Dear reader,
“It has turned State Finance Ministers into municipal commissioners.” I don’t recall who said this about the goods and services tax regime when it was launched in India back on July 1, 2017. Was it P. Chidambaram? Amit Mitra? N. Chandrababu Naidu in his old avatar? Or was it Y.V. Reddy, much later? Or comrade Ashok Mitra with his quintessential sarcasm? But whoever said it was having a moment of supreme clairvoyance. Because as things have turned out in 2024, GST and the tax governance ecosystem it heralded have literally made State Budgets and State Finance Ministers irrelevant in an alarming way, the impacts of which many States, especially those who are not in the good books of the BJP-led Central dispensation, are feeling now.
Fiscal federalism, a system where different levels of government share financial responsibilities and powers, has been a cornerstone of many federal nations. Interestingly, the trend towards centralisation of fiscal powers is not new. In the US, the New Deal era (government programmes fighting the Great Depression) saw a significant expansion of federal fiscal power. The Depression showed the limitations of State-level responses to national economic crises, leading to increased federal intervention. In Europe, the aftermath of World War II saw many countries adopt more centralised fiscal systems to facilitate reconstruction and maintain economic stability.
But in recent years, there has been a growing concern about the erosion of financial autonomy of subnational governments (States, provinces, or regions) by central governments. This trend has been observed across various federal systems, including in the US, Europe, and Africa. In the US, the balance of fiscal power has been a subject of debate since the country’s founding, but recent decades have seen a notable shift towards centralisation. It is pointed out that in 1977, federal grants-in-aid accounted for a little over 15 per cent of State and local government general revenue in the US, but by 2019, this had risen to more than 22 per cent. It indicates the growing financial dependence of States on federal funding.
In the EU, the tension between centralisation and member-state autonomy is particularly evident in fiscal matters. The introduction of the euro and the subsequent debt crisis led to increased fiscal oversight from Brussels (headquarters of EU, for starters). The European Fiscal Compact, signed in 2012, required member states to include balanced budget rules (meaning government spending should not exceed revenue) in national law. While aimed at ensuring fiscal stability, critics argue it has reduced national fiscal sovereignty. One economist called the Fiscal Compact a straitjacket on national budgetary policies.
In Spain, the central government’s control over regional finances has been a bone of contention, particularly in Catalonia. The 2012 Organic Law on Budgetary Stability and Financial Sustainability gave Madrid greater control over regional budgets, provoking protests from Catalans. Students of international economics tell this writer that the law is of particular interest to those who are looking at how the Centre has been eroding the fiscal autonomy of the States in India—factors such as imposing stricter deficit and debt limits on all levels of government, introducing an expenditure rule to limit the growth of non-financial spending based on medium-term potential GDP growth, and setting up a correction mechanism to address non-compliance with fiscal rules sound a lot like a scenario playing out in India as well.
Nigeria, Africa’s most populous country, faces ongoing debates about fiscal federalism. The central government controls the majority of the country’s oil revenues, distributing them to states based on a formula that has been criticised as unfair and opaque. Nigeria’s revenue-sharing system has reportedly contributed to a culture of dependency on oil revenues and weakened incentives for States to generate internal revenue. There are many such examples.
One of the main strands of this debate is the concept of a “divisible pool” of taxes, which is a crucial element in fiscal federalism, particularly in countries with multi-tiered governance structures. It refers to a system where certain tax revenues collected by the central government are pooled and then distributed among different levels of government according to predetermined formulae or criteria. The idea goes back to the early days of federalism, but the formalisation of a “divisible pool” system happened in the mid-20th century as countries struggled to balance fiscal autonomy and national economic management.
India, after Independence, was one of the early adopters of a formalised divisible pool system. Its Constitution provided for the sharing of certain taxes between the Union (central) government and the States. Article 270 of the Constitution specifically mentions the taxes that shall be collected by the Union and shared with the States. The First Finance Commission of India, established in 1951, recommended the sharing of income tax revenues.
Over time, this was expanded to include other taxes, forming a comprehensive divisible pool. But after the introduction of the GST, the concept of a divisible pool of taxes became increasingly controversial. The Centre’s increased use of cesses and surcharges, which are not part of the divisible pool, further adds to the controversy. Issues surrounding GST compensation worsened during the COVID-19 pandemic. States like Kerala and Tamil Nadu now say that the new system has reduced their fiscal autonomy and ability to address State-specific development needs. This has led to heated debates about fiscal federalism and the balance of financial power between the Centre and the States.
Obviously the erosion of financial autonomy of State governments has implications for democratic governance, economic policy, welfare programmes (something the Tamil Nadu government has pointed out), and intergovernmental relations. While central governments often justify increased fiscal control as necessary for economic stability or national cohesion, critics argue that it undermines the principles of federalism and local autonomy. As federal systems continue to evolve, finding the right balance between central coordination and State autonomy remains a critical challenge.
It is in this context that Frontline decided to take a deeper look at the state of fiscal federalism in India. We have an impressive line-up: C.P. Chandrasekhar, M. Suresh Babu, T.M. Thomas Isaac, and Jawhar Sircar. You can start reading with the opening essay, “Politics over the purse”, by C.P. Chandrasekhar, and, as always, write back with comments.
Also, if you know who said that line I started this newsletter with, do write in.
Wishing you a fiscally healthy week,
For Frontline,
Jinoy Jose P.
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