In a previous column, I argued that linguistic pluralism and a federal structure are two of the three pillars that have held the Republic of India together, and have allowed this diverse and complex country to do better than all its neighbors. The third of these pillars is fiscal federalism: because, as even high-schoolers know, a club’s survival and success is how money is raised, shared, and spent by its members.
Union and State are both political creations. Their boundaries are not necessarily tied to economically self-sufficient societies. Thus, a sub-continental union allows the forces of comparative advantage to benefit all: each region can produce what it is better at and trade with the others. Yet, balancing similarity, similarity, and efficiency in a highly-diverse union is complicated. At the time the Constitution came into force, some regions were endowed with high human capital, infrastructure and industrial potential, others had abundant natural resources, and some had very limited economies. While linguistic reorganization of states helped to satisfy political aspirations, fiscal federalism was the important but invisible factor that allowed political reorganization. What we believe to this day is actually part of the ‘secret formula’ of India’s success.
As in other parts of the formula, we have been careless about maintaining fiscal federalism. The Constitution created an independent, non-partisan Finance Commission to determine how financial resources should be shared between the Union and the States. However, as M. Govinda Rao points out in his new book, Studies in Indian Public Finance, the Planning Commission became an important intermediary in how funds were shared. Central planning, Rao argues, “constrained both the market and state governments in the allocation of resources” and the nationalization of banks further centralized resource allocation and combined them with planning. This is one reason why states in India have relatively weak financial capabilities.
Thus the dissolution of the Planning Commission in 2014 was a significant reform, but remnants of central planning remain and the mentality of the states’ political elite is not yet conducive to reducing central constraints. Similarly, with the introduction of GST and the formation of the GST Council, the states gained a powerful platform to negotiate their financial interests. Despite its complexities and controversies, GST has brought fiscal federalism to the fore in the public discourse, and that is a good thing.
The Planning Commission may have strengthened New Delhi’s hand over the states, but the calm, transparent and professional functioning of the Finance Commission ensured that the latter was not pushed over the edge. In a discussion on national security, Vijay Kelkar once pulled me aside and pointed out the fundamental role of the Finance Commission in keeping the country united. Many politically sensitive and border states receive a disproportionately large share of the funds. More importantly, the advisory and non-partisan character of frequent finance commissions means that the Center and states see its allocation as justified, even if they felt they were more deserving.
2015 marked the beginning of a new era of fiscal federalism when the 14th Finance Commission (2015-2020) increased the share of states’ wealth from 32% to 42%. With the abolition of the Planning Commission in the same year and the adoption of the GST two years later, India is today in unknown waters.
On the one hand, states enjoy greater financial autonomy than before, but on the other, the central government has a greater role to play in directing expenditure through a large number of “centrally sponsored schemes” such as education, health and rural employment guarantees. The 15th Finance Commission (2021–2026) retained the share of the states, and its method of assigning weights based on population is likely to be a factor in the politics of federalism.
Furthermore, as Rao wrote in his book, “everyone wants decentralisation, but only to their level. States have been zealous for their rights, calling for state finance commissions to transfer money to municipalities and panchayats.” have lagged behind in establishment. State governments and local bodies have also been reluctant to raise their own revenues. Political considerations prevent taxing rich farmers and bureaucratic inefficiencies at the municipal level to prevent the collection of property taxes. As Arvind Subramaniam observed, “the closer the government is to the people, the more reluctant it is to raise taxes”.
So the states have to learn how to formulate fiscal policy. If they don’t, the fiscal balance will tilt towards the centre.
There is an institutional debate on whether the Finance Commission should have a permanent secretariat or not. Much more important than I think is that the Inter-State Council should be upgraded into a national forum, chaired by the Prime Minister and attended by the Chief Minister of the State.
In these three pillars, I have tried to draw attention to the structural pillars of India’s unity and success. Linguistic pluralism, a federal structure and fiscal federalism have served us well and enabled us to succeed where others have failed. We must not allow popular sentiment and polarized discourse to weaken further.
Nitin Pai is the co-founder and director of the Taxila Institution, an independent center for research and education in public policy.