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.
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.
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