March 9, 2015

The evolving dynamics of union–state fiscal relations

Focusing on the altered public financial management dynamics of state governments and analysing the opportunities and challenges.

There have been many developments recently that will significantly alter the dynamics of the fiscal relations between the Union Government on the one hand and the States and Urban and Local bodies on the other. These developments will profoundly impact public financial management practices at all levels of government, creating both opportunities and challenges.


This article focuses on the altered public financial management dynamics of state governments. Their role in public finances is crucial as indicated by the share of net Union Government taxes contributing about 43 percent of total taxes of the Union and State Governments in 2013-14, with states accounting for the rest. The corresponding proportions for total expenditure for 2013-14 are 49 percent for the Union government and 51 percent for the State Governments. The key objective function (requiring well-considered trade-offs in a medium-term perspective) at all levels of government, in an environment of co-operative as well constructively competitive federalism, will continue to be the following:
One, To progress towards fiscal consolidation (i.e. adhering to fiscal deficit, debt level, and contingent fiscal liabilities guidelines), enhancing fiscal flexibility (i.e. the ability to reallocate public spending  towards priority areas), and  increasing government investment in identified priority areas;
Two, to improve public expenditure management, involving spending less, (by measures such as more effective procurement practices), spending well (i.e. improvements in relationship between expenditures incurred and output obtained in physical terms), and spending wisely (i.e.  improving overall societal welfare);
Three, enhancing competence in generating resources from non-conventional methods including using state assets more productively through various measures such as monetising and auctioning of state’s tangible and intangible property rights.

The above is indeed a complex objective function, requiring much greater level of professionalism in management of public finances and public governance at all levels of government. The term co-operative federalism is meant to create a process and an environment of greater trust between the Union Government and the States, as without such trust government initiatives are severely constrained in obtaining desired outcomes.  The Union Governments’ decision to let the States benefit from the recent coal auctions is an illustration of the steps which can improve trust between the Union and States.The competition among the States will increase as the gap between their resources and responsibilities reduces over time. Such competition however should not occur at the cost of overall national progress.

Among the several developments impacting on Union-State fiscal relations, three are highlighted below.
First, the Report of the 14th Finance Commission (FC). The Report of the 14th Finance Commission represents a changed paradigm for Union –State fiscal relations. As Prime Minister Modi, in accepting the recommendations of the 14th FC stated “there is a shift from scheme and grant- based support from the Central Government to a devolution based support”. The distinction between plan and non-plan revenue and expenditure has outlived its usefulness as all state plan revenue expenditure will need to be met from resources devolved to the States. It is in this context that the increase of 10 percentage point devolution of divisible resources to the state to 42 percent must be viewed. The 14th FC has also proposed a new horizontal formula for the distribution of state’s share in the divisible pool. While all states will gain from the 14th FC’s recommendations, the gains will be uneven. In general, spending capacity of the states will increase substantially.

The 14th FC also attempts to change the incentive structure of the states towards greater professionalism and accountability in their fiscal management, and suggests institutional mechanisms for better monitoring of fiscal rules and to progress towards ‘cooperative federalism’. The above has the potential to create a dynamics in which states can compete constructively on achieving desirable outcomes for the society, rather than the current practice of focusing only on getting larger share from the Union Government, while making insufficient effort to improve their public financial management.

The above will require a mind-set change and higher level of political and citizenry maturity. The devolution –based approach will make more resources available to the States (signifying opportunities) but will also increase their responsibilities and make greater demands on their capabilities and capacities (signifying challenges). Those states that focus on initiatives in public financial management and in improving governance to enable taking advantage of the opportunities will be in a better position to better improve welfare of their residents.

Second, the NITI Aayog: The establishment of the National Institution for Transforming India (NITI) Aayog (the word Aayog appears redundant, and could be dropped) on January 1, 2015, as a replacement for the unlamented former Planning Commission, represents another significant development which is likely to change the dynamics of the Union–State financial relations.

The structure of NITI Aayog, in which Chief Ministers of States are represented, has the potential to facilitate Union-State coordination, coherence, and effectiveness of the policy initiatives, including in public financial management. NITI Aayog could also help in generating ideas and body of knowledge that could contribute to better understanding of the implications of the policy/program/scheme proposals before they are implemented, and thereby helping to achieve better outcomes. Its success however will require a degree of trust between the Union Government and the States, and to put greater focus on outcomes or results obtained from public policy initiatives than on spending.

In the first meeting of NITI Aayog on February 8, 2015, three sub-committees of Chief Ministers were constituted. One of these schemes on analysing the Central Sponsored Scheme (CSS), with a view to reducing their number drastically, and transferring some entirely to states to design and implement to realise state-specific desired outcomes, is relevant for the discussion here. The outcome of the deliberations will provide States with greater control over their resources and initiatives, but will also require greater institutional and organisational capacities and accountability from the States.

As NITI Aayog evolves as an institution, states will have increasing opportunities to shape Union-State relations in the spirit of co-operative federalism, while competing with each other in terms of improving outcomes of public policies.

Third, the GST (Goods and Services Tax): The proposed introduction of dual GST at the Union Government and at the State level is among the most ambitions consumption tax reforms attempted in India. The current constitution does not permit the Union Government to levy sales tax on goods and does not permit the States to levy sales tax on services. This anomaly is what the GST Constitutional Amendment Bill (introduced on December 19, 2014) seeks to correct. The GST will permit goods and services to be taxed in uniform manner, substantially reducing compliance costs, tax, structure, and will enable unified national level market goods and services to emerge.

Among the proposals in the Bill is for establishing GST council in which the states will have two-third of the voting share, with one-third for the Union government. The concept of GST council for administering a sales tax in a federal country is unique. The representation of the States in the GST council, and the inclusion of services in the tax-basket of the states (in many states, services account for between half and two-third) of the Gross State Domestic Product (GSDP), will impact on public financial management practices in the States.  Substantially higher devolution of Union Government’s divisible taxes (42 percent), could also give states an incentive to improve GST revenue through better compliance and higher growth.

The States so far have had no experience of levying taxes on services. GST will extensively use Information Technology (IT) based platforms, require more elaborate M(TIN) arrangements (which have so far not been instituted for so called indirect taxes), and require much higher level of data mining capabilities nationally. The proposed GST provides a good opportunity to all levels of Government to enhance professionalism and modernisation of tax administration and compliance organisations at all levels of government.

The proposed GST thus represents another area with significant impact on Union-State financial relations. Establishing a task force to help smoothen GST implementation (in many states, sales tax comprise between half and two-third of state’s own tax revenue), and improve fiscal systems. In design and implementation of the GST, there is scope for co-operative federalism initiatives, such as in shared services, particularly in IT, TIN, and data mining areas.

In conclusion, the above three developments will significantly alter the dynamics of Union government-State relations, particularly in the area of public financial management. There is strong merit in initiating a high quality public policy dialogue on how the States can prepare themselves to take advantage of the opportunities arising from the changed dynamics of Union-State relations.

Photo: Wikimedia

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