India's Federalism Works, but there is Room for Improvment

June 22, 2016Indiaby East Asia Forum

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Federalism in India is an imperative.

In economic terms, the federal system was created with the intention of maximising economies of scale, while still providing public services to cater to people’s divergent preferences. However, there is more to federalism than just the economics.

In political terms, federalism involves building a strong national polity by combining sub-national entities and, in emotional terms, federalism provides a national bond while permitting multiple local identities to be retained.

For a country such as India — inhabited by over 1.2 billion people with wide social, ethnic, religious, linguistic and economic diversities — federalism is not an option but an imperative. Fiscal federalism in India has evolved considerably over the past 69 years and now holds the country together. Nevertheless, there remains a great deal of scope for improvement.

Although India’s growth rate has steadily accelerated, there is a growing awareness that it is still far below India’s growth potential. One key reason for India’s underwhelming growth performance is the lack of policy coordination between its seven union territories and 29 states.

In the Indian constitution, the Seventh Schedule assigns functional responsibilities to Central and State governments in terms of ‘union’, ‘state’ and ‘concurrent’ or joint subjects. Taxes are then assigned according to whether the union — that is, the central government — or the states have jurisdiction.

However, this separation only exists in the legal sense and there is considerable overlap in the tax bases. For example, taxes on agricultural incomes and wealth are assigned to the states, whereas taxes on non-agricultural incomes and wealth can only be levied by the union government. This makes the levy of comprehensive income tax extremely difficult and has opened up a major avenue for tax evasion.

The proposed comprehensive goods and services tax (GST) faces similar problems. The GST has become difficult to implement because states that have the power to levy sales taxes on goods cannot also levy taxes on services. The union has the power to levy excise duty on all manufactured products —, which is actually a sales tax at the first point of sale — but cannot extend the tax to subsequent stages.

While there have been serious attempts to levy the GST at both union and state levels for about a decade, the exercise has been mired in political gamesmanship and lacks the political consensus required for a constitutional amendment.

When it comes to expenditure, a considerable degree of cooperation is necessary to enable both the union and states to provide diversified public services while reaping the cost advantages arising from economies of scale. However, this is not currently present in India.

As with taxes, India’s constitution assigns separate expenditure functions to the union, state and concurrent governments, resulting in significant overlap. India must put in place a mechanism to ensure a greater degree of cooperation and coordination between the union and states, while still promoting healthy competition.

The union’s role is also often uncoordinated as it must cover some costs to ensure minimum standards are met, regardless of whether the public services in question fall within the union category of spending or not. Even where the union is legally responsible, different local conditions means that it is sometimes necessary to use the states to deliver services.

Another area in which the union and states have to work together is in ensuring healthy intergovernmental competition. There must be a clear mechanism to ensure coordination, promote cooperation and activate healthy competition among the states.

In general, the asymmetry between tax powers and expenditure functions is a feature seen in all federations. General purpose transfers by way of tax devolution or block grants enable the states to provide comparable levels of public services at comparable tax rates. It is also important to ensure that public services meet minimum quality standards. This can be achieved through specific purpose transfers.

In India, the constitution provides for tax devolution and block grants from the union to the states based on the recommendation of the Finance Commission, a constitutional body appointed by the president every five years. So far, 14 Finance Commissions have made recommendations, which have then been generally accepted and implemented.

Nevertheless, questions have been raised on the design of general purpose transfers as they do not fully offset the states’ fiscal disabilities and they create adverse incentives on tax effort and expenditure.

The major problem is in the disbursement of specific-purpose transfers. The existing centrally sponsored schemes face several difficulties in terms of number of services chosen for equalisation, their one-size-fits-all design, and the inability of many of the states to match union contributions.

After assuming power, the National Democratic Alliance (NDA) government appointed a committee to rationalise the various transfer schemes. However, even after consolidation, there are more than 30 schemes with uniform matching contributions of 40 percent of the cost required from the states.

With such a large number of available schemes, it is impossible to link a tangible outcome to a specific transfer.

The most important requirement for the successful working of a federation is an institutional mechanism for intergovernmental coordination, bargaining and conflict resolution. At present, no such institution exists. This has resulted in little coordination and a multitude of ad-hoc arrangements.

The Indian government has tried to address this institutional failing by setting up the Inter-State Council. Yet instead of setting up an independent institution, the government constituted the Inter-State Council under the Union Home Ministry. In 2015, the Modi government established the National Institute for Transforming India (NITI Aayog).

Hopefully, with time, the Inter-State Council will be merged with NITI Aayog to become an independent constitutional body. It could then undertake the important tasks of promoting trust and cooperation between the union and the states, regulating intergovernmental competition and promoting harmonious development.

One of the most significant failings of Indian federalism is the lack of effective decentralisation below the state level. Some of India’s states are larger than many countries. Decentralisation is, therefore, essential to ensure effective delivery of public services that respond to people’s diversified requirements.

Making federalism work for India requires substantial reform of federal institutions and a general decentralisation of policy. However, more importantly, federalism also requires the harmonious participation of diverse groups.

Without this, nation-wide product and factor markets cannot operate smoothly. Similarly, for optimal efficiency in service delivery and accountability, it is important to foster the spirit of cooperation and intergovernmental competition.

Making federalism work for India is republished with permission from East Asia Forum