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The Hindu Editorial Analysis | PDF Download

Date: 25 March 2019

Another look at fiscal transfers

  • The time has come to amend the Constitution to fix the proportion of shareable taxes for the States
  • Federalism is an old concept. Its origin is mainly political. It is well known that the efficiency of a government depends on, among other factors, its structure. In large countries, it has been felt that only a federal structure can efficiently meet the requirements of people from different regions. Underlying this proposition is the premise that preferences vary across regions.
  • In our country during the independence struggle, provincial autonomy was regarded as an integral part of the freedom movement. However, after Independence, several compulsions, which included defence and internal security, led to a scheme of federalism in which the Centre assumed greater importance.
  • Also in the immediate period following Independence, when the Centre and all States were ruled by the same party and when many of the powerful provincial leaders migrated to the Centre, the process of centralization gathered further momentum. Economic planning at a nation-wide level helped this centralizing process.

Fiscal Federalism

  • Fiscal federalism is the economic counterpart to political federalism. Fiscal federalism is concerned with the assignment on the one hand of functions to different levels of government, and with appropriate fiscal instruments for carrying out these functions on the other. It is generally believed that the Central government must provide national public goods that render services to the entire population.
  • A typical example cited is defence. Sub-national governments are expected to provide goods and services whose consumption is limited to their own jurisdictions. An equally important question in fiscal federalism is the determination of the specific fiscal instruments that would enable the different levels of government to carry out their functions.
  • This is the ‘tax-assignment problem’ which is much discussed in the literature on the subject. In determining the taxes that are best suited for use at different levels of government, one basic consideration is in relation to the mobility of economic agents, goods and resources. It is generally argued that the de-centralized levels of government should avoid non-benefit taxes and taxes on mobile units.
  • This implies that the Central government should have the responsibility to levy non-benefit taxes and taxes on mobile units or resources. Building these principles into an actual scheme of assignment of taxes to different levels of government in a Constitution is indeed very difficult. Different Constitutions interpret differently what is mobile and what is purely a benefit tax.
  • For example, in the United States and Canada, both Federal and State governments have concurrent powers to levy income tax. On the contrary, in India, income tax is levied only by the Central government though shared with the States. Recognising the possibility of imbalance between resources and responsibilities, many countries have a system of inter-governmental transfers.
  • The Indian Constitution lays down the functions as well as taxing powers of the Centre and States. It is against this background that the issues relating to the correction of vertical and horizontal imbalances have been addressed by every Finance Commission, taking into account the prevailing set of circumstances. However, Central transfers to States are not confined to the recommendations of the Finance Commissions. There are other channels such as those through the Planning Commission until recently as well the discretionary grants of the Central government.
  • In 2010-11, in the combined revenue receipts of the Centre and States, the share of the Centre was 64.68%. After transfer, the share came down to 40.20%. In the case of the States, their share before transfers was 35.32%. After the receipts of transfers the share of States went up to 59.80%. Thus the shares got reversed.
  • In 2016-17, the share of the Centre after transfers was 33.37% and that of the States was 66.63%.
  • In the case of total expenditures, the share of the Centre in 2014-15 was 41.14% and that of the States was 58.86%. The ultimate position appears reasonable. The question may be on the mode of transfers.

NEW DEVELOPMENTS

  • The Fourteenth Finance Commission has broken new ground in terms of allocation of resources. One of its major recommendations has been to increase the share of tax devolution to 42% of the divisible pool. This is a substantial increase by almost 10 percentage points. The commission has argued that this does not necessarily affect the overall transfers but only enhances the share of unconditional transfers.
  • It is true that Centrally sponsored schemes, which have ballooned in recent years, may have ‘encroached’ on the territory of States. Over years, the performance of the Central government is judged not only on the basis of actions taken which fall strictly in its jurisdiction but also on initiatives undertaken in the areas which fall in the Concurrent and even State lists.
  • Centralised planning has something to do with it. Today, the Central government is held responsible for everything that happens, including, for example, agrarian distress. In viewing the responsibilities of the Centre and States we must take a broader view than what is stipulated in the Constitution.
  • On the allocation of unconditional transfers, two questions arise. The first is to determine the total transfers that need to be made, while the second is whether all transfers must be done by the Finance Commission alone. Finance Commissions prior to the Fourteenth recognised that some transfers were being made by the Planning Commission; this was kept in mind while deciding on tax devolution. By the time the Fourteenth Finance Commission was required to submit its report, a fundamental change in the institutional framework had occurred.
  • The Planning Commission was replaced by the NITI Aayog, which was simply a think-tank with no powers of resource allocation. In this context perhaps what the Fourteenth Finance Commission did was justifiable.
  • Of course, the Fourteenth Finance Commission did what it did because the terms of reference had not made any distinction between Plan and non-Plan revenue expenditures. The moot question is about what happens if any future government revives the Planning Commission with financial powers. This will put the Central government in a fix.

SOME SUGGESTIONS

  1. Perhaps the time has come for the Constitution to be amended and the proportion of shareable taxes that should go to the States fixed at the desired level. The shareable tax pool must also include cesses and surcharges as these have sharply increased in recent years. Fixing the ratio at 42% of shareable taxes, including cesses and surcharges, seems appropriate.
  2. Another possible route is to follow the practice in the U.S. and Canada: of allowing the States to levy tax on personal income, with some limitations. Since one of the concerns is that resources do not match functions, this may be a way out. But, as in the U.S., the scheme should be simple and ride on federal income tax, that is, just a levy on the income assessed by federal authorities. The freedom given to the States must be limited. It is important to note that the levy by the Centre and States together should be reasonable . Also once this power is given to the States, the transfers from the Centre need adjustment. As far as India is concerned, this is an area which needs a fuller study. Adoption of any one of these alternatives will avoid friction between the Centre and the States. Perhaps the first alternative of constitutionally fixing the ratio is the easiest.
  3. There are issues relating to horizontal distribution. Equity considerations have dominated the allocations. This is as it should be. However, the ability of bringing about equalization across States in India has limitations. Even the relatively richer States have their own problems and they feel ‘cheated’ because of the overuse of the equity criterion. An appropriate balancing of criteria is needed particularly in the context of the rise in unconditional transfers. Of course, appropriate balancing is what all Finance Commissions are concerned about.

Parallel Tracks On Trade Ties

  • Economic diplomacy can still prevent the removal of the U.S.’s trade benefits to Indian exports
  • Could it be that the strained trade relations between India and the U.S. are an outcome not of the U.S.’s domestic politics but of India’s? The timeline of U.S. President Donald Trump’s decision to rescind the benefits Indian exports enjoy under the Generalised System of Preferences (GSP) programme is revealing. E-commerce Rules
  • It begins with the change in foreign direct investment (FDI) rules in India. The tightened norms that came into effect on February 1 place several restrictions on e-commerce companies, including Walmart-owned Flipkart and Amazon.
  • The unexpected changes came after Walmart, the world’s largest retailer, paid over $16 billion to acquire Flipkart last May. To raise the resources needed, Walmart put one of its biggest international operations, Asda, on the block for $10 billion.
  • The calculations behind the $500 billion retail giant’s investment in India have gone awry after the change in the FDI rules. The Walmart family are close friends of Mr. Trump. On February 20, Walmart CEO Doug McMillon said the company was disappointed that New Delhi had changed the FDI rules without consultation and hoped for a more collaborative process going forward. Days later, on March 4, Mr. Trump notified Congress of his intention to slap punitive action on India by ending preferential treatment for the country’s exports.
  • Walmart has a reputation for killing small retail businesses with ultra-low prices, a concern that influenced New Delhi’s decision to tighten the FDI rules. While the FDI policy might be irreversible, economic diplomacy can still defuse the situation and prevent the removal of the GSP benefits that will not take effect for until at least 60 days after the notifications to Congress and the Indian government.
  • The simmering tensions go back to April 2018 when the United States Trade Representative (USTR) launched a review of New Delhi’s eligibility for the GSP programme.
  • Tensions escalated in June, as New Delhi, in response to Washington’s 25% tariff hikes on steel and 10% levies on aluminium, immediately accused it of unfair trade practices, and, seeking to signal a muscular approach, threatened retaliatory tariffs on $235 million of U.S. imports.
  • Bilateral talks since then have failed to ease tensions and India now stares at losing the GSP benefits. Foreign Secretary V.K. Gokhale returned empty-handed from Washington recently.
  • India’s GSP status came under review after the U.S. medical and dairy industries complained that New Delhi is not providing them “equitable and reasonable access to its market”. India’s data localization policies deepened the rift.
  • New Delhi’s use of price control measures against imported drugs and medical devices has grown noticeably. Cardiac stents were put under price controls in February 2016 and knee implants attracted similar action in August 2017, after which trade margins for many medical devices are sought to be capped.
  • U.S. manufacturers complain that in doing so, New Delhi has meted out differential treatment to them vis-à-vis domestic players.
  • For domestic companies, the price to distributors is considered while in the case of global manufacturers the base proposed is the landed costs of imports. The U.S. medical device industry wants price controls on cardiac stents and knee implants withdrawn and would like products to be treated on parity with domestic medical devices through a trade margin rationalization regime.
  • New Delhi has preferred to act against unreasonable price mark-ups through price controls when exactly the same outcomes can be achieved through other types of policy alternatives. The USTR is right in pointing out that price capping counts as a trade barrier. New Delhi can easily address the concerns by replacing price controls with trade margin rationalisation measures, applying them equally to domestic and foreign manufacturers.
  • India is the largest beneficiary of the GSP, the largest and oldest U.S. trade preference programme. The GSP is aimed at promoting economic development by allowing duty-free entry of products from designated beneficiary countries. Nearly 4,800 different goods from 129 designated countries enjoy duty-free access under the programme.
  • The immediate loss for India is preferential access at zero or minimal tariffs to the U.S. in case of about 1,900 products, or about half of all Indian products.
  • New Delhi has downplayed the impact of the proposed withdrawal of benefits, saying exports worth $190 million only are likely to be affected and that the tariff advantage was 4% or more on only 2,165 of a total of 18,770 tariff lines.

 ESTIMATING LOSSES

  • This is an underestimation. The loss to the economy would be much larger than what the Department of Commerce is projecting. While it is true that the actual tariff advantage from the programme works out to a meagre $190 million, which is just 0.4% of the total Indian exports to the U.S., the actual loss will not be limited to the immediate tariff advantage.
  • Indian exporters are competing for market share in the U.S. with other lowincome countries in industries where margins are wafer thin. Even minor price hikes can drive significant drops in export volumes. In which case, losing GSP access will be costlier than the projections.
  • Among price-sensitive products eligible for higher GSP benefits that risk losing out to competition from other countries are processed food, leather products, plastic products, building materials, tiles, hand tools, engineering goods, cycles and made-ups such as pillow/cushion sleeves and woven women’s apparel.
  • Many of these are the very industries the new e-commerce FDI rules seek to protect.