Adhere to principles of fiscal federalism

Fiscal federalism should be about good economics, not bad politics. Do our leaders have the sagacity?

India’s fiscal federalism, though asymmetric, has so far worked well to maintain macroeconomic stability and drive economic growth. There are well-designed and structured mechanisms of fiscal transfers from the Centre to the states to address resource constraints faced by the latter.

Fiscal transfers from the national government address the vertical imbalance by compensating sub-national governments for differences between incurred expenditures and own revenues. The channels of these transfers are statutory as well as non-statutory. Yet, more recently, the asymmetry has begun to show signs of stress. The vertical asymmetry has, in practice, resulted in disproportionate allocations of revenue sources and responsibilities to be discharged by the Union and the states, adversely impacting the fiscal capacity of the state governments in discharging their constitutionally-mandated responsibilities.

Three recent instances of the stress in fiscal federal relations are worth noting as signs of a problem that go beyond issues of allocation of revenues and expenditure, fiscal responsibility, or even macroeconomic stability. The face-off between three states in the South -- Kerala, Karnataka, and Tamil Nadu -- and the Union government has resulted in petitions in the Supreme Court of India, no less, with the states seeking a judicial remedy to what are essentially matters of executive decisions. On and off, there have been similar conflicts in the past but political-economy factors and the principle of cooperative federalism always played a role in their resolution.

The disputes centre on Article 293, which confers executive power on the states to borrow money within limits prescribed by the respective state legislature. It also allows the Union to extend loans and guarantees to the states, and requires the Centre to give its consent and impose conditions for states to raise further loans while earlier ones are outstanding. Under Article 275 of the Constitution, Finance Commissions recommend conditional or unconditional grants-in-aid to help states provide comparable levels of services, at comparable tax rates, while ensuring a budget balance in the revenue account. However, transfers based on a gap-filling approach can also cause moral hazard issues since the state
governments can then afford to be
fiscally profligate.

Consider the following: Kerala moved the apex court last year on what the state considered was the Union government arbitrarily imposing a Net Borrowing Ceiling (NBC) on the state. It challenged the imposition by the Union government of the ceiling on the amount it can borrow, saying this had pushed the state finances to the point of a grave crisis. Therefore, the state argued, the Union government’s decision was violative of the principles of fiscal federalism. The Union government countered that if states indulge in reckless borrowing to finance unproductive expenditure or poorly-targeted subsidies, it will crowd out private borrowing from the market. It also pointed out that the Union government keeps in mind the overall objectives of macroeconomic stability of the country as a whole and fixes a borrowing limit for the state seeking its permission, under Article 293(4). 

At the heart of the dispute are certain amendments made to the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, that imposed borrowing limits on states. A 2018 amendment to the Fiscal FRBM Act capped the ‘general government debt’, or the sum total of the debts of the central and state governments, at 60 per cent of GDP.

The Union government argues that public finance being a national issue, it wanted to prevent the use of off-budget borrowings to bypass the borrowing ceiling, a common practice resorted to by some states.

Soon after, Tamil Nadu approached the apex court. The Union government, it argued, was giving a ‘step-motherly’ treatment to Tamil Nadu by delaying the release of disaster relief funds to the tune of nearly Rs 38,000 crore that the state had sought to deal with the twin natural disasters it had faced -- cyclone Michaung and the unprecedented floods in the state’s southern districts. 

More recently, Karnataka also petitioned the Supreme Court against what it termed as inordinate delay by the Union government in considering the state’s request for financial relief to meet the “grave humanitarian crisis” brought on by widespread and unrelenting drought. The state had sought Rs 18,171 crore under the National Disaster Response Fund (NDRF) over six months ago, only to be met with silence. It argued that the inaction of the Centre violated the statutory scheme of the Disaster Management Act, 2005.

How much of the dissonance in the fiscal federal relations is politics and how much economics is worth reflecting on. The problem gets compounded by the fact that since monetary controls are with the Union government, it can -- in fact it does -- use them to counterbalance any fiscal profligacy committed on account of political expediency. Equally, on its part, it does so for political expediency, when dealing with Opposition-ruled states. On both counts, such fiscal measures are politically sensitive and hence contentious. There is empirical evidence that fiscal transfers do not necessarily succeed in bringing about revenue equalisation or augmenting the fiscal capacity of states but do often become instances of the Union government transgressing into the fiscal space of the states.

The renewed concern with issues of allocation of resources and expenditure must draw our attention to state and local finances because in a large country like ours, it is the states that are the theatres of human development action and where the provision of social goods primarily occurs. The essential point is that certain specific services -- drought relief or flood relief -- must be considered as being of particular merit from the national point of view and hence to be deserving of special and expeditious support. In times of crises, the Union government cannot fail to recognise the inescapable result of the fiscal distress that several states find themselves in.

Fiscal federalism should be about good economics, not bad politics. Instead of governments litigating against each other, we need to adhere to time-tested principles of fiscal federalism: fiscal discipline, reciprocity,
and the common objective of supporting merit goods. Do our leaders have the sagacity?

(The writer is Director, School of Social Sciences, M S Ramaiah University of Applied Sciences)