Fiscal federalism has been variously defined. The main idea is a system whereby the federal government aims to achieve horizontal and vertical equity amongst the sub-national units of government in such a way that all have enough resources to provide the necessary social and economic facilities to every citizen, without encouraging either individuals or business to shift outside the state. Under the theory of fiscal federalism, a general framework allows for the assignment of responsibilities to the local governments that are closest to the people and so can understand local preferences. The result is that public goods can be delivered efficiently at the least cost. This would mean that the resources required to meet these responsibilities are also assigned to them.

In the modern era, globalisation with its consequent economic integration, large-scale movement of capital between countries, foreign direct investment, and on many occasions the movement of workers leads to regional economic imbalances. The results are not far to seek. Some states develop faster than the rest, giving rise to political problems in the relatively underdeveloped areas. India is no exception and one could directly ascribe the emergence of strong regional parties to local economic—and political—ambitions. This then gives rise to the federal government tending to become stronger with greater responsibilities to make laws and to regulate the new sectors of economic and social activities. In this process, the central government inevitably garners more resources than are available to the states. This seems to be inevitable but undesirable and has been universal across federations.

One of the central principles in a federation is that responsibilities are allocated so that they are implemented to maximise welfare of the people. Ipso facto, this means that the resources needed for this purpose are accordingly assigned to the units of government that assume the responsibilities. The functions that require maximum resources are education, health, roads, transport, irrigation, power, agriculture and, in most cases, industries that generate skilled employment. The central government has to be responsible only for defence, macro-economic policy, foreign policy, the postal service, and currency and coinage. But with the emergence of the welfare state and growing imbalances in the regions, the central government, to correct these imbalances, has—in many federations—had to step in with various schemes and projects falling within the sphere of the local governments with conditions attached to financial grants for specific projects. Regional governments abhor such tied grants as they restrict their political freedom to act.

It is interesting to note an observation in the case of Australia. According to one researcher, “as the welfare state developed, the Commonwealth wished more and more to intervene in policy areas that were constitutionally reserved to the states. The scope to do so by constitutional amendment being extremely restricted, it did so by tied grants, known in Australia as special purpose payments (SPPs). An SPP offers a grant to a State in a policy area that is constitutionally in the State’s domain, but with Commonwealth conditions attached” (Fiscal Federalism in Australia, Iain Maclean, 2002 version). This is the equivalent of the centrally sponsored and central sector schemes in India, mostly financed out of central plan funds, in regard to responsibilities that are those of the local governments.

In Australia, problems similar to India’s—of vertical imbalance in revenues as between the centre and the states and among the states—have not been solved satisfactorily. In fact, there was even a demand for doing away with the Commonwealth Grants Commission, which would periodically make recommendation on sharing of resources. 

In Australia, problems similar to India’s—of vertical imbalance in revenues as between the centre and the states and among the states—have not been solved satisfactorily. In fact, there was even a demand for doing away with the Commonwealth Grants Commission, which would periodically make recommendation on sharing of resources. The commission by and large has tried maintaining horizontal equity amongst the states of the Commonwealth. The total amount transferred in 2012-13 to other levels of government in Australia was AUD (Australian dollars) 56.37 billion; the bulk of it was for health-related expenditures. This was out of a total budgeted expenditure of AUD 259 billion for the same year, a little less than 25 per cent of the total.

Most taxing powers are with the federal government, so that even the goods and service tax (GST) introduced in 2000 in replacement of the sales taxes of the states is levied by the federal government but distributed to the states. Compare it with what is proposed in India: a twin GST, both at the same rates, one for the central government and another for the states; both being collected at a single point, but one half going into the central treasury and another to the respective state where it is collected. Even this has not been agreed to by the states.

The US has also similar problems but the tax and legislative powers with the states are immense and hence discordant voices are generally subdued. The American constitution gives concurrent taxation power on income to the states, local bodies and the Union. Taxes on consumption have been exclusively assigned to the states, and on property, the local bodies have exclusive rights. In 2009, the total tax revenue of the federal government was $2.05 trillion and the states and local bodies $1.25 trillion; i.e., in the proportion of 68 per cent and 32 per cent.

According to data from the Congressional Budget Office, in 2011, the total federal government transfers to the states and local governments was $607 billion or 30 percent of total federal government expenditure: a small increase of two per cent over the 1980 figures.

In the US, the situation has been changing. In the beginning of the US as a country, the states had all the powers but with the Depression and consequent New Deal, the American government started programmes in many areas reserved for the states. Many grants were given to states to implement these programmes with strings attached.

For almost 200 years, with many wars fought by the American armed forces outside US soil and the US emerging as a super military and economic power, the federal-state relationship shifted more and more in favour of Washington, D.C., the federal centre. According to the US government’s history website, the process is being reversed over the past 20 years, with power shifting back to the states. The website states that Presidents Richard Nixon, Ronald Reagan, and George Bush tried to slow down the growth of the national government by giving more responsibilities to the states under the banner of “New Federalism”.

In the US too, the Congress gives conditional grants to the states for specific purposes. For example, road grants were given to those states which increased the drinking age to 21: a clear instance of fiscal reform going hand in hand with social reform, the obvious purpose being to cut the accident rate. States complied with this condition as they did not want to forgo the grants. But in recent times, the states have gained all their earlier powers and expenditure by the federal government is restricted only to macro responsibilities such as defence etc., apart from Medicare in which the states also have a role to play. In November 2013, a bill was introduced in the Senate to transfer federal transportation programmes and revenues to the states.

The allocation of grants among the states is based on approved formulae established by law according to demographic and other factors, on the basis of competitive bidding by states for education reforms and transportation project grants or project grants based on meeting certain criteria. The highest outlay of grants has been for health spending. In these grants there are mandatory spending and discretionary spending components for the states to adhere to.

In the UK, although it cannot be called a federal state, there is pressure from Scotland to secede and Wales also to become independent; and devolution of government to both gives a kind of federal result. The same appears in the case of Catalonia in Spain. France, despite being a unitary state, has sub–national governments with tax powers which the regions can determine themselves.

Canada has certain constitutional provisions which lay down broadly the principles of fiscal federalism. The Canadian Constitution (Constitution Act, 1982) states at s.36:

“(1) Without altering the legislative authority of Parliament or of the
provincial legislatures, or the rights of any of them with respect to the exercise of their legislative authority, Parliament and the legislatures, together with the government of Canada and the provincial governments, are committed to

(a) Promoting equal opportunities for the well-being of Canadians;

(b) Furthering economic development to reduce disparity in opportunities; and

(c) Providing essential public services of reasonable quality to all Canadians.

(2) Parliament and the government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation.”

Since 2004-2005 the Canadian federal government’s transfers to the provinces and territories have increased from Canadian $41.9 billion to C$62.5 billion: an increase of 50 per cent. This indicates that the federal government is laying increasing emphasis on the provinces and territories getting closer to ground level governance. In Canada, just as in the US, transfers for health spending are 50 per cent of the total transfers. Distribution is based on a principle of equalisation of needs and fiscal capacity.

Chinese fiscal federalism was revamped with the tax reforms of 1994. China has a five-tier administrative structure, with 31 provinces including five autonomous regions and four municipalities, 331 prefectures and municipalities at the prefecture level, 2,109 counties, and 44,741 townships, city districts, and towns.

Before 1994, China had a complex system with two-way transfer of resources between the provinces and the central government. Under the 1994 reforms, the centre had exclusive right to many taxes. The provinces have personal income tax, and income tax on locally owned enterprises, collectives and private firms. Taxes on farm land, urban and rural land use tax, house property tax, etc. were assigned to the sub-national units. VAT is shared on a 3:1 basis between the centre and the sub-national units.

Besides this division of taxation powers, the centre also transfers resources to the provinces under various schemes including for fiscal equalisation amongst provinces. It is reported that on the whole, the centre and the provinces have about 50:50 of the revenue resources available under various taxes. As there is widespread income development disparity in China, an attempt is being made to develop other regions to “level up” to a more equal state of affairs. Being an autocratic country with stable governments, China may be able to achieve regional balance in the medium term.

It is interesting to note that a study by Lars P. Feld and Tarik Dede of 19 Organisation for Economic Cooperation and Development (OECD) countries shows that the tax autonomy of sub-national governments does not have a robust effect on economic growth (“Fiscal Federalism and Economic Growth: Cross country Studies for OECD countries”, Discussion Philips University of Marburg). There could be other studies that may show an opposite effect.

The above broad survey shows that, except for Australia, the tendency is to allow states to have greater powers at the grass roots level so that governance can be effective and delivery of public goods can be achieved at the least cost and most efficiently. In Australia there has been a centralisation of powers to tax and the resources transferred also have also been less than 25 per cent of the total revenue receipts.

Indian fiscal federalism has to be evaluated against this general background. Part XII of the Constitution, Chapter 1, dealing with finance, contains detailed provisions relating to the federal fiscal arrangement to be made every five years through a Finance Commission (FC) specially constituted for this purpose.

Accordingly, all the taxes levied by the central government are shareable with the states, excepting those that are specifically excluded by the Constitution such as surcharges levied on the taxes for specific purposes. Articles 268, 269 and 270 clearly indicate the taxes that are to be to be shared. While surcharges are not shareable, states always agitate for them to be made shareable. The central government argues that these surcharges are mostly for specific purposes like the education cess on all direct and indirect taxes of the central government. The states have a strong case as otherwise the centre could increase the surcharges and keep them outside the divisible pool.

So far, 13 Finance Commissions have given their recommendations and the 14th is now deliberating on their terms of reference. The terms of reference have been broadening over the years with a view to giving a certain amount of freedom to the Commission to enable it to tie up transfer of resources to the states, contingent on their performance. The 12th Commission tied debt relief to states passing Fiscal Responsibility Acts.

As the report of the 12th FC makes clear, “Each State must enact a fiscal responsibility legislation prescribing specific annual targets with a view to eliminating the revenue deficit by 2008-09 and reducing fiscal deficits based on a path for reduction of borrowings and guarantees. Enacting the fiscal responsibility legislation will be necessary pre-condition for availing of debt relief”. Specific purpose grants are also tied to performance criteria laid down by the Commission. The 13th Commission went further in laying down conditions for availing of almost all the grants in aid provided by them for specific purposes.

Over the years the composition of the Commission has changed so much that now only economists are members of the Commission. Dr. Y. V. Reddy, a former IAS officer, heads the 14th Commission. He is an economist. The progressive “economistising” of the commissions to the exclusion of politicians, judges, sociologists, etc. has underlain a trend to devolution based on econometric equations constructed out of the criteria used for devolution. This, no doubt, has eliminated bias and made devolution a by-product of equations. Unfortunately, those who are keenly interested in this important national issue   have not been formally invited to make their views known; except that they are free to do so in response to the notice to the general public inviting views.

Reports of the Commissions clearly show that the recommendations are wholly an in-house matter and the elaborate consultation process with the states has become just a ritual. This is evidenced by the fact that the commissions have chosen to ignore devolution criteria suggested by states in their memoranda. If Commissions are going to use econometrics for devolution, based on what they consider the best, then why go to every state and put them to a lot of inconvenience?

An analysis of the reports would show that the Commissions do not really bother much about the states’ own assessment of their revenue receipts and expenditure. The Commissions appear to consider these to be underestimates of revenue and overestimates of expenditure. They project the receipts and expenditure on a normative basis, differentiating between states, and arrive at the revenue surplus or deficit for individual states. Much preliminary work by the states can be avoided if they are just told to submit their audited receipts and expenditure for the latest available years and the audited balance sheets of their PSUs. The states could also project any of their special demands. This would save time, effort and money for the states as in any case their assessment of receipts and expenditures are just consigned to the archives.

The one healthy trend has been that the overall transfers to the states out of central revenue receipts has been moving up. The 13th Commission raised it to 39.5 per cent of revenue receipts of the centre, which was 37.5 per cent at the end of the award of the Eleventh Commission. The Thirteenth Commission has given the actual transfers done in the last few decades in Annexe 4.2 of its report, volume II. It is clear that the transfers have been always above 37 per cent of the gross revenue receipts of the centre except during the period 1989-2000. One-third of the total transfers are accounted for by plan and non-plan transfers. Compared with other federations like the US or Canada, India has done well in transferring more resources to the states out of central resources.

The percentage share of each state in the devolution of central resources as recommended by the 13th FC when compared to the (1971) population share of the respective states brings out the glaring fact that the following states have got far less than their share of population (Annexe 8.2 Vol. I state-wise shares and Annexe 8.2 Vol. II for 1971 population). This is shown in the figure.

One could briefly conclude from the above figures that two-thirds of the resources are transferred to roughly 50 per cent of the population. There is nothing wrong in this redistribution in favour of the less favourably placed states. But then (and it is a huge but), some states which are by far richer in natural resources than many so-called developed states have not moved up in the scale despite the favourable discriminatory treatment meted out to them. This indicates a need for the current FC to put these states on notice: that they have to adopt policies of governance that are consistent with the development ambitions of the people of the states and set targets in certain specific areas where performance can be measured.

The government of India should add a term of reference to the FCs, enjoining them to measure performance of states against yardsticks adopted by the Commissions in the past in different areas of economic and social administration.

The 14th FC suo motu can examine whether the states have improved their performance in areas such as education, health, forest cover, maintenance expenditure on roads, irrigation and buildings and reduced losses in their PSUs. If the states have not, then the FC can link a certain percentage of devolution to be released year after year after the performance level is achieved. The FCs have gone far in many areas and it is time for them to look at  what devolution formulae or criteria for grants can be adopted that would force states to come out of the quagmire of inefficiency and politicalisation of even rational economic decision making in their governments. It also leads to an inevitable question “should the recommendations of the finance commissions lead to increasing state autonomy to tax and spend or the reverse”. The question has not yet been examined and offers potential for research.