Stronger fiscal federalism

For better governance

Former prime minister Manmohan Singh recently urged the Centre 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 15th Finance Commission (15FC). These changes were made in July, quite late in the tenure of the 15FC, and especially when the final report was expected by the end of October. The 15FC has been given one more month, presumably to accommodate the changes in its mandate. These changes were made unilaterally by the Narendra Modi government, whereas Singh said state chief ministers should have been consulted. The issue is that the Centre wants the 15FC 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 15FC’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 Centre, 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 15FC was asked to find a more secure funding option. But this raised the concern that the 15FC would cut down the share of states, which are already struggling to fund their own state-level policing expenses. As such, the 14th 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. Fact is, two-thirds 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 set-up, 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 into the design of 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 secure, non-lapsable funding for internal security 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 100 million 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 15FC recommendation. Which means that the 15FC 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 that 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. The 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. Two, expand the ambit of tax autonomy to lower levels, including property taxation at the third tier. Three, 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.

(The writer is an economist and Senior Fellow, Takshashila Institution)

(Syndicate: The Billion Press)