union
government incurs a fiscal deficit to the extent of 5.9% of GDP. Thus,
the Union government wields enormous financial powers with limited
expenditure responsibilities

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2. Imbalance between the Functional Responsibility and Financial
Resources – Vertical and Horizontal Imbalance

Imbalance between the Functional Responsibility and Financial Resources

 Fiscal imbalance is a mismatch in the revenue powers and expenditure
responsibilities of a government.
 The revenue powers are divided between two or more tiers of government in a
federation (i.e. centre, state, local).
 In effecting a division of resources, the Constitution provides for a strong
centre and is entrusted with more financial resources
 The Constitution ensures the supremacy of the action of the Union
Government over the fairly comprehensive Union list as also over concurrent
jurisdiction.
 Allocation of the heads of taxation between the union and the states is based on
the broad principle that taxes which are location-specific and relate to subjects
of local consumption have been assigned to the states
 Those taxes like for example Income tax which are of inter-state significance
and where the place of residence is not a correct guide to the true incidence of
tax have been vested in the union
 The property of the union is exempt from state taxation. The property and
income of the states are exempt from the union taxation
 In India, the allocation of financial resources is elastic and substantial sources
of revenue have been assigned to the centre whereas the states, which have
been entrusted with important developmental and welfare functions, have been
entrusted with inelastic and inadequate sources of revenue

Vertical and Horizontal Imbalance

 Horizontal Imbalances
o The horizontal imbalances arise because of differing levels of
attainment by the states due to differential growth rates and their
developmental status in terms of the state of social or infrastructure
capital.
o It arises when there are variations in revenue-generating capacities and
expenditure needs across different regions or states.

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 o As a result, some regions may have more financial resources at their
disposal, leading to disparities in service delivery and economic
development.
o Factors:
 rapid population growth or decline in certain regions
 regional disparities in economic development and natural
resource endowments
 historical factors such as uneven infrastructure development,
imbalanced investment patterns, and regional economic policies
can perpetuate horizontal imbalances

o Horizontal imbalances involve two types of imbalances:

 Type I is to do with the adequate provision of basic public goods
and services.
 Type II is due to growth accelerating infrastructure or the
transformational capital deficits.
o Replacing the Planning Commission (which was mandated to give
grants to the states as conditional transfers using the Gadgil-Mukherjee
formula) with NITI Aayog (Government think tank with no resources to
dispense) has reduced the policy outreach of government by relying
only on single instrument of fiscal federalism i.e. Finance commission.
o This approach if not reviewed can lead to a serious problem of
increasing regional and sub-regional inequities.

 Vertical Imbalance
o In India’s fiscal federalism (three levels of Governments: Central
Government, State Governments and the elected Local Bodies) central
government has a far greater domain of taxation (e.g., income taxes
personal or corporate, taxing consumption of goods and services
(CGST), taxing foreign transactions, etc).
o Factors:
 the economic structure and the push-pull powers between the
states and the centre
 marked distinction between the revenue-generating and
spending responsibilities of the states and the centre

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 o Central Government collects around 60% of the total taxes, while its
expenditure responsibility (for carrying out its constitutionally
mandated responsibility such as defense, etc.) is only 40% of the total
public expenditure.
o Such vertical imbalances are even sharper in the case of the third tier
consisting of elected local bodies and panchayats.
o Vertical imbalances can adversely affect India’s urbanization, the
quality of local public goods and thus further aggravating the negative
externalities for the environment and climate change

Restructuring the Fiscal Federalism – A way forward

 India’s Fiscal Federalism needs to be restructured around the four pillars
namely Finance Commission, NITI Aayog, GST and decentralization in order
to eliminate the inadequacies of vertical and horizontal imbalances

 Finance Commission
o must be relieved from the dual task of dealing with provision of basic
public goods and services and capital deficits. It should be confined to
focussing on removal of basic public goods imbalance (Type I)

 NITI Aayog
o can serve as the second pillar for dealing in the realm of infrastructure
and capital deficits (Type II)
o It should be engaged with the allocation of capital in a way different
than that used by the Finance Commission with different parameters for
allocation.
o Regional Imbalances: NITI Aayog should receive significant resources
(1% to 2% of the GDP) to remove regional and subregional disparities
among states by reducing development imbalances in the areas of
infrastructure deficit.
 Independent Evaluation Office: NITI Aayog should be mandated
to create an independent evaluation office which will monitor
and evaluate the efficacy of the utilization of revenue and capital
grants.

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  Decision-Making Body: It should also be an integral part of the
decision making processes as it can effectively negotiate
between the states for the transfer of resources

 Decentralization
o can serve as the third pillar of the new fiscal federalism by
strengthening local finances and state finance commission
o Local public finance: the creation of an urban local body/Panchayati
Raj institutions consolidated fund.
 Centre and States should contribute an equal proportion of their
Central GST (CGST) and State GST (SGST) collections and
send the money to the consolidated fund of the third tier.
 One-sixth sharing of the CGST and SGST with the third tier can
generate more than 1% of the GDP every year for the financing
of public goods by urban-level bodies.

o State Finance Commissions should be accorded the same status as the

Union Finance Commission and the 3Fs of democratic decentralization
(funds, functions, and functionaries) should be implemented properly

 Goods and Services Tax

o should be simplified in its structure and can serve as the fourth pillar of
our fiscal federalism, by ensuring:
 Single Rate GST: with suitable surcharges on “sin goods,”
(goods that are harmful to society and individuals, for example,
alcohol and tobacco, drugs, etc), zero ratings of exports and
reforming the Integrated Goods and Services Tax (IGST) and the
e-way bill.
 Transparency: The GST Council should undertake reforms in an
informed and transparent manner, by creating its own secretariat
and independent experts (as its staff)

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3. Tax sharing under the Indian Constitution from itemized sharing to
Universal sharing – Introduction to GST – Tax sharing after GST

Tax sharing under the Indian Constitution

 The Centre imposes taxes, while the states are in charge of collecting them.
(Article 268):
o Stamp duty is charged on bills of exchange, promissory notes,
insurance policies, checks, stock transfers, and other documents
o The collected duties levied by any state (inside the state) are given to
the state rather than to the Consolidated Fund of India
o The centre imposes a service tax, but the states collect and appropriate
it (Article 268-A) (now outlawed amid GST)

 Taxes levied and collected by the federal government but distributed to state
(article 269):
o Various tariffs were levied on the sale or purchase of commodities
(other than newspapers) in the course of interstate commerce or trade
o Various tariffs on products sent in the course of interstate trade or
commerce
o All of these taxes’ net proceeds do not go into the Consolidated Fund of
India (CFI). According to the principles established by the Parliament,
they are assigned to the involved states

 Imposition and collection of Goods and Services Tax in line with interstate
trade or commerce (Article 269- A):
o The Centre imposes and collects the Goods and Services Tax (GST) on
supplies made in the course of interstate trade or commerce
o However, this tax is split between the Centre and the States in the
manner proposed by Parliament based on the GST Council’s
recommendations
o Furthermore, the Parliament has the authority to develop standards for
establishing the site of supply and when commodities or services, or
both, are supplied in the course of interstate trade or commerce

 Taxes imposed and collected by the Centre but distributed amongst the Centre
and the States proportionately (Article 270):

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 This category comprises all taxes and duties referred to in the Union List
except the following:
o Articles 268, 269, and 269-A deal with duties and taxes (mentioned
above).
o Article 271 imposes a surcharge on taxes and duties (mentioned below).
o Any tax imposed for a specified purpose. The President, on the
recommendation of the Finance Commission, prescribes the method for
distributing the net earnings of all these taxes and duties (FCs).

 Article 271-Surcharges on certain taxes and duties for purposes of the centre
o Articles 269 and 270 of the Constitution provide that the Parliament
may impose surcharges on taxes and duties at any time (mentioned
above).
o The Centre receives all of the profits from such surcharges. In other
words, the states aren’t paying any of the levies. This fee is not
applicable to the Goods and Services Tax (GST). To put it another way,
the GST will not be subject to this surcharge.
o State Government Taxes: Taxes of this nature are entirely the
responsibility of the governments. They are 18 in number and are
included on the State List.

Grants-in-Aid to the States

 In addition to taxation shared between the Union and the states, the
Constitution provides grants-in-aid to the states from federal funds.
 Statutory grants and discretionary grants are the two types of grants-in-aid to
states

 Statutory Grants
o Article 275 empowers the Parliament to offer grants to states which are
in need of financial assistance, rather than to all states. Each year, these
grants are charged to the Consolidated Fund of India (CFI)
o Aside from this standard provision, the Constitution additionally
provides for special funds to promote the welfare of scheduled tribes
(STs) in a state or to improve the quality of administration of scheduled
territories in a state, such as Assam

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 o Under Article 275 statutory grants (both general and particular) are
awarded to states on the Finance Commission’s recommendation

 Discretionary Grants
o The Centre is responsible for enforcing this regulation
o Article 282 empowers the Union and the states to give grants for any
public purpose, even if it falls outside of their own legislative
jurisdiction.

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Introduction to GST
 GST in India was first proposed by the Kelkar Task Force on Indirect taxes in
2000
 GST was introduced through the 101st Constitution Amendment Act, 2016.
 It is one of the biggest indirect tax reforms in the country.
o It was introduced with the slogan of ‘One Nation One Tax’.
 The GST has subsumed indirect taxes like excise duty, Value Added Tax
(VAT), service tax, luxury tax etc.
 It is essentially a consumption tax and is levied at the final consumption point.
 This has helped mitigate the double taxation, cascading effect of taxes,
multiplicity of taxes, classification issues etc., and has led to a common
national market.
 The GST that a merchant pays to procure goods or services (i.e. on inputs) can
be set off later against the tax applicable on supply of final goods and services.
 The set off tax is called input tax credit.
 The GST avoids the cascading effect or tax on tax which increases the tax
burden on the end consumer.
 Tax Structure under GST:
o Central GST to cover Excise duty, Service tax etc,
o State GST to cover VAT, luxury tax etc.
o Integrated GST (IGST) to cover inter-state trade.
 IGST per se is not a tax but a system to coordinate state and
union taxes.
 It has a 4-tier tax structure for all goods and services under the slabs - 5%,
12%, 18% and 28%

Tax sharing after GST

 The implementation of GST has brought about a fundamental shift in the
financial relations between the Central Government and the State Governments
in India.

 GST Taxation
o The GST system follows a dual structure, comprising Central GST
(CGST) and State GST (SGST), levied concurrently by the Central and
State governments, respectively.

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 o Additionally, an Integrated GST (IGST) is levied on interstate supplies
and imports, which is collected by the Central Government but
apportioned to the destination state.
o Under GST, both the Central and State Governments share the authority
to levy and collect taxes on goods and services.
o This has led to greater harmonization and uniformity in the tax structure
across States, promoting economic integration.

 Revenue Distribution:
o the GST Council plays a crucial role.
o It is a joint forum consisting of the Union Finance Minister and
representatives from all States and Union Territories.
o The Council makes decisions on various aspects of GST, including tax
rates, exemptions, and revenue sharing between the Central and State
Governments.

 Compensation Mechanism
o States are guaranteed compensation for any revenue shortfall below
14% growth (base year 2015-16) for the first five years ending 2022.
 GST compensation is paid out of Compensation Cess every two
months by the Centre to states.
 The compensation cess was specified by the GST
(Compensation to States) Act, 2017.
 All the taxpayers, except those who export specific notified
goods and those who have opted for GST composition scheme,
are liable to collect and remit the GST compensation cess to the
central government.
 Compensation Cess Fund: The GST Act states that the cess
collected and the amount as may be recommended by the GST
Council would be credited to the fund
o This compensation was meant to bridge the gap between the expected
revenue growth and the actual revenue collected by the States.

 Concerns of States
o Decreasing Centre Devolution
 the Centre’s share in centrally-sponsored schemes has gradually
reduced and states' share has increased.
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  Due to this, their most significant demand is increasing share in
centrally-sponsored schemes.

o Revenue Shortfall
 The state’s GST revenue gap in 2020-21 is expected to be about
Rs.3 lakh crore, while cess collections are only projected to
reach Rs.65,000 crore, leaving a shortfall of Rs.2.35 lakh crore.

o Economic Slowdown
 At a time when growth is faltering, the delays in paying
compensation to states as guaranteed by the GST Act will make
it more difficult for them to meet their own finances.

o Fiscal Autonomy
 The reduction in the fiscal autonomy of the States
 Manufacturing states lose revenue on a bigger scale
 The capacity of State tax authorities, so far used to taxing goods
and not services, to deal with the latter is an unknown quantity

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