The Road To Co-operative Federalism

In its one year in tenure, the Modi government has charted a new course for Union-State relationship. However, that is only the beginning. The part where it is all implemented comes now. 

The process of progressing towards co-operative federalism envisaged by Prime Minister Narendra Modi is gathering pace due to several recent commendable policy initiatives. To realize full potential of this process requires much greater competence and professionalism in Public Financial Management (PFM) by the individual states and by the urban and local bodies (ULBs).

The individual states will need to manage a rather complex set of three PFM objectives, involving difficult trade-offs, sequencing decisions, and staffing and organizational restructuring initiatives.

The first is to improve the quality and sustainability of fiscal deficits, contingent liabilities, and overall fiscal risks. The second is to increase public investment level ( budgetary capital expenditure in many states is only between 1 and 2 percent of GSDP, with some states, such as Gujarat, exhibiting a ratio between 3 and 4 percent) while enhancing private investment. The third is to focus on outcomes of government expenditure rather than merely on financial outlays.

This requires spending less for government purchases of goods, services, and assets (requires more effective procurement processes); spending well by improving relationship between outputs on the one hand (such as time in which a given quality school or a road is built) and government expenditure on the other; and spending wisely by focusing on improving citizens’ welfare and laying foundations for future economic growth.

The individual states, particularly those with large populations, will also need to find context specific ways to devolve fiscal resources to lower levels of government, including to the ULBs. Revitalizing the institution of the State Finance Commission (SFC) should be an integral part of such development especially for the states with large populations.

Four commendable set of interrelated policy initiatives by the Union government have fundamentally altered the dynamics of Union–State fiscal relations:

Acceptance of the recommendations of the 14th Finance Commission (FC):

The 14th FC was set up by the previous government, but the Prime Minister Narendra Modi led government has refreshingly continued to accept ideas and recommendations which are consistent with improving governance and with creating a problem-solving, positive environment in the country.

Among the several important recommendations of the 14th FC accepted by the government, the most relevant is the statutory increase in the share of divisible tax-pool from 32 percent to 42 percent. As the Union government has also raised the non-statutory share from 21 percent to 26 percent, about 68 percent of the divisible pool is to be transferred to the states.

These imply that about half of the total receipts (including non-tax) of the Union government will be transferred to the states. The larger transfers to the states are accompanied by the significant reduction in the so-called central schemes of the Union government, and rationalization of remaining schemes to give greater flexibility and control to the individual states.

The above also suggests that the Union government is moving away from a scheme-and-grant based support to a devolution based support. The intention of the 14th FC appears to be to de-link planning, and plan and non-plan expenditure classification from the budgeting exercise; and foster cultivation of development outcomes orientation in the budgeting process rather than adhering mechanically to pre-defined plans. Indeed, the state of Jammu and Kashmir has already abolished the plan-non-plan expenditure classification from the 2015-16 budget.

The acceptance of the 14th FC’s recommendations lends greater urgency to enhance the professionalism with which PFM is undertaken by the Union government (as its share of gross revenue declines), individual states, and by the ULBs. How to progress in this direction deserves to be carefully considered in a context specific manner, particularly as there is limited expertise in the country in this area, and requires a mind-set change on the part of the all stakeholders, particularly political leadership and the civil service.

NITI:

The second policy initiative is the establishment the National Institution for Transforming India (NITI) Aayog (‘Aayog’ should be dropped as it is redundant) on January 1, 2015 as a replacement for the unlamented former Planning Commission. This has the potential to better facilitate Union-State policy coordination and coherence. Inclusion of the Chief Ministers of the states, and their regular interactions with the Union government would help in policy and scheme formulation and design.

Using NITI Aayog as a key institution to reorient PFM in the country merits serious consideration. States could consider consultations with it on specific PFM issues, such as procurement process, improving tax administration and compliance, and delivery of key public amenities and services. NITI Aayog could play a role in the process of finding an appropriate balance between co-operative federalism and constructive competition among the states. It could also help India better utilize limited expertise base on PFM in India, and on re-orienting Union-State financial relations.

GST:

The third policy initiative is the urgency demonstrated by the current government in implementing GST (Goods and Services Tax). It has far reaching implications as it will enable both the Union and the states to levy a sales tax on goods and on services, thus ending artificial restriction imposed by the Constitution. It will thus help unify the whole country as a market, and lead to uniformity in taxes on goods and services.

The GST will be a dual tax (levied by the Union government and individual States) in a federal structure. It is thus among the most ambitions tax reforms attempted in India, requiring much greater professionalism in sales tax administration. The aim should not be to get the ‘best’ GST but a reasonable workable GST, which can be improved overtime.

Resources from non-conventional sources:

The fourth initiative is that in sharp contrast to the previous governments, Prime Minister Narendra Modi’s government has demonstrated high degree of competence in generating resources from non-conventional sources, such as use of auctions, and increasing state assets more productivity. Thus, the auctioning of coal blocks from 32 mines is expected to generate Rs 2 lakh crore.  Most of which will be turned over to the concerned states, substantially improving their fiscal base. The government revenue generated was Rs 1.1 lakh crore. Thus, a total of Rs 3.1 lakh crore has been generated, equivalent to 2.5 percent of GDP. States also need to begin acquiring proficiency in such revenue generation if they are to cope with the added responsibilities.  As a part of this process, establishing Fiscal Risk Management Group (FRMG) in each state and large cities merits serious consideration.

The case for urgently initiating the process of enhancing competency in PFM at all levels of government is compelling, and therefore those putting impediments to this process would be conspiring against the public interest.