Federalism in a Post-Covid World

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.