India's Fiscal Federalism: Harmonising a Strong Centre with Robust States

Centralization Concerns in India's Fiscal Federalism

India's journey towards a $5 trillion economy is marked by significant changes in fiscal federalism, yet concerns about centralization persist. Key issues include the shrinking divisible tax pool for states, increasing centrally sponsored schemes (CSS), GST compensation worries, limited devolution to local bodies, and substantial inter-state disparities. Understanding these challenges is crucial for addressing them effectively.

Shrinking Divisible Tax Pool

One of the major concerns in India's fiscal federalism is the shrinking divisible tax pool for states, at least in relative terms. The share of cesses and surcharges in central tax revenues has nearly doubled, increasing from 10.4% in 2011-12 to 19.9% in 2020-21. These cesses and surcharges are kept outside the divisible pool, thus reducing the overall tax revenues shared with states. The 15th Finance Commission has recommended reducing states' share in the divisible pool from 42% to 41% for the period of 2021-26. This reduction further strains the financial autonomy of states, limiting their capacity to address local needs independently.

Increasing Centrally Sponsored Schemes

Centrally Sponsored Schemes (CSS) have seen a substantial increase in funding, with allocations ballooning from ₹1.57 lakh crore in 2014-15 to ₹3.83 lakh crore in 2021-22, marking a 144% increase. In contrast, untied funds given to states grew by only 61% during the same period. CSS accounted for 23% of total transfers to states in 2021-22, up from 17% in 2014-15. This increase in CSS funding, where states have limited flexibility, constrains their ability to tailor programs to local needs and priorities effectively.

Fiscal Challenges Post-GST Compensation End

The end of GST compensation in June 2022 has left many states worried about revenue shortfalls. Compensation cess collections fell short by ₹70,000 crore in 2020-21 and ₹1.59 lakh crore in 2021-22 compared to the payouts due. The compensation cess is levied on certain luxury and demerit goods like tobacco, cigarettes, aerated waters, and high-end motorcycles. This cess is credited to the GST Compensation Fund, from which compensation to states is paid out.

While the original compensation scheme was to end in June 2022, the levy of the compensation cess has been extended until March 31, 2026. This extension aims to repay the loans taken by the Centre in the last two fiscal years to compensate states for GST revenue shortfall. This shortfall poses significant fiscal challenges for states that have been relying on these compensations, and the originally committed 14% increase, to manage their budgets and fund development projects.

Limited Devolution to Local Bodies

Despite the 73rd and 74th Constitutional Amendments mandating decentralization, the actual transfer of funds, functions, and functionaries to rural and urban local bodies remains inadequate. The 15th Finance Commission recommended grants of ₹4.36 lakh crore to local bodies for 2021-26, a 52% increase from the ₹2.87 lakh crore allocated by the 14th Finance Commission. However, much of this funding is tied, limiting the autonomy of local bodies to use these resources effectively for local development needs.

Inter-State Disparities

Substantial horizontal imbalances between states persist, with significant differences in per capita Gross State Domestic Product (GSDP). For instance, in 2019-20, the per capita GSDP of Goa (₹4.67 lakh) was 9.7 times that of Bihar (₹48,093). The share of northern and eastern states in tax devolution is much higher than that of southern and western states, causing resentment and highlighting the need for a more balanced approach to fiscal federalism.

Proposed Reforms for Fiscal Federalism

To address these issues, experts suggest several reforms:

• Expanding the divisible pool by including cesses and surcharges.

• Rationalizing CSS and giving states more untied funds.

• Extending GST compensation for a few more years to help states manage their budgets.

• Incentivizing states to devolve more funds and powers to local bodies.

• Revisiting horizontal devolution criteria to balance equity and efficiency.

• Allowing states to levy income taxes to reduce vertical imbalances.

• Institutionalizing the GST Council and Inter-State Council for cooperative federalism.

Summing Up

While the 15th Finance Commission has made some progress, more comprehensive reforms are needed to strengthen fiscal federalism in India. Empowering all levels of government—central, state, and local—with adequate resources and responsibilities is essential to meet the diverse needs and aspirations of India's populace. The tiers of governance, now on a constitutional pedestal, require not only funds but also functions and functionaries, which state governments are generally loath to provide. Achieving an equitable balance among the three tiers of government is essential if India aims to become a sustainable $5 trillion economy, ensuring that the benefits of economic growth are equitably shared across the nation.