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NDA Coalition Takes Office: Will India’s Fiscal Federalism Get Restored?

With the basic complexion of the Modi sarkar changing into a coalition, how is fiscal federalism likely to shape up?

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India has a new coalition government under the BJP-led NDA (Bharatiya Janata Party, National Democratic Alliance). Narendra Modi is now in his third tenure as prime minister with the BJP contributing 240 MPs for the requisite parliamentary majority of 272. While many small regional parties make up the NDA with a total strength of 293, the TDP and JD(U) are two strong constituents with 28 seats between them, enough to destabilise the NDA government anytime they want.

In the last 10 years, Narendra Modi de facto functioned as a one-man decision-maker on account of the absolute majority of the BJP, and as a very strong centralising force converting his party's governments in the states into unquestioning second engines.

He also kept Opposition state governments on a very tight leash by tightly controlling central funds, using governors to put sand in their tracks, and stopping bills from being passed by their legislatures. Occasionally, non-BJP governments were also toppled, transforming the people’s mandate into BJP-led governments.

The federal polity of India, therefore, had been effectively converted into a highly centralised one. With the basic complexion of the Modi government now changing into an NDA government, how is India’s fiscal federalism likely to shape up?
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Second Engine Sputtered

The Indian Constitution has a built-in double-engine sarkar mechanism with the centre and the states. After the 72nd and 73rd Amendments, India intended to constitutionally convert into a triple-engine sarkar, with the local bodies empowered as the third engine. Alas, that did not happen.

The states have significant independent taxation powers making them sub-sovereigns. They have large and independent developmental and expenditure jurisdiction with about three-fifths of all expenditures undertaken within their jurisdiction. Constitutionally, they also have full powers to borrow except in one situation — if they have outstanding loans to the centre.

The states agreed to pool their sales/value-added tax sovereignty and a few other taxation powers into the GST (Goods and Services Tax), believing that they would be equal partners in deciding the GST policy and administering it. The Modi government, using the centre’s and the BJP states’ combined power, converted the GST policy and administration into central government-administered tax, literally.

The Modi government’s absolute refusal to listen to the states on payment of assured GST compensation during the pandemic years epitomised this dominance.

Centrally Sponsored Schemes (CSS) were turned into instruments of strangulating states’ expenditure and development authority. The CSSs were renamed to make these appear as central government schemes. The centre controlled allocations and micro-managed the programme interventions.

The counterpart share of states in CSSs was raised substantially and the overall size of states’ programmes was downsized, forcing the states to bear a disproportionally large share of the schemes' costs. The release of central funds was regulated, and intrusive auditing of expenditure, especially in the Opposition states, was undertaken to block the release of funds.

The CSSs had transformed into favours that the central government would do for the states.

Borrowings of states, especially of Opposition states facing tighter budgetary situations like Kerala and Andhra Pradesh for example, were regulated with a heavy hand. Their borrowing limits were reduced by recovering alleged past excess borrowings. The additional borrowing allowed during the time of COVID-19 was subjected to so many conditions that the states were always scurrying to comply with these conditions.

The centre has the authority to approve borrowing only when the states have outstanding debts. To make sure that the states don’t escape the centre’s clutches, the Modi government brought in the interest-free 50-year capital expenditure loans to bribe the state so that they stay indebted, by reversing the well-considered policy decision taken in 2005-06 to stop central government loans to the states.

The state engine sputtered. In fact, the state engine lost most of its automotive power and got converted into a tractor-trolly hitched to the central engine.

India Needs Restoration of Federalism; Make States Pre-eminent in GST Council

India needs the restoration of federalism. India, after all, is a union of states. It is a federal country and can never be governed and developed as a centralised polity.

What needs to be done to restore state autonomy and authority?

It is highly unlikely that one political party would rule at the centre and the other in all or majority of the states, as it is also unlikely that one political party will rule both at the centre and in all the states.

To make the states the primary decision-making force in the GST Council, it is important to reduce the centre’s voting power to less than 15 percent from the current one-third in the council. This will make sure that the centre is not the exclusive force in the GST Council and that the states ruled by different political parties would need to negotiate hard to build a consensus and take decisions.

The central government was on course to make offences under the GST law a predicate offence under the PMLA, which would provide excessive jurisdiction to the Enforcement Directorate, an exclusive central agency. This move needs to be stopped in its tracks.

The compensation cess extended up to 2025-26 will bring revenues far more than that required for discharging the loans taken for meeting the GST compensation shortfall during the pandemic. The government should share the entire surplus in compensation cess with the states.

While there are quite a few more measures required, the restoration of the states’ authority in the GST council will be a big boost to genuine fiscal federalism in the country.

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Eliminate CSSs or Transfer Real Decision Making to States

All the CSSs are in a space that is constitutionally placed in the states’ domain (List II). There is no original and real justification for the central government to be in that space through the device of CSSs. Instead, the Modi government had converted the CSSs into millstones around the states’ necks.

The best solution, in line with the constitutional spirit, is to dismantle CSSs and transfer the current level of the CSS funds to the states in accordance with the Finance Commission devolution formula.

The central government, however, does have a legitimate reason to nudge the states to undertake certain critical programmes of national development and provide succour to the poor and marginalised, like controlling pollution and carbon emissions, institutionalising an unemployment fall-back scheme like MGNREGA, establishing a sound primary health infrastructure in the country, and so on.

The central government, if it wishes to undertake such programmes through the CSS, may transfer the requisite funds to the states and link the same to specified milestones in achieving the key programme indicators (KPIs). Every other decision-making authority, regarding what interventions to make, the scale of assistance to be provided, and where to implement, must all be left to the states.

If their interventions succeed, the concerned states will get promised central funds. If they fail or achieve outcomes partially, they don’t get any funds or only proportional funds linked to the success scale.

There is no place for any special packages or justification for declaring any general state like Andhra Pradesh and Bihar as a special category state. That only distorts fiscal federalism further.

This fundamental re-orientation of central interventions in the states’ development and expenditure domain would not only restore pre-eminence in their own expenditure and developmental space but also improve the outcomes of the schemes.

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Free States From Control on Borrowings

Indian states are strong fiscal entities. They can manage their borrowings. The limits on their borrowings have been prescribed in their fiscal responsibility and budget management laws.

To unravel the intrusive central authority in the matter of borrowing, the central government should stop providing loans to states. The NDA government should discontinue the capital expenditure loan scheme.

Instead, the central government should bring, as the Atal Bihari Vajpayee-led NDA government did in 2003, a debt swap scheme to enable the states to borrow from the market to repay all existing central loans. The debt swap scheme can be implemented over a two-to-three-year period. The states would have no outstanding loans and the central authority to regulate their borrowings would disappear.

The Reserve Bank of India presently manages cash and borrowings of the states. This results in an implicit RBI guarantee of no default with respect to the states’ market securities. This cosy arrangement wipes out the risk differential between different states’ securities, leading to a situation where highly debt-stressed states like Kerala and Punjab are also able to borrow at the same yield as the fiscally disciplined states do.

The states need to be subjected to market tests for the pricing of their bonds. The RBI must allow default on interest or principal payment if there are no funds in the defaulting state’s account. The fundamental logic of a coalition government in India is to operate a true and cooperative fiscal federal system in the country.

The NDA coalition government provides an excellent opportunity for Prime Minister Narendra Modi to course correct and reboot India from a fiscal union to a fiscal federal nation.

This, I am sure, the Opposition would also support wholeheartedly as their alliance is, in fact, a better representative of the federal character of India’s polity.

(The author is former Economic Affairs Secretary and former Finance Secretary of India. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)

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