Towards India’s new fiscal federalism


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THE Indian economy today is on a growth turnpike. The deep determinants of India’s remarkable growth have been institutions, demographic transition, modern technology and accumulation of both human and physical capital. In my view, the most important of these factors has been our democratic framework, a key foundational institution.

In a country as beautifully diverse as ours, federalism as an organising principle is clearly the only way to succeed. In the analytical literature, ‘coming together’ and ‘holding together’ are the recognized forms of federalism. The United States is the classic illustration of the first whereas the erstwhile Pakistan or Yugoslavia perhaps could be seen as illustrating the second.

Our approach to federalism is idiosyncratic. The distinguished jurist Fali Nariman calls it ‘quasi federalism’. I think it is better described as ‘cooperative federalism’, where governance has a multi-level form with evolving relations between different levels of government. Our model of cooperative federalism also offers flexibility for creatively responding to evolving structural changes. An example perhaps is the concurrent list, an unique feature of our Constitution.

Fiscal federalism has been one of the most important pillars for the success of our enduring democracy. It mainly comprises allocation of rights and duties related to taxation and expenditure responsibilities and system of transfers between the different jurisdictions/levels of government such as the Centre, state and local governments.

In the framework of fiscal federalism, federations have tried to tackle two important issues, i.e. vertical imbalance and horizontal imbalance. Vertical imbalance essentially arises due to the fiscal asymmetry in powers of taxation vested with the different levels of government in relation to their expenditure responsibilities prescribed by the Constitution. Horizontal imbalance arises because of the differential capacity to tax amongst the states as against the expenditures required for providing pubic goods of comparable quantity and quality to those residing in their states. This in turn arises because of the vast regional imbalances in terms of per capita incomes, stage of demographic transition, physical infrastructure levels, social capital endowment and so on. The unevenness of developmental outcomes, of course, gets further compounded by the differences in the levels of effective governance.


In India, these regional disparities in terms of per capita incomes are becoming sharper leading to yet another imbalance, i.e. a ‘development imbalance’. For instance, in developed countries the ratio of per capita incomes between the most and least developed regions seldom exceeds two, whereas in our case it is more than six. This is accounted for by differences in growth rates between states over a period of time, i.e. due to a ‘development imbalance’.

These three imbalances if not satisfactorily resolved, will provide the seeds for political discontent and thus threaten the very democratic fabric and the national security. For successfully meeting the challenges posed by the three imbalances requires us to move to what I call a ‘New Fiscal Federalism’.

Our Constitution and creative democratic politics had addressed such issues by creating two institutions, viz. the Finance Commission and Planning Commission for promoting fiscal federalism. The Finance Commission derives its raison de etre from Articles 275, 280 and their sub-clauses to meet horizontal and vertical imbalance, whereas our political process leveraged Article 282 to create the Planning Commission.

Over the years, successive Finance Commissions played an important role towards strengthening fiscal federalism. Let me take the example of the more recent ones. The 10th FC chaired by K.C. Pant combined all the taxes into one pool for the purpose of devolution rather than doing it based on tax sources. This paved the way for important tariff reforms. The 12th FC under the Chairmanship of Dr Rangarajan enhanced the fiscal stability of the states by linking grants conditional upon observable fiscal discipline by the states. This was very effective in improving the fiscal health of the states. The 13th FC opened up the possibility of formulaic tax devolution to the third tier in order to strengthen and empower democratic decentralization process. The 14th FC gave a sharp increase in the percentage share of taxes devolved to the states whilst virtually in effect eliminating conditional transfers via the Planning Commission grants or grants under Central Sector/Sponsored Schemes. This along with the replacement of the Planning Commission by the NITI Aayog is considered by some, a major reform for our cooperative federalism.

However, in the present scheme of things, the collapsing of two different sources of transfers, aimed at differing objectives, is deeply problematic.


Let me step back here for a bit and recall the two different types of horizontal imbalances that I talked about. Each of these imbalances is important and needs to be rectified. One has to do with the differing levels of per capita consumption of basic public goods and services. The other has to do with the differing levels of stock of infrastructure leading the differential growth, accelerating potential development. These are two distinct policy goals and following the Tinbergen Principle warrant two distinct policy instruments. Eliminating the Planning Commission and replacing this with NITI Aayog, merely as a think tank, leaves us with only one instrument; namely the Finance Commission. This approach, if not reviewed, can lead to a serious problem of increasing regional and sub-regional inequities.


There are not many studies in India which have looked at regional growth patterns. The paper by Arvind Panagariya published in 2010 argued that the relatively poorer regions are experiencing a faster rate of growth and higher rate of poverty reduction.1 A recent paper by Pinaki Chakraborty, my colleague at NIPFP, gives a more nuanced answer.2 He argues that India has been experiencing a process of ‘conditional convergence’ amongst the different states. Even this qualified result suggests that our policy approach of using an additional policy instrument such as the Planning Commission for resource transfers to the states through plan grants has been useful in reducing the ‘development imbalance’. The challenge, of course, is how to make it more effective.

There is, therefore, a deep analytical foundation for a case where the NITI Aayog gets significant levels of resources for allocating to different states. These resource transfers will be aimed at mitigating the development imbalances by promoting accelerated growth of lagging states and sub-regions. Given our political economy, these grants need to be conditional and formulaic. The purpose of these grants would be to enable the lagging states to build capacities in infrastructure sectors such as roads, ports, railways and digital connectivity, supply of power, access to credit and for improving governance. This will serve the objective of helping the lagging states and regions to attain growth acceleration and a reduction in the developmental gap.


It is possible to suggest that such allocation of transfer grants be administered by the Ministry of Finance. But, by nature of its mandate, the Ministry of Finance is primarily concerned with the issues related to short/medium-term macroeconomic stability including managing balance of payments, inflation and business cycle, not with structural transformation. Invoking the Tinbergen’s assignment principle, viz. number of objectives matching the number of instruments, it is desirable that a functionally distinct entity such as the new NITI Aayog or NITI Aayog 2.0 be put to use to do the job at hand related to the structural issues including removal of regional imbalances in the economy.

Let me hasten to add that I am not suggesting for a moment that NITI Aayog 2.0 should take the form of the old Planning Commission. In the age of globalization and an open economy, the macro-economic framework has to be different in terms of an analytical framework and approach. It should refrain from the micro-management of central ministries and state governments via excessive bureaucratization. Similarly, NITI Aayog 2.0 need not be involved with the approval of the states’ annual expenditure programmes. It should rather be a think tank with ‘praxis’ possessing considerable financial muscle and devote its energies to outline coherent medium and long-term strategy and the corresponding investment resources for transforming India.

Towards this end, my preliminary study suggests that the NITI Aayog 2.0 will annually need resources of around 1.5% to 2% of the GDP to provide suitable grants to the states for mitigating the development imbalance. These formulaic annual grants, whether capital grants or revenue grants for the relevant CSS, will need to be conditional to ensure that (i) outcomes are commensurate and (ii) it discourages an individual state to adopt policies that have negative policy externalities, e.g. creation of populist subsidies, to avoid a race to the bottom.


In order to make the new NITI Aayog more effective, it is essential to ensure that the institution is at the ‘high table’ of decision making of the government. This means the Vice Chairman of the new NITI Aayog will need to be a permanent invitee to the Cabinet Committee on Economic Affairs. Thus, the new NITI Aayog will make available to the highest level of policy making knowledge-based advice and provide the national and long-term perspective on the policy proposals. Today, there is no such advice available to our Cabinet. I cannot overemphasize the need for such a perspective as every ministry tends to take a sectional or sectoral view. Equally, individual ministries cannot fully take into account the inter-sectoral implications or the long-term implications for the different regions of India.

I should also mention here that to enable this, the establishment of an Independent Evaluation Office in the new NITI Aayog will be sine qua non as it will be an important instrument in improving development outcomes, expenditure efficiency and accountability. With the Finance Commission being the first pillar, NITI Aayog 2.0 will be the second pillar of the ‘new fiscal federalism’.

As stated earlier, ‘development imbalance’ issues exist at the state level too due to intra-state/regional disparities.3 Hence, the State Finance Commissions and the State Planning Boards will also need to keep the above perspective. This means that the State Finance Commissions will need to be strengthened in terms of their mandate, and their recommendations should receive acceptance similar to the Central Finance Commission. This can be achieved by amending (i) Article 266 of the Constitution to include a consolidated fund for municipalities and panchayats, and (ii) Articles 243H and 243X to ensure that revenue allocated by the central and state Finance Commissions to municipalities and panchayats do not form part of the consolidated fund of the state. The funds should flow directly to the consolidated fund thus created.


It is necessary to vigorously implement the 73rd and 74th Amendments. This will promote democratic decentralization by empowering the third tier of our federalism. To give content to such empowerment involves transferring functions and functionaries from the second tier to the third tier and strengthening the fiscal base of the third tier. Towards empowering of the third tier, a reformed NITI Aayog will also need to play an important role.

To provide the necessary fiscal base for the 3rd tier, I would strongly urge the necessary constitutional amendments to enable both states and the Centre to share an equal percentage of their GST, i.e. of SGST and CGST with the 3rd tier. This will provide a buoyant fiscal base to the 3rd tier and, more importantly, align the interests of elected officials with the citizens as GST is essentially a consumption-based tax. Towards this, I would propose the following rates: a single GST rate of 12% with CGST and SGST of 6% each, with both Centre and state sharing 1/6th of this with the 3rd tier. This would provide a fiscal base of not less than 1% of GDP to the 3rd tier in a predictable manner.


Strengthening the fiscal base of the 3rd tier by sharing the GST, i.e. giving greater autonomy for funds, will incentivize the state governments to hand over the control of relevant functions and functionaries to the 3rd tier and thus truly empower it. Hence, I have no doubt that the proposed constitutional arrangements for sharing the GST with the 3rd tier, along with strengthening of the state finance commissions, will provide a third pillar to India’s new fiscal federalism in addition to the two pillars, i.e. the Finance Commission and the NITI Aayog 2.0.

Let me now turn to the fourth pillar of India’s new fiscal federalism, viz. the constitutional amendment that adopted the GST. The GST is a ‘grand bargain’ with the Centre undertaking to implement a commonly agreed GST through a joint GST Council. The GST Council so created by a constitutional amendment is a landmark event in the history of India’s fiscal federalism. The Centre and the states being good ‘fiscal neighbours’ will now become equal fiscal partners in sharing a common indirect tax base.

Ruefully, the current GST arrangement is a rather weak pillar, and more reforms are necessary. A flawless GST requires comprehensive coverage, one single rate for both goods and services, and a single market with single documentation for the seamless inter-regional and regional trade. I would urge the GST Council and the government to move towards the ‘flawless’ GST model as early as possible. To achieve this, the government and the GST Council will have to undertake the important GST Reforms such as4 including real estate, electricity, liquor, tobacco and petroleum products in GST; putting exports at ‘zero rate’; reducing transaction costs and completely doing away with the system of e-way bills. All these measures will allow us to adopt a single rate of 12% of GST where 10% is equally shared as CGST and SGST and 2% to local bodies.

Finally, the Secretariat of the GST Council must be strengthened and measures for promoting capabilities and transparency in the working of the GST Council must be introduced. It is also necessary to have at least some open sessions of the GST Council, like our parliamentary sessions. Finally, we need to recalibrate the GST administrative structure so that a taxpayer is required to be audited only by a single tax authority, i.e. for a larger taxpayer by the central authority and for smaller taxpayer by the state authority.


I have emphasized the need to revisit the fiscal federal architecture in contemporary India. I have also suggested some innovative reforms towards creating a four-pillar based architecture for India’s new fiscal federalism. While the final resolution of these matters will be attained through a dialectic that will play out in the domain of real politik, it is important that such a process be helped along by evidence based analysis and debate. I hope this will contribute to a debate on the issues that are vital to our country.


* This is an edited excerpt of the 2019 Professor Sukhamoy Chakravarty Memorial Lecture by Dr. Vijay Kelkar delivered at the 55th Annual Conference of the Indian Econometric Society, Mumbai School of Economics and Public Policy and National Institute of Securities Markets, Mumbai. Our thanks to Dr. Kelkar for allowing us to publish it in this issue.


1. Arvind Panagariya, ‘India on the Growth Turnpike: No State Left Behind’, in Sameer Kochhar (ed.), India on the Growth Turnpike, Essays in Honour of Vijay L. Kelkar. Academic Foundation, Delhi, 2010.

2. Pinaki Chakraborty, ‘Federalism, Fiscal Asymmetries and Economic Convergence: Evidence from Indian States’, Asia-Pacific Regional Science Journal, 2018.

3. Report of the High Level Committee on Balanced Regional Development Issues in Maharashtra, Government of Maharashtra, Mumbai, October 2013.

4. V. Bhaskar and Vijay Kelkar, ‘Reforming the GST: Do We Need the eWay Bill?’, Pune International Centre Policy Brief, 2018.



N.R. Bhanumurthy, ‘What Explains Regional Imbalances in Public Infrastructure Expenditure? Evidence from Indian States’, Asia-Pacific Development Journal, December 2017.

V. Bhaskar and Vijay Kelkar, ‘Reforming Integrated GST (IGST): Towards Accelerating Exports’, Pune International Centre Policy Brief, 2018.