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Q 33- The economic complement to political federalism is fiscal federalism. Provide appropriate examples to illustrate your point. ( 250 words)

  • Paper & Topic: GS I à Functions and responsibilities of the Union and the    

     States, issues and challenges pertaining to the federal structure, devolution of

     powers and finances up to local levels and challenges therein.


  • Model Answer:


  • Introduction:


  • The financial interactions between units of government in a federal government system are known as fiscal federalism.


  • It's part of a larger public-finance framework.
  • Richard Musgrave, a German-born American economist, coined the term in 1959.
  • The separation of governmental activities and financial links among tiers of government is referred to as fiscal federalism.


  • Body:


  • India has a federal government, which means it has a federal fiscal system.
  • The backbone of a federal government's successful operation is financial independence and adequacy.
  • The necessity for fiscal federalism was stressed in the Economic Survey 2017-18.


  • Fiscal federalism and political federalism are linked:


  • Fiscal federalism is concerned with the delegation of functions to various levels of government on the one hand, and the use of suitable fiscal tools to carry out these functions on the other.
  • The central government is widely regarded to be required to deliver national public goods that benefit the entire people. Defense is a common example given.
  • Sub-national governments are required to offer commodities and services that are only consumed within their borders.
  • The identification of the exact fiscal tools that would enable the various levels of government to carry out their tasks is an equally essential subject in fiscal federalism. This is known as the 'tax-assignment issue.'
  • It is generally agreed that non-benefit taxes and taxes on movable units should be avoided at the decentralised levels of government.
  • Income tax is only levied by the central government in India, albeit it is shared with the states. Many countries have an inter-governmental transfer system in place to address the possibility of resource and responsibility imbalances.
  • The Indian Constitution establishes the functions of the Centre and States, as well as their taxing powers.
  • Every Finance Commission has handled issues linked to the rectification of vertical and horizontal imbalances against this backdrop, taking into consideration the current set of circumstances.
  • Transfers from the federal government to the states, on the other hand, are not limited to the recommendations of the Finance Commissions. Other options include the Planning Commission, which existed until recently, and the Central Government's discretionary grants.


  • Concerns and obstacles that go along with it:


  • Trends in Tax Revenue: A comparison of the proportion of central and state-owned taxes and expenditures reveals that the states own 38 percent and 58 percent of their own tax revenue and expenditure, respectively.
  • This reflects the states' higher-than-proportionate expenditure commitments, as well as their limited revenue-raising powers in comparison to the federal government.
  • After the 80th Constitutional Amendment, the net earnings of all taxes levied by the union, except surcharges and cesses, are divided with the states under Article 270 of the Constitution.
  • Article 279 of the Constitution defines net revenues as the center's gross tax revenue less surcharges and cesses, as well as collection costs. The amount of net proceeds, however, is not included in the union's budget statements.
  • However, the proportion of surcharges and cesses in the federal government's gross tax collection is increasing, counteracting the higher shares proposed by previous finance commissions.
  • FRBM Acts and Asymmetric Impacts: In the early 2000s, the FRBM Acts were passed at the national and state levels.
  • It was solely focused on meeting objectives. In exchange, if revenues could not be increased, expenditure (even if it was necessary) would be reduced.
  • States have been required to restrict their deficits due to financial commission punishments, although the federal government is not bound by any such conditions.
  • States have inefficient cash management because they are afraid of the implications of not adhering to deficit targets, which are not only a legislative constraint but also a conditionality enforced by finance commissions.


  • Steps to take/Conclusion:


  • Perhaps now is the moment to alter the Constitution to ensure that the percentage of shared taxes that should go to the states is set at the appropriate amount.
  • Because cesses and surcharges have risen dramatically in recent years, they must be included in the sharing tax pool.
  • It appears reasonable to set the ratio at 42 percent of shareable taxes, including cesses and surcharges.
  • Another option is to adopt the approach of the United States and Canada, which is to enable states to impose personal income taxes with limited restrictions.
  • States must be restricted in their freedom. It's crucial to highlight that the levy levied by the federal government and the states should be reasonable.
  • The transfers from the Centre will also need to be adjusted once this power is given to the States.
  • Horizontal Distribution: In India, the ability to achieve equalisation between states is limited.
  • Even the relatively wealthier countries face problems and feel cheated as a result of the overuse of the equity criterion.
  • Particularly in light of the surge in unconditional payments, a proper balancing of criteria is required.


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