Fiscal federalism

Syllabus
GS Paper 2: Government Budgeting

Applications where to apply?
When asked about
Fiscal federalism
Cooperative federalism
Financial prudence
Prelims terms

Context
The financial dynamics between the central and state governments in India have recently come under scrutiny due to various policies and decisions that affect fiscal federalism. Kerala, in particular, has raised concerns over the imposition of a Net Borrowing Ceiling (NBC) by the central government

Source
The Hindu | Editorial dated 7^th  February 2024

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Union government’s reins on financial transfers to States; The severe erosion of fiscal federalism

The financial relationship between the central and state governments in India is a critical aspect of fiscal federalism. Recent policies and decisions, including the imposition of a Net Borrowing Ceiling (NBC), have sparked debates regarding the balance of power and autonomy between the two tiers of government.

Key Terms in the article

1. Net Borrowing Ceiling (NBC): The NBC limits the amount of money that states can borrow from all sources, including open market borrowings. It includes deductions for liabilities arising from public accounts and borrowings by state-owned enterprises.
2. Open Market Operations (OMO): Open Market Operations refer to the buying and selling of government securities (bonds) by the central bank in the open market to control the money supply and influence interest rates. When the central bank buys government securities, it injects money into the banking system, increasing the money supply and lowering interest rates. Conversely, when it sells government securities, it withdraws money from the banking system, reducing the money supply and raising interest rates.
3. Fiscal Federalism: Fiscal federalism refers to the division of financial responsibilities and powers between the central and state governments within a federal system. It involves revenue generation, expenditure allocation, and borrowing authority, aiming to achieve equitable distribution of resources and efficient public service delivery.
4. Finance Commission: The Finance Commission is a constitutional body under Article 280 of the constitution.It recommends the distribution of financial resources between the central and state governments. It also suggests principles governing grants-in-aid to states and other financial matters to promote fiscal stability and equity.
5. Centrally Sponsored Schemes (CSS): CSS are schemes or programs implemented by the central government, where both the central and state governments contribute funds. The central government typically provides a larger share of the funding, and states are required to match a portion of it.
6. Central Sector Schemes (CSec): CSec schemes are fully funded by the central government and implemented in sectors where it has exclusive legislative or administrative control. The central government allocates funds directly to these schemes, influencing resource allocation and development priorities at the state level.
7. Gross Tax Revenue: Gross tax revenue refers to the total revenue generated by the government through various taxes before any deductions or adjustments.
8. Statutory Grants: Statutory grants are financial transfers mandated by law or through constitutional provisions, such as those recommended by the Finance Commission. These grants aim to support states in meeting their expenditure requirements and achieving balanced economic growth.
9. Cooperative Federalism: Cooperative federalism is a model of federal governance where the central and state governments collaborate and coordinate their efforts to address shared challenges and achieve common goals. It emphasizes partnership, mutual respect, and shared decision-making in matters of governance and policy implementation.

 Constitutional and legal provisions

1. Article 293(3) of the Constitution: This provision pertains to the requirement for states to obtain the consent of the Centre for raising loans if any part of the previous loan extended by the Centre is outstanding.
2. Article 266(2) of the Constitution: This article indicates that money collected by the Central or State government, which does not pertain to the consolidated fund, can be brought under the head of ‘public accounts’. The State relies upon this article to argue that balances in the public account of the State should not be included in the NBC.
3. Article 202 of the Constitution: This article tasks the State government with determining the revenue and receipts and corresponding expenditure and with presenting the Budget of the State before the Legislative Assembly. It emphasizes that budget management of the State is the discretion of the State government.
4. Entry 43 of the State List of the Constitution: This entry deals with the “Public Debt of the State”. It implies that Parliament does not have the power to legislate upon the public debt of the State as it falls under the domain of the State Legislature.

These constitutional provisions are crucial in understanding the legal framework and the distribution of powers between the central and state governments regarding fiscal matters and financial management.

Erosion of Fiscal federalism

Declining Financial Transfers to States:

• Despite recommendations by the Fourteenth and Fifteenth Finance Commissions to increase financial transfers to states, the central government has reduced such transfers, impacting state budgets and development initiatives.
• The declining share of states in gross tax revenue and reduced grants-in-aid indicate a trend of centralization of financial resources and discretionary expenditure by the central government.

Imposition of Net Borrowing Ceiling (NBC):

• The NBC limits state governments’ borrowings from all sources, including open market borrowings, leading to financial constraints.
• Kerala, in particular, opposes the inclusion of debt taken by state-owned enterprises, such as the Kerala Infrastructure Investment Fund Board (KIIFB), in the NBC, which impedes its ability to fund essential projects and welfare schemes.

Central Sector Schemes (CSec) and Centrally Sponsored Schemes (CSS):

• The central government’s emphasis on CSec and CSS schemes influences state priorities and financial commitments, potentially exacerbating inter-state inequality.
• The non-statutory nature of financial transfers through CSec and CSS schemes limits state autonomy in public expenditure and fosters dependence on the central government.

Conclusion

The financial policies and decisions of the central government have significant implications for fiscal federalism and state autonomy in India. Kerala’s protest against the NBC and concerns over declining financial transfers highlight the need for a balanced approach to intergovernmental relations and fiscal management. Upholding cooperative federalism requires meaningful dialogue and collaboration between the central and state governments to address disparities and ensure equitable development across regions.

RELATED TOPICS

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003

The FRBM Act is a crucial piece of legislation that aims to bring fiscal discipline and transparency to the Indian government’s budget management.

Objectives:

• Reduce India’s fiscal deficit: The Act aimed to eliminate the revenue deficit by 2006 and bring down the fiscal deficit to 3% of GDP by 2008. These targets have been revised over time.
• Improve macroeconomic management: By controlling deficits and debt, the Act aims to foster long-term economic stability and growth.
• Enhance transparency: Regular fiscal reports and adherence to established targets aim to increase public accountability and understanding of government finances.

Key Provisions:

• Fiscal deficit and debt targets: The Act sets specific targets for the central government’s fiscal deficit and debt-to-GDP ratio. These targets are reviewed periodically and can be adjusted based on economic conditions.
• Fiscal policy statements: The government is required to present two key statements to Parliament each year.
  • Fiscal Policy Statement: Outlines the medium-term fiscal framework and targets.
  • Macroeconomic Framework Statement: Provides an overview of the broader economic context and assumptions underlying the fiscal strategy.
• Escape clause: Under exceptional circumstances, the government can deviate from the fiscal targets but needs to present a corrective action plan to Parliament.

Fiscal deficit targets

• The target for the current fiscal year, ending March 31, 2024, is 5.9% of GDP
• The government aims to bring the fiscal deficit down to 4.5% of GDP by 2025-26.
• The interim budget presented in February 2024 set a target of 5.1% for 2024-25, down from the revised estimate of 5.8% for the current year.

References

Investopedia

PIB.

The Hindu

Economic Times

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Practice Question

Discuss the potential implications of recent reduction in central government financial transfers to states.[150 words]