What do you understand by fiscal federalism? Why is it needed in India? What are the challenges we face in realizing this objective? (250 Words)

Mentors Comments:
1. Define fiscal federalism
2. What are the various constitutional provisions, laws and institutions for ensuring FF?
3. What challenges does the FF in India face? How to resolve them?


Fiscal federalism, financial relations between units of governments in a federal government system. It is part of the broader public finance discipline.

Two things can be made out of the constitutional assignment between the centre and states.

  • Firstly, national public goods have been assigned to the central government while local public goods as well as items with regional tastes and preferences have been assigned to the state governments.
  • Secondly, the central government has been assigned larger tax base compared to the state governments, while later is required to make most of the expenditures. In practice, the centre collects nearly two-third of taxes while incurs one-third of total government expenditure.
  • Case is the opposite of the expenditure and revenue shares of the state governments. This centralization of revenue collection and decentralization of expenditure inherently leads to vertical imbalance. Indian federal system is also marked by huge regional income disparities, which automatically leads to horizontal fiscal imbalances as well.
  • The Indian Constitution has all specification of financial powers and functional
    responsibilities of the Centre and the States and the institutions needed for a federal structure and a well-defined mechanism for intergovernmental transfers to address vertical and horizontal imbalances.
  • Recognizing the inbuilt vertical and horizontal imbalances, Constitution framers made explicit provisions for intergovernmental fiscal transfers like Finance Commission, Grant in Aid, etc.

1. Horizontal imbalances and rising regional inequalities: Replacing the Planning Commission with NITI Aayog has reduced the policy outreach of government by relying only on a single instrument of fiscal federalism i.e Finance commission. This approach if not reviewed can lead to a serious problem of increasing regional and sub-regional inequities.

2. Vertical imbalance- Vertical imbalance arises due to the fiscal asymmetry in powers of taxation vested with the different levels of government in relation to their expenditure responsibilities prescribed by the constitution. Central Government collects around 60% of the total taxes, while its expenditure responsibility (for carrying out its constitutionally mandated responsibility such as defense, etc.) is only 40% of the total public expenditure.

3. There are a number of Central legislations, the compliance and enforcement cost of which are entirely borne by the States. Central legislations, such as the Environment Protection Act, etc. At present, States are not compensated for the cost of compliance and the revenue loss on account of compliance.

4. The periodic pay revision by the Central Government gives rise to demand on the part of State government employees for a similar pay hike. For the States, it is a demand which is difficult to resist.

5. The main grievances of the States are that the provision of revision of royalty rates is not being adhered to and that there are undue delays in the revision of these rates at periodic intervals depriving the States of potential revenue.

6. With the increased exploitation of offshore oil and gas reserves, the non-tax revenues of the Centre are likely to improve considerably through higher royalty collections. Under the present Constitutional arrangements, offshore royalty accrues entirely to the Centre.

Recommendation by Punchi commission are as follows-

  • The Commission recommends a comprehensive review of all transfers to States with a view to minimizing the component of discretionary transfers, particularly those channeled through CSS.
  • As the resources at the command of the States are limited, we recommend higher Central transfers to backward States to enable them to improve their physical and human infrastructure.
  • All future Central legislations involving States’ involvement should provide for cost-sharing as in the case of the RTE Act.
  • The ToR of future Finance Commissions should be formulated in such a way that the additional commitments of States on account of pay revision are fully taken into account.
  • The royalty rates on major minerals should be revised at least every three years without any delay. States should be properly compensated for any delay in the revision of royalty beyond three years.
  • A part of the sale proceeds of the spectrum should be devolved to States for expenditure on infrastructure projects.
  • This ‘one-size fits all’ approach to fiscal consolidation has constrained fiscally strong States to raise more resources. Therefore, State-specific targets of fiscal deficit in the FRBM legislation of States. The fiscal correction path may factor in the variations in the initial fiscal situation across States and be made State-specific.
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