Table of Contents
Abstract:
Are India’s states being financially squeezed by a powerful central government? This essay delves into the contentious issue of fiscal federalism, examining the ongoing battle between states and the Union over borrowing powers, revenue sharing, and political representation. With Southern states voicing growing discontent, the question arises: can India’s federal structure withstand the strain?
Introduction
Fiscal federalism forms the bedrock of the financial relationships between various levels of government within a federal system. In the Indian context, it dictates the allocation of financial resources, responsibilities, and powers among the central government, state governments, and local bodies. This structure plays a critical role in determining the efficacy and sustainability of governance across the country. India’s Constitution provides a comprehensive framework that delineates taxation and expenditure powers between the Union and state governments. Institutions such as the Finance Commission and the recently established Goods and Services Tax (GST) Council under Article 279A(1) of the constitution are instrumental in operationalizing these fiscal arrangements.
Recent developments in India’s fiscal landscape have brought the issue of state borrowing into the spotlight, particularly in light of the ongoing economic and political tensions between the central government and the states. Southern states, in particular, have expressed concerns about fiscal inequities and their diminishing political influence.
The Constitutional Framework for State Borrowing
Article 293 of the Indian Constitution is central to understanding the borrowing powers of state governments. It grants states the authority to borrow within India, secured by their Consolidated Fund, but subject to limits prescribed by their respective state legislatures. However, if a state has any outstanding loans owed to the Union, it must obtain the Union’s consent for any additional borrowing. This clause allows the central government to impose conditions on state borrowing, thereby ensuring macroeconomic stability at the national level. Nevertheless, the oversight under Article 293 is contingent upon states having existing debt obligations to the Union. As states gradually clear these debts, they gain more autonomy in borrowing, raising concerns about the potential for fiscal indiscipline.
The balance between state autonomy and Union oversight in borrowing practices is delicate and often contentious. On one hand, states argue for greater autonomy to address region-specific needs and to fund large-scale developmental projects. On the other hand, the Union government emphasizes the need for fiscal prudence and macroeconomic stability. The use of Public Sector Undertakings (PSUs) by states to bypass borrowing restrictions under Article 293 exemplifies this tension. States contend that debts raised by PSUs should not be counted towards their borrowing limits, a loophole that obscures true state indebtedness and risks undermining fiscal transparency.
Shifting Patterns in State Borrowing
The evolution of state borrowing patterns in India reflects broader economic shifts. According to Reserve Bank of India (RBI) data, there has been a significant decline in the Union’s share of state loans—from 57% in 1991 to a mere 3% by the fiscal year 2020—as states increasingly turn to market borrowings.[1] This trend highlights the growing fiscal independence of states and their reliance on market mechanisms rather than Union assistance. However, the COVID-19 pandemic temporarily disrupted this pattern, with states once again relying on Union loans to manage the economic fallout. As the economy recovers, it is anticipated that states will revert to their pre-pandemic borrowing practices, further diminishing the Union’s regulatory power under Article 293.
Vertical Distribution and the Role of Finance Commissions
The Finance Commission plays a central role in India’s fiscal federalism by recommending how the divisible pool of central taxes should be shared between the Union and the States.[2] The divisible pool includes taxes like income tax, customs duties, and excise duties. However, the Union also collects cesses and surcharges that are not part of this divisible pool, which has been a growing concern for states.
The 14th Finance Commission, covering the period from 2015 to 2020, increased the States share in the divisible pool from 32% to 42%, significantly enhancing state-level fiscal autonomy. However, the 15th Finance Commission[3] (2020–2025) reduced the States’ share to 41%, citing the need for central fiscal responsibility. Despite the relatively small decrease, states—particularly in southern India—have criticized this reduction. Southern states, which contribute significantly to the national exchequer, feel they are being shortchanged by the central government.
Southern States’ Protests: Economic and Political Dimensions
One of the main points of contention in India’s fiscal federalism is the Union government’s increasing reliance on cesses and surcharges, which are not shared with states. Cesses are levied for specific purposes, such as education or healthcare, and contribute significantly to the Union’s revenue. For example, cesses and surcharges accounted for up to 28% of the Union’s gross tax revenue in recent years.
States argue that the growing reliance on these revenue sources reduces their share of the divisible pool, limiting their ability to finance essential public services like healthcare, education, and infrastructure development. Southern states, which contribute significantly to the national exchequer, feel particularly aggrieved by this arrangement.
One of the grievances of Southern states is the perceived fiscal inequity in the distribution of tax revenues.[4] These states, which are economically more developed, contribute significantly to the national economy but feel they receive disproportionately less in return. For example, Tamil Nadu has often highlighted that it receives only 29 paise for every rupee it contributes in taxes, whereas states like Bihar receive more than ₹7. [5]
With the principle of equalization, a state gets more than what it pays in terms of tax because of fiscal federalism, which boosts balanced development. The wealthier states may be able to pay more in taxes, while more economically weakened states, those experiencing greater poverty levels, or greater infrastructural needs are likely to receive greater amounts of funds from the central government to help finance their development such as size of population, income levels, and the state responsibility in delivering public services, which can make it receive more than what it contributes in taxes.
Beyond economic issues, the protests by Southern states are also fueled by concerns over political representation and cultural autonomy. The push for initiatives like “One Nation, One Election” and population-based delimitation are seen as attempts to centralize power and increase the dominance of North Indian states. The impending delimitation exercise, which is expected to increase the parliamentary representation of North Indian states, is viewed as a significant threat by Southern leaders, who fear a reduction in their states’ political influence. The equalization formula adopted by the 15th Finance Commission, which uses the 2011 census data instead of the 1971 criterion, has further deepened the South’s sense of fiscal injustice. Southern states, which have historically managed their populations more effectively, feel they are being penalized for their success in population control.[6]
Legal Challenges and the Debate on Borrowing Autonomy
In a landmark legal challenge, State of Kerala v. Union of India (2024) 7 SCC 183, the state has invoked Article 131 of the Constitution to contest the Union government’s borrowing limits. This case has brought Article 293 into sharp focus, particularly the balance between state autonomy and Union control. Kerala’s plea to remove borrowing limits imposed by the Union highlights the ongoing tension between state financial independence and the need for macroeconomic stability. The Supreme Court’s forthcoming interpretation of this issue, which has been referred to a five-judge Constitution Bench, is expected to have far-reaching implications for fiscal federalism in India.
The outcome of Kerala’s legal challenge will likely influence future borrowing practices and state autonomy. If the Court rules in favor of Kerala, it could pave the way for other states to demand greater borrowing freedoms, potentially leading to a more decentralized fiscal framework. However, there are also concerns that unchecked borrowing could result in fiscal indiscipline, increasing the risk of unsustainable debt levels and macroeconomic instability. The case underscores the need for a balanced approach that respects state autonomy while ensuring fiscal responsibility.
Potential Reforms to Strengthen Fiscal Federalism
One of the key reforms proposed to address the fiscal disparities between the Centre and the states is the expansion of the divisible poolto include portions of cesses and surcharges. By gradually reducing the reliance on these revenue sources, the Union government could enhance the financial autonomy of states and reduce the sense of fiscal imbalance. This reform would also ensure a more equitable distribution of resources, particularly for states that contribute significantly to the national economy.
To balance fiscal prudence with state autonomy, there is a need to revise the borrowing limits imposed on states. One approach could involve tying borrowing limits to fiscal performance, with states that demonstrate fiscal responsibility being granted greater borrowing freedoms. Additionally, the establishment of independent fiscal councils at the state level could provide objective assessments and recommendations, fostering sustainable debt management and fiscal transparency across states.
The growing concerns over political representation, particularly in light of the impending delimitation exercise, call for a reevaluation of the Rajya Sabah’s structure. Reforming the Rajya Sabha to provide equal representation for all states, regardless of population, could help balance the political power between the North and South. This would address Southern concerns about diminished representation and ensure that regional interests are adequately represented in national decision-making.
Conclusion
This essay has explored the complex interplay between state borrowing, fiscal disparities, and regional tensions within India’s federal framework. The issues surrounding state borrowing limits, the protests by Southern states, and the broader political and cultural dimensions of fiscal federalism highlight the need for a nuanced approach to governance. As India continues to navigate the challenges of fiscal federalism, it is essential to strike a balance between state autonomy and national stability. The proposed reforms, including the expansion of the divisible pool, the revision of borrowing limits, and the ensuring of equitable political representation, offer a roadmap for a more balanced and sustainable federal future. By addressing the concerns of all regions and fostering a spirit of cooperative federalism, India can ensure that its federal structure remains robust and resilient in the face of evolving economic and political challenges.
This article is authored by Ms. Shreya Ramteke, student at Dharmashastra National Law University, Jabalpur (DNLU).
[1] “Recent RBI Data Shows a Decline in Non-Performing Assets,” Drishti IAS, Drishti The Vision Foundation, accessed November 13, 2024.
[2] “Finance Commissions,” Drishti IAS, Drishti The Vision Foundation, accessed November 13, 2024.
[3] “What Is the Role of the Finance Commission? Explained,” The Hindu, The Hindu Group, accessed November 13, 2024.
[4] “What Is the Role of the Finance Commission? Explained,” The Hindu, The Hindu Group, accessed November 13, 2024.
[5] “Inside the Centre vs States Battle Over Funds,” Hindustan Times, HT Media Ltd., accessed November 13, 2024.
[6]“Why India Needs Concessionary Federalism to Address the Grievances of Its Southern States,” Scroll.in, Scroll Media Inc., accessed November 13, 2024.
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