India needs stronger fiscal federalism

Former Prime Minister Manmohan Singh urged the government of India to do more to enhance the spirit of cooperative federalism. His comments were in the context of the changes made to the terms of reference to the Fifteenth Finance Commission. These changes were made in July, quite late in the tenure of the FFC, and especially when the final report was expected by the end of October. The FFC has been given one more month, presumably to accommodate the changes in its mandate. These changes were made unilaterally by the Central government, whereas Dr.Singh said State Chief Ministers should have been consulted. The issue is that the Central government wants the FFC to examine ways of enhancing Union budgetary support for military and internal security, through funding which is non-lapsable.  

One could go into the merits of this particular issue. Increased allocation to the Centre means less allocation to the States. So, this change in mandate has a material impact on the FFC’s final recommendations. Moreover, of the internal security budget more than 81% is spent on the police which is a State subject. Under the constitution, the police and public order are State subjects. But the Centre runs seven different armed police agencies plus the Delhi police. This is to help States ensure better public order, fight extremism and also modernise the State police. Of course, there is substantial expenditure on intelligence gathering by the Central government too. 

Over the past decade the union budget allocation for the Ministry of Home Affairs which oversees internal security, has grown at a compound annual growth rate of 12% per year. It is one of the fast- growing segments of the Union budget. Due to fiscal constraints this allocation has grown only 5.1% this year, and this is possibly one reason why the FFC was asked to find a more secure funding option. But this raised the concern, that the FFC will cut down the share of States, which anyway are struggling to fund their own State level policing expenses. As such the fourteenth finance commission had significantly increased the allocation to States which may have to be attenuated by the 15FC. We will find out in the next three months.

The larger point however is of fiscal federalism. The fact is that two third of all government expenditure happens at the State or local government level, but they have only one third of revenue raising autonomy. Hence the gap has to be filled by a constitutional mechanism called the Finance Commission. In a truly federal setup, we would not have such a large divergence between obligations and resource raising power. The rollout of the nationwide Goods and Services Tax (GST) also involved voluntary surrender of taxing powers.

The States agreed to give up their power to impose VAT (sales tax), and the Centre gave up its power to impose excise and services tax. It was supposed to be a grand bargain to eventually increase GDP growth, reduce tax evasion, increase collection buoyancy, reduce tax rates and inflation. The sharing of GST revenues was to be 50:50 at least for the CGST and SGST. Why 50:50 you may ask? Why was the 60:40 ratio, in favour of States, not put in at the design of the GST revenue sharing itself? This gap, that has now to be filled by the Finance Commission would have been smaller. But we are stuck with 50:50. There is of course the IGST which also has to be shared with the States, but that formula is opaque. To swing the grand bargain, the initial launch of GST included a promise to the States to fund any shortfall in the GST collection share going to the States for three years. They were in some ways guaranteed an increase of indirect taxes by 14% every year. This is turning out to be a costly promise, and the way forward is not clear.

Just like the demand for a secure, non-lapsable funding for internal security and police, is the issue of Ayushman Bharat, or the Prime Minister’s Jan Arogya Yojana (PM-JAY). Health too is in the State list. But the universal health insurance scheme announced by the Centre, which aims to cover 10 crore households or nearly 500 million people, will also impose health related expenditure at the State level. The health insurance is subsidised, and most States are adopting the “trust based” model, and not bidding it out to private players. Which means that the State exchequer will have to bear an incremental cost, since the scheme envisages a 60:40 cost sharing. The scheme is being hailed as revolutionary and unique in the world. In the absence of a Western style social security system, such a health insurance scheme is indeed welcome. How to fund it? If the States’ revenue raising capacity or power is not increased, it will have to be funded from the share as per the FFC recommendation.  Which means that the FFC cannot diminish the share going to the States, as compared to the previous commission.

The above two examples from health and the police, are among many others, which illustrate the challenge of ushering genuine fiscal federalism in India. Of course, unlike the United States, India is not a federation of States which came together. States of India are creations of the Centre, and who knows in the coming years we may have 50 different states like America. But unless the lower tiers of governments also have sufficient revenue raising powers, the funding gap will only increase. Three suggestions toward a possible solution are as follows. One is, change the GST sharing ratio from 50:50 to 60:40 in favour of the states, as described above. Second, expand the ambit of tax autonomy to lower levels, including a property taxation at the third tier.  Third, amend the constitution to carve out a part of the consolidated fund to secure funding for local self governments, without any discretion at the State government level. This too will strengthen the spirit of cooperative federalism. After all, people are concerned most about the government which is nearest to them.

( Dr.Ajit Ranade is an economist and Senior Fellow, Takshashila Institution)