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Mains Answer Writing

6-March-2024

Q1) The Finance Commission serves as the balancing wheel of fiscal federalism, but despite its efforts to widen the share of states in the divisible pool of taxes, the struggle for financial resources between the center and states has only intensified. Analyse the factors contributing to this paradox and its implications for fiscal federalism in India.

(250 Words/15 Marks)

ANSWER

The Finance Commission (FC) is a constitutional body established under Article 280 of the Constitution of India. It has the responsibility of recommending the distribution of financial resources between the central government and state governments.

 FC serves as the balancing wheel of fiscal federalism in the following ways:

  1. Vertical Distribution: It determines the share of taxes and grants that the states receive from the divisible pool of taxes.

E.g., increase in share of states from 30.5% (12th FC) to 41% (15th FC).

  1. Horizontal Distribution: FC allocates distribution of taxes among the states based on the needs of each state and federal issues.

E.g., demographic performance criteria by the 15th FC for successful population control measures by some states.

  1. Local Government Resources: It recommends grants-in-aid to rural and urban local bodies for providing essential services and implementing developmental projects.

E.g., million-plus city challenge.

  1. Democratic decentralization: FC incentivizes financial devolution to local self-government through conditional grants based on implementation of State Finance Commissions’ recommendations.

 

Despite efforts of FC to widen the share of states in the divisible pool of taxes, the struggle for financial resources between the center and states has intensified due to the following reasons:

  1. Vertical Imbalance: The Centre has access to a wider range of revenue streams, including direct and indirect taxes. Reforms such as GST council restricts state autonomy in indirect taxes.
  2. Horizontal Imbalance: Some states have low resource mobilization capacity. Factors such as agricultural dependency and limited tax base make them heavily reliant on central transfers.
  3. Increasing Welfare Role: There has been a substantial increase in both state and central government expenditure due to welfare schemes and freebies. Centrally-sponsored schemes require 40% contribution from states.
  4. Increasing role of States:
  5. Competitive federalism has increased investments in infrastructure development with desire to attract investments and promote economic growth.

E.g., Rs. 23.73 lakh crore in infrastructure development by states between 2014 and 2019 as per the Ministry of Finance.

  1. Democratic decentralization (73rd and 74th amendment) and increased awareness among citizens has increased democratic accountability.
  2. Fiscal Responsibility and Budget Management (FRBM) Act restricts the borrowing capacity of both the central and state governments for cultivating fiscal discipline. It poses challenges in times of increased expenditure requirements such as during Covid-pandemic.

 

The implications of the paradox of increasing devolution and increasing struggle on fiscal federalism are as follows:

  1. Regional Inequities: Unequal distribution of resources can widen the regional imbalances.

E.g., reduced weightage to population factor by the 15th FC.

  1. Limits on growth: Lack of fiscal autonomy for well-performing states could harm the goals of rapid economic growth and industrialization due to resource constraints.
  2. Political Instabilities: Inability to resolve the demand for resources could lead towards political unrest due to unmet development aspirations, such as left-wing extremism or demand for Dravida Nadu.
  3. Unequal distribution of resources harms the socialist aims of the state under directive principles of state policy (DPSP).
  4. Short-term struggle for resources hinders long-term development goals such as utilization of India’s demographic potential.

 

Intensified struggle for financial resources between the Centre and States necessitates measures to strengthen fiscal federalism. Implementation of the Direct Tax Code, improving tax compliance, new sources for revenue mobilization and enhancing the tax-to-GDP ratio can play a significant role in alleviating the financial strains faced by both the center and states.

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