The State of the Fiscal Union: Ⅰ
Ashwath Damle, TY BSc. ‘24
8 min read
We are about to enter a period of unprecedented reexamination with regards to the nature of the Indian Union. The delimitation freeze that has held for half a century is coming to an end. There seems to be an air of anticipation around this crisis in the waiting. Justified or not, the media was quick to see the December 2023 polls as proof that the North and South vote differently. The current news cycle has once again presented a north-south divide. This time it is driven by southern discontent over their share of federal financing. I don’t think it is an exaggeration to say that inevitably, no matter how much the powers that be may try to delay it, India will have to negotiate for itself a “new” Union.
The delimitation question and the fiscal devolution question are fundamentally intertwined. Southern discontent with proportional seat allotment and their share of union taxes stems from a common source. The fact that the southern States pay far more in union taxes in per capita terms. They believe this entitles them to a larger say in the house that spends the union’s money. And a larger share of the federal funds that are doled out to the States. [1]
I will however limit myself to the problems with our current fiscal devolution system. As there seems to exist a broad consensus on the question of delimitation. We must return to a democratic form of seat allocation. On the question of our fiscal federalism however there seems to be no such settled body of opinion. Most importantly it seems that the conversation has overlooked a question of great importance. How should we divide up the devolved share among the States?
However before we address the question itself, we must examine the narratives that surround this conversation. There are in my view 2 problematic narratives that often mislead us and pull this conversation in strange directions.
First, the issue is not a north vs south one. This is well acknowledged but worth repeating. The divide is between States that are net contributors and net receivers of implicit or explicit transfers
(Direct tax payment is an imperfect way to identify the amount contributed by a state but it does give us a rough idea).
This divide does not fall on purely north south lines. As such it is both strange and troubling when this problem is seen to lie on ethnolinguistic, regional or cultural lines. All the way back in 1952, the first finance commission recognized this divide. [2] It spoke of it in terms of Industrial vs Non Industrial States. In those days it was Bombay State and Bengal that were the major tax producers. In fact more than 3 quarters of income tax collection occurred in just these 2 States. And of that a majority within the cities of Bombay and Calcutta.
The second problematic narrative regards the nature of the devolution of funds. I used the phrase “doled out” earlier and this may be an over exaggeration. Both there does exist a view that in some way the States aren’t wholly entitled to these funds. There’s in fact academic literature arguing that the States have an improper or unhealthy dependance on their share of union taxes [3]. And that the States should seek to reduce this dependance by growing their own tax revenues.
I find this strange given that the States only have direct access to half of GST collections, whose rates they do not set, and motley crew of left over taxes. I find this to be akin to arguing that Britain is unhealthy dependent on the income tax(in the broadest sense), import duties to fund the NHS, pay for the police and pay for the schools. My point is that we should not view fiscal devolution as money given to the States because they are living beyond their means. But rather we should see it as a fundamental part of federal structure.
This is not an argument in favour of federalism, I have a more specific point. The constitution gives a certain mandate to the States. Health, education, law and order and so on. And it funds this mandate via the sharing of certain taxes or post the reforms a certain share of tax revenue, between the centre and the States. To analyse the fiscal condition of the States only in terms of their own tax revenue, is to create in your perspective massive unfunded mandates. The role of the finance commission is to determine the terms under which this tax sharing occurs. It does not “transfer” funds from the centre to the State. Admittedly this is a pedantic point but one worth making in a nation that often seeks to deny its natural and constitutional federal characteristics.
However this question of the dependence of States on devolution is important. As this dependance is problematic from the perspective of the States. There are 3 related problems with this dependance.
The States can not vary the rates of these taxes. This leaves them without an important and borderline essential tool for managing the economy. This seems to be, in my view, a problem that simultaneously is the least pressing and without any good fixes. As such I shall address this last.
Another relatively minor problem is the uncertainty created by the fact that the formula,by which the amount devolved to each State is determined, changes every five years. This uncertainty can complicate the budget setting in the States. There is a straightforward solution, creating a permanent settlement as it were. Fixing both the percentage to be devolved to the States and the formula to calculate their relative shares. An argument against this is that the needs of the States change and with it the amount they receive should change. However, as you will see next time, I don’t think we should pay much attention to this “needs based” argument.
The most important flaw with the current system is the nature of the formula used to determine the relative shares of the individual. Specifically the supremacy of a State’s needs over all other considerations. As I shall argue next time this experiment with a needs based formula has been a failure.