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Finances: Maintaining Centre-State Balance


The Constitution of India laid out clearly in its seventh schedule which legislative and policy areas would be with the Centre and which would be with the states. There are three lists in the seventh schedule, called the Union list, the states list and the concurrent list. This demarcates not only the responsibilities but also their “powers.” Two more schedules were added (eleventh and twelfth) to the Constitution after the 73rd and 74th amendments which gave constitutional status to village councils (panchayats) and urban local bodies. These schedules too specified the power, authority and responsibilities of the local governments in rural and urban areas.

Balance of power

India is a Union of states, but the states themselves are creation of the Union. They did not voluntarily come together to form a United States of India. So from the beginning, the balance of power was always tilted toward the central government. But the Constitution recognised the immense diversity and sheer size of the nation State, and hence we have a federal polity. The empowerment of the states (and lower tier local governments) is a work in progress. Economic liberalisation also calls for further decentralisation of powers to lower tiers of government. What needs to remain with the Centre are only national issues like defence, foreign policy and nationwide infrastructure. In recent times, what we see is encroachment of the Union into the states’ list, i.e. the Centre playing an increasing role in discharging duties and making policies which are the domain of the states.

This past week saw the passing away of Marxist doyen Ashok Mitra, who became finance minister of Bengal in 1977. He played an important and effective role in pushing for more devolution of power, autonomy and resources to the states, which led to the formation of the Sarkaria Commission on Centre-State relations in 1983. That resulted in the historic formation of the Inter-State Council in 1990. The Council is not a permanent one and has to be reconstituted from time to time. Unfortunately, in the past 28 years, it has met less than a dozen times. The Council is a forum to discuss not just Centre-State issues but also inter-state issues like the sharing of river waters.

More to states

The economic reforms of 1991 implicitly granted more powers to the states. Since industrial licensing was discontinued, the Centre gave up its “permission” power. States started competing in attracting investments in terms of tax holidays (now not possible under GST), and on quality of infrastructure, ease of doing business, land allocation etc. The rollout of the nationwide goods and services tax (GST) signals that the pendulum is swinging back to more centralisation. This is because the states have given up their taxing powers (to collect VAT). In exchange, the Centre has given up its taxing power of excise and service taxes. Henceforth, all indirect tax policy and rates will be decided by the national body i.e. the GST Council. But in this Council, the Centre has more powers.

While the unified, one nation one tax has advantages like creation of a seamless national economic market, it does imply lower tax autonomy for individual states. Since states also have to abide by nationally determined fiscal discipline laws, their freedom to spend more on state-specific initiatives or respond to local needs is curtailed. They also cannot borrow from the market without the permission of the Reserve Bank of India (RBI) and the Centre.

In the past, a lot of innovation on the fiscal and development front did come from the states. Two shining examples are the mid-day meal scheme of Tamil Nadu, and the employment guarantee scheme of Maharashtra. Both have become national programmes and are now funded by the Centre. But when they were launched, they were very much state-specific, and funded by the states’ own resources. At that time, the respective states were even accused of being fiscally profligate. But the conviction of local government and local leaders carried the day.

It is perhaps because of these considerations that the Fourteenth Finance Commission (14FC) increased the share of tax resources that go to the states sharply from 32 to 42 per cent. This was in the spirit of cooperative federalism. Give more resources to the states, and let them decide their priorities. The FC has a constitutional responsibility of recommending a vertical split between Centre and states, and then a further horizontal split between various states. This is the split of the net tax proceeds exclusive of the states’ share of GST which anyway remains with them.

But lest this sounds as if the power balance is shifting to the states, look again. We find now that the Centre is increasingly involved in areas which were earmarked for the states as per the seventh schedule. This may be called “Centre’s creep” of governance. So now areas like employment, food security, education and even health insurance have a substantial provision by the Centre. These are respectively through the national rural employment guarantee scheme, the food security act, the Sarva Shiksha Abhiyaan and now the national health protection scheme. All of these will require more resources, and hence puts an upper limit on how much more can be devolved to the states by
the FC.

The FC is simply an arbiter of the balance of power (resources) between the Centre and states. Its recommendations are supposed to be based on fiscal needs of governments net of their own capacity to raise resources. If poorer states get more allocation, it is because they have bigger funding gaps. In the age of GST and increasing role of the Centre in the ‘states’ list,’ it implies lesser leeway for the states. The 15FC has already run into some rough weather, with the southern states demanding a change in the Terms of Reference, which mandate the use of 2011 census as the basis for population. This, however, is an inter-state issue rather than Centre-State issue. Irrespective of the issue of population basis, the 15FC has its task cut out in restoring the right balance between the Centre and states. These flows and ebbs in the Centre State tides of relationship are the sign of a robust federal democracy.

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