NDA hits reset on fiscal federalism

Devolution of taxes alone will not usher in a new federal set-up; it’s time for fiscal federalism to be linked to resource federalism


Finance minister Arun Jaitley. Photo: Ramesh Pathania/Mint
Finance minister Arun Jaitley. Photo: Ramesh Pathania/Mint

The federalization initiatives of the Bharatiya Janata Party (BJP) government have been led by the past two budgets of Union finance minister Arun Jaitley.

The Union budget for 2015-16 was arguably independent India’s first federal budget. No budget in recent or distant history transferred financial resources to the states in the method and magnitude that this budget did. It was not the quantum of resources that was significantly higher but the entitlement, ownership and certainty that it gave the states about these resources.

Gone were the tedious negotiations from a subservient position with the Planning Commission and its highly arbitrary plan financing. It can be easily shown that much of the fiscal mess in the states was a direct result of the mythical plan financing scheme that had become so convoluted over time that it had lost not only its relevance but also its meaning.

In policy terms, the biggest reform undertaken in this budget, which is not readily evident, is that public expenditure policy has now been moved decisively and firmly to the jurisdiction of the state governments. This, along with the ongoing trend in decentralization of fiscal policy, including the taxation policy, will alter the design of fiscal federalism in India.

Over time, the system will attain equilibrium with revenue raising being centralized thereby availing of the efficiency gains, and the expenditure management resting with the states resulting in major gains in allocative efficiency.

After laying the foundation of the union of states budget, the finance minister followed it up by another landmark budget that decisively empowered the third tier of governance. The single most important budgetary initiative in the 2016-17 budget that would radically change the political economy of the country was the allocation of nearly Rs.3 trillion to gram panchayats. The two in tandem are a game-changer for federalization.

There are 250,000 panchayats in the country that will now get almost Rs.1 crore every year. This is by far the most important measure for the democratization of public spending in India. Over the next five years, if state governments understand the value of this move and supplement it, the entire public expenditure policy of the country will change for the better.

This direct statutory allocation from the centre to the gram panchayats, based on the recommendations of the 14th Finance Commission, strengthens the third tier of governance by giving it financial empowerment and autonomy. The statutory funding of gram panchayats will give the village democracy—galvanized by the passage of the 73rd constitutional amendment in 1993—a decisive transformative push.

Allocating almost 15% of the Union budget to panchayats will be the beginning of effective village governments and governance in India. Gram panchayats will now discharge their responsibility for maintaining local amenities such as village roads, drains, street lights and drinking water facilities, and for identifying beneficiaries for federal and state poverty alleviation programmes. And these things matter in not only changing the quality of lives but also improving market access to the rural enterprises.

There is no denying the fact that local governments are better placed than, say, centrally appointed bureaucrats to identify and respond to villagers’ needs. The villagers who are on-spot stakeholders will find it much easier to ensure better monitoring. This will improve the efficiency of public expenditure.

To see it in a larger context, the democratization of public expenditure can lead to a democratization of the public service delivery system, which has been a crucial missing aspect in the Indian decentralization experiment.

Barring these structural changes on the fiscal front, Prime Minster Narendra Modi’s agenda is limited to the operational governance challenges faced by states in a federal set-up. Obviously, his views on this matter have been formed by his decade-long stint as a chief minister and that too from an opposition party to the one at the centre.

The clearest exposition of his thinking thus far on the issue of federalism is in his Republic Day message in 2012: “A vast and diverse country such as ours cannot survive without a vibrant and functional federal structure. Sitting in New Delhi, the centre may not always be able to do justice to the potential and needs of various states across India. By virtue of being closer to the people, state governments can respond much better in understanding and fulfilling the expectations of the people through good governance.”

To a certain extent, this goes against the view held by the BJP as a party that has traditionally been a votary of a powerful centre. So, a greater depth of federalism will be seen as a weakening of the centre, though it need not be so. Going beyond the operational irritants of centre-state relations, there are compelling systemic reasons to restructure the federal set-up in India.

What is, of course, adding tailwind to the federalization initiatives of the BJP is the juncture at which they have come to power at the centre. The existing framework of centre-state relations was conceived, designed and operated in the pre-liberalization era. The underlying logic of governance was control and it was this mindset that determined centre-state relations. Now, with the economy having been liberalized for 25 years, the institutionalized unitary framework is constraining the growth prospects of various regions and sub-national economies. Hence, a systemic pressure of decentralized decision is building up for greater federalization.

Economic reforms changed not only the macroeconomic policy framework, by assigning a greater role to the market, they also redefined the role, quality and instrumentalities of government intervention at all levels. In such a situation, local interventions are becoming more relevant and purposeful driven as they are by local interests and provide for regional diversities.

In the new situation, state governments have had to reorient to provide public services to cater to the diversified demand conditions prevailing in different regions and to regulate and monitor the functioning of the market.

The fiscal federalization has also been nudged along by the growing regionalization of politics in the country. To assert their power and political clout, states have been asserting in different ways, for instance, by building entry barriers and becoming protectionist. Be it the entry tax on goods entering or passing through West Bengal, or the tax on crude oil in Uttar Pradesh, or the so-called export duty on iron ore in Goa.

These fiscal measures apart, even physical controls are being enforced. All this adds up to a restrictive policy of economic protection and threatens not only the federal set-up, but also the overall macroeconomic regime. The cooperative federal system that is being envisaged can become competitive federalism in a negative sense and even coercive.

In such a situation, the type of consultative federalism being advocated by Prime Minister Modi will not be sufficient to reform the system.

The need for a systemic solution arises from the fact that under such a situation, the logic of a federation undergoes a change. As such, what should the design of the new federal framework be?

Economic liberalization has caused huge regional imbalances across states. But state governments have no instruments to redress these imbalances. The constitutional assignment of powers to states has to be meaningful such that the sanctity of state taxes is maintained. All lucrative and revenue-yielding taxes are with the Union government; all poor country cousin taxes are given to the states.

As such, devolution of financial resources alone will not usher in a new federal set-up, which is in line with the needs of the new emerging economy in India. It’s time for fiscal federalism to be linked to resource federalism.

In the market-led economy, natural resources—minerals, oil, natural gas and hydropower—are the key revenue drivers of, and major constraints to, growth and its spread across the sub-national economies. This requires a framework for resource revenue-sharing in addition to the transactional revenue-sharing that is being done.

In the post-reform era, state governments have had to reorient to provide public services to cater to the diversified demand conditions prevailing in different regions and to regulate and monitor the functioning of the market. This has shifted the focus of governments from direct participation and distribution activities to one of enabling and regulating provision of services.

Assigning a greater role to the market in economic activity has necessitated diffusion of the economic power of the central government, and more active participation of sub-central governments in the regulatory system.

At present, most of the regulatory powers are vested with or are subservient to the Union government. This needs to change.

This institutional structure was designed at a time when the Union government was the principal driver of development. In the planned economy with quantitative controls, fiscal policy was geared to finance investment by raising the level of domestic savings, and transfer household savings to public investment. This had a major impact on the operation of the fiscal federal system.

Today, the situation is radically different. It is no longer public investment, but private investment that is driving development, helped by a liberalized domestic and foreign investment regime. And hence the need for sharing regulatory power.

This alternative framework can start with a fair scheme for distribution of resource rents, but must eventually graduate to a more robust and institutionalized system of resource federalism. In doing so, the future finance commissions must capture the changes needed in a fiscal federal set-up to work in an open, but regulated, market economy as against a closed controlled one, the vestiges of which remain in this segment of the economy.

Haseeb Drabu is the finance minister of Jammu and Kashmir.

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