Model Answer
0 min readIntroduction
Fiscal federalism, in India, refers to the division of financial powers and responsibilities between the Union and State governments, aiming to ensure both autonomy and coordination. Rooted in constitutional provisions (Articles 264-293), this relationship has continuously evolved from a largely centralized planned economy towards a more liberalized and cooperative federal structure. The pattern of Centre-State financial relations has been a dynamic interplay influenced by various institutional mechanisms like the Finance Commissions and the erstwhile Planning Commission, adapting to changing economic realities and political imperatives over decades.
Evolving Pattern of Centre-State Financial Relations in Planned Development
India's journey since independence has seen a significant shift in the Centre-State financial matrix, particularly in the context of planned development. This evolution can be broadly categorized into distinct phases:
- Centralized Planning Era (1950-1991):
- The Planning Commission (established 1950) played a dominant role, allocating resources to states through "plan grants" and loans, often using discretionary formulas like the Gadgil formula.
- States were heavily dependent on the Centre for financial transfers for their Five-Year Plans, leading to a "top-down" approach and often less autonomy in setting their own developmental priorities.
- This period was marked by vertical fiscal imbalance, where states had greater expenditure responsibilities but limited revenue-raising powers, increasing their reliance on central transfers.
- The Finance Commissions (constitutional body under Article 280) primarily focused on non-plan revenue deficit grants and tax devolution, with their role somewhat overshadowed by the Planning Commission in overall resource allocation.
- Post-1991 Liberalization and Reforms:
- Economic reforms brought greater autonomy for states in resource mobilization, attracting private and foreign investment.
- The role of Finance Commissions became more pronounced, with a gradual shift towards rules-based, rather than discretionary, transfers.
- The Fiscal Responsibility and Budget Management (FRBM) Act (2003) encouraged fiscal discipline and borrowing limits for both Centre and States.
Impact of Recent Reforms on Fiscal Federalism in India
Recent reforms, particularly since 2014, have significantly reshaped India's fiscal federalism, aiming to foster greater cooperation and efficiency, albeit with some emergent challenges:
1. Abolition of Planning Commission and establishment of NITI Aayog (2015)
- Shift from Plan to Non-Plan transfers: With the abolition of the Planning Commission, the distinction between plan and non-plan expenditure largely ceased, and the discretionary 'plan grants' mechanism was removed.
- Increased Devolution via Finance Commissions: This empowered the Finance Commissions to become the primary channel for vertical and horizontal devolution. The 14th Finance Commission (2015-2020) famously increased the states' share in the divisible pool of central taxes from 32% to 42%. The 15th Finance Commission (2021-26) retained it at 41% (adjusting 1% for the newly formed UTs of J&K and Ladakh).
- Cooperative and Competitive Federalism: NITI Aayog's role is advisory, focusing on policy formulation, monitoring, and fostering collaboration. It promotes competitive federalism through indices and rankings, encouraging states to perform better.
2. Goods and Services Tax (GST) (2017)
The introduction of GST was a landmark reform:
| Aspect | Earlier Framework (Pre-GST) | Post-GST Impact (2017 onwards) |
|---|---|---|
| Taxation Powers | Fragmented indirect tax structure; states had control over VAT, entry tax, etc. | Unified indirect tax regime; subsumed multiple central and state taxes. Centralized taxation powers, reducing states' independent taxation autonomy. |
| Decision-Making | Unilateral tax decisions by Centre/States. | GST Council as a unique institutional forum for joint decision-making (Centre has 1/3rd, States 2/3rd voting power), fostering cooperative federalism. |
| Revenue Distribution | States retained their collected indirect taxes. | States receive SGST and a portion of IGST. Compensation mechanism for revenue loss initially provided for five years (extended due to COVID-19 related revenue shortfalls). |
| Economic Impact | Cascading effect of taxes, fragmented market. | Simplified tax system, improved compliance, unified national market, boosting inter-state trade. |
While GST has streamlined tax collection and promoted a unified market, concerns persist regarding states' fiscal autonomy, particularly given the reliance on the GST Council for rate decisions and the cessation of guaranteed compensation. There have also been issues of rising cesses and surcharges (not part of the divisible pool) shrinking the actual share of states.
3. Finance Commission Recommendations (14th and 15th FCs)
- The 14th FC’s recommendation of increasing states’ share to 42% (later 41% by 15th FC) in the divisible pool was a significant step towards untied funds, granting states greater fiscal space and flexibility.
- Performance-based grants (e.g., for power sector reforms, urban local bodies, population management) incentivise states to achieve national objectives.
- The 15th FC recommended a fiscal roadmap aiming to reduce the Centre's fiscal deficit to 4% of GDP by 2025-26 and for states to 3% of GSDP by 2023-26, along with a review of the FRBM Act.
4. Centrally Sponsored Schemes (CSS)
- Despite the higher devolution, CSS continue to be a significant channel of transfers, often coming with conditionalities that may limit states' flexibility in spending according to their specific needs.
- However, there has been some rationalization of CSS, providing states with more flexibility.
Conclusion
The Centre-State financial relations have undeniably evolved from a centralized, plan-driven model to a more rules-based, cooperative framework. Reforms like the GST and NITI Aayog have institutionalized mechanisms for joint decision-making and increased untied resource transfers, strengthening fiscal federalism. However, challenges such as the erosion of states' fiscal autonomy under GST, the continued dominance of conditional Centrally Sponsored Schemes, and the increasing use of non-shareable cesses and surcharges by the Centre highlight ongoing tensions. A truly robust fiscal federalism in India requires a continuous balancing act between national priorities and state autonomy, fostering trust, transparency, and a genuine spirit of collaborative governance.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.