Centre-State Fiscal Relations in India - Need for Restructuring

It is well-known that federal form of government is best suited for a society with vastly diverse economic and cultural background such as India. There are not only political reasons but also powerful economic arguments for preferring a federal system to unitary system of governance. In India the necessary institutional structure has been evolving over the past six decades. Yet, the system in India remains imperfect: Firstly, there exist several unresolved issues in the operationalization of the federal fiscal sharing management; and, Secondly, the changing contours in the economy and the resultant policy changes in the economic governance call for fundamental revamping of the federal fiscal mechanism. Especially, in recent years with the land mark changes such as the shift towards liberalization in 1991, the introduction of the Fiscal Responsibility and Budgetary Management (FRBM) Act, the replacement of the Planning Commission with National Institution for Transforming India (NITI) Aaayog, implementation of the Direct Tax Code, and introduction of the Goods and Services Tax (GST) that might alter the revenue positions of the Centre, State and Local level governments. All this signal that it is time for revamping of the system of federal fiscal arrangements for inter-governmental transfers in India. The purpose of the present paper is to suggest suitable alterations in the federal fiscal system in India considering the possible changes in the structure of the economy and the potential revenue generation at different levels of government. It lists out the broad requirements of federal fiscal system; analyzes the Indian experience so far; explains the need for reforming and revamping the system; explains the methods for revamping the system; and suggests broad lines of reform. The suggestions include: 1. Set up a permanent Finance Commission2. Converge the relevant bodies into the Commission3. Extend the terms of reference, and expand the membership4. Involve the National Development Council for States' cooperation5. Federal fiscal sharing should be from all revenue sources6. Transfers should be consensus based7. Vertical sharing choices and methods8. Horizontal sharing should be more rational and objectively determined9. Grants-in-aid to reflect broad economic policy objectives10. Incentivize the Grants-in-aid11. Capital grants should be project by project based on economic and financial viability