Toward a new paradigm of fiscal federalism

The resolution passed by the Karnataka Assembly on the unfair tax devolution treatment to the state by the Union government is not without significance. It echoes the sentiments of other similarly placed southern states.

It draws attention to the asymmetry in tax devolution and the principles determining the states’ share of taxes.  The concerns of the South have been summarily dismissed by the Union government, with Prime Minister Narendra Modi alluding to attempts by some parties to divide the country. Such a response is naive at best and myopic at worst. 

India is on a growth trajectory now, not unlike the miracle economies -- the ‘Asian Tigers’ -- in previous decades. This growth has been driven by science and technology, demographic transition, and the accumulation of human and physical capital built up over decades. But above all, we must credit our democracy, and within it federalism, for this remarkable progress.

The states of India have contributed in substantial measure to the India development story, as much as the Union government has. Therefore, while acknowledging regional disparities in the country, in our quest to strengthen the weak states, we must not weaken the strong states. Simply put, don’t kill the geese that lay golden eggs.

Fiscal federalism constitutes one of the most important bridges for the allocation of rights and duties related to taxation and expenditure and helps address vertical and horizontal imbalance. Vertical imbalance reflects the fiscal asymmetry in the powers of taxation vested with the Union and the states in relation to their expenditure responsibilities as mandated by the Constitution.

The Union government has a far wider domain to raise taxes: income taxes -- personal and corporate, taxing consumption of goods and services (CGST), taxing foreign transactions (exports/imports), and capturing natural resources rents, such as on telecom spectrum auction. In contrast, post-GST, the state governments may only tax the consumption of goods and services (SGST). 

Consequently, the Union government mobilises about 60% of the taxes while its expenditure to discharge its constitutionally mandated responsibilities, such as defence, external affairs, etc., is estimated at about 40% of the total public expenditure. 

The states in India are the theatres of development action, with responsibilities for agriculture, education, health, women and child development, rural development, and social protection and welfare. This casts considerable fiscal demands on the states.

Horizontal imbalance arises because of the vast regional imbalances in terms of incomes, infrastructure, and social capital endowment. This is exacerbated by the differences in the levels of effective governance.

Therefore, India’s fiscal transfer principles adopted by successive Finance Commissions -- giving priority to equity over efficiency is inarguably progressive; and by using population and income distance as the criteria, they advance the dictum ‘from each according to its ability, to each according to its need’.

But within the broad equity principle, efficiency and performance parameters plummet so low in the devolution formula that two regressive facets emerge that should not be lost sight of:

First, when the equity principle is applied in the aggregate, it often misses ground truths that are iniquitous. But let me first get the untenable argument out of the way: The argument that Karnataka, for instance, gets back only 46 paise for every rupee it contributes while Uttar Pradesh gets Rs 1.79 against each rupee it contributes is specious simply because in per capita terms, Uttar Pradesh and Bihar get much less than Karnataka or Kerala. However, it is worth noting that there are regions within states such as Uttar Pradesh which are richer compared to some sub-regions in the South. Paschim Pradesh or even Awadh Pradesh, for instance, is richer in per capita consumption terms (an indicator for income) than the Kalyana Karnataka region. 

Second, as in the case of the Union, the states too have development expenditure responsibilities that require a certain minimum fiscal resource value regardless of the population, and that should not be predicated on per capita calculations. In addition to the demand for welfare spending, the fiscal needs of the southern states have been rising rapidly owing to the ageing population, considerable in-migration from the poorer states and regions of the country, and increasing pace of urbanisation. Just as the Union places a 40% pre-emptive weight to its commitments, it is time that floor-level devolution is defined for every so-called rich state also, guaranteeing a minimum share of, say, 40% against the contribution it makes. This can be the premium on efficiency. And per contra, a ceiling is defined for every so-called poor state of, say, 150% against the contribution it makes. This can serve the equity principle.

Third, the introduction of the GST was a ‘grand bargain’. However, the current GST regime is a weak pillar of fiscal federalism and needs reform. The move from the principle of origin of goods and services to the principle of destination has reconfigured the balance of power amongst states. Yet, the federal fiscal transfer system continues to be designed for, and is based on, the principles of jurisdictional separation that is germane to the era of origin-based taxation.

This dichotomy between the operational tax regime and the principles of tax sharing is inimical to fiscal federalism. It is time to rethink the architecture and the operational principles of the GST. The GST must have comprehensive coverage, and one single rate for both goods and services. Adopting a single rate of, say, 12%, equally shared as CGST and SGST, will also be in line with best international practice. This will improve compliance, remove distortions, and promote growth.

Finally, there has been a 133% rise in collection of major cesses and surcharges levied by the Union government on various products during the five-year period between 2017-18 and 2022-23. Surcharge on taxes and duties and cesses account for about 25% of the total taxes but are excluded from being distributed to the states. This tendency to grow the cess-surcharge route runs counter to fiscal federalism. 

There is much for the Union and the states to think about; perhaps a new paradigm for fiscal federalism in India.

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