Fiscal federalism refers to the financial relationships between different levels of government, such as the central and state governments. In India, fiscal federalism plays a crucial role in determining how resources are allocated and managed across the country. As India continues to grow and develop, the future of fiscal federalism will likely focus on improving efficiency, equity, and accountability in the distribution of funds. This means ensuring that both central and state governments have the financial resources they need to address local needs while promoting overall economic stability and growth. Innovations in technology and data analysis, along with policy reforms, are expected to enhance transparency and responsiveness in the financial system, ultimately benefiting all citizens.
Tags: GS – 3, Economy– Fiscal Policy— Monetary Policy– Inclusive Growth
Why in the news?
- Kerala recently filed a suit in the Supreme Court under Article 131 of the Constitution, urging the court to direct the Union government to lift the ceiling on state borrowing limits.
- This case has spotlighted Article 293 of the Indian Constitution, which governs state borrowing powers and Union regulation thereof.
- Kerala seeks greater autonomy in borrowing, while the Union government stresses macroeconomic stability through debt regulation.
Constitutional Interpretation by Supreme Court:
- Given the first-time interpretation of Article 293, the matter has been referred to the Constitution bench under Article 145, comprising five judges.
- The upcoming decision by the Supreme Court holds significant implications for fiscal federalism in India.
Provisions of Article 293: Provisions:
- State Borrowing Power: States can borrow within India against their Consolidated Fund of State, under limits set by their legislature.
- Union Guarantees: The Union government may guarantee state loans within limits set by Parliament.
- Consent Requirement: States must seek Union government consent for loans if they owe any previous loans to or guaranteed by the Union. Conditions can be imposed on this consent.
- Exception: Temporary overdrafts or arrangements with the Reserve Bank of India do not require prior consent.
- Continuation of Existing Loans: Loans taken by states before the Constitution’s commencement remain valid under the same terms.
Limitations of Article 293:
- Article 293’s authority is contingent upon states owing money to the Union, creating a gap if states clear their Union debts. The article lacks provisions for regulating state borrowing in the absence of such debts.
- Economically stronger states could potentially clear Union debts and then borrow without Union oversight.
- States increasingly use Public Sector Undertakings (PSUs) to circumvent Article 293, as seen in Kerala’s argument that PSU debts should not count towards state debt calculations.
- Growing reliance on non-central sources for borrowing may render Article 293 irrelevant for some states, complicating fiscal transparency and accountability.
Key Questions for the Constitution Bench:
- Does Article 293 confer a state with an inherent right to borrow, and can the Union government regulate this right?
- Are debts raised by state PSUs within the scope of Article 293’s regulation?
Recent Trends in State Borrowing from the Union:
- Recent data from the RBI indicates a significant decline in states’ reliance on Union loans, plummeting from 57% in 1991 to merely 3% by FY 2020.
- This shift underscores states’ increasing preference for market borrowings and alternative financing sources.
- The diminishing Union loans impact the relevance of Article 293, as its regulatory scope hinges on states owing money to the Union.
- During the Covid-19 pandemic, state borrowing from the Union temporarily rose from 3% in FY 2020 to 8.6% in FY 2024 due to economic pressures and revenue shortfalls.
- However, this uptick is expected to be transient, with states likely reverting to pre-pandemic borrowing patterns as the economy rebounds.
Arguments For and Against State’s Right to Borrow Uninterruptedly: Arguments in Favor:
- Fiscal Autonomy: State borrowing empowers fiscal independence, aligning with federal principles. It allows states to finance development projects and address local needs without sole reliance on Union grants, promoting self-reliance.
- Economic Development: Borrowing enables financing of large-scale infrastructure projects, stimulating economic growth and providing continuity in essential services during revenue shortfalls.
- Flexibility in Financial Management: It buffers states against economic shocks and revenue fluctuations, enhancing financial resilience without resorting to politically challenging tax hikes.
- Accountability to Electorate: Borrowing makes state governments accountable to voters for financial decisions, promoting transparency and informed electoral choices.
- Competitive Federalism: Allows states to compete for investments and innovate in development strategies, potentially leading to national best practices and overall development.
Arguments against:
- Risk of Fiscal Indiscipline:
- Unrestricted borrowing may lead states to accumulate unsustainable debt levels, jeopardising their long-term fiscal health.
- Political considerations, like short-term electoral gains, might override economic prudence, leading to misallocation of resources.
- Excessive state debts, such as Punjab’s debt-to-GSDP ratio of 53.3% in 2021-22 due partly to borrowing for populist schemes, could destabilise the national economy and impact other states.
- Macroeconomic Stability Concerns:
- Uncoordinated state borrowing can interfere with national monetary and fiscal policies, complicating economic management at the Union level.
- It may negatively affect the country’s credit rating and borrowing costs in international markets, impacting the entire nation’s financial standing.
- For instance, the increase in states’ gross market borrowings by 55% in 2020-21 led to higher yields on state development loans, potentially affecting overall interest rates and Union government borrowing costs.
- Inter-State Disparities:
- Variations in states’ economic strengths can lead to significant differences in their borrowing capacities, exacerbating regional inequalities.
- Economically stronger states may secure loans at more favourable terms, while poorer states face higher borrowing costs, straining their finances.
- This dynamic may require increased Union intervention to balance regional development, potentially complicating federal relations.
- Complexity in Debt Management:
- Independent state borrowings complicate national public debt management.
- Monitoring and regulating diverse state borrowings pose administrative challenges and require sophisticated oversight mechanisms.
- There’s a risk of overlapping or conflicting debt obligations between states and the Union, creating legal and financial complexities.
- For instance, the Ujwal DISCOM Assurance Yojana (UDAY) introduced in 2015 added complexity by transferring power distribution companies’ debts to states, blurring lines between state and PSU borrowings.
- Potential for Default and Bailouts:
- States in financial distress might default on loans, impacting creditors and the broader financial system.
- There’s an implicit expectation that the Union government would bail out states in such cases, creating a moral hazard that encourages irresponsible borrowing.
- State defaults or bailouts could undermine investor confidence in the Indian market, affecting overall economic stability.
| What are the Other Federal Systems of Managing Subnational Debts? Brazil: The Fiscal Responsibility Law imposes strict borrowing limits on all levels of government, ensuring fiscal discipline. United States: States have high autonomy in borrowing but are subject to market discipline, balancing independence with financial accountability. Germany: A cooperative federalism model with shared fiscal responsibility between federal and state governments ensures coordinated and balanced financial management. |
Measures Can be Adopted to Improve Fiscal Health of States:
- Incentive-Based Fiscal Responsibility Framework:
- Implement a tiered system of borrowing limits based on comprehensive fiscal performance metrics.
- Beyond traditional indicators like debt-to-GSDP ratio, include metrics such as revenue generation efficiency, development outcomes, and fiscal transparency.
- For example, states improving their own tax revenue by 10% annually could be allowed to borrow an additional 0.5% of GSDP.
- This approach creates a positive incentive for states to enhance fiscal management continually.
- Technology-Driven Fiscal Monitoring System:
- Develop a real-time, AI-powered fiscal monitoring system for all states to revolutionise fiscal management.
- Track revenue, expenditure, and borrowing patterns to provide early warnings of fiscal stress.
- Implement blockchain technology for transparency and immutability of fiscal data to prevent manipulation and build trust.
- Fiscal Insurance Pools:
- Establish collective insurance funds where states contribute based on their fiscal health.
- These funds would provide temporary relief during economic shocks, reducing reliance on excessive borrowing.
- Incentivize fiscal prudence by linking contributions and payouts to long-term fiscal performance metrics.
- Cross-State Fiscal Mentorship Programs:
- Pair fiscally stronger states with weaker ones in mentorship programs.
- Mentor states would provide expertise and guidance on effective fiscal management.
- Consider granting additional borrowing rights to mentor states as a reward for successful mentorship.
- Foster inter-state cooperation and spread best practices in fiscal management organically through peer-to-peer learning.
- Independent Fiscal Councils:
- Establish independent fiscal councils at the state level to ensure unbiased analysis of state budgets.
- These non-partisan bodies would assess fiscal health objectively and recommend sustainable debt management practices.
- Provide transparency and accountability in fiscal decision-making to promote responsible fiscal behaviour among states.
| UPSC Civil Services Examination, Previous Year Questions (PYQs) Prelims: Q:1 Consider the following statements: (2018) 1. The Fiscal Responsibility and Budget Management (FRBM) Review Committee Report has recommended a debt to GDP ratio of 60% for the general (combined) government by 2023, comprising 40% for the Central Government and 20% for the State Governments. 2. The Central Government has domestic liabilities of 21% of GDP as compared to that of 49% of GDP of the State Governments. 3. As per the Constitution of India, it is mandatory for a State to take the Central Government’s consent for raising any loan if the former owes any outstanding liabilities to the latter. Which of the statements given above is/are correct? (a) 1 only (b) 2 and 3 only (c) 1 and 3 only (d) 1, 2 and 3 Ans: C Mains: Q:1 Public expenditure management is a challenge to the Government of India in the context of budget-making during the post-liberalization period. Clarify it. (2019) |
Source: EP
FAQs
Q: What is fiscal federalism?
Fiscal federalism is about how money is shared between different levels of government in a country. In India, it involves how the central government and state governments manage and distribute financial resources to provide services and infrastructure to the public.
Q: Why is fiscal federalism important for India’s future?
Fiscal federalism is crucial because it ensures that money is used efficiently and fairly across the country. It helps make sure that all states, whether rich or poor, have enough funds to meet their citizens’ needs, promoting balanced growth and development nationwide.
Q: How will technology impact the future of fiscal federalism in India?
Technology will play a big role in making the distribution of funds more transparent and efficient. With better data and digital tools, both central and state governments can track and manage finances more effectively, reducing corruption and ensuring that money reaches the people who need it most.
Q: What are the main challenges facing fiscal federalism in India?
One of the main challenges is ensuring fair distribution of resources between richer and poorer states. Another challenge is maintaining a balance of power, so both central and state governments have enough financial autonomy to address their unique needs while working together on national priorities.
Q: What changes can we expect in fiscal federalism in India in the coming years?
We can expect reforms that aim to improve the efficiency and fairness of resource distribution. This might include new policies to ensure more equitable sharing of tax revenues, increased financial support for underdeveloped regions, and enhanced cooperation between central and state governments to tackle economic and social issues collaboratively.
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