Federalism in a Post-Covid World

Business Standard     5th September 2020     Save    

Context: There is a need to modify the fiscal devolution principles in the light of economic shocks provided by the COVID crisis.

Issues with the current fiscal devolution:

  • Failure of Compensation Framework under the Good and Services Tax regime: The promise of 14% revenue growth has proved difficult for the Centre to afford because:
    • It creates a moral hazard for the states- allowing them to propose rate reductions without fear of revenue consequences.
    • Low revenue collection due to COVID by the Centre.
  • Neglect of Counter-Cyclical fiscal policy: which leads to inefficient macro-economic behaviour.
    • When the economy faces a negative shock, and economic activity goes down, the government should cushion its impact by spending more and taking fewer taxes from the private sector
    • However, States are forced to constrain their deficits under the fiscal responsibility laws.
  • Violation of responsibility by the Centre: in terms of optimal allocation:
    • The optimal borrower for counter-cyclical purposes is the Centre, because
      • It has greater financing options (it can even borrow abroad); can borrow at low rates
      • It has much greater taxing authority under the Constitution.

Modified Devolution Framework: would contain three critical features:

  • Counter-cyclical: to be provided only during crises;
  • Targeted: provided to fiscally responsible states that have brought their debt below certain levels, or reduced their debt by certain amounts.
  • Automatic: avoiding the delays and the political jockeying that would come into play if the transfers were to be discretionary.

Significance of the framework

  • Defining a crisis: The Finance Commission should define a crisis that would trigger such a transfer, For, E.g. decline in GDP growth of 3% points, would increase the regular devolution (41%) by 3 %.
  • Promoting counter-cyclical transfers: A large step toward counter-cyclical transfers was already taken under goods and services tax (GST) in the form of compensation.
      • This acts as de-facto insurance.
  • Incorporates the lessons learned from compensation debacle:
  • Promotion of desirable incentives: because it would be given to fiscally prudent states, it would promote fiscal responsibility and provide only during the crises.
  • Affordable costs: due to low-interest rates borne by the Centre as compared to the states.
  • Advantages of the Framework: 
      • Provides states with incentives to rebuild their shattered finances. 
  • Aid macro-management of the economy: through the following of the key principle of counter-cyclicality.
  • Helps restore trust between the Centre and states.

Conclusion: Automatic, counter-cyclical transfers can build trust — and, crucially, they can help prevent the trust from being corroded.