FEDERAL-STATE FISCAL ARRANGEMENTS IN INDIA BY A. T. EAPEN 1 INTRODUCTION 1 In no Federal union existing today does the allocation of financial resources between the Federal Government and its constituent units correspond to the allocation of functional responsibilities between them. Such imbalance is aggravated by considerable interregional differences in the distribution of wealth and income within a federation. And yet for the effective functioning of a federation and for its continued existence, it is imperative that each level of government must be able to command the means essential to meet the calls made upon it. This requires a substantial transfer of resources made from one level of government-usually the Federal-to the other generally the States. The pattern of financial arrangements between the National and the State Governments which achieves this transfer in a federation is bound to be influenced by its peculiar economic, social, and political characteristics and historical accidents. Such pattern of financial arrangements between the National and the State Governments in India is the subject matter of this paper. Important aspects of Federal-State fiscal arrangements since the inauguration of India's Federal Constitution in 1950 will be considered here. Of course, the history of intergovernmental financial relations in India spans a much longer period. In fact, the year 1970 would mark the completion of a century of such relations. Needless to say, the financial and other provisions of the present constitution have been very much influenced by the various prior Acts of the British Parliament concerning the governance of India. In particular, the Government of India Act of 1935, and the financial arrangements made thereunder have leavened the present Indian constitutional provisions. Moreover, being a relatively new Federation, India, through the architects of its constitution, was able to profit from the experience of others. A study of Indian fiscal federalism should prove to be of 1 State University of New York at Binghamton. The author is indebted to Ana N. Eapen for many valuable comments and suggestions. Even a cursory study of the three Anglo-Saxon federations-the United States, Canada. and Australia-reveals this. Federal-State financial transfers in the United States have been largely devised for the principal purpose of encouraging the performance of specific activities at the State and local levels. În Canada, the history of Dominion-Provincial financial relations is fraught with political bargaining and at present Dominion financial transfers to provinces are subject to quinquennial review by the Dominion and the Provinces. The Commonwealth of Australia has developed some successful institutions like the Commonwealth Grants Commission and the Australian Loan Council to put Commonwealth-State financial relations on as objective a basis as possible, even though Commonwealth payments to States under the Uniform Income Tax Plan continue to be subject to political pressure. 3 For a brief historical account, see "Report of the Finance Commission, 1952" (New Delhi, 1953) (hereinafter cited as the First Report). considerable interest to other federations however much they may differ from India. This paper is divided into seven sections. The first section gives a summary view of the nature of the Indian federation. Following this, Section II deals with the constitutional allocation of legislative powers. The disequilibrium in the State and Federal budgets resulting from the division of financial powers and functional responsibilities is examined in the third section. The financial adjustments envisaged in the constitution to remedy the disequilibrium are considered in the fourth section. The fifth section presents a trend of the magnitudes of these adjustments in the Federal and State budgets during the period 1952-66. The sixth section is primarily an appraisal of Indian fiscal federalism. Finally, some alternative proposals for modifying the existing Federal-State financial adjustments are put forward in the seventh and last section. I. NATURE OF THE INDIAN FEDERATION Unlike other federations such as the United States, Canada, or Australia, the progress of India toward a federation was through very gradual steps beginning in 1871 and culminating in 1947. The Federation of Indian States is unique in many respects. It is the result of a process of centralization as well as decentralization. The highly centralized administration of British India of 1858 was gradually decentralized and finally Provinces with more or less automonous powers slowly began to evolve. The princely States in India were a class by themselves in their relation to the British Crown. Their political relations with the British Crown were defined by treaties which largely respected their autonomy in internal administration. In 1947, when the British left India, they became legally sovereign in all respects. Therefore, as far as princely States are concerned, the federation is the result of a process of integration. By and large, the Indian Federation is not the result of an agreement among its constituent units. The constituent units have no freedom to secede from the Federation. The Indian Union indeed represents a Federal structure with many unitary features.5 4 II. ALLOCATION OF LEGISLATIVE POWERS The distribution of legislative powers between the Federal and State Governments in the Indian Constitution adopted in 1950 has been largely influenced by similar arrangements in the Government of India Act, 1935. The constitution gives a rather exhaustive enumera The constitution adopted in 1950 classified the States into three groups: Part A States corresponded to the former provinces of British India, Part B States to the former princely States either single or merged, and Part C States to the former Chief Commissioner's Provinces. In 1956 after the reorganization of the boundaries of the States on a linguistic basis, the three separate classifications of States were abolished by the Constitution (Seventh Amendment) Act, 1956. 6 Under art. 353 (a) of the Constitution of India, when a proclamation of emergency is in operation, then "notwithstanding anything in this Constitution, the executive power of the Union shall extend to the giving of directives to any State as to the manner in which the executive power thereof is to be exercised". See "The Government of India Act, 1935," sec. 100, and the Seventh Schedule for the enumerated items in the Federal, Provincial, and concurrent legislative lists. There were 59 items in the Federal list, 54 in the provincial, and 36 in the concurrent. tion of legislative powers classified under three groups: (1) exclusively Federal subjects, enumerated in the Union List; (2) exclusively State subjects, enumerated in the State List; and (3) concurrent subjects, enumerated in the Concurrent List." The Union List includes defense, external affairs, currency, coinage and legal tender, customs, Union excises and taxes, etc. The State List includes, among others, maintenance of law and order, local government, public works, public health, education, agriculture, roads and State taxes. The Concurrent List covers criminal law and procedure, marriage and divorce, economic and social planning, social insurance, etc. In the event of any conflict between Federal and State legislation over matters in the Concurrent List, the former shall prevail over the latter. The constitution vests residual powers in the Union.9 TAX POWERS The allocation of fiscal powers in the Indian Constitution is quite complex. This complexity arises primarily because of an elaborate scheme of demarcation of tax powers between the Federal and State Governments. This demarcation is designed to mitigate a variety of tax problems endemic to Federal systems such as double taxation between the Federal and State Governments, tax rivalry among States, overlapping taxation by States, duplicate tax administrations, excessive compliance costs, and tax evasion. To be sure, the Indian Constitution has succeeded in reducing such problems to a minimum; but this has left the States with inadequate tax resources of their own to carry out the responsibilities placed on their shoulders. In order to correct this situation, but thereby adding to the complexity of financial provisions, the constitution explicitly provides for both mandatory and optional sharing of receipts of certain taxes levied by the Federal Government. These provisions, being essentially methods of financial adjustment, are discussed later. With a view toward safeguarding the interests of the States in Federal taxes that are shared with them, Article 274 of the constitution provides in effect that no proposal, which in any way affects existing or prospective financial interest of a State, shall be presented to Parliament except on the recommendation of the President. The Indian Constitution is fairly explicit on the division of tax powers between the Union and the States. The Federal Government has the exclusive power to levy the following: customs, taxes on corporations and non-agricultural income, estate taxes on property other than agricultural land, and all excises except those on alcohol and See the "Constitution of India," Sevenuth Schedule (hereinafter cited as C. I.). Ibid., art. 248. The three lists are, however, so exhaustive as to leave very little in the residual category. The constitutions of the United States, Canada, and Australia do not have any elaborate scheme of division of legislative powers. The residual powers in the United States and Australia rest with the States whereas in Canada they rest with the Dominion. narcotic drugs. The States have the exclusive power to levy taxes on agricultural income and estate taxes on agricultural land.1 10 Just as in the Government of India Act of 1935, the Indian constitution of 1950 permits the States to levy sales taxes. However, a State is prohibited from levying such taxes on transactions which occur outside its boundaries or which arise in the course of interstate or international trade. In spite of this prohibition, it still required a constitutional amendment in 1956 to clear the conflicts that arose concerning the taxation of interstate and international commerce.11 Furthermore, the 1956 amendment gives the Indian Parliament power to restrict State tax laws on goods declared to be of "special importance." 12 in interstate trade. Following the constitutional amendment, Parliament enacted the Central Sales Tax Act in 1957, which levied a Federal interstate sales tax and which defined the restrictions on State sales tax laws concerning goods declared to be of "special importance" in interstate trade. The proceeds of the Federal interstate sales tax are collected by the States. In the same year, in order to eliminate tax evasion and minimize tax compliance problems, the Federal and State Governments agreed to replace State sales taxes on three widely used commodities-namely factory-made textiles, sugar, and tobacco-by additional Union excises on these items. This is in the nature of a tax rental agreement, with the net proceeds from the additional Union excises being allocated among the States. BORROWING POWERS OF THE STATES The borrowing powers of the States in the Indian Union are very much restricted by the constitution and in this regard the Indian States differ considerably from the States in the United States or the Provinces in Canada which enjoy independent powers to raise loans. The Indian States, although denied the right to borrow outside India,13 may borrow within Indian territory. However, if a State is already indebted to the Union, it may not raise any additional loans without the prior consent of the Federal Government.1 With the advent of 10 Until the adoption of the Government of India Act, 1935, agricultural incomes were exempt from any income tax. This Act permitted a provincial levy on agricultural incomes. Owing to significant disparties in land taxes between the Provinces and presumably for administrative reasons, it was considered desirable that the provinces administer agricul tural income tax. To eliminate one of the glaring inequities in the Indian tax system, the Taxation Inquiry Commission of 1953-54 recommended standardization of land revenue and the eventual merging of agricultural and nonagricultural income for income tax purposes. See Government of India, Ministry of Finance, Department of Economic Affairs, Report of the Taxation Enquiry Commission, 1953-54, vol. III (New Delhi, 1955) pp. 220-236. 11 See R. N. Bhargava, "Indian Public Finances" (London, 1962), pp. 126–138. 12 These goods as defined by the Central Sales Tax Act of 1957 include coal, cotton, cotton fabrics and yarn, hides and skins, iron and steel, jute, oilseeds, rayon or articial silk fabrics, sugar, tobacco, and woolen fabrics. See Bhargava, Ibid., p. 137. 13 C. I., art 293 (1). 14 Ibid., art. 293(3). 80-491-67-vol. 1 -30 the 5-Year Plans, all the States have borrowed heavily from the Federal Government in order to finance various developmental projects. Consequently, the borrowing powers of the Indian States are pretty much under Federal control. FEDERAL-STATE TAX IMMUNITIES Tax immunities are a source of friction in Federal-State relations as demonstrated by the United States experience. In the case of India, the constitution provides for three immunities. It exempts Federal property from State and local taxation; however, the Indian Parliamen may waive this exemption.15 Similarly, the property and income of the States are exempted from Federal taxation; however, again Parliament may waive such exemption in the case of State business undertakings.16 The constitution also exempts the Federal Government from State taxation on the sale or consumption of electricity." The States are prohibited from levying taxes on water or electricity supplied by interstate river authorities established by the Federal Government; there is a saving clause under which the States may do so with the consent of the President of the Indian Union.18 III. EFFECTS OF ALLOCATION OF FISCAL POWERS ON FEDERAL AND STATE BUDGETS The imbalance between the constitutional allocation of fiscal powers, on the one hand, and functional responsibilities, on the other, has inevitably left the States vis-a-vis the Federal Government with inadequate resources to meet their needs. A rough measure of the imbalance between resources and needs both at the Federal and State levels, before Federal-State financial adjustments, is indicated by a cursory study of their estimated tax collections and expenditures in the fiscal year 1965–66. The total tax and nontax revenues of the Federal Government in 1965-66 were estimated at Rs24.5 billion (see table 1). Characteristic of underdeveloped economies, excises and customs accounted for about 65 percent of Federal tax revenues. Income and corporation taxes accounted for practically the rest of Federal tax revenues. Considering only the revenue account (i.e. excluding the capital account), before any Federal-State financial adjustments, the Federal budget had an estimated surplus of Rs5 billion. 15 Ibid., art. 285. 16 Ibid., art. 289. 17 Ibid., art. 287. 18 Ibid., art. 288. |