Fiscal Federalism and Equalisation

In one line

Every federation collects revenue mostly at the centre and spends it mostly at the units, so every federation needs machinery to move money and to even out the differences between rich and poor units.

In the wording a student can write in an exam: fiscal federalism is the constitutional allocation of powers of taxation and of expenditure between the levels of a federation, together with the machinery for transferring revenue from one to the other; equalisation is the transfer of resources to units with weaker revenue capacity so that comparable services can be provided at comparable levels of taxation.

The vertical and horizontal problems

Vertical imbalance. The centre has the efficient taxes, income tax, customs and a broad-based consumption tax, and the units have the expensive functions, health, education, policing and roads. Every federation on this syllabus has this imbalance, and every one solves it by transfers.

Horizontal imbalance. Some units are richer than others. Left alone, a poor unit either taxes its people more heavily for worse services or provides worse services. Equalisation transfers address it.

India: articles 264 to 293

The distribution. Article 268 provides for duties levied by the Union and collected and appropriated by the States. Article 269 for taxes levied and collected by the Union but assigned to the States. Article 269A for the levy and apportionment of goods and services tax on inter-State supply. Article 270 for taxes levied and distributed between the Union and the States. Article 271 permits a surcharge for the purposes of the Union, which is not shared. Article 272 was omitted by the Eightieth Amendment.

The Finance Commission, articles 280 and 281. The President shall constitute a Finance Commission every fifth year or earlier, consisting of a Chairman and four other members, to make recommendations on the distribution of the net proceeds of taxes between the Union and the States and the allocation among the States, on the principles governing grants-in-aid out of the Consolidated Fund, on measures to augment the Consolidated Fund of a State to supplement the resources of panchayats and municipalities, and on any other matter referred to it. Article 281 requires every recommendation, with an explanatory memorandum on the action taken, to be laid before each House.

Grants and borrowing. Article 275 provides for statutory grants-in-aid. Article 282 permits the Union or a State to make any grant for any public purpose, notwithstanding that the purpose is not one on which it may legislate; that article is the constitutional basis of centrally sponsored schemes and is the most consequential fiscal provision in Part XII. Article 292 permits Union borrowing on the security of the Consolidated Fund of India within limits fixed by Parliament. Article 293 permits a State to borrow within India, and requires the consent of the Government of India while any part of a loan made by the Union to that State remains outstanding.