Central Idea:

The article discusses Kerala’s protest against the imposition of a Net Borrowing Ceiling (NBC) by the Central Government, which restricts the state’s ability to borrow funds. It argues that this imposition undermines fiscal federalism and challenges the constitutional authority of the state legislature over financial matters.

Key Highlights:

• Kerala Chief Minister Pinarayi Vijayan leads a protest against the Central Government’s imposition of a financial embargo on Kerala.
• The NBC limits states’ borrowings, including those from state-owned enterprises like the Kerala Infrastructure Investment Fund Board (KIIFB), leading to a severe financial crisis in Kerala.
• The article questions the constitutionality of including state-owned enterprises’ debt in the state’s total debt, arguing that it encroaches on the state legislature’s authority over financial matters.
• Kerala’s Fiscal Responsibility Act, 2003, aims to reduce fiscal deficit, demonstrating the state’s commitment to fiscal discipline.
• The article criticizes the move towards “annihilative federalism,” where the central government’s actions detrimentally affect states’ ability to meet welfare obligations.

Key Challenges:

• Balancing fiscal discipline with the need for states to fund development projects and welfare schemes.
• Addressing the erosion of fiscal federalism and the encroachment of central authority over state finances.
• Resolving the conflict between the powers of the central government and state legislatures regarding financial matters.
• Mitigating the impact of borrowing restrictions on states’ ability to fulfill their financial obligations.

Key Terms:

• Net Borrowing Ceiling (NBC): Limit imposed on states’ borrowings from all sources.
• Kerala Infrastructure Investment Fund Board (KIIFB): State-owned body responsible for funding infrastructure projects.
• Fiscal Responsibility Act: Legislation aimed at reducing fiscal deficit and promoting financial discipline.
• Fiscal Federalism: Distribution of financial powers and responsibilities between the central government and states.
• Annihilative Federalism: Central government actions that undermine states’ financial autonomy and welfare obligations.

Key Quotes:

• “The wide array of constitutional issues…point at the severe erosion of fiscal federalism in the country.”
• “The borrowing restrictions are an example of ‘annihilative federalism’ at play.”

Key Examples and References:

• Kerala’s protest led by Chief Minister Pinarayi Vijayan against the financial embargo imposed by the Central Government.
• The inclusion of KIIFB’s debt in Kerala’s total debt, leading to funding constraints for welfare schemes.
• Comparison of Kerala’s fiscal deficit reduction efforts with the central government’s fiscal deficit estimates.

Key Facts and Data:

• Kerala’s fiscal deficit reported to have reduced to 2.44% of the GSDP.
• Central government’s fiscal deficit estimated to be 5.8% for 2023-2024.

Critical Analysis:

The article underscores the tension between central authority and state autonomy in financial matters, highlighting the constitutional ambiguity surrounding the imposition of borrowing restrictions. It argues for a balanced approach that acknowledges states’ fiscal responsibilities while ensuring fiscal discipline.

Way Forward:

• Reevaluate the imposition of borrowing restrictions to ensure they do not unduly impede states’ ability to meet financial obligations.
• Enhance dialogue and cooperation between the central government and states to address fiscal challenges while respecting constitutional principles.
• Clarify the division of financial powers between the central government and state legislatures to mitigate conflicts and promote fiscal federalism.

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Context

• The centralisation of fiscal powers in India has been blamed for the poor fiscal health of the states.

Why in news?

• Chief Ministers expressed their concern about dwindling State revenues in a NITI Aayog meeting chaired by the Prime Minister.
• They sought a higher share in the divisible pool of taxes and an extension of GST compensation, both of which have long remained a bone of contention between the Union government and the States.

Need for financial devolution

• To strengthen democracy at grass root level with more revenue resources for better service delivery.
• To increase accountability to people so performance can be realized as direct contact with people.

What is divisible pool of taxes?

• The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States. The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of collection charges.

What is fiscal federalism?

• Fiscal federalism refers to how federal, state, and local governments share funding and administrative responsibilities within our federal system. The funding for these programs comes from taxes and fees.

Poor state of state finances

• Stagnant revenue: Since States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol — the revenue has been stagnant at 6% of GDP in the past decade.
• Distorted expenditure: While States lost their capacity to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime, their expenditure pattern too was distorted by the Union’s intrusion, particularly through its centrally sponsored schemes.
• Decline in share: The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20.
• Stress on finance: States’ financial health had taken a turn for the worse with the implementation of the Ujwal DISCOM Assurance Yojana, farm loan waivers, as also the slowdown in growth in 2019- 20.

Key fact to remember

Finance Commission keeps tax devolution for states at 41% in FY22

How fiscal centralisation impacts on states?

• Cut in the corporate tax: The recent drastic cut in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.
• States paying high interest rates: States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings.
• Centrally sponsored schemes curbing autonomy: There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost.

 Suggestions for strong fiscal federalism

• Creation of federal institution: We need to create another institution in the form of a GST state secretariat that can bring together senior officers from the Centre and states in an institutional forum registered under the Society Act.
• 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.
• Robust GST regime: Transparency, simplification and rationalisation of GST will help states to recover soon.

Way Forward

• Relook on various exemptions to rationalise the taxes/levies
• Augmentation of Tax Administration Structure
• Technology-based Tax Administration may also be further expanded to cover even utility charges like water, street lights, sanitation charges, etc.

Conclusion

• It is important now to rethink the design and structure of a genuine fiscal partnership, which should not merely be a race to garner more resources, but a creative attempt to move towards a vibrant Indian value chain that can catapult India’s growth rate closer to the quest for double-digit growth.

Mains question

Q. Why it is important now to rethink the design and structure of a genuine fiscal partnership? Discuss this in context of Skewed divisible pool and state of fiscal federalism in India.

 

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Context

The centralisation of fiscal powers in India has been blamed for the poor fiscal health of the states.

Centralisation of fiscal powers: A background

• Jawaharlal Nehru believed that socio-economic inequities could be addressed through the planning process.
• A degree of centralisation in fiscal power was required to address the concerns of socio-economic and regional disparities.
• As a result asymmetric federalism is inherent to the Indian Constitution.
• India was never truly federal — it was a ‘holding together federalism’ in contrast to the ‘coming together federalism,’ in which smaller independent entities come together to form a federation (as in the United States of America).
• In fact, the Government of India Act 1935 was more federal in nature than the Constitution adopted on January 26, 1950 as the first offered more power to its provincial governments.
• Historically, India’s fiscal transfer worked through two pillars, i.e., the Planning Commission and the Finance Commission. 
• But the waning of planning since the 1990s, and its abolition in 2014, led to the Finance Commission becoming a major means of fiscal transfer as the commission itself broadened its scope of sharing all taxes since 2000 from its original design of just two taxes — income tax and Union excise duties.
•  Today, the Finance Commission became a politicised institution with arbitrariness and inherent bias towards the Union government.
• Tamil Nadu government constituted a committee under Justice P.V. Rajamannar in 1969, the first of its kind by a State government, to look at Centre-State fiscal relations and recommend more transfers and taxation powers for regional governments.

Declining fiscal capacity of the states

• While States lost their capacity to generate revenue by surrendering their rights in the wake of the Goods and Services Tax (GST) regime, their expenditure pattern too was distorted by the Union’s intrusion, particularly through its centrally sponsored schemes.
• The ability of States to finance current expenditures from their own revenues has declined from 69% in 1955-56 to less than 38% in 2019-20.
• While the expenditure of the States has been shooting up, their revenues did not.
• Stagnant revenue: Since States cannot raise tax revenue because of curtailed indirect tax rights — subsumed in GST, except for petroleum products, electricity and alcohol — the revenue has been stagnant at 6% of GDP in the past decade.

Implications of fiscal centralisation in India

• Use of non-divisive cess: Even the increased share of devolution, mooted by the Fourteenth Finance Commission, from 32% to 42%, was subverted by raising non-divisive cess and surcharges that go directly into the Union kitty.
•  This non-divisive pool in the Centre’s gross tax revenues shot up to 15.7% in 2020 from 9.43% in 2012, shrinking the divisible pool of resources for transfers to States.
• Cut in the corporate tax: The recent drastic cut in corporate tax, with its adverse impact on the divisible pool, and ending GST compensation to States have had huge consequences.
• States paying high interest rates: States are forced to pay differential interest — about 10% against 7% — by the Union for market borrowings.
• Centrally sponsored schemes curbing autonomy:  There are 131 centrally sponsored schemes, with a few dozen of them accounting for 90% of the allocation, and States required to share a part of the cost.
• They spend about 25% to 40% as matching grants at the expense of their priorities.
• These schemes, driven by the one-size-fits-all approach, are given precedence over State schemes, undermining the electorally mandated democratic politics of States.
• In fact, it is the schemes conceived by States that have proved to be beneficial to the people and that have contributed to social development.
• Driven by democratic impulses, States have been successful in innovating schemes that were adopted at the national level.
• The diversion of a State’s own funds to centrally sponsored schemes, thereby depleting resources for its own schemes, violates constitutional provision.
• Deepening inequality: The World Inequality Report estimates ‘that the ratio of private wealth to national income increased from 290% in 1980 to 555% in 2020, one of the fastest such increases in the world.
• The poorest half of the population has less than 6% of the wealth while the top 10% nearly grab two-third of it’.
• India’s tax-GDP ratio has been one of the lowest in the world — 17% of which is well below the average ratios of emerging market economies and OECD countries’ about 21% and 34%, respectively.
• Its income tax base has been very narrow.
• Indirect tax still accounts for about 56% of total taxes.
• Instead of strengthening direct taxation, the Union government slashed corporate tax from 35% to 25% in 2019 and went on to monetise its public sector assets to finance infrastructure.

Conclusion

In sum, India’s fiscal federalism driven by political centralisation has deepened socio-economic inequality, belying the dreams of the founding fathers who saw a cure for such inequities in planning. It has not altered inter-state disparities either.

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Faultlines in the Centre-State fiscal relations have widened due to Covid. This article examines how States are not getting what they should as per the 14th Finance Commission report.

Centre-state tussle

• The tussle for the rights of States has been focused on Article 356.
• Partial behaviour by the Governors, regional party governments were politically destabilised.
• Little was done to implement the report of  Justice R.S. Sarkaria Commission on Centre-State relations.
• The new faultline in the Centre-State relation could be over the way report of 14th Finance Commission is being implemented.
• This began well before COVID-19, but the pandemic and its economic disruption have brought things to an edge.

Issues over the implementation of 14th Finance Commission report

• The 14th Finance Commission report in 2015 promised devolution of more finances to the States.
• As part of the process, States would have new responsibilities, especially in the social sector.
•  The Goods and Services Tax (GST) regime was also justified as a grand bargain that would eventually leave all States better off.
• In reality, tax devolution to States has been consistently below 14th Finance Commission projections.
• One reason for this has been the economic slowdown, and lower-than-expected GST collections.
• The shortfall in GST collection for 2018-2019 was 22% when compared to projections.
• Payments to the States have been delayed as well.
• There is a ₹6.84 lakh crore gap between what the 14th Finance Commission promised to States and what they have received.
• States undertook programmes and projects spending 46% more than the Central Government; today the figure is 64%.
• Despite spending less than the states the Centre’s fiscal deficit exceeds the consolidated State deficit by 14%.

Need to revisit the FRBM provisions

• Due to pandemic, the fiscal deficit for States, collectively, is inevitably going to breach the projection of 2.04%.
• As per provisions of the Fiscal Responsibility and Budget Management (FRBM) Act, the GSDP can actually accommodate a fiscal deficit of 3%.
• Now, post-pandemic, this limit will be crossed.
• The FRBM has an “escape clause” that allows for a one-time relaxation of the fiscal deficit threshold upto 0.5% in a time of exigency.
• The escape clause has been utilised by the Centre but it has proven woefully insufficient in addressing the current crisis.
• Fiscal policymakers and technocrats agree that the rigidity of the FRBM has to be revisited.
• It should allow for greater flexibility and consultation as to when and how the “escape clause” can be applied.
• The Centre has gone in for subjective interpretation, imposing conditions that are outside the scope of the FRBM.

Consider the question “Fiscal tensions have emerged as  a new front in the Centre-State relations. Suggest the steps the Centre should take to address it.”

Conclusion

Centre government needs to be more considerate of the financial woes of the State and try to deliver on the recommendations of the 14th Finance Commission report.

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Context

Even as States have taken up positions of leadership in the pandemic response, federal limitations are becoming hurdles.

State governments at the position of leadership

• In the fight against the pandemic, one of the striking features of governance has been the signal role played by State Chief Ministers across India.
• Proactive measures: Even before the Union government invoked the Disaster Management Act, 2005, many State governments triggered the Epidemic Diseases Act, 1897, and installed a series of measures to combat what was then an oncoming onslaught of COVID-19.
• These actions have not always been perfect. Some of them have even disproportionately trenched upon basic civil liberties.
• But, by and large, they have been tailored to the reality faced on the ground by the respective governments.
• Policies to address local concerns: States such as Maharashtra, Kerala, Tamil Nadu, Rajasthan, and Karnataka have shaped their policies to address their direct, local concerns.
• They have communicated these decisions to the public with clarity and consideration, helping, in the process, to lay out a broad framework for the nation.
• Not just the laboratories of democracy: In doing so, they have acted not merely as “laboratories of democracy”, to paraphrase the former U.S. Supreme Court Justice Louis Brandeis, but also as founts of reasoned authority.

Federal arrangements placing limitations on the states

• Equally, though, as much as State governments have taken up positions of leadership, they have repeatedly found themselves throttled by the limitations of the extant federal arrangement.
• The Centre for Policy Research has pointed out at least three specific limitations.
• Funds and structuring own package: The inability of States to access funds and thereby structure their own welfare packages.
• Curbs imposed by PFMS: The curbs imposed by a public finance management system (PFMS) that is mired in officialdom.
• This has prevented States from easily and swiftly making payments for the purchase of health-care apparatus such as ventilators and personal protective equipment.
• Disruption of supply chains: Three, the colossal disruption of supply chains not only of essential goods and services but also of other systems of production and distribution, which has placed States in a position of grave economic uncertainty.
• Need to decentralise: As these limitations demonstrate an urgent need to decentralise administration, where States — and local bodies acting through such governments — are allowed greater managerial freedom.
• Under such a model, the Union government will command less but coordinate more.

Indian federalism-two distinct levels

• There are varying accounts of what Indian federalism truly demands.
• Two levels: What is manifest from a reading of the Constitution is that it creates two distinct levels of government: one at the Centre and the other at each of the States.
• The Seventh Schedule to the Constitution divides responsibilities between these two layers.
• The Union government is tasked with matters of national importance, such as foreign affairs, defence, and airways.
• But the responsibilities vested with the States are no less important. Issues concerning public health and sanitation, agriculture, public order, and police, among other things, have each been assigned to State governments.
• In these domains, the States’ power is plenary.
• This federal architecture is fortified by a bicameral Parliament.
• Significantly, this bicameralism is not achieved through a simple demarcation of two separate houses, but through a creation of two distinct chambers that choose their members differently-
• A House of the People [Lok Sabha] comprising directly elected representatives and a Council of States [Rajya Sabha] comprising members elected by the legislatures of the States.

Financial autonomy of the states

• Ensuring financial autonomy: In formulating this scheme of equal partnership, the framers were also conscious of a need to make States financially autonomous.
• No overlap: To that end, when they divided the power to tax between the two layers of government they took care to ensure that the authority of the Union and the States did not overlap.
• Therefore, while the Centre, for example, was accorded the power to tax all income other than agricultural income and to levy indirect taxes in the form of customs and excise duties, the sole power to tax the sale of goods and the entry of goods into a State was vested in the State governments.
• The underlying rationale was simple: States had to be guaranteed fiscal dominion to enable them to mould their policies according to the needs of their people.

History of paradox in federal system of India

• Despite this plainly drawn arrangement, the history of our constitutional practice has been something of a paradox.
• It is invariably at the level of the States that real development has fructified.
• But the Union has repeatedly displayed a desire to treat States, as the Supreme Court said in R. Bommai v. Union of India, as mere “appendages of the Centre”.
• Time and again, efforts have been made to centralise financial and administrative power, to take away from the States their ability to act independently and freely.
• Following five examples demonstrated that the point made here.

1 Matters of finance-what was expected in theory did not realise

• Consider the widely hailed decision to accept the 14th Finance Commission’s recommendation for an increase in the share of the States in total tax revenues from 32% to 42%.
• While, in theory, this ought to have enabled the States to significantly increase their own spending, in reality, as a paper authored by Amar Nath H.K. and Alka Singh of the National Institute of Public Finance and Policy suggests, this has not happened.
• What went wrong? Gains made by the States, as the paper underlines, have been entirely offset by a simultaneous decline in share of grants and by a concomitant increase in the States’ own contribution towards expenditures on centrally sponsored schemes.

2. Goods and Service Tax

• The decline in the sovereignty of the states: Notably, the creation of a Goods and Services Tax regime, which far from achieving its core purpose of uniformity has rendered nugatory the internal sovereignty vested in the States.
• By striking at the Constitution’s federal edifice, it has made the very survival of the States dependent on the grace of the Union.
• The tension today is so palpable that a number of the States are reported to have written to the Union Finance Ministry.
• More than four months’ worth of Goods and Services Tax compensation to the States — reportedly totalling about a sum of ₹40,000 crore — remains unreleased.

3. Passing a bill as a money bill

• The Union government’s centralising instinct, though, has not been restricted to matters of finance.
• It has also introduced a slew of legislation as money bills, in a bid to bypass the Rajya Sabha’s sanction, even though these laws scarcely fit the constitutional definition.

4. Role of the Governors

• Similarly, the role of the Governors has been weaponised to consolidate political power.

5. Article 370

• But perhaps most egregious among the moves made is the gutting of Article 370 and the division of Jammu and Kashmir into two Union Territories.
• It was done without securing consent from the State Legislative Assembly.

Conclusion

Perhaps a crisis of the kind that COVID-19 has wrought will show us that India needs greater decentralisation of power; that administration through a single central executive unit is unsuited to its diverse and heterogeneous polity. We cannot continue to regard the intricate niceties of our federal structure as a nettlesome trifle. In seeing it thus, we are reducing the promise of Article 1 of the Constitution, of an India that is a Union of States, to an illusory dream.

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