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[Indian Journal of Federal Studies]









Indian Journal of Federal Studies

Fiscal Federalism: Some Current Concerns

 - C. Rangarajan

[ Fiscal dimensions of federalism are only a reflection of the political federal structure. The traditional concerns of fiscal federalism such as the assignment of taxes and responsibilities as well as the correction of vertical and horizontal imbalances continue to remain important. But, fiscal federalism must enable national and sub-national governments to operate in such a way that it leads to efficiency in the use of resources. This improvement in efficiency must be reflected not only in the services provided by the various levels of Government but also in creating an environment in which all economic agents use resources efficiently. . ]

Two sets of factors have pushed to the fore contemporary discussions on federalism. First is the impact of globalisation and the growing integration of countries on the way federal structures function. If we are moving towards a borderless world, how much boundaries within a country matter or should matter? Federal structures will have to undergo a change in order to be able to respond to the forces of globalisation and international competition that emerges as a consequence. Globalisation is also occurring at a time when the respective roles of government and markets are being re-written. Private sector and markets are being given a larger space in which to operate, even in countries which have been traditionally state- centered. The role of State as a producer of marketable goods and services is being de-emphasized. However, this has not diminished the role of the government. As is being somewhat paradoxically remarked: "More market does not mean less government but only different government". The critical question is in what way this Government is different. Obviously the increasing role of market does alter the rules of the game for the government as a whole and for different levels of government. The second set of factors relates to another trend where the advantages of de-centralization are being emphasized. There has always been a school of thought which has emphasized the importance of sub-national governments and local bodies as an essential part of the democratic process. The Seventy Third and Seventy Fourth Amendments to the Indian Constitution in 1988 giving explicit recognition to the roles of local bodies in the governance process are reflective of this trend. Similarly, in the United Kingdom, both Scotland and Wales have their own regional parliaments.
Federalism -as a form of government

Federalism is an old concept. Its origin is mainly political. I am neither a political scientist nor a constitutional expert to be able to trace fully the evolution of federalism in various countries. It is, however, well known that the efficiency of government depends, among other factors, on the structure of government. Federalism as a form of government has, therefore, been concerned with functions and instruments that are best centralized and those that are best placed in the sphere of de-centralized levels of government. Particularly, in large countries, it has been felt that sub-national governments are required and that only a federal structure can efficiently meet the requirements of people from different regions. Underlying this proposition is the premise that preferences vary from region to region. Thus the rationale of federalism lies in promoting welfare through decentralization and sub-national autonomy in combination with the benefits of a large market and size.

In our own country during the Independence Struggle, provincial autonomy was regarded as an integral part of the Freedom Movement. However, after lndependence, several compulsions including Defence and Internal Security led to a scheme of federalism in which the Centre assumed greater importance. Also in the immediate post-Independence period when the Centre and all States were ruled by the same party and when many of the powerful provincial leaders migrated to the Centre, the process of centralization gathered further momentum. Economic planning at a nation-wide level and the allocation of resources by a central authority also helped this centralizing process. The size of the States in India is largely determined by language. After the formation of linguistic States, the size and population of a State is determined by the number of people speaking the same language. However, more recently in large States where people are speaking the same language, demands have been made for dividing them on grounds of regional neglect. Some of these demands have also been met. A similar evolutionary process has been noted elsewhere. Even in the American case, there has been a transition from the earlier era of 'dualism' where the two tiers had comparable responsibilities to growing centralization, which according to some writers has passed through successive phases of 'centralizing federalism' to 'cooperative federalism', and more recently, to 'creative federalism' where the Central Government continues to take an active part in the State and local problems.

Fiscal Federalism

Fiscal federalism is the economic counterpart to political federalism. Fiscal federalism is concerned with the assignment, on the one hand of functions to different levels of government and on the other with appropriate fiscal instruments for carrying out these functions. It is generally believed that the Central Government must provide national public goods that render services to the entire population of the country. A typical example cited is Defence. Local governments are expected to provide goods and services whose consumption is limited to their own jurisdictions. The argument here is that output of such goods and services can be tailored to meet the preferences and circumstances of the people in that jurisdiction. Such a process of de.centralization enhances the economic welfare above that which could result from the more uniform levels of such services that are likely under a centralized regime. Apart from the provision of national public goods, the Central Government is to be vested with the responsibilities for economic stabilization and for income re- distribution. While income re-distribution to some extent is possible even within sub-national government jurisdictions, a truly re- distribution effort is possible only at the national level. An equally important question in fiscal federalism is the determination of the specific fiscal instruments that would enable the different levels of government to carry out their functions. This is the 'tax-assignment problem' which is djscussed very much in the literature. In determining the taxes that are best suited for use at different levels of government, one basic assumption that is made is in relation to the mobility of economic agents, goods and resources. Very often it is assumed that while there is no mobility across national barriers, there is a much greater mobility at de-centralized levels. This proposition holds good only partly in an era of globalisation. Once again, it is generally argued that the de-centralized levels of government should avoid non-benefit taxes on mobile units. This has the implication that Central Government should have the responsibility to levy non-benefit taxes and taxes on mobile units or resources. Building these principles into an actual scheme of assignment of taxes to different levels of government in a Constitution is indeed very difficult. Different Constitutions interpret differently what is mobile and what is purely a benefit tax. For example, in the United States and Canada, both federal and state governments have concurrent powers to levy income-tax. On the contrary, in India, income-tax is levied only by the Central Government though shared with the States. It is interesting to note that the revenues collected by the Federal or Central government vary very sharply among different countries. For example, the federal government collects 69% of the total revenue in Australia, 65% in India and 48% in Canada. Thus, the traditional issues in fiscal federalism have been how to determine the assignment of taxes and responsibilities to different levels of government. Recognizing, the possibility of imbalance between resources and responsibilities, many countries have a system of inter governmental transfers. In fact, inter governmental transfers constitute a distinctive economic policy instrument in fiscal federalism. For example, inter-governmental transfers as a percentage of provincial or state revenues have been 41 % in Australia, 40% in India and 20% in Canada in recent years. Correcting vertical and horizontal imbalances has been a major concern with which fiscal federalism has wrestled with. While actual designs of fiscal transfer systems differ across federations, these constitute experiments in search of satisfying the twin objectives of equity and efficiency in a multi-tiered system of government. Conceptually, the emphasis has been on providing enough resources at the sub-national tevel to ensure provision of a set of services at comparable or minimum acceptable levels in all jurisdictions. This attempt at 'equalization' impedes the search for efficiency through relocation of households and firms, but is justified on the grounds of congestibility of service provision and on ethical grounds such as those related to equity. There has also been a consideration of rigidities in the mobility of households, which may itself be a function of education, which is one of the services considered for equalization.

Fiscal Transfers

Let me further elaborate the implications of these 'old' issues on fiscal federalism in the Indian context before I move on to some of the newer Issues.

The roots of fiscal federalism in India go back to the Govt of India Acts of 1919 and 1935. While the Act of 1919 provided for a separation of revenue heads between the Centre and the Provinces, the 1935 Act allowed for the sharing of Centre's revenues and for the provision of grants-in-aid to Provinces. The Indian Constitution carried these provisions a step forward by providing for a Finance Commission to determine the distribution between the Union and the States of the net proceeds of taxes and the grants-in-aid to be provided to the States which are in need of assistance. While the Constitutional provisions relating to the functions of the Finance Commissions have remained unchanged, one notable change in the framework of federal fiscal arrangements was brought out by the 80th Amendment which broadened the ambit of the sharable Central taxes. The enlargement of the sharable pool to cover all Central taxes except those listed in Articles 268 and 269 and earmarked cesses and surcharges, has enabled States to share in the overall buoyancy of taxes. It has also provided greater stability to resource transfers as fluctuations in individual taxes are evened out. With the 73rd and 74th Amendments to the Constitution which have provided constitutional support to the process of decentralization, the Finance Commissions are also required to suggest measures to augment the resources for the panchayats and municipalities.

The Indian Constitution lays down the functions as well as taxing powers of the Centre and States. It is against this background that the issues relating to the correction of vertical and horizontal imbalances have been addressed by every Finance Commission, taking into account the prevailing set of circumstances. Central transfers to States are not, however, confined to the recommendations of the Finance Commissions. There are other channels such as those through the Planning Commission as well the discretionary grants of the Central Government. The Eleventh Finance Commission recommended that 29.5% of the net proceed of the sharable taxes should go to the States. It suggested that in the over all scheme of transfer, 37.5% of the gross revenue receipts of the Centre should be transferred to the States. One important issue that has been raised in this regard in the light of the recent changes of the economic policy aimed at liberalization is whether the vertical imbalance has increased or decreased. At least one State Government has argued before the Twelfth Finance Commission that assigning a greater role to the market, in economic activity has diminished the function of the Central Government as compared with State Governments. The shift in economic policy has altered the functions of the both Central and State Governments. While the constitutionally mandated functions have remained the same, the emphasis has changed. It is not clear whether the shift in economic policy has necessarily increased vertical imbalance. However, this is an aspect which needs 8 fuller consideration.

Fiscal transfers require to be guided by certain definitive principles. Most analysts agree that a good transfer system should serve the objectives of equity and efficiency and should be characterized by predictability and stability. Equity can be conceptualized and understood in a number of ways both with respect to its vertical and horizontal dimensions. The considerations that should go in determining the distribution of transferred resources among States have been examined in great length by the various Finance Commissions. Equity issues have dominated such discussions as they should be. The effort has been to identify variables which reflect the equity concerns. Equity factors have had a maximum weight in resource transfer formulae. In designing a suitable scheme of fiscal transfers, three considerations seem relevant -needs, cost disability and fiscal efficiency. Needs refer to expenditures required to be made but not met by own resources. Cost disabilities refer to such characteristics of a State that necessitate more than average per capita cost in service provision due to factors that are largely beyond its control like large areas with low density of population, hilly terrains, poor infrastructure, proneness to floods and droughts. Fiscal efficiency encompasses parameters like maintaining revenue account balance, robust revenue effort, economies of expenditure linked to efficient provision of services and the quality of governance. Equity considerations must in effect aim for ensuring the provision of selected services at minimum acceptable standards across the country. It is seen that on average, the low income States spend only half of the average per person expenditure of high income States in social services. In a competitive environment, States that are able to access the market better are likely to grow faster than others. The growth experience of the 1990s shows that developed States with broad industrial base and developed market institutions and infrastructure have perfOm1ed much better than those without them. The transfer system has also to take this factor into account. At the same time, 'efficiency' in the use of resource should be ensured and promoted. States that perform more efficiently in the delivery of services or raise more revenues relative to their tax bases should not be penalized. The task of formulating a sound transfer system has to establish a fine balance between equity and efficiency, a system where fiscal disadvantage is taken care of but fiscal imprudence is effectively discouraged.

Competitive and Cooperative Federalism

Much of the mainstream literature on federalism assumes that (i) governments are run by altruistic agents and are essentially benevolent and (ii) different units of the government have essentially a co-operative relationship. Thus, federalism and its corollary - decentralization is supposed to bring in welfare gains. One school of thought has argued that ideas of co-operative federalism founded on these premises do not always function efficiently and Coasian bargains do not always work.

Existence of competitive relationship between governmental units is a key feature of the literature on competitive federalism. Existence of competition brings in the importance of transaction costs of coordinating policies and their implementation vertically between different levels of government and horizontally between different units within each of the levels. it looks at the system of checks and balances and in such a system, explores the pre-conditions for achieving efficient intergovernmental competition. The efficiency is not merely in terms of providing public services but also in creating a favourable environment in which the markets can function. It is also argued that governments tend to emulate policies of other governments, and the voters and opposition parties benchmark performances of other governments and pressurize their own governments to emulate them. The American tradition is focused more on inducing efficiency by the process of 'voting by feet' where households or firms locate themselves in those jurisdictions where the mix of the publicly provided 'goods is closer to their preferences. In the original Tiebout formulation, jurisdictional competition leads to increase in efficiency through 'sorting and matching'. Others have suggested that such inter-jurisdictional competition may also serve as a disciplinary device to punish inappropriate market intervention by lower governmental officials.

There is a parallel development in the federalism literature from the potitical science perspective and that is called the "market preserving federalism". This approach, however, assumes that the various levels of government have a common philosophical approach to the importance of the market. Obviously, if there is a convergence of opinion on the role of the markets, it follows, that the structure must reflect this philosophy and try to act in a way in which the markets are allowed to function effectively. You may recall the famous book in management literature entitled "Strategy and Structure". An essential message of this book is that the structure of any corporate unit must flow from the strategy it has adopted to fulfill its objectives. Government interventions can be market-distorting or market- complementary. For example, administered prices are market- distorting, while a good legal system with enforceable contracts is market-complementary.

The extent and areas in which various levels of government in a country function in a competitive manner are to be determined partly empirically and partly by the nature of the Government structures. Sub-national governments such as State Governments in India, do compete for capital, both domestic and foreign. That is why the policy framework and infrastructural availability are key elements in this competitive process. However, this competition should not result in a 'race to the bottom' when the States taken as a whole suffer. In fact competition in tax concession leads to' serious erosion of revenues. With this realization, State Governments in India have come together to fix floor levels with respect to taxation and to reduce tax concessions. It is no doubt true, not only capital but also people will move to jurisdictions where the provision of services is better. However, one must recognize that there are areas in which such competition may have a limited role. With mobility of people constrained by various considerations, primary health and primary education are some areas in which competition is not possible. However, bench marking and rating sub-national governments, whether it be in terms of human development or fiscal performance or infrastructural facilities has had a beneficial effect. In some ways, competition and coordination have to co-exist.

In meeting the challenges of globalisation, the Indian federal structure must respond in such a way as to create in the first place a large common market within the country. Restrictions on movement of goods and various other impediments have to go. Reform of the tax system has become essential. Introduction of a nation-wide Value Added Tax will require a cooperative agreement among the States. While some States have expressed difficulties in introducing VAT, there is at least an agreement in principle to introduce VAT. We have to move faster in this direction.

The economic policy environment in India has undergone a fundamental change. Transition to an increasingly market based development and opening up of the economy to face global competition will require policy changes, creation of market institutions and a responsive de-centralized system of governance. The reform agenda of both the Centre and States should be calibrated in a coordinated manner in the spirit of cooperative federalism. At the same time, it is necessary to recognize that governmental units in the federation have also a competitive relationship. It is important to nurture this competition to secure efficiency gains. Thus, we need both coordination and competition and this makes the challenge formidable.

The traditional concerns of fiscal federalism such as the assignment of taxes and responsibilities as well as the correction of vertical and horizontal imbalances continue to remain important. However, it is necessary to take note of the changes in the environment in which Governments operate. Fiscal federalism must enable national and sub-national governments to operate in such a way that it leads to efficiency in the use of resources. This improvement in efficiency must be reflected not only in the services provided by the various levels of Government but also in creating an environment in which all economic agents use resources efficiently.

In fact fiscal dimensions of federalism are only a reflection of the political federal structure. Issues in federalism can be discussed at two levels. At one level, the existing arrangement can be taken as given and then one can proceed to discuss measures that would make the system more efficient and more responsive to the changing times. At another level, one can go deeper and try to re-examine the existing division of responsibilities and powers itself. However, the latter will require amendments to the existing Constitution, if changes are sought for.

{ The paper is based on the inaugural Address delivered by Dr Rangarajan at the Theme Conference on Distribution of Responsibilities in Federal Polities", organised by the Centre for Federal Studies, in Nov. 03, under the Global Project on Federalism sponsored by the Forum of Federations )


Copyright (c) Center for Federal Studies, Jamia Hamdard, New Delhi, India