The Hindu Business Line : Correct the federal fiscal imbalance

State governments are overloaded with expenditure responsibilities and expectations, whereas they are not endowed with enough resources to finance public expenditures. The economic reforms have amplified the vertical fiscal imbalances in the Indian federation, say R. Srinivasan and S. Raja Sethu Durai.

"By federal principle, I mean the method of dividing powers so that the general and regional governments are each, within a sphere, coordinate and independent."

— K. C. Wheare in `Federal Government'

ONE symptom of the economic crisis in the early 1990s, the huge fiscal deficit, was treated by downsizing the public sector. This was achieved by freezing recruitment and disinvesting public sector undertakings. Obviously, both flouted the objectives of welfare consideration and social responsibility of economic governance in the country. The symptom has not disappeared and the diagnosis is still imperfect.

State governments — latecomers to the reform process — are implementing the prescriptions of the Union Government without making much headway. Instead, both the levels of government should have expanded public expenditure efficiently and improved the buoyancy of public revenue mobilisation; a better medicine for the real disease — political bosses running the public sector inefficiently.

The economic crisis and the reforms that followed can be given a new twist if seen with a federal lens. In most federations, States are burdened with more functions necessitating huge public expenditures but are vested with few revenue powers.

It is usually the converse for the Union Government. The consequent creation of vertical imbalance is to be redressed by federal transfers. India is no exception.

Only, the vertical imbalance is more pronounced here, and the federal relations are lopsided compelling legal luminaries to characterise the Indian Constitution as quasi-federal.

Given this federal setup, if the Centre had stuck to a few functions, as originally envisaged in the Constitution, and improved the revenue buoyancy — facilitating more transfers to the States — the public sector's growth would have matched that of the population and the economy. But the Union Government encroached upon the States' functions with little advantage to their economies. Instead, it damaged the public finances of States and its own in the process. Thus, the diagnosis points to correction of federal fiscal imbalance as one of the desirable aspects of the economic reforms.

Fiscal dependence of States

In its report, the study team on Centre-State relationships under the Administrative Reforms Commission in 1967 identified three main reasons for the States to be fiscally dependent on the Centre.

First, the resources for raising funds available with the States are comparatively inelastic. Second, the functions allocated to the States are such that it leads to expanding responsibilities particularly in the context of ambitious development plans. Third, important sources for financing national plans are foreign-aid and deficit-financing, both tend to strengthen Central rather than State resources.

Besides this fiscal dependence, the functional autonomy of the States was also undermined by the Centre intruding on the responsibilities assigned in the State List of the Constitution's Seventh Schedule.

The intrusion was achieved by amendments that altered the State List by removing some subjects and adding them on to the Union and the Concurrent Lists wherein the Union government has overriding powers in addition to the residual power vested with it. Thus, the Union government often attempted to increase its legislative sphere of influence at the cost of the States.

Transformation of Seventh Schedule

The first major change in the Indian federal financial relation was effected by the Third Amendment to the Constitution in 1954, which added more goods under the subject trade and commerce to entry 33 of the Concurrent List. Then, in 1956, the Sixth Amendment added the taxes on the sale and purchase of goods that happen in the course of inter-State trade or commerce to the Union List as Entry 92A.

Later further additions were made to this by including taxes on the consignment of the goods taking place in the inter-State trade or commerce to the Union List as Entry 92B. The Seventh Amendment made changes to Entries 40, 42 of the Concurrent List by enlarging its scope.

These intrusions, within 10 years of Independence, forced the States to argue for a re-look at Centre-State relations.

The Tamil Nadu Government was the first to constitute a committee to inquire into this relationship under the chairmanship of P.V Rajamannar in 1968. The committee submitted its report in 1971. Apart from other suggestions, the Committee insisted on constituting the inter-State council under Article 263 and recommended that 11 out of 97 entries in the Union List and 22 out of 47 in the Concurrent List should be transferred to the State list to enhance the States' fiscal and legislative autonomy.

In 1976, during Emergency, the then Prime Minister, Indira Gandhi, took steps that affected the autonomy of States. The 42nd Amendment Act in 1976 literally restructured the State and the Concurrent Lists. The first infringement was made in terms of giving more power to the Union for deployment of armed forces in the States by inserting the Entry 2A in the Union List.

Out of 66 subjects in the State List, five — education, forests, protection of wild animals and birds, administration of justice, and weights and measurements — have been shifted to the Concurrent List. Population control and family planning were also inserted into the Concurrent List. The scope of the Entry 55 of the State List has been limited to tax on advertisements other than the newspapers and advertisements broadcast by radio or television.

Many States opposed the increasing encroachment by the Centre. After a conference of the southern Chief Ministers on Centre-State relations, the Union Government constituted the Sarkaria Commission in 1983 to review the Centre-State relationship. It submitted its report in 1988.

The report substantiated the role of the Union government and made no significant recommendations on the Seventh Schedule. It recommended shifting of Entry 97 residuary powers on non-tax matters of the Union List to the State List. It also suggested shifting Entry 5 of the State List (power to legislate the local governments) to the Concurrent List.

The continuous encroachment into State affairs by the Union government may only be substantiated from the fact that the Centre's expenditure has skyrocketed after 1955. In the early 1950s the annual average growth rate of State government expenditure was 8.3 per cent and the Union government 4.9 per cent. After that, while the average annual growth rate of State government expenditure remained at 11 per cent, that of the Centre was 58 per cent from 1955-56 to 1960-61.

In consecutive periods too the growth rate of Union government expenditure was greater than that of the State governments. While the growth rate of expenditure of the State governments was about around 13 per cent from 1960-61 to 1999-2000, that of the Centre was 20 per cent in the 1960s, 14 per cent in the 1970s and 16 per cent in the 1980s. In the 1990s, due to reforms, it came down to 12.2 per cent compared to 13.3 per cent for the States.

The centralisation process of Indian fiscal federalism lead not only to acceleration of public expenditure, but also ineffective provision of public services. This can be attributed to decision-making of the level of government — that is, the Union government which is not as close to the people as the State government. The centralised planning process and license raj lead to arbitrary allocation of investments, which accentuated regional imbalances, rather than mitigate them.

Further, the correction of vertical imbalances is also not appreciable. The total federal transfers as a proportion to States' revenue and expenditures have been steadily declining from 75.2 per cent in 1995-96 to 71 per cent in 2000-01 and 33.1 per cent in 1995-96 to 28.7 per cent in 2000-01.

It is interesting that during the 1990s as the Union government cut its own expenditure, it also reduced the quantum of financial transfers to the States. From the citizens' point of view, the reduced expenditure by the Centre ought to be filled by the State governments; they responded by a 13.35 per cent growth in their expenditure during the 1990s when the Union government's expenditure grew only by 12.2 per cent. Thus, the State governments are overloaded with expenditure responsibilities and expectations, whereas they are not endowed with enough resources to finance public expenditures. The economic reforms amplified the vertical fiscal imbalances in the Indian federation.

The fiscal dependence of the States is due to quasi-federal character of the Constitution. According to Myron Weiner, a renowned political scientist, the fiscal dependence was the main reason for fiscal laxity of the States. He argues that mere transfer of resources from one level of government to another is no assurance that the money will be well spent. So, fiscal responsibility can be ensured if each level of government has its own tax base and is made accountable to its electorate for the taxes the people pay.

The recent report of The National Commission to Review the Working of the Constitution correctly suggested creating a consensus list of services to be taxed by the States and also emphasised the enumeration of services that could be taxed exclusively by the State governments, and transferring a few of the existing tax powers from the Union to the States should get the priority attention of the policy-makers to augment the States' resource pool.

The quasi-federal character of the Constitution along with amendments facilitating the encroachment by Union government into legislative powers of the States has been the source of federal frictions.

The citizens are directly affected by this lopsided power-equation and improper decentralisation of public sector resulting in ineffective but enlarging public sector. Therefore, by invoking principles of federation, there is need to ensure fiscal and functional autonomy of the State governments to "right size" the public sector.

(The authors are academicians and can be contacted at sri_ni@vsnl.net or srsethu@hotmail.com)