In search of a new federal bargain

Gov-Shastra: The growing disparity in economic and human development between the relatively prosperous southern and western parts of India and the poorer but more populous northern and eastern states is placing strains on long-accepted principles of redistributive tax-sharing.

India’s delicate federal consensus is back in contention. On September 12, the Government of Kerala organised a conclave of Finance Ministers from non-BJP-ruled states to debate Centre-state fiscal relations and recommendations to present to the 16th Finance Commission (FC).

Alongside, Karnataka Chief Minister Siddaramaiah wrote a letter to his counterparts in several states, including BJP-ruled Maharashtra, proposing to host a CM-level meet to collectively deliberate on the “unfair devolution of taxes” from the Union to states with higher GSDP per capita so as to arrive at a coordinated set of proposals to present to the 16th FC. These are important initiatives. They are the first concrete steps toward building a new political consensus on India’s fiscal federal bargain.

The context is well-known. The growing disparity in economic and human development between the relatively prosperous southern and western parts of India and the poorer but more populous northern and eastern states is placing strains on long-accepted principles of redistributive tax-sharing.

Inevitably, these are the states that contribute a greater part of the gross tax revenue of the Union government. Historically, India’s fiscal federal bargain held together on the principle of redistribution and equity that guided the tax-sharing formulae adopted by successive FCs. This ensured that the poorer states received a larger share of central taxes and grants to meet their development needs. The expectation was that their growth would eventually result in greater convergence amongst states.

This, of course, has not come to pass, and the richer southern states, whose economic momentum is growing (India’s big economic success stories in recent years -- from Foxconn to the global capability centres -- are all in the South), in particular, are now beginning to ask why, as Siddaramaiah put it, they are being “penalised”.

To put this in perspective, as Siddaramaiah pointed out to the 16th FC, “For every rupee that Karnataka contributes, only 15 paise is returned to it”. Effectively, the political consensus on redistribution being the basis for India’s fiscal federal bargain is now breaking, and with good reason.

The challenge raised by India’s widening economic disparities have been exacerbated by the Union government’s blatant attempts to deepen fiscal centralisation. Despite two successive FCs’ recommendations to deepen fiscal devolution by mandating that the states’share in the divisible pool of taxes be enhanced from 32% to 42%, the Union government has avoided fulfilling this recommendation. Actual transfers to states, as a percentage of gross tax revenue, have been in the range of 32-35% since the implementation of the 14th FC recommendations.

Meanwhile, calculations by Takshashila Institute’s Pranay Kotasthane and Sarthak Pradhan show that the Union’s use of cess and surcharges grew at a compounded annual growth rate of 16.7% between 2011-12 and 2024-25. Revenues collected from cess and surcharges are not part of the divisible pool of taxes that are shared with states. Thus, in effect, even as the Union’s gross tax revenue increased in this period, states’ share did not grow in equal measure.

Then there’s centralisation by stealth: From rejecting compensatory grants recommended by the 15th FC -- Karnataka’s big complaint is that the Union refused to accept the recommendation for a state-specific grant of Rs 11,495 crore -- to the grand betrayal of the Goods and Services Tax (GST), which has not only made it impossible to buy and sell buns (as a good businessman reminded us recently) but has also created a significant trust deficit, with the Centre routinely dragging its feet on the compensation cess to states, even using Covid-19 as an excuse to convert it into loans. The states willingly gave up fiscal autonomy to arrive at the grand bargain of GST, but its failure to deliver for them has raised the stakes for their fiscal autonomy.

In the political realm, the looming question of delimitation and its impact on political representation has added to the sense of urgency. As Karnataka’s Revenue Minister put it at the Kerala conclave, “Those of us who contribute enormously to the Union’s cause…deserve justice.” Karnataka has identified a set of recommendations that are a useful starting point for a sensible political debate on the issue. These include putting a cap on cess and surcharges, rebalancing the devolution formulae to balance equity and efficiency, grants to growth engines. The 16th FC will do well to pay attention.

But, arriving at a new bargain is a political issue, not a technical matter of just tweaking formulae. It requires a sustained commitment to principles of federalism within our institutional and political culture. The Union government’s contribution, particularly in the last decade, to deepening centralisation is well-known. Ideologically, the BJP is impatient with principles of accommodation that are at the heart of the federal bargain, seeking instead a singular national identity in one nation governed by ‘double-engine’ efficiency.

But states, too, have played their part, fighting not for the principle but for their own self-interest. Two state governments were recently stripped of their powers to function as autonomous elected governments -- Jammu and Kashmir, which was downgraded to a Union Territory; and Delhi, which has been brought under central control by hostile action and law-making against the elected government. This blatant undermining of states’ rights hardly provoked protest by parties that were not directly affected by these.

The penchant for undermining federal institutions extends to the states -- a rare few have lived up to their constitutional commitments to local governments that are starved of funds; most states prefer to centralise power in the Chief Minister’s Office.

Upholding federalism requires political maturity and a far greater commitment to the federal principle than is currently on display. An important start has been made this week, in the fiscal realm, but this will only succeed if it mobilises around the principles of federalism across our institutional and political culture.